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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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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 March 31, 2004



OR



 ̈Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934



Commission File Number: 0-27696



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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 May 12, 2004 there were 7,160,016 shares of the Registrants Common Stock outstanding.



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##### Table of Contents

GENSYM CORPORATION



INDEX



|                             |  |                                                                                                     |  |   
|---------------------------- |  | --------------------------------------------------------------------------------------------------- |  | --
|                             | 
|Part IFinancial Information |  |                                                                                                    
|                             |  |                                                                                                    
|Item 1.                      |  | Consolidated Financial Statements (Unaudited)                                                       |  |   
|                             |  |                                                                                                    
|                             |  | Consolidated Balance Sheets as of March 31, 2004 and December 31, 2003 (Unaudited)                  |  | 3 
|                             |  |                                                                                                    
|                             |  | Consolidated Statements of Operations for the Three Months Ended March 31, 2004and 2003 (Unaudited) |  | 4 
|                             |  |                                                                                                    
|                             |  | Consolidated Statements of Cash Flows for the Three Months Ended March 31, 2004and 2003 (Unaudited) |  | 5 
|                             |  |                                                                                                    
|                             |  | Notes to Consolidated Financial Statements                                                          |  | 6 
|                             |  |                                                                                                    
|Item 2.                      |  | Managements Discussion and Analysis of Financial Condition and Results of Operations               |  | 10
|                             |  |                                                                                                    
|Item 3.                      |  | Qualitative and Quantitative Disclosures About Market Risk                                          |  | 19
|                             |  |                                                                                                    
|Item 4.                      |  | Controls and Procedures                                                                             |  | 19
|                             | 
|Part IIOther Information    |  |                                                                                                    
|                             |  |                                                                                                    
|Item 6.                      |  | Exhibits and Reports on Form 8-K                                                                    |  | 21
|                             |  |                                                                                                    
|                             |  | Signatures                                                                                          |  | 22
|                             |  |                                                                                                    
|                             |  | Exhibit Index                                                                                       |  | 23



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##### Table of Contents

PART I. FINANCIAL INFORMATION



|ITEM 1. | Consolidated Financial Statements
|------- | ---------------------------------



GENSYM CORPORATION



CONSOLIDATED BALANCE SHEETS

(Unaudited)

(in thousands, except share amounts)



|                                                                                                                        |  |               |         |   |                  |   |         |  
|----------------------------------------------------------------------------------------------------------------------- |  | ------------- | ------- | - | ---------------- | - | ------- | -
|                                                                                                                        |  | March 31,2004 |         |   | December 31,2003 |  
|ASSETS                                                                                                                  |  |               |         |   |                  |   |         |  
|                                                                                                                        |  |              
|Current Assets:                                                                                                         |  |               |         |   |                  |   |         |  
|Cash and cash equivalents                                                                                               |  | $             | 2,033   |   |                  | $ | 1,818   |  
|Accounts receivable, net                                                                                                |  |               | 3,776   |   |                  |   | 4,015   |  
|Prepaid and other current assets                                                                                        |  |               | 896     |   |                  |   | 872     |  
|                                                                                                                        |  |               |         |   |                  |   |         |  
|Total current assets                                                                                                    |  |               | 6,705   |   |                  |   | 6,705   |  
|Property and equipment, net                                                                                             |  |               | 774     |   |                  |   | 908     |  
|Deposits and other assets                                                                                               |  |               | 569     |   |                  |   | 673     |  
|                                                                                                                        |  |               |         |   |                  |   |         |  
|Total Assets                                                                                                            |  | $             | 8,048   |   |                  | $ | 8,286   |  
|                                                                                                                        |  |               |         |   |                  |   |         |  
|                                                                                                                        |  |              
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                    |  |               |         |   |                  |   |         |  
|                                                                                                                        |  |              
|Current Liabilities:                                                                                                    |  |               |         |   |                  |   |         |  
|Accounts payable                                                                                                        |  |               | 284     |   |                  |   | 235     |  
|Accrued expenses                                                                                                        |  |               | 1,928   |   |                  |   | 2,134   |  
|Current portion of capital lease obligations                                                                            |  |               | 66      |   |                  |   | 83      |  
|Deferred revenue                                                                                                        |  |               | 4,771   |   |                  |   | 4,991   |  
|                                                                                                                        |  |               |         |   |                  |   |         |  
|Total current liabilities                                                                                               |  |               | 7,049   |   |                  |   | 7,443   |  
|Other long-term liabilities                                                                                             |  |               | 32      |   |                  |   | 41      |  
|Long-term deferred revenue                                                                                              |  |               | 140     |   |                  |   | 150     |  
|                                                                                                                        |  |               |         |   |                  |   |         |  
|Total liabilities                                                                                                       |  |               | 7,221   |   |                  |   | 7,634   |  
|                                                                                                                        |  |               |         |   |                  |   |         |  
|                                                                                                                        |  |              
|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7,511,105 shares in 2004 and 7,501,105 shares in
2003 |  |               |         |   |                  |   |         |  
|Outstanding7,130,736 shares in 2004 and 7,111,893 in 2003                                                              |  |               | 75      |   |                  |   | 75      |  
|Capital in excess of par value                                                                                          |  |               | 21,892  |   |                  |   | 21,889  |  
|Treasury stock380,369 shares in 2004 and 389,212 shares in 2003, at cost                                               |  |               | (1,421  | ) |                  |   | (1,458  | )
|Accumulated deficit                                                                                                     |  |               | (19,995 | ) |                  |   | (20,086 | )
|Accumulated other comprehensive income                                                                                  |  |               | 276     |   |                  |   | 232     |  
|                                                                                                                        |  |               |         |   |                  |   |         |  
|Total stockholders equity                                                                                              |  |               | 827     |   |                  |   | 652     |  
|                                                                                                                        |  |               |         |   |                  |   |         |  
|Total liabilities and stockholders equity                                                                              |  | $             | 8,048   |   |                  | $ | 8,286   |  
|                                                                                                                        |  |               |         |   |                  |   |         |  



