As Of                Filer                Filing    For·On·As Docs:Size              Issuer               Agent

 6/22/06  Webmethods Inc                    10-K        3/31/06    8:1.0M                                   Bowne - DC/FA

Document/Exhibit                   Description                      Pages   Size 

 1: 10-K        Webmethods Inc. Form 10-K                           HTML    811K 
 2: EX-10.9     Material Contract                                   HTML     16K 
 3: EX-21.1     Subsidiaries of the Registrant                      HTML      9K 
 4: EX-23.1     Consent of Experts or Counsel                       HTML      7K 
 5: EX-31.1     Certification per Sarbanes-Oxley Act (Section 302)  HTML     14K 
 6: EX-31.2     Certification per Sarbanes-Oxley Act (Section 302)  HTML     14K 
 7: EX-32.1     Certification per Sarbanes-Oxley Act (Section 906)  HTML      8K 
 8: EX-32.2     Certification per Sarbanes-Oxley Act (Section 906)  HTML      8K 

(Mark One)

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

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

ANNUAL REPORT ON FORM 10-K

TABLE OF CONTENTS

      References in this Annual Report on Form 10-K to “webMethods,” “we,” “us” or “our” include webMethods, Inc. and its subsidiaries unless a statement specifically refers to webMethods, Inc.

      This Annual Report on Form 10-K 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:

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 reflected in the forward-looking statements could prove to be incorrect, and actual results could differ materially from those indicated by the forward-looking statements. Our future financial condition and results of operations, as well as any forward-looking statements, are subject to risks and uncertainties, including (but not limited to) those discussed in Item 1A under the caption “Risk Factors.” 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 we disclaim any obligation to publicly update or revise such forward-looking statements or reasons why actual results may differ.

      webMethods is a leading provider of business integration and optimization software. Our products and solutions enable our customers to improve the performance of their organizations by implementing and accelerating business process improvements. We work with our customers to increase the efficiency of their activities, improve their ability to adapt to changing market conditions, and create competitive advantage through a focus on the business processes that run their organizations. We use the term “Business Process Productivity” to describe this process-centric approach to business performance improvement.

      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 systems integrators with whom we have strategic alliances, other strategic partners and distributors and, to a lesser extent, resellers. We license our software primarily on a perpetual basis.

      In our fiscal year ended March 31, 2006, we added approximately 140 new customers, and no single customer accounted for more than 10% of our revenue in any quarter of that fiscal year. As of March 31, 2006, we had approximately 1,400 customers around the world, distributed across our target markets 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.

webMethods Fabric

      Our primary offering is webMethods Fabric^tm, a unified business integration and optimization product suite that combines the following capabilities into a single integrated software platform:

      Although similar capabilities can be found in competing software products, we believe that the unification of these technologies into a common architecture, common operating environment, and common user experience differentiates webMethods Fabric from the products offered by our competitors.

      In April 2005, we launched webMethods Fabric 6.5. In addition to numerous detailed feature enhancements, this release delivered significantly higher levels of integration between the components discussed above, as well as considerable usability improvements designed to make end-users of the technology more productive. The latest version of the product suite provides users with a seamless end-to-end experience from defining a business process, assigning the real-time business metrics that they want to use to track business performance, creating the services and linking in the systems involved in the process, deploying the results for end-users, and then monitoring the solution in action.

      Other significant developments in the fiscal year ended March 31, 2006 include the following:

      webMethods Fabric’s capabilities are organized into four product groupings: Enterprise Services Platform, Business Process Management, Business Activity Monitoring and Composite Application Framework.

      The webMethods Enterprise Services Platform^tm is the integration and SOA foundation of the webMethods Fabric product suite. Conceptually, it serves as the basis by which systems are integrated and made available as reusable business services, which can then be linked together into new business processes or assembled into new software applications. The key capabilities of the webMethods Enterprise Services Platform include the following:

      Our BPM capabilities facilitate the design, deployment, and monitoring of business processes that involve interactions between computer systems as well as people. Some business processes are automated, requiring minimal manual intervention (usually only to address exceptions), whereas other types of business processes, such as loan or claims processing, are primarily manual in nature. Our BPM offerings support both scenarios. By providing an easy-to-use process modeling environment that shields users from the underlying software applications and technical complexity, our solution makes it feasible for non-technical staff to play a productive role in defining business processes. The visual design environment allows customers to create workflow solutions, including the associated user interfaces for presenting users with tasks and information, with minimal software coding effort.

      Our BAM offering has capabilities that are based on a patent-pending technology that provide customers with a real-time view into key business performance indicators (for example, order processing time), and the ability to be alerted proactively when results deviate from established norms (for instance, if orders start taking longer than normal to process). The close integration between our BPM and BAM capabilities means there is minimal incremental effort for the user to identify which metrics to monitor for a given business process. Our BAM offering further reduces the effort on the part of the user by automatically monitoring certain pre-identified metrics and using statistical analysis to establish normal patterns of behavior. This allows the system to alert the user to an exception to such patterns of behavior, through a unique feature called “fingerprinting,” enabled once the system observes current readings deviating from previously-seen ranges. The advantage of our approach is that users are not required to define limits manually, and the system automatically adjusts thresholds based on actual data (for example, accommodating variations in order processing time depending on the time of day). The real-time nature of these capabilities enables customers to anticipate exceptions, allowing them to respond quickly and, potentially, to avoid impact to the business. The ability to do root-cause analysis is a further decision-making benefit, helping customers determine the specific factors contributing to a business process exception.

      The webMethods Composite Application Framework^tm enables customers to assemble new applications from the services made available by the webMethods Enterprise Services Platform and other sources of Web services. It provides an alternative to coding traditional client/server or Web applications from scratch and is especially advantageous when there is an inventory of existing business components from which to assemble new software applications. The webMethods Composite Application Framework includes a portal that serves as the primary user interface for these composite software applications, allowing people — both inside and outside the organization — to be provided with personalized, secure, access to the application functionality, information, and business processes that are relevant to their job function or relationship to the organization.

