UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

FORM 10-Q

(Mark One)

		þ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES      EXCHANGE ACT OF 1934 FOR THE THREE MONTHS ENDED JUNE 30, 2004
		o TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES      EXCHANGE ACT OF 1934

Commission File Number

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, $0.01 par value

     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 þ No o

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

     As of August 4, 2004, there were outstanding 53,077,440 shares of the registrant’s Common Stock.

WEBMETHODS, INC.

QUARTERLY REPORT ON FORM 10-Q
FOR THE THREE MONTHS ENDED JUNE 30, 2004
TABLE OF CONTENTS

PART I

FINANCIAL INFORMATION

ITEM 1: FINANCIAL STATEMENTS

WEBMETHODS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS
(UNAUDITED)

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

WEBMETHODS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS
(UNAUDITED)

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

WEBMETHODS, INC.
 
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(UNAUDITED)

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

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 (the “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, 2004. 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 months ended June 30, 2004 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 quarters ended June 30, 2004 and 2003:

     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:

     The weighted average fair value per share for stock option grants that were awarded during the quarters ended June 30, 2004 and 2003 was $9.78 and $8.93, 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 a non-employee warrant exercisable for 595,405 and 991,083 shares for the quarters ended June 30, 2004 and 2003, 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 regions being the Americas, Europe, Japan and Asia Pacific region. Revenue is primarily attributable to the region in which the contract is signed and the product is deployed. Information regarding geographic regions is as follows:

6. RESTRUCTURING CHARGES

     The Company has recorded restructuring charges to align its cost structure with changing market conditions. These restructuring plans resulted in reductions in headcount and the consolidation of offices.

     During the quarter ended September 30, 2001, the Company recorded a restructuring charge of $7.2 million relating to headcount reductions, consolidation of facilities, and other related restructuring charges. During the quarter ended December 31, 2002, the Company recorded a restructuring charge of $2.2 million due to a further reduction in headcount. During the quarter ended December 31, 2003, the Company recorded a restructuring charge of $1.3 million due to additional headcount reductions. During the quarter ended March 31, 2004, the Company recorded a restructuring charge of $2.6 million due to further headcount reductions, and the consolidation of certain offices.

     As of June 30, 2004 and March 31, 2004, respectively, $2.7 million and $3.1 million of restructuring charges remained unpaid. This portion primarily relates to rent on the excess facilities and will be paid over the remaining rental periods.

     The following table sets forth a summary of total restructuring and related charges, payments made against those charges and the remaining liabilities as of June 30, 2004.

7. INVESTMENTS IN PRIVATE COMPANIES

     In April 2000, the Company made an investment in a third party totaling $2,000,000 of which $1,000,000 was equity and $1,000,000 was convertible debt. The Company and this third party share a common Board member. In March 2002, the Company recorded an other-than-temporary decline in value of $200,000 in the equity investment. In June 2003, the Company received $1,000,000 as repayment of the convertible debt and converted $257,000 of interest income into additional equity. The third party was a business partner of the Company. As of June 30, 2004 and 2003, the carrying value of the investment in this third party was $1,057,000. The Company incurred royalty expense of $36,000 to this third party in the quarter ended June 30, 2004 and $363,000 in the quarter ended June 30, 2003.

8. SUBSEQUENT EVENT

     In July 2004, the Company announced and implemented a restructuring plan consisting of headcount reductions and the consolidation of facilities to further align our cost structure with expected revenue. The Company is still evaluating the total costs associated with this restructuring.

