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SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-Q

(MARK ONE)

[X]
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934FOR THE THREE MONTHS ENDED DECEMBER 31, 2002OR[  ]
    
    TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934


COMMISSION FILE NUMBER 001-15681



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WEBMETHODS, INC.

(Exact Name of Registrant as Specified in its Charter)

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

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



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

As of
February 5, 2003, 51,656,796 shares of the registrants Common
Stock, par value $.01 per share, were issued and outstanding.

1



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WEBMETHODS, INC.
QUARTERLY REPORT ON FORM 10-Q
FOR THE THREE MONTHS ENDED DECEMBER 31, 2002
TABLE OF CONTENTS

|        |  |                                                                    |  | 
|------- |  | ------------------------------------------------------------------ |  | 
|Part I  |  | Financial Information                                             
|Item 1  |  | Financial Statements                                              
|        |  | Condensed Consolidated Financial Statements                       
|        |  | Condensed Consolidated Balance Sheets as of December 31, 2002     
|        |  | (unaudited) and March 31, 2002                                    
|        |  | Condensed Consolidated Statements of Operations and Comprehensive 
|        |  | Loss (unaudited) - Three and nine months ended December 31, 2002  
|        |  | and 2001                                                          
|        |  | Condensed Consolidated Statements of Cash Flows (unaudited) - Nine
|        |  | months ended December 31, 2002 and 2001                           
|        |  | Notes to Condensed Consolidated Financial Statements (unaudited)  
|Item 2  |  | Management's Discussion and Analysis of Financial Condition and   
|        |  | Results of Operations                                             
|Item 3  |  | Quantitative and Qualitative Disclosures About Market Risk        
|Item 4  |  | Controls and Procedures                                           
|        |  |                                                                    |  | 
|Part II |  | Other Information                                                 
|Item 1  |  | Legal Proceedings                                                 
|Item 2  |  | Changes in Securities and Use of Proceeds                         
|Item 6  |  | Exhibits and Reports on Form 8-K                                  
|        |  | (a) Exhibits                                                      
|        |  | (b) Reports on Form 8-K                                           

2



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##### 



PART I
FINANCIAL INFORMATION

ITEM 1: FINANCIAL STATEMENTS

WEBMETHODS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share and per share amounts)

|                                         |                                                                                                                       |                                            |        |              |         |           |        |          |         | 
|---------------------------------------- | --------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ------ | ------------ | ------- | --------- | ------ | -------- | ------- | 
|                                         |                                                                                                                       |                                            |        | DECEMBER 31, |         | MARCH 31,
|                                         |                                                                                                                       |                                            |        | 2002         |         | 2002     
|                                         |                                                                                                                       |                                            |        | (UNAUDITED)  |         |          
|ASSETS                                   |                                                                                                                       |                                            |        |              |         |           |        |         
|Current assets:                          |                                                                                                                       |                                            |        |              |         |           |        |         
|                                         | Cash and cash equivalents                                                                                             |                                            | $      | 74,264       |         |           | $      | 98,497   |        
|                                         | Marketable securities available for sale                                                                              |                                            |        | 116,420      |         |           |        | 113,345  |        
|                                         | Accounts receivable, net of allowance of $2,875 and $3,685                                                            |                                            |        | 44,656       |         |           |        | 46,417   |        
|                                         | Prepaid expenses and other current assets                                                                             |                                            |        | 6,670        |         |           |        | 7,516    |        
|                                         |                                                                                                                       |                                            |        |              |         |           |        |          |        
|                                         |                                                                                                                       |                                            |        |              |         |           |        |         
|                                         |                                                                                                                       | Total current assets                       |        |              | 242,010 |           |        |          | 265,775 | 
|Marketable securities available for sale |                                                                                                                       |                                            | 9,335  |              |         |           |       |         
|Property and equipment, net              |                                                                                                                       |                                            | 13,435 |              |         |           | 17,181 |         
|Goodwill and acquired intangibles, net   |                                                                                                                       |                                            | 29,838 |              |         |           | 29,838 |         
|Other assets                             |                                                                                                                       |                                            | 9,648  |              |         |           | 11,269 |         
|                                         |                                                                                                                       |                                            |        |              |         |           |        |          |        
|                                         |                                                                                                                       |                                            |        |              |         |           |        |         
|                                         |                                                                                                                       | Total assets                               |        | $            | 304,266 |           |        | $        | 324,063 | 
|                                         |                                                                                                                       |                                            |        |              |         |           |        |          |        
|                                         |                                                                                                                       |                                            |        |              |         |           |        |         
|LIABILITIES AND STOCKHOLDERS EQUITY     |                                                                                                                       |                                            |        |              |         |           |        |         
|Current liabilities:                     |                                                                                                                       |                                            |        |              |         |           |        |         
|                                         | Accounts payable                                                                                                      |                                            | $      | 9,015        |         |           | $      | 15,105   |        
|                                         | Accrued expenses                                                                                                      |                                            |        | 14,469       |         |           |        | 16,170   |        
|                                         | Accrued salaries and commissions                                                                                      |                                            |        | 12,879       |         |           |        | 15,594   |        
|                                         | Deferred revenue                                                                                                      |                                            |        | 39,373       |         |           |        | 37,298   |        
|                                         | Current portion of capital lease obligations                                                                          |                                            |        | 3,747        |         |           |        | 2,699    |        
|                                         |                                                                                                                       |                                            |        |              |         |           |        |          |        
|                                         |                                                                                                                       |                                            |        |              |         |           |        |         
|                                         |                                                                                                                       | Total current liabilities                  |        |              | 79,483  |           |        |          | 86,866  | 
|                                         | Capital lease obligations, net of current portion and other                                                           |                                            |        | 823          |         |           |        | 1,765    |        
|                                         | Long term deferred revenue                                                                                            |                                            |        | 9,208        |         |           |        | 19,888   |        
|                                         |                                                                                                                       |                                            |        |              |         |           |        |          |        
|                                         |                                                                                                                       |                                            |        |              |         |           |        |         
|                                         |                                                                                                                       | Total liabilities                          |        |              | 89,514  |           |        |          | 108,519 | 
|                                         |                                                                                                                       |                                            |        |              |         |           |        |          |        
|Stockholders equity:                    |                                                                                                                       |                                            |        |              |         |           |        |         
|                                         | Common stock, $0.01 par value; 500,000,000 shares authorized; 51,343,397 and
50,477,383 shares issued and outstanding |                                            |        | 513          |         |           |        | 505      |        
|                                         | Additional paid-in capital                                                                                            |                                            |        | 514,340      |         |           |        | 510,281  |        
|                                         | Deferred stock compensation and warrant charge                                                                        |                                            |        | (11,630      | )       |           |        | (14,875  | )      
|                                         | Accumulated deficit                                                                                                   |                                            |        | (288,606     | )       |           |        | (279,864 | )      
|                                         | Accumulated other comprehensive income (loss)                                                                         |                                            |        | 135          |         |           |        | (503     | )      
|                                         |                                                                                                                       |                                            |        |              |         |           |        |          |        
|                                         |                                                                                                                       |                                            |        |              |         |           |        |         
|                                         |                                                                                                                       | Total stockholders equity                 |        |              | 214,752 |           |        |          | 215,544 | 
|                                         |                                                                                                                       |                                            |        |              |         |           |        |          |        
|                                         |                                                                                                                       |                                            |        |              |         |           |        |         
|                                         |                                                                                                                       | Total liabilities and stockholders equity |        | $            | 304,266 |           |        | $        | 324,063 | 
|                                         |                                                                                                                       |                                            |        |              |         |           |        |          |        

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

3



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WEBMETHODS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS

(In thousands, except share and per share amounts)

(UNAUDITED)

|                                                                     |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |        |         |         |        |  
|-------------------------------------------------------------------- | -------------------------------------- | ------------------------ | ------------------------- | ------------------------------------------------------------------ | ------ | ------------------ | ---------- | ----------------- | ------- | ------- | ---------- | ------ | ------- | ------ | ---------- | ------ | ------- | ------- | ------ | -
|                                                                     |                                        |                          |                           |                                                                    |        | THREE MONTHS ENDED |            | NINE MONTHS ENDED
|                                                                     |                                        |                          |                           |                                                                    |        | DECEMBER 31,       |            | DECEMBER 31,     
|                                                                     |                                        |                          |                           |                                                                    |        |                    |            |                  
|                                                                     |                                        |                          |                           |                                                                    |        | 2002               |            | 2001              |         | 2002    |            | 2001  
|                                                                     |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |       
|Revenue:                                                             |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |       
|                                                                     | License                                |                          | $                         | 33,940                                                             |        |                    | $          | 30,434            |         |         | $          | 89,084 |         |        | $          | 88,980 |        
|                                                                     | Professional services                  |                          |                           | 7,951                                                              |        |                    |            | 8,852             |         |         |            | 24,737 |         |        |            | 27,944 |        
|                                                                     | Maintenance                            |                          |                           | 11,919                                                             |        |                    |            | 9,828             |         |         |            | 33,832 |         |        |            | 28,324 |        
|                                                                     |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |        |        
|                                                                     |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |       
|                                                                     |                                        | Total revenue            |                           |                                                                    | 53,810 |                    |            |                   | 49,114  |         |            |        | 147,653 |        |            |        | 145,248 |        
|                                                                     |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |        |        
|                                                                     |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |       
|Cost of revenue:                                                     |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |       
|                                                                     | License                                |                          |                           | 765                                                                |        |                    |            | 613               |         |         |            | 1,425  |         |        |            | 1,965  |        
|                                                                     | Professional services and maintenance: |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |        |        
|                                                                     |                                        |                          |                           | Stock based compensation                                           |        |                    | 65         |                   |         |         | 47         |        |         |        | 218        |        |         |         | 368    |  
|                                                                     |                                        |                          |                           | Other professional services and
maintenance costs                  |        |                    | 10,409     |                   |         |         | 10,050     |        |         |        | 31,344     |        |         |         | 32,417 |  
|                                                                     |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |        |        
|                                                                     |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |       
|                                                                     |                                        | Total cost of revenue    |                           |                                                                    | 11,239 |                    |            |                   | 10,710  |         |            |        | 32,987  |        |            |        | 34,750  |        
|                                                                     |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |        |        
|                                                                     |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |       
|Gross profit                                                         |                                        |                          | 42,571                    |                                                                    |        |                    | 38,404     |                   |         |         | 114,666    |        |         |        | 110,498    |       
|Operating expenses:                                                  |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |       
|                                                                     | Sales and marketing:                   |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |        |        
|                                                                     |                                        |                          |                           | Stock based compensation and
warrant charge                        |        |                    | 896        |                   |         |         | 411        |        |         |        | 2,848      |        |         |         | 2,077  |  
|                                                                     |                                        |                          |                           | Other sales and marketing costs                                    |        |                    | 24,309     |                   |         |         | 26,063     |        |         |        | 71,211     |        |         |         | 80,372 |  
|                                                                     | Research and development:              |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |        |        
|                                                                     |                                        |                          |                           | Stock based compensation                                           |        |                    | 26         |                   |         |         | 1,872      |        |         |        | 85         |        |         |         | 12,077 |  
|                                                                     |                                        |                          |                           | Other research and development
costs                               |        |                    | 12,059     |                   |         |         | 12,219     |        |         |        | 36,159     |        |         |         | 37,628 |  
|                                                                     | General and administrative:            |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |        |        
|                                                                     |                                        |                          |                           | Stock based compensation                                           |        |                    |           |                   |         |         | 27         |        |         |        | 44         |        |         |         | 166    |  
|                                                                     |                                        |                          |                           | Other general and administrative
costs                             |        |                    | 4,758      |                   |         |         | 4,573      |        |         |        | 13,051     |        |         |         | 15,187 |  
|Restructuring costs                                                  |                                        |                          | 2,237                     |                                                                    |        |                    |           |                   |         |         | 2,237      |        |         |        | 7,243      |       
|Amortization of goodwill and acquired intangibles                    |                                        |                          |                          |                                                                    |        |                    | 8,876      |                   |         |         |           |        |         |        | 29,901     |       
|                                                                     |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |        |        
|                                                                     |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |       
|                                                                     |                                        | Total operating expenses |                           |                                                                    | 44,285 |                    |            |                   | 54,041  |         |            |        | 125,635 |        |            |        | 184,651 |        
|                                                                     |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |        |        
|                                                                     |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |       
|Operating loss                                                       |                                        |                          | (1,714                    | )                                                                  |        |                    | (15,637    | )                 |         |         | (10,969    | )      |         |        | (74,153    | )     
|Interest income, net                                                 |                                        |                          | 975                       |                                                                    |        |                    | 1,782      |                   |         |         | 3,227      |        |         |        | 7,189      |       
|Impairment of equity investment in private company                   |                                        |                          |                          |                                                                    |        |                    |           |                   |         |         | (1,000     | )      |         |        |           |       
|                                                                     |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |        |        
|                                                                     |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |       
|                                                                     |                                        | Net loss                 |                           | $                                                                  | (739   | )                  |            | $                 | (13,855 | )       |            | $      | (8,742  | )      |            | $      | (66,964 | )      
|                                                                     |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |        |        
|                                                                     |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |       
|Basic and diluted net loss per common share                          |                                        | $                        | (0.01                     | )                                                                  |        | $                  | (0.28      | )                 |         | $       | (0.17      | )      |         | $      | (1.36      | )     
|                                                                     |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |        |        
|                                                                     |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |       
|Shares used in computing basic and diluted net loss per common share |                                        |                          | 51,046,792                |                                                                    |        |                    | 49,574,861 |                   |         |         | 50,821,804 |        |         |        | 49,255,976 |       
|                                                                     |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |        |        
|                                                                     |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |       
|Comprehensive loss:                                                  |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |       
|                                                                     |                                        |                          | Net loss                  |                                                                    | $      | (739               | )          |                   | $       | (13,855 | )          |        | $       | (8,742 | )          |        | $       | (66,964 | )     
|                                                                     |                                        |                          | Other comprehensive loss: |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |        |         |         |       
|                                                                     |                                        |                          |                           | Unrealized gain (loss) on
marketable
securities available for sale |        |                    | 128        |                   |         |         | (373       | )      |         |        | (102       | )      |         |         | (85    | )
|                                                                     |                                        |                          |                           | Foreign currency cumulative
translation adjustment                 |        |                    | 414        |                   |         |         | (240       | )      |         |        | 740        |        |         |         | (409   | )
|                                                                     |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |        |        
|                                                                     |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |       
|Total comprehensive loss                                             |                                        | $                        | (197                      | )                                                                  |        | $                  | (14,468    | )                 |         | $       | (8,104     | )      |         | $      | (67,458    | )     
|                                                                     |                                        |                          |                           |                                                                    |        |                    |            |                   |         |         |            |        |         |        |            |        |        

