##### 



UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
 FORM 10-Q (Mark One)  þ QUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(d)OF THE
SECURITIES      EXCHANGE ACT OF 1934 FOR THE THREE MONTHS ENDED JUNE 30, 2004o
TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d)OF
THE SECURITIES      EXCHANGE ACT OF 1934 Commission File Number 1-15681
   webMethods, Inc. (Exact name of Registrant as Specified in its Charter) Delaware
    
    54-1807654(State or Other Jurisdiction of
Incorporation or Organization)
    
    (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 Securities registered pursuant to Section 12(b) of the Act: None Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.01 par value    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 þ No o Indicate by check mark whether the registrant is an accelerated filer (as
defined in Exchange Act Rule 12b-2). Yes þ No o As
of August 4, 2004, there were outstanding 53,077,440 shares of the
registrants Common Stock.




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##### 



WEBMETHODS, INC. QUARTERLY REPORT ON FORM 10-Q
FOR THE THREE MONTHS ENDED JUNE 30, 2004
TABLE OF CONTENTS Part I
    
    Financial InformationItem 1
    
    Financial StatementsCondensed Consolidated Financial StatementsCondensed Consolidated Balance Sheets (unaudited) as of
June 30, 2004 and March 31, 2004Condensed Consolidated Statements of Operations and Comprehensive Loss (unaudited) -
Three months ended June 30, 2004 and 2003Condensed Consolidated Statements of Cash Flows (unaudited) -
Three months ended June 30, 2004 and 2003Notes to Condensed Consolidated Financial Statements (unaudited)Item 2
    
    Managements Discussion and Analysis of Financial Condition and Results of OperationsItem 3
    
    Quantitative and Qualitative Disclosures About Market RiskItem 4
    
    Controls and ProceduresPart II
    
    Other InformationItem 1
    
    Legal ProceedingsItem 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
(UNAUDITED) JUNE 30,
    
    MARCH 31,2004
    
    2004(In thousands)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    63,443
    
    
    $
    75,462Marketable securities available for sale
    
    
    70,814
    
    
    
    44,328Accounts receivable, net of allowance of $2,001 and $2,103
    
    
    36,705
    
    
    
    47,050Prepaid expenses and other current assets
    
    
    7,501
    
    
    
    6,398Total current assets
    
    
    178,463
    
    
    
    173,238Marketable securities available for sale
    
    
    13,072
    
    
    
    36,157Property and equipment, net
    
    
    7,967
    
    
    
    8,106Goodwill
    
    
    46,704
    
    
    
    46,704Intangibles assets, net
    
    
    10,188
    
    
    
    10,787Other assets
    
    
    8,672
    
    
    
    9,130Total assets
    
    $
    265,066
    
    
    $
    284,122LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    8,481
    
    
    $
    11,055Accrued expenses
    
    
    15,063
    
    
    
    17,084Accrued salaries and commissions
    
    
    8,809
    
    
    
    11,560Deferred revenue
    
    
    35,733
    
    
    
    36,785Current portion of capital lease obligations
    
    
    724
    
    
    
    909Total current liabilities
    
    
    68,810
    
    
    
    77,393Capital lease obligations, net of current portion
    
    
    247
    
    
    
    373Other long term liabilities
    
    
    908
    
    
    
    1,000Long term deferred revenue
    
    
    2,103
    
    
    
    2,802Total liabilities
    
    
    72,068
    
    
    
    81,568Commitments and contingenciesStockholders equity:Common
stock, $0.01 par value; 500,000,000 shares 
authorized; 53,076,440 and 52,746,722 shares issued and outstanding
    
    
    531
    
    
    
    527Additional paid-in capital
    
    
    523,272
    
    
    
    521,455Deferred stock compensation and warrant charge
    
    
    (4,963
    )
    
    
    (5,625
    )Accumulated deficit
    
    
    (327,114
    )
    
    
    (316,360
    )Accumulated
other comprehensive income
    
    
    1,272
    
    
    
    2,557Total stockholders equity
    
    
    192,998
    
    
    
    202,554Total liabilities and stockholders equity
    
    $
    265,066
    
    
    $
    284,122
 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
(UNAUDITED) THREE MONTHS ENDED JUNE 30,2004
    
    2003(in thousands, except per share data)Revenue:License
    
    $
    14,174
    
    
    $
    21,802Professional services
    
    
    12,860
    
    
    
    8,873Maintenance
    
    
    14,795
    
    
    
    12,550Total revenue
    
    
    41,829
    
    
    
    43,225Cost of revenue:Amortization of intangibles
    
    
    599
    
    
    
    License
    
    
    620
    
    
    
    467Professional services and maintenance:Stock based compensation
    
    
    
    
    
    
    22Other professional services and maintenance
    
    
    14,239
    
    
    
    11,659Total cost of revenue
    
    
    15,458
    
    
    
    12,148Gross profit
    
    
    26,371
    
    
    
    31,077Operating expenses:Sales and marketing:Stock based compensation and warrant charge
    
    
    661
    
    
    
    696Other sales and marketing costs
    
    
    20,958
    
    
    
    22,450Research and development
    
    
    11,050
    
    
    
    11,200General and administrative:Stock based compensation
    
    
    
    
    
    
    3Other general and administrative costs
    
    
    5,073
    
    
    
    4,423Total operating expenses
    
    
    37,742
    
    
    
    38,772Operating loss
    
    
    (11,371
    )
    
    
    (7,695
    )Interest income
    
    
    553
    
    
    
    1,007Interest expense
    
    
    (27
    )
    
    
    (89
    )Other income
    
    
    112
    
    
    
    16Loss before income taxes
    
    
    (10,733
    )
    
    
    (6,761
    )Provision for income taxes
    
    
    21
    
    
    
    Net loss attributable to common shareholders
    
    $
    (10,754
    )
    
    $
    (6,761
    )Basic and diluted net loss per share
    
    $
    (0.20
    )
    
    $
    (0.13
    )Shares used in computing basic and diluted net loss per share
    
    
    52,827,120
    
    
    
    51,804,692Comprehensive loss:Net loss
    
    $
    (10,754
    )
    
    $
    (6,761
    )Other comprehensive income (loss):Unrealized loss on securities available for sale
    
    
    (429
    )
    
    
    (58
    )Foreign currency cumulative translation adjustment
    
    
    (855
    )
    
    
    157Total comprehensive loss
    
    $
    (12,038
    )
    
    $
    (6,662
    )
 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
(UNAUDITED) THREE MONTHS ENDED JUNE 30,2004
    
    2003(in thousands)Cash flows from operating activities:Net loss
    
    $
    (10,754
    )
    
    $
    (6,761
    )Adjustments to reconcile net loss to net cash (used in)/provided by operating activities:Depreciation and amortization
    
    
    1,704
    
    
    
    2,146Provision for doubtful accounts
    
    
    228
    
    
    
    Amortization of deferred stock compensation related to employee stock options and
non-employee stock warrant
    
    
    661
    
    
    
    721Amortization of acquired intangibles
    
    
    599
    
    
    
    Conversion of interest income into equity in private company
    
    
    
    
    
    
    (257
    )Increase (decrease) in cash resulting from changes in assets and liabilities:Accounts receivable
    
    
    9,567
    
    
    
    12,266Prepaid expenses and other current assets
    
    
    (1,152
    )
    
    
    (408
    )Other assets
    
    
    397
    
    
    
    778Accounts payable
    
    
    (2,442
    )
    
    
    1,021Accrued
expenses and other liabilities
    
    
    (1,962
    )
    
    
    (290
    )Accrued salaries and commissions
    
    
    (2,659
    )
    
    
    (2,081
    )Deferred revenue
    
    
    (1,380
    )
    
    
    (3,880
    )Net cash (used in)/provided by operating activities
    
    
    (7,193
    )
    
    
    3,255Cash flows from investing activities:Purchases of property and equipment
    
    
    (1,647
    )
    
