MICROMUSE INC - 10-Q Quarterly Report

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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 x No ¨

80,681,648 shares of Common Stock, $0.01 par value, were outstanding as of May 4, 2005

The condensed consolidated financial statements are the unaudited historical financial statements of Micromuse Inc. and subsidiaries (the “Company”) and reflect all adjustments (consisting only of normal recurring adjustments) that, in the opinion of management, are necessary for a fair presentation of interim period results. These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Company’s Form 10-K as filed with the Securities and Exchange Commission on December 14, 2004. The September 30, 2004 condensed consolidated balance sheet included herein was derived from audited financial statements, but does not include all disclosures, including notes, required by generally accepted accounting principles.

The results of operations for the current interim period are not necessarily indicative of results to be expected for the entire current fiscal year or other future interim periods.

Certain reclassifications, none of which affected net income, have been made to prior amounts to conform to the current year presentation. Certain amounts in fiscal 2004 as reported on the Condensed Consolidated Balance Sheet and Condensed Statements of Cash Flows have been reclassified to conform to the current year presentation. We reclassified $52.5 million in auction rate securities from cash and cash equivalents to long-term investments on the September 30, 2004 consolidated balance sheet. This reclassification is based on the latest interpretation of cash equivalents pursuant to Statement of Financial Accounting Standards No. 95 (SFAS 95”), “Statement of Cash Flows.”

The preparation of condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America 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 these estimates.

On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, allocation of technical services department costs among expense categories, provision for doubtful accounts and sales returns, fair value of investments, fair value of acquired intangible assets and goodwill, useful lives of intangible assets, property and equipment, income taxes, restructuring costs, and contingencies and litigation, among others. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ significantly from the estimates made by management with respect to these items and other items that require management’s estimates. The costs of our technical services department are allocated between cost of revenue, sales and marketing expenses, and research and development expenses based upon an estimate of the time spent by the technical services employees in various departments and the areas benefited by that time. Total costs of the technical services department were $5.0 million and $10.7 million for the three-month and the six-month periods ended March 31, 2005, respectively, and $6.5 million and $12.7 million for the three-month and the six-month periods ended March 31, 2004, respectively. The allocation rates applied to these department costs were 28% to cost of revenue, 66% to sales and marketing, and 7% to research and development in the three-month period ended March 31, 2005, 30% to cost of revenue, 63% to sales and marketing, and 7% to research and development in the six-month period ended March 31, 2005; 21% to cost of revenue, 74% to sales and marketing, and 5% to research and development in the three-month period ended March 31, 2004, 21% to cost of revenue, 75% to sales and marketing, and 4% to research and development in the six months ended March 31, 2004. The allocation estimate is subject to change and, if changed, will impact the allocation of expenses in the statement of operations but will not impact net income.

The Company considers all highly liquid instruments with an original maturity of three months or less to be cash equivalents.

Basic per share amounts are calculated using the weighted-average number of common shares outstanding during the period. Diluted per share amounts are calculated using the weighted-average number of common shares outstanding during the period and, when dilutive, the weighted-average number of potential common shares from the exercise of outstanding options and warrants to purchase common stock using the treasury stock method. Excluded from the computation of diluted earnings per share for the three months and six months ended March 31, 2005 were options to acquire 16.9 million and 16.8 million shares of common stock, respectively, because their effect would be anti-dilutive. Also excluded from the computation of the diluted earnings per share for the three months and six months ended March 31, 2005 was a warrant to acquire 50,000 shares of common stock at $7.27 per share, because their effect would be anti-dilutive. Excluded from the computation of diluted earnings per share for the three months and six months ended March 31, 2004 were options to acquire 9.3 million and 10.5 million shares of common stock, respectively, because their effect would be anti-dilutive. A reconciliation of the numerators and denominators used in the basic and diluted net income per share amounts follows (in thousands):

One third-party distributor customer accounted for approximately 13% and 17% of revenues for the three-month and the six-month periods ended March 31, 2005, respectively, as compared to 17% in each of the same periods of the prior year. No one end-user customer accounted for greater than 10% of revenues for the three-month and six-month periods ended March 31, 2005 and 2004.

Accounts receivable includes an allowance for doubtful accounts of $960 thousand and $1.0 million as of March 31, 2005 and September 30, 2004, respectively.

The only component of accumulated other comprehensive loss is net foreign currency translation adjustments. Other comprehensive income (loss), net of tax, for the quarter ended March 31, 2005 was a gain of $51 thousand, as compared to a loss of $0.1 million for the quarter ended March 31, 2004. Other comprehensive loss, net of tax, for the six months ended March 31, 2005, was $1.8 million and other comprehensive loss, net of tax, for the six months ended March 31, 2004, was $0.2 million.

At March 31, 2005, the Company had two stock-based employee compensation plans, which are described more fully in the notes included in the Form 10-K as filed with the Securities Exchange Commission on December 14, 2004. The Company accounts for those plans under the recognition and measurement principles of APB Opinion No. 25, Accounting for Stock Issued to Employees, and related Interpretations. All options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of the grant, therefore no stock-based employee compensation cost is reflected in the condensed consolidated statement of operations related to option grants for the three months and six months ended March 31, 2005. In February 2005, the Company amended certain provisions of its Employee Stock Purchase Plan (“Plan”) by adding a sub-plan for new participants (eligible employees who had not participated in the Plan prior to February 1, 2005). The Plan specifically authorizes the Compensation Committee of the Company’s Board of Directors to adopt rules and make other policy decisions with regard to the administration and operation of the Plan. The Committee determined that it was appropriate and advisable to establish a sub-plan to the Plan, effective from February 1, 2005, for the purpose of allowing eligible employees to participate in a revised form of the Plan beginning with the February 1, 2005 offering. In particular, the sub-plan reduced the offering periods to six months, with no look-back or re-set provisions and provided that the purchase price for each share of stock purchased at the close of an offering period under the sub-plan shall be 85% of the fair market value of such share on the last trading day before the commencement of the next applicable offering period. See also Recently Issued Accounting Pronouncements below concerning new requirements to expense share-based payments.

The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FASB Statement No. 123, Accounting for Stock-Based Compensation, and SFAS No. 148, Accounting for Stock-Based Compensation – Transition and Disclosure, to stock-based employee compensation.

The Company’s chief operating decision-maker is considered to be the Company’s Chief Executive Officer (“CEO”). The CEO reviews financial information presented on a consolidated basis accompanied by certain geographic information for purposes of making operating decisions and assessing financial performance. Therefore, the Company operates as a single operating segment: service and business assurance software.

The Company markets its products primarily from the United States. International sales are primarily to customers in continental Europe and Asia Pacific. Information regarding regional revenues, which are based on the location of the end-user, and long lived assets in different geographic regions are as follows (in thousands):

As a result of the adoption of SFAS No. 142 on October 1, 2002, the Company ceased the amortization of goodwill. As of March 31, 2005 and September 30, 2004, the Company had unamortized goodwill and other intangible assets of $57.4 million and $57.0 million, respectively. This included $50.5 million and $50.2 million of goodwill as of March 31, 2005 and September 30, 2004, respectively. The change in goodwill is due to foreign exchange fluctuations related to certain goodwill denominated in British pounds. The change in intangible assets is primarily due to the purchase of certain patents, net of amortization recorded during the period.

The following tables set forth the carrying amount of other intangibles assets that will continue to be amortized (in thousands):

The total amortization expense related to other intangible assets is set forth in the table below (in thousands):

The amortization of developed technology is recorded as a cost of revenue line item with the remaining amortization being reflected as an operating expense.

The total expected future amortization related to other intangible assets is set forth in the table below (in thousands):

In December 2004, the FASB revised SFAS No. 123 (“SFAS 123(R)”), Share-Based Payment, which requires companies to expense the estimated fair value of employee stock options and similar awards. The accounting provisions of SFAS 123(R) will be effective for the Company beginning on October 1, 2005. The Company is in the process of determining how the new method of valuing stock-based compensation as prescribed in SFAS 123(R) will be applied to valuing stock-based awards granted after the effective date and the impact the recognition of compensation expense related to such awards will have on its financial statements.

In March 2005, the SEC staff issued guidance on SFAS 123(R). Staff Accounting Bulletin No. 107 (“SAB 107”) was issued to assist preparers by simplifying some of the implementation challenges of SFAS 123(R) while enhancing the information that investors receive. SAB 107 creates a framework that is premised on two overarching themes: (a) considerable judgment will be required by preparers to successfully implement SFAS 123(R), specifically when valuing employee stock options; and (b) reasonable individuals, acting in good faith, may conclude differently on the fair value of employee stock options. Key topics covered by SAB 107 include: (a) valuation models – SAB 107 reinforces the flexibility allowed by SFAS 123(R) to choose an option-pricing model that meets the standard’s fair value measurement objective; (b) expected volatility – SAB 107 provides guidance on when it would be appropriate to rely exclusively on either historical or implied volatility in estimating expected volatility; and (c) expected term – the new guidance includes examples and some simplified approaches to determining the expected term under certain circumstances. The Company will apply the principles of SAB 107 in conjunction with its adoption of SFAS 123(R). The Company believes adoption of SFAS No. 123(R) will have a material impact on its results of operations and financial condition.

In December 2004, the Financial Accounting Standards Board issued SFAS No. 153, “Exchanges of Nonmonetary Assets,” an amendment of APB Opinion No. 29. SFAS No. 153 addresses the measurement of exchanges of nonmonetary assets and redefines the scope of transactions that should be measured based on the fair value of the assets exchanged. SFAS No. 153 is effective for nonmonetary asset exchanges beginning in our first quarter of fiscal 2006. The Company does not believe adoption of SFAS No. 153 will have a material impact on its results of operations and financial condition.

In December 2004, the FASB issued Staff Position SFAS No. 109-1, Application of FASB Statement No. 109, Accounting for Income Taxes (“FSP No. 109-1”) to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004 which was signed into law by the President of the United States on October 22, 2004. Companies that qualify for the recent tax law’s deduction for domestic production activities must account for it as a special deduction under SFAS No. 109 and reduce their tax expense in the period or periods the amounts are deductible, according to FSP No. 109-1. The FASB’s guidance is not expected to have a material impact on the Company’s results of operations and financial condition.

In December 2004, the FASB also issued Staff Position SFAS No. 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision (“FSP No. 109-2”) within the American Jobs Creation Act of 2004. The Act provides for a one-time deduction of 85 percent of certain foreign earnings that are repatriated in either an enterprise’s last tax year that began before the date of enactment, or the first tax year that begins during the one year period beginning on the date of enactment. FSP No. 109-2 allows companies additional time to evaluate whether foreign earnings will be repatriated under the repatriation provisions of the new tax law and requires specified disclosures for companies needing the additional time to complete the evaluation. The Company is currently evaluating the repatriation provisions of the Act and shall complete its evaluation once guidance has been issued by the Treasury Department on the repatriation provision, which is expected sometime in 2005, however, at this time the Company does not anticipate making repatriations under the Act.

In March 2005, the FASB issued Interpretation No. (FIN) 47, Accounting for Conditional Asset Retirement Obligations, to clarify the requirement to record liabilities stemming from a legal obligation to clean up and retire fixed assets, such as a plant or factory, when an asset retirement depends on a future event. The Company is evaluating the requirements of FIN 47 and does not expect the application of FIN 47 to have a material impact on its results of operations or financial position.

The Company did not execute any acquisitions during the quarter ended March 31, 2005.

On April 7, 2005, the Company entered into an agreement to acquire Quallaby Corporation, a privately-held software company based in Lowell, Massachusetts, for $33 million in cash and to assume and convert outstanding options to purchase Quallaby common stock into options to acquire Micromuse common stock as adjusted for the value of the per share merger consideration. The Company expects this transaction to be completed during the quarter ended June 30, 2005, subject to completion of certain closing conditions. Lloyd Carney, who currently serves as Chairman of the Board and Chief Executive Officer of the Company, is a limited partner, with no voting rights, in two investment funds that hold preferred stock in Quallaby Corporation. Based on the current agreement to acquire Quallaby, Mr. Carney’s interest in the consideration to be received by these funds is estimated to be less than $20,000, which the Company’s Board deemed immaterial.

