##### Table of Contents

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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 June 30, 2005



| ̈ | 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)



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



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



80,218,634 shares of Common Stock, $0.01 par value, were outstanding as of August 3, 2005



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##### Table of Contents

MICROMUSE INC.



TABLE OF CONTENTS



|                             |  |                                                                                                                   |  |     
|---------------------------- |  | ----------------------------------------------------------------------------------------------------------------- |  | ----
|                             |  |                                                                                                                   |  | Page
|PART I Financial Information |  | 3                                                                                                                
|                             |  |                                                                                                                  
|Item 1.                      |  | Condensed Consolidated Financial Statements (Unaudited):                                                          |  | 3   
|                             |  |                                                                                                                  
|                             |  | Condensed Consolidated Balance Sheets as of June 30, 2005 and September 30, 2004                                  |  | 3   
|                             |  |                                                                                                                  
|                             |  | Condensed Consolidated Statements of Operations for the three months and nine months ended June 30, 2005 and 2004 |  | 4   
|                             |  |                                                                                                                  
|                             |  | Condensed Consolidated Statements of Cash Flows for the nine months ended June 30, 2005 and 2004                  |  | 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   |  | 26                                                                                                               
|                             |  |                                                                                                                  
|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)



|                                                                                                                                                        |  |               |         |   |                    |   |         |  
|------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------- | ------- | - | ------------------ | - | ------- | -
|                                                                                                                                                        |  | June 30, 2005 |         |   | September 30,2004* |  
|                                                                                                                                                        |  | (unaudited)   |         |   |                    |  
|ASSETS                                                                                                                                                  |  |               |         |   |                    |   |         |  
|Current assets:                                                                                                                                         |  |               |         |   |                    |   |         |  
|Cash and cash equivalents                                                                                                                               |  | $             | 79,031  |   |                    | $ | 38,232  |  
|Short-term investments                                                                                                                                  |  |               | 58,770  |   |                    |   | 24,469  |  
|Accounts receivable, net                                                                                                                                |  |               | 25,587  |   |                    |   | 19,901  |  
|Prepaid expenses and other current assets                                                                                                               |  |               | 12,588  |   |                    |   | 8,893   |  
|                                                                                                                                                        |  |               |         |   |                    |   |         |  
|Total current assets                                                                                                                                    |  |               | 175,976 |   |                    |   | 91,495  |  
|Property and equipment, net                                                                                                                             |  |               | 6,913   |   |                    |   | 5,002   |  
|Long-term investments                                                                                                                                   |  |               | 66,144  |   |                    |   | 130,873 |  
|Goodwill                                                                                                                                                |  |               | 82,747  |   |                    |   | 50,240  |  
|Other intangible assets, net                                                                                                                            |  |               | 15,168  |   |                    |   | 6,743   |  
|                                                                                                                                                        |  |               |         |   |                    |   |         |  
|Total assets                                                                                                                                            |  | $             | 346,948 |   |                    | $ | 284,353 |  
|                                                                                                                                                        |  |               |         |   |                    |   |         |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                    |  |               |         |   |                    |   |         |  
|Current liabilities:                                                                                                                                    |  |               |         |   |                    |   |         |  
|Accounts payable                                                                                                                                        |  | $             | 4,968   |   |                    | $ | 4,283   |  
|Accrued expenses                                                                                                                                        |  |               | 27,566  |   |                    |   | 9,545   |  
|Accrued payroll                                                                                                                                         |  |               | 10,648  |   |                    |   | 10,863  |  
|Income taxes payable                                                                                                                                    |  |               | 9,352   |   |                    |   | 6,460   |  
|Deferred revenue, current portion                                                                                                                       |  |               | 63,294  |   |                    |   | 40,912  |  
|                                                                                                                                                        |  |               |         |   |                    |   |         |  
|Total current liabilities                                                                                                                               |  |               | 115,828 |   |                    |   | 72,063  |  
|Deferred revenue, less current portion                                                                                                                  |  |               | 17,765  |   |                    |   | 3,023   |  
|                                                                                                                                                        |  |               |         |   |                    |   |         |  
|Total liabilities                                                                                                                                       |  |               | 133,593 |   |                    |   | 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; 81,076 and 79,982 shares outstanding as of June 30, 2005 and September 30, 2004,
respectively |  |               | 811     |   |                    |   | 800     |  
|Additional paid-in capital                                                                                                                              |  |               | 230,907 |   |                    |   | 216,580 |  
|Deferred stock compensation                                                                                                                             |  |               | (3,111  | ) |                    |   |        |  
|Treasury stock                                                                                                                                          |  |               | (7,147  | ) |                    |   | (7,147  | )
|Accumulated other comprehensive loss                                                                                                                    |  |               | (3,239  | ) |                    |   | (1,833  | )
|Retained earnings                                                                                                                                       |  |               | (4,866  | ) |                    |   | 867     |  
|                                                                                                                                                        |  |               |         |   |                    |   |         |  
|Total stockholders equity                                                                                                                              |  |               | 213,355 |   |                    |   | 209,267 |  
|                                                                                                                                                        |  |               |         |   |                    |   |         |  
|Total liabilities and stockholders equity                                                                                                              |  | $             | 346,948 |   |                    | $ | 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



3



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##### Table of Contents

MICROMUSE INC.



CONDENSED
CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)



|                                                                         |  |                            |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|------------------------------------------------------------------------ |  | -------------------------- | ------- | - | ------------------------- | - | ------ | ---- |  | - | ------- | - |  | - | ------- | -
|                                                                         |  | Three months endedJune 30, |         |   | Nine months endedJune 30, |  
|                                                                         |  | 2005                       |         |   | 2004                      |   |        | 2005 |  |   | 2004    |  
|Revenues:                                                                |  |                            |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|License                                                                  |  | $                          | 17,691  |   |                           | $ | 17,690 |      |  | $ | 56,981  |   |  | $ | 58,297  |  
|Maintenance and services                                                 |  |                            | 21,579  |   |                           |   | 17,135 |      |  |   | 59,061  |   |  |   | 52,002  |  
|                                                                         |  |                            |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Total revenues                                                           |  |                            | 39,270  |   |                           |   | 34,825 |      |  |   | 116,042 |   |  |   | 110,299 |  
|                                                                         |  |                            |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Cost of revenues:                                                        |  |                            |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|License                                                                  |  |                            | 1,983   |   |                           |   | 1,468  |      |  |   | 5,035   |   |  |   | 4,355   |  
|Maintenance and services                                                 |  |                            | 3,934   |   |                           |   | 3,140  |      |  |   | 10,824  |   |  |   | 8,456   |  
|Amortization of developed technology                                     |  |                            | 1,018   |   |                           |   | 1,527  |      |  |   | 3,214   |   |  |   | 4,515   |  
|Amortization of deferred stock compensation                              |  |                            | 24      |   |                           |   |       |      |  |   | 24      |   |  |   |        |  
|                                                                         |  |                            |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Total cost of revenues                                                   |  |                            | 6,959   |   |                           |   | 6,135  |      |  |   | 19,097  |   |  |   | 17,326  |  
|                                                                         |  |                            |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Gross profit                                                             |  |                            | 32,311  |   |                           |   | 28,690 |      |  |   | 96,945  |   |  |   | 92,973  |  
|                                                                         |  |                            |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Operating expenses:                                                      |  |                            |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Sales and marketing                                                      |  |                            | 16,075  |   |                           |   | 15,696 |      |  |   | 46,224  |   |  |   | 47,181  |  
|Research and development                                                 |  |                            | 8,838   |   |                           |   | 8,102  |      |  |   | 23,990  |   |  |   | 24,121  |  
|General and administrative                                               |  |                            | 6,786   |   |                           |   | 6,684  |      |  |   | 20,456  |   |  |   | 17,975  |  
|Stock based compensation and amortization of deferred stock compensation |  |                            | 903     |   |                           |   |       |      |  |   | 903     |   |  |   | 553     |  
|Write-off of in-process research and development                         |  |                            | 2,200   |   |                           |   |       |      |  |   | 2,200   |   |  |   |        |  
|Restatement and related litigation costs                                 |  |                            | 191     |   |                           |   | 1,616  |      |  |   | 447     |   |  |   | 5,466   |  
|Litigation settlement expense                                            |  |                            | 10,900  |   |                           |   |       |      |  |   | 10,900  |   |  |   |        |  
|Amortization of other intangible assets                                  |  |                            | 240     |   |                           |   | 48     |      |  |   | 461     |   |  |   | 143     |  
|Restructuring costs (recoveries)                                         |  |                            | 21      |   |                           |   |       |      |  |   | (281    | ) |  |   |        |  
|                                                                         |  |                            |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Total operating expenses                                                 |  |                            | 46,154  |   |                           |   | 32,146 |      |  |   | 105,300 |   |  |   | 95,439  |  
|                                                                         |  |                            |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Loss from operations                                                     |  |                            | (13,843 | ) |                           |   | (3,456 | )    |  |   | (8,355  | ) |  |   | (2,466  | )
|Other income, net                                                        |  |                            | 1,448   |   |                           |   | 1,151  |      |  |   | 3,916   |   |  |   | 2,865   |  
|                                                                         |  |                            |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Income (loss) before income taxes                                        |  |                            | (12,395 | ) |                           |   | (2,305 | )    |  |   | (4,439  | ) |  |   | 399     |  
|Income tax provision                                                     |  |                            | 220     |   |                           |   | 181    |      |  |   | 1,294   |   |  |   | 938     |  
|                                                                         |  |                            |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Net loss                                                                 |  | $                          | (12,615 | ) |                           | $ | (2,486 | )    |  | $ | (5,733  | ) |  | $ | (539    | )
|                                                                         |  |                            |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Per share data:                                                          |  |                            |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Basic net loss per share                                                 |  | $                          | (0.16   | ) |                           | $ | (0.03  | )    |  | $ | (0.07   | ) |  | $ | (0.01   | )
|Diluted net loss per share                                               |  | $                          | (0.16   | ) |                           | $ | (0.03  | )    |  | $ | (0.07   | ) |  | $ | (0.01   | )
|Weighted average shares used in computing:                               |  |                            |         |   |                           |   |        |      |  |   |         |   |  |   |         |  
|Basic net loss per share                                                 |  |                            | 80,882  |   |                           |   | 78,993 |      |  |   | 80,641  |   |  |   | 78,760  |  
|Diluted net loss per share                                               |  |                            | 80,882  |   |                           |   | 78,993 |      |  |   | 80,641  |   |  |   | 78,760  |  



