UNITED STATES SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549.

Form 10-Q

(Mark One)
þ	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
	For the Quarterly Period Ended December 31, 2005
o	TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

Commission File Number 1-15681

webMethods, Inc.

(Exact name of Registrant as Specified in its Charter)

Delaware	54-1807654
(State or Other Jurisdiction of Incorporation or Organization)	(I.R.S. Employer Identification No.)
3877 Fairfax Ridge Road, South Tower, Fairfax, Virginia (Address of Principal Executive Offices)	22030 (Zip Code)

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, together with related 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 þ          No o

      Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, or a non-accelerated filer. See definition of “accelerated filer” and “large accelerated filer” in Rule 12b-2 of the Exchange Act (Check one):

Large accelerated filer o          Accelerated Filer þ          Non-accelerated filer o

      Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act).          Yes o          No þ

      As of February 8, 2006, there were outstanding 54,336,853 shares of the registrant’s Common Stock.

WEBMETHODS, INC.

QUARTERLY REPORT ON FORM 10-Q

TABLE OF CONTENTS

Part I	Financial Information
Item 1	Financial Statements
Condensed Consolidated Financial Statements
Condensed Consolidated Balance Sheets (unaudited) as of December 31, 2005 and March 31, 2005		3
Condensed Consolidated Statements of Operations and Comprehensive Income or Loss (unaudited) — Three and nine months ended December 31, 2005 and 2004		4
Condensed Consolidated Statements of Cash Flows (unaudited) — Nine months ended December 31, 2005 and 2004		5
Notes to Condensed Consolidated Financial Statements (unaudited)		6
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations	10
Item 3	Quantitative and Qualitative Disclosures About Market Risk	31
Item 4	Controls and Procedures	32
Part II	Other Information
Item 1	Legal Proceedings	33
Item 6	Exhibits	33

2

PART I

FINANCIAL INFORMATION

ITEM 1:     FINANCIAL STATEMENTS

WEBMETHODS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(UNAUDITED)

			December 31,			March 31,
			2005			2005
			(In thousands)
ASSETS
Current assets:
	Cash and cash equivalents		$	69,047		$	57,209
	Marketable securities available for sale			79,825			78,332
	Accounts receivable, net of allowance of $992 and $1,862			48,243			47,326
	Prepaid expenses and other current assets			5,762			6,401
		Total current assets		202,877			189,268
Marketable securities available for sale				—			14,513
Property and equipment, net				10,323			10,342
Goodwill				46,704			46,704
Intangibles assets, net				6,593			8,390
Other assets				4,074			6,127
		Total assets	$	270,571		$	275,344
LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
	Accounts payable		$	6,821		$	8,673
	Accrued expenses			11,050			16,506
	Accrued salaries and commissions			9,362			12,219
	Deferred revenue			41,298			43,055
	Current portion of capital lease obligations			338			475
		Total current liabilities		68,869			80,928
	Capital lease obligations, net of current portion			51			139
	Other long-term liabilities			3,346			3,374
	Long-term deferred revenue			4,492			6,371
		Total liabilities		76,758			90,812
Commitments and contingencies
Stockholders’ equity:
	Common stock, $0.01 par value; 500,000,000 shares authorized; 53,996,771 and 53,346,623 shares issued and outstanding			540			533
	Additional paid-in capital			528,068			524,487
	Deferred warrant charge			(915	)		(2,480	)
	Accumulated deficit			(332,671	)		(340,224	)
	Accumulated other comprehensive income (loss)			(1,209	)		2,216
		Total stockholders’ equity		193,813			184,532
		Total liabilities and stockholders’ equity	$	270,571		$	275,344

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 INCOME OR LOSS

(UNAUDITED)

			Three Months Ended						Nine Months Ended
			December 31,						December 31,
			2005			2004			2005			2004
			(In thousands, except share and per share data)
Revenue:
	License		$	21,964		$	25,953		$	59,821		$	64,610
	Professional services			11,627			11,854			34,636			36,455
	Maintenance			18,908			17,156			54,945			46,601
		Total revenue		52,499			54,963			149,402			147,666
Cost of revenue:
	Amortization of intangibles			599			599			1,797			1,797
	License			218			252			703			1,117
	Professional services and maintenance			13,232			13,764			40,267			42,317
		Total cost of revenue		14,049			14,615			42,767			45,231
Gross profit				38,450			40,348			106,635			102,435
Operating expenses:
	Sales and marketing			19,549			22,764			53,875			65,126
	Research and development			8,980			10,877			30,224			32,747
	General and administrative			5,927			7,093			17,542			17,034
	Restructuring costs			(117	)		—			602			2,756
		Total operating expenses		34,339			40,734			102,243			117,663
Operating income (loss)				4,111			(386	)		4,392			(15,228	)
Other income (expense)
	Interest income			1,137			615			3,116			1,700
	Interest expense			(14	)		(28	)		(77	)		(84	)
	Other income (expense)			346			(27	)		578			(31	)
	Impairment of equity investment in private company			—			—			—			(1,057	)
Income (loss) before income taxes				5,580			174			8,009			(14,700	)
		Provision for income taxes		70			126			455			195
Net income (loss)			$	5,510		$	48		$	7,554		$	(14,895	)
Basic and diluted net income (loss) per common share			$	0.10		$	0.00		$	0.14		$	(0.28	)
Weighted average shares used in computing per share amounts:
	Basic			53,772,555			53,155,607			53,586,645			53,024,466
	Diluted			55,777,814			54,144,369			54,592,431			53,024,466
Comprehensive income (loss):
	Net income (loss)		$	5,510		$	48		$	7,554		$	(14,895	)
	Other comprehensive income (loss):
		Unrealized (loss) gain on securities available for sale		17			(70	)		153			(388	)
		Foreign currency cumulative translation adjustment		(1,014	)		1,880			(3,579	)		1,604
Total comprehensive income (loss)			$	4,513		$	1,858		$	4,128		$	(13,679	)

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)

		Nine Months Ended
		December 31,
		2005			2004
		(In thousands)
Cash flows from operating activities:
	Net income (loss)	$	7,554		$	(14,895	)
	Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities:
	Depreciation and amortization		4,045			4,725
	(Recovery of) provision for doubtful accounts		(249	)		241
	Amortization of deferred stock compensation related to employee stock options and non-employee stock warrants		2,056			1,984
	Amortization of acquired intangibles		1,798			1,798
	Amortization of deferred rent		(343	)		—
	Impairment of equity investment in private company		—			1,057
Increase (decrease) in cash resulting from changes in assets and liabilities:
	Accounts receivable		(1,999	)		(4,131	)
	Prepaid expenses and other current assets		513			(258	)
	Other assets		1,879			1,400
	Accounts payable		(1,456	)		267
	Accrued expenses and other liabilities		(5,146	)		(4,512	)
	Accrued salaries and commissions		(2,554	)		1,132
	Deferred revenue		(2,025	)		3,786
	Other liabilities		210			—
Net cash provided by (used in) operating activities			4,283			(7,406	)
Cash flows from investing activities:
	Purchases of property and equipment		(3,921	)		(3,851	)
	Net maturities of marketable securities available for sale		13,174			3,366
	Net cash provided by (used in) investing activities		9,253			(485	)
Cash flows from financing activities:
	Short-term borrowings		—			3,533
	Payments on short-term borrowings		—			(6,080	)
	Payments on capital leases		(466	)		(747	)
	Proceeds from exercise of stock options and stock issued under the ESPP		3,096			2,932
Net cash provided by (used in) financing activities			2,630			(362	)
Effect of exchange rate on cash and cash equivalents			(4,328	)		1,987
Net increase (decrease) in cash and cash equivalents			11,838			(6,266	)
Cash and cash equivalents at beginning of period			57,209			75,462
Cash and cash equivalents at end of period		$	69,047		$	69,196

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, “webMethods” or 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, 2005. 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 statement 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 or nine months ended December 31, 2005 are not necessarily indicative of the results to be expected for the full year or any future period.

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 by the Company 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 Statement of Financial Accounting Standard (“SFAS”) No. 123, “Accounting for Stock-Based Compensation,” for the three months and nine months ended December 31, 2005 and 2004:

	Three Months Ended						Nine Months Ended
	December 31,						December 31,
	2005			2004			2005			2004
	(In thousands, except per share data)
Net income (loss) attributable to common stockholders, as reported	$	5,510		$	48		$	7,554		$	(14,895	)
Add: Stock-based compensation expense determined under the intrinsic value method		42			—			72			—
Less: Stock-based compensation expense determined under fair value method		(17,224	)		(6,349	)		(26,012	)		(25,964	)
Net loss attributable to common stockholders, pro forma	$	(11,672	)	$	(6,301	)	$	(18,386	)	$	(40,859	)
Basic and diluted net income (loss) per common share, as reported	$	0.10		$	0.00		$	0.14		$	(0.28	)
Basic and diluted net loss per common share, pro forma	$	(0.22	)	$	(0.12	)	$	(0.34	)	$	(0.77	)

      On December 16, 2005, the Compensation Committee of the Board of Directors of the Company approved the acceleration of vesting of all outstanding, unvested and “out-of-the-money” stock options of the Company previously granted to employees, consultants or directors of the Company prior to September 30, 2005 with an exercise price higher than the closing price of the Company’s Common Stock on December 16, 2005, which was $7.53. The acceleration of such options was effective as of December 16, 2005, provided the holder of such options was an employee, consultant or director of the Company on such date. The total number of options accelerated was 2,172,180. The decision to accelerate the vesting of these options was made

6

WEBMETHODS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

primarily to eliminate future compensation expense attributable to these options, which otherwise would have been expensed beginning on April 1, 2006 as a result of the adoption of SFAS No. 123R, “Share-Based Payment.” In the above table, the pro forma stock-based compensation expense determined under the fair value method for the three months and nine months ended December 31, 2005 reflects approximately $13.0 million attributable to the acceleration of the vesting of these options.

3. COMPUTATION OF NET INCOME OR LOSS PER SHARE

      The Company’s net income or loss per share calculation (basic and diluted) is based on the weighted average number of common shares outstanding. For the three and nine months ended December 31, 2005, 2,005,259 and 1,005,786 common shares issuable upon the exercise of options have been included in the net income per share calculation because the effect of the exercise of these options would be dilutive, and 11,420,758 and 13,429,978 common shares issuable upon the exercise of options and warrants have been excluded from the net income per share calculation because the effect of the exercise of these options and warrants would be anti-dilutive.

      For the three months ended December 31, 2004, 988,762 common shares issuable upon the exercise of options have been included in the net income per share calculation because the effect of the exercise of these options would be dilutive, and 16,075,665 common shares issuable upon the exercise of options and warrants have been excluded from the net income per share calculation because the effect of the exercise of these options and warrants would be anti-dilutive. For the nine months ended December 31, 2004, 19,199,441 common shares issuable upon the exercise of options and warrants have been excluded from the net loss per share calculation because the effect of the exercise of these options and warrants would be anti-dilutive.

