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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

For the quarterly period ended September 30, 2004

OR

Commission File Number: 0-30925

BLUE MARTINI SOFTWARE, INC.

(Exact name of Registrant as specified in its charter)

2600 Campus Drive

San Mateo, California 94403

(Address of principal executive offices)

Telephone Number (650) 356-4000

(Registrant’s telephone number, including area code)

Indicate by check mark whether the Registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the Registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days:    Yes  x     No  ¨

Indicate by check mark whether the Registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).    Yes  ¨     No  x

As of November 1, 2004, there were approximately 12,465,000 shares of the Registrant’s common stock outstanding.

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BLUE MARTINI SOFTWARE, INC.

INDEX

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PART I.    FINANCIAL INFORMATION

BLUE MARTINI SOFTWARE, INC.

Condensed Consolidated Balance Sheets

(In thousands, except per share data)

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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BLUE MARTINI SOFTWARE, INC.

Condensed Consolidated Statements of Operations

(In thousands, except per share data)

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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BLUE MARTINI SOFTWARE, INC.

Condensed Consolidated Statements of Cash Flows

(In thousands)

(Unaudited)

See accompanying notes to condensed consolidated financial statements.

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BLUE MARTINI SOFTWARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Note 1.    Basis of Presentation

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim financial information and with the instructions to Form 10-Q and Article 10 of Regulation S-X. Accordingly, they do not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. In the opinion of management, all adjustments (consisting of normal recurring adjustments) considered necessary for a fair presentation have been included. Operating results for the three and nine months ended September 30, 2004 are not necessarily indicative of the results that may be expected for any subsequent quarter or for the entire year ending December 31, 2004.

The preparation of the unaudited condensed consolidated financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those estimates.

The balance sheet at December 31, 2003 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. For further information, refer to the consolidated financial statements and notes thereto included in the Blue Martini Software, Inc. (“Blue Martini” or the “Company”) Annual Report on Form 10-K for the year ended December 31, 2003 filed with the Securities and Exchange Commission on March 15, 2004, as amended by Amendment No.1 on Form 10-K/A filed on March 24, 2004.

The Company has adopted Statement of Financial Accounting Standards (SFAS) No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure”, which amended SFAS 123, “Accounting for Stock-Based Compensation”. As permitted under SFAS 148, the Company has elected to continue to follow the intrinsic value method in accounting for its stock-based employee compensation arrangements.

Reclassification

Restricted cash of $648,000 and $962,000 on the balance sheet as of September 30, 2004 and December 31, 2003, respectively, were reclassified from cash and cash equivalents for the same periods. On the Consolidated Condensed Statements of Cash Flows for the nine months ended September 30, 2003, the movement in sales return reserve of approximately $1.1 million was reclassified from the provision for doubtful accounts to accounts receivable to conform with the 2004 presentation.

Note 2.    Letter of Credit and Restricted Cash

The Company obtained a letter of credit totaling $1.2 million as of December 31, 2002 in lieu of security deposits to secure facility lease obligations. As of September 30, 2004, the remaining balance on the letter of credit was $583,000, and the Company pledged $648,000 of cash equivalents as security for the letter of credit.

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BLUE MARTINI SOFTWARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Note 3.    Restructuring Charges

From 2001 through 2003, the Company implemented various restructuring plans intended to strengthen the Company’s operating performance and competitive position by reducing the Company’s workforce across all functional areas and consolidating facilities in North America and worldwide. In order to continue to reduce expense levels and to further improve the operating performance, the Company initiated an additional restructuring of its operations during the third quarter of 2004 (the “2004 Restructuring”). The following table summarizes the activities related to accrued restructuring charges (in thousands) for the nine months ended September 30, 2004:

At September 30, 2004, we had aggregate operating lease commitments of approximately $5.9 million, payable through 2006, of which, approximately $1.9 million have been accrued and reflected on the balance sheet as accrued restructuring charges net of expected sublease income. The quarterly lease commitments relating to accrued restructuring charges net of expected sublease income are approximately $600,000.

The costs associated with the Company’s workforce reductions consist primarily of severance payments, health benefits, payroll taxes and other associated termination costs incurred in connection with the 2004 Restructuring. The remaining obligations as of September 30, 2004 relate to a few remaining terminations that have yet to be completed. The Company expects to complete the reduction of the remaining employees within the next two months.

