##### 









UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549


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 MONTHS ENDED
    SEPTEMBER 30, 2004
| 
|o | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
    SECURITIES EXCHANGE ACT OF 1934                                                       

Commission File Number


1-15681





webMethods, Inc.


(Exact name of Registrant as Specified in its Charter)


|                                                                             |  |                                                   
|---------------------------------------------------------------------------- |  | --------------------------------------------------
|Delaware(State or Other Jurisdiction
    of Incorporation or Organization)   |  | 54-1807654(I.R.S. Employer
    Identification No.)
|                                                                            
|3930 Pender Drive, Fairfax, Virginia(Address of Principal Executive Offices) |  | 22030(Zip Code)                                   

(703) 460-2500











x o


x o












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##### 



WEBMETHODS, INC.


QUARTERLY REPORT ON FORM 10-Q


FOR THE THREE MONTHS ENDED SEPTEMBER 30, 2004


TABLE OF CONTENTS


|        |  |                                                                                                                                                     |  |   
|------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------- |  | --
|Part I  |  | Financial Information                                                                                                                               |  |   
|Item 1  |  | Financial Statements                                                                                                                                |  | 1 
|        |  | Condensed Consolidated Financial Statements                                                                                                         |  | 1 
|        |  | Condensed Consolidated Balance Sheets (unaudited) as
    of September 30, 2004 and March 31, 2004                                                   |  | 1 
|        |  | Condensed Consolidated Statements of Operations and
    Comprehensive Loss (unaudited)  Three and six months
    ended September 30, 2004 and 2003 |  | 2 
|        |  | Condensed Consolidated Statements of Cash Flows
    (unaudited)  Six months ended September 30, 2004 and
    2003                                  |  | 3 
|        |  | Notes to Condensed Consolidated Financial Statements
    (unaudited)                                                                                |  | 4 
|Item 2  |  | Managements Discussion and Analysis of Financial Condition
    and Results of Operations                                                           |  | 10
|Item 3  |  | Quantitative and Qualitative Disclosures About Market Risk                                                                                          |  | 28
|Item 4  |  | Controls and Procedures                                                                                                                             |  | 29
|Part II |  | Other Information                                                                                                                                   |  |   
|Item 1  |  | Legal Proceedings                                                                                                                                   |  | 31
|Item 4  |  | Submission of Matters to a Vote of Security Holders                                                                                                 |  | 31
|Item 6  |  | Exhibits                                                                                                                                            |  | 32





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##### 



PART I


FINANCIAL INFORMATION


ITEM 1:     FINANCIAL
STATEMENTS


WEBMETHODS, INC.


CONDENSED CONSOLIDATED BALANCE SHEETS


(Unaudited)


|                                         |                                                                                                                           |                           |                                            |             |           |         |        |          |        |         | 
|---------------------------------------- | ------------------------------------------------------------------------------------------------------------------------- | ------------------------- | ------------------------------------------ | ----------- | --------- | ------- | ------ | -------- | ------ | ------- | 
|                                         |                                                                                                                           | September 30,             |                                            |             | March 31, |        
|                                         |                                                                                                                           | 2004                      |                                            |             | 2004      |        
|                                         |                                                                                                                           |                           |                                            |             |           |        
|                                         |                                                                                                                           |                           |                                            | As restated |          
|                                         |                                                                                                                           | (In thousands)            |                                           
|ASSETS                                   |                                                                                                                           |                           |                                            |             |           |         |        |         
|Current assets:                          |                                                                                                                           |                           |                                            |             |           |         |        |         
|                                         | Cash and cash equivalents                                                                                                 |                           | $                                          | 63,582      |           |         | $      | 75,462   |       
|                                         | Marketable securities available for sale                                                                                  |                           |                                            | 72,926      |           |         |        | 44,328   |       
|                                         | Accounts receivable, net of allowance of $1,809 and $2,103                                                                |                           |                                            | 45,208      |           |         |        | 46,741   |       
|                                         | Prepaid expenses and other current assets                                                                                 |                           |                                            | 7,797       |           |         |        | 6,235    |       
|                                         |                                                                                                                           |                           |                                            |             |           |        
|                                         |                                                                                                                           |                           | Total current assets                       |             |           | 189,513 |        |          |        | 172,766 | 
|Marketable securities available for sale |                                                                                                                           |                           | 6,366                                      |             |           |         | 36,157 |         
|Property and equipment, net              |                                                                                                                           |                           | 7,448                                      |             |           |         | 8,106  |         
|Goodwill                                 |                                                                                                                           |                           | 46,704                                     |             |           |         | 46,704 |         
|Intangible assets, net                   |                                                                                                                           |                           | 9,589                                      |             |           |         | 10,787 |         
|Other assets                             |                                                                                                                           |                           | 7,028                                      |             |           |         | 9,130  |         
|                                         |                                                                                                                           |                           |                                            |             |           |        
|                                         |                                                                                                                           |                           | Total assets                               |             | $         | 266,648 |        |          | $      | 283,650 | 
|                                         |                                                                                                                           |                           |                                            |             |           |        
|                                        
|LIABILITIES AND STOCKHOLDERS EQUITY     |                                                                                                                           |                           |                                            |             |           |         |        |         
|Current liabilities:                     |                                                                                                                           |                           |                                            |             |           |         |        |         
|                                         | Accounts payable                                                                                                          |                           | $                                          | 8,968       |           |         | $      | 10,919   |       
|                                         | Accrued expenses                                                                                                          |                           |                                            | 15,345      |           |         |        | 17,084   |       
|                                         | Accrued salaries and commissions                                                                                          |                           |                                            | 11,647      |           |         |        | 11,560   |       
|                                         | Deferred revenue                                                                                                          |                           |                                            | 37,387      |           |         |        | 36,018   |       
|                                         | Short-term borrowings                                                                                                     |                           |                                            | 1,693       |           |         |        | 2,584    |       
|                                         | Current portion of capital lease obligations                                                                              |                           |                                            | 583         |           |         |        | 909      |       
|                                         |                                                                                                                           |                           |                                            |             |           |        
|                                         |                                                                                                                           | Total current liabilities |                                            |             | 75,623    |         |        |          | 79,074 |        
|                                         | Capital lease obligations, net of current portion                                                                         |                           |                                            | 152         |           |         |        | 373      |       
|                                         | Other long term liabilities                                                                                               |                           |                                            | 799         |           |         |        | 1,000    |       
|                                         | Long term deferred revenue                                                                                                |                           |                                            | 5,269       |           |         |        | 6,066    |       
|                                         |                                                                                                                           |                           |                                            |             |           |        
|                                         |                                                                                                                           |                           | Total liabilities                          |             |           | 81,843  |        |          |        | 86,513  | 
|                                         |                                                                                                                           |                           |                                            |             |           |        
|Commitments and contingencies            |                                                                                                                           |                           |                                            |             |           |         |        |         
|Stockholders equity:                    |                                                                                                                           |                           |                                            |             |           |         |        |         
|                                         | Common stock, $0.01 par value; 500,000,000 shares authorized;
    53,101,682 and 52,746,722 shares issued and outstanding |                           |                                            | 531         |           |         |        | 527      |       
|                                         | Additional paid-in capital                                                                                                |                           |                                            | 523,333     |           |         |        | 521,455  |       
|                                         | Deferred stock compensation and warrant charge                                                                            |                           |                                            | (4,302      | )         |         |        | (5,625   | )     
|                                         | Accumulated deficit                                                                                                       |                           |                                            | (336,416    | )         |         |        | (321,473 | )     
|                                         | Accumulated other comprehensive income                                                                                    |                           |                                            | 1,659       |           |         |        | 2,253    |       
|                                         |                                                                                                                           |                           |                                            |             |           |        
|                                         |                                                                                                                           |                           | Total stockholders equity                 |             |           | 184,805 |        |          |        | 197,137 | 
|                                         |                                                                                                                           |                           |                                            |             |           |        
|                                         |                                                                                                                           |                           | Total liabilities and stockholders equity |             | $         | 266,648 |        |          | $      | 283,650 | 
|                                         |                                                                                                                           |                           |                                            |             |           |        

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


1



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##### 



WEBMETHODS, INC.


CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND
COMPREHENSIVE LOSS


(Unaudited)


|                                                              |                                        |                                                           |                          |             |                  |        |            |        |             |        |            |         |        |         |            |         |        |         |  
|------------------------------------------------------------- | -------------------------------------- | --------------------------------------------------------- | ------------------------ | ----------- | ---------------- | ------ | ---------- | ------ | ----------- | ------ | ---------- | ------- | ------ | ------- | ---------- | ------- | ------ | ------- | -
|                                                              |                                        | Three Months Ended                                        |                          |             | Six Months Ended |       
|                                                              |                                        | September 30,                                             |                          |             | September 30,    |       
|                                                              |                                        |                                                           |                          |             |                  |       
|                                                              |                                        | 2004                                                      |                          |             | 2003             |        |            | 2004   |             |        | 2003       |        
|                                                              |                                        |                                                           |                          |             |                  |        |            |        |             |        |            |        
|                                                              |                                        |                                                           |                          | As restated |                  |        |            |        | As restated |       
|                                                              |                                        | (In thousands, except per share amounts)                  |                         
|Revenue:                                                      |                                        |                                                           |                          |             |                  |        |            |        |             |        |            |         |        |         |            |        
|                                                              | License                                |                                                           | $                        | 23,851      |                  |        | $          | 20,850 |             |        | $          | 38,657  |        |         | $          | 42,024  |       
|                                                              | Professional services                  |                                                           |                          | 12,077      |                  |        |            | 10,460 |             |        |            | 24,601  |        |         |            | 19,333  |       
|                                                              | Maintenance                            |                                                           |                          | 14,838      |                  |        |            | 12,766 |             |        |            | 29,445  |        |         |            | 25,317  |       
|                                                              |                                        |                                                           |                          |             |                  |        |            |        |             |        |            |        
|                                                              |                                        |                                                           | Total revenue            |             |                  | 50,766 |            |        |             | 44,076 |            |         |        | 92,703  |            |         |        | 86,674  |  
|                                                              |                                        |                                                           |                          |             |                  |        |            |        |             |        |            |        
|Cost of revenue:                                              |                                        |                                                           |                          |             |                  |        |            |        |             |        |            |         |        |         |            |        
|                                                              | Amortization of intangibles            |                                                           |                          | 599         |                  |        |            |       |             |        |            | 1,198   |        |         |            |        |       
|                                                              | License                                |                                                           |                          | 245         |                  |        |            | 555    |             |        |            | 865     |        |         |            | 1,022   |       
|                                                              | Professional services and maintenance: |                                                           |                          |             |                  |        |            |        |             |        |            |         |        |         |            |         |       
|                                                              |                                        | Stock based compensation                                  |                          |             |                 |        |            |        | 22          |        |            |         |       |         |            |         | 44     |        
|                                                              |                                        | Other professional services and maintenance               |                          |             | 14,280           |        |            |        | 12,403      |        |            |         | 28,553 |         |            |         | 24,062 |        
|                                                              |                                        |                                                           |                          |             |                  |        |            |        |             |        |            |        
|                                                              |                                        |                                                           | Total cost of revenue    |             |                  | 15,124 |            |        |             | 12,980 |            |         |        | 30,616  |            |         |        | 25,128  |  
|                                                              |                                        |                                                           |                          |             |                  |        |            |        |             |        |            |        
|Gross profit                                                  |                                        |                                                           | 35,642                   |             |                  |        | 31,096     |        |             |        | 62,087     |         |        |         | 61,546     |        
|                                                              |                                        |                                                           |                          |             |                  |        |            |        |             |        |            |        
|Operating expenses:                                           |                                        |                                                           |                          |             |                  |        |            |        |             |        |            |         |        |         |            |        
|                                                              | Sales and marketing:                   |                                                           |                          |             |                  |        |            |        |             |        |            |         |        |         |            |         |       
|                                                              |                                        | Stock based compensation and warrant charge               |                          |             | 661              |        |            |        | 721         |        |            |         | 1,322  |         |            |         | 1,417  |        
|                                                              |                                        | Other sales and marketing costs                           |                          |             | 19,926           |        |            |        | 21,467      |        |            |         | 41,040 |         |            |         | 43,917 |        
|                                                              | Research and development:              |                                                           |                          |             |                  |        |            |        |             |        |            |         |        |         |            |         |       
|                                                              |                                        | Stock based compensation                                  |                          |             |                 |        |            |        | 10          |        |            |         |       |         |            |         | 10     |        
|                                                              |                                        | Other research and development costs                      |                          |             | 10,820           |        |            |        | 10,857      |        |            |         | 21,870 |         |            |         | 22,058 |        
|                                                              | General and administrative:            |                                                           |                          |             |                  |        |            |        |             |        |            |         |        |         |            |         |       
|                                                              |                                        | Stock based compensation                                  |                          |             |                 |        |            |        | 3           |        |            |         |       |         |            |         | 6      |        
|                                                              |                                        | Other general and administrative costs                    |                          |             | 4,868            |        |            |        | 4,524       |        |            |         | 9,941  |         |            |         | 8,947  |        
|                                                              | Restructuring and related charges      |                                                           |                          | 2,756       |                  |        |            |       |             |        |            | 2,756   |        |         |            |        |       
|                                                              |                                        |                                                           |                          |             |                  |        |            |        |             |        |            |        
|                                                              |                                        |                                                           | Total operating expenses |             |                  | 39,031 |            |        |             | 37,582 |            |         |        | 76,929  |            |         |        | 76,355  |  
|                                                              |                                        |                                                           |                          |             |                  |        |            |        |             |        |            |        
|Operating loss                                                |                                        |                                                           | (3,389                   | )           |                  |        | (6,486     | )      |             |        | (14,842    | )       |        |         | (14,809    | )      
|Interest income                                               |                                        |                                                           | 532                      |             |                  |        | 721        |        |             |        | 1,085      |         |        |         | 1,728      |        
|Interest expense                                              |                                        |                                                           | (29                      | )           |                  |        | (17        | )      |             |        | (56        | )       |        |         | (107       | )      
|Other (expense) income                                        |                                        |                                                           | (116                     | )           |                  |        | (5         | )      |             |        | (4         | )       |        |         | 24         |        
|Impairment of equity investment in private company            |                                        |                                                           | (1,057                   | )           |                  |        |           |        |             |        | (1,057     | )       |        |         |           |        
|                                                              |                                        |                                                           |                          |             |                  |        |            |        |             |        |            |        
|                                                              | Loss before income taxes               |                                                           | $                        | (4,059      | )                |        | $          | (5,787 | )           |        | $          | (14,874 | )      |         | $          | (13,164 | )     
|Provision for income taxes                                    |                                        |                                                           | 65                       |             |                  |        |           |        |             |        | 69         |         |        |         |           |        
|                                                              |                                        |                                                           |                          |             |                  |        |            |        |             |        |            |        
|                                                              | Net loss                               |                                                           | $                        | (4,124      | )                |        | $          | (5,787 | )           |        | $          | (14,943 | )      |         | $          | (13,164 | )     
|                                                              |                                        |                                                           |                          |             |                  |        |            |        |             |        |            |        
|Basic and diluted net loss per share                          |                                        | $                                                         | (0.08                    | )           |                  | $      | (0.11      | )      |             | $      | (0.28      | )       |        | $       | (0.25      | )      
|                                                              |                                        |                                                           |                          |             |                  |        |            |        |             |        |            |        
|Shares used in computing basic and diluted net loss per share |                                        |                                                           | 53,088,527               |             |                  |        | 52,038,339 |        |             |        | 52,958,538 |         |        |         | 51,922,154 |        
|                                                              |                                        |                                                           |                          |             |                  |        |            |        |             |        |            |        
|Comprehensive loss:                                           |                                        |                                                           |                          |             |                  |        |            |        |             |        |            |         |        |         |            |        
|                                                              | Net loss                               |                                                           | $                        | (4,124      | )                |        | $          | (5,787 | )           |        | $          | (14,943 | )      |         | $          | (13,164 | )     
|                                                              | Other comprehensive income (loss):     |                                                           |                          |             |                  |        |            |        |             |        |            |         |        |         |            |         |       
|                                                              |                                        | Unrealized income (loss) on securities available for sale |                          |             | 111              |        |            |        | (32         | )      |            |         | (318   | )       |            |         | (90    | )      
|                                                              |                                        | Foreign currency cumulative translation adjustment        |                          |             | 354              |        |            |        | 799         |        |            |         | (276   | )       |            |         | 944    |        
|                                                              |                                        |                                                           |                          |             |                  |        |            |        |             |        |            |        
|                                                              |                                        |                                                           | Total comprehensive loss |             | $                | (3,659 | )          |        | $           | (5,020 | )          |         | $      | (15,537 | )          |         | $      | (12,310 | )
|                                                              |                                        |                                                           |                          |             |                  |        |            |        |             |        |            |        

