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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549



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FORM 10-Q

(MARK ONE)

[X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE THREE AND NINE MONTHS ENDED
DECEMBER 31, 2001 AND 2000

OR

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

COMMISSION FILE NUMBER 001-15681



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WEBMETHODS, INC.

(Exact Name of Registrant as Specified in its Charter)

|                                         |  |                    
|---------------------------------------- |  | -------------------
|DELAWARE                                 |  | 54-1807654         
|(State or other jurisdiction of          |  | (I.R.S. Employer   
|incorporation or organization)           |  | Identification No.)
|                                        
|3930 PENDER DRIVE, FAIRFAX, VIRGINIA     |  | 22030              
|(Address of principal executive offices) |  | (Zip Code)         



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Registrants Telephone Number, Including Area Code: (703) 460-2500

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 [  ]

As of
February 7, 2002, 50,400,446 shares of the registrants Common Stock,
par value $.01 per share, were issued and outstanding.



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1



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WEBMETHODS, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE THREE MONTHS AND NINE MONTHS ENDED DECEMBER 31, 2001 AND 2000
TABLE OF CONTENTS

|        |  |                                                                                      |  | 
|------- |  | ------------------------------------------------------------------------------------ |  | 
|Part I  |  | Financial Information                                                               
|Item 1  |  | Financial Statements                                                                
|        |  | Condensed Consolidated Balance Sheets as of                                         
|        |  | December 31, 2001 (unaudited) and March 31, 2001                                    
|        |  | Condensed Consolidated Statements of Operations and Comprehensive Loss (unaudited) -
|        |  | Three and nine months ended December 31, 2001 and 2000                              
|        |  | Condensed Consolidated Statements of Cash Flows (unaudited) -                       
|        |  | Nine months ended December 31, 2001 and 2000                                        
|        |  | Notes to Condensed Consolidated Financial Statements (unaudited)                    
|Item 2  |  | Management's Discussion and Analysis of Financial                                   
|        |  | Condition and Results of Operations                                                 
|Item 3  |  | Quantitative and Qualitative Disclosures About Market Risk                          
|Part II |  | Other Information                                                                   
|Item 1  |  | Legal Proceedings                                                                   
|Item 2  |  | Changes in Securities and Use of Proceeds                                           
|Item 6  |  | Exhibits and Reports on Form 8-K                                                    
|        |  | (a) Exhibits                                                                        
|        |  | (b) Reports on Form 8-K                                                             

2



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PART I

ITEM 1: FINANCIAL STATEMENTS

WEBMETHODS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(in thousands, except share information)

|                                         |                                                                                                                                     |                                            |        |              |         |           |        |          |         | 
|---------------------------------------- | ----------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ------ | ------------ | ------- | --------- | ------ | -------- | ------- | 
|                                         |                                                                                                                                     |                                            |        | DECEMBER 31, |         | MARCH 31,
|                                         |                                                                                                                                     |                                            |        | 2001         |         | 2001     
|                                         |                                                                                                                                     |                                            |        |              |         |          
|                                         |                                                                                                                                     |                                            |        | (UNAUDITED)  |         |           |        |         
|ASSETS                                   |                                                                                                                                     |                                            |        |              |         |           |        |         
|Current assets:                          |                                                                                                                                     |                                            |        |              |         |           |        |         
|                                         | Cash and cash equivalents                                                                                                           |                                            | $      | 70,847       |         |           | $      | 109,713  |        
|                                         | Marketable securities available for sale                                                                                            |                                            |        | 106,205      |         |           |        | 96,676   |        
|                                         | Accounts receivable, net of allowances of
$4,124 and $4,342, respectively                                                           |                                            |        | 42,582       |         |           |        | 58,757   |        
|                                         | Prepaid expenses and other current assets                                                                                           |                                            |        | 6,617        |         |           |        | 9,846    |        
|                                         |                                                                                                                                     |                                            |        |              |         |           |        |         
|                                         |                                                                                                                                     | Total current assets                       |        |              | 226,251 |           |        |          | 274,992 | 
|Marketable securities available for sale |                                                                                                                                     |                                            | 33,248 |              |         |           |       |         
|Property and equipment, net              |                                                                                                                                     |                                            | 18,203 |              |         |           | 17,364 |         
|Goodwill and acquired intangibles, net   |                                                                                                                                     |                                            | 38,634 |              |         |           | 68,535 |         
|Other assets                             |                                                                                                                                     |                                            | 12,270 |              |         |           | 14,397 |         
|                                         |                                                                                                                                     |                                            |        |              |         |           |        |         
|                                         |                                                                                                                                     | Total assets                               |        | $            | 328,606 |           |        | $        | 375,288 | 
|                                         |                                                                                                                                     |                                            |        |              |         |           |        |         
|LIABILITIES AND STOCKHOLDERS EQUITY     |                                                                                                                                     |                                            |        |              |         |           |        |         
|Current liabilities:                     |                                                                                                                                     |                                            |        |              |         |           |        |         
|                                         | Accounts payable                                                                                                                    |                                            | $      | 8,562        |         |           | $      | 8,368    |        
|                                         | Accrued expenses                                                                                                                    |                                            |        | 21,979       |         |           |        | 13,008   |        
|                                         | Accrued salaries and commissions                                                                                                    |                                            |        | 12,898       |         |           |        | 15,536   |        
|                                         | Deferred revenue                                                                                                                    |                                            |        | 36,678       |         |           |        | 45,585   |        
|                                         | Current portion of capital lease obligations                                                                                        |                                            |        | 2,884        |         |           |        | 1,773    |        
|                                         |                                                                                                                                     |                                            |        |              |         |           |        |         
|                                         |                                                                                                                                     | Total current liabilities                  |        |              | 83,001  |           |        |          | 84,270  | 
|                                         |                                                                                                                                     |                                            |        |              |         |           |        |         
|                                         | Capital lease obligations, net of current portion                                                                                   |                                            |        | 2,302        |         |           |        | 2,613    |        
|                                         | Long term deferred revenue                                                                                                          |                                            |        | 22,142       |         |           |        | 22,796   |        
|                                         |                                                                                                                                     |                                            |        |              |         |           |        |         
|                                         |                                                                                                                                     | Total liabilities                          |        |              | 107,445 |           |        |          | 109,679 | 
|                                         |                                                                                                                                     |                                            |        |              |         |           |        |         
|Stockholders equity:                    |                                                                                                                                     |                                            |        |              |         |           |        |         
|                                         | Common stock, $0.01 par value; 500,000,000 shares authorized;
49,806,803 and 48,732,800 shares issued and outstanding, respectively |                                            |        | 498          |         |           |        | 487      |        
|                                         | Additional paid-in capital                                                                                                          |                                            |        | 503,132      |         |           |        | 499,825  |        
|                                         | Deferred stock compensation                                                                                                         |                                            |        | (18,461      | )       |           |        | (38,154  | )      
|                                         | Accumulated deficit                                                                                                                 |                                            |        | (264,120     | )       |           |        | (197,155 | )      
|                                         | Accumulated other comprehensive income                                                                                              |                                            |        | 112          |         |           |        | 606      |        
|                                         |                                                                                                                                     |                                            |        |              |         |           |        |         
|                                         |                                                                                                                                     | Total stockholders equity                 |        |              | 221,161 |           |        |          | 265,609 | 
|                                         |                                                                                                                                     |                                            |        |              |         |           |        |         
|                                         |                                                                                                                                     | Total liabilities and stockholders equity |        | $            | 328,606 |           |        | $        | 375,288 | 
|                                         |                                                                                                                                     |                                            |        |              |         |           |        |         

The accompanying notes are an integral part of these condensed consolidated financial statements.

3



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WEBMETHODS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(in thousands, except share and per share data)
(UNAUDITED)

