##### 









UNITED STATES SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





Form 10-Q


|           |  |                                                                                             
|---------- |  | --------------------------------------------------------------------------------------------
|(Mark One) |  |                                                                                             
|þ          |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
    SECURITIES EXCHANGE ACT OF 1934 
|          
|           |  | For the quarterly period ended June 30, 2006                                                
|          
|           |  | OR                                                                                          
|          
|o          |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
    SECURITIES EXCHANGE ACT OF 1934
|           |  | For the transition period
    from           to                                             

Commission File Number 1-15681





webMethods, Inc.


(Exact name of Registrant as Specified in its Charter)


|                                                                   |  |                                         
|------------------------------------------------------------------ |  | ----------------------------------------
|Delaware                                                           |  | 54-1807654                              
|(State or Other Jurisdiction of
    Incorporation or Organization) |  | (I.R.S. Employer
    Identification No.)
|                                                                  
|3877 Fairfax Ridge Road,
    South Tower, Fairfax, Virginia        |  | 22030                                   
|(Address of Principal Executive Offices)                           |  | (Zip Code)                              

(703) 460-2500


(Registrants telephone number, including area code)


Securities registered pursuant to Section 12(b) of the
Act:


Common Stock, $0.01 par value, together with related
Preferred Stock Purchase Rights


Securities registered pursuant to Section 12(g) of the
Act:


None


þ o


12b-2


o þ o


12b-2 o þ












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##### 










WEBMETHODS, INC.


QUARTERLY REPORT ON
FORM 10-Q


TABLE OF CONTENTS


|         |  |                                                                                                                                                        |  |   
|-------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------ |  | --
|Part I   |  | Financial Information                                                                                                                                  |  |   
|Item 1.  |  | Financial Statements                                                                                                                                   |  |   
|         |  | Condensed Consolidated Financial
    Statements                                                                                                        |  |   
|         |  | Condensed Consolidated Balance Sheets
    (unaudited) as of June 30, 2006 and March 31, 2006                                                           |  | 3 
|         |  | Condensed Consolidated Statements of
    Operations and Comprehensive Income or Loss (unaudited) for the
    three months ended June 30, 2006 and 2005 |  | 4 
|         |  | Condensed Consolidated Statements of Cash
    Flows (unaudited) for the three months ended June 30, 2006
    and 2005                                  |  | 5 
|         |  | Notes to Condensed Consolidated Financial
    Statements (unaudited)                                                                                   |  | 6 
|Item 2.  |  | Managements Discussion and Analysis
    of Financial Condition and Results of Operations                                                              |  | 18
|Item 3.  |  | Quantitative and Qualitative Disclosures
    About Market Risk                                                                                         |  | 28
|Item 4.  |  | Controls and Procedures                                                                                                                                |  | 28
|Part II  |  | Other Information                                                                                                                                      |  |   
|Item 1.  |  | Legal Proceedings                                                                                                                                      |  | 30
|Item 1A. |  | Risk Factors                                                                                                                                           |  | 30
|Item 6.  |  | Exhibits                                                                                                                                               |  | 30



2



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##### 






PART I  FINANCIAL INFORMATION





ITEM 1:     FINANCIAL
STATEMENTS


WEBMETHODS, INC.





CONDENSED CONSOLIDATED BALANCE SHEETS


(UNAUDITED)


|                                                  |                                                                                                               |                                            |        |          |           |  |        |          |         | 
|------------------------------------------------- | ------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ------ | -------- | --------- |  | ------ | -------- | ------- | 
|                                                  |                                                                                                               | June 30,                                   |        |          | March 31, | 
|                                                  |                                                                                                               | 2006                                       |        |          | 2006      | 
|                                                  |                                                                                                               |                                            |        |          |           | 
|                                                  |                                                                                                               | (In thousands)                             |       
|ASSETS                                           
|Current assets:                                   |                                                                                                               |                                            |        |          |           |  |        |         
|                                                  | Cash and cash equivalents                                                                                     |                                            | $      | 129,162  |           |  | $      | 82,371   |        
|                                                  | Marketable securities available for sale                                                                      |                                            |        | 45,927   |           |  |        | 79,943   |        
|                                                  | Accounts receivable, net of allowance of $850 and $652                                                        |                                            |        | 45,455   |           |  |        | 64,298   |        
|                                                  | Deferred income tax assets, net                                                                               |                                            |        | 158      |           |  |        | 138      |        
|                                                  | Prepaid expenses and other current assets                                                                     |                                            |        | 7,772    |           |  |        | 6,830    |        
|                                                  |                                                                                                               |                                            |        |          |           | 
|                                                  |                                                                                                               | Total current assets                       |        |          | 228,474   |  |        |          | 233,580 | 
|Property and equipment, net                       |                                                                                                               |                                            | 9,582  |          |           |  | 10,274 |         
|Goodwill                                          |                                                                                                               |                                            | 46,704 |          |           |  | 46,704 |         
|Intangible assets, net                            |                                                                                                               |                                            | 5,394  |          |           |  | 5,993  |         
|Long-term deferred income tax assets, net         |                                                                                                               |                                            | 2,044  |          |           |  | 1,961  |         
|Other assets                                      |                                                                                                               |                                            | 5,509  |          |           |  | 4,299  |         
|                                                  |                                                                                                               |                                            |        |          |           | 
|                                                  |                                                                                                               | Total assets                               |        | $        | 297,707   |  |        | $        | 302,811 | 
|                                                  |                                                                                                               |                                            |        |          |           | 
|                                                 
|LIABILITIES AND STOCKHOLDERS EQUITY             
|Current liabilities:                              |                                                                                                               |                                            |        |          |           |  |        |         
|                                                  | Accounts payable                                                                                              |                                            | $      | 5,782    |           |  | $      | 7,323    |        
|                                                  | Accrued expenses                                                                                              |                                            |        | 12,037   |           |  |        | 10,866   |        
|                                                  | Accrued salaries and commissions                                                                              |                                            |        | 9,624    |           |  |        | 12,694   |        
|                                                  | Deferred revenue                                                                                              |                                            |        | 54,293   |           |  |        | 59,168   |        
|                                                  | Current portion of capital lease obligations                                                                  |                                            |        | 183      |           |  |        | 259      |        
|                                                  |                                                                                                               |                                            |        |          |           | 
|                                                  |                                                                                                               | Total current liabilities                  |        |          | 81,919    |  |        |          | 90,310  | 
|Capital lease obligations, net of current portion |                                                                                                               |                                            |       |          |           |  | 10     |         
|Other long-term liabilities                       |                                                                                                               |                                            | 3,789  |          |           |  | 3,941  |         
|Long-term deferred revenue                        |                                                                                                               |                                            | 2,226  |          |           |  | 1,772  |         
|                                                  |                                                                                                               |                                            |        |          |           | 
|                                                  |                                                                                                               | Total liabilities                          |        |          | 87,934    |  |        |          | 96,033  | 
|                                                  |                                                                                                               |                                            |        |          |           | 
|Commitments and contingencies                     |                                                                                                               |                                            |        |          |           |  |        |         
|Stockholders equity:                             |                                                                                                               |                                            |        |          |           |  |        |         
|                                                  | Common stock, $0.01 par value; 500,000 shares
    authorized; 55,432 and 54,479 shares issued and outstanding |                                            | $      | 554      |           |  | $      | 545      |        
|                                                  | Additional paid-in capital                                                                                    |                                            |        | 537,945  |           |  |        | 529,972  |        
|                                                  | Deferred stock compensation                                                                                   |                                            |        |         |           |  |        | (357     | )      
|                                                  | Accumulated deficit                                                                                           |                                            |        | (328,006 | )         |  |        | (322,202 | )      
|                                                  | Accumulated other comprehensive loss                                                                          |                                            |        | (720     | )         |  |        | (1,180   | )      
|                                                  |                                                                                                               |                                            |        |          |           | 
|                                                  |                                                                                                               | Total stockholders equity                 |        |          | 209,773   |  |        |          | 206,778 | 
|                                                  |                                                                                                               |                                            |        |          |           | 
|                                                  |                                                                                                               | Total liabilities and stockholders equity |        | $        | 297,707   |  |        | $        | 302,811 | 
|                                                  |                                                                                                               |                                            |        |          |           | 



3



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##### 



WEBMETHODS, INC.





CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS


AND COMPREHENSIVE LOSS


(UNAUDITED)


|                    |                                                               |                            |                                                    |        |        |     |        |        |        |        |  
|------------------- | ------------------------------------------------------------- | -------------------------- | -------------------------------------------------- | ------ | ------ | --- | ------ | ------ | ------ | ------ | -
|                    |                                                               | Three Months Ended         |                                                   
|                    |                                                               | June 30,                   |                                                   
|                    |                                                               |                            |                                                   
|                    |                                                               | 2006                       |                                                    |        | 2005   |    
|                    |                                                               |                            |                                                    |        |        |    
|                    |                                                               | (In thousands, except      |                                                   
|                    |                                                               | per share data)            |                                                   
|Revenue:            |                                                               |                            |                                                    |        |        |     |        |       
|                    | License                                                       |                            | $                                                  | 12,637 |        |     | $      | 18,467 |       
|                    | Professional services                                         |                            |                                                    | 13,152 |        |     |        | 11,683 |       
|                    | Maintenance                                                   |                            |                                                    | 20,217 |        |     |        | 17,585 |       
|                    |                                                               |                            |                                                    |        |        |    
|                    |                                                               | Total revenue              |                                                    |        | 46,006 |     |        |        | 47,735 |       
|Cost of revenue:    |                                                               |                            |                                                    |        |        |     |        |       
|                    | Amortization of intangibles                                   |                            |                                                    | 599    |        |     |        | 599    |       
|                    | License                                                       |                            |                                                    | 324    |        |     |        | 214    |       
|                    | Professional services                                         |                            |                                                    | 12,153 |        |     |        | 10,299 |       
|                    | Maintenance                                                   |                            |                                                    | 3,197  |        |     |        | 3,255  |       
|                    |                                                               |                            |                                                    |        |        |    
|                    |                                                               | Total cost of revenue      |                                                    |        | 16,273 |     |        |        | 14,367 |       
|                    |                                                               |                            |                                                    |        |        |    
|Gross profit        |                                                               |                            | 29,733                                             |        |        |     | 33,368 |       
|Operating expenses: |                                                               |                            |                                                    |        |        |     |        |       
|                    | Sales and marketing                                           |                            |                                                    | 19,488 |        |     |        | 17,275 |       
|                    | Research and development                                      |                            |                                                    | 10,976 |        |     |        | 11,118 |       
|                    | General and administrative                                    |                            |                                                    | 7,129  |        |     |        | 6,214  |       
|                    | Restructuring costs                                           |                            |                                                    |       |        |     |        | 288    |       
|                    |                                                               |                            |                                                    |        |        |    
|                    |                                                               | Total operating expenses   |                                                    |        | 37,593 |     |        |        | 34,895 |       
|                    | Operating loss                                                |                            |                                                    | (7,860 | )      |     |        | (1,527 | )     
|                    |                                                               | Interest income            |                                                    |        | 1,801  |     |        |        | 966    |       
|                    |                                                               | Interest expense           |                                                    |        | (7     | )   |        |        | (17    | )     
|                    |                                                               | Other income               |                                                    |        | 490    |     |        |        | 206    |       
|                    |                                                               |                            |                                                    |        |        |    
|                    | Loss before income taxes                                      |                            | $                                                  | (5,576 | )      |     | $      | (372   | )     
|                    |                                                               |                            |                                                    |        |        |    
|                    |                                                               | Provision for income taxes |                                                    |        | 228    |     |        |        | 142    |       
|                    |                                                               |                            |                                                    |        |        |    
|                    | Net loss                                                      |                            | $                                                  | (5,804 | )      |     | $      | (514   | )     
|                    |                                                               |                            |                                                    |        |        |    
|                    | Basic and diluted net loss per share                          |                            | $                                                  | (0.11  | )      |     | $      | (0.01  | )     
|                    |                                                               |                            |                                                    |        |        |    
|                    | Shares used in computing basic and diluted net loss per share |                            |                                                    | 54,987 |        |     |        | 53,375 |       
|                    |                                                               |                            |                                                    |        |        |    
|                    | Comprehensive loss:                                           |                            |                                                    |        |        |     |        |        |       
|                    |                                                               | Net loss                   |                                                    | $      | (5,804 | )   |        | $      | (514   | )     
|                    |                                                               | Other comprehensive loss:  |                                                    |        |        |     |        |        |        |       
|                    |                                                               |                            | Unrealized gain on securities available for sale   |        |        | 48  |        |        |        | 138    |  
|                    |                                                               |                            | Foreign currency cumulative translation adjustment |        |        | 411 |        |        |        | (2,110 | )
|                    |                                                               |                            |                                                    |        |        |    
|                    | Total comprehensive loss                                      |                            | $                                                  | (5,345 | )      |     | $      | (2,486 | )     
|                    |                                                               |                            |                                                    |        |        |    



4



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WEBMETHODS, INC.





CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


(UNAUDITED)