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


2



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##### 



WEBMETHODS, INC.


CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


(Unaudited)


|                                                     |                                                                                   |                                                                                                                                    |         |             |        |   |         |         |        |  
|---------------------------------------------------- | --------------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------- | ------- | ----------- | ------ | - | ------- | ------- | ------ | -
|                                                     |                                                                                   | Six Months Ended                                                                                                                   |        
|                                                     |                                                                                   | September 30,                                                                                                                      |        
|                                                     |                                                                                   |                                                                                                                                    |        
|                                                     |                                                                                   | 2004                                                                                                                               |         |             | 2003   |  
|                                                     |                                                                                   |                                                                                                                                    |         |             |        |  
|                                                     |                                                                                   |                                                                                                                                    |         | As restated |       
|                                                     |                                                                                   | (In thousands)                                                                                                                     |        
|Cash flows from operating activities:                |                                                                                   |                                                                                                                                    |         |             |        |   |         |        
|                                                     | Net loss                                                                          |                                                                                                                                    | $       | (14,943     | )      |   | $       | (13,164 | )     
|                                                     | Adjustments to reconcile net loss to net cash used in operating
    activities:   |                                                                                                                                    |         |             |        |   |         |         |       
|                                                     |                                                                                   | Depreciation and amortization                                                                                                      |         |             | 3,243  |   |         |         | 4,320  |  
|                                                     |                                                                                   | Provision for doubtful accounts                                                                                                    |         |             | 241    |   |         |         |       |  
|                                                     |                                                                                   | Amortization of deferred stock compensation related to employee
    and non-employee stock options and non-employee stock warrants |         |             | 1,322  |   |         |         | 1,477  |  
|                                                     |                                                                                   | Amortization of acquired intangibles                                                                                               |         |             | 1,198  |   |         |         |       |  
|                                                     |                                                                                   | Impairment of equity investment in private company                                                                                 |         |             | 1,057  |   |         |         |       |  
|                                                     |                                                                                   | Conversion of interest income into equity in private company                                                                       |         |             |       |   |         |         | (257   | )
|                                                     | Increase (decrease) in cash resulting from changes in
    assets and liabilities: |                                                                                                                                    |         |             |        |   |         |         |       
|                                                     |                                                                                   | Accounts receivable                                                                                                                |         |             | 952    |   |         |         | 2,345  |  
|                                                     |                                                                                   | Prepaid expenses and other current assets                                                                                          |         |             | (1,598 | ) |         |         | (1,210 | )
|                                                     |                                                                                   | Other assets                                                                                                                       |         |             | 980    |   |         |         | 41     |  
|                                                     |                                                                                   | Accounts payable                                                                                                                   |         |             | (1,866 | ) |         |         | (217   | )
|                                                     |                                                                                   | Accrued expenses and other liabilities                                                                                             |         |             | (1,851 | ) |         |         | (686   | )
|                                                     |                                                                                   | Accrued salaries and commissions                                                                                                   |         |             | 149    |   |         |         | (622   | )
|                                                     |                                                                                   | Deferred revenue                                                                                                                   |         |             | 911    |   |         |         | (4,720 | )
|                                                     |                                                                                   |                                                                                                                                    |         |             |        |  
|Net cash used in operating activities                |                                                                                   |                                                                                                                                    | (10,205 | )           |        |   | (12,693 | )      
|                                                     |                                                                                   |                                                                                                                                    |         |             |        |  
|Cash flows from investing activities:                |                                                                                   |                                                                                                                                    |         |             |        |   |         |        
|                                                     | Purchases of property and equipment                                               |                                                                                                                                    |         | (2,660      | )      |   |         | (1,597  | )     
|                                                     | Net maturities of marketable securities available for sale                        |                                                                                                                                    |         | 874         |        |   |         | 8,712   |       
|                                                     | Repayment of investment in private company                                        |                                                                                                                                    |         |            |        |   |         | 1,000   |       
|                                                     |                                                                                   |                                                                                                                                    |         |             |        |  
|Net cash (used in)/provided by investing activities  |                                                                                   |                                                                                                                                    | (1,786  | )           |        |   | 8,115   |        
|                                                     |                                                                                   |                                                                                                                                    |         |             |        |  
|Cash flows from financing activities:                |                                                                                   |                                                                                                                                    |         |             |        |   |         |        
|                                                     | Short-term borrowings                                                             |                                                                                                                                    |         | 3,533       |        |   |         | 3,189   |       
|                                                     | Payments on short-term borrowings                                                 |                                                                                                                                    |         | (4,284      | )      |   |         |        |       
|                                                     | Payments on capital leases                                                        |                                                                                                                                    |         | (547        | )      |   |         | (2,085  | )     
|                                                     | Proceeds from exercise of stock options and stock issued under
    the ESPP       |                                                                                                                                    |         | 1,882       |        |   |         | 1,636   |       
|                                                     |                                                                                   |                                                                                                                                    |         |             |        |  
|Net cash provided by financing activities            |                                                                                   |                                                                                                                                    | 584     |             |        |   | 2,740   |        
|                                                     |                                                                                   |                                                                                                                                    |         |             |        |  
|Effect of exchange rate on cash and cash equivalents |                                                                                   |                                                                                                                                    | (473    | )           |        |   | 1,211   |        
|                                                     |                                                                                   |                                                                                                                                    |         |             |        |  
|Net decrease in cash and cash equivalents            |                                                                                   |                                                                                                                                    | (11,880 | )           |        |   | (627    | )      
|Cash and cash equivalents at beginning of period     |                                                                                   |                                                                                                                                    | 75,462  |             |        |   | 79,702  |        
|                                                     |                                                                                   |                                                                                                                                    |         |             |        |  
|Cash and cash equivalents at end of period           |                                                                                   | $                                                                                                                                  | 63,582  |             |        | $ | 79,075  |        
|                                                     |                                                                                   |                                                                                                                                    |         |             |        |  