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

4



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##### 



WEBMETHODS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(UNAUDITED)

|                                                                              |                                                                                                               |   |                                |         |      |   |         |         |  
|----------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------- | - | ------------------------------ | ------- | ---- | - | ------- | ------- | -
|                                                                              |                                                                                                               |   | NINE MONTHS ENDED DECEMBER 31,
|                                                                              |                                                                                                               |   |                               
|                                                                              |                                                                                                               |   | 2002                           |         | 2001
|                                                                              |                                                                                                               |   |                                |         |     
|Cash flows from operating activities:                                         |                                                                                                               |   |                                |         |      |   |         |        
|                                                                              | Net loss                                                                                                      |   | $                              | (8,742  | )    |   | $       | (66,964 | )
|                                                                              | Adjustments to reconcile net loss to net
cash used in operating activities:                                   |   |                                |         |      |   |         |         |  
|                                                                              | Depreciation and amortization                                                                                 |   |                                | 7,531   |      |   |         | 6,146   |  
|                                                                              | Provision for allowance for doubtful
accounts                                                                 |   |                                | 214     |      |   |         | 2,360   |  
|                                                                              | Loss on disposal of equipment                                                                                 |   |                                |        |      |   |         | 572     |  
|                                                                              | Amortization of deferred stock
compensation related to employee stock
options and non-employee stock warrants |   |                                | 3,195   |      |   |         | 14,688  |  
|                                                                              | Impairment of equity investment in
private company                                                            |   |                                | 1,000   |      |   |         |        |  
|                                                                              | Amortization of goodwill and intangibles                                                                      |   |                                |        |      |   |         | 29,901  |  
|Increase (decrease) in cash resulting from changes in assets and
liabilities: |                                                                                                               |   |                                |         |      |   |         |        
|                                                                              | Accounts receivable                                                                                           |   |                                | 3,392   |      |   |         | 13,880  |  
|                                                                              | Prepaid expenses and other current assets                                                                     |   |                                | 1,039   |      |   |         | 3,736   |  
|                                                                              | Other non-current assets                                                                                      |   |                                | 910     |      |   |         | (378    | )
|                                                                              | Accounts payable                                                                                              |   |                                | (6,699  | )    |   |         | 76      |  
|                                                                              | Accrued expenses                                                                                              |   |                                | (1,928  | )    |   |         | 8,956   |  
|                                                                              | Accrued salaries and commissions                                                                              |   |                                | (2,493  | )    |   |         | (155    | )
|                                                                              | Accrued ESPP                                                                                                  |   |                                | (891    | )    |   |         | (2,497  | )
|                                                                              | Deferred revenue                                                                                              |   |                                | (10,054 | )    |   |         | (9,603  | )
|                                                                              |                                                                                                               |   |                                |         |      |   |         |         |  
|                                                                              |                                                                                                               |   |                                |         |      |   |         |        
|Net cash (used in) provided by operating activities                           |                                                                                                               |   | (13,526                        | )       |      |   | 718     |        
|                                                                              |                                                                                                               |   |                                |         |      |   |         |         |  
|                                                                              |                                                                                                               |   |                                |         |      |   |         |        
|Cash flows from investing activities:                                         |                                                                                                               |   |                                |         |      |   |         |        
|                                                                              | Purchases of property and equipment                                                                           |   |                                | (2,459  | )    |   |         | (4,642  | )
|                                                                              | Net purchases of marketable securities
available for sale                                                     |   |                                | (12,515 | )    |   |         | (42,860 | )
|                                                                              | Sale of investment in private company                                                                         |   |                                |        |      |   |         | 2,000   |  
|                                                                              |                                                                                                               |   |                                |         |      |   |         |         |  
|                                                                              |                                                                                                               |   |                                |         |      |   |         |        
|                                                                              | Net cash used in investing activities                                                                         |   |                                | (14,974 | )    |   |         | (45,502 | )
|                                                                              |                                                                                                               |   |                                |         |      |   |         |         |  
|                                                                              |                                                                                                               |   |                                |         |      |   |         |        
|Cash flows from financing activities:                                         |                                                                                                               |   |                                |         |      |   |         |        
|                                                                              | Borrowings under leasing agreements                                                                           |   |                                | 2,500   |      |   |         |        |  
|                                                                              | Payments on capital leases                                                                                    |   |                                | (3,467  | )    |   |         | (2,167  | )
|                                                                              | Proceeds from exercise of stock options
and stock issued under the ESPP                                       |   |                                | 4,119   |      |   |         | 8,321   |  
|                                                                              |                                                                                                               |   |                                |         |      |   |         |         |  
|                                                                              |                                                                                                               |   |                                |         |      |   |         |        
|Net cash provided by financing activities                                     |                                                                                                               |   | 3,152                          |         |      |   | 6,154   |        
|Effect of exchange rate on cash and cash equivalents                          |                                                                                                               |   | 1,115                          |         |      |   | (236    | )      
|                                                                              |                                                                                                               |   |                                |         |      |   |         |         |  
|                                                                              |                                                                                                               |   |                                |         |      |   |         |        
|Net decrease in cash and cash equivalents                                     |                                                                                                               |   | (24,233                        | )       |      |   | (38,866 | )      
|Cash and cash equivalents at beginning of period                              |                                                                                                               |   | 98,497                         |         |      |   | 109,713 |        
|Cash and cash equivalents at end of period                                    |                                                                                                               | $ | 74,264                         |         |      | $ | 70,847  |        
|                                                                              |                                                                                                               |   |                                |         |      |   |         |         |  

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

5



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

1. BASIS OF PRESENTATION

The accompanying consolidated financial statements of webMethods, Inc. and
its subsidiaries (collectively, the Company) have been prepared by the
Company pursuant to the rules and regulations of the Securities and Exchange
Commission (SEC). This Quarterly Report on Form 10-Q should be read in
conjunction with the Companys Annual Report on Form 10-K for the year ended
March 31, 2002. Certain information and footnote disclosures which are normally
included in financial statements prepared in accordance with generally accepted
accounting principles have been condensed or omitted pursuant to SEC rules and
regulations. The information reflects all normal and recurring adjustments,
which, in the opinion of management, are necessary for a fair presentation of
the financial position of the Company, and its results of operations for the
interim periods set forth herein. The results for the three and nine months
ended December 31, 2002 are not necessarily indicative of the results to be
expected for the full year or any future period.

2. RECENT ACCOUNTING PRONOUNCEMENTS

In July 2001, the Financial Accounting Standards Board issued SFAS No.
141, Business Combinations and SFAS No. 142, Goodwill and Other Intangible
Assets. SFAS No. 141 requires that all business combinations initiated after
June 30, 2001 be accounted for under the purchase method and addresses the
initial recognition and measurement of goodwill and other intangible assets
acquired in a business combination. SFAS No. 142 addresses the initial
recognition and measurement of intangible assets acquired outside of a business
combination and the accounting for goodwill and other intangible assets
subsequent to their acquisition. SFAS No. 142 provides that intangible assets
with finite useful lives will be amortized and that goodwill and intangible
assets with indefinite lives will not be amortized, but will rather be tested
at least annually for impairment. Under the provisions of SFAS No. 142, any
impairment loss identified upon adoption of this standard is recognized as a
cumulative effect of a change in accounting principle. Any impairment loss
incurred subsequent to initial adoption of SFAS No. 142 is recorded as a charge
to current period earnings. In the event the Company acquires goodwill
subsequent to June 30, 2001 it will not be amortized. The Company adopted SFAS
No. 142 on April 1, 2002 and, at that time, stopped amortizing goodwill that
resulted from business combinations completed prior to the adoption of SFAS No.
141.