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



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GENSYM CORPORATION



CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(in thousands, except per share amounts)



|                                                   |  |                             |       |   |      |   |       |  
|-------------------------------------------------- |  | --------------------------- | ----- | - | ---- | - | ----- | -
|                                                   |  | Three months endedMarch 31, |      
|                                                   |  | 2004                        |       |   | 2003 |  
|Revenues:                                          |  |                             |       |   |      |   |       |  
|Product                                            |  | $                           | 1,740 |   |      | $ | 1,044 |  
|Services                                           |  |                             | 2,317 |   |      |   | 2,414 |  
|                                                   |  |                             |       |   |      |   |       |  
|Total revenues                                     |  |                             | 4,057 |   |      |   | 3,458 |  
|                                                   |  |                             |       |   |      |   |       |  
|                                                   |  |                            
|Cost of revenues:                                  |  |                             |       |   |      |   |       |  
|Product                                            |  |                             | 141   |   |      |   | 227   |  
|Services                                           |  |                             | 814   |   |      |   | 707   |  
|                                                   |  |                             |       |   |      |   |       |  
|Total cost of revenues                             |  |                             | 955   |   |      |   | 934   |  
|                                                   |  |                             |       |   |      |   |       |  
|                                                   |  |                            
|Gross profit                                       |  |                             | 3,102 |   |      |   | 2,524 |  
|                                                   |  |                             |       |   |      |   |       |  
|Operating expenses:                                |  |                             |       |   |      |   |       |  
|Sales and marketing                                |  |                             | 1,070 |   |      |   | 1,529 |  
|Research and development                           |  |                             | 857   |   |      |   | 862   |  
|General and administrative                         |  |                             | 980   |   |      |   | 715   |  
|                                                   |  |                             |       |   |      |   |       |  
|Total operating expenses                           |  |                             | 2,907 |   |      |   | 3,106 |  
|                                                   |  |                             |       |   |      |   |       |  
|                                                   |  |                            
|Operating income (loss)                            |  |                             | 195   |   |      |   | (582  | )
|Other income (expense), net                        |  |                             | (53   | ) |      |   | 23    |  
|                                                   |  |                             |       |   |      |   |       |  
|                                                   |  |                            
|Income (loss) before provision for income taxes    |  |                             | 142   |   |      |   | (559  | )
|Provision for income taxes                         |  |                             | 25    |   |      |   | 77    |  
|                                                   |  |                             |       |   |      |   |       |  
|Net income (loss)                                  |  | $                           | 117   |   |      | $ | (636  | )
|                                                   |  |                             |       |   |      |   |       |  
|                                                   |  |                            
|Basic earnings (loss) per share                    |  | $                           | 0.02  |   |      | $ | (0.09 | )
|Diluted earnings (loss) per share                  |  | $                           | 0.02  |   |      | $ | (0.09 | )
|                                                   |  |                            
|Basic weighted average common shares outstanding   |  |                             | 7,122 |   |      |   | 6,860 |  
|Diluted weighted average common shares outstanding |  |                             | 7,674 |   |      |   | 6,860 |  





