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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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



For the quarterly period ended March 31, 2004



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



For the transition period from
 to  .



Commission file number 000-23783



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MICROMUSE INC.

(Exact name of registrant as specified in its charter)



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



139 TOWNSEND STREET

SAN FRANCISCO, CALIFORNIA 94107

(415) 538-9090

(Address, including ZIP code, and telephone number)



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



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



78,270,124 shares of Common Stock, $0.01 par value, were outstanding as of May
3, 2004



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##### Table of Contents

MICROMUSE INC.



TABLE OF CONTENTS



|                               |  |                                                                                                                                                                                                                                                                                                           |  |     
|------------------------------ |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----
|                               |  |                                                                                                                                                                                                                                                                                                           |  | Page
|Explanatory Note               |  | 3                                                                                                                                                                                                                                                                                                        
|                               | 
|PART I - Financial Information |  |                                                                                                                                                                                                                                                                                                          
|                               |  |                                                                                                                                                                                                                                                                                                          
|Item 1.                        |  | Condensed Consolidated Financial Statements (Unaudited):                                                                                                                                                                                                                                                  |  |     
|                               |  |                                                                                                                                                                                                                                                                                                          
|                               |  | Condensed Consolidated Balance Sheets as of March 31, 2004 and September 30, 2003                                                                                                                                                                                                                         |  | 4   
|                               |  |                                                                                                                                                                                                                                                                                                          
|                               |  | Condensed Consolidated Statements of Operations for the three and six months ended March 31, 2004 and 2003*                                                                                                                                                                                               |  | 5   
|                               |  |                                                                                                                                                                                                                                                                                                          
|                               |  | Condensed Consolidated Statements of Cash Flows for the six months ended March 31, 2004 and 2003*                                                                                                                                                                                                         |  | 6   
|                               |  |                                                                                                                                                                                                                                                                                                          
|                               |  | Notes to Condensed Consolidated Financial Statements                                                                                                                                                                                                                                                      |  | 7   
|                               |  |                                                                                                                                                                                                                                                                                                          
|                               |  | *The Condensed Consolidated Statements of Operations for the three and six months ended March 31, 2003 and the Condensed Consolidated Statements of Cash Flows for the six months ended March
31, 2003 have been restated as described in Note 2 of Notes to Condensed Consolidated Financial Statements. |  |     
|                               |  |                                                                                                                                                                                                                                                                                                          
|Item 2.                        |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                                                                                                                                                                                                                     |  | 12  
|                               |  |                                                                                                                                                                                                                                                                                                          
|Item 3.                        |  | Quantitative and Qualitative Disclosures about Market Risk                                                                                                                                                                                                                                                |  | 26  
|                               |  |                                                                                                                                                                                                                                                                                                          
|Item 4.                        |  | Controls and Procedures                                                                                                                                                                                                                                                                                   |  | 27  
|                               | 
|PART II - Other Information    |  |                                                                                                                                                                                                                                                                                                          
|                               |  |                                                                                                                                                                                                                                                                                                          
|Item 1.                        |  | Legal Proceedings                                                                                                                                                                                                                                                                                         |  | 28  
|                               |  |                                                                                                                                                                                                                                                                                                          
|Item 2.                        |  | Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities                                                                                                                                                                                                                          |  | 29  
|                               |  |                                                                                                                                                                                                                                                                                                          
|Item 3.                        |  | Defaults upon Senior Securities                                                                                                                                                                                                                                                                           |  | 29  
|                               |  |                                                                                                                                                                                                                                                                                                          
|Item 4.                        |  | Submission of Matters to a Vote of Security Holders                                                                                                                                                                                                                                                       |  | 29  
|                               |  |                                                                                                                                                                                                                                                                                                          
|Item 5.                        |  | Other Information                                                                                                                                                                                                                                                                                         |  | 29  
|                               |  |                                                                                                                                                                                                                                                                                                          
|Item 6.                        |  | Exhibits and Reports on Form 8-K                                                                                                                                                                                                                                                                          |  | 29  
|                               | 
|Signatures                     |  | 30                                                                                                                                                                                                                                                                                                       



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EXPLANATORY NOTE



This Form 10-Q includes
restated financial information for certain periods indicated below in this report that ended prior to our fiscal quarter that began on October 1, 2003.



The Company has restated its consolidated financial statements for the fiscal years ended September 30, 2001 and 2002 and for the quarters ended December 31, 2000 through
June 30, 2003. Accordingly, the financial statements for those fiscal periods described above that have been included in the Companys previous filings with the Securities and Exchange Commission in 2003 or earlier or included in previous
announcements in 2003 or earlier should not be relied upon.



The Companys
Form 10-K for the fiscal year ended September 30, 2003, filed with the SEC on May 17, 2004, contains restated information for all of the above periods to which the restatement applies and other information relating to the restatement, in the Form
10-K Item 6 Selected Financial Data, Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations  Restatement of Financial Statements, Notes 2 and 11 of the Notes to Consolidated
Financial Statements included in Item 8, and Item 9A, Controls and Procedures.



Certain information concerning the restatement relating to the periods included in this report is contained in Part I to this Form 10-Q in Note 2 below to the Condensed Consolidated Financial Statements (Unaudited),
Item 2 Managements Discussion and Analysis of Financial Condition and Results of Operations, and Item 4, Controls and Procedures. This information should be read in conjunction with relevant information in the
Companys most recent Form 10-K referred to above.



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MICROMUSE INC.



PART I - FINANCIAL INFORMATION



Item 1.
 Condensed Consolidated Financial Statements



CONDENSED CONSOLIDATED BALANCE SHEETS

(In thousands, except per share data)

(Unaudited)



|                                                                                                                                                         |  |               |         |   |                   |   |         |  
|-------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------- | ------- | - | ----------------- | - | ------- | -
|                                                                                                                                                         |  | March 31,2004 |         |   | September 30,2003 |  
|ASSETS                                                                                                                                                   |  |               |         |   |                   |   |         |  
|Current assets:                                                                                                                                          |  |               |         |   |                   |   |         |  
|Cash and cash equivalents                                                                                                                                |  | $             | 119,592 |   |                   | $ | 89,385  |  
|Short-term investments                                                                                                                                   |  |               | 16,095  |   |                   |   | 33,196  |  
|Accounts receivable, net                                                                                                                                 |  |               | 17,182  |   |                   |   | 13,439  |  
|Prepaid expenses and other current assets                                                                                                                |  |               | 8,822   |   |                   |   | 6,269   |  
|                                                                                                                                                         |  |               |         |   |                   |   |         |  
|Total current assets                                                                                                                                     |  |               | 161,691 |   |                   |   | 142,289 |  
|Property and equipment, net                                                                                                                              |  |               | 6,326   |   |                   |   | 5,976   |  
|Long-term investments                                                                                                                                    |  |               | 59,486  |   |                   |   | 67,529  |  
|Goodwill, net                                                                                                                                            |  |               | 50,956  |   |                   |   | 49,032  |  
|Other intangible assets, net                                                                                                                             |  |               | 9,768   |   |                   |   | 12,861  |  
|                                                                                                                                                         |  |               |         |   |                   |   |         |  
|                                                                                                                                                         |  | $             | 288,227 |   |                   | $ | 277,687 |  
|                                                                                                                                                         |  |               |         |   |                   |   |         |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                                                     |  |               |         |   |                   |   |         |  
|Current liabilities:                                                                                                                                     |  |               |         |   |                   |   |         |  
|Accounts payable                                                                                                                                         |  | $             | 4,609   |   |                   | $ | 6,849   |  
|Accrued expenses                                                                                                                                         |  |               | 25,738  |   |                   |   | 20,387  |  
|Income taxes payable                                                                                                                                     |  |               | 6,366   |   |                   |   | 6,368   |  
|Deferred revenue                                                                                                                                         |  |               | 44,473  |   |                   |   | 40,327  |  
|                                                                                                                                                         |  |               |         |   |                   |   |         |  
|Total current liabilities                                                                                                                                |  |               | 81,186  |   |                   |   | 73,931  |  
|Stockholders equity                                                                                                                                     |  |               |         |   |                   |   |         |  
|Preferred stock; $0.01 par value; 5,000 shares authorized no shares issued and outstanding                                                               |  |               |         |   |                   |   |         |  
|Common stock; $0.01 par value; 200,000 shares authorized; 78,670 and 78,544 shares outstanding as of March 31, 2004 and September 30, 2003,
respectively |  |               | 787     |   |                   |   | 785     |  
|Additional paid-in capital                                                                                                                               |  |               | 212,267 |   |                   |   | 210,697 |  
|Treasury stock                                                                                                                                           |  |               | (2,657  | ) |                   |   | (2,657  | )
|Accumulated other comprehensive loss                                                                                                                     |  |               | (1,782  | ) |                   |   | (1,548  | )
|Accumulated deficit                                                                                                                                      |  |               | (1,574  | ) |                   |   | (3,521  | )
|                                                                                                                                                         |  |               |         |   |                   |   |         |  
|Total stockholders equity                                                                                                                               |  |               | 207,041 |   |                   |   | 203,756 |  
|                                                                                                                                                         |  |               |         |   |                   |   |         |  
|                                                                                                                                                         |  | $             | 288,227 |   |                   | $ | 277,687 |  
|                                                                                                                                                         |  |               |         |   |                   |   |         |  



See accompanying
notes to the condensed consolidated financial statements



4



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MICROMUSE INC.



CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)

(Unaudited)



|                                           |  |                             |        |               |                            |        |      |  |               |        |  |   |        |  
|------------------------------------------ |  | --------------------------- | ------ | ------------- | -------------------------- | ------ | ---- |  | ------------- | ------ |  | - | ------ | -
|                                           |  | Three months endedMarch 31, |        |               | Six months ended March 31, |       
|                                           |  | 2004                        |        | 2003          |                            |        | 2004 |  | 2003          |       
|                                           |  |                             |        | (As Restated) |                            |        |      |  | (As Restated) |       
|Revenues:                                  |  |                             |        |               |                            |        |      |  |               |        |  |   |        |  
|License                                    |  | $                           | 20,288 |               | $                          | 18,534 |      |  | $             | 40,607 |  | $ | 32,157 |  
|Maintenance and services                   |  |                             | 17,997 |               |                            | 13,582 |      |  |               | 34,867 |  |   | 27,362 |  
|                                           |  |                             |        |               |                            |        |      |  |               |        |  |   |        |  
|Total revenues                             |  |                             | 38,285 |               |                            | 32,116 |      |  |               | 75,474 |  |   | 59,519 |  
|                                           |  |                             |        |               |                            |        |      |  |               |        |  |   |        |  
|Cost of revenues:                          |  |                             |        |               |                            |        |      |  |               |        |  |   |        |  
|License                                    |  |                             | 1,542  |               |                            | 1,302  |      |  |               | 2,887  |  |   | 2,084  |  
|Maintenance and services                   |  |                             | 2,749  |               |                            | 2,427  |      |  |               | 5,316  |  |   | 5,522  |  
|Amortization of developed technology       |  |                             | 1,532  |               |                            | 1,050  |      |  |               | 2,988  |  |   | 2,036  |  
|                                           |  |                             |        |               |                            |        |      |  |               |        |  |   |        |  
|Total cost of revenues                     |  |                             | 5,823  |               |                            | 4,779  |      |  |               | 11,191 |  |   | 9,642  |  
|                                           |  |                             |        |               |                            |        |      |  |               |        |  |   |        |  
|Gross profit                               |  |                             | 32,462 |               |                            | 27,337 |      |  |               | 64,283 |  |   | 49,877 |  
|                                           |  |                             |        |               |                            |        |      |  |               |        |  |   |        |  
|Operating expenses:                        |  |                             |        |               |                            |        |      |  |               |        |  |   |        |  
|Sales and marketing                        |  |                             | 15,809 |               |                            | 16,446 |      |  |               | 31,485 |  |   | 31,397 |  
|Research and development                   |  |                             | 8,245  |               |                            | 7,026  |      |  |               | 16,019 |  |   | 14,309 |  
|General and administrative                 |  |                             | 7,878  |               |                            | 4,434  |      |  |               | 15,141 |  |   | 8,676  |  
|Stock based compensation                   |  |                             | 438    |               |                            |       |      |  |               | 553    |  |   |       |  
|Amortization of other intangible assets    |  |                             | 47     |               |                            | 355    |      |  |               | 95     |  |   | 921    |  
|Restructuring costs                        |  |                             |       |               |                            |       |      |  |               |       |  |   | 3,140  |  
|                                           |  |                             |        |               |                            |        |      |  |               |        |  |   |        |  
|Total operating expenses                   |  |                             | 32,417 |               |                            | 28,261 |      |  |               | 63,293 |  |   | 58,443 |  
|                                           |  |                             |        |               |                            |        |      |  |               |        |  |   |        |  
|Income (loss) from operations              |  |                             | 45     |               |                            | (924   | )    |  |               | 990    |  |   | (8,566 | )
|Other income, net                          |  |                             | 732    |               |                            | 1,252  |      |  |               | 1,714  |  |   | 2,685  |  
|                                           |  |                             |        |               |                            |        |      |  |               |        |  |   |        |  
|Income (loss) before income taxes          |  |                             | 777    |               |                            | 328    |      |  |               | 2,704  |  |   | (5,881 | )
|Income tax provision                       |  |                             | 218    |               |                            | 552    |      |  |               | 757    |  |   | 1,043  |  
|                                           |  |                             |        |               |                            |        |      |  |               |        |  |   |        |  
|Net income (loss)                          |  | $                           | 559    |               | $                          | (224   | )    |  | $             | 1,947  |  | $ | (6,924 | )
|                                           |  |                             |        |               |                            |        |      |  |               |        |  |   |        |  
|Per share data:                            |  |                             |        |               |                            |        |      |  |               |        |  |   |        |  
|Basic net income (loss)                    |  | $                           | 0.01   |               | $                          | 0.00   |      |  | $             | 0.02   |  | $ | (0.09  | )
|Diluted net income (loss)                  |  | $                           | 0.01   |               | $                          | 0.00   |      |  | $             | 0.02   |  | $ | (0.09  | )
|Weighted average shares used in computing: |  |                             |        |               |                            |        |      |  |               |        |  |   |        |  
|Basic net income (loss) per share          |  |                             | 78,670 |               |                            | 75,744 |      |  |               | 78,645 |  |   | 75,490 |  
|Diluted net income (loss) per share        |  |                             | 82,546 |               |                            | 75,744 |      |  |               | 82,267 |  |   | 75,490 |  



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, |         
|                                                                                         |  | 2004                       |          |   | 2003          |  
|                                                                                         |  |                            |          |   | (As Restated) |  
|Cash flows from operating activities:                                                    |  |                            |          |   |               |   |         |  
|Net income (loss)                                                                        |  | $                          | 1,947    |   |               | $ | (6,924  | )
|Adjustments to reconcile net income (loss) to net cash provided by operating activities: |  |                            |          |   |               |   |         |  
|Depreciation and amortization                                                            |  |                            | 5,642    |   |               |   | 6,682   |  
|Purchased in process research & development                                              |  |                            |         |   |               |   | 142     |  
|Non-cash stock-based compensation                                                        |  |                            | 553      |   |               |   |        |  
|Non-cash compensation expense related to restructuring                                   |  |                            |         |   |               |   | 54      |  
|Tax benefit related to exercise of stock options                                         |  |                            | 464      |   |               |   | 623     |  
|Accounts receivable, net                                                                 |  |                            | (3,743   | ) |               |   | 9,497   |  
|Prepaid expenses and other current assets                                                |  |                            | (2,554   | ) |               |   | (1,213  | )
|Accounts payable                                                                         |  |                            | (2,240   | ) |               |   | 1,888   |  
|Accrued expenses                                                                         |  |                            | 5,351    |   |               |   | (4,377  | )
|Income taxes payable                                                                     |  |                            | (2       | ) |               |   | 40      |  
|Deferred revenue                                                                         |  |                            | 4,146    |   |               |   | 11,469  |  
|                                                                                         |  |                            |          |   |               |   |         |  
|Net cash provided by operating activities                                                |  |                            | 9,564    |   |               |   | 17,881  |  
|                                                                                         |  |                            |          |   |               |   |         |  
|Cash flows from investing activities:                                                    |  |                            |          |   |               |   |         |  
|Capital expenditures                                                                     |  |                            | (2,767   | ) |               |   | (464    | )
|Investment purchases                                                                     |  |                            | (103,837 | ) |               |   | (54,073 | )
|Investment sales                                                                         |  |                            | 128,981  |   |               |   | 37,333  |  
|Acquisition of business, net of cash received                                            |  |                            | (425     | ) |               |   | (1,196  | )
|Repayment of long term debt assumed upon acquisition                                     |  |                            |         |   |               |   | (855    | )
|                                                                                         |  |                            |          |   |               |   |         |  
|Cash provided by (used in) investing activities                                          |  |                            | 21,952   |   |               |   | (19,255 | )
|                                                                                         |  |                            |          |   |               |   |         |  
|Cash flows from financing activities:                                                    |  |                            |          |   |               |   |         |  
|Proceeds from issuance of common stock                                                   |  |                            | 555      |   |               |   | 2,206   |  
|                                                                                         |  |                            |          |   |               |   |         |  
|Net cash provided by financing activities                                                |  |                            | 555      |   |               |   | 2,206   |  
|                                                                                         |  |                            |          |   |               |   |         |  
|Effects of exchange rate changes on cash and cash equivalents                            |  |                            | (1,864   | ) |               |   | (782    | )
|                                                                                         |  |                            |          |   |               |   |         |  
|Net increase in cash and cash equivalents                                                |  |                            | 30,207   |   |               |   | 50      |  
|Cash and cash equivalents at beginning of period                                         |  |                            | 89,385   |   |               |   | 117,218 |  
|                                                                                         |  |                            |          |   |               |   |         |  
|Cash and cash equivalents at end of period                                               |  | $                          | 119,592  |   |               | $ | 117,268 |  
|                                                                                         |  |                            |          |   |               |   |         |  



See accompanying
notes to the condensed consolidated financial statements



6



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##### Table of Contents

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 May 17, 2004. The September 30, 2003 condensed consolidated balance sheet included herein was derived from audited financial statements, but does not include all disclosures, including notes,
required by generally accepted accounting principles.



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



Reclassifications



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



Use of Estimates



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



On an ongoing basis, we evaluate our estimates, including those related to revenue recognition, allocation of technical services department
costs among expense categories, provision for doubtful accounts and sales returns, fair value of investments, fair value of acquired intangible assets and goodwill, useful lives of intangible assets and property and equipment, income taxes,
restructuring costs, and contingencies and litigation, among others. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for
making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results could differ significantly from the estimates made by management with respect to these items and other items that
require managements estimates.



The costs of our technical services
department are allocated between cost of revenue, sales and marketing expenses, and research and development expenses based upon an estimate of the time spent by the technical services employees in various departments and the areas benefited
by that time. Total costs of the technical services department were $6.5 million and $12.7 million for the quarter and the six month period ended March 31, 2004, respectively, and $5.5 million and $11.7 million for the quarter and the six month
period ended March 31, 2003, respectively. The allocation rates applied to these department costs were 21% to cost of revenue, 74% to sales and marketing, and 5% to research and development in the quarter ended March 31, 2004; 21% to cost of
revenue, 75% to sales and marketing, and 4% to research and development in the six month period ended March 31, 2004; 20% to cost of revenue, 75% to sales and marketing, and 5% to research and development in the quarter ended March 31, 2003; and 22%
to cost of revenue, 73% to sales and marketing, and 5% to research and development in the six month period ended March 31, 2003. The allocation estimate is subject to change and, if changed, will impact the allocation of expenses in the statement of
operations but will not impact net income or loss.



