UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

Commission File Number

1-15681

webMethods, Inc.

(Exact name of Registrant as Specified in its Charter)

Registrant’s telephone number, including area code: (703) 460-2500

Securities registered pursuant to Section 12(b) of the Act: None

Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.01par value

Preferred Stock Purchase Rights

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

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

     As of February 12, 2004, there were outstanding 52,624,711 shares of the registrant’s Common Stock.

WEBMETHODS, INC.

QUARTERLY REPORT ON FORM 10-Q
FOR THE THREE MONTHS ENDED DECEMBER 31, 2003
TABLE OF CONTENTS

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PART I

FINANCIAL INFORMATION

ITEM 1: FINANCIAL STATEMENTS

WEBMETHODS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands, except share
and per share data)

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

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WEBMETHODS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE
LOSS

(UNAUDITED)

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

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WEBMETHODS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

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

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WEBMETHODS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
(UNAUDITED)

1.

BASIS OF PRESENTATION

     The accompanying consolidated financial statements of webMethods, Inc. and its subsidiaries (collectively, the “Company”) have been prepared by the Company pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). This Quarterly Report on Form 10-Q should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended March 31, 2003. Certain information and footnote disclosures which are normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to SEC rules and regulations. The information reflects all normal and recurring adjustments that, in the opinion of management, are necessary for a fair presentation of the financial position of the Company, and its results of operations for the interim periods set forth herein. The results for the three and nine months ended December 31, 2003 are not necessarily indicative of the results to be expected for the full year or any future period. Certain amounts previously reported have been reclassified to conform with current year presentation.

2.

PRO FORMA STOCK BASED COMPENSATION

     The Company measures compensation expense for its employee stock based compensation using the intrinsic value method and provides pro forma disclosures of net loss as if the fair value method had been applied in measuring compensation expense. Under the intrinsic value method of accounting for stock based compensation, when the exercise price of options granted to employees is less than the fair value of the underlying stock on the grant date, compensation expense is recognized over the applicable vesting period.

     The following table summarizes the Company’s results on a pro forma basis as if it had recorded compensation expense based upon the fair value at the grant date for awards consistent with the methodology prescribed in SFAS 123, “Accounting for Stock Based Compensation,” for the three and nine months ended December 31, 2003 and 2002 :

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     The fair value of each option grant is estimated on the date of grant using the Black-Scholes valuation model with the following weighted average assumptions: Risk-free interest rates of 2.93% and 4.30% for the three and nine months ended December 31, 2003 and 2002, respectively; expected volatility of 97% and 125% for the three and nine months ended December 31, 2003 and 2002, respectively; expected life of 4 years, and no anticipated dividends.

     The weighted average fair value per share for stock option grants awarded during the three months ended December 31, 2003 and 2002 was $8.79 and $7.45, respectively. The weighted average fair value per share for stock option grants awarded during the nine months ended December 31, 2003 and 2002 was $8.88 and $8.83, respectively.

3.

COMPUTATION OF NET LOSS PER SHARE

     The Company’s net loss per share calculation for basic and diluted is based on the weighted average number of common shares outstanding. There are no reconciling items in the numerator and denominator of the Company’s net loss per share calculation. Employee stock options and warrants of 871,056 and 953,619 for the three months ended December 31, 2003 and 2002, respectively, have been excluded from the net loss per share calculation because their effect would be anti-dilutive. Employee stock options and warrants of 829,031 and 1,194,459 for the nine months ended December 31, 2003 and 2002, respectively, have been excluded from the net loss per share calculation because their effect would be anti-dilutive.

4.

SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION

5.

SEGMENT INFORMATION

     The Company conducts operations worldwide and is primarily managed on a geographic basis with those geographic segments being the Americas, Europe/Middle-East/Africa (“EMEA”), Japan and Asia Pacific regions. Revenue is primarily attributable to the region in which the contract is signed and the product is deployed. Information regarding geographic areas is as follows:

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6.

RESTRUCTURING CHARGES

     In response to changing market conditions, including the decline in information technology spending, the Company implemented restructuring plans in the second quarter of fiscal 2002, third quarter of fiscal 2003 and third quarter of fiscal 2004.

     During the quarter ended September 30, 2001, the Company recorded a restructuring charge of $7.2 million, consisting of headcount reductions, consolidations of facilities, and other related restructuring charges. During the quarter ended December 31, 2002, the Company recorded a restructuring charge of $2.2 million to further reduce headcount. In addition, in October 2003, the Company recorded a restructuring charge of $1.3 million due to an additional headcount reduction of approximately 39 employees or 4% of the workforce

     As of December 31, 2003 and March 31, 2003, respectively, $2.2 million and $1.8 million of restructuring charges remained unpaid. The accrual primarily relates to rent on excess facilities and severance payable related to the October 2003 restructuring.

7.