As a result of the Company’s change in strategy and its desire to improve its cost structure and profitability, the Company announced and implemented two separate restructuring plans, which were accounted for under EITF No. 94-3 Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including certain costs incurred in a Restructuring). The Company does not have any exit or disposal activities as defined under SFAS No. 146, “Accounting for Costs Associated with Exit or Disposal Activities,” that were initiated after the effective date of SFAS No. 146.

The fiscal 2002 restructuring plan, which was announced during the quarter ended September 30, 2002, resulted in a decrease of the Company’s workforce by 85 employees and the elimination of excess facilities. In connection with implementation of the restructuring plan, the Company incurred restructuring charges of $4.4 million in the quarter ended September 30, 2002. In the quarter ended June 30, 2003, as a result of a potential tenant terminating negotiations, an additional restructuring charge of $1.7 million was incurred due to an adjustment of assumptions on property leases relating to the fiscal 2002 restructuring plan. The Company determined that it would not be able to sub-lease some of the excess facilities that it had expected to sub-lease when calculating the original restructuring charge.

The fiscal 2003 restructuring plan, which was announced during the quarter ended December 31, 2002, resulted in a decrease of the Company’s workforce by 117 employees and total restructuring charges of $3.1 million, relating to severance and employment related charges.

Severance and employment-related charges consist primarily of severance, health benefits, other termination costs and legal expenses as a result of the termination of employees. Severance and employment related charges could be higher than the Company has estimated should there be additional arbitration and legal proceedings. The total severance accrual balance of $0.3 million as of March 31, 2005 is expected to be paid by September 30, 2005.

Facility costs primarily represent closure and downsizing costs related to offices in Europe and North America that were vacated as part of the fiscal 2002 restructuring program. Closure and downsizing costs include payments required under lease contracts, after the properties were abandoned, less any applicable estimated sublease income during the period after abandonment. To determine the lease loss portion of the closure and downsizing costs, certain estimates were made related to the (1) time period over which the relevant building would remain vacant, (2) sublease terms, and (3) sublease rates, including common area charges. The lease loss accrual is an estimate and will be adjusted in the future upon triggering events (such as changes in estimates of time to sublease and actual sublease rates). As of March 31, 2005, the remaining $345 thousand accrual of lease termination costs, net of estimated sublease income, is expected to be paid on various dates through December 2005.

The following table sets forth the restructuring activity for the six months ended March 31, 2005 (in thousands):

In addition to the matters specifically listed in Part II, Item 1 Legal Proceedings, the Company is also subject to other pending or threatened litigation from time to time, including other cases now pending. The Company records liabilities based on claims for which management believes a loss is probable and for which management can reasonably estimate the amount and range of loss. Management of the Company is unable to make a reasonable estimate of the losses that could result from any of the pending proceedings due to the inherent unpredictability of litigation and the uncertainties related to both the amount and range of losses in the event of an unfavorable outcome in these matters.

On April 27, 2005, the Company announced a program under which Micromuse may repurchase up to 6,000,000 shares of its common stock over the next 12 months. Purchases may be made from time to time in the open market, and will be funded from available working capital. The number of shares to be purchased and the timing of purchases will be based on several factors, including the price of Micromuse stock, general business and market conditions, and other investment opportunities. No purchases under this program have been made to date.

The following information should be read in conjunction with the condensed consolidated historical financial information and the notes thereto included in Item 1 of this Quarterly Report on Form 10-Q and Management’s Discussion and Analysis of Financial Condition and Results of Operations contained in our Form 10-K as filed with the Securities and Exchange Commission on December 14, 2004.

The statements contained in this Form 10-Q that are not purely historical are forward-looking statements within the meaning of Section 21E of the Securities Exchange Act of 1934, including statements regarding our expectations, beliefs, hopes, intentions or strategies regarding the future. All forward-looking statements in this Form 10-Q are based upon information available to us as of the date hereof, and we assume no obligation to update any such forward-looking statements. Actual results could differ materially from our current expectations. Factors that could cause or contribute to such differences include, but are not limited to: variation in demand for our software products and services; the level and timing of sales; the extent of product and price competition; introductions or enhancements of products or delays in introductions or enhancements of products; hiring and retention of personnel; changes in the mix of products and services sold; general domestic and international economic and political conditions; and other factors and risks discussed in “Risk Factors” below and elsewhere in this Quarterly Report, and other Micromuse filings with the Securities and Exchange Commission.

Micromuse Inc. develops, markets and supports a family of scalable, highly configurable, rapidly deployable software solutions that enable fault management and service assurance — the effective monitoring and management of multiple elements underlying an Information Technology infrastructure, including network devices, computing systems and applications, and the mapping of these elements to the business services they impact. The Company was founded in 1989 and subsequently developed our Netcool/OMNIbus software, which we began shipping in January 1995. All of our revenues continue to be derived from licenses for our Netcool family of products and related maintenance, training and consulting services. We currently expect that Netcool-related revenues will continue to account for all or substantially all of our revenues for the foreseeable future. As a result, our future operating results are dependent upon continued market acceptance of our Netcool products and enhancements thereto.

The Company generated $37.9 million in total revenue in the three-month period ended March 31, 2005, a decrease of 3% sequentially and 1% decrease year-over-year. License revenue was $20.0 million, up 3% sequentially. Net income for the quarter was $4.1 million or $0.05 per diluted share as compared with $559 thousand or $0.01 per diluted share in the comparable period of the prior fiscal year.

Cash, cash equivalents and investments at March 31, 2005 were $193.3 million, up by about $0.6 million sequentially, but down by about $1.8 million from a year ago. Cash flow from operations was negative for the three months, but positive for the six months, ended March 31, 2005 and the Company remains debt free. Deferred revenue was $50.6 million at March 31, 2005, up from $47.7 million in the prior quarter.

We expect significant expenses for professional fees to continue during fiscal 2005 and perhaps beyond due to pending litigation. We currently estimate that professional service fees associated with pending litigation will be in the range of $5 million to $6 million during fiscal 2005. Actual fees incurred may be higher or lower depending on many factors beyond our control. See Part II, Item 1 – “Legal Proceedings” for additional information on current legal proceedings. We also expect significant increases in operating expenses related to the implementation of the internal control requirements of Section 404 of the Sarbanes-Oxley Act of 2002 (“Section 404”). We currently estimate that professional service fees associated with the implementation of Section 404 will be in the range of $1.0 million to $1.5 million during fiscal 2005.

As a result of our multinational operations and sales, our operating results are subject to significant fluctuations based upon changes in the exchange rates of certain currencies, particularly the British pound, in relation to the U.S. dollar. For example, while our United States headquarters is located in San Francisco, California, our principal product development operations are located in London, England. As a result, a substantial portion of our costs and expenses are denominated in currencies other than the U.S. dollar.

On April 7, 2005, we entered into an agreement to acquire Quallaby Corporation, a private-held software company based in Lowell, Massachusetts, for $33 million in cash and to assume and convert outstanding options to purchase Quallaby common stock into options to acquire Micromuse common stock as adjusted for the value of the per share merger consideration. We expect this transaction to be completed during the quarter ended June 30, 2005, subject to completion of certain closing conditions.

On April 27, 2005, we announced a program under which Micromuse may repurchase up to 6,000,000 shares of its common stock over the next 12 months. Purchases may be made from time to time in the open market, and will be funded from available working capital. The number of shares to be purchased and the timing of purchases will be based on several factors, including the price of Micromuse stock, general business and market conditions, and other investment opportunities.

Our discussion and analysis of our financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, allocation of technical services department costs among expense categories, provision for doubtful accounts and sales returns, fair value of investments, fair value of acquired intangible assets and goodwill, useful lives of intangible assets and property and equipment, income taxes, restructuring costs, and contingencies and litigation, among others. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

We believe the following are the critical accounting policies and estimates that are used in the preparation of our consolidated financial statements:

Revenue Recognition. Our revenues are derived from license revenues for our Netcool family of products, as well as associated maintenance, consulting and training services revenues. We recognize revenue in accordance with Statement of Position 97-2, Software Revenue Recognition (SOP 97-2), as amended by Statement of Position 98-9, Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions (SOP 98-9), and recognize revenue using the residual method. Under the residual method, revenue is recognized when vendor specific objective evidence of fair value exists for all of the undelivered elements in the arrangement (i.e., maintenance and professional services), but does not exist for one or more of the delivered elements in the arrangement (i.e., the software product). We allocate revenue to each undelivered element based on its respective fair value, with the fair value determined by the price charged when that element is sold separately. We determine the fair value of the maintenance portion of the arrangement based on the renewal price charged to the customer when maintenance is sold separately or the option price for annual maintenance renewals included in the underlying customer contracts. The fair value of the professional services portion of the arrangement is based on the hourly rates that we charge for these services when sold independently from a software license. If evidence of fair value cannot be established for the undelivered elements of a license agreement, the entire amount of revenue from the arrangement is deferred and recognized ratably over the period that these elements are delivered.

For all of our software arrangements, we defer revenue for the fair value of the undelivered elements and recognize revenue for the delivered elements when the basic criteria of SOP 97-2 have been met—(1) persuasive evidence of an arrangement exists, (2) delivery has occurred, (3) the vendor’s fee is fixed or determinable and (4) collectibility is probable. We evaluate each as follows:

Maintenance revenues from ongoing customer support and product upgrades are deferred and recognized ratably over the term of the maintenance agreement, typically 12 months. Payments for maintenance fees (on initial order or on renewal) are generally made in advance and are nonrefundable. Revenues for professional services are recognized as the services are performed. Professional services generally are not essential to the functionality of the software. Our software products are fully functional upon delivery and do not require any significant modification or alteration.

Deferred revenue includes revenue not yet recognized as a result of deferred maintenance, professional services not yet rendered and license revenue deferred until all the requirements of SOP 97-2 are met.

Allowance for Doubtful Accounts. We regularly review the adequacy of our allowance for doubtful accounts after considering the size of the accounts receivable aging, the age of each invoice, each customer’s expected ability to pay and our collection history with each customer. We review any invoice greater than 30 days past due to determine if a specific allowance is appropriate based on its risk category. In addition, we maintain a general reserve for all invoices by applying a percentage to each 30-day age category. In determining these percentages, we analyze our historical collection experience by region and current economic trends. If the historical data we use to calculate the allowance provided for doubtful accounts does not reflect the future ability to collect outstanding receivables, additional provisions for doubtful accounts may be needed and the future results of operations could be materially affected. However, historically the reserve has proven to be adequate.

Circumstances that have caused revisions to the allowance calculation have been primarily due to the contraction of the overall economy. Deterioration in the economy could result in more customers being placed in the specific reserve category, thereby increasing our reserve estimate and negatively impacting operating results.

Impairment Assessments. We review the carrying amount of goodwill for impairment during the fourth quarter of the fiscal year in accordance with Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets. In addition we perform an impairment assessment of goodwill and other intangible assets whenever events or changes in circumstances indicate that the carrying value of goodwill and other intangible assets may not be recoverable. Significant changes in circumstances can be both internal to our strategic and financial direction, as well as changes to the competitive and economic landscape. Changes in circumstances that are considered important for asset impairment include, but are not limited to, a decrease in our market capitalization, contraction of the telecommunications industry, reduction or elimination of geographic economic growth, reductions in our forecasted growth and significant changes to operating costs.

As part of our impairment assessment, we examine economic conditions, products, customer base and geography. Based on these criteria, we determine which products we will continue to support and sell and, thereby, determine which assets will continue to have future strategic value and benefit. If indicators suggest the carrying value of our long-lived assets may not be recoverable we then estimate the fair value of these long-lived assets based on the sum of the expected discounted future cash flows expected to result from the use of the assets and their eventual disposition under the requirements of SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets.

