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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



For the quarterly period ended December 31, 2004



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



For the transition period from  to
 .



Commission file number 000-23783



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MICROMUSE INC.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                  
|-------------------------------------------------------------- |  | ---------------------------------
|DELAWARE                                                       |  | 94-3288385                       
|(State or other jurisdiction of incorporation or organization) |  | (IRS Employer Identification No.)



139 TOWNSEND STREET

SAN FRANCISCO, CALIFORNIA 94107

(415) 538-9090

(Address, including ZIP code, and telephone number)



---



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



Indicate by check mark whether the registrant is an accelerated filer (as defined in rule 12b-2 of the Exchange
Act).    Yes  x    No ̈



79,129,711 shares of Common Stock, $0.01 par value, were outstanding as of January 31, 2005



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##### Table of Contents

MICROMUSE INC.



TABLE OF CONTENTS



|                               |  |                                                                                                       |  |     
|------------------------------ |  | ----------------------------------------------------------------------------------------------------- |  | ----
|                               |  |                                                                                                       |  | Page
|PART I -
Financial Information |  |                                                                                                      
|                               |  |                                                                                                      
|Item 1.                        |  | Condensed Consolidated Financial Statements (Unaudited):                                              |  |     
|                               |  |                                                                                                      
|                               |  | Condensed Consolidated Balance Sheets as of December 31, 2004 and September 30, 2004                  |  | 3   
|                               |  |                                                                                                      
|                               |  | Condensed Consolidated Statements of Operations for the three months ended December 31, 2004 and 2003 |  | 4   
|                               |  |                                                                                                      
|                               |  | Condensed Consolidated Statements of Cash Flows for the three months ended December 31, 2004 and 2003 |  | 5   
|                               |  |                                                                                                      
|                               |  | Notes to Condensed Consolidated Financial Statements                                                  |  | 6   
|                               |  |                                                                                                      
|Item 2.                        |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                 |  | 11  
|                               |  |                                                                                                      
|Item 3.                        |  | Quantitative and Qualitative Disclosures about Market Risk                                            |  | 24  
|                               |  |                                                                                                      
|Item 4.                        |  | Controls and Procedures                                                                               |  | 25  
|                               | 
|PART II -
Other Information    |  |                                                                                                      
|                               |  |                                                                                                      
|Item 1.                        |  | Legal Proceedings                                                                                     |  | 26  
|                               |  |                                                                                                      
|Item 2.                        |  | Unregistered Sales of Equity Securities and Use of Proceeds                                           |  | 27  
|                               |  |                                                                                                      
|Item 3.                        |  | Defaults upon Senior Securities                                                                       |  | 27  
|                               |  |                                                                                                      
|Item 4.                        |  | Submission of Matters to a Vote of Security Holders                                                   |  | 27  
|                               |  |                                                                                                      
|Item 5.                        |  | Other Information                                                                                     |  | 27  
|                               |  |                                                                                                      
|Item 6.                        |  | Exhibits                                                                                              |  | 28  
|                               | 
|Signatures                     |  | 29                                                                                                   



2



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##### Table of Contents

PART I - FINANCIAL INFORMATION



Item 1. Condensed Consolidated Financial Statements



MICROMUSE INC.



CONDENSED
CONSOLIDATED BALANCE SHEETS

(In thousands, except per share data)



|                                                                                                                                                            |  |                  |         |   |                    |   |         |  
|----------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ---------------- | ------- | - | ------------------ | - | ------- | -
|                                                                                                                                                            |  | December, 312004 |         |   | September 30,2004* |  
|                                                                                                                                                            |  | (unaudited)      |         |   |                    |  
|ASSETS                                                                                                                                                      |  |                  |         |   |                    |   |         |  
|Current assets:                                                                                                                                             |  |                  |         |   |                    |   |         |  
|Cash and cash equivalents                                                                                                                                   |  | $                | 84,891  |   |                    | $ | 90,781  |  
|Short-term investments                                                                                                                                      |  |                  | 39,662  |   |                    |   | 24,469  |  
|Accounts receivable, net                                                                                                                                    |  |                  | 30,910  |   |                    |   | 19,901  |  
|Prepaid expenses and other current assets                                                                                                                   |  |                  | 8,817   |   |                    |   | 8,893   |  
|                                                                                                                                                            |  |                  |         |   |                    |   |         |  
|Total current assets                                                                                                                                        |  |                  | 164,280 |   |                    |   | 144,044 |  
|Property and equipment, net                                                                                                                                 |  |                  | 5,813   |   |                    |   | 5,002   |  
|Long-term investments                                                                                                                                       |  |                  | 68,219  |   |                    |   | 78,324  |  
|Goodwill, net                                                                                                                                               |  |                  | 50,983  |   |                    |   | 50,240  |  
|Other intangible assets, net                                                                                                                                |  |                  | 7,883   |   |                    |   | 6,743   |  
|                                                                                                                                                            |  |                  |         |   |                    |   |         |  
|Total Assets                                                                                                                                                |  | $                | 297,178 |   |                    | $ | 284,353 |  
|                                                                                                                                                            |  |                  |         |   |                    |   |         |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                        |  |                  |         |   |                    |   |         |  
|Current liabilities:                                                                                                                                        |  |                  |         |   |                    |   |         |  
|Accounts payable                                                                                                                                            |  | $                | 4,892   |   |                    | $ | 4,283   |  
|Accrued expenses                                                                                                                                            |  |                  | 12,990  |   |                    |   | 9,545   |  
|Accrued payroll                                                                                                                                             |  |                  | 12,407  |   |                    |   | 10,863  |  
|Income taxes payable                                                                                                                                        |  |                  | 8,313   |   |                    |   | 6,460   |  
|Deferred revenue, current portion                                                                                                                           |  |                  | 41,659  |   |                    |   | 40,912  |  
|                                                                                                                                                            |  |                  |         |   |                    |   |         |  
|Total current liabilities                                                                                                                                   |  |                  | 80,261  |   |                    |   | 72,063  |  
|Deferred revenue, less current portion                                                                                                                      |  |                  | 6,037   |   |                    |   | 3,023   |  
|                                                                                                                                                            |  |                  |         |   |                    |   |         |  
|Total liabilities                                                                                                                                           |  |                  | 86,298  |   |                    |   | 75,086  |  
|                                                                                                                                                            |  |                 
|Stockholders equity:                                                                                                                                       |  |                  |         |   |                    |   |         |  
|Preferred stock; $0.01 par value; 5,000 shares authorized; no shares issued and outstanding                                                                 |  |                  |        |   |                    |   |        |  
|Common stock; $0.01 par value; 200,000 shares authorized; 80,169 and 79,982 shares outstanding as of December 31, 2004 and September 30, 2004,
respectively |  |                  | 802     |   |                    |   | 800     |  
|Additional paid-in capital                                                                                                                                  |  |                  | 217,263 |   |                    |   | 216,580 |  
|Treasury stock                                                                                                                                              |  |                  | (7,147  | ) |                    |   | (7,147  | )
|Accumulated other comprehensive loss                                                                                                                        |  |                  | (3,646  | ) |                    |   | (1,833  | )
|Retained earnings                                                                                                                                           |  |                  | 3,608   |   |                    |   | 867     |  
|                                                                                                                                                            |  |                  |         |   |                    |   |         |  
|Total stockholders equity                                                                                                                                  |  |                  | 210,880 |   |                    |   | 209,267 |  
|                                                                                                                                                            |  |                  |         |   |                    |   |         |  
|Total liabilities and stockholders equity                                                                                                                  |  | $                | 297,178 |   |                    | $ | 284,353 |  
|                                                                                                                                                            |  |                  |         |   |                    |   |         |  

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|* | September 30, 2004 balances are derived from the audited financial statements included in the Companys 2004 Annual Report on Form 10-K.
|- | ----------------------------------------------------------------------------------------------------------------------------------------



See accompanying notes to the condensed consolidated financial statements



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MICROMUSE INC.



CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)



|                                           |  |                                 |        |      |   |       
|------------------------------------------ |  | ------------------------------- | ------ | ---- | - | ------
|                                           |  | Three months ended December 31,
|                                           |  | 2004                            |        | 2003
|Revenues:                                  |  |                                 |        |      |   |       
|License                                    |  | $                               | 19,320 |      | $ | 20,319
|Maintenance and services                   |  |                                 | 19,586 |      |   | 16,870
|                                           |  |                                 |        |      |   |       
|Total revenues                             |  |                                 | 38,906 |      |   | 37,189
|                                           |  |                                 |        |      |   |       
|Cost of revenues:                          |  |                                 |        |      |   |       
|License                                    |  |                                 | 1,283  |      |   | 1,345 
|Maintenance and services                   |  |                                 | 3,536  |      |   | 2,567 
|Amortization of developed technology       |  |                                 | 1,311  |      |   | 1,456 
|                                           |  |                                 |        |      |   |       
|Total cost of revenues                     |  |                                 | 6,130  |      |   | 5,368 
|                                           |  |                                 |        |      |   |       
|Gross profit                               |  |                                 | 32,776 |      |   | 31,821
|                                           |  |                                 |        |      |   |       
|Operating expenses:                        |  |                                 |        |      |   |       
|Sales and marketing                        |  |                                 | 15,997 |      |   | 15,676
|Research and development                   |  |                                 | 7,541  |      |   | 7,774 
|General and administrative                 |  |                                 | 7,229  |      |   | 5,411 
|Restatement costs                          |  |                                 | 118    |      |   | 1,967 
|Amortization of other intangible assets    |  |                                 | 48     |      |   | 48    
|                                           |  |                                 |        |      |   |       
|Total operating expenses                   |  |                                 | 30,933 |      |   | 30,876
|                                           |  |                                 |        |      |   |       
|Income from operations                     |  |                                 | 1,843  |      |   | 945   
|                                           |  |                                 |        |      |   |       
|Other income, net:                         |  |                                 |        |      |   |       
|Interest income, net                       |  |                                 | 1,024  |      |   | 738   
|Foreign exchange gain                      |  |                                 | 345    |      |   | 204   
|Other income, net                          |  |                                 | 33     |      |   | 40    
|                                           |  |                                 |        |      |   |       
|Total other income, net                    |  |                                 | 1,402  |      |   | 982   
|Income before income taxes                 |  |                                 | 3,245  |      |   | 1,927 
|Income tax provision                       |  |                                 | 504    |      |   | 539   
|                                           |  |                                 |        |      |   |       
|Net income                                 |  | $                               | 2,741  |      | $ | 1,388 
|                                           |  |                                 |        |      |   |       
|Per share data:                            |  |                                 |        |      |   |       
|Basic net income                           |  | $                               | 0.03   |      | $ | 0.02  
|Diluted net income                         |  | $                               | 0.03   |      | $ | 0.02  
|                                           |  |                                
|Weighted average shares used in computing: |  |                                 |        |      |   |       
|Basic net income per share                 |  |                                 | 80,065 |      |   | 78,619
|Diluted net income per share               |  |                                 | 81,301 |      |   | 82,063



See accompanying
notes to the condensed consolidated financial statements



4



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##### Table of Contents

MICROMUSE INC.



CONDENSED
CONSOLIDATED STATEMENTS OF CASH FLOWS

(In thousands)

(Unaudited)



|                                                                                            |  |                                |         |   |      |   |         |  
|------------------------------------------------------------------------------------------- |  | ------------------------------ | ------- | - | ---- | - | ------- | -
|                                                                                            |  | Three months endedDecember 31, |        
|                                                                                            |  | 2004                           |         |   | 2003 |  
|Cash flows from operating activities:                                                       |  |                                |         |   |      |   |         |  
|Net income                                                                                  |  | $                              | 2,741   |   |      | $ | 1,388   |  
|Adjustments to reconcile net income to net cash provided by (used in) operating activities: |  |                                |         |   |      |   |         |  
|Depreciation and amortization                                                               |  |                                | 2,140   |   |      |   | 2,590   |  
|Non-cash stock based compensation                                                           |  |                                |        |   |      |   | 115     |  
|Tax benefit related to exercise of stock options                                            |  |                                |        |   |      |   | 318     |  
|Changes in assets and liabilities                                                           |  |                                |         |   |      |   |         |  
|Accounts receivable, net                                                                    |  |                                | (11,009 | ) |      |   | (5,401  | )
|Prepaid expenses and other current assets                                                   |  |                                | 76      |   |      |   | (1,475  | )
|Accounts payable                                                                            |  |                                | 609     |   |      |   | 1,786   |  
|Accrued expenses                                                                            |  |                                | 2,489   |   |      |   | 875     |  
|Income taxes payable                                                                        |  |                                | 1,957   |   |      |   | 34      |  
|Deferred revenue                                                                            |  |                                | 3,761   |   |      |   | (437    | )
|                                                                                            |  |                                |         |   |      |   |         |  
|Net cash provided by (used in) operating activities                                         |  |                                | 2,764   |   |      |   | (207    | )
|                                                                                            |  |                                |         |   |      |   |         |  
|Cash flows from investing activities:                                                       |  |                                |         |   |      |   |         |  
|Capital expenditures                                                                        |  |                                | (1,415  | ) |      |   | (1,426  | )
|Investment purchases                                                                        |  |                                | (31,875 | ) |      |   | (45,314 | )
|Investment sales                                                                            |  |                                | 26,787  |   |      |   | 59,991  |  
|Acquisition of business, net of cash received                                               |  |                                |        |   |      |   | (239    | )
|Receipt of historical Riversoft tax refund                                                  |  |                                | 310     |   |      |   |        |  
|                                                                                            |  |                                |         |   |      |   |         |  
|Net cash provided by (used in) investing activities                                         |  |                                | (6,193  | ) |      |   | 13,012  |  
|                                                                                            |  |                                |         |   |      |   |         |  
|Cash flows from financing activities:                                                       |  |                                |         |   |      |   |         |  
|Proceeds from issuance of common stock from options exercised                               |  |                                | 581     |   |      |   | 555     |  
|                                                                                            |  |                                |         |   |      |   |         |  
|Net cash provided by financing activities                                                   |  |                                | 581     |   |      |   | 555     |  
|                                                                                            |  |                                |         |   |      |   |         |  
|Effects of exchange rate changes                                                            |  |                                | (3,042  | ) |      |   | (1,252  | )
|                                                                                            |  |                                |         |   |      |   |         |  
|Net increase (decrease) in cash and cash equivalents                                        |  |                                | (5,890  | ) |      |   | 12,108  |  
|Cash and cash equivalents at beginning of period                                            |  |                                | 90,781  |   |      |   | 89,385  |  
|                                                                                            |  |                                |         |   |      |   |         |  
|Cash and cash equivalents at end of period                                                  |  | $                              | 84,891  |   |      | $ | 101,493 |  
|                                                                                            |  |                                |         |   |      |   |         |  



See accompanying
notes to the condensed consolidated financial statements



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##### Table of Contents

MICROMUSE INC.