|                                                     |                                                                                               |                                               |         |        |        |   |        |         |        |  
|---------------------------------------------------- | --------------------------------------------------------------------------------------------- | --------------------------------------------- | ------- | ------ | ------ | - | ------ | ------- | ------ | -
|                                                     |                                                                                               | Three Months Ended                            |        
|                                                     |                                                                                               | June 30,                                      |        
|                                                     |                                                                                               |                                               |        
|                                                     |                                                                                               | 2006                                          |         |        | 2005   |  
|                                                     |                                                                                               |                                               |         |        |        |  
|                                                     |                                                                                               | (In thousands)                                |        
|Cash flows from operating activities:                |                                                                                               |                                               |         |        |        |   |        |        
|                                                     | Net loss                                                                                      |                                               | $       | (5,804 | )      |   | $      | (514    | )     
|                                                     | Adjustments to reconcile net loss to net cash provided by (used
    in) operating activities: |                                               |         |        |        |   |        |         |       
|                                                     |                                                                                               | Depreciation and amortization                 |         |        | 1,277  |   |        |         | 1,392  |  
|                                                     |                                                                                               | Provision for (recovery of) doubtful accounts |         |        | 333    |   |        |         | (117   | )
|                                                     |                                                                                               | Stock-based compensation                      |         |        | 2,698  |   |        |         |       |  
|                                                     |                                                                                               | Deferred tax asset                            |         |        | 40     |   |        |         |       |  
|                                                     |                                                                                               | Amortization of deferred warrant charge       |         |        |       |   |        |         | 661    |  
|                                                     |                                                                                               | Amortization of acquired intangibles          |         |        | 599    |   |        |         | 599    |  
|                                                     |                                                                                               | Amortization of deferred rent                 |         |        | (114   | ) |        |         | (114   | )
|                                                     |                                                                                               | Deferred compensation for directors           |         |        | 33     |   |        |         | 38     |  
|                                                     | Increase (decrease) in cash resulting from changes in assets and
    liabilities:             |                                               |         |        |        |   |        |         |       
|                                                     |                                                                                               | Accounts receivable                           |         |        | 19,635 |   |        |         | 2,806  |  
|                                                     |                                                                                               | Prepaid expenses and other current assets     |         |        | (882   | ) |        |         | 251    |  
|                                                     |                                                                                               | Other non-current assets                      |         |        | (1,131 | ) |        |         | 476    |  
|                                                     |                                                                                               | Accounts payable                              |         |        | (1,796 | ) |        |         | (81    | )
|                                                     |                                                                                               | Accrued expenses and other liabilities        |         |        | 825    |   |        |         | (4,007 | )
|                                                     |                                                                                               | Accrued salaries and commissions              |         |        | (3,241 | ) |        |         | (2,225 | )
|                                                     |                                                                                               | Deferred revenue                              |         |        | (5,179 | ) |        |         | (2,282 | )
|                                                     |                                                                                               |                                               |         |        |        |  
|Net cash provided by (used in) operating activities  |                                                                                               |                                               | 7,293   |        |        |   | (3,117 | )      
|                                                     |                                                                                               |                                               |         |        |        |  
|Cash flows from investing activities:                |                                                                                               |                                               |         |        |        |   |        |        
|                                                     | Purchases of property and equipment                                                           |                                               |         | (539   | )      |   |        | (1,497  | )     
|                                                     | Proceeds from maturities of marketable securities available for
    sale                      |                                               |         | 34,664 |        |   |        | 34,556  |       
|                                                     | Purchases of marketable securities available for sale                                         |                                               |         | (600   | )      |   |        | (22,761 | )     
|                                                     |                                                                                               |                                               |         |        |        |  
|Net cash provided by investing activities            |                                                                                               |                                               | 33,525  |        |        |   | 10,298 |        
|                                                     |                                                                                               |                                               |         |        |        |  
|Cash flows from financing activities:                |                                                                                               |                                               |         |        |        |   |        |        
|                                                     | Payments on capital leases                                                                    |                                               |         | (87    | )      |   |        | (178    | )     
|                                                     | Proceeds from exercise of stock options                                                       |                                               |         | 4,501  |        |   |        | 172     |       
|                                                     | Proceeds from ESPP common stock issuances                                                     |                                               |         | 1,109  |        |   |        | 609     |       
|                                                     |                                                                                               |                                               |         |        |        |  
|Net cash provided by financing activities            |                                                                                               |                                               | 5,523   |        |        |   | 603    |        
|                                                     |                                                                                               |                                               |         |        |        |  
|Effect of exchange rate on cash and cash equivalents |                                                                                               |                                               | 450     |        |        |   | (2,487 | )      
|                                                     |                                                                                               |                                               |         |        |        |  
|Net increase in cash and cash equivalents            |                                                                                               |                                               | 46,791  |        |        |   | 5,297  |        
|Cash and cash equivalents at beginning of period     |                                                                                               |                                               | 82,371  |        |        |   | 57,209 |        
|                                                     |                                                                                               |                                               |         |        |        |  
|Cash and cash equivalents at end of period           |                                                                                               | $                                             | 129,162 |        |        | $ | 62,506 |        
|                                                     |                                                                                               |                                               |         |        |        |  



5



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##### 



WEBMETHODS, INC.





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS


(UNAUDITED)




|   |                                       
|-- | --------------------------------------
|1. | ORGANIZATION AND BASIS OF PRESENTATION

10-Q




10-Q 10-K




|   |                                           
|-- | ------------------------------------------
|2. | SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES



| |                                     
| | ------------------------------------
| | Adoption of New Accounting Standards



| |                         
| | ------------------------
| | Stock-Based Compensation









6



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##### 



WEBMETHODS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)


paid-in






Recently Issued Accounting Pronouncements




| |                                                                                                
| | -----------------------------------------------------------------------------------------------
| | Transition Election Related to Accounting for the Tax
    Effects of Share-Based Payment Awards

123R-3,




| |                                           
| | ------------------------------------------
| | Accounting for Uncertainty in Income Taxes



7



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##### 



WEBMETHODS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)






| |                                                                      
| | ---------------------------------------------------------------------
| | Income Statement Classification of Taxes Collected from
    Customers

06-03). 06-03 06-03 06-03




|   |                      
|-- | ---------------------
|3. | MARKETABLE SECURITIES



|                    |  |                |         |       |            |   |      |            |          |   |             |        |  |             |        |  |             |   |        |  |  |   |   | 
|------------------- |  | -------------- | ------- | ----- | ---------- | - | ---- | ---------- | -------- | - | ----------- | ------ |  | ----------- | ------ |  | ----------- | - | ------ |  |  | - | - | 
|                    |  |                |         | Gross |            |   |      |            | Cash and |   |             | Short- |  |             |       
|                    |  | Purchase/      |         |       | Unrealized |   |      | Aggregate  |          |   | Cash        |        |  | Term        |        |  | Long-Term  
|As of June 30, 2006 |  | Amortized Cost |         |       | Losses     |   |      | Fair Value |          |   | Equivalents |        |  | Investments |        |  | Investments
|                    |  |                |         |       |            |   |      |            |          |   |             |        |  |             |        |  |            
|                    |  | (In thousands)
|Corporate bonds     |  | $              | 83,655  |       |            | $ | (103 | )          |          | $ | 83,552      |        |  | $           | 37,625 |  |             | $ | 45,927 |  |  | $ |  | 
|Money market funds  |  |                | 40,457  |       |            |   |     |            |          |   | 40,457      |        |  |             | 40,457 |  |             |   |       |  |  |   |  | 
|                    |  |                |         |       |            |   |      |            |          |   |             |        |  |             |        |  |             |  
|Total               |  | $              | 124,112 |       |            | $ | (103 | )          |          | $ | 124,009     |        |  | $           | 78,082 |  |             | $ | 45,927 |  |  | $ |  | 
|                    |  |                |         |       |            |   |      |            |          |   |             |        |  |             |        |  |             |  

|                                          |  |                |         |       |            |   |      |            |          |   |             |        |  |             |        |  |             |   |        |  |  |   |   | 
|----------------------------------------- |  | -------------- | ------- | ----- | ---------- | - | ---- | ---------- | -------- | - | ----------- | ------ |  | ----------- | ------ |  | ----------- | - | ------ |  |  | - | - | 
|                                          |  |                |         | Gross |            |   |      |            | Cash and |   |             | Short- |  |             |       
|                                          |  | Purchase/      |         |       | Unrealized |   |      | Aggregate  |          |   | Cash        |        |  | Term        |        |  | Long-Term  
|As of March 31, 2006                      |  | Amortized Cost |         |       | Losses     |   |      | Fair Value |          |   | Equivalents |        |  | Investments |        |  | Investments
|                                          |  |                |         |       |            |   |      |            |          |   |             |        |  |             |        |  |            
|                                          |  | (In thousands)
|Taxable municipal auction rate securities |  | $              | 9,850   |       |            | $ |     |            |          | $ | 9,850       |        |  | $           |       |  |             | $ | 9,850  |  |  | $ |  | 
|Corporate bonds                           |  |                | 82,217  |       |            |   | (163 | )          |          |   | 82,054      |        |  |             | 11,961 |  |             |   | 70,093 |  |  |   |  | 
|Money market funds                        |  |                | 30,137  |       |            |   |     |            |          |   | 30,137      |        |  |             | 30,137 |  |             |   |       |  |  |   |  | 
|                                          |  |                |         |       |            |   |      |            |          |   |             |        |  |             |        |  |             |  
|Total                                     |  | $              | 122,204 |       |            | $ | (163 | )          |          | $ | 122,041     |        |  | $           | 42,098 |  |             | $ | 79,943 |  |  | $ |  | 
|                                          |  |                |         |       |            |   |      |            |          |   |             |        |  |             |        |  |             |  