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)



|                                                                                |  |                           |         |   |      |   |          |  
|------------------------------------------------------------------------------- |  | ------------------------- | ------- | - | ---- | - | -------- | -
|                                                                                |  | Nine months endedJune 30, |        
|                                                                                |  | 2005                      |         |   | 2004 |  
|Cash flows from operating activities:                                           |  |                           |         |   |      |   |          |  
|Net loss                                                                        |  | $                         | (5,733  | ) |      | $ | (539     | )
|Adjustments to reconcile net loss to net cash provided by operating activities: |  |                           |         |   |      |   |          |  
|Depreciation and amortization                                                   |  |                           | 6,056   |   |      |   | 7,576    |  
|Stock based compensation and amortization of deferred stock compensation        |  |                           | 927     |   |      |   | 553      |  
|Tax benefit related to exercise of stock options                                |  |                           | 827     |   |      |   | 464      |  
|Write-off of in-process research and development                                |  |                           | 2,200   |   |      |   |         |  
|Changes in assets and liabilities:                                              |  |                           |         |   |      |   |          |  
|Accounts receivable, net                                                        |  |                           | (4,818  | ) |      |   | (12,551  | )
|Prepaid expenses and other current assets                                       |  |                           | (3,275  | ) |      |   | (3,133   | )
|Accounts payable                                                                |  |                           | 447     |   |      |   | (1,108   | )
|Accrued expenses                                                                |  |                           | 13,081  |   |      |   | 3,025    |  
|Income taxes payable                                                            |  |                           | 1,573   |   |      |   | (40      | )
|Deferred revenue                                                                |  |                           | 32,542  |   |      |   | 8,789    |  
|                                                                                |  |                           |         |   |      |   |          |  
|Net cash provided by operating activities                                       |  |                           | 43,827  |   |      |   | 3,036    |  
|                                                                                |  |                           |         |   |      |   |          |  
|Cash flows from investing activities:                                           |  |                           |         |   |      |   |          |  
|Capital expenditures                                                            |  |                           | (3,243  | ) |      |   | (2,862   | )
|Investment purchases                                                            |  |                           | (59,517 | ) |      |   | (165,980 | )
|Investment sales                                                                |  |                           | 89,945  |   |      |   | 176,672  |  
|Acquisition of business, net of cash received                                   |  |                           | (31,546 | ) |      |   | (425     | )
|Receipt of historical Riversoft tax refund                                      |  |                           | 310     |   |      |   |         |  
|Payments for purchase of patents                                                |  |                           | (2,000  | ) |      |   |         |  
|                                                                                |  |                           |         |   |      |   |          |  
|Net cash provided by (used in) investing activities                             |  |                           | (6,050  | ) |      |   | 7,405    |  
|                                                                                |  |                           |         |   |      |   |          |  
|Cash flows from financing activities:                                           |  |                           |         |   |      |   |          |  
|Proceeds from issuance of common stock from options exercised                   |  |                           | 3,552   |   |      |   | 3,170    |  
|                                                                                |  |                           |         |   |      |   |          |  
|Net cash provided by financing activities                                       |  |                           | 3,552   |   |      |   | 3,170    |  
|                                                                                |  |                           |         |   |      |   |          |  
|Effects of exchange rate changes                                                |  |                           | (530    | ) |      |   | (1,564   | )
|                                                                                |  |                           |         |   |      |   |          |  
|Net increase in cash and cash equivalents                                       |  |                           | 40,799  |   |      |   | 12,047   |  
|Cash and cash equivalents at beginning of period                                |  |                           | 38,232  |   |      |   | 89,385   |  
|                                                                                |  |                           |         |   |      |   |          |  
|Cash and cash equivalents at end of period                                      |  | $                         | 79,031  |   |      | $ | 101,432  |  
|                                                                                |  |                           |         |   |      |   |          |  



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, and amended and on May 10, 2005. 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.
In particular, certain amounts in fiscal 2004 as reported on the Condensed Consolidated Balance Sheet and Condensed Statements of Cash Flows have been reclassified to conform to the current year presentation. We reclassified $52.5 million in auction
rate securities from cash and cash equivalents to long-term investments on the September 30, 2004 consolidated balance sheet. This reclassification is based on the Companys interpretation of the definition of cash equivalents pursuant to
Statement of Financial Accounting Standards No. 95 (SFAS 95), Statement of Cash Flows.



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, 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 $6.1 million and $16.9 million for the three-month and the nine-month periods ended June 30, 2005, respectively, and $6.6 million and $19.3 million for the three-month and the nine-month periods ended June 30, 2004, 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 three-month period ended June 30, 2005, 31% to cost of revenue, 62% to sales and marketing, and 8% to research
and development in the nine-month period ended June 30, 2005, and 21% to cost of revenue, 74% to sales and marketing, and 5% to research and development in the three-month and nine-month periods ended June 30, 2004. The allocation estimate is
subject to change and, if changed, will impact the allocation of expenses in the consolidated statement of operations but will not impact net income.



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 earnings per share for the three months and nine months ended June 30, 2005 were options to acquire 13.2 million and 15.3 million shares of common stock, respectively, because
its effect would be anti-dilutive. Also excluded from the computation of the diluted earnings per share for the three months and nine months ended June 30, 2005 was a warrant to acquire 50,000 shares of common stock at $7.27 per share, because their
effect would be anti-dilutive. Excluded from the computation of diluted loss per share for the three months and nine months ended June 30, 2004 were options to acquire 13.5 million and 7.7 million shares of common stock, respectively, because their
effect would be anti-dilutive. Our diluted earnings per share is equal to the basic earnings per share for the three months and nine months ended June 30, 2005 and 2004.



6



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##### Table of Contents

MICROMUSE INC.



Concentration of Revenues and Accounts Receivable



One third-party distributor customer accounted for approximately 10% and 14% of revenues for
the three-month and the nine-month periods ended June 30, 2005, respectively, as compared to 15% and 16% in each of the same periods of the prior year. No single end-user customer accounted for greater than 10% of revenues for the three-month and
nine-month periods ended June 30, 2005 and 2004. As of June 30, 2005, no single customer has an account balance greater than 10% of accounts receivable. As of September 30, 2004, one customer has an account balance greater than 10% of accounts
receivable.