Cash Equivalents



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



Earnings Per Share



Basic per share amounts are calculated using the weighted-average number of common shares outstanding during the period. Diluted per share amounts are calculated using
the weighted-average number of common shares outstanding during the period and, when dilutive, the weighted-average number of potential common shares from the exercise of outstanding options and warrants to purchase common stock using the treasury
stock method. Excluded from the computation of diluted loss per share for the quarter and six months ended March 31, 2003 were options to acquire 9.8 million and 14.1 million shares of common stock and a warrant to acquire 54,321 shares of common
stock at $5.42 per share because their effect would be anti-dilutive. Excluded from the computation of diluted earnings per share for the quarter and six months ended March 31, 2004, were options to acquire 9.3 million and 10.5 million shares of
common stock, respectively because of the application of the treasury method to calculate fully diluted shares outstanding. A reconciliation of the numerators and denominators used in the basic and diluted net income per share amounts follows (in
thousands):



|                                                                                        |  |                             |        |               |                            |        |      |  |               |        |  |   |        |  
|--------------------------------------------------------------------------------------- |  | --------------------------- | ------ | ------------- | -------------------------- | ------ | ---- |  | ------------- | ------ |  | - | ------ | -
|                                                                                        |  | Three months endedMarch 31, |        |               | Six months ended March 31, |       
|                                                                                        |  | 2004                        |        | 2003          |                            |        | 2004 |  | 2003          |       
|                                                                                        |  |                             |        | (As Restated) |                            |        |      |  | (As Restated) |       
|Numerator for basic and diluted net income (loss)                                       |  | $                           | 559    |               | $                          | (224   | )    |  | $             | 1,947  |  | $ | (6,924 | )
|                                                                                        |  |                             |        |               |                            |        |      |  |               |        |  |   |        |  
|Denominator for basic net income (loss) per share  weighted-average shares outstanding |  |                             | 78,670 |               |                            | 75,744 |      |  |               | 78,645 |  |   | 75,490 |  
|Dilutive effect of:                                                                     |  |                             |        |               |                            |        |      |  |               |        |  |   |        |  
|Common stock options                                                                    |  |                             | 3,772  |               |                            |       |      |  |               | 3,518  |  |   |       |  
|Warrants                                                                                |  |                             | 104    |               |                            |       |      |  |               | 104    |  |   |       |  
|                                                                                        |  |                             |        |               |                            |        |      |  |               |        |  |   |        |  
|Denominator for diluted net income (loss) per share                                     |  |                             | 82,546 |               |                            | 75,744 |      |  |               | 82,267 |  |   | 75,490 |  
|                                                                                        |  |                             |        |               |                            |        |      |  |               |        |  |   |        |  



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MICROMUSE INC.



Concentration of Revenues



One third-party distributor customer accounted for approximately 17% of revenues for both the quarter and six months ended March 31, 2004,
as compared to 46% and 34% in the same periods of the prior year. One end-user customer accounted for 33% and 18% of revenues for the quarter and six months ended March 31, 2003. No one end-user customer accounted for greater than 10% of revenues
for the quarter and six months ended March 31, 2004.



Accounts Receivable



Accounts receivable includes an allowance
for doubtful accounts of $1.7 million and $1.2 million as of March 31, 2004 and September 30, 2003, respectively.



Accumulated Other Comprehensive Loss



The only component of accumulated other comprehensive loss is net foreign currency translation adjustments. Other comprehensive loss, net of tax, for the quarter ended
March 31, 2004, was $0.1 million, as compared to a loss of $0.1 million for the quarter ended March 31, 2003. Other comprehensive loss, net of tax, for the six months ended March 31, 2004 was $0.2 million and other comprehensive loss, net of tax,
for the six months ended March 31, 2003, was $0.6 million.



Stock-Based Compensation



At March 31,
2004, the Company had two stock-based employee compensation plans, which are described more fully in the notes included in the Form 10-K as filed with the Securities Exchange Commission on May 17, 2004. The Company accounts for those plans under the
recognition and measurement principles of APB Opinion No. 25,Accounting for Stock Issued to Employees, and related Interpretations. All options granted under those plans had an exercise price equal to the market value of the underlying
common stock on the date of the grant, therefore no stock-based employee compensation cost is reflected in condensed consolidated statement of operations related to option grants. However, since certain employee stock options were modified during
the quarter and six months, the Company accounted for those options under the variable accounting requirements of APB Opinion 25 and FIN 44, Accounting for Certain Transactions Involving Stock Compensation. Accordingly, the Company recorded
stock-based compensation expense of $0.4 million and $0.6 million for the quarter and six months ended March 31, 2004, respectively, since the current market price of the underlying stock exceeded the exercise price on the date the grants were
modified.



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



|                                                                     |  |                             |        |   |                            |   |        |      |  |   |              |   |  |   |         |  
|-------------------------------------------------------------------- |  | --------------------------- | ------ | - | -------------------------- | - | ------ | ---- |  | - | ------------ | - |  | - | ------- | -
|                                                                     |  | Three months endedMarch 31, |        |   | Six months ended March 31, |  
|                                                                     |  | 2004                        |        |   | 2003                       |   |        | 2004 |  |   | 2003         |  
|                                                                     |  |                             |        |   | (AsRestated)               |   |        |      |  |   | (AsRestated) |  
|Net income (loss), as reported                                       |  | $                           | 559    |   |                            | $ | (224   | )    |  | $ | 1,947        |   |  | $ | (6,924  | )
|Add: Stock based compensation expense, included in net income (loss) |  |                             | 438    |   |                            |   |       |      |  |   | 553          |   |  |   | 54      |  
|Less: Stock based compensation determined under SFAS No.123          |  |                             | (6,947 | ) |                            |   | (9,177 | )    |  |   | (14,325      | ) |  |   | (18,112 | )
|                                                                     |  |                             |        |   |                            |   |        |      |  |   |              |   |  |   |         |  
|Net loss, pro-forma                                                  |  | $                           | (5,950 | ) |                            | $ | (9,401 | )    |  | $ | (11,825      | ) |  | $ | (24,982 | )
|                                                                     |  |                             |        |   |                            |   |        |      |  |   |              |   |  |   |         |  
|Basic net income (loss) per share, as reported                       |  | $                           | 0.01   |   |                            | $ | 0.00   |      |  | $ | 0.02         |   |  | $ | (0.09   | )
|Basic net loss per share, pro-forma                                  |  | $                           | (0.08  | ) |                            | $ | (0.12  | )    |  | $ | (0.15        | ) |  | $ | (0.33   | )
|Diluted net income (loss) per share, as reported                     |  | $                           | 0.01   |   |                            | $ | 0.00   |      |  | $ | 0.02         |   |  | $ | (0.09   | )
|Diluted net loss per share, pro-forma                                |  | $                           | (0.08  | ) |                            | $ | (0.12  | )    |  | $ | (0.15        | ) |  | $ | (0.33   | )





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MICROMUSE INC.



Geographic and Segment Information



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



The Company markets its
products primarily from the United States. International sales are primarily to customers in 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,
|                    |  | 2004                         |        | 2003                       |   | 2004   |  | 2003         
|                    |  |                              |        | (As Restated)              |   |        |  | (As Restated)
|Revenues:           |  |                              |        |                            |   |        |  |               |        |  |   |       
|United States       |  | $                            | 23,354 |                            | $ | 21,812 |  | $             | 41,949 |  | $ | 40,884
|United Kingdom      |  |                              | 5,360  |                            |   | 2,872  |  |               | 9,079  |  |   | 5,072 
|Other international |  |                              | 9,571  |                            |   | 7,432  |  |               | 24,446 |  |   | 13,563
|                    |  |                              |        |                            |   |        |  |               |        |  |   |       
|Total               |  | $                            | 38,285 |                            | $ | 32,116 |  | $             | 75,474 |  | $ | 59,519
|                    |  |                              |        |                            |   |        |  |               |        |  |   |       



|                     |  |               |        |                   |   |       
|-------------------- |  | ------------- | ------ | ----------------- | - | ------
|                     |  | March 31,2004 |        | September 30,2003
|Long - lived assets: |  |               |        |                   |   |       
|United States        |  | $             | 48,165 |                   | $ | 50,637
|International        |  |               | 18,885 |                   |   | 17,232
|                     |  |               |        |                   |   |       
|Total                |  | $             | 67,050 |                   | $ | 67,869
|                     |  |               |        |                   |   |       



Goodwill and Other Intangible assets



As a result of the
adoption of SFAS No. 142 on October 1, 2002, the Company ceased the amortization of goodwill. As of March 31, 2004 and September 30, 2003, the Company had unamortized goodwill of $51.0 million and $49.0 million, respectively. The movement in
goodwill is due to foreign exchange fluctuations.



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



|                                             |  |                      |        |                         |   |         |                    |  |   |      
|-------------------------------------------- |  | -------------------- | ------ | ----------------------- | - | ------- | ------------------ |  | - | -----
|                                             |  | As of March 31, 2004
|                                             |  | GrossCarryingAmount  |        | AccumulatedAmortization |   |         | Net CarryingAmount
|Developed technology                         |  | $                    | 24,410 |                         | $ | (15,000 | )                  |  | $ | 9,410
|Customer contracts                           |  |                      | 1,388  |                         |   | (1,249  | )                  |  |   | 139  
|Trademarks                                   |  |                      | 807    |                         |   | (588    | )                  |  |   | 219  
|Other intangible assets                      |  |                      | 868    |                         |   | (868    | )                  |  |   |     
|                                             |  |                      |        |                         |   |         |                    |  |   |      
|Intangibles related to business acquisitions |  | $                    | 27,473 |                         | $ | (17,705 | )                  |  | $ | 9,768
|                                             |  |                      |        |                         |   |         |                    |  |   |      



|                                             |  |                          |        |                         |   |         |                    |  |   |       
|-------------------------------------------- |  | ------------------------ | ------ | ----------------------- | - | ------- | ------------------ |  | - | ------
|                                             |  | As of September 30, 2003
|                                             |  | GrossCarryingAmount      |        | AccumulatedAmortization |   |         | Net CarryingAmount
|Developed technology                         |  | $                        | 24,247 |                         | $ | (11,841 | )                  |  | $ | 12,406
|Customer contracts                           |  |                          | 1,283  |                         |   | (1,131  | )                  |  |   | 152   
|Trademarks                                   |  |                          | 807    |                         |   | (504    | )                  |  |   | 303   
|Other intangible assets                      |  |                          | 868    |                         |   | (868    | )                  |  |   |      
|                                             |  |                          |        |                         |   |         |                    |  |   |       
|Intangibles related to business acquisitions |  | $                        | 27,205 |                         | $ | (14,344 | )                  |  | $ | 12,861
|                                             |  |                          |        |                         |   |         |                    |  |   |       



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MICROMUSE INC.