Allowance for Sales Returns. For customers having a right of return, we estimate future returns based on historical experience and other assumptions, to determine if an allowance is appropriate. To date, we have experienced an immaterial level of returns, and as a result, the Company’s allowance for returns has been insignificant. If historical data used to calculate the allowance for returns does not reflect actual future returns, additional provisions for returns may be needed and future results of operations could be materially affected. However, historically the reserve has proven to be adequate.

Restructuring-related Assessments. Our critical accounting policy and judgment as it relates to restructuring-related assessments in accordance with Emerging Issues Task Force (EITF) No. 94-3 Liability Recognition for Certain Employee Benefits and Other Costs to Exit an Activity (including certain costs incurred in a restructuring) includes our estimate of the loss related to facility costs and severance-related costs. To determine the facility costs, which is the loss after our cost recovery efforts from subleasing a building, certain estimates were made related to the (1) time period over which the relevant building would remain vacant, (2) sublease terms, and (3) sublease rates, including common area charges. This lease loss is an estimate and will be adjusted in the future upon triggering events (such as changes in estimates of time to sublease and actual sublease rates). In the quarter ended September 30, 2002, the fiscal 2002 restructuring plan resulted in the elimination of excess facilities. In the quarter ended June 30, 2003, as a result of a potential tenant terminating negotiations with us, an additional restructuring charge of $1.7 million was incurred on property leases relating to the fiscal 2002 restructuring plan. The fiscal 2003 restructuring plan, which was announced during the quarter ended December 31, 2002, resulted in a decrease of our workforce by 117 employees and total restructuring charges of $3.1 million, relating to severance and employment related charges.

To determine the severance and employment-related charges, we have made certain estimates as they relate to severance benefits including the remaining time employees will be retained, the estimated severance period, health benefits and other termination costs as well as the estimated legal costs. Severance and employment-related charges for the fiscal 2002 and 2003 restructuring plans could be higher than we have estimated should there be additional arbitration and legal proceedings.

Legal contingencies. We are subject to various claims and legal actions arising in the ordinary course of business. When we believe in the likelihood that a loss has occurred and is probable and the amount of loss is reasonably estimable, we will accrue for estimated losses in the accompanying consolidated financial statements. Currently, we have not accrued for a legal contingency. Although we currently believe that the outcome of outstanding legal proceedings, claims and litigation involving us will not have a material adverse effect on our business, results of operations or financial condition, litigation is inherently uncertain, and there can be no assurance that existing or future litigation will not have a material adverse effect on our business or results of operations for any actual losses that may be incurred.

Accrued Sales Commission Policy. We account for commission accruals and related expenses to reflect a liability in the period the obligation arose for the actual amounts to be paid, with the related expense being recorded in the period in which the related revenue was recognized. We calculate the total commission liability for all valid purchase orders or approved written contracts received in the period and adjust commission expense for purchase orders or approved written contracts not recognized as revenue in the period because they did not meet one or more of the revenue recognition requirements of SOP 97-2. Preparation of the sales commission accrual and expense includes certain estimates that could vary from actual results and impact the accuracy of the recorded accrual and expense.

We prepare and release quarterly unaudited financial statements prepared in accordance with accounting principles generally accepted in the United States (“GAAP”). We also disclose and discuss certain non-GAAP financial information in the related earnings release and investor conference call. This non-GAAP financial information may exclude certain non-cash and special charges, consisting primarily of the amortization and impairment of goodwill and other intangible assets, write-off of in-process research and development, restructuring costs, costs of the restatement and related litigation, certain stock-based compensation, executive recruiting costs, and related income tax effects. We believe the disclosure of the non-GAAP financial information helps investors more meaningfully evaluate the results of our ongoing operations. However, we urge investors to carefully review the GAAP financial information included as part of our Quarterly Reports on Form 10-Q, our Annual Reports on Form 10-K, and our quarterly earnings releases.

The following table sets forth certain items in our condensed consolidated statement of operations as a percentage of total revenues, except as indicated:

Revenues decreased to $37.9 million and increased to $76.8 million in the three months and six months ended March 31, 2005, from $38.3 million and $75.5 million in the comparable periods of the prior year. License revenues decreased to $20.0 million and $39.3 million in the three months and six months ended March 31, 2005, respectively, from $20.3 million and $40.6 million in the comparable periods of the prior year. The decrease in license revenues in the three and six months ended March 31, 2005 was primarily due to increased purchasing scrutiny by our customers and the lengthening of the sales cycle. Maintenance and services revenues decreased to $17.9 million and increased to $37.5 million in the three months and six months ended March 31, 2005, respectively, from $18.0 million and $34.9 million in the comparable periods of the prior year. Maintenance and services revenues in the three months ended March 31, 2005 were essentially flat compared to the three months ended March 31, 2004. The increase in maintenance and services in the six months ended March 31, 2005 was primarily due to an increase in the renewal of back maintenance contracts that had previously expired. License revenues as a percentage of total revenues was 52.7% and 51.2% in the quarter and six months ended March 31, 2005, as compared to 53.0% and 53.8% in the comparable periods of the prior year.

The cost of license revenues consists primarily of technology license fees paid to third-party software vendors and production costs. Cost of license revenues as a percentage of license revenues was 8.9% and 7.8% in the three months and six months ended March 31, 2005, as compared to 7.6% and 7.1% in the comparable periods of the prior year. The change in cost of license revenue as a percentage of license revenue in the three months and six months ended March 31, 2005 is mainly due to a change in the mix of license revenue and related licensing agreements in those periods that led to an increase in sales of licenses with related technology license fees payable to third parties. The cost of maintenance and services revenues consists primarily of personnel-related costs incurred in providing maintenance, consulting and training to customers. Cost of maintenance and services revenues as a percentage of maintenance and services revenues was 18.7% and 18.4% in the quarter and six months ended March 31, 2005, as compared to 15.3% and 15.2% in the comparable periods of the prior year. The change in cost of maintenance and service revenues as a percentage of maintenance and services revenue in the three months and six months ended March 31, 2005 is principally due to additional headcount and travel expenses related to training our technical services employees and customers and higher technical support costs.

Cost of amortization of developed technology relates to the amortization of developed technology acquired in the acquisitions of CAN, NetOps Corporation, RiverSoft plc, Lumos Technologies Inc. and NHI over two to six years. The decrease in the cost of the amortization of developed technology in the three months and six months ended March 31, 2005 as compared to the same periods of the prior year is due to certain intangibles becoming fully amortized during the three and six months ended March 31, 2005.

Sales and marketing expenses decreased to $14.2 million and $30.1 million in the quarter and six months ended March 31, 2005, from $15.8 million and $31.5 million in the comparable periods of the prior year. The decrease in sales and marketing expenses in the three months ended March 31, 2005 as compared to the same period of the prior year is primarily due to a decrease in payroll related costs, including a reduction in the allocation of costs of the technical services department to sales related activities, which totaled $1.8 million. This was offset by an increase in recruiting and consulting fees. The decrease in sales and marketing expenses in the six months ended March 31, 2005 as compared to the same period of the prior year is primarily due to a decrease in the allocation of costs of the technical services department to sales related activities, offset by an increase in payroll related costs in the first quarter ended December 31, 2004, which totaled $1.8 million in the six months ended March 31, 2005. This was offset by an increase in costs associated with a user group conference and tradeshows in the first quarter ended December 31, 2004. Sales and marketing expenses as a percentage of total revenues decreased to 37.4% and 39.3% in the quarter and six months ended March 31, 2005, as compared to 41.3% and 41.7% in the comparable periods of the prior year. We anticipate that our sales and marketing expenses in the coming year will increase in absolute dollars but will vary as a percentage of revenues.

Research and development expenses decreased to $7.6 million and $15.1 million in the quarter and six months ended March 31, 2005, from $8.2 million and $16.0 million in the comparable periods of the prior year. The decrease in research and development expenses in the three months ended March 31, 2005 as compared to the same period of the prior year is primarily due to a decrease in consulting fees of $0.2 million, a decrease in payroll related expenses of $0.1 million, and decrease in general overhead expenses of $0.3 million. The decrease in research and development expenses in the six months ended March 31, 2005 as compared to the same period of the prior year is primarily due to a decrease in general overhead expenses of $0.8 million, a decrease in payroll related expenses of $0.3 million, offset by an increase in allocation of the costs of the technical services department of $0.2 million. Research and development costs as a percentage of total revenues decreased to 20.1% and 19.7% in the quarter and six months ended March 31, 2005, as compared to 21.5% and 21.2% the comparable periods of the prior year. We anticipate that our research and development expenses in the coming year will increase in absolute dollars but will vary as a percentage of revenues.

General and administrative expenses increased to $6.4 million and $13.7 million in the quarter and six months ended March 31, 2005, from $6.0 million and $11.3 million in the comparable periods of the prior year. The increase in general and administrative expenses in the three months ended March 31, 2005 is primarily due to an increase in payroll related expenses of $0.3 million, increased recruiting fees of $0.3 million, increased accounting and legal professional fees of $0.3 million, and increased other miscellaneous expenses of $0.2 million, offset by a decrease in bad debt expense of $0.7 million. The increase in general and administrative expenses in the six months ended March 31, 2005 is primarily due to an increase in payroll related expenses of $0.6 million, increased recruiting fees of $0.5 million, increased consulting fees of $0.4 million, and increased accounting and legal professional fees of $0.9 million. General and administrative expenses as a percentage of revenues decreased to 17.0% and 17.8% in the quarter and six months ended March 31, 2005, from 20.6% and 20.1% in the comparable periods of the prior year. Additional information relating to expense trends in fiscal 2005 is set forth under “Overview” above.

Amortization of other intangible assets increased to $173 thousand and $221 thousand in the quarter and six months ended March 31, 2005, from $47 thousand and $95 thousand in the comparable period of the prior year. The charges reflect the amortization of intangible assets over estimated useful lives of six months to six years. The increase in the three months and six months ended March 31, 2005 as compared to the same periods of the prior year is primarily due to certain intangibles becoming fully amortized during the current period.

A credit of $0.3 million was recorded in the three months ended March 31, 2005 primarily as a result of a favorable settlement in relation to a restructuring severance case.

Other income, net, increased to $1.1 million and $2.5 million in the three months and six months ended March 31, 2005, from $732 thousand and $1.7 million in the comparable period of the prior year. The increase was primarily due to increased interest income resulting from higher interest rates.

Income taxes increased to $0.6 million and $1.1 million in the quarter and six months ended March 31, 2005, from $0.2 million and $0.8 million in the comparable periods of the prior year. The increase was mainly due to the increase of income before tax and offset by a decrease in the income tax rate. The decrease in the income tax rate is a result of a larger proportion of income being earned in lower taxed jurisdictions in the quarter and six months ended March 31, 2005.

As of March 31, 2005, we had $73.5 million in cash and cash equivalents and $119.8 million in marketable securities, as compared to $38.2 million in cash and cash equivalents and $155.3 million in marketable securities as of September 30, 2004. The net increase in cash and cash equivalents in the six months ended March 31, 2005, was due primarily to net sales of marketable securities of $35.5 million, in addition to proceeds from the issuance of common stock of $2.1 million, offset by capital expenditures of $2.7 million, payments for the purchase of patents of $2.0 million, and the effect of unfavorable changes in foreign exchange rates of $0.9 million. The most significant adjustments to reconcile net income to net cash provided by operating activities were the net increase in accounts receivables of $11.5 million which was primarily the result of a majority of our sales occurring toward the end of the period, the net increase in deferred revenue of $6.7 million which is attributable to the increase in the customer base and the renewal of several large maintenance contracts in the three months ended March 31, 2005, and the net increase in accrued expenses of $0.8 million which was primarily the result of increased trade accruals, and also depreciation and amortization expenses of $4.0 million.