Accounts Receivable



Accounts receivable includes an allowance for doubtful accounts of $0.7
million and $1.0 million as of June 30, 2005 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 income (loss), net of tax, for the quarter
ended June 30, 2005 was a gain of $0.4 million, as compared to a gain of $0.2 million for the quarter ended June 30, 2004. Other comprehensive loss, net of tax, for the nine months ended June 30, 2005 and 2004, was $1.4 million and $29 thousand,
respectively.



Stock Based Compensation



At June 30, 2005, 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, and amended on May 10, 2005. 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 three months and nine months ended June 30, 2005. In June 2005, the Company
completed the acquisition of Quallaby Corporation (refer to Note 2) and assumed and converted Quallaby options to 1.6 million Company options. In connection with this acquisition, the Company recorded deferred compensation in the amount of $3.6
million, based on the intrinsic value of unvested options at the date of acquisition, which is being amortized over the remaining service period underlying the options. In the three months ended June 30, 2005, the Company recorded $0.4 million of
stock based compensation related to this amortization. In addition, the Company recorded $0.5 million of stock based compensation related to the accelerated vesting provisions of a former executives stock options awards.



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, effective from February 1, 2005, for the
purpose of allowing eligible employees to participate in a revised form of the Plan beginning with the February 1, 2005 offering. In particular, the sub-plan reduced the offering period 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. In July 2005, the Company further amended certain provisions of its Plan. In particular, the amendment reduces all ongoing offering periods to 6 months; the purchase price for each share of stock purchased at the close of an
offering period under the amended Plan remains at 85% of the fair market value of such share on the last trading day before the commencement of the next applicable offering period, there remains no look-back or re-set provisions and the dates for
the commencement of each subsequent offering periods have been extended to February 10 and August 10. See also Recently Issued Accounting Pronouncements 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 endedJune 30, |         |   | Nine months ended June 30, |  
|                                                                              |  | 2005                       |         |   | 2004                       |   |        | 2005 |  |   | 2004    |  
|Net loss, as reported                                                         |  | $                          | (12,615 | ) |                            | $ | (2,486 | )    |  | $ | (5,733  | ) |  | $ | (539    | )
|Add: Stock based compensation expense, included in net loss, net of tax of $0 |  |                            | 927     |   |                            |   |       |      |  |   | 927     |   |  |   | 553     |  
|Less: Stock based compensation determined under SFAS No.123, net of tax of $0 |  |                            | (4,481  | ) |                            |   | (7,129 | )    |  |   | (13,549 | ) |  |   | (21,454 | )
|                                                                              |  |                            |         |   |                            |   |        |      |  |   |         |   |  |   |         |  
|Net loss, pro-forma                                                           |  | $                          | (16,169 | ) |                            | $ | (9,615 | )    |  | $ | (18,355 | ) |  | $ | (21,440 | )
|                                                                              |  |                            |         |   |                            |   |        |      |  |   |         |   |  |   |         |  
|Basic and diluted net loss per share, as reported                             |  | $                          | (0.16   | ) |                            | $ | (0.03  | )    |  | $ | (0.07   | ) |  | $ | (0.01   | )
|Basic and diluted net loss per share, pro-forma                               |  | $                          | (0.20   | ) |                            | $ | (0.12  | )    |  | $ | (0.23   | ) |  | $ | (0.27   | )



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 endedJune 30, |        | Nine months ended June30,
|                    |  | 2005                       |        | 2004                      |   | 2005   |  | 2004
|Revenues:           |  |                            |        |                           |   |        |  |      |         |  |   |        
|United States       |  | $                          | 17,372 |                           | $ | 19,348 |  | $    | 54,394  |  | $ | 61,297 
|United Kingdom      |  |                            | 9,885  |                           |   | 5,597  |  |      | 20,733  |  |   | 14,676 
|Other international |  |                            | 12,013 |                           |   | 9,880  |  |      | 40,915  |  |   | 34,326 
|                    |  |                            |        |                           |   |        |  |      |         |  |   |        
|Total               |  | $                          | 39,270 |                           | $ | 34,825 |  | $    | 116,042 |  | $ | 110,299
|                    |  |                            |        |                           |   |        |  |      |         |  |   |        



|                     |  |              |         |                   |   |       
|-------------------- |  | ------------ | ------- | ----------------- | - | ------
|                     |  | June 30,2005 |         | September 30,2004
|Long  lived assets: |  |              |         |                   |   |       
|United States        |  | $            | 89,732  |                   | $ | 44,193
|International        |  |              | 15,096  |                   |   | 17,792
|                     |  |              |         |                   |   |       
|Total                |  | $            | 104,828 |                   | $ | 61,985
|                     |  |              |         |                   |   |       



7



---

##### 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 June 30, 2005 and September 30, 2004, the Company had unamortized goodwill and other intangible assets of $97.9 million and $57.0 million, respectively. These amounts included $82.7 million and $50.2 million of
goodwill as of June 30, 2005 and September 30, 2004, respectively. The change in goodwill is primarily due to the acquisition of Quallaby and foreign exchange fluctuations related to certain goodwill denominated in British pounds. The change in
other intangible assets is primarily due to the acquisition of Quallaby, the purchase of certain patents, all net of amortization recorded during the period. The amortization period of other intangible assets is over their estimated useful lives of
six months to six years.



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



|                                             |  |                          |        |                         |   |         |                    |  |   |       
|-------------------------------------------- |  | ------------------------ | ------ | ----------------------- | - | ------- | ------------------ |  | - | ------
|                                             |  | As of June 30, 2005     
|                                             |  | GrossCarryingAmount      |        | AccumulatedAmortization |   |         | Net CarryingAmount
|Developed technology                         |  | $                        | 30,564 |                         | $ | (21,098 | )                  |  | $ | 9,466 
|Customer contracts                           |  |                          | 3,758  |                         |   | (1,298  | )                  |  |   | 2,460 
|Trademarks and patents                       |  |                          | 5,425  |                         |   | (2,182  | )                  |  |   | 3,243 
|                                             |  |                          |        |                         |   |         |                    |  |   |       
|Intangibles related to business acquisitions |  | $                        | 39,747 |                         | $ | (24,578 | )                  |  | $ | 15,169
|                                             |  |                          |        |                         |   |         |                    |  |   |       
|                                             | 
|                                             |  | As of September 30, 2004
|                                             |  | GrossCarryingAmount      |        | AccumulatedAmortization |   |         | Net CarryingAmount
|Developed technology                         |  | $                        | 24,371 |                         | $ | (17,892 | )                  |  | $ | 6,479 
|Customer contracts                           |  |                          | 1,362  |                         |   | (1,233  | )                  |  |   | 129   
|Trademarks and patents                       |  |                          | 807    |                         |   | (672    | )                  |  |   | 135   
|                                             |  |                          |        |                         |   |         |                    |  |   |       
|Intangibles related to business acquisitions |  | $                        | 26,540 |                         | $ | (19,797 | )                  |  | $ | 6,743 
|                                             |  |                          |        |                         |   |         |                    |  |   |       



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



|                     |  |                            |       |                           |   |       |  |      |       |  |   |      
|-------------------- |  | -------------------------- | ----- | ------------------------- | - | ----- |  | ---- | ----- |  | - | -----
|                     |  | Three months endedJune 30, |       | Nine months endedJune 30,
|                     |  | 2005                       |       | 2004                      |   | 2005  |  | 2004
|Developed technology |  | $                          | 1,018 |                           | $ | 1,527 |  | $    | 3,214 |  | $ | 4,515
|Customer contracts   |  |                            | 56    |                           |   | 6     |  |      | 68    |  |   | 19   
|Trademarks           |  |                            | 184   |                           |   | 42    |  |      | 393   |  |   | 124  
|                     |  |                            |       |                           |   |       |  |      |       |  |   |      
|Total amortization   |  | $                          | 1,258 |                           | $ | 1,575 |  | $    | 3,675 |  | $ | 4,658
|                     |  |                            |       |                           |   |       |  |      |       |  |   |      