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


3



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##### 



WEBMETHODS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(Unaudited)




|   |                      
|-- | ---------------------
|1. | Basis of Presentation





|   |             
|-- | ------------
|2. | Restatements









4



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##### 



WEBMETHODS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)


(Unaudited)


2.     Restatements 
(Continued)




Summary of the Significant
Effects of the Restatement on the Consolidated Statements of
Operations


|                                     |                       |                                          |        |        |                                     |   |               |             |        |   |          |        |        |             |         |        |             |   |        |        |        |   |         |        |        | 
|------------------------------------ | --------------------- | ---------------------------------------- | ------ | ------ | ----------------------------------- | - | ------------- | ----------- | ------ | - | -------- | ------ | ------ | ----------- | ------- | ------ | ----------- | - | ------ | ------ | ------ | - | ------- | ------ | ------ | 
|                                     |                       | Three Months Ended September 30, 2003    |        |        | Six Months Ended September 30, 2003 |  
|                                     |                       |                                          |        |        |                                     |  
|                                     |                       | As previously                            |        |        |                                     |   | As previously |             |        |  
|                                     |                       | reported                                 |        |        | Adjustments                         |   |               | As restated |        |   | reported |        |        | Adjustments |         |        | As restated |  
|                                     |                       |                                          |        |        |                                     |   |               |             |        |   |          |        |        |             |         |        |             |  
|                                     |                       | (In thousands, except per share amounts) |       
|Revenue:                             |                       |                                          |        |        |                                     |   |               |             |        |   |          |        |        |             |         |        |             |   |        |        |        |   |         |       
|                                     | License               |                                          | $      | 22,025 |                                     |   | $             | (1,175      | )      |   | $        | 20,850 |        |             | $       | 43,827 |             |   | $      | (1,803 | )      |   | $       | 42,024 |       
|                                     | Professional services |                                          |        | 10,578 |                                     |   |               | (118        | )      |   |          | 10,460 |        |             |         | 19,451 |             |   |        | (118   | )      |   |         | 19,333 |       
|                                     | Maintenance           |                                          |        | 12,786 |                                     |   |               | (20         | )      |   |          | 12,766 |        |             |         | 25,336 |             |   |        | (19    | )      |   |         | 25,317 |       
|                                     |                       |                                          |        |        |                                     |   |               |             |        |   |          |        |        |             |         |        |             |  
|                                     |                       | Total revenue                            |        |        | 45,389                              |   |               |             | (1,313 | ) |          |        | 44,076 |             |         |        | 88,614      |   |        |        | (1,940 | ) |         |        | 86,674 | 
|Cost of revenue                      |                       |                                          | 12,980 |        |                                     |   |              |             |        |   | 12,980   |        |        |             | 25,128  |        |             |   |       |        |        |   | 25,128  |       
|                                     |                       |                                          |        |        |                                     |   |               |             |        |   |          |        |        |             |         |        |             |  
|Gross profit                         |                       |                                          | 32,409 |        |                                     |   | (1,313        | )           |        |   | 31,096   |        |        |             | 63,486  |        |             |   | (1,940 | )      |        |   | 61,546  |       
|Operating expenses                   |                       |                                          | 37,582 |        |                                     |   |              |             |        |   | 37,582   |        |        |             | 76,355  |        |             |   |       |        |        |   | 76,355  |       
|                                     |                       |                                          |        |        |                                     |   |               |             |        |   |          |        |        |             |         |        |             |  
|Operating loss                       |                       |                                          | (5,173 | )      |                                     |   | (1,313        | )           |        |   | (6,486   | )      |        |             | (12,869 | )      |             |   | (1,940 | )      |        |   | (14,809 | )     
|Interest and other income, net       |                       |                                          | 699    |        |                                     |   |              |             |        |   | 699      |        |        |             | 1,634   |        |             |   | 11     |        |        |   | 1,645   |       
|                                     |                       |                                          |        |        |                                     |   |               |             |        |   |          |        |        |             |         |        |             |  
|Net loss                             |                       | $                                        | (4,474 | )      |                                     | $ | (1,313        | )           |        | $ | (5,787   | )      |        | $           | (11,235 | )      |             | $ | (1,929 | )      |        | $ | (13,164 | )     
|                                     |                       |                                          |        |        |                                     |   |               |             |        |   |          |        |        |             |         |        |             |  
|Basic and diluted net loss per share |                       | $                                        | (0.09  | )      |                                     | $ | (0.02         | )           |        | $ | (0.11    | )      |        | $           | (0.22   | )      |             | $ | (0.03  | )      |        | $ | (0.25   | )     
|                                     |                       |                                          |        |        |                                     |   |               |             |        |   |          |        |        |             |         |        |             |  

Summary of the Significant
Effects of the Restatement on the Consolidated Balance Sheet


|                                          |  |                |          |   |             |   |        |             |  |   |          |  
|----------------------------------------- |  | -------------- | -------- | - | ----------- | - | ------ | ----------- |  | - | -------- | -
|                                          |  | March 31, 2004 |         
|                                          |  |                |         
|                                          |  | As previously  |          |   |            
|                                          |  | reported       |          |   | Adjustments |   |        | As restated | 
|                                          |  |                |          |   |             |   |        |             | 
|                                          |  | (In thousands) |         
|Accounts receivable, net                  |  | $              | 47,050   |   |             | $ | (309   | )           |  | $ | 46,741   |  
|Prepaid expenses and other current assets |  |                | 6,398    |   |             |   | (163   | )           |  |   | 6,235    |  
|Total current assets                      |  |                | 173,238  |   |             |   | (472   | )           |  |   | 172,766  |  
|Total assets                              |  |                | 284,122  |   |             |   | (472   | )           |  |   | 283,650  |  
|Short-term borrowings                     |  |                |         |   |             |   | 2,584  |             |  |   | 2,584    |  
|Accounts payable                          |  |                | 11,055   |   |             |   | (136   | )           |  |   | 10,919   |  
|Deferred revenue                          |  |                | 36,785   |   |             |   | (767   | )           |  |   | 36,018   |  
|Long term deferred revenue                |  |                | 2,802    |   |             |   | 3,264  |             |  |   | 6,066    |  
|Total liabilities                         |  |                | 81,568   |   |             |   | 4,945  |             |  |   | 86,513   |  
|Accumulated deficit                       |  |                | (316,360 | ) |             |   | (5,113 | )           |  |   | (321,473 | )
|Accumulated other comprehensive income    |  |                | 2,557    |   |             |   | (304   | )           |  |   | 2,253    |  

5



---



##### 



WEBMETHODS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)


(Unaudited)