NOTES TO CONDENSED
CONSOLIDATED FINANCIAL STATEMENTS (Unaudited)



Note 1. Basis of Presentation



The condensed consolidated financial statements are the unaudited
historical financial statements of Micromuse Inc. and subsidiaries (the Company) and reflect all adjustments (consisting only of normal recurring adjustments) that, in the opinion of management, are necessary for a fair presentation of
interim period results. These unaudited condensed consolidated financial statements should be read in conjunction with the consolidated financial statements and notes thereto included in the Companys Form 10-K as filed with the Securities and
Exchange Commission on December 14, 2004. The September 30, 2004 condensed consolidated balance sheet included herein was derived from audited financial statements, but does not include all disclosures, including notes, required by generally
accepted accounting principles.



The results of operations for the current
interim period are not necessarily indicative of results to be expected for the entire current fiscal year or other future interim periods.



Reclassifications



Certain reclassifications, none of which affected net income, have been made to prior amounts to conform to the current year presentation.



Use of Estimates



The preparation of condensed consolidated financial statements in conformity with accounting principles generally accepted in the United States of America requires
management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the condensed consolidated financial statements and the reported amounts of
revenues and expenses during the reporting period. Actual results could differ from these estimates.



On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, allocation of technical services department costs among expense categories, provision for doubtful accounts and sales
returns, fair value of investments, fair value of acquired intangible assets and goodwill, useful lives of intangible assets and property and equipment, income taxes, restructuring costs, and contingencies and litigation, among others. 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 could differ significantly from the estimates made by management with respect to these items and other items that require managements estimates. The costs of our technical services department
are allocated between cost of revenue, sales and marketing expenses, and research and development expenses based upon an estimate of the time spent by the technical services employees in various departments and the areas benefited by that time.
Total costs of the technical services department were $5.8 million and $6.2 million for the quarter ended December 31, 2004 and 2003, respectively. The allocation rates applied to these department costs were 32% to cost of revenue, 60% to sales and
marketing, and 8% to research and development in the quarter ended December 31, 2004, 20% to cost of revenue, 76% to sales and marketing, and 4% to research and development in the quarter ended December 31, 2003. The allocation estimate is subject
to change and, if changed, will impact the allocation of expenses in the statement of operations but will not impact net income or loss.



Cash Equivalents



The Company considers all highly liquid instruments with an original maturity of three months or less to be cash equivalents.



Earnings Per Share



Basic per share amounts are calculated using the weighted-average number of common shares outstanding during the period. Diluted per share amounts are calculated using
the weighted-average number of common shares outstanding during the period and, when dilutive, the weighted-average number of potential common shares from the exercise of outstanding options and warrants to purchase common stock using the treasury
stock method. Excluded from the computation of diluted income per share for the quarter ended December 31, 2004 were options to acquire 14.4 million shares of common stock because their effect would be anti-dilutive. Also excluded from the
computation of the diluted loss per share for the quarter ended December 31, 2004, was a warrant to acquire 50,000 shares of common stock at $7.27 per share, because its effect would be anti-dilutive. Excluded from the computation of diluted
earnings per share for the quarter December 31, 2003, were options to acquire 9.0 million shares of common stock because their effect would be anti-dilutive. A reconciliation of the numerators and denominators used in the basic and diluted net
income per share amounts follows (in thousands):



|                                                                                 |  |                                |        |      |   |       
|-------------------------------------------------------------------------------- |  | ------------------------------ | ------ | ---- | - | ------
|                                                                                 |  | Three months endedDecember 31,
|                                                                                 |  | 2004                           |        | 2003
|Numerator for basic and diluted net income                                       |  | $                              | 2,741  |      | $ | 1,388 
|                                                                                 |  |                                |        |      |   |       
|Denominator for basic net income per share  weighted-average shares outstanding |  |                                | 80,065 |      |   | 78,619
|Dilutive effect of:                                                              |  |                                |        |      |   |       
|Common stock options                                                             |  |                                | 1,236  |      |   | 3,340 
|Warrants                                                                         |  |                                |       |      |   | 104   
|                                                                                 |  |                                |        |      |   |       
|Denominator for diluted net income per share                                     |  |                                | 81,301 |      |   | 82,063
|                                                                                 |  |                                |        |      |   |       



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##### Table of Contents

MICROMUSE INC.



Concentration of Revenues



One third-party distributor customer accounted for approximately 20% of revenues the quarter ended December 31, 2004, as compared to 17% in the same period of the prior
year. No one end-user customer accounted for greater than 10% of revenues for the quarters ended December 31, 2004 and 2003.



Accounts Receivable



Accounts receivable includes an allowance for doubtful accounts of $1.4 million and $1.0 million as of December 31, 2004 and September 30, 2004, respectively.



Accumulated Other Comprehensive Loss



The only component of accumulated other comprehensive loss is net foreign currency
translation adjustments. Other comprehensive loss, net of tax, for the quarters ended December 31, 2004 and 2003 was $1.8 million and $0.1 million, respectively.



Stock-Based Compensation



At December 31, 2004, the Company had two stock-based employee compensation plans, which are described more fully in the notes included in the Form 10-K as filed with the
Securities Exchange Commission on December 14, 2004. The Company accounts for those plans under the recognition and measurement principles of APB Opinion No. 25,Accounting for Stock Issued to Employees, and related Interpretations. All
options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of the grant, therefore no stock-based employee compensation cost is reflected in the condensed consolidated statement of
operations related to option grants for the quarter ended December 31, 2004. In February 2005, the Company amended certain provisions of its Employee Stock Purchase Plan (Plan) by adding a sub-plan for new participants (eligible employees who had
not participated in the Plan prior to February 1, 2005). The Plan specifically authorizes the Compensation Committee of the Companys Board of Directors to adopt rules and make other policy decisions with regard to the administration and
operation of the Plan. The Committee determined that it was appropriate and advisable to establish a sub-plan to the Plan, with effect from February 1, 2005, for the purpose of allowing eligible employees to participate in a modified form of the
Plan beginning with the February 1, 2005 offering period in order to reduce the expense charge associated with the offering of this equity program. In particular, the sub-plan reduced the offering periods to six months, with no look-back or re-set
provisions and provided that the purchase price for each share of stock purchased at the close of an offering period under the sub-plan shall be 85% of the Fair Market Value of such share on the last trading day before the commencement of the next
applicable offering Period. See also Recently Issued Accounting Pronoucements below concerning new requirements to expense share-based payments.



The following table illustrates the effect on net income and earnings per share if the Company had applied the fair value recognition provisions of FASB Statement No.
123,Accounting for Stock-Based Compensation, and SFAS No. 148, Accounting for Stock-Based Compensation  Transition and Disclosure, to stock-based employee compensation.



|                                                                          |  |                                |        |   |      |   |        |  
|------------------------------------------------------------------------- |  | ------------------------------ | ------ | - | ---- | - | ------ | -
|                                                                          |  | Three months endedDecember 31, |       
|                                                                          |  | 2004                           |        |   | 2003 |  
|Net income, as reported                                                   |  | $                              | 2,741  |   |      | $ | 1,388  |  
|Add: Stock based compensation expense, included in net income, net of tax |  |                                |       |   |      |   | 115    |  
|Less: Stock based compensation determined under SFAS No.123               |  |                                | (5,328 | ) |      |   | (7,378 | )
|                                                                          |  |                                |        |   |      |   |        |  
|Net loss, pro-forma                                                       |  | $                              | (2,587 | ) |      | $ | (5,875 | )
|                                                                          |  |                                |        |   |      |   |        |  
|Basic net income per share, as reported                                   |  | $                              | 0.03   |   |      | $ | 0.02   |  
|Basic net loss per share, pro-forma                                       |  | $                              | (0.03  | ) |      | $ | (0.07  | )
|Diluted net income per share, as reported                                 |  | $                              | 0.03   |   |      | $ | 0.02   |  
|Diluted net loss per share, pro-forma                                     |  | $                              | (0.03  | ) |      | $ | (0.07  | )



Geographic and Segment Information



The Companys chief operating decision-maker is considered to be the
Companys Chief Executive Officer (CEO). The CEO reviews financial information presented on a consolidated basis accompanied by certain geographic information for purposes of making operating decisions and assessing financial
performance. Therefore, the Company operates as a single operating segment: service and business assurance software.



The Company markets its products primarily from the United States. International sales are primarily to customers in continental Europe and Asia Pacific. Information
regarding regional revenues, which are based on the location of the end-user, and long lived assets in different geographic regions is as follows (in thousands):



|                    |  |                                |        |      |   |       
|------------------- |  | ------------------------------ | ------ | ---- | - | ------
|                    |  | Three months endedDecember 31,
|                    |  | 2004                           |        | 2003
|Revenues:           |  |                                |        |      |   |       
|United States       |  | $                              | 17,953 |      | $ | 18,595
|United Kingdom      |  |                                | 6,169  |      |   | 3,719 
|Other international |  |                                | 14,784 |      |   | 14,875
|                    |  |                                |        |      |   |       
|Total               |  | $                              | 38,906 |      | $ | 37,189
|                    |  |                                |        |      |   |       



|                   |  |                  |        |                   |   |       
|------------------ |  | ---------------- | ------ | ----------------- | - | ------
|                   |  | December 31,2004 |        | September 30,2004
|Long lived assets: |  |                  |        |                   |   |       
|United States      |  | $                | 46,165 |                   | $ | 44,193
|International      |  |                  | 18,514 |                   |   | 17,792
|                   |  |                  |        |                   |   |       
|Total              |  | $                | 64,679 |                   | $ | 61,985
|                   |  |                  |        |                   |   |       



7



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##### Table of Contents

Goodwill and Other Intangible assets



As a result of the adoption of SFAS No. 142 on October 1, 2002, the Company ceased the amortization of goodwill. As of December 31, 2004 and
September 30, 2004, the Company had unamortized goodwill of $51.0 million and $50.2 million, respectively. The change in goodwill is due to foreign exchange fluctuations. The change in intangibles is due to the purchase of certain developed
technology.



The following tables set forth the carrying amount of other
intangibles assets that will continue to be amortized (in thousands):



|                        |  |                         |        |                         |   |         |                   |  |   |      
|----------------------- |  | ----------------------- | ------ | ----------------------- | - | ------- | ----------------- |  | - | -----
|                        |  | As of December 31, 2004
|                        |  | GrossCarryingAmount     |        | AccumulatedAmortization |   |         | NetCarryingAmount
|Developed technology    |  | $                       | 26,984 |                         | $ | (19,316 | )                 |  | $ | 7,668
|Customer Contracts      |  |                         | 1,435  |                         |   | (1,313  | )                 |  |   | 122  
|Trademarks              |  |                         | 807    |                         |   | (714    | )                 |  |   | 93   
|Other intangible assets |  |                         | 868    |                         |   | (868    | )                 |  |   |     
|                        |  |                         |        |                         |   |         |                   |  |   |      
|Intangibles             |  | $                       | 30,094 |                         | $ | (22,211 | )                 |  | $ | 7,883
|                        |  |                         |        |                         |   |         |                   |  |   |      



|                        |  |                          |        |                         |   |         |                   |  |   |      
|----------------------- |  | ------------------------ | ------ | ----------------------- | - | ------- | ----------------- |  | - | -----
|                        |  | As of September 30, 2004
|                        |  | GrossCarryingAmount      |        | AccumulatedAmortization |   |         | NetCarryingAmount
|Developed technology    |  | $                        | 24,371 |                         | $ | (17,892 | )                 |  | $ | 6,479
|Customer Contracts      |  |                          | 1,362  |                         |   | (1,233  | )                 |  |   | 129  
|Trademarks              |  |                          | 807    |                         |   | (672    | )                 |  |   | 135  
|Other intangible assets |  |                          | 868    |                         |   | (868    | )                 |  |   |     
|                        |  |                          |        |                         |   |         |                   |  |   |      
|Intangibles             |  | $                        | 27,408 |                         | $ | (20,665 | )                 |  | $ | 6,743
|                        |  |                          |        |                         |   |         |                   |  |   |      



The total amortization expense related
to other intangible assets is set forth in the table below (in thousands):



|                     |  |                                |       |      |   |      
|-------------------- |  | ------------------------------ | ----- | ---- | - | -----
|                     |  | Three months endedDecember 31,
|                     |  | 2004                           |       | 2003
|Developed technology |  | $                              | 1,311 |      | $ | 1,456
|Customer contracts   |  |                                | 6     |      |   | 6    
|Trademarks           |  |                                | 42    |      |   | 42   
|                     |  |                                |       |      |   |      
|Total amortization   |  | $                              | 1,359 |      | $ | 1,504
|                     |  |                                |       |      |   |      



The amortization of developed
technology is recorded as a cost of revenue line item with the remaining amortization being reflected as an operating expense.



The total expected future amortization related to other intangible assets is set forth in the table below (in thousands):



|           |  |                     |      
|---------- |  | ------------------- | -----
|Year       |  | FutureAmortizations
|2005       |  | $                   | 2,752
|2006       |  |                     | 2,064
|2007       |  |                     | 1,892
|2008       |  |                     | 526  
|2009       |  |                     | 524  
|Thereafter |  |                     | 125  
|           |  |                     |      
|Total      |  | $                   | 7,883
|           |  |                     |      



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Recently Issued Accounting Pronouncements



In March 2004, the Emerging Issues Task Force (EITF) reached a consensus on Issue No. 03-01, The Meaning of Other-Than-Temporary
Impairment and Its Application to Certain Investments. EITF 03-01 provides guidance on other-than-temporary impairment models for marketable debt and equity securities accounted for under SFAS No. 115, Accounting for Certain Investments
in Debt and Equity Securities, and SFAS No. 124, Accounting for Certain Investments Held by Not-for-Profit Organizations, and non-marketable equity securities accounted for under the cost method. The EITF developed a basic
three-step model to evaluate whether an investment is other-than-temporarily impaired. The provisions of EITF 03-01 were effective for Micromuses fourth quarter of fiscal 2004. We do not expect the adoption of EITF 03-01 to have a material
affect on our results of operations and financial condition. The Company has complied with the quantitative and qualitative disclosures for investments accounted for under SFAS No. 115 for the fiscal year ended September 30, 2004.



In January 2003, the Financial Accounting Standards Board issued Interpretation No. 46,
Consolidation of Variable Interest Entities (FIN 46), which was amended by FIN 46R issued in December 2003. This interpretation of Accounting Research Bulletin No. 51, Consolidated Financial Statements, addresses
consolidation by business enterprises of variable interest entities (VIEs) that either: (1) do not have sufficient equity investment at risk to permit the entity to finance its activities without additional subordinated financial support, or (2) for
which the equity investors lack an essential characteristic of a controlling financial interest. This Interpretation applies immediately to VIEs created after January 31, 2003. It also applies in the first fiscal year or interim period ending after
March 15, 2004, to VIEs created before February 1, 2003 in which an enterprise holds a variable interest. FIN 46 requires disclosure of VIEs in financial statements issued after January 31, 2003, if it is reasonably possible that as of the
transition date: (1) the company will be the primary beneficiary of an existing VIE that will require consolidation or, (2) the company will hold a significant variable interest in, or have significant involvement with, an existing VIE. We have
completed our review of the requirements of FIN 46. As a result of our review, no entities were identified requiring disclosure or consolidation under FIN 46.