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):



|                                |  |                     |       
|------------------------------- |  | ------------------- | ------
|                                |  | FutureAmortizations
|Fiscal Year                     |  |                     |       
|2005 (remainder of fiscal year) |  | $                   | 1,222 
|2006                            |  |                     | 4,412 
|2007                            |  |                     | 4,241 
|2008                            |  |                     | 2,876 
|2009                            |  |                     | 2,159 
|Thereafter                      |  |                     | 259   
|                                |  |                     |       
|Total                           |  | $                   | 15,169
|                                |  |                     |       



8



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##### Table of Contents

Recently Issued Accounting Pronouncements



In May 2005, the FASB issued SFAS No. 154 (SFAS 154), Accounting Changes and
Error Correctionsa replacement of APB Opinion No. 20 and FASB Statement No. 3. SFAS 154 shall be effective for accounting changes and corrections of errors made in fiscal years beginning after December 15, 2005. SFAS 154 replaces APB
Opinion No. 20, Accounting Changes, and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements, and changes the requirements for the accounting for and reporting of a change in accounting principle. SFAS 154
applies to all voluntary changes in accounting principle, and it also applies to changes required by an accounting pronouncement in the unusual instance that the pronouncement does not include specific transition provisions. When a pronouncement
includes specific transition provisions, those provisions should be followed. The Company is evaluating the requirements of SFAS 154 and does not expect the application of SFAS 154 to have a material impact on its results of operations or financial
position.



In March 2005, the FASB issued Interpretation No. (FIN) 47,
Accounting for Conditional Asset Retirement Obligations, to clarify the requirement to record liabilities stemming from a legal obligation to clean up and retire fixed assets, such as a plant or factory, when an asset retirement depends on a
future event. The Company is evaluating the requirements of FIN 47 and does not expect the application of FIN 47 to have a material impact on its results of operations or financial position.



In December 2004, the FASB revised SFAS No. 123 (SFAS 123(R)), Share-Based
Payment, which requires companies to expense the estimated fair value of employee stock options and similar awards. The accounting provisions of SFAS 123(R) will be effective for the Company beginning on October 1, 2005. The Company is in the
process of determining how the new method of valuing stock-based compensation as prescribed in SFAS 123(R) will be applied to valuing stock-based awards granted after the effective date.



In March 2005, the SEC staff issued guidance on SFAS 123(R). Staff Accounting Bulletin No. 107 (SAB 107) was issued to assist
preparers by simplifying some of the implementation challenges of SFAS 123(R) while enhancing the information that investors receive. SAB 107 creates a framework that is premised on two overarching themes: (a) considerable judgment will be required
by preparers to successfully implement SFAS 123(R), specifically when valuing employee stock options; and (b) reasonable individuals, acting in good faith, may conclude differently on the fair value of employee stock options. Key topics covered by
SAB 107 include: (a) valuation models  SAB 107 reinforces the flexibility allowed by SFAS 123(R) to choose an option-pricing model that meets the standards fair value measurement objective; (b) expected volatility  SAB 107 provides
guidance on when it would be appropriate to rely exclusively on either historical or implied volatility in estimating expected volatility; and (c) expected term  the new guidance includes examples and some simplified approaches to determining
the expected term under certain circumstances. The Company will apply the principles of SAB 107 in conjunction with its adoption of SFAS 123(R). The Company believes adoption of SFAS No. 123(R) will have a material impact on its 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 the first quarter of fiscal 2006. The Company does not believe adoption of SFAS No. 153 will have a material adverse
impact on its 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 on the Companys results of operations and financial condition.



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



On June 30, 2005, the Company entered into an agreement to acquire
GuardedNet, Inc., a privately-held software company based in Atlanta, Georgia, for $16.2 million in cash. On August 1, 2005, the acquisition was completed.



On April 8, 2005, the Company entered into an agreement to acquire Quallaby Corporation (Quallaby), a privately-held software company based in Lowell,
Massachusetts. On June 1, 2005, the Company completed its acquisition of Quallaby. Subject to the terms of the merger agreement, the Company paid $33.0 million in cash for all the issued share capital of Quallaby, assumed and converted certain stock
options held by Quallaby employees, resulting in issuance of options to purchase 1.6 million shares of the Companys common stock, valued at $5.9 million, and incurred transaction costs of $1.6 million consisting primarily of legal and
financial services fees, for a total of $40.5 million. The valuation of the options assumed pursuant to the acquisition uses the following assumptions: 4-year term, volatility of 0.5439, annual interest rate of 3.60%, 0.00% dividend yield, and the
closing price of the Companys stock on June 1, 2005. The transaction was accounted for under the purchase method of accounting with Quallabys results of operations included from the acquisition date.



Under purchase accounting, the purchase price is allocated to assets purchased and
liabilities assumed based on their relative fair values with the excess recorded as goodwill. Based on an evaluation and review of the net assets acquired, the amounts and components of the purchase price along with the allocation of the purchase
price are as follows: (in millions)



|                                                                            |  |   |      |  
|--------------------------------------------------------------------------- |  | - | ---- | -
|Options assumed                                                             |  | $ | 5.9  |  
|Cash                                                                        |  |   | 33.0 |  
|Transaction costs                                                           |  |   | 1.6  |  
|                                                                            |  |   |      |  
|Total purchase price                                                        |  | $ | 40.5 |  
|                                                                            |  |   |      |  
|Fair market value of liabilities assumed less tangible assets acquired, net |  | $ | (4.2 | )
|Intangible assets:                                                          |  |   |      |  
|In-process research and development                                         |  |   | 2.2  |  
|Existing technology                                                         |  |   | 5.2  |  
|Core technology                                                             |  |   | 1.0  |  
|Maintenance agreements                                                      |  |   | 1.4  |  
|Trademark                                                                   |  |   | 1.0  |  
|Customer relationships                                                      |  |   | 1.0  |  
|Goodwill                                                                    |  |   | 32.9 |  
|                                                                            |  |   |      |  
|Total intangible assets                                                     |  |   | 44.7 |  
|                                                                            |  |   |      |  
|Net assets acquired                                                         |  | $ | 40.5 |  
|                                                                            |  |   |      |  



The value of identifiable intangible
assets was determined in accordance with Statement of Financial Accounting Standard No. 141 Business Combinations. Existing technology represents the value of the existing technology for products which have been developed and reached technological
feasibility. The value is calculated based on the implicit income derived from revenues for sales of existing technology. Based on the product life cycle, historical product lives, and new functionality arising from each product release, existing
technology is estimated to have a useful life of four to five years and will be amortized on a straight line basis. Core technology represents a combination of design methodologies, processes and trade secrets. The acquired core technology
represents core modular architecture that is used in the Quallaby products, both current and planned future releases. The value is calculated based on an estimate of the royalties saved because Quallaby owns the technology. Core technology is
estimated to have a useful life of four to five years, and will be amortized on a straight line basis. The value of maintenance agreements represents the implicit income derived as a result of the fees customers pay Quallaby when customers enter
into maintenance and support contracts. Based on historical attrition rates, the useful life of the maintenance agreements is estimated to be four to five years, and will be amortized on a straight line basis. The value of the trademark represents
the estimated royalties saved because Quallaby owns the trademark, based on an estimated royalty rate. Based on the estimated useful life of the technology, the useful life of the trademark is estimated to be five years, and will be amortized on a
straight line basis. The value of customer relationships represents revenue generated by Quallaby from sales of future versions of the existing product to existing customers. The value is calculated based on an estimate of the implicit income
derived from this. Based on customer attrition and technology obsolescence, the useful life of customer relationships is estimated to be four to five years.



Residual goodwill has been recorded based on the purchase price remaining after allocating the purchase price to the fair market value of tangible and intangible assets
purchased less liabilities assumed. Residual goodwill arises as a result of, among other factors, future unidentified new products, new technologies and new customers as well as the implicit value of future cost savings as a result of the combining
of entities. In accordance with SFAS No. 142, goodwill will not be amortized but will be tested at least annually for impairment.