8



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##### 



WEBMETHODS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|                |  |                     |        |                  |                        |                |     |            |                  |   |        |  |  |                  |    |   |        |   |        |  |  |   |      |  
|--------------- |  | ------------------- | ------ | ---------------- | ---------------------- | -------------- | --- | ---------- | ---------------- | - | ------ |  |  | ---------------- | -- | - | ------ | - | ------ |  |  | - | ---- | -
|                |  | Less than 12 Months |        |                  | Greater than 12 Months |                |     | Total      |                 
|                |  |                     |        |                  |                        |                |     |            |                 
|                |  |                     |        | Gross Unrealized |                        |                |     |            | Gross Unrealized |   |        |  |  | Gross Unrealized |   
|                |  | Fair Value          |        |                  | Losses                 |                |     | Fair Value |                  |   | Losses |  |  | Fair Value       |    |   | Losses |  
|                |  |                     |        |                  |                        |                |     |            |                  |   |        |  |  |                  |    |   |        |  
|                |  |                     |        |                  |                        | (In thousands) |     |            |                  |   |       
|Corporate bonds |  | $                   | 44,684 |                  |                        | $              | (99 | )          |                  | $ | 1,243  |  |  | $                | (4 | ) |        | $ | 45,927 |  |  | $ | (103 | )







|   |                         
|-- | ------------------------
|4. | STOCK-BASED COMPENSATION



| |                     
| | --------------------
| | Stock Incentive Plan











9



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##### 



WEBMETHODS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)






|                            |           |               |            |          |                |          |             |              |  |           |                 |  |  |   |            |  | 
|--------------------------- | --------- | ------------- | ---------- | -------- | -------------- | -------- | ----------- | ------------ |  | --------- | --------------- |  |  | - | ---------- |  | 
|                            |           |               |            |          |                | Weighted |             |              | 
|                            |           |               |            |          |                | Average  |             |              | 
|                            |           |               |            | Weighted |                |          | Remaining   |              |  |          
|                            |           |               |            | Average  |                |          | Contractual |              |  | Aggregate |                
|                            |           | Stock Options |            |          | Exercise Price |          |             | Life (Years) |  |           | Intrinsic Value | 
|                            |           |               |            |          |                |          |             |              |  |           |                 | 
|Outstanding, March 31, 2006 |           |               | 18,198,486 |          |                | $        | 10.56       |              |  |           |                 |  |  |   |            | 
|                            | Granted   |               |            | 444,538  |                |          |             | 9.19         |  |           |                 |  |  |   |            |  | 
|                            | Exercised |               |            | (724,532 | )              |          |             | 6.21         |  |           |                 |  |  |   |            |  | 
|                            | Forfeited |               |            | (430,827 | )              |          |             | 6.48         |  |           |                 |  |  |   |            |  | 
|                            | Expired   |               |            | (230,966 | )              |          |             | 14.98        |  |           |                 |  |  |   |            |  | 
|                            |           |               |            |          |                |          |             |              |  |           |                 | 
|Outstanding, June 30, 2006  |           |               | 17,256,699 |          |                | $        | 10.75       |              |  |           | 7.44            |  |  | $ | 35,408,010 | 
|                            |           |               |            |          |                |          |             |              |  |           |                 | 
|Options exercisable         |           |               | 11,140,180 |          |                | $        | 13.12       |              |  |           | 6.57            |  |  | $ | 14,472,995 | 
|                            |           |               |            |          |                |          |             |              |  |           |                 | 

(in-the






|                        |       |           |        |    |           |                  |        |                  |                     |  |            |        |          |           |                  |          |          |       |         |  |  |  |            |  |  |  |      |  |  |   |       | 
|----------------------- | ----- | --------- | ------ | -- | --------- | ---------------- | ------ | ---------------- | ------------------- |  | ---------- | ------ | -------- | --------- | ---------------- | -------- | -------- | ----- | ------- |  |  |  | ---------- |  |  |  | ---- |  |  | - | ----- | 
|                        |       |           |        |    |           | Outstanding      |        |                  | Options Exercisable | 
|                        |       |           |        |    |           |                  |        |                  |                     | 
|                        |       |           |        |    |           |                  |        | Weighted         |                     |  |            |        | Weighted |           |                  | Weighted |         
|                        |       |           |        |    |           |                  |        | Weighted Average |                     |  | Average    |        |          |           |                  | Average  |          |       | Average | 
|                        |       | Number of |        |    | Remaining |                  |        | Exercise         |                     |  | Number of  |        |          | Remaining |                  |          | Exercise |      
|Range of Exercise Price |       |           | Shares |    |           | Contractual Life |        |                  | Price               |  |            | Shares |          |           | Contractual Life |          |          | Price |        
|                        |       |           |        |    |           |                  |        |                  |                     |  |            |        |          |           |                  |          |          |       |        
|$                       | 0.11  |           |        | to |           | $                | 5.89   |                  |                     |  | 5,154,620  |        |          |           | 8.57             |          |          | $     | 5.35    |  |  |  | 1,700,187  |  |  |  | 8.56 |  |  | $ | 4.88  | 
|                        | 5.93  |           |        | to |           |                  | 8.21   |                  |                     |  | 3,602,322  |        |          |           | 8.10             |          |          |       | 7.20    |  |  |  | 1,394,401  |  |  |  | 7.47 |  |  |   | 7.14  | 
|                        | 8.25  |           |        | to |           |                  | 9.80   |                  |                     |  | 3,682,095  |        |          |           | 7.57             |          |          |       | 9.19    |  |  |  | 3,249,930  |  |  |  | 7.35 |  |  |   | 9.20  | 
|                        | 9.83  |           |        | to |           |                  | 14.36  |                  |                     |  | 3,906,973  |        |          |           | 5.91             |          |          |       | 13.00   |  |  |  | 3,884,973  |  |  |  | 5.89 |  |  |   | 13.01 | 
|                        | 14.70 |           |        | to |           |                  | 115.75 |                  |                     |  | 910,689    |        |          |           | 4.56             |          |          |       | 52.06   |  |  |  | 910,689    |  |  |  | 4.56 |  |  |   | 52.06 | 
|                        |       |           |        |    |           |                  |        |                  |                     |  |            |        |          |           |                  |          |          |       |         |  |  |  |            | 
|$                       | 0.11  |           |        | to |           | $                | 115.75 |                  |                     |  | 17,256,699 |        |          |           | 7.44             |          |          | $     | 10.75   |  |  |  | 11,140,180 |  |  |  | 6.57 |  |  | $ | 13.12 | 
|                        |       |           |        |    |           |                  |        |                  |                     |  |            |        |          |           |                  |          |          |       |         |  |  |  |            | 





| |                                                  
| | -------------------------------------------------
| | Valuation and Expense Information under SFAS 123R