The following table presents the impact of SFAS No. 142 on net loss and
net loss per share had SFAS No. 142 been in effect for the quarter and nine
months ended December 31, 2001 and 2002 (in thousands, except share and per
share amounts):

|                                          |  |                                 |            |                                |  |      |            |      |  |   |            |   |  |   |            |  
|----------------------------------------- |  | ------------------------------- | ---------- | ------------------------------ |  | ---- | ---------- | ---- |  | - | ---------- | - |  | - | ---------- | -
|                                          |  | THREE MONTHS ENDED DECEMBER 31, |            | NINE MONTHS ENDED DECEMBER 31,
|                                          |  | 2002                            |            | 2001                           |  | 2002 |            | 2001
|                                          |  |                                 |            |                                |  |      |            |     
|Net loss                                  |  | $                               | (739       | )                              |  | $    | (13,855    | )    |  | $ | (8,742     | ) |  | $ | (66,964    | )
|Adjustments:                              |  |                                 |            |                                |  |      |            |      |  |   |            |   |  |   |            |  
|Amortization of goodwill                  |  |                                 |           |                                |  |      | 8,849      |      |  |   |           |   |  |   | 29,691     |  
|                                          |  |                                 |            |                                |  |      |            |     
|Adjusted net loss                         |  | $                               | (739       | )                              |  | $    | (5,006     | )    |  | $ | (8,742     | ) |  | $ | (37,273    | )
|Weighted average shares-basic
and diluted |  |                                 | 51,046,792 |                                |  |      | 49,574,861 |      |  |   | 50,821,804 |   |  |   | 49,255,976 |  
|                                          |  |                                 |            |                                |  |      |            |     
|Adjusted basic and diluted EPS            |  | $                               | (0.01      | )                              |  | $    | (0.10      | )    |  | $ | (0.17      | ) |  | $ | (0.76      | )
|Reported basic and diluted EPS            |  | $                               | (0.01      | )                              |  | $    | (0.28      | )    |  | $ | (0.17      | ) |  | $ | (1.36      | )

There was no impairment recorded for the quarter and nine months ended
December 31, 2002.

6



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In June 2002, the Financial Accounting Standards Board issued SFAS No. 146
Accounting for Costs Associated with Exit or Disposal Activities. This
standard is effective for exit or disposal activities that are initiated after
December 31, 2002. The adoption of this standard is not expected to have a
material effect on the Companys financial position or results of operations.

In December 2002, the
Financial Accounting Standards Board issued SFAS No. 148, Accounting for Stock Based
Compensation-Transition and Disclosure-an Amendment to FAS 123. SFAS
148 provides two additional transition methods for entities that
adopt the preferable method of accounting for stock based
compensation. Further, the statement requires disclosure of
comparable information for all companies regardless of whether, when,
or how an entity adopts the preferable, fair value based method of
accounting. These disclosures are now required for interim periods in
addition to the traditional annual disclosure. The amendments to
SFAS No. 123, which provides for additional transition methods, are
effective for periods beginning after December 15, 2002, although
earlier application is permitted. The amendments to the disclosure
requirements are required for financial reports containing condensed
financial statements for interim periods beginning after December 15,
2002.

3. INVESTMENTS IN PRIVATE COMPANIES

In April 2002, the
Company made an equity investment of approximately $1 million and a
$1 million convertible debt investment in a third party, as a result
of which the Company held, at December 31, 2002, an equity ownership
position of less than 4% on a fully-diluted basis (excluding
conversion of convertible notes). The Company recorded approximately
$453,000 in royalty expenses for the quarter ended December 31, 2002
and approximately $794,000 for the nine months ended December 31,
2002 with this third party who shares a common Board member with the
Company. In March 2002, the Company recorded an other-than-temporary
decline in value of $200,000 in this equity investment. After that
impairment charge, the Company had a remaining balance of $1.8
million in equity investment in this private company. There was no
impairment of this investment recorded in the quarter ended December
31, 2002 or December 31, 2001.
In September 2002, the Company
recorded an other-than-temporary
decline in value of $1.0 million in another one of the equity
investments the Company made in a private company during 2000. After that
impairment charge, the Company had a remaining balance of $0 in equity investment in this private company.

4. SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION

Information regarding cash flow is as follows (in thousands):

|                                                       |  |                   |       |      |  |   |       |  
|------------------------------------------------------ |  | ----------------- | ----- | ---- |  | - | ----- | -
|                                                       |  | NINE MONTHS ENDED
|                                                       |  | DECEMBER 31,     
|                                                       |  |                  
|                                                       |  | 2002              |       | 2001
|                                                       |  |                   |       |     
|Cash paid during the period for interest               |  | $                 | 546   |      |  | $ | 387   |  
|                                                       |  |                   |       |      |  |   |       |  
|                                                       |  |                   |       |      |  |   |       |  
|Non-cash investing and financing activities:           |  |                   |       |      |  |   |       |  
|Equipment purchased under capital lease                |  | $                 | 1,070 |      |  | $ | 2,911 |  
|                                                       |  |                   |       |      |  |   |       |  
|                                                       |  |                   |       |      |  |   |       |  
|Change in net unrealized loss on marketable
securities |  | $                 | 102   |      |  | $ | (85   | )
|                                                       |  |                   |       |      |  |   |       |  

5. SEGMENT INFORMATION

The Company conducts operations worldwide and is primarily managed on a
geographic basis with those geographic segments being the Americas, Europe and
Asia Pacific region. Revenue is primarily attributable to the region in which
the contract is signed and the product is deployed. Information regarding
geographic areas is as follows (in thousands):

|             |  |                    |        |                   |  |      |        |      |  |   |         |  |  |   |         | 
|------------ |  | ------------------ | ------ | ----------------- |  | ---- | ------ | ---- |  | - | ------- |  |  | - | ------- | 
|             |  | THREE MONTHS ENDED |        | NINE MONTHS ENDED
|             |  | DECEMBER 31,       |        | DECEMBER 31,     
|             |  |                    |        |                  
|REVENUE      |  | 2002               |        | 2001              |  | 2002 |        | 2001
|             |  |                    |        |                   |  |      |        |     
|Americas     |  | $                  | 38,847 |                   |  | $    | 35,130 |      |  | $ | 102,112 |  |  | $ | 105,442 | 
|Europe       |  |                    | 9,463  |                   |  |      | 8,734  |      |  |   | 26,001  |  |  |   | 26,552  | 
|Asia Pacific |  |                    | 5,500  |                   |  |      | 5,250  |      |  |   | 19,540  |  |  |   | 13,254  | 
|             |  |                    |        |                   |  |      |        |      |  |   |         |  |  |   |         | 
|             |  |                    |        |                   |  |      |        |      |  |   |         |  |  |   |         | 
|Total        |  | $                  | 53,810 |                   |  | $    | 49,114 |      |  | $ | 147,653 |  |  | $ | 145,248 | 
|             |  |                    |        |                   |  |      |        |      |  |   |         |  |  |   |         | 

7



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|                  |       |      |              |        |           |   |        |        | 
|----------------- | ----- | ---- | ------------ | ------ | --------- | - | ------ | ------ | 
|                  |       |      | AS OF        |        | AS OF    
|                  |       |      | DECEMBER 31, |        | MARCH 31,
|LONG LIVED ASSETS |       | 2002 |              | 2002  
|                  |       |      |              |       
|Americas          |       | $    | 58,830       |        |           | $ | 55,360 |       
|Europe            |       |      | 1,885        |        |           |   | 1,555  |       
|Asia Pacific      |       |      | 1,541        |        |           |   | 1,373  |       
|                  |       |      |              |        |           |   |        |       
|                  |       |      |              |        |           |   |        |       
|                  | Total |      | $            | 62,256 |           |   | $      | 58,288 | 
|                  |       |      |              |        |           |   |        |       

6. RESTRUCTURING CHARGES

During the quarter ended September 30, 2001, the Company recorded a
restructuring charge of $7.2 million, consisting of $2.5 million for headcount
reductions, $4.0 million for consolidations of facilities, and $700,000 of
other related restructuring charges. These restructuring charges were incurred
to align the Companys cost structure with changing market conditions. The
restructuring plan resulted in a headcount reduction of approximately 150
employees or 14% of the workforce.

During the quarter ended December 31, 2002, the Company recorded a
restructuring charge of $2.2 million due to a further headcount reduction of
approximately 43 employees or 5% of the workforce. As of December 31, 2002 and
March 31, 2002, respectively, $2.0 million and $3.0 million of restructuring
charges remained unpaid. This unpaid portion primarily relates to rent on the
excess facilities and will be paid over the remaining rental periods.

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

Readers are advised that this report contains forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933, as amended,
and Section 21E of the Securities Exchange Act of 1934, as amended.
Forward-looking statements are subject to certain risks and uncertainties that
could cause actual results to differ materially from those indicated by the
forward-looking statements. Statements using the words believes,
anticipates, plans, expects, intends, may, will, should,
estimates, predicts, continue and similar expressions are intended to
identify forward-looking statements. Examples of forward-looking statements
include, but are not limited to, (i) projections of revenue, costs or expense,
margins, income or loss, earnings or loss per share, capital expenditures, cash
requirements or other financial items and projections regarding the market for
integration software, (ii) statements of the plans or objectives of the Company
or its management, including the development or enhancement of software,
development and continuation of strategic partnerships and alliances,
implementation and effect of sales and marketing initiatives by the Company,
focus on geographic or specific vertical markets and allocation of resources to
them, predictions of the timing and type of customer or market reaction to those
initiatives, the ability to control expenses, future hiring, the Companys business

8



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strategy and the execution of it, and
actions by customers and competitors, (iii) statements of future economic
performance or economic conditions and (iv) statements of assumptions
underlying other statements or statements about the Company or its business.

This report also identifies important factors that could cause actual
results to differ materially from those indicated by the forward-looking
statements. These risks and uncertainties include those factors discussed in
this Item under the caption Factors that May Affect Future Operating Results.
Forward-looking statements are beyond the ability of the Company to control,
and in many cases, the Company cannot predict what factors may cause actual
results to differ from those indicated by the forward-looking statements. The
Company disclaims any obligation to publicly update or revise any
forward-looking statements, whether as a result of new information, future
events or otherwise.

OVERVIEW

Background

We are a leading provider of software and services for comprehensive
end-to-end integration solutions. We develop and deliver software products and
provide related services that give large organizations the ability, seamlessly
and in real-time, to integrate disparate information resources, to connect
customers, vendors and business partners with the organization and its
employees, to view and manage the connected information resources, data,
business processes and human workflows and to provide Enterprise Web Services.
By deploying the webMethods integration platform, customers can reduce costs,
create new revenue opportunities, strengthen relationships with customers,
vendors and business partners, substantially increase supply chain efficiencies
and streamline internal business processes.

Overview of Third Quarter of Fiscal 2003

Our total revenue for the third quarter ended December 31, 2002 was $53.8
million, an increase of 10% compared to the quarter ended December 31, 2001.
This increase in revenue was due primarily to the $3.5 million, or 12%,
increase in license revenue and the $2.1 million, or 21%, increase in
maintenance revenue, offset by the $901,000, or 10%, decrease in professional
services revenue for the quarter. We decreased our net loss to $739,000 in the
quarter ended December 31, 2002 from $13.9 million from the quarter ended
December 31, 2001 primarily due to an increase in revenue of $4.7 million, a
reduction in goodwill amortization of $8.9 million resulting from the adoption
of SFAS No. 142 (see Recently Issued Accounting Pronouncements), a reduction
of $1.4 million of amortization relating to deferred compensation costs and a
reduction in other operating expenses, offset by a $2.2 million increase in
restructuring costs.