4. SUPPLEMENTAL DISCLOSURES OF CASH FLOW INFORMATION

		Nine Months
		Ended
		December 31,
		2005		2004
		(In thousands)
Cash paid during the period for interest		$	77	$	102
Non-cash investing and financing activities:
	Equipment purchased under capital lease	$	270	$	43
	Change in net unrealized gain or (loss) on marketable securities	$	153	$	(388	)

5. SEGMENT INFORMATION

      Revenue is primarily attributable to the geographic region in which the contract is signed and the product is deployed. The regions in which the Company operates are the Americas, Europe/ Middle East/ Africa (“EMEA”), Japan and Asia Pacific. Information regarding the Company’s revenues and long-lived assets, by region, is as follows:

	Three Months Ended				Nine Months Ended
	December 31,				December 31,
Revenue	2005		2004		2005		2004
	(In thousands)
Americas	$	31,713	$	31,290	$	92,743	$	89,379
EMEA		15,193		16,965		38,112		35,250
Japan		1,843		2,173		7,159		11,838
Asia Pacific		3,750		4,535		11,388		11,199
Total	$	52,499	$	54,963	$	149,402	$	147,666

7

WEBMETHODS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

	As of		As of
	December 31,		March 31,
Long-Lived Assets	2005		2005
	(In thousands)
Americas	$	11,142	$	12,478
EMEA		1,381		1,852
Japan		1,176		1,509
Asia Pacific		698		630
Total	$	14,397	$	16,469

6. RESTRUCTURING COSTS

      During the three months ended December 31, 2005, the Company recorded a $117,000 reduction in the accrual for excess facilities costs to reflect future payments expected to be received under a sublease agreement entered into during the period. During the nine months ended December 31, 2005, the Company incurred restructuring costs of $602,000, which includes restructuring costs of $719,000 that consist primarily of severance and related benefits, net of the $117,000 reduction in the accrual for excess facilities costs.

      During the year ended March 31, 2005, the Company recorded restructuring costs of $5.9 million, consisting of $2.8 million for headcount reductions and $3.1 million for excess facility costs related to the relocation of the Company’s headquarters. The estimated excess facility costs were based on the Company’s contractual obligations, net of estimated sublease income, based on current comparable lease rates. The Company reassesses this liability each period based on market conditions. Revisions to the estimates of this liability could materially impact the 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. In connection with the lease on the new headquarters facility, the Company received certain rent abatements and allowances totaling approximately $3.1 million as of March 31, 2005 and will receive additional incentives totaling $2.0 million through December 2007. Such rent abatements and allowances are deferred and will be amortized as a reduction to rent expense over the 11-year term of the lease. For the three months and nine months ended December 31, 2005, the Company amortized $114,000 and $343,000, respectively, as a reduction to rent expense.

      During the year ended March 31, 2004, the Company recorded restructuring and related charges of $3.9 million consisting of $2.2 million for headcount reductions and $1.7 million for consolidation of facilities and related impairment of fixed assets. The excess facility costs were based on the Company’s contractual obligations, net of sublease income.

      During the year ended March 31, 2003, the Company recorded restructuring costs of $2.2 million for headcount reductions.

      As of December 31, 2005 and March 31, 2005, respectively, $2.8 million and $4.4 million of restructuring costs remained unpaid. This portion primarily relates to rent on the excess facilities and will be paid over the remaining rental periods.

8

WEBMETHODS, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS — (Continued)

      The following table sets forth a summary of total restructuring costs, payments made against those charges and the remaining liabilities as of December 31, 2005.

	Excess									Severance
	Facilities			Excess			Excess			and
	Santa Clara, CA			Facilities			Facilities			Related
	and Fairfax, VA			Berkeley, CA			Fairfax, VA			Benefits			Total
	(In thousands)
Balance at March 31, 2005	$	534		$	1,007		$	2,900		$	—		$	4,441
First quarter fiscal 2006 charges		—			—			—			288			288
Cash payments made in first quarter of fiscal 2006		(43	)		(91	)		(124	)		(246	)		(504	)
Second quarter fiscal 2006 charges		—			—			—			431			431
Cash payments made in second quarter of fiscal 2006		(43	)		(82	)		(546	)		(264	)		(935	)
Reduction in accrual made in third quarter of fiscal 2006		(117	)		—			—			—			(117	)
Cash payments made in third quarter of fiscal 2006		(46	)		(83	)		(496	)		(209	)		(834	)
Balance at December 31, 2005	$	285		$	751		$	1,734		$	—		$	2,770

7. BORROWINGS

      The Company has a line of credit agreement with a bank to borrow up to a maximum principal amount of $20 million and a $2 million equipment line of credit facility. Both facilities have a maturity date of June 29, 2006.

      The Company may borrow the entire $20 million operating line of credit as long as the aggregate balances of domestic cash, cash equivalents and marketable securities available for sale are at least $85 million; otherwise, borrowings under this facility are limited to 80% of eligible accounts receivable. Interest is payable on any unpaid principal balance at the bank’s prime rate. Borrowings under the equipment line of credit will bear interest at a fixed 8% rate or prime plus 1%, at the Company’s option and will be repaid over 36 months. The agreement for both facilities include restrictive covenants which require the Company to maintain, among other things, a ratio of quick assets (as defined in the agreement) to current liabilities, excluding deferred revenue, of at least 1.5 to 1.0 and a quarterly revenue covenant such that total revenue for each fiscal quarter must be at least $45 million. At December 31, 2005, the Company was in compliance with these covenants.

      As of December 31, 2005, the Company had not borrowed against the operating line of credit or the equipment line of credit. In connection with the operating line of credit agreement, the Company has obtained letters of credit totaling approximately $2.6 million related to office leases. As of December 31, 2005, the Company had $17.4 million available under the operating line of credit and $2.0 million available under the equipment line of credit.

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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, continued profitability, 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 the Company 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 below under the caption “Factors That May Affect Future Operating Results” and in the “Business” discussion contained in Item 1 of our Form 10-K for the year ended March 31, 2005 under the caption “Factors That May Affect Future Operating Results.” In addition, the following discussion should be read in conjunction with the consolidated financial statements and related notes of the Company appearing elsewhere in this Form 10-Q and our Form 10-K for the year ended March 31, 2005. 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 business integration and optimization software. Our solutions enable organizations to deliver strategic applications to their business faster while allowing them to understand what is happening with their business in real-time and to predict what can be expected to happen. webMethods calls this “Business Process Productivity”, which we use to describe the desire of organizations to increase the efficiency of their activities, improve the ability of the enterprise to adapt to changing market conditions, and create competitive advantage through a focus on the business processes that run their organizations. We believe that our primary offering, the webMethods Fabric^tm product suite, is the only business integration and optimization suite on the market developed specifically to address the diverse and comprehensive requirements to achieve Business Process Productivity.

10

      webMethods Fabric gives customers the ability to integrate, assemble and optimize their mission critical business processes. webMethods Fabric does this by helping organizations link their enterprise software applications and databases, connect electronically with their trading partners, automate and optimize the business processes that span these systems and interfaces, and implement software applications that provide people with the information and capabilities necessary to run the business more effectively. We believe that the principal customer benefits of our products include:

•  eliminating significant costs from the organization’s information technology environment,

•  automating and streamlining interactions with their customers and suppliers,

•  becoming more competitive by capturing more market share in terms of increased revenue from new and existing customers,

•  gaining more timely access to information to make better decisions about the business, and

•  allowing staff to focus their attention on higher value business activities.

      webMethods Fabric builds upon our history as a leader and innovator in the business integration market. Introduced in October 2004, the webMethods Fabric product suite unifies the enterprise application integration and business-to-business capabilities for which webMethods is widely known, with our existing Business Process Management and workflow functionality and the Business Activity Monitoring, portal, and Web services technologies we acquired in October 2003. We believe that by integrating these particular capabilities into a single product suite, taking advantage of synergies between different elements of the solution, and merging the products to provide a seamless user experience, we have created a unique offering in the marketplace. By combining best-of-breed capabilities into one platform, we offer customers the ability to lower their total cost of ownership and to streamline the overall implementation process relative to using different stand-alone software products.

      webMethods Fabric is based on a Service-Oriented Architecture (“SOA”) foundation. SOA enables organizations to extend the value of their existing IT assets, transforming them into reusable components that can be applied to new business needs. Customers who want “true SOA” need the infrastructure software to provide an integrated approach to the creation, organization, management and security of Web services. webMethods Fabric incorporates an integrated registry and management, as well as security, for Web services. Our approach offers an alternative to custom software development, helping our customers deliver software applications to the business faster and with less risk, while real-time monitoring and patent-pending analytics gives organizations the insight necessary for achieving continuous process improvements in their business.

      In addition to our webMethods Fabric product suite, we have a strategy to combine our software capabilities, professional services, strategic partnerships, and domain expertise into well-defined solutions that address specific horizontal and vertical industry problems. Our first planned solutions are in the areas of payment and lending processing in the financial services industry, integration in the retail industry and regulatory compliance requirements impacting many organizations.

      We market and sell our products and solutions primarily to the largest 2,000 corporations worldwide (the “Global 2000”) and major government agencies. 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. As of December 31, 2005, we had approximately 1,400 customers around the world, distributed across our target verticals in manufacturing, process industries (such as chemicals, oil and gas, life sciences, metals, paper and plastics), financial services, consumer goods manufacturing and retail, government and telecommunications.

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

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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 ongoing basis, including those related to allowances for bad debts, investments, intangible assets, income taxes, restructuring accrual, contingencies and litigation. We base our estimates on historical experience and on various other assumptions that we believe are 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). 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 and evolving business practices. 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 or determinable, collection is probable, and where applicable, if vendor-specific objective evidence of fair value exists for undelivered elements of the contract. If we made different judgments or utilized different estimates for any period, material differences in the amount and timing of revenue recognized could result.

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 creditworthiness of each customer with a receivable balance, determined by credit reports from third parties, published or publicly available financial information, each customer’s 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 December 31, 2005 and March 31, 2005, the allowance for doubtful accounts was $992,000 and $1.9 million, respectively.

Business Combinations

      We are required to allocate the purchase price of acquired companies to the tangible and intangible assets acquired, liabilities assumed, as well as in-process research and development (IPR&D) based on their estimated fair values. This valuation requires management to make significant estimates and assumptions, especially with respect to intangible assets.

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      Critical estimates in valuing certain of the intangible assets and subsequently assessing the realizability of such 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 and subsequent assessment of impairment of the assets may change as additional information becomes available regarding the assets acquired and liabilities assumed.

Goodwill and Intangible 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 one reporting unit, as we do not have multiple reporting units. Accordingly, on an annual basis we perform the impairment assessment required under SFAS 142 at the enterprise level. We have used the Company’s total market capitalization to assess the fair value of the enterprise. If our estimates or the related assumptions change in the future, we may be required to record impairment charges to reduce the carrying value of these assets, which could be substantial.

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.

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, which is a separate component of stockholder’s equity. Transaction gains or losses are included in net income or loss in the period in which they occur.