      In 2005, we launched a series of targeted Business Process Productivity^tm solutions that address specific industry needs. Our solutions combine the webMethods Fabric suite with intellectual assets that include the following:

      Our initial set of solutions are directed in the areas of compliance, financial services, and demand-driven enterprises (e.g., manufacturing, retail). We anticipate developing further solutions in these and other areas in the future.

      webMethods for Compliance includes a continuous controls monitoring solution for Sarbanes-Oxley and other regulatory requirements. The solution provides businesses with the ability to continuously and automatically monitor their compliance control points without the risks or costs associated with manual testing and controls. A compliance dashboard alerts users to exceptions when control points are violated, while document management capabilities improve and secure information flow by managing control and disclosure procedures. As part of our strategy to target the compliance market, we entered into strategic partnerships with Bwise, Inc., a provider of compliance and enterprise risk management software, and Certus Software, Inc., a provider of corporate governance and compliance software.

      webMethods for Financial Services includes a payments processing solution that helps wholesale banks and other financial institutions optimize their corporate payments operations and reduce transaction costs while effectively managing associated customer service level commitments. This solution helps organizations avoid financial penalties by continuously measuring adherence to important customer-specific Key Performance Indicators. This enhanced, real-time process monitoring can also be used to deliver additional customer benefits, such as the ability for end-users to immediately determine payment status, which provides corporate customers with greater control over the execution of these transactions while allowing banks the opportunity to assess additional fees as a result.

      webMethods for the Demand-Driven Enterprise includes solutions for demand fulfillment monitoring, sales and operations planning, and store integration. Collectively, the solutions help enterprises bridge the gaps within their supply chains that prevent them from responding effectively to changes in demand.

      The demand fulfillment monitoring solution helps manufacturers to increase the accuracy of order fulfillment by more effectively and consistently matching supply with demand throughout their operations. Increases in proper order fulfillment translate into benefits such as inventory reduction and shorter order-to-cash cycle times.

      The sales and operations planning monitoring solution helps retailers and manufacturers predict and respond more rapidly to changes in demand. By providing supply chain executives with a consolidated, real-time view into their sales and operational planning environment, organizations can quickly detect changes in demand and respond accordingly. This approach can be critical in bringing products to market and aligning the various resources needed across sales, marketing, production, and manufacturing. We entered into an agreement with Blue Agave Software, a provider of software solutions for improving replenishment, demand management and fulfillment execution, to complement our offering.

      The store integration solution allows retailers to monitor sales at an item and category level and to analyze point-of-sale data in near real-time to spot trends and to compare actual sales against forecast data. The benefits of this solution include more responsive promotional activities and improved time-to-market.

      We offer a range of professional services to assist our customers both during the initial deployment of our products and thereafter to address our customers’ needs through the entire project lifecycle. Our professional services consultants are located throughout the Americas, Europe/Middle East/Africa (“EMEA”), Japan and Asia Pacific regions, allowing us to provide localized, on-site support across our

      Our professional services organization has developed GEAR, an implementation methodology derived from our experience and specific to our products. GEAR provides customers with best practices, project templates, white papers, and other tools. Together, these resources assist in gathering requirements, capturing the scope of the project, defining the architecture, implementing a solution, and rolling out the finished system.

      We have invested in developing a Service-Oriented Architecture strategy and architecture service offering to help customers clarify their SOA strategy and cost-justify investments for both IT and business management. Our SOA methodology involves a 10-step roadmap for customers that culminates in the delivery of an SOA business vision, architecture blueprint, and plan that addresses the organizational and procedural aspects of implementing SOA.

      We offer training and continuing education to help ensure the success of our customer implementations. We provide a mix of classroom, onsite, and online training designed to best meet our users’ requirements. We have regularly scheduled courses covering our entire product line and more than 20 key topics of interest to developers, administrators, and business analysts.

      We offer our customers a variety of support and maintenance plans designed to meet their specific needs, including the option of 24-hour coverage, seven days per week. We have established a “follow-the sun” support model designed to ensure that our personnel are available during the business day in a variety of time zones around the world, with major support centers in Virginia and California in the United States, and in Australia, Japan and the Netherlands. Our resellers and distributors generally provide initial software support to their customers, and we provide secondary support on more complicated issues. Our support and maintenance customers and partners also have access to the webMethods Advantage^tm extranet, which provides access to product documentation, discussion groups, implementation guides, technical advisories and access to our customer service management system that allows individuals to submit and monitor the status of any technical issues.

      We license our software and sell our services primarily through our direct sales organization. Secondary sales channels include our strategic software vendor partners, major systems integrators with whom we have strategic alliances, other partners and distributors. In Japan and our Asia Pacific region and, to a lesser extent, in EMEA and the Americas, we also license our software through resellers who may also sell our consulting and implementation services. We have relationships with a number of resellers or distributors with expertise in certain industry sectors or countries in which we do not currently have a significant number of direct sales personnel. We license our software primarily on a perpetual basis.

      Our direct sales organization consists of sales representatives and pre-sales consultants supported by personnel with experience within the industries we target. At March 31, 2006, our sales and marketing personnel serving North America were located in our headquarters in Fairfax, Virginia, and in approximately 19 other offices in the United States and Canada. At that date, our sales and marketing personnel in EMEA were located in nine countries, and our sales and marketing personnel in Japan and our Asia Pacific region were located in Australia, Japan and five other countries. Information on revenue we derived from our Americas, EMEA, Japan and Asia Pacific operations, as well as long lived assets located in those geographic regions, is included in Note 20 of the Notes to Consolidated Financial Statements included elsewhere in this report. We expect to continue expanding our sales and marketing group through targeted recruitment of qualified individuals.

      Our sales efforts are focused on customers, prospective customers and business partners 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.

      The sales cycle for our software typically ranges from six to nine months. A prospective customer’s decision to use our products may involve a substantial financial commitment, which may require a significant evaluation period and approval from or by the customer’s senior management. A customer’s decision to license certain of our products may also involve significant user education and deployment costs, as well as substantial involvement of the customer’s personnel. Due to the nature of our business, we have no inventory.

      We have experienced quarterly fluctuations in our operating results and anticipate fluctuations in the future. In the past we have experienced certain general seasonal factors, from time to time, such as when revenue in our second fiscal quarter (ending September 30) has been positively impacted by budgeting cycles of the U.S. Government, and has been negatively impacted because businesses often defer purchase decisions during summer months. In addition, revenue in our third fiscal quarter (ending December 31) has been positively impacted by the end-of-year budgeting cycles of many Global 2000 companies, and revenue in our fourth fiscal quarter (ending March 31) has been positively impacted, as revenue in our first fiscal quarter (ending June 30) has been negatively impacted, by the annual nature of our sales compensation plans. Quarterly revenue and operating results depend on the volume and timing of orders received, which may be affected by large individual transactions that sometimes are difficult to predict.