Note 4.    Comprehensive Net Loss

Accumulated other comprehensive net loss refers to revenues, expenses, gains and losses that, under generally accepted accounting principles, are recorded in stockholders’ equity, but are excluded from net loss and consist primarily of unrealized gains or losses on available-for-sale investments and foreign currency translation adjustments. The components of comprehensive net loss are as follows (in thousands):

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BLUE MARTINI SOFTWARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Note 5.    Net Loss Per Common Share

The following potential common shares have been excluded from the calculation of diluted net loss per share for all periods presented because the effect would have been anti-dilutive (in thousands):

Note 6.    Commitments and Contingencies

Legal Actions

From time to time, the Company may be subject to legal proceedings and claims, asserted or unasserted, that are in the ordinary course of business. The Company cannot predict the outcome of these proceedings and claims or the possible impact on the Company is not probable or estimable.

Indemnifications

The Company sells software licenses and services to its customers under contracts which the Company refers to as Software License and Service Agreements (each an “SLSA”). Each SLSA contains the key terms of the contractual arrangement with the customer, and generally includes certain provisions for indemnifying the customer against losses, expenses and liabilities from damages that may be awarded against the customer in the event the Company’s software is found to infringe upon a patent, copyright, trademark or other proprietary right of a third party. The SLSA generally limits the scope of, and remedies for, such indemnification obligations in a variety of industry-standard respects, including the right to replace an infringing product.

The Company believes its internal development processes and other policies and practices are designed to limit its exposure related to the indemnification provisions of the SLSA. In addition, the Company requires its employees to sign a proprietary information and inventions agreement, which, with limited exception, assigns the rights to its employees’ development work to the Company. To date, the Company has not had to reimburse any of its customers for any losses related to these indemnification provisions and no material claims are outstanding as of September 30, 2004. For several reasons, including the lack of prior indemnification claims and the lack of a monetary liability limit for certain infringement claims under the SLSA, the Company cannot determine the maximum amount of potential future payments, if any, related to such indemnification provisions.

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BLUE MARTINI SOFTWARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

Note 7.    Accounting for Stock-Based Compensation

The Company has adopted Statement of Financial Accounting Standards (SFAS) No. 148, “Accounting for Stock-Based Compensation—Transition and Disclosure”, which amended SFAS 123, “Accounting for Stock-Based Compensation”. As permitted under SFAS 148, the Company has elected to continue to follow the intrinsic value method in accounting for its stock-based employee compensation arrangements. The following table illustrates the effect on net loss and net loss per share if the Company had applied the fair value recognition provisions of SFAS 123 to stock-based employee compensation (in thousands, except per share data):

Consistent with the Company’s accounting for deferred tax assets resulting from the exercise of employee stock options in the accompanying condensed consolidated financial statements, the Company has not provided a tax benefit on the proforma expense in the above table.

For the above calculation, the fair value of each option granted was estimated on the date of grant using the Black-Scholes option valuation model with no expected dividends. The risk-free interest rate used is the U.S. Treasury bill rates for the relevant expected useful lives. The Company estimated the expected useful lives based on vesting and purchase periods and terms of the options. The expected volatility was based on the historical volatility of the Company’s stock equal to the expected lives of the options. The following table shows the weighted average assumptions for stock options:

Stock options granted for the three months ended September 30, 2004 and 2003 had estimated fair values of $0.88 and $1.68, respectively, and $1.32 and $1.75 for the nine months ended September 30, 2004 and 2003, respectively, as calculated using the Black-Scholes option valuation model.

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BLUE MARTINI SOFTWARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS—(Continued)

(Unaudited)

The weighted average fair values of common stock purchase rights (per-share) granted under the 2000 Employee Stock Purchase Plan were estimated using the Black-Scholes option valuation model with the following weighted average assumptions used for purchases:

The weighted average estimated fair values of the common stock purchase rights granted under the 2000 Employee Stock Purchase Plan were $1.35 and $1.17 for the three months ended September 30, 2004 and 2003, respectively, and $1.26 and $1.32 for the nine months ended September 30, 2004 and 2003, respectively, using the Black-Scholes option valuation model.

Note 8.    Significant Customer Information

For the three months ended September 30, 2004, two customers, respectively, accounted for 15% and 10% of total revenues. Three customers, respectively, accounted for 31%, 12% and 11% of net accounts receivable. For the three months ended September 30, 2003, three customers, respectively, accounted for 25%, 20% and 11% of total revenues. Two customers, respectively, accounted for 43% and 12% of net accounts receivable.