License revenue increased by approximately $3.5 million, or 12%, to $33.9
million for the quarter ended December 31, 2002 from $30.4 million for the
quarter ended December 31, 2001. Professional services revenue decreased by
approximately $901,000, or 10%, to $8.0 million for the quarter ended December
31, 2002 from $8.9 million for the quarter ended December 31, 2001. This
decrease in professional services revenue was due primarily to a decrease in
our billable consultants and, to a lesser extent, an increase in the
self-sufficiency of our customers to do their own implementations and an
increase in systems integrator led customer implementations. Maintenance
revenue increased by approximately $2.1 million, or 21%, to $11.9 million for
the quarter ended December 31, 2002 from $9.8 million for the quarter ended
December 31, 2001. This increase is due primarily to the increase in customers
purchasing our software and related maintenance contracts.

We have continued to focus on cost management while continuing to expand
and service our customer base. While our total revenues increased by 10% during
the quarter ended December 31, 2002, as compared to the quarter ended December
31, 2001, our operating expenses were lower in the same period. The increase in
revenue and the decrease in expenses resulted in an improvement in operating
loss and net loss for the quarter ended December 31, 2002.

We continue to sell our integration platform to Global 2000 customers
through our direct sales force augmented by system integrators, through our
relationships with application software partners and internationally through
resellers and distributors. We license our software to customers primarily on a

9



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perpetual basis and to a lesser extent on a renewable
basis. As of December 31, 2002, we had over 900 customers. Existing customers
accounted for more than 50% of our license revenue in the quarter ended
December 31, 2002 as a result of their expanded use of our software. No
customer accounted for more than 10% of our total revenue in the quarters ended
December 31, 2002 and 2001.

We continue to believe one of our competitive differentiators is our
strong partnerships with application software companies and system integrators.
Under our partnerships with application software vendors, which include i2
Technologies, J.D. Edwards, SAP AG and Siebel Systems, the partner may resell
or embed our software with their applications under limited use licenses for a
license or royalty fee. Our application and system integrator partners actively
assist us in selling the full webMethods integration platform to their
customers, making us the logical choice for enterprise-wide integration
initiatives. Under certain partnership arrangements, we may share license fees
derived from joint selling opportunities with our partners. In other
partnership arrangements, we may pay a sales assistance fee to a partner who
performs or assists in certain sales activities, and that fee usually is paid
once the license fee payment from the joint customer is received. We believe
our partners influenced, directly or indirectly, a substantial portion of our
license revenue during the quarter ended December 31, 2002.

Our focus on customer success and satisfaction has resulted in an
increasing number of referenceable customers, and a substantial portion of our
license revenue in the quarter ended December 31, 2002 came from our existing
customers. We strive to provide the most comprehensive integration platform
available, and will continue to invest as we strive to achieve an advantageous
positioning relative to our competition resulting in recognized industry and
technology leadership and increasing market share.

During the quarter ended September 30, 2002, we began shipping webMethods
Manager and webMethods 6, the next-generation of our comprehensive integration
platform. webMethods 6 is a standards-based, massively scalable integration
platform designed to be the foundation for next generation integration suites,
and is built on a fully service-oriented architecture so that customers can
leverage integration and Web services more widely and flexibly across their
enterprise and assemble solutions that meet their specific needs. During the
quarter ended March 31, 2002, we introduced and began shipping our Workflow
product, which provides powerful workflow capabilities enabling non-programmers
to model, prototype and deploy sophisticated human workflows within a business
process without any coding.

Critical Accounting Policies and Estimates

Our discussion and analysis of our financial condition and results of
operations are based upon our consolidated financial statements, which have
been prepared in accordance with accounting principles generally accepted in
the United States of America. The preparation of these financial statements requires us to
make estimates and judgments that affect the reported amounts of assets,
liabilities, revenue and expenses, and related disclosures. We evaluate our
estimates, on an on-going basis, including those related to allowances for bad
debts, investments, intangible assets, income taxes, contingencies and
litigation. We base our estimates on historical experience and on various other
assumptions that are believed to be reasonable under the circumstances, the
results of which form the basis for making judgments about the carrying values
of assets and liabilities that are not readily apparent from other sources.
Actual results may differ for these estimates under different assumptions or
conditions.

We believe the following critical accounting policies affect the more
significant judgments and estimates used in the preparation of our consolidated
financial statements.

Revenue Recognition

We enter into arrangements, which may include the sale of licenses of our
software, professional services and maintenance or various combinations of each
element. We recognize revenue based on Statement of Position (SOP) 97-2,
Software Revenue Recognition, as amended and modified by SOP 98-9,
Modification of SOP 97-2, Software Revenue Recognition, With Respect to
Certain Transactions. SOP 98-9 modified SOP 97-2 by requiring revenue to be
recognized using the residual method if certain conditions are met. Revenue
is recognized based on the residual method when an agreement has been
signed by both parties, the fees are fixed or determinable, collection of the
fees is probable, delivery of the

10



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product has occurred, vendor specific
objective evidence of fair value exists for any undelivered element, and no
other significant obligations remain. Revenue allocated to the undelivered
elements is deferred using vendor-specific objective evidence of fair value of
the elements and the remaining portion of the fee is allocated to the delivered
elements (generally the software license).

Policies related to revenue recognition require difficult judgments on
complex matters that are often subject to multiple sources of authoritative
guidance. These sources may publish new authoritative guidance, which might
impact our current revenue recognition policy. We continue to evaluate our
revenue recognition policy as new authoritative interpretations and guidance
are published, and where appropriate, may modify our revenue recognition
policy. Application of our revenue recognition policy requires a review of our
license and professional services agreements with customers and may require
management to exercise judgment in evaluating, among other things, whether
delivery has occurred, payments are fixed and determinable, collection is
probable, and where applicable, if vendor-specific objective evidence of fair
value exists for undelivered elements of the contract. In the event judgment in
the application of our revenue recognition policy is incorrect, the revenue
recognized by us could be impacted.

Allowance for Doubtful Accounts

We maintain allowances for doubtful accounts for estimated losses, which
may result from the inability of our customers to make required payments to us.
These allowances are established through analysis of the creditworthiness of
customers and collectability of receivables by using information such as credit
reports from third parties, published or publicly available financial
information, customer specific experience including payment practices and
history, inquiries, and other financial information from our customers. The use
of different estimates or assumptions could produce materially different
allowance balances. If the financial condition of our customers were to
deteriorate, resulting in an impairment of their ability to make payments,
additional allowances may be required.

Valuation of Private Company Equity Investments

We record an investment impairment charge when we believe an investment in
corporate debt securities or in equity securities of private companies has
declined in value and that such a decline is other than temporary. The
determination of the value of the investments is based on information provided
to us from the private companies such as audited financial statements,
valuations based on recent sales of equity, projections, representations by
management, and third party valuations if available. Future adverse changes in
market conditions or poor operating results of the underlying companies could
result in losses or a perceived inability to recover the carrying value of the
investments that may not be reflected in an investments current carrying
value, thereby possibly requiring an impairment charge in the future. As of
December 31, 2002, we had a remaining balance of $1.8 million in private
company equity investments.

Goodwill and Indefinite Lived Intangible Assets

Under SFAS No. 142, which we adopted on April 1, 2002, all of our goodwill
will be associated with our corporate reporting unit as we do not have multiple
reporting units. On an annual basis we will evaluate whether an impairment of
the goodwill may exist by comparing the book value of our outstanding common
stock to the market value of our outstanding common stock. If the market value
exceeds the book value, impairment does not exist. If the market value is less
than the book value, we will evaluate whether the condition is other than
temporary based primarily on fluctuations in our stock price. If we determine
that the condition is other than temporary, we will record an impairment equal
to the excess book value. See Recently Issued Accounting Pronouncements, for
more information.

Foreign Currency Effects

The functional currency for our foreign operations is the local currency.
The financial statements of foreign subsidiaries have been translated into
United States dollars. Asset and liability accounts have been translated using
the exchange rate in effect at the balance sheet date. Revenue and expense
accounts have been translated using the average exchange rate for the period.
The gains and losses associated with the translation of the financial statements
resulting from the changes in exchange rates from period to period

11



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have been reported in other comprehensive income or
loss. To the extent assets and liabilities of the foreign operations are
realized or the foreign operations are expected to pay back the intercompany
debt in the foreseeable future, amounts previously reported in other
comprehensive income or loss would be included in net income or loss in the
period in which the transaction occurs. Transaction gains or losses, other than
intercompany debt deemed to be of a long-term nature, are included in net
income or loss in the period in which they occur.

Accounting for Income Taxes

We have recorded a tax valuation allowance to reduce our deferred tax
assets to the amount that is expected to be realized. While we have considered
future taxable income and ongoing prudent and feasible tax planning strategies
in assessing the need for the valuation allowance, in the event we were to
determine that we would be able to realize our deferred tax asset in the future
in excess of its net recorded amount, an adjustment to the deferred tax asset
would increase income in the period such determination was made. Likewise,
should we determine that we would not be able to realize all or part of our net
deferred tax asset in the future, an adjustment to the deferred tax asset would
be charged to income in the period such determination was made.

RESULTS OF OPERATIONS

The following table summarizes the results of our operations for the quarter
and nine months ended December 31, 2002 compared with the
quarter and nine months
ended December 31, 2001 (in thousands):

|                         |  |                    |        |                   |  |            |         |              |  |              |     |            |  |   |         |    |  |   |         |    |  |  |     |   
|------------------------ |  | ------------------ | ------ | ----------------- |  | ---------- | ------- | ------------ |  | ------------ | --- | ---------- |  | - | ------- | -- |  | - | ------- | -- |  |  | --- | --
|                         |  | Three Months Ended |        | Nine Months Ended
|                         |  |                    |        |                  
|                         |  | December 31,       |        | December 31,      |  | Percentage |         | December 31, |  | December 31, |     | Percentage
|                         |  | 2002               |        | 2001              |  | Change     |         | 2002         |  | 2001         |     | Change    
|                         |  |                    |        |                   |  |            |         |              |  |              |     |           
|Total revenue            |  | $                  | 53,810 |                   |  | $          | 49,114  |              |  |              | 10  | %          |  | $ | 147,653 |    |  | $ | 145,248 |    |  |  | 2   | % 
|Gross Profit             |  |                    | 42,571 |                   |  |            | 38,404  |              |  |              | 11  | %          |  |   | 114,666 |    |  |   | 110,498 |    |  |  | 4   | % 
|% of total revenue       |  |                    | 79     | %                 |  |            | 78      | %            |  |              |     |            |  |   | 78      | %  |  |   | 76      | %  |  |  |     |   
|Total operating
expenses |  |                    | 44,285 |                   |  |            | 54,041  |              |  |              | (18 | )%         |  |   | 125,635 |    |  |   | 184,651 |    |  |  | (32 | )%
|% of total revenue       |  |                    | 82     | %                 |  |            | 110     | %            |  |              |     |            |  |   | 85      | %  |  |   | 127     | %  |  |  |     |   
|Operating loss           |  |                    | (1,714 | )                 |  |            | (15,637 | )            |  |              | (89 | )%         |  |   | (10,969 | )  |  |   | (74,153 | )  |  |  | (85 | )%
|% of total revenue       |  |                    | (3     | )%                |  |            | (32     | )%           |  |              |     |            |  |   | (7      | )% |  |   | (51     | )% |  |  |     |   
|Net loss                 |  | $                  | (739   | )                 |  | $          | (13,855 | )            |  |              | (95 | )%         |  | $ | (8,742  | )  |  | $ | (66,964 | )  |  |  | (87 | )%
|% of total revenue       |  |                    | (1     | )%                |  |            | (28     | )%           |  |              |     |            |  |   | (6      | )% |  |   | (46     | )% |  |  |     |   

Total revenue increased by approximately $2.4 million, or 2%, to $147.6
million for the nine months ended December 31, 2002 from $145.2 million for the
nine months ended December 31, 2001. This increase is primarily attributable to
an increase in sales to new and existing customers. During the quarter ended
December 31, 2002, total revenue increased approximately $4.7 million, or 10%,
to $53.8 million from $49.1 million for the quarter ended December 31, 2001.
The increase was principally due to increased license revenue and maintenance
revenue offset by a decrease in professional services revenue.

