---

UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





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FORM 10-Q





xQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d)


OF THE SECURITIES EXCHANGE ACT OF 1934





For the quarterly period ended December 31, 2001





 ̈ 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





MICROMUSE INC.


(Exact name of registrant as specified in its charter)





DELAWARE (State or other jurisdiction of incorporation or organization)

94-3288385 (IRS Employer Identification No.)





139 TOWNSEND STREET


SAN FRANCISCO, CALIFORNIA 94107


(415) 538-9090


(Address, including ZIP code,
and telephone number)





Indicate by check mark whether the registrant (1) has filed all reports required to be filed by
Section 13 or 15 (d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.





Yes x            No  ̈





74,213,212 shares of Common
Stock, $0.01 par value, were outstanding as of January 31, 2002





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MICROMUSE INC.





TABLE OF
CONTENTS





PagePART IFinancial InformationItem 1.

Condensed Consolidated Financial Statements:Condensed Consolidated Balance Sheets as of December 31, 2001 and September 30, 2001

3Condensed Consolidated Statements of Operations for the three months ended December 31, 2001 and 2000

4Condensed Consolidated Statements of Cash Flows for the three months ended December 31, 2001 and 2000

5Notes to Condensed Consolidated Financial Statements

6Item 2.

Managements Discussion and Analysis of Financial Condition and Results of Operations

9Item 3.

Quantitative and Qualitative Disclosures about Market Risk

27PART IIOther InformationItem 1.

Legal Proceedings

28Item 2.

Changes in Securities and Use of Proceeds

28Item 3.

Defaults upon Senior Securities

28Item 4.

Submission of Matters to a Vote of Security Holders

28Item 5.

Other Information

28Item 6.

Exhibits and Reports on Form 8-K

29Signature



30




2




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PART 1FINANCIAL INFORMATION





Item 1.
 Condensed Consolidated Financial Statements





MICROMUSE INC.





CONDENSED CONSOLIDATED BALANCE SHEETS


(In thousands, except per share data)


(Unaudited)


December 31, 2001


September 30, 2001ASSETSCurrent assets:Cash and cash equivalents

$
144,161


$
138,581Short-term investments


18,483



16,109Billed receivables, net


29,009



31,067Prepaid expenses and other current assets


12,863



15,656Total current assets


204,516



201,413Property and equipment, net


13,935



15,221Long-term investments


20,893



20,891Goodwill and other intangible assets, net


33,346



36,113$
272,690


$
273,638LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable

$
6,160


$
5,686Accrued expenses


24,273



27,407Income taxes payable


6,841



6,152Deferred revenue


33,523



34,212Total current liabilities


70,797



73,457Stockholders equityPreferred stock; $0.01 par value; 5,000 shares authorized no shares issued and outstanding






Common stock; $0.01 par value; 200,000 shares authorized; 74,212 and 73,903 shares outstanding as of December 31, 2001 and September
30, 2001, respectively


742



739Additional paid-in capital


187,457



187,755Treasury stock


(605
)


(2,657
)Accumulated other comprehensive loss


(1,978
)


(1,317
)Retained earnings


16,277



15,661Total stockholders equity


201,893



200,181$
272,690


$
273,638


See accompanying notes to the condensed consolidated financial statements




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MICROMUSE INC.





CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS


(In thousands, except per share data)


(Unaudited)





Three months ended December 31,2001


2000Revenues:License

$
23,216


$
36,368Maintenance and services


16,831



13,452Total revenues


40,047



49,820Cost of revenues:License


1,595



2,068Maintenance and services


5,208



5,228Total cost of revenues


6,803



7,296Gross profit


33,244



42,524Operating expenses:Sales and marketing


18,085



21,613Research and development


7,570



7,966General and administrative


4,938



4,187Amortization of goodwill and other intangible assets


2,767



2,767Executive recruiting costs


449



Total operating expenses


33,809



36,533Income (loss) from operations


(565
)


5,991Other income, net


1,608



2,052Income before income taxes


1,043



8,043Income tax provision


427



2,574Net income

$
616


$
5,469Per share data:Basic net income

$
0.01


$
0.08Diluted net income

$
0.01


$
0.07Weighted average shares used in computing:Basic net income per share


74,043



70,951Diluted net income per share


78,246



80,021





See accompanying notes to the condensed consolidated financial statements




4




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MICROMUSE INC.





CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


(In thousands)


(Unaudited)


Three months ended December 31,2001


2000Cash flows from operating activities:Net income

$
616


$
5,469Adjustments to reconcile net income to net cash provided by operating activities:Depreciation and amortization


5,066



3,994Amortization of deferred employee compensation






14Compensation expense related to issuance of warrant


170



Tax benefit related to exercise of stock options






2,574Changes in operating assets and liabilities net of acquired amounts:Billed receivables, net


2,003



(2,923
)Prepaid expenses and other current assets


2,789



368Accounts payable


508



(704
)Accrued expenses


(2,970
)


4,470Income taxes payable


688



Deferred revenue


(621
)


6,698Net cash provided by operating activities


8,249



19,960Cash flows from investing activities:Capital expenditures


(1,073
)


(2,879
)Investment purchases, net


(2,376
)


(15,506
)Cash used in investing activities


(3,449
)


(18,385
)Cash flows from financing activities:Proceeds from issuance of common stock


1,587



4,408Net cash provided by financing activities


1,587



4,408Effects of exchange rate changes on cash and cash equivalents


(807
)


(55
)Net increase in cash and cash equivalents


5,580



5,928Cash and cash equivalents at beginning of period


138,581



83,679Cash and cash equivalents at end of period

$
144,161


$
89,607





See accompanying notes to the condensed consolidated financial statement




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MICROMUSE INC.





NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS





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 condensed consolidated financial statements should be read in conjunction with
the consolidated financial statements and notes thereto included in our Form 10-K as filed with the Securities and Exchange Commission on December 21, 2001. The September 30, 2001, 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 year or other future interim periods.





Reclassifications





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





Use of Estimates





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





Cash Equivalents





The Company considers all highly liquid instruments with a maturity at purchase of 90 days or less to be cash equivalents.





Shareholders Equity and Stock Split





All share and per-share numbers herein reflect the 2 for 1 stock split of our common stock
that occurred for stockholders of record on December 5, 2000.




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MICROMUSE INC.





Per Share Data





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. A reconciliation of the numerators and denominators used in the basic and diluted net income per share amounts follows (in thousands):





Three months ended December 31,2001

2000Numerator for basic and diluted net income

$
616

$
5,469Denominator for basic net income per shareweighted-average shares outstanding


74,043


70,951Dilutive effect of:Common stock options


4,149


9,070Warrants


54


Denominator for diluted net income per share


78,246


80,021





Concentration of Revenues





One third-party distributor customer accounted for approximately 15% of revenues for the quarter ended December 31, 2001. Another third party distributor also accounted for approximately 15% of revenues for the
quarter ended December 31, 2001, primarily from a transaction with one end-user customer, a European Telco incumbent. No one third-party distributor or end-user customer accounted for greater than 10% of revenues for the quarter ended December 31,
2000.





Accounts Receivable





Accounts Receivable
includes an allowance for doubtful accounts of $5.1 million and $4.2 million as of December 31, 2001 and September 30, 2001, respectively.





Accumulated Other Comprehensive Loss





The only component of accumulated other comprehensive loss is net foreign currency translation
adjustments. Other comprehensive loss for the quarters ended December 31, 2001 and 2000 was $661,000 and $55,000, respectively.





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: fault management and service assurance software.




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MICROMUSE INC.





The Company markets its products primarily from the United States. International sales are primarily to customers in France, Germany and the United Kingdom. Information regarding regional revenues, which are based on
the location of the end-user, and operations in different geographic regions is as follows (in thousands):





Three months ended December 31,2001

2000Revenues:United States

$
21,277

$
32,615United Kingdom


4,820


8,768Other international


13,950


8,437Total

$
40,047

$
49,820December 31, 2001

September 30, 2001Long-lived assets:United States

$
42,797

$
46,395Other international


39,759


4,939Total

$
47,281

$
51,334





Recent Pronouncement





In July 2001, the FASB issued SFAS No. 142, Goodwill and Other Intangible Assets. SFAS No. 142 addresses financial accounting and reporting for acquired goodwill and other intangible assets. SFAS No. 142 changes the
accounting for goodwill from an amortization method to an impairment-only approach. Goodwill will be tested annually and whenever events or circumstances occur indicating that goodwill might be impaired. Upon adoption of SFAS No. 142, amortization
of goodwill recorded for business combinations consummated prior to July 1, 2001 will cease, and intangible assets acquired prior to July 1, 2001 that do not meet the criteria for recognition under SFAS No. 141 will be reclassified to goodwill.
Companies are required to adopt SFAS No. 142 for fiscal years beginning after December 15, 2001, but early adoption is permitted. The Company will adopt SFAS No. 142 on October 1, 2002. As of October 1, 2002, approximately $16.4 million of goodwill
will no longer be amortized but will be tested annually for impairment.