Micromuse identified four research projects in areas for which technological feasibility had not been established and no alternative future uses existed. These four
projects represent research and development to create the next generation versions and new applications of its primary software products. Two of the four projects were approximately 11% to 15% complete, and the other two of the four projects were
approximately 85% to 88% complete, as of the date of the close of the transaction. Micromuse estimates that it will cost approximately $1.2 million in additional research and development expenses to complete these four projects. The value for each
of the projects was determined by estimating the expected cash flows from the projects once commercially viable, discounting the net cash flows to their present value, and then applying a percentage of completion to the calculated value. Key
assumptions utilized in determining these values include:



| |  |  | discount rate of 20 to 22%, representing the cost of capital as related to the estimated time to complete the projects and the level of risk involved; and
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | the percentage of completion for the projects, determined using costs incurred prior to the acquisition date compared to the remaining research and development to be completed to
bring the projects to technological feasibility.
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Results for the
Quallaby acquisition have been included in our consolidated results of operations beginning on June 1, 2005. The following pro forma results of operations for the six months ended March 31, 2005 and 2004 assume the acquisition occurred at the
beginning of the year ended September 30, 2004. The pro forma information has been presented for illustrative purposes only and is not necessarily indicative of the combined financial position or results of operations for future periods or the
results of operations or financial position that actually would have been realized had the companies been combined during the specified period. The pro forma information excludes non-recurring items which consist only of acquired in-process
technology expense of $2.2 million: (in million, except per share amounts)



|                           |  |                           |        |   |      |   |        |  
|-------------------------- |  | ------------------------- | ------ | - | ---- | - | ------ | -
|                           |  | Six months endedMarch 31, |       
|                           |  | 2005                      |        |   | 2004 |  
|Net revenue                |  | $                         | 78,869 |   |      | $ | 77,922 |  
|Net loss                   |  | $                         | (2,329 | ) |      | $ | (2,874 | )
|Basic net loss per share   |  | $                         | (0.03  | ) |      | $ | (0.04  | )
|Diluted net loss per share |  | $                         | (0.03  | ) |      | $ | (0.03  | )



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. 94-3Liability 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. As of June 30, 2005, no severance accrual balance is outstanding related to the 2002 or 2003 restructuring plan.



9



---

##### 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 June 30, 2005, the remaining $0.3
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 nine months ended June 30, 2005 (in thousands):



|                                                       |  |                                       |     |   |                                        |   |      |       |  |   |      |  
|------------------------------------------------------ |  | ------------------------------------- | --- | - | -------------------------------------- | - | ---- | ----- |  | - | ---- | -
|                                                       |  | Fiscal 2002Restructuring PlanFacility |     |   | Fiscal 2003Restructuring PlanSeverance |   |      | Total | 
|Accrual balance at September 30, 2004                  |  | $                                     | 347 |   |                                        | $ | 646  |       |  | $ | 993  |  
|Non-cash charges                                       |  |                                       | 4   |   |                                        |   |     |       |  |   | 4    |  
|                                                       |  |                                       |     |   |                                        |   |      |       |  |   |      |  
|Accrual balance at December 31, 2004                   |  |                                       | 351 |   |                                        |   | 646  |       |  |   | 997  |  
|Restructuring charges                                  |  |                                       | 4   |   |                                        |   |     |       |  |   | 4    |  
|Recoveries                                             |  |                                       |    |   |                                        |   | (306 | )     |  |   | (306 | )
|Changes due to foreign currency exchange rates         |  |                                       | (2  | ) |                                        |   | (7   | )     |  |   | (9   | )
|Cash paid during the three months ended March 31, 2005 |  |                                       | (8  | ) |                                        |   |     |       |  |   | (8   | )
|                                                       |  |                                       |     |   |                                        |   |      |       |  |   |      |  
|Accrual balance at March 31, 2005                      |  | $                                     | 345 |   |                                        | $ | 333  |       |  | $ | 678  |  
|Restructuring charges                                  |  |                                       |    |   |                                        |   | 21   |       |  |   | 21   |  
|Changes due to foreign currency exchange rates         |  |                                       | (14 | ) |                                        |   |     |       |  |   | (14  | )
|Cash paid during the three months ended June 30, 2005  |  |                                       | (8  | ) |                                        |   | (354 | )     |  |   | (362 | )
|                                                       |  |                                       |     |   |                                        |   |      |       |  |   |      |  
|Accrual balance at June 30, 2005                       |  |                                       | 323 |   |                                        |   |     |       |  | $ | 323  |  
|                                                       |  |                                       |     |   |                                        |   |      |       |  |   |      |  



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. As noted in Part II, Item 1 Legal Proceedings, the Company reached an agreement with Agilent Technologies, Inc. to settle two patent infringement lawsuits. In addition to this matter, the Company
recorded a provision, reflecting a probable amount the Company will be required to pay in settlement of the two patent infringement suits between the Company and Aprisma. A charge for both of these settlements, which totals $10.9 million, is
included in the Companys consolidated results of operations for the three months and nine months ended June 30, 2005.



Note 5. Subsequent Events



In June, 2005, the Company executed a lease agreement for new corporate office space in San Francisco with an initial term, beginning August 1, 2005, of ten years and
five two-year renewal terms which the Company does not consider, on an individual basis, to be a material obligation. The Company expects to complete the move-in to the new corporate office space at the beginning of fiscal year 2006.



On April 27, 2005, the Company announced a program under which Micromuse may repurchase up to
6,000,000 shares of its common stock over the next 12 months. 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. The Company began repurchasing its shares under this program in August, 2005.



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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, and amended on May 10, 2005.



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 $39.3 million in total revenue in the three-month period ended June 30, 2005, an increase of 4% sequentially and a 13% increase year-over-year.
License revenue was $17.7 million, down 11% sequentially. Net loss for the three-month period was $12.6 million or $0.16 per diluted share as compared with a net loss of $2.5 million or $0.03 per diluted share in the comparable period of the prior
fiscal year.



Cash, cash equivalents and investments at June 30, 2005 were
$203.9 million, up by $10.6 million sequentially, and up by $12.5 million from a year ago. Cash flow from operations was positive for the three months and nine months ended June 30, 2005 and the Company remains debt free. Deferred revenue was $81.1
million at June 30, 2005, up from $50.6 million in the prior quarter.



As a
result of our multinational operations and sales, our operating results are subject to fluctuations based upon changes in the exchange rates of certain currencies, particularly the British pound, in relation to the U.S. dollar. For example, while
our United States headquarters is located in San Francisco, California, our principal product development operations are located in London, England. As a result, a substantial portion of our costs and expenses are denominated in currencies other
than the U.S. dollar. The net foreign exchange impact to the consolidated results of operations is insignificant.



Recent Events



On April 27, 2005, the Company announced a program under which Micromuse may repurchase up to 6,000,000 shares of its common stock over the next 12 months. 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. The Company began repurchasing its shares under this program in August, 2005.



On June 30, 2005, the Company entered into an agreement to acquire GuardedNet, Inc., a privately-held software company based in Atlanta, Georgia, for $16.2 million in cash. On August 1, 2005, the acquisition was
completed.



In June, 2005, the Company executed a lease agreement for new
corporate office space in San Francisco with an initial term of ten years and five two-year renewal terms which the Company does not consider, on an individual basis, to be a material obligation. The Company expects to fully move into the new
corporate office space at the beginning of fiscal year 2006.



On June 1, 2005,
the Company completed its acquisition of Quallaby Corporation, a privately-held software company based in Lowell, Massachusetts, pursuant to an Agreement and Plan of Merger dated as of April 7, 2005. Subject to the terms of the merger agreement, the
purchase price was $33 million in cash, and the Company also assumed and converted outstanding options to purchase Quallaby common stock into options to acquire approximately 1.6 million shares of the Companys common stock.



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.



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



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
maintenance of a license agreement, the entire amount of revenue from the arrangement is deferred and recognized ratably over the period that maintenance is 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 an equivalent document 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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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. 94-3Liability 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 are 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 that a loss has occurred or 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 except for the expected Aprisma settlement described below. 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. As noted in Note 4, Litigation, the Company reached an agreement with Agilent
Technologies, Inc. to settle two patent infringement lawsuits. In addition, the Company recorded a provision, reflecting a probable amount the Company will be required to pay in order to reach a settlement, related to a patent infringement suit
brought against the Company by Aprisma. A charge for both of these items, which totals $10.9 million, is included in our results of operations for the three months and nine months ended June 30. 2005.



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
may exclude 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.



