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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



FORM 10-Q



(Mark one)



x    Quarterly report pursuant to Section 13 or 15(d) of the

Securities
Exchange Act of 1934



For the quarterly period ended
September 30, 2003



OR



 ̈Transition report pursuant to Section 13 or 15(d) of the

Securities Exchange Act of 1934



Commission File Number: 0-27696



GENSYM
CORPORATION

(Exact name of registrant as specified in its charter)



|Delaware                                                       |  | 04-2932756                          
|-------------------------------------------------------------- |  | ------------------------------------
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)



52 Second Avenue

Burlington, MA 01803

(Address of principal executive offices)



Telephone Number (781) 265-7100

(Registrants telephone number, including area code)



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 checkmark whether the registrant is an accelerated filer (as defined in Rule 12-b-2 of the Exchange Act)



Yes ̈No x



As of November 11, 2003 there were 7,035,598 shares of the Registrants Common Stock outstanding.



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PART I.    FINANCIAL INFORMATION



ITEM 1.    Consolidated Financial Statements



GENSYM CORPORATION

CONSOLIDATED BALANCE SHEETS

(Unaudited)

(in thousands, except share amounts)



|                                                                                          |  | September 30,2003 |         |   | December 31,2002 |  
|----------------------------------------------------------------------------------------- |  | ----------------- | ------- | - | ---------------- | -
|ASSETS                                                                                    |  |                   |         |   |                  |  
|                                                                                          |  |                  
|Current Assets:                                                                           |  |                   |         |   |                  |  
|Cash and cash equivalents                                                                 |  | $                 | 1,973   |   |                  | $
|Accounts receivable, net                                                                  |  |                   | 2,914   |   |                  |  
|Prepaid and other current assets                                                          |  |                   | 1,049   |   |                  |  
|                                                                                          |  |                   |         |   |                  |  
|Total current assets                                                                      |  |                   | 5,936   |   |                  |  
|Property and equipment, net                                                               |  |                   | 1,027   |   |                  |  
|Intangible assets                                                                         |  |                   | 208     |   |                  |  
|Deposits and other assets                                                                 |  |                   | 489     |   |                  |  
|                                                                                          |  |                   |         |   |                  |  
|Total Assets                                                                              |  | $                 | 7,660   |   |                  | $
|                                                                                          |  |                   |         |   |                  |  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                      |  |                   |         |   |                  |  
|                                                                                          |  |                  
|Current Liabilities:                                                                      |  |                   |         |   |                  |  
|Current portion of capital lease obligation                                               |  |                   | 104     |   |                  |  
|Accounts payable                                                                          |  |                   | 357     |   |                  |  
|Accrued expenses                                                                          |  |                   | 2,303   |   |                  |  
|Restructuring                                                                             |  |                   | 211     |   |                  |  
|Deferred revenue                                                                          |  |                   | 4,314   |   |                  |  
|                                                                                          |  |                   |         |   |                  |  
|Total current liabilities                                                                 |  |                   | 7,289   |   |                  |  
|Long-term deferred revenue                                                                |  |                   | 200     |   |                  |  
|Other long-term liabilities                                                               |  |                   | 51      |   |                  |  
|                                                                                          |  |                   |         |   |                  |  
|Total liabilities                                                                         |  |                   | 7,540   |   |                  |  
|                                                                                          |  |                   |         |   |                  |  
|Stockholders Equity                                                                      |  |                   |         |   |                  |  
|Preferred stock, $.01 par value                                                          |  |                   |         |   |                  |  
|Authorized2,000,000 shares; issued and outstandingnone                                  |  |                   |        |   |                  |  
|Common stock, $.01 par value                                                             |  |                   |         |   |                  |  
|Authorized20,000,000 shares; issued7,422,029 shares in 2003and 7,315,949 shares in 2002 |  |                   |         |   |                  |  
|Outstanding7,019,167 shares in 2003 and 6,850,606 in 2002                                |  |                   | 74      |   |                  |  
|Capital in excess of par value                                                            |  |                   | 21,842  |   |                  |  
|Treasury stock402,862 shares in 2003 and 465,343 shares in                               |  |                   |         |   |                  |  
|2002, at cost                                                                             |  |                   | (1,521  | ) |                  |  
|Accumulated deficit                                                                       |  |                   | (20,419 | ) |                  |  
|Cumulative translation adjustment                                                         |  |                   | 144     |   |                  |  
|                                                                                          |  |                   |         |   |                  |  
|Total stockholders equity                                                                |  |                   | 120     |   |                  |  
|                                                                                          |  |                   |         |   |                  |  
|Total liabilities and stockholders equity                                                |  | $                 | 7,660   |   |                  | $
|                                                                                          |  |                   |         |   |                  |  



The accompanying notes
are an integral part of these unaudited consolidated financial statements.



2



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GENSYM CORPORATION

CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(in thousands, except per share amounts)



|                                                |  | Three months endedSeptember 30, |       |   | Nine months ended September 30, |  
|----------------------------------------------- |  | ------------------------------- | ----- | - | ------------------------------- | -
|Revenues                                        |  | 2003                            |       |   | 2002                            |  
|Product                                         |  | $                               | 1,267 |   |                                 | $
|Services                                        |  |                                 | 2,603 |   |                                 |  
|                                                |  |                                 |       |   |                                 |  
|Total revenues                                  |  |                                 | 3,870 |   |                                 |  
|                                                |  |                                 |       |   |                                 |  
|Cost of revenues                                |  |                                 |       |   |                                 |  
|Product                                         |  |                                 | 248   |   |                                 |  
|Services                                        |  |                                 | 884   |   |                                 |  
|                                                |  |                                 |       |   |                                 |  
|Total cost of revenues                          |  |                                 | 1,132 |   |                                 |  
|                                                |  |                                 |       |   |                                 |  
|Gross profit                                    |  |                                 | 2,738 |   |                                 |  
|Operating expenses                              |  |                                 |       |   |                                 |  
|Sales and marketing                             |  |                                 | 1,200 |   |                                 |  
|Research and development                        |  |                                 | 869   |   |                                 |  
|General and administrative                      |  |                                 | 1,214 |   |                                 |  
|Restructuring charge                            |  |                                 |      |   |                                 |  
|                                                |  |                                 |       |   |                                 |  
|Total operating expenses                        |  |                                 | 3,283 |   |                                 |  
|                                                |  |                                 |       |   |                                 |  
|Operating income (loss)                         |  |                                 | (545  | ) |                                 |  
|Other income (expense), net                     |  |                                 | 220   |   |                                 |  
|                                                |  |                                 |       |   |                                 |  
|Income (loss) before provision for income taxes |  |                                 | (325  | ) |                                 |  
|Provision for income taxes                      |  |                                 | 16    |   |                                 |  
|                                                |  |                                 |       |   |                                 |  
|Net income (loss)                               |  | $                               | (341  | ) |                                 | $
|                                                |  |                                 |       |   |                                 |  
|Net income (loss) per share:                    |  |                                 |       |   |                                 |  
|Basic                                           |  | $                               | (0.05 | ) |                                 | $
|Diluted                                         |  | $                               | (0.05 | ) |                                 | $
|Weighted average shares used to compute         |  |                                 |       |   |                                 |  
|Net Income (loss) per share:                    |  |                                 |       |   |                                 |  
|Basic                                           |  |                                 | 7,012 |   |                                 |  
|Diluted                                         |  |                                 | 7,012 |   |                                 |  



The accompanying notes
are an integral part of these unaudited consolidated financial statements.