In December 2004, the Financial Accounting Standards Board issued Statement of Financial Accounting Standard No. 123 (revised 2004), Share-Based Payment
(SFAS 123R). SFAS 123R requires measurement of all employee stock-based compensation awards using a fair value method and the recording of such expense in the consolidated financial statements. In addition, the adoption of SFAS 123R will require
additional accounting related to the income tax effects and additional disclosure regarding the cash flow effects resulting from share-based payment arrangements. SFAS 123R is effective beginning in our fourth quarter of fiscal 2005. We are
evaluating the requirements of SFAS 123R and we expect that the adoption of SFAS 123R will have a material adverse impact on our results of operations and financial condition.



In December 2004, the Financial Accounting Standards Board issued SFAS No. 153, Exchanges of Nonmonetary Assets, an amendment of
APB Opinion No. 29. SFAS No. 153 addresses the measurement of exchanges of nonmonetary assets and redefines the scope of transactions that should be measured based on the fair value of the assets exchanged. SFAS No. 153 is effective for nonmonetary
asset exchanges beginning in our first quarter of fiscal 2006. We do not believe adoption of SFAS No. 153 will have a material impact on our results of operations and financial condition.



In December 2004, the FASB issued Staff Position SFAS No. 109-1, Application of FASB Statement No. 109, Accounting for Income Taxes
(FSP No. 109-1) to the Tax Deduction on Qualified Production Activities Provided by the American Jobs Creation Act of 2004 which was signed into law by the President of the United States on October 22, 2004. Companies that qualify for
the recent tax laws deduction for domestic production activities must account for it as a special deduction under SFAS No. 109 and reduce their tax expense in the period or periods the amounts are deductible, according to FSP No. 109-1. The
FASBs guidance is not expected to have a material impact to the Companys financial results.



In December 2004, the FASB also issued Staff Position SFAS No. 109-2, Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision (FSP No. 109-2) within the American Jobs Creation
Act of 2004. The Act provides for a one-time deduction of 85 percent of certain foreign earnings that are repatriated in either an enterprises last tax year that began before the date of enactment, or the first tax year that begins during the
one year period beginning on the date of enactment. FSP No. 109-2 allows companies additional time to evaluate whether foreign earnings will be repatriated under the repatriation provisions of the new tax law and requires specified disclosures for
companies needing the additional time to complete the evaluation. The Company is currently evaluating the repatriation provisions of the Act and shall complete its evaluation once guidance has been issued by the Treasury Department on the
repatriation provision, which is expected sometime in 2005, however, at this time the Company does not anticipate making repatriations under the Act.



Note 2. Acquisitions



The Company did not execute any acquisitions during the quarter ended December 31, 2004.



Note 3. Restructuring Costs



As a result of the Companys change in strategy and its desire to improve its cost structure and profitability, the Company announced and implemented two separate
restructuring plans, which were accounted for under EITF No. 94-3 Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (including certain costs incurred in a Restructuring). The Company does not
have any exit or disposal activities as defined under SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities, that were initiated after the effective date of SFAS No. 146.



The fiscal 2002 restructuring plan, which was announced during the quarter ended September
30, 2002, resulted in a decrease of the Companys workforce by 85 employees and the elimination of excess facilities. In connection with implementation of the restructuring plan, the Company incurred restructuring charges of $4.4 million in the
quarter ended September 30, 2002. In the quarter ended June 30, 2003, as a result of a potential tenant terminating negotiations, an additional restructuring charge of $1.7 million was incurred due to an adjustment of assumptions on property leases
relating to the fiscal 2002 restructuring plan. The Company determined that it would not be able to sub-lease some of the excess facilities that it had expected to sub-lease when calculating the original restructuring charge.



The fiscal 2003 restructuring plan, which was announced during the quarter ended December 31,
2002, resulted in a decrease of the Companys workforce by 117 employees and total restructuring charges of $3.1 million, relating to severance and employment related charges.



Severance and employment-related charges consist primarily of severance, health benefits, other termination costs and legal expenses as a
result of the termination of employees. Severance and employment related charges could be higher than the Company has estimated should there be additional arbitration and legal proceedings. The total severance accrual balance of $0.6 million as of
December 31, 2004 is expected to be paid by March 31, 2005.



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##### Table of Contents

Facility costs primarily represent closure and downsizing costs related to offices in Europe and North America that were
vacated as part of the fiscal 2002 restructuring program. Closure and downsizing costs include payments required under lease contracts, after the properties were abandoned, less any applicable estimated sublease income during the period after
abandonment. To determine the lease loss portion of the closure and downsizing costs, certain estimates were made related to the (1) time period over which the relevant building would remain vacant, (2) sublease terms, and (3) sublease rates,
including common area charges. The lease loss accrual is an estimate and will be adjusted in the future upon triggering events (such as changes in estimates of time to sublease and actual sublease rates). As of December 31,2004, the remaining $0.4
million accrual of lease termination costs, net of estimated sublease income, is expected to be paid on various dates through December 2005.



The following table sets forth the restructuring activity for the three months ended December 31, 2004 (in thousands):



|                                      |  |                                |     |                               |   |           |  |       |     |  |   |    
|------------------------------------- |  | ------------------------------ | --- | ----------------------------- | - | --------- |  | ----- | --- |  | - | ---
|                                      |  | Fiscal 2002 Restructuring Plan |     | Fiscal 2003Restructuring Plan |   |          
|                                      |  | Facility                       |     | Severance                     |   | Severance |  | Total
|Accrual balance at September 30, 2004 |  | $                              | 347 |                               | $ | 290       |  | $     | 356 |  | $ | 993
|Non-cash charges                      |  |                                | 4   |                               |   |          |  |       |    |  |   | 4  
|Accrual balance at December 31, 2004  |  | $                              | 351 |                               |   | 290       |  |       | 356 |  |   | 997
|                                      |  |                                |     |                               |   |           |  |       |     |  |   |    



Note 4. Litigation



In addition to the matters specifically listed in Part II, Item 1 Legal Proceedings, the
Company is also subject to other pending or threatened litigation from time to time, including other cases now pending. The Company records liabilities based on claims for which management believes a loss is probable and for which management can
reasonably estimate the amount and range of loss. Management of the Company is unable to make a reasonable estimate of the losses that could result from any of the pending proceedings due to the inherent unpredictability of litigation and the
uncertainties related to both the amount and range of losses in the event of an unfavorable outcome in these matters.



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##### Table of Contents

MICROMUSE INC.



Item 2. Managements
Discussion and Analysis of Financial Condition and Results of Operations



The following information should be read in conjunction with the condensed consolidated historical financial information and the notes thereto included in Item 1 of this Quarterly Report on Form 10-Q and Managements Discussion and
Analysis of Financial Condition and Results of Operations contained in our Form 10-K as filed with the Securities and Exchange Commission on December 14, 2004.



The statements contained in this Form 10-Q that are not purely historical are forward-looking statements within the meaning of Section 21E of the Securities Exchange
Act of 1934, including statements regarding our expectations, beliefs, hopes, intentions or strategies regarding the future. All forward-looking statements in this Form 10-Q are based upon information available to us as of the date hereof, and we
assume no obligation to update any such forward-looking statements. Actual results could differ materially from our current expectations. Factors that could cause or contribute to such differences include, but are not limited to: variation in demand
for our software products and services; the level and timing of sales; the extent of product and price competition; introductions or enhancements of products or delays in introductions or enhancements of products; hiring and retention of personnel;
changes in the mix of products and services sold; general domestic and international economic and political conditions; and other factors and risks discussed in Risk Factors below and elsewhere in this Quarterly Report, and other
Micromuse filings with the Securities and Exchange Commission.



Overview



Micromuse Inc. develops, markets and supports a family of scalable,
highly configurable, rapidly deployable software solutions that enable fault management and service assurance  the effective monitoring and management of multiple elements underlying an Information Technology infrastructure, including network
devices, computing systems and applications, and the mapping of these elements to the business services they impact. The Company was founded in 1989 and subsequently developed our Netcool/OMNIbus software, which we began shipping in January 1995.
All of our revenues continue to be derived from licenses for our Netcool family of products and related maintenance, training and consulting services. We currently expect that Netcool-related revenues will continue to account for all or
substantially all of our revenues for the foreseeable future. As a result, our future operating results are dependent upon continued market acceptance of our Netcool products and enhancements thereto.



The Company generated $38.9 million in total revenue in the quarter, an increase of 7%
sequentially and 5% year-over-year. License revenue was $19.3 million, up 9% sequentially. The increase in revenue for the quarter was impacted positively by exchange rates, primarily the strengthening of the British Pound, by approximately $800
thousand, offset by the impact of the same exchange rates on expenses of $600 thousand.



Net income for the quarter was $2.7 million or $0.03 per diluted share as compared with $1.4 million or $0.02 per diluted share in the comparable period of the prior fiscal year.



Cash, cash equivalents and investments at December 31, 2004 were $192.8 million, down about $800 thousand sequentially, but up about $5.2
million from a year ago. Cash flow from operations was positive for the quarter ended December 31, 2004 and the Company remains debt free. Deferred revenue was $47.7 million at December 31, 2004, up from $43.9 million in the prior quarter.



We expect significant expenses for professional fees to continue during fiscal
2005 and perhaps beyond due to pending litigation. We currently estimate that professional service fees associated with pending litigation will be in the range of $5 million to $6 million during fiscal 2005. Actual fees incurred may be higher or
lower depending on many factors beyond our control. See Part II, Item 1  Legal Proceedings for additional information on current legal proceedings. We also expect significant increases in operating expenses related to the
implementation of the internal control requirements of Section 404 of the Sarbanes-Oxley Act of 2002 (Section 404). We currently estimate that professional service fees associated with the implementation of Section 404 will be in the
range of $1.0 million to $1.5 million during fiscal 2005.



Recent Events



On December 8, 2004, we announced that Ian Halifax has been appointed
as Chief Financial Officer effective January 17, 2005.



Critical
Accounting Policies and Estimates



Our discussion and analysis of our
financial condition and results of operations are based upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these
condensed consolidated financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an ongoing basis,
we evaluate our estimates, including those related to revenue recognition, allocation of technical services department costs among expense categories, provision for doubtful accounts and sales returns, fair value of investments, fair value of
acquired intangible assets and goodwill, useful lives of intangible assets and property and equipment, income taxes, restructuring costs, and contingencies and litigation, among others. We base our estimates on historical experience and on various
other assumptions that we believe 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 from these estimates under different assumptions or conditions.



We
believe the following are the critical accounting policies and estimates that are used in the preparation of our consolidated financial statements:



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##### Table of Contents

Revenue Recognition.Our revenues are derived from license revenues for our Netcool family of products, as well as
associated maintenance, consulting and training services revenues. We recognize revenue in accordance with Statement of Position 97-2, Software Revenue Recognition (SOP 97-2), as amended by Statement of Position 98-9, Modification of SOP
97-2, Software Revenue Recognition, With Respect to Certain Transactions (SOP 98-9), and recognize revenue using the residual method. Under the residual method, revenue is recognized when vendor specific objective evidence of fair value
exists for all of the undelivered elements in the arrangement (i.e., maintenance and professional services), but does not exist for one or more of the delivered elements in the arrangement (i.e., the software product). We allocate revenue to each
undelivered element based on its respective fair value, with the fair value determined by the price charged when that element is sold separately. We determine the fair value of the maintenance portion of the arrangement based on the renewal price
charged to the customer when maintenance is sold separately or the option price for annual maintenance renewals included in the underlying customer contracts. The fair value of the professional services portion of the arrangement is based on the
hourly rates that we charge for these services when sold independently from a software license. If evidence of fair value cannot be established for the undelivered elements of a license agreement, the entire amount of revenue from the arrangement is
deferred and recognized ratably over the period that these elements are delivered.



For all of our software arrangements, we defer revenue for the fair value of the undelivered elements and recognize revenue for the delivered elements when the basic criteria of SOP 97-2 have been met - (1) persuasive evidence of an
arrangement exists, (2) delivery has occurred, (3) the vendors fee is fixed or determinable and (4) collectibility is probable. We evaluate each as follows:



| |  |  | Persuasive evidence of an arrangement exists: For license arrangements with end-users, an arrangement is evidenced by a written contract, which is signed by both the customer and
the Company, or a purchase order from those customers who have previously negotiated a standard license arrangement with us. Sales to our resellers are evidenced by a master agreement governing the relationship together with a purchase order on a
transaction-by-transaction basis. For certain of our OEM arrangements, an arrangement is evidenced on receipt of a delivery notification to the end user. Further, in the case of arrangements with resellers and OEMs, evidence of sell-through to
an end user is required as additional evidence that the arrangement exists. Evidence of sell-through usually comes in the form of a purchase order or contract identifying the end user and sell-through shipping reports, identifying the ship
to location.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Delivery has occurred: Delivery to both our direct customers and our resellers and OEMs is considered to have occurred when media containing the licensed programs is provided
to a common carrier or, in the case of electronic delivery, the customer is given access to the fully functional licensed programs.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Fixed or determinable fee: We consider the fee to be fixed or determinable when normal payment terms exist and the fee is not subject to refund or adjustment. If the arrangement fee
is not fixed or determinable, we recognize the revenue as amounts become due and payable.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Collection is probable: We conduct a credit review for all significant transactions at the time of the arrangement to determine the creditworthiness of the customer. Collection is
deemed probable if we expect that the customer will be able to pay amounts under the arrangement as payments become due. If we determine that collection is not probable, we defer the revenue and recognize the revenue upon cash collection.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Maintenance revenues from ongoing customer support and product
upgrades are deferred and recognized ratably over the term of the maintenance agreement, typically 12 months. Payments for maintenance fees (on initial order or on renewal) are generally made in advance and are nonrefundable. Revenues for
professional services are recognized as the services are performed. Professional services generally are not essential to the functionality of the software. Our software products are fully functional upon delivery and do not require any significant
modification or alteration.



Deferred revenue includes revenue not yet
recognized as a result of deferred maintenance, professional services not yet rendered and license revenue deferred until all the requirements of SOP 97-2 are met.



Allowance for Doubtful Accounts. We regularly review the adequacy of our allowance for doubtful accounts after considering the size
of the accounts receivable aging, the age of each invoice, each customers expected ability to pay and our collection history with each customer. We review any invoice greater than 30 days past due to determine if a specific allowance is
appropriate based on its risk category. In addition, we maintain a general reserve for all invoices by applying a percentage to each 30-day age category. In determining these percentages, we analyze our historical collection experience by region and
current economic trends. If the historical data we use to calculate the allowance provided for doubtful accounts does not reflect the future ability to collect outstanding receivables, additional provisions for doubtful accounts may be needed and
the future results of operations could be materially affected. However, historically the reserve has proven to be adequate.



Circumstances that have caused revisions to the allowance calculation have been primarily due to the contraction of the overall economy. Deterioration in the economy
could result in more customers being placed in the specific reserve category, thereby increasing our reserve estimate and negatively impacting operating results.