      We pursue a judicious mix of internal development, technology acquisition, and strategic partnerships to allow us to offer a compelling and differentiated solution.

      We focus our ongoing product development efforts on a combination of enhancing, broadening, and deepening the functionality of our core products to address new industries, marketplaces, geographies and software alliances as well as bringing about innovations to meet emerging opportunities. We have dedicated a significant amount of effort to integrating our various product capabilities to realize the vision of webMethods Fabric as a unified product suite. We maintain our primary development centers in Fairfax, Virginia, Sunnyvale, California and Bangalore, India and have additional development teams in Denver, Colorado and Bellevue, Washington. Our research and development expenses, including stock-based compensation, were $40.2 million, $44.5 million and $45.1 million in our fiscal years ended March 31, 2006, 2005 and 2004, respectively. The significant decrease in our research and development expenses in fiscal 2006 was primarily the result of increasing the proportion of our product development staff based in Bangalore, India, which has lower personnel and operating expenses than our product development centers in the United States.

      We work closely with several major systems integrators and other strategic partners including Accenture, Atos Origin, BearingPoint, Capgemini, CGI-AMS, Crowe Chizek, CSC, Deloitte, EDS, Global eXchange Services, HP and TCS to support our customers’ integration needs and to expand the resources available to implement our software. We invest in education to assist our strategic partners in staying knowledgeable in, and proficient with, our software products and solutions. We believe that our investment in these relationships is important because our strategic partners’ promotion of our products as the most appropriate solution for their clients augments our direct sales force.

      We also have strategic Original Equipment Manufacturer (“OEM”) relationships with enterprise application vendors, including Oracle Corporation and SAP AG, which help us in selling to prospective customers that own or plan to purchase products from these companies in which a license-limited version of our software may be embedded. We believe that this provides us with an incumbency advantage for many of the new business opportunities for which we compete.

      We believe that the relationships with our strategic partners resulted in, directly or indirectly, a significant portion of our license revenue during the fiscal year ending March 31, 2006 and in prior fiscal years, and we expect this to continue in future periods.

      The market for our software and services is extremely competitive and subject to rapid change. We believe that we have a compelling offering in the webMethods Fabric product suite, significant expertise in application and trading partner integration, a track record of innovation, and are a recognized leader in our industry. However, we compete with numerous other providers of integration software products. Our competitors include BEA Systems, Inc., IBM, Microsoft Corporation, Oracle Corporation, SAP AG, TIBCO Software, Inc. and a wide range of smaller vendors associated with the capabilities that we offer. We may encounter further competition from other emerging companies. In addition, we may face pricing pressures from our current competitors and new market entrants in the future. We believe that the competitive factors affecting the market for our software and services are numerous and the specific importance of any one of these factors varies significantly for each customer. These competitive factors include product functionality and features; performance and price; ease and cost of product implementation; vendor and product reputation; quality of customer support services; financial strength; customer training and documentation; and quality of professional services offerings. Although we believe that our software and services currently compete favorably with respect to such factors, we may not be able to maintain our competitive position against current and potential competitors.

      Some of our current and potential competitors have longer operating histories, significantly greater financial, technical, product development and marketing resources, greater brand recognition and larger installed customer bases than we do. Our present or future competitors may be able to develop software similar to or even superior in functionality to what we offer, some may be able to adapt more quickly than we do to new technologies, evolving industry trends or new customer requirements, or devote greater resources to the marketing, design and development, and sale of their products. Accordingly, it is possible that we may not be able to compete effectively in our markets, which may harm our business and operating results. If we are not successful in developing new software and enhancements to our existing software or in achieving customer acceptance, our gross margins may decline, and our business and operating results may suffer.

      Our success is heavily dependent upon the technological and creative skills of our personnel and how successfully we can safeguard their efforts in developing and enhancing our software and related technology through the protection of our intellectual property rights, brand name, and associated goodwill. We depend upon our ability to develop and protect our proprietary technology and intellectual property rights to distinguish our software from our competitors’ products. We rely on a combination of confidentiality agreements, confidentiality procedures and contractual provisions, as well as trade secret, copyright, trademark and patent laws, to establish and protect our proprietary rights and accomplish these goals.

      For example, we take measures to avoid disclosure of our trade secrets, including, but not limited to, requiring all employees and certain consultants, customers, prospective customers, and others with which we have business relationships to execute confidentiality agreements that prohibit the unauthorized use and disclosure of our trade secrets and other proprietary materials and information. Further, we enter into license agreements with our customers, strategic partners, resellers and distributors that limit the unauthorized access to, use and distribution of our software, documentation and other proprietary information. Our license agreements with our customers, strategic partners, resellers and distributors impose restrictions on the use of our technology, including prohibiting the reverse engineering or de-compiling of our software, impose restrictions on the licensee’s ability to utilize the software and provide for specific remedies in the event of a breach of these restrictions. We also restrict access to our source code. While some of our license agreements require us to place the source code for our software in escrow

      We also seek to protect our technology, software, documentation and other proprietary information under the copyright, trademark and patent laws. We assert copyright in our software, documentation and other works of authorship, and periodically register copyrights with the U.S. Copyright Office in qualifying works of authorship. We assert trademark rights in and to our name, product names, logos and other markings that are designed to permit consumers to identify our goods and services. We routinely file for and have been granted trademark protection from the U.S. Patent and Trademark Office for qualifying marks. We currently hold a trademark registration in the United States for various marks, including the “webMethods,” “B2B Integration Server” and “Glue” marks, and a trademark registration in certain other countries and the European Union for the “webMethods” mark. We have two patents issued in the United States and several patent applications pending for technology related to our software. We may file additional patent applications in the United States or other countries in the future.

      Despite our efforts to protect our proprietary rights, contractual provisions, licensing restrictions and existing laws and remedies afford us only limited protection. The steps we have taken to protect our proprietary rights and intellectual property may not be adequate to deter misappropriation of our technology, and the protections we have may not prevent our competitors from developing products with functionality or features similar to our software. For more information regarding our proprietary rights, see Item 1A “Risk Factors — 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” and “Third-party claims that we infringe upon their intellectual property rights may be costly to defend and could damage our business.”

      webMethods, Inc. was organized in Delaware in 1996. We completed our initial public offering in February 2000. Our executive offices are located at 3877 Fairfax Ridge Road, South Tower, Fairfax, Virginia 22030, and our main telephone number is (703) 460-2500. We operate in a single segment of software and related services.