      SFAS 52, “Foreign Currency Translation,” requires that foreign exchange gains and losses resulting from the translation of intercompany debt balances be accounted for based on the characterization of the intercompany debt balances. Intercompany debt balances are considered long-term permanent advances if settlement is not planned or anticipated in the foreseeable future. Translation gains and losses on long-term intercompany debt balances for which repayment is not planned or anticipated in the foreseeable future are recognized as other comprehensive income or loss, whereas translation gains or losses on short-term or long-term intercompany debt balances expected to be settled in the foreseeable future are recognized as a charge or credit to other income (expense). If there is a change in the characterization of long-term intercompany debt balances that were previously characterized as permanent advances, to short-term intercompany debt balances repayable in the foreseeable future, then translation gains or losses would be recognized as a charge or credit to other income (expense) prospectively. During the three months ended December 31, 2005, a number of foreign subsidiaries repaid certain long-term intercompany debt balances that were previously characterized as permanent advances, and it is expected that they will settle future intercompany transactions on a short-term

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basis. As a result, translation gains or losses on certain intercompany debt balances will now be recognized as a charge or credit to other income (expense).

Accounting for Income Taxes

      Although we believe that our future taxable income may be sufficient to utilize a substantial amount of the benefits of our net operating loss carryforwards and to realize our deferred tax assets, we have recorded a valuation allowance to completely offset the carrying value of the deferred tax assets as we have concluded that the realization of the deferred tax assets does not meet the “more likely than not” and “foreseeable future” criteria. If we should determine that we would be able to realize our deferred tax assets in the foreseeable 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 included in income in the period such determination was made.

Stock-Based Compensation

      We measure compensation expense for employee stock-based compensation using the intrinsic value method. Under this method, if 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. We also provide pro forma disclosures of net loss as if the fair value method had been applied in measuring compensation expense, consistent with the methodology prescribed in SFAS No. 123, “Accounting for Stock-Based Compensation.”

      Effective April 1, 2006, we will adopt SFAS No. 123R “Share-Based Payment.” Under SFAS 123R, share-based compensation cost is measured at the grant date based on the fair value of the award and is recognized as expense over the vesting period. We are currently evaluating the impact of the adoption of SFAS 123R on our financial position and results of operations, including the valuation methods and support for the assumptions that underlie the valuation of the awards. However, we believe that the adoption of SFAS 123R will have a material effect on our results of operations.

Restructuring and Related Charges

      We have recorded restructuring and related charges to align our cost structure with changing market conditions. These restructuring and related charges consist of headcount reductions, consolidation and relocation of facilities and related impairment of fixed assets. Excess facility costs related to the consolidation and relocation of facilities are based on our contractual obligations, net of estimated sublease income based on current comparable lease rates. 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.

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RESULTS OF OPERATIONS

      The following table summarizes the results of our operations for the three months and nine months ended December 31, 2005 and 2004 (all percentages are calculated using the underlying data in thousands):

	Three Months Ended December 31,									Nine Months Ended December 31,
							Percentage									Percentage
	2005			2004			Change			2005			2004			Change
	($ in thousands)
Total revenue	$	52,499		$	54,963			(4	)%	$	149,402		$	147,666			1	%
Gross profit		38,450			40,348			(5	)%		106,635			102,435			4	%
% of total revenue		73	%		73	%					71	%		69	%
Total operating expenses		34,399			40,734			(16	)%		102,243			117,663			(13	)%
% of total revenue		66	%		74	%					68	%		80	%
Operating income (loss)		4,111			(386	)		*			4,392			(15,228	)		*
% of total revenue		8	%		(1	)%					3	%		(10	)%
Net income (loss)	$	5,510		$	48			114	%	$	7,554		$	(14,895	)		*
% of total revenue		10	%		0	%					5	%		(10	)%

*  Not applicable.

      Total revenue decreased by $2.5 million, or 4%, for the three months ended December 31, 2005 compared to the three months ended December 31, 2004, due primarily to decreases in license and professional services revenue, which were partially offset by an increase in maintenance revenue. For the nine months ended December 31, 2005, total revenue increased by $1.7 million, or 1%, compared to the nine-month period in the prior year, due primarily to an increase in maintenance revenue, which was partially offset by decreases in license and professional services revenue.

      We recorded net income of $5.5 million for the three months ended December 31, 2005, which was a $5.5 million improvement from our net income of $48,000 in the three months ended December 31, 2004. This result was due primarily to decreases of approximately $6.4 million in operating expenses and $566,000 in cost of revenue and a $522,000 increase in interest income, which were partially offset by a $2.5 million decrease in total revenue, in the three months ended December 31, 2005 compared to the three months ended December 31, 2004. For the nine months ended December 31, 2005, we recorded net income of $7.5 million, which was a $22.4 million improvement from our net loss of $14.9 million in the prior year period. This result was due primarily to decreases of approximately $15.4 million in operating expenses, $2.5 million in cost of revenue and $1.1 million in impairment of equity investment, and increases of approximately $1.7 million in total revenue and $1.4 million in interest income in the nine months ended December 31, 2005 compared to the nine months ended December 31, 2004. Foreign currency fluctuations had a negative impact on net income of $389,000 for the three months and $406,000 for the nine months ended December 31, 2005.

Revenue

      The following table summarizes our revenue for three months and nine months ended December 31, 2005 and 2004:

	Three Months Ended December 31,							Nine Months Ended December 31,
					Percentage							Percentage
	2005		2004		Change			2005		2004		Change
	($ in thousands)
License	$	21,964	$	25,953		(15	)%	$	59,821	$	64,610		(7	)%
Professional services		11,627		11,854		(2	)%		34,636		36,455		(5	)%
Maintenance		18,908		17,156		10	%		54,945		46,601		18	%
Total revenue	$	52,499	$	54,963		(4	)%	$	149,402	$	147,666		1	%

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      Total revenue decreased $2.5 million, or 4%, for the three months ended December 31, 2005 compared to the three months ended December 31, 2004, due primarily to decreases of approximately $4.0 million in license revenue and $227,000 in professional services revenue, which were partially offset by an approximately $1.7 million increase in maintenance revenue. In the nine months ended December 31, 2005, total revenue increased by $1.7 million, or 1%, primarily due to an approximately $8.3 million increase in maintenance revenue, which was partially offset by a $4.8 million decrease in license revenue and $1.8 million decrease in professional services revenue. Foreign currency fluctuations had a negative impact on total revenue of $1.4 million in the three months ended December 31, 2005 and a negative impact of $916,000 in the nine months then ended.

      License revenue decreased by approximately $4.0 million, or 15%, in the three months ended December 31, 2005 compared to the three months ended December 31, 2004, primarily due to decreases in sales in the EMEA and Asia Pacific regions. In the nine months ended December 31, 2005, license revenue decreased by $4.8 million, or 7%, compared to the nine months ended December 31, 2004, primarily due to decreases in sales in the Japan, Asia Pacific and EMEA regions, partially offset by an increase in sales in the Americas. Our Japanese business was negatively impacted by management turnover and other changes in the business of our Japanese subsidiary related to the internal investigation that we disclosed in fiscal year 2005. Foreign currency fluctuations had a negative impact of $520,000 on license revenue in the three months ended December 31, 2005 and a negative impact of $399,000 in the nine months then ended.

      Professional services revenue decreased by $227,000, or 2%, in the three months ended December 31, 2005 compared to the three months ended December 31, 2004. In the nine months ended December 31, 2005, professional services revenue decreased $1.8 million, or 5%, compared to the nine months ended December 31, 2004. These declines were primarily attributable to lower professional services revenue from sub-contractors because we have shifted more of this business to our systems integration partners. Foreign currency fluctuations had a negative impact of $357,000 on professional services revenue in the three months ended December 31, 2005 and a negative impact of $213,000 in the nine months then ended.

      Maintenance revenue increased $1.7 million, or 10%, in the three months ended December 31, 2005 compared to the three months ended December 31, 2004. In the nine months ended December 31, 2005, maintenance revenue increased $8.3 million, or 18%, compared to the nine months ended December 31, 2004. Our existing customers contract with us, separately from licensing our software, for software upgrades and technical support of software they have licensed from us. As our customers generally continue to subscribe for maintenance and support when they are no longer required to pay license fees, we experience increases in maintenance revenue (unlike license revenue) as the cumulative number of licensed copies of our software increase. The increases in maintenance revenue in the three months and nine months ended December 31, 2005 were due primarily to the increase in the total number of copies of our software licensed to customers, the cumulative effect of agreements for post-contract maintenance and support, which are recognized as revenue ratably over the term of the agreement, and the increased number of customers subscribing for our 24 × 7 support plans, which involve somewhat higher prices than our standard support plans. Foreign currency fluctuations had a negative impact of $539,000 on maintenance revenue in the three months ended December 31, 2005 and a negative impact of $305,000 in the nine months then ended.

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      The following table summarizes the Company’s revenue by geographic region for the three months and nine months ended December 31, 2005 and 2004:

	Three Months Ended December 31,							Nine Months Ended December 31,
					Percentage							Percentage
	2005		2004		Change			2005		2004		Change
	($ in thousands)
Americas	$	31,713	$	31,290		1	%	$	92,743	$	89,379		4	%
EMEA		15,193		16,965		(10	)%		38,112		35,250		8	%
Japan		1,843		2,173		(15	)%		7,159		11,838		(40	)%
Asia Pacific		3,750		4,535		(17	)%		11,388		11,199		2	%
Total revenue	$	52,499	$	54,963		(4	)%	$	149,402	$	147,666		1	%

      In the three months ended December 31, 2005, revenue from the Americas increased by $423,000, or 1%, compared to the three months ended December 31, 2004. International revenue accounted for 40% of our total revenue in the three months ended December 31, 2005, as compared to 43% in the three months ended December 31, 2004. In the nine months ended December 31, 2005, revenue from the Americas increased $3.4 million, or 4%, compared to the nine months ended December 31, 2004, and international revenue decreased $1.6 million, or 3%. International revenue accounted for 38% of our total revenue in the nine months ended December 31, 2005 and 39% for the nine months ended December 31, 2004. The 4% increase in revenue from the Americas for the nine months ended December 31, 2005 is attributable in part to growth in our Federal Government business. The 3% decrease in international revenue for the nine months ended December 31, 2005 is due to a 40% decline in revenue from Japan, which was partially offset by increases in revenue from our EMEA and Asia Pacific Regions. Our Japanese business was negatively impacted by the management turnover and changes in the business of our Japanese subsidiary related to the internal investigation that we disclosed in fiscal year 2005.