Our net loss of $8.7 million for the nine months ended December 31, 2002
decreased by approximately $58.2 million, or 87%, from the nine months ended
December 31, 2001. During the quarter ended December 31, 2002, our net loss
decreased by approximately $13.1 million, or 95%, to $739,000 from $13.8
million for the quarter ended December 31, 2001. The decrease in net loss for
the quarter and nine months ended December 31, 2002 was primarily due to a
reduction in goodwill amortization, amortization of
deferred compensation costs and a decrease in other operating
expenses. The decrease in net loss for the nine months ended
December 31, 2002 was also impacted by a reduction in
restructuring charges.

Revenue

The following table summarizes the Companys revenue for the quarter and
nine months ended December 31, 2002 compared with the quarter and nine months
ended December 31, 2001 (in thousands):

12



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##### 



|                      |  |                    |        |                   |  |            |        |              |  |              |     |            |  |   |         |  |  |   |         |  |  |  |     |   
|--------------------- |  | ------------------ | ------ | ----------------- |  | ---------- | ------ | ------------ |  | ------------ | --- | ---------- |  | - | ------- |  |  | - | ------- |  |  |  | --- | --
|                      |  | Three Months Ended |        | Nine Months Ended
|                      |  |                    |        |                  
|                      |  | December 31,       |        | December 31,      |  | Percentage |        | December 31, |  | December 31, |     | Percentage
|                      |  | 2002               |        | 2001              |  | Change     |        | 2002         |  | 2001         |     | Change    
|                      |  |                    |        |                   |  |            |        |              |  |              |     |           
|License               |  | $                  | 33,940 |                   |  | $          | 30,434 |              |  |              | 12  | %          |  | $ | 89,084  |  |  | $ | 88,980  |  |  |  | 0   | % 
|Professional
services |  |                    | 7,951  |                   |  |            | 8,852  |              |  |              | (10 | )%         |  |   | 24,737  |  |  |   | 27,944  |  |  |  | (11 | )%
|Maintenance           |  |                    | 11,919 |                   |  |            | 9,828  |              |  |              | 21  | %          |  |   | 33,832  |  |  |   | 28,324  |  |  |  | 19  | % 
|                      |  |                    |        |                   |  |            |        |              |  |              |     |            |  |   |         |  |  |   |         |  |  |  |     |   
|                      |  |                    |        |                   |  |            |        |              |  |              |     |            |  |   |         |  |  |   |         |  |  |  |     |   
|Total revenue         |  | $                  | 53,810 |                   |  | $          | 49,114 |              |  |              | 10  | %          |  | $ | 147,653 |  |  | $ | 145,248 |  |  |  | 2   | % 

Total revenue increased by approximately 2% for the nine months ended
December 31, 2002 compared to the nine months ended December 31, 2001. The
increase in license and maintenance revenue during the nine month period was
substantially offset by a decrease in professional services revenue. During the
quarter ended December 31, 2002, total revenue increased 10% compared to the
quarter ended December 31, 2001 due to an increase in license and maintenance
revenue, which was partially offset by a decrease in professional services
revenue. License revenue for the quarter ended December 31, 2002 was positively
affected by an increase in the number of larger deals as well as the
introduction of new products such as webMethods Workflow, webMethods Manager,
and webMethods 6.

For the nine months ended December 31, 2002, license revenue remained
relatively flat at $89.0 million as compared to the nine months ended December 31, 2001.
License revenue increased by approximately $3.5 million, or 12%, to $33.9
million in the quarter ended December 31, 2002 from $30.4 million in the
quarter ended December 31, 2001. This increase is primarily attributable to an
increase in sales to new and existing customers. License revenue increased in
both Americas and Europe and decreased in Asia Pacific during the quarter ended
December 31, 2002 as compared to the quarter ended December 31, 2001.

For the nine months ended December 31, 2002, professional services revenue
decreased by approximately $3.2 million, or 11%, to $24.7 million from $27.9
million for the nine months ended December 31, 2001. For the quarter ended
December 31, 2002, professional services revenue decreased by approximately
$901,000, or 10%, to $8.0 million from $8.9 million for the quarter ended
December 31, 2001. This decrease in professional services revenue was due to a
decrease in billable consultants, the increase in system integrator led
customer implementations, and, to a lesser extent, an increase in the
self-sufficiency of existing customers to expand the deployment of our
products.

For the nine months ended December 31, 2002, maintenance revenue increased
by approximately $5.5 million, or 19%, to $33.8 million from $28.3 million for
the nine months ended December 31, 2001. For the quarter ended December 31,
2002, maintenance revenue increased by approximately $2.1 million, or 21%, to
$11.9 million from $9.8 million for the quarter ended December 31, 2001. This
increase is due primarily to the increase in customers purchasing our software
and related maintenance contracts.

The following table summarizes the Companys net revenue by geographic
region for the quarter and nine months ended December 31, 2002 compared with
the quarter and nine months ended December 31, 2001 (in thousands):

13



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##### 



|              |  |                    |        |                   |  |            |        |              |  |              |    |            |  |   |         |  |  |   |         |  |  |  |    |   
|------------- |  | ------------------ | ------ | ----------------- |  | ---------- | ------ | ------------ |  | ------------ | -- | ---------- |  | - | ------- |  |  | - | ------- |  |  |  | -- | --
|              |  | Three Months Ended |        | Nine Months Ended
|              |  |                    |        |                  
|              |  | December 31,       |        | December 31,      |  | Percentage |        | December 31, |  | December 31, |    | Percentage
|              |  | 2002               |        | 2001              |  | Change     |        | 2002         |  | 2001         |    | Change    
|              |  |                    |        |                   |  |            |        |              |  |              |    |           
|Americas      |  | $                  | 38,847 |                   |  | $          | 35,130 |              |  |              | 11 | %          |  | $ | 102,112 |  |  | $ | 105,442 |  |  |  | (3 | )%
|Europe        |  |                    | 9,463  |                   |  |            | 8,734  |              |  |              | 8  | %          |  |   | 26,001  |  |  |   | 26,552  |  |  |  | (2 | )%
|Asia Pacific  |  |                    | 5,500  |                   |  |            | 5,250  |              |  |              | 5  | %          |  |   | 19,540  |  |  |   | 13,254  |  |  |  | 47 | % 
|              |  |                    |        |                   |  |            |        |              |  |              |    |            |  |   |         |  |  |   |         |  |  |  |    |   
|Total Revenue |  | $                  | 53,810 |                   |  | $          | 49,114 |              |  |              | 10 | %          |  | $ | 147,653 |  |  | $ | 145,248 |  |  |  | 2  | % 

For the nine months ended December 31, 2002, revenue from the Americas
decreased by approximately $3.3 million, or 3%, to $102.1 million from $105.4
million for the nine months ended December 31, 2001. We believe this decrease
was due primarily to the continued economic slowdown and the decline in
technology spending. For the quarter ended December 31, 2002, revenue from the
Americas increased approximately $3.7 million, or 11%, to $38.8 million from
$35.1 million for the quarter ended December 31, 2001.
Increases in Americas
license and maintenance revenue during the quarter ended December 31, 2002 were
offset by a decline in professional services revenue.

For the quarter and
nine month periods ended December 31, 2002, combined revenue
from Europe and Asia Pacific (international revenue) increased by
approximately $979,000, or 7%, and approximately $5.7 million,
or 14%, to $15.0
million and $45.5 million, respectively, as compared to the quarter and nine
months ended December 31, 2001. International revenue accounted for 28%
and 31% of our total revenue for the quarter and nine months ended December 31,
2002 as compared to 28% and 27% for the quarter and nine months ended December
31, 2001. The increases in international revenue were principally due to our
increased focus and investments in the Asia Pacific region, an increased
acceptance of our software in this region and larger deal sizes.

Gross Margin

The following table summarizes the Companys gross profit by type of
revenue, excluding stock based compensation, for the quarter and nine months
ended December 31, 2002 compared with the quarter and nine months ended
December 31, 2001:

|                                             |  |                    |    |                   |  |              |    |              |  |  |    |   |  |  |    |  
|-------------------------------------------- |  | ------------------ | -- | ----------------- |  | ------------ | -- | ------------ |  |  | -- | - |  |  | -- | -
|                                             |  | Three Months Ended |    | Nine Months Ended
|                                             |  |                    |    |                  
|                                             |  | December 31,       |    | December 31,      |  | December 31, |    | December 31,
|                                             |  | 2002               |    | 2001              |  | 2002         |    | 2001        
|                                             |  |                    |    |                   |  |              |    |             
|License margin                               |  |                    | 98 | %                 |  |              | 98 | %            |  |  | 98 | % |  |  | 98 | %
|Professional
services and
maintenance margin |  |                    | 48 | %                 |  |              | 46 | %            |  |  | 46 | % |  |  | 42 | %
|Gross margin                                 |  |                    | 79 | %                 |  |              | 78 | %            |  |  | 78 | % |  |  | 76 | %

We improved our total gross margin, excluding stock based compensation, to
78% for the nine months ended December 31, 2002 from 76% for the nine months
ended December 31, 2001. For the quarter ending December 31, 2002, we improved
our total gross margin, excluding stock based compensation, to 79% from 78% for
the quarter ending December 31, 2001.

Our cost of license revenue, excluding stock based compensation, consists
of royalties for products licensed from third parties. Our gross profit on
license revenue, excluding stock based compensation, was 98% for the quarters
and nine months ended December 31, 2002 and 2001, respectively.

14



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##### 



Our cost of professional services and maintenance, excluding stock based
compensation, consists of costs related to internal professional services and
support personnel, and subcontractors hired to provide implementation and
support services. Our gross margin on maintenance and services, excluding stock
based compensation, was 46% and 42%, respectively, for the nine months ended
December 2002 and 2001 and 48% and 46%, respectively, for the quarters ended
December 31, 2002 and 2001. The nine month and quarterly improvement in these
margins is due primarily to lower costs of professional services due to a
decrease in our number of professional services personnel and reduced use of
subcontractors.