      Our internet address is www.webMethods.com. We provide free of charge on the Investor Relations page of our web site access to our annual report on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K and amendments to those reports as soon as reasonably practicable after electronically filed with or furnished to the Securities and Exchange Commission (“SEC”). Information appearing on our website is not incorporated by reference in and is not a part of this report.

      As of March 31, 2006, we employed approximately 826 full-time employees. These included approximately 244 in sales and marketing, 221 in professional services and technical support, approximately 234 in research and development and approximately 127 in other administrative areas, including accounting, finance, human resources, facilities and information technology. Our future success will depend in part on our ability to attract, retain and motivate highly qualified technical and management personnel, for whom competition is intense. From time to time, we have employed, and will continue to employ, independent contractors and consultants to support research and development, sales and marketing, and business development. Our employees generally are not represented by a collective bargaining agreement, although employees in certain of our international subsidiaries have claimed membership in trade unions or sought to invoke union representation in certain personnel matters. We

      You should consider the following risks and uncertainties when evaluating our statements in this report and elsewhere and prior to making an investment decision as to our securities. We are 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 operations or the market price of our 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. Factors that may cause our quarterly operating results to vary substantially in the future include:

      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

      The market price for our common stock has experienced significant fluctuation over the years and may continue to do so. From our initial public offering in February 2000 until June 12, 2006, the closing price of our 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 our common stock may be affected by a number of other factors, including:

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

      The markets for business integration solutions, Service-Oriented Architecture capabilities, Business Activity Monitoring and Business Process Management solutions and Composite Application Framework 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:

      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

      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 an actual or anticipated weakening of the economy, domestically or internationally, may result in a decrease in our revenue and growth rates.

      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 our common stock. Further, as discussed below, the expensing of stock options in the future is expected to add significant option compensation expense that could significantly impair 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 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

      Our operating results are subject to fluctuations in foreign currency exchange rates. We have not engaged in foreign currency hedging activities to mitigate a portion of these risks. Fluctuations in exchange rates between the U.S. dollar and foreign currencies in markets where we do business could adversely affect our operating results, if we continue to not engage in hedging activities.

      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, license revenue or operating results 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.

      In addition, 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 our common stock may fall significantly.

      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

      Our success in expanding the scope of our operations is dependent on successfully managing our workforce. As we grow, we must invest significantly in building our sales, marketing and product development groups. Competition for these people in the software industries is intense, and we may not be able to successfully recruit, train or retain qualified personnel. In addition, we must successfully integrate new employees into our operations and generate sufficient revenues to justify the costs associated with these employees. If we fail to successfully integrate employees or to generate the revenue necessary to offset employee-related expenses, we may be forced to reduce our headcount, which would force us to incur significant expenses and would adversely affect our business and operating results.

      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 these issues. In addition, because our customers, prospective customers and certain strategic partners depend on our adapting and enhancing our software products to meet technological changes and to conform to new industry standards, any failure or perceived failure on our part to do so could result in potential losses of customers, prospective customers, strategic partners and future revenue opportunities.

      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. If our software experiences performance problems or ceases to demonstrate technology leadership, we may have to increase our product development costs and divert our product development resources to address the problems.

      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. 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 have established strategic relationships with system integrators 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 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 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 strategic 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 our common stock.

      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 achieving our 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.

      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; develop new software or services; or respond 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.

      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 technology. Despite our efforts to protect our proprietary rights, contractual provisions, licensing restrictions and existing laws and remedies afford us only limited protection. The steps we have taken to protect our proprietary rights and intellectual property may not be adequate to deter misappropriation of our technology. 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, the protections that we have may not prevent our competitors from developing products with functionality or features similar to our software.

      It is possible that the copyrights, trademarks or patents held by us could be challenged and invalidated. For example, we cannot be certain that the two patents we hold, those that we have applied for, if issued, or our potential future patents will not be successfully challenged. Further, we cannot be certain that we will be able to develop proprietary products or technologies that are patentable, that any patent issued to us will provide us with any competitive advantage or that the patents of others will not seriously limit or harm our ability to do business. 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. We may not be able to detect unauthorized use of our proprietary information or take appropriate steps to enforce our intellectual property rights effectively. Policing the unauthorized use of our products and other proprietary rights is difficult and expensive, particularly given the global nature and reach of the Internet. Effective protection of our intellectual property rights may be limited in certain countries because the laws of some foreign countries do not protect proprietary rights to the same extent as do the laws of the United States. 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. 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 have a material adverse effect on our business, operating results and financial condition.

      In addition, we license technology from third parties that is incorporated into our software, and we bundle technology from third parties with our software. We also incorporate into our software certain “open source” software code or software tools, the use of which in commercial software products, such as ours, may be prohibited or restricted now or in the future. Any significant interruption in the supply or support of any technology we license from third parties, or our inability to continue to use “open source” software in our products, could adversely affect our business, unless and until we can replace the functionality provided by the licensed technology or “open source” software. Our use of licensed

      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 or our customers’ 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. These 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 two such claims 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 our 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.

      “Open source” software is software that is covered by a license agreement which permits the user to liberally copy, modify and distribute the software for free. Certain open source software is licensed pursuant to license agreements that require a user who intends to distribute the open source software as a component of the user’s software to disclose publicly part or all of the source code to the user’s software. This effectively renders what was previously proprietary software open source software. Many features we may wish to add to our products in the future may be available as open source software and our development team may wish to make use of this software to reduce development costs and speed up the development process. While we monitor the use of all open source software and try to ensure that no open source software is used in such a way as to require us to disclose the source code to the related product, such use could inadvertently occur. Additionally, if a third party has incorporated certain types of open

      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, 2006 and concluded, based upon their assessment, that a material weakness existed and, accordingly, that our internal control over financial reporting was not effective regarding the reliability of financial reporting and the preparation of financial statements for external purposes in accordance with generally accepted accounting principles. As a result of management’s conclusion that our internal control over financial reporting was not effective at March 31, 2006, due to a material weakness, we must change our internal control over financial reporting to remediate such material weakness. In this 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 cannot predict the outcome of our assessments in future periods. 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 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 our common stock.