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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 endedJune 30, |   |  | Nine months endedJune 30, |  
|                                                                         |  | 2005                       |   |  | 2004                      |   |  | 2005  |   |  | 2004  |  
|As a Percentage of Total Revenues:                                       |  |                            |   |  |                           |   |  |       |   |  |       |  
|Revenues:                                                                |  |                            |   |  |                           |   |  |       |   |  |       |  
|License                                                                  |  | 45.0                       | % |  | 50.8                      | % |  | 49.1  | % |  | 52.9  | %
|Maintenance and services                                                 |  | 55.0                       | % |  | 49.2                      | % |  | 50.9  | % |  | 47.1  | %
|                                                                         |  |                            |   |  |                           |   |  |       |   |  |       |  
|Total revenues                                                           |  | 100.0                      | % |  | 100.0                     | % |  | 100.0 | % |  | 100.0 | %
|                                                                         |  |                            |   |  |                           |   |  |       |   |  |       |  
|Cost of revenues:                                                        |  |                            |   |  |                           |   |  |       |   |  |       |  
|License                                                                  |  | 5.0                        | % |  | 4.2                       | % |  | 4.3   | % |  | 3.9   | %
|Maintenance and services                                                 |  | 10.0                       | % |  | 9.0                       | % |  | 9.3   | % |  | 7.7   | %
|Amortization of developed technology                                     |  | 2.6                        | % |  | 4.4                       | % |  | 2.8   | % |  | 4.1   | %
|Amortization of deferred stock compensation                              |  | 0.1                        | % |  | 0.0                       | % |  | 0.0   | % |  | 0.0   | %
|                                                                         |  |                            |   |  |                           |   |  |       |   |  |       |  
|Total cost of revenues                                                   |  | 17.7                       | % |  | 17.6                      | % |  | 16.4  | % |  | 15.7  | %
|                                                                         |  |                            |   |  |                           |   |  |       |   |  |       |  
|Gross profit                                                             |  | 82.3                       | % |  | 82.4                      | % |  | 83.6  | % |  | 84.3  | %
|                                                                         |  |                            |   |  |                           |   |  |       |   |  |       |  
|Operating expenses:                                                      |  |                            |   |  |                           |   |  |       |   |  |       |  
|Sales and marketing                                                      |  | 40.9                       | % |  | 45.1                      | % |  | 39.8  | % |  | 42.8  | %
|Research and development                                                 |  | 22.5                       | % |  | 23.3                      | % |  | 20.7  | % |  | 21.9  | %
|General and administrative                                               |  | 17.3                       | % |  | 19.2                      | % |  | 17.6  | % |  | 16.3  | %
|Stock based compensation and amortization of deferred stock compensation |  | 2.3                        | % |  | 0.0                       | % |  | 0.8   | % |  | 0.5   | %
|Write-off of in-process research and development                         |  | 5.6                        | % |  | 0.0                       | % |  | 1.9   | % |  | 0.0   | %
|Restatement and related litigation costs                                 |  | 0.5                        | % |  | 4.6                       | % |  | 0.4   | % |  | 5.0   | %
|Litigation settlement expenses                                           |  | 27.8                       | % |  | 0.0                       | % |  | 9.4   | % |  | 0.0   | %
|Amortization of other intangible assets                                  |  | 0.6                        | % |  | 0.1                       | % |  | 0.4   | % |  | 0.0   | %
|Restructuring costs                                                      |  | 0.1                        | % |  | 0.0                       | % |  | -0.2  | % |  | 0.1   | %
|                                                                         |  |                            |   |  |                           |   |  |       |   |  |       |  
|Total operating expenses                                                 |  | 117.6                      | % |  | 92.3                      | % |  | 90.8  | % |  | 86.6  | %
|                                                                         |  |                            |   |  |                           |   |  |       |   |  |       |  
|Loss from operations                                                     |  | -35.3                      | % |  | -9.9                      | % |  | -7.2  | % |  | -2.3  | %
|Other income, net                                                        |  | 3.7                        | % |  | 3.3                       | % |  | 3.4   | % |  | 2.6   | %
|                                                                         |  |                            |   |  |                           |   |  |       |   |  |       |  
|Income (loss) before income taxes                                        |  | -31.6                      | % |  | -6.6                      | % |  | -3.8  | % |  | 0.3   | %
|Income tax provision                                                     |  | 0.6                        | % |  | 0.5                       | % |  | 1.1   | % |  | 0.9   | %
|                                                                         |  |                            |   |  |                           |   |  |       |   |  |       |  
|Net loss                                                                 |  | -32.2                      | % |  | -7.1                      | % |  | -4.9  | % |  | -0.6  | %
|                                                                         |  |                            |   |  |                           |   |  |       |   |  |       |  
|As a Percentage of Related Revenues:                                     |  |                            |   |  |                           |   |  |       |   |  |       |  
|Cost of license revenues                                                 |  | 11.2                       | % |  | 8.3                       | % |  | 8.8   | % |  | 7.5   | %
|Cost of maintenance and services revenues                                |  | 18.2                       | % |  | 18.3                      | % |  | 18.3  | % |  | 16.3  | %



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MICROMUSE INC.



Revenues



Revenues increased to $39.3 million and $116.0 million in the three months and nine months ended June 30, 2005, from $34.8 million and $110.3 million in the comparable
periods of the prior year. License revenues remained at $17.7 million for the three months ended June 30, 2005 and 2004, but decreased to $57.0 million from $58.3 million in the nine months ended June 30, 2005 and 2004, respectively. The decrease in
license revenues in the nine months ended June 30, 2005 was primarily due to increased purchasing scrutiny by our customers and the lengthening of the sales cycle. Maintenance and services revenues increased to $21.6 million and increased to $59.1
million in the three months and nine months ended June 30, 2005, respectively, from $17.1 million and $52.0 million in the comparable periods of the prior year. The increase in maintenance and services in the three months and nine months ended June
30, 2005 was primarily due to an increase in the renewal of back maintenance contracts that had previously expired, plus the addition of a contract with significant maintenance portion earned during the three months ended June 30, 2005, as well as
increased revenues from our professional services organization. License revenues as a percentage of total revenues was 45.0% and 49.1% in the three months and nine months ended June 30, 2005, as compared to 50.8% and 52.9% in the comparable periods
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 was 5.0% and 4.3% in the three months and nine months ended June 30, 2005, as compared to 4.2% and 3.9% in the comparable periods of the
prior year. The change in cost of license revenue as a percentage of license revenue in the three months and nine months ended June 30, 2005 is mainly due to a change in the mix of license revenue and related licensing agreements in those periods
that led to an increase in sales of licenses with related technology license fees payable to third parties.



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 10.0% and 9.3% in the three months and nine months ended June 30, 2005, as compared to 9.0% and 7.7% in the comparable periods of the prior year. The change in cost of maintenance and service
revenues as a percentage of maintenance and services revenue in the three months and nine months ended June 30, 2005 is principally due to additional headcounts in our professional services group and higher technical support costs.



Cost of amortization of developed technology relates to the amortization of developed
technology acquired in the acquisitions of CAN, NetOps Corporation, RiverSoft plc, Lumos Technologies Inc., NHI, and Quallaby over two to six years. The decrease in the cost of the amortization of developed technology in the three months and nine
months ended June 30, 2005 as compared to the same periods of the prior year is due to certain intangibles becoming fully amortized during the three and nine months ended June 30, 2005.



Cost of amortization of deferred stock compensation relates to the amortization of deferred stock compensation expense recorded in the
acquisition of Quallaby, to be amortized over the remaining service period underlying the options.