As of March 31, 2005, our principal commitments consisted primarily of obligations under operating leases.

We believe that our current cash balances and the cash flows generated by operations will be sufficient to meet our anticipated cash needs for working capital and capital expenditures for the next 12 months. Thereafter, if cash generated from operations is insufficient to satisfy our liquidity requirements, we may seek to sell additional equity or convertible debt securities or obtain credit facilities. The decision to sell additional equity or debt securities could be made at any time and would likely result in additional dilution to our stockholders. A portion of our cash may be used to acquire or invest in complementary businesses or products or to obtain the right to use complementary technologies or repurchase shares of our common stock. From time to time, in the ordinary course of business, we evaluate potential acquisitions of such businesses, products or technologies.

We do not have any financial partnerships with unconsolidated entities, such as entities often referred to as structured finance or special purpose entities, which are often established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes. Accordingly, we are not exposed to any financing, liquidity, market or credit risk that could arise if we had such relationships.

There were no material changes outside the ordinary course of our business during the quarter ended March 31, 2005, in the contractual obligations that we reported in this portion of “Management’s Discussion and Analysis of Financial Condition and Results of Operations” contained in our most recent Annual Report on Form 10-K.

Our working capital was $77.4 million at March 31, 2005 as compared to $19.4 million at September 30, 2004, an increase of $58.0 million. The increase in working capital was primarily the result of a $47.5 million increase in cash and short-term investments, an $11.5 million increase in net accounts receivable, offset by a $1.7 million increase in income taxes payable, a $2.7 million increase in the current portion of deferred revenue, and a $2.3 million increase in accounts payable and accrued expenses. As stated in Note 1 “reclassifications,” certain amounts in fiscal 2004 as reported on the Condensed Consolidated Balance Sheet and Condensed Statements of Cash Flows have been reclassified to conform to the current year presentation. We reclassified $52.5 million in auction rate securities from cash and cash equivalents to long-term investments on the September 30, 2004 consolidated balance sheet. This reclassification is based on the latest interpretation of cash equivalents pursuant to Statement of Financial Accounting Standards No. 95 (“SFAS 95”), “Statement of Cash Flows.” The working capital amounts given above include the effects of this reclassification.

The following factors, in addition to the other information contained in this report, should be considered carefully in evaluating the Company and our prospects. This Form 10-Q (including without limitation the following Risk Factors) contains forward-looking statements (within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934) regarding the Company and our business, financial condition, results of operations and prospects. Words such as “expects,” “anticipates,” “intends,” “plans,” “believes,” “seeks,” “estimates” and similar expressions or variations of such words are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this Form 10-Q. Additionally, statements concerning future matters such as the development of new products, enhancements or technologies, possible changes in legislation and other statements regarding matters that are not historical are forward-looking statements.

Although forward-looking statements in this report reflect the good faith judgment of our management, such statements can only be based on facts and factors we currently know about. Consequently, forward-looking statements are inherently subject to risks and uncertainties, and actual results and outcomes may differ materially from the results and outcomes discussed in the forward-looking statements. Factors that could cause or contribute to such differences in results and outcomes include, but are not limited to, those discussed below or elsewhere in this report. Readers are urged not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. We undertake no obligation to revise or update any forward-looking statements in order to reflect any event or circumstance that may arise after the date of this report.

We face uncertainty in the degree to which the economic slowdown experienced over the 2001 to 2003 fiscal years will continue to negatively affect growth and capital spending by our existing and potential customers. We continue to experience instances of customers delaying or deferring licenses of our software and maintenance agreement, and longer lead times needed to close our customer sales. In addition, recent political turmoil in many parts of the world, including terrorist and military actions, may continue to put pressure on global economic conditions. Although there have been signs of improvement in general economic conditions, the improved conditions may not continue or lead to significantly improved demand for our software. If the economic conditions that affect our customers and our part of the software industry in the United States and globally do not show continued improvement, or if we experience a worsening in the global economic slowdown, we may continue to experience material adverse impacts on our business, operating results, and financial condition. We may not be able to accurately anticipate the magnitude of these impacts on future quarterly and annual results.

We restated our annual and quarterly financial statements for 2001, 2002, and the first three quarters of 2003, we did not file our Annual Report on Form 10-K for fiscal year 2003 on a timely basis, and we did not file our Quarterly Report on Form 10-Q for the first quarter of 2004 on a timely basis. Litigation and regulatory proceedings regarding the restatement of our Consolidated Financial Statements could seriously harm our business.

On December 30, 2003, we announced that we would not be able to file our Annual Report on Form 10-K on a timely basis, that we had initiated an internal inquiry regarding the accounting for certain items, and that we expected that this inquiry would lead to a restatement of historical financial statements. On February 10, 2004, we announced that the filing of our Form 10-Q for the first quarter of fiscal year 2004 would also be delayed. The adjustments to previously filed financial results affected our financial statements for the fiscal years ended September 30, 2002 and 2001 and our quarterly financial statements for the quarters ended December 31, 2000 through June 30, 2003. Please see our Annual Report on Form 10-K for the year ended September 30, 2003, as filed on May 17, 2004, for additional information regarding the restatement and adjustments.

Due to the failure to timely file our periodic reports described above, we were not in compliance with the filing requirements for continued listing on Nasdaq as set forth in Nasdaq Marketplace Rule 4310(c)(14). As a result, we made a timely request for a hearing before a Nasdaq Listings Qualifications Panel to address the filing delinquency, and the Nasdaq panel granted our request for an extension of time to complete our filings, subject to certain conditions.

In addition to conditions we fulfilled relating to filing the Form 10-K for the fiscal year ended September 30, 2003, and Forms 10-Q for the first two quarters in fiscal 2004, the Nasdaq panel decision requires the Company to file timely with the SEC all periodic reports for all reporting periods ended on or before March 31, 2005. If the Company fails to do so, it will not be entitled to a new hearing on the matter and its securities may be immediately delisted from the Nasdaq Stock Market. If there should be any other events of noncompliance with the Nasdaq listing standards other than required SEC filings, the Company would be entitled to notice of the deficiency and an opportunity to present a definitive plan to regain compliance.

We also previously announced that the Company and certain of our former and current officers and directors have been named in several lawsuits arising from the restatement announcement. These cases are still in their early stages and we intend to defend against them vigorously. See Part II, Item 1 “Legal Proceedings” for a description of this pending litigation.

Defending against existing and potential securities and class action litigation relating to the restatement of our consolidated financial statements will likely require significant attention and resources of management and, regardless of the outcome, result in significant legal expenses. If our defenses are ultimately unsuccessful, or if we are unable to achieve a favorable settlement, we could be liable for large damage awards that could seriously harm our business and results of operations.

In addition, as previously reported, the SEC commenced an informal inquiry regarding the circumstances leading up to the restatement of our consolidated financial statements. If we are required to respond in the future to this inquiry, this could require significant diversion of management’s attention and resources. For example, if the SEC elects to pursue an enforcement action, the defense against this type of action could be costly and require additional management resources. If we are unsuccessful in defending against this or other investigations or proceedings, we may face civil or criminal penalties or fines that would seriously harm our business and results of operations.

If we fail to achieve and maintain effective disclosure controls and procedures and internal control over financial reporting, our stock price and investor confidence in our company could be materially and adversely affected.

Although we are endeavoring to document and test internal control over financial reporting with a goal of reporting effective internal control in our fiscal year 2005 Form 10-K due in December 2005, we may not achieve this goal. We have not fully remediated the material weaknesses that contributed to the restatement of our financial statements reported in our fiscal year 2003 Form 10-K filed in May 2004, and we have subsequently identified other material weaknesses described in Part I, Item 4 of this Form 10-Q.

There is a risk that we may not be able to timely remediate and test those material weaknesses prior to the end of fiscal year 2005 and that we may discover other additional material weaknesses, not currently known, as of the end of our fiscal year 2005. Under SEC rules and accounting standards, if there is any material weakness outstanding as of the end of an annual reporting period, we must report that our internal control over financial reporting is not effective. To the extent that ineffective internal controls are part of our disclosure controls and procedures, we would also likely conclude that our disclosure controls and procedures are not effective. We are also required to maintain both disclosure controls and procedures and internal control over financial reporting that are effective for their intended purposes. If we fail to do so, our business, results of operations or financial condition, and the value of our stock, could be materially harmed.

If our accounting controls and procedures are circumvented or otherwise fail to achieve their intended purposes, our business could be seriously harmed.

Although we evaluate our disclosure controls and procedures as of the end of each fiscal quarter, have instituted remedial measures concerning our accounting controls and procedures, and are in the process of reviewing and establishing internal control over financial reporting in order to comply with SEC rules effective for us for years ending on or after November 15, 2004, relating to internal control over financial reporting adopted pursuant to the Sarbanes-Oxley Act of 2002, we may not be able to prevent all instances of accounting errors or fraud in the future. We have also reported in Part I, Item 4 of this Form 10-Q additional and continuing material weaknesses in internal control over financial reporting identified by our outside auditors. Our controls and procedures do not provide absolute assurance that all deficiencies in design or operation of these control systems, or all instances of errors or fraud, will be prevented or detected. These control systems are designed to provide reasonable assurance of achieving the goals of these systems in light of legal requirements, our resources and the nature of our business operations. These control systems remain subject to risks of human error and the risk that controls can be circumvented for wrongful purposes by one or more individuals in management or non-management positions. Our business could be seriously harmed by any material failure of these control systems.

Our operating results may vary from quarter to quarter, causing our stock price to fluctuate.

Our operating results have in the past, and will continue to be, subject to quarterly and annual fluctuations. Our quarterly revenues and operating results in geographic segments that we track fluctuate and are difficult to predict. It is possible that in some quarter or quarters our operating results will be below the expectations of public market analysts or investors. In such event, or in the event adverse conditions prevail, or are perceived to prevail, with respect to our business or financial markets generally, the market price of our common stock may decline significantly.

We typically realize a significant portion of our license revenues in the last month of a quarter, frequently in the last weeks or even days of a quarter. As a result, license revenues in any quarter are difficult to forecast because it is substantially dependent on orders booked and shipped in that quarter. Moreover, our sales cycle, from initial evaluation to delivery of software, varies substantially from customer to customer. Further, we base our expense levels in part on forecasts of future orders and sales, which are extremely difficult to predict. A substantial portion of our operating expenses is related to personnel, facilities, and sales and marketing programs. The level of spending for such expenses cannot be adjusted quickly and is, therefore, relatively fixed in the short term. Accordingly, our operating results will be harmed if revenues fall below our expectations in a particular quarter. In addition, the number and timing of large individual sales has been difficult for us to predict, and large individual sales have, in some cases, occurred in quarters subsequent to those we anticipated, or have not occurred at all. The loss or deferral of one or more significant sales in a quarter could harm our operating results.

Because of these fluctuations we believe that quarter-to-quarter comparisons of our operating results are not necessarily meaningful or indicative of our future performance. A number of other factors are likely to cause these variations, including:

Therefore, operating results for a particular future period are difficult to predict and prior results are not necessarily indicative of results to be expected in future periods. Any of the foregoing factors, or others discussed elsewhere herein, could have a material adverse effect on our business, operating results, financial condition and stock price.

Failure to align our employee base with our business may adversely affect our financial results.

Over the past few years, we have added customers, personnel and expanded the scope and geographic area of our operations that have placed and will continue to place a significant strain upon our management and our operating and financial systems and resources. In addition, we have increased our headcount from 532 employees on September 30, 2004 to 551 employees on March 31, 2005. Given the uncertainties discussed in this Risk Factors section, together with factors that might affect our ability to quickly expand or contract our work force around the world, it is difficult to predict future requirements for the number and type of employees in the fields and geographies in which we operate. Failure to align employee skills and populations with revenue and market requirements would have a material adverse impact on our business and its operating results.