    
    (890
    )Proceeds from sale of investment in private company
    
    
    
    
    
    
    1,000Net (purchases) sales of marketable securities available for sale
    
    
    (3,831
    )
    
    
    14,659Net cash (used in)/provided by investing activities
    
    
    (5,478
    )
    
    
    14,769Cash flows from financing activities:Payments on capital leases
    
    
    (311
    )
    
    
    (1,460
    )Proceeds from exercise of stock options and stock issued under the ESPP
    
    
    1,821
    
    
    
    1,491Net cash provided by financing activities
    
    
    1,510
    
    
    
    31Effect of exchange rate on cash and cash equivalents
    
    
    (858
    )
    
    
    426Net (decrease)/increase in cash and cash equivalents
    
    
    (12,019
    )
    
    
    18,481Cash and cash equivalents at beginning of period
    
    
    75,462
    
    
    
    79,702Cash and cash equivalents at end of period
    
    $
    63,443
    
    
    $
    98,183
 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 (the 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, 2004. 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
that, 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 months ended June
30, 2004 are not necessarily indicative of the results to be expected for the
full year or any future period. Certain amounts previously reported have been
reclassified to conform with current year presentation. 2. PRO FORMA STOCK BASED COMPENSATION The Company measures compensation expense for its employee stock-based
compensation using the intrinsic value method and provides pro forma
disclosures of net loss as if the fair value method had been applied in
measuring compensation expense. Under the intrinsic value method of accounting
for stock based compensation, when the exercise price of options granted to
employees is less than the fair value of the underlying stock on the grant
date, compensation expense is recognized over the applicable vesting period. The following table summarizes the Companys results on a pro forma basis
as if it had recorded compensation expense based upon the fair value at the
grant date for awards consistent with the methodology prescribed in SFAS 123,
Accounting for Stock-Based Compensation, for quarters ended June 30, 2004 and
2003: THREE MONTHS ENDED JUNE 30,2004
    
    2003(In thousands except per share data)Net loss attributable to common stockholders, as reported
    
    $
    (10,754
    )
    
    $
    (6,761
    )Add: Stock-based compensation expense determined under the intrinsic value method
    
    
    
    
    
    
    60Less: Stock-based compensation expense determined under fair value method
    
    
    (6,578
    )
    
    
    (7,757
    )Net loss attributable to common stockholders, pro forma
    
    $
    (17,332
    )
    
    $
    (14,458
    )Basic and diluted net loss per common share, as reported
    
    $
    (.20
    )
    
    $
    (.13
    )Basic and diluted net loss per common share, pro forma
    
    $
    (.33
    )
    
    $
    (.28
    )
 The fair value of each option grant is estimated on the date of grant
using the Black-Scholes valuation model with the following weighted average
assumptions: Employee Stock
    
    Employee StockOption Plans
    
    Purchase PlanThree Months Ended
    
    Three Months EndedJune 30,
    
    June 30,2004
    
    2003
    
    2004
    
    2003Expected volatility
    
    
    51
    %
    
    
    53
    %
    
    
    54
    %
    
    
    65
    %Risk-free interest rate
    
    
    3.93
    %
    
    
    2.79
    %
    
    
    3.93
    %
    
    
    2.79
    %Expected life (years)
    
    
    4
    
    
    
    4
    
    
    
    1.5
    
    
    
    0.5Expected dividend yield
    
    
    0.00
    %
    
    
    0.00
    %
    
    
    0.00
    %
    
    
    0.00
    %
 The weighted average fair value per share for stock option grants that
were awarded during the quarters ended June 30, 2004 and 2003 was $9.78 and
$8.93, respectively. 6




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3. COMPUTATION OF NET LOSS PER SHARE The Companys net loss per share calculation for basic and diluted is
based on the weighted average number of common shares outstanding. There are no
reconciling items in the numerator and denominator of the Companys net loss
per share calculation. Employee stock options and a non-employee
warrant exercisable for 595,405 and
991,083 shares for the quarters ended June 30, 2004 and 2003, respectively, have been
excluded from the net loss per share calculation because their effect would be
anti-dilutive. 4. SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION THREE MONTHS ENDED JUNE 30,2004
    
    2003(in thousands)Cash paid during the period for interest
    
    $
    27
    
    
    $
    89Non-cash investing and financing activities:Equipment purchased under capital lease
    
    $
    
    
    
    $
    1,006Conversion of debt and interest to equity in a private company
    
    $
    
    
    
    $
    1,257Change in net unrealized loss on marketable securities
    
    $
    (429
    )
    
    $
    (58
    )
 5. SEGMENT INFORMATION The Company conducts operations worldwide and is primarily managed on a
geographic basis with those geographic regions being the Americas, Europe,
Japan 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 regions is as follows: THREE MONTHS ENDEDJUNE 30,REVENUE
    
    2004
    
    2003(in thousands)Americas
    
    $
    25,550
    
    
    $
    25,331Europe
    
    
    7,773
    
    
    
    10,697Japan
    
    
    4,688
    
    
    
    4,245Asia Pacific
    
    
    3,818
    
    
    
    2,952Total
    
    $
    41,829
    
    
    $
    43,225
 AS OF
    
    AS OFJUNE 30,
    
    MARCH 31,LONG LIVED ASSETS
    
    2004
    
    2004(in thousands)Americas
    
    $
    69,470
    
    
    $
    70,497Europe
    
    
    2,053
    
    
    
    2,189Japan
    
    
    1,586
    
    
    
    1,681Asia Pacific
    
    
    422
    
    
    
    360Total
    
    $
    73,531
    
    
    $
    74,727
 7




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6. RESTRUCTURING CHARGES The Company has recorded
restructuring charges to align its cost structure with changing
market conditions. These restructuring plans resulted in
reductions
in headcount and the consolidation of offices. During the quarter ended September 30, 2001, the Company recorded a
restructuring charge of $7.2 million relating to headcount reductions,
consolidation of facilities, and other related restructuring charges. During
the quarter ended December 31, 2002, the Company recorded a restructuring
charge of $2.2 million due to a further reduction in headcount.
During the quarter ended December 31, 2003, the Company recorded a restructuring charge of $1.3 million due
to additional headcount reductions. During the quarter ended March 31, 2004, the Company recorded a
restructuring charge of $2.6 million due to further headcount
reductions, and the consolidation of certain offices. As of June 30, 2004 and March 31, 2004, respectively, $2.7 million and
$3.1 million of restructuring charges remained unpaid. This portion primarily
relates to rent on the excess facilities and will be paid over the remaining
rental periods. The following table sets forth a summary of total restructuring and
related charges, payments made against those charges and the remaining
liabilities as of June 30, 2004. Excess
    
    Severance andFacilities
    
    Related Benefits
    
    Total(in thousands)Balance at March 31, 2004
    
    $
    2,360
    
    
    $
    749
    
    
    $
    3,109Cash payments made during the quarter ended June 30, 2004
    
    
    (205
    )
    
    
    (181
    )
    
    
    (386
    )Balance at June 30, 2004
    
    $
    2,155
    
    
    $
    568
    
    
    $
    2,723
 7. INVESTMENTS IN PRIVATE COMPANIES In April 2000, the Company made an investment in a third party totaling
$2,000,000 of which $1,000,000 was equity and $1,000,000 was convertible debt.
The Company and this third party share a common Board member. In March 2002,
the Company recorded an other-than-temporary decline in value of $200,000 in
the equity investment. In June 2003, the Company received $1,000,000 as
repayment of the convertible debt and converted $257,000 of interest income
into additional equity. The third party was a business partner of the Company.
As of June 30, 2004 and 2003, the carrying value of the investment in this
third party was $1,057,000. The Company incurred royalty expense of $36,000 to
this third party in the quarter ended June 30, 2004 and $363,000 in the quarter
ended June 30, 2003. 8. SUBSEQUENT EVENT In
July 2004, the Company announced and implemented a restructuring
plan consisting of headcount reductions and the consolidation of
facilities to further align our cost structure with expected revenue. The Company is still evaluating the total costs associated with
this restructuring. 8