3



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GENSYM CORPORATION

CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)



(in thousands)

|                                                                                                   |  | Nine months endedSeptember 30, |       
|-------------------------------------------------------------------------------------------------- |  | ------------------------------ | ------
|                                                                                                   |  | 2003                           |       
|CASH FLOWS FROM OPERATING ACTIVITIES:                                                              |  |                                |       
|Net (loss) income                                                                                  |  | $                              | (2,165
|Adjustments to reconcile net (loss) income to net cash provided by (used in) operating activities: |  |                                |       
|Depreciation and amortization                                                                      |  |                                | 548   
|Loss on disposal of equipment                                                                      |  |                                | 30    
|Non-cash impact of foreign currency translation adjustment                                         |  |                                |      
|Non-cash compensation                                                                              |  |                                | 45    
|Provision for bad debt                                                                             |  |                                | 9     
|Changes in assets and liabilities:                                                                 |  |                                |       
|Accounts receivable                                                                                |  |                                | 1,004 
|Other assets                                                                                       |  |                                | (150  
|Accounts payable                                                                                   |  |                                | 68    
|Accrued expenses                                                                                   |  |                                | (262  
|Restructuring                                                                                      |  |                                | 211   
|Deferred revenue                                                                                   |  |                                | (872  
|                                                                                                   |  |                                |       
|Net cash (used in) provided by operating activities                                                |  |                                | (1,534
|                                                                                                   |  |                                |       
|CASH FLOWS FROM INVESTING ACTIVITIES:                                                              |  |                                |       
|Purchases of property and equipment                                                                |  |                                | (309  
|Purchase of intangible assets                                                                      |  |                                | (250  
|                                                                                                   |  |                                |       
|Net cash used in investing activities                                                              |  |                                | (559  
|                                                                                                   |  |                                |       
|CASH FLOWS FROM FINANCING ACTIVITIES:                                                              |  |                                |       
|Borrowings under capital lease arrangements                                                        |  |                                | 102   
|Payments on capital lease obligations                                                              |  |                                | (113  
|Proceeds from exercise of stock options and issuance of common stock under stock plans             |  |                                | 50    
|                                                                                                   |  |                                |       
|Net cash provided by financing activities                                                          |  |                                | 39    
|                                                                                                   |  |                                |       
|EFFECT OF EXCHANGE RATE CHANGES ON CASH                                                            |  |                                | 143   
|                                                                                                   |  |                                |       
|NET (DECREASE) INCREASE IN CASH AND CASH EQUIVALENTS                                               |  |                                | (1,911
|CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD                                                     |  |                                | 3,884 
|                                                                                                   |  |                                |       
|CASH AND CASH EQUIVALENTS, END OF PERIOD                                                           |  | $                              | 1,973 
|                                                                                                   |  |                                |       



The accompanying notes
are an integral part of these unaudited consolidated financial statements.



4



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GENSYM CORPORATION

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)



1. Operations



We are a provider of operations management and expert systems software products and services. Our products emulate the
reasoning of human experts using process knowledge and often real-time data and then, on the basis of such reasoning, make recommendations or take direct operational actions. Many applications of our products are in the areas of abnormal condition
management in manufacturing environments, supply chain and logistics management, and network management. Benefits derived from the use of our products include waste reduction, avoidance of off-specification product, avoidance of system down time in
mission-critical networks, and proactive alarms that signify potential process problems and avoid plant shutdowns. Our products have been used in the chemical, oil, gas, manufacturing, transportation, communications, aerospace and government sectors
for many years.



2. Basis of Presentation



The unaudited consolidated financial statements included herein have been
prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (the SEC) for interim financial reporting. Certain information and footnote disclosures, normally included in financial statements
prepared for the full year in accordance with accounting principles generally accepted in the United States of America, have been condensed or omitted pursuant to such SEC rules and regulations; nevertheless, the management of the Company believes
that the disclosures herein are adequate to make the information presented not misleading. In the opinion of management, the consolidated financial statements reflect all adjustments (of a normal and recurring nature) that are necessary to present
fairly the consolidated financial position of the Company as of September 30, 2003 and the results of its operations for the three- and nine- month periods ended September 30, 2003 and 2002. These consolidated financial statements and notes thereto
should be read in conjunction with the consolidated financial statements and notes thereto included in our Annual Report on Form 10-K for the year ended December 31, 2002, filed with the SEC on March 31, 2003. The results of operations for interim
periods are not necessarily indicative of the results of operations for the full year or any other interim period. Certain prior period amounts have been reclassified to conform to the current period presentation.



We achieved operating and overall profitability as well as positive cash
flows for the year ended December 31, 2002. Previously, we had incurred operating losses for both years ended December 31, 2001 and 2000. We have incurred an operating loss in the nine months ended September 30, 2003 as a result of declining
revenues, primarily in the chemical, oil and gas markets, which are a significant component of our business and have been adversely affected by the situation in the Middle East. In addition, generally poor economic conditions in Europe have resulted
in a decline in new orders from many old as well as new customers. We achieved profitability in 2002 based on expense control, cost reductions completed in 2001, and maintaining revenues from existing sales of licenses. License sales have declined,
which has contributed to our net losses in the first, second, and third quarters of 2003. In June, 2003, we announced restructuring and workforce reduction actions as steps toward aligning expenses with anticipated revenues. We will continue to
pursue new license sales to generate additional product revenue in 2003 and will continue to evaluate the results of our June 2003 cost reduction efforts. We expect our operating expenses to decline at least through the end of 2003 as a result of
the restructuring initiated in June 2003. We also expect that our cash flows from operations will be favorably impacted in the next two quarters due to traditionally higher levels of maintenance renewals in these periods. Based on these factors, we
believe that our current cash and cash equivalent balances and cash flows from operations will be sufficient to meet our operating, investing and financing activities through at least the next 12 months.



3. Comprehensive Income (Loss )



The components of comprehensive income (loss) for the three- and nine-month
periods ended September 30, 2003 and 2002 are as follows (in thousands):



|                                        |  | Three months ended |      | Nine months ended
|--------------------------------------- |  | ------------------ | ---- | -----------------
|                                        |  | September 30,      |      | September 30,    
|                                        |  | 2003               |      |                  
|Net income (loss)                       |  | $                  | (341 | )                
|Other comprehensive income (loss):      |  |                    |      |                  
|Foreign currency translation adjustment |  |                    | 47   |                  
|                                        |  |                    |      |                  
|Comprehensive income (loss)             |  | $                  | (294 | )                
|                                        |  |                    |      |                  



5



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4. Net Income (Loss) Per Share



The following is a reconciliation of basic and diluted weighted average shares used in the computation of net income (loss)
per share (in thousands):



|                                             |  | Three months ended |  | Nine months ended
|-------------------------------------------- |  | ------------------ |  | -----------------
|                                             |  | September 30,      |  | September 30,    
|                                             |  | 2003               |  | 2002             
|Weighted average common shares outstanding   |  | 7,012              |  | 6,756            
|Additional dilutive common stock equivalents |  |                   |  | 353              
|                                             |  |                    |  |                  
|Diluted weighted average shares              |  | 7,012              |  | 7,109            
|                                             |  |                    |  |                  



Options to purchase
492,000 shares of common stock with an exercise price between $0.79 and $10.00 per share were outstanding in the third quarter of 2002, and options to purchase 512,000 shares of common stock with an exercise price between $0.78 and $10.00 per share
were outstanding in the nine-month period ended September 30, 2002, but were excluded from the computation of diluted earnings per share because such options were anti-dilutive in the respective periods. All options to purchase a total of 1,401,619
shares of common stock were outstanding at September 30, 2003, but were excluded from the computation of diluted earnings per share for each of the three- and nine- month periods ended because such options were anti-dilutive as we had net losses in
those periods.