Gross Profit

      The following table summarizes the Company’s gross profit by type of revenue:

	Three Months				Nine Months
	Ended				Ended
	December 31,				December 31,
	2005		2004		2005		2004
License margin		96%		97%		96%		95%
Professional services and maintenance margin		57%		53%		55%		49%
Gross margin		73%		73%		71%		69%

      Total gross profit was 73% for the three months ended December 31, 2005 and 2004. In the nine months ended December 31, 2005, total gross profit increased to 71% compared to 69% in the nine months ended December 31, 2004 due primarily to an increase in maintenance revenue, as well as a decrease in our cost of licenses and our cost of professional services and maintenance principally as a result of decreased subcontractor costs. Foreign currency fluctuations had a positive impact of $398,000 on cost of revenue and a negative impact on total gross profit of $1.0 million in the three months ended December 31, 2005 and a positive impact of $193,000 on cost of revenue and a negative impact of $723,000 on total gross profit in the nine months then ended.

      Our cost of license revenue consists of royalties for products embedded in our software licensed from third parties and amortization of acquired technology. In the three months ended December 31, 2005, our gross profit on license revenue decreased to 96% from 97% in the prior year period due to a decrease in license revenue. In the nine months ended December 31, 2005, our gross profit on license revenue increased to 96% from 95% in prior year period. The increase in license gross profit was primarily due to a decrease in the fees we paid for third-party software embedded in or licensed with our software products.

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      Our cost of professional services and maintenance consists primarily of costs related to internal professional services and support personnel, and subcontractors hired to provide implementation and support services. Our gross profit on maintenance and services was approximately 57% and 53% in the three months ended December 31, 2005 and 2004, respectively. The increase in gross profit was due to a $1.7 million increase in maintenance revenue and a decrease in the cost of professional services and maintenance primarily due to a $1.3 million decrease in subcontractor costs. In the nine months ended December 31, 2005, our gross profit on maintenance and services increased to 55% from 49% in the prior year period. The increase in gross profit was due to a $8.3 million increase in maintenance revenue and a decrease in the cost of professional services and maintenance primarily due to a $5.4 million decrease in subcontractor costs.

Operating Expenses

      The following table presents certain information regarding the Company’s operating expenses during the three and nine months ended December 31, 2005 and 2004:

	Three Months Ended December 31,									Nine Months Ended December 31,
							Percentage									Percentage
	2005			2004			Change			2005			2004			Change
	($ in thousands)
Operating expenses:
Sales and marketing	$	19,549		$	22,764			(14	)%	$	53,875		$	65,126			(17	)%
% of Total revenue		37	%		41	%					36	%		44	%
Research and development		8,980			10,877			(17	)%		30,224			32,747			(8	)%
% Total revenue		17	%		20	%					20	%		22	%
General and administrative		5,927			7,093			(16	)%		17,542			17,034			3	%
% of Total revenue		11	%		13	%					12	%		12	%
Restructuring charges		(117	)		—			—			602			2,756			(78	)%
% of Total revenue		0	%		0	%					0	%		2	%
Total operating expenses	$	34,339		$	40,734			(16	)%	$	102,243		$	117,663			(13	)%
% of Total revenue		65	%		74	%					68	%		80	%

      Our operating expenses are primarily classified as sales and marketing, research and development and general and administrative. Each category includes related expenses for compensation, employee benefits, professional fees, travel, communications and allocated facilities, recruitment and overhead costs. Our sales and marketing expenses also include expenses which are specific to the sales and marketing activities, such as commissions, trade shows, public relations, business development costs, promotional costs, costs of collateral and amortization of deferred warrant charge.

      In the three months ended December 31, 2005, our operating expenses decreased $6.4 million, or 16%, from the three months ended December 31, 2004. In the nine months ended December 31, 2005, our operating expense decreased $15.4 million, or 13%, from the nine months ended December 31, 2004. The decrease during the three months ended December 31, 2005, was due primarily to a substantial reduction in sales and marketing expense and to a lesser degree, decreases in research and development and general and administrative expenses. For the nine months ended December 31, 2005, the decrease in operating expenses was primarily due to a substantial reduction in sales and marketing expense, research and development expense and restructuring expense, which was partially offset by an increase in general and administrative expense. Our decreases in operating expenses in the three months and nine months ended December 31, 2005 reflect management’s continued focus on our cost structure and management’s focus on increasing profitability and operating margins. Foreign currency fluctuations had a positive impact of $646,000 on operating expenses in the three months ended December 31, 2005 and a positive impact of $308,000 in the nine months then ended.

      Sales and marketing expense declined in amount and as a percentage of total revenue in the three months and nine months ended December 31, 2005 compared to the same periods ended December 31, 2004. In the

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three months ended December 31, 2005, sales and marketing expense decreased $3.2 million, or 14%, compared to the three months ended December 31, 2004 primarily due to decreases of approximately $804,000 in commission expense, approximately $877,000 in personnel costs and the associated allocated overhead costs, approximately $495,000 in sales assistance fees paid to third parties, $679,000 in marketing program costs and $306,000 in travel expenses. The decrease in personnel costs and the associated allocated overhead costs was due primarily to our realignment of our sales and marketing organization, in which we have had a net decrease in sales and marketing headcount despite adding 20 quota-bearing sales representatives. The decreases in travel expenses and marketing program costs were due primarily to our continued efforts in cost control. In the nine months ended December 31, 2005, sales and marketing expense decreased $11.2 million, or 17%, compared to the nine months ended December 31, 2004 primarily due to decreases of approximately $5.2 million in personnel costs and the associated allocated overhead costs, $2.0 million in commission expense, $1.2 million in sales assistance fees paid to third parties, $1.1 million in marketing programs costs, $1.1 million in travel expense and $500,000 in professional services expenses. The decrease in personnel costs and associated allocated overhead was due primarily to our realignment of our sales and marketing organization, and the decreases in travel expenses, marketing program costs and professional services were due primarily to our continued focus on cost controls. Sales and marketing expense included amortization of deferred warrant charge of $661,000 in the three months ended December 31, 2005 and 2004 and $2.0 million in the nine months ended December 31, 2005 and 2004. The deferred warrant charge was recorded as a result of a warrant issued in connection with an OEM agreement with i2 Technologies (i2) in March 2001; that warrant, as amended, permits i2 to purchase 710,000 shares of webMethods, Inc. We expect amortization of the deferred warrant charge to terminate at the end of March 2006. Foreign currency fluctuations had a positive impact of $551,000 on sales and marketing expense in the three months ended December 31, 2005 and a positive impact of $223,000 in the nine months then ended.

      Research and development expense declined in the three-month and nine-month periods ended December 31, 2005 compared to the same periods ended December 31, 2004. In three months ended December 31, 2005, research and development expense decreased $1.9 million, or 17%, compared to the three months ended December 31, 2004 primarily due to decreases of approximately $1.8 million in personnel costs and the associated allocated overhead costs. The decrease in personnel costs and associated allocated overhead was due primarily to our realignment of our product development organization and our transfer of certain functions to our development center in India, compared to 6% at December 31, 2004. At December 31, 2005, approximately 18% of our research and development staff were located at our development center in India. Research and development expense in nine months ended December 31, 2005 decreased $2.5 million, or 8%, compared to the nine months ended December 31, 2004 primarily due to decreases of approximately $3.1 million in personnel costs and the associated allocated overhead costs and $177,000 in travel expense, which were partially offset by a $781,000 increase in professional services costs. Foreign currency fluctuations had an insignificant impact on research and development expense in the three months and nine months ended December 31, 2005.

      General and administrative expense decreased in amount and as a percentage of total revenue in the three-month ended December 31, 2005 compared to the same period in 2004 and increased in amount and as a percentage of total revenue in the nine-month ended December 31, 2005 compared to the same periods in 2004. In the three months ended December 31, 2005, general and administrative expenses decreased $1.2 million, or 16%, compared to the three months ended December 31, 2004 primarily due to decreases of $454,000 in legal and other professional services costs, $366,000 in personnel costs and the associated allocated overhead costs and $430,000 in accounting fees expenses, partially offset by an increase of $127,000 in bad debt expense. Legal and other professional services costs and personnel costs decreased primarily because the prior year period included costs related to legal investigations and compliance matters and increased staffing and use of consultants to assist in the documentation and testing of internal controls as required by the Sarbanes-Oxley Act of 2002. General and administrative expense for the nine months ended December 31, 2005 increased $508,000 or 3%, compared to the nine months ended December 31, 2004 primarily due to increases of $884,000 in legal and other professional services costs, $510,000 in personnel costs and the associated allocated overhead costs, and $334,000 in recruiting expenses, which was partially offset by decreases of $491,000 in bad debt expense, $370,000 in accounting fees, $241,000 in business

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insurance and $230,000 in general business taxes. Foreign currency fluctuations had an insignificant impact on general and administrative expense in the three months and nine months ended December 31, 2005.

      We have incurred restructuring and other related charges to align our cost structure with changing market conditions. Restructuring costs decreased in both amount and as a percentage of total revenue in the three months and nine months ended December 31, 2005 compared to the same periods in 2004. During the three months ended December 31, 2005, we recorded a $117,000 reduction in the accrual for excess facilities costs to reflect future payments expected to be received under a sublease agreement entered into during the period. During the nine months ended December 31, 2005, we incurred restructuring costs of $602,000, which includes restructuring costs of $719,000 consisting primarily of severance and related benefits, net of the $117,000 reduction in the accrual for excess facilities costs. There were no restructuring cost incurred during the three months ended December 31, 2004 and there were $2.8 million in restructuring costs incurred for the nine months ended December 31, 2004 consisting primarily of severance and related benefits.

Interest Income

      Interest income was $1.1 million for the three months ended December 31, 2005 compared to $615,000 for the prior year period. For the nine months ended December 31, 2005, interest income was $3.1 million compared to $1.7 million for the prior year period. These increases were attributable to higher interest rates on corporate paper, bonds and money market funds compared to those in the same period of the prior year and increased cash balances in the three and nine months ended December 31, 2005, compared to those in the prior year periods.

Interest Expense

      Interest expense is primarily due to equipment leasing arrangements in the Americas. During the three and nine months ended December 31, 2005, interest expense was $14,000 and $77,000, respectively, as compared to $28,000 and $84,000, respectively for the prior year periods.

Other Income (Expense), Net

      Other income (expense), net includes gains and losses on foreign currency transactions. During the three and nine months ended December 31, 2005, our other income was $346,000 and $578,000, respectively, compared to other expense of $27,000 and $31,000 for the prior year periods.

Income Taxes

      We have recorded a valuation allowance for the full amount of our net deferred tax assets, as the realizability of the deferred tax assets is not currently predictable.

      As of March 31, 2005, we had net operating loss (“NOL”) carry-forwards of approximately $230 million. These NOL carry-forwards are available to reduce future taxable income and begin to expire in fiscal year 2007. The realization of benefits of the NOLs is dependent on sufficient taxable income in future years. Lack of future earnings, a change in the ownership of the Company, or the application of the alternative minimum tax rules could adversely affect the Company’s ability to utilize the NOLs.

      During the three and nine months ended December 31, 2005, we incurred tax expense of $70,000 and $455,000 respectively, compared to $126,000 and $195,000 for the prior year periods. The Company could not offset these tax expenses by utilizing its NOLs generated in prior years.