2.     Restatements 
(Continued)








|   |                                   
|-- | ----------------------------------
|3. | Pro Forma Stock Based Compensation





|                                                         |                                                                                       |                                          |         |             |                  |   |         |         |             |   |         |         |   |   |         |         |  
|-------------------------------------------------------- | ------------------------------------------------------------------------------------- | ---------------------------------------- | ------- | ----------- | ---------------- | - | ------- | ------- | ----------- | - | ------- | ------- | - | - | ------- | ------- | -
|                                                         |                                                                                       | Three Months Ended                       |         |             | Six Months Ended |  
|                                                         |                                                                                       | September 30,                            |         |             | September 30,    |  
|                                                         |                                                                                       |                                          |         |             |                  |  
|                                                         |                                                                                       | 2004                                     |         |             | 2003             |   |         | 2004    |             |   | 2003    |        
|                                                         |                                                                                       |                                          |         |             |                  |   |         |         |             |   |         |        
|                                                         |                                                                                       |                                          |         | As restated |                  |   |         |         | As restated |  
|                                                         |                                                                                       | (In thousands, except per share amounts) |        
|Net loss, as reported                                    |                                                                                       | $                                        | (4,124  | )           |                  | $ | (5,787  | )       |             | $ | (14,943 | )       |   | $ | (13,164 | )      
|                                                         | Add: Stock-based compensation expense determined under the
    intrinsic value method |                                          |         |            |                  |   |         | 95      |             |   |         |        |   |   |         | 155     |  
|                                                         | Less: Stock-based compensation expense determined under fair
    value method         |                                          |         | (9,173      | )                |   |         | (11,946 | )           |   |         | (19,615 | ) |   |         | (26,827 | )
|                                                         |                                                                                       |                                          |         |             |                  |   |         |         |             |   |         |        
|Net loss, pro forma                                      |                                                                                       | $                                        | (13,297 | )           |                  | $ | (17,638 | )       |             | $ | (34,558 | )       |   | $ | (39,836 | )      
|                                                         |                                                                                       |                                          |         |             |                  |   |         |         |             |   |         |        
|Basic and diluted net loss per common share, as reported |                                                                                       | $                                        | (0.08   | )           |                  | $ | (0.11   | )       |             | $ | (0.28   | )       |   | $ | (0.25   | )      
|Basic and diluted net loss per common share, pro forma   |                                                                                       | $                                        | (0.25   | )           |                  | $ | (0.34   | )       |             | $ | (0.65   | )       |   | $ | (0.77   | )      



|   |                                  
|-- | ---------------------------------
|4. | Computation of Net Loss Per Share



6



---



##### 



WEBMETHODS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)


(Unaudited)




|   |                                                  
|-- | -------------------------------------------------
|5. | Supplemental Disclosures of Cash Flow Information

|                                             |                                                              |                  |    |             |      |   |     |       |  
|-------------------------------------------- | ------------------------------------------------------------ | ---------------- | -- | ----------- | ---- | - | --- | ----- | -
|                                             |                                                              | Six Months Ended |   
|                                             |                                                              | September 30,    |   
|                                             |                                                              |                  |   
|                                             |                                                              | 2004             |    |             | 2003 |  
|                                             |                                                              |                  |    |             |      |  
|                                             |                                                              |                  |    | As restated |     
|                                             |                                                              | (In thousands)   |   
|Cash paid during the period for interest     |                                                              | $                | 67 |             |      | $ | 105 |      
|Non-cash investing and financing activities: |                                                              |                  |    |             |      |   |     |      
|                                             | Equipment purchased under capital lease                      |                  | $  |            |      |   | $   | 1,111 |  
|                                             | Conversion of interest income into equity in private company |                  | $  |            |      |   | $   | 257   |  
|                                             | Change in net unrealized loss on marketable securities       |                  | $  | (318        | )    |   | $   | (90   | )



|   |                    
|-- | -------------------
|6. | Segment Information



|             |       |                    |        |             |                  |   |        |        |             |   |        |        |  |   |        |        | 
|------------ | ----- | ------------------ | ------ | ----------- | ---------------- | - | ------ | ------ | ----------- | - | ------ | ------ |  | - | ------ | ------ | 
|             |       | Three Months Ended |        |             | Six Months Ended |  
|             |       | September 30,      |        |             | September 30,    |  
|             |       |                    |        |             |                  |  
|Revenue      |       | 2004               |        |             | 2003             |   |        | 2004   |             |   | 2003   |       
|             |       |                    |        |             |                  |   |        |        |             |   |        |       
|             |       |                    |        | As restated |                  |   |        |        | As restated |  
|             |       | (In thousands)     |       
|Americas     |       | $                  | 32,540 |             |                  | $ | 26,083 |        |             | $ | 58,090 |        |  | $ | 51,413 |       
|Europe       |       |                    | 10,513 |             |                  |   | 11,965 |        |             |   | 18,286 |        |  |   | 22,662 |       
|Japan        |       |                    | 4,869  |             |                  |   | 3,182  |        |             |   | 9,665  |        |  |   | 6,800  |       
|Asia Pacific |       |                    | 2,844  |             |                  |   | 2,846  |        |             |   | 6,662  |        |  |   | 5,799  |       
|             |       |                    |        |             |                  |   |        |        |             |   |        |       
|             | Total |                    | $      | 50,766      |                  |   | $      | 44,076 |             |   | $      | 92,703 |  |   | $      | 86,674 | 
|             |       |                    |        |             |                  |   |        |        |             |   |        |       

|                  |       |                |        |        |           |   |        |        | 
|----------------- | ----- | -------------- | ------ | ------ | --------- | - | ------ | ------ | 
|                  |       | As of          |        |        | As of     |  
|                  |       | September 30,  |        |        | March 31, |  
|Long Lived Assets |       | 2004           |        |        | 2004      |  
|                  |       |                |        |        |           |  
|                  |       | (In thousands) |       
|Americas          |       | $              | 66,908 |        |           | $ | 70,497 |       
|Europe            |       |                | 1,941  |        |           |   | 2,189  |       
|Japan             |       |                | 1,531  |        |           |   | 1,681  |       
|Asia Pacific      |       |                | 389    |        |           |   | 360    |       
|                  |       |                |        |        |           |  
|                  | Total |                | $      | 70,769 |           |   | $      | 74,727 | 
|                  |       |                |        |        |           |  



|   |                                  
|-- | ---------------------------------
|7. | Restructuring and Related Charges





7



---



##### 



WEBMETHODS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)


(Unaudited)




7.     Restructuring and Related
Charges  (Continued)






|                                                                           |  |                |       |   |                  |   |        |       |  |   |        |  
|-------------------------------------------------------------------------- |  | -------------- | ----- | - | ---------------- | - | ------ | ----- |  | - | ------ | -
|                                                                           |  | Excess         |       |   | Severance and    |   |        |      
|                                                                           |  | Facilities     |       |   | Related Benefits |   |        | Total | 
|                                                                           |  |                |       |   |                  |   |        |       | 
|                                                                           |  | (In thousands) |      
|Balance at March 31, 2004                                                  |  | $              | 2,360 |   |                  | $ | 749    |       |  | $ | 3,109  |  
|Charges recorded during the six months ended September 30,
    2004        |  |                |      |   |                  |   | 3,012  |       |  |   | 3,012  |  
|Adjustment due to revision in estimated severance and related
    benefits |  |                |      |   |                  |   | (256   | )     |  |   | (256   | )
|Cash payments made during the six months ended
    September 30, 2004      |  |                | (408  | ) |                  |   | (1,398 | )     |  |   | (1,806 | )
|                                                                           |  |                |       |   |                  |   |        |       | 
|Balance at September 30, 2004                                              |  | $              | 1,952 |   |                  | $ | 2,107  |       |  | $ | 4,059  |  
|                                                                           |  |                |       |   |                  |   |        |       | 



|   |                              
|-- | -----------------------------
|8. | Investment in Private Company





|   |           
|-- | ----------
|9. | Borrowings







8



---



##### 



WEBMETHODS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)


(Unaudited)




9.     Borrowings 
(Continued)






9



---



##### 





|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|Item 2. | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL
    CONDITION AND RESULTS OF OPERATIONS