In October 2001, the FASB issued SFAS No. 144, which is effective for fiscal
years beginning after December 15, 2001 and early adoption is permitted. SFAS No. 144 supersedes certain provisions of APB Opinion No. 30 Reporting the Results of Operations-Reporting the Effects of Disposal of a Segment of a Business, and
Extraordinary, Unusual and Infrequently Occurring Events and Transactions (APB 30) and supersedes SFAS No. 121 Accounting for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of (SFAS
No.121). Although SFAS No. 144 supersedes SFAS No.121 and the provisions of APB 30 regarding the accounting and reporting of the disposal of a segment of a business, it retains many of the fundamental provisions of SFAS No.121 and the
requirements in APB 30 to report separately discontinued operations. SFAS No. 144 also extends the reporting of discontinued operations to a component of an entity that either has been disposed of (by sale, abandonment, or in a distribution to
owners) or is classified as held for sale. The Company will adopt SFAS No. 144 on October 1, 2002 and does not expect that adoption will have a material effect on its consolidated financial position, results of operations, or cash flows.




8




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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 21, 2001.





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.





Critical Accounting Policies and Estimates





Micromuses
discussion and analysis of its financial condition and results of operations are based upon Micromuses consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United
States. The preparation of these financial statements requires Micromuse 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 on-going basis, Micromuse evaluates its estimates, including bad debts, product returns, warranty obligations, investments, intangible assets, income taxes, contingencies and litigation. Micromuse bases its estimates on historical experience and
on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources.
Actual results may differ from these estimates under different assumptions or conditions.





Micromuse believes the following critical accounting policies
affect its more significant judgments and estimates used in the preparation of its consolidated financial statements:





Accounts
receivable.    Micromuse maintains allowances for doubtful accounts for estimated losses resulting from the inability of its customers to make required payments. If the financial condition of Micromuses customers were
to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required.





Goodwill and other intangible
assets.    Micromuse regularly performs reviews to determine if the carrying value of goodwill and other intangible assets are impaired. If market conditions were to




9




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MICROMUSE INC.





deteriorate, which may result in the carrying amount not being recoverable, an impairment charge would be required.





Overview





Micromuse Inc. develops, markets and supports a family of scalable, highly configurable, rapidly deployable software solutions
that enable realtime 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.





Micromuse Ltd (formerly known as Micromuse plc) was incorporated in England in 1989
and in March 1997 became a subsidiary of Micromuse Inc., a Delaware corporation formed in connection with a corporate reorganization and relocation of the corporate headquarters to San Francisco, California. As used herein, the term
Micromuse or the Company refers to Micromuse Inc., Micromuse Ltd, and their other subsidiaries, unless the context otherwise requires or unless otherwise expressly stated. Our principal executive offices are located at 139
Townsend Street, San Francisco, California 94107, and our telephone number at that address is (415) 538-9090.




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MICROMUSE INC.





Results of Operations





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





Three months ended December 31,2001


2000As a Percentage of Total Revenues:Revenues:License

58.0
%

73.0
%Maintenance and services

42.0
%

27.0
%Total revenues

100.0
%

100.0
%Cost of revenues:License

4.0
%

4.2
%Maintenance and services

13.0
%

10.5
%Total cost of revenues

17.0
%

14.7
%Gross profit

83.0
%

85.3
%Operating expenses:Sales and marketing

45.1
%

43.4
%Research and development

18.9
%

16.0
%General and administrative

12.3
%

8.4
%Amortization of goodwill and other intangible assets

6.9
%

5.5
%Executive recruiting costs

1.2
%

0.0
%Total operating expenses

84.4
%

73.3
%Income (loss) from operations

(1.4
%)

12.0
%Other income, net

4.0
%

4.1
%Income before income taxes

2.6
%

16.1
%Income tax provision

1.1
%

5.1
%Net income

1.5
%

11.0
%As a Percentage of Related Revenues:Cost of license revenues

6.9
%

5.7
%Cost of maintenance and services revenues

30.9
%

38.9
%




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MICROMUSE INC.