      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

      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 may incur additional expense relating to the ongoing informal investigation by the Securities and Exchange Commission with respect to improper activities of personnel at our Japanese subsidiary. Further investigations or any future legal compliance or regulatory compliance matters could significantly increase expense and demands on management time and attention 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 under the Sarbanes-Oxley Act of 2002.

      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:

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

      Our software enables customers’ and certain strategic partners’ software applications to provide Web services, or to integrate with networks and software applications, and is often used for mission critical

      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 our 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 shares of our common stock, could discourage, delay or prevent a merger or acquisition of webMethods that stockholders 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.

      Not applicable.

      Our principal administrative, sales, marketing and research and development facility is located in Fairfax, Virginia, and consists of approximately 106,000 square feet of office space held under a lease that expires in March 2016. We maintain offices for sales and research and development in Sunnyvale, California, Denver, Colorado and Bellevue, Washington and a development center in Bangalore, India. We also maintain offices for sales, professional services and other personnel in the United States in California, Colorado, Georgia, Illinois, Indiana, Massachusetts, Michigan, Minnesota, New York, New Jersey, North Carolina, Ohio, Pennsylvania and Texas. We maintain offices outside the United States for sales, professional services and other personnel in Australia, Belgium, Canada, Hong Kong, France, Germany, India, Italy, Japan, Malaysia, the Netherlands, People’s Republic of China, Singapore, South Korea, Spain, Sweden, Switzerland and the United Kingdom.

      We provide customer technical support from our facilities in Virginia and California in the United States and in Australia, India, Japan, Malaysia and the Netherlands. We regularly evaluate the suitability and adequacy of our existing facilities and the availability of space for facilities in new locations, and we believe that suitable space for new, replacement or expanded facilities, as needed, generally will be available on commercially reasonable terms.

      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 our IPO were not disclosed in the registration statement and final prospectus for our IPO or disclosed to the public after our IPO, and sought unspecified damages on behalf of a purported class of purchasers of our 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 our executive officer defendants have been dismissed without prejudice. We have 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. A fairness hearing was held on April 24, 2006, and a motion for final approval of the settlement is currently under submission before the Court. Under the proposed settlement, the plaintiffs would dismiss and release their claims against us 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. We believe that any material liability on behalf of webMethods that may accrue under the proposed settlement would be covered by its insurance policies.

      From time to time, we are involved in other disputes and litigation in the normal course of business.

      No matters were submitted to a vote of security holders during the fourth quarter of the fiscal year covered by this report.

      webMethods common stock is publicly traded on the Nasdaq National Market under the symbol “WEBM”. The high and low sales prices of our common stock as reported by the Nasdaq National Market during the last two fiscal years are shown below:

      As of June 12, 2006, there were approximately 325 holders of record of our common stock. The number of holders of record of our common stock does not reflect the number of beneficial holders whose shares are held by depositories, brokers or other nominees. As of June 12, 2006, the closing price of our common stock was $9.30.

      We have never declared or paid any cash dividends on our common stock. We currently intend to retain earnings, if any, to support our growth strategy and do not anticipate paying cash dividends in the foreseeable future.

      The following selected historical consolidated financial data should be read in conjunction with the Consolidated Financial Statements and notes thereto and “Management’s Discussion and Analysis of Financial Condition and Results of Operations,” which are included elsewhere in this report. The historical consolidated statement of operations data for the years ended March 31, 2006, 2005 and 2004 and the historical consolidated balance sheet data as of March 31, 2006 and 2005 are derived from our consolidated financial statements, which have been audited by PricewaterhouseCoopers LLP, our independent registered public accounting firm, and are included elsewhere in this report. The historical consolidated statement of operations data for the years ended March 31, 2003 and 2002 and the historical consolidated balance sheet data as of March 31, 2004, 2003 and 2002 are derived from our audited consolidated financial statements not contained in this report. Historical results are not necessarily indicative of future results.

      Management’s discussion and analysis of financial condition, changes in financial condition and results of operations is provided as a supplement to the accompanying consolidated financial statements and notes to help provide an understanding of webMethods, Inc.’s financial condition and results of operations. This item of our Annual Report on Form 10-K is organized as follows:

      We are a leading provider of business integration and optimization software. Our products and solutions enable our customers to improve the performance of their organizations by implementing and accelerating business process improvements. Our primary offering is webMethods Fabric, a unified business integration and optimization product suite.

      Management uses quantitative performance indicators to assess our financial condition and operating results. These performance indicators include total revenues, license revenues, maintenance revenues, services revenues, operating margin and earnings per share. Each provides a measurement of the performance of our business and how well we are executing our operating plan.

      Our total revenues for the year ended March 31, 2006 were approximately $208.8 million. This represents an increase of approximately 4% over the prior fiscal year.

      Our license revenues for the year ended March 31, 2006 were $87.4 million, or 42%, of our total revenues. This represents an increase of 1% over the prior fiscal year. We receive license revenues from the sale of licenses of our software products worldwide in various industries. We sell licenses of our products through a direct sales force, resellers or distributors, and through alliances with strategic software vendor partners and major system integrators.

      Our maintenance revenues for the year ended March 31, 2006 were $74.2 million, or 36%, of our total revenues. This represents an increase of 15% over the prior fiscal year. We receive maintenance revenues from the sale of a variety of support and maintenance plans to our customers. First-year maintenance is usually sold with the related software license and is typically renewed on an annual basis. Maintenance revenue is recognized ratably over the term of the maintenance contract, which is typically twelve months.

      Our professional services revenues for the year ended March 31, 2006 were $47.2 million, or 23%, of our total revenues. This represents a 4% decline over the prior fiscal year. We receive professional services revenues from consulting and training services provided to our customers. These services primarily consist

      Our operating margin for the year ended March 31, 2006 was 5%, compared to negative 10% for the prior fiscal year. Operating margin is the percentage of operating income (loss) to total revenue.

      For the year ended March 31, 2006, our earnings per share on a fully-diluted basis was $0.33, compared to a loss per share of $0.35 for the prior fiscal year.

      The significant improvement in our financial results for the year ended March 31, 2006 is primarily due to a $21.2 million decrease in operating expenses, an $8.2 million increase in total revenue, a $4.0 million increase in interest income and other non-operating income, net, and a $1.3 million income tax benefit in fiscal year 2006 as compared to a $235,000 provision for taxes in fiscal year 2005.