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ITEM 2: MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This quarterly report on Form 10-Q 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. Examples of
forward-looking statements include, but are not limited to, (i) projections of
financial performance or financial results, including items such as revenue,
costs or expense, cost savings, margins, income or loss, earnings or loss per
share, return to profitability on a pro-forma or GAAP basis, capital
expenditures, cash requirements or other financial items or metrics, the impact
of expenses on levels of cash and marketable securities, sufficiency of working
capital and projections regarding the market for the Companys current and
anticipated software offerings, (ii) statements of the plans or objectives of
webMethods, Inc. or its management, including the development or enhancement of
software, dates of availability of new products and new releases of existing
products, competitive strategies and the impact of competition, development and
continuation of strategic partnerships and alliances, contributions to future
financial performance of any of our new or existing products, technologies or
businesses, contribution to our financial performance by business partners,
implementation and effect of sales and marketing initiatives by webMethods,
strength of results from geographic or specific vertical markets and allocation
of resources to those markets, predictions of the timing and type of customer
or market reaction to those initiatives or our product offerings, the ability
to control expenses or achieve projected expense levels, future hiring,
webMethods business strategy and the execution on it and actions by customers
and competitors, (iii) statements of future economic performance, economic
conditions or the impact of recent changes in accounting standards and (iv)
assumptions underlying any of the foregoing. In some instances, forward-looking
statements can be identified by the use of the words believes, anticipates,
plans, expects, intends, may, will, should, estimates,
predicts, continue, the negative thereof or similar expressions. Although
we believe that the expectations reflected in the forward-looking statements
are reasonable, our expectations or the forward-looking statements could prove
to be incorrect, and actual results could differ materially from those
indicated by the forward-looking statements. Our future financial condition and
results of operations, as well as any forward-looking statements, are subject
to risks and uncertainties, including (but not limited to) those discussed in
Item 1 of our Form 10-K for the year ended March 31, 2004 under the caption
Factors That May Affect Future Operating Results and under this Item under
the caption Factors That May Affect Future Operating Results. Achieving the
future results or accomplishments described or projected in forward-looking
statements depends upon events or developments that are often beyond our
ability to control. All forward-looking statements and all reasons why actual
results may differ that are included in this report are made as of the date of
this report, and webMethods disclaims any obligation to publicly update or
revise such forward-looking statements or reasons why actual results may
differ. OVERVIEW Background We are a leading provider of software and services for end-to-end business
integration solutions. We offer a set of software products that enable
organizations to run, manage and optimize their business. Our software products
and related services give 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 Web services at the enterprise level. In
October 2003, we completed the business and asset acquisitions of The
Mind Electric, Inc. (TME), The Dante Group Inc. and the portal
solution previously known as Data Channel. TME was a leading provider
of software for service-oriented architectures and The Dante Group
was a provider of business activity monitoring software. The
aggregate acquisition cost for these three acquisitions was
approximately $32.4 million in cash. Overview of First Quarter
of Fiscal 2005 Our net loss of $10.8 million for the quarter ended June 30, 2004
increased by $4.0 million from a net loss of $6.8 million in the quarter ended
June 30, 2003. The increase in net loss was due primarily to a $7.6 million
decrease in license revenue in the quarter ended June 30, 2004 compared to the
quarter ended June 30, 2003. During the June 2004 quarter, many enterprises
unexpectedly became more cautious in their enterprise software
spending. They subjected their proposed information
technology purchases to rigorous internal reviews and approvals or
requests for contract contingencies, which often
resulted in longer sales cycles, the postponement of information technology
projects, customers placing smaller orders, or difficulty in closing large
deals. We did not close a number of expected opportunities we were
working on near the end of the June 2004 quarter, and lower closure rates of large
transactions near the end of June 2004 across almost every
geographic region contributed significantly to our decrease in
license revenue compared to the June 2003
quarter. That decrease in license revenue was partially offset by a $4.0
million increase in professional services revenue and a $2.2 million increase
in maintenance revenue in the quarter ended June 30, 2004 compared to the
quarter ended June 30, 2003. We
maintained our focus on managing operating expenses throughout
the quarter ended June 30, 2004 and decreased our operating expenses by $1.0
million in the quarter ended June 30, 2004 compared to the quarter ended June
30, 2003. This 3% reduction in operating expenses is a result of reductions in
total sales and marketing expense and research and development expense compared
to the same quarter in the prior year. 9




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##### 



We license software and sell our services primarily through our direct
sales organization augmented by other sales channels, including our strategic
software vendor partners, major system integrators with whom we have strategic
alliances, other partners and distributors and, to a lesser extent, resellers.
We license our software primarily on a perpetual basis and, to a lesser extent,
on a renewable term basis. As of June 30, 2004, we had over 1,200 customers,
compared to over 975 customers as of June 30, 2003. We believe our strong focus and track record of ensuring that our software
is successfully put into production is a strong competitive advantage and
differentiator. During the first quarter of fiscal year 2005, our global
customer services group reported and documented more than 155 separate customer
projects going into production events as compared to 100 such events reported
and documented during the quarter ended June 30, 2003. Ensuring that our
customers put our software into production in a timely manner enables them to
achieve a greater return on their investment and, in many cases, encourages
them to purchase additional software for other business integration projects
and serve as a reference customer for us in our future sales efforts. We believe one
of our competitive differentiators is our strategic
partnerships with enterprise software companies and system
integrators. Under our partnerships with enterprise software
vendors, the partner may resell or, in some instances, embed or otherwise
utilize our software with their products under limited use licenses for a
license or royalty fee. Enterprise software vendors with whom we
have relationships include American Management Systems (AMS), Hewlett-Packard
Company, Informatica, i2 Technologies, Microsoft, Peoplesoft and Siebel
Systems. We believe our systems integrator and enterprise
software partners influenced, directly or indirectly, a
significant portion of our license revenue during our quarters ended June 30,
2004 and 2003, and we expect this influence to continue in future periods. Under
certain partnership arrangements, we may share license fees derived from joint
selling opportunities with our partner. In systems integrator and 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 payment from the joint customer of license fees is received. 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 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). See Note 2 in the Consolidated
Financial Statements included in the Companys Annual Report on Form 10-K for
the year ended March 31, 2004 for a more comprehensive discussion of our
revenue recognition policies. Judgments we make regarding these items,
including collection risk, can materially impact the timing of recognition of
license revenue. 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 current revenue recognition policies. We continue to evaluate our
revenue recognition policies as new authoritative interpretations and guidance
are published, and where appropriate, may modify our revenue recognition
policies. 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 whether delivery has occurred,
payments are fixed and determinable, collection is probable, and where
applicable, if vendor-specific 10