Revenues.    Revenues decreased to $40.0 million in the quarter ended December 31, 2001, from $49.8 million in the comparable period of the prior year. License revenues decreased to $23.2
million in the quarter ended December 31, 2001, from $36.4 million in the comparable period of the prior year. The decline in license revenues was primarily due to the current economic slowdown that is limiting the overall capital spending of our
existing and potential customers. Additionally, results for the quarter were negatively impacted by the terrorist attacks in New York and Washington on September 11, 2001. Maintenance and services revenues increased to $16.8 million in the quarter
ended December 31, 2001, from $13.5 million in the comparable period of the prior year. The increase in maintenance and services revenues was a result of providing maintenance and services to a larger installed base of customers. License revenues as
a percentage of total revenues was 58.0% and in the quarter ended December 31, 2001, as compared to 73.8% in the comparable period of the prior year.





Cost of Revenues.    The cost of license revenues consists primarily of technology license fees paid to third-party software vendors and production costs. Cost of license revenues as a percentage of license
revenues increased to 6.9% in the quarter ended December 31, 2001, as compared to 5.7% in the comparable period of the prior year. The increase was mainly due to a change in the mix of license revenue in the current quarter. 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 decreased to
30.9% in the quarter ended December 31, 2001, from 38.9% in the comparable period of the prior year. This improvement, which was principally due to a proportionally greater percentage of higher-margin maintenance revenues and economies of scale, was
partially offset by increased personnel, facilities, and travel costs associated with expanding the customer support and technical service organizations.





Sales and Marketing Expenses.    Sales and marketing expenses decreased to $18.1 million in the quarter ended December 31, 2001, from $21.6 million in the comparable period of the prior year. This decrease, which
was primarily due to the related decrease in revenue, was offset by increased personnel costs associated with the expansion of the sales and technical services departments and increased facilities costs. Sales and marketing expenses as a percentage
of total revenues increased to 45.1% in the quarter ended December 31, 2001, from 43.4% in the comparable period of the prior year.





Research and
Development Expenses.    Research and development expenses decreased to $7.6 million in the quarter ended December 31, 2001, from $8.0 million in the comparable period of the prior year. Research and development costs as a
percentage of total revenues have increased to 18.9% in the quarter ended December 31, 2001, as compared to 16.0% in the same period of the prior year. This increase is primarily due to increased personnel, additional facilities costs, and an
increase in the computer systems and software development tools required by the additional personnel.





General and Administrative
Expenses.    General and administrative expenses increased to $4.9 million in the quarter ended December 31, 2001, from $4.2 million in the comparable period of the prior year. This increase was primarily due to an increase
in the bad debt reserve, mainly related to Global Crossing. Global Crossing subsequently filed for Chapter 11 bankruptcy protection in January 2002. Management believes that the Company is adequately reserved at December 31, 2001 for this customer.
As of the date of this filing, Micromuse had a receivable of $1.9 million, net, with Global Crossing. This receivable is related to an agreement to provide future maintenance service which management believes to be critical to Global Crossings
plan of reorganization. Management also believes that it is probable that Global Crossing will assume the agreement in connection with its bankruptcy proceedings and that all amounts due under the agreement will be paid. Also refer to risk factor
general economic and market conditions may impair our business. The increase in general and administrative expenses




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MICROMUSE INC.





was also due to increased personnel costs, professional fees, facilities costs and associated expenses to support the increased scale of operations. General and administrative expenses as a percentage of revenues have
increased to 12.3% in the quarter ended December 31, 2001, from 8.4% in the comparable period of the prior year.





Amortization of Goodwill and Other
Intangible Assets.    The charge of $2.8 million in the quarter ended December 31, 2001 and 2000, reflects the amortization of the goodwill and other intangible assets over estimated useful lives of three to five years.





Executive Recruiting Costs.    The executive recruiting costs of $0.4 million in the quarter ended December 31, 2001 are
primarily costs incurred in the recruitment of a new Chief Financial Officer. The costs relate to the fair value of a warrant issued to an executive recruiting firm, fees paid to the recruiting firm and certain relocation costs.