      Further analyses of our performance indicators can be found in “Results of Operations.”

      Our focus in fiscal year 2007 is building on our success in 2006 by executing in key areas, including continuing to innovate on our integrated software platform, delivering compelling value propositions to customers, responding effectively to customer needs, and continuing to focus on product excellence, business efficiency, and accountability across the company.

      The key opportunities in our markets for fiscal year 2007 include:

      We believe that with webMethods Fabric we are well-positioned to take advantage of these market opportunities.

      Our license revenues historically have fluctuated quarterly and have generally been the highest in the third and fourth quarters of our fiscal year due to corporate calendar year-end spending trends as well as the typical seasonality related to the end of our fiscal year. We believe that the seasonality of our license revenue is likely to continue.

      We believe that continued investment in research and development is critical to achieving our strategic objectives. We intend to increase our staff in the direct sales organization and increase our marketing efforts. We will continue to invest in our corporate infrastructure to improve the effectiveness of management. As a result, we expect that research and development, sales and marketing, and general and administrative expenditures will increase in absolute dollars in fiscal year 2007.

      We have adopted SFAS No. 123R “Share-Based Payment” for all periods beginning with the quarter ending June 30, 2006. 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 earnings per share.

      The following table summarizes the results of our operations for each of the past three fiscal years (all percentages are calculated using the underlying data in thousands):

      Net income for our fiscal year ended March 31, 2006 increased to approximately $18.0 million from a net loss of $18.8 million in fiscal year 2005, or an improvement of $36.8 million. This improvement is due primarily to a $21.2 million decrease in total operating expenses, an $8.2 million increase in total revenue, a $4.0 million increase in interest income and other non-operating income, net, a $1.7 million decrease in total cost of revenue and a $1.3 million income tax benefit in fiscal year 2006 as compared to a $235,000 provision for taxes in fiscal year 2005. Net loss for fiscal year 2005 decreased to $18.8 million from $33.0 million in fiscal year 2004, or an improvement of $14.3 million. This improvement is due primarily to an $11.1 million increase in total revenue and an $8.1 million decrease in total operating expenses, partially offset by a $3.7 million increase in total cost of revenue, a $1.0 million decrease in interest income and other non-operating income, net, and a $235,000 increase in income taxes.

      Total revenue for fiscal year 2006 included a $2.6 million negative foreign currency impact from certain international markets, which was partially offset by a $1.6 million positive foreign currency impact on total cost of revenue and total operating expenses, resulting in a negative impact of $1.0 million to operating income in fiscal year 2006. Total revenue for fiscal year 2005 included a $5.5 million positive foreign currency impact from certain international markets, which was partially offset by a $4.3 million negative foreign currency impact on total cost of revenue and total operating expenses, resulting in a positive impact of $1.2 million to operating loss in fiscal year 2005.

      The following table summarizes our revenue for each of the past three fiscal years:

      The following table summarizes our revenue by geographic region for each of the past three fiscal years:

      Total revenue for fiscal year 2006 increased by approximately $8.2 million, or 4%, compared to fiscal year 2005. The increase in total revenue was due to increases of $9.6 million in maintenance revenue and $649,000 in license revenue, partially offset by a $2.0 million decrease in professional services revenue. Total revenue for fiscal year 2005 increased by $11.1 million, or 6%, compared to fiscal year 2004. The increase in total revenue was due to increases of $11.4 million in maintenance revenue and $5.6 million in professional services revenue, which were partially offset by a $5.9 million decrease in license revenue.

      Total revenue from the Americas for fiscal year 2006 increased by $11.8 million, or 10%, compared to fiscal year 2005. Total international revenue for fiscal year 2006 from Europe, the Middle East and Africa (“EMEA”), Asia Pacific and Japan decreased by $3.6 million, or 4%, compared to fiscal year 2005. The decrease in total international revenue for fiscal year 2006 is primarily due to a $6.1 million, or 40%, decline in revenue from Japan, which was partially offset by increases in revenue from EMEA and Asia Pacific. Our Japanese operations were 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. Total revenue from the Americas for fiscal year 2005 increased by $5.1 million, or 4%, compared to fiscal year 2004. Total international revenue for fiscal year 2005 increased by $6.0 million, or 8%, compared to fiscal year 2004. International revenue accounted for 37% of our total revenue in fiscal year 2006 and 40% in fiscal years 2005 and 2004.

      License revenue for fiscal year 2006 increased by $649,000, or 1%, compared to fiscal year 2005. License revenue for fiscal year 2005 decreased by $5.9 million, or 6%, in fiscal year 2005 compared to fiscal year 2004. The decrease in license revenue in fiscal year 2005 was due in part to a significant decrease in license revenue in the first fiscal quarter of 2005 as many enterprises became more cautious in their enterprise software spending. The decrease in license revenue was also due in part to lower license revenue from Japan due to the disruption associated with the internal investigation of our Japanese operations and related management changes.

      Foreign currency fluctuations had a negative impact on license revenue of $1.0 million in fiscal year 2006 and a positive impact of $2.8 million and $4.8 million in fiscal years 2005 and 2004, respectively.

      Professional services revenue for fiscal year 2006 decreased by $2.0 million, or 4%, compared to fiscal year 2005. The decrease was primarily due to lower professional services revenue from subcontractors because we shifted a portion of our lower margin integration services to our systems integration partners. Professional services revenue for fiscal year 2005 increased by $5.6 million, or 13%, compared to fiscal year 2004. The increase was primarily due to an increase in the volume and size of customer engagements.

      Foreign currency fluctuations had a negative impact on professional services revenue of $628,000 in fiscal year 2006 and a positive impact of $1.1 million and $1.9 million in fiscal years 2005 and 2004, respectively.

      Maintenance revenue for fiscal year 2006 increased by $9.6 million, or 15%, compared to fiscal year 2005. Maintenance revenue for fiscal year 2005 increased by $11.4 million, or 21%, compared to fiscal year 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. Our customers generally continue to subscribe for maintenance and support when they are no longer required to pay license fees. This results in increases in maintenance revenue as the cumulative number of licensed copies of our software increase. The increases in maintenance revenue in fiscal years 2006 and 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 on maintenance revenue of $949,000 in fiscal year 2006 and a positive impact of $1.6 million and $2.1 million in fiscal years 2005 and 2004, respectively.