Sales and Marketing Expenses



Sales and
marketing expenses increased to $16.1 million, but decreased to $46.2 million, in the three and nine months ended June 30, 2005, from $15.7 million and $47.2 million in the comparable periods of the prior year. The increase in sales and marketing
expenses in the three months ended June 30, 2005 as compared to the same period of the prior year is primarily due to an increase in consulting fees of $0.2 million, an increase in recruiting costs of $0.1 million, and an increase in marketing and
development expenses of $0.1 million. The decrease in sales and marketing expenses in the nine months ended June 30, 2005 as compared to the same period of the prior year is primarily due to a decrease of $4.0 million in the allocation of costs of
the technical services department to sales related activities, offset by an increase in payroll related costs of $2.0 million, an increase in consulting fee of $0.4 million, an increase in recruiting costs of $0.2 million, and an increase in
marketing and development expenses of $0.2 million. Sales and marketing expenses as a percentage of total revenues decreased to 40.9% and 39.8% in the three months and nine months ended June 30, 2005, as compared to 45.1% and 42.8% in the comparable
periods 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 increased to $8.8 million, but decreased to $24.0 million, in the three months and nine months ended June 30, 2005, from $8.1 million
and $24.1 million in the comparable periods of the prior year. The increase in research and development expenses in the three months ended June 30, 2005 as compared to the same period of the prior year is primarily due to an increase in payroll
related expenses of $0.7 million. The research and development expenses in the nine months ended June 30, 2005 did not decrease significantly as compared to the same period of the prior year. Research and development costs as a percentage of total
revenues decreased to 22.5% and 20.7% in the three months and nine months ended June 30, 2005, as compared to 23.3% and 21.9% the comparable periods 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



General and
administrative expenses increased to $6.8 million and $20.5 million in the three months and nine months ended June 30, 2005, respectively, from $6.7 million and $18.0 million in the comparable periods of the prior year. The general and
administrative expenses for the three months ended June 30, 2005 did not change significantly from the comparable period of the prior year. The increase in general and administrative expenses for the nine months ended June 30, 2005, as compared to
the same period of the prior year, is primarily due to an increase in outside professional accounting and consulting fees of $1.2 million, a charge of $0.5 million pursuant to the severance agreement with one of the Companys former executives,
and an increase in payroll related expenses of $0.8 million. General and administrative expenses as a percentage of revenues decreased to 17.3%, but increased to 17.6%, in the three months and nine months ended June 30, 2005, from 19.2% and 16.3% in
the comparable periods of the prior year. Additional information relating to expense trends in fiscal 2005 is set forth under Overview above.



Stock Based Compensation and Amortization of Deferred Stock Compensation



The increase in stock based compensation and amortization of deferred stock compensation expenses in the three months and nine months ended June 30, 2005 is primarily
due to a charge of $0.9 million in the three months ended June 30, 2005 of which $0.5 million is related to the accelerated vesting provisions of a former executives stock option awards, and $0.4 million in amortization of deferred stock based
compensation expense in relation to the assumption and conversion of Quallaby options as a result of the completion of the Quallaby acquisition.



Write-off of in-process research and development



At the time of the Quallaby acquisition, the Companys management identified research projects in areas for which technological feasibility had not been established
and no alternative future uses existed. The value for each of the projects was determined by estimated the expected cash flows from the projects once commercially viable, discounting the net cash flows to their present value, and applying a
percentage of completion to the calculated value. This amount represents the value of research and development efforts related to technologies that had not reached technological feasibility and for which there was no future alternative use, as
determined on the acquisition date, and accordingly expensed at the acquisition date.



Litigation settlement expense



On July 5, 2005, the Company
reached an agreement with Agilent Technologies, Inc. to settle two patent infringement lawsuits. In addition, the Company recorded a provision, reflecting a probable amount the Company will be required to pay in settlement of the two patent
infringement suits between the Company and Aprisma. A charge for both of these settlements, which totals $10.9 million, is included in our results of operations for the three months and nine months ended June 30. 2005.



Amortization of Other Intangible Assets



Amortization of other intangible assets increased to $0.2 million and $0.5 million in the
three months and nine months ended June 30, 2005, from $48 thousand and $0.1 million 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. The
increase in the three months and nine months ended June 30, 2005 as compared to the same periods of the prior year is primarily due to certain patents acquired during the three months ending March 31, 2005 and other intangibles acquired as part of
the Quallaby acquisition.



Restructuring Costs



A credit of $0.3 million was recorded in the three months ended March 31, 2005 primarily as
a result of a favorable settlement in relation to a restructuring severance case, offset by an additional charge of $21 thousand recorded in the three months ended June 30, 2005.



Other Income, Net



Other income, net, increased to $1.4 million and $3.9 million in the three months and nine months ended June 30, 2005, from $1.2 million and $2.9 million in the
comparable period of the prior year. The increase was primarily due to increased interest income resulting from higher interest rates.



Income Tax Provision



Income taxes did not change significantly at $0.2 million, but increased to $1.3 million, in the three months and nine months ended June 30, 2005, from $0.2 million and $0.9 million in the comparable periods of the
prior year. The increase was mainly a result of a larger proportion of income being earned in higher taxed jurisdictions in the nine months ended June 30, 2005.



Liquidity and Capital Resources



As of June 30, 2005, we had $79.0 million in cash and cash equivalents and $124.9 million in marketable securities, as compared to $38.2 million in cash and cash
equivalents and $155.3 million in marketable securities as of September 30, 2004. The net increase of $40.8 million in cash and cash equivalents in the nine months ended June 30, 2005, was due primarily to an increase in deferred revenue of $32.5
million, net sales of investment securities of $30.4 million, an increase in accrued liabilities of $13.0 million, offset by the net cash paid of $31.5 million for the Quallaby acquisition. The most significant adjustments to reconcile net loss to
net cash provided by operating activities were the net increase in deferred revenue of $32.5 million which was primarily the result of a license and maintenance contract signed with a customer, the increase in the customer base and the renewal of
several large maintenance contracts in the nine months ended June 30, 2005, and the net increase in accrued liabilities of $13.1 million which was primarily the result of increased trade accruals, and also depreciation and amortization expenses of
$6.1 million.



On April 27, 2005, the Company announced a program under which
Micromuse may repurchase up to 6,000,000 shares of its common stock over the next 12 months. 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. The Company began repurchasing its shares under this program in August 2005.



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As of June 30, 2005, 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 three months ended June 30, 2005, 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. However, the Company did enter into a lease commitment for the Companys new corporate office in San
Francisco, as described in Part 1, Item 1, Note 5 Subsequent Events. The office leases acquired as a result of the Quallaby acquisition will expire between February 2006 to December 2009. The annual aggregated cost of these leases is less than $0.8
million.



Working Capital



Our working capital was $60.5 million at June 30, 2005 as compared to $19.4 million at
September 30, 2004, an increase of $41.1 million. The increase in working capital was primarily the result of a $75.1 million increase in cash and short-term investments, and a $5.7 million increase in net accounts receivable, offset by a $18.0
million increase in accrued expenses and a $22.4 million increase in the current portion of deferred revenue. As stated in Note 1 reclassifications, certain amounts in fiscal 2004 as reported on the Condensed Consolidated Balance Sheet
and Condensed Statements of Cash Flows have been reclassified to conform to the current year presentation. We reclassified $52.5 million in auction rate securities from cash and cash equivalents to long-term investments on the September 30, 2004
consolidated balance sheet. This reclassification is based on the Companys interpretation of the definition of cash equivalents pursuant to Statement of Financial Accounting Standards No. 95 (SFAS 95), Statement of Cash
Flows. The working capital amounts given above include the effects of this reclassification.



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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.



If we fail to achieve and maintain effective disclosure controls and procedures and internal control over financial reporting, our
stock price and investor confidence in our company could be materially and adversely affected.



Although we are endeavoring to document and test internal control over financial reporting with a goal of reporting effective internal control in our fiscal year 2005 Form 10-K due in December 2005, we may not achieve
this goal. During the past year, we have been remediating the material weaknesses that contributed to the restatement of our financial statements reported in our fiscal year 2003 Form 10-K filed in May 2004, and we have subsequently identified other
material weaknesses described in Part I, Item 4 of this Form 10-Q.



There is a
risk that we may not be able to timely remediate and test those material weaknesses prior to the end of fiscal year 2005 and that we may discover other additional material weaknesses, not currently known, as of the end of our fiscal year 2005. Under
SEC rules and accounting standards, if there is any material weakness outstanding as of the end of an annual reporting period, we must report that our internal control over financial reporting is not effective. To the extent that ineffective
internal controls are part of our disclosure controls and procedures, we would also likely conclude that our disclosure controls and procedures are not effective. We are also required to maintain both disclosure controls and procedures and internal
control over financial reporting that are effective for their intended purposes. If we fail to do so, our business, results of operations or financial condition, and the value of our stock, could be materially harmed.



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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 I, Item 4 of this Form 10-Q material weaknesses in internal control over financial reporting identified by our outside auditors in prior periods. Even though
weve since made significant progress in remediating these material weakenesses, 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 the 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. In addition, we have increased our headcount from
532 employees on September 30, 2004 to 627 employees on June 30, 2005. 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 recruitment 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 June 30, 2005, 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), Alcatel, 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 57%, 64% and 60% of our total revenues in the three months ended June 30, 2005, 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 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. In calendar year 2004, we have also experienced difficulties and associated risks in hiring and retaining employees in our Finance department.