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



|                        |  |                             |       |                            |   |       |  |               |       |  |   |      
|----------------------- |  | --------------------------- | ----- | -------------------------- | - | ----- |  | ------------- | ----- |  | - | -----
|                        |  | Three months endedMarch 31, |       | Six months ended March 31,
|                        |  | 2004                        |       | 2003                       |   | 2004  |  | 2003         
|                        |  |                             |       | (As Restated)              |   |       |  | (As Restated)
|Developed technology    |  | $                           | 1,532 |                            | $ | 1,050 |  | $             | 2,988 |  | $ | 2,036
|Customer contracts      |  |                             | 6     |                            |   | 238   |  |               | 13    |  |   | 694  
|Trademarks              |  |                             | 41    |                            |   | 42    |  |               | 82    |  |   | 84   
|Other intangible assets |  |                             |      |                            |   | 75    |  |               |      |  |   | 143  
|                        |  |                             |       |                            |   |       |  |               |       |  |   |      
|Total amortization      |  | $                           | 1,579 |                            | $ | 1,405 |  | $             | 3,083 |  | $ | 2,957
|                        |  |                             |       |                            |   |       |  |               |       |  |   |      



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



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



|           |  |                     |      
|---------- |  | ------------------- | -----
|Year       |  | FutureAmortizations
|2004       |  | $                   | 3,023
|2005       |  |                     | 3,740
|2006       |  |                     | 1,564
|2007       |  |                     | 1,392
|2008       |  |                     | 25   
|Thereafter |  |                     | 24   
|           |  |                     |      
|Total      |  | $                   | 9,768
|           |  |                     |      



Note 2. Restatement of Financial
Statements



The Company has restated its consolidated financial statements
for the fiscal years ended September 30, 2001 and 2002 and for the quarters ended December 31, 2000 through June 30, 2003. All applicable financial information contained in this Form 10-Q gives effect to these restatements. Accordingly, the
financial statements for those fiscal periods described above that have been included in the Companys previous filings with the Securities and Exchange Commission in 2003 or earlier or included in previous announcements in 2003 or earlier
should not be relied upon.



The Companys Form 10-K for the fiscal year
ended September 30, 2003, filed with the SEC on May 17, 2004, contains restated information for all of the above periods to which the restatement applies and other information relating to the restatement, in the Form 10-K Item 6 Selected
Financial Data, Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations  Restatement of Financial Statements, Notes 2 and 11 of the Notes to Consolidated Financial Statements included
in Item 8, and Item 9A, Controls and Procedures.



The net effect of
all of the restatement adjustments is to decrease the Companys net income by $1.2 million for the quarter ended March 31, 2003 and to increase the loss by $0.6 million for the six months ended March 31, 2003. The Companys consolidated
statements of cash flows have been restated to reflect the reclassification of changes in assets and liabilities during the period as discussed above. The Companys Form 10-K for the fiscal year ended September 30, 2003, filed with the SEC on
May 17, 2004, describes the net effect of other adjustments made pursuant to the restatement.



The information contained in these Condensed Consolidated Financial Statements (Unaudited) should be read in conjunction with the relevant information contained in that Form 10-K.



Note 3. Acquisitions



On December 19, 2002, the Company acquired all of the outstanding common stock of Lumos Technologies Inc. (Lumos), a
privately-held developer of sophisticated technology for managing Layer 1 networks. By integrating their capabilities with existing Netcool applications, the Company will be able to deliver comprehensive Layer 1 network visibility, event
correlation, and problem resolution to current and future users of the Netcool suite. Under the terms of the acquisition agreement, the Company paid $2.6 million in cash and assumed $0.9 million in outstanding debt. Approximately $1.0 million of the
cash purchase price was paid at closing, with the remainder payable in connection with certain earnouts in relation to revenue, development and employee retention goals, until the quarter ending December 31, 2003. The Company paid $1.6 million in
earnouts and all earnouts were fully paid by the quarter ended March 31, 2004. The earnout payments primarily increase the amount of goodwill, except for amounts related to employee retention which are expensed. The debt assumed of $0.9 million was
repaid shortly after acquisition. The transaction was accounted for under the purchase method of accounting with Lumos results of operations included from the acquisition date.



A summary of the allocation of the initial purchase price plus the earnouts is as follows (in millions):



|                                    |  |   |      |  
|----------------------------------- |  | - | ---- | -
|Total liabilities, net              |  | $ | (1.3 | )
|Intangible assets:                  |  |   |      |  
|In process research and development |  |   | 0.1  |  
|Developed technology                |  |   | 1.2  |  
|Customer contracts                  |  |   | 0.2  |  
|Goodwill                            |  |   | 2.1  |  
|Other                               |  |   | 0.3  |  
|                                    |  |   |      |  
|Total intangible assets             |  |   | 3.9  |  
|                                    |  |   |      |  
|Total                               |  | $ | 2.6  |  
|                                    |  |   |      |  



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MICROMUSE INC.



At the time of the acquisition, the estimated aggregate fair value of Lumos research and development efforts that had not reached
technological feasibility as of the acquisition date and had no alternative future uses was estimated by the Companys management to be $0.1 million, and was expensed at the acquisition date. Goodwill, which represents the excess of the
purchase price over the fair value of identifiable tangible and intangible assets acquired less liabilities assumed, will be tested annually for impairment or whenever events or circumstances occur indicating the goodwill might be impaired.
Identifiable intangible assets will be amortized on a straight line basis over a period ranging from six months to two years.



The following summary, unaudited and prepared on a pro forma basis, combines the Companys consolidated results of operations with Lumos results of operations,
as if the combination had occurred at the beginning of the periods presented. The table includes the impact of certain adjustments including the elimination of the charge for acquired in process research and development, and the additional
amortization relating to intangible assets acquired (in thousands, except per share amounts):



|                                      |  |                                 |        |                                |   |        |  
|------------------------------------- |  | ------------------------------- | ------ | ------------------------------ | - | ------ | -
|                                      |  | Three monthsended March 31,2003 |        | Six monthsended March 31, 2003 |  
|                                      |  | (As Restated)                   |        | (As Restated)                  |  
|Revenues                              |  | $                               | 32,116 |                                | $ | 60,371 |  
|Net income (loss)                     |  | $                               | 14     |                                | $ | (7,399 | )
|Net income (loss) per share:          |  |                                 |        |                                |   |        |  
|Basic                                 |  | $                               | 0.00   |                                | $ | (0.10  | )
|Diluted                               |  | $                               | 0.00   |                                | $ | (0.10  | )
|Shares used in per share computation: |  |                                 |        |                                |   |        |  
|Basic                                 |  |                                 | 75,744 |                                |   | 75,490 |  
|Diluted                               |  |                                 | 75,744 |                                |   | 75,490 |  



Note 4. Restructuring Costs



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



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



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



Severance and employment-related charges consist primarily of severance, health benefits, other termination costs and legal expenses as a
result of the termination of employees. Severance and employment related charges could be higher than the Company has estimated should there be additional arbitration and legal proceedings. The total severance accrual balance of $0.7 million as of
March 31, 2004 is expected to be paid by September 30, 2004.



Facility costs
primarily represent closure and downsizing costs related to offices in Europe and North America that were vacated as part of the fiscal 2002 restructuring program. Closure and downsizing costs include payments required under lease contracts, after
the properties were abandoned, less any applicable estimated sublease income during the period after abandonment. To determine the lease loss portion of the closure and downsizing costs, certain estimates were made related to the (1) time period
over which the relevant building would remain vacant, (2) sublease terms, and (3) sublease rates, including common area charges. The lease loss accrual is an estimate and will be adjusted in the future upon triggering events (such as changes in
estimates of time to sublease and actual sublease rates). As of March 31, 2004, the remaining $0.8 million accrual of lease termination costs, net of estimated sublease income, is expected to be paid on various dates through December 2005.



The following table sets forth the restructuring activity for the six months
ended March 31, 2003 (in thousands):



|                                                          |  |                               |       |   |                               |   |      |           |  |   |       |   |  |   |       |  
|--------------------------------------------------------- |  | ----------------------------- | ----- | - | ----------------------------- | - | ---- | --------- |  | - | ----- | - |  | - | ----- | -
|                                                          |  | Fiscal 2002Restructuring Plan |       |   | Fiscal 2003Restructuring Plan |   |      |           | 
|                                                          |  | Facility                      |       |   | Severance                     |   |      | Severance |  |   | Total |  
|                                                          |  |                               |       |   |                               |   |      |           |  |   |       |   |  |   |       |  
|Accrual balance at September 30, 2003                     |  | $                             | 1,643 |   |                               | $ | 465  |           |  | $ | 451   |   |  | $ | 2,559 |  
|Restructuring charges                                     |  |                               |      |   |                               |   |     |           |  |   |      |   |  |   |      |  
|Cash paid during the three months ended December 31, 2003 |  |                               | (423  | ) |                               |   | (175 | )         |  |   | (58   | ) |  |   | (656  | )
|Non-cash charges                                          |  |                               | (30   | ) |                               |   |     |           |  |   |      |   |  |   | (30   | )
|                                                          |  |                               |       |   |                               |   |      |           |  |   |       |   |  |   |       |  
|Accrual balance at December 31, 2003                      |  |                               | 1,190 |   |                               |   | 290  |           |  |   | 393   |   |  |   | 1,873 |  
|Restructuring charges                                     |  |                               |      |   |                               |   |     |           |  |   |      |   |  |   |      |  
|Amount utilized:                                          |  |                               |       |   |                               |   |      |           |  |   |       |   |  |   |       |  
|Cash paid during the three months ended March 31, 2004    |  |                               | (337  | ) |                               |   |     |           |  |   | (8    | ) |  |   | (345  | )
|Non-cash charges                                          |  |                               | (30   | ) |                               |   |     |           |  |   | 17    |   |  |   | (13   | )
|                                                          |  |                               |       |   |                               |   |      |           |  |   |       |   |  |   |       |  
|Accrual balance at March 31, 2004                         |  | $                             | 823   |   |                               | $ | 290  |           |  | $ | 402   |   |  | $ | 1,515 |  
|                                                          |  |                               |       |   |                               |   |      |           |  |   |       |   |  |   |       |  



Note 5. Litigation



Refer to the Companys Form 10-K for the fiscal year ended September 30, 2003, filed
with the SEC on May 17, 2004 for information related to its commitments and contingencies, which includes reference to several recent litigation matters filed against the Company.





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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 May 17, 2004.