|                                                                     |                                                   |                                             |                                                         |        |                    |      |                   |        |         |      |            |        |         |      |            |        |         |      |  
|-------------------------------------------------------------------- | ------------------------------------------------- | ------------------------------------------- | ------------------------------------------------------- | ------ | ------------------ | ---- | ----------------- | ------ | ------- | ---- | ---------- | ------ | ------- | ---- | ---------- | ------ | ------- | ---- | -
|                                                                     |                                                   |                                             |                                                         |        | THREE MONTHS ENDED |      | NINE MONTHS ENDED
|                                                                     |                                                   |                                             |                                                         |        | DECEMBER 31,       |      | DECEMBER 31,     
|                                                                     |                                                   |                                             |                                                         |        |                    |      |                  
|                                                                     |                                                   |                                             |                                                         |        | 2001               |      | 2000              |        | 2001    |      | 2000      
|                                                                     |                                                   |                                             |                                                         |        |                    |      |                   |        |         |      |           
|Revenue:                                                             |                                                   |                                             |                                                         |        |                    |      |                   |        |         |      |            |        |         |      |            |       
|                                                                     | License                                           |                                             | $                                                       | 30,434 |                    |      | $                 | 43,425 |         |      | $          | 88,980 |         |      | $          | 99,835 |        
|                                                                     | Professional services                             |                                             |                                                         | 8,852  |                    |      |                   | 8,780  |         |      |            | 27,944 |         |      |            | 24,964 |        
|                                                                     | Maintenance                                       |                                             |                                                         | 9,828  |                    |      |                   | 7,175  |         |      |            | 28,324 |         |      |            | 15,384 |        
|                                                                     |                                                   |                                             |                                                         |        |                    |      |                   |        |         |      |            |        |         |      |            |       
|                                                                     |                                                   | Total revenue                               |                                                         |        | 49,114             |      |                   |        | 59,380  |      |            |        | 145,248 |      |            |        | 140,183 |     
|                                                                     |                                                   |                                             |                                                         |        |                    |      |                   |        |         |      |            |        |         |      |            |       
|Cost of revenue:                                                     |                                                   |                                             |                                                         |        |                    |      |                   |        |         |      |            |        |         |      |            |       
|                                                                     | License                                           |                                             |                                                         | 613    |                    |      |                   | 1,659  |         |      |            | 1,965  |         |      |            | 3,964  |        
|                                                                     | Professional services and maintenance:            |                                             |                                                         |        |                    |      |                   |        |         |      |            |        |         |      |            |        |        
|                                                                     | Stock based compensation                          |                                             |                                                         | 47     |                    |      |                   | 270    |         |      |            | 368    |         |      |            | 1,016  |        
|                                                                     | Other professional services and maintenance costs |                                             |                                                         | 10,050 |                    |      |                   | 12,533 |         |      |            | 32,417 |         |      |            | 33,393 |        
|                                                                     |                                                   |                                             |                                                         |        |                    |      |                   |        |         |      |            |        |         |      |            |       
|                                                                     |                                                   | Total cost of revenue                       |                                                         |        | 10,710             |      |                   |        | 14,462  |      |            |        | 34,750  |      |            |        | 38,373  |     
|                                                                     |                                                   |                                             |                                                         |        |                    |      |                   |        |         |      |            |        |         |      |            |       
|Gross profit                                                         |                                                   |                                             | 38,404                                                  |        |                    |      | 44,918            |        |         |      | 110,498    |        |         |      | 101,810    |       
|                                                                     |                                                   |                                             |                                                         |        |                    |      |                   |        |         |      |            |        |         |      |            |       
|Operating expenses:                                                  |                                                   |                                             |                                                         |        |                    |      |                   |        |         |      |            |        |         |      |            |       
|                                                                     | Sales and marketing:                              |                                             |                                                         |        |                    |      |                   |        |         |      |            |        |         |      |            |        |        
|                                                                     |                                                   | Stock based compensation and warrant charge |                                                         |        | 411                |      |                   |        | 1,060   |      |            |        | 2,077   |      |            |        | 4,093   |     
|                                                                     |                                                   | Other sales and marketing costs             |                                                         |        | 26,063             |      |                   |        | 27,317  |      |            |        | 80,372  |      |            |        | 68,893  |     
|                                                                     | Research and development:                         |                                             |                                                         |        |                    |      |                   |        |         |      |            |        |         |      |            |        |        
|                                                                     |                                                   | Stock based compensation                    |                                                         |        | 1,872              |      |                   |        | 3,007   |      |            |        | 12,077  |      |            |        | 9,396   |     
|                                                                     |                                                   | Other research and development costs        |                                                         |        | 12,219             |      |                   |        | 12,774  |      |            |        | 37,628  |      |            |        | 31,307  |     
|                                                                     | General and administrative:                       |                                             |                                                         |        |                    |      |                   |        |         |      |            |        |         |      |            |        |        
|                                                                     |                                                   | Stock based compensation                    |                                                         |        | 27                 |      |                   |        | 402     |      |            |        | 166     |      |            |        | 1,574   |     
|                                                                     |                                                   | Other general and administrative costs      |                                                         |        | 4,573              |      |                   |        | 5,723   |      |            |        | 15,187  |      |            |        | 14,936  |     
|                                                                     | Restructuring costs                               |                                             |                                                         |       |                    |      |                   |       |         |      |            | 7,243  |         |      |            |       |        
|                                                                     | Acquisition related expenses                      |                                             |                                                         |       |                    |      |                   |       |         |      |            |       |         |      |            | 34,039 |        
|                                                                     | Amortization of goodwill and acquired intangibles |                                             |                                                         | 8,876  |                    |      |                   | 10,604 |         |      |            | 29,901 |         |      |            | 30,888 |        
|                                                                     | In-process research and development               |                                             |                                                         |       |                    |      |                   |       |         |      |            |       |         |      |            | 2,311  |        
|                                                                     |                                                   |                                             |                                                         |        |                    |      |                   |        |         |      |            |        |         |      |            |       
|                                                                     |                                                   | Total operating expenses                    |                                                         |        | 54,041             |      |                   |        | 60,887  |      |            |        | 184,651 |      |            |        | 197,437 |     
|                                                                     |                                                   |                                             |                                                         |        |                    |      |                   |        |         |      |            |        |         |      |            |       
|Operating loss                                                       |                                                   |                                             | (15,637                                                 | )      |                    |      | (15,969           | )      |         |      | (74,153    | )      |         |      | (95,627    | )     
|Interest income, net                                                 |                                                   |                                             | 1,782                                                   |        |                    |      | 3,300             |        |         |      | 7,189      |        |         |      | 10,850     |       
|                                                                     |                                                   |                                             |                                                         |        |                    |      |                   |        |         |      |            |        |         |      |            |       
|                                                                     |                                                   | Net loss                                    |                                                         | $      | (13,855            | )    |                   | $      | (12,669 | )    |            | $      | (66,964 | )    |            | $      | (84,777 | )   
|                                                                     |                                                   |                                             |                                                         |        |                    |      |                   |        |         |      |            |        |         |      |            |       
|Basic and diluted net loss per common share                          |                                                   | $                                           | (.28                                                    | )      |                    | $    | (.27              | )      |         | $    | (1.36      | )      |         | $    | (1.82      | )     
|                                                                     |                                                   |                                             |                                                         |        |                    |      |                   |        |         |      |            |        |         |      |            |       
|Shares used in computing basic and diluted net loss per common share |                                                   |                                             | 49,574,861                                              |        |                    |      | 47,217,615        |        |         |      | 49,255,976 |        |         |      | 46,618,217 |       
|                                                                     |                                                   |                                             |                                                         |        |                    |      |                   |        |         |      |            |        |         |      |            |       
|Comprehensive loss:                                                  |                                                   |                                             |                                                         |        |                    |      |                   |        |         |      |            |        |         |      |            |       
|                                                                     |                                                   | Net loss                                    |                                                         | $      | (13,855            | )    |                   | $      | (12,669 | )    |            | $      | (66,964 | )    |            | $      | (84,777 | )   
|                                                                     |                                                   | Other comprehensive loss:                   |                                                         |        |                    |      |                   |        |         |      |            |        |         |      |            |        |         |     
|                                                                     |                                                   |                                             | Unrealized
(loss) gain on securities
available for sale |        |                    | (373 | )                 |        |         | 560  |            |        |         | (85  | )          |        |         | 907  |  
|                                                                     |                                                   |                                             | Foreign currency cumulative translation
adjustment      |        |                    | (240 | )                 |        |         | (415 | )          |        |         | (409 | )          |        |         | (316 | )
|                                                                     |                                                   |                                             |                                                         |        |                    |      |                   |        |         |      |            |        |         |      |            |       
|                                                                     |                                                   | Total comprehensive loss                    |                                                         | $      | (14,468            | )    |                   | $      | (12,524 | )    |            | $      | (67,458 | )    |            | $      | (84,186 | )   
|                                                                     |                                                   |                                             |                                                         |        |                    |      |                   |        |         |      |            |        |         |      |            |       

The accompanying notes are an integral part of these condensed consolidated financial statements.

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WEBMETHODS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(in thousands)
(UNAUDITED)

|                                                 |                                                                             |   |                                                                               |         |                                |         |         |         |   |         |  
|------------------------------------------------ | --------------------------------------------------------------------------- | - | ----------------------------------------------------------------------------- | ------- | ------------------------------ | ------- | ------- | ------- | - | ------- | -
|                                                 |                                                                             |   |                                                                               |         | NINE MONTHS ENDED DECEMBER 31,
|                                                 |                                                                             |   |                                                                               |         | 2001                           |         | 2000   
|                                                 |                                                                             |   |                                                                               |         |                                |         |        
|Cash flows from operating activities:            |                                                                             |   |                                                                               |         |                                |         |         |        
|                                                 | Net loss                                                                    |   | $                                                                             | (66,964 | )                              |         | $       | (84,777 | )
|                                                 | Adjustments to reconcile net loss to net
cash used in operating activities: |   |                                                                               |         |                                |         |         |         |  
|                                                 |                                                                             |   | Depreciation and
amortization                                                 |         |                                | 6,146   |         |         |   | 2,681   |  
|                                                 |                                                                             |   | Provision for allowance
for doubtful accounts                                 |         |                                | 2,360   |         |         |   | 2,808   |  
|                                                 |                                                                             |   | Loss on disposal of
equipment                                                 |         |                                | 572     |         |         |   | 44      |  
|                                                 |                                                                             |   | Amortization of
deferred stock compensation
and warrant charge                |         |                                | 14,688  |         |         |   | 16,079  |  
|                                                 |                                                                             |   | Amortization of goodwill
and other intangibles                                |         |                                | 29,901  |         |         |   | 30,888  |  
|                                                 |                                                                             |   | Write-off of in-process
research and
development                              |         |                                |        |         |         |   | 2,311   |  
|                                                 |                                                                             |   | Increase (decrease) in cash resulting from changes in
assets and liabilities: |         |                                |         |         |         |   |         |  
|                                                 |                                                                             |   | Accounts receivables                                                          |         |                                | 13,880  |         |         |   | (26,199 | )
|                                                 |                                                                             |   | Prepaid expenses and
other current assets                                     |         |                                | 3,736   |         |         |   | (3,528  | )
|                                                 |                                                                             |   | Other assets                                                                  |         |                                | (378    | )       |         |   | (8,233  | )
|                                                 |                                                                             |   | Accounts payable                                                              |         |                                | 76      |         |         |   | 5,105   |  
|                                                 |                                                                             |   | Accrued expenses                                                              |         |                                | 8,956   |         |         |   | 8,032   |  
|                                                 |                                                                             |   | Accrued ESPP                                                                  |         |                                | (2,497  | )       |         |   |        |  
|                                                 |                                                                             |   | Accrued salaries and
commissions                                              |         |                                | (155    | )       |         |   | 4,357   |  
|                                                 |                                                                             |   | Deferred revenue                                                              |         |                                | (9,603  | )       |         |   | 40,567  |  
|                                                 |                                                                             |   |                                                                               |         |                                |         |         |        
|                                                 |                                                                             |   | Net cash provided by (used in) operating activities                           |         |                                | 718     |         |         |   | (9,865  | )
|                                                 |                                                                             |   |                                                                               |         |                                |         |         |        
|Cash flows from investing activities:            |                                                                             |   |                                                                               |         |                                |         |         |        
|                                                 | Purchases of property and equipment                                         |   |                                                                               | (4,642  | )                              |         |         | (7,794  | )
|                                                 | Acquisition of business net of cash
acquired                                |   |                                                                               |        |                                |         |         | (4,741  | )
|                                                 | Net purchases of marketable securities
available for sale                   |   |                                                                               | (42,860 | )                              |         |         | (60,630 | )
|                                                 | Sale
of investment in private company                                       |   |                                                                               | 2,000   |                                |         |         |        |  
|                                                 |                                                                             |   |                                                                               |         |                                |         |         |        
|                                                 |                                                                             |   | Net cash used by investing activities                                         |         |                                | (45,502 | )       |         |   | (73,165 | )
|                                                 |                                                                             |   |                                                                               |         |                                |         |         |        
|Cash flows from financing activities:            |                                                                             |   |                                                                               |         |                                |         |         |        
|                                                 | Repayments under notes and lines of credit                                  |   |                                                                               |        |                                |         |         | (1,029  | )
|                                                 | Payments on capital leases                                                  |   |                                                                               | (2,167  | )                              |         |         | (516    | )
|                                                 | Proceeds from exercise of
stock options and stock
issued under the ESPP     |   |                                                                               | 8,321   |                                |         |         | 12,951  |  
|                                                 |                                                                             |   |                                                                               |         |                                |         |         |        
|                                                 |                                                                             |   | Net cash provided by financing activities                                     |         |                                | 6,154   |         |         |   | 11,406  |  
|                                                 |                                                                             |   |                                                                               |         |                                |         |         |        
|Effect of the exchange rate on cash              |                                                                             |   | (236                                                                          | )       |                                |         | (222    | )      
|Net decrease in cash and cash equivalents        |                                                                             |   | (38,866                                                                       | )       |                                |         | (71,846 | )      
|Cash and cash equivalents at beginning of period |                                                                             |   | 109,713                                                                       |         |                                |         | 171,716 |        
|                                                 |                                                                             |   |                                                                               |         |                                |         |         |        
|Cash and cash equivalents at end of period       |                                                                             | $ | 70,847                                                                        |         |                                | $       | 99,870  |        
|                                                 |                                                                             |   |                                                                               |         |                                |         |         |        

The accompanying notes are an integral part of these condensed consolidated financial statements.