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objective evidence of fair value exists for undelivered elements of the
contract. In the event judgment in the application of our revenue recognition
policies is incorrect, the revenue recognized by webMethods 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 credit-worthiness of
each customer with a receivable balance, determined by 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. At June 30, 2004, and March 31, 2004, the allowance for doubtful
accounts was $2,001,000 and $2,103,000 respectively. Business Combinations We are
required to allocate the purchase price of acquired companies to
the tangible and intangible assets acquired, liabilities assumed,
and in-process research and development (IPR&D) acquired based on their estimated fair
values. We engaged independent third-party appraisal firms to assist us in
determining the fair values of assets acquired and liabilities assumed. Such a
valuation requires management to make significant estimates and assumptions,
especially with respect to intangible assets. Critical estimates in valuing certain of the intangible assets include but
are not limited to: future expected cash flows from license sales, maintenance
agreements, consulting contracts, customer contracts, and acquired developed
technologies and IPR&D projects, and discount rates. Managements estimates of
fair value are based upon assumptions believed to be reasonable, but which are
inherently uncertain and unpredictable. Assumptions may be incomplete or
inaccurate, and unanticipated events and circumstances may occur. Other estimates associated with the accounting for these acquisitions may
change as additional information becomes available regarding the assets
acquired and liabilities assumed. Goodwill and Intangibles Assets We record goodwill and intangible assets when we acquire other businesses.
The allocation of acquisition cost to intangible assets and goodwill involves
the extensive use of managements estimates and assumptions, and the result of
the allocation process can have a significant impact on our future operating
results. Financial Accounting Standards Board No. 142, Goodwill and Other
Intangible Assets (SFAS 142), which was issued during fiscal year 2002 and
adopted by us on April 1, 2002, eliminated the amortization of goodwill and
indefinite lived intangible assets. Intangible assets with finite lives are
amortized over their useful lives while goodwill and indefinite lived assets
are not amortized under SFAS 142, but are periodically tested for impairment.
In accordance with SFAS 142, all of our goodwill is associated with our
corporate reporting unit, as we do not have multiple reporting units. On an
annual basis, or as events occur or circumstances change, we will evaluate whether an impairment of the goodwill may exist.
Goodwill is tested for impairment using a two-step process. The first step is
to identify a potential impairment and the second step measures the amount of
the impairment loss, if any. Goodwill is deemed to be impaired if the carrying
amount of the asset exceeds its estimated fair value. Acquired In-process Research and Development Costs to acquire in-process research and development technologies which
have no alternative future use and which have not reached technological
feasibility at the date of acquisition are expensed as incurred (see Note 12
in the Consolidated Financial Statements included in the Companys Annual
Report on Form 10-K for the year ended March 31, 2004 for more comprehensive
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
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 11




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##### 



or losses 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 assets 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. Restructuring and Related Charges We have recorded restructuring costs to align our cost structure with
changing market conditions. These restructuring plans resulted in a reduction
in headcount and consolidation of facilities through the closing of excess
offices. Our restructuring costs included accruals for the estimated loss on
facilities that we intend to sublease based on estimates of the timing and
amount of sublease income. We reassess this liability each period based on
market conditions. Revisions to our estimates of this liability could
materially impact our operating results and financial position in future periods
if anticipated events and key assumptions, such as the timing and amounts of
sublease rental income, either change or do not materialize. Litigation and Contingencies We are subject to the possibility of various loss contingencies arising in
the ordinary course of business. We consider the likelihood of loss or
impairment of an asset or the incurrence of a liability, as well as our ability
to reasonably estimate the amount of loss in determining loss contingencies. An
estimated loss contingency is accrued when it is probable that an asset has
been impaired or a liability has been incurred and the amount of loss can be
reasonably estimated. We regularly evaluate current information available to us
to determine whether such accruals should be adjusted. RESULTS OF OPERATIONS The following table summarizes the results of our operations for the
fiscal quarters ended June 30, 2004 and 2003 (all percentages are calculated
using the underlying data in thousands): June 30,
    
    Percentage
    
    June 30,2004
    
    Change
    
    2003($ in thousands)Total revenue
    
    $
    41,829
    
    
    
    (3.2
    )%
    
    $
    43,225Gross profit
    
    $
    26,371
    
    
    
    (15.1
    )%
    
    $
    31,077% of total revenue
    
    
    63.0
    %
    
    
    
    
    
    
    71.9
    %Total operating expenses
    
    $
    37,742
    
    
    
    (2.7
    )%
    
    $
    38,772% of total revenue
    
    
    90.2
    %
    
    
    
    
    
    
    89.7
    %Operating loss
    
    $
    (11,371
    )
    
    
    47.8
    %
    
    $
    (7,695
    )% of total revenue
    
    
    (27.2
    )%
    
    
    
    
    
    
    (17.8
    )%Net loss
    
    $
    (10,754
    )
    
    
    59.1
    %
    
    $
    (6,761
    )% of total revenue
    
    
    (25.7
    )%
    
    
    
    
    
    
    (15.6
    )%
 Our net loss of $10.8 million for the quarter ended June 30, 2004
increased by $4.0 million from a net loss of $6.8 million in the quarter ended
June 30, 2003. The increase in net loss was due primarily to a
$7.6 million decrease in license revenue in the quarter ended
June 30, 2004 compared to the quarter ended June 30, 2003.
That decrease in
license revenue was partially offset by a $4.0 million increase in professional
services revenue and a $2.2 million increase in maintenance revenue in the
quarter ended June 30, 2004 compared to the quarter ended June 30, 2003. In
addition, we decreased our operating expenses by $1.0 million, or approximately
3%, in the quarter ended June 30, 2004 compared to the quarter ended June 30,
2003. 12




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##### 



Revenue The following table
summarizes our revenue for the fiscal quarters ended June
30, 2004 and 2003: June 30,
    
    Percentage
    
    June 30,2004
    
    Change
    
    2003($ in thousands)License
    
    $
    14,174
    
    
    
    (35.0
    )%
    
    $
    21,802Professional services
    
    
    12,860
    
    
    
    44.9
    %
    
    
    8,873Maintenance
    
    
    14,795
    
    
    
    17.9
    %
    
    
    12,550Total revenue
    
    $
    41,829
    
    
    
    (3.2
    )%
    
    $
    43,225
 The following table summarizes the Companys net revenue by geographic
region for the fiscal quarters ended June 30, 2004 and 2003: June 30,
    
    Percentage
    
    June 30,2004
    
    Change
    
    2003($ in thousands)Americas
    
    $
    25,550
    
    
    
    0.9
    %
    
    $
    25,331Europe
    
    
    7,773
    
    
    
    (27.3
    )%
    
    
    10,697Japan
    
    
    4,688
    
    
    
    10.4
    %
    
    
    4,245Asia Pacific
    
    
    3,818
    
    
    
    29.3
    %
    
    
    2,952Total revenue
    
    $
    41,829
    
    
    
    (3.2
    )%
    
    $
    43,225
 Total revenue decreased to $41.8 million for the quarter ended June 30,
2004 from $43.2 million for the quarter ended June 30, 2003. The decrease in
total revenue was due primarily to a $7.6 million decrease in license revenue
for the quarter ended June 30, 2004 from the same period in the prior year,
which was partially offset by an increase of $4.0 million in professional
services revenue and an increase of $2.2 million in maintenance revenue in the
quarter ended June 30, 2004 from the same quarter in the prior year. In the quarter ended June 30, 2004, revenue from the Americas increased
0.9% to $25.6 million from $25.3 million in the quarter ended June 30, 2003.
International revenue decreased from $17.9 million in the quarter ended June
30, 2003 to $16.3 million in the quarter ended June 30,
2004. This
decrease was partially offset by a $1.2 million favorable foreign currency impact. International
revenue accounted for 39% of our total revenue in the quarter ended June 30,
2004, as compared to 41% in the quarter ended June 30, 2003. We had
unexpectedly low license revenue in the quarter ended
June 30, 2004, as license revenue decreased by 35% to $14.2 million from $21.8
million in the quarter ended June 30, 2003. During the June 2004 quarter,
many enterprises unexpectedly became more cautious in their
enterprise software spending. They subjected their proposed
information technology purchases to rigorous internal reviews and approvals
or requests for contract contingencies, which often resulted in longer sales cycles, the postponement of information
technology projects, customers placing smaller orders, or difficulty in closing
large deals. We did not close a number of expected opportunities we
were working on near the end of the June 2004 quarter, and lower closure rates of
large transactions near the end of June 2004 across almost every
geographical region contributed significantly to our decrease in
license revenue in the June 2004
quarter. We believe that prospects exhibited an unexpected degree of
cautiousness during the June 2004 quarter, with greater involvement of their
procurement departments and greater demands for various contractual
contingencies unacceptable to us, which extended or delayed anticipated closure
of license transactions. We also had occasional sales execution or
forecasting issues that contributed to license transactions not closing in the June
2004 quarter as we anticipated. Professional services revenue increased 45% to $12.9 million in the
quarter ended June 30, 2004 from $8.9 million in the quarter ended June 30,
2003. This increase in professional services revenue was primarily attributable
to increased billable hours. Maintenance revenue increased 18% to $14.8 million in the quarter ended
June 30, 2004 from $12.6 million in the quarter ended June 30, 2003. This
increase was due primarily to the increase in the number of copies of our
software licensed to customers and the cumulative effect of agreements for
post-contract maintenance and support, which are recognized as revenue ratably
over the term of the agreement. 13