Other Income, Net.    Other income decreased to $1.6 million in the quarter ended December 31, 2001, from $2.1 million in the comparable
period of the prior year. This net decrease was primarily due to the decline in interest rates over the past year.





Liquidity and Capital Resources





As of December 31, 2001, we had $144.2 million in cash and cash equivalents and $39.4 million in marketable securities, as compared to $138.6
million in cash and cash equivalents and $37.0 million in marketable securities as of September 30, 2001. The net increase in cash and cash equivalents in the quarter ended December 31, 2001, was due primarily to the net income adjusted for non-cash
expenses, the decrease in billed receivables and prepaid expenses and other current assets, and the proceeds from the issuance of common stock. These sources of cash and cash equivalents were partially offset by capital expenditures, the purchase of
marketable securities and the increase in accrued expenses and deferred revenues.





As of December 31, 2001, the Companys principal commitments
consisted 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. From time to time, in the ordinary course of business, we evaluate potential acquisitions of such businesses, products or
technologies.




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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 report (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
report. 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 and in Managements Discussion and Analysis of Financial Condition and
Results of Operations as well as those discussed 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 the report.





Our operating
results may vary as a result of the current economic slowdown





We face uncertainty in the degree to which the current economic slowdown will
negatively affect growth and capital spending by our existing and potential customers. We have recently experienced increased instances of customers delaying or deferring licenses of our software and maintenance agreement, and longer lead times
needed to close our customer sales. If the economic conditions in the United States and globally do not improve, 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 results.





The recent terrorist attacks are unprecedented events that have created many economic and political uncertainties, some of which may harm our business and prospects and our ability in general to conduct business in the ordinary
course.





Terrorist attacks in New York and Washington, D.C. in September 2001 have disrupted commerce throughout the world. The continued threat
of terrorism and the resulting military, economic and political response and heightened security measures may cause significant disruption to commerce throughout the world. To the extent that this disruption results in a general decrease in our
customers spending, our business and results of operations could be materially and adversely affected. Following the attack, one of our New York offices was closed for a number of weeks causing some delays in our product development effort and
business travel was seriously disrupted. We also may experience delays in receiving payments from customers that have been affected by the attacks, which, in turn, would harm our cash flow. We are unable to predict whether the threat of terrorism or
the responses thereto will result in any long-term commercial disruptions or if such activities or responses will have a long-




14




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MICROMUSE INC.





term adverse effect on our business, results of operations or financial condition. These and other developments arising out of the attacks may make the occurrence of one or more of the factors discussed under
Risk Factors more likely to occur.





Because we have a limited operating history in a dynamic market, it is difficult to predict our
future operating results.





Because we have a relatively limited operating history in a rapidly evolving and dynamic market, it is difficult to
predict our future operating results. We first shipped our Netcool/OMNIbus product in January of 1995 and therefore have a limited operating history of developing and providing service level management software. Our limited operating history and
rapidly changing product development, installation, maintenance and market dynamics make the prediction of future results of operations difficult. Our prospects must be considered in light of the risks, costs and difficulties frequently encountered
by emerging companies, particularly companies in the competitive software industry. We intend to increase our operating expenses to hire experienced senior managers, develop new distribution channels, increase our sales and marketing efforts,
implement and improve operational, financial and management information systems, broaden technical services and customer support capabilities, fund higher levels of research and development and expand administrative resources in anticipation of
future growth. Our operating results will be harmed if these increased expenditures do not result in increased revenues and profitability.





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





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 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;
|- |  | ------------------------------------------------------------------------------------------------------------------------------



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MICROMUSE INC.





|· |  | 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;
|- |  | ------------------------------------------------------




|· |  | 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; and
|- |  | ---------------------------------------




|· |  | software defects and other product quality problems.
|- |  | ----------------------------------------------------




Failure to manage our growth may adversely affect our business.





We have grown rapidly, adding customers, personnel and expanding
the scope and geographic area of our operations. Our growth has resulted in new and increased responsibilities for our management personnel and has placed and will continue to place a significant strain upon our management and our operating and
financial systems and resources. As of December 31, 2001 we had 731 employees. 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.





Failure to improve our infrastructure may adversely affect our business.