5



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WEBMETHODS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

1.  BASIS OF PRESENTATION

The accompanying unaudited interim condensed consolidated financial
statements of webMethods, Inc. and its subsidiaries (collectively, the
Company) reflect all adjustments which, in the opinion of management, are
necessary for a fair presentation of the results of the interim periods
presented in conformity with accounting principles generally accepted in the
United States of America for interim financial information. Such
adjustments are of a normal recurring nature. Intercompany balances and
transactions have been eliminated in consolidation.

The results of the interim periods presented are not necessarily
indicative of the results for the year or any current or future period.

2. RECENT ACCOUNTING PRONOUNCEMENTS

In July 2001, the Financial Accounting Standards Board issued SFAS No.
141, Business Combinations and SFAS No. 142, Goodwill and Other Intangible
Assets. SFAS No. 141 requires that all business combinations initiated after
June 30, 2001 be accounted for under the purchase method and addresses the
initial recognition and measurement of goodwill and other intangible assets
acquired in a business combination. SFAS No. 142 addresses the initial
recognition and measurement of intangible assets acquired outside of a business
combination and the accounting for goodwill and other intangible assets
subsequent to their acquisition. SFAS No. 142 provides that intangible assets
with finite useful lives be amortized and that goodwill and intangible assets
with indefinite lives will not be amortized, but will rather be tested at least
annually for impairment. Under the provisions of SFAS No. 142, any impairment
loss identified upon adoption of this standard is recognized as a cumulative
effect of a change in accounting principle. Any impairment loss incurred
subsequent to initial adoption of SFAS No. 142 is recorded as a charge to
current period earnings. In the event the Company acquires goodwill subsequent
to June 30, 2001 it will not be amortized. The Company will adopt SFAS No. 142
in fiscal 2003 and, at that time, will stop amortizing goodwill that resulted
from business combinations completed prior to the adoption of SFAS No. 141.
It is possible that the Company may incur impairment charges upon adoption of SFAS 142 in the future.

In October 2001, the FASB issued SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets, which supercedes SFAS No. 121
Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets
to Be Disposed Of. SFAS No. 144 addresses the accounting and reporting for the
impairment or disposal of long-lived assets, including discontinued operations.
SFAS No. 144 is effective April 1, 2002 for the Company. The Company is
reviewing the provisions of SFAS No. 144 and does not anticipate that the
adoption will have a material impact on the Companys financial condition or
results of operations.

3. SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION

|                                             |                                                               |                                                  |                      |       |                                |   |      |         |        |         |  
|-------------------------------------------- | ------------------------------------------------------------- | ------------------------------------------------ | -------------------- | ----- | ------------------------------ | - | ---- | ------- | ------ | ------- | -
|                                             |                                                               |                                                  |                      |       | NINE MONTHS ENDED DECEMBER 31,
|                                             |                                                               |                                                  |                      |       | 2001                           |   | 2000
|                                             |                                                               |                                                  |                      |       |                                |   |     
|                                             |                                                               |                                                  |                      |       | (in thousands)                
|Cash paid during the period for interest     |                                                               | $                                                | 387                  |       |                                | $ | 129  |        
|                                             |                                                               |                                                  |                      |       |                                |   |      |        
|Non-cash investing and financing activities: |                                                               |                                                  |                      |       |                                |   |      |        
|                                             | Equipment purchased under capital lease                       |                                                  | $                    | 2,911 |                                |   | $    | 2,302   |       
|                                             |                                                               |                                                  |                      |       |                                |   |      |        
|                                             | Change
in net unrealized (loss) gain on marketable
securities |                                                  | $                    | (85)  |                                |   | $    | 1,451   |       
|                                             |                                                               |                                                  |                      |       |                                |   |      |        
|Translink Acquisition:                       |                                                               |                                                  |                      |       |                                |   |      |        
|                                             |                                                               | Fair value of assets acquired                    |                      |       |                               |   |      | $       | 82,209 |        
|Less:                                        |                                                               |                                                  |                      |       |                                |   |      |        
|                                             |                                                               | Liabilities assumed                              |                      |       |                               |   |      |         | (593   | )      
|                                             |                                                               | Common stock issued in connection                |                      |       |                                |   |      |         |        |        
|                                             |                                                               |                                                  | with the acquisition |       |                                |  |      |         |        | (79,678 | )
|                                             |                                                               |                                                  |                      |       |                                |   |      |        
|                                             |                                                               |                                                  |                      |       |                                |  |      |         |        | 1,938   |  
|                                             |                                                               | Write-off of in-process
research and development |                      |       |                               |   |      |         | 2,311  |        
|                                             |                                                               |                                                  |                      |       |                                |   |      |        
|                                             |                                                               | Cash paid for acquisition                        |                      | $     |                               |   |      | $       | 4,249  |        
|                                             |                                                               |                                                  |                      |       |                                |   |      |        
|Premier Acquisition:                         |                                                               |                                                  |                      |       |                                |   |      |        
|                                             | Fair value of assets acquired                                 |                                                  |                      |      |                                |   | $    | 13,947  |       
|Less:                                        |                                                               |                                                  |                      |       |                                |   |      |        
|                                             | Liabilities assumed                                           |                                                  |                      |      |                                |   |      | (462    | )     
|                                             | Common stock issued in connection with the
acquisition        |                                                  |                      |      |                                |   |      | (12,993 | )     
|                                             |                                                               |                                                  |                      |       |                                |   |      |        
|                                             | Cash paid for acquisition                                     |                                                  | $                    |      |                                |   | $    | 492     |       
|                                             |                                                               |                                                  |                      |       |                                |   |      |        

6



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WEBMETHODS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

4. SEGMENT INFORMATION

The Company markets its products in the Americas and in foreign
countries. Information regarding geographic areas are as follows:

|             |       |      |                    |        |                   |      |        |        |  |   |         |         |  |   |         |         | 
|------------ | ----- | ---- | ------------------ | ------ | ----------------- | ---- | ------ | ------ |  | - | ------- | ------- |  | - | ------- | ------- | 
|             |       |      | THREE MONTHS ENDED |        | NINE MONTHS ENDED
|             |       |      | DECEMBER 31,       |        | DECEMBER 31,     
|             |       |      |                    |       
|REVENUES     |       | 2001 |                    | 2000   |                   | 2001 |        | 2000  
|             |       |      |                    |        |                   |      |        |       
|             |       |      | (in thousands)    
|Americas     |       | $    | 35,130             |        |                   | $    | 52,143 |        |  | $ | 105,442 |         |  | $ | 129,447 |        
|Europe       |       |      | 8,734              |        |                   |      | 5,773  |        |  |   | 26,552  |         |  |   | 9,159   |        
|Asia Pacific |       |      | 5,250              |        |                   |      | 1,464  |        |  |   | 13,254  |         |  |   | 1,577   |        
|             |       |      |                    |        |                   |      |        |        |  |   |         |         |  |   |         |        
|             | Total |      | $                  | 49,114 |                   |      | $      | 59,380 |  |   | $       | 145,248 |  |   | $       | 140,183 | 
|             |       |      |                    |        |                   |      |        |        |  |   |         |         |  |   |         |        

|                  |       |                   |   |                |  |                |        |         |  |   |        | 
|----------------- | ----- | ----------------- | - | -------------- |  | -------------- | ------ | ------- |  | - | ------ | 
|                  |       |                   |   |                |  | AS OF          |        | AS OF  
|LONG LIVED ASSETS |       | DECEMBER 31, 2001 |   | MARCH 31, 2001
|                  |       |                   |   |               
|                  |       |                   |   |                |  | (in thousands)
|Americas          |       |                   |   |                |  | $              | 99,599 |         |  | $ | 97,853 | 
|Europe            |       |                   |   |                |  |                | 1,423  |         |  |   | 1,236  | 
|Asia Pacific      |       |                   |   |                |  |                | 1,333  |         |  |   | 1,207  | 
|                  |       |                   |   |                |  |                |        |         |  |   |        | 
|                  | Total |                   | $ | 102,355        |  |                | $      | 100,296 | 
|                  |       |                   |   |                |  |                |        |         |  |   |        | 

5. OPTION EXCHANGE PROGRAM

In April 2001, the Company implemented an option exchange program whereby
employees were offered the opportunity to exchange stock options with
split-adjusted exercise prices of $40.00 and above for new options to purchase
an equal number of shares. New options were granted at least six months
and one day following the date the options were accepted for exchange but no
later than December 31, 2001. The exercise price of the new
options was the
closing market price of the Companys common stock on the Nasdaq Stock Market
on the grant date of the new options. A total of 7,489,000 options were
surrendered for exchange under this program. A total of 6,015,713 new options
were granted on November 16, 2001 with an exercise price of
$14.36 per share and 1,473,287 surrendered options
terminated before that date.

ITEM 2: MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion of the Companys financial condition and results
of operations should be read in conjunction with Managements Discussion and
Analysis of Financial Condition and Results of Operations contained in the
Companys Annual Report on Form 10-K for the year ended March 31, 2001 (File
No. 001-15681). The information contained herein is not a comprehensive
discussion and analysis of the financial condition and results of operations,
but rather updates the disclosures made in the Companys Annual Report on Form
10-K.