Our restructuring of operations may not achieve the results we intend and may harm our business.

In the quarters ended September 30, 2002 and December 31, 2002, we initiated plans to streamline operations and reduce expenses, which included cuts in discretionary spending, reductions in capital expenditures, reductions in the work force and consolidation of certain office locations, as well as other steps to reduce expenses. The implementation of our restructuring plans has placed, and may continue to place, a significant strain on our managerial, operational, financial, employee and other resources. Additionally, the Company periodically engages in internal reorganizations and/or integrating acquired companies or technologies that may negatively affect our performance and our employee turnover as well as recruitment and retention of important employees. It is possible that these reductions could impair our marketing, sales and customer support efforts or alter our product development plans. If we experience difficulties in carrying out the restructuring plans, our expenses could increase more quickly than we expect. If we find that our planned restructurings do not achieve our objectives, it may be necessary to implement further reduction of our expenses, to perform additional reductions in our headcount, or to undertake additional restructurings of our business.

To succeed in the implementation of our business strategy, we must execute our sales strategy and further develop products and expand service capabilities, while managing future operations by implementing effective planning and operating processes. If we fail to manage effectively, our business could suffer. To manage, we must:

We need to continue to expand our distribution channels and retain our existing third-party distributors.

We need to continue to develop relationships with leading network equipment and telecommunications providers and to expand our third-party channels of distribution through OEMs, resellers and systems integrators. We currently invest significant resources to develop these relationships and channels of distribution, which could reduce our ability to generate profits. Third-party distributors accounted for approximately 50%, 46% and 48% of our total revenues in the three months ended March 31, 2005, fiscal 2004 and fiscal 2003 respectively. Our business will be harmed if we are not able to retain and attract additional distributors that market our products effectively. Further, many of our agreements with third-party distributors are nonexclusive, and many of the companies with which we have agreements also have similar agreements with our competitors or potential competitors. Our third-party distributors have significantly greater sales and marketing resources than we do, and their sales and marketing efforts may conflict with our direct sales efforts. In addition, although sales through third-party distributors result in reduced sales and marketing expense with respect to such sales, we sell our products to third-party distributors at reduced prices, resulting in lower gross margins on such third-party sales. We believe that our success in penetrating markets for our fault and service level management applications depends substantially on our ability to maintain our current distribution relationships, in particular, those with Cisco Systems, IBM, Ericsson, Unisphere (Siemens) and Sun Microsystems. Our business will be harmed if network equipment and telecommunications providers and distributors discontinue their relationships with us, compete directly with us or form additional competing arrangements with our competitors.

We are dependent on the market for software designed for use with advanced communications services, this market is very dynamic and difficult to predict.

The market for our products is in constant flux and in significant areas is not highly penetrated. Although the rapid expansion and increasing complexity of computer networks in recent years and the resulting emergence of service level agreements has increased, the demand for fault and service level management software products, the awareness of and the need for such products is a recent development. Therefore, it is difficult to assess the size of this market, the appropriate features and prices for products to address this market, the optimal distribution strategy and the competitive environment that will develop.

We are substantially dependent upon telecommunications carriers and other service providers continuing to purchase our products.

Telecommunications carriers, including Internet service providers that deliver advanced communications services to their customers accounted for approximately 55%, 64% and 60% of our total revenues in the three months ended March 31, 2005, fiscal 2004 and fiscal 2003 respectively. In addition, these providers are an important focus of our sales strategy. If these customers cease to deploy advanced communications services for any reason, the market for our products will be harmed. Also, delays in the introduction of advanced services or the failure of such services to gain widespread market acceptance or the decision of telecommunications carriers and other service providers not to use our products in the deployment of these services would harm our business.

Consolidations in, or a continued slowdown in, the telecommunications industry could harm our business.

We have derived and expect to continue to derive a substantial amount of our revenues from sales of products and related services to the telecommunications industry. The telecommunications industry has experienced significant consolidation in the past few years. Capital spending by this industry has decreased and may continue to decrease in the future as a result of a general decline in economic growth in local and international markets. Recent indicators, however, suggest that certain sectors have stabilized. Our business is highly dependent on the telecommunications industry and on continued capital spending by our customers in that industry. In the event of further significant slowdown in capital spending of the telecommunications industry, our business would be adversely affected. Furthermore, as a result of industry consolidation, there may be fewer potential customers requiring our software in the future. Larger, consolidated telecommunications companies may also use their purchasing power to create pressure on the prices and the margins we could realize.

Our business depends on the continued growth in use and improvement of the Internet.

A significant portion of our revenues comes from telecommunications carriers, Internet service providers and other customers that rely upon or are driven by the Internet. As a result, our future results of operations substantially depend on the continued acceptance and use of the Internet as a medium for commerce and communication. Our business could be harmed if this growth does not continue or if the rate of technological innovation, deployment or use of the Internet slows or declines.

Furthermore, the growth and development of the market for Internet-based services may prompt the introduction of new laws and regulations. Laws, which impose additional burdens on those companies that conduct business online, could decrease the expansion of the use of the Internet. A decline in the growth of the Internet could decrease demand for our products and services and increase our cost of doing business, or otherwise harm our business, which could result in a material adverse effect on the market price of our common stock.

We face intense competition, including from larger competitors with greater resources than our own, which could result in our losing market share or experiencing a decline in gross margins.

We face intense competition in our markets. As we enter new markets, we encounter additional, market-specific competitors. In addition, because the software market has relatively low barriers to entry, we are aware of new and potential entrants in portions of our market space. Increased competition is likely to result in price reductions and may result in reduced gross margins and loss of market share.

Further, many of our competitors have longer operating histories and have significantly greater financial, technical, sales, marketing and other resources, as well as greater name recognition and a larger customer base, than we do. As a result, they may be able to devote greater resources to the development, promotion, sale and support of their products or to respond more quickly to new or emerging technologies and changes in customer requirements than we can. Existing competitors could also increase their market share by bundling products having functionality offered by our products with their current applications. Moreover, our current and potential competitors may increase their share of the fault and service level management market by strategic alliances and/or the acquisition of competing companies. In addition, network operating system vendors could introduce new or upgrade and extend existing operating systems or environments that include functionality offered by our products, which could render our products obsolete and unmarketable.

Our current and prospective competitors offer a variety of solutions to address the fault and service level and enterprise network management markets and generally fall within the following five categories:

Many of our existing and potential customers and distributors continuously evaluate whether to design and develop their own network operations support and management applications or purchase them from outside vendors. Sometimes these customers internally design and develop their own software solutions for their particular needs and therefore may be reluctant to purchase products offered by independent vendors such as ours. As a result, we must continuously educate existing and prospective customers as to the advantages of our products versus internally developed network operations support and management applications.

If we ship products that contain defects, the market acceptance of our products and our reputation will be harmed, and our customers could seek to recover their damages from us.

Complex software products frequently contain errors or defects, especially when first introduced or when new versions or enhancements are released. Because of defects, we could continue to experience delays in or failure of market acceptance of products, or damage to our reputation or relationships with our customers. Any defects and errors in new versions or enhancements of our products after commencement of commercial shipments would harm our business.

In addition, because our products are used to monitor and address network problems and avoid failures of the network to support critical business functions, any design defects, software errors, misuse of our products, incorrect data from network elements or other potential problems within or out of our control that may arise from the use of our products could result in financial or other damages to our customers. Our customers could seek to have us pay for these losses. Although we maintain product liability insurance, it may not be adequate. Further, although our license agreements with our customers typically contain provisions designed to limit our exposure to potential claims as well as any liabilities arising from such claims, such provisions may not effectively protect us against such claims and the liability and costs associated therewith.

The sales cycle for our software products is long, and the delay or failure to complete one or more large license transactions in a quarter could cause our operating results to fall below our expectations.

Our sales cycle is highly customer specific and can vary from a few weeks to many months. The software requirements of customers are highly dependent on many factors, including but not limited to their projections of business growth, capital budgets and anticipated cost savings from implementation of our software. Our delay or failure to complete one or more large license transactions in a quarter could harm our operating results. Our software is generally used for division-wide or enterprise-wide, business-critical purposes and involves significant capital commitments by customers. Potential customers generally commit significant resources to an evaluation of available enterprise software and require us to expend substantial time, effort and money educating them about the value of our solutions. Licensing of our software products often requires an extensive sales effort throughout a customer’s organization because decisions to license such software generally involve the evaluation of the software by a significant number of customer personnel in various functional and geographic areas, each often having specific and conflicting requirements. A variety of factors, including actions by competitors and other factors over which we have little or no control, may cause potential customers to favor a particular supplier or to delay or forego a purchase.

We depend on our key personnel, and the loss of any of our key personnel could harm our business.

Our success is substantially dependent upon a limited number of key management, sales, product development, technical services and customer support personnel. The loss of the services of one or more of such key employees could harm our business. In addition, we are dependent upon our continuing ability to attract, train and retain additional highly qualified management, sales, product development, technical services and customer support personnel. We have at times experienced and continue to experience difficulty in recruiting qualified personnel. Also, the volatility or lack of positive performance in our stock price may also adversely affect our ability to attract and retain key employees, who often expect to realize value from stock options. Because we face intense competition in our recruiting activities, we may be unable to attract and/or retain qualified personnel. We have also experienced difficulties and associated risks in hiring and retaining employees in our Finance department described in Part I, Item 4 of this Form 10-Q.

Our success depends upon the performance of our executive officers and other key employees and the ability of our management team to work together effectively. There can be no assurance that the management team will be able to work together effectively, and the effective execution of our business strategy will depend in large part on how well key management and other personnel perform in their positions and are integrated within our company.

We have relied on stock options and Employee Stock Purchase Plan participation as a significant element of our compensation philosophy, and the requirement to expense options and other share-based payments commencing with our fiscal first quarter ending December 31, 2005 will adversely affect our results of operations and financial condition, and may negatively affect the goals of our compensation philosophy.

In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 123 (revised 2004), “Share-Based Payment” (“SFAS 123R”). SFAS 123R requires measurement of all employee stock-based compensation awards using a fair value method and the recording of such expense in the consolidated financial statements. In addition, the adoption of SFAS 123R will require additional accounting related to the income tax effects and additional disclosure regarding the cash flow effects resulting from share-based payment arrangements. In April 2005, the Securities and Exchange Commission announced the adoption of a new rule that amends the effective date of SFAS 123R. The effective date of the new standard under these new rules for our consolidated financial statements is October 1, 2005. We are evaluating the requirements of SFAS 123R and we expect that the adoption of SFAS 123R will have a material adverse impact on our results of operations and financial condition. In addition, this requirement and possible future changes in our share-based payment plans and compensation practices in response to this requirement may negatively affect our ability to use share-based payments to attract, retain and motivate our employees.

We have acquired other businesses and we may make additional acquisitions in the future, which will complicate our management tasks and could result in substantial expenditures.

We have acquired other businesses and we may make additional acquisitions in the future, which will complicate our management tasks and could result in substantial expenditures. In August 2002, we completed the acquisition of RiverSoft plc, a developer of flexible object modeling and root-cause analysis software. In December 2002, we completed the acquisition of Lumos Technologies, Inc., a developer of sophisticated technology for managing Layer 1 networks. In August 2003, we completed the acquisition of NETWORK HARMONi, Inc. (NHI) a former OEM partner and developer of intelligent agents which provides the core data collection technology within Netcool^{^®}/System Service Monitors^{^™} (Netcool/SSMs) and Netcool^{^®}/Application Service Monitors^{^™} (Netcool/ASMs), which gather realtime information about distributed systems, servers, and applications across the IT infrastructure. NHI’s OpCenter product is a lightweight centralized IT management and problem resolution system that is ideally tailored for mid-sized enterprise IT infrastructures. The Company also assumed several pending patent applications that had already been filed by NHI. In April 2005, we entered into an agreement to acquire Quallaby Corporation, a privately-held software company.