Impairment Assessments. We review the carrying amount of goodwill for impairment during the fourth quarter of the fiscal year in
accordance with Statement of Financial Accounting Standards (SFAS) No. 142, Goodwill and Other Intangible Assets. In addition we perform an impairment assessment of goodwill and other intangible assets whenever events or changes in
circumstances indicate that the carrying value of goodwill and other intangible assets may not be recoverable. Significant changes in circumstances can be both internal to our strategic and financial direction, as well as changes to the competitive
and economic landscape. Changes in circumstances that are considered important for asset impairment include, but are not limited to, a decrease in our market capitalization, contraction of the telecommunications industry, reduction or elimination of
geographic economic growth, reductions in our forecasted growth and significant changes to operating costs.



As part of our impairment assessment, we examine economic conditions, products, customer base and geography. Based on these criteria, we determine which products we will continue to support and sell and, thereby,
determine which assets will continue to have future strategic value and benefit. If indicators suggest the carrying value of our long-lived assets may not be recoverable we then estimate the fair value of these long-lived assets based on the sum of
the expected discounted future cash flows expected to result from the use of the assets and their eventual disposition under the requirements of SFAS No. 144,Accounting for the Impairment or Disposal of Long-Lived Assets.



Allowance for Sales Returns. For customers having a right of return, we estimate
future returns based on historical experience and other assumptions, to determine if an allowance is appropriate. To date, we have experienced an immaterial level of returns, and as a result, the Companys allowance for returns has been
insignificant. If historical data used to calculate the allowance for returns does not reflect actual future returns, additional provisions for returns may be needed and future results of operations could be materially affected. However,
historically the reserve has proven to be adequate.



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##### Table of Contents

Restructuring-related Assessments. Our critical accounting policy and judgment as it relates to
restructuring-related assessments in accordance with Emerging Issues Task Force (EITF) No. 94-3 Liability Recognition for Certain Employee Benefits and Other Costs to Exit an Activity (including certain costs incurred in a restructuring)
includes our estimate of the loss related to facility costs and severance-related costs. To determine the facility costs, which is the loss after our cost recovery efforts from subleasing a building, certain estimates were made related to the (1)
time period over which the relevant building would remain vacant, (2) sublease terms, and (3) sublease rates, including common area charges. This lease loss is an estimate and will be adjusted in the future upon triggering events (such as changes in
estimates of time to sublease and actual sublease rates). In the quarter ended September 30, 2002, the fiscal 2002 restructuring plan resulted in the elimination of excess facilities. In the quarter ended June 30, 2003, as a result of a potential
tenant terminating negotiations with us, an additional restructuring charge of $1.7 million was incurred on property leases relating to the fiscal 2002 restructuring plan. The fiscal 2003 restructuring plan, which was announced during the quarter
ended December 31, 2002, resulted in a decrease of our workforce by 117 employees and total restructuring charges of $3.1 million, relating to severance and employment related charges.



To determine the severance and employment-related charges, we have made certain estimates as they relate to severance benefits including the
remaining time employees will be retained, the estimated severance period, health benefits and other termination costs as well as the estimated legal costs. Severance and employment-related charges for the fiscal 2002 and 2003 restructuring plans
could be higher than we have estimated should there be additional arbitration and legal proceedings.



Legal contingencies. We are subject to various claims and legal actions arising in the ordinary course of business. When we believe in the likelihood that a loss has occurred and is probable and the amount of
loss is reasonably estimable, we will accrue for estimated losses in the accompanying consolidated financial statements. Currently, we have not accrued for a legal contingency. Although we currently believe that the outcome of outstanding legal
proceedings, claims and litigation involving us will not have a material adverse effect on our business, results of operations or financial condition, litigation is inherently uncertain, and there can be no assurance that existing or future
litigation will not have a material adverse effect on our business or results of operations for any actual losses that may be incurred.



Accrued Sales Commission Policy. We account for commission accruals and related expenses to reflect a liability in the period the obligation arose for the actual
amounts to be paid, with the related expense being recorded in the period in which the related revenue was recognized. We calculate the total commission liability for all valid purchase orders or approved written contracts received in the period and
adjust commission expense for purchase orders or approved written contracts not recognized as revenue in the period because they did not meet one or more of the revenue recognition requirements of SOP 97-2. Preparation of the sales commission
accrual and expense includes certain estimates that could vary from actual results and impact the accuracy of the recorded accrual and expense.



Non-GAAP Financial Results



We prepare and release quarterly unaudited financial statements prepared in accordance with accounting principles generally accepted in the United States
(GAAP). We also disclose and discuss certain non-GAAP financial information in the related earnings release and investor conference call. This non-GAAP financial information excludes certain non-cash and special charges, consisting
primarily of the amortization and impairment of goodwill and other intangible assets, write-off of in-process research and development, restructuring costs, costs of the restatement and related litigation, certain stock-based compensation, executive
recruiting costs, and related income tax effects. We believe the disclosure of the non-GAAP financial information helps investors more meaningfully evaluate the results of our ongoing operations. However, we urge investors to carefully review the
GAAP financial information included as part of our Quarterly Reports on Form 10-Q, our Annual Reports on Form 10-K, and our quarterly earnings releases.



13



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##### Table of Contents

MICROMUSE INC.



Results of Operations



The following table sets forth certain items in our condensed consolidated statement of operations as a percentage of total revenues, except as indicated:



|                                          |  |                                |   |  |       |  
|----------------------------------------- |  | ------------------------------ | - |  | ----- | -
|                                          |  | Three months endedDecember 31, |  
|                                          |  | 2004                           |   |  | 2003  |  
|As a Percentage of Total Revenues:        |  |                                |   |  |       |  
|Revenues:                                 |  |                                |   |  |       |  
|License                                   |  | 49.7                           | % |  | 54.6  | %
|Maintenance and services                  |  | 50.3                           | % |  | 45.4  | %
|                                          |  |                                |   |  |       |  
|Total revenues                            |  | 100.0                          | % |  | 100.0 | %
|                                          |  |                                |   |  |       |  
|Cost of revenues:                         |  |                                |   |  |       |  
|License                                   |  | 3.3                            | % |  | 3.6   | %
|Maintenance and services                  |  | 9.1                            | % |  | 6.9   | %
|Amortization of developed technology      |  | 3.4                            | % |  | 3.9   | %
|                                          |  |                                |   |  |       |  
|Total cost of revenues                    |  | 15.8                           | % |  | 14.4  | %
|                                          |  |                                |   |  |       |  
|Gross profit                              |  | 84.2                           | % |  | 85.6  | %
|                                          |  |                                |   |  |       |  
|Operating expenses:                       |  |                                |   |  |       |  
|Sales and marketing                       |  | 41.1                           | % |  | 42.2  | %
|Research and development                  |  | 19.4                           | % |  | 20.9  | %
|General and administrative                |  | 18.6                           | % |  | 14.6  | %
|Restatement costs                         |  | 0.3                            | % |  | 5.2   | %
|Amortization of other intangible assets   |  | 0.1                            | % |  | 0.1   | %
|                                          |  |                                |   |  |       |  
|Total operating expenses                  |  | 79.5                           | % |  | 83.0  | %
|                                          |  |                                |   |  |       |  
|Income from operations                    |  | 4.7                            | % |  | 2.6   | %
|                                          |  |                               
|Other income, net:                        |  |                                |   |  |       |  
|Interest income, net                      |  | 2.6                            | % |  | 2.0   | %
|Foreign exchange gain                     |  | 0.1                            | % |  | 0.1   | %
|Other income, net                         |  | 0.9                            | % |  | 0.5   | %
|                                          |  |                                |   |  |       |  
|Total other income, net                   |  | 3.6                            | % |  | 2.6   | %
|Income before income taxes                |  | 8.3                            | % |  | 5.2   | %
|Income tax provision                      |  | 1.3                            | % |  | 1.5   | %
|                                          |  |                                |   |  |       |  
|Net income                                |  | 7.0                            | % |  | 3.7   | %
|                                          |  |                                |   |  |       |  
|As a Percentage of Related Revenues:      |  |                                |   |  |       |  
|Cost of license revenues                  |  | 6.6                            | % |  | 6.6   | %
|Cost of maintenance and services revenues |  | 18.1                           | % |  | 15.2  | %



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MICROMUSE INC.



Revenues.



Revenues increased to $38.9 million in the quarter ended December 31, 2004, from $37.2 million in the comparable period of the prior year. License revenues decreased to
$19.3 million in the quarter ended December 31, 2004, from $20.3 million in the comparable period of the prior year. The decrease in license revenue for the three month period ended December 31, 2004 is due primarily to increased purchasing scrutiny
in the enterprise sector. Maintenance and services revenues increased to $19.6 million in the quarter ended December 31, 2004, from $16.9 million in the comparable period of the prior year. The increase in maintenance and services revenues was the
result of an increase in the renewable maintenance base and renewal of back maintenance contracts that had previously expired. License revenues as a percentage of total revenues was 49.7% in the quarter ended December 31, 2004, as compared to 54.6%
in the comparable period of the prior year. Maintenance revenues as a percentage of total revenues was 50.3% in the quarter ended December 31, 2004, as compared to 45.4% in the comparable period of the prior year.



Cost of Revenues.



The cost of license revenues consists primarily of technology license fees paid to third-party software vendors and production costs. Cost
of license revenues as a percentage of license revenues remained constant at 6.6% in the quarter ended December 31, 2004 and in the comparable period of the prior year. The cost of maintenance and services revenues consists primarily of
personnel-related costs incurred in providing maintenance, consulting and training to customers. Cost of maintenance and services revenues as a percentage of maintenance and services revenues was 18.1% in the quarter ended December 31, 2004, as
compared to 15.2% in the comparable period of the prior year. This increase for the quarter ended December 31, 2004 is principally due to additional headcount and travel expenses related to the establishment of an educational services group to train
our technical services employees and customers.



Cost of the amortization of
developed technology relates to the amortization of developed technology acquired in the acquisitions of CAN, NetOps Corporation, RiverSoft plc, Lumos Technologies Inc. and NHI (Network Harmoni, Inc.) over two to six years. The decrease in the
quarter ended December 31, 2004 as compared to the same period of the prior year is due to certain intangibles that were fully amortized in prior periods.



Sales and Marketing Expenses.



Sales and marketing expenses increased to $16.0 million in the quarter ended December 31, 2004, from $15.7 million in the comparable period of the prior year. This
increase was primarily due to costs associated with a user group conference and tradeshows. Sales and marketing expenses as a percentage of total revenues decreased to 41.1% in the quarter ended December 31, 2004, as compared to 42.2% in the
comparable period of the prior year. We anticipate that our sales and marketing expenses in the coming year will increase in absolute dollars but will vary as a percentage of revenues.



Research and Development Expenses.



Research and development expenses decreased to $7.5 million in the quarter ended December 31, 2004, from $7.8 million in the comparable period of the prior year. The
decrease was primarily due to a decrease in headcount in the quarter ended December 31, 2004. Research and development costs as a percentage of total revenues decreased to 19.4% in the quarter ended December 31, 2004, as compared to 20.9% in the
comparable period of the prior year. We anticipate that our research and development expenses in the coming year will increase in absolute dollars but will vary as a percentage of revenues.



General and Administrative Expenses and Restatement Costs.



General and administrative expenses decreased to $7.3 million in the quarter ended December
31, 2004, from $7.4 million in the comparable period of the prior year. The decrease in general and administrative expenses is due to a decrease of $1.9 million of professional fees incurred in connection with the restatement of financial statements
announced in the quarter ended December 31, 2003 offset by increased professional fees of $0.4 million incurred by the Company in connection with various litigation matters described in Part II, Item 1 of this report, an increase in bad debt
reserves of $0.7 million due to the aging of accounts receivable and increased revenue, and an increase in consulting fees of $0.3 million. General and administrative expenses as a percentage of revenues decreased to 18.9% in the quarter ended
December 31, 2004, from 19.8% in the comparable period of the prior year. Additional information relating to expense trends in fiscal 2005 is set forth under Overview above. We anticipate that our general and administrative expenses in
the coming year will increase in absolute dollars but will vary as a percentage of revenues.



Amortization of Other Intangible Assets.



Amortization of other intangible assets remained at $48.0 thousand in the quarter ended December 31, 2004, and in the comparable period of the prior year. The charges reflect the amortization of intangible assets over estimated useful lives
of six months to six years.



Other Income, Net.



Other income, net increased to $1.4 million in the quarter ended December 31, 2004, from
$1.0 million in the comparable period of the prior year. This net increase was due primarily to foreign exchange gains of $0.1 million for the quarter and an increase of $0.3 million in interest income.



Income Taxes Provision.



Income taxes were unchanged at $0.5 million in the quarter ended December 31, 2004 and the comparable period of the prior year. Income
before tax in the quarter ended December 31, 2004 was $3.2 million, which is an increase from $1.9 million in the comparable period of the prior year. The unchanged amount of income taxes given the increase in the amount of income before tax
reflects a decrease in the income tax rate for the quarter ended December 31, 2004 versus the comparable period of the prior year. This decrease in the income tax rate is a result of a larger proportion of income being earned in lower taxed
jurisdictions and the utilization of loss carryforwards in the quarter ended December 31, 2004.



Liquidity and Capital Resources.



As of
December 31, 2004, we had $84.9 million in cash and cash equivalents and $107.9 million in marketable securities, as compared to $90.8 million in cash and cash equivalents and $102.8 million in marketable securities as of September 30, 2004. The net
decrease in cash and cash equivalents in the quarter ended December 31, 2004 was due primarily to net purchases of marketable securities of $5.1 million, capital expenditures of $1.4 million, and the effect of unfavorable changes in foreign exchange
rates of $3.0 million. These uses of cash and cash equivalents were partially offset by proceeds from the issuance of common stock of $0.6 million. The most significant adjustments to reconcile net income to net cash provided by operating activities
were the net increase in accounts receivables of $11.0 million which was primarily the result of aging of the accounts receivable and increases in revenue, the net increase in deferred revenue of $3.8 million which is attributable to the increase in
the customer base and the renewal of several large maintenance contracts in the quarter ended December 31, 2004, the net increase in accrued expenses of $2.5 million which was primarily the result of increased sales commissions due to higher revenue
in the quarter, increased legal fees related to pending litigation, increased trade accruals and depreciation and amortization expenses of $2.1 million.



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As of December 31, 2004, our principal commitments consisted primarily of obligations under operating leases.



We believe that our current cash balances and the cash flows generated by operations will
be sufficient to meet our anticipated cash needs for working capital and capital expenditures for the next 12 months. Thereafter, if cash generated from operations is insufficient to satisfy our liquidity requirements, we may seek to sell additional
equity or convertible debt securities or obtain credit facilities. The decision to sell additional equity or debt securities could be made at any time and would likely result in additional dilution to our stockholders. A portion of our cash may be
used to acquire or invest in complementary businesses or products or to obtain the right to use complementary technologies or repurchase shares of our common stock. From time to time, in the ordinary course of business, we evaluate potential
acquisitions of such businesses, products or technologies.