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



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GENSYM CORPORATION



CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)



|                                                                                                   |  |                              |       |   |      |   |       |  
|-------------------------------------------------------------------------------------------------- |  | ---------------------------- | ----- | - | ---- | - | ----- | -
|                                                                                                   |  | Three months ended March 31, |      
|                                                                                                   |  | 2004                         |       |   | 2003 |  
|CASH FLOWS FROM OPERATING ACTIVITIES:                                                              |  |                              |       |   |      |   |       |  
|Net income (loss)                                                                                  |  | $                            | 117   |   |      | $ | (636  | )
|Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: |  |                              |       |   |      |   |       |  
|Depreciation and amortization                                                                      |  |                              | 151   |   |      |   | 132   |  
|Loss on disposal of equipment                                                                      |  |                              | 7     |   |      |   | 19    |  
|Non-cash compensation                                                                              |  |                              | 11    |   |      |   | 8     |  
|Changes in assets and liabilities:                                                                 |  |                              |       |   |      |   |       |  
|Accounts receivable                                                                                |  |                              | 229   |   |      |   | 861   |  
|Prepaid expenses and other assets                                                                  |  |                              | (134  | ) |      |   | (127  | )
|Accounts payable                                                                                   |  |                              | 49    |   |      |   | 390   |  
|Accrued expenses                                                                                   |  |                              | (201  | ) |      |   | (153  | )
|Deferred revenue                                                                                   |  |                              | (225  | ) |      |   | (221  | )
|                                                                                                   |  |                              |       |   |      |   |       |  
|Net cash provided by operating activities                                                          |  |                              | 4     |   |      |   | 273   |  
|                                                                                                   |  |                              |       |   |      |   |       |  
|                                                                                                   |  |                             
|CASH FLOWS FROM INVESTING ACTIVITIES:                                                              |  |                              |       |   |      |   |       |  
|Purchases of property and equipment                                                                |  |                              | (5    | ) |      |   | (91   | )
|Purchase of intangible assets                                                                      |  |                              |      |   |      |   | (250  | )
|Decrease (increase) in other assets                                                                |  |                              | 167   |   |      |   | (275  | )
|                                                                                                   |  |                              |       |   |      |   |       |  
|Net cash provided by (used in) investing activities                                                |  |                              | 162   |   |      |   | (616  | )
|                                                                                                   |  |                              |       |   |      |   |       |  
|                                                                                                   |  |                             
|CASH FLOWS FROM FINANCING ACTIVITIES:                                                              |  |                              |       |   |      |   |       |  
|Payments on capital lease obligations                                                              |  |                              | (27   | ) |      |   | (20   | )
|Proceeds from exercise of stock options and issuance of common stock under stock plans             |  |                              | 3     |   |      |   |      |  
|                                                                                                   |  |                              |       |   |      |   |       |  
|Net cash used in financing activities                                                              |  |                              | (24   | ) |      |   | (20   | )
|                                                                                                   |  |                              |       |   |      |   |       |  
|                                                                                                   |  |                             
|EFFECT OF EXCHANGE RATE CHANGES ON CASH                                                            |  |                              | 73    |   |      |   | 113   |  
|                                                                                                   |  |                              |       |   |      |   |       |  
|                                                                                                   |  |                             
|NET INCREASE (DECREASE) IN CASH AND CASH EQUIVALENTS                                               |  |                              | 215   |   |      |   | (250  | )
|CASH AND CASH EQUIVALENTS, BEGINNING OF PERIOD                                                     |  |                              | 1,818 |   |      |   | 3,884 |  
|                                                                                                   |  |                              |       |   |      |   |       |  
|                                                                                                   |  |                             
|CASH AND CASH EQUIVALENTS, END OF PERIOD                                                           |  | $                            | 2,033 |   |      | $ | 3,634 |  
|                                                                                                   |  |                              |       |   |      |   |       |  



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



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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. Most applications of our products are in the areas of abnormal condition
and process performance management in manufacturing, 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
downtime in mission-critical networks, and proactive alarms that signify potential process problems and avoid plant shutdowns. Our products have been used in the 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, 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 March 31, 2004 and the results of its operations and its cash flows for the three- month periods ended March 31, 2004 and 2003. 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, 2003, filed with the SEC on March 30, 2004. 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.



During the year ended December 31, 2003, we sustained a significant loss in
the first half of the year. Based on these results, management effected a restructuring plan designed to return the company to profitability by years end without sacrificing our significant engineering investments in a next generation of
products. Previously, we had achieved operating and overall profitability as well as positive cash flows for the year ended December 31, 2002. We believe that our cash and cash equivalents and cash flows from operations will be sufficient to meet
our operating, investing and financing cash flow requirements through at least the next 12 months. Our ability to maintain growth and profitability in 2004 and beyond is dependent on successful releases of our next generation of G2 and G2
based products, on market acceptance of our existing and next generation of products and related services, and on renewal of maintenance contracts for customer support at near-current levels.



Our financial statements have been prepared under the assumption that we will
continue as a going concern. Based on current forecasts, management believes that we have sufficient liquidity to finance operations for the next twelve months. Managements expectations for future revenue growth, profitability, and operating
cash flows involve significant judgments and estimates. Should these judgments and estimates prove to be inaccurate, we have the intent and ability to reduce our costs and delay, scale back, or eliminate certain of our activities in order to ensure
that we maintain positive cash and working capital. Any of these actions could have a material adverse long-term effect on our business, financial condition and results of operations.