Note 9.    Recent Accounting Pronouncements

In June 2004, the Financial Accounting Standards Board (“FASB”) issued Emerging Issues Task Force (“EITF”) Issue No. 03-1 (“EITF 03-1”), The Meaning of Other-Than-Temporary Impairment and Its Application to Certain Investments. EITF Issue No. 03-1 includes new guidance for evaluating and recording impairment losses on debt and equity investments, as well as new disclosure requirements for investments that are deemed to be temporarily impaired. In September 2004, the FASB issued EITF 03-1-1, which delayed the accounting provisions of EITF Issue No. 03-1; however the disclosure requirements are effective for the Company’s annual period ending December 31, 2004. The Company will evaluate the impact of EITF Issue No. 03-1 once final guidance is issued but does not expect the adoption of EITF 03-01 will have a material effect on its financial position, results of operations or cash flows.

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The following discussion of the financial condition and results of operations of Blue Martini should be read in conjunction with the Management’s Discussion and Analysis of Financial Condition and Results of Operations and the Consolidated Financial Statements and the Notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2003. This quarterly report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including statements using terminology such as “can,” “may,” “believe,” “designated to,” “will,” “expect,” “plan,” “anticipate,” “estimate,” “potential,” or “continue,” or the negative thereof or other comparable terminology regarding beliefs, plans, expectations or intentions regarding the future. These forward-looking statements are not guarantees of future performance and are subject to risks, uncertainties and assumptions, including those under Item 2 in the section entitled “Risk Factors” and elsewhere in this quarterly report and the risk factors fully described under Item 7 in our Annual Report on Form 10-K for the year ended December 31, 2003. All forward-looking statements and risk factors included in this document are made as of the date hereof, based on information available to us as of the date thereof, and we assume no obligation to update any forward-looking statement or risk factors, unless we are required to do so by law.

Overview

We provide sales optimization systems designed to enable companies to increase revenues by guiding salespeople, channel partners, and customers through sales interactions. Our revenues are derived from the licensing of our software and the sale of related services. The license agreement for our software typically provides for an initial fee to use the software in perpetuity, with use limited by the number of servers (CPUs), business unit, geographic area, brand or other similar limitations. Service revenues are principally derived from consulting services, maintenance and training. Our maintenance agreements are typically payable in advance, entitle customers to receive software updates, maintenance releases and technical support, and typically have a one-year term. Consulting services and training are generally sold on a time-and-materials basis.

We market our application suite primarily through a direct sales force. We also engage in alliances with systems integrators and technology vendors to assist us in marketing and selling our software and related services. Some of our customers use systems integrators to implement our product, and systems integrators can significantly influence our customers’ purchasing decisions. We primarily target our products to customers competing in the commercial and consumer markets.

While the majority of our revenues to date have been derived from customers in the United States, international revenues accounted for 28% of our revenues for the nine months ended September 30, 2004. We believe that international revenues may fluctuate as a percentage of revenues in the near term due to variability in the number and size of our license deals and related service engagements. We believe that, if we are not successful selling through indirect channels, the percentage of revenue from international sources will decline in the future as a result of our most recent reduction in force which significantly reduced our sales and marketing resources. Our quarterly operating results have experienced seasonal fluctuations in the past and may continue to fluctuate based on several factors, including our customers’ budgeting cycles, sales incentive plans, and general economic conditions in markets where we conduct business.

To date, we have derived a significant portion of our revenues from a small number of customers. The loss of a major customer or the delay or cancellation of anticipated significant license contracts would adversely affect our revenues and operating results in a particular quarter. Failure to obtain a significant number of new customers or additional orders from existing customers in any period would adversely affect our business and operating results. For the three months ended September 30, 2004, two customers respectively accounted for 15% and 10% of total revenues. Three customers respectively accounted for 31%, 12% and 11% of net accounts receivable. See Note 8, Significant Customer Information, above.

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Our operating expenses are based in part on our expectations of future revenues over the long term, and are largely fixed in the short term. As such, a delay in completion of new customer license contracts or the recognition of revenues from one or more license contracts could cause significant variations in our operating results from quarter to quarter and could result in lower-than-expected revenues in a given quarter, resulting in greater-than-expected net losses for that quarter.

We believe that our greatest challenges as a company are to increase our sales pipeline, to assist current and prospective customers to realize the value of our solutions, to maintain and expand relationships with existing customers and partners and thereby, to achieve profitability. In 2004, our license and total revenues for the second and third quarters were significantly below our expectations primarily due to the continued uncertainty surrounding information technology (IT) spending by both current and prospective customers. We believe this uncertainty will continue in the near term. Companies have significantly reduced their budgets for IT projects and streamlined their IT organizations, thus limiting their capacity to execute new projects. They are maintaining their current IT systems rather than investing in system upgrades or replacements. In this environment, sales transactions require a prolonged and expensive evaluation process as customers are cautious to commit their resources. As a result, we are adjusting our marketing strategy to address the cautious spending environment and its commensurate IT resource constraints and to further reduce our cost structure.