LIQUIDITY AND CAPITAL RESOURCES

      As of December 31, 2005 we had cash, cash equivalents and short-term and long-term securities available for sale in the amount of $149.0 million as compared to $150.1 million as of March 31, 2005.

      Net cash provided by operating activities was $4.3 million in the nine months ended December 31, 2005, representing an improvement of $11.7 million over the use of $7.4 million of net cash in operating activities in

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the nine months ended December 31, 2004. Net cash provided by operating activities in the nine months ended December 31, 2005 resulted from net income of $7.5 million and $7.3 million of non-cash charges, offset by $10.6 million of net changes in assets and liabilities. The net changes in assets and liabilities included a $2.0 million increase in accounts receivable, $6.4 million decrease in accounts payable, accrued expenses and other liabilities, $2.6 million decrease in accrued salaries and commissions and a $2.0 million decrease in deferred revenue offset by a $2.4 million decrease in other assets. Net cash used in operating activities was $7.4 million in the nine months ended December 31, 2004, resulting from a net loss of $14.9 million and $2.3 million of net changes in assets and liabilities, offset by $9.8 million of non-cash charges. The net changes in assets and liabilities included a $4.1 million increase in accounts receivable, a $4.2 million decrease in accrued expenses, accounts payable and other liabilities offset by a $3.8 million increase in deferred revenue, $1.1 million decrease in other assets and $1.1 million increase in accrued salaries and commissions.

      Net cash provided by investing activities was $9.2 million in the nine months ended December 31, 2005, as compared to net cash used in investing activities of $485,000 in the nine months ended December 31, 2004. The increase in cash provided by investing activities was primarily due to net maturities of $13.2 million of marketable securities for the nine months ended December 31, 2005, as compared to the net maturities of $3.4 million of marketable securities for the nine months ended December 31, 2004. Capital expenditures were $3.9 million and $3.8 million in the nine months ended December 31, 2005 and 2004, respectively. Capital expenditures consisted of purchases of operating resources to manage operations, including computer hardware and software, office furniture and equipment and leasehold improvements. Since our inception, we have generally funded capital expenditures through the use of capital leases and working capital.

      Net cash provided by financing activities was $2.6 million in the nine months ended December 31, 2005, as compared to net cash used in financing activities of $362,000 for the nine months ended December 31, 2004. These cash flows primarily reflect net cash proceeds from exercises of stock options, net cash proceeds from Employee Stock Purchase Plan (“ESPP”) common stock issuances and net cash proceeds from short-term borrowings by our Japanese subsidiary, offset by payments on capital leases and short-term borrowings. Net cash proceeds from exercises of stock options were $1.8 million and $932,000 in the nine months ended December 31, 2005 and 2004, respectively. Net cash proceeds from ESPP common stock issuances were $1.3 million and $2.0 million in nine months ended December 31, 2005 and 2004, respectively. During the nine months ended December 31, 2004, net cash proceeds from short-term borrowings by our Japanese subsidiary were $3.5 million and payments on short-term borrowings by our Japanese subsidiary were $6.1 million. As of December 31, 2005 and 2004, our Japanese subsidiary had no short-term borrowings outstanding. Payments on capital leases were $466,000 and $747,000 in the nine months ended December 31, 2005 and 2004, respectively.

      We have an operating line of credit facility to borrow up to a maximum principal amount of $20 million and an equipment loan facility to borrow up to a maximum amount of $2 million. Both facilities have a maturity date of June 29, 2006. Any borrowings under the operating line of credit will bear interest at the bank’s prime rate per annum and any borrowings under the equipment loan facility will bear interest at either 8% or a floating rate equal to the bank’s prime rate plus 1%. We may borrow the entire $20 million operating line of credit as long as the aggregate balances of domestic cash, cash equivalents and marketable securities available for sale are at least $85 million; otherwise, borrowings under this facility are limited to 80% of eligible accounts receivable. As of December 31, 2005, there were no borrowings outstanding under the operating line of credit or equipment line of credit. In connection with the line of credit, we have letters of credit totaling approximately $2.6 million related to office leases. As of December 31, 2005, we had $17.4 million available under the operating line of credit and $2.0 million available under the equipment line of credit.

      We believe that our existing working capital and our operating line of credit facility and equipment loan facility will be sufficient to meet our working capital and operating resource expenditure requirements for at least the next twelve months. However, we may utilize cash resources to fund acquisitions or investments in complementary businesses, technologies or product lines.

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RECENTLY ISSUED ACCOUNTING PRONOUNCEMENTS

      In December 2004 the Financial Accounting Standards Board issued revised SFAS 123R, “Share-Based Payment,” which sets forth accounting requirements for “share-based” compensation to employees. SFAS 123R requires companies to recognize in the statement of operations the grant-date fair value of stock options and other equity-based compensation. We currently provide pro forma disclosure of the effect on net income or loss and earnings or loss per share of the fair value recognition provisions of SFAS 123, “Accounting for Stock-Based Compensation.” Under SFAS 123R, such pro forma disclosure will no longer be an alternative to financial statement recognition. SFAS 123R is effective for annual periods beginning after June 15, 2005 and, accordingly, we must adopt the new accounting provisions effective April 1, 2006 and recognize the cost of all share-based payments to employees, including stock option grants, in the income statement based on their fair values. We are currently evaluating the impact of the adoption of SFAS 123R on our financial position and results of operations, including the valuation methods and support for the assumptions that underlie the valuation of the awards. However, we currently believe that the adoption of SFAS 123R will have a material effect on our results of operations.

FACTORS THAT MAY AFFECT FUTURE OPERATING RESULTS

      You should consider the following risks and uncertainties when evaluating our statements in this report and elsewhere. webMethods is subject to risks and uncertainties in addition to those described below, which, at the date of this report, we may not be aware of or which we may not consider significant. Each of these factors may adversely affect our business, financial condition, results of operation or the market price of webMethods’ common stock, and investors may potentially lose all or part of their investment.

Our quarterly revenue, especially the amount of license revenue we recognize in a quarter and our operating results could fluctuate materially, which could significantly affect the market price of webMethods’ common stock.

      Our quarterly operating results have fluctuated in the past and are likely to do so in the future. A significant reason for these fluctuations is variation in the level of our quarterly revenue, especially the amount of license revenue we recognize in a quarter, which is difficult to predict with certainty and which varies depending on a number of factors. These fluctuations may cause quarter-to-quarter or year-to-year comparisons of our financial results not to be reliable indicators of our future revenue, license revenue or operating results. If our quarterly or annual total revenue, license revenue or operating results fail to meet the guidance we provide publicly or the expectations of investors or securities analysts by a material amount, there could be a material adverse effect on the market price of webMethods’ common stock. Our quarterly operating results have varied substantially in the past and may vary substantially in the future depending upon a number of factors, including:

•  changes in demand for our software products and services;

•  the timing and terms of large transactions with customers;

•  the spending environment for business integration and optimization solutions;

•  competitive pressures;

•  fluctuations in the revenue and license revenue of our geographic regions;

•  our ability to execute on our business strategy and sales strategies within the timeframes we anticipate;

•  the number of our quota-bearing sales representatives, their experience with our solutions, software products and sales processes and their capability to utilize our solution-selling approach;

•  the timing and amount of revenue from acquired technologies or businesses;

•  the amount and timing of operating expenses and the success of attempts to increase expense efficiency and the timing and amount of non-recurring or non-cash charges;

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•  delays in the availability of new products or new releases of existing products;

•  costs of legal compliance, including compliance with the Sarbanes-Oxley Act of 2002 and regulatory requirements and investigating allegations that may be made or resolving pending or threatened legal claims; and

•  changes that we may make in our business, operations and infrastructure.

      We generally close a substantial number of license transactions in the last month of each quarter, which makes it difficult to predict with certainty the level of license revenue we will have in any quarter until near to, or after, its conclusion. Our operating expenses, which include sales and marketing, research and development and general and administrative expenses, are based on our expectations of future revenue and are relatively fixed in the short term. If total revenue or license revenue falls below our expectations in a quarter and we are not able to quickly reduce our spending in response, our operating results for that quarter could be significantly below the guidance we provide publicly or expectations of investors or securities analysts. As a result, the market price of webMethods’ common stock may fall significantly.

If we fail accurately to forecast our future total revenue, license revenue or operating results, we may not satisfy the expectations of investors or securities analysts.

      We forecast our future total revenue and license revenue and operating results based upon information from our sales organization, finance and accounting department and other groups within our organization. The information on which our forecasts are based reflect expectations of future performance and beliefs regarding continuation of trends and anticipated future achievements, which are uncertain and are subject to a number of risks and uncertainties that we attempt to articulate for investors and securities analysts. We may fail accurately to forecast our future total revenue or license revenue due to a number of factors, including changes in customer demand, economic conditions, the timing and terms of large transactions with customers, competitive pressures, fluctuations in the total revenue and license revenue of our geographic regions, our ability to execute on our business strategy and sales strategies, changes in the number of quota bearing sales representatives and their experience with our solutions, software products and sales processes, the timing and amount of revenue from acquired technologies or businesses, delays in the availability of new products or new releases of existing products, changes that we may make in our business, operations and infrastructure, seasonal factors or major, unanticipated events.

      We also may experience delays or declines in expected total revenue or license revenue due to patterns in the capital budgeting and purchasing cycles of our current and prospective customers, purchasing practices and requirements of prospective customers, including contract provisions or contingencies they may request, changes in demand for our software and services, changes that we may make in our business or operations, economic uncertainties, geopolitical developments or uncertainties, travel limitations, terrorist acts, actual or threatened epidemics or other major unanticipated events. These periods of slower or no growth may lead to lower total revenue or license revenue or both, which could cause fluctuations in our quarterly operating results. In addition, variations in sales cycles may have an impact on the timing of our recognition of license revenue, which in turn could cause our quarterly total revenue and operating results to fluctuate. To successfully sell our software and services, we generally must educate our potential customers regarding their use and benefits, which can require significant time and resources. Any misperception by us in the needs of our customers and prospective customers or any delay in sales of our software and services could cause our revenue and operating results to vary significantly from our prior public forecasts. Any failure to achieve our prior public forecasts could cause us to fail to satisfy the expectations of investors or securities analysts, which could have a significant adverse effect on the market price of webMethods’ common stock.

                  The market price of webMethods’ common stock fluctuates as a result of factors other than our quarterly total revenue, license revenue and operating results, including actions taken by or performance of our

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competitors, estimates and recommendations of securities analysts, industry volatility and changes to accounting rules.

      The market price for webMethods’ common stock has experienced significant fluctuation over the years and may continue to do so. From our initial public offering in February 2000 until February 7, 2006, the closing price of webMethods’ stock on the Nasdaq National Market has ranged from a high of $308.06 to a low of $3.96. In addition to our quarterly total revenue, license revenue or operating results, this volatility in the market price for webMethods’ common stock may be affected by a number of other factors, including:

•  the overall volatility of the stock market, particularly the stock prices of software and technology companies;

•  fluctuation in the levels of total revenue, license revenue and operating results of competitors;

•  changes in securities analysts’ estimates, recommendations or expectations with respect to webMethods’ business, common stock or our industry;

•  rapid developments, consolidation and technology changes within our industry; and

•  changes to accounting rules.