10



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##### 



WEBMETHODS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|                                                                                |                            |                                                                 |       |     |       |   |   |   |   | 
|------------------------------------------------------------------------------- | -------------------------- | --------------------------------------------------------------- | ----- | --- | ----- | - | - | - | - | 
|                                                                                |                            | Three Months                                                   
|                                                                                |                            | Ended June 30,                                                 
|                                                                                |                            |                                                                
|                                                                                |                            | 2006                                                            |       |     | 2005 
|                                                                                |                            |                                                                 |       |     |      
|                                                                                |                            | (In thousands)                                                 
|Employee stock-based compensation included in:                                  |                            |                                                                 |       |     |       |   |   |  
|Cost of revenue:                                                                |                            |                                                                 |       |     |       |   |   |  
|                                                                                | Professional services      |                                                                 | $     | 324 |       |   | $ |  |  
|                                                                                | Maintenance                |                                                                 |       | 109 |       |   |   |  |  
|                                                                                |                            |                                                                 |       |     |       |  
|                                                                                |                            | Stock-based compensation expense included in cost of revenue    |       |     | 433   |   |   |   |  | 
|Operating expenses:                                                             |                            |                                                                 |       |     |       |   |   |  
|                                                                                | Sales and marketing        |                                                                 |       | 848 |       |   |   |  |  
|                                                                                | Research and development   |                                                                 |       | 679 |       |   |   |  |  
|                                                                                | General and administrative |                                                                 |       | 738 |       |   |   |  |  
|                                                                                |                            |                                                                 |       |     |       |  
|                                                                                |                            | Stock-based compensation expense included in operating expenses |       |     | 2,265 |   |   |   |  | 
|                                                                                |                            |                                                                 |       |     |       |  
|Total stock-based compensation expense related to stock-based
    equity awards |                            | $                                                               | 2,698 |     |       | $ |  |  
|                                                                                |                            |                                                                 |       |     |       |  









11



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##### 



WEBMETHODS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|                     |                         |                |  |       |      |  |  |       | 
|-------------------- | ----------------------- | -------------- |  | ----- | ---- |  |  | ----- | 
|                     |                         | Three Months   | 
|                     |                         | Ended June 30, | 
|                     |                         |                | 
|                     |                         | 2006           |  |       | 2005 | 
|                     |                         |                |  |       |      | 
|Stock option grants: |                         |                |  |       |      |  |  |      
|                     | Risk free interest rate |                |  | 5.1%  |      |  |  | 3.8%  | 
|                     | Expected lives in years |                |  | 4.69  |      |  |  | 4.00  | 
|                     | Expected volatility     |                |  | 68.9% |      |  |  | 79.8% | 
|                     | Dividend yield          |                |  | 0.0%  |      |  |  | 0.0%  | 
|ESPP:                |                         |                |  |       |      |  |  |      
|                     | Risk free interest rate |                |  | 4.1%  |      |  |  | 3.3%  | 
|                     | Expected lives in years |                |  | 1.46  |      |  |  | 1.45  | 
|                     | Expected volatility     |                |  | 54.0% |      |  |  | 60.4% | 
|                     | Dividend yield          |                |  | 0.0%  |      |  |  | 0.0%  | 



|                                                              |  |                |      |  |      |   |      | 
|------------------------------------------------------------- |  | -------------- | ---- |  | ---- | - | ---- | 
|                                                              |  | Three Months   |     
|                                                              |  | Ended June 30, |     
|                                                              |  |                |     
|                                                              |  | 2006           |      |  | 2005 |  
|                                                              |  |                |      |  |      |  
|Weighted-average grant date fair value of options granted     |  | $              | 5.48 |  |      | $ | 3.03 | 
|Weighted-average fair value of employee stock purchase rights |  | $              | 2.45 |  |      | $ | 3.52 | 

catch-up


12



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##### 



WEBMETHODS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




| |                                                                            
| | ---------------------------------------------------------------------------
| | Pro-forma Information under SFAS 123 for Periods Prior
    to April 1, 2006

|                                                         |                                                                               |                      |        |        |  
|-------------------------------------------------------- | ----------------------------------------------------------------------------- | -------------------- | ------ | ------ | -
|                                                         |                                                                               | Three Months Ended   |       
|                                                         |                                                                               | June 30, 2005        |       
|                                                         |                                                                               |                      |       
|                                                         |                                                                               | (In thousands except |       
|                                                         |                                                                               | per share data)      |       
|Net loss, as reported                                    |                                                                               | $                    | (514   | )     
|                                                         | Less: Stock-based compensation expense determined under fair
    value method |                      |        | (4,028 | )
|                                                         |                                                                               |                      |       
|Net loss, pro forma                                      |                                                                               | $                    | (4,542 | )     
|                                                         |                                                                               |                      |       
|Basic and diluted net loss per common share, as reported |                                                                               | $                    | (0.01  | )     
|                                                         |                                                                               |                      |       
|Basic and diluted net loss per common share, pro forma   |                                                                               | $                    | (0.09  | )     
|                                                         |                                                                               |                      |       





| |                             
| | ----------------------------
| | Employee Stock Purchase Plan









13



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##### 



WEBMETHODS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)






|   |                      
|-- | ---------------------
|5. | EMPLOYEE BENEFIT PLAN





|   |                                  
|-- | ---------------------------------
|6. | COMPUTATION OF NET LOSS PER SHARE





|                                                                                               |  |                       |        |   |      |   |        |  
|---------------------------------------------------------------------------------------------- |  | --------------------- | ------ | - | ---- | - | ------ | -
|                                                                                               |  | Three Months Ended    |       
|                                                                                               |  | June 30,              |       
|                                                                                               |  |                       |       
|                                                                                               |  | 2006                  |        |   | 2005 |  
|                                                                                               |  |                       |        |   |      |  
|                                                                                               |  | (In thousands, except |       
|                                                                                               |  | per share data)       |       
|Net loss                                                                                       |  | $                     | (5,804 | ) |      | $ | (514   | )
|Weighted-average common stock shares used to compute basic net
    loss per share              |  |                       | 54,987 |   |      |   | 53,375 |  
|Effect of dilutive common stock equivalents                                                    |  |                       |       |   |      |   |       |  
|                                                                                               |  |                       |        |   |      |  
|Weighted-average common stock shares used in computing diluted
    net income per common share |  |                       | 54,987 |   |      |   | 53,375 |  
|                                                                                               |  |                       |        |   |      |  
|Basic net loss per share                                                                       |  | $                     | (0.11  | ) |      | $ | (0.01  | )
|                                                                                               |  |                       |        |   |      |  
|Diluted net loss per share                                                                     |  | $                     | (0.11  | ) |      | $ | (0.01  | )
|                                                                                               |  |                       |        |   |      |  



|                                                   |  |                |        |  |      |  |        | 
|-------------------------------------------------- |  | -------------- | ------ |  | ---- |  | ------ | 
|                                                   |  | Three Months   |       
|                                                   |  | Ended June 30, |       
|                                                   |  |                |       
|                                                   |  | 2006           |        |  | 2005 | 
|                                                   |  |                |        |  |      | 
|                                                   |  | (In thousands) |       
|Anti-dilutive weighted-average common stock shares |  |                | 13,489 |  |      |  | 16,561 | 
|                                                   |  |                |        |  |      | 