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



Restatement of Financial Statements



The Company has restated its consolidated financial statements for the fiscal years ended September 30, 2001 and 2002 and for the quarters ended December 31, 2000 through
June 30, 2003. All applicable financial information contained in this Form 10-Q gives effect to these restatements. Accordingly, the financial statements for those fiscal periods described above that have been included in the Companys previous
filings with the Securities and Exchange Commission in 2003 or earlier or included in previous announcements in 2003 or earlier should not be relied upon.



The Companys Form 10-K for the fiscal year ended September 30, 2003, filed with the SEC on May 17, 2004, contains restated information for all of the above periods
to which the restatement applies and other information relating to the restatement, in the Form 10-K Item 6 Selected Financial Data, Item 7 Managements Discussion and Analysis of Financial Condition and Results of Operations
 Restatement of Financial Statements, Notes 2 and 11 of the Notes to Consolidated Financial Statements included in Item 8, and Item 9A, Controls and Procedures.



The information contained in this Form 10-Q should be read in conjunction with the relevant information contained in that Form 10-K.



In September 2003, the Audit Committee of our Board of Directors, with
assistance from independent legal counsel and subsequently, independent forensic accountants, undertook an internal investigation regarding questions raised internally, primarily concerning the accounting for accrued expenses, expense recognition
and certain journal entries. The Audit Committee initially determined on December 28, 2003, that it was likely the Company would have to restate its financial statements for the periods described above based upon the status of the investigation at
that date. On December 29, 2003, the Company informed Nasdaq and the SEC that the Company would not timely file its Form 10-K for fiscal year 2003. On December 30, 2003, we filed a Notification of Late Filing on Form 12b-25 with the SEC disclosing
that this Form 10-K would be delayed pending completion of that internal investigation and issued a press release stating the same. The Companys December 30, 2003 press release also announced that the Company expected that this inquiry would
lead to a restatement of historical financial statements including adjustments to previously filed and published financial results, resulting in a positive impact to earnings in certain periods and a negative impact in others. Also on December 30,
2003, Lloyd Carney and Michael Luetkemeyer hosted a conference call to inform the public of the accounting inquiry and explain the delay in filing the Companys Form 10-K. The Company furnished a copy of the transcript of that call as an
exhibit to a Form 8-K filed on December 31, 2003.



On January 29, 2004, the
Audit Committee met with its independent legal counsel at which time the investigations findings and conclusions were presented. The Audit Committee approved those findings and conclusions that certain accruals for certain expenses were
overstated in certain periods, understated in other periods and that adjustments were required in certain other areas. The Audit Committee has discussed with the Companys independent accountants, KPMG LLP, the Committees findings and
conclusions and the adjustments described below.



The Company has adopted and
implemented a number of remedial measures that were recommended or identified in the course of the investigation. These measures are summarized in Part I, Item 4, Controls and Procedures.



The net effect of all of the restatement adjustments is to decrease the Companys net
income by $1.2 million for the quarter ended March 31, 2003 and to increase the loss by $0.6 million for the six months ended March 31, 2003. The Companys consolidated statements of cash flows have been restated to reflect the reclassification
of changes in assets and liabilities during the period as discussed above. The Companys Form 10-K for the fiscal year ended September 30, 2003, filed with the SEC on May 17, 2004, describes the net effect of other adjustments made pursuant to
the restatement.



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MICROMUSE INC.



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. The Company was founded in 1989 and subsequently developed our Netcool/OMNIbus software, which we began shipping in January 1995. All of our revenues continue to be derived from licenses for our Netcool family of
products and related maintenance, training and consulting services. We currently expect that Netcool-related revenues will continue to account for all or substantially all of our revenues for the foreseeable future. As a result, our future operating
results are dependent upon continued market acceptance of our Netcool products and enhancements thereto.



In the first two quarters of fiscal 2004, the Company incurred an unanticipated increase in General and Administrative Expenses. This increase consisted initially of professional fees associated with the retention of
independent legal counsel and forensic accountants separate from our independent auditors to assist the investigation undertaken by the Audit Committee of the Companys Board of Directors in connection with the restatement of financial
statements described above under Restatement of Financial Statements in this section and in Note 2 of the Notes to Condensed Consolidated Financial Statements (Unaudited) in this report. This increase also includes unanticipated
professional fees to our independent auditors in connection with the delayed completion of the audit of our financial statements included in our Form 10-K for fiscal year 2003, and the fees payable to an accounting firm (separate from the forensic
accountants and independent auditors) that we retained to assume day-to-day responsibility for the restatement process in January 2004 and preparation of the Form 10-K and Forms 10-Q for the first two fiscal quarters of fiscal 2004. The Company
estimates that accounting and legal fees associated with this investigation and related matters, including additional costs incident to the completion of the audit of the financial statements included in the Form 10-K, will be in the range of
approximately $4.0 to $5.0 million.



We also expect expenses for professional
fees to increase during fiscal 2004 and perhaps beyond, as compared to prior periods, due to pending litigation. We currently estimate that professional service fees associated with pending litigation will be in the range of $4.0 to $5.0 million
during fiscal 2004. Actual fees incurred may be higher or lower depending on many factors beyond our control. See Part II, Item 1  Legal Proceedings for additional information on current legal proceedings.



Recent Events



On January 12, 2004, the Company announced the appointment of Arun Oberoi as Executive Vice President, Global Sales and Technical Services.



Critical Accounting Policies and Estimates



Our discussion and analysis of our financial condition and results of operations are based
upon our condensed consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these consolidated financial statements requires us to make estimates
and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosure of contingent assets and liabilities. On an on-going basis, we evaluate our estimates, including, but not limited to, revenue
recognition, bad debts, warranty obligations, investments, intangible assets, income taxes, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe to be reasonable under the
circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions
or conditions.



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



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



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



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



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



| |  | Fixed or determinable fee: 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 creditworthiness of the customer.
Collection is deemed probable if the Company expects that the customer will be able to pay amounts under the 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.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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



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



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



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



Allocations of Technical Services Department Costs. The costs of our technical services department are allocated between cost of revenue, sales and marketing expenses, and research and development expenses
based upon an estimate of the time spent by the technical services employees in various departments and the areas benefited by that time. Total costs of the technical services department were $6.5 million and $12.7 million for the quarter and
the six month period ended March 31, 2004, respectively, and $5.5 million and $11.7 million for the quarter and the six month period ended March 31, 2003, respectively. The allocation rates applied to these department costs were 21% to cost of
revenue, 74% to sales and marketing, and 5% to research and development in the quarter ended March 31, 2004; 21% to cost of revenue, 75% to sales and marketing, and 4% to research and development in the six month period ended March 31, 2004; 20% to
cost of revenue, 75% to sales and marketing, and 5% to research and development in the quarter ended March 31, 2003; and 22% to cost of revenue, 73% to sales and marketing, and 5% to research and development in the six month period ended March 31,
2003. The allocation estimate is subject to change and, if changed, will impact the allocation of expenses in the statement of operations but will not impact net income or loss.



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



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



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



Restructuring-related
Assessments. Our critical accounting policy and judgment as it relates to restructuring-related assessments in accordance with Emerging Issues Task Force (EITF) No. 94-3 Liability Recognition for Certain Employee Benefits and Other Costs to
Exit an Activity (including certain costs incurred in a restructuring) and SFAS No. 146 Accounting for Costs Associated with Exit or Disposal Activitiesincludes our estimate of the loss related to facility costs and severance-related
costs. To determine the facility costs, which is the loss after our cost recovery efforts from subleasing a building, certain estimates were made related to the (1) time period over which the relevant building would remain vacant, (2) sublease
terms, and (3) sublease rates, including common area charges. This lease loss is an estimate and will be adjusted in the future upon triggering events (such as changes in estimates of time to sublease and actual sublease rates). In the quarter ended
September 30, 2002, the fiscal 2002 restructuring plan resulted in the elimination of excess facilities. In the quarter ended June 30, 2003, as a result of a potential tenant terminating negotiations with us, an additional restructuring charge of
$1.7 million was incurred on property leases relating to the fiscal 2002 restructuring plan. The fiscal 2003 restructuring plan, which was announced during the quarter ended December 31, 2002, resulted in a decrease of the Companys workforce
by 117 employees and total restructuring charges of $3.1 million, relating to severance and employment related charges.



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



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



Accrued Commission Policy. The Company accounts for commission accruals and related
expenses to reflect a liability in the period the obligation arose for the actual amounts to be paid, with the related expense being recorded in the period in which the related revenue was recognized. The Company calculates the total commission
liability for all valid purchase orders or approved written contracts received in the period and adjusts the accrued liability for purchase orders or approved written contracts not recognized as revenue in the period because they did not meet one or
more of the revenue recognition requirements of SOP 97-2.



Non-GAAP
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 non-GAAP financial information in the related earnings release and investor conference call. This
non-GAAP financial information excludes certain non-cash and special charges, consisting primarily of the amortization and impairment of goodwill and other intangible assets, write-off of in-process research and development, restructuring costs,
costs of the internal inquiry and restatement, certain stock-based compensation, executive recruiting costs, and related income tax effects. We believe the disclosure of the non-GAAP financial information helps investors more meaningfully evaluate
the results of our ongoing operations. However, we urge investors to carefully review the GAAP financial information included as part of our Quarterly Reports on Form 10-Q, our Annual Reports on Form 10-K, and our quarterly earnings releases.



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MICROMUSE INC.