RECENT DEVELOPMENTS


Restatements






10



---



##### 











OVERVIEW


Background








11



---



##### 







Critical Accounting Policies and Estimates






Revenue Recognition






12



---



##### 



Allowance for Doubtful Accounts




Goodwill and Intangible Assets




Acquired In-process Research and Development




Foreign Currency Effects




Accounting for Income Taxes




13



---



##### 





Restructuring and Related Charges




Litigation and Contingencies




RESULTS OF OPERATIONS




|                         |  |                                  |        |             |                                |   |        |        |            |  |             |    |  |      |         |    |        |   |         |    |  |  |    |  
|------------------------ |  | -------------------------------- | ------ | ----------- | ------------------------------ | - | ------ | ------ | ---------- |  | ----------- | -- |  | ---- | ------- | -- | ------ | - | ------- | -- |  |  | -- | -
|                         |  | Three Months Ended September 30, |        |             | Six Months Ended September 30, |  
|                         |  |                                  |        |             |                                |  
|                         |  |                                  |        | Percentage  |                                |   |        |        | Percentage | 
|                         |  | 2004                             |        |             | 2003                           |   |        | Change |            |  | 2004        |    |  | 2003 |         |    | Change |  
|                         |  |                                  |        |             |                                |   |        |        |            |  |             |    |  |      |         |    |        |  
|                         |  |                                  |        | As restated |                                |   |        |        |            |  | As restated |    |  |     
|                         |  | ($ in thousands)                 |       
|Total revenue            |  | $                                | 50,766 |             |                                | $ | 44,076 |        |            |  | 15          | %  |  | $    | 92,703  |    |        | $ | 86,674  |    |  |  | 7  | %
|Gross profit             |  |                                  | 35,642 |             |                                |   | 31,096 |        |            |  | 15          | %  |  |      | 62,087  |    |        |   | 61,546  |    |  |  | 0  | %
|% of total revenue       |  |                                  | 70     | %           |                                |   | 71     | %      |            |  |             |    |  |      | 67      | %  |        |   | 71      | %  |  |  |    |  
|Total operating expenses |  |                                  | 39,031 |             |                                |   | 37,582 |        |            |  | 4           | %  |  |      | 76,929  |    |        |   | 76,355  |    |  |  | 1  | %
|% of total revenue       |  |                                  | 77     | %           |                                |   | 85     | %      |            |  |             |    |  |      | 83      | %  |        |   | 88      | %  |  |  |    |  
|Operating loss           |  |                                  | (3,389 | )           |                                |   | (6,486 | )      |            |  | (48         | )% |  |      | (14,842 | )  |        |   | (14,809 | )  |  |  | 0  | %
|% of total revenue       |  |                                  | (7     | )%          |                                |   | (15    | )%     |            |  |             |    |  |      | (16     | )% |        |   | (17     | )% |  |  |    |  
|Net loss                 |  | $                                | (4,124 | )           |                                | $ | (5,787 | )      |            |  | (29         | )% |  | $    | (14,943 | )  |        | $ | (13,164 | )  |  |  | 14 | %
|% of total revenue       |  |                                  | (8     | )%          |                                |   | (13    | )%     |            |  |             |    |  |      | (16     | )% |        |   | (15     | )% |  |  |    |  



14



---



##### 



Revenue




|                      |  |                                  |        |            |                                |             |    |      |  |   |            |  |             |        |        |  |      |  |    |    |  |   |        | 
|--------------------- |  | -------------------------------- | ------ | ---------- | ------------------------------ | ----------- | -- | ---- |  | - | ---------- |  | ----------- | ------ | ------ |  | ---- |  | -- | -- |  | - | ------ | 
|                      |  | Three Months Ended September 30, |        |            | Six Months Ended September 30, |            
|                      |  |                                  |        |            |                                |            
|                      |  |                                  |        | Percentage |                                |             |    |      |  |   | Percentage |  |             |       
|                      |  | 2004                             |        |            | Change                         |             |    | 2003 |  |   | 2004       |  |             | Change |        |  | 2003 | 
|                      |  |                                  |        |            |                                |             |    |      |  |   |            |  |             |        |        |  |      | 
|                      |  |                                  |        |            |                                | As restated |    |      |  |   |            |  | As restated |       
|                      |  | ($ in thousands)                 |       
|License               |  | $                                | 23,851 |            |                                |             | 14 | %    |  | $ | 20,850     |  |             | $      | 38,657 |  |      |  | (8 | )% |  | $ | 42,024 | 
|Professional services |  |                                  | 12,077 |            |                                |             | 15 | %    |  |   | 10,460     |  |             |        | 24,601 |  |      |  | 27 | %  |  |   | 19,333 | 
|Maintenance           |  |                                  | 14,838 |            |                                |             | 16 | %    |  |   | 12,766     |  |             |        | 29,445 |  |      |  | 16 | %  |  |   | 25,317 | 
|                      |  |                                  |        |            |                                |             |    |      |  |   |            |  |             |        |        |  |      | 
|Total revenue         |  | $                                | 50,766 |            |                                |             | 15 | %    |  | $ | 44,076     |  |             | $      | 92,703 |  |      |  | 7  | %  |  | $ | 86,674 | 
|                      |  |                                  |        |            |                                |             |    |      |  |   |            |  |             |        |        |  |      | 



|              |  |                                  |        |            |                                |             |     |      |  |   |            |  |             |        |        |  |      |  |     |    |  |   |        | 
|------------- |  | -------------------------------- | ------ | ---------- | ------------------------------ | ----------- | --- | ---- |  | - | ---------- |  | ----------- | ------ | ------ |  | ---- |  | --- | -- |  | - | ------ | 
|              |  | Three Months Ended September 30, |        |            | Six Months Ended September 30, |            
|              |  |                                  |        |            |                                |            
|              |  |                                  |        | Percentage |                                |             |     |      |  |   | Percentage |  |             |       
|              |  | 2004                             |        |            | Change                         |             |     | 2003 |  |   | 2004       |  |             | Change |        |  | 2003 | 
|              |  |                                  |        |            |                                |             |     |      |  |   |            |  |             |        |        |  |      | 
|              |  |                                  |        |            |                                | As restated |     |      |  |   |            |  | As restated |       
|              |  | ($ in thousands)                 |       
|Americas      |  | $                                | 32,540 |            |                                |             | 25  | %    |  | $ | 26,083     |  |             | $      | 58,090 |  |      |  | 13% |    |  | $ | 51,413 | 
|Europe        |  |                                  | 10,513 |            |                                |             | (12 | )%   |  |   | 11,965     |  |             |        | 18,286 |  |      |  | (19 | )% |  |   | 22,662 | 
|Japan         |  |                                  | 4,869  |            |                                |             | 53  | %    |  |   | 3,182      |  |             |        | 9,665  |  |      |  | 42% |    |  |   | 6,800  | 
|Asia Pacific  |  |                                  | 2,844  |            |                                |             |    |      |  |   | 2,846      |  |             |        | 6,662  |  |      |  | 15% |    |  |   | 5,799  | 
|              |  |                                  |        |            |                                |             |     |      |  |   |            |  |             |        |        |  |      | 
|Total revenue |  | $                                | 50,766 |            |                                |             | 15  | %    |  | $ | 44,076     |  |             | $      | 92,703 |  |      |  | 7%  |    |  | $ | 86,674 | 
|              |  |                                  |        |            |                                |             |     |      |  |   |            |  |             |        |        |  |      | 









15



---



##### 







Cost of Revenue and Gross Margin




|                                             |  |                    |    |             |                  |  |    |      |             |  |      |   |  |  |    |  
|-------------------------------------------- |  | ------------------ | -- | ----------- | ---------------- |  | -- | ---- | ----------- |  | ---- | - |  |  | -- | -
|                                             |  | Three Months Ended |    |             | Six Months Ended | 
|                                             |  | September 30,      |    |             | September 30,    | 
|                                             |  |                    |    |             |                  | 
|                                             |  | 2004               |    |             | 2003             |  |    | 2004 |             |  | 2003 |  
|                                             |  |                    |    |             |                  |  |    |      |             |  |      |  
|                                             |  |                    |    | As restated |                  |  |    |      | As restated | 
|License margin                               |  |                    | 96 | %           |                  |  | 97 | %    |             |  | 95   | % |  |  | 98 | %
|Professional services and maintenance margin |  |                    | 47 | %           |                  |  | 47 | %    |             |  | 47   | % |  |  | 46 | %
|Gross margin                                 |  |                    | 70 | %           |                  |  | 71 | %    |             |  | 67   | % |  |  | 71 | %