14



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##### 



WEBMETHODS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




|   |                                                  
|-- | -------------------------------------------------
|7. | SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION

|                                             |                                                               |                |   |     |      |  |   |     | 
|-------------------------------------------- | ------------------------------------------------------------- | -------------- | - | --- | ---- |  | - | --- | 
|                                             |                                                               | Three Months   |  
|                                             |                                                               | Ended June 30, |  
|                                             |                                                               |                |  
|                                             |                                                               | 2006           |   |     | 2005 | 
|                                             |                                                               |                |   |     |      | 
|                                             |                                                               | (In thousands) |  
|Non-cash investing and financing activities: |                                                               |                |   |     |      |  |   |    
|                                             | Equipment purchased under capital lease                       |                | $ |    |      |  | $ | 270 | 
|                                             |                                                               |                |   |     |      | 
|                                             | Change in net unrealized gain (loss) on marketable securities |                | $ | (48 | )    |  | $ | 138 | 
|                                             |                                                               |                |   |     |      | 



|   |                    
|-- | -------------------
|8. | SEGMENT INFORMATION





|             |  |                    |        |  |      |   |        | 
|------------ |  | ------------------ | ------ |  | ---- | - | ------ | 
|             |  | Three Months Ended |       
|             |  | June 30,           |       
|             |  |                    |       
|Revenue      |  | 2006               |        |  | 2005 |  
|             |  |                    |        |  |      |  
|             |  | (In thousands)     |       
|Americas     |  | $                  | 28,710 |  |      | $ | 30,168 | 
|EMEA         |  |                    | 10,792 |  |      |   | 10,809 | 
|Japan        |  |                    | 2,174  |  |      |   | 2,571  | 
|Asia Pacific |  |                    | 4,330  |  |      |   | 4,187  | 
|             |  |                    |        |  |      |  
|Total        |  | $                  | 46,006 |  |      | $ | 47,735 | 
|             |  |                    |        |  |      |  

|                  |  |                |        |  |                |   |        | 
|----------------- |  | -------------- | ------ |  | -------------- | - | ------ | 
|                  |  | As of          |        |  | As of          |  
|Long Lived Assets |  | June 30, 2006  |        |  | March 31, 2006 |  
|                  |  |                |        |  |                |  
|                  |  | (In thousands) |       
|Americas          |  | $              | 11,415 |  |                | $ | 10,981 | 
|EMEA              |  |                | 1,420  |  |                |   | 1,393  | 
|Japan             |  |                | 1,084  |  |                |   | 1,132  | 
|Asia Pacific      |  |                | 935    |  |                |   | 843    | 
|                  |  |                |        |  |                |  
|Total             |  | $              | 14,854 |  |                | $ | 14,349 | 
|                  |  |                |        |  |                |  



|   |                    
|-- | -------------------
|9. | RESTRUCTURING COSTS



15



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##### 



WEBMETHODS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)




11-year








|                                                            |  |                   |     |   |              |   |     |             |  |   |           |   |       |   |   |  |  |   |       |  
|----------------------------------------------------------- |  | ----------------- | --- | - | ------------ | - | --- | ----------- |  | - | --------- | - | ----- | - | - |  |  | - | ----- | -
|                                                            |  | Excess Facilities |     |   | Excess       |   |     | Excess      |  |   | Severance |   |      
|                                                            |  | Santa Clara, CA   |     |   | Facilities   |   |     | Facilities  |  |   | and       |   |      
|                                                            |  | and Fairfax, VA   |     |   | Berkeley, CA |   |     | Fairfax, VA |  |   | Benefits  |   | Total |  
|                                                            |  |                   |     |   |              |   |     |             |  |   |           |   |       |  
|                                                            |  | (In thousands)    |    
|Balance at March 31, 2006                                   |  | $                 | 166 |   |              | $ | 747 |             |  | $ | 1,250     |   |       | $ |  |  |  | $ | 2,163 |  
|First quarter fiscal year 2007 charges                      |  |                   |    |   |              |   |    |             |  |   |          |   |       |   |  |  |  |   |      |  
|Cash payments made in the first quarter of fiscal year 2007 |  |                   | (55 | ) |              |   | (91 | )           |  |   | (225      | ) |       |   |  |  |  |   | (371  | )
|                                                            |  |                   |     |   |              |   |     |             |  |   |           |   |       |   |  
|Balance at June 30, 2006                                    |  | $                 | 111 |   |              | $ | 656 |             |  | $ | 1,025     |   |       | $ |  |  |  | $ | 1,792 |  
|                                                            |  |                   |     |   |              |   |     |             |  |   |           |   |       |   |  



|    |           
|--- | ----------
|10. | BORROWINGS





16



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##### 



WEBMETHODS, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)








|    |                              
|--- | -----------------------------
|11. | COMMITMENTS AND CONTINGENCIES







|    |                           
|--- | --------------------------
|12. | RELATED-PARTY TRANSACTIONS





|    |                 
|--- | ----------------
|13. | SUBSEQUENT EVENT



17



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##### 








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

FORWARD-LOOKING STATEMENTS


10-Q




| |   |                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
| | - | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | projections of revenue, costs or expense, margins, income or
    loss, earnings or loss per share, capital expenditures, cash
    requirements or other financial items, effective tax rate,
    sufficiency of working capital and projections regarding the
    market for our software and services;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                     
|
| |  | statements of our plans, objectives or expectations, including
    the development or enhancement of software, development and
    continuation of strategic partnerships and alliances,
    contributions to revenue by our business partners,
    implementation and effect of sales and marketing initiatives,
    future financial results, future financial results within
    geographic or specific markets and the allocation of resources
    to those markets, predictions of the timing and type of customer
    or market reaction to sales and marketing initiatives, the
    ability to control expenses, anticipated cost savings or expense
    reduction strategies, future hiring, business strategy and the
    execution on it and actions by customers and competitors;
|
| |  | statements of future economic performance or economic
    conditions, the continuation of patterns identified as trends or
    seasonal occurrences or the impact of recent or anticipated
    changes in accounting standards;                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                             
|
| |  | statements of our plans for remediation of a material weakness,
    or other changes, in our internal controls over financial
    reporting; and                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                            
|
| |  | assumptions underlying any of the foregoing.                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                                

10-K.


INTRODUCTION


10-Q




| |   |                                                                                                                                                                                                  
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Overview. This section provides a general description of
    our business and the performance indicators that management uses
    in assessing our financial condition and results of operations.
|
| |  | Results of Operations. This section provides an analysis
    of our results of operations for the three months ended
    June 30, 2006 and 2005.                                                 

18



---



##### 





| |   |                                                                                                                                                                                                                                                                          
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Liquidity and Capital Resources. This section provides an
    analysis of our cash flows for the three months ended
    June 30, 2006, and a discussion of our capital requirements
    and the resources available to us to meet those requirements.                    
|
| |  | Critical accounting policies. This section discusses
    accounting policies that are considered important to our
    financial condition and results of operations, require
    significant judgment and require estimates on the part of
    management in application.