We need to continue to implement and improve a variety of operational, financial and management information systems, procedures and controls. In
particular, we need to improve our accounting and financial reporting systems, which currently require substantial management effort, and to successfully manage an increasing number of relationships with customers, suppliers and employees. These
demands require the addition of new management personnel, and we are currently in the process of recruiting individuals to fill important management positions. Further, we need to continue to develop a global financial and accounting system. Our
business will be harmed if we are unable to recruit and




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MICROMUSE INC.





retain these key personnel, if our current and future executive officers do not operate effectively, both independently and as a group, or if we fail to implement improved operational, financial and management
systems.





We need to continue to expand and improve the productivity of our sales force and our technical services and customer support
organization.





Our success has always depended in large part on our ability to attract and retain highly skilled sales and technical personnel.
In spite of the economic slowdown, competition for these personnel is intense. Sales personnel are in high demand and are difficult to attract and retain and require nine months, or longer, to become fully productive. Further, because of the recent
expansion of the installed base of our products, the demands on our technical services and customer support resources have grown rapidly. The loss of services of any of our key personnel, the inability to retain and attract qualified personnel in
the future, or delays in hiring required personnel, particularly sales and technical personnel, could make it difficult to meet key objectives, such as timely product introductions.





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 are currently investing,
and plan to continue to 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 50%, 42% and 34% of our total
revenues in the quarter ended December 31, 2001, fiscal 2001 and 2000, respectively. Our business will be harmed if we are not able to 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, Ericsson, Unisphere (Siemens), Sun Microsystems and others. 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, and the size of this market is unproven.





The market for our products is in an early stage of development and is very dynamic. 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. Because the market for these products is only beginning to
develop, 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.




17




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MICROMUSE INC.





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 have accounted for approximately 68%, 79% and 82% of our total in the quarter ended
December 31, 2001, fiscal 2001 and 2000, respectively. In addition, these providers are the central 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, such as network management outsourcing, 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.





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





We have derived a substantial amount of our revenues from sales of products and related
services to the telecommunications industry. The telecommunications industry has experienced significant growth and consolidation in the past few years, although recent trends indicate that this growth and 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. Our business is highly dependent on the growth of the telecommunications industry and on continued capital
spending by our customers in that industry. In the event of a continued or further significant slowdown in the growth or 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. We cannot be certain that consolidations in, or a slowdown in the growth of, the telecommunication industry will not harm our business.





Our business depends on the continued growth 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. Rapid growth in the use of and interest in the Internet and online services is a recent phenomenon. Our business could be harmed if this rapid growth does not continue or if the rate of technological innovation, deployment or use
of the Internet slows or declines. Recent data and reports indicate that both the growth of significant portions of the Internet and technological innovations have slowed. If these trends continue, they will likely have an adverse impact on our
business.





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.





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.




18




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MICROMUSE INC.





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 Compaq, Hewlett-Packard Company and Cabletron Systems, Inc.;
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




|· |  | vendors of network and systems management frameworks including Computer Associates International, Inc. and International Business Machines Corporation;
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------




|· |  | vendors of network and systems management applications including Hewlett-Packard Company, BMC Software, Inc, and International Business Machines Corporation;
|- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------




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




|· |  | systems integrators serving the telecommunications industry which primarily provide programming services to develop customer specific applications including TCSI Corporation,
TTI and Agilent Technologies, Inc. with its acquisition of Objective Systems Integrators, 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.




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MICROMUSE INC.





Complex software products frequently contain errors or defects, especially when first introduced or when new versions or enhancements are released. Despite our extensive product testing, we have in the past released
versions of Netcool/OMNIbus with defects and have discovered software errors in certain of our products after their introduction. For example, version 3.0 of Netcool/OMNIbus, released in 1996, had a number of material defects. Version 1.0 of
Netcool/Reporter, released in 1998, had features and performance characteristics that limited market acceptance. A significant portion of our technical personnel resources were required to address these defects. Because of these 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.





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.





The 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 requires 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. We do not generally have employment contracts with key personnel. 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




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MICROMUSE INC.





stock options. Because we face intense competition in our recruiting activities, we may be unable to attract and/or retain qualified personnel.





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.
For example, on December 28, 1999 we completed the acquisition of Calvin Alexander Networking, Inc., a developer of network auto-discovery software. On July 18, 2000, the Company completed the acquisition of NetOps Corporation, a developer of
network diagnostic software. 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, the incurrence of debt, large one-time write-offs and creation of goodwill or other intangible assets that could result in
amortization expense. It is possible that our efforts to consummate or integrate acquisitions will not be successful, which would harm our business.