Certain information contained herein should be considered forward-looking
information, which is subject to a number of substantial risks and
uncertainties. Statements contained herein that are not statements of
historical fact may be deemed to be forward-looking information. Without
limiting the foregoing, words such as anticipates, believes, could,
estimate, expect, intend, may, might, should, will, and would
and other forms of these words or similar words are intended to identify
forward-looking information. Such forward-looking statements are made only as
of the date of this
report. The Companys actual results could differ materially from those
contained in forward-looking statements. Important factors known to the Company that could cause

7



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such material differences are discussed under the caption
Factors that May Affect Future Operating Results, below, in this report. The
Company undertakes no obligations to publicly update or revise any
forward-looking information, whether as a result of new information, future
events or otherwise.

OVERVIEW

Background

We are a leading provider of integration software and services for
automating business processes across the extended enterprise. Our award winning
integration platform allows customers to achieve a return on
investment by linking business processes, enterprise and legacy applications,
databases and workflows for true Global Business Visibility. By deploying the
webMethods integration platform, companies can reduce costs, create new revenue
opportunities, strengthen relationships with customers, substantially increase
supply chain efficiencies and streamline internal business processes.

webMethods was founded in June 1996. In August 2000, webMethods acquired
Active Software, Inc. (Active) in a transaction which was accounted for as a
pooling of interests. Active was founded in September 1995. We have grown from
94 employees as of March 31, 1998 to 907 employees as of December 31, 2001.

Revenue

We enter into arrangements, which may include the sale of licenses of our
integration software, professional services and maintenance or various
combinations of each element. We recognize revenue based on Statement of
Position (SOP) 97-2, Software Revenue Recognition, as amended, and modified
by SOP 98-9, Modification of SOP 97-2, Software Revenue Recognition, With
Respect to Certain Transactions. SOP 98-9 modified SOP 97-2 by requiring
revenue to be recognized using the residual method if certain conditions are
met. Revenue is recognized based on the residual method when an agreement has
been signed by both parties, the fees are fixed or determinable, collection of
the fees is probable, delivery of the product has occurred and no other
significant obligations remain. Historically we have not experienced
significant returns or offered exchanges of our products.

For multi-element arrangements, each element of the arrangement is
analyzed and we allocate a portion of the total fee under the arrangement to
the undelivered elements, such as professional services, training and
maintenance. Revenue allocated to the undelivered elements is deferred using
vendor-specific objective evidence of fair value of the elements and the
remaining portion of the fee is allocated to the delivered elements (generally
the software license), under the residual method. Vendor specific-objective
evidence of fair value is based on the price the customer is required to pay
when the element is sold separately (i.e., hourly time and material rates
charged for consulting services when sold separately from a software license
and the optional renewal rates charged for maintenance arrangements).

For electronic delivery, the product is considered to have been delivered
when the access code to download the software from our website and activation
key, as applicable, have been provided to the customer. If an element of the
license agreement has not been delivered, revenue for the element is deferred
based on its vendor-specific objective evidence of fair value. If
vendor-specific objective evidence of fair value does not exist, all revenue is
deferred until sufficient objective evidence exists or all elements have been
delivered. If the fee due from the customer is not fixed or determinable,
revenue is recognized as payments become due. If collectibility is not
considered probable, revenue is recognized when the fee is collected.

License Revenue:Amounts allocated to license revenue under the residual
method are recognized at the time of delivery of the software when
vendor-specific objective evidence of fair value exists for the undelivered
elements, if any, and all the other revenue recognition criteria discussed
above have been met.

Professional Services Revenue:Revenue from professional services is
comprised of consulting, implementation services and training. Consulting
services are generally sold on a time-and-materials basis and include services
such as installation and building non-complex interfaces to allow the software
to operate in customized environments. Services are generally separable from
the other elements under the arrangement since the performance of the services
is not essential to the functionality (i.e., the services do not involve
significant production, modification or customization of the software or
building complex interfaces) of any other element of the transaction.

8



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Revenue for professional
services and training is recognized when the services are performed.

Maintenance Revenue:Maintenance revenue consists primarily of fees for
providing when-and-if-available unspecified software upgrades and technical
support over a specified term. Maintenance revenue is recognized on a
straight-line basis over the term of the contract.

Costs of Revenue

Our cost of license revenue primarily includes royalties related to third
parties software embedded in our products or sold to our customers. Our cost
of professional services and maintenance revenue includes compensation and
related expenses for our professional services and technical support
organizations, costs of third-party consultants we use to provide professional
services to customers and an allocation of overhead and recruitment costs.

Operating Expenses

Our operating expenses are primarily classified as sales and marketing, research and
development and general and administrative. Each category includes related
expenses for compensation, employee benefits, professional fees, travel,
communications and allocated facilities, recruitment and overhead costs. Our
sales and marketing expenses also includes expenses which are specific to the
sales and marketing activities, such as commissions, trade shows, public
relations, promotional costs and marketing collateral. Also included in our
operating expenses is the amortization of deferred stock compensation and
deferred warrant charge.

RESULTS OF OPERATIONS

Revenue

Total revenue increased by approximately $5.0 million, or 3.6%, to $145.2
million for the nine months ended December 31, 2001 from $140.2 million for the
nine months ended December 31, 2000. During the three month period ending
December 31, 2001, total revenue decreased by approximately $10.3 million, or 17.3%, to $49.1
million from $59.4 million for the three month period ended December 31, 2000.

License.License revenue decreased by approximately $10.8 million, or
10.9%, to $89.0 million for the nine months ended December 31, 2001 from $99.8
million for the nine months ended December 31, 2000. During the three month
period ended December 31, 2001, total license revenue decreased $13.0 million,
or 29.9%, to $30.4 million from $43.4 million for the three month period ended
December 31, 2000. License revenue as a percentage of total revenue was 61.3%
and 71.2% for the nine months ended December 31, 2001 and 2000, respectively.
License revenue as a percentage of total revenue was 62.0% and 73.1% for the
quarters ended December 31, 2001 and 2000, respectively. The decrease in
license revenue was primarily attributable to a global economic slowdown,
extended sales cycles to prospective customers and a reduction in information
technology spending by our customers and prospects.

Professional Services.Professional services revenue increased by
approximately $2.9 million, or 11.9%, to $27.9 million for the nine months
ended December 31, 2001 from $25.0 million for the nine months ended December
31, 2000. During the three month period ended December 31, 2001, total
professional services revenue increased $100,000 or 0.8%, to $8.9 million
from $8.8 million for the three month period ended December 31, 2000.
Professional services revenue as a percentage of total revenue was 19.2% and
17.8% for the nine months ended December 31, 2001 and 2000, respectively.
Professional services revenue as a percentage of total revenue was 18.0% and
14.8% for the quarters ended December 31, 2001 and 2000, respectively. These
increases in professional services revenue are primarily attributable to the
increased customer base, which has resulted in increased follow-on professional
services and increased customer implementation.

Maintenance.Maintenance revenue increased by
approximately $12.9 million,
or 84.1%, to $28.3 million for the nine months ended December 31, 2001 from
$15.4 million for the nine months ended December 31, 2000. During the three
month period ended December 31, 2001, maintenance revenue increased $2.6
million, or 37.0%, to $9.8 million from $7.2 million for the three month period
ended December 31, 2000. Maintenance revenue as a percentage of total revenue
was 19.5% and 11.0% for the nine months ended December 31, 2001 and 2000,
respectively. Maintenance revenue as a percentage of total revenue was 20.0%
and 12.1% for the quarters ended December 31, 2001 and 2000, respectively.
These increases are due primarily to our increased customer base as described
above and additional license
activity since most license contracts include post contract maintenance and
support which is recognized as revenue on a ratable basis over the term of the
maintenance agreement.



9



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Cost of Revenue

License.Cost of license revenue decreased
by approximately $2.0 million,
or 50.4%, to $2.0 million for the nine months ended December 31, 2001 from $4.0
million for the nine months ended December 31, 2000. During the three month
period ended December 31, 2001, cost of license revenue decreased $1.1
million, or 63.1%, to $613,000 from $1.7 million for the three month
period ended December 31, 2000. Cost of license revenue as a percentage of
total revenue was 1.4% and 2.8% for the nine months ended December 31, 2001
and 2000, respectively. Cost of license revenue as a percentage of total
revenue was 1.2% and 2.8% for the quarters ended December 31, 2001 and 2000,
respectively. This decrease in the cost of license revenue was primarily attributable to a smaller proportion of products sold that incorporate third party technology for
which we pay royalties, and to a lesser extent, a decrease in the amortization
of prepaid third party software licensing fees. Gross profit margin on license
revenue increased to 97.8% for the nine months ended December 31, 2001 compared
to 96.0% for the nine months ended December 31, 2000. The improvement in gross
margin was attributable to a smaller proportion of products sold that
incorporated third party technology for which we pay royalties and a
decrease in the amortization of prepaid third party software
licensing fee.

Professional Services and Maintenance.Cost of professional services and
maintenance, excluding stock based compensation, decreased by approximately
$1.0 million, or 2.9%, to $32.4 million for the nine months ended December 31,
2001 from $33.4 million for the nine months ended December 31, 2000. During the
three month period ended December 31, 2001, cost of professional services and
maintenance excluding stock based compensation, decreased $2.4 million or
19.8%, to $10.1 million from $12.5 million for the three month period ended
December 31, 2000. Cost of professional services and maintenance excluding stock based compensation, as a percentage of total revenue was 22.3%
and 23.8% for the nine months ended December 31, 2001 and 2000, respectively.
Cost of professional services and maintenance excluding stock based
compensation, as a percentage of total revenue was 20.5% and 21.1% for the
quarters ended December 31, 2001 and 2000, respectively. The
decrease in professional services and maintenance costs, excluding
stock based compensation, was primarily attributable to a decrease in the cost of
subcontractor, contractor and travel expenses, and to a lesser extent
a decrease in the cost of professional service and technical support
personnel.
 Gross profit margin on professional services
and maintenance, excluding stock based compensation, increased to 42.4% of
professional services and maintenance revenue for the nine months ended
December 31, 2001 compared to 17.2% for the nine months ended December 31,
2000. The increase in gross profit margin was due primarily to the increase in
maintenance revenue, which has a lower cost, as well as improved utilization of professional services staff
and cost reductions program for professional services.

Gross Profit

Gross profit increased by approximately $8.7 million, or 8.5%, to $110.5
million for the nine months ended December 31, 2001 from $101.8 million for the
nine months ended December 31, 2000. During the three month period ended
December 31, 2001, gross profit decreased $6.5 million, or 14.5%, to $38.4
million from $44.9 million for the three month period ended December 31, 2000.
This decrease in gross profit during the three months ended December 31, 2001
compared to the same period in the prior year was attributable to the decrease
in license revenue during the same time period. The gross profit margin was
76.1% for the nine months ended December 31, 2001, up from 72.6% for the
nine months ended December 31, 2000.