      If any of these market or industry-based factors has a significant negative impact on the market price for webMethods’ common stock, investors could lose all or part of their investment, regardless of our actual operating performance.

Our markets are highly competitive, and we may not compete effectively.

      The markets for business integration solutions, Service-Oriented Architecture (“SOA”) capabilities, Business Activity Monitoring (“BAM”) and Business Process Management (“BPM”) solutions and Composite Application Framework (“CAF”) capabilities are rapidly changing and intensely competitive. There are a variety of methods available to integrate software applications, monitor and optimize business processes and workflows, provide SOA, enable Web services and provide customers the capabilities to run, manage and optimize their enterprise. We expect that competition will remain intense as the number of entrants and new technologies increases. We do not know if our markets will widely adopt and deploy our SOA technology, our webMethods Fabric product suite or other solutions we offer or have announced. If our technology, software and solutions are not widely adopted by our markets or if we are not able to compete effectively against current or future competitors, our business, operating results and financial condition may be harmed.

      Our current and potential competitors include, among others, large software vendors; companies that develop their own integration software or Web services technology; business integration software vendors; electronic data interchange vendors; vendors of proprietary enterprise application integration; and application server vendors. We also face competition from providers of various technologies to enable Web services. Further, we face competition for some aspects of our software and service offerings from major system integrators, both independently and in conjunction with corporate in-house information technology departments, which have traditionally been the prevalent resource for application integration. In addition, application software vendors with whom we have or had strategic relationships sometimes offer competitive solutions or may become or are competitors. Some of our competitors or potential competitors may have more experience developing technologies or solutions competitive with ours, larger technical staffs, larger customer bases, more established distribution channels, greater brand recognition and greater financial, marketing and other resources than we do. Our competitors may be able to develop products and services that are superior to our solutions, that achieve greater customer acceptance or that have significantly improved functionality or performance as compared to our existing solutions and future software and services. In addition, negotiating and maintaining favorable customer and strategic relationships is critical to our business. Our competitors may be able to negotiate strategic relationships on more favorable terms than we are able to negotiate or may preclude us from entering into or continuing strategic relationships. Many of our competitors may also have well-established relationships with our existing and prospective customers. Increased competition may result

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in reduced margins, loss of sales, decreased market share or longer sales cycles or sales processes involving more extensive demonstrations of product capabilities, which in turn could harm our business, operating results and financial condition.

Economic conditions could adversely affect our revenue growth and cause us not to achieve our forecasts of license revenue and total revenue.

      Our ability to achieve revenue growth and profitability of our business depends on the overall demand for business integration and optimization software and services. Our business depends on overall economic conditions, the economic and business conditions in our target markets and the spending environment for information technology projects, and specifically for business integration and optimization solutions, in those markets. A weakening of the economy in one or more of our geographic regions, unanticipated major events and economic uncertainties may make more challenging the spending environment for our software and services, reduce capital spending on information technology projects by our customers and prospective customers, result in longer sales cycles for our software and services or cause customers or prospective customers to be more cautious in undertaking larger license transactions. Those situations may cause a decrease in our license revenue and total revenue. A decrease in demand for our software and services caused, in part, by a actual or anticipated weakening of the economy, domestically or internationally, may result in a decrease in our revenue and growth rates. In that event, we could fail to achieve our prior public forecasts of revenue and operating results or otherwise fail to satisfy the expectations of investors or securities analysts, which could have a material adverse effect on the market price of webMethods’ common stock.

We rely on strategic alliances with major system integrators and other similar relationships to promote and implement our software.

      We have established strategic relationships with system integration partners and others. These strategic partners provide us with important sales and marketing opportunities, create opportunities to license our solutions, and increase our implementation and professional services delivery capabilities. We also have similar relationships with resellers, distributors and other technology leaders. During our fiscal year 2005 and the first nine months of fiscal year 2006, our systems integrator partners directly or indirectly influenced a significant portion of our license revenue, and we expect that trend to continue in future periods. If our relationships with our strategic business partners diminish or terminate or if we fail to work effectively with our partners or to grow our base of strategic partners, resellers and distributors, we might lose important opportunities, including sales and marketing opportunities, our business may suffer and our financial results could be adversely impacted. Our partners often are not required to market or promote our software and generally are not restricted from working with vendors of competing software or solutions or offering their own solutions providing similar capabilities. Accordingly, our success will depend on their willingness and ability to devote sufficient resources and efforts to marketing our software and solutions rather than the products of competitors or that they offer themselves. If these relationships are not successful or if they terminate, our revenue and operating results could be materially adversely affected, our ability to increase our penetration of our markets could be impaired, we may have to devote substantially more resources to the distribution, sales and marketing, implementation and support of our software than we would otherwise, and our efforts may not be as effective as those of our competitors, which could harm our business, our operating results and materially impact the market price of webMethods’ common stock.

Before the current fiscal year, we had a history of operating losses, and our failure to sustain profitability could impact our prospect of achieving our growth targets and have a material adverse effect on the market price of webMethods’ common stock.

      During much of our history, we have sustained losses from operations. For a number of reasons described in other factors listed here, we may not be able to achieve our anticipated levels of total revenue and license revenue or to control our operating expenses, which could prevent us from achieving our forecasts of operating results, including sustaining profitability. Any failure on our part to remain profitable could have a material adverse effect on the market price of webMethods’ common stock. Further, the expensing of stock options in

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the future is expected to add significant option compensation expense that could significantly or delay our ability to maintain profitability . If we do not generate sufficient revenue to achieve and maintain income from operations, our growth could be limited unless we are willing to incur operating losses that may be substantial and are able to fund those operating losses from our available assets or, if necessary, from the sale of additional capital through public or private equity or debt financings.

The Sarbanes-Oxley Act of 2002 requires that we undertake periodic evaluations of our internal control over financial reporting, which may identify material weaknesses that could harm our reputation and impact the market price of webMethods’ common stock.

      The Sarbanes-Oxley Act of 2002 requires that our management establish and maintain internal control over financial reporting and annually assess the effectiveness of our internal control over financial reporting and report the results of such assessment. Our management assessed the effectiveness of our internal control over financial reporting at March 31, 2005 and concluded, based upon their assessment, that our internal control over financial reporting was effective regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. We cannot predict the outcome of our assessments in future periods. If our management concludes in the future that our internal control over financial reporting is not effective due to material weakness, we expect that we must then change our internal control over financial reporting to remediate such material weakness. In that situation, investors and stock analysts may lose confidence in the reliability of our financial statements, we may not be successful in effecting the necessary remediation and we may be subject to investigation or sanctions by regulatory authorities. We also expect that we will continue to identify areas of internal control over financial reporting that require improvement, and that we will continue to enhance processes and controls to address those issues, reduce the number of critical controls and expand the global use of critical controls, which will involve additional expense and diversion of management’s time and may impact our results of operations.

Our disclosure controls and procedures and our internal control over financial reporting may not be effective to detect all errors or to detect and deter wrongdoing, fraud or improper activities in all instances.

      While we believe we currently have adequate internal control over financial reporting, our management does not expect that our disclosure controls and procedures or our internal control over financial reporting will prevent all errors or detect or deter all fraud. In designing our control systems, management recognizes that any control system, no matter how well designed and operated, can provide only reasonable, not absolute, assurance of achieving the desired control objectives. Further the design of a control system must reflect the necessity of considering the cost-benefit relationship of possible controls and procedures. Because of inherent limitations in any control system, no evaluation of controls can provide absolute assurance that all control issues and instances of wrongdoing, if any, that may affect our operations have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, that breakdowns can occur because of simple error or mistake and that controls may be circumvented by individual acts by some person, by collusion of two or more people or by management’s override of the control. The design of any control system also is based in part upon certain assumptions about the likelihood of a potential future event, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions. Because of the inherent limitations in cost-effective control systems, misstatements due to error or wrongdoing may occur and not be detected. Over time, it is also possible that controls may become inadequate because of changes in conditions that could not be, or were not, anticipated at inception or review of the control systems. Any breakdown in our control systems, whether or not foreseeable by management, could cause investors to lose confidence in the accuracy of our financial reporting and may have an adverse impact on the market price for webMethods’ common stock.

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If we fail to attract and retain key executive officers and other key personnel who are essential to our business, our ability to execute effectively on our business strategy or our results of operations or financial condition may be adversely affected.

      Our success depends upon the continued service of key employees who are essential to our business, including our executive officers. None of our current executive officers or key employees is bound by an employment agreement for any specific term. The loss of any key executive officers or key employees could potentially impede our ability to execute effectively on our business strategy and could also potentially harm our operating results or financial condition. Our future success will also depend in large part on our ability to attract and retain qualified executives and experienced technical, sales, professional services, marketing and management personnel.

Third-party claims that we infringe upon their intellectual property rights may be costly to defend and could damage our business.

      We cannot be certain that our software products and services do not infringe issued patents, copyrights, trademarks or other intellectual property rights of third parties. Litigation regarding intellectual property rights is common in the software industry, and we have been subject to, and may be increasingly subject to, legal proceedings and claims from time to time, including claims of alleged infringement of intellectual property rights of third parties by us or our licensees concerning their use of our software products, technologies and services. Although we believe that our intellectual property rights are sufficient to allow us to market our software without incurring liability to third parties, third parties have brought, and may bring in the future, claims of infringement against us or our licensees. Because our software products are integrated with our customers’ networks and business processes, as well as other software applications, third parties may bring claims of infringement against us, as well as our customers and other software suppliers, if the cause of the alleged infringement cannot easily be determined. We have previously incurred expenses related to, and may agree in the future to indemnify certain of our customers against, claims that our software products infringe upon the intellectual property rights of others. Furthermore, former employers of our current and future employees may assert that our employees have improperly disclosed confidential or proprietary information to us. Such claims may be with or without merit.

      Claims of alleged infringement, regardless of merit, may have a material adverse effect on our business in a number of ways. Claims may discourage potential customers from doing business with us on acceptable terms, if at all. Litigation to defend against claims of infringement or contests of validity may be very time-consuming and may result in substantial costs and diversion of resources, including our management’s attention to our business. In addition, in the event of a claim of infringement, we, as well as our customers, may be required to obtain one or more licenses from third parties, which may not be available on acceptable terms, if at all. Furthermore, a party making such a claim could secure a judgment that requires us to pay substantial damages, and also include an injunction or other court order that could prevent us from selling some or all of our software products or require that we re-engineer some or all of our software products. Certain customers have been subject to such claims and litigation in the past, and we or other customers may in the future be subject to additional claims and litigation. We have settled one such claim and may in the future settle any other such claims with which we may be involved, regardless of merit, to avoid the cost and uncertainty of continued litigation. Defense of any lawsuit or failure to obtain any such required licenses could significantly harm our business, operating results and financial condition and the price of webMethods’ common stock. Although we carry general liability insurance, our current insurance coverage may not apply to, and likely would not protect us from, all liability that may be imposed under these types of claims. Our current insurance programs do not cover claims of patent infringement.