OVERVIEW




First Quarter Fiscal 2007 Review
















Stock-Based Compensation




19



---



##### 





|                                                                                |                            |                                                                 |       |     |       |   |   |   |   | 
|------------------------------------------------------------------------------- | -------------------------- | --------------------------------------------------------------- | ----- | --- | ----- | - | - | - | - | 
|                                                                                |                            | Three Months                                                   
|                                                                                |                            | Ended June 30,                                                 
|                                                                                |                            |                                                                
|                                                                                |                            | 2006                                                            |       |     | 2005 
|                                                                                |                            |                                                                 |       |     |      
|Employee stock-based compensation included in:                                  |                            |                                                                
|                                                                                |                            | (In thousands)                                                 
|Cost of revenue:                                                                |                            |                                                                 |       |     |       |   |   |  
|                                                                                | Professional services      |                                                                 | $     | 324 |       |   | $ |  |  
|                                                                                | Maintenance                |                                                                 |       | 109 |       |   |   |  |  
|                                                                                |                            |                                                                 |       |     |       |  
|                                                                                |                            | Stock-based compensation expense included in cost of revenue    |       |     | 433   |   |   |   |  | 
|Operating expenses:                                                             |                            |                                                                 |       |     |       |   |   |  
|                                                                                | Sales and marketing        |                                                                 |       | 848 |       |   |   |  |  
|                                                                                | Research and development   |                                                                 |       | 679 |       |   |   |  |  
|                                                                                | General and administrative |                                                                 |       | 738 |       |   |   |  |  
|                                                                                |                            |                                                                 |       |     |       |  
|                                                                                |                            | Stock-based compensation expense included in operating expenses |       |     | 2,265 |   |   |   |  | 
|                                                                                |                            |                                                                 |       |     |       |  
|Total stock-based compensation expense related to stock-based
    equity awards |                            | $                                                               | 2,698 |     |       | $ |  |  
|                                                                                |                            |                                                                 |       |     |       |  

-of-the


RESULTS OF OPERATIONS




|                         |  |                             |        |    |      |   |        |          |  |  |     |   
|------------------------ |  | --------------------------- | ------ | -- | ---- | - | ------ | -------- |  |  | --- | --
|                         |  | Three Months Ended June 30, |       
|                         |  |                             |       
|                         |  | 2006                        |        |    | 2005 |   |        | % Change | 
|                         |  |                             |        |    |      |   |        |          | 
|                         |  | (In thousands)              |        |    |     
|Total revenue            |  | $                           | 46,006 |    |      | $ | 47,735 |          |  |  | (4  | )%
|Total cost of revenue    |  |                             | 16,273 |    |      |   | 14,367 |          |  |  | 13  | % 
|% of total revenue       |  |                             | 35     | %  |      |   | 30     | %        |  |  |     |   
|Gross profit             |  |                             | 29,733 |    |      |   | 33,368 |          |  |  | (11 | )%
|% of total revenue       |  |                             | 65     | %  |      |   | 70     | %        |  |  |     |   
|Total operating expenses |  |                             | 37,593 |    |      |   | 34,895 |          |  |  | 8   | % 
|% of total revenue       |  |                             | 82     | %  |      |   | 73     | %        |  |  |     |   
|Operating loss           |  |                             | (7,860 | )  |      |   | (1,527 | )        |  |  | N/A |   
|% of total revenue       |  |                             | (17    | )% |      |   | (3     | )%       |  |  |     |   
|Net loss                 |  |                             | (5,804 | )  |      |   | (514   | )        |  |  | N/A |   
|% of total revenue       |  |                             | (13    | )% |      |   | (1     | )%       |  |  |     |   



20



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##### 







Revenue




|                      |  |                             |        |  |      |   |        |          |  |  |     |   
|--------------------- |  | --------------------------- | ------ |  | ---- | - | ------ | -------- |  |  | --- | --
|                      |  | Three Months Ended June 30, |       
|                      |  |                             |       
|                      |  | 2006                        |        |  | 2005 |   |        | % Change | 
|                      |  |                             |        |  |      |   |        |          | 
|                      |  | (In thousands)              |        |  |     
|License               |  | $                           | 12,637 |  |      | $ | 18,467 |          |  |  | (32 | )%
|Professional services |  |                             | 13,152 |  |      |   | 11,683 |          |  |  | 13  | % 
|Maintenance           |  |                             | 20,217 |  |      |   | 17,585 |          |  |  | 15  | % 
|                      |  |                             |        |  |      |   |        |          | 
|Total revenue         |  | $                           | 46,006 |  |      | $ | 47,735 |          |  |  | (4  | )%
|                      |  |                             |        |  |      |   |        |          | 



|              |  |                             |        |  |      |   |        |          |  |  |     |   
|------------- |  | --------------------------- | ------ |  | ---- | - | ------ | -------- |  |  | --- | --
|              |  | Three Months Ended June 30, |       
|              |  |                             |       
|              |  | 2006                        |        |  | 2005 |   |        | % Change | 
|              |  |                             |        |  |      |   |        |          | 
|              |  | (In thousands)              |        |  |     
|Americas      |  | $                           | 28,710 |  |      | $ | 30,168 |          |  |  | (5  | )%
|EMEA          |  |                             | 10,792 |  |      |   | 10,809 |          |  |  | 0   | % 
|Japan         |  |                             | 2,174  |  |      |   | 2,571  |          |  |  | (15 | )%
|Asia Pacific  |  |                             | 4,330  |  |      |   | 4,187  |          |  |  | 3   | % 
|              |  |                             |        |  |      |   |        |          | 
|Total revenue |  | $                           | 46,006 |  |      | $ | 47,735 |          |  |  | (4  | )%
|              |  |                             |        |  |      |   |        |          | 







| |                
| | ---------------
| | License Revenue





| |                              
| | -----------------------------
| | Professional Services Revenue



21



---



##### 







| |                    
| | -------------------
| | Maintenance Revenue



Cost of Revenue




|                                      |  |                             |        |   |      |   |        |          |  |  |    |   
|------------------------------------- |  | --------------------------- | ------ | - | ---- | - | ------ | -------- |  |  | -- | --
|                                      |  | Three Months Ended June 30, |       
|                                      |  |                             |       
|                                      |  | 2006                        |        |   | 2005 |   |        | % Change | 
|                                      |  |                             |        |   |      |   |        |          | 
|                                      |  | (In thousands)              |        |   |     
|Amortization of Intangibles           |  | $                           | 599    |   |      | $ | 599    |          |  |  | 0  | % 
|% of License Revenue                  |  |                             | 5      | % |      |   | 3      | %        |  |  |    |   
|Cost of License Revenue               |  |                             | 324    |   |      |   | 214    |          |  |  | 51 | % 
|% of License Revenue                  |  |                             | 3      | % |      |   | 1      | %        |  |  |    |   
|Cost of Professional Services Revenue |  |                             | 12,153 |   |      |   | 10,299 |          |  |  | 18 | % 
|% of Professional Services Revenue    |  |                             | 92     | % |      |   | 88     | %        |  |  |    |   
|Cost of Maintenance Revenue           |  |                             | 3,197  |   |      |   | 3,255  |          |  |  | (2 | )%
|% of Maintenance Revenue              |  |                             | 16     | % |      |   | 19     | %        |  |  |    |   
|Total cost of revenue                 |  |                             | 16,273 |   |      |   | 14,367 |          |  |  | 13 | % 
|% of Total revenue                    |  |                             | 35     | % |      |   | 30     | %        |  |  |    |   