To help our existing and prospective customers overcome their IT budget and resource limitations and to lower the perceived risk of investing in a new IT solution, we will allow them to try our solutions before committing to a full implementation. We will also offer new solution packs that will allow customers to implement certain product functionality in a packaged implementation that is less expensive and faster to implement than a broader enterprise software solution. The pricing for these solution packs will differ from our previous approach to pricing, which may affect our revenues accordingly.

In the third quarter of 2004, we reduced our cost structure to align both headcount and program expenditure resources with areas of highest revenue generation potential and with our adjusted marketing strategy. We reduced our workforce from approximately 200 employees at the end of the second quarter of 2004 to 134 employees as of September 30, 2004 and to approximately 120 employees at the end of October 2004. The workforce reductions during the third quarter of 2004 affected all organizations including product development, professional services, general and administrative and sales and marketing. In addition, as part of our cost management structure, we also outsourced our information technology infrastructure and may outsource portions of other functions.

As a result of these cost reductions, our operating expenses in the third quarter of 2004 were in transition and reflected restructuring charges as well as one-time benefits derived from reduced business activity level. The one-time benefits resulted in reductions to our general and administrative and research and development expenses. In the fourth quarter of 2004, we anticipate operating expenses under our adjusted ongoing cost structure to be in the range of $4.5 to $5 million, reflecting a 40% reduction from the second quarter of 2004, which was the last full quarter before the third quarter’s cost reductions.

During the third quarter of 2004, we filled key positions in our executive team. The new executives lead our global consulting services and product development organizations.

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Results of Operations for the Three and Nine Months Ended September 30, 2004 and 2003

Revenues

License

The decrease in license revenues for the three months ended September 30, 2004 as compared to the same period in 2003 was due to a reduction in the average selling price and to a lesser extent a decrease in the number of license transactions. The reduction in the average selling price reflects three unusually large transactions in the third quarter of 2003. We attribute the lower average selling price and reduced number of license transactions in the third quarter of 2004 to the uncertainty in information technology spending by potential customers in our markets. The decrease in license revenue for the nine months ended September 30, 2004 as compared to the same period in 2003 was due to the decrease in the average selling price of our software license transactions and a decrease in the number of license transactions, mostly attributable to the unusually high average selling price in the third quarter of 2003 as discussed above, and a decrease in the number of license transactions.

Service

Service revenues include maintenance and professional services revenues. The increase in professional services revenues for the three months ended September 30, 2004 as compared to the corresponding period in the prior year was due to the unusually low professional services revenue in the third quarter of 2003 which resulted from allocating extra professional services employees to a fixed priced consulting services project during that quarter. The decrease in professional services revenues for the nine months ended September 30, 2004 as compared to the corresponding period in the prior year was due to the continued transitioning of professional services to our system integrator partners combined with the decrease in license revenue. The increase in maintenance revenues for the three and nine months ended September 30, 2004 as compared to the corresponding periods in the prior year resulted from the increase over time of the customer base under maintenance arrangements. Our annual maintenance renewal rates continue to exceed 90% on both ongoing customer count and dollar amount bases.

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Cost of Revenues

Cost of License Revenues

Cost of license revenues consists primarily of royalties payable to third parties, and through the end of 2003, amortization of purchased intangible assets for software that is either embedded in or bundled with our products. The decline in cost of license revenues as a percentage of total revenues for the three and nine months ended September 30, 2004 as compared to the corresponding period in the prior year is primarily due to two factors: the full amortization of purchased intangibles at the end of 2003, and the impact of a fixed component of cost of license on a higher license revenue base. Since these purchased intangibles were fully amortized in December 2003, cost of license revenue, when expressed in dollar terms, decreased for the third quarter of 2004 as compared to the corresponding period in the prior year. The increase in costs as a percentage of license revenues for the three months ended September 30, 2004 compared to the same period in the prior year was attributable to the fixed component of the cost of license on a significantly lower revenue base. In the near term, our cost of license revenues, when expressed in dollar terms, is expected to fluctuate with license revenues.

Cost of Service Revenues

Cost of service revenues consists primarily of salaries and other personnel-related expenses, reimbursable expenses, costs of services provided by third-party consultants engaged by the Company, allocated overhead costs, and depreciation of equipment used to provide consulting services, technical support and training. Allocated overhead costs for costs of services and other expense categories include facilities and information systems. The decrease in dollar terms for the three and nine months ended September 30, 2004 as compared to the corresponding periods in the prior year was primarily due to a decrease in average headcount in our consulting services organization of approximately 25%. Our cost of service revenues may fluctuate in the near term, based on fluctuations in related service revenues and the extent to which we use subcontractors.