INVESTMENTS IN PRIVATE COMPANY

     The Company has an investment in a private company and shares a common Board member. In September 2003, the Company received $1,000,000 as repayment of convertible debt and converted $257,000 of interest into additional equity in this private company. As of December 31, 2003 and March 31, 2003, the carrying value of the investment in this private company was $1,057,000 and $1,800,000, respectively, and the Company’s equity position, excluding conversion of other convertible debt, was less than 4%.

     The Company incurred royalty expense of $320,000 and $483,000 to this private company in the three months ended December 31, 2003 and 2002, respectively, and $1,079,000 and $824,000 in the nine months ended December 31, 2003 and 2002, respectively.

8.

BUSINESS COMBINATIONS AND ACQUISITION OF TECHNOLOGY

     In October 2003, the Company completed the business acquisitions of The Mind Electric, Inc. (“TME”) and The Dante Group, Inc. as well as the asset acquisition of the portal solution previously known as DataChannel. TME was a leading provider of software for service-oriented architectures, and The Dante Group was a provider of business activity monitoring software. DataChannel (previously marketed as PortalMinder by Netegrity) was a comprehensive portal platform for creating secure, identity-driven portals within a scalable architecture.

DataChannel

     The Company acquired the portal solution technology and certain fixed assets from DataChannel for $5,278,000 in cash, including $176,000 in direct acquisition costs. The Company also assumed deferred revenue of $66,000 related to on-going maintenance contracts.

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     The acquisition of the existing portal solution technology of $5,243,000 was recorded as purchased technology and is amortized over the estimated useful life of 60 months. The technology is expected to complement the Company’s existing technology and the incremental efforts required to market the portal solution product were minimal. The Company determined that as of the date of the technology purchase the purchased technology had alternative future use and had attained technological feasibility.

TME and The Dante Group

     The acquisitions of TME and The Dante Group were accounted for under the purchase method of accounting and, accordingly, the results of operations of each acquisition are included in the accompanying unaudited condensed consolidated statements of operations and comprehensive loss since the acquisition date. As a result of these acquisitions, the Company has recorded charges for in-process research and development and has recorded assets related to existing technology.

     In-process research and development represents in-process technology that, as of the date of the acquisition, had not reached technological feasibility and had no alternative future use. Based on valuation assessments, the value of these projects was determined by estimating the projected net cash flows from the sale of the completed products, reduced by the portion of the revenue attributable to developed technology. The resulting cash flows were then discounted back to their present values at appropriate discount rates. Consideration was given to the stage of completion, complexity of the work completed to date, the difficulty of completing the remaining development and the costs already incurred. The amounts allocated to the acquired in-process research and development were immediately expensed in the period the acquisition was completed.

     Existing technology represents purchased technology for which development had been completed as of the date of acquisition. This amount was determined using the income approach. This method consisted of estimating future net cash flows attributable to existing technology for a discrete projection period and discounting the net cash flows to their present value. The existing technology will be amortized over its expected useful life of 60 months.

     The aggregate purchase price for these acquisitions, including $593,000 in direct acquisition costs, has been allocated to the assets acquired and liabilities assumed based upon their estimated fair values at the date of acquisition as follows (in thousands):

     We determined the valuation of the identifiable intangible assets using the income approach and a valuation report from an independent appraiser. The amounts allocated to the identifiable intangible assets were determined through established valuation techniques accepted in the technology and software industries. The Company is in the process of finalizing the valuations of the businesses, thus the allocation of the purchase price is preliminary.

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     The income approach, which includes an analysis of the cash flows and risks associated with achieving such cash flows, was the primary technique utilized in valuing the other identifiable intangible assets. Key assumptions included discount factors ranging from 26% to 31%, and estimates of revenue growth, maintenance renewal rates, cost of sales, operating expenses and taxes. The purchase price in excess of the net liabilities assumed and the identifiable intangible assets acquired was allocated to goodwill.

     The following unaudited pro forma supplemental table presents selected financial information as though the purchases of TME and The Dante Group, which may be material acquisitions for this purpose, had been completed at the beginning of the periods presented. The unaudited pro forma data gives effect to actual operating results prior to the acquisition, adjusted to include the pro forma effect of amortization of intangibles, reduction in interest income on cash paid for the acquisitions and the elimination of the charge for acquired in-process research and development. The unaudited pro forma data for the three and nine months ended December 31, 2003, includes a $1.4 million nonrecurring compensation charge for accelerated vesting of options of The Dante Group which occurred just prior to the transaction. These unaudited pro forma amounts do not purport to be indicative of the results that would have actually been obtained if the acquisitions occurred as of the beginning of the periods presented or that may be obtained in the future (in thousands, except per share data):

9.

GOODWILL AND INTANGIBLE ASSETS

     Goodwill

     The change in carrying amount of goodwill for the nine months ended December 31, 2003, is as follows (in thousands):