Operating Expenses

Sales and Marketing.Sales and marketing expenses, excluding stock based
compensation and warrant charge, increased by approximately $11.5 million, or 16.7%, to $80.4
million for the nine months ended December 31, 2001 from $68.9 million for the
nine months ended December 31, 2000. During the three month period ended
December 31, 2001, sales and marketing expenses, excluding stock based
compensation and warrant charge, decreased $1.2 million, or 4.6%, to $26.1 million from $27.3
million for the three month period ended December 31, 2000. Sales and
marketing expenses, excluding stock based compensation and warrant charge, as a
percentage of total revenue was 55.3% and 49.1% for the nine months ended
December 31, 2001 and 2000, respectively. Sales and marketing expenses, excluding stock
based compensation and warrant charge, as a percentage of total revenue was 53.1% and 46.0% for
the quarters ended December 31, 2001 and 2000, respectively. The decrease in sales and marketing
expense, excluding stock based compensation and warrant charge, for the three months ended December 31, 2001 as compared to December
31, 2000 was primarily attributable to a decrease in the commission expense and
marketing programs offset by an increase in the number of sales and marketing
employees. The increase in sales and marketing expenses, excluding stock based compensation and warrant charge, for the nine months
ended December 31, 2001 as compared to the nine months ended December 31, 2000
was primarily attributable to an increase in the number of sales and marketing
employees, referral fees paid to partners, and international expansion.

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Research and Development.Research and development expenses, excluding
stock based compensation, increased by approximately $6.3 million, or 20.2%, to
$37.6 million for the nine months ended December 31, 2001 from $31.3 million
for the nine months ended December 31, 2000. During the three month period
ended December 31, 2001, research and development expenses, excluding stock
based compensation, decreased $600,000, or 4.3%, to $12.2 million from $12.8
million for the three month period ended December 31, 2000. Research and
development expenses, excluding stock based compensation, as a percentage of
total revenue, was 25.9% and 22.3% for the nine months ended December 31,
2001 and 2000, respectively. Research and development expenses, excluding stock
based compensation, as a percentage of total revenue was 24.9% and 21.5% for the
quarters ended December 31, 2001 and 2000, respectively. The decrease in
research and development expenses, excluding stock based compensation, for the three months ended December 31, 2001
as compared to the three months ended December 31, 2000 is primarily
attributable to a decrease in the use of outside consultants offset by a slight
increase in the number of research and development
employees. The increase in research and development expenses, excluding stock based compensation, for the nine
months ended December 31, 2001 as compared to the nine months ended December
31, 2000 was primarily attributable to increases in the number of research and development personnel.

General and Administrative.General and administrative expenses, excluding
stock based compensation, increased by approximately $300,000, or 1.7%, to
$15.2 million for the nine months ended December 31, 2001 from $14.9 million
for the nine months ended December 31, 2000. During the three month period
ended December 31, 2001, general and administrative expenses, excluding stock
based compensation, decreased $1.1 million, or 20.1%, to $4.6 million from $5.7
million for the three month period ended December 31, 2000. General and
administrative expense, excluding stock based compensation, as a percentage of
total revenue was 10.5% and 10.7% for the nine months ended December 31, 2001
and 2000, respectively. General and administrative expense, excluding stock
based compensation, as a percentage of total revenue was 9.3% and 9.6% for the
quarters ended December 31, 2001 and 2000, respectively. The increase in
general and administrative expenses, excluding stock based compensation, for
the nine months ended December 31, 2001 compared with the nine months ended
December 31, 2000 was primarily attributable to increases in the number of
accounting, finance and human resources personnel, and implementation of
systems infrastructure. The decrease in general and administrative expenses, excluding stock based compensation, for
the three months ended December 31, 2001 compared with the three months ended
December 31, 2000 is due to efficiencies related to the merger with Active
Software which resulted in consolidation of the two companies administration
functions and a decrease in the provision for allowance for doubtful accounts
and consulting costs for implementation of systems infrastructure offset by an increase in headcount related to
international expansion.

Stock Based Compensation and Warrant Charge.In connection with the grant
of stock options to employees and non-employee directors during the years ended
March 31, 2000 and 1999, we recorded aggregate unearned compensation of $15.5
million, representing the difference between the deemed fair value of our
common stock at the date of grant and the exercise price of such options. As a
result of the acquisitions of companies in February and April 2000 we recorded
a deferred stock compensation charge of $27.9 million related to restricted
stock issued to stockholders of the acquired companies. In connection with the
Active merger, 50% of Actives remaining options vested upon consummation of
the merger which resulted in an acceleration of amortization of deferred stock
compensation.

In March 2001 we entered into an OEM/Reseller agreement with i2
Technologies (i2) and issued a warrant, as amended, to i2 to purchase 710,000
shares of our common stock at an exercise price of $28.70 per share. The fair
value of the original warrant based on the Black-Scholes valuation model was
$23.6 million on the date of issuance which has been recorded as a deferred
warrant charge. As part of the agreement, i2 will pay us OEM fees of
$10.0 million over the term of the agreement which will be recorded as a
reduction to the deferred warrant charge and will not be recorded as revenue.

The deferred stock compensation and deferred warrant charge is presented
as a reduction of stockholders equity and is amortized over the vesting period
of the applicable equity arrangement and is shown by expense category. Of the
total deferred stock compensation and warrant charge recorded for options,
restricted stock and warrants, approximately $14.7 million was amortized during
the nine months ended December 31, 2001, compared to $16.1 million during the
nine months ended December 31, 2000. During the three month period ending
December 31, 2001 and 2000 total deferred stock compensation and warrant charge
recorded for options was $2.4 million and $4.7 million, respectively.

Restructuring Charge.During the second quarter of fiscal 2002, the Company
recorded a restructuring charge of $7.2 million, consisting of $2.5 million for
headcount reductions, $4.0 million for consolidation of facilities, and
$700,000 of other related restructuring charges. These restructuring charges
were a result of our efforts to align the Companys cost structure with changing market
conditions. The plan resulted in headcount reduction of approximately 150
employees. We reduced the number of facilities by closing excess field offices
and consolidating our California facilities into two locations. We used $4.0 million in cash since the restructuring through
December 31, 2001 for restructuring costs, primarily headcount reductions. The remaining restructuring costs of $3.2 million, primarily related to real estate rental obligations, are expected to be incurred over the next 7 years.

11



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Acquisition Related Expenses.In connection with the acquisition of
Active, we expensed $34.0 million in acquisition related expenses during the
nine months ending December 31, 2000.

Amortization of Goodwill and Acquired Intangibles.Amortization of
goodwill and acquired intangibles was $29.9 million for the nine months ended
December 31, 2001 and $30.9 million for the nine months ended December 31,
2000. The estimated useful life of the goodwill and the acquired intangibles is
3 years for trained and acquired assembled workforce, one year for license
agreements, 2 years for non-compete agreements, 3 years for goodwill and 4
years for favorable lease terms. The goodwill and acquired intangibles relate
to the acquisitions of companies in February and April 2000.

In-process research and development.In-process research and development
was expensed upon consummation of an acquisition of technology in April 2000 as acquired
technology had not reached technological feasibility and, in the opinion of
management, has no alternative future use. For the nine months ended December
31, 2000, $2.3 million was expensed related to in-process research and
development.

Interest Income, Net

Interest income, net decreased by approximately $3.7 million, or 33.7%, to
$7.2 million for the nine months ended December 31, 2001 from $10.9 million for
the nine months ended December 31, 2000. During the three month
period ended
December 31, 2001, interest income, net decreased $1.5 million, or 46.0%, to
$1.8 million from $3.3 million for the three month period
ended December 31,
2000. These decreases were primarily attributable to lower interest rates on
corporate paper, bonds and money market funds available in the three and nine
month periods ended December 31, 2001, compared to those in the same periods in
the prior year.

LIQUIDITY AND CAPITAL RESOURCES

We have financed our operations through an initial public offering of our
common stock in February  2000, private sales of
mandatorily redeemable, convertible preferred stock, prior to that time,
and, to a lesser extent, through bank loans and equipment leases. As of
December 31, 2001, we had approximately $70.8 million in cash and cash
equivalents, approximately $106.2 million in short-term marketable securities,
approximately $33.2 million in long-term marketable securities and
approximately $143.3 million in working capital.

Net cash provided by
operating activities was approximately $718,000 for
the nine months ended December 31, 2001, and approximately $9.9 million was
used in operating activities for the nine months ended December 31, 2000. Net
cash provided by operating activities reflects net losses offset by a decrease
in accounts receivable for the nine months ended December 31, 2001.

Net cash used in investing activities was approximately $45.5 million for
the nine months ended December 31, 2001, and approximately $73.2 million for
the nine months ended December 31, 2000. Cash used in investing activities
primarily reflects purchases of marketable securities available for sale in
each period. Capital expenditures were approximately $4.6 million for the nine
months ended December 31, 2001 and $7.8 million for the nine months ended
December 31, 2000. Capital expenditures consisted primarily of purchases of
operating resources to manage operations, including computer hardware and
software, office furniture and equipment and leasehold improvements. Since
inception we have generally funded capital expenditures either through capital
leases, the use of working capital, or bank loans.

Net cash provided by financing activities was approximately $6.2 million for the
nine months ended December 31, 2001, and approximately $11.4 million for the
nine months ended December 31, 2000. These cash flows in the nine months ended
December 31, 2001 primarily reflect net cash proceeds from the exercise of
stock options and issuance of shares of our common stock through the employee
stock purchase plan. As of December 31, 2001, we had a line of credit to borrow
up to a maximum principal amount of $10.0 million with a maturity date of July
10, 2002. Borrowings under this line of credit are limited to 80% of eligible
accounts receivable. Interest is payable on the unpaid principal balance at the
banks prime rate. As of December 31, 2001 and 2000, we had not borrowed against this line of credit. In
connection with the line of credit, we obtained a letter of credit totaling
$750,000 outstanding as of December 31, 2000, which was subsequently reduced to
$475,000 outstanding as of December 31, 2001. This letter of credit expires in
May 2002 and relates to an office lease.

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We believe that our
current cash and investment balances and cash flow from operations
will be sufficient to meet our working capital and capital
expenditure requirements for at least the next twelve months.

FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS

You should consider the following factors when evaluating the statements
of the Company in this report and elsewhere. The Company is subject to risks in
addition to those described below, which, at the date of this report, we may
not be aware of or which we may not consider significant. Those risks may
adversely affect our business, financial condition, results of operations or
our stock price.