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##### 



Gross Profit The following table summarizes the Companys gross profit by type of
revenue, excluding stock based compensation: Fiscal Quarter EndedJune 30,
    
    June 30,2004
    
    2003License
    
    
    91.4
    %
    
    
    97.9
    %Professional services and maintenance
    
    
    48.5
    %
    
    
    45.6
    %Total revenue
    
    
    63.0
    %
    
    
    71.9
    %
 Total gross profit, excluding stock based compensation, decreased to 63%
in the quarter ended June 30, 2004 from 72% in the quarter ended June 30, 2003.
This decrease was due primarily to a decrease in license revenue, as well as an
increase in our cost of licenses and an increase in the cost of professional
services and maintenance due principally to increased subcontractor costs. Our cost of license revenue in the June 2003 quarter consisted primarily
of royalties for products embedded in our software licensed from third parties.
Because we acquired certain technology in fiscal 2004, our cost of license
revenue in the June 2004 quarter also included a charge for amortization of
intangibles in the amount of $599,000. Our gross profit on license revenue was
91% and 98% in the quarters ended June 30, 2004 and 2003, respectively. The
decrease in license gross profit was due to a decrease in license revenue and
an increase in the fees we paid for third-party software embedded in or
licensed with our software products and the amortization of intangibles. Our cost of professional services and maintenance consists primarily of
costs related to internal professional services and support personnel, and
subcontractors hired to provide implementation and support services. Our gross
profit on maintenance and services, excluding stock based compensation, was
approximately 49% and 46% in the quarters ended June 30, 2004 and 2003,
respectively. Operating Expenses The following table presents certain information regarding the Companys
operating expenses during the fiscal quarters ended June 30, 2004 and 2003: Fiscal Quarter EndedJune 30,
    
    Percentage
    
    June 30,2004
    
    Change
    
    2003($ in thousands)Operating Expenses:Sales and marketing*
    
    $
    20,958
    
    
    
    (6.6
    )%
    
    $
    22,450% of total revenue
    
    
    50.1
    %
    
    
    
    
    
    
    51.9
    %Research and development*
    
    $
    11,050
    
    
    
    (1.3
    )%
    
    $
    11,200% of total revenue
    
    
    26.4
    %
    
    
    
    
    
    
    25.9
    %General and administrative*
    
    $
    5,073
    
    
    
    14.7
    %
    
    $
    4,423% of total revenue
    
    
    12.1
    %
    
    
    
    
    
    
    10.2
    %Stock based compensation and warrant charge
    
    $
    661
    
    
    
    (5.4
    )%
    
    $
    699% of total revenue
    
    
    1.6
    %
    
    
    
    
    
    
    1.6
    %Operating expense
    
    $
    37,742
    
    
    
    (2.7
    )%
    
    $
    38,772% of total revenue
    
    
    90.2
    %
    
    
    
    
    
    
    89.7
    %
  *
    
    Excludes stock based compensation and warrant charge, as applicable. 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 and warrant charge, 14




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##### 



as applicable.
In the quarter ended June 30, 2004, our operating expenses, excluding stock
based compensation and warrant charge, decreased $1.0 million from $38.1
million in the quarter ended June 30, 2003, to $37.1 million despite a $850,000
unfavorable foreign currency impact. Sales and marketing expense, excluding stock based compensation and
warrant charge, was 50% and 52% of total revenue in the quarters ended June 30,
2004 and 2003, respectively. In the quarter ended June 30, 2004, sales and
marketing expense decreased to $21.0 million from $22.5 million in the quarter
ended June 30, 2003, excluding stock based compensation and
warrant charge. This decrease was
primarily due to a decrease in the number of sales and marketing employees,
commission expense, sales assistance fees and marketing programs expense. In
addition, during the quarter ended June 30, 2004, sales and marketing expenses
reflected a $728,000 unfavorable foreign currency impact. Research
and development expense was
$11.1 million and $11.2 million in the quarters ended
June 30, 2004 and 2003, respectively, which represents 26% of total revenue. In the quarter ended June
30, 2004, research and development expense decreased $150,000 from
research and development expense in the quarter ended June 30, 2003 primarily due to a
decrease in the use of external consultants. General and administrative expense, excluding stock based compensation, as
a percentage of total revenue was approximately 12% and 10% for the quarters
ended June 30, 2004 and 2003, respectively. In the quarter ended June 30, 2004,
general and administrative expense, excluding stock based compensation,
increased $650,000 from the quarter ended June 30, 2003, to $5.1 million. This
increase is primarily due to an increase in consulting fees
associated with Sarbanes-Oxley Act compliance initiatives and an increase in bad debt expense.
During the quarter ended June 30, 2004, general and administrative expenses
reflected a $105,000 unfavorable foreign currency impact. Stock based compensation and warrant charge was $661,000 and $721,000 in
the quarters ended June 30, 2004 and 2003, respectively, of which $22,000 was
included in cost of sales for the quarter ended June 30, 2003. Deferred stock
based compensation and warrant charge was recorded for the following
transactions:  (i)
    
    The grant of stock options to employees and non-employee
directors at exercise prices less than the deemed fair value of our
common stock at the date of the grant; and(ii)
    
    An OEM/Reseller agreement we entered into with i2 Technologies (i2) in
March 2001 under which we issued a warrant which, as amended, permits i2
to purchase 710,000 shares of webMethods, Inc. common stock at an
exercise price of $28.70 per share. The fair value of the warrant,
based on the Black-Scholes valuation model, was $23.6 million on the date
of issuance which has been recorded as a deferred warrant charge. As part
of the amended agreement, i2 will pay us OEM fees of $8.8 million over
the amended term of the OEM/Reseller agreement which will be recorded as
a reduction to the deferred warrant charge and will not be recorded as
revenue. 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. Interest Income Interest income decreased by approximately $454,000, or 45%, to $553,000
for the quarter ended June 30, 2004 from $1.0 million for the quarter ended
June 30, 2003. This decrease was primarily attributable to decreased cash
balances and lower interest rates on commercial paper, corporate bonds and
money market funds in the quarter ended June 30, 2004, compared to those in the
same period in the prior year. Interest Expense Interest expense is primarily due to equipment leasing arrangements in the
Americas. During the quarter ended June 30, 2004, interest expense decreased
by approximately $62,000, or 70%, to $27,000 from $89,000 for the quarter ended
June 30, 2003. This decrease is primarily due to the completion of previously
established leases. Other Income Other income includes gains and losses on foreign currency
transactions. During the quarter ended June 30, 2004, our foreign currency
transaction gain increased $96,000, or 600%, to $112,000 from $16,000 for the
quarter ended June 30, 2003. 15