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GENSYM CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



3. Comprehensive Income (Loss )



The components of comprehensive income (loss) for the three-month periods ended March 31, 2004 and 2003 are as follows (in
thousands):



|                                        |  |                              |     |      |   |      |  
|--------------------------------------- |  | ---------------------------- | --- | ---- | - | ---- | -
|                                        |  | Three months ended March 31, |    
|                                        |  | 2004                         |     | 2003 |  
|Net income (loss)                       |  | $                            | 117 |      | $ | (636 | )
|Other comprehensive income:             |  |                              |     |      |   |      |  
|Foreign currency translation adjustment |  |                              | 44  |      |   | 66   |  
|                                        |  |                              |     |      |   |      |  
|Comprehensive income (loss)             |  | $                            | 161 |      | $ | (570 | )
|                                        |  |                              |     |      |   |      |  



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 monthsended March 31,
|                                             |  | 2004                        |  | 2003 
|Weighted average common shares outstanding   |  | 7,122                       |  | 6,860
|Additional dilutive common stock equivalents |  | 552                         |  |     
|                                             |  |                             |  |      
|Diluted weighted average shares              |  | 7,674                       |  | 6,860
|                                             |  |                             |  |      



Options to purchase
292,016 shares of common stock with an exercise price between $1.05 and $10.00 per share were outstanding in the first quarter of 2004, but were excluded from the computation of diluted earnings per share because such options were anti-dilutive in
the period since their exercise price exceeded the market value of the Companys common stock . All options to purchase a total of 1,349,692 shares of common stock were outstanding at March 31, 2003, but were excluded from the computation of
diluted earnings per share for the three-month period then ended because such options were anti-dilutive as we had net losses in the period.



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.



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GENSYM CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



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 monthsended March 31, |     
|(in thousands except per share data)                               |  | 2004                        |      | 2003 |  
|Net income (loss) as reported                                      |  | $                           | 117  |      | $ | (636  | )
|Stock based compensation expense under the fair value-based method |  |                             | 29   |      |   | 54    |  
|                                                                   |  |                             |      |      |   |       |  
|Pro forma net income (loss)                                        |  | $                           | 88   |      | $ | (690  | )
|                                                                   |  |                            
|Basic earnings (loss) per share as reported                        |  | $                           | 0.02 |      | $ | (0.09 | )
|Diluted earnings (loss) per share as reported                      |  | $                           | 0.02 |      | $ | (0.09 | )
|                                                                   |  |                            
|Pro forma basic (loss) earnings per share                          |  | $                           | 0.01 |      | $ | (0.10 | )
|Pro forma diluted (loss) earnings per share                        |  | $                           | 0.01 |      | $ | (0.10 | )



6. 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 March 31, |  
|               |  | 2004                        |   |  | 2003 |  
|United States  |  | 39                          | % |  | 45   | %
|United Kingdom |  | 9                           | % |  | 12   | %
|Rest of Europe |  | 29                          | % |  | 24   | %
|Rest of World  |  | 23                          | % |  | 19   | %
|               |  |                             |   |  |      |  
|               |  | 100                         | % |  | 100  | %
|               |  |                             |   |  |      |  



Revenues from one
customer represented 12% of total revenues for the quarter ending March 31, 2004.



The following table presents the Companys long-lived assets, net of depreciation and amortization, as of March 31, 2004 and December 31, 2003 (in thousands):



|              |  |               |     |                  |   |      
|------------- |  | ------------- | --- | ---------------- | - | -----
|              |  | March 31,2004 |     | December 31,2003
|United States |  | $             | 768 |                  | $ | 899  
|Europe        |  |               | 173 |                  |   | 197  
|              |  |               |     |                  |   |      
|              |  | $             | 941 |                  | $ | 1,096
|              |  |               |     |                  |   |      



7. 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,



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GENSYM CORPORATION



NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



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:



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 March 31, 2004 are immaterial.



8. 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 then current levels of revenue. In
accordance with this plan, we recorded a restructuring charge of $216,000 in 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 $165,100 of this amount was paid through March 31, 2004. We expect to pay the remaining accrued amounts by June 30, 2004.



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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 That May Affect Future Results. Should one or more
of these risks or uncertainties materialize, or should an 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 assess, diagnose, 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 17,000 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 a major version of G2, version 7.0, in March 2003, which constituted a significant advance in our product. Version 7.0 included many significant enhancements
intended to bring G2 into line with current industry standards. Version 7.1 was released in December 2003, adding to G2s integration capabilities with support for message-oriented middleware and other capabilities. We have begun field testing
a pre-release version of G2 8.0, which when commercially released will represent a generational advance in our G2 product line.



