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UNITED STATES


SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549





---




FORM 10-Q





xQUARTERLY REPORT PURSUANT TO SECTION 13 OR 15 (d)


OF THE SECURITIES
EXCHANGE ACT OF 1934





For the quarterly period ended March 31, 2002





 ̈ 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

94-3288385(State or other jurisdiction of incorporation or
organization)

(IRS Employer Identification No.)





139 TOWNSEND STREET


SAN FRANCISCO, CALIFORNIA 94107


(415) 538-9090


(Address, including ZIP code,
and telephone number)





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





Yes  x        No  ̈





74,702,134 shares of Common
Stock, $0.01 par value, were outstanding as of April 30, 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 March 31, 2002 and September 30, 2001

3Condensed Consolidated Statements of Operations for the three and six months ended March 31, 2002 and 2001

4Condensed Consolidated Statements of Cash Flows for the six months ended March 31, 2002 and 2001

5Notes to Condensed Consolidated Financial Statements

6Item 2.

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

10Item 3.

Quantitative and Qualitative Disclosures about Market Risk

29PART IIOther InformationItem 1.

Legal Proceedings

30Item 2.

Changes in Securities and Use of Proceeds

30Item 3.

Defaults upon Senior Securities

30Item 4.

Submission of Matters to a Vote of Security Holders

30Item 5.

Other Information

30Item 6.

Exhibits and Reports on Form 8-K

31Signatures

32




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##### Table of Contents

PART 1FINANCIAL INFORMATION





Item 1. Condensed Consolidated Financial Statements





MICROMUSE INC.





CONDENSED CONSOLIDATED BALANCE SHEETS


(In thousands, except per share data)


(Unaudited)





March 31, 2002


September 30, 2001ASSETSCurrent assets:Cash and cash equivalents

$
102,792


$
138,581Short-term investments


33,831



16,109Billed receivables, net


28,019



31,067Prepaid expenses and other current assets


11,630



15,656Total current assets


176,272



201,413Property and equipment, net


12,142



15,221Long-term investments


52,020



20,891Goodwill and other intangible assets, net


30,577



36,113$
271,011


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

$
2,007


$
5,686Accrued expenses


21,635



27,407Income taxes payable


6,850



6,152Deferred revenue


34,770



34,212Total current liabilities


65,262



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; 74,682 and 73,903 shares outstanding as of March 31, 2002 and September
30, 2001, respectively


747



739Additional paid-in capital


193,263



187,755Treasury stock


(2,657
)


(2,657
)Accumulated other comprehensive loss


(2,300
)


(1,317
)Retained earnings


16,696



15,661Total stockholders equity


205,749



200,181$
271,011


$
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 March 31,

Six months ended March 31,2002


2001

2002


2001Revenues:License

$
24,639


$
43,193

$
47,855


$
79,561Maintenance and services


14,399



16,129


31,230



29,581Total revenues


39,038



59,322


79,085



109,142Cost of revenues:License


1,506



2,381


3,101



4,449Maintenance and services


4,605



7,011


9,813



12,239Total cost of revenues


6,111



9,392


12,914



16,688Gross profit


32,927



49,930


66,171



92,454Operating expenses:Sales and marketing


18,092



24,584


36,177



46,197Research and development


8,060



9,009


15,630



16,975General and administrative


4,079



4,922


9,017



9,109Amortization of goodwill and other intangible assets


2,767



2,767


5,534



5,534Executive recruiting costs









449



Total operating expenses


32,998



41,282


66,807



77,815Income (loss) from operations


(71
)


8,648


(636
)


14,639Other income, net


1,305



1,590


2,913



3,642Income before income taxes


1,234



10,238


2,277



18,281Income tax provision


815



3,277


1,242



5,851Net income

$
419


$
6,961

$
1,035


$
12,430Per share data:Basic net income

$
0.01


$
0.10

$
0.01


$
0.17Diluted net income

$
0.01


$
0.09

$
0.01


$
0.16Weighted average shares used in computing:Basic net income per share


74,429



72,061


74,233



71,468Diluted net income per share


77,663



79,278


77,858



79,546





See accompanying notes to the condensed consolidated financial statements




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MICROMUSE INC.





CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS


(In thousands)


(Unaudited)





Six months ended March 31,2002


2001Cash flows from operating activities:Net income

$
1,035


$
12,430Adjustments to reconcile net income to net cash provided by operating activities:Depreciation and amortization


10,054



8,333Amortization of deferred employee compensation






28Compensation expense related to issuance of warrant


170



Tax benefit related to exercise of stock options


634



1,120Deferred income taxes






2,100Changes in operating assets and liabilities:Billed receivables, net


2,765



(9,911
)Prepaid expenses and other current assets


3,916



(1,815
)Accounts payable


(3,590
)


(916
)Accrued expenses


(5,355
)


12,617Income taxes payable


699



2,568Deferred revenue


771



11,657Net cash provided by operating activities


11,099



38,211Cash flows from investing activities:Capital expenditures


(1,589
)


(6,079
)Investment purchases, net


(48,864
)


10,024Cash provided by (used in) investing activities


(50,453
)


3,945Cash flows from financing activities:Proceeds from issuance of common stock


4,712



18,960Net cash provided by financing activities


4,712



18,960Effects of exchange rate changes on cash and cash equivalents


(1,147
)


10Net increase (decrease) in cash and cash equivalents


(35,789
)


61,126Cash and cash equivalents at beginning of period


138,581



83,679Cash and cash equivalents at end of period

$
102,792


$
144,605





See accompanying notes to the condensed consolidated financial statements




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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 the Companys 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 affected 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 three months or less to be cash equivalents.





Shareholders 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 March 31,

Six months ended March 31,2002

2001

2002

2001Numerator for basic and diluted net income

$
419

$
6,961

$
1,035

$
12,430Denominator for basic net income per shareweighted-average shares outstanding


74,429


72,061


74,233


71,468Dilutive effect of:Common stock options


3,180


7,217


3,571


8,078Warrant


54





54


Denominator for diluted net income per share


77,663


79,278


77,858


79,546





As of March 31, 2002 and 2001, there were approximately 13.1 million and 12.8 million options outstanding,
respectively.





Concentration of Revenues





One
third-party distributor customer accounted for approximately 23% and 19% of revenues for the quarter and six months ended March 31, 2002, as compared to 12% and 11% in the same periods of the prior year. One end-user customer accounted for
approximately 12% of revenues for the quarter ended March 31, 2002. No one end-user customer accounted for greater than 10% of revenues for the quarter and six months ended March 31, 2001.





Accounts Receivable





Accounts Receivable includes an allowance for doubtful accounts of $5.0 million
and $4.2 million as of March 31, 2002 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 quarter ended March 31, 2002 was
$322,000 as compared to income of $51,000 for the quarter ended March 31, 2001. Other comprehensive loss for the six months ended March 31, 2002 and 2001, was $983,000 and $4,000 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




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MICROMUSE INC.





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 the United Kingdom and continental Europe. 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 March 31,

Six months ended March 31,2002

2001

2002

2001Revenues:United States

$
19,202

$
35,735

$
41,479

$
68,350United Kingdom


3,808


8,496


8,628


17,264International


16,028


15,091


28,978


23,528Total

$
39,038

$
59,322

$
79,085

$
109,142March 31, 2002

September 30, 2001Long-lived assets:United States

$
38,922

$
46,395International


3,797


4,939Total

$
42,719

$
51,334





Recent Pronouncement





In July 2001, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 141, Business Combinations. Under SFAS No. 141, entities are required to account for
all business combinations initiated after June 30, 2001 using one method, the purchase method. SFAS No. 141 also requires that an intangible asset acquired in a business combination be recognized apart from goodwill if (i) the intangible asset
arises from contractual or other legal rights or (ii) the acquired intangible is capable of being separated from the acquired enterprise, as defined in SFAS No. 141. The Company adopted SFAS No. 141 on July 1, 2001. The adoption did not have an
effect on the Companys consolidated financial position or results of operations.





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 rior 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. Upon adoption, approximately $16.4 million of goodwill will no longer be amortized but will be tested annually for impairment.




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MICROMUSE INC.





In October 2001, the FASB
issued SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, 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. 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.