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##### 



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 probable. As
of March 31, 2004, we had net operating loss carry-forwards of
approximately $276.9 million. These net operating loss carry-forwards are
available to reduce future taxable income and begin to expire in fiscal year
2007. Under the provisions of the Internal Revenue Code, certain substantial
changes in our ownership have limited the amount of net operating loss
carry-forwards that could be utilized annually in the future to offset taxable
income. For the quarter ended June 30, 2004, our operations in Japan incurred
minimum tax expense of $21,000 that the Company can not off-set by utilizing
its net operating losses generated in prior years. LIQUIDITY AND CAPITAL RESOURCES Historically we have financed our operations and met our capital
requirements though the sales of equity securities. Our liquidity and financial
position at June 30, 2004, showed a 28% decrease in our cash and investments,
to $147.3 million and a 31% decrease in our working capital, to $109.7 million
from our positions at June 30, 2003. The decrease in working capital is
primarily due to approximately $32.4 million of cash payments
related to the acquisitions of The Mind Electric, Inc., The Dante
Group and the portal solution previously known as DataChannel in October 2003. The decrease in
working capital also reflects a decrease in our current liabilities offset by
an increase in accounts receivable balances at June 30, 2004, as compared to
June 30, 2003. Net cash used in operating activities was $7.2 million for the quarter
ended June 30, 2004, and net cash provided by operating activities was $3.3
million for the quarter ended June 30, 2003. The increase in cash used in
operating activities during the quarter ended June 30, 2004, compared to
quarter ended June 30, 2003, was due primarily to a larger net
loss and changes in accounts receivable balances, accounts payable balances and
accrued salaries and commissions. Net cash used in investing activities was $5.5 million for the quarter
ended June 30, 2004, and net cash provided by investing activities was $14.8
million for the quarter ended June 30, 2003. The increase in cash used by
investing activities was primarily due to the purchase of $3.8
million of marketable securities for the quarter ended June 30, 2004
as compared to the sale of $14.7 million of marketable securities for
the quarter ended June 30, 2003. Capital expenditures were $1.6 million and $890,000 in the quarters ended June
30, 2004 and 2003, respectively. 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 through capital leases and the use of
working capital. Additionally, for the quarter ended June 30, 2003, we received
$1.0 million in proceeds from the sale of a substantial portion of an
investment in a private company. Net cash provided by financing activities was $1.5 million and $31,000 in
the quarters ended June 30, 2004 and 2003, respectively. These cash flows
primarily reflect net cash proceeds from exercises of stock options and
Employee Stock Purchase Plan common stock issuances offset by payments on
capital leases in the quarters ended June 30, 2004 and 2003. Net cash proceeds
from exercises of stock options were $634,000 and $262,000 in quarters ended
June 30, 2004 and 2003 respectively. Net cash proceeds from ESPP common stock
issuances were $1.2 million in the quarters ended June 30, 2004 and 2003.
Payments on capital leases were $311,000 and $1.5 million in quarters ended
June 30, 2004 and 2003, respectively. We have a line of credit to borrow up to a maximum principal amount of
$20,000,000 with a maturity date of October 10, 2004, which we expect to renew.
Any borrowings under this line bear interest at the banks prime rate per
annum. As of June 30, 2004, we had not borrowed against this line of credit. In
connection with the line of credit, we have a letter of credit totaling
$115,000 related to an office lease. In connection with leasing of
replacement office space, we will be required to supply additional
letters of credit that are expected to total $2.5 million. Borrowings under this line are limited to
80% of eligible accounts receivable. We believe that our existing working capital and our line of credit will
be sufficient to meet our operating resource expenditure requirements for at
least the next twelve 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. We are not a party to
any agreements with, or commitments to, any special-purpose entities
that would constitute off-balance sheet financing. FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS You should
consider the following factors when evaluating our statements
in this report and elsewhere. We are subject to risks in addition to
those we describe 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, Inc. common stock. 16




---



##### 



Unanticipated fluctuations in our quarterly revenue or operating results, or
failure to return to and maintain profitability, could significantly affect the
price of webMethods, Inc. common 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 guidance we provide publicly or the expectations of investors
or analysts, that could have a material adverse effect on the market price of
webMethods, Inc. common stock. 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, the timing and terms of large transactions with customers,
competitive pressures, our ability to execute on our business plans, the amount
and timing of operating costs, delays in the availability of new products or
new releases of existing products and changes that we may make in our business,
operations and infrastructure. In addition, economic conditions and other
events beyond our control, such as economic uncertainties, geopolitical
developments or uncertainties, travel limitations, infectious outbreaks like
SARS, terrorist acts and other major, unanticipated events may have significant
negative impact on our quarterly operating results and delay our ability to
return to and maintain profitability on a basis determined in accordance with
accounting principles generally accepted in the United States (GAAP). Further,
the expensing of stock options in the future, the costs of compliance with the
Sarbanes-Oxley Act and other legal and compliance requirements could add
significant costs that may impede or delay our ability to return to and
maintain profitability on a GAAP basis. If our quarterly revenue or operating
results are adversely impacted, that could have a material adverse effect on
the market price of webMethods, Inc. common stock. We generally close 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 or our operating costs increase 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 guidance we provide publicly or
expectations of investors or analysts. It is possible that our revenue or
operating results in the future may be below the guidance we provide publicly
and the expectations of investors or analysts and, as a result, the market
price of webMethods, Inc. common stock may fall significantly. 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 June 30, 2004, the closing price of
webMethods, Inc. stock on the
Nasdaq National Market has ranged from a high of $308.06 to a low of $4.32. Growth of our sales may slow from time to time, causing our quarterly operating
results to fluctuate and possibly resulting in significant volatility in the
market price of webMethods, Inc. common stock. Due to customer demand, economic conditions, the timing and terms of large
transactions with customers, competitive pressures, our ability to execute on
our business plan, changes that we may make in our business or operations,
seasonal factors or major, unanticipated events, we may experience a lower
growth rate for, no growth in, or a decline in quarterly or annual revenue from
sales of our software and services in some or all of the geographic regions in
which we operate. For example, the growth rate for revenue from sales of our
software and services during summer months may be lower than at other times
during the year, particularly in European markets, and may be impacted by the
annual nature of our sales compensation plans. We also may experience delays or declines in expected revenue due to
patterns in the capital budgeting and purchasing cycles of our current and
prospective customers, purchasing practices and requirements of prospective
customers, including contract provisions or contingencies they may request,
changes in demand for our software and services, changes that we may make in
our business or operations, economic uncertainties, geopolitical developments
or uncertainties, travel limitations, infectious outbreaks like SARS, terrorist
acts 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 misperception
by us in the needs of our customers and prospective customers, or 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 significant volatility in the market price of
webMethods, Inc. common stock. 17




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We are a relatively young company and have a relatively limited operating
history with which to evaluate our business and the prospects of achieving our
anticipated growth and our forecasts of operating results. We commenced operations in September 1996. Active Software, with which we
completed a merger in August 2000, was incorporated in September 1995. We have
been operating as a combined company since August 2000. In addition, we have
acquired several businesses and technologies with limited operating histories.
During much of our history, we have sustained losses from operations. For a
number of reasons described in other factors listed here, we may not be able to
achieve our anticipated revenue growth, and control costs of operations, to
achieve our forecasts of operating results, including returning to and
maintaining profitability on a GAAP basis. That situation could have a material
adverse effect on the market price of webMethods common stock. If we do not
generate sufficient revenue to achieve and maintain income from 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 grow as
planned, our chances of returning to 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
common stock. Our target markets are highly competitive, and we may not be able to compete
effectively. The markets for
business integration solutions, Service-Oriented
Architecture capabilities, Business Activity Monitoring and Business Process
Management solutions and Composite Application framework capabilities are
rapidly changing and intensely competitive. There are a variety of methods
available to integrate software applications, monitor and optimize business
processes and workflows, provide Service-Oriented Architectures, enable Web
services and provide customers the capabilities to run, manage and optimize
their enterprise. 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 our Service-Oriented Architecture
technology, our Enterprise Services Platform solution, our Business Process
Management solution, our Business Activity Monitoring solution, our Composite
Application Framework or other solutions we offer or have announced. If our
technology, software and solutions 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 that develop their own integration software or Web
services technology; software vendors offering business integration software,
Service-Oriented Architecture technology, Web services capabilities, Business
Process Management software and Business Activity Monitoring software;
electronic data interchange vendors; vendors of proprietary enterprise
application integration; vendors of portal products; and application server
vendors. We also face competition from providers of various technologies to
enable Web services. 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, application software vendors with whom we
currently have or have had strategic relationships sometimes offer competitive
solutions or become competitors. Some of our competitors or
potential competitors may have more experience developing technologies or
solutions competitive with ours, 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
solutions, that achieve greater customer acceptance or that have significantly
improved functionality or performance as compared to our existing solutions 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, decreased
market share or longer sales cycles or sales processes involving more extensive
demonstrations of product capabilities, 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 promote and implement our
software and, if these relationships diminish or terminate, we may lose
important deals and marketing opportunities. We have
established strategic relationships with enterprise
software vendors and system integration partners. These strategic partners
provide us with important sales and marketing opportunities, create
opportunities to license our solutions, upsell our products to customers
already using license-limited versions of our software embedded in their
enterprise products, and greatly increase our implementation
capabilities. We also have similar relationships with resellers, distributors
and other technology leaders. During our fiscal year 2004 and the first quarter
of our fiscal year 2005, our enterprise software and systems integrator
partners directly or indirectly influenced a significant portion of our
license revenue, and we expect that leverage to continue in future periods. If
our relationships with our strategic business partners diminished or terminated
or if we failed to work effectively with our partners or to grow our base of
strategic partners, resellers and distributors, we might lose important
opportunities, including sales and marketing opportunities, our business may
suffer and our financial results could be adversely impacted. Our partners
often are not required to market or promote our software and generally are not
restricted from working with vendors of competing software or 18