5. Stock Based Compensation



We follow the disclosure requirements of Statement of Financial Accounting
Standards No. 123, Accounting for Stock-Based Compensation and SFAS No. 148, Accounting for Stock-Based Compensation  Transition and Disclosure  an amendment of SFAS Statement No. 123. We continue to recognize
compensation costs using the intrinsic value based method described in Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees.



Net income (loss) and net income (loss) per share as reported in these consolidated financial statements on a pro forma
basis, as if the fair value based method described in SFAS No. 123 had been adopted, are as follows:



|                                              |  | Three months endedSeptember 30, |       | Nine months endedSeptember 30,
|--------------------------------------------- |  | ------------------------------- | ----- | ------------------------------
|(in thousands except per share data)          |  | 2003                            |       |                               
|Net income (loss) as reported                 |  | $                               | (341  | )                             
|Stock based compensation expense              |  |                                 | 13    |                               
|                                              |  |                                 |       |                               
|Pro forma net income (loss)                   |  | $                               | (354  | )                             
|                                              |  |                                 |       |                               
|Basic earnings (loss) per share as reported   |  | $                               | (0.05 | )                             
|Diluted earnings (loss) per share as reported |  | $                               | (0.05 | )                             
|                                              |  |                                 |       |                               
|Pro forma basic (loss) earnings per share     |  | $                               | (0.05 | )                             
|Pro forma diluted (loss) earnings per share   |  | $                               | (0.05 | )                             



6. Intangible assets



On March 12, 2003, we acquired certain intellectual
property from Key Control, Inc. This intellectual property comprises intelligent objects for embedding in process management applications. In connection with the acquisition, we agreed to pay $250,000 under deferred payment terms. All payments had
been made by September 30, 2003.



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7. Segment Reporting



Revenue is presented geographically based on the country to where the product is shipped or where the services are provided. The following table presents
revenues by geographic area:



|               |  | Three monthsended September 30, |   |  | Nine monthsended September 30, |  
|-------------- |  | ------------------------------- | - |  | ------------------------------ | -
|               |  | 2003                            |   |  | 2002                           |  
|United States  |  | 48                              | % |  | 39                             | %
|United Kingdom |  | 7                               | % |  | 13                             | %
|Rest of Europe |  | 26                              | % |  | 26                             | %
|Rest of World  |  | 19                              | % |  | 22                             | %
|               |  |                                 |   |  |                                |  
|               |  | 100                             | % |  | 100                            | %
|               |  |                                 |   |  |                                |  



The following table
presents the Companys long-lived assets, net of depreciation and amortization, as of September 30, 2003 and December 31, 2002 (in thousands):



|              |  | September 30, |       | December 31,
|------------- |  | ------------- | ----- | ------------
|              |  | 2003          |       | 2002        
|United States |  | $             | 1,033 |             
|Europe        |  |               | 202   |             
|              |  |               |       |             
|              |  | $             | 1,235 |             
|              |  |               |       |             



8. Guarantor Arrangements



In November 2002, the FASB issued FASB Interpretation
(FIN) No. 45, Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others. FIN No. 45 clarifies that a guarantor is required to recognize, at the inception of a
guarantee, a liability for the fair value of the obligation undertaken in issuing the guarantee. The initial recognition and initial measurement provisions of FIN No. 45 are applicable on a prospective basis to guarantees issued or modified after
December 31, 2002, while the disclosure requirements are applicable in 2002. We have adopted FIN No. 45, and the adoption of FIN No. 45 did not have a material impact on our financial position or results of operations



The following is a summary of our agreements that the Company has determined
are within the scope of FIN No. 45:



As permitted under
Delaware law, we have agreements whereby we indemnify our officers and directors for certain events or occurrences while the officer or director is, or was serving, at our request in such capacity. The term of the indemnification period is for the
officers or directors lifetime. The maximum potential amount of future payments we could be required to make under these indemnification agreements is unlimited; however, we have a Director and Officer insurance policy that limits its
exposure and enables us to recover a portion of any future amounts paid. As a result of our insurance policy coverage, we believe the estimated fair value of these indemnification agreements is minimal. All of these indemnification agreements were
grandfathered under the provisions of FIN No. 45 as they were in effect prior to December 31, 2002. Accordingly, we believe that our liabilities recorded for these agreements as of September 30, 2003 are immaterial.



We enter into standard indemnification agreements in our ordinary course of
business. Pursuant to these agreements, we indemnify, hold harmless, and agree to reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally our business partners or customers, in connection with any U.S.
patent, or any copyright or other intellectual property infringement claim by any third party with respect to our products. The term of these indemnification agreements is generally perpetual any time after execution of the agreement. The maximum
potential amount of future payments we could be required to make under these indemnification agreements is unlimited. We have never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, we
believe the estimated fair value of these agreements is minimal. Accordingly, we believe our liabilities recorded for these agreements as of September 30, 2003 are immaterial.



7



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9. Restructuring Charges





In June 2003, our board of directors approved a workforce reduction plan.
Given the uncertain economic conditions, we decided to take certain actions to reduce our expenses to a level commensurate with current levels of revenue. In accordance with this plan, we recorded a restructuring charge of $250,000 in the second
quarter of 2003. The charge was based on estimates of the cost of the workforce reduction program, including special termination benefits; settlement and involuntary severance benefits related to postretirement benefit plans in Europe and related
legal costs. Approximately $39,000 of this amount was paid through September 30, 2003. We expect to complete the plan by March 31, 2004. Some of the expense reduction impact of the actions has already been realized. We expect that additional savings
will be realized by December 31, 2003.



10. Recent Accounting Pronouncements



In May 2003, the FASB issued Statement of Financial
Accounting Standards No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity SFAS No. 150. This statement affects the classification, measurement, and disclosure requirements of the
following three types of freestanding financial instruments: 1) mandatorily redeemable shares, which the issuing company is obligated to buy back with cash or other assets; 2) instruments that do or may require the issuer to buy back some of its
shares in exchange for cash or other assets, which includes put options and forward purchase contracts; and 3) obligations that can be settled with shares, the monetary value of which is fixed, tied solely or predominantly to a variable such as a
market index, or varies inversely with the value of the issuers shares. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective for interim periods beginning after June 15, 2003.
The adoption of SFAS 150 did not have an impact on the Companys financial statements.



8



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ITEM 2. MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS



Forward-Looking Statements



This quarterly report contains forward-looking statements and information
relating to us and our subsidiaries, which are based on managements beliefs, as well as assumptions made by our management and information currently available to us. These statements are made pursuant to the safe harbor provisions of the
Private Securities Litigation Reform Act of 1995. When used herein, words such as anticipate, believe, estimate, expect, intend and similar expressions, as they relate to our management or
us, identify forward-looking statements. Such statements reflect our current views with respect to future events and are subject to certain risks, uncertainties, and assumptions, including but not limited to those factors set forth below under the
caption Factors Affecting Future Operating Results. Should one or more of these risks or uncertainties materialize, or should underlying assumption prove incorrect, actual results may vary materially from those described in this report
as anticipated, believed, estimated, expected or intended. Investors are cautioned not to place undue reliance on these forward-looking statements, which speak only as of their respective dates. We undertake no obligation to update or revise any
forward-looking statements.



Business Overview



We were incorporated in Delaware in 1986 to develop and sell software
products for expert operations management. Our flagship product has been, and continues to be, G2, which can emulate the reasoning of human experts as they assesses, diagnoses and respond to unusual operating situations or as they seek to optimize
operations. We have also developed a number of market-specific products using G2 as a platform. Since our inception, we have sold over 15,000 licenses to customers in a variety of industries.