If we are unable effectively to protect our intellectual property, we may lose a valuable asset, experience reduced market share or incur costly litigation to protect our rights.

      Our success depends, in part, upon our proprietary technology and other intellectual property rights. To date, we have relied primarily on a combination of copyright, trade secret, trademark and patent laws, and nondisclosure and other contractual restrictions on copying and distribution to protect our proprietary

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technology. We have one patent and several pending patent applications for technology related to our software, but we cannot assure you that this patent is valid or that these applications will be successful. A small number of our agreements with customers and system integrators contain provisions regarding the rights of third parties to obtain the source code for our software, which may limit our ability to protect our intellectual property rights in the future. Despite our efforts to protect our proprietary rights, unauthorized parties may copy aspects of our software and obtain and use information that we regard as proprietary. Competitors may use such information to enhance their own products or to create similar technology which directly competes with our products, potentially diminishing our market share. In addition, other parties may breach confidentiality agreements or other protective contracts we have entered into, and we may not be able to enforce our rights in the event of these breaches. Furthermore, we expect to continue increasing our international operations in the future, and the laws of certain foreign countries may not protect our intellectual property rights to the same extent as do the laws of the United States.

      Our means of protecting our intellectual property rights in the United States or abroad may not effectively protect our intellectual property rights. Litigation to enforce our intellectual property rights or protect our trade secrets could result in substantial costs, may not result in timely relief and may not be successful. Any inability to protect our intellectual property rights could seriously harm our business, operating results and financial condition.

Our business strategy contemplates possible future acquisitions of companies or technologies that may result in disruptions to our business, integration difficulties, increased debt or contingent liabilities, dilution to our stockholders or other adverse effects on future financial results.

      We may make investments in, or acquisitions of, technology, products or companies in the future to maintain or improve our competitive position. We may not be able to identify future suitable acquisition or investment candidates, and even if we identify suitable candidates, may not be able to make these acquisitions or investments on commercially acceptable terms, or at all. With respect to potential future acquisitions, we may not be able to realize future benefits we expected to achieve at the time of entering into the transaction, or our recognition of those benefits may be delayed. In such acquisitions, we will likely face many or all of the risks inherent in integrating corporate cultures, product lines, operations and businesses. We will be required to train our sales, professional services and customer support staff with respect to acquired software products, which can detract from executing against goals in the current period, and we may be required to modify priorities of our product development, customer support, systems engineering and sales organizations. Further, we may have to incur debt or issue equity securities to pay for any future acquisitions or investments, the issuance of which could be dilutive to our stockholders.

Treating stock options and employee stock purchase plan participation as a compensation expense could significantly impair our ability to return to and sustain profitability on a GAAP basis, and may have an adverse impact on our ability to attract and retain key personnel.

      The Financial Accounting Standards Board has adopted SFAS 123R, “Share-Based Payment,” which will require us to measure compensation cost for all share-based payments (such as employee stock options and participation in our employee stock purchase plan) and record such compensation costs in our consolidated financial statements beginning in our three month period ending June 30, 2006. We grant stock options to our employees, officers and directors and we administer an employee stock purchase plan (“ESPP”). Information on our stock option plan and ESPP, including the shares reserved for issuance under those plans, the terms of options granted, the terms of ESPP participation, and the shares subject to outstanding stock options, is included in Note 14 of the Notes to Consolidated Financial Statements of webMethods, Inc. included in webMethods’ Form 10-K for the fiscal year ended March 31, 2005. Although we have not completed our final evaluation of the impact of SFAS 123R, we expect that it will have a material adverse impact on our results of operations by increasing our operating expenses and reducing our net income and earnings per share, which we expect to significantly impair our ability to return to and sustain profitability. That impact could have a material adverse effect on the market price of webMethods’ common stock. In addition, to the extent SFAS 123R makes it more difficult or costly to issue stock option grants to our

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executive officers and employees, we may be forced to alter our stock-based compensation plans in ways that reduce potential benefits to our employees and impede our ability to attract, retain and motivate executive officers and key personnel, which could adversely affect our business.

If we are unable to adapt and enhance our software products to meet rapid technological changes, to provide desired product interfaces or to conform to new industry standards, we could lose partners, customers and future revenue opportunities.

      We expect that the rapid evolution of business integration and optimization software and related standards and technologies and protocols, as well as general technology trends such as changes in or introductions of operating systems or enterprise applications, will require us to adapt our software and solutions to remain competitive. Our software and solutions could become obsolete, unmarketable or less desirable to prospective customers if we are unable to adapt to new technologies or standards or if we fail to adapt our products to new platforms or provide desired product interfaces. If our software ceases to demonstrate technology leadership, conform to industry standards, adapt to new platforms or develop and maintain adapters or interfaces to popular products, we may have to increase our product development costs and divert our product development resources to address the issues. In addition, because our customers, prospective customers and certain partners depend on our adapting and enhancing of our software products to meet technological changes and to conform to new industry standards, any failure or perceived failure by us to do so could result in potential losses of customers, prospective customers, partners and future revenue opportunities.

Our business may be adversely impacted if we do not provide professional services to implement our solutions or if we are unable to establish and maintain relationships with third-party implementation providers.

      Customers that license our software typically engage our professional services staff or third-party consultants to assist with product implementation, training and other professional consulting services, and we believe our strong focus on ensuring that our software is successfully put into production is a strong competitive advantage and differentiator. We believe that many of our software sales depend, in part, on our ability to provide our customers with these services and to attract and educate third-party consultants to provide similar services. New professional services personnel and service providers require training and education and take time and significant resources to reach full productivity. Competition for qualified personnel and service providers is intense within our industry. Our business may be harmed if we are unable to provide professional services to our customers to effectively implement our solutions of if we are unable to establish and maintain relationships with third-party implementation providers.

We may face product liability claims, damage to the reputation of our software and a loss of revenue if our software products fail to perform as intended or contain significant defects.

      Our software products are complex, and significant defects may be found following introduction of new software or enhancements to existing software or in product implementations in varied information technology environments. Internal quality assurance testing and customer testing may reveal product performance issues or desirable feature enhancements that could lead us to reallocate product development resources or postpone the release of new versions of our software. The reallocation of resources or any postponement could cause delays in the development and release of future enhancements to our currently available software, require significant additional professional services work to address operational issues, damage the reputation of our software in the marketplace and result in potential loss of revenue. Although we attempt to resolve all errors that we believe would be considered serious by our partners and customers, our software is not error-free. Undetected errors or performance problems may be discovered in the future, and known errors that we consider minor may be considered serious by our partners and customers. This could result in lost revenue, delays in customer deployment or legal claims and would be detrimental to our reputation, which could harm our business, operating results and financial condition. If our software experiences performance problems or ceases to demonstrate technology leadership, we may have to increase our product development costs and

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divert our product development resources to address the problems. In addition, because our customers and certain partners depend on our software for their critical systems and business functions, any interruptions in operation of our software or solutions could cause our customers and certain partners to initiate warranty or product liability suits against us.

Costs of legal investigations and regulatory compliance matters may increase our operating expenses and impact our operating results.

      Investigations of allegations concerning activities of personnel and investigation and resolution of legal claims have resulted in significant expense and management time and attention, and we anticipate that we will incur additional expense relating to the ongoing informal investigation by the Securities and Exchange Commission. Further investigations or any future legal compliance or regulatory compliance matters could significantly increase expense and demands on management time and attention, thereby potentially adversely impacting our operating results, which could materially impact the market price of webMethods’ common stock. In addition, we have incurred and will continue to incur significant additional expense related to our efforts to comply with the rules and regulations enacted pursuant to the Sarbanes-Oxley Act of 2002.

Our financial statements may in the future be impacted by improper activities of our personnel.

      As we have recently experienced with our restatements of financial statements for the fiscal year ended March 31, 2004 and the three months ended June 30, 2004, our financial statements can be adversely impacted by our employees’ improper activities and unauthorized actions and their concealment of their activities. For instance, revenue recognition depends upon the terms of our agreements with our customers, resellers and distributors, among other things. Our personnel may act outside of their authority, such as by negotiating additional terms or modifying terms without the knowledge of management that could impact our ability to recognize revenue in a timely manner, and they could commit us to obligations or arrangements that may have a serious financial impact to our results of operations or financial condition. In addition, depending upon when we learn of any such improper activities or unauthorized actions, we may have to restate our financial statements for a previously reported period, which could have a significant adverse impact on our business, operating results and financial condition and on the market price of webMethods’ common stock. We have implemented, and are implementing, new or additional steps to prevent such conduct, but we cannot be certain that these new or additional controls will be effective in deterring all improper conduct by our personnel.

Our international sales efforts could subject us to greater or unique uncertainties and additional risk.

      We have significant international sales efforts. Our international operations require a significant amount of attention from our management and substantial financial resources. If we are unable to manage our international operations successfully and in a timely manner, our business and operating results could be harmed. In addition, doing business internationally involves additional risks, particularly: the difficulties and costs of staffing and managing foreign operations; the difficulty of ensuing adherence to our revenue recognition and other policies; the difficulty of monitoring and enforcing internal controls and disclosure controls; unexpected changes in regulatory requirements, business practices, taxes, trade laws and tariffs; differing intellectual property rights; differing labor regulations; and changes in a specific country’s or region’s political or economic conditions.

      We currently do not engage in any currency hedging transactions. Our foreign sales generally are invoiced in the local currency, and, as we expand our international operations or if there is continued volatility in exchange rates, our exposure to gains and losses in foreign currency transactions may increase when we determine that foreign operations are expected to repay intercompany debt in the foreseeable future. Moreover, the costs of doing business abroad may increase as a result of adverse exchange rate fluctuations. For example, if the United States dollar declines in value relative to a local currency and we are funding operations in that country from our U.S. operations, we could be required to pay more for salaries, commissions, local operations and marketing expenses, each of which is paid in local currency. In addition,

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exchange rate fluctuations, currency devaluations or economic crises may reduce the ability of our prospective customers to purchase our software and services.

Because our software could interfere with the operations of our partners’ and customers’ other network and software applications, we may be subject to potential product liability and warranty claims by these partners and customers.

      Our software enables customers’ and certain partners’ software applications to provide Web services, or to integrate with networks and software applications, and is often used for mission critical functions or applications. Errors, defects or other performance problems in our software or failure to provide technical support could result in financial or other damages to our partners and customers. Partners and customers could seek damages for losses from us, which, if successful, could have a material adverse effect on our business, operating results or financial condition. In addition, the failure of our software and solutions to perform to partners’ and customers’ expectations could give rise to warranty claims. Although our license agreements typically contain provisions designed to limit our exposure to potential product liability claims, existing or future laws or unfavorable judicial decisions could negate these limitation of liability provisions. Although we have not experienced any product liability claims to date, sale and support of our software entail the risk of such claims. The use of our software to enable partners’ and customers’ software applications to provide Web services, and the integration of our software with our partners’ and customers’ networks and software applications, increase the risk that a partner or customer may bring a lawsuit against several suppliers if an integrated computer system fails and the cause of the failure cannot easily be determined. Even if our software is not at fault, a product liability claim brought against us, even if not successful, could be time consuming and costly to defend and could harm our reputation. In addition, although we carry general liability insurance, our current insurance coverage would likely be insufficient to protect us from all liability that may be imposed under these types of claims.