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solutions or
offering their own solutions providing similar capabilities. Accordingly, our
success will depend on their willingness and ability to devote sufficient
resources and efforts to marketing our software and solutions rather than the
products of competitors or that they offer themselves. 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 our target markets 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 could harm our business, our
operating results and the market price of webMethods, Inc. common stock. Recent and future acquisitions of companies or technologies may result in
disruptions to our business, dilution or other adverse effects on future
financial results or the distraction of our management. In October 2003, we acquired businesses and technologies, and we may
acquire or make investments in other complementary businesses and technologies
in the future. Although the October 2003 acquisitions produced results at or
above our expectations on a cumulative basis through the first quarter of our
fiscal year 2005, we may not be able to realize benefits or results in the
future that we expect to achieve from those businesses and technologies. We may make investments in, or acquisitions of, technology, products or
companies in the future to maintain or improve our competitive position. We may
not be able to identify 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. With
respect to our potential future acquisitions, we may not be able to realize
future benefits we expected to achieve at the time of entering into the
transaction, or our recognition of those benefits may be delayed. In such
acquisitions, we will likely face many or all of the risks inherent in
integrating corporate cultures, product lines, operations and businesses. We
will be required to train our sales, professional services and customer support
staff with respect to acquired software products, which can detract from
executing against goals in the current period, and we may be required to modify
priorities of our product development, customer support, systems engineering
and sales organizations. 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 stockholders. Treating stock options and employee stock purchase plan participation as a
compensation expense could significantly impair our ability to return to and
maintain profitability. The Financial Accounting Standards Board has proposed requiring companies
to record compensation expense regarding stock options and participation in
employee stock purchase plans. We grant stock options to our employees,
officers and directors and we administer an employee stock purchase plan
(ESPP). Information on our stock option plan and ESPP, including the shares
reserved for issuance under those plans, the terms of options granted, the
terms of ESPP participation, and the shares subject to outstanding stock
options, is included in Note 14 of the Notes to Consolidated Financial
Statements of webMethods, Inc. included in our Annual Report on Form 10-K for
our fiscal year ended March 31, 2004. If we choose, or are required, to record
an expense for our stock-based compensation plans, we could incur a significant
compensation expense, and any such expense could significantly impair our
ability to return to and maintain profitability on a GAAP basis. That impact on
our ability to return to and maintain profitability on a GAAP basis could have
a material adverse effect on the market price of webMethods, Inc. common stock. Our operating results may decline and our customers may become dissatisfied if
we do not provide professional services to implement our solutions or if we are
unable to establish and maintain relationships with third-party implementation
providers. Customers that license our software typically engage our professional
services staff or third-party consultants to assist with product
implementation, training and other professional consulting services, and we
believe our strong focus on ensuring that our software is successfully put into
production is a strong competitive advantage and differentiator. 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. 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 to implement our solutions of if we are unable to
establish and maintain relationships with third-party implementation providers. 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, our business, operating
results and financial condition could be harmed. In particular, Phillip
Merrick, our 19




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Chairman of the Board and Chief Executive Officer, would be
particularly difficult to replace. Our future success will also depend in large
part on our ability to attract and retain experienced technical, sales,
marketing and management personnel. We 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 and solutions require a sophisticated sales effort targeted
at multiple departments within an organization. Competition for qualified sales
and marketing personnel is intense, and we might not be able to hire and retain
adequate numbers of such personnel. Our competitors have attempted to hire
employees away from us, and we expect that they will continue such attempts in
the future. We also plan to use 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 relatively limited experience in marketing, selling and
supporting our software and services in certain international markets.
Expansion of our international operations will require a significant amount of
attention from our management and substantial financial resources. If we are
unable to continue expanding our international operations successfully and in a
timely manner, our business and operating results could be harmed. In addition,
doing business internationally involves additional risks, particularly: the
difficulties and costs of staffing and managing foreign operations; unexpected
changes in regulatory requirements, business practices, 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. We currently do not engage in any currency hedging transactions. Our
foreign sales generally are invoiced in the local currency, and, as we expand
our international operations or if there is continued volatility in exchange
rates, our exposure to gains and losses in foreign currency transactions may
increase when we determine that foreign operations are expected to repay
intercompany debt in the foreseeable future. Moreover, the costs of doing
business abroad may increase as a result of adverse exchange rate fluctuations.
For example, if the United States dollar declines in value relative to a local
currency and we are funding operations in that country from our U.S.
operations, we could be required to pay more for salaries, commissions, local
operations and marketing expenses, each of which is paid in local currency. In
addition, exchange rate fluctuations, currency devaluations or economic crises
may reduce the ability of our prospective customers to purchase our software
and services. If we experience delays in developing solutions, or if our software contains
defects, we could lose partners, customers and revenue. We expect that the rapid evolution of business integration software,
Service-Oriented Architecture technology, Business Process Management
solutions, Business Activity Monitoring solutions, Composite Application
technologies, and related standards and 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 and
solutions to remain competitive. Our software and solutions could become
obsolete, unmarketable or less desirable to prospective customers if we are
unable to adapt to new technologies or standards. Serious defects may be found
during the period immediately following introduction of new software or
enhancements to existing software or in product implementations in varied
information technology environments. Internal quality assurance testing and
customer testing may reveal product performance issues or desirable feature
enhancements that could lead us to reallocate product development resources or
postpone the release of new versions of our software. The reallocation of
resources associated or any postponement could cause delays in the development
and release of future enhancements to our currently available software, could
require significant additional professional services work to address
operational issues 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 partners and 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 partners and 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 or ceases to demonstrate technology
leadership, we may have to increase our product development costs and divert
our product development resources to address
the problems. In addition, because our customers and certain partners depend on
our software for their critical systems and business functions, any
interruptions in operation of our software or solutions could cause our
customers and certain partners to initiate warranty or product liability suits
against us. Because our software could interfere with the operations of our partners and
customers other software applications, we may be 20