Over the years we have developed and improved G2 and its related products on
a regular basis, in terms of performance, functionality and ability to integrate with a wide variety of industry-standard products and protocols. We released our latest major version of G2, version 7.0, in March 2003. Version 7.0 included many
significant enhancements intended to bring G2 into line with current industry standards.



In addition to our continuous efforts to upgrade and enhance all of our products, which provide customers with important reasons to renew their maintenance contracts, we are pursuing a more collaborative approach with
our customers to develop and maintain applications on an ongoing basis. We anticipate that these collaborations will give us increased opportunities for incremental professional services beyond just implementation assistance, which may result in
higher margins and more revenue per customer.



We conduct
business in North and South America, Europe, the Middle East, Africa, and the Asia-Pacific region. For the nine-month periods ended September 30, 2003, approximately 31% of our revenues were generated from license sales, 15% from consulting and
training, and 54% from customer support services. Prices for our products are generally denominated in U.S. dollars, although we do some business in local currencies. Chemical, oil and gas companies are a major market for us. Due to the current
geopolitical situation in the Middle East, we have experienced and may continue to experience a near-term reduction in the amount of business that we are able to conduct with these companies. We are affected both by the slowdown in spending by these
companies and by the logistical difficulties of negotiating business and implementing solutions.



Detailed industry knowledge and expertise are critical elements for the success of our product implementations. Therefore, we frequently work closely with
partners who are able to provide such expertise and are familiar with those markets and applications. Our partners may be value-added resellers, original equipment manufacturers, or systems integrators. These partner relationships are key to us and
have accounted for approximately half of our year-to-date product revenues in 2003.



On March 12, 2003, we acquired certain intellectual property from Key Control, Inc. This intellectual property comprises intelligent objects for process management applications. The use of intelligent objects is
expected to significantly shorten development time and avoid implementation risk for certain applications.



9



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Critical Accounting Policies



The discussion and analysis of our financial condition and results of operations are based upon our consolidated financial
statements, which have been prepared in accordance with accounting principles generally accepted in the United States of America. The preparation of these 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 those related to bad debts, income taxes, and contingencies. 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.



For a more detailed explanation of the judgments made in these areas, refer to our Annual Report on Form 10-K for the year ended December 31, 2002. Our
critical accounting policies, as detailed in our Form 10-K for the year ended December 31, 2002, have not changed during the nine-month period ended September 30, 2003.



Results of Operations



The following table sets forth, as a percentage of total revenues, consolidated statement of operations data for the periods indicated:



|                                                |  | Three months ended |    |  | Nine months ended |   
|----------------------------------------------- |  | ------------------ | -- |  | ----------------- | --
|                                                |  | September 30,      |    |  | September 30,     |   
|                                                |  | 2003               |    |  | 2002              |   
|REVENUES:                                       |  |                    |    |  |                   |   
|Product                                         |  | 33                 | %  |  | 32                | % 
|Services                                        |  | 67                 | %  |  | 68                | % 
|                                                |  |                    |    |  |                   |   
|Total revenues                                  |  | 100                | %  |  | 100               | % 
|                                                |  |                    |    |  |                   |   
|COST OF REVENUES:                               |  |                    |    |  |                   |   
|Product                                         |  | 6                  | %  |  | 4                 | % 
|Services                                        |  | 23                 | %  |  | 14                | % 
|                                                |  |                    |    |  |                   |   
|Total cost of revenues                          |  | 29                 | %  |  | 18                | % 
|                                                |  |                    |    |  |                   |   
|Gross margin                                    |  | 71                 | %  |  | 82                | % 
|                                                |  |                    |    |  |                   |   
|OPERATING EXPENSES:                             |  |                    |    |  |                   |   
|Sales and marketing                             |  | 31                 | %  |  | 29                | % 
|Research and development                        |  | 22                 | %  |  | 20                | % 
|General and administrative                      |  | 31                 | %  |  | 22                | % 
|Restructuring charge                            |  | 0                  | %  |  | 0                 | % 
|                                                |  |                    |    |  |                   |   
|Total operating expenses                        |  | 84                 | %  |  | 71                | % 
|                                                |  |                    |    |  |                   |   
|Operating (loss) income                         |  | (13                | %) |  | 11                | % 
|OTHER INCOME (EXPENSES), NET                    |  | 6                  | %  |  | (6                | %)
|                                                |  |                    |    |  |                   |   
|Income (loss) before provision for income taxes |  | (7                 | %) |  | 5                 | % 
|PROVISION FOR INCOME TAXES                      |  | 0                  | %  |  | 2                 | % 
|                                                |  |                    |    |  |                   |   
|Net (loss) income                               |  | (7                 | %) |  | 3                 | % 
|                                                |  |                    |    |  |                   |   



10



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Revenues



Three and nine months ended September 30, 2003 and 2002



Revenues



We derive revenue from two sources: product and services. Product revenues include revenues from sales of licenses for use of our software products.
Services revenues consist of fees for support and maintenance (generally provided on an annual contract basis), consulting services, and training courses related to our products.



Total revenues for the three-month period ended September 30, 2003 were $3,870,000, a decrease of $205,000, or 5%, from the
same period in 2002. This reduction was attributable to a decrease of $35,000, or 3%, in license revenue and a decrease of $170,000, or 6% in services revenue. Total revenues for the nine-month period ended September 30, 2003 were $10,678,000, a
decrease of $2,195,000, or 17%, from the same period in 2002. This reduction was attributable to a decrease of $1,181,000, or 27%, in license revenue and a decrease of $1,014,000, or 12%, in services revenue.



Product.    Product revenues for the three-month
period ended September 30, 2003 were $1,267,000, a decrease of $35,000, or 3%, from the same period in 2002. This decrease was attributable to difficult economic conditions in many of the areas in which we compete including the US, Europe, and the
Middle East. The primary reason for our decrease in revenue has been weak demand for our products in the chemicals, oil and gas markets, which are major markets for us that have been severely disrupted by the situation in the Middle East. Product
revenues for the nine-month period ended September 30, 2003 were $3,269,000, a decrease of $1,181,000, or 27%, from the same period in 2002. The reasons for the decrease in product revenues in the nine-month period are the same as those pertaining
to the quarter recently completed.



Services.    Services revenues for the three-month period ended September 30, 2003 were $2,603,000, a decrease of $170,000, or 6%, from the same period in 2002. This decrease was primarily due to a decline in
customer support revenue of $180,000, or 8%. The decline in support and consulting revenues was directly related to the decline in license sales, which negatively affected our ability to sell service agreements. Services revenues for the
nine-month period ended September 30, 2003 were $7,409,000, a decrease of $1,014,000, or 12%, from the same period in 2002. This decrease was due to a decline in consulting and training revenues of $401,000, or 20%, between the two periods, for the
same reasons discussed above. Customer support revenue decreased by $613,000, or 10%, between the nine-month period ended September 30, 2003 and the same period in 2002 due to the decreases in recent product revenues.



Cost of Revenues



Cost of revenues primarily consists of consulting labor, technical support
costs, general office expenses, and the costs of material and labor involved in producing and distributing our software. These costs for the three-month period ended September 30, 2003 were $1,132,000, an increase of $367,000, or 48%, from the same
period in 2002. This increase was primarily due to the use of subcontractors in delivering consulting services, increased royalty fees, and amortization of intangible assets acquired in 2003. Our gross margin percentage decreased to 71% for the
three-month period ended September 30, 2003 from 82% for the same period in 2002 as lower product sales, particularly in Europe and the Middle East, resulted in lower utilization of our consultants. Cost of revenues for the nine-month period ended
September 30, 2003 was $2,855,000, an increase of $197,000, or 7%, from the same period in 2002. The reasons for the increase are the same as those pertaining to the quarter recently completed. Our gross margin percentage fell to 74% for the
nine-month period ended September 30, 2003 from 79% for the same period in 2002 primarily due to the decrease in revenues for the period.