Results of Operations



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



|                                          |  |                             |   |  |                           |    |  |       |   |  |               |   
|----------------------------------------- |  | --------------------------- | - |  | ------------------------- | -- |  | ----- | - |  | ------------- | --
|                                          |  | Three months endedMarch 31, |   |  | Six months endedMarch 31, |   
|                                          |  | 2004                        |   |  | 2003                      |    |  | 2004  |   |  | 2003          |   
|                                          |  |                             |   |  | (As Restated)             |    |  |       |   |  | (As Restated) |   
|As a Percentage of Total Revenues:        |  |                             |   |  |                           |    |  |       |   |  |               |   
|Revenues:                                 |  |                             |   |  |                           |    |  |       |   |  |               |   
|License                                   |  | 53.0                        | % |  | 57.7                      | %  |  | 53.8  | % |  | 54.0          | % 
|Maintenance and services                  |  | 47.0                        | % |  | 42.3                      | %  |  | 46.2  | % |  | 46.0          | % 
|                                          |  |                             |   |  |                           |    |  |       |   |  |               |   
|Total revenues                            |  | 100.0                       | % |  | 100.0                     | %  |  | 100.0 | % |  | 100.0         | % 
|                                          |  |                             |   |  |                           |    |  |       |   |  |               |   
|Cost of revenues:                         |  |                             |   |  |                           |    |  |       |   |  |               |   
|License                                   |  | 4.0                         | % |  | 4.1                       | %  |  | 3.8   | % |  | 3.5           | % 
|Maintenance and services                  |  | 7.2                         | % |  | 7.5                       | %  |  | 7.0   | % |  | 9.3           | % 
|Amortization of developed technology      |  | 4.0                         | % |  | 3.3                       | %  |  | 4.0   | % |  | 3.4           | % 
|                                          |  |                             |   |  |                           |    |  |       |   |  |               |   
|Total cost of revenues                    |  | 15.2                        | % |  | 14.9                      | %  |  | 14.8  | % |  | 16.2          | % 
|                                          |  |                             |   |  |                           |    |  |       |   |  |               |   
|Gross profit                              |  | 84.8                        | % |  | 85.1                      | %  |  | 85.2  | % |  | 83.8          | % 
|                                          |  |                             |   |  |                           |    |  |       |   |  |               |   
|Operating expenses:                       |  |                             |   |  |                           |    |  |       |   |  |               |   
|Sales and marketing                       |  | 41.3                        | % |  | 51.2                      | %  |  | 41.7  | % |  | 52.8          | % 
|Research and development                  |  | 21.5                        | % |  | 21.9                      | %  |  | 21.2  | % |  | 24.0          | % 
|General and administrative                |  | 20.6                        | % |  | 13.8                      | %  |  | 20.1  | % |  | 14.6          | % 
|Stock based compensation                  |  | 1.1                         | % |  | 0.0                       | %  |  | 0.8   | % |  | 0.0           | % 
|Amortization of other intangible assets   |  | 0.1                         | % |  | 1.1                       | %  |  | 0.1   | % |  | 1.5           | % 
|Restructuring costs                       |  | 0.0                         | % |  | 0.0                       | %  |  | 0.0   | % |  | 5.3           | % 
|                                          |  |                             |   |  |                           |    |  |       |   |  |               |   
|Total operating expenses                  |  | 84.6                        | % |  | 88.0                      | %  |  | 83.9  | % |  | 98.2          | % 
|                                          |  |                             |   |  |                           |    |  |       |   |  |               |   
|Income (loss) from operations             |  | 0.2                         | % |  | (2.9                      | )% |  | 1.3   | % |  | (14.4         | )%
|Other income, net                         |  | 1.9                         | % |  | 3.9                       | %  |  | 2.3   | % |  | 4.5           | % 
|                                          |  |                             |   |  |                           |    |  |       |   |  |               |   
|Income (loss) before income taxes         |  | 2.1                         | % |  | 1.0                       | %  |  | 3.6   | % |  | (9.9          | )%
|Income tax provision                      |  | 0.6                         | % |  | 1.7                       | %  |  | 1.0   | % |  | 1.7           | % 
|                                          |  |                             |   |  |                           |    |  |       |   |  |               |   
|Net income (loss)                         |  | 1.5                         | % |  | (0.7                      | )% |  | 2.6   | % |  | (11.6         | )%
|                                          |  |                             |   |  |                           |    |  |       |   |  |               |   
|As a Percentage of Related Revenues:      |  |                             |   |  |                           |    |  |       |   |  |               |   
|Cost of license revenues                  |  | 7.6                         | % |  | 7.0                       | %  |  | 7.1   | % |  | 6.5           | % 
|Cost of maintenance and services revenues |  | 15.3                        | % |  | 17.9                      | %  |  | 15.2  | % |  | 20.2          | % 





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MICROMUSE INC.



Revenues.



Revenues increased to $38.3 million and $75.5 million in the quarter and six months ended March 31, 2004, from $32.1 million and $59.5 million in the comparable periods
of the prior year. License revenues increased to $20.3 million and $40.6 million in the quarter and six months ended March 31, 2004, from $18.5 million and $32.2 million in the comparable periods of the prior year. The increase in license revenues
was primarily due to the decreasing impact of the economic slowdown. Maintenance and services revenues increased to $18.0 million and $34.9 million in the quarter and six months ended March 31, 2004, from $13.6 million and $27.4 million in the
comparable periods of the prior year. The increase in maintenance and services revenues was a result of the related increase in license revenue and the increase in the Companys overall customer base. License revenues as a percentage of total
revenues was 53.0% and 53.8% in the quarter and six months ended March 31, 2004, as compared to 57.7% and 54.0% in the comparable periods of the prior year.



Cost of Revenues.



The cost of license revenues consists primarily of technology license fees paid to third-party software vendors and production costs. Cost of license revenues as a
percentage of license revenues was 7.6% and 7.1% in the quarter and six months ended March 31, 2004, as compared to 7.0% and 6.5% in the comparable periods of the prior year. The change is mainly due to a change in the mix of license revenue in the
current quarter and six months ended March 31, 2004 that led to an increase in sales of licenses with related technology license fees. The cost of maintenance and services revenues consists primarily of personnel-related costs incurred in providing
maintenance, consulting and training to customers. Cost of maintenance and services revenues as a percentage of maintenance and services revenues was 15.3% and 15.2% in the quarter and six months ended March 31, 2004, as compared to 17.9% and 20.2%
in the comparable periods of the prior year. This improvement was principally due to a proportionally greater percentage of higher-margin maintenance revenues over services revenue in addition to economies of scale, and the decrease in headcount,
facilities, and travel costs related to the Companys previously announced restructuring.



Cost of the amortization of developed technology relates to the amortization of developed technology acquired in the acquisitions of CAN, NetOps Corporation, RiverSoft plc, Lumos Technologies Inc. and NHI over two to
six years. The increase in the quarter and six months ended March 31, 2004 as compared to the same periods of the prior year is due to the amortization of the core technology in connection with the acquisition of NHI in the quarter ended September
30, 2003.



Sales and Marketing Expenses.



Sales and marketing expenses decreased to $15.8 million and $31.5 million in the quarter and
six months ended March 31, 2004, from $16.4 million and $31.4 million in the comparable periods of the prior year. This decrease was primarily due to a decrease in sales commission expense as a result of a high commission earned on one revenue deal
in the quarter ended March 31, 2003. Sales and marketing expenses as a percentage of total revenues decreased to 41.3% and 41.7% in the quarter and six months ended March 31, 2004, as compared to 51.2% and 52.8% in the comparable periods of the
prior year. We anticipate that our sales and marketing expenses in the coming year will increase in absolute dollars but will vary as a percentage of revenues.



Research and Development Expenses.



Research and development expenses increased to $8.2 million and $16.0 million in the quarter and six months ended March 31, 2004, from $7.0 million and $14.3 million in
the comparable periods of the prior year. The increase was primarily due to the increase in headcount as a result of the acquisition of NHI in the quarter ended September 30, 2003. Research and development costs as a percentage of total revenues
increased to 21.5% and 21.2% in the quarter and six months ended March 31, 2004, as compared to 21.9% and 24.0% the comparable periods of the prior year. We anticipate that our research and development expenses in the coming year will increase in
absolute dollars but will vary as a percentage of revenues.



General and
Administrative Expenses.



General and administrative expenses increased to
$7.9 million and $15.1 million in the quarter and six months ended March 31, 2004, from $4.4 million and $8.7 million in the comparable periods of the prior year. The increase in general and administrative expenses is due to increased professional
fees incurred by the Company in connection with various litigation actions, as detailed in Part II, Item 1 of this filing. In addition, the Company has incurred professional fees of $1.5 million and $3.5 million in the quarter and six months ended
March 31, 2004 associated with the retention of independent legal counsel and forensic accountants separate from our independent auditors to assist the investigation undertaken by the Audit Committee of the Companys Board of Directors in
connection with the restatement of financial statements described above under Restatement of Financial Statements. General and administrative expenses as a percentage of revenues increased to 20.6% and 20.1% in the quarter and six months
ended March 31, 2004, from 13.8% and 14.6% in the comparable periods of the prior year. Additional information relating to expense trends in fiscal 2004 is set forth under Overview above.



Stock based Compensation.



The company incurred stock based compensation charges of $0.4 million and $0.6 million in
the quarter and six months ended March 31, 2004. These charges relate to modifications of awards of terminated employees who were not able to exercise their vested options due to the Company being unable to issue securities as a result of the
Companys late filings with the SEC.



Amortization of Goodwill and
Other Intangible Assets.



Amortization of goodwill and other intangible
assets decreased to $47 thousand and $0.1million in the quarter and six months ended March 31, 2004, from $0.4 million and $0.9 million in the comparable periods of the prior year. The charges reflect the amortization of intangible assets over
estimated useful lives of six months to six years. The decrease was mainly due to the certain intangibles been no longer amortized as they have been fully amortized in prior periods.



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MICROMUSE INC.



Restructuring Costs.



During the six months ended March 31, 2003, we incurred $3.1 million in restructuring costs. (See Restructuring-related Assessment under Critical Accounting
Policies and also Note 4 of Notes to Condensed Consolidated Financial Statements.)



Other Income, Net.



Other income decreased to $0.7 million and
$1.7 million in the quarter and six months ended March 31, 2004, from $1.3 million and $2.7 million in the comparable periods of the prior year. This net decrease was due to the decline in interest rates over the past year and foreign exchange
losses of $0.1 million for the quarter and gains of $0.1 million for the six months ended March 31, 2004.



Provision for Income Taxes.



Income
taxes decreased to $0.2 million and $0.8 million in the quarter and six months ended March 31, 2004, from $0.6 million and $1.0 million in the comparable periods of the prior year. The decrease was mainly due to the related decline in taxable income
and a decline in projected taxes in fiscal year 2004 from fiscal year 2003.



Liquidity and Capital Resources.



As of March 31, 2004, we had
$119.6 million in cash and cash equivalents and $75.6 million in marketable securities, as compared to $89.4 million in cash and cash equivalents and $100.7 million in marketable securities as of September 30, 2003. The net increase in cash and cash
equivalents in the six months ended March 31, 2004, was due primarily to net income adjusted for non-cash expenses, the increase in accrued expenses, the increase in deferred revenue, the proceeds from the issuance of common stock, and the sales of
investments. These sources of cash and cash equivalents were partially offset by capital expenditures, the increase in accounts receivable, the increase in prepaid expenses and other current assets, the decrease in accounts payable, and the purchase
of investments.