      The following table summarizes our cost of revenue by type of revenue for each of the past three fiscal years:

      Total cost of revenue for fiscal year 2006 decreased by approximately $1.7 million, or 3%, compared to fiscal year 2005. The decrease is due to a $1.3 million decrease in cost of professional services revenue, a $250,000 decrease in cost of license revenue and a $191,000 decrease in cost of maintenance revenue. Total cost of revenue for fiscal year 2005 increased by $3.7 million, or 6%, compared to fiscal year 2004. The increase is due to a $1.8 million increase in cost of maintenance revenue, a $1.7 million increase in cost of professional services revenue and a $1.2 million increase in amortization of intangibles, partially offset by a $1.0 million decrease in cost of license revenue.

      Total gross profit margin increased to 72% in fiscal year 2006 as compared to 70% in fiscal years 2005 and 2004. The increase in fiscal year 2006 was primarily due to an increase in license and maintenance revenue, as well as a decrease in our total cost of revenue.

      Cost of license revenue for fiscal year 2006 decreased $250,000, or 20%, compared to fiscal year 2005 due to lower royalty fees from products embedded in our software that are licensed from third parties.

      Cost of professional services revenue consists primarily of costs related to internal professional services and subcontractors hired to provide implementation services. Cost of professional services revenue for fiscal year 2006 decreased $1.3 million, or 3%, compared to fiscal year 2005 due primarily to our hiring of fewer subcontractors to provide implementation services. Cost of professional services revenue for fiscal year 2005 increased $1.7 million, or 4%, compared to fiscal year 2004 due primarily to an increase in the volume and size of customer engagements. Gross profit margin on professional services revenue was 10%, 11% and 3% in fiscal years 2006, 2005 and 2004, respectively.

      Cost of maintenance revenue for fiscal year 2006 decreased $191,000, or 1%, compared to fiscal year 2005 due to reduced costs of third party contractors. Cost of maintenance revenue for fiscal year 2005 increased $1.8 million, or 16%, compared to fiscal year 2004 due primarily to increased costs of third party contractors. Gross profit margin on maintenance revenue was 83%, 80% and 79% in fiscal years 2006, 2005 and 2004, respectively. The increase in fiscal years 2006 and 2005 was primarily due to increases in maintenance revenue.

      The following table presents certain information regarding our operating expenses during each of the past three fiscal years:

      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, allocated facilities, recruitment, amortization of deferred stock compensation and overhead costs. Our sales and marketing expenses also include expenses which are specific to our sales and marketing activities, such as commissions, trade shows, public relations, business development costs, promotional costs, marketing materials and deferred warrant charge. Also included in

      Total operating expenses for fiscal year 2006 decreased approximately $21.2 million, or 13%, compared to fiscal year 2005. The decrease was due to a $10.2 million decrease in sales and marketing costs, a $5.4 million decrease in restructuring and other related charges, a $4.3 million decrease in research and development costs and a $1.2 million decrease in general and administrative costs. Total operating expenses for fiscal year 2005 decreased $8.1 million, or 5%, compared to fiscal year 2004. The decrease was due to a $10.1 million decrease in sales and marketing costs, a $4.3 million decrease in in-process research and development write-offs, a $2.3 million decrease in settlement of intellectual property matter and a $542,000 decrease in research and development costs, partially offset by a $7.2 million increase in general and administrative costs and a $1.9 million increase in restructuring and other related charges. Foreign currency fluctuations had a positive impact on total operating expenses of $920,000 in fiscal year 2006 and a negative impact of $3.0 million in fiscal year 2005.

      Sales and marketing expense for fiscal year 2006 decreased $10.2 million, or 12%, compared to fiscal year 2005. The decrease was primarily due to a $5.2 million decrease in personnel and related overhead costs, a $1.6 million decrease in referrals and external commissions, a $1.4 million decrease in travel costs, a $924,000 decrease in marketing costs and a $558,000 decrease in professional services. Sales and marketing expense for fiscal year 2005 decreased $10.1 million, or 11%, compared to fiscal year 2004. The decrease was primarily due to a $5.6 million decrease in personnel and related overhead costs, a $1.1 million decrease in travel expenses, an $844,000 decrease in marketing program costs and a $542,000 decrease in commission expenses. The decreases in sales and marketing expenses for fiscal year 2006 and fiscal year 2005 are primarily the result of a worldwide program to reduce costs that commenced in the second half of fiscal year 2005 and included headcount reductions, consolidation of facilities and reductions in travel costs, marketing programs and other expenses. Included in sales and marketing expense was amortization of deferred warrant charge of $2.5 million, $2.6 million and $2.6 million for the fiscal years 2006, 2005 and 2004, respectively. 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, permitted i2 to purchase 710,000 shares of our common stock. The amortization of deferred warrant charge terminated at the end of March 2006. Sales and marketing expense was 35%, 42% and 50% of total revenue in fiscal years 2006, 2005 and 2004, respectively.

      Research and development expense for fiscal year 2006 decreased $4.3 million, or 10%, compared to fiscal year 2005. The decrease was primarily due to a $4.6 million decrease in personnel costs and related overhead charges, primarily as a result of the increased utilization of our product development center in Bangalore, India during fiscal year 2005, which has lower personnel costs and operating expenses than our product development centers in the United States, and a $278,000 decrease in travel costs, partially offset by a $418,000 increase in professional services costs. Research and development expense for fiscal year 2005 was relatively flat compared to fiscal year 2004. Research and development expense was 19%, 22% and 24% of total revenue in fiscal years 2006, 2005 and 2004, respectively. As of March 31, 2006, approximately 20% of our worldwide product development staff are located in India.

      General and administrative expenses for fiscal year 2006 decreased $1.2 million, or 5%, compared to fiscal year 2005. The decrease was primarily due to a $1.1 million decrease in legal fees, a $722,000 decrease in bad debt expense, a $286,000 decrease in business insurance and a $245,000 decrease in property, franchise and other taxes, partially offset by a $1.2 million increase in personnel and related overhead costs. Included in general and administrative expense was a $750,000 charge for a litigation settlement payment, net of insurance reimbursement. General and administrative expenses for fiscal year 2005 increased $7.2 million, or 40%, compared to fiscal year 2004. The increase was primarily due to a $2.7 million increase in legal fees, a $2.2 million increase in accounting and audit fees and a $1.4 million increase in personnel and related overhead costs. General and administrative expense as a percentage of total revenue, was 11%, 12% and 9% for fiscal years 2006, 2005 and 2004, respectively.