Product.    Product cost of revenues for the three-month period ended September 30, 2003 was $248,000, an increase of $71,000,
or 40%, from the same period in 2002. This increase was primarily attributable to the use of subcontractors and licensing in of certain technologies in the delivery of a contract. Product costs for the nine-month period ended September 30, 2003 were
$579,000, an increase of $53,000, or 10%, from the same period in 2002. The increase in the current nine-month period as compared to the prior nine month period was mainly attributable to the reasons noted above.



Services.    Services cost of revenues for the
three-month period ended September 30, 2003 was $884,000, an increase of $296,000, or 50%, from the same period in 2002. Services costs for the nine-month period ended September 30, 2003 were $2,276,000, a increase of $144,000, or 7%, from the same
period in 2002.





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Operating Expenses



Sales and Marketing.    Sales and marketing expenses consist primarily of costs associated with
personnel involved in the sales and marketing process, sales commissions, sales facilities, travel and lodging, trade shows and seminars, advertising, and promotional materials. These expenses for the three-month periods ended September 30, 2003 and
2002 were relatively flat. Sales and marketing expenses for the nine-month period ended September 30, 2003 were $4,315,000, an increase of $691,000, or 19%, from the same period in 2002. This increase was primarily attributable to an increase in
sales personnel costs and their related travel costs. Sales and marketing expenses for the three-month period ended September 30, 2003 increased to 31% of revenues from 29% for the same period in 2002 as a result of the decrease in both product and
service revenues. Sales and marketing expenses for the nine-month period ended September 30, 2003 increased to 40% of revenues from 28% for the same period in 2002. The increase in sales and marketing expenses as a percentage of revenue for both the
three- and nine-month periods ended September 30, 2003 as compared to the same periods in 2002 partly reflects the addition of new sales resources, who typically take some amount of time to reach full levels of productivity.



Research and Development.    Research and
development expenses consist primarily of costs of personnel, equipment and facilities. These expenses for the three-month period ended September 30, 2003 were $869,000, a increase of $56,000, or 7%, from the same period in 2002. This increase was
primarily attributable to higher personnel costs. Research and development expenses for the nine-month period ended September 30, 2003 were $2,547,000, an increase of $201,000, or 9%, from the same period in 2002. This increase was primarily
attributable to investment in a potential new product line. Research and development expenses for the three-month period ended September 30, 2003 increased to 22% of revenues from 20% for the same period in 2002. For the nine-month period ended
September 30, 2003, research and development expenses as a percent of revenues increased to 24%, from 18% for the same period in 2002.



General and Administrative.    General and administrative expenses consist primarily of personnel costs for finance,
administration, operations and general management, as well as legal and accounting expenses. Expenses for the three-month period ended September 30, 2003 were $1,214,000, an increase of $335,000, or 38%, from the same period in 2002. The increase
was mainly attributable to higher than anticipated professional service costs. General and administrative expenses for the nine-month period ended September 30, 2003 and 2002 were $3,010,000 and $2,675,000 respectively. The increase of $335,000 was
also the result of higher professional services costs.



Restructuring Charges.    In June 2003, our board of directors approved a workforce reduction plan. Given the uncertain economic conditions, we decided to take certain actions to reduce our expenses to a level
that is commensurate with current levels of revenue. As a result implementation of this plan, we recorded a pre-tax restructuring charge of $250,000 in the second quarter of 2003. The charge is based on estimates of the cost of the workforce
reduction program, including special termination benefits, settlement and involuntary severance benefits related to postretirement benefit plans in Europe and related legal costs. Approximately $39,000 of this amount was paid through September 30,
2003. We expect to complete the plan by March 31, 2004. Some of the expense reduction impact of the actions has already been realized. We expect that additional savings will be realized by December 31, 2003.



Other income, net.    Other
income, net consists primarily of interest income and expense, realized gains or losses on foreign exchange transactions, and translation adjustments charged to income. Other income, net for the three-month period ended September 30, 2003 was
$220,000, compared to expense of $243,000 for the same period in 2002. The current level of income is primarily due to foreign exchange rate gains due to the strength of the Euro. Other income, net for the nine-month period ended September 30, 2003
was $329,000, compared to expense of $225,000 for the same period in 2002. The increase is again primarily due to foreign exchange rate gains due to the strength of the Euro.



Income Taxes.    Our provision for income taxes primarily pertains to foreign withholding tax and
income taxes in foreign jurisdictions where our wholly owned subsidiaries have taxable income but do not have operating loss carry forwards. The increase in the tax provision for the 9 months ended September 30, 2003 is due to income in
jurisdictions with higher tax rates compared to 2002. Our effective tax rate is lower than the statutory tax rate because our domestic operations have recorded losses for the nine-months ended September 30, 2003 and we have no federal or state tax
liabilities in the United States.



LIQUIDITY AND CAPITAL RESOURCES



Our September 30, 2003 cash and cash equivalents amounted
to $1,973,000, a decrease of $1,911,000 from $3,884,000 at December 31, 2002. Net cash used in operating activities for the nine-month period ended September 30, 2003 was $(1,534,000). Specifically, we had a net loss of $(2,165,000), net of non-cash
expenses of $632,000 (depreciation and amortization, loss on disposal of equipment, non-cash compensation and provision for bad debt), $1,004,000 in cash received from accounts receivable, $211,000 increase in restructuring and a $68,000 decrease in
accounts payable offset by a decrease of $262,000 in accrued expenses and $872,000 in deferred revenue and an increase in other assets of $150,000.



12



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Cash used in investing activities for the nine-month period ended September 30, 2003 was $559,000, which
consisted of $309,000 in purchases of property and equipment and $250,000 used to purchase an intangible asset.



Cash provided by financing activities for the nine-month period ended September 30, 2003 was $39,000, consisting of $102,000 in additional capital lease
obligations, and $50,000 in proceeds from exercise of stock options and issuance of common stock under stock plans, offset by $113,000 in payments under capital leases.



On March 28, 2001, we entered into an accounts receivable financing agreement with Silicon Valley Bank. The financing
agreement provides us with the ability to borrow up to 80% of our qualified and eligible gross domestic accounts receivable up to a maximum of $2.5 million. Borrowings under this agreement will be at an interest rate of 2% per month of the average
gross daily purchase account balance, plus an administration fee of 1% of gross purchased account receivables. On August 16, 2001, we renegotiated the terms of the financing agreement, and signed an accounts receivable purchase agreement that does
not include restrictive financial covenants. The total available borrowings, interest rate and administrative fee under the renegotiated facility remain unchanged. At September 30, 2003 we had no borrowings outstanding under this facility. Amounts
borrowed under this facility are secured by a pledge of substantially all of our corporate assets. The facility may be terminated by either party at any time. As of September 30, 2003, the amount of eligible borrowings under this facility was
approximately $700,000.



We currently finance our operations,
along with capital expenditures, primarily through cash flows from operations and our current cash. Our lease commitments consist of operating leases primarily for our facilities and computer equipment. We also have capital leases for certain
computer and communications equipment.