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Operating Expenses

Sales and Marketing

Sales and marketing expenses consist primarily of salaries, commissions, and other personnel-related expenses associated with our direct sales and marketing personnel, allocated overhead expenses, and costs of marketing programs including trade shows, promotional activities and media events. The decrease in sales and marketing expenses for the three and nine months ended September 30, 2004 as compared to the same periods in 2003 was primarily due to decreased commissions resulting from lower license revenues and the partial consequence of the 42% decrease in our sales and marketing headcount resulting from the restructuring events that occurred in the third quarter of 2004. In dollar terms, we expect sales and marketing expenses to continue to decrease in the near term reflecting the reduction in force and cost structure during the third quarter of 2004.

Research and Development

Research and development expenses consist primarily of salaries and other personnel-related expenses for engineering personnel, allocated overhead costs, costs of contractors, and depreciation of equipment used in the development of our software products. To date, all costs related to the development of our software have been expensed as incurred. The decrease in our research and development operations in the three and nine months ended September 30, 2004 as compared to the same periods in 2003 was primarily due to a 46% decrease in headcount resulting from the July 2004 workforce reduction and natural attrition and a reversal of employee compensation accrual of approximately $240,000 due to the reduced level of headcount and overall activity.

In the near term, we expect research and development expenses, in dollar terms, to remain consistent with the third quarter 2004 level.

General and Administrative

General and administrative expenses include costs associated with our finance, human resources, legal, and other administrative functions. These costs consist primarily of salaries and other personnel-related expenses, professional fees, insurance premiums, provision for doubtful accounts, equipment depreciation, and allocated

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overhead costs. The decrease in general and administrative expenses in the three and nine months ended September 30, 2004 from the corresponding periods in the prior year was primarily due to a headcount decrease of 33% during the third quarter of 2004, a $294,000 reduction in the allowance for bad debt in the third quarter of 2004 due to the revised estimates of potential losses in certain receivables, the reduction of compensation-related accruals related to reduced headcount and reduced general activity level and other cost savings from lower insurance premiums and reductions in outside services costs. In addition, while our costs relating to the Sarbanes-Oxley 404 compliance are minimal at this time, we expect our costs to increase in the next 12 months as we progress though the compliance process. We expect general and administrative expenses to be within the range of $1.3 million to $1.5 million per quarter in the near term.

Amortization of Deferred Stock Compensation

Amortization of deferred stock compensation consists of the amortization of deferred stock compensation using the accelerated method, net of an adjustment for unvested options of terminated employees during the quarter that reverses previously recognized expenses.

As of December 31, 2003, all deferred stock compensation was fully amortized. Deferred stock compensation expenses for the nine months ended September 30, 2004 consists of a charge of $96,000 in the first quarter of 2004 due to the accelerated vesting of options in connection with a termination agreement with a former Company executive.

Restructuring

As further discussed in Note 3 to the Company’s Notes to Condensed Consolidated Financial Statements, in July and September 2004, the Company implemented restructuring plans intended to strengthen its future operating performance and competitive position by preserving cash and reducing costs. The restructuring resulted in a headcount decrease of more than 60 employees and severance related expenses of $1.3 million. In addition, the Company vacated excess facilities and accrued approximately $232,000 related to the costs with satisfying remaining lease commitments. The restructuring charges of $180,000 for the nine months ended 2003 related to severance and other related charges.

Stock Option Plans

Description of Plans. The Company’s stock option program consists of two plans: the 2000 Equity Incentive Plan and the 2000 Non-Employee Directors’ Stock Option Plan. Stock options granted under these plans expire no later than ten years from the grant date and generally vest over a year to four years. The Incentive Plan is administered by our board of directors, which has the authority to designate participants and to determine the number and type of options to be granted, the time when options become exercisable, the method of payment and any other terms or conditions of the options. The Directors’ Plan designates participants and specifies the number, type, term and pricing of options granted, the exercisability and vesting schedule of such options, the method of payment and other terms and conditions. The Directors’ Plan is administered by our board of directors, which has the authority to determine provisions of options only to the extent not specified in the

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Directors’ Plan. Please refer to Note 10, Stockholders’ Equity, of the Company’s Annual Report on Form 10-K for the year ended December 31, 2003 for further information regarding the Company’s stock plans.

The following table summarizes plan activity for the nine months ended September 30, 2004 (in thousands, except per share amounts):

The following table summarizes information about stock options as of September 30, 2004 (option amounts in thousands):

Interest Income and Other, Net