Because of these acquisitions, we are integrating distinct products, customers and corporate cultures into our own. These past and potential future acquisitions create numerous risks for us, including:

Further, some of the products we acquire would require significant additional development before they can be marketed and may not generate revenue at levels we anticipate. Moreover, our future acquisitions, if any, may result in issuances of our equity securities which dilute our stockholders’ equity, the incurrence of debt, large one-time write-offs and creation of goodwill or other intangible assets that could result in amortization and impairment expense. It is possible that our efforts to consummate or integrate acquisitions will not be successful, which would harm our business.

We have relied and expect to continue to rely on a limited number of products for a significant portion of our revenues.

All of our revenues have been derived from licenses for our Netcool family of products and related maintenance, training and consulting services. We currently expect that Netcool/OMNIbus-related revenues will continue to account for a substantial percentage of our revenues beyond fiscal 2005 and for the foreseeable future thereafter. Although we have Netcool/OMNIbus for Voice Networks, Netcool/Precision, Netcool/Visionary and other products, our future operating results, particularly in the near term, are significantly dependent upon the continued market acceptance of Netcool/OMNIbus, improvements to the product and new and enhanced Netcool/OMNIbus applications. Our business will be harmed if Netcool/OMNIbus does not continue to achieve market acceptance or if we fail to develop and market improvements to Netcool/OMNIbus or new or enhanced products. The life cycles of Netcool/OMNIbus, including its applications, are difficult to estimate due in large part to the recent emergence of many of our markets, the effect of future product enhancements and competition. A decline in the demand for Netcool/OMNIbus as a result of competition, technological change or other factors would harm our business.

We have relied and expect to continue to rely on a limited number of customers for a significant portion of our revenues.

We derive a significant portion of our revenues in any particular period from a limited number of customers. See “Concentration of Credit Risk” in Note 1 of the Notes to Condensed Consolidated Financial Statements. We expect to derive a significant portion of our revenues from a limited number of customers in the future. If a significant customer, or group of customers, cancels or delays orders for our products, or does not continue to purchase our products at or above historical levels, our business will be harmed. For example, pre-existing customers may be part of, or become part of, large organizations that standardize using a competitive product. The terms of our agreements with our customers typically contain a one-time license fee and a prepayment of one year of maintenance fees. The maintenance agreement is renewable annually at the option of the customer and there are no minimum payment obligations or obligations to license additional software. Therefore, we generally do not have long-term customer contracts upon which we can rely for future revenues.

Our business is subject to risks from global operations and we are exposed to fluctuations in currency exchange rates.

We license our products in foreign countries. In addition, we maintain a significant portion of our operations, including the bulk of our software development operations, in the United Kingdom. Fluctuations in the value of these currencies relative to the United States dollar have adversely impacted our results in the past and may do so in the future. See Note 1 “Geographic and Segment Information” in Notes to Condensed Consolidated Financial Statements for information concerning revenues outside the United States. We expect that international license, maintenance and consulting revenues will continue to account for a significant portion of our total revenues in the future. We pay the expenses of our international operations in local currencies and do not currently engage in hedging transactions with respect to such obligations.

Our international operations and revenues involve a number of other inherent risks, including:

We intend to enter into additional international markets and to continue to expand our operations outside of the United States. Such expansion will require significant management attention and expenditure of significant financial resources and could adversely affect our ability to generate profits. If we are unable to establish additional foreign operations in a timely manner, our growth in international sales will be limited, and our business could be harmed.

Rapid technological change, including evolving industry standards and regulations and new product introductions by our competitors, could render our products obsolete.

Rapid technological change, including evolving industry standards and regulations and new product introductions by our competitors, could render our products obsolete. As a result, the life cycles of our products are difficult to estimate and we must constantly develop, market and sell new and enhanced products. If we fail to do so, our business will be harmed. For example, the widespread adoption of new architecture standards for managing telecommunications networks would force us to adapt our products to such standard, which we may be unable to do on a timely basis or at all. In addition, to the extent that any product upgrade or enhancement requires extensive installation and configuration, current customers may postpone or forgo the purchase of new versions of our products. Further, the introduction or announcement of new product offerings by us or one or more of our competitors may cause our customers to defer licensing of our existing products.

Our products operate on third-party software platforms, and we could lose market share if our products do not operate on the hardware and software operating platforms employed by our customers.

Our products operate on third-party software platforms and we could lose market share if our products do not operate on the hardware and software operating platforms employed by our customers. Our products are designed to operate on a variety of hardware and software platforms employed by our customers in their networks. We must continually modify and enhance our products to keep pace with changes in hardware and software platforms and database technology. As a result, uncertainties related to the timing and nature of new product announcements, introductions or modifications by systems vendors, particularly Sun Microsystems, Inc., International Business Machines Corporation, Hewlett-Packard Company, Cabletron Systems, Inc. and Cisco Systems, Inc. and by vendors of relational database software, particularly Oracle Corporation and Sybase, Inc., could harm our business.

Our efforts to protect our intellectual property may not be adequate and third-parties have in the recent past claimed and may claim in the future that we are infringing their proprietary rights.

We cannot guarantee that the steps we have taken to protect our proprietary rights will be adequate to deter misappropriation of our intellectual property. In addition, we may not be able to detect unauthorized use of our intellectual property and take appropriate steps to enforce our rights. If third parties infringe or misappropriate our trade secrets, copyrights, patents, trademarks or other proprietary information or intellectual property, our business could be harmed. In addition, protection of intellectual property in many foreign countries is weaker and less reliable than in the United States, so as our international operations expand, the risk that we will fail to adequately protect our intellectual property increases. Further, while we believe that our products and trademarks do not infringe upon the proprietary rights of third parties, other parties may assert that our products infringe, or may infringe, their proprietary rights or we have not fulfilled the terms of agreements with them. Any litigation, whether brought by or against us, may be time-consuming, result in high or unanticipated professional expenses and costs, and diversion of technical and management personnel, cause product shipment delays or require us to develop non-infringing technology or enter into royalty, licensing or other agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to us or at all. We expect that software product developers will be increasingly subject to infringement claims as the number of products and competitors in our industry segment grows and the functionality of products in different industry segments overlaps.

See Part II, Item 1 “Legal Proceedings” for a description of pending litigation relating to claims of infringement against us.

We rely on software that we have licensed from third-party developers to perform key functions in our products.

We rely on software that we license from third parties, including software that is integrated with internally developed software and used in our products to perform key functions. We could lose the right to use this software or it could be made available to us only on commercially unreasonable terms. Although we believe that alternative software is available from other third-party suppliers or internal developments, the loss of or inability to maintain any of these software licenses or the inability of the third parties to enhance in a timely and cost-effective manner their products in response to changing customer needs, industry standards or technological developments could result in delays or reductions in product shipments by us until equivalent software could be developed internally or identified, licensed and integrated, which would harm our business.

Our stock price is volatile, exposing us to possible risks of costly and time-consuming securities class action litigation.

The market price of our common stock has been and is likely to continue to be highly volatile. The market price may vary in response to many factors, some of which are outside our control, including:

In addition, the stock market has from time to time experienced significant price and volume fluctuations that have particularly affected the market price for the common stock of technology companies. These types of broad market fluctuations may adversely affect the market price of our common stock. In the past, following periods of volatility in the market price of a company’s securities, securities class action litigation has often been initiated against such company. Such litigation could result in substantial costs and a diversion of our management’s attention and resources that could harm our business.

Due to rapidly changing market conditions, our goodwill and other long-lived assets may become impaired such that their carrying amounts may not be recoverable, and we may be required to record an impairment charge impacting our financial position. As of March 31, 2005, we had approximately $57.4 million of goodwill and other intangible assets, which relates primarily to the acquisitions of CAN, NetOps, RiverSoft, Lumos and NHI. The Company regularly performs reviews to determine if the carrying value of assets is impaired. As part of our impairment assessment, we examine economic conditions, products, customer base and geography. Based on these criteria, we determine which products we will continue to support and sell and, thereby, determine which assets will continue to have future strategic value and benefit. No such impairment has been indicated to date. Asset impairment charges of this nature could be large and could have a material adverse effect on our financial condition and reported results of operations.

Future sales of our common stock may affect the market price of our common stock.

As of March 31, 2005, we had approximately 80.6 million shares of common stock outstanding, excluding approximately 18.7 million shares subject to options outstanding as of such date under our stock option plans that are exercisable at prices ranging from approximately $0.63 to $106.22 per share. We cannot predict the effect, if any, that future sales of common stock, or the availability of shares of common stock for future sale, will have on the market price of common stock prevailing from time to time. Sales of substantial amounts of common stock (including shares issued upon the exercise of stock options), or the perception such sales could occur, may materially and adversely affect prevailing market prices for common stock. In addition, tax charges resulting from the exercise of stock options could adversely affect the reported results of operations.

Certain provisions of our certificate of incorporation and bylaws and certain provisions of Delaware law could delay or make difficult a change in control of Micromuse that a stockholder may consider favorable. The provisions include:

In addition, Section 203 of the General Corporation Law of the State of Delaware, which is applicable to us, and our stock incentive plans, may discourage, delay or prevent a change of control of Micromuse.

Our future effective tax rates could be adversely affected by earnings being lower than anticipated in countries where we have lower statutory rates, changes in the valuation of our deferred tax assets and liabilities, or by changes in tax laws or interpretations thereof.

Our business is especially subject to the risks of earthquakes, floods and other natural catastrophic events, and to interruption by manmade problems such as computer viruses or terrorism.

Our corporate headquarters are located in San Francisco, California a region known for seismic activity. A significant natural disaster, such as an earthquake or a flood, could have a material adverse impact on our business, operating results and financial condition. In addition, our servers are vulnerable to computer viruses, break-ins and similar disruptions from unauthorized tampering with our computer systems. Any such event could have a material adverse effect on our business, operating results and financial condition. In addition, the effects of war or acts of terrorism could have a material adverse effect on our business, operating results and financial condition. The terrorist attacks in New York and Washington, D.C. on September 11, 2001 disrupted commerce throughout the world and intensified the uncertainty of the U.S. and other economies. The continued threat of terrorism and heightened security and military action in response to this threat, or any future acts of terrorism, may cause further disruptions to these economies and create further uncertainties. To the extent that such disruptions or uncertainties result in delays or cancellations of customer orders, or the manufacture or shipment of our products, our business, operating results and financial condition could be materially and adversely affected.

We transact business in various foreign currencies. Accordingly, we are subject to exposure from adverse movements in foreign currency exchange rates. This exposure is primarily related to local currency denominated revenues and operating expenses in the U.K. However, as of March 31, 2005, no hedging contracts were outstanding.

We operate internationally and thus are exposed to potentially adverse movements in foreign currency rate changes. We have entered into foreign exchange forward contracts to reduce our exposure to foreign currency rate changes on receivables, payables and intercompany balances denominated in a nonfunctional currency. The objective of these contracts is to neutralize the impact of foreign currency exchange rate movements on our operating results. These contracts require us to exchange currencies at rates agreed upon at the inception of the contracts. These contracts reduce the exposure to fluctuations in exchange rate movements because the gains and losses associated with foreign currency balances and transactions are generally offset with the gains and losses of the foreign exchange forward contracts. Because the impact of movements in currency exchange rates on forward contracts offsets the related impact on the underlying items being hedged, these financial instruments help alleviate the risk that might otherwise result from changes in currency exchange rates. To date, we have not designated our foreign exchange forward contracts as hedges and, accordingly, if such forward contracts remained open at period end, we would adjust these instruments to fair value through earnings in the period of change in their fair value.

The primary objective of our investment activities is to preserve principal while maximizing yields without significantly increasing risk. Our exposure to market risks for changes in interest rates relate primarily to investments in debt securities issued by U.S. government agencies and corporate debt securities. We place our investments with high credit quality issuers and, by policy, limit the amount of the credit exposure to any one issuer.