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subject to potential product
liability and warranty claims by these partners and customers, which may be
time consuming, costly to defend and may not be adequately covered by
insurance. Our software enables customers and certain partners software
applications to provide Web services, or to integrate with networks and
software applications, and is often used for mission-critical functions or
applications. Errors, defects, other performance problems in our software or
failure to provide technical support could result in financial or other damages
to our partners and customers. Partners and 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 and solutions to perform to partners and customers
expectations could give rise to warranty claims. Although our license
agreements typically contain provisions designed to limit our exposure to
potential product liability claims, existing or future laws or unfavorable
judicial decisions could negate these limitation of liability provisions.
Although we have not experienced any product liability claims to date, sale and
support of our software entail the risk of such claims. The use of our software
to enable partners and customers software applications to provide Web
services, and the integration of our software with our partners and customers
networks and software applications, increase the risk that a partner or
customer may bring a lawsuit against several suppliers if an integrated
computer system fails and the cause of the failure cannot easily be determined.
Even if our software is not at fault, 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 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, acquisition, 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; developing new software or services;
or responding 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. Third-party claims that we infringe upon their intellectual property rights may
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, trademarks or other intellectual property rights of
third parties. Litigation regarding intellectual property rights is common in
the software industry, and we have been subject to, and 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, 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 have brought, and may bring in the future, claims
of infringement against us or our licensees. Because our software is integrated
with our customers networks and business processes, as well as other software
applications, third parties may bring claims of infringement against us, as
well as our customers and other software suppliers, if the cause of the alleged
infringement cannot easily be determined. 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. Furthermore, former
employers of our current and future employees may assert that our employees
have improperly disclosed confidential or proprietary information to us. Such
claims may be with or without merit. Claims of alleged infringement, regardless of merit, may have a material
adverse effect on our business in a number of ways. Claims 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 may
be very time-consuming and may result in substantial costs and diversion of
resources, including our managements attention to our business. In addition,
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
available on acceptable terms, if at all. Furthermore, a party making such a
claim could secure a judgment that requires us to pay substantial damages, and
also include an injunction or other court order that could prevent us from
selling our software or require that we re-engineer some or all of our
products. Five of our customers have been subject to such claims and
litigation, and we or other customers may in the future be subject to
additional claims and litigation. We have settled one such claim and may in the
future settle any other such claims with which we may be involved, regardless
of merit, to avoid the cost and uncertainty of continued litigation. Defense of
any lawsuit or failure to obtain any such required licenses could significantly
harm our business, operating results and financial condition and the price of
webMethods common stock. Although we carry general liability insurance, our
current insurance coverage may not apply to, 21




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and likely would not protect us
from, all liability that may be imposed under these types of claims. Our
current insurance programs do not cover claims of patent infringement. 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 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 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 financial services industries and consumer
goods manufacturing and retail 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 stockholder 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 stockholder rights plan and declared a dividend
distribution of one right for each outstanding share of webMethods,
Inc. stock. 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, Inc. 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 without the support of our Board of
Directors, even if doing so would be beneficial to our stockholders. 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 March 31, 2004, 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 22




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such securities to no
more than twenty-four months with a maximum average maturity to our whole
portfolio of such investments at twelve months, placing our investments with
high credit quality issuers and limiting the amount of credit exposure with any
one issuer. Foreign currency exchange rate risk.Our exposure to market risk due to
fluctuations in foreign currency exchange rates relates primarily to the
intercompany balances with our subsidiaries located in Australia, Canada,
United Kingdom, France, Germany, Japan, the Netherlands, South Korea, Hong
Kong, Malaysia 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, Malaysian ringgit, South Korean won,
Canadian dollar or Japanese 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 As of June 30, 2004, webMethods management, including our Chief Executive
Officer and Chief Financial Officer, have conducted an evaluation of the
effectiveness of disclosure controls and procedures pursuant to
Rule 13a-15 promulgated under the Securities Exchange Act of
1934, as amended. Based on that evaluation, the Chief Executive Officer and Chief
Financial Officer have concluded that our disclosure controls and procedures
are effective at the reasonable assurance level to ensure that information we are required to disclose in reports
that we file or submit under the Securities Exchange Act of 1934, as amended,
is recorded, processed, summarized and reported within the time periods
specified in Securities and Exchange Commission rules and forms. While
webMethods continues the process of documenting, testing and enhancing, where
necessary or appropriate, its internal controls over financial reporting, there
have been no significant changes in internal controls, or in factors that could
significantly affect internal controls, during the quarter ended June 30, 2004
that have materially affected, or are reasonably likely to materially affect,
webMethods internal control over financial reporting. 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, several of its executive
officers at the time of our initial public offering (IPO) and the managing
underwriters of our initial public offering as defendants. The amended
complaint alleges, among other things, that underwriters of webMethods IPO
solicited and received excessive commissions and demanded tie-in arrangements
from the underwriters customers in connection with their allocation of shares
in webMethods IPO, and that those activities allegedly undertaken by the
underwriters of webMethods IPO were not disclosed in the registration
statement and final prospectus for webMethods IPO or disclosed to the public
after webMethods IPO. The amended complaint also alleges that false analysts
reports were issued by the underwriters. The amended complaint seeks
unspecified damages on behalf of a purported class of purchasers of
webMethods, Inc. common stock between February 10, 2000 and December 6, 2000. This case has been
consolidated as part of In Re Initial Public Offering Securities Litigation
(SDNY). Claims against webMethods executive officer defendants have been
dismissed without prejudice. webMethods has considered and conditionally agreed
to enter into a proposed settlement with representatives of the plaintiffs in
the consolidated proceeding. Under the proposed settlement, the plaintiffs
would dismiss and release their claims against webMethods in exchange for a
contingent payment guaranty by the insurance companies collectively responsible
for insuring the issuers in the consolidated action and assignment or surrender
to the plaintiffs by the settling issuers of certain claims that may be held
against the underwriter defendants. We believe that any material liability on
behalf of webMethods or its executive officers that may accrue under that
settlement offer would be covered
by our insurance policies. From time to time, webMethods is involved in other disputes and litigation
in the normal course of business. 23




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ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K.  (a)
    
    Exhibits. ExhibitNumber
    
    Description2.1(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 amended3.2(3)
    
    Amended and Restated Bylaws of webMethods, Inc.4.1(3)
    
    Specimen certificate for shares of webMethods Common Stock4.2(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 Agreement10.2(5)
    
    webMethods, Inc. Amended and Restated Stock Option Plan10.3(3)
    
    Employee Stock Purchase Plan10.4(3)
    
    Indemnification Agreement entered into between
webMethods, Inc. and each of its directors and executive
officers10.5*
    
    Executive Agreement entered into
between webMethods, Inc. and certain of its executive officers31.1*
    
    Rule 13a-14(a) Certification of Chief Executive Officer31.2*
    
    Rule 13a-14(a) Certification of Chief Financial Officer32.1*#
    
    Section 1350 Certification of Chief Executive Officer32.2*#
    
    Section 1350 Certification of Chief Financial Officer
   (1)
    
    Incorporated by reference to webMethods Registration Statement on Form S-4, as amended (File No. 333-39572).(2)
    
    Incorporated by reference to webMethods Annual Report on Form 10-K for the year ended March 31, 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 March 31, 2002 (File No.
001-15681).(6)
    
    Incorporated by reference to webMethods Form 10-K for the year ended March 31, 2003 (File No. 1-15681).*
    
    Filed herewith.#
    
    This item is furnished as an exhibit to this
report but is not filed with the Securities and Exchange Commission. (b) Reports onForm 8-K.The following reports on Form 8-K have been filed
by webMethods, Inc. since the beginning of its fiscal quarter on April 1, 2004: Date of Report
    
    Item No.
    
    Item ReportedApril 27, 2004
    
    
    7,12
    
    
    Press release dated April 27, 2004.July 2, 2004
    
    
    7,12
    
    
    Press release dated July 2, 2004.July 22, 2004
    
    
    7,12
    
    
    Press release dated July 22, 2004.
 24




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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, INCDate: August 9, 2004
    
    By: /s/ PHILLIP MERRICKPhillip MerrickChairman of the Board andChief Executive OfficerDate: August 9, 2004
    
    By: /s/ MARY DRIDIMary DridiChief Financial Officer(Principal Financial Officer)
 25