Operating Expenses

The following table presents certain information regarding the Companys
operating expenses during the quarter and nine months ended December 31, 2002
compared with the quarter and nine months ended December 31, 2001 (in
thousands):

|                                          |  |                    |        |                   |  |            |        |              |  |              |      |            |  |   |         |   |  |   |         |   |  |  |      |   
|----------------------------------------- |  | ------------------ | ------ | ----------------- |  | ---------- | ------ | ------------ |  | ------------ | ---- | ---------- |  | - | ------- | - |  | - | ------- | - |  |  | ---- | --
|                                          |  | Three Months Ended |        | Nine Months Ended
|                                          |  |                    |        |                  
|                                          |  | December 31,       |        | December 31,      |  | Percentage |        | December 31, |  | December 31, |      | Percentage
|                                          |  | 2002               |        | 2001              |  | Change     |        | 2002         |  | 2001         |      | Change    
|                                          |  |                    |        |                   |  |            |        |              |  |              |      |           
|Operating Expenses:                       |  |                    |        |                   |  |            |        |              |  |              |      |            |  |   |         |   |  |   |         |   |  |  |      |   
|Sales and Marketing*                      |  | $                  | 24,309 |                   |  | $          | 26,063 |              |  |              | (7   | )%         |  | $ | 71,211  |   |  | $ | 80,372  |   |  |  | (11  | )%
|% of Total Revenue                        |  |                    | 45     | %                 |  |            | 53     | %            |  |              |      |            |  |   | 48      | % |  |   | 55      | % |  |  |      |   
|Research and Development*                 |  |                    | 12,059 |                   |  |            | 12,219 |              |  |              | (1   | )%         |  |   | 36,159  |   |  |   | 37,628  |   |  |  | (4   | )%
|% Total Revenue                           |  |                    | 22     | %                 |  |            | 25     | %            |  |              |      |            |  |   | 24      | % |  |   | 26      | % |  |  |      |   
|General and Administrative*               |  |                    | 4,758  |                   |  |            | 4,573  |              |  |              | 4    | %          |  |   | 13,051  |   |  |   | 15,187  |   |  |  | (14  | )%
|% of Total Revenue                        |  |                    | 9      | %                 |  |            | 9      | %            |  |              |      |            |  |   | 9       | % |  |   | 10      | % |  |  |      |   
|Stock Based Compensation                  |  |                    | 922    |                   |  |            | 2,310  |              |  |              | (60  | )%         |  |   | 2,977   |   |  |   | 14,320  |   |  |  | (79  | )%
|% of Total Revenue                        |  |                    | 2      | %                 |  |            | 5      | %            |  |              |      |            |  |   | 2       | % |  |   | 10      | % |  |  |      |   
|Restructuring costs                       |  |                    | 2,237  |                   |  |            |       |              |  |              | 100  | %          |  |   | 2,237   |   |  |   | 7,243   |   |  |  | (69  | )%
|% of Total Revenue                        |  |                    | 4      | %                 |  |            | 0      | %            |  |              |      |            |  |   | 2       | % |  |   | 5       | % |  |  |      |   
|Amoritization of Goodwill and
Intangibles |  |                    |       |                   |  |            | 8,876  |              |  |              | (100 | )%         |  |   |        |   |  |   | 29,901  |   |  |  | (100 | )%
|% of Total Revenue                        |  |                    | 0      | %                 |  |            | 18     | %            |  |              |      |            |  |   | 0       | % |  |   | 21      | % |  |  |      |   
|Operating Expenses:                       |  | $                  | 44,285 |                   |  | $          | 54,041 |              |  |              | (18  | )%         |  | $ | 125,635 |   |  | $ | 184,651 |   |  |  | (32  | )%
|% of Total Revenue                        |  |                    | 82     | %                 |  |            | 110    | %            |  |              |      |            |  |   | 85      | % |  |   | 127     | % |  |  |      |   



---

|* |  | Excludes stock based compensation and warrant charge; such amounts are shown separately on the line entitled stock based compensation.
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------

Our operating expenses are primarily classified as sales and marketing,
research and development and general and administrative. Each category includes
related expenses for compensation, employee benefits, professional fees,
travel, communications and allocated facilities, recruitment and overhead
costs. Our sales and marketing expenses also include expenses which are
specific to the sales and marketing activities, such as commissions, trade
shows, public relations, business development costs, promotional costs and
marketing collateral. Also included in our operating expenses is the
amortization of deferred stock compensation, restructuring charges, and, during
2001, amortization of goodwill and intangibles. Our sales and marketing
expenses also include amortization of a warrant charge.

In July 2001, we took decisive actions to reduce our operating expenses to
realign our cost structure to address the changing market conditions caused by
the slowing of the global economy and technology spending. As part of this
action, we reduced our headcount by 14% or 150 employees through a reduction in
force, closed excess sales offices and consolidated our California facilities
into two locations. The headcount reductions were across all departments with
the exception of customer support. During the

15



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##### 



quarter ended December 31, 2002, the Company further reduced its headcount by
5% or an additional 43 employees.

Sales and marketing expenses, excluding stock based compensation and
warrant charge, decreased by approximately $9.2 million, or 11%, to $71.2
million for the nine months ended December 31, 2002 from $80.4 for the nine
months ended December 31, 2001 and represented 48% and 55% of total revenue,
respectively. This decrease was primarily due to sales and marketing headcount
reductions which were done in July of 2001. During the quarter ended December
31, 2002, sales and marketing expense, excluding stock based compensation and
warrant charge, decreased approximately $1.8 million, or 7% to
$24.3 million from $26.1
million for the quarter ended December 31, 2001 and represented 45% and 53% of
total revenue respectively. This decrease was primarily due to lower sales and
marketing personnel costs, a reduction in sales assistance fees, and a decrease
in recruiting fees. These decreases were offset by an increase in marketing
trade show activity, particularly our annual Integration World event in October
2002.

Research and development expenses, excluding stock based compensation,
decreased by approximately $1.5 million, or 4% to $36.1 million for the nine
months ended December 31, 2002 from $37.6 million for the nine months ended
December 31, 2001 and represented 24% and 26% of total revenue, respectively.
This decrease is primarily due to reduced headcount associated with the July
2001 restructuring. During the quarter ended December 31, 2002, research and
development expenses, excluding stock based compensation, decreased
approximately $160,000, or 1% to $12.0 million from $12.2 million for the
quarter ended December 31, 2001 and represented 22% and 25% of total revenues,
respectively. This decrease was primarily due to decreases in contractor
expenses and travel, offset by increases in personnel costs.

General and administrative expenses, excluding stock based compensation,
decreased by approximately $2.1 million, or 14% to $13.1 million for the nine
months ended December 31, 2002 from $15.2 million for the nine months ended
December 31, 2001 and represented 9% and 10% of total revenue, respectively.
This decrease was primarily due to reduced headcount associated with the July
2001 restructuring. During the quarter ended December 31, 2002, general and
administrative expenses, excluding stock based compensation, increased
approximately $185,000, or 4% to $4.8 million from $4.6 million for the quarter
ended December 31, 2001 and both represented 9% of total revenue. This increase
was primarily attributable to an increase in personnel costs and insurance
expense.

Stock based compensation and warrant charge were $3.2 million and $14.7
million during the nine months ended December 31, 2002 and 2001, respectively,
of which $218,000 and $368,000, respectively, was included in cost of sales.
During the quarters ended December 31, 2002 and 2001, stock based compensation
and warrant charge were $987,000 and $2.4 million, respectively, of which
$65,000 and $47,000 was included in cost of sales. Deferred stock based
compensation and warrant charge were recorded for the following transactions:

(i)  In connection with the grant of stock options to employees and
non-employee directors during the quarters ended June 30, 2000 and 1999, we
recorded aggregate unearned compensation of $15.5 million, representing the
difference between the deemed fair value of our common stock at the date of
grant and the exercise price of such options.

(ii)  As a result of the acquisitions of Translink Software, Inc., Premier
Software Technology, Inc. and Alier, Inc., we recorded a deferred stock
compensation charge of $27.9 million related to restricted stock issued to
stockholders of the acquired companies.

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

16



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##### 



The deferred stock compensation and warrant charge is presented as a
reduction of stockholders equity and is amortized over the vesting period of
the applicable equity arrangement and is shown by expense category.

We recorded goodwill and intangible assets in connection with the
acquisition of Premier and Translink in fiscal 2001 and Alier in fiscal 2000.
The estimated useful life of the goodwill and the acquired intangibles during
the quarter ended December 31, 2001 was three years for trained and acquired
assembled workforce, one year for license agreements, two years for non-compete
agreements, three years for goodwill and four years for favorable lease terms.
We recorded $8.9 million of amortization of goodwill and acquired intangibles
in the quarter ended December 31, 2001. Amortization of the goodwill and
acquired intangibles ceased on April 1, 2002 upon our adoption of SFAS No. 142
(see Recently Issued Accounting Pronouncements for more information).

Interest income, net

Net interest income decreased by approximately $4.0 million, or 55%, to
$3.2 million for the nine months ended December 31, 2002 from $7.2 million for
the nine months ended December 31, 2001. During the quarter ended December 31,
2002, net interest income decreased $807,000, or 45%, to $975,000 from $1.8
million for the quarter ended December 31, 2001. These decreases were primarily
attributable to our lower average cash balance as well as lower interest rates
on corporate paper, bonds and money market funds in the respective period of
fiscal 2003, compared to those in the same period in the prior year.

Income taxes

We have recorded a valuation allowance for the full amount of our net
deferred tax assets, as the realizability of the deferred tax assets is not
currently predictable.

LIQUIDITY AND CAPITAL RESOURCES

The following table presents selected financial statistics and information
as of December 31, 2002 compared to March 31, 2002:

|                                                                |  |                |         |           |  |   |         | 
|--------------------------------------------------------------- |  | -------------- | ------- | --------- |  | - | ------- | 
|                                                                |  | December 31,   |         | March 31,
|                                                                |  | 2002           |         | 2002     
|                                                                |  |                |         |          
|                                                                |  | (in thousands)
|Cash, marketable securities and long term
marketable securities |  | $              | 200,019 |           |  | $ | 211,842 | 
|Working capital                                                 |  | $              | 162,527 |           |  | $ | 178,909 | 

Historically we have financed our operations and met our capital
requirements through our revenue and the sales of equity securities. Our liquidity and financial
position at December 31, 2002, showed a 6% decrease in our cash and investments
and a 9% decrease in our working capital from our positions at March 31, 2002.
The decrease in working capital is primarily due to a decrease in cash and cash
equivalents, offset by decreases in accounts payable, and a decrease in accrued salaries
and commissions at December 31, 2002, as compared to December 31, 2001.

Net cash used in operating activities was $13.5 million during the nine
months ended December 31, 2002, and as compared to $718,000 provided by
operating activities during the nine months ended December 31, 2001. The
increase in net cash used in operating activities from 2001 to 2002 was due
primarily to larger decreases in our accounts payable, accrued expenses and
accrued salaries and commissions for the nine months ended December 31, 2002
compared to the nine months ended December 31, 2001.

Net cash used in investing activities during the nine months ended
December 31, 2002 and 2001, was $15.0 million and $45.5 million, respectively.
This was primarily due to the purchase of marketable securities and, to a
lesser extent, to the purchase of property and equipment. Capital expenditures
were $2.5 million and $4.6 million during the nine months ended December 31,
2002 and 2001, respectively.

17



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Capital expenditures consisted of purchases of operating resources to manage
operations, including computer hardware and software, office furniture and
equipment and leasehold improvements. We generally fund capital expenditures either through capital leases or the use
of working capital. Net cash used in investing activities was offset by the
sale of an investment in a private company during the nine months ended
December 31, 2001.