In 2003, we refocused our direct sales force on generation of new business in three vertical markets: chemical, oil and gas; government, and water
utilities. Our sales to these vertical markets involve a mix of direct sales to end users and indirect sales through partners. In geographic areas where we do not have direct sales force coverage, or in market sectors where we do not possess the
requisite detailed industry knowledge to deploy our products successfully, we work with channel partners. These partners pursue new business based on Gensym products in various markets including business process management, various manufacturing
sectors, telecommunications, and transportation.



To assist our
end users and partners in developing applications, we offer professional services in the U.S., Europe, and the Middle East. In some cases we enter into fixed price contracts to deliver application solutions.



We conduct our business in North and South America, Europe, the Middle East,
Africa and the Asia-Pacific region. In the first quarter of 2004, approximately 43% of our revenues were generated from license sales, 15% from consulting and training and 42% from customer support services. In the same quarter of 2003, these
percentages were 30%, 13% and 57%, respectively. Prices for our products are generally denominated in U.S. dollars, although we do some business in local currencies. The chemical, oil and gas industries are a major market for us. The U.S.
Government, particularly the Department of Defense, is a major customer. We have several significant OEM partners, among them Siemens, Ericsson, and Motorola.



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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, 2003.
Our critical accounting policies, as detailed in our Form 10-K for the year ended December 31, 2003, have not changed during the three-month period ended March 31, 2004.



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 endedMarch 31, |   
|                                                |  | 2004                        |    |  | 2003 |   
|                                                |  | (Unaudited)                 |   
|REVENUES:                                       |  |                             |    |  |      |   
|Product                                         |  | 43                          | %  |  | 30   | % 
|Services                                        |  | 57                          | %  |  | 70   | % 
|                                                |  |                             |    |  |      |   
|Total revenues                                  |  | 100                         | %  |  | 100  | % 
|                                                |  |                             |    |  |      |   
|COST OF REVENUES:                               |  |                             |    |  |      |   
|Product                                         |  | 4                           | %  |  | 7    | % 
|Services                                        |  | 20                          | %  |  | 20   | % 
|                                                |  |                             |    |  |      |   
|Total cost of revenues                          |  | 24                          | %  |  | 27   | % 
|                                                |  |                             |    |  |      |   
|Gross margin                                    |  | 76                          | %  |  | 73   | % 
|                                                |  |                             |    |  |      |   
|OPERATING EXPENSES:                             |  |                             |    |  |      |   
|Sales and marketing                             |  | 26                          | %  |  | 44   | % 
|Research and development                        |  | 21                          | %  |  | 25   | % 
|General and administrative                      |  | 24                          | %  |  | 21   | % 
|                                                |  |                             |    |  |      |   
|Total operating expenses                        |  | 71                          | %  |  | 90   | % 
|                                                |  |                             |    |  |      |   
|Operating income (loss)                         |  | 5                           | %  |  | (17  | %)
|OTHER INCOME (EXPENSES), NET                    |  | (1                          | %) |  | 1    | % 
|                                                |  |                             |    |  |      |   
|Income (loss) before provision for income taxes |  | 4                           | %  |  | (16  | %)
|PROVISION FOR INCOME TAXES                      |  | 1                           | %  |  | 2    | % 
|                                                |  |                             |    |  |      |   
|Net (loss) income                               |  | 3                           | %  |  | (18  | %)
|                                                |  |                             |    |  |      |   



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Revenues



Three months ended March 31, 2004 and 2003



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 March 31, 2004 were $4,057,000 an increase of $599,000, or 17%, from the
same period in 2003. The increase was attributable to an increase of $696,000, or 67%, in license revenue and a decrease of $97,000, or 4%, in services revenue.



International revenues represented 61% and 55% of our total revenues for the three-month periods ending March 31, 2004 and 2003, respectively. This
increase is primarily due to increased orders from one Italian customer.



Product.    Product revenues for the three-month period ended March 31, 2004 were $1,740,000 an increase of $696,000, or 67%, from the same period in 2003. This increase was mainly
attributable to significant orders from a major manufacturing sector OEM customer.



Services.    Services revenues for the three-month period ended March 31, 2004 were $2,317,000, a decrease of $97,000, or 4%, from the same period in 2003. This decrease was primarily due to
a decline in customer support revenue of $236,000, or 12%. The decline in support revenues was due to the non-renewal in the fourth quarter of 2003 of three large maintenance accounts.



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 March 31, 2004 were $955,000, an increase of $21,000, or 2%, from the same period
in 2003. This increase was primarily due to the use of subcontractors delivering revenue generating consulting services. Our gross margin percentage increased to 76% for the three-month period ended March 31, 2004 from 73% for the same period in
2003 as a result of higher product sales.



Product.    Product cost of revenues for the three-month period ended March 31, 2004 was $141,000, a decrease of $86,000, or 38%, from the same period in 2003. This decrease was primarily attributable to a $47,000
reduction in personnel costs and lower royalty fees of $30,000.