Off-Balance
Sheet Arrangements



We do not have any financial partnerships with
unconsolidated entities, such as entities often referred to as structured finance or special purpose entities, which are often established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited
purposes. Accordingly, we are not exposed to any financing, liquidity, market or credit risk that could arise if we had such relationships.



Contractual Obligations



There were no material changes outside the ordinary course of our business during the quarter ended December 31, 2004, in the contractual obligations that we reported in this portion of Managements
Discussion and Analysis of Financial Condition and Results of Operations contained in our most recent Annual Report on Form 10-K.



Working Capital



Our working capital was $84.0 million at December 31, 2004 as compared to $72.0 million at September 30, 2004, an increase of $12.0 million or 16.7%. The increase in
working capital was primarily the result of a $9.3 million increase in cash and short-term investments, an $11.0 million increase in net accounts receivable, offset by a $1.9 million increase in income taxes payable and a $5.6 million increase in
accounts payable and accrued expenses.



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MICROMUSE INC.



RISK FACTORS



The following factors, in addition to the other information contained in this report, should be considered carefully in evaluating the Company and our prospects. This
Form 10-Q (including without limitation the following Risk Factors) contains forward-looking statements (within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934) regarding the Company
and our business, financial condition, results of operations and prospects. Words such as expects, anticipates, intends, plans, believes, seeks, estimates and
similar expressions or variations of such words are intended to identify forward-looking statements, but are not the exclusive means of identifying forward-looking statements in this Form 10-Q. Additionally, statements concerning future matters such
as the development of new products, enhancements or technologies, possible changes in legislation and other statements regarding matters that are not historical are forward-looking statements.



Although forward-looking statements in this report reflect the good faith judgment of our
management, such statements can only be based on facts and factors we currently know about. Consequently, forward-looking statements are inherently subject to risks and uncertainties, and actual results and outcomes may differ materially from the
results and outcomes discussed in the forward-looking statements. Factors that could cause or contribute to such differences in results and outcomes include, but are not limited to, those discussed below or elsewhere in this report. Readers are
urged not to place undue reliance on these forward-looking statements, which speak only as of the date of this report. We undertake no obligation to revise or update any forward-looking statements in order to reflect any event or circumstance that
may arise after the date of this report.



Our operating results may vary
as a result of economic uncertainties.



We face uncertainty in the
degree to which the economic slowdown experienced over the 2001 to 2003 fiscal years will continue to negatively affect growth and capital spending by our existing and potential customers. We continue to experience instances of customers delaying or
deferring licenses of our software and maintenance agreement, and longer lead times needed to close our customer sales. In addition, recent political turmoil in many parts of the world, including terrorist and military actions, may continue to put
pressure on global economic conditions. Although there have been signs of improvement in general economic conditions, the improved conditions may not continue or lead to significantly improved demand for our software. If the economic conditions that
affect our customers and our part of the software industry in the United States and globally do not show continued improvement, or if we experience a worsening in the global economic slowdown, we may continue to experience material adverse impacts
on our business, operating results, and financial condition. We may not be able to accurately anticipate the magnitude of these impacts on future quarterly and annual results.



We restated our annual and quarterly financial statements for 2001, 2002, and the first three quarters of 2003, we did not file our
Annual Report on Form 10-K for fiscal year 2003 on a timely basis, and we did not file our Quarterly Report on Form 10-Q for the first quarter of 2004 on a timely basis. Litigation and regulatory proceedings regarding the restatement of our
Consolidated Financial Statements could seriously harm our business.



On December 30, 2003, we announced that we would not be able to file our Annual Report on Form 10-K on a timely basis, that we had initiated an internal inquiry regarding the accounting for certain items, and that we expected that this
inquiry would lead to a restatement of historical financial statements. On February 10, 2004, we announced that the filing of our Form 10-Q for the first quarter of fiscal year 2004 would also be delayed. The adjustments to previously filed
financial results affected our financial statements for the fiscal years ended September 30, 2002 and 2001 and our quarterly financial statements for the quarters ended December 31, 2000 through June 30, 2003. Please see our Annual Report on Form
10-K for the year ended September 30, 2003, as filed on May 17, 2004, for additional information regarding the restatement and adjustments.



Due to the failure to timely file our periodic reports described above, we were not in compliance with the filing requirements for continued listing on Nasdaq as set
forth in Nasdaq Marketplace Rule 4310(c)(14). As a result, we made a timely request for a hearing before a Nasdaq Listings Qualifications Panel to address the filing delinquency, and the Nasdaq panel granted our request for an extension of time to
complete our filings, subject to certain conditions.



In addition to conditions
we fulfilled relating to filing the Form 10-K for the fiscal year ended September 30, 2003, and Forms 10-Q for the first two quarters in fiscal 2004, the Nasdaq panel decision requires the Company to file timely with the SEC all periodic reports for
all reporting periods ending on or before March 31, 2005. If the Company fails to do so, it will not be entitled to a new hearing on the matter and its securities may be immediately delisted from the The Nasdaq Stock Market. If there should be any
other events of noncompliance with the Nasdaq listing standards other than required SEC filings, the Company would be entitled to notice of the deficiency and an opportunity to present a definitive plan to regain compliance.



We also previously announced that the Company and certain of our former and current officers
and directors have been named in several lawsuits arising from the restatement announcement. These cases are still in their early stages and we intend to defend against them vigorously. See Part II, Item 1 Legal Proceedings for a
description of this pending litigation.



Defending against existing and
potential securities and class action litigation relating to the restatement of our consolidated financial statements will likely require significant attention and resources of management and, regardless of the outcome, result in significant legal
expenses. If our defenses were ultimately unsuccessful, or if we were unable to achieve a favorable settlement, we could be liable for large damage awards that could seriously harm our business and results of operations.



In addition, as previously reported, the SEC commenced an informal inquiry regarding the
circumstances leading up to the restatement of our consolidated financial statements. If we are required to respond in the future to this inquiry, this could require significant diversion of managements attention and resources. For example, if
the SEC elects to pursue an enforcement action, the defense against this type of action could be costly and require additional management resources. If we are unsuccessful in defending against this or other investigations or proceedings, we may face
civil or criminal penalties or fines that would seriously harm our business and results of operations



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If our accounting controls and procedures are circumvented or otherwise fail to achieve their intended purposes,
our business could be seriously harmed.



Although we evaluate our
disclosure controls and procedures as of the end of each fiscal quarter, have instituted remedial measures concerning our accounting controls and procedures, and are in the process of reviewing and establishing internal control over financial
reporting in order to comply with SEC rules effective for us for years ending on or after November 15, 2004, relating to internal control over financial reporting adopted pursuant to the Sarbanes-Oxley Act of 2002, we may not be able to prevent all
instances of accounting errors or fraud in the future. We have also reported in Part II, Item 4 of this Form 10-Q additional and continuing material weaknesses in internal control over financial reporting identified by our outside auditors. Our
controls and procedures do not provide absolute assurance that all deficiencies in design or operation of these control systems, or all instances of errors or fraud, will be prevented or detected. These control systems are designed to provide
reasonable assurance of achieving the goals of these systems in light of legal requirements, our resources and nature of our business operations. These control systems remain subject to risks of human error and the risk that controls can be
circumvented for wrongful purposes by one or more individuals in management or non-management positions. Our business could be seriously harmed by any material failure of these control systems.



Our operating results may vary from quarter to quarter, causing our stock price to
fluctuate.



Our operating results have in the past, and will continue
to be, subject to quarterly and annual fluctuations. Our quarterly revenues and operating results in geographic segments that we track fluctuate and are difficult to predict. It is possible that in some quarter or quarters our operating results will
be below the expectations of public market analysts or investors. In such event, or in the event adverse conditions prevail, or are perceived to prevail, with respect to our business or financial markets generally, the market price of our common
stock may decline significantly.



We typically realize a significant portion of
our license revenues in the last month of a quarter, frequently in the last weeks or even days of a quarter. As a result, license revenues in any quarter are difficult to forecast because it is substantially dependent on orders booked and shipped in
that quarter. Moreover, our sales cycle, from initial evaluation to delivery of software, varies substantially from customer to customer. Further, we base our expense levels in part on forecasts of future orders and sales, which are extremely
difficult to predict. A substantial portion of our operating expenses is related to personnel, facilities, and sales and marketing programs. The level of spending for such expenses cannot be adjusted quickly and is, therefore, relatively fixed in
the short term. Accordingly, our operating results will be harmed if revenues fall below our expectations in a particular quarter. In addition, the number and timing of large individual sales has been difficult for us to predict, and large
individual sales have, in some cases, occurred in quarters subsequent to those we anticipated, or have not occurred at all. The loss or deferral of one or more significant sales in a quarter could harm our operating results.



Because of these fluctuations we believe that quarter-to-quarter comparisons of our operating
results are not necessarily meaningful or indicative of our future performance. A number of other factors are likely to cause these variations, including:



| |  | changes in the demand for our software products and services and the level of product and price competition that we encounter;
|- |  | ------------------------------------------------------------------------------------------------------------------------------



| |  | the timing of new hires and our ability to attract, retain and motivate qualified personnel, including changes in our sales incentives;
|- |  | ---------------------------------------------------------------------------------------------------------------------------------------



| |  | the mix of products and services sold, including the mix of sales to new and existing customers and through third-party distributors and our direct sales force;
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | changes in the mix of, and lack of demand from, distribution channels through which our products are sold;
|- |  | ----------------------------------------------------------------------------------------------------------



| |  | the length of our sales cycles and the success of our new customer generation activities;
|- |  | -----------------------------------------------------------------------------------------



|· | spending patterns and budgetary resources of our customers on network management software solutions;
|- | ----------------------------------------------------------------------------------------------------



| |  | product life-cycles and the timing of introductions or enhancements of products, or delays in the introductions or enhancements of our products and those of our competitors;
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | market acceptance of new products;
|- |  | ----------------------------------



| |  | changes in the renewal rate of maintenance agreements;
|- |  | ------------------------------------------------------



| |  | fluctuations in our gross margins;
|- |  | ----------------------------------



| |  | our ability to achieve targeted cost reductions;
|- |  | ------------------------------------------------



| |  | actual events, circumstances, outcomes and amounts differing from judgments, assumptions and estimates used in determining the value of certain assets, liabilities and other items
reflected in our financial statements;
|- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | expansion of international operations, including gains and losses on the conversion to United States dollars of accounts receivable and accounts payable arising from international
operations and the mix of international and domestic revenue;
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | the extent of market consolidation;
|- |  | -----------------------------------



| |  | software defects and other product quality problems; and
|- |  | --------------------------------------------------------



| |  | the impact of the restatement of our consolidated financial statements and our legal proceedings and their potential effect on customer demand.
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------



Therefore, operating results for a particular future period are difficult to predict and
prior results are not necessarily indicative of results to be expected in future periods. Any of the foregoing factors, or others discussed elsewhere herein, could have a material adverse effect on our business, operating results, financial
condition and stock price.



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Failure to align our employee base with our business may adversely affect our financial results.



Over the past few years, we have added customers, personnel and
expanded the scope and geographic area of our operations that have placed and will continue to place a significant strain upon our management and our operating and financial systems and resources. However, we have reduced our headcount from 660
employees on September 30, 2002 to 573 employees on September 30, 2003 to 532 employees on September 30, 2004 and December 31, 2004 mainly as a result of planned reductions and attrition. Given the uncertainties discussed in this Risk Factors
section, together with factors that might affect our ability to quickly expand or contract our work force around the world, it is difficult to predict future requirements for the number and type of employees in the fields and geographies in which we
operate. Failure to align employee skills and populations with revenue and market requirements would have a material adverse impact on our business and its operating results.



Our restructuring of operations may not achieve the results we intend and may harm our business.



In the quarters ended September 30, 2002 and December 31, 2002, we initiated plans to
streamline operations and reduce expenses, which included cuts in discretionary spending, reductions in capital expenditures, reductions in the work force and consolidation of certain office locations, as well as other steps to reduce expenses. The
implementation of our restructuring plans has placed, and may continue to place, a significant strain on our managerial, operational, financial, employee and other resources. Additionally, the Company periodically engages in internal reorganizations
and/or integrating acquired companies or technologies that may negatively affect our performance and our employee turnover as well as recruiting and retention of important employees. It is possible that these reductions could impair our marketing,
sales and customer support efforts or alter our product development plans. If we experience difficulties in carrying out the restructuring plans, our expenses could increase more quickly than we expect. If we find that our planned restructurings do
not achieve our objectives, it may be necessary to implement further reduction of our expenses, to perform additional reductions in our headcount, or to undertake additional restructurings of our business.



We may fail to support our operations.



To succeed in the implementation of our business strategy, we must execute our sales
strategy and further develop products and expand service capabilities, while managing future operations by implementing effective planning and operating processes. If we fail to manage effectively, our business could suffer. To manage, we must:



| |  | successfully manage the business with fewer employees due to the restructuring plans;
|- |  | -------------------------------------------------------------------------------------



| |  | continue to implement and improve our operational, financial and management information systems;
|- |  | ------------------------------------------------------------------------------------------------



| |  | hire, train and retain qualified personnel, especially if the business climate improves;
|- |  | ----------------------------------------------------------------------------------------



| |  | continue to expand and upgrade core technologies;
|- |  | -------------------------------------------------



| |  | effectively manage multiple relationships with various OEMs, resellers and system integrators; and
|- |  | --------------------------------------------------------------------------------------------------



| |  | successfully integrate the businesses of our acquired companies.
|- |  | ----------------------------------------------------------------



We need to continue to expand our distribution channels and retain our existing third-party distributors.



We need to continue to develop relationships with leading network equipment and
telecommunications providers and to expand our third-party channels of distribution through OEMs, resellers and systems integrators. We currently invest significant resources to develop these relationships and channels of distribution, which could
reduce our ability to generate profits. Third-party distributors accounted for approximately 43%, 46% and 48% of our total revenues in the three months ended December 31, 2004, fiscal 2004 and fiscal 2003 respectively. Our business will be harmed if
we are not able to retain and attract additional distributors that market our products effectively. Further, many of our agreements with third-party distributors are nonexclusive, and many of the companies with which we have agreements also have
similar agreements with our competitors or potential competitors. Our third-party distributors have significantly greater sales and marketing resources than we do, and their sales and marketing efforts may conflict with our direct sales efforts. In
addition, although sales through third-party distributors result in reduced sales and marketing expense with respect to such sales, we sell our products to third-party distributors at reduced prices, resulting in lower gross margins on such
third-party sales. We believe that our success in penetrating markets for our fault and service level management applications depends substantially on our ability to maintain our current distribution relationships, in particular, those with Cisco
Systems, IBM, Ericsson, Unisphere (Siemens) and Sun Microsystems. Our business will be harmed if network equipment and telecommunications providers and distributors discontinue their relationships with us, compete directly with us or form additional
competing arrangements with our competitors.



We are dependent on the
market for software designed for use with advanced communications services, this market is very dynamic and difficult to predict.