Our general policy is to limit the risk of principal loss and ensure the safety of invested funds by limiting market and credit risk. All highly liquid investments with less than three months to maturity at the date of purchase are considered to be cash equivalents; investments with maturities at the date of purchase between three and twelve months are considered to be short-term investments; investments with maturities in excess of twelve months are considered to be long-term investments. The weighted average pre-tax interest rate on the investment portfolio is approximately 2.4%.

Based on their evaluation as of the end of the period covered by this Quarterly Report on Form 10-Q, our Company’s Chief Executive Officer and Chief Financial Officer have concluded that their evaluation has provided them with reasonable assurance that the Company’s disclosure controls and procedures, as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”), are effective to ensure that information required to be disclosed by our Company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission’s rules and forms. In connection with the evaluation described above, we identified no change in our internal control over financial reporting that occurred during our fiscal quarter ended March 31, 2005, and that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

In connection with the restatement of our financial statements discussed in our Form 10-K for the year ended September 30, 2003, as filed on May 17, 2004 (and referred to in Part I Item 2 and Part II Item 1 of this report), our auditors identified material weaknesses consisting of deficiencies in internal controls related to the recording of accrued liabilities, deficiencies in internal controls related to the documentation of support for journal entries and ineffective review of financial information, although the letter from the auditors noted that the Company regularly conducted thorough and timely review and analysis of revenue recognition.

On January 26, 2005, the Audit Committee of the Board of Directors received a letter from our outside auditors reiterating the previously noted material weakness consisting of ineffective review of financial information, although the letter noted that the Company had significantly improved the level of review being afforded to its financial statements. The letter also identified material weaknesses consisting of continued operations with an inadequately staffed finance department, and lack of timely reconciliation, due to human oversight and systems limitations, of a significant unapplied cash balance for one customer and consequent lack of adequate control procedures to appropriately recognize revenue related to the transactions underlying the cash balance.

Although our management originally concluded in the Form 10-K filed on December 14, 2004, that disclosure controls and procedures were effective as of our fiscal year end at September 30, 2004, the subsequent first quarter review and discovery of certain errors relating back to September 30, 2004, has recently led management to conclude that disclosure controls and procedures were not effective as of September 30, 2004. The primary error related to the under-reporting of a sales commission expense due to an arithmetic mistake in computing the amount owed. Micromuse concluded these errors did not warrant a correction to the previously filed financial statements for the fiscal year ended September 30, 2004, as these errors in aggregate were not material to the financial statements. Nevertheless, management has re-evaluated disclosure controls and procedures in light of the subsequent facts.

Based on the procedures in place at the end of the first fiscal quarter at December 31, 2004, our management concluded in the Form 10-Q filed on February 9, 2005, that disclosure controls and procedures were effective as of the end of that quarter. The errors discussed above did not alter management’s conclusion with respect to December 31, 2004.

Our overall plan in 2004 to improve our financial processes and internal control over financial reporting included the hiring of a principal accounting officer to serve as Vice President of Global Finance. The individual we hired for this purpose in July 2004 left Micromuse in September 2004 to pursue other opportunities. Other finance department employees have also left Micromuse during calendar year 2004, and we announced in July 2004 that our current Chief Financial Officer, Mr. Mike Luetkemeyer, would leave Micromuse at the end of calendar year 2004. Micromuse appointed Ian Halifax as the Company’s Chief Financial Officer, effective January 17, 2005. Mr. Luetkemeyer will remain with the Company as an employee during the transition period. The Company has also appointed a Vice President of Finance and Corporate Controller effective January 27, 2005. Although we have hired a new Chief Financial Officer and a Vice President of Finance and Corporate Controller and intend to hire additional personnel in the Finance department, these staffing circumstances have delayed our ability to implement certain of the controls and procedures we described in Item 9A of our Form 10-K for the fiscal year ended September 30, 2003, filed on May 17, 2004, and contributed to material weaknesses in our internal control described above. Items delayed include improved systems processes intended to reduce manual journal entries and implementation of a global purchase order system.

See also Risk Factors – “We restated our annual and quarterly financial statements for 2001, 2002, and the first three quarters of 2003, we did not file our Annual Report on Form 10-K for fiscal year 2003 on a timely basis, and we did not file our Quarterly Report on Form 10-Q for the first quarter of 2004 on a timely basis. Litigation and regulatory proceedings regarding the restatement of our Consolidated Financial Statements could seriously harm our business,” “If we fail to achieve and maintain effective disclosure controls and procedures and internal control over financial reporting, our stock price and investor confidence in our company could be materially and adversely affected,” and “If our accounting controls and procedures are circumvented or otherwise fail to achieve their intended purposes, our business could be seriously harmed” in Part I, Item 2 of this report.

On December 9, 2002, Aprisma Management Technologies, Inc. filed a complaint against Micromuse Inc. in the U.S. District Court for the District of New Hampshire. The complaint alleges that Micromuse’s network and systems management products, including our Netcool products, infringe six patents held by Aprisma. The complaint seeks injunctive relief as well as unspecified compensatory and enhanced damages, attorneys’ fees, interest, costs and expenses. The parties have engaged in fact discovery, the period for which ended in May 2004, with the parties continuing to address outstanding fact and expert discovery issues. The case has been removed from the trial calendar pending consideration of claim construction issues and the Company’s defenses. The Company has presented significant defenses to Aprisma’s claims of patent infringement, but it is premature to assess the likely outcome of this litigation. Micromuse will continue to vigorously defend its position and pursue the counterclaims against Aprisma. On January 26, 2005, the Company filed an action in the United States District Court for the Southern District of New York against Aprisma Management Technologies, Inc., alleging that certain Aprisma SPECTRUM products infringe patents now owned or jointly owned by Micromuse. Micromuse is seeking compensatory and enhanced damages and injunctive and other relief in that suit. Additionally, Micromuse has filed with the U.S. Patent and Trademark Office (PTO) requests to re-examine three of the patents at issue in the Aprisma suit on the basis that they are invalid. The PTO has granted all three of these requests and the results of the PTO’s re-examinations are pending.

On November 10, 2003, Agilent Technologies, Inc. (“Agilent”) filed a complaint against the Company in the United States District Court for the Eastern District of Virginia. The complaint alleges that the Company infringes two patents, one of which is held by Agilent and the other of which is jointly owned by Agilent and Hewlett-Packard Company (“HP”). The complaint seeks injunctive relief, as well as unspecified compensatory and enhanced damages, attorneys’ fees, interest, costs and expenses. In a ruling dated April 15, 2004, the court granted Micromuse’s motion to transfer and ordered that the lawsuit be moved to the United States District Court for the Southern District of New York, where that court granted the Company’s motion for a more definite statement, requiring Agilent to file a more definite statement of its claims. In response to Agilent’s amended complaint filed pursuant to the court’s order, the Company asserted counterclaims seeking a declaration that the two patents in suit are invalid and unenforceable and are not infringed by the Company or its products, and seeking dismissal. In addition, the Company filed a counterclaim against Agilent asserting that certain Agilent products infringe a patent owned by the Company (the “Infringement Counterclaim”). Pre-trial discovery in the Agilent Litigation has commenced. Based upon current knowledge, the Company maintains that it has not and does not infringe the patents asserted by Agilent. It is not possible at the present time to assess the likelihood of a favorable or unfavorable outcome in the Agilent Litigation, including with respect to the Infringement Counterclaim, or the range of possible loss to the Company in the event of an unfavorable outcome. The Company intends to vigorously defend itself against Agilent’s infringement claims. Additionally, on January 26, 2005, the Company filed an action in the United States District Court for the Southern District of New York against Agilent Technologies, Inc., alleging that certain Agilent OSS Service Assurance Solution Products including one or more of its NETeXPERT VSM, FIREHUNTER and/or Service Assurance Application products infringe patents now owned or jointly owned by Micromuse. Micromuse is seeking compensatory and enhanced damages and injunctive and other relief in that suit.

Between January 12, 2004 and March 5, 2004, seven securities class action complaints were filed in the United States District Court for the Northern District of California against the Company and certain of its current and former officers and directors. The complaints were filed as purported class actions by individuals who allege that they purchased the Company’s common stock during a purported class period and seek an unspecified amount of damages. The complaints assert causes of action for alleged violations of Section 10(b) and 20(a) of the Securities Exchange Act of 1934 and SEC Rule 10b-5, arising out of the Company’s decision to restate its previously issued financial statements for the fiscal years ended September 30, 2001 and 2002 and for the quarters ended December 31, 2000 through June 30, 2003 and the Company’s decision to adjust its preliminary consolidated financial statement information for the quarter and fiscal year ended September 30, 2003, as initially announced on October 29, 2003. The Court has granted plaintiffs’ motion to consolidate those actions and name the law firm of Berman, DeValerio, Pease, Tabacco, Burt & Pucillo as Lead Plaintiffs’ Counsel. Plaintiffs have filed a consolidated amended complaint in accordance with the court-ordered schedule. The Company will continue to vigorously defend these lawsuits until their conclusion.

Between February 2, 2004 and March 16, 2004, the Company was also named as a nominal defendant along with certain of its current and former officers and directors in three derivative actions, purportedly brought by shareholders on the Company’s behalf, filed in the Superior Court of California, County of San Francisco. On April 21, 2004, those actions were consolidated and the law firm of Robbins, Umeda & Fink was named as Lead Plaintiffs’ Counsel in those actions. On March 3, 2004, the Company was also named as a nominal defendant along with certain of its current and former officers and directors in another derivative action, purportedly brought by shareholders on the Company’s behalf, filed in the District Court for the Northern District of California. The derivative complaints allege that, as a result of the events underlying the restatement, certain of the Company’s current and former officers and directors breached their fiduciary duties to the Company, and that certain current and former officers and directors engaged in insider trading in violation of California law. The plaintiffs seek unspecified damages on the Company’s behalf from the defendants. The Federal District Court has abstained from exercising jurisdiction over the federal derivative action and has dismissed the action. Plaintiffs have appealed the Federal District Court’s ruling to the Ninth Circuit Court of Appeals, which appeal is pending.

On January 15, 2004, the Securities and Exchange Commission notified the Company that it had initiated an informal inquiry regarding the Company. During 2004 the Company responded to requests for information relating to the restatement and believes it has fully cooperated with these requests.

The Company is also subject to other pending or threatened litigation from time to time in addition to the matters specifically listed above, including other cases now pending. When we believe there is a likelihood that a loss has occurred or is probable and the amount of that loss is reasonably estimable, we will accrue for estimated losses in the accompanying consolidated financial statements. Currently, we have not accrued for a legal contingency.

The litigation matters specifically listed above and other pending or future litigation are inherently unpredictable, could be costly and divert our management’s attention away from our business, and could have a material adverse effect on our business, financial results or condition, or cash flow. See also Risk Factors in Part I, Item 2 of this Form 10-Q “Our efforts to protect our intellectual property may not be adequate, and third-parties have in the recent past claimed and may claim in the future that we are infringing their proprietary rights” and “We restated our annual and quarterly financial statements for 2001, 2002, and the first three quarters of 2003, we did not file our Annual Report on Form 10-K for fiscal year 2003 on a timely basis, and we did not file our Quarterly Report on Form 10-Q for the first quarter of 2004 on a timely basis. Litigation and regulatory proceedings regarding the restatement of our Consolidated Financial Statements could seriously harm our business.”

Due to the inherent unpredictability of litigation, the Company cannot predict the outcome of these or other pending matters with any certainty. Because of the uncertainties related to both the amount and range of losses in the event of an unfavorable outcome in the lawsuits listed above or in certain other pending proceedings for which loss estimates have not been recorded, management of the Company is unable to make a reasonable estimate of the losses that could result from these matters.