We may not have sufficient resources available to us in the future to take advantage of certain opportunities, potentially harming our operating results and financial condition.

      In the future, we may not have sufficient resources available to us to take advantage of growth, acquisition, product development or marketing opportunities. We may need to raise additional funds in the future through public or private debt or equity financings in order to: take advantage of opportunities, including more rapid international expansion or acquisitions of complementary businesses or technologies; developing new software or services; or responding to competitive pressures. Additional financing needed by us in the future may not be available on terms favorable to us, if at all. If adequate funds are not available, not available on a timely basis, or are not available on acceptable terms, we may not be able to take advantage of opportunities, develop new software or services or otherwise respond to unanticipated competitive pressures. In such case, our business, operating results and financial condition could be harmed.

Some provisions of the Delaware General Corporation Law, our certificate of incorporation and our bylaws, as well as our stockholder rights plan, may deter potential acquisition bids, discourage changes in our management or Board of Directors and have anti-takeover effects.

      The certificate of incorporation, as amended, of webMethods and our bylaws contain certain provisions, as does the Delaware General Corporation Law, which may discourage, delay or prevent a change of control of webMethods or a change in our management or Board of Directors, including through a proxy contest. In addition, our Board of Directors in 2001 adopted a rights plan and declared a dividend distribution of one right for each outstanding share of webMethods’ common stock. Each right, when exercisable, entitles the registered holder to purchase certain securities at a specified purchase price, subject to adjustment. The rights plan may have the anti-takeover effect of causing substantial dilution to a person or group that attempts to acquire webMethods on terms not approved by our Board of Directors. The existence of the rights plan and the other provisions of the Delaware General Corporation Law, our certificate of incorporation and our bylaws could limit the price that certain investors might be willing to pay in the future for share of webMethods’ common stock, could discourage, delay or prevent a merger or acquisition of webMethods that stockholders

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may consider favorable and could make it more difficult for a third party to acquire us without the support of our Board of Directors, even if doing so would be beneficial to our stockholders.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

      We are exposed to a variety of risks, including changes in interest rates affecting the return on our investments and foreign currency fluctuations. We have established policies and procedures to manage our exposure to fluctuations in interest rates and foreign currency exchange rates.

      Interest rate risk. We maintain our funds in money market accounts, corporate bonds, commercial paper, Treasury notes and agency notes. Our exposure to market risk due to fluctuations in interest rates relates primarily to our interest earnings on our deposits. These securities are subject to interest rate risk inasmuch as their fair value will fall if market interest rates increase. If market interest rates were to increase immediately and uniformly by 10% from the levels prevailing as of December 31, 2005, the fair value of the portfolio would not decline by a material amount. We do not use derivative financial instruments to mitigate risks. However, we do have an investment policy that would allow us to invest in short-term and long-term investments such as money market instruments and corporate debt securities. Our policy attempts to reduce such risks by typically limiting the maturity date of such securities to no more than twenty-four months with a maximum average maturity to our whole portfolio of such investments at twelve months, placing our investments with high credit quality issuers and limiting the amount of credit exposure with any one issuer.

      Foreign currency exchange rate risk. Our exposure to market risk due to fluctuations in foreign currency exchange rates relates primarily to the intercompany balances with our subsidiaries located in Australia, Canada, China, France, Germany, Hong Kong, India, Japan, the Netherlands, Malaysia, Singapore, South Korea and the United Kingdom. Transaction gains or losses have not been significant in the past, and there is no hedging activity on foreign currencies. We would not experience a material foreign exchange loss based on a hypothetical 10% adverse change in the price of the euro, Great Britain pound, Singapore dollar, Australian dollar, Malaysian ringgit, South Korean won, Canadian dollar, Chinese yuan, Indian rupee or Japanese yen against the U.S. dollar. Consequently, we do not expect that a reduction in the value of such accounts denominated in foreign currencies resulting from even a sudden or significant fluctuation in foreign exchange rates would have a direct material impact on our financial position, results of operations or cash flows.

      Notwithstanding the foregoing, the direct effects of interest rate and foreign currency exchange rate fluctuations on the value of certain of our investments and accounts, and the indirect effects of fluctuations in foreign currency could have a material adverse effect on our business, financial condition and results of operations. For example, international demand for our products is affected by foreign currency exchange rates. In addition, interest rate fluctuations may affect the buying patterns of our customers. Furthermore, interest rate and currency exchange rate fluctuations have broad influence on the general condition of the U.S. foreign and global economics, which could materially adversely affect our business, financial condition results of operations and cash flows.

ITEM 4. CONTROLS AND PROCEDURES

      Evaluation of Disclosure Controls and Procedures. We maintain disclosure controls and procedures, as defined in Rule 13a-15(e) under the Securities Exchange Act of 1934 (the “Exchange Act”), which are designed to ensure that information required to be disclosed in our reports filed or submitted under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the rules and forms of the Securities and Exchange Commission, and that such information is accumulated and communicated to our management, including our principal executive and principal financial officers, as appropriate to allow timely decisions regarding required disclosure.

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      In designing our system of disclosure controls and procedures, our management recognizes that our disclosure controls and procedures, no matter how well designed and operated, can provide only reasonable, not absolute, assurance of achieving the desired control objectives. Further, in designing our system of disclosure controls and procedures, our management is required to apply its judgment in considering the cost-benefit relationship of possible controls and procedures.

      Our management, including our principal executive and principal financial officers, conducted an evaluation of the effectiveness of our disclosure controls and procedures pursuant to Exchange Act Rule 13a-15 as of December 31, 2005, which included an evaluation of disclosure controls and procedures applicable to the period covered by this Form 10-Q. Based upon that evaluation, our principal executive and principal financial officers concluded that, as of December 31, 2005, our disclosure controls and procedures were effective at the reasonable assurance level.

      Changes in Internal Control Over Financial Reporting. There was no change in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

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PART II

OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

      A purported class action lawsuit was filed in the U.S. District Court for the Southern District of New York in 2001 that named webMethods, several of our executive officers at the time of our initial public offering (IPO) and the managing underwriters of our initial public offering as defendants. This action made various claims, including that alleged actions by underwriters of webMethods’ IPO were not disclosed in the registration statement and final prospectus for webMethods’ IPO or disclosed to the public after webMethods’ IPO, and sought unspecified damages on behalf of a purported class of purchasers of webMethods’ common stock between February 10, 2000 and December 6, 2000. This action was consolidated with similar actions against more than 300 companies as part of In Re Initial Public Offering Securities Litigation (SDNY). Claims against webMethods’ executive officer defendants have been dismissed without prejudice. The Company has considered and agreed with representatives of the plaintiffs in the consolidated proceeding to enter into a proposed settlement, which was amended in March 2005 and preliminarily approved by the court in late August 2005, with a settlement fairness hearing scheduled for April 2006. Under the proposed settlement, the plaintiffs would dismiss and release their claims against the Company in exchange for a contingent payment guaranty by the insurance companies collectively responsible for insuring the issuers in the consolidated action and assignment or surrender to the plaintiffs by the settling issuers of certain claims that may be held against the underwriter defendants, plus reasonable cooperation with the plaintiffs with respect to their claims against the underwriter defendants. The Company believes that any material liability on behalf of the Company that may accrue under the proposed settlement would be covered by its insurance policies. From time to time, webMethods is involved in other disputes and litigation in the normal course of business.

ITEM 6. EXHIBITS

      The exhibits required by this item are set forth on the Exhibit Index attached hereto.

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SIGNATURES

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

WEBMETHODS, INC.

By:  /s/ DAVID MITCHELL

David Mitchell

President and Chief Executive Officer

Date: February 9, 2006

By:  /s/ MARK WABSCHALL

Mark Wabschall

Executive Vice President and Chief Financial Officer

Date: February 9, 2006

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INDEX TO EXHIBITS

Exhibit
Number			Description
	3	.1(1)	Fifth Amended and Restated Certificate of Incorporation of webMethods, Inc., as amended
	3	.2(2)	Amended and Restated Bylaws of webMethods, Inc.
	4	.1(3)	Specimen certificate for shares of webMethods, Inc. Common Stock
	4	.2(4)	Rights Agreement dated as of October 18, 2001 between webMethods, Inc. and American Stock Transfer & Trust Company
	10	.2(5)	webMethods, Inc. Amended and Restated Stock Option Plan, as Amended
	10	.3(3)	Employee Stock Purchase Plan
	10	.4(3)	Indemnification Agreement entered into between webMethods, Inc. and each of its directors
	10	.5(6)	Executive Agreement entered into between webMethods, Inc. and certain of its executive officers
	10	.6(7)	Form of Stock Option Agreement for stock option grants to employees or officers other than California residents
	10	.7(8)	Form of Stock Option Agreement for stock option grants to directors
	10	.8(7)	Form of notice of grant of stock option
	10	.9(9)	Deferred Compensation Plan for Directors, as amended
	10	.10(8)	Consulting Agreement dated October 3, 2004 between Phillip Merrick and webMethods, Inc.
	31	.1*	Rule 13a-14(a) Certification of Chief Executive Officer
	31	.2*	Rule 13a-14(a) Certification of Chief Financial Officer
	32	.1*#	Section 1350 Certification of Chief Executive Officer
	32	.2*#	Section 1350 Certification of Chief Financial Officer

(1)	Incorporated by reference to webMethods’ Form 10-K for the year ended March 31, 2002 (File No. 1-15681).
(2)	Incorporated by reference to webMethods’ Form 10-Q for the three months ended December 31, 2004 (File No. 1-15681).
(3)	Incorporated by reference to webMethods’ Registration Statement on Form S-1, as amended (File No. 333-91309).
(4)	Incorporated by reference to webMethods’ Registration Statement on Form 8-A (File No. 1-15681).
(5)	Incorporated by reference to webMethods’ Form 10-K for the year ended March 31, 2003 (File No. 1-15681).
(6)	Incorporated by reference to webMethods’ Form 10-Q for the three months ended June 30, 2004 (File No. 1-15681).
(7)	Incorporated by reference to webMethods’ Form 8-K dated October 2, 2004 (File No. 1-15681).
(8)	Incorporated by reference to webMethods’ Form 10-Q for the three months ended December 31, 2004 (File No. 1-15681).
(9)	Incorporated by reference to webMethods’ Form 10-Q for the three months ended September 30, 2005 (File No. 1-15681).

*  Filed herewith.

#  This item is furnished as an exhibit to this report but is not filed with the Securities and Exchange Commission.