The market for our products is in constant flux and in significant areas is not highly penetrated. Although the rapid expansion and increasing complexity of computer
networks in recent years and the resulting emergence of service level agreements has increased, the demand for fault and service level management software products, the awareness of and the need for such products is a recent development. Therefore,
it is difficult to assess the size of this market, the appropriate features and prices for products to address this market, the optimal distribution strategy and the competitive environment that will develop.



We are substantially dependent upon telecommunications carriers and other service
providers continuing to purchase our products.



Telecommunications
carriers, including Internet service providers, that deliver advanced communications services to their customers accounted for approximately 61%, 64% and 60% of our total revenues in the three months ended December 31, 2004, fiscal 2004 and fiscal
2003 respectively. In addition, these providers are an important focus of our sales strategy. If these customers cease to deploy advanced communications services for any reason, the market for our products will be harmed. Also, delays in the
introduction of advanced services or the failure of such services to gain widespread market acceptance or the decision of telecommunications carriers and other service providers not to use our products in the deployment of these services would harm
our business.



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Consolidations in, or a continued slowdown in, the telecommunications industry could harm our business.



We have derived and expect to continue to derive a substantial amount
of our revenues from sales of products and related services to the telecommunications industry. The telecommunications industry has experienced significant consolidation in the past few years. Capital spending by this industry has decreased and may
continue to decrease in the future as a result of a general decline in economic growth in local and international markets. Recent indicators, however, suggest that certain sectors have stabilized. Our business is highly dependent on the
telecommunications industry and on continued capital spending by our customers in that industry. In the event of further significant slowdown in capital spending of the telecommunications industry, our business would be adversely affected.
Furthermore, as a result of industry consolidation, there may be fewer potential customers requiring our software in the future. Larger, consolidated telecommunications companies may also use their purchasing power to create pressure on the prices
and the margins we could realize.



Our business depends on the continued
growth in use and improvement of the Internet.



A significant portion
of our revenues comes from telecommunications carriers, Internet service providers and other customers that rely upon or are driven by the Internet. As a result, our future results of operations substantially depend on the continued acceptance and
use of the Internet as a medium for commerce and communication. Our business could be harmed if this growth does not continue or if the rate of technological innovation, deployment or use of the Internet slows or declines.



Furthermore, the growth and development of the market for Internet-based services may prompt
the introduction of new laws and regulations. Laws, which impose additional burdens on those companies that conduct business online, could decrease the expansion of the use of the Internet. A decline in the growth of the Internet could decrease
demand for our products and services and increase our cost of doing business, or otherwise harm our business, which could result in a material adverse effect on the market price of our common stock.



We face intense competition, including from larger competitors with greater resources
than our own, which could result in our losing market share or experiencing a decline in gross margins.



We face intense competition in our markets. As we enter new markets, we encounter additional, market-specific competitors. In addition, because the software market has
relatively low barriers to entry, we are aware of new and potential entrants in portions of our market space. Increased competition is likely to result in price reductions and may result in reduced gross margins and loss of market share.



Further, many of our competitors have longer operating histories and have significantly
greater financial, technical, sales, marketing and other resources, as well as greater name recognition and a larger customer base, than we do. As a result, they may be able to devote greater resources to the development, promotion, sale and support
of their products or to respond more quickly to new or emerging technologies and changes in customer requirements than we can. Existing competitors could also increase their market share by bundling products having functionality offered by our
products with their current applications. Moreover, our current and potential competitors may increase their share of the fault and service level management market by strategic alliances and/or the acquisition of competing companies. In addition,
network operating system vendors could introduce new or upgrade and extend existing operating systems or environments that include functionality offered by our products, which could render our products obsolete and unmarketable.



Our current and prospective competitors offer a variety of solutions to address the fault and
service level and enterprise network management markets and generally fall within the following five categories:



| |  | customers internal design and development organizations that produce service level management and network management applications for their particular needs, in some cases
using multiple instances of products from hardware and software vendors such as Hewlett-Packard Company;
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | vendors of network and systems management frameworks including Computer Associates International, Inc.;
|- |  | -------------------------------------------------------------------------------------------------------



| |  | vendors of network and systems management applications including Hewlett-Packard Company and BMC Software, Inc;
|- |  | ---------------------------------------------------------------------------------------------------------------



| |  | providers of specific market applications; and
|- |  | ----------------------------------------------



| |  | systems integrators serving the telecommunications industry which primarily provide programming services to develop customer specific applications including TCSI Corporation, TTI
and Agilent Technologies, Inc.
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Many of our existing and
potential customers and distributors continuously evaluate whether to design and develop their own network operations support and management applications or purchase them from outside vendors. Sometimes these customers internally design and develop
their own software solutions for their particular needs and therefore may be reluctant to purchase products offered by independent vendors such as ours. As a result, we must continuously educate existing and prospective customers as to the
advantages of our products versus internally developed network operations support and management applications.



If we ship products that contain defects, the market acceptance of our products and our reputation will be harmed, and our customers could seek to recover their damages from us.



Complex software products frequently contain errors or defects, especially when first
introduced or when new versions or enhancements are released. Because of defects, we could continue to experience delays in or failure of market acceptance of products, or damage to our reputation or relationships with our customers. Any defects and
errors in new versions or enhancements of our products after commencement of commercial shipments would harm our business.



In addition, because our products are used to monitor and address network problems and avoid failures of the network to support critical business functions, any design
defects, software errors, misuse of our products, incorrect data from network elements or other potential problems within or out of our control that may arise from the use of our products could result in financial or other damages to our customers.
Our customers could seek to have us pay for these losses. Although we maintain product liability insurance, it may not be adequate. Further, although our license agreements with our customers typically contain provisions designed to limit our
exposure to potential claims as well as any liabilities arising from such claims, such provisions may not effectively protect us against such claims and the liability and costs associated therewith.



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The sales cycle for our software products is long, and the delay or failure to complete one or more large license
transactions in a quarter could cause our operating results to fall below our expectations.



Our sales cycle is highly customer specific and can vary from a few weeks to many months. The software requirements of customers is highly dependent on many factors, including but not limited to their projections of
business growth, capital budgets and anticipated cost savings from implementation of our software. Our delay or failure to complete one or more large license transactions in a quarter could harm our operating results. Our software is generally used
for division-wide or enterprise-wide, business-critical purposes and involves significant capital commitments by customers. Potential customers generally commit significant resources to an evaluation of available enterprise software and require us
to expend substantial time, effort and money educating them about the value of our solutions. Licensing of our software products often requires an extensive sales effort throughout a customers organization because decisions to license such
software generally involve the evaluation of the software by a significant number of customer personnel in various functional and geographic areas, each often having specific and conflicting requirements. A variety of factors, including actions by
competitors and other factors over which we have little or no control, may cause potential customers to favor a particular supplier or to delay or forego a purchase.



We depend on our key personnel, and the loss of any of our key personnel could harm our business.



Our success is substantially dependent upon a limited number of key management, sales,
product development, technical services and customer support personnel. The loss of the services of one or more of such key employees could harm our business. In addition, we are dependent upon our continuing ability to attract, train and retain
additional highly qualified management, sales, product development, technical services and customer support personnel. We have at times experienced and continue to experience difficulty in recruiting qualified personnel. Also, the volatility or lack
of positive performance in our stock price may also adversely affect our ability to attract and retain key employees, who often expect to realize value from stock options. Because we face intense competition in our recruiting activities, we may be
unable to attract and/or retain qualified personnel. We have also experienced difficulties and associated risks in hiring and retaining employee in our Finance department described in Part II, Item 4 of this Form 10-Q.



On December 8, 2004, we announced that Ian Halifax has been appointed Chief Financial Officer
effective January 17, 2005.



Our success depends upon the performance of our
executive officers and other key employees and the ability of our management team to work together effectively. There can be no assurance that the management team will be able to work together effectively, and the effective execution of our business
strategy will depend in large part on how well key management and other personnel perform in their positions and are integrated within our company.



We have relied on stock options and Employee Stock Purchase Plan participation as a significant element of our compensation philosophy, and the requirement to
expense options and other share-based payments commencing with our fiscal fourth quarter ending September 30, 2005 will adversely affect our results of operations and financial condition, and may negatively affect the goals of our compensation
philosophy.



In December 2004, the Financial Accounting Standards
Board issued Statement of Financial Accounting Standard No. 123 (revised 2004), Share-Based Payment (SFAS 123R). SFAS 123R requires measurement of all employee stock-based compensation awards using a fair value method and the recording
of such expense in the consolidated financial statements. In addition, the adoption of SFAS 123R will require additional accounting related to the income tax effects and additional disclosure regarding the cash flow effects resulting from
share-based payment arrangements. SFAS 123R is effective beginning in our fourth quarter of fiscal 2005. We are evaluating the requirements of SFAS 123R and we expect that the adoption of SFAS 123R will have a material adverse impact on our results
of operations and financial condition. In addition, this requirement and possible future changes in our share-based payment plans and compensation practices in response to this requirement may negatively affect our ability to use share-based
payments to attract, retain and motivate our employees.



We have acquired
other businesses and we may make additional acquisitions in the future, which will complicate our management tasks and could result in substantial expenditures.



We have acquired other businesses and we may make additional acquisitions in the future, which will complicate our management tasks and
could result in substantial expenditures. In August 2002, we completed the acquisition of RiverSoft plc, a developer of flexible object modeling and root-cause analysis software. In December 2002, we completed the acquisition of Lumos Technologies,
Inc., a developer of sophisticated technology for managing Layer 1 networks. In August 2003, we completed the acquisition of NETWORK HARMONi, Inc. (NHI) a former OEM partner and developer of intelligent agents which provides the core data collection
technology within Netcool®/System Service Monitors(Netcool/SSMs) and Netcool®/Application Service Monitors(Netcool/ASMs), which gather realtime information about distributed systems, servers, and applications across the IT infrastructure.
NHIs OpCenter product is a lightweight centralized IT management and problem resolution system that is ideally tailored for mid-sized enterprise IT infrastructures. The Company also assumed several pending patent applications that had already
been filed by NHI. Because of these acquisitions, we are integrating distinct products, customers and corporate cultures into our own. These past and potential future acquisitions create numerous risks for us, including:



| |  | failure to successfully assimilate acquired operations and products;
|- |  | --------------------------------------------------------------------



| |  | diversion of our managements attention from other matters;
|- |  | -----------------------------------------------------------



| |  | loss of key employees of acquired companies;
|- |  | --------------------------------------------



| |  | substantial transaction costs;
|- |  | ------------------------------



| |  | substantial liabilities or exposures in the acquired entity that were not known or accurately evaluated or forecast by us; and
|- |  | ------------------------------------------------------------------------------------------------------------------------------



| |  | substantial additional costs charged to operations as a result of the failure to consummate a potential acquisition.
|- |  | --------------------------------------------------------------------------------------------------------------------



Further, some of the products we acquire would require significant additional development
before they can be marketed and may not generate revenue at levels we anticipate. Moreover, our future acquisitions, if any, may result in issuances of our equity securities which dilute our stockholders equity, the incurrence of debt, large
one-time write-offs and creation of goodwill or other intangible assets that could result in amortization and impairment expense. It is possible that our efforts to consummate or integrate acquisitions will not be successful, which would harm our
business.



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We have relied and expect to continue to rely on a limited number of products for a significant portion of our
revenues.



All of our revenues have been derived from licenses for our
Netcool family of products and related maintenance, training and consulting services. We currently expect that Netcool/OMNIbus-related revenues will continue to account for a substantial percentage of our revenues beyond fiscal 2004 and for the
foreseeable future thereafter. Although we have Netcool/OMNIbus for Voice Networks, Netcool/Precision, Netcool/Visionary and other products, our future operating results, particularly in the near term, are significantly dependent upon the continued
market acceptance of Netcool/OMNIbus, improvements to the product and new and enhanced Netcool/OMNIbus applications. Our business will be harmed if Netcool/OMNIbus does not continue to achieve market acceptance or if we fail to develop and market
improvements to Netcool/OMNIbus or new or enhanced products. The life cycles of Netcool/OMNIbus, including its applications, are difficult to estimate due in large part to the recent emergence of many of our markets, the effect of future
product enhancements and competition. A decline in the demand for Netcool/OMNIbus as a result of competition, technological change or other factors would harm our business.



We have relied and expect to continue to rely on a limited number of customers for a significant portion of our revenues.



We derive a significant portion of our revenues in any particular
period from a limited number of customers. See Concentration of Credit Risk in Note 1 of the Notes to Condensed Consolidated Financial Statements. We expect to derive a significant portion of our revenues from a limited number of
customers in the future. If a significant customer, or group of customers, cancels or delays orders for our products, or does not continue to purchase our products at or above historical levels, our business will be harmed. For example, pre-existing
customers may be part of, or become part of, large organizations that standardize using a competitive product. The terms of our agreements with our customers typically contain a one-time license fee and a prepayment of one year of maintenance fees.
The maintenance agreement is renewable annually at the option of the customer and there are no minimum payment obligations or obligations to license additional software. Therefore, we generally do not have long-term customer contracts upon which we
can rely for future revenues.



Our business is subject to risks from
global operations and we are exposed to fluctuations in currency exchange rates.



We license our products in foreign countries. In addition, we maintain a significant portion of our operations, including the bulk of our software development operations, in the United Kingdom. Fluctuations in the
value of these currencies relative to the United States dollar have adversely impacted our results in the past and may do so in the future. See Note 1 Geographic and Segment Information in Notes to Condensed Consolidated Financial
Statements for information concerning revenues outside the United States. We expect that international license, maintenance and consulting revenues will continue to account for a significant portion of our total revenues in the future. We pay the
expenses of our international operations in local currencies and do not currently engage in hedging transactions with respect to such obligations.



Our international operations and revenues involve a number of other inherent risks, including:



| |  | longer receivables collection periods and greater difficulty in accounts receivable collection;
|- |  | -----------------------------------------------------------------------------------------------



| |  | difficulty in staffing and generally higher costs associated with managing foreign operations;
|- |  | ----------------------------------------------------------------------------------------------



| |  | an even lengthier sales cycle than with domestic customers;
|- |  | -----------------------------------------------------------



| |  | the impact of possible recessionary environments in economies outside the United States;
|- |  | ----------------------------------------------------------------------------------------



| |  | sales in Europe and certain other parts of the world generally are adversely affected in the quarter ending September 30, as many customers reduce their business activities during
the summer months. If our international sales become a greater component of total revenue, these seasonal factors may have a more pronounced effect on our operating results;
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | changes in regulatory requirements, including a slowdown in the rate of privatization of telecommunications service providers, reduced protection for intellectual property rights in
some countries and tariffs and other trade barriers;
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | changes in or failure to be aware of or to account for payroll, stock option, employee stock purchase and business related taxation;
|- |  | ------------------------------------------------------------------------------------------------------------------------------------



| |  | political, economic or terrorism induced instability;
|- |  | -----------------------------------------------------



| |  | lack of acceptance of non-localized products;
|- |  | ---------------------------------------------



| |  | legal and cultural differences in the conduct of business; and
|- |  | --------------------------------------------------------------



| |  | immigration regulations that limit our ability to deploy our employees.
|- |  | -----------------------------------------------------------------------



We intend to enter into additional international markets and to continue to expand our operations outside of the United States. Such expansion will require significant
management attention and expenditure of significant financial resources and could adversely affect our ability to generate profits. If we are unable to establish additional foreign operations in a timely manner, our growth in international sales
will be limited, and our business could be harmed.