As of March 31, 2004, 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.



Off-Balance Sheet Arrangements



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



Contractual Obligations



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



Working Capital



Our working capital was $80.5 million at March 31, 2004 as compared to $68.4 million at September 30, 2003, an increase of $12.1 million or 17.7%. The increase in working
capital was primarily the result of the $13.1 million increase in cash and short-term investments, the $3.7 million increase in net accounts receivable, the $4.1 million increase in deferred revenue and the $3.1 million increase in accounts payable
and accrued expenses.



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MICROMUSE INC.



RISK FACTORS



The following factors, in addition to the other information contained in this report, should be considered carefully in evaluating the Company and our prospects. This
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 economic uncertainties.



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



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



On December 30, 2003, we announced that
we would not be able to file our Annual Report on Form 10-K on a timely basis, that we had initiated an internal inquiry regarding the accounting for certain items, and that we expected that this inquiry would lead to a restatement of historical
financial statements. The adjustments to previously filed financial results affect our financial statements for the fiscal years ended September 30, 2002 and 2001 and our quarterly financial statements for the quarters ended December 31, 2000
through June 30, 2003. On December 29, 2003, we notified the Securities and Exchange Commission of the internal inquiry and decision to restate previously published financial results. The SEC is conducting an informal inquiry of the events
surrounding the restatement, and the Company is cooperating fully.



On December
30, 2003, we also received a letter from the Nasdaq Staff indicating that, because of our previously announced failure to timely file our Annual Report on Form 10-K for the fiscal year ended September 30, 2003, we were not in compliance with the
filing requirements for continued listing on Nasdaq as set forth in Nasdaq Marketplace Rule 4310(c)(14). As a result, our securities were subject to delisting from the Nasdaq National Market, and the trading symbol for our common stock was changed
from MUSE to MUSEE at the opening of business on January 2, 2004. We made a timely request for a hearing before a Nasdaq Listings Qualifications Panel to address the filing delinquency. On April 14, 2004, we received a letter
from the Nasdaq Staff stating that subject to certain conditions, the Nasdaq Stock Market granted our request for an extension until May 17, 2004 to fulfill the listing requirements under Nasdaq rules.



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



On February 10, 2004, we announced that the filing of our Form 10-Q for the first quarter of fiscal year 2004 ended December 31, 2003 would also be delayed pending
completion of our internal accounting inquiry and the restatement of our historical financial statements. We also announced that the Company and certain of our former and current officers and directors have been named in several lawsuits arising
from the restatement announcement. These cases are still in their early stages and we intend to defend against them vigorously. See Part II, Item 1 Legal Proceedings for a description of this pending litigation.



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



Over the past few years, we have added customers, personnel
and expanded the scope and geographic area of our operations that has placed and will continue to place a significant strain upon our management and our operating and financial systems and resources. However, we have reduced our headcount from 573
employees on September 30, 2003 to 555 employees on March 31, 2004, mainly as a result of planned reductions and attrition. Given the uncertainties discussed in this Risk Factors section, together with factors that might affect our ability to
quickly expand or contract our work force around the world, it is difficult to predict future requirements for the number and type of employees in the fields and geographies in which we operate. Failure to align employee skills and populations with
revenue and market requirements would have a material adverse impact on our business and its operating results.



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



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



We may fail to support our operations.



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



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



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



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



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



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



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



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



We need to continue to develop relationships with leading network equipment and
telecommunications providers and to expand our third-party channels of distribution through OEMs, resellers and systems integrators. We currently invest significant resources to develop these relationships and channels of distribution, which could
reduce our ability to generate profits. Third-party distributors accounted for approximately 52%, 48% and 48% of our total revenues in the six months ended March 31, 2004, fiscal 2003, and 2002, respectively. Our business will be harmed if we are
not able to retain and attract additional distributors that market our products effectively. Further, many of our agreements with third-party distributors are nonexclusive, and many of the companies with which we have agreements also have similar
agreements with our competitors or potential competitors. Our third-party distributors have significantly greater sales and marketing resources than we do, and their sales and marketing efforts may conflict with our direct sales efforts. In
addition, although sales through third-party distributors result in reduced sales and marketing expense with respect to such sales, we sell our products to third-party distributors at reduced prices, resulting in lower gross margins on such
third-party sales. We believe that our success in penetrating markets for our fault and service level management applications depends substantially on our ability to maintain our current distribution relationships, in particular, those with Cisco
Systems, IBM, Ericsson, Unisphere (Siemens) and Sun Microsystems. Our business will be harmed if network equipment and telecommunications providers and distributors discontinue their relationships with us, compete directly with us or form additional
competing arrangements with our competitors.



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



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



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



Telecommunications
carriers, including Internet service providers, that deliver advanced communications services to their customers accounted for approximately 62%, 60% and 74% of our total revenues in the six months ended March 31, 2004, fiscal 2003, and 2002,
respectively. In addition, these providers are an important focus of our sales strategy. If these customers cease to deploy advanced communications services for any reason, the market for our products will be harmed. Also, delays in the introduction
of advanced services or the failure of such services to gain widespread market acceptance or the decision of telecommunications carriers and other service providers not to use our products in the deployment of these services would harm our business.



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



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



During fiscal 2003,
Gregory Q. Brown voluntarily resigned as Chairman and Chief Executive Officer effective December 31, 2002, to accept an executive position at another company. On July 28, 2003, Lloyd A. Carney was appointed Chairman of the Board of Directors and
Chief Executive Officer of the Company. Between December 31, 2002, and July 28, 2003, director David Schwab, served as Chairman, and Michael L. Luetkemeyer, our Chief Financial Officer, served as interim Chief Executive Officer. Effective September
30, 2003, Michael S. Donohue resigned his officer position as Senior Vice President, Sales and Business Operations.



Subsequent to fiscal year 2003, the Company appointed Arun Oberoi as Executive Vice President, Global Sales and Technical Services.



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



We have relied on stock options and Employee Stock Purchase Plan participation as a significant element of our compensation philosophy, and any requirement to expense options could negatively affect this.



If we are required to account for options under our employee stock
plans as a compensation expense, it would significantly reduce our net income and earnings per share. Although we are not currently required to record any compensation expense in connection with option grants to employees that have an exercise price
at or above fair market value, it is possible that accounting standards and/or future laws or regulations will require us to treat all employee stock options as a compensation expense. We have acquired other businesses and we may make additional
acquisitions in the future, which will complicate our management tasks and could result in substantial expenditures.



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



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



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



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



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



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



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



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



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



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



All of our revenues have been derived from licenses for our Netcool
family of products and related maintenance, training and consulting services. We currently expect that Netcool/OMNIbus-related revenues will continue to account for a substantial percentage of our revenues beyond fiscal 2003 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 Credit Risk in Note 1 of the Notes to Consolidated Financial Statements. We expect to derive a significant portion of our revenues from a limited number of customers in the
future. If a significant customer, or group of customers, cancels or delays orders for our products, or does not continue to purchase our products at or above historical levels, our business will be harmed. For example, pre-existing customers may be
part of, or become part of, large organizations that standardize using a competitive product. The terms of our agreements with our customers typically contain a one-time license fee and a prepayment of one year of maintenance fees. The maintenance
agreement is renewable annually at the option of the customer and there are no minimum payment obligations or obligations to license additional software. Therefore, we generally do not have long-term customer contracts upon which we can rely for
future revenues.



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



We
license our products in foreign countries. In addition, we maintain a significant portion of our operations, including the bulk of our software development operations, in the United Kingdom. Fluctuations in the value of these currencies relative to
the United States dollar have adversely impacted our results in the past and may do so in the future. See Note 8 Geographic and Segment Information in Notes to Consolidated Financial Statements for information concerning revenues outside
the United States. We expect that international license, maintenance and consulting revenues will continue to account for a significant portion of our total revenues in the future. We pay the expenses of our international operations in local
currencies and do not currently engage in hedging transactions with respect to such obligations.



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



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



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



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



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



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



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



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



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



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



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



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



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



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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.



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



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 plus software operating platforms
employed by our customers. Our products are designed to operate on a variety of hardware and software platforms employed by our customers in their networks. We must continually modify and enhance our products to keep pace with changes in hardware
and software platforms and database technology. As a result, uncertainties related to the timing and nature of new product announcements, introductions or modifications by systems vendors, particularly Sun Microsystems, Inc., International Business
Machines Corporation, Hewlett-Packard Company, Cabletron Systems, Inc. and Cisco Systems, Inc. and by vendors of relational database software, particularly Oracle Corporation and Sybase, Inc., could harm our business.



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



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



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



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



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



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



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



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



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



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



| | adoption of new accounting standards affecting the software industry;
|- | ---------------------------------------------------------------------



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



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



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



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



Due to rapidly changing market conditions, our goodwill and other
long-lived assets may become impaired such that their carrying amounts may not be recoverable, and we may be required to record an impairment charge impacting our financial position. As of March 31, 2004, we had approximately $60.7 million of
goodwill and other intangible assets, which relate to the acquisitions of CAN, NetOps, RiverSoft, Lumos and NHI. The Company regularly performs reviews to determine if the carrying value of assets is impaired. As part of our impairment assessment,
we examine economic conditions, products, customer base and geography. Based on these criteria, we determine which products we will continue to support and sell and, thereby, determine which assets will continue to have future strategic value and
benefit. No such impairment has been indicated to date. Asset impairment charges of this nature could be large and could have a material adverse effect on our financial condition and reported results of operations. In the quarter ended September 30,
2003, the Company performed its goodwill impairment test required under SFAS No. 142 and concluded that no goodwill was impaired.



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



As of March 31, 2004, we had approximately 78.7 million shares of common stock outstanding, excluding approximately 18.8 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.



Changes in effective tax rates could affect our results.



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



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



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



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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, 2004, no hedging contracts were outstanding.