     ITEM 2: MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     This quarterly report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Examples of forward-looking statements include, but are not limited to, (i) projections of financial performance or financial results, including items such as revenue, costs or expense, cost savings, margins, income or loss, earnings or loss per share, return to profitability on a pro-forma or GAAP basis, capital expenditures, cash requirements or other financial items or metrics, the impact of expenses on levels of cash and marketable securities, sufficiency of working capital and projections regarding the market for the Company’s current and anticipated software offerings, (ii) statements of the plans or objectives of webMethods, Inc. or its management, including the development or enhancement of software, dates of availability of new products and new releases of existing products, competitive strategies and the impact of competition, development and continuation of strategic partnerships and alliances, contributions to future financial performance of any of our new or existing products, technologies or businesses, contribution to our financial performance by business partners, implementation and effect of sales and marketing initiatives by webMethods, strength of results from geographic or specific vertical markets and allocation of resources to those markets, predictions of the timing and type of customer or market reaction to those initiatives or our product offerings, the ability to control expenses or achieve projected expense levels, future hiring, webMethods’ business strategy and the execution on it and actions by customers and competitors, (iii) statements of future economic performance, economic conditions or the impact of recent changes in accounting standards and (iv) assumptions underlying any of the foregoing. In some instances, forward-looking statements can be identified by the use of the words “believes,” “anticipates,” “plans,” “expects,” “intends,” “may,” “will,” “should,” “estimates,” “predicts,” “continue”, the negative thereof or similar expressions. Although we believe that the expectations reflected in the forward-looking statements are reasonable, our expectations or the forward-looking statements could prove to be incorrect, and actual results could differ materially from those indicated by the forward-looking statements. Our future financial condition and results of operations, as well as any forward-looking statements, are subject to risks and uncertainties, including (but not limited to) those discussed in Item 1 of our Form 10-K for the year ended March 31, 2004 under the caption “Factors That May Affect Future Operating Results” and under this Item under the caption “Factors That May Affect Future Operating Results”. Achieving the future results or accomplishments described or projected in forward-looking statements depends upon events or developments that are often beyond our ability to control. All forward-looking statements and all reasons why actual results may differ that are included in this report are made as of the date of this report, and webMethods disclaims any obligation to publicly update or revise such forward-looking statements or reasons why actual results may differ.

OVERVIEW

Background

     We are a leading provider of software and services for end-to-end business integration solutions. We offer a set of software products that enable organizations to run, manage and optimize their business. Our software products and related services give organizations the ability, seamlessly and in real-time, to integrate disparate information resources, to connect customers, vendors and business partners with the organization and its employees, to view and manage the connected information resources, data, business processes and human workflows and to provide Web services at the enterprise level.

     In October 2003, we completed the business and asset acquisitions of The Mind Electric, Inc. (“TME”), The Dante Group Inc. and the portal solution previously known as Data Channel. TME was a leading provider of software for service-oriented architectures and The Dante Group was a provider of business activity monitoring software. The aggregate acquisition cost for these three acquisitions was approximately $32.4 million in cash.

Overview of First Quarter of Fiscal 2005

     Our net loss of $10.8 million for the quarter ended June 30, 2004 increased by $4.0 million from a net loss of $6.8 million in the quarter ended June 30, 2003. The increase in net loss was due primarily to a $7.6 million decrease in license revenue in the quarter ended June 30, 2004 compared to the quarter ended June 30, 2003. During the June 2004 quarter, many enterprises unexpectedly became more cautious in their enterprise software spending. They subjected their proposed information technology purchases to rigorous internal reviews and approvals or requests for contract contingencies, which often resulted in longer sales cycles, the postponement of information technology projects, customers placing smaller orders, or difficulty in closing large deals. We did not close a number of expected opportunities we were working on near the end of the June 2004 quarter, and lower closure rates of large transactions near the end of June 2004 across almost every geographic region contributed significantly to our decrease in license revenue compared to the June 2003 quarter. That decrease in license revenue was partially offset by a $4.0 million increase in professional services revenue and a $2.2 million increase in maintenance revenue in the quarter ended June 30, 2004 compared to the quarter ended June 30, 2003.

     We maintained our focus on managing operating expenses throughout the quarter ended June 30, 2004 and decreased our operating expenses by $1.0 million in the quarter ended June 30, 2004 compared to the quarter ended June 30, 2003. This 3% reduction in operating expenses is a result of reductions in total sales and marketing expense and research and development expense compared to the same quarter in the prior year.

     We license software and sell our services primarily through our direct sales organization augmented by other sales channels, including our strategic software vendor partners, major system integrators with whom we have strategic alliances, other partners and distributors and, to a lesser extent, resellers. We license our software primarily on a perpetual basis and, to a lesser extent, on a renewable term basis. As of June 30, 2004, we had over 1,200 customers, compared to over 975 customers as of June 30, 2003.

     We believe our strong focus and track record of ensuring that our software is successfully put into production is a strong competitive advantage and differentiator. During the first quarter of fiscal year 2005, our global customer services group reported and documented more than 155 separate customer projects going into production events as compared to 100 such events reported and documented during the quarter ended June 30, 2003. Ensuring that our customers put our software into production in a timely manner enables them to achieve a greater return on their investment and, in many cases, encourages them to purchase additional software for other business integration projects and serve as a reference customer for us in our future sales efforts.