Unanticipated fluctuations in our quarterly operating results could affect the price of our stock.

We believe that
quarter-to-quarter or year to year comparisons of our financial results
are not necessarily meaningful indicators of our future operating results and
should not be relied on as an indication of our future performance. If our
quarterly operating results fail to meet the expectations of analysts, the
trading price of shares of our common stock could be negatively affected. Our
quarterly operating results have varied substantially in the past and may vary
substantially in the future depending upon a number of factors, including the
changes in demand for our products and services, economic factors, competitive
pressures, amount and timing of operating costs and changes that we may make in
our business, operations and infrastructure. In addition, uncertainties and
economic after-effects of the recent terrorist acts may impact our quarterly
operating results. We expect to continue devoting resources to our sales and
marketing operations and our research and development activities. Our operating
expenses, which include sales and marketing, research and development and
general and administrative expenses, are based on our expectations of future
revenues and are relatively fixed in the short term. If revenue falls below our
expectations in a quarter and we are not able to quickly reduce our spending in
response, our operating results for that quarter could be harmed. It is
possible that our operating results in the future may be below the expectations
of public market analysts and investors and, as a result, the price of our
common stock may fall. In addition, the stock market, particularly the stock
prices of infrastructure software companies, has been very volatile. This
volatility is often not related to the operating performance of the companies.
From our initial public offering in February 2000 until
February 1, 2002, the
closing price of our common stock on The Nasdaq National Market has ranged from
a high of $308.06 to a low of $6.32. Fluctuations in the price of our common
stock may affect our visibility and credibility in our market.

Growth of our sales may slow down from time to time, causing our quarterly operating results to fluctuate.

Due to customer demand, economic conditions, competitive pressures or
seasonal factors, we may experience a lower growth rate for, or no growth in,
sales of our software products and services. For example, the growth rate for
the sale of our products and services during summer months may be slower than
at other times during year, particularly in European markets. We also may have
slower or no growth due to patterns in the capital budgeting and purchasing
cycles of our current and prospective customers, changes in demand for our
products and services and deferrals of purchases due to uncertainties and
economic after-effects of the recent terrorist acts. These periods of slower or
no growth may lead to fluctuations in our quarterly operating results. In
addition, variations in sales cycles may have an impact on the timing of our
revenue, which in turn could cause our quarterly operating results to
fluctuate. To successfully sell our software and services, we generally must
educate our potential customers regarding their use and benefits, which can
require significant time and resources. Any delay in sales of our products and
services could cause our operating results to vary significantly from quarter
to quarter, which could result in volatility in the stock price of the Company.

We are a young company and have a limited operating history with which to evaluate our respective business and prospects.

We commenced operations in June 1996 and commercially released our first
software product in June 1998. Active Software, with which we completed a
merger in August 2000, was incorporated in September 1995 and commercially
released its first software product in August 1996. We have been operating as a
combined company since August 2000. If we do not generate sufficient cash
resources from our business to fund operations, our growth could be limited
unless we are able to obtain additional capital through public or private
equity or debt financings. If we are unable to grow as planned, our chances of
achieving and maintaining profitability and the anticipated or forecasted
results of operations could be reduced, which, in turn, could have a material adverse effect on
the market

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price of our common
stock. Our products are complex and generally involve significant capital
expenditures by our customers. We do not have a long history of selling our
products and will have to devote substantial resources to educate prospective
customers about the benefits of our software products. Our efforts to educate
potential customers may not result in our products achieving market acceptance.
In addition, many of these prospective customers have made significant
investments in internally developed or custom systems and would incur
significant costs in switching to third party products such as ours.
Furthermore, even if our products are effective, our target customers may not
choose them for technical, cost, support or other reasons. If the market for
our products fails to grow or grows more slowly than we anticipate, our
business could suffer.

Our executive officers and certain key personnel are critical to our business,
and these officers and key personnel may not always remain with us.

Our success depends upon the continued service of our executive officers
and other key employees, and none of these officers or key employees is bound
by an employment agreement for any specific term. If we lose the services of
one or more of our executive officers or key employees, or if one or more of
them decide to join a competitor or otherwise compete directly or indirectly
with us, our business, operating results and financial condition could be
harmed. In particular, Phillip Merrick, our Chairman of the Board and Chief
Executive Officer, David Mitchell, our President and Chief Operating Officer,
R. James Green, our Chief Technology Officer and Executive Vice President, and
Mary Dridi, our Chief Financial Officer and Executive Vice President, would be
particularly difficult to replace. Our future success will also depend in large
part on our ability to attract and retain experienced technical, sales,
marketing and management personnel.

We rely on system integrators and other strategic relationships to implement
and promote our software products and, if these relationships terminate, we may
lose important deals and marketing opportunities.

We have established strategic relationships with enterprise application
software providers, hardware platform and software applications developers,
service providers, system integrators, resellers and other technology leaders.
These relationships expose our software to many potential customers to which we
may not otherwise have access. In addition, these relationships provide us with
insights into new technology and with third-party service providers that our
customers can use for implementation assistance. If our relationships with any
of these organizations were terminated or if we failed to work effectively with
our partners or to grow our base of these types of partners, we might lose
important opportunities, including sales and marketing opportunities, and our
business may suffer. In general, our partners are not required to market or
promote our products and generally are not restricted from working with
competing software companies. Accordingly, our success will depend on their
willingness and ability to devote sufficient resources and efforts to marketing
our software products rather than the products of others. If these
relationships are not successful, we will have to devote substantially more
resources to the distribution, sales and marketing, implementation and support
of our products than we would otherwise, and our efforts may not be as
effective as those of our partners, which would harm our business.

Our software must integrate with applications made by third parties, and, if we
lose access to the programming interfaces for these applications, or if we are
unable to modify our products or develop new products in response to changes in
these applications, our business could suffer.

Our software uses software components called adapters to communicate with
our customers enterprise applications. Our ability to develop these adapters
is largely dependent on our ability to gain access to the application
programming interfaces, or APIs, for the applications, and we may not have
access to necessary APIs in the future. APIs are written and controlled by the
application provider. Accordingly, if an application provider becomes a
competitor by entering the integration market, it could restrict access to its
APIs for competitive reasons. Our business could suffer if we are unable to
gain access to these APIs. Furthermore, we may need to modify our software
products or develop new adapters in the future as new applications or newer
versions of existing applications are introduced. If we fail to continue to
develop adapters or respond to new applications or newer versions of existing
applications, our business could suffer. We rely in part on third parties to
develop adapters necessary for the integration of applications using our
software. We cannot be certain that these companies will continue to develop
these adapters, or that, if they do not continue to do so, that we will be able
to develop these adapters internally in a timely or efficient manner. In
addition, we cannot be certain that adapters developed by third parties will
not contain undetected errors or defects, which could harm our reputation,
result in product liability or decrease the market acceptance of our products.

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Our operating results may decline and our customers may become dissatisfied if
we do not provide professional services or if we are unable to establish and
maintain relationships with third-party implementation providers.

Customers that license our software typically engage our professional
services staff or third party consultants to assist with support, training,
consulting and implementation. We believe that many of our software sales
depend, in part, on our ability to provide our customers with these services
and to attract and educate third-party consultants to provide similar services.
New professional services personnel and service providers require training and
education and take time to reach full productivity, and competition for
qualified personnel and service providers is intense. Our business may be
harmed if we are unable to provide professional services to our customers and
establish and maintain relationships with third-party implementation providers.

Our revenues may decline and we may lose important sales and marketing
opportunities if our relationship with some of our strategic partners changes
or terminates.

We currently have several strategic partners, such as Accenture, SAP AG,
Deloitte Consulting, J. D. Edwards, EDS, Hewlett-Packard, i2 Technologies, KPMG
Consulting and Siebel Systems, that we believe provide us with important sales
and marketing opportunities. In addition, these relationships may include
additional business opportunities, such as the i2 Technologies OEM / Reseller agreement, under which we are the supplier of enterprise application
integration technology that is integrated into certain i2 products. Although the specific
partners or the opportunities they present for us may change from period to
period, we expect that curtailing or terminating our relationship with any of
our key strategic partners, or having them decide to compete against us in
providing integration solutions could result in decreased sales and marketing
opportunities, and reduce our exposure to new customer bases, which could have
a material adverse effect on our business, financial condition and results.

If our customers do not renew their licenses, we may lose a recurring revenue
stream, which could harm our operating results.

Although most enterprise software providers offer perpetual licenses with
a single payment received at the time of the license grant, we offer renewable
term licenses to our customers as another licensing model. If a
significant portion of our customers were to elect not to renew their licenses
for our software or were to seek perpetual licenses in the future, we would
lose a recurring revenue stream that is a factor in our business model, which
could harm our business, operating results and financial condition.

We may not be able to increase market awareness and sales of our software if we
do not maintain our sales and distribution capabilities.

We need to maintain
and further develop our direct and indirect sales and
distribution efforts, both domestically and internationally, in order to
increase market awareness and sales of our software products and the related
services we offer. Our software products require a sophisticated sales effort
targeted at multiple departments within an organization. Competition for
qualified sales and marketing personnel is intense, and we might not be able to
hire and retain adequate numbers of such personnel. Our competitors have
attempted to hire employees away from us, and we expect that they will continue
such attempts in the future. We also plan to expand our relationships with
system integrators, enterprise software vendors and other third-party resellers
to further develop our indirect sales channel. As we continue to develop our
indirect sales channel, we will need to manage potential conflicts between our
direct sales force and third party reselling efforts, which may impact our
business and operating results.

We intend to continue expanding our international sales efforts but do not have
substantial experience in international markets.

We have been, and intend to continue, expanding our international sales
efforts. We have limited experience in marketing, selling and supporting our
software and services abroad. Expansion of our international operations will
require a significant amount of attention from our management and substantial
financial resources. If we are unable to continue expanding our international
operations successfully and in a timely manner, our business and operating
results could be harmed. In addition, doing business internationally involves
additional risks, particularly: the difficulties and costs of staffing and
managing foreign operations; unexpected changes in regulatory requirements,
taxes, trade laws and tariffs; differing intellectual property rights;
differing labor regulations; and changes in a specific countrys or regions
political or economic conditions.

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The integration software and web
services markets are highly competitive, and we may not be able
to compete effectively.