Rapid technological
change, including evolving industry standards and regulations and new product introductions by our competitors, could render our products obsolete.



Rapid technological change, including evolving industry standards and regulations and new product introductions by our competitors, could render our products obsolete. As
a result, the life cycles of our products are difficult to estimate and we must constantly develop, market and sell new and enhanced products. If we fail to do so, our business will be harmed. For example, the widespread adoption of new architecture
standards for managing telecommunications networks would force us to adapt our products to such standard, which we may be unable to do on a timely basis or at all. In addition, to the extent that any product upgrade or enhancement requires extensive
installation and configuration, current customers may postpone or forgo the purchase of new versions of our products. Further, the introduction or announcement of new product offerings by us or one or more of our competitors may cause our customers
to defer licensing of our existing products.



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Our products operate on third-party software platforms, and we could lose market share if our products do not
operate on the hardware and software operating platforms employed by our customers.



Our products operate on third-party software platforms and we could lose market share if our products do not operate on the hardware and software operating platforms employed by our customers. Our products are
designed to operate on a variety of hardware and software platforms employed by our customers in their networks. We must continually modify and enhance our products to keep pace with changes in hardware and software platforms and database
technology. As a result, uncertainties related to the timing and nature of new product announcements, introductions or modifications by systems vendors, particularly Sun Microsystems, Inc., International Business Machines Corporation,
Hewlett-Packard Company, Cabletron Systems, Inc. and Cisco Systems, Inc. and by vendors of relational database software, particularly Oracle Corporation and Sybase, Inc., could harm our business.



Our efforts to protect our intellectual property may not be adequate and third-parties
have in the recent past claimed and may claim in the future that we are infringing their proprietary rights.



We cannot guarantee that the steps we have taken to protect our proprietary rights will be adequate to deter misappropriation of our intellectual property. In addition,
we may not be able to detect unauthorized use of our intellectual property and take appropriate steps to enforce our rights. If third parties infringe or misappropriate our trade secrets, copyrights, patents, trademarks or other proprietary
information or intellectual property, our business could be harmed. In addition, protection of intellectual property in many foreign countries is weaker and less reliable than in the United States, so as our international operations expand, the risk
that we will fail to adequately protect our intellectual property increases. Further, while we believe that our products and trademarks do not infringe upon the proprietary rights of third parties, other parties may assert that our products
infringe, or may infringe, their proprietary rights or we have not fulfilled the terms of agreements with them. Any litigation, whether brought by or against us, may be time-consuming, result in high or unanticipated professional expenses and costs,
and diversion of technical and management personnel, cause product shipment delays or require us to develop non-infringing technology or enter into royalty, licensing or other agreements. Such royalty or licensing agreements, if required, may not be
available on terms acceptable to us or at all. We expect that software product developers will be increasingly subject to infringement claims as the number of products and competitors in our industry segment grows and the functionality of products
in different industry segments overlaps.



See Part II, Item 1 Legal
Proceedings for a description of pending litigation relating to claims of infringement against us.



We rely on software that we have licensed from third-party developers to perform key functions in our products.



We rely on software that we license from third parties, including software that is integrated with internally developed software and used in our products to perform
key functions. We could lose the right to use this software or it could be made available to us only on commercially unreasonable terms. Although we believe that alternative software is available from other third-party suppliers or internal
developments, the loss of or inability to maintain any of these software licenses or the inability of the third parties to enhance in a timely and cost-effective manner their products in response to changing customer needs, industry standards or
technological developments could result in delays or reductions in product shipments by us until equivalent software could be developed internally or identified, licensed and integrated, which would harm our business.



Our stock price is volatile, exposing us to possible risks of costly and time-consuming
securities class action litigation.



The market price of our common
stock has been and is likely to continue to be highly volatile. The market price may vary in response to many factors, some of which are outside our control, including:



| |  | actual or anticipated fluctuations in our operating results;
|- |  | ------------------------------------------------------------



| |  | announcements of technological innovations, new products or new contracts by us or our competitors;
|- |  | ---------------------------------------------------------------------------------------------------



| |  | developments with respect to intellectual property rights;
|- |  | ----------------------------------------------------------



| |  | adoption of new accounting standards;
|- |  | -------------------------------------



| |  | litigation related to the restatement of our Consolidated Financial Statements; and
|- |  | -----------------------------------------------------------------------------------



| |  | general market conditions and other factors.
|- |  | --------------------------------------------



In addition, the stock market has from time to time experienced significant price and volume fluctuations that have particularly affected the market price for the common
stock of technology companies. These types of broad market fluctuations may adversely affect the market price of our common stock. In the past, following periods of volatility in the market price of a companys securities, securities class
action litigation has often been initiated against such company. Such litigation could result in substantial costs and a diversion of our managements attention and resources that could harm our business.



Our goodwill and other long-lived assets may become impaired.



Due to rapidly changing market conditions, our goodwill and other long-lived assets may
become impaired such that their carrying amounts may not be recoverable, and we may be required to record an impairment charge impacting our financial position. As of December 31, 2004, we had approximately $58.8 million of goodwill and other
intangible assets, which relate to the acquisitions of CAN, NetOps, RiverSoft, Lumos and NHI. The Company regularly performs reviews to determine if the carrying value of assets is impaired. As part of our impairment assessment, we examine economic
conditions, products, customer base and geography. Based on these criteria, we determine which products we will continue to support and sell and, thereby, determine which assets will continue to have future strategic value and benefit. No such
impairment has been indicated to date. Asset impairment charges of this nature could be large and could have a material adverse effect on our financial condition and reported results of operations.



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Future sales of our common stock may affect the market price of our common stock.



As of December 31, 2004, we had approximately 80.2 million shares of common stock
outstanding, excluding approximately 19.3 million shares subject to options outstanding as of such date under our stock option plans that are exercisable at prices ranging from approximately $0.63 to $106.22 per share. We cannot predict the effect,
if any, that future sales of common stock or the availability of shares of common stock for future sale, will have on the market price of common stock prevailing from time to time. Sales of substantial amounts of common stock (including shares
issued upon the exercise of stock options), or the perception such sales could occur, may materially and adversely affect prevailing market prices for common stock. In addition, tax charges resulting from the exercise of stock options could
adversely affect the reported results of operations.



We have various
mechanisms in place to discourage takeover attempts.



Certain
provisions of our certificate of incorporation and bylaws and certain provisions of Delaware law could delay or make difficult a change in control of Micromuse that a stockholder may consider favorable. The provisions include:



| |  | blank check preferred stock that could be used by our board of directors to increase the number of outstanding shares and thwart a takeover attempt; and
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | a classified board of directors with staggered, two-year, terms, which may lengthen the time required to gain control of the board of directors.
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------



In addition, Section 203 of the General Corporation Law of the State of Delaware, which is
applicable to us, and our stock incentive plans, may discourage, delay or prevent a change of control of Micromuse.



Changes in effective tax rates could affect our results.



Our future effective tax rates could be adversely affected by earnings being lower than anticipated in countries where we have lower statutory rates, changes in the
valuation of our deferred tax assets and liabilities, or by changes in tax laws or interpretations thereof.



Our business is especially subject to the risks of earthquakes, floods and other natural catastrophic events, and to interruption by manmade problems such as computer viruses or terrorism.



Our corporate headquarters are located in San Francisco, California a region known for
seismic activity. A significant natural disaster, such as an earthquake or a flood, could have a material adverse impact on our business, operating results and financial condition. In addition, our servers are vulnerable to computer viruses,
break-ins and similar disruptions from unauthorized tampering with our computer systems. Any such event could have a material adverse effect on our business, operating results and financial condition. In addition, the effects of war or acts of
terrorism could have a material adverse effect on our business, operating results and financial condition. The terrorist attacks in New York and Washington, D.C. on September 11, 2001 disrupted commerce throughout the world and intensified the
uncertainty of the U.S. and other economies. The continued threat of terrorism and heightened security and military action in response to this threat, or any future acts of terrorism, may cause further disruptions to these economies and create
further uncertainties. To the extent that such disruptions or uncertainties result in delays or cancellations of customer orders, or the manufacture or shipment of our products, our business, operating results and financial condition could be
materially and adversely affected.



Item 3.Quantitative and Qualitative Disclosures About Market Risk



Foreign Currency Hedging Instruments



We transact business in various foreign currencies. Accordingly, we are subject to exposure from adverse movements in foreign currency exchange rates. This exposure is
primarily related to local currency denominated revenues and operating expenses in the U.K. However, as of December 31, 2004, no hedging contracts were outstanding.



We operate internationally and thus are exposed to potentially adverse movements in foreign currency rate changes. We have entered into
foreign exchange forward contracts to reduce our exposure to foreign currency rate changes on receivables, payables and intercompany balances denominated in a nonfunctional currency. The objective of these contracts is to neutralize the impact of
foreign currency exchange rate movements on our operating results. These contracts require us to exchange currencies at rates agreed upon at the inception of the contracts. These contracts reduce the exposure to fluctuations in exchange rate
movements because the gains and losses associated with foreign currency balances and transactions are generally offset with the gains and losses of the foreign exchange forward contracts. Because the impact of movements in currency exchange rates on
forward contracts offsets the related impact on the underlying items being hedged, these financial instruments help alleviate the risk that might otherwise result from changes in currency exchange rates. To date, we have not designated our foreign
exchange forward contracts as hedges and, accordingly, if such forward contracts remained open at period end, we would adjust these instruments to fair value through earnings in the period of change in their fair value.



Fixed Income Investments



The primary objective of our investment activities is to preserve principal while maximizing
yields without significantly increasing risk. Our exposure to market risks for changes in interest rates relate primarily to investments in debt securities issued by U.S. government agencies and corporate debt securities. We place our investments
with high credit quality issuers and, by policy, limit the amount of the credit exposure to any one issuer.



Our general policy is to limit the risk of principal loss and ensure the safety of invested funds by limiting market and credit risk. All highly liquid investments with less than three months to maturity at the date
of purchase are considered to be cash equivalents; investments with maturities at the date of purchase between three and twelve months are considered to be short-term investments; investments with maturities in excess of twelve months are considered
to be long-term investments. The weighted average pre-tax interest rate on the investment portfolio is approximately 1.6 %.



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MICROMUSE INC.



Item 4. Controls and Procedures



Based on their
evaluation as of the end of the period covered by this Quarterly Report on Form 10-Q, our Companys Chief Executive Officer and Chief Financial Officer have concluded that their evaluation has provided them with reasonable assurance that the
Companys disclosure controls and procedures, as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the Exchange Act), are effective to ensure that information required to be disclosed by our Company in the reports
that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commissions rules and forms. In connection with the evaluation described above, we
identified no change in our internal control over financial reporting that occurred during our fiscal quarter ended December 31, 2004, and that has materially affected, or is reasonably likely to materially affect, our internal control over
financial reporting.



In connection with the restatement of our financial
statements discussed in our Form 10-K for the year ended September 30, 2003, as filed on May 17, 2004 (and referred to in Part I Item 2 and Part II Item 1 of this report), our auditors identified material weaknesses consisting of deficiencies in
internal controls related to the recording of accrued liabilities, deficiencies in internal controls related to the documentation of support for journal entries and ineffective review of financial information, although the letter from the auditors
noted that the Company regularly conducted thorough and timely review and analysis of revenue recognition.



On January 26, 2005 the Audit Committee of the Board of Directors received a letter from our outside auditors reiterating the previously noted material weakness consisting of ineffective review of financial
information, although the letter noted that the Company had significantly improved the level of review being afforded to its financial statements. The letter also identified material weaknesses consisting of continued operations with an inadequately
staffed finance department, and lack of timely reconciliation, due to human oversight and systems limitations, of a significant unapplied cash balance for one customer and consequent lack of adequate control procedures to appropriately recognize
revenue related to the transactions underlying the cash balance.



Our overall
plan in 2004 to improve our financial processes and internal control over financial reporting included the hiring of a principal accounting officer to serve as Vice President of Global Finance. The individual we hired for this purpose in July 2004
left Micromuse in September 2004 to pursue other opportunities. Other finance department employees have also left Micromuse during calendar year 2004, and we announced in July 2004 that our current Chief Financial Officer, Mr. Mike Luetkemeyer,
would leave Micromuse at the end of calendar year 2004. Micromuse appointed Ian Halifax as the Companys Chief Financial Officer, effective January 17, 2005. Mr. Luetkemeyer will remain with the Company as an employee during the transition
period. The Company has also appointed a Vice President of Finance and Corporate Controller effective January 27, 2005. Although we have hired a new Chief Financial Officer and a Vice President of Finance and Corporate Controller and intend to hire
additional personnel in the Finance department, these staffing circumstances have delayed our ability to implement certain of the controls and procedures we described in Item 9A of our Form 10-K for the fiscal year ended September 30, 2003, filed on
May 17, 2004, and contributed to material weaknesses in our internal control described above. Items delayed include improved systems processes intended to reduce manual journal entries and implementation of a global purchase order system.



See also Risk Factors  We restated our annual and quarterly
financial statements for 2001, 2002, and the first three quarters of 2003, we did not file our Annual Report on Form 10-K for fiscal year 2003 on a timely basis, and we did not file our Quarterly Report on Form 10-Q for the first quarter of 2004 on
a timely basis. Litigation and regulatory proceedings regarding the restatement of our Consolidated Financial Statements could seriously harm our business, and If our accounting controls and procedures are circumvented or otherwise fail
to achieve their intended purposes, our business could be seriously harmed in Part I, Item 2 of this report.



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MICROMUSE INC.



|Part | II  OTHER INFORMATION
|---- | ----------------------



Item 1. Legal Proceedings.



On December 9, 2002,
Aprisma Management Technologies, Inc. filed a complaint against Micromuse Inc. in the U.S. District Court for the District of New Hampshire. The complaint alleges that Micromuses network and systems management products, including our Netcool
products, infringe six patents held by Aprisma. The complaint seeks injunctive relief as well as unspecified compensatory and enhanced damages, attorneys fees, interest, costs and expenses. The parties have engaged in fact discovery, the
period for which ended in May 2004, with the parties continuing to address outstanding fact and expert discovery issues. The case has been removed from the trial calendar pending consideration of claim construction issues and the Companys
defenses. In December 2004, the court in the Aprisma Litigation set December 20, 2004 as the date on which the Company and Aprisma were to move, respectively, for summary judgment of non-infringement and infringement of three of the patents in suit.
The parties exchanged their opening summary judgment briefs on December 20, 2004, and on January 20, 2005, the parties exchanged briefs in opposition to one anothers respective summary judgment motions. The court has scheduled oral argument to
take place on February 23, 2005. In its motion for summary judgment of non-infringement, as well as in its opposition to Aprismas motion for summary judgment of infringement, the Company presented significant defenses to Aprismas claims
of patent infringement, but it is premature to assess the likely outcome of the motions for summary judgment or the Aprisma Litigation generally. Micromuse will continue to vigorously defend its position and pursue the counterclaims against Aprisma.
Additionally, on January 26, 2005 the Company filed an action in the United States District Court for the Southern District of New York against Aprisma Management Technologies, Inc., alleging that certain Aprisma SPECTRUM products infringe patents
now owned or jointly owned by Micromuse. Micromuse is seeking compensatory and enhanced damages and injunctive and other relief in that suit.