     We believe one of our competitive differentiators is our strategic partnerships with enterprise software companies and system integrators. Under our partnerships with enterprise software vendors, the partner may resell or, in some instances, embed or otherwise utilize our software with their products under limited use licenses for a license or royalty fee. Enterprise software vendors with whom we have relationships include American Management Systems (AMS), Hewlett-Packard Company, Informatica, i2 Technologies, Microsoft, Peoplesoft and Siebel Systems. We believe our systems integrator and enterprise software partners influenced, directly or indirectly, a significant portion of our license revenue during our quarters ended June 30, 2004 and 2003, and we expect this influence to continue in future periods. Under certain partnership arrangements, we may share license fees derived from joint selling opportunities with our partner. In systems integrator and other partnership arrangements, we may pay a sales assistance fee to a partner who performs or assists in certain sales activities, and that fee usually is paid once payment from the joint customer of license fees is received.

Critical Accounting Policies and Estimates

     Our 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, revenue and expenses, and related disclosures. We evaluate our estimates, on an on-going basis, including those related to allowances for bad debts, investments, intangible assets, income taxes, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ for these estimates under different assumptions or conditions.

     We believe the following critical accounting policies affect the more significant judgments and estimates used in the preparation of our consolidated financial statements.

Revenue Recognition

     We enter into arrangements, which may include the sale of licenses of our software, professional services and maintenance or various combinations of each element. We recognize revenue based on Statement of Position (“SOP”) 97-2, “Software Revenue Recognition,” as amended, and modified by SOP 98-9, “Modification of SOP 97-2, Software Revenue Recognition, With Respect to Certain Transactions.” SOP 98-9 modified SOP 97-2 by requiring revenue to be recognized using the “residual method” if certain conditions are met. Revenue is recognized based on the residual method when an agreement has been signed by both parties, the fees are fixed or determinable, collection of the fees is probable, delivery of the product has occurred, vendor specific objective evidence of fair value exists for any undelivered element, and no other significant obligations remain. Revenue allocated to the undelivered elements is deferred using vendor-specific objective evidence of fair value of the elements and the remaining portion of the fee is allocated to the delivered elements (generally the software license). See Note 2 in the Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended March 31, 2004 for a more comprehensive discussion of our revenue recognition policies. Judgments we make regarding these items, including collection risk, can materially impact the timing of recognition of license revenue.

     Policies related to revenue recognition require difficult judgments on complex matters that are often subject to multiple sources of authoritative guidance. These sources may publish new authoritative guidance which might impact current revenue recognition policies. We continue to evaluate our revenue recognition policies as new authoritative interpretations and guidance are published, and where appropriate, may modify our revenue recognition policies. Application of our revenue recognition policy requires a review of our license and professional services agreements with customers and may require management to exercise judgment in evaluating whether delivery has occurred, payments are fixed and determinable, collection is probable, and where applicable, if vendor-specific

objective evidence of fair value exists for undelivered elements of the contract. In the event judgment in the application of our revenue recognition policies is incorrect, the revenue recognized by webMethods could be impacted.

Allowance for Doubtful Accounts

     We maintain allowances for doubtful accounts for estimated losses which may result from the inability of our customers to make required payments to us. These allowances are established through analysis of the credit-worthiness of each customer with a receivable balance, determined by credit reports from third parties, published or publicly available financial information, customer-specific experience including payment practices and history, inquiries, and other financial information from our customers. The use of different estimates or assumptions could produce materially different allowance balances. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. At June 30, 2004, and March 31, 2004, the allowance for doubtful accounts was $2,001,000 and $2,103,000 respectively.

Business Combinations

     We are required to allocate the purchase price of acquired companies to the tangible and intangible assets acquired, liabilities assumed, and in-process research and development (IPR&D) acquired based on their estimated fair values. We engaged independent third-party appraisal firms to assist us in determining the fair values of assets acquired and liabilities assumed. Such a valuation requires management to make significant estimates and assumptions, especially with respect to intangible assets.