Services.    Services cost of revenues for the three-month period ended March 31, 2004 was $814,000, an increase of $107,000, or 15%, from the same period in 2003. The increase in service costs was primarily due
to subcontractors and personnel related costs.



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 period ended March 31, 2004 were $1,070,000, a decrease of $459,000 or 30%, from the same period in 2003. The decrease was primarily attributable to a decrease in sales
personnel costs and their related travel costs. This was primarily due to the cost control program implemented in June of 2003. Sales and marketing expenses for the three-month period ended March 31, 2004 decreased to 26% of revenues from 44% for
the same period in 2003. The decrease in percent of revenue was the result of an increase in product revenues and a decrease in expenses.



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Research and Development. Research and development expenses consist primarily of costs of
personnel, equipment and facilities. These expenses for the three-month period ended March 31, 2004 were $857,000, a decrease of $5,000, or 1%, from the same period in 2003. Research and development expenses for the three-month period ended March
31, 2004 decreased to 21% of revenues from 25% for the same period in 2003. The decrease in percent of revenue was the result of an increase of product revenues.



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. These expenses for the three-month period ended March 31, 2004 were $980,000, an increase of $265,000, or 37%, from the same period in 2003. The increase
was mainly attributable to higher than anticipated professional service costs. General and administrative expenses for the three-month period ended March 31, 2004 increased to 24% of revenues from 21% for the same period in 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 (expense), net for the three-month period ended March 31, 2004 was $(53,000), compared
to income of $23,000 for the same period in 2003. The current expense is primarily due to foreign exchange rate losses due to the continued weakening of the US dollar.



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. Provision for income taxes for the three-month period ended March 31, 2004 was $25,000, compared to $77,000
for the same period in 2003. The decrease in the tax provision for the three months ended March 31, 2004 is due to losses in certain foreign jurisdictions where we had income for the three months ended March 31, 2003.



LIQUIDITY AND CAPITAL RESOURCES



Our March 31, 2004 cash and cash equivalents amounted to $2,033,000, an
increase of $215,000 from $1,818,000 at December 31, 2003. Net cash provided by operating activities for the three-month period ended March 31, 2004 was $4,000. Specifically, we had a net income of $117,000, net of non-cash expenses of $169,000
(depreciation and amortization, loss on disposal of equipment, and non-cash compensation), $229,000 in cash received from accounts receivable and a $49,000 decrease in accounts payable offset by an increase of $134,000 in prepaid expenses and other
assets, and decreases of $201,000 in accrued expenses and $225,000 in deferred revenue.



Cash provided by investing activities for the three-month period ended March 31, 2004 was $162,000, which consisted of a decrease of $167,000 in other assets primarily related to a release of restricted cash to cash
offset by purchases of property and equipment of $5,000.



Cash
used in financing activities for the three-month period ended March 31, 2004 was $24,000, consisting of $27,000 in payments under capital leases offset by $3,000 in proceeds from exercise of stock options and issuance of common stock under stock
plans.



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 financial statements have been
prepared under the assumption that we will continue as a going concern. Based on current forecasts, management believes that we have sufficient liquidity to finance operations for the next twelve months. Managements expectations for future
revenue growth, profitability, and operating cash flows involve significant judgments and estimates. Should these judgments and estimates prove to be inaccurate, we have the intent and ability to reduce our costs and delay, scale back, or eliminate
certain of our activities in order to ensure that we maintain positive cash and working capital. Any of these actions could have a material adverse long-term effect on our business, financial condition and results of operations.



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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 March
31, 2004 are as follows:



|                                              |  |                       |       |               |   |    
|--------------------------------------------- |  | --------------------- | ----- | ------------- | - | ---
|                                              |  | Amounts(In thousands)
|For the period ended December 31,             |  | OperatingLeases       |       | CapitalLeases
|2004                                          |  |                       | 704   |               |   | 61 
|2005                                          |  |                       | 896   |               |   | 43 
|2006                                          |  |                       | 188   |               |   |   
|2007                                          |  |                       | 36    |               |   |   
|2008                                          |  |                       | 5     |               |   |   
|                                              |  |                       |       |               |   |    
|Total minimum lease payments                  |  | $                     | 1,829 |               |   | 104
|                                              |  |                       |       |               |   |    
|Less: Amount representing interest            |  |                       |       |               |   | 6  
|                                              |  |                       |       |               |   |    
|Present value of minimum lease payments       |  |                       |       |               |   | 98 
|Less: Current portion                         |  |                       |       |               |   | 66 
|                                              |  |                       |       |               |   |    
|Long-term portion of capital lease obligation |  |                       |       |               | $ | 32 
|                                              |  |                       |       |               |   |    



Litigation



On November 13, 2001, we, and our directors were served
with a complaint filed by one of our stockholders, Special Situations Fund, III, L.P., in Delaware Chancery Court in and for New Castle County. In April, 2004, the Company received notice that the plaintiff dismissed this action without prejudice as
to all defendants.