On November 10, 2003, Agilent Technologies, Inc. (Agilent) filed a complaint against the Company in the United States District Court for the Eastern District
of Virginia. The complaint alleges that the Company infringes two patents, one of which is held by Agilent and the other of which is jointly owned by Agilent and Hewlett-Packard Company (HP). The complaint seeks injunctive relief, as
well as unspecified compensatory and enhanced damages, attorneys fees, interest, costs and expenses. In response, the Company moved to: (i) dismiss the case or require Agilent to file a more definite statement of its claims; (ii) join HP as a
necessary party; and (iii) transfer the case to the Southern District of New York, or in the alternative, to the Northern District of California. In a ruling dated April 15, 2004, the court granted Micromuses motion to transfer and ordered
that the lawsuit be moved to the United States District Court for the Southern District of New York, where that court granted the Companys motion for a more definite statement, requiring Agilent to file a more definite statement of its claims.
The court denied the Companys motion to join HP as a necessary party with leave to renew such motion. In response to Agilents amended complaint filed pursuant to the courts order, the Company asserted counterclaims seeking a
declaration that the two patents in suit are invalid and unenforceable and are not infringed by the Company or its products, and seeking dismissal. In addition, the Company filed a counterclaim against Agilent in the Agilent Litigation asserting
that certain Agilent products infringe a patent owned by the Company (the Infringement Counterclaim). Pre-trial discovery in the Agilent Litigation has commenced. Based upon current knowledge, the Company maintains that it has not and
does not infringe the patents asserted by Agilent. It is not possible at the present time to assess the likelihood of a favorable or unfavorable outcome in the Agilent Litigation, including with respect to the Infringement Counterclaim, or the range
of possible loss to the Company in the event of an unfavorable outcome. The Company intends to vigorously defend against the action. Additionally, on January 26, 2005, the Company filed an action in the United States District Court for the Southern
District of New York against Agilent Technologies, Inc., alleging that certain Agilent OSS Service Assurance Solution Products including one or more of its NETeXPERT VSM, FIREHUNTER and/or Service Assurance Application products infringe patents now
owned or jointly owned by Micromuse. Micromuse is seeking compensatory and enhanced damages and injunctive and other relief in that suit.



Between January 12, 2004 and March 5, 2004, seven securities class action complaints were filed in the United States District Court for the Northern District of
California against the Company and certain of its current and former officers and directors. The complaints were filed as purported class actions by individuals who allege that they purchased the Companys common stock during a purported class
period and seek an unspecified amount of damages. The complaints assert causes of action for alleged violations of Section 10(b) and 20(a) of the Securities Exchange Act of 1934 and SEC Rule 10b-5, arising out of the Companys decision to
restate its previously issued financial statements for the fiscal years ended September 30, 2001 and 2002 and for the quarters ended December 31, 2000 through June 30, 2003 and the Companys decision to adjust its preliminary consolidated
financial statement information for the quarter and fiscal year ended September 30, 2003, as initially announced on October 29, 2003. The Court has granted plaintiffs motion to consolidate those actions and name the law firm of Berman,
DeValerio, Pease, Tabacco, Burt & Pucillo as Lead Plaintiffs Counsel. Plaintiffs have filed a consolidated amended complaint in accordance with the court-ordered schedule. In response, the Company has filed its Motion to Dismiss the
amended complaint. A hearing on the Companys Motion to Dismiss is currently scheduled in March 2005. The Company will continue to vigorously defend these lawsuits.



Between February 2, 2004 and March 16, 2004, the Company was also named as a nominal defendant along with certain of its current and former
officers and directors in three derivative actions, purportedly brought by shareholders on the Companys behalf, filed in the Superior Court of California, County of San Francisco. On April 21, 2004 those actions were consolidated and the law
firm of Robbins, Umeda & Fink was named as Lead Plaintiffs Counsel in those actions. On March 3, 2004, the Company was also named as a nominal defendant along with certain of its current and former officers and directors in another
derivative action, purportedly brought by shareholders on the Companys behalf, filed in the District Court for the Northern District of California. The derivative complaints allege that, as a result of the events underlying the restatement,
certain of the Companys current and former officers and directors breached their fiduciary duties to the Company, and that certain current and former officers and directors engaged in insider trading in violation of California law. The
plaintiffs seek unspecified damages on the Companys behalf from the defendants. The Company has filed a demurrer, seeking to dismiss the complaint, in response to which the plaintiffs are seeking to file an amended complaint. The Federal
District Court has abstained from exercising jurisdiction over the federal derivative action and has remanded the action to the California Superior Court. Plaintiffs have appealed the Federal District Courts ruling to the Ninth Circuit Court
of Appeals, which appeal is pending.



On January 15, 2004, the Securities &
Exchange Commission notified the Company that it had initiated an informal inquiry regarding the Company. This inquiry is ongoing and the Company is cooperating fully. It is our understanding that it is customary for the SEC to undertake an informal
inquiry of many announced accounting restatements. The detailed information contained in our most recent Form 10-K and this report relating to the restatement of financial statements has not been reviewed previously by the SEC.



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The Company is also subject to other pending or threatened litigation from time to time in addition to the matters
specifically listed above, including other cases now pending. When we believe in the likelihood that a loss has occurred and is probable and the amount of loss is reasonably estimable, we will accrue for estimated losses in the accompanying
consolidated financial statements. Currently, we have not accrued for a legal contingency.



The litigation matters specifically listed above and other pending or future litigation are inherently unpredictable, could be costly and divert our managements attention away from our business, and could have a
material adverse effect on our business, financial results or condition, or cash flow. See also Risk Factors in Part I, Item 2 of this Form 10-Q. Our efforts to protect our intellectual property may not be adequate, and third-parties have in
the recent past claimed and may claim in the future that we are infringing their proprietary rights and We restated our annual and quarterly financial statements for 2001, 2002, and the first three quarters of 2003, we did not file our
Annual Report on Form 10-K for fiscal year 2003 on a timely basis, and we did not file our Quarterly Report on Form 10-Q for the first quarter of 2004 on a timely basis. Litigation and regulatory proceedings regarding the restatement of our
Consolidated Financial Statements could seriously harm our business.



Due
to the inherent unpredictability of litigation, the Company cannot predict the outcome of these or other pending matters with any certainty. Because of the uncertainties related to both the amount and range of losses in the event of an unfavorable
outcome in the lawsuits listed above or in certain other pending proceedings for which loss estimates have not been recorded, management of the Company is unable to make a reasonable estimate of the losses that could result from these matters.



Item 2. Unregistered Sales of Equity Securities and Use of Proceeds



Micromuse did not repurchase shares of its common stock during the fiscal quarter ended December 31, 2004. On July 22, 2004, we announced a program under which Micromuse may repurchase up to 2,000,000 shares of its
common stock over the next 12 months. After purchases of 1,000,000 shares in the fourth quarter of fiscal 2004 reported in our Form 10-K filed on December 14, 2004, 1,000,000 shares may yet be purchased under this program. Purchases may be made from
time to time in the open market, and will be funded from available working capital. The number of shares to be purchased and the timing of purchases will be based on several factors, including the price of Micromuse stock, general business and
market conditions, and other investment opportunities.



Item 3. Defaults upon Senior Securities.



Not
applicable.



Item 4. Submission of Matters to a Vote of Security Holders.



The Companys Annual Meeting of Shareholders was held on February 3, in San Francisco, California. Of the 78,729,750 shares outstanding as of the record date, 75,179,839 shares were present or represented by
proxy at the meeting. The following matters were submitted to a vote of security holders:



|(1) | To elect the following to serve as Directors of the Company:
|--- | ------------------------------------------------------------



|                |  |            |  |                |  |                 
|--------------- |  | ---------- |  | -------------- |  | ----------------
|Nominee         |  | Votes for  |  | Votes Withheld |  | Broker Non-Votes
|Lloyd A. Carney |  | 72,525,335 |  | 2,654,504      |  | 0               
|                |  |            | 
|David C. Schwab |  | 60,928,904 |  | 14,250,935     |  | 0               



|(2) | To ratify the Audit Committees appointment of KPMG LLP as independent accountants for the Company for the fiscal year ending September 30, 2005.
|--- | -------------------------------------------------------------------------------------------------------------------------------------------------



|                  |  |           
|----------------- |  | ----------
|Votes For:        |  | 54,750,744
|Votes Against:    |  | 20,410,449
|Votes Abstaining: |  | 18,646    
|Broker Non-Votes: |  | 0         



|Item | 5. Other Information.
|---- | ---------------------



On January 31, 2005, the Companys Chief Executive Officer approved a quarterly performance bonus of $18,750 with respect to the fiscal 2005 first quarter ended
December 31, 2004, to Nell ODonnell, Senior Vice President and Corporate Secretary.



In accordance with SEC rules, the following information in this Item 5 is provided in lieu of a Current Report on Form 8-K, Item 1.01, Entry into a Material Agreement, that would otherwise be due within 4 business
days after the February 3, 2005, date noted below on which certain management compensation arrangements were approved.



On February 3, 2005, the Compensation Committee of the Micromuse Board of Directors adopted the Fiscal Year 2005 Worldwide Incentive Compensation Plan (ICP). The ICP
provides for quarterly cash bonus payments to each eligible employee. Eligible employees include those who are not participants in a sales compensation or commission plan, employees who do not participate in any other bonus program, and employees in
those countries where, in the judgment of local management, it is culturally appropriate and competitively necessary to have an incentive compensation plan to attract and retain talented employees.



Under the ICP, the Company will set an annualized bonus target amount for each eligible
employee, which is then payable on a quarterly basis multiplied by a percentage equal to, less than or more than 100% depending on the combination of quarterly net revenues and pro-forma earnings per share achieved by the Company, and multiplied by
a further percentage based on individual performance. The specific quantitative revenue and pro forma earnings per share performance targets are not public information.



The net revenue and pro-forma earnings per share performance targets under the ICP will be used to determine quarterly bonus payments for
fiscal 2005 for our named executive officers listed below, beginning with the fiscal 2005 first quarter for Messrs. Carney and Oberoi, and beginning with the fiscal 2005 second quarter for Ms. ODonnell. Ms. ODonnells bonus, but not
the bonuses of the other listed officers, will also be subject to individual performance objectives. Other Micromuse employees are expected to become eligible under the ICP in or after the fiscal 2005 third quarter.



The following table sets forth the quarterly target bonus amount for each of our current
named executive officers payable under the ICP performance measure and the percentage range below and above that amount that may be paid quarterly if minimum performance is achieved:



|                                                                             |  |                                 |  |                                                                                       
|---------------------------------------------------------------------------- |  | ------------------------------- |  | --------------------------------------------------------------------------------------
|Name and Office                                                              |  | Target Bonus (quarterly amount) |  | % Range (quarterly dollar range, would be zero if minimum performance is not achieved)
|Lloyd A. Carney, Chairman and Chief Executive Officer                        |  | $100,000                        |  | 20% to 150% of target achieved ($20,000 to $150,000)(1)                               
|                                                                             |  |                                
|Arun Oberoi, Executive Vice President of Global Sales and Technical Services |  | $62,500                         |  | 75% to 140% of target achieved ($30,000 to $172,710)(2)                               
|                                                                             |  |                                
|Nell ODonnell, Senior Vice President and Corporate Secretary                |  | $18,750                         |  | 20% to 150% of target achieved ($3,750 to $28,125)                                    

---

|(1) | Mr. Carneys bonus for the fiscal 2005 first quarter is $130,000.
|--- | -----------------------------------------------------------------

|(2) | Mr. Oberois bonus for the fiscal 2005 first quarter is $95,396. His bonus is adjusted under an amendment to his employment agreement previously included as an exhibit to our
Form 10-K filed on December 14, 2004, and the payment above or below the target is not proportionate to the percentage of the target achieved by the Company, as indicated by his dollar payment range above. In addition, on February 3, 2005, the
Compensation Committee further adjusted his bonus terms to apply the ICP performance measures with a higher weighting for quarterly revenue and to provide a linear payment for percentage achievement above the target in lieu of the previously
established cliff payments.
|--- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Ian Halifax joined
Micromuse as Chief Financial Officer effective January 17, 2005, and his employment agreement previously filed with our Current Report on Form 8-K on December 8, 2004, guarantees him an annual bonus of $137,500 paid quarterly for his service during
his first year of employment. Therefore, his bonus will not be affected by the specific performance measures described above.



On February 3, 2005, the Compensation Committee also approved a bonus of $100,000 payable to Michael L. Luetkemeyer, whose service as Chief Financial Officer ended on
January 17, 2005, with respect to the fiscal 2005 first quarter and his agreement to provide specified transition services through a date to be determined in early 2005, after which he will be eligible for 12 months of continued base salary, bonus,
benefits and vesting of stock options.



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MICROMUSE INC.



Item 6. Exhibits



(a) Exhibits



|               |  |                                                                                                                                                                                                     
|-------------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|Exhibit Number |  | Description                                                                                                                                                                                         
|3.1            |  | Restated Certificate of Incorporation of the Registrant (incorporated by reference from exhibit 3.1 in our Form 10-K filed with the SEC on December 21, 2001).                                      
|               | 
|3.2            |  | Amended and Restated Bylaws of the Registrant (incorporated by reference from exhibit 3.2 in our amended registration statement on Form S-1, No. 333-58975, as filed with the SEC on July 13,
1998).
|               | 
|10.18          |  | Employment Agreement as of December 3, 2004 by and between Ian Halifax and Micromuse Inc. (incorporated by reference from our Current Report on Form 8-K filed with the SEC on December 8,
2004).   
|               | 
|10.19          |  | Executive Employment Continuation Agreement as of January 19, 2004 by and between Micromuse Inc. and Michael Luetkemeyer, as filed herewith.                                                        
|               | 
|31             |  | Separate Certifications of the Chief Executive Officer and Chief Financial Officer of the Registrant required by Section 302 of the Sarbanes-Oxley Act of 2002.                                     
|               | 
|32             |  | Combined Certification of the Chief Executive Officer and Chief Financial Officer of the Registrant required by Section 906 of the Sarbanes-Oxley Act of 2002.                                      



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MICROMUSE INC.



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, on February 8, 2005.



MICROMUSE INC.(Registrant)By:

/s/ LLOYD A. CARNEYLloyd A. Carney Chairman and Chief Executive Officer (Duly Authorized Officer)By:

/s/ IAN HALIFAXIan Halifax Chief Financial Officer (Principal Financial Officer)




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