The market for
integration software solutions and technology to implement enterprise
web services is rapidly changing and
intensely competitive. There are a variety of methods available to
integrate
software applications and to implement web services. We expect that competition will remain intense as the number of
entrants and new technologies increases. We do not know if our target markets
will widely adopt and deploy integration products such as our software
products. If our software products and enterprise web services are not widely
adopted by our target markets or if we are not able to compete successfully
against current or future competitors, our business, operating results and
financial condition may be harmed. Our current and potential competitors
include, among others, large software vendors, companies and trading exchanges
that develop their own integration and web service solutions, electronic data
interchange, or EDI, vendors, vendors of proprietary enterprise application
integration (EAI), solutions and application server vendors. We also face
competition from various providers of application integration
solutions technologies to implement enterprise web services and
companies offering products and services that address specific aspects of
application integration or web services integration. Further, we face competition for some aspects of our
product and service offerings from major system integrators, both independently
and in conjunction with corporate in-house information technology departments,
which have traditionally been the prevalent resource for application
integration. In addition, our customers and companies with whom we currently
have strategic relationships may become competitors in the future. Some of our
competitors or potential competitors may have more experience developing
integration software or implementing web services, larger technical staffs, larger customer bases, more
established distribution channels, greater brand recognition and greater
financial, marketing and other resources than we do. Our competitors may be
able to develop products and services that are superior to our software and
services, that achieve greater customer acceptance or that have significantly
improved functionality or performance as compared to our existing software and
future products and services. In addition, negotiating and maintaining
favorable customer and strategic relationships is critical to our business. Our
competitors may be able to negotiate strategic relationships on more favorable
terms than we are able to negotiate. Many of our competitors may also have
well-established relationships with our existing and prospective customers.
Increased competition may result in reduced margins, loss of sales or decreased
market share, which in turn could harm our business, operating results and
financial condition.

If we experience delays in developing our software, or if our software contains
defects, we could lose customers and revenue.

We expect that the
rapid evolution of integration software and standards and web
services technologies and protocols,
as well as general technology trends such as changes in or introductions of
operating systems, will require us to adapt our software products to remain
competitive. Our products could become obsolete and unmarketable if we are
unable to adapt to new technologies or standards. Software as complex as ours
often contains known and undetected errors or performance problems. Many
serious defects are frequently found during the period immediately following
introduction of new software or enhancements to existing software. Internal
quality assurance testing and customer testing may reveal product performance
issues or desirable feature enhancements that could lead us to postpone the
release of new versions of our software. The reallocation of resources
associated with any postponement could cause delays in the development and
release of future enhancements to our currently available software. Although we
attempt to resolve all errors that we believe would be considered serious by
our customers, our software is not error-free. Undetected errors or performance
problems may be discovered in the future, and known errors that we consider
minor may be considered serious by our customers. This could result in lost
revenue or delays in customer deployment and would be detrimental to our
reputation, which could harm our business, operating results and financial
condition. If our software products experience performance problems, we may
have to increase our product development costs and divert our product
development resources to address the problems. In addition, because our
customers depend on our software for their critical systems and business
functions, any interruptions could cause our customers to initiate product
liability suits against us.

We may not be able to manage our future development and growth successfully.

Our ability to successfully offer software and services and implement our
business plan in a rapidly evolving market requires an effective planning and
management process. Our development could be limited if we or our partners are
unable to provide to our customers in a timely manner the integration solutions
they desire or the implementation services sometimes required for the
successful installation and use of our products. In addition, our management
team may not be able to achieve the rapid execution necessary to fully exploit
the market for our products and services. Our total revenues have grown to
approximately $202.0 million for the
year ended March 31, 2001, from $60.1 million for the year ended March 31,
2000. The number of people we employ has grown substantially and will
continue to grow.

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As of March 31, 2000, we had a total of 522 employees. As of
December 31, 2001, we had a total of 907 employees. Future development,
execution and growth could be expensive and may strain our managerial and other
resources. To manage future development and growth effectively, we must
maintain and enhance our financial and accounting systems and controls,
integrate new personnel and manage expanded operations and our relationships
with our customers, suppliers and partners. If we do not manage our future
development and growth properly, it could harm our business, operating results
and financial condition.

We may still face challenges that may prevent us from successfully completing
the integration of our recent acquisitions.

The integration of acquired businesses into our existing business is a
complex, time-consuming and expensive process. We have acquired several
businesses after our public offering in February 2000 and still face certain challenges that, if not met
successfully, may prevent us from integrating these businesses into our Company. We may still encounter difficulties, costs
and delays involved in integrating operations, including: the inability to
market successfully an integrated line of products and services to our
customers; the inability to retain key employees over a long period of time;
and the diversion of managements attention and financial resources from other
ongoing business concerns. If we do not fully the integrate these acquired businesses into our company, or if we are unable to achieve
the perceived benefits of these acquisitions as rapidly as, or to the extent,
anticipated by financial or industry analysts, the market price of our common
stock may decline.

Any future acquisitions of companies or technologies may result in disruptions
to our business or the distraction of our management.

We may acquire or make investments in other complementary businesses and
technologies in the future. We may not be able to identify other future
suitable acquisition or investment candidates, and even if we identify suitable
candidates, may not be able to make these acquisitions or investments on
commercially acceptable terms, or at all. If we acquire or invest in other
companies, we may not be able to realize the benefits we expected to achieve at
the time of entering into the transaction. In any future acquisitions, we will
likely face many or all of the risks inherent in integrating two corporate
cultures, product lines, operations and businesses. Further, we may have to
incur debt or issue equity securities to pay for any future acquisitions or
investments, the issuance of which could be dilutive to our existing
stockholders.

We may not have sufficient resources available to us in the future to take
advantage of certain opportunities.

In the future, we may not have sufficient resources available to us to
take advantage of growth, product development or marketing opportunities. We
may need to raise additional funds in the future through public or private debt
or equity financings in order to: take advantage of opportunities, including
more rapid international expansion or acquisitions of complementary businesses
or technologies; develop new products or services; or respond to competitive
pressures. Additional financing needed by us in the future may not be available
on terms favorable to us, if at all. If adequate funds are not available, not
available on a timely basis, or are not available on acceptable terms, we may
not be able to take advantage of opportunities, develop new products or
services or otherwise respond to unanticipated competitive pressures. In such
case, our business, operating results and financial condition could be harmed.

If we are unable to protect our intellectual property, we may lose a valuable
asset, experience reduced market share, or incur costly litigation to protect
our rights.

Our success depends, in part, upon our proprietary technology and other
intellectual property rights. To date, we have relied primarily on a
combination of copyright, trade secret, trademark and patent laws, and
nondisclosure and other contractual restrictions on copying and distribution to
protect our proprietary technology. We have pending patent applications for
technology related to our software, but we cannot assure you that these
applications will be successful. A small number of our agreements with
customers and system integrators contain provisions regarding the rights of
third parties to obtain the source code for our software, which may limit our
ability to protect our intellectual property rights in the future. Despite our
efforts to protect our proprietary rights, unauthorized parties may copy
aspects of our products and obtain and use information that we regard as
proprietary. In addition, other parties may breach confidentiality agreements
or other protective contracts we have entered into, and we may not be able to
enforce our rights in the event of these breaches. Furthermore, we expect to
continue increasing our international operations in the future, and the laws of
certain foreign countries may not protect our intellectual property rights to
the same extent as do the laws of the United States.

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Our means of protecting our
intellectual property rights in the United States or abroad may not be adequate
to fully protect our intellectual property rights. Litigation to enforce our
intellectual property rights or protect our trade secrets could result in
substantial costs and may not be successful. Any inability to protect our
intellectual property rights could seriously harm our business, operating
results and financial condition.

Third party claims that we infringe upon their intellectual property rights
could be costly to defend or settle.

Litigation regarding intellectual property rights is common in the
software industry. We expect that integration technologies and software
products and services may be increasingly subject to third-party infringement
claims as the number of competitors in our industry segment grows and the
functionality of products in different industry segments overlaps. We may from
time to time encounter disputes over rights and obligations concerning
intellectual property. Although we believe that our intellectual property
rights are sufficient to allow us to market our software without incurring
liability to third parties, third parties may bring claims of infringement
against us. Such claims may be with or without merit. Any litigation to defend
against claims of infringement or invalidity could result in substantial costs
and diversion of resources. Furthermore, a party making such a claim could
secure a judgment that requires us to pay substantial damages. A judgment could
also include an injunction or other court order that could prevent us from
selling our software. Our business, operating results and financial condition
could be harmed if any of these events occurred. Furthermore, former employers
of our current and future employees may assert that our employees have
improperly disclosed confidential or proprietary information to us. In
addition, we have agreed, and may agree in the future, to indemnify certain of
our customers against claims that our software infringes upon the intellectual
property rights of others. We could incur substantial costs in defending
ourself and our customers against infringement claims. In the event of a claim
of infringement, we, as well as our customers, may be required to obtain one or
more licenses from third parties. We, or our customers, may be unable to obtain
necessary licenses from third parties at a reasonable cost, or at all. Defense
of any lawsuit or failure to obtain any such required licenses could harm our
business, operating results and financial condition.

We recently adopted a shareholder rights
plan which may have anti-takeover effects.

Our Board of
Directors adopted a shareholder rights plan and declared a dividend
distribution of one right for each outstanding share of Company
common stock, payable to stockholders of record at the close of
business on October 18, 2001. Each right, when exercisable, entitles
the registered holder to purchase from the Company a fraction of a
share of Series A Junior Participating Preferred Stock at a specified
purchase price, subject to adjustment. The rights plan may have the
anti-takeover effect of causing substantial dilution to a person or
group that attempts to acquire the Company on terms not approved by
our Board of Directors. The existence of the rights plan could limit
the price that certain investors might be willing to pay in the
future for shares of Company common stock and could discourage, delay
or prevent a merger or acquisition of the Company that stockholders
may consider favorable.

Because our products could interfere with the operations of our customers
other software applications, we may be subject to potential product liability
and warranty claims by these customers, which may be time consuming, costly to
defend and may not be adequately covered by insurance.

Our software is integrated with our customers networks and software
applications and is often used for mission critical applications. Errors,
defects or other performance problems could result in financial or other
damages to our customers. Customers could seek damages for losses from us,
which, if successful, could have a material adverse effect on our business,
operating results or financial condition. In addition, the failure of our
products to perform to customer expectations could give rise to warranty
claims. Although our license agreements typically contain provisions designed
to limit our exposure to product liability claims, existing or future laws or
unfavorable judicial decisions could negate these limitation of liability
provisions. We have not experienced any product liability claims to date.
However, a product liability claim brought against us, even if not successful,
could be time consuming and costly to defend and could harm our reputation. In
addition, although we carry general liability insurance, our current insurance
coverage would likely be insufficient to protect us from all liability that may
be imposed under these types of claims.