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 March 31, 2004, 501,300 shares had been repurchased at a cost of approximately $1,869,000. No shares were purchased in 2004 or 2003. During the three months ending March 31, 2004 and 2003,
respectively, we reissued 4,800 and 13,948 shares of common stock to non-employee directors and a consultant. As of March 31, 2004, 380,369 shares remained in treasury at a cost of $1,419,000.



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 three employees who continue 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 three-month period ended March 31, 2004, we paid Integration Objects a total of
$21,000.



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 remain profitable.



We incurred operating losses for two out of the three years ending December
31, 2003, including fiscal year 2003. 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 fiscal quarter of 2002 and for the year ended December 31, 2002, although our revenues declined from the fiscal year ended December 31, 2001. In June of



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2003, our Board of Directors approved a workforce reduction plan. We incurred operating losses in each of the first three quarters of 2003 and for the year
ended December 31, 2003 but achieved net income profitability in the fourth quarter of 2003 and the first quarter of 2004. Our ability to achieve and maintain profitability is dependent on continued revenue from new and existing customers and
expense control. There can be no assurance that we will return to profitability.



We are increasingly reliant on fees from maintenance contracts and renewals. If we fail to retain our maintenance customers, our revenues may be adversely affected.



We rely on maintenance contract renewals for a significant percentage of our
revenue, as software maintenance fees have become a larger component of our total revenues, representing 44%, 39% and 37% of our total revenues in the years ended December 31, 2003, 2002 and 2001, respectively. For the three months ended March 31,
2004, software maintenance fees represented 42% of our total revenues. While a maintenance contract on our products is mandatory for the first year after purchase, subsequent renewals of the maintenance contract are at the discretion of our
customers. Accordingly, our failure to retain maintenance customers or a significant decline in the rate of maintenance contract renewals could have a material adverse effect on our business, results of operations, cash flows, and financial
position.



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. Sales of our products by such channel partners represented 56%, 52% and 55% of our product revenues in years ended December 31, 2003, 2002 and 2001, respectively. For the three months ended March 31, 2004, sales through such channel
partners represented 84% of our product revenues. 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, cash
flows or financial position. 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 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, cash flows, or financial position.



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, results of operations, cash flows, or financial position.



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 or annual basis in the future. Our sales cycle typically ranges from 6 to 12 months, and the cost of acquiring our software, building and deploying applications, and training users represents a significant



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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 have 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 large 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 results of operations and cash flows, which may impact our ability to continue as an independent concern.



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 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, cash flows, or financial position.



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 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, cash flows, or financial position.



Our business may be adversely affected if we fail to develop new products and respond to changes in technology if we develop new technology and it is not accepted
by the market.



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



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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 61% and 55% of our total revenues for the quarter ending March 31, 2004 and 2003, 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, cash flows, or financial position.



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.



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 increasingly reliant on indirect channel
partners, including original equipment manufacturers, value-added resellers, and systems integrators, to satisfy market requirements. A number of software companies offer products that compete in specific application areas addressed by these
partners, such as cement kiln control, manufacturing execution systems, logistics systems, and network management, and they could be successful in supplying alternatives to products based on our software.



Certain companies, such as Micromuse and Aspen Technology, sell point
solutions that compete with our expert operations management products with respect to specific applications or uses. Several companies, including 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. 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.



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.





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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 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, cash flows, or financial position.



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 that we offer 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, cash flows, or financial position.



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.



In August 2001, we received a letter from a third party alleging that we are infringing one or more of their patents relating to neural networks and
expert systems and the control of processes. At this time, no formal legal action has been filed. 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.



Our research and development in new reasoning technologies may not lead to profitable commercialization.



We are developing a new software reasoning platform, TrueManage, that is designed for handheld computing devices and targeted at application markets not
currently addressed by our G2 and G2-based products. We have also begun to develop a TrueManage application product called LifeVisor, a cell phone device for self-management of chronic conditions such as diabetes and obesity. Development of
TrueManage and LifeVisor is complex, requiring specialized technical expertise. The targeted handheld computing markets are experiencing rapid advancements in related technologies and applications. We anticipate that it will require significant
funding to develop, launch, and build distribution channels for TrueManage and LifeVisor. Our strategy is to distribute these products through other companies that have significantly larger presence and scale in the targeted markets than we do.
There can be no assurance that we will be able to successfully complete the development of TrueManage and LifeVisor, that we will be able to provide functionality that is accepted by the targeted markets, or that we will be able to build
partnerships for profitable distribution of these products.



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Our stockholders may face an illiquid market for the shares of our stock that they own.