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





All of
our revenues have been derived from licenses for our Netcool family of products and related maintenance, training and consulting services. We currently expect that Netcool/OMNIbus-related revenues will continue to account for a substantial
percentage of our revenues beyond fiscal 2001 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 Netcool/OMNIbus 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 the Netcool/OMNIbus applications, are difficult to estimate due in large part to
the recent emergence of many of our markets, the effect of future product enhancements




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MICROMUSE INC.





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 in 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 international sales and
operations expose us to currency fluctuation risks and other inherent risks.





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 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;
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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MICROMUSE INC.





|· |  | 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 by expanding our direct sales force and pursuing additional strategic relationships. 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 (for example TMN architecture) 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.





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. For example, we are modifying certain of our products to operate with the Linux operating system.





Our efforts to protect our
intellectual property may not be adequate, or a third-party could claim that we are infringing its proprietary rights.




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MICROMUSE INC.





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 such claims, with or without merit could be time-consuming, result in costly litigation 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.





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.





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 affecting the software industry; 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




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MICROMUSE INC.





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.





General economic and market conditions may impair our business.





Segments of the software industry have experienced significant economic downturns characterized by decreased product demand, price erosion, work slowdowns and layoffs. Our operations may in the future experience substantial fluctuations as
a consequence of general economic conditions affecting the timing of orders from major customers and other factors affecting capital spending. Although we have a diverse client base, we target certain market segments. Therefore, any economic
downturns in general or in the targeted segments in particular would harm our business. For example, Global Crossing filed for bankruptcy protection in January 2002 when we had a receivable with them of $1.9 million, net. As of the date of this
filing, management believes that all remaining amounts due will be collectible.





Our goodwill and other intangible assets may become impaired.





Due to rapidly changing market conditions, our goodwill and other intangible assets may become impaired such that their carrying amounts may not
be recoverable, and we may be required to record an impairment charge impacting our financial position. As of December 31, 2001, we had approximately $33.3 million of goodwill and other intangible assets, which were primarily related to the
acquisitions of CAN in December 1999 and NetOps in July 2000. The Company regularly performs reviews to determine if the carrying value of assets is impaired. The purpose for the review is to identify any facts or circumstances, either internal or
external, which indicate that the carrying value of the asset cannot be recovered. No such impairment has been indicated to date. However, if for example the demand for the products and services underlying this goodwill decreases as a result of the
general economic slowdown or other causes and, as a result, the estimated future undiscounted net cash flows from the acquired businesses are insufficient to recover the carrying value of the assets over their estimated lives, we will record an
impairment of our goodwill and recognize asset impairment charges in the quarter in which that impairment is determined. Asset impairment charges of this nature could be large and could have a material adverse effect on our financial condition and
reported results of operations.





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





As of December 31, 2001, we had approximately 74.2 million shares of common stock outstanding, excluding approximately 13.6 million shares subject to options outstanding as of
such date under our stock option plans that are exercisable at prices ranging from approximately $0.58 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.




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MICROMUSE INC.





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.





Year 2000 issues could impair our business.





We have designed and tested our products to be Year 2000 compliant. We continue to believe that our products performed well during the roll-over from 1999 to 2000 and February
29, 2000. However, any undetected or unreported errors or defects associated with Year 2000 date functions could result in material costs to us. In addition, certain components of our products process timestamp information from third-party
applications or local operating systems. If such third-party applications or local operating systems are not Year 2000 compliant, our products that process such timestamp information may not be Year 2000 compliant.





In our standard license agreements, we provide certain warranties to licensees that our software routines and programs are Year 2000 compliant. If any of our licensees
experience Year 2000 problems, such licensees could assert claims for damages against us. Any such claims or litigation could result in substantial costs and diversion of our resources even if ultimately decided in our favor. Based on work done to
date and our best estimates, we have not incurred material costs and do not expect to incur future material costs in addressing the Year 2000 issue in our systems and products.





Euro conversion may adversely affect our business.