In November 2001, the Emerging Issues Task Force (EITF) reached consensus on EITF
No. 01-9, Accounting for Consideration Given by a Vendor to a Customer or a Reseller of the Vendors Products. EITF No. 01-9 addresses the accounting for consideration given by a vendor to a customer and is a codification of EITF No.
00-14, Accounting for Certain Sales Incentives, EITF No. 00-22, Accounting for Points and Certain Other Time-Based or Volume-Based Sales Incentives Offers and Offers for Free Products or Services to be Delivered in the
Future, and EITF No. 00-25, Vendor Income Statement Characterization of Consideration Paid to a Reseller of the Vendors Products. The Company adopted EITF No. 01-9 in the quarter ending March 31, 2002 and it did not have an effect
on the Companys financial statements.




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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.





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.





Critical Accounting Policies and Estimates





Micromuses discussion and analysis of its financial condition
and results of operations are based upon Micromuses condensed 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, but not limited to, 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.




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MICROMUSE INC.





Micromuse believes the following are the critical accounting policies and estimates that are used in the preparation of its 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. The Company recognizes revenue in accordance with Statement of Position 97-2, Software Revenue Recognition (SOP 97-2), as amended by SOP 98-9, Software Revenue Recognition with Respect to Certain Arrangements, and recognizes
revenue using the residual method. Under the residual method, revenue is recognized when Company-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). The Company allocates 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. The Company determines the fair value of the maintenance portion of the arrangement to be 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 the Company charges for these services when sold independently from a
software license. At the outset of the arrangement with the customer, 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. If evidence of
fair value cannot be established for the undelivered elements of a license agreement, the entire amount of revenue from the arrangement is deferred and recognized over the period that these elements are delivered.





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





| |  | Persuasive evidence of an arrangement exists: For license arrangements with end-users, an arrangement is evidence by a written contract, which is signed by both the customer
and us, or a purchase order from those customers who have previously negotiated a standard license arrangement with us. Sales to our resellers are evidenced by a master agreement governing the relationship together with a purchase order on a
transaction-by-transaction basis. For certain of our OEM arrangements, an arrangement is evidenced on receipt of a delivery notification to the end user.
|- |  | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  | Deliver has occurred: Delivery 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 licensed programs. In the case of arrangements with resellers and OEMs, revenue is recognized upon sell-through. Evidence of sell-through usually comes in the form of a purchase order or contract
identifying the end-user and sell-through shipping reports, usually identifying the ship to location.
|- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  | Fixed or determinable fee: The Company considers the fee to be fixed or determinable if the fee is not subject to refund or adjustment. If the arrangement fee is not fixed or
determinable, the Company recognizes the revenue as amounts become due and payable.
|- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------




| |  | Collection is probable: The Company conducts a credit review for all significant transactions at the time of the arrangement to determine the credit worthiness of the customer.
Collection is deemed probable if the Company expects that the customer will be able to pay amounts under the
|- |  | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| | arrangement as payments become due. If the Company determines that collection is not probable, the Company defers the revenue and recognizes 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.





Provision for Doubtful accounts.    Micromuse maintains allowances for doubtful accounts for estimated losses resulting from
the inability of its customers to make required payments. In estimating the provision for doubtful accounts, management considers the age of the accounts receivable, the Companys historical write-offs, the credit worthiness of the customer,
the economic conditions of the customers industry, and general economic conditions, among other factors. Should any of these factors change, the estimates made by management will also change, which could impact the level of the Companys
future provision for doubtful accounts. Specifically, if the financial condition of the Company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.    The Company regularly performs reviews to determine if the carrying value of goodwill and other
intangible assets are impaired. The purpose of 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. If management determines the existence of
impairment, under the current policy, the Company would use undiscounted cash flows to initially determine whether impairment should be recognized. If necessary, the Company would perform a subsequent calculation to measure the amount of the
impairment loss based on the excess of the carrying value over the fair value of the impaired assets. If quoted market prices for the assets are not available, the fair value would be calculated using the present value of estimated expected future
cash flows. The cash flow calculation would be based on managements best estimates, using appropriate assumptions and projections at the time.