On August 21, 2001, our stock was delisted from the NASDAQ National Market
because we failed to meet the applicable listing standards. Our common stock currently trades on the OTC Bulletin Board. 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.



|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 March 31, 2004, 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. We transact business in various countries and thus have exposure to
adverse movements in foreign currency exchange rates. This exposure is primarily related to intercompany receivable and payable balances that are recorded on the balance sheet in currencies other than the functional currency. These amounts are
translated at each month end to the functional currency in each country, and any resulting gain or loss is recorded in the statement of operations. In addition, we have certain cash balances held in currencies other than our functional currency or
the functional currency of our subsidiaries. These amounts are translated at each month end to the functional currency in each country, and any resulting gain or loss is recorded in the appropriate statements of operations.



|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 December 31, 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 chief financial officer
concluded that, as of March 31, 2004, 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 March 31, 2004 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 and did not
return to full-time status until October 2003. Furthermore, our former chief financial officer left the Company in early August 2003.



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Management has determined that the loss, or temporary absence of, these personnel 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, insufficiently developed accounting processes to support efficient preparation and independent
auditor review of the consolidated financial statements, and insufficient resources to oversee the preparation of the consolidated financial statements.



In addition to these weaknesses, our independent auditors, PricewaterhouseCoopers LLP (PwC), identified certain other matters representing
significant deficiencies in internal controls over financial reporting in connection with their audit of our financial statements for the year ended December 31, 2003. These deficiencies include our ability to obtain timely information from our
foreign subsidiaries.



During the fiscal quarters ended
September 30, 2003, December 31, 2003 and March 31, 2004 and as of the date of this Form 10-Q, we took the following corrective actions to address these issues:



| | (a) | We engaged David Ramsdell as a consultant, on a part-time basis, during the quarter ended September 30, 2003 to perform the chief financial officer function. Mr. Ramsdell had
served us in a similar capacity from late 1998 to early 2000.
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (b) | During the quarter ending September 30, 2003, we began actively conducting a search for a new permanent chief financial officer. In March 2004, Stephen D. Allison joined our company
as our Chief Financial Officer. He has more than 25 years experience in finance, in both large and small organizations, public and private. For 15 of those years, he has served as chief financial officer and vice president of finance.
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (c) | Beginning in October 2003, we engaged a full-time contract accounting professional to supplement our accounting and financial reporting resources. We are presently working to
further strengthen our permanent accounting staff.
| | --- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (d) | 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 are
continuing to enhance this process during 2004.
| | --- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | (e) | We have invested in updates and improvements to our Oracle accounting systems.
| | --- | ------------------------------------------------------------------------------



We are continuing to take similar and other actions in 2004 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 1. | Legal Proceedings
|------- | -----------------



On November 13, 2001, we and our directors were served with a complaint filed by one of our stockholders, Special Situations Fund, III, L.P., in Delaware
Chancery Court in and for New Castle County. The lawsuit asserted claims for, among other things, alleged breach of fiduciary duty and waste of corporate assets in connection with our rejection of a merger proposal by Rocket Software, the adoption
of our proposed rights offering, and the execution of a letter of intent with Rocket Software relating to the sale of our NetCure product line. The complaint sought injunctive relief with respect to the Rocket Software merger proposal, the proposed
rights offering and the sale of the NetCure product line to Rocket Software. On November 16, 2001, we and our directors were served with an amended and supplemental complaint further asserting that our directors breached fiduciary duties by
consummating the sale of the NetCure product line to Rocket Software and allegedly refusing to negotiate with Rocket Software in connection with its merger proposal. The amended complaint also added Rocket Software as a defendant and asserted a
claim against Rocket Software for aiding and abetting the alleged breaches of fiduciary duties. The amended complaint sought injunctive relief with respect to the Rocket Software merger proposal, rescission of the NetCure sale, and compensatory
and/or rescissionary monetary damages. On November 26, 2001, the court conducted a telephonic hearing on the plaintiffs motion for expedited proceedings, and denied the motion at the conclusion of that hearing. On November 27, 2001, we were
advised by plaintiffs counsel that, in light of the courts decision on the motion to expedite proceedings, the plaintiffs intended to file a further amended complaint. In April 2004, the Company received notice that the plaintiff
dismissed this action without prejudice as to all defendants.



ITEMS
25.    None



|ITEM 6. | Exhibits and Reports on Form 8-K
|------- | --------------------------------



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



|              |  |                                                                                                                                                                                                  
|------------- |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|ExhibitNumber |  | 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          |  | Certification 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.                                               
|              | 
|32.2          |  | Certification of Chief Financial Officer Pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.                                               



(b) The following
Current Reports on Form 8-K were filed or furnished by us during the quarter ended March 31, 2004: None



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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 May 13, 2004 |  | /s/    STEPHEN D. ALLISON                                                
|                   |  | Stephen D. Allison Chief Financial Officer (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.                                              
|               | 
|32.2           |  | Certifications of Chief Financial 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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