Net cash provided by
financing activities was $3.2 million and $6.2
million during the nine months ended December 31, 2002 and 2001, respectively.
These cash flows primarily reflect net cash proceeds from exercises of stock
option and employee stock purchase plan purchases during the respective periods
and borrowings under lease agreements during the nine months ended December 31,
2002.

We believe that our existing working capital and our line of credit will
be sufficient to meet our working capital and operating resource expenditure
requirements for at least the next twenty-four months. However, we may utilize
cash resources to fund acquisitions or investments in complementary businesses,
technologies or product lines. In the event additional financing is required,
we may not be able to raise it on acceptable terms or at all.

FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS

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

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

We believe that quarter-to-quarter or year-to-year comparisons of our
financial results are not necessarily meaningful indicators of our future
revenue or operating results and should not be relied on as an indication of
our future performance. If our quarterly or annual revenue or operating results
fail to meet the expectations of investors or analysts, the market price of
webMethods stock could be negatively affected. Our quarterly operating results
have varied substantially in the past and may vary substantially in the future
depending upon a number of factors, including the changes in demand for our
products and services, economic conditions, competitive pressures, amount and
timing of operating costs and changes that we may make in our business,
operations and infrastructure. In addition, uncertainties and economic
after-effects of terrorist acts or other major, unanticipated events may impact
our quarterly operating results. In our fiscal 2002 and the first three
quarters of fiscal year 2003, we closed a substantial number of license
transactions in the last month of each quarter, which makes it more difficult
to gauge the level of license revenue we will have in any quarter until near
to, or after, its conclusion. We expect to continue devoting resources to our
sales and marketing operations and our research and development activities. Our
operating expenses, which include sales and marketing, research and development
and general and administrative expenses, are based on our expectations of
future revenue and are relatively fixed in the short term. If revenue falls
below our expectations in a quarter and we are not able to quickly reduce our
spending in response, our operating results for that quarter could be
significantly below the expectations of investors or analysts. It is possible
that our revenue or operating results in the future may be below the
expectations of investors or analysts and, as a result, the market price of
webMethods stock may fall. In addition, the stock market, particularly the
stock prices of independent infrastructure software companies, has been very
volatile. This volatility is often not related to the operating performance of
the companies. From our initial public offering in February 2000 until February
1, 2003, the closing price of webMethods stock on NASDAQ has ranged from a
high of $336.25 to a low of $4.32.

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

Due to customer demand, economic conditions, competitive pressures or
seasonal factors, we may experience a lower growth rate for, no growth in, or a
decline in quarterly or annual revenue from sales of

18



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##### 



our software and services. For example, the growth rate for revenue from sales
of our software and services during summer months may be slower than at other
times during year, particularly in European markets.

We also may experience declines in expected revenue due to patterns in the
capital budgeting and purchasing cycles of our current and prospective
customers, changes in demand for our software and services and deferrals of
purchases due to uncertainties and economic after-effects of terrorist acts,
geopolitical developments or uncertainties or other major, unanticipated
events. These periods of slower or no growth may lead to lower revenue, which
could cause fluctuations in our quarterly operating results. In addition,
variations in sales cycles may have an impact on the timing of our revenue,
which in turn could cause our quarterly operating results to fluctuate. To
successfully sell our software and services, we generally must educate our
potential customers regarding their use and benefits, which can require
significant time and resources. Any delay in sales of our software and services
could cause our revenue and operating results to vary significantly from
quarter to quarter, which could result in volatility in the market price of
webMethods stock.

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

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

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

We have established strategic relationships with enterprise application
software vendors and system integration partners. These strategic partners
provide us with important sales and marketing opportunities, create
opportunities to upsell our products to customers already using our software
embedded in their enterprise application products, and greatly increase our
implementation capabilities. We also have similar relationships with
resellers, distributors and other technology leaders. If our relationships with
any of these organizations were terminated or if we failed to work effectively
with our partners or to grow our base of

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strategic partners, resellers and distributors, we might lose important
opportunities, including sales and marketing opportunities, and our business
may suffer. In general, our partners are not required to market or promote our
software and generally are not restricted from working with competing
integration software companies. Accordingly, our success will depend on their
willingness and ability to devote sufficient resources and efforts to marketing
our software rather than the products of competitors. If these relationships
are not successful or if they terminate, our revenue and operating results
could be materially adversely affected, our ability to increase our penetration
of the market for integration software could be impaired, we may have to devote
substantially more resources to the distribution, sales and marketing,
implementation and support of our software than we would otherwise, and our
efforts may not be as effective as those of our partners, which would harm our
business.

We are trying to increase our sales to the US Government and to others in the
public sector, and we may face difficulties in our attempts to procure new
contracts with them.

We are attempting to expand our customer base to include more entities and
agencies within the US Government and state and local governments. Developing
new business in the public sector often requires companies to develop
relationships with different agencies or entities, as well as other government
contractors. If we are unable to develop or sustain these relationships, we may
be unable to procure new contracts within the timeframe we expect, and our
business and financial results may be adversely affected. Contracting with the
US Government also requires businesses to participate in a highly competitive
bidding process to obtain new contracts. We are a young company, and we lack
substantial experience in bidding for public sector contracts. We may be unable
to bid competitively if our software and services are improperly priced or if
we are incapable of providing our software and services at a competitive price.
The bidding process is an expensive and time-consuming endeavor that may result
in a loss for webMethods if we fail to win a contract on which we submitted a
bid. Furthermore, some agencies within the US Government may also require some
or all of our personnel to obtain a security clearance. If our key personnel
are unable to obtain or retain this clearance, we may be unsuccessful in our
bid for some government contracts. The US Government may choose to change the
way it procures new contracts, and it may adopt new rules or regulations
governing contracts such as cost accounting standards. If these changes were
implemented, they could cause our costs to increase and may make it difficult
or impossible for us to obtain new contracts or keep any existing contracts
when they expire or are subject to renewal.

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

We cannot be certain that our software and the services do not infringe
issued patents, copyrights or other intellectual property rights of third
parties. Litigation regarding intellectual property rights is common in the
software industry, and we may be increasingly subject to legal proceedings and
claims from time to time, including claims of alleged infringement of
intellectual property rights of third parties by us or our licensees concerning
their use of our software products and integration technologies and services.
Although we believe that our intellectual property rights are sufficient to
allow us to market our software without incurring liability to third parties,
third parties may bring claims of infringement against us. Such claims may be
with or without merit. Claims of alleged infringement may have a material
adverse effect on our business and may discourage potential customers from
doing business with us on acceptable terms, if at all. Litigation to defend
against claims of infringement or contests of validity could be very
time-consuming and could result in substantial costs and diversion of
resources, including our managements attention to our business. Furthermore, a
party making such a claim could secure a judgment that requires us to pay
substantial damages. A judgment could also include an injunction or other court
order that could prevent us from selling our software. Our business, operating
results and financial condition could be harmed significantly if any of these
events occurred, and the price of webMethods common stock could be adversely
affected. Furthermore, former employers of our current and future employees may
assert that our employees have improperly disclosed confidential or proprietary
information to us. In addition, we have agreed, and may agree in the future, to
indemnify certain of our customers against claims that our software infringes
upon the intellectual property rights of others. We could incur substantial
costs in defending ourself and our customers against infringement claims. In
the event of a claim of infringement, we, as well as our customers, may be
required to obtain one or more licenses from third parties, which may not be

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available on acceptable terms, if at all. Defense of any lawsuit or failure to
obtain any such required licenses could harm our business, operating results
and financial condition and the price of webMethods common stock.

Contracting with the US Government or state and local governments is very
different from contracting in the private sector, and these differences could
have a detrimental effect on our operating results.

Contracts with the US Government or with many state and local governments
frequently include provisions not found in the private sector and are often
governed by laws and regulations that do not affect private contracts. These
differences permit the public sector customer to take action not available to
customers in the private sector. This may include termination of current
contracts for convenience or due to a default. If a public sector customer
cancels a contract for convenience, which can occur if need for a product
changes, we may only be able to collect costs for work done prior to the
termination of the contract. If the public sector customer cancels because of
default, we may only be able to collect revenue for work we have completed, and
we may be forced to pay any costs the public sector customer incurs for
procuring the promised product from another source. The US Government can also
suspend operations if Congress does not allocate sufficient funds, and the US
Government may allow our competitors to protest our successful bids. The US
Government also may ban webMethods from doing business with any government
entity, and could also impose fines, levy sanctions or subject us to a criminal
prosecution. The US Government may refuse to invoke an option to extend a
contract and it could attempt to claim rights in technologies and systems we
invent. Some government agencies we contract with may prohibit us from seeking
contracts with certain other government agencies. If any of these events occur,
they may negatively affect our business and financial results. In order to
maintain contracts with the US Government, webMethods must also comply with
many rules and regulations that may affect our relationship with other
customers. The US Government can terminate its contract with us if we come
under foreign government control or influence, may require that we disclose our
pricing data during the course of negotiations, and may require us to prevent
access to classified data. If the US Government requires us to meet any of
these demands, it could result in increased costs or an inability to take
advantage of certain opportunities that may present themselves in the future.
US Government agencies routinely investigate and audit government contractors
administrative processes. They may audit our performance and our pricing, and
review our compliance with rules and regulations. If they find that we have
improperly allocated costs, they may require us to refund those costs or may
refuse to pay us for outstanding balances related to the improper allocation.
An unfavorable audit could result in a reduction of revenue, and may result in
civil or criminal liability if the audit uncovers improper or illegal
activities. This could harm our business, financial results and reputation.

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

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

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

Our software uses software components called adapters to communicate with
our customers enterprise applications. Our ability to develop these adapters
is largely dependent on our ability to gain access to the application
programming interfaces, or APIs, for the applications, and we may not have
access to necessary APIs in the future. APIs are written and controlled by the
application provider. Accordingly, if an

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

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

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

If our customers do not renew their product support and maintenance agreements,
we may lose a recurring revenue stream, which could harm our operating results.

Many of our customers subscribe for software support and maintenance
services, which we recognize over the term of those support and maintenance
agreements. If a significant portion of those customers chose not to continue
subscribing for product support and maintenance, our recurring revenue from
those services would be adversely affected, which could harm our business,
operating results and financial condition.

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

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

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

We have been, and intend to continue, expanding our international sales
efforts. We have limited experience in marketing, selling and supporting our
software and services abroad. Expansion of our international operations will
require a significant amount of attention from our management and substantial
financial resources. If we are unable to continue expanding our international
operations successfully and in a timely manner, our business and operating
results could be harmed. In addition, doing business

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internationally involves additional risks, particularly: the difficulties and
costs of staffing and managing foreign operations; unexpected changes in
regulatory requirements, taxes, trade laws and tariffs; differing intellectual
property rights; differing labor regulations; and changes in a specific
countrys or regions political or economic conditions.

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

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

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

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

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

We commenced operations in September 1996 and commercially released our
first software product in September 1998. Active Software, with which we
completed a merger in August 2000, was incorporated in September 1995 and
commercially released its first software product in August 1996. We have been
operating as a combined company since August 2000. If we do not generate
sufficient revenue from our business to fund operations, our growth could be
limited unless we are willing to incur operating losses that may be substantial
and are able to fund those operating losses from our available assets or, if
necessary, from the sale of additional capital through public or private equity
or debt financings. If we are unable to

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grow as planned, our chances of achieving and maintaining profitability and the
anticipated or forecasted results of operations could be reduced, which, in
turn, could have a material adverse effect on the market price of webMethods
stock.