16



---



##### 



Operating Expenses




|                                            |  |                                  |        |             |                                |   |        |        |            |  |             |    |  |      |        |   |        |   |        |   |  |  |    |   
|------------------------------------------- |  | -------------------------------- | ------ | ----------- | ------------------------------ | - | ------ | ------ | ---------- |  | ----------- | -- |  | ---- | ------ | - | ------ | - | ------ | - |  |  | -- | --
|                                            |  | Three Months Ended September 30, |        |             | Six Months Ended September 30, |  
|                                            |  |                                  |        |             |                                |  
|                                            |  |                                  |        | Percentage  |                                |   |        |        | Percentage | 
|                                            |  | 2004                             |        |             | 2003                           |   |        | Change |            |  | 2004        |    |  | 2003 |        |   | Change |  
|                                            |  |                                  |        |             |                                |   |        |        |            |  |             |    |  |      |        |   |        |  
|                                            |  |                                  |        | As restated |                                |   |        |        |            |  | As restated |    |  |     
|                                            |  | ($ in thousands)                 |       
|Operating expenses:                         |  |                                  |        |             |                                |   |        |        |            |  |             |    |  |      |        |   |        |   |        |   |  |  |    |   
|Sales and marketing*                        |  | $                                | 19,926 |             |                                | $ | 21,467 |        |            |  | (7          | )% |  | $    | 41,040 |   |        | $ | 43,917 |   |  |  | (7 | )%
|% of total revenue                          |  |                                  | 39     | %           |                                |   | 49     | %      |            |  |             |    |  |      | 44     | % |        |   | 51     | % |  |  |    |   
|Research and development*                   |  |                                  | 10,820 |             |                                |   | 10,857 |        |            |  | (0          | )% |  |      | 21,870 |   |        |   | 22,058 |   |  |  | (1 | )%
|% total revenue                             |  |                                  | 21     | %           |                                |   | 25     | %      |            |  |             |    |  |      | 24     | % |        |   | 25     | % |  |  |    |   
|General and administrative*                 |  |                                  | 4,868  |             |                                |   | 4,524  |        |            |  | 8           | %  |  |      | 9,941  |   |        |   | 8,947  |   |  |  | 11 | % 
|% of total revenue                          |  |                                  | 10     | %           |                                |   | 10     | %      |            |  |             |    |  |      | 11     | % |        |   | 10     | % |  |  |    |   
|Stock based compensation and warrant charge |  |                                  | 661    |             |                                |   | 734    |        |            |  | (10         | )% |  |      | 1,322  |   |        |   | 1,433  |   |  |  | (8 | )%
|% of total revenue                          |  |                                  | 1      | %           |                                |   | 2      | %      |            |  |             |    |  |      | 1      | % |        |   | 2      | % |  |  |    |   
|Restructuring charges                       |  |                                  | 2,756  |             |                                |   |       |        |            |  |            |    |  |      | 2,756  |   |        |   |       |   |  |  |   |   
|% of total revenue                          |  |                                  | 5      | %           |                                |   | 0.0    | %      |            |  |             |    |  |      | 3      | % |        |   | 0.0    | % |  |  |    |   
|Total operating expenses                    |  | $                                | 39,031 |             |                                | $ | 37,582 |        |            |  | (4          | )% |  | $    | 76,929 |   |        | $ | 76,355 |   |  |  | 1  | % 
|% of total revenue                          |  |                                  | 77     | %           |                                |   | 85     | %      |            |  |             |    |  |      | 83     | % |        |   | 88     | % |  |  |    |   






|  |                                                                         
|- | ------------------------------------------------------------------------
|* | Excludes stock based compensation and warrant charge, as
    applicable.







17



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##### 









| |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
| | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| | (i) The grant of stock options to employees and
    non-employee directors at exercise prices less than the deemed
    fair value of our common stock at the date of the grant; and                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                        
|
| | (ii) An OEM/ Reseller agreement we entered into with
    i2 Technologies (i2) in March 2001 under which we issued a
    warrant which, as amended, permits i2 to
    purchase 710,000 shares of webMethods, Inc. common
    stock at an exercise price of $28.70 per share. The fair
    value of the 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
    amended agreement, i2 will pay us OEM fees of $8.8 million
    over the amended term of the OEM/ Reseller agreement which will
    be recorded as a reduction to the deferred warrant charge and
    will not be recorded as revenue.



Interest Income




Interest Expense




Other Income (Expense)




Income Taxes




18



---



##### 







LIQUIDITY AND CAPITAL RESOURCES














19



---



##### 





FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS




Unanticipated fluctuations in our quarterly revenue or
operating results, or failure to return to and maintain
profitability, could significantly affect the price of
webMethods common stock.






20



---



##### 



Growth of our sales may slow from time to time, causing
our quarterly operating results to fluctuate and possibly
resulting in significant volatility in the market price of
webMethods common stock.






We are a relatively young company and have a relatively
limited operating history with which to evaluate our business
and the prospects of achieving our anticipated growth and our
forecasts of operating results.




Our target markets are highly competitive, and we may not
be able to compete effectively.




21



---



##### 





Costs of legal investigations and compliance matters, and
demands on management time and attention relating to those
matters, may increase our operating expenses and impact our
operating results.




Our financial statements have been impacted, and could
again be impacted, by improper activities of our
personnel.




22



---



##### 



We rely on strategic alliances with major system
integrators and other similar relationships to promote and
implement our software and, if these relationships diminish or
terminate, we may lose important deals and marketing
opportunities.




Our assessment as to the adequacy of our internal controls
over financial reporting as required by Section 404 of the
Sarbanes-Oxley Act of 2002 may cause our operating expenses to
increase. If we are unable to certify the adequacy of our
internal controls and our independent auditors are unable to
attest thereto, investors could lose confidence in the
reliability of our financial statements, which could result in a
decrease in the value of webMethods common stock.




23



---



##### 



Our disclosure controls and procedures and our internal
controls over financial reporting may not be effective to detect
all errors or to detect and deter wrongdoing, fraud or improper
activities in all instances.




Treating stock options and employee stock purchase plan
participation as a compensation expense could significantly
impair our ability to return to and maintain
profitability.




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




24



---



##### 



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




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 intend to continue expanding our international sales
efforts, and our inability to do so could harm our business and
operating results.






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




25



---



##### 





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




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




26



---



##### 





Third-party claims that we infringe upon their
intellectual property rights may be costly to defend or settle
or could damage our business.






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.




27



---



##### 







Future acquisitions of companies or technologies may
result in disruptions to our business, dilution or other adverse
effects on future financial results or the distraction of our
management.




We adopted a stockholder rights plan in October 2001, and
previously implemented certain provisions in our certificate of
incorporation and bylaws, that may have anti-takeover
effects.






|        |                                                         
|------- | --------------------------------------------------------
|Item 3. | QUANTATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK



Interest rate risk.