     Critical estimates in valuing certain of the intangible assets include but are not limited to: future expected cash flows from license sales, maintenance agreements, consulting contracts, customer contracts, and acquired developed technologies and IPR&D projects, and discount rates. Management’s estimates of fair value are based upon assumptions believed to be reasonable, but which are inherently uncertain and unpredictable. Assumptions may be incomplete or inaccurate, and unanticipated events and circumstances may occur.

     Other estimates associated with the accounting for these acquisitions may change as additional information becomes available regarding the assets acquired and liabilities assumed.

Goodwill and Intangibles Assets

     We record goodwill and intangible assets when we acquire other businesses. The allocation of acquisition cost to intangible assets and goodwill involves the extensive use of management’s estimates and assumptions, and the result of the allocation process can have a significant impact on our future operating results. Financial Accounting Standards Board No. 142, “Goodwill and Other Intangible Assets” (SFAS 142), which was issued during fiscal year 2002 and adopted by us on April 1, 2002, eliminated the amortization of goodwill and indefinite lived intangible assets. Intangible assets with finite lives are amortized over their useful lives while goodwill and indefinite lived assets are not amortized under SFAS 142, but are periodically tested for impairment. In accordance with SFAS 142, all of our goodwill is associated with our corporate reporting unit, as we do not have multiple reporting units. On an annual basis, or as events occur or circumstances change, we will evaluate whether an impairment of the goodwill may exist. Goodwill is tested for impairment using a two-step process. The first step is to identify a potential impairment and the second step measures the amount of the impairment loss, if any. Goodwill is deemed to be impaired if the carrying amount of the asset exceeds its estimated fair value.

Acquired In-process Research and Development

     Costs to acquire in-process research and development technologies which have no alternative future use and which have not reached technological feasibility at the date of acquisition are expensed as incurred (see Note 12 in the Consolidated Financial Statements included in the Company’s Annual Report on Form 10-K for the year ended March 31, 2004 for more comprehensive information).

Foreign Currency Effects

     The functional currency for our foreign operations is the local currency. The financial statements of foreign subsidiaries have been translated into United States dollars. Asset and liability accounts have been translated using the exchange rate in effect at the balance sheet date. Revenue and expense accounts have been translated using the average exchange rate for the period. The gains and losses associated with the translation of the financial statements resulting from the changes in exchange rates from period to period have been reported in other comprehensive income or loss. To the extent assets and liabilities of the foreign operations are realized or the foreign operations are expected to pay back the intercompany debt in the foreseeable future, amounts previously reported in other comprehensive income or loss would be included in net income or loss in the period in which the transaction occurs. Transaction gains

or losses are included in net income or loss in the period in which they occur.

Accounting for Income Taxes

     We have recorded a tax valuation allowance to reduce our deferred tax assets to the amount that is expected to be realized. While we have considered future taxable income and ongoing prudent and feasible tax planning strategies in assessing the need for the valuation allowance, in the event we were to determine that we would be able to realize our deferred tax assets in the future in excess of its net recorded amount, an adjustment to the deferred tax asset would increase income in the period such determination was made. Likewise, should we determine that we would not be able to realize all or part of our net deferred tax asset in the future, an adjustment to the deferred tax asset would be charged to income in the period such determination was made.

Restructuring and Related Charges

     We have recorded restructuring costs to align our cost structure with changing market conditions. These restructuring plans resulted in a reduction in headcount and consolidation of facilities through the closing of excess offices. Our restructuring costs included accruals for the estimated loss on facilities that we intend to sublease based on estimates of the timing and amount of sublease income. We reassess this liability each period based on market conditions. Revisions to our estimates of this liability could materially impact our operating results and financial position in future periods if anticipated events and key assumptions, such as the timing and amounts of sublease rental income, either change or do not materialize.

Litigation and Contingencies

     We are subject to the possibility of various loss contingencies arising in the ordinary course of business. We consider the likelihood of loss or impairment of an asset or the incurrence of a liability, as well as our ability to reasonably estimate the amount of loss in determining loss contingencies. An estimated loss contingency is accrued when it is probable that an asset has been impaired or a liability has been incurred and the amount of loss can be reasonably estimated. We regularly evaluate current information available to us to determine whether such accruals should be adjusted.

RESULTS OF OPERATIONS

     The following table summarizes the results of our operations for the fiscal quarters ended June 30, 2004 and 2003 (all percentages are calculated using the underlying data in thousands):