Our liquidity is
affected by many factors, some based on the normal operations of our business and others related to the uncertainties of our industry and global economies. We achieved operating and overall profitability as well as positive cash flows for the year
ended December 31, 2002. Previously, we had incurred operating losses for both years ended December 31, 2001 and 2000. We have incurred an operating loss in the nine months ended September 30, 2003 as a result of declining revenues, primarily in the
chemical, oil and gas markets, which are a significant component of our business and have been adversely affected by the situation in the Middle East. In addition, generally poor economic conditions in Europe have resulted in a decline in new orders
from many old as well as new customers. We achieved profitability in 2002 based on expense control, cost reductions completed in 2001, and maintaining revenues from existing sales of licenses. License sales have declined, which has contributed to
our net losses in the first, second and third quarters of 2003. In June, 2003, we announced restructuring and workforce reduction actions as steps towards aligning expenses with anticipated revenues. We will continue to pursue new license sales to
generate additional product revenue in 2003 and will continue to evaluate the results of our June 2003 cost reduction efforts. We expect our operating expenses to decline at least through the end of 2003 as a result of the restructuring initiated in
June 2003. We also expect that our cash flows from operations will be favorably impacted in the next two quarters due to traditionally higher levels of maintenance renewals in these periods. Although our future cash flows will fluctuate based on the
factors set forth below in Factors That May Affect Future Results, we believe that our current cash and cash equivalent balances will be sufficient to meet our operating, investing, and financing activities through at least the next 12
months.



Commitments and Contingencies



Leases



The Company leases its facilities and certain equipment under operating and capital leases. The future minimum annual
payments under these leases at September 30, 2003 are as follows:



|                                              |  | Amounts(In thousands)
|--------------------------------------------- |  | ---------------------
|For the period ended December 31,             |  | OperatingLeases      
|2003                                          |  | $                    
|2004                                          |  |                      
|2005                                          |  |                      
|2006                                          |  |                      
|                                              |  |                      
|Total minimum lease payments                  |  | $                    
|                                              |  |                      
|Less: Amount representing interest            |  |                      
|                                              |  |                      
|Present value of minimum lease payments       |  |                      
|Less: Current portion                         |  |                      
|                                              |  |                      
|Long-term portion of capital lease obligation |  |                      
|                                              |  |                      



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Stock Repurchase Program



In the third quarter of 1998, we began a program to repurchase up to 650,000 shares of our common stock on the open market. As of September 30, 2003,
501,300 shares had been repurchased at a cost of approximately $1,869,000. No shares were purchased in 2003 or 2002. During the nine months ending September 30, 2003 and 2002, respectively, we reissued 62,481 and 18,024 shares of common stock to
non-employee directors and a consultant. As of September 30, 2003, 402,862 shares remained in treasury at a cost of $1,520,860.



Related party transaction



On January 9, 2002 we entered into a three-year Original Equipment Manufacturer agreement with Integration Objects Inc., an offshore Tunisian corporation
involving an employee who continues to work for us. The agreement calls for the payment of royalties, based on a fixed and determinable percentage of the product sales price, in connection with our use of their product. These payments are to be made
within 30-days after payment from the end user is received. During the nine month period ended September 30, 2003, we paid Integration Objects a total of $116,000.



Factors That May Affect Future Results



The following important factors, among others, could cause our actual operating results to differ materially from those indicated or suggested by
forward-looking statements made in this Form 10-Q or presented elsewhere by our management from time to time.



We have a history of operating losses, and we may not return to profitability.



We have incurred operating losses for four of the five years in the period ended December 31, 2002. In August 2001, we
announced a strategic restructuring of our company that included a 40% reduction in workforce, a realignment of our software and services product lines and a renewed focus on our existing customers. With the restructuring, we achieved profitability
for each of the quarters in 2002. However, due to declines in our product and service revenues, which we were not able to offset by additional reductions in expenses, we incurred losses for the first three quarters of 2003. Our ability to return to
profitability will depend on our ability to control our expenses, achieve cost reductions, and achieve additional revenue from new and existing customers. However, there can be no assurance that we will be able to return to profitability in the
future.



Competition in the market for expert operations
management systems is intensifying and may reduce our revenues.



Substantially all of our revenues are derived from the licensing and support of software platforms and products for expert operations management. Although organizations such as Micromuse and Systems Management Arts (SMARTS) have begun to
deploy, or have announced plans to deploy, such systems, our systems are different from the basic monitoring and control systems that are traditionally employed by these organizations. There can be no assurance that these organizations will be able
to introduce expert operations management systems successfully, nor that such systems will gain widespread acceptance. In addition, the timing of the implementation of expert operations management systems by organizations may be affected by economic
factors, government regulations, and other factors. Delays in the introduction of expert operations management systems or the failure of these systems to gain widespread market acceptance would materially and adversely affect our business, results
of operations, or financial condition. In addition, we believe that end-users in our markets are increasingly seeking application-specific products and components as well as complete solutions, rather than general software tools to develop
application-specific functionality and solutions. Meeting this demand has required us to modify our sales approach. We are also increasingly reliant on value-added resellers and systems integrators to satisfy market requirements. The modified sales
approach may also lengthen our average sales cycle. Our failure to respond appropriately to shifts in market demand could have a material adverse effect on our business, results of operations, or financial condition.



We rely heavily on indirect distribution channels and strategic partner
relationships for the sales of our products. If these relationships are disrupted, our revenues may be adversely affected.



We sell our products in part through value-added resellers, systems integrators, original equipment manufacturers and distributors, which are not under
our control. Product sales through these channels represented 47% and 44% of our product revenues in the nine-month periods ending September 30, 2003 and 2002 respectively. We rely heavily on our indirect sales partners for sales of our expert
operations management products to new customers. The loss of major original equipment manufacturers or resellers of our products, a significant decline in their sales, or difficulty on the part of such third-party developers or resellers in
developing successful G2-based applications could have a material adverse effect on our business, results of operations, or financial condition. There can be no assurance that we will be able to attract or retain additional qualified third-party
resellers, or that third-party resellers will be able to effectively sell and implement our products. In addition, we rely



14



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on third-party resellers to provide post-sales service and support to our customers, and any deficiencies in such service
and support could adversely affect our business, results of operations, or financial condition.



We depend heavily on our sales and marketing force.



Our future success in the expert operations management marketplace will depend, in part, upon the productivity of our sales and marketing personnel and
our ability to continue to attract, integrate, train, motivate and retain new sales and marketing personnel. There can be no assurance that our investment in sales and marketing will ultimately prove to be successful. In addition, there can be no
assurance that our sales and marketing personnel will be able to compete successfully against the significantly more extensive and better-funded sales and marketing operations of many of our current and potential competitors. Our inability to manage
our sales and marketing personnel effectively could have a material adverse effect on our business, operating results and financial condition.



Our quarterly operating results may vary, leading to fluctuations in trading prices for our common stock and possible liquidity problems.



We have experienced, and may experience in the future,
significant quarter-to-quarter fluctuations in our operating results. There can be no assurance that revenue growth or profitable operations can be attained on a quarterly basis in the future. Our sales cycle typically ranges from six to twelve
months, and the cost of acquiring our software, building and deploying applications, and training users represents a significant expenditure for customers. Our relatively long sales cycle and high license fees, together with fixed short-term
expenses, can cause significant variations in operating results from quarter to quarter, based on a relatively small variation in the timing of major orders. Factors such as the timing of new product introductions and upgrades and the timing of
significant orders could contribute to this quarterly variability. In addition, we ship software products within a short period after receipt of an order and typically do not have a material backlog of unfilled orders of software products.
Therefore, revenues from software licenses in any quarter are substantially dependent on orders booked in that quarter. Historically, a majority of each quarters revenues from software licenses has come from license contracts that have been
executed in the final weeks of that quarter. The revenues for a quarter may include some large orders. If the timing of any of these orders is delayed, it could result in a substantial reduction in revenues for that quarter. Our expense levels are
based in part on expectations of future revenue levels. A shortfall in expected revenues could therefore result in a disproportionate decrease in our net income and cash flows, which may impact our ability to continue as an independent concern.