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



Fixed Income Investments



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



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



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Item 4. Controls and Procedures



Based on their
evaluation as of the end of the period covered by this Quarterly Report on Form 10-Q, subject to and except for the discussion below and elsewhere in this Form 10-Q concerning the restatement of our financial statements, our companys Chief
Executive Officer and Chief Financial Officer have concluded that the Companys disclosure controls and procedures, as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the Exchange Act), are effective to ensure
that information required to be disclosed by our company in the reports that it files or submits under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commissions
rules and forms.



In connection with the evaluation described above, we
identified no change in our internal control over financial reporting that occurred during our fiscal quarter ended March 31, 2004, and that has materially affected, or is reasonably likely to materially affect, our internal control over financial
reporting, except for the following: recruitment of additional personnel in our finance department and enhancement of procedures implemented during the previous quarter as reported in Part I, Item 4 of our Form 10-Q for the fiscal quarter ended
December 31, 2003. These and other changes relating to internal control over financial reporting are summarized further below.



We have described the restatement of our financial statements contained in this Form 10-Q in Part I, Item 2, Managements Discussion and Analysis of Financial
Condition and Results of Operations  Restatement of Financial Statements, and in Note 2 of the Notes to the Condensed Consolidated Financial Statements included in Part I, Item 1. Remedial measures relating to our accounting controls and
procedures that were recommended or identified in the course of the restatement process are summarized below.



In connection with its audit for the years ended September 30, 2001 through 2003, KPMG LLP issued a letter May 10, 2004 to the Audit Committee of our Board of Directors that identified three material weaknesses in our
internal controls over financial reporting. The identified weaknesses were deficiencies in internal controls related to the recording of accrued liabilities, deficiencies in internal controls related to the documentation of support for journal
entries and ineffective review of financial information, although the letter noted that the Company regularly conducted thorough and timely review and analysis of revenue arrangements. We believe all of these have been addressed or are being
addressed in the measures summarized below.



In connection with the evaluation
described above, and in connection with the restatement of our financial statements as described under the Restatement of Financial Statements in Part I, Item 2, the Company has adopted and implemented numerous measures in connection with its
ongoing process improvement, compliance and governance activities, some of which have been enhanced further or implemented in connection with the restatement process. Included among these changes are the following:



| |  | The Company implemented a Code of Business Conduct that includes a section entitled Financial Code of Ethics for Employees with Financial Reporting Obligations. This
section contains specific ethical and related standards applicable to those with responsibilities for financial reporting and disclosure to investors and is applicable to our Chief Executive Officer, Chief Financial Officer, and other members of our
finance team.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | We have recruited personnel in our finance department with expertise in financial controls and reporting, including hiring a Vice President of Global Finance and Corporate
Controller and an Americas Controller. We have also approved the staffing of an internal audit function.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | We have re-emphasized to finance employees their responsibility for appropriate journal entries that are properly documented, in particular relating to non-system generated journal
entries.
| | - | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | We have revised procedures to enhance documentation procedures and to improve the segregation of duties in connection with account reconciliations, manual journal entries, and the
preparation and review of documentation to support quarterly reported financial statements.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Regional controllers are expected to review and sign off on the reconciliation of all accrual accounts balances quarterly.
| | - | --------------------------------------------------------------------------------------------------------------------------



| |  | We have implemented an enhanced quarterly closing process including a formal closing meeting each quarter chaired by the Chief Financial Officer and including other appropriate
finance staff.
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | We have identified the following additional enhancements that we intend to implement during the remainder of fiscal 2004: annual technical training for finance employees, improved
systems processes intended to reduce manual journal entries, and implementation of a global purchase order system.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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MICROMUSE INC.



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



|Item | 1. Legal Proceedings.
|---- | ---------------------



On December 9, 2002, Aprisma Management Technologies, Inc. filed a complaint against Micromuse Inc. in the U.S. District Court for the District of New Hampshire. The complaint alleges that Micromuses network and
systems management products, including our Netcool products, infringe six patents held by Aprisma. The complaint seeks preliminary and permanent injunctive relief as well as unspecified compensatory and enhanced damages, attorneys fees,
interest, costs and expenses. The complaint was served on Micromuses counsel on February 20, 2003. Micromuse filed its answer to the complaint on April 11, 2003, in which Micromuse alleged affirmative defenses of patent invalidity and
non-infringement of the patents by Micromuses products, as well as other equitable defenses. The answer also contains Micromuses counterclaims against Aprisma regarding patent invalidity, non-infringement and patent unenforceability on
the grounds that Aprisma failed to disclose material prior art to the Patent Office. Micromuse will continue to vigorously defend its position and pursue the counterclaims against Aprisma.



On November 10, 2003, Agilent Technologies, Inc. (Agilent) filed a complaint
against the Company in the United States District Court for the Eastern District of Virginia. The complaint alleges that the Company infringes two patents, one of which is held by Agilent and the other of which is jointly owned by Agilent and
Hewlett-Packard Company (HP). The complaint seeks injunctive relief, as well as unspecified compensatory and enhanced damages, attorneys fees, interest, costs and expenses. In response, the Company moved to: (i) dismiss the case or
require Agilent to file a more definite statement of its claims; (ii) join HP as a necessary party; and (iii) transfer the case to the Southern District of New York, or in the alternative, to the Northern District of California. In a ruling dated
April 15, 2004, the court granted Micromuses motion to transfer and ordered that the lawsuit be moved to the United States District Court for the Southern District of New York, where the remaining motions described in (i) and (ii) above are
expected to be decided. Based upon current knowledge, the Company maintains that it has not infringed and does not infringe the patents in suit, and the Company intends to vigorously defend against the action.



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



Between February 2, 2004 and March 16, 2004, the Company was also named as a nominal defendant along with certain of its current and former
officers and directors in three derivative actions, purportedly brought by shareholders on the Companys behalf, filed in the Superior Court of California, County of San Francisco. On April 21, those actions were consolidated and the law firm
of Robbins, Umeda & Fink was named as Lead Plaintiffs Counsel in those actions. On March 3, 2004, the Company was also named as a nominal defendant along with certain of its current and former officers and directors in another derivative
action, purportedly brought by shareholders on the Companys behalf, filed in the District Court for the Northern District of California. The derivative complaints allege that, as a result of the events underlying the restatement, certain of
the Companys current and former officers and directors breached their fiduciary duties to the Company, and that certain current and former officers and directors engaged in insider trading in violation of California law. The plaintiffs seek
unspecified damages on the Companys behalf from the defendants. The Company has not yet responded to the complaints.



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



The Company is also subject to other pending or threatened litigation from time to time in addition to the matters specifically listed above, including other cases now pending. The Company has recorded certain
liabilities it does not believe to be material related to some of the pending litigation (other than the patent and securities litigation specifically listed above) based on claims for which management believes a loss is probable and for which
management can reasonably estimate the amount and range of loss.



The
litigation matters specifically listed above and other pending or future litigation are inherently unpredictable, could be costly and divert our managements attention away from our business, and could have a material adverse effect on our
business, financial results or condition, or cash flow. See also Risk Factors in Part II, Item 7, Our efforts to protect our intellectual property may not be adequate, and third-parties have in the recent past claimed and may claim in the
future that we are infringing their proprietary rights and We restated our annual and quarterly financial statements for 2001, 2002, and the first three quarters of 2003, we did not file our Annual Report on Form 10-K for fiscal year
2003 on a timely basis, and we did not file our Quarterly Report on Form 10-Q for the first quarter of 2004 on a timely basis. Litigation and regulatory proceedings regarding the restatement of our Consolidated Financial Statements could seriously
harm our business.



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



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Item 2. Changes in Securities, Use of Proceeds and Issuer Purchases of Equity Securities



Not applicable.



Item 3. Defaults upon Senior Securities.



Not
applicable.



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



Not applicable.



Item 5. Other Information.



Not applicable.



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



(a)
Exhibits



|              |  |                                                                                                                                                                                                                                                                    
|------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | Description                                                                                                                                                                                                                                                        
|              | 
|3.1           |  | Restated Certificate of Incorporation of the Registrant (incorporated by reference from exhibit 3.1 in our Form 10-K filed with the SEC on December 21, 2001).                                                                                                     
|              | 
|3.2           |  | Amended and Restated Bylaws of the Registrant (incorporated by reference from exhibit 3.2 in our amended registration statement on Form S-1, No. 333-58975, as filed with the SEC on July 13,
1998).                                                               
|              | 
|10.14         |  | Employment Agreement as of January 12, 2004, by and between Arun Oberoi and Micromuse Inc. (incorporated by reference from exhibit 10.14 in our Form 10-K for fiscal year 2003 as filed with
the SEC on May 17, 2004).                                             
|              | 
|10.15         |  | Notice of Stock Option Grant and Stock Option Agreement dated as of February 9, 2004, by and between Lloyd A. Carney and Micromuse Inc. (incorporated by reference from exhibit 10.15 in our
Form 10-K for fiscal year 2003 as filed with the SEC on May 17, 2004).
|              | 
|31            |  | Certifications of Principal Executive Officer and Chief Financial Officer of Registrant required by Section 302 of the Sarbanes-Oxley Act of 2002.                                                                                                                 
|              | 
|32            |  | Certification of Principal Executive and Financial Officer of Registrant required by Section 906 of the Sarbanes-Oxley Act of 2002.                                                                                                                                



(b) Reports on Form 8-K



A current report on Form 8-K was furnished to the Securities and Exchange Commission by
Micromuse Inc. on January 5, 2004 to report information under Item 12 relating to the Companys delayed filing of its Form 10-K and request for a Nasdaq hearing.



A current report on Form 8-K was filed with the Securities and Exchange Commission by Micromuse Inc. on January 12, 2004, to report
information under Item 5 announcing the appointment of Arun Oberoi as Executive Vice President of Global Sales and Technical Services.



A current report on Form 8-K was furnished to the Securities and Exchange Commission by Micromuse Inc. on February 10, 2004, to report information under Item 12
concerning our results of operations and financial condition for our fiscal quarter ended December 31, 2003, and related information



A current report on Form 8-K was furnished to the Securities and Exchange Commission by Micromuse Inc. on March 23, 2004 to report information under Item 12 concerning
notice from Nasdaq relating to the delayed filing of the Companys Form 10-Q for the quarter ended December 31, 2003.



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MICROMUSE INC.



SIGNATURES



Pursuant to the requirements of the
Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned, thereunto duly authorized, on May 17, 2004.



MICROMUSE INC.(Registrant)By:

/s/ LLOYD A. CARNEYLloyd A. Carney 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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