Pro Forma Financial Results





We prepare and release quarterly unaudited financial statements prepared in accordance with generally
accepted accounting principles (GAAP). We also disclose and discuss certain pro forma financial information in the related earnings release and investor conference call. This pro forma financial information excludes certain non-cash and
special charges, consisting primarily of the amortization of goodwill and other intangible assets and executive recruiting costs. We believe the disclosure of the pro forma 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 consolidated statement of operations as
a percentage of total revenues, except as indicated:





Three months ended March 31,


Six months ended March 31,2002


2001


2002


2001As a Percentage of Total Revenues:Revenues:License

63.1
%

72.8
%

60.5
%

72.9
%Maintenance and services

36.9
%

27.2
%

39.5
%

27.1
%Total revenues

100.0
%

100.0
%

100.0
%

100.0
%Cost of revenues:License

3.9
%

4.0
%

3.9
%

4.1
%Maintenance and services

11.8
%

11.8
%

12.4
%

11.2
%Total cost of revenues

15.7
%

15.8
%

16.3
%

15.3
%Gross profit

84.3
%

84.2
%

83.7
%

84.7
%Operating expenses:Sales and marketing

46.3
%

41.4
%

45.7
%

42.3
%Research and development

20.6
%

15.2
%

19.8
%

15.6
%General and administrative

10.4
%

8.3
%

11.4
%

8.3
%Amortization of goodwill and other intangible assets

7.1
%

4.7
%

7.0
%

5.1
%Executive recruiting costs

0.0
%

0.0
%

0.6
%

0.0
%Total operating expenses

84.5
%

69.6
%

84.5
%

71.3
%Income (loss) from operations

(0.2
%)

14.6
%

(0.8
%)

13.4
%Other income, net

3.3
%

2.7
%

3.7
%

3.3
%Income before income taxes

3.2
%

17.3
%

2.9
%

16.7
%Income tax provision

2.1
%

5.5
%

1.6
%

5.3
%Net income

1.1
%

11.8
%

1.3
%

11.4
%As a Percentage of Related Revenues:Cost of license revenues

6.1
%

5.5
%

6.5
%

5.6
%Cost of maintenance and services revenues

32.0
%

43.5
%

31.4
%

41.4
%




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MICROMUSE INC.





Revenues.    Revenues decreased to $39.0 million and $79.1 million in the quarter and six months ended March 31, 2002, from $59.3 million and $109.1 million in the comparable periods of the prior year.
License revenues decreased to $24.6 million and $47.9 million in the quarter and six months ended March 31, 2002, from $43.2 million and $79.6 million in the comparable periods 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 six months were negatively impacted by the terrorist attacks in New York and Washington D.C. on
September 11, 2001. Maintenance and services revenues were $14.4 million and $31.2 million in the quarter and six months ended March 31, 2002, as compared to $16.1 million and $29.6 million in the comparable periods of the prior year. The
decrease in maintenance and services revenues in the quarter ended March 31, 2002, as compared to the prior year period was mainly a result of lower overall services revenue. The increase in maintenance and services revenues in the six months ended
March 31, 2002, as compared to the prior year period was mainly a result of providing maintenance to a larger installed base of customers. License revenues as a percentage of total revenues were 63.1% and 60.5% and in the quarter and six months
ended March 31, 2002, as compared to 72.8% and 72.9% 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 increased to 6.1% and 6.5% in the quarter and six months
ended March 31, 2002, as compared to 5.5% and 5.6% in the comparable periods of the prior year. The increase was mainly due to a change in the mix of license revenue. 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 32.0% and 31.4% in the quarter and six
months ended March 31, 2002, from 43.5% and 41.4% in the comparable periods 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 and $36.2 million in the quarter and six months ended March 31, 2002, from $24.6 million and $46.2 million in the comparable
periods 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 46.3% and 45.7% in the quarter and six months ended March 31, 2002, from 41.4% and 42.3% in the comparable periods of the prior year.





Research and Development Expenses.    Research and development expenses decreased to $8.0 million and $15.6 million in the quarter and six months
ended March 31, 2002, from $9.0 million and $17.0 million in the comparable periods of the prior year. The decrease was mainly due to a decrease in travel related expenditures. Research and development costs as a percentage of total revenues have
increased to 20.6% and 19.8% in the quarter and six months ended March 31, 2002, as compared to 15.2% and 15.6% in the same periods of the prior year.