Our common stock has been delisted from the Nasdaq National
Market. As a result of the delisting, our stockholders may face an illiquid market for the shares of our stock that they own.



Our common stock was delisted from the Nasdaq National Market on August 20, 2001 because we failed to meet the listing standards required by Nasdaq. The
delisting may negatively impact the liquidity of our common stock, not only in the number of shares that can be bought or sold, but also through delays in the timing of transactions and the reductions in potential security analyst and media
coverage. This may reduce the demand for our common stock and its trading price. The delisting may also impair our ability to raise additional working capital.



Sales of our products are highly dependent on our customers capital expenditure budgets. If an economic downturn causes our customers to
reduce their capital expenditures, our revenues may be further adversely affected.



Because capital expenditures are often viewed as discretionary by organizations, sales of our products for capital budget projects are subject to general economic conditions. Future recessionary conditions in the
industries that use our products may adversely affect our business, results of operations, or financial condition.



We rely heavily on revenues from our G2 and G2-based products. If demand for the G2 product declines, our revenues may be adversely affected.



Substantially all of our license revenues are derived
from G2, a customizable object-oriented development and deployment platform for building expert operations management systems, and from software application products based on G2 and other core technologies. Accordingly, our business and financial
results are substantially dependent upon the continued customer acceptance and deployment of G2 and our other products. The timing of major G2 releases may affect the timing of purchases of our products. We have introduced several G2-based products
for building applications and are developing others. We believe that market acceptance of these products will be important to our future growth. There can be no assurance that such products will achieve market acceptance or that new products will be
successfully developed.



In addition, we rely on many of our
distribution partners to develop G2-based products for specialized markets. Accordingly, our business and financial results are also linked to the continued successful product development by our partners



15



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and market acceptance of such G2-based products. Any decline in the demand for G2 and our other products, whether as a
result of competitive products, price competition, the lack of success of our partners, technological change, the shift in customer demand toward complete solutions, or other factors, could have a material adverse effect on our business, results of
operations, or financial condition.



Our business may be
adversely affected if we fail to develop new products and respond to changes in technology.



The market for our products is characterized by rapid technological change, evolving industry standards, changes in end-user requirements, and frequent
new product introductions and enhancements. Our future success will depend in part upon our ability to enhance our existing products, to introduce new products and features to meet changing customer requirements and emerging industry standards, and
to manage transitions from one product release to the next. We have from time to time experienced delays in introducing new products and product enhancements. There can be no assurance that we will not experience difficulties that could delay or
prevent the successful development, introduction and marketing of these new products and product enhancements. There also can be no assurance that we will successfully complete the development of new or enhanced products, that we will successfully
manage the transition to future versions of G2, or to successor technology, or that our future products will achieve market acceptance. In addition, the introduction of products embodying new technologies and the emergence of new industry standards
could render our existing products and products currently under development obsolete and unmarketable. From time to time, new products, capabilities, or technologies may be announced that have the potential to replace or shorten the life cycle of
our existing product offerings. There can be no assurance that announcements of currently planned or other new product offerings will not cause customers to defer purchasing our existing products.



Our business may suffer if we fail to address the challenges associated
with international operations.



Our international revenues
represented 53% and 55% of our total revenues for the nine-month periods ending September 30, 2003 and 2002, respectively. We categorize our revenues according to product shipment destination, which therefore does not necessarily reflect the
ultimate country of installation. The international portion of our business is subject to a number of inherent risks, including difficulties in building and managing international operations, difficulties in localizing products and translating
documentation into local languages, fluctuations in the value of international currencies including the euro, fluctuating import/export duties and quotas, and unexpected regulatory, economic, or political changes in international markets. There can
be no assurance that these factors will not adversely affect our business, results of operations, or financial condition.



Our business may suffer if we fail to remain competitive with other companies offering similar products and services.



A number of companies offer products that perform certain functions of G2
for specific applications. In all of our markets, there is competition from point solutions, real-time and expert system products, and internally developed software. There are commercially available software development tools that
software application developers or potential customers could use to build software that has functionality similar to our products.



Certain companies, such as Micromuse and Systems Management Arts (SMARTS), sell point solutions that compete with our expert operations
management products with respect to specific applications or uses. Several companies, including Aspen Technologies, Ilog S.A., Pavilion and System Management Arts, offer expert operations management products with limited real-time, expert system, or
fault isolation capabilities, but at lower price points than those provided by us. Many of these products often require extensive programming with languages such as C or C++ for complete implementation. Although we believe that these products offer
a less productive development environment than G2 and that they lack the comprehensive capabilities of G2-based products, certain competitors in this category have greater financial and other resources than we do and might introduce new or improved
products to compete with G2, possibly at lower prices.



Our
software is also integrated into industry-specific solutions by value-added resellers. A number of software companies offer products that compete in specific application areas addressed by these value-added resellers, such as cement kiln control and
refinery scheduling, and they could be successful in supplying alternatives to products based on our software.



Many of our customers have significant investments in their existing solutions and have the resources necessary to enhance existing products and to
develop future products. These customers may develop and incorporate competing technologies into their systems or may outsource responsibility for such systems to others who do not use our products. There is no assurance that we can successfully
persuade development personnel within these customers organizations to use G2-based products that can cost effectively compete with their internally developed products. Thus, there could be a reduction in the need for our products and services
that may limit our future opportunities.



We believe that
continued investment in research and development and sales and marketing will be required to maintain our competitive position. There can be no assurance that competitors will not develop products or provide services that are superior to our
products or services or achieve greater market acceptance. Competitive pressures faced by us could force us to



16



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reduce our prices, which could result in reduced profitability. There can be no assurance that we will be able to compete
successfully against current and future sources of competition or that such competition will not have a material adverse effect on our business, results of operations, or financial condition.



Our software is complex and may contain undetected errors. Such errors
could cause costly delays in product introduction or require costly software design modifications.



Complex software products such as those offered by us may contain unintended errors or failures commonly referred to as bugs. There can be no
assurance that, despite significant testing by us and by current and potential customers, errors will not be found in new products after commencement of commercial shipments. Although we have not experienced material adverse effects resulting from
any such errors or defects to date, there can be no assurance that errors or defects will not be discovered in the future that could cause delays in product introduction and shipments or require design modifications that could adversely affect our
business, results of operations, or financial condition.



Because we rely heavily upon proprietary technology, our business could be adversely affected if we are unable to protect our proprietary technology or if third parties successfully assert infringement claims against us.



Our success is heavily dependent upon our proprietary technology. We rely
upon a combination of trade secret, contract, copyright, patent, and trademark law to protect our proprietary rights in our products and technology. We enter into confidentiality and/or license agreements with our employees, third-party resellers,
and end-users and limit access to and distribution of our software, documentation, and other proprietary information. In addition, we have placed technical inhibitors in our software that prevent such software from running on unauthorized computers.
However, effective patent, copyright, and trade secret protection may not be available in every country in which our products are distributed. There can be no assurance that the steps taken by us to protect our proprietary technology will be
adequate to prevent misappropriation of our technology by third parties, or that third parties will not be able to develop similar technology independently. In addition, there can be no assurance that third parties will not assert infringement
claims in the future or that such claims will not be successful.