22



---



##### 







Operating Expenses




|                           |  |                             |        |   |      |   |        |          |  |  |      |   
|-------------------------- |  | --------------------------- | ------ | - | ---- | - | ------ | -------- |  |  | ---- | --
|                           |  | Three Months Ended June 30, |       
|                           |  |                             |       
|                           |  | 2006                        |        |   | 2005 |   |        | % Change | 
|                           |  |                             |        |   |      |   |        |          | 
|                           |  | (In thousands)              |        |   |     
|Operating Expenses:        |  |                             |        |   |      |   |        |          |  |  |      |   
|Sales and marketing        |  | $                           | 19,488 |   |      | $ | 17,275 |          |  |  | 13   | % 
|% of total revenue         |  |                             | 42     | % |      |   | 36     | %        |  |  |      |   
|Research and development   |  |                             | 10,976 |   |      |   | 11,118 |          |  |  | (1   | )%
|% of total revenue         |  |                             | 24     | % |      |   | 23     | %        |  |  |      |   
|General and administrative |  |                             | 7,129  |   |      |   | 6,214  |          |  |  | 15   | % 
|% of total revenue         |  |                             | 15     | % |      |   | 13     | %        |  |  |      |   
|Restructuring costs        |  |                             | -      |   |      |   | 288    |          |  |  | (100 | )%
|% of total revenue         |  |                             | 0      | % |      |   | 1      | %        |  |  |      |   
|Total operating expenses   |  |                             | 37,593 |   |      |   | 34,895 |          |  |  | 8    | % 
|% of total revenue         |  |                             | 82     | % |      |   | 73     | %        |  |  |      |   







23



---



##### 











Interest income




Interest expense




Other income (expense), net




Income taxes




24



---



##### 









LIQUIDITY AND CAPITAL RESOURCES


Cash Flows










Liquidity Requirements




| |               
| | --------------
| | Debt Financing





25



---



##### 









| |                  
| | -----------------
| | Liquidity Outlook







| |                               
| | ------------------------------
| | Off Balance Sheet Arrangements



CRITICAL ACCOUNTING POLICIES AND ESTIMATES






10-K


26



---



##### 





| |                         
| | ------------------------
| | Stock-Based Compensation







paid-in






27



---



##### 



Recently Issued Accounting Pronouncements




| |                                                                                                
| | -----------------------------------------------------------------------------------------------
| | Transition Election Related to Accounting for the Tax
    Effects of Share-Based Payment Awards





| |                                           
| | ------------------------------------------
| | Accounting for Uncertainty in Income Taxes





| |                                                                      
| | ---------------------------------------------------------------------
| | Income Statement Classification of Taxes Collected from
    Customers

06-03). 06-03 06-03 06-03







|        |                                                               
|------- | --------------------------------------------------------------
|ITEM 3. | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET
    RISK

10-K







|        |                        
|------- | -----------------------
|ITEM 4. | CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures. 13a-15(e)


28



---



##### 





13a-15 10-Q.


10-Q 10-Q


Material Weakness in Internal Control Over Financial
Reporting. 10-K




Material Weakness Remediation Plans.




| |   |                                                                                                                                                                                                                                                                                          
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | Implement formal procedures to evaluate the continued
    profitability of each of our subsidiaries on a quarterly basis
    in order to determine the income tax benefit of reducing the
    valuation allowances on net operating loss carryforwards and
    other deferred tax assets.
|
| |  | Implement formal procedures to monitor net deferred tax assets
    relating to goodwill and intangible assets of companies that we
    acquire.                                                                                                                                          
|
| |  | Evaluate the implementation of a new tax accounting and
    reporting system and improve our procedures with respect to
    communicating, documenting, and reconciling the detailed
    components of income tax assets and liabilities of each of our
    subsidiaries.                
|
| |  | Expand staffing and resources, including the continued use of
    external consultants, and provide training on income tax
    accounting and reporting.                                                                                                                                 

Changes in Internal Control Over Financial Reporting.


29



---



##### 






PART II


OTHER INFORMATION







|        |                  
|------- | -----------------
|ITEM 1. | LEGAL PROCEEDINGS








|         |             
|-------- | ------------
|ITEM 1A. | RISK FACTORS

10-K







|        |         
|------- | --------
|ITEM 6. | EXHIBITS



30



---



##### 



SIGNATURES






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



| |     |                   
| | --- | ------------------
| | By: | /s/ DAVID MITCHELL

| |                                      
| | -------------------------------------
| |                                      
| | David Mitchell                       
| | President and Chief Executive Officer





| |     |                   
| | --- | ------------------
| | By: | /s/ MARK WABSCHALL

| |                                                     
| | ----------------------------------------------------
| |                                                     
| | Mark Wabschall                                      
| | Executive Vice President and Chief Financial Officer



31



---



##### 



EXHIBIT INDEX


|        |    |             |  |                                                                                                                           
|------- | -- | ----------- |  | --------------------------------------------------------------------------------------------------------------------------
|Exhibit |    |            
|Number  |    | Description
|        |    |            
|        | 3  | .1(1)       |  | Fifth Amended and Restated Certificate of Incorporation of
    webMethods, Inc., as amended                               
|        | 3  | .2(2)       |  | Second Amended and Restated Bylaws of webMethods, Inc.                                                                    
|        | 4  | .1(3)       |  | Specimen certificate for shares of webMethods, Inc. Common Stock                                                          
|        | 4  | .2(4)       |  | Rights Agreement dated as of October 18, 2001 between
    webMethods, Inc. and American Stock Transfer & Trust
    Company
|        | 10 | .1(5)       |  | webMethods, Inc. Amended and Restated Stock Option Plan, as
    Amended                                                   
|        | 10 | .2(6)       |  | Restated Employee Stock Purchase Plan                                                                                     
|        | 10 | .3(3)       |  | Indemnification Agreement entered into between webMethods, Inc.
    and each of its directors and executive officers      
|        | 10 | .4(7)       |  | Executive Agreement entered into between webMethods, Inc. and
    certain of its executive officers                       
|        | 10 | .5(8)       |  | Form of Stock Option Agreement for stock option grants to
    employees or officers other than California residents       
|        | 10 | .6(9)       |  | Form of Stock Option Agreement for stock option grants to
    directors                                                   
|        | 10 | .7(8)       |  | Form of notice of grant of stock option                                                                                   
|        | 10 | .8(10)      |  | Deferred Compensation Plan for Directors, as amended                                                                      
|        | 10 | .9*         |  | Description of salary and bonus arrangements for certain
    executive officers                                           
|        | 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
    Form 10-K for the
    year ended March 31, 2001 (File
    No. 1-15681).            
|
| | (2) | Incorporated by reference to webMethods
    Form 10-Q for the
    three months ended December 31, 2004 (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. 000-33329).                   
|
| | (5) | Incorporated by reference to webMethods
    Form 10-K for the
    year ended March 31, 2002 (File
    No. 1-15681).            
|
| | (6) | Incorporated by reference to webMethods Registration
    Statement on
    Form S-8 (File
    No. 333-136261).                  
|
| | (7) | Incorporated by reference to webMethods
    Form 10-Q for the
    three months ended June 30, 2004 (File No. 1-15681).         
|
| | (8) | Incorporated by reference to webMethods
    Form 8-K dated
    October 2, 2004 (File No. 1-15681).                             
|
| | (9) | Incorporated by reference to webMethods
    Form 10-Q for the
    three months ended September 30, 2004 (File
    No. 1-15681).



|     |                                                                                                                                 
|---- | --------------------------------------------------------------------------------------------------------------------------------
|(10) | Incorporated by reference to webMethods
    Form 10-Q for the
    three months ended September 30, 2005 (File
    No. 1-15681).



| |   |                
| | - | ---------------
| | * | Filed herewith.