General and Administrative Expenses.    General and administrative expenses decreased to $4.1 million and $9.0 million in the quarter and six months ended March 31, 2002, from $4.9 million and $9.1 million in
the comparable periods of the prior year. The decrease in the quarter ended March 31, 2002 as compared to the prior year period, was primarily due to lower bad debt expense and a decrease in personnel costs. The decrease in the six months ended
March 31, 2002 as compared to the prior year




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period, was mainly due to
a decrease in personnel costs but was offset by a bad debt reserve related to Global Crossing, which was recorded in the quarter ended December 31, 2001. Global Crossing filed for Chapter 11 bankruptcy protection in January 2002. However, Global
Crossing has continued to make payments in accordance with the terms of the agreement and management believes that the Company is adequately reserved at March 31, 2002 for this customer.





General and administrative expenses as a percentage of revenues have increased to 10.4% and 11.4% in the quarter and six months ended March 31, 2002, from 8.3% in the comparable periods of the prior year.





Amortization of Goodwill and Other Intangible Assets.    The charge of $2.8 million and $5.5 million in the quarter and six
months ended March 31, 2002 and 2001, 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 six months ended March 31, 2002 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 $1.3 million and $2.9 million in the quarter and six months ended March 31, 2002, from $1.6 million and $3.6 million in the comparable periods of the prior year. This net decrease was
primarily due to the decline in interest rates over the past year.





Provision for Income Taxes.    Income taxes
decreased to $0.8 million and $1.2 million in the quarter and six months ended March 31, 2002, as compared to $3.2 million and $5.8 million in the comparable periods of the prior year. The decrease was mainly due to the related decline in taxable
income.





Liquidity and Capital Resources





As of
March 31, 2002, we had $102.8 million in cash and cash equivalents and $85.9 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
decrease in cash and cash equivalents in the six months ended March 31, 2002, was due primarily to the purchase of marketable securities, capital expenditures and the decrease in accounts payable and accrued expenses. These outflows of cash and cash
equivalents were partially offset by net income adjusted for non-cash expenses, the decrease in billed receivables and prepaid expenses and other current assets, the proceeds from the issuance of common stock and the increase in deferred revenues.





As of March 31, 2002, 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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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.





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




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




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



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|· |  | 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 over the past few years, 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 March 31, 2002, we had 717 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 continue to improve our accounting and financial reporting systems and to successfully manage an increasing number of relationships with customers, suppliers and employees. Further, we need to continue to develop
our global financial and accounting system. Our business will be harmed if we are unable to recruit and retain 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.




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We need to continue to
develop and retain 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 53%, 42% and 34% of our total revenues in the six
months ended March 31, 2002, fiscal 2001 and 2000, respectively. Our business will be harmed if we are not able to retain existing distributors or 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.





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 76%, 79% and
82% of our total in the six months ended March 31, 2002, 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




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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 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, 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.




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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.;
|- |  | -------------------------------------------------------------------------------------------------------




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




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




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




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





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





Complex software products frequently contain errors or defects,
especially when first introduced or when new versions or enhancements are released. 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




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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 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;
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|· |  | 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 and large one-time write-offs. 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 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.




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




|· |  | 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.




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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.





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.




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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 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.





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




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impairment charge
impacting our financial position. As of March 31, 2002, we had approximately $30.6 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 March 31, 2002, we had approximately 74.7 million shares of common stock outstanding, excluding approximately 13.1 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.





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.





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. We are




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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-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.





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 replaced their national currencies with 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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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 March 31, 2002, 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 3.1%.




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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.





Not applicable.





Item 3.
Defaults upon Senior Securities.





Not applicable.





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





The voting results and related information from our annual meeting held
on January 31, 2002, were reported in Item 4 of our Quarterly Report on Form 10-Q filed with the SEC on February 13, 2002, which item is incorporated herein by this reference.





Item 5.
Other Information.





Not applicable.




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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).





(b) Reports on Form 8-K





There were no reports on Form 8-K filed during the quarter ended March 31, 2002.




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SIGNATURES





Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to
be signed on its behalf by the undersigned, thereunto duly authorized, on May 13, 2002.








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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