On August 2, 2001, we received a letter from a third party alleging that we are infringing one or more of their patents relating to neural networks expert systems and the control of processes. While we believe that these allegations are
without merit, there can be no assurance that the third party will not file formal legal action relating to its claims or, if formal legal action is filed, that our defense against those claims will be successful.



Recent Accounting Pronouncements



In May 2003, the FASB issued Statement of Financial Accounting Standards No.
150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity (SFAS 150). This statement affects the classification, measurement and disclosure requirements of the following three types of
freestanding financial instruments: 1) mandatorily redeemable shares, which the issuing company is obligated to buy back with cash or other assets; 2) instruments that do or may require the issuer to buy back some of its shares in exchange for cash
or other assets, which includes put options and forward purchase contracts; and 3) obligations that can be settled with shares, the monetary value of which is fixed, tied solely or predominantly to a variable such as a market index, or varies
inversely with the value of the issuers shares. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective for interim periods beginning after June 15, 2003. The adoption of
FAS 150 did not have an impact on our financial statements.



17



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ITEM 3. Qualitative and Quantitative Disclosures About Market Risk



Investment Portfolio



We do not use derivative financial instruments in our investment portfolio. If we place our funds in other than demand
deposit accounts we use instruments that meet high credit quality standards, such as money market funds, government securities, and commercial paper. We limit the amount of credit exposure to any one issuer. At September 30, 2003, substantially all
of our funds were in demand deposit accounts.



Impact of Foreign Currency
Rate Changes



Our contracts with customers are generally
denominated in U.S. dollars or Euros and, in general, exchange rate fluctuations have not had a material impact on our consolidated financial position, results of operations or cash flows. We do not use foreign exchange forward contracts to hedge
our foreign currency denominated receivables. There can be no assurance that changes in foreign currency rates, relative to the U.S. dollar, will not materially affect our consolidated results in the future.



ITEM 4. Controls and Procedures.



Our management, with the participation of our chief executive officer and
principal financial officer, evaluated the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of September 30, 2003. In designing and evaluating our disclosure controls and
procedures, our management recognized that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving their objectives and our management necessarily applied its judgment in evaluating
the cost-benefit relationship of possible controls and procedures. Based on this evaluation, our chief executive officer and principal financial officer concluded that, as of September 30, 2003, except as set forth below, our disclosure controls and
procedures were (1) designed to ensure that material information relating to us, including our consolidated subsidiaries, is made known to our chief executive officer and principal financial officer by others within those entities, particularly
during the period in which this report was being prepared and (2) effective, in that they provide reasonable assurance that information required to be disclosed by us in the reports that we file or submit under the Exchange Act is recorded,
processed, summarized and reported within the time periods specified in the SECs rules and forms.



Except as set forth below, no change in our internal control over financial reporting (as defined in Rules 13a-15(f) and 15d-15(f) under the Exchange Act)
occurred during the fiscal quarter ended September 30, 2003 that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.



During, and shortly following, the fiscal quarter ended June 30, 2003, we experienced turnover in our accounting and finance
organization. In particular, our corporate controller left the company and our European controller was on a personal leave of absence beginning in June 2003. Furthermore, our former chief financial officer left the company in early August 2003.



Management has determined that the loss, or temporary absence
of, these personnel has resulted in certain conditions which, when considered collectively, constitute a material weakness in our internal controls. Such conditions include: insufficient resources to perform an appropriate review and supervision of
the preparation of accounting records related to our foreign subsidiaries, insufficient resources to accurately prepare consolidated financial statements from detailed accounting records, and insufficient resources to oversee the preparation of the
consolidated financial statements.



During the fiscal quarter
ended September 30, 2003 and as of the date of this Form 10-Q, we took the following corrective actions to address these issues:



| |  | We engaged David Ramsdell as a consultant, on a part-time basis, to perform the chief financial officer function. Mr. Ramsdell had served us in a similar capacity from late
1998 to early 2000.
| | - | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



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| |  | We began actively conducting a search for a new permanent chief financial officer.
| | - | ----------------------------------------------------------------------------------



| |  | We are seeking to supplement our accounting and financial reporting resources.
| | - | ------------------------------------------------------------------------------



| |  | We reviewed our procedures for oversight of the accounting records of the foreign subsidiaries and for preparation of our consolidation for financial reporting purposes.
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | We have invested in updates and improvements to our Oracle accounting systems.
| | - | ------------------------------------------------------------------------------



Certain of these actions have taken longer than anticipated to implement and, as a result, we will continue with these actions in the fourth quarter to
address the internal control weaknesses referred to above.



We
have performed additional procedures to evaluate the extent to which these internal control deficiencies could have led to material misstatements in our consolidated financial statements. We do not believe that the insufficient resources and
consequent control weaknesses noted above led to any material misstatements in the consolidated financial statements included in this report.



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PART II.    OTHER INFORMATION



Item 5. Submission of Matters to a Vote of Security Holders



(a)    Our 2003 annual meeting of stockholders was held on May 12, 2003.



(b)    At our 2003 annual meeting of stockholders, our stockholders
elected John A. Shane and Thomas E. Swithenbank to serve as directors of the Company until our 2006 annual meeting of stockholders and until their successors are duly elected and qualified. In addition to the directors listed above who were elected
at the 2003 annual meeting of stockholders, the terms of the following directors continued after the 2003 annual meeting: Frank Cianciotta, Robert A. Degan, Barry R. Gorsun and Lowell B. Hawkinson.



(c)    The matters acted upon at the 2003 annual meeting of stockholders,
and the voting tabulation for each such matter, is as follows:



Proposal 1:    To elect two Class I directors to the board of directors for the ensuing three years:



|                      |  | Number of Votes
|--------------------- |  | ---------------
|Nominees              |  | For            
|John A. Shane         |  | 5,223,591      
|Thomas E. Swithenbank |  | 5,223,691      



Each of the above
named individuals was elected as a Class I director.



| | Proposal 2: | To ratify the appointment of PricewaterhouseCoopers LLP as our independent accountants for the fiscal year ending December 31, 2003:
| | ----------- | ------------------------------------------------------------------------------------------------------------------------------------



|Number of Votes
|---------------
|For            
|5,626,527      



The proposal was
approved.



ITEM 6. Exhibits



(a) Exhibits. The following exhibit is filed as part of this Report on Form
10-Q:



Exhibit

Number   Description



| | 31.1 | Certification of Principal Executive Officer pursuant to Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002.
| | ---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 31.2 | Certification of Principal Financial Officer pursuant to Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the Sarbanes-Oxley
Act of 2002.
| | ---- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | 32.1 | Certifications of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
| | ---- | ---------------------------------------------------------------------------------------------------------------------------------------------------



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SIGNATURES



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



GENSYM CORPORATION

(Registrant)



|Dated November 19, 2003 |  |  |  | /s/ MICHAEL A. MORNEAU Michael A. Morneau Corporate Controller (Principal Accounting Officer)
|----------------------- |  |  |  | ---------------------------------------------------------------------------------------------
|                        |  |  |  |                                                                                              
|                        |  |  |  |                                                                                              



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EXHIBIT INDEX



|Exhibit Number |  | Description                                                                                                                                                                                      
|-------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|               | 
|31.1           |  | Certification of Principal Executive Officer pursuant to Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
|               | 
|31.2           |  | Certification of Principal Financial Officer pursuant to Rules 13a-14 and 15d-14 under the Securities Exchange Act of 1934, as adopted pursuant to Section 302 of the
Sarbanes-Oxley Act of 2002.
|               | 
|32.1           |  | Certifications of Chief Executive Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                              



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