Because our products incorporate technology licensed from third parties, the
loss of our right to use this licensed technology could harm our business.

We license technology that is incorporated into our products from third
parties. Any significant interruption in the supply or support of any licensed
software could adversely affect our sales, unless and until we can replace the
functionality provided by this licensed software. Because our products
incorporate software developed and maintained by third parties, we depend on
these third parties to deliver and support reliable products, enhance our
current products, develop new products on a timely and cost-effective basis and
respond to emerging industry standards and other technological changes. The
failure of these third parties to meet these criteria could harm our business.

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Because market participants in some markets have adopted industry specific
technologies, we may need to expend significant resources in order to address
specific markets.

Our strategy is to continue developing our integration software to be
broadly applicable to many industries. However, in some markets, market
participants have adopted core technologies that are specific to their markets.
For example, many companies in the healthcare and financial services industries
have adopted industry-specific protocols for the interchange of information. In
order to successfully sell our products to companies in these markets, we may
need to expand or enhance our products to adapt to these industry-specific
technologies, which could be costly and require the diversion of engineering
resources.

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In July 2001, the Financial Accounting Standards Board issued SFAS No.
141, Business Combinations and SFAS No. 142, Goodwill and Other Intangible
Assets. SFAS No. 141 requires that all business combinations initiated after
June 30, 2001 be accounted for under the purchase method and addresses the
initial recognition and measurement of goodwill and other intangible assets
acquired in a business combination. SFAS No. 142 addresses the initial
recognition and measurement of intangible assets acquired outside of a business
combination and the accounting for goodwill and other intangible assets
subsequent to their acquisition. SFAS No. 142 provides that intangible assets
with finite useful lives be amortized and that goodwill and intangible assets
with indefinite lives will not be amortized, but will rather be tested at least
annually for impairment. Under the provisions of SFAS No. 142, any impairment
loss identified upon adoption of this standard is recognized as a cumulative
effect of a change in accounting principle. Any impairment loss incurred
subsequent to initial adoption of SFAS No. 142 is recorded as a charge to
current period earnings. In the event the Company acquires goodwill subsequent
to June 30, 2001 it will not be amortized. The Company will adopt SFAS No. 142
in fiscal in 2003 and, at that time, will stop amortizing goodwill that
resulted from business combinations completed prior to the adoption of SFAS No.
141. It is possible the Company may incur impairment charges upon the adoption of SFAS 142 in the future.

In October 2001, the FASB issued SFAS No. 144, Accounting for the
Impairment or Disposal of Long-Lived Assets, which supersedes SFAS No. 121
Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets
to Be Disposed Of. SFAS No. 144 addresses the accounting and reporting for the
impairment or disposal of long-lived assets, including discontinued operations.
SFAS No. 144 is effective April 1, 2002 for the Company. The Company is
reviewing the provisions of SFAS No. 144 and does not anticipate that the
adoption will have a material impact on the Companys financial condition or
results of operations.

ITEM 3. QUANTATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

We are exposed to a variety of risks, including changes in interest rates
affecting the return on our investments and foreign currency fluctuations. We
have established policies and procedures to manage our exposure to fluctuations
in interest rates and foreign currency exchange rates.

Interest rate risk.We maintain our funds in money market and certificate of
deposit accounts at financial institutions. Our exposure to market risk due to
fluctuations in interest rates relates primarily to our interest earnings on
our cash deposits. These securities are subject to interest rate risk in as
much as their fair value may fall if market interest rates increase. If market
interest rates were to increase immediately and uniformly by 10% from the
levels prevailing as of December 31, 2001, the fair value of the portfolio
would not decline by a material amount. We do not use derivative financial
instruments to mitigate risks. However, we do have an investment policy that
would allow us to invest in short-term and long-term investments such as money
market instruments and corporate debt securities. Our policy attempts to reduce
such risks by typically limiting the maturity date of such securities to no
more than twenty-four months with a maximum average maturity to our whole
portfolio of such investments at twelve months, placing our investments with
high credit quality issuers and limiting the amount of credit exposure with any
one issuer.

Foreign currency exchange rate risk.Our exposure to market risk due to
fluctuations in foreign currency exchange rates relates primarily to the
intercompany balances with our subsidiaries located in Australia, England,
France, Germany, Japan, the Netherlands, Singapore, Hong Kong and Korea.
Although we transact business in various foreign countries, settlement amounts
are usually based on U.S. currency. Transaction gains or losses have not been
significant in the past, and there is no hedging activity on foreign
currencies. We would not experience a material foreign exchange loss based on a
hypothetical 10% adverse change in the price of the euro, Great Britain pound,
French franc, deutschmark, guilder, Singapore dollar, Australian dollar, yen,
the Hong Kong dollar or the won against the U.S. dollar. Consequently, we do
not expect that a reduction in the value of such accounts denominated in
foreign currencies resulting from even a sudden or significant fluctuation in foreign exchange rates would have a
direct material impact on our financial position, results of operations or cash
flows.

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Notwithstanding the foregoing analysis of the direct effects of interest rate
and foreign currency exchange rate fluctuations on the value of certain of our
investments and accounts, the indirect effects of fluctuations in foreign
currency could have a material adverse effect on our business, financial
condition and results of operations. For example, international demand for our
products is affected by foreign currency exchange rates. In addition, interest
rate fluctuations may affect the buying patterns of our customers. Furthermore,
interest rate and currency exchange rate fluctuations have broad influence on
the general condition of the U.S. foreign and global economics, which could
materially adversely affect our business, financial condition results of
operations and cash flows.

PART II

OTHER INFORMATION

ITEM 1.  LEGAL PROCEEDINGS

On November 30, 2001,
a purported class action lawsuit was filed in the Southern District
of New York naming the Company, several of its executive officers at
the time of our initial public offering and the managing underwriters
of our initial public offering as defendants. The complaint alleges
that the Companys initial public offering registration
statement and final prospectus contained material misrepresentations
and omissions related in part to certain commissions allegedly
solicited and received by the underwriters, and tie-in arrangements
allegedly demanded by the underwriters, in connection with their
allocation of shares in our initial public offering. The complaint
seeks unspecified damages on behalf of a purported class of
purchasers of common stock between February 10, 2000 and December 6,
2000. This case  is at a very early stage, and the Company has not
formally responded to the allegations. However, management believes that the
claims against the Company and its officers are without merit, and we
intend to defend against the complaint vigorously.

From time to time, the Company is involved in other disputes and
litigation in the normal course of business.

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

On February 10, 2000, in connection with our initial public offering, a
Registration Statement on Form S-1 (No. 333-91309) was declared effective by
the Securities and Exchange Commission, pursuant to which 4,715,000 share of
our common stock were offered and sold for our account at a price of $35.00 per
share, generating aggregate gross proceeds of $165 million for the account of
the Company. The managing underwriters were Morgan Stanley Dean Witter, Merrill
Lynch & Co., RBC Dain Rauscher Inc. and Freidman Billings Ramsey. After
deduction approximately $11.6 million in underwriting discounts and $1.5
million in other related expenses, the net proceeds of the offering were
approximately $151.9 million. As of December 31, 2001, $151.9 million of the
net proceeds were invested in cash and cash equivalents, short-term and
long-term investments. We intend to use such proceeds for capital expenditures
and for general corporate purposes, including working capital to fund
anticipated operating losses.

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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.

(a)  Exhibits.

|        |  |                                                                                                                                       
|------- |  | --------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |  |                                                                                                                                       
|Number  |  | Description                                                                                                                           
|        |  |                                                                                                                                       
|       
|2.1(1)  |  | Agreement and Plan of Merger dated as of May 20, 2000, by
and among webMethods, Inc., Wolf Acquisition, Inc. and
Active Software, Inc.
|3.1(2)  |  | Fifth Amended and Restated Certificate of Incorporation of
webMethods, Inc., as amended                                               
|3.2(3)  |  | Amended and Restated Bylaws of webMethods, Inc.                                                                                       
|4.1(3)  |  | Specimen certificate for shares of webMethods Common Stock                                                                            
|4.2(4)  |  | Rights Agreement dated as of October 18, 2001 between
webMethods, Inc. and American Stock Transfer & Trust
Company.                   
|10.1(3) |  | Second Amended and Restated Investor Rights Agreement                                                                                 
|10.2(5) |  | webMethods, Inc. Amended and Restated Stock Option Plan                                                                               
|10.3(3) |  | Employee Stock Purchase Plan                                                                                                          
|10.4(3) |  | Indemnification Agreement entered into between
webMethods, Inc. and each of its directors                                             



---

|(1) |  | Incorporated by reference to webMethods Registration Statement on Form
S-4, as amended (File No. 333-39572).                                                                                      
|--- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(2) |  | Incorporated by reference to webMethods Annual Report on Form 10-K for
the year ended March 31, 2001 (File No. 001-15681) and webMethods
Registration Statement on Form 8-A (File No. 001-15681).

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|(3) |  | Incorporated by reference to webMethods Registration Statement on Form
S-1, as amended (File No. 333-91309).                                               
|--- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------
|   
|(4) |  | Incorporated by reference to webMethods Registration Statement on Form
8-A (File No. 001-15681).                                                           
|   
|(5) |  | Incorporated by reference to webMethods definitive Proxy Statements filed
with the Securities and Exchange Commission on July 27, 2001 (File No.
001-15681)

(b)  Reports on Form 8-K.webMethods, Inc. filed the following report on
Form 8-K since the beginning of its fiscal quarter on October 1, 2001:

|                 |  |          |   |               |  |                                                                                                 |  |  |  | 
|---------------- |  | -------- | - | ------------- |  | ----------------------------------------------------------------------------------------------- |  |  |  | 
|Date of Report   |  | Item No. |   | Item Reported |  |                                                                                                 |  | 
|                 |  |          |   |               |  |                                                                                                 |  | 
|October 18, 2001 |  |          | 5 |               |  | Announcement that Board of Directors
of webMethods, Inc. had adopted a shareholder rights plan.

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SIGNATURES

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.

|                        |  |                              
|----------------------- |  | -----------------------------
|                        |  | WEBMETHODS, INC              
|Date: February 13, 2002 |  |                              
|                        |  | By: /s/ PHILLIP MERRICK      
|                        |  |                              
|                        |  | Phillip Merrick              
|                        |  | Chairman of the Board and    
|                        |  | Chief Executive Officer      
|                       
|Date: February 13, 2002 |  |                              
|                        |  | By: /s/ MARY DRIDI           
|                        |  |                              
|                        |  | Mary Dridi                   
|                        |  | Chief Financial Officer      
|                        |  | (Principal Financial Officer)

23