On January 1, 2002, various European countries
introduced a new single currency known as the Euro. Issues we are reviewing as a result of the Euro include updating information technology systems, assessing currency risk, reviewing licensing agreements and contracts for currency issues, and
processing tax and accounting records. Although we have experienced no adverse effect on our financial conditions or results of operations since its introduction and do not currently expect a material adverse effect, we cannot assure that issues
relating to the Euro will not harm our business.





Power blackouts and rising energy costs in California could disrupt our business and increase our
expenses.





Our principal executive offices are located in San Francisco, California. Our principal product development operations are located in
London, and we have other offices in more than 10 cities outside California. In fiscal 2001, California experienced rolling blackouts of electricity and rising energy costs throughout the state. We have not experienced any material power disruptions
or material energy expense increases to date. However, a continuation or worsening of these adverse energy circumstances may disrupt our ability to market our products or provide services to customers or otherwise adversely affect our business.




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MICROMUSE INC.





Item 3. Quantitative and Qualitative Disclosures about Market Risk





Foreign Currency Hedging Instruments





We transact business in various foreign currencies. Accordingly, we are subject to exposure from adverse movements in foreign currency exchange rates. This exposure
is primarily related to local currency denominated revenues and operating expenses in the U.K. However, as of December 31, 2001, no hedging contracts were outstanding.





We currently do not use financial instruments to hedge local currency denominated operating expenses in the U.K. Instead, we believe that a natural hedge exists, in that local currency revenues will substantially
offset the local currency denominated operating expenses. We assess the need to utilize financial instruments to hedge currency exposures on an ongoing basis.





We do not use derivative financial instruments for speculative trading purposes, nor do we hedge our foreign currency exposure in a manner that entirely offsets the effects of changes in foreign exchange rates. We regularly review our
hedging program and may as part of this review determine at any time to change our hedging program.





Fixed Income Investments





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, limits 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 are considered to be cash equivalents;
investments with maturities 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 3.2%.




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MICROMUSE INC.





Part II  OTHER INFORMATION





Item 1. Legal Proceedings.





The Company is routinely involved in legal and administrative proceedings in the ordinary course
of its business. Management does not regard any of those proceedings to be material.





Item 2. Changes in Securities and Use of Proceeds.





On October 1, 2002, the Company issued a warrant to purchase stock to an
executive recruiting firm entitling them to purchase 54,321 shares of common stock at an exercise price of $5.42 for a period of three years. The warrants were not registered under the Securities Act of 1993, as amended, pursuant to an exemption
under, among other things, Section 4(2) promulgated there under.





Item 3. Defaults upon Senior Securities.





Not applicable.





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





The Companys Annual Meeting of Shareholders was held on
January 31, 2002 in San Francisco, California. Of the 73,779,163 shares outstanding as of the record date, 65,269,267 shares were present or represented by proxy at the meeting. The following matters were submitted to a vote of security holders:





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





Nominee

Votes for

Votes Withheld

Broker Non-VotesGregory Q. Brown

54,207,924

11,061,343

0Michael E.W. Jackson

65,154,067

115,020

0Kathleen M.H. Wallman

65,154,071

115,196

0





(2) To ratify the Companys appointment of KPMG LLP as independent accountants for the Company for
the fiscal year ending September 30, 2002.





Votes For

63,601,858Votes Against

1,651,462Votes Abstaining

15,997Broker Non-Votes

0





Item 5. Other Information.





On October 17, 2001, we announced that Michael L. Luetkemeyer was appointed to the position of
Chief Financial Officer.




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MICROMUSE INC.





Item 6. Exhibits and Reports on Form 8-K:





(a) Exhibits





Exhibit Number

Description3.1

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).10.15

Offer of employment as of October 1, 2001, by and between Michael L. Luetkemeyer and Micromuse Inc. *





|* |  | Indicates management contracts.
|- |  | -------------------------------

|(b) |  | Reports on Form 8-K
|--- |  | -------------------




There were no reports on Form 8-K filed
during the quarter ended December 31, 2001.




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MICROMUSE INC.





SIGNATURE





Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to
be signed on its behalf by the undersigned, thereunto duly authorized, on February 12, 2001.





MICROMUSE INC. (Registrant)By:

/S/    GREGORY Q. BROWNGregory Q. Brown Chairman and Chief Executive
Officer (Duly Authorized Officer)





By:

/S/    MICHAEL L. LUETKEMEYERMichael L. Luetkemeyer Senior Vice President and Chief
Financial Officer (Principal Financial Officer)






















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