Micromuse did not repurchase shares of its common stock during the fiscal quarter ended March 31, 2005. On July 22, 2004, we announced a program under which Micromuse may repurchase up to 2,000,000 shares of its common stock over the next 12 months. We reported purchases of 1,000,000 shares in the fourth quarter of fiscal 2004 in our Form 10-K filed on December 14, 2004. On April 27, 2005, we announced a program which supersedes the previous repurchase program and under which Micromuse may repurchase up to 6,000,000 shares of its common stock over the next 12 months. Purchases may be made from time to time in the open market, and will be funded from available working capital. The number of shares to be purchased and the timing of purchases will be based on several factors, including the price of Micromuse stock, general business and market conditions, and other investment opportunities. No purchases under this plan have been made to date.

The Company’s Annual Meeting of Shareholders was held on February 3, 2005, in San Francisco, California. Of the 78,729,750 shares outstanding as of the record date, 75,179,839 shares were present or represented by proxy at the meeting. The following matters were submitted to a vote of security holders:

(2) To ratify the Audit Committee’s appointment of KPMG LLP as independent accountants for the Company for the fiscal year ending September 30, 2005.

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on May 10, 2005.


MICROMUSE INC.
(Registrant)

By:		/s/ LLOYD A. CARNEY
		Lloyd A. Carney *Chairman and Chief Executive Officer* *(Duly Authorized Officer)*

By:		/s/ IAN HALIFAX
		Ian Halifax *Chief Financial Officer* *(Principal Financial Officer)*


DELAWARE		94-3288385
(State or other jurisdiction of incorporation or organization)		(IRS Employer Identification No.)


		Page
PART I - Financial Information		3

Item 1.	Condensed Consolidated Financial Statements (Unaudited):	3

	Condensed Consolidated Balance Sheets as of March 31, 2005 and September 30, 2004	3

	Condensed Consolidated Statements of Operations for the three months and six months ended March 31, 2005 and 2004	4

	Condensed Consolidated Statements of Cash Flows for the six months ended March 31, 2005 and 2004	5

	Notes to Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	11

Item 3.	Quantitative and Qualitative Disclosures about Market Risk	24

Item 4.	Controls and Procedures	25

PART II - Other Information		26

Item 1.	Legal Proceedings	26

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	27

Item 3.	Defaults upon Senior Securities	27

Item 4.	Submission of Matters to a Vote of Security Holders	27

Item 5.	Other Information	27

Item 6.	Exhibits	28

Signatures		29


	March, 31 2005			September 30, 2004*
	*(unaudited)*
ASSETS
Current assets:
Cash and cash equivalents	$	73,534		$	38,232
Short-term investments		36,665			24,469
Accounts receivable, net		31,404			19,901
Prepaid expenses and other current assets		9,962			8,893

Total current assets		151,565			91,495
Property and equipment, net		6,252			5,002
Long-term investments		83,150			130,873
Goodwill and other intangible assets, net		57,355			56,983

Total Assets	$	298,322		$	284,353

LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
Accounts payable	$	2,297		$	4,283
Accrued expenses		10,399			9,545
Accrued payroll		9,691			10,863
Income taxes payable		8,162			6,460
Deferred revenue, current portion		43,657			40,912

Total current liabilities		74,206			72,063
Deferred revenue, less current portion		6,985			3,023

Total liabilities		81,191			75,086

Stockholders’ equity:
Preferred stock; $0.01 par value; 5,000 shares authorized; no shares issued and outstanding		—			—
Common stock; $0.01 par value; 200,000 shares authorized; 80,626 and 79,982 shares outstanding as of March 31, 2005 and September 30, 2004, respectively		806			800
Additional paid-in capital		219,318			216,580
Treasury stock		(7,147	)		(7,147	)
Accumulated other comprehensive loss		(3,595	)		(1,833	)
Retained earnings		7,749			867

Total stockholders’ equity		217,131			209,267

Total liabilities and stockholders’ equity	$	298,322		$	284,353


	Three months ended March 31,					Six months ended March 31,
	2005			2004		2005			2004
Revenues:
License	$	19,970		$	20,288	$	39,290		$	40,607
Maintenance and services		17,896			17,997		37,482			34,867

Total revenues		37,866			38,285		76,772			75,474

Cost of revenues:
License		1,769			1,542		3,052			2,887
Maintenance and services		3,354			2,749		6,890			5,316
Amortization of developed technology		885			1,532		2,196			2,988

Total cost of revenues		6,008			5,823		12,138			11,191

Gross profit		31,858			32,462		64,634			64,283

Operating expenses:
Sales and marketing		14,152			15,809		30,149			31,485
Research and development		7,611			8,245		15,152			16,019
General and administrative		6,441			6,036		13,670			11,291
Stock based compensation		—			438		—			553
Restatement and related litigation costs		138			1,842		256			3,850
Amortization of other intangible assets		173			47		221			95
Restructuring costs		(302	)		—		(302	)		—

Total operating expenses		28,213			32,417		59,146			63,293

Income from operations		3,645			45		5,488			990
Other income, net		1,066			732		2,468			1,714

Income before income taxes		4,711			777		7,956			2,704
Income tax provision		570			218		1,074			757

Net income	$	4,141		$	559	$	6,882		$	1,947

Per share data:
Basic net income per share	$	0.05		$	0.01	$	0.09		$	0.02
Diluted net income per share	$	0.05		$	0.01	$	0.08		$	0.02
Weighted average shares used in computing:
Basic net income per share		80,447			78,670		80,247			78,645
Diluted net income per share		81,542			82,546		81,413			82,267


	Six months ended March 31,
	2005			2004
Cash flows from operating activities:
Net income	$	6,882		$	1,947
Adjustments to reconcile net income to net cash provided by operating activities:
Depreciation and amortization		3,982			5,642
Non-cash stock based compensation		—			553
Tax benefit related to exercise of stock options		604			464
Changes in assets and liabilities:
Accounts receivable, net		(11,503	)		(3,743	)
Prepaid expenses and other current assets		(1,068	)		(2,554	)
Accounts payable		(1,986	)		(2,240	)
Accrued expenses		(819	)		5,351
Income taxes payable		71			48
Deferred revenue		6,707			4,146

Net cash provided by operating activities		2,870			9,614

Cash flows from investing activities:
Capital expenditures		(2,689	)		(2,767	)
Investment purchases		(24,485	)		(123,945	)
Investment sales		60,012			138,186
Acquisition of business, net of cash received		—			(425	)
Receipt of historical Riversoft tax refund		310			—
Payments for purchase of patents		(2,000	)		—

Net cash provided by investing activities		31,148			11,049

Cash flows from financing activities:
Proceeds from issuance of common stock from options exercised		2,140			555

Net cash provided by financing activities		2,140			555

Effects of exchange rate changes		(856	)		(1,914	)

Net increase (decrease) in cash and cash equivalents		35,302			19,304
Cash and cash equivalents at beginning of period		38,232			51,480

Cash and cash equivalents at end of period	$	73,534		$	70,784

Nominee

Votes for

Votes Withheld

Broker Non-Votes

Lloyd A. Carney

David C. Schwab


	March 31, 2005		September 30, 2004
Long - lived assets:
United States	$	45,580	$	44,193
International		18,027		17,792

Total	$	63,607	$	61,985


	As of March 31, 2005
	Gross Carrying Amount		Accumulated Amortization			Net Carrying Amount
Developed technology	$	24,442	$	(20,164	)	$	4,278
Customer contracts		1,408		(1,285	)		123
Trademarks and patents		3,307		(881	)		2,426
Other intangible assets		868		(868	)		—

Intangibles related to business acquisitions	$	30,025	$	(23,198	)	$	6,827


	As of September 30, 2004
	Gross Carrying Amount		Accumulated Amortization			Net Carrying Amount
Developed technology	$	24,371	$	(17,892	)	$	6,479
Customer contracts		1,362		(1,233	)		129
Trademarks and patents		807		(672	)		135
Other intangible assets		868		(868	)		—

Intangibles related to business acquisitions	$	27,408	$	(20,665	)	$	6,743


Fiscal Year	Future Amortizations
2005(remainder of fiscal year)	$	1,696
2006		2,064
2007		1,892
2008		526
2009		524
Thereafter		125

Total	$	6,827


	Fiscal 2002 Restructuring Plan Facility			Fiscal 2003 Restructuring Plan Severance			Total
Accrual balance at September 30, 2004	$	347		$	646		$	993
Non-cash charges		4			—			4

Accrual balance at December 31, 2004		351			646			997
Restructuring charges		4			—			4
Non-cash charges		—			(306	)		(306	)
Changes due to foreign currency exchange rates		(2	)		(7	)		(9	)
Cash paid during the three months ended March 31, 2005		(8	)					(8	)

Accrual balance at March 31, 2005	$	345		$	333		$	678


Votes For:		54,750,744
Votes Against:		20,410,449
Votes Abstaining:		18,646
Broker Non-Votes:		0


Exhibit Number		Description
2.1		Agreement and Plan of Merger by and among Micromuse Inc., Sydney Acquisition Inc. (subsidiary of Micromuse) and Quallaby Corporation (incorporated by reference from Exhibit 2.1 in our Form 8-K filed with the SEC on April 13, 2005).

3.1		Restated Certificate of Incorporation of the Registrant (incorporated by reference from exhibit 3.1 in our Form 10-K filed with the SEC on December 21, 2001).

3.2		Amended and Restated Bylaws of the Registrant (incorporated by reference from exhibit 3.2 in our amended registration statement on Form S-1, No. 333-58975, as filed with the SEC on July 13, 1998).

10.03		1998 Employee Stock Purchase Plan, as amended and restated effective February 1, 2005, as filed herewith.

10.20†		Micromuse Inc. FY2005 Incentive Compensation Program, effective February 3, 2005, as filed herewith.

31		Separate Certifications of the Chief Executive Officer and Chief Financial Officer of the Registrant required by Section 302 of the Sarbanes-Oxley Act of 2002.

32		Combined Certification of the Chief Executive Officer and Chief Financial Officer of the Registrant required by Section 906 of the Sarbanes-Oxley Act of 2002.


	Three months ended March 31,				Six months ended March 31,
	2005		2004		2005		2004
As a Percentage of Total Revenues:
Revenues:
License	52.7	%	53.0	%	51.2	%	53.8	%
Maintenance and services	47.3	%	47.0	%	48.8	%	46.2	%

Total revenues	100.0	%	100.0	%	100.0	%	100.0	%

Cost of revenues:
License	4.7	%	4.0	%	4.0	%	3.8	%
Maintenance and services	8.9	%	7.2	%	9.0	%	7.0	%
Amortization of developed technology	2.3	%	4.0	%	2.9	%	4.0	%

Total cost of revenues	15.9	%	15.2	%	15.8	%	14.8	%

Gross profit	84.1	%	84.8	%	84.2	%	85.2	%

Operating expenses:
Sales and marketing	37.4	%	41.3	%	39.3	%	41.7	%
Research and development	20.1	%	21.5	%	19.7	%	21.2	%
General and administrative	17.0	%	15.7	%	17.8	%	15.1	%
Stock based compensation	0.0	%	1.1	%	0.0	%	0.7	%
Restatement and related litigation costs	0.3	%	4.8	%	0.3	%	5.1	%
Amortization of other intangible assets	0.5	%	0.1	%	0.3	%	0.1	%
Restructuring costs	-0.8	%	0.0	%	-0.4	%	0.0	%

Total operating expenses	74.5	%	84.7	%	77.0	%	83.9	%

Income from operations	9.6	%	0.1	%	7.1	%	1.3	%
Other income, net	2.8	%	1.9	%	3.2	%	2.3	%

Income before income taxes	12.4	%	2.0	%	10.4	%	3.6	%
Income tax provision	1.5	%	0.6	%	1.4	%	1.0	%

Net income	10.9	%	1.5	%	9.0	%	2.6	%

As a Percentage of Related Revenues:
Cost of license revenues	8.9	%	7.6	%	7.8	%	7.1	%