28



---



##### 





Foreign currency exchange rate risk.






|        |                        
|------- | -----------------------
|Item 4. | CONTROLS AND PROCEDURES

Disclosure Controls and Procedures








29



---



##### 





Internal Controls Over Financial Reporting








| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                          
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | We have placed the employees of our Japanese subsidiary who were
    principally involved in the improper activities on a special
    status under Japanese labor law under which they have no further
    access to the offices or e-mail system of our Japanese
    subsidiary and are precluded from conducting business on behalf
    of the Company. We are pursuing disciplinary actions, which may
    include termination and restitution, concerning each employee
    implicated in wrongdoing in accordance with Japanese labor law
    and the work rules of the Companys Japanese subsidiary.                                                                                                                              
|
| |  | We have engaged an experienced financial consulting firm in
    Japan to assist the Company in providing financial and
    accounting services on behalf of our Japanese subsidiary.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|
| |  | We have recommunicated to employees of our Japanese subsidiary,
    and have confirmed their understanding of, our policy requiring
    collection and preservation of appropriate documentation that
    evidences an end-users purchase of a license to the
    Companys products in the quarter in which the revenue is
    recognized. We have reiterated this policy to all of our senior
    management, sales management and finance managers.                                                                                                                                                                                                                                                                                  
|
| |  | We have reiterated to all of our senior management, sales
    management and finance managers that borrowing from banks or any
    third party is strictly prohibited unless specifically
    authorized in writing by certain specified executive officers of
    the Company and by the Board of Directors of the respective
    borrowing entity. Verification of compliance with this policy
    has been added to certifications collected from members of
    management of the Company and our subsidiaries each quarter.                                                                                                                                                                                                         
|
| |  | We have reiterated to all of our senior management, sales
    management and finance managers that no employee of the Company
    may engage in verbal or written side agreements, including
    without limitation, side agreements that modify, cancel or agree
    to cancel any order or agreement for the license of our software
    products from a reseller or end-user or that modify, cancel or
    agree to modify or cancel any associated account receivable
    without complying with the applicable Company procedures.
    Clarification and verification of compliance with this policy
    has been added to certifications collected from members of
    management of the Company and our subsidiaries each quarter.
|
| |  | We have recruited and hired a Director, Internal Audit, who will
    be developing and implementing internal audit plans and
    procedures with respect to the Companys domestic and
    international operations.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     

30



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##### 





| |   |                                                                                                                                                                                                                                                                                           
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | We are evaluating more comprehensive procedures for the timely
    detection, deterrence, and mitigation of wrongdoing and improper
    activities, as well as procedures to test compliance with our
    revenue recognition policy and our code of business conduct.                    
|
| |  | We are implementing organizational changes to clarify that
    persons responsible for finance, accounting and legal functions
    concerning the Companys Japanese subsidiary report
    directly to persons responsible for the appropriate function in
    the global management team.
|
| |  | We are evaluating our relationships with each of our Japanese
    resellers, including reviewing arrangements with them to ensure
    that they are providing to the Company those materials required
    by the Companys revenue recognition policy.                                    
|
| |  | We are studying new or modified procedures under which the
    appropriate persons within the Companys global management
    team will have greater levels of involvement in, and oversight
    of, international operations.                                                            



31



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##### 



PART II


OTHER INFORMATION




|        |                  
|------- | -----------------
|Item 1. | LEGAL PROCEEDINGS







|        |                                                      
|------- | -----------------------------------------------------
|Item 4. | SUBMISSION OF MATTERS TO A VOTE OF SECURITIES HOLDERS



32



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##### 



Item 6.     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 and entered into between
    webMethods, Inc. and each of its directors and executive
    officers                  
|        | 10 | .5(6)       |  | Executive Agreement entered into between webMethods, Inc.
    and certain of its executive officers                                           
|        | 10 | .6(7)       |  | Form of Stock Option Agreement for stock option grants to
    employees or officers other than California residents                           
|        | 10 | .7*         |  | Form of Stock Option Agreement for stock option grants to
    directors                                                                       
|        | 10 | .8(7)       |  | Form of notice of grant of stock option                                                                                                       
|        | 10 | .9*         |  | Form of Deferred Compensation Plan for Directors                                                                                              
|        | 10 | .10*        |  | Consulting Agreement dated October 3, 2004 between Phillip
    Merrick and webMethods, Inc.                                                   
|        | 31 | .1*         |  | Rule 13a-14(a) Certification of Chief Executive Officer                                                                                       
|        | 31 | .2*         |  | Rule 13a-14(a) Certification of Chief Financial Officer                                                                                       
|        | 32 | .1*#        |  | Section 1350 Certification of Chief Executive Officer                                                                                         
|        | 32 | .2*#        |  | Section 1350 Certification of Chief Financial Officer                                                                                         






|    |                                                                                                                                  
|--- | ---------------------------------------------------------------------------------------------------------------------------------
|(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, 2002
    (File No. 1-15681).
|   
|(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. 1-15681).                              
|   
|(5) | Incorporated by reference to webMethods Annual Report on
    Form 10-K for the year ended March 31, 2003
    (File No. 1-15681).
|   
|(6) | Incorporated by reference to webMethods Form 10-Q for
    the quarter ended June 30, 2004
    (File No. 1-15681).               
|   
|(7) | Incorporated by reference to webMethods Form 8-K
    dated October 2, 2004 (File No. 1-15681).                                  
|   
|*   | Filed herewith.                                                                                                                  
|   
|#   | This item is furnished as an exhibit to this report but is not
    filed with the Securities and Exchange Commission.            

33



---



##### 



SIGNATURES






| |                 
| | ----------------
| | WEBMETHODS, INC.

|                        |  |                                                                                               
|----------------------- |  | ----------------------------------------------------------------------------------------------
|Date: February 14, 2005 |  | By: /s/ David
    MitchellDavid
    Mitchell
    President and Chief Executive Officer        
|                       
|Date: February 14, 2005 |  | By: /s/ Mary DridiMary
    Dridi
    Chief Financial Officer
    (Principal Financial Officer)

34



---



##### 



INDEX TO 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 and executive
    officers                      
|        | 10 | .5(6)       |  | Executive Agreement entered into between webMethods, Inc.
    and certain of its executive officers                                           
|        | 10 | .6(7)       |  | Form of Stock Option Agreement for stock option grants to
    employees or officers other than California residents                           
|        | 10 | .7*         |  | Form of Stock Option Agreement for stock option grants to
    directors                                                                       
|        | 10 | .8(7)       |  | Form of notice of grant of stock option                                                                                                       
|        | 10 | .9*         |  | Form of Deferred Compensation Plan for Directors                                                                                              
|        | 10 | .10*        |  | Consulting Agreement dated October 3, 2004 between Phillip
    Merrick and web Methods, Inc.                                                  
|        | 31 | .1*         |  | Rule 13a-14(a) Certification of Chief Executive Officer                                                                                       
|        | 31 | .2*         |  | Rule 13a-14(a) Certification of Chief Financial Officer                                                                                       
|        | 32 | .1*#        |  | Section 1350 Certification of Chief Executive Officer                                                                                         
|        | 32 | .2*#        |  | Section 1350 Certification of Chief Financial Officer                                                                                         






|    |                                                                                                                                  
|--- | ---------------------------------------------------------------------------------------------------------------------------------
|(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, 2002
    (File No. 1-15681).
|   
|(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. 1-15681).                              
|   
|(5) | Incorporated by reference to webMethods Annual Report on
    Form 10-K for the year ended March 31, 2003
    (File No. 1-15681).
|   
|(6) | Incorporated by reference to webMethods Form 10-Q for
    the quarter ended June 30, 2004
    (File No. 1-15681).               
|   
|(7) | Incorporated by reference to webMethods Form 8-K
    dated October 2, 2004 (File No. 1-15681).                                  
|   
|*   | Filed herewith.                                                                                                                  
|   
|#   | This item is furnished as an exhibit to this report but is not
    filed with the Securities and Exchange Commission.            

35