Our penetration of the integration software market and the growth of our
business achieved in our limited operating history is not necessarily
indicative of our ability in the future to continue to penetrate that market
and to grow our business as we anticipate. Our software is complex and
generally involves significant capital expenditures by our customers. We often
have to devote substantial resources to educate prospective customers about the
benefits of our software. Our efforts to educate potential customers may not
result in our software being accepted by the potential customer or achieving
market acceptance. In addition, many of these prospective customers have made
significant investments in internally developed or custom systems and would
incur significant costs in switching to third party software such as ours.
Furthermore, even if our software is effective, our potential customers may not
choose it for technical, cost, support, competitive, economic or other reasons.
If the market for our software fails to grow or grows more slowly than we
anticipate, or if our penetration of the integration software market and the
growth of our business is less or slower than we anticipate, our business could
suffer, and our ability to achieve and maintain profitability and the
anticipated or forecasted results of operations could be reduced, which, in
turn, could have a material adverse effect on the market price of webMethods
stock.

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

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

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

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

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

Our success depends, in part, upon our proprietary technology and other
intellectual property rights. To date, we have relied primarily on a
combination of copyright, trade secret, trademark and patent laws, and
nondisclosure and other contractual restrictions on copying and distribution to
protect our proprietary technology. We have one patent and several pending
patent applications for technology related to our software, but we cannot
assure you that this patent is valid or that these applications will be
successful. A small number of our agreements with customers and system
integrators contain provisions regarding the rights of third parties to obtain
the source code for our software, which may limit our ability to protect our
intellectual property rights in the future. Despite our efforts to protect our
proprietary rights, unauthorized parties may copy aspects of our software and
obtain and use information that we regard as proprietary. In addition, other
parties may breach confidentiality agreements or other protective contracts we
have entered

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into, and we may not be able to enforce our rights in the event of these
breaches. Furthermore, we expect to continue increasing our international
operations in the future, and the laws of certain foreign countries may not
protect our intellectual property rights to the same extent as do the laws of
the United States.

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

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

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

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

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

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

Our Board of Directors adopted a shareholder rights plan and declared a
dividend distribution of one right for each outstanding share of webMethods
stock, payable to stockholders of record at the close of business on October
18, 2001. Each right, when exercisable, entitles the registered holder to
purchase certain securities at a specified purchase price, subject to
adjustment. The rights plan may have the anti-takeover effect of causing
substantial dilution to a person or group that attempts to acquire webMethods
on terms not approved by our Board of Directors. The existence of the rights
plan could limit the price that certain investors might be willing to pay in
the future for shares of webMethods stock and could discourage, delay or
prevent a merger or acquisition of webMethods, Inc. that stockholders may
consider favorable. In addition, provisions of the current certificate of
incorporation and bylaws of webMethods, Inc., as well as Delaware corporate
law, could make it more difficult for a third party to acquire us with the
support of our Board of Directors, even if doing so would be beneficial to our
stockholders.

RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

In July 2001, the Financial Accounting Standards Board issued SFAS No.
141, Business Combinations and SFAS No. 142, Goodwill and Other Intangible
Assets. SFAS No. 141 requires that all business combinations initiated after
June 30, 2001 be accounted for under the purchase method and addresses the
initial recognition and measurement of goodwill and other intangible assets
acquired in a business combination. SFAS No. 142 addresses the initial
recognition and measurement of intangible assets acquired outside of a business
combination and the accounting for goodwill and other intangible assets
subsequent to their acquisition. SFAS No. 142 provides that intangible assets
with finite useful lives be amortized and that goodwill and intangible assets
with indefinite lives will not be amortized, but will rather be tested at least
annually for impairment. Under the provisions of SFAS No. 142, any impairment
loss

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identified upon adoption of this standard is recognized as a cumulative effect
of a change in accounting principle. Any impairment loss incurred subsequent to
initial adoption of SFAS No. 142 is recorded as a charge to current period
earnings. In the event we acquire goodwill subsequent to June 30, 2001 it will
not be amortized. We adopted SFAS No. 142 on April 1, 2002 and, at that time,
stopped amortizing goodwill that resulted from business combinations completed
prior to the adoption of SFAS No. 141. See note 2 to the financial statements
(recent accounting pronouncements) for the impact of these standards.

In September 2002, the Financial Accounting Standards Board issued SFAS
No. 146 Accounting for Costs Associated with Exit or Disposal Activities.
This standard is effective for exit or disposal activities that are initiated
after December 31, 2002. The adoption of this standard is not expected to have
a material effect on the Companys financial position or results of operations.

In December 2002, the
FAS issued SFAS No. 148, Accounting for Stock Based
Compensation-Transition and Disclosure-an Amendment to FAS 123. SFAS
148 provides two additional transition methods for entities that
adopt the preferable method of accounting for stock based
compensation. Further, the statement requires disclosure of
comparable information for all companies regardless of whether, when,
or how an entity adopts the preferable, fair value based method of
accounting. These disclosures are now required for interim periods in
addition to the traditional annual disclosure. The amendments to
SFAS No. 123, which provides for additional transition methods, are
effective for periods beginning after December 15, 2002, although
earlier application is permitted. The amendments to the disclosure
requirements are required for financial reports containing condensed
financial statements for interim periods beginning after December 15,
2002.

ITEM 3. QUANTATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

Interest rate risk.We maintain our funds in money market accounts,
corporate bonds, commercial paper, Treasury notes, and agency notes. Our
exposure to market risk due to fluctuations in interest rates relates primarily
to our interest earnings on our cash deposits. These securities are subject to
interest rate risk inasmuch as their fair value will fall if market interest
rates increase. If market interest rates were to increase immediately and
uniformly by 10% from the levels prevailing as of December 31, 2002, the fair
value of the portfolio would not decline by a material amount. We do not use
derivative financial instruments to mitigate risks. However, we do have an
investment policy that would allow us to invest in short-term and long-term
investments such as money market instruments and corporate debt securities. Our
policy attempts to reduce such risks by typically limiting the maturity date of
such securities to no more than twenty-four months with a maximum average
maturity to our whole portfolio of such investments at twelve months, placing
our investments with high credit quality issuers and limiting the amount of
credit exposure with any one issuer.

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

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

ITEM 4. CONTROLS AND PROCEDURES

Within 90 days prior to the filing of this report, the Companys
management, including the Chief Executive Officer and Chief Financial Officer,
have conducted an evaluation of the effectiveness of disclosure controls and
procedures pursuant to Exchange Act Rule 13a-14. Based on that evaluation, the
Chief Executive Officer and Chief Financial Officer concluded that the
disclosure controls and procedures

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are effective in ensuring that all material information required to be filed in
this quarterly report on Form 10-Q has been made known to them in a timely
fashion. There have been no significant changes in internal controls, or in
factors that could significantly affect internal controls, subsequent to the
date the Chief Executive Officer and Chief Financial Officer completed their
evaluation.

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PART II

OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

On November 30, 2001, a purported class action lawsuit was filed in the
Southern District of New York naming webMethods, Inc., several of its executive
officers at the time of our initial public offering and the managing
underwriters of our initial public offering as defendants. The complaint, as
amended, alleges that webMethods initial public offering registration
statement and final prospectus contained material misrepresentations and
omissions related in part to certain commissions allegedly solicited and
received by the underwriters, and tie-in arrangements allegedly demanded by the
underwriters, in connection with their allocation of shares in our initial
public offering. The complaint seeks unspecified damages on behalf of a
purported class of purchasers of common stock between February 10, 2000 and
December 6, 2000. This case is at an early stage and has been consolidated with
similar actions; the defendant issuers have moved to dismiss part or all of the
complaints. Management believes that the claims against webMethods and its
officers are without merit, and we intend to defend against the complaint
vigorously.

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

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS

On February 10, 2000, in connection with our initial public offering, a
Registration Statement on Form S-1 (No. 333-91309) was declared effective by
the Securities and Exchange Commission, pursuant to which 4,715,000 share of
our common stock were offered and sold for our account at a price of $35.00 per
share, generating aggregate gross proceeds of $165 million for the account of
the Company. The managing underwriters were Morgan Stanley Dean Witter, Merrill
Lynch & Co., Dain Rauscher Wessels and Freidman Billings Ramsey. After
deduction approximately $11.6 million in underwriting discounts and $1.5
million in other related expenses, the net proceeds of the offering were
approximately $151.9 million. As of December 31, 2002, $151.9 million of the
net proceeds were invested in cash and cash equivalents, short-term and
long-term investments. We intend to use such proceeds for capital expenditures
and for general corporate purposes, including working capital to fund
anticipated operating losses.

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

(a)  Exhibits.

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|        |  |                                                                                                                                       
|------- |  | --------------------------------------------------------------------------------------------------------------------------------------
|Exhibit |  |                                                                                                                                       
|Number  |  | Description                                                                                                                           
|        |  |                                                                                                                                       
|2.1(1)  |  | Agreement and Plan of Merger dated as of May 20,
2000, by and among webMethods, Inc., Wolf
Acquisition, Inc. and Active Software, Inc.
|3.1(2)  |  | Fifth Amended and Restated Certificate of
Incorporation of webMethods, Inc., as amended                                               
|3.2(3)  |  | Amended and Restated Bylaws of webMethods, Inc.                                                                                       
|4.1(3)  |  | Specimen certificate for shares of webMethods Common
Stock                                                                            
|4.2(4)  |  | Rights Agreement dated as of October 18, 2001 between
webMethods, Inc. and American Stock Transfer & Trust
Company.                   
|10.1(3) |  | Second Amended and Restated Investor Rights Agreement                                                                                 
|10.2(5) |  | webMethods, Inc. Amended and Restated Stock Option
Plan                                                                               
|10.3(3) |  | Employee Stock Purchase Plan                                                                                                          
|10.4(3) |  | Indemnification Agreement entered into between
webMethods, Inc. and each of its directors and
executive officers                      
|99.1*   |  | Certification of Chief Executive Officer                                                                                              
|99.2*   |  | Certification of Chief Financial Officer                                                                                              



---



| | (1) |  | Incorporated by reference to webMethods Registration Statement on
Form S-4, as amended (File No. 333-39572).             
| | --- |  | --------------------------------------------------------------------------------------------------------------------------
|
| | (2) |  | Incorporated by reference to webMethods Annual Report on Form 10-K
for the year ended June 31, 2001 (File No. 001-15681).
|
| | (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. 001-15681)                          
|
| | (5) |  | Incorporated by reference to webMethods Annual Report on Form 10-K
for the year ended June 31, 2002 (File No. 001-15681).
|
| |     |  | * Filed herewith.                                                                                                         

(b)  Reports on Form 8-K.webMethods, Inc. filed no reports on Form 8-K
since the beginning of its fiscal quarter on October 1, 2002.

29



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##### 



SIGNATURES

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

|                       |  |                                                                  
|---------------------- |  | -----------------------------------------------------------------
|                       |  | WEBMETHODS, INC                                                  
|                      
|Date: February 7, 2003 |  | By: /s/ PHILLIP MERRICK                                          
|                      
|                       |  | Phillip Merrick
Chairman of the Board and
Chief Executive Officer
|                      
|                       |  |                                                                  
|                      
|Date: February 7, 2003 |  | By: /s/ MARY DRIDI                                               
|                      
|                       |  | Mary Dridi
Chief Financial Officer
(Principal Financial Officer) 

30