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 first quarter ending December 31, 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.
In April 2005, the Securities and Exchange Commission announced the adoption of a new rule that amends the effective date of SFAS 123R. The effective date of the new standard under these new rules for our consolidated financial statements is October
1, 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. In December 2002, we completed the acquisition of Lumos Technologies, Inc. In August 2003, we completed the acquisition of NETWORK HARMONi, Inc. In June and August 2005, we completed the acquisitions of Quallaby
Corporation and GuardedNet, Inc., each privately-held software companies. 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.



Substantially, 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 2005
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 its 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 Revenues and Accounts Receivable 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 a claim 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; 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 June 30, 2005, we had approximately $82.7 million of goodwill and other intangible
assets, which relates primarily to the acquisitions of CAN, NetOps, RiverSoft, Lumos, NHI, and Quallaby. 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 consolidated 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 June 30, 2005, we had approximately 81.1 million shares of common stock outstanding,
including 1.4 million treasury shares, and excluding approximately 20.0 million shares subject to options outstanding as of such date under our stock option plans that are exercisable at prices ranging from approximately $0.23 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 June 30, 2005, 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 2.9%.



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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 June 30, 2005, 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 calendar year 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 then current Chief Financial Officer, Mr. Mike Luetkemeyer, would leave Micromuse at the end of calendar
year 2004. Micromuse appointed Ian Halifax as our Chief Financial Officer, effective January 17, 2005. We also appointed a Vice President, Finance and Corporate Controller effective January 27, 2005, and hired a number of other finance department
personnel since then. In late July, we also designated our Vice President, Finance and Corporate Controller as our principal accounting officer.



Although in 2005 we hired a new Chief Financial Officer, a Vice President, Finance and Corporate Controller and additional personnel in the Finance department, these
staffing circumstances 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 previously delayed include improved systems processes intended to reduce manual journal entries and implementation of a global purchase order system.



We believe we have addressed most of the prior weaknesses in staffing our Finance department
and have made progress in upgrading our financial processes. However, until our management formally assesses internal control over financial reporting and obtains our auditors attestation report on that assessment required to be included in
our next Form 10-K, we are not able to provide a meaningful report on the status of our internal control remediation efforts.



See also Risk Factors  If we fail to achieve and maintain effective disclosure controls and procedures and internal control over financial reporting, our
stock price and investor confidence in our company could be materially and adversely affected, 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. The Company has presented significant defenses to Aprismas claims of patent infringement. 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. Additionally, Micromuse has filed with the U.S. Patent and Trademark Office (PTO) requests to re-examine three of the patents at issue in the Aprisma suit on the basis that they are invalid. The PTO has
granted all three of these requests and the results of the PTOs re-examinations are pending. The parties are currently working on the terms of a settlement agreement, which the Company expects to execute shortly. Once finalized, the Company
intends to set forth the material terms of such agreement in a filing with the Commission. The Company has accrued a liability for the expected settlement payment.



On July 5, 2005, the Company announced that it had entered into a settlement agreement relating to the previously disclosed patent lawsuits
with Agilent Technologies, Inc. Under the settlement, the lawsuits were terminated in exchange for a broad cross-license between the parties and the payment by Micromuse of a non-material sum of money to Agilent. The settlement was reached with no
admission of liability or wrongdoing by any party.



On June 27, 2005, the
Company announced that settlement agreements relating to the federal securities class action lawsuit and related federal derivative suit had been reached. The agreements have been submitted to the United States District Court for the Northern
District of California for approval. If the agreements are approved, the lawsuits will be terminated in exchange for a payment by Micromuse that will have no material adverse financial impact on the Company, as it will be covered largely by the
Companys insurance policies. The agreements were reached with no admission of liability by any party and were entered into to avoid costly and time consuming litigation by all parties.



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 this case is still pending. The derivative complaints allege that, as a result of the events underlying the restatement in early 2004, 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.



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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 there is a likelihood that a loss has occurred or is probable and the amount of that 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 except for the expected Aprisma settlement described above.



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.



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 June 30, 2005. 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. We reported purchases of 1,000,000 shares in the fourth quarter of fiscal 2004 in our Form 10-K filed on December 14, 2004, and amended on May 10, 2005. On April 27,
2005, the Company announced a program under which Micromuse may repurchase up to 6,000,000 shares of its common stock over the next 12 months. 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. The Company began
repurchasing its shares under this program in August 2005.



|Item 3. | Defaults upon Senior Securities.
|------- | --------------------------------



Not applicable.



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



None.



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



The information in this item is provided in lieu of filing a Form 8-K to report equivalent information under Form 8-K Item 1.01 Entry into a Material Definitive Agreement and Item 5.02 Departure of Directors or
Principal Officers; Election of Directors; Appointment of Principal Officers.



Appointment of Principal Accounting Officer.



On August 9,
2005, Micromuse Inc. announced in a press release that it has appointed Steven Vattuone, as Principal Accounting Officer, effective July 27, 2005.



Mr. Vattuone, age 37, joined Micromuse on January 27, 2005, as Micromuses Vice President, Finance and Corporate Controller. Prior to joining Micromuse, Mr. Vattuone
served as the Corporate Controller of Macrovision, a developer and licensor of copy protection, electronic licensing and rights management technologies. Before joining Macrovision in November 2002, he served as the Vice President, Finance of
Organic, Inc., an internet professional services provider from November 2000 to August 2002. From November 1996 to November 2000, Mr. Vattuone served as the Corporate Controller and a Director in the finance department of Brio Software. Prior to
Brio Software, Mr. Vattuone held several positions at PricewaterhouseCoopers LLP, most recently as a Business Assurance Manager in their San Jose, California office. He holds an M.B.A. from Santa Clara University and a B.S. in Business
Administration from California Polytechnic State University, San Luis Obispo. He is also a Certified Public Accountant in the State of California.



Micromuse entered into an employment agreement with Mr. Vattuone as of January 27, 2005, a copy of which is attached to this report as Exhibit 10.21. Under the employment
agreement, Mr. Vattuone is employed on an at will basis, is entitled to a base salary at a gross annual rate of not less than $175,000, and is eligible to receive an incentive bonus with a quarterly target bonus amount of $12,500 per
quarter ($50,000 per year). Micromuse also agreed to grant Mr. Vattuone non-statutory stock options covering 75,000 shares, with a term of 7 years and vesting over 4 years such that 18,750 shares are exercisable and vested upon his completing 12
continuous months of full-time employment following the date of grant, and thereafter 1/48th of the total option shares become vested and exercisable monthly. If Micromuse terminates his employment for any reason other than cause or permanent
disability, or he resigns for good reason, or he is terminated in connection with a change of control or a corporate transaction involving an acquisition of Micromuse (all as respectively defined in the agreement), he is entitled to additional
benefits specified in the agreement.



This brief description of the employment
agreement is qualified by reference to the provisions of the agreement attached to this report as Exhibit 10.21.



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MICROMUSE INC.



|Item 6. | Exhibits
|------- | --------



| | (a) | Exhibits
| | --- | --------



|              |  |                                                                                                                                                                                                                                                           
|------------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description                                                                                                                                                                                                                                               
|              | 
|2.1           |  | Agreement and Plan of Merger by and among Micromuse Inc., Sydney Acquisition Inc. (subsidiary of Micromuse) and Quallaby Corporation (incorporated by reference from Exhibit 2.1 in our Form
8-K filed with the SEC on April 13, 2005).                   
|              | 
|2.2           |  | Agreement and Plan of Merger dated as of June 30, 2005, by and among Micromuse Inc., Brinks Acquisition, Inc. (subsidiary of Micromuse), and GuardedNet, Inc. (incorporated by reference from
Exhibit 2.2 to Form 8-K filed by Micromuse on July 1, 2005).
|              | 
|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).                                                      
|              | 
|10.21         |  | Employment Agreement as of January 27, 2005, by and between Steven Vattuone and Micromuse Inc.                                                                                                                                                            
|              | 
|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 August 9, 2005.



MICROMUSE INC.(Registrant)By:

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

/s/ IAN HALIFAXIan HalifaxChief Financial Officer(Principal Financial Officer)




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