      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 fiscal year 2006 as compared to fiscal years 2005 and 2004. During fiscal year 2006, we incurred restructuring costs of $411,000, which includes restructuring costs of $719,000 consisting primarily of severance and related benefits, net of a $308,000 reduction in the accrual for excess facilities costs. During fiscal year 2005, we recorded restructuring and related charges 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 our headquarters. During fiscal year 2004, we recorded restructuring and related charges of $3.9 million, consisting of $2.2 million for headcount reductions and $1.7 million for excess facilities cost related to the consolidation of facilities and related impairment of fixed assets. The estimated excess facility costs were 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 the 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.

      We incurred an in-process research and development charge of $4.3 million for fiscal year 2004. There was no in-process research and development charge for fiscal years 2006 and 2005. The $4.3 million charge during fiscal year 2004 consists of: (i) a one-time charge of $3.1 million recorded in connection with the acquisition and write-off of The Dante Group technology and (ii) a one-time charge of $1.2 million recorded in connection with the acquisition and write-off of The Mind Electric technology. We also incurred a $2.3 million charge in fiscal year 2004 related to the settlement of an intellectual property matter.

      Interest income was $4.5 million for fiscal year 2006 compared to $2.5 million for fiscal year 2005. The $2.0 million increase was primarily due to the higher average balances of cash and marketable securities during fiscal year 2006 and higher interest rates on corporate paper, bonds and money market funds. Interest income was $2.5 million for fiscal year 2005 compared to $2.9 million for fiscal year 2004. The $364,000 decrease was primarily due to the lower average balances of cash and marketable securities during fiscal year 2005 as a result of the use of cash in connection with payments for acquisitions in October 2003.

      Interest expense is primarily due to equipment leasing arrangements in the Americas. For fiscal year 2006, interest expense decreased to $82,000, as compared to $98,000 in fiscal year 2005 and $205,000 in fiscal year 2004.

      Other income (expense), net includes gains and losses on foreign currency transactions. Other income was $807,000 for fiscal year 2006 as compared to other expense of $124,000 for fiscal year 2005 and $461,000 for fiscal year 2004.

      We recognized an other-than-temporary decline in value of $1.0 million in private company investments in fiscal year 2005.

      We recorded an income tax benefit of $1.3 million in fiscal year 2006, which included a $2.1 million reduction of valuation allowance on net operating loss carryforwards and other deferred tax assets of our Australian subsidiary. This benefit was partially offset by income tax expense of $757,000 incurred in our

      Deferred income taxes reflect the net tax effects of the temporary differences between the carrying amounts of assets and liabilities for financial reporting purposes and the amounts used for income tax purposes. The recognition of deferred tax assets is recorded when the realization of such assets is more likely than not, considering all available evidence, both positive and negative, including historical levels of income, expectations and risks associated with estimates of future taxable income and ongoing prudent and feasible tax planning strategies. We had provided a full valuation allowance against our net deferred tax assets as of March 31, 2005 based on a number of factors, which included historical operating performance and cumulative net losses. During fiscal year 2006, we released the $2.1 million valuation allowance for the net deferred tax assets of our Australian subsidiary because we determined that it was more likely than not that the net deferred tax assets would be realizable based on our analysis of all available evidence, both positive and negative.

      As of March 31, 2006, we had net operating loss (“NOL”) carry-forwards of approximately $197 million. These NOL carry-forwards are available to reduce future taxable income and begin to expire in fiscal year 2011. The realization of benefits of the NOLs is dependent on sufficient taxable income in future years. Lack of future earnings, a change in our ownership, or the application of the alternative minimum tax rules could adversely affect our ability to utilize the NOLs.

      The following tables set forth consolidated statement of operations data for each of the eight quarters ended March 31, 2006 as well as that data expressed as a percentage of the total revenue for the quarters presented. This information has been derived from our unaudited consolidated financial statements. The unaudited consolidated financial statements have been prepared on the same basis as the audited consolidated financial statements contained elsewhere in this report and include all adjustments, consisting only of normal recurring adjustments that we consider necessary for a fair statement of such information. You should read this information in conjunction with our annual audited consolidated financial statements and related notes appearing elsewhere in this report. Historical results may not be indicative of future results.

Cash Flows

      As of March 31, 2006 we had cash, cash equivalents and short-term and long-term securities available for sale in the amount of $162.3 million, as compared to $150.1 million as of March 31, 2005.

      Net cash provided by operating activities was $18.0 million in fiscal year 2006, resulting from net income of $18.0 million, adjusted for $7.3 million of non-cash charges and partially offset by $7.3 million of net changes in assets and liabilities. The non-cash charges included $5.3 million for depreciation and amortization expense, $2.6 million for amortization of stock-based compensation, $2.4 million for amortization of acquired intangibles and $2.2 million for the release of deferred tax valuation allowance. The net changes in assets and liabilities included an $17.6 million increase in accounts receivable, a $12.9 million increase in deferred revenue and a $4.4 million decrease in accrued expenses.

      Net cash provided by investing activities was $7.1 million in fiscal year 2006, resulting from the net maturities of marketable securities of $13.1 million, partially offset by $5.1 million of capital expenditures and an $899,000 increase in restricted cash. Capital expenditures consisted of purchases of operating resources to manage operations, including computer hardware and software, office furniture and equipment and leasehold improvements.

      Net cash provided by financing activities was $4.3 million in fiscal year 2006, resulting from $3.6 million of net cash proceeds from exercises of stock options and $1.3 million of net cash proceeds from our Employee Stock Purchase Plan (“ESPP”) common stock issuances, partially offset by payments of $585,000 on capital leases.

     Debt Financing

      We have 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.

      We may borrow the entire $20 million operating line of credit as long as the aggregate balances of cash and cash equivalents on deposit with financial institutions in the United States and marketable securities trading on a national exchange 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 our option and must be repaid over 36 months. The agreement for both facilities include restrictive covenants that require us 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 March 31, 2006, we were in compliance with these covenants.

      As of March 31, 2006, we had not borrowed against the operating line of credit or the equipment line of credit. In connection with the operating line of credit agreement, we have obtained letters of credit totaling approximately $2.6 million related to office leases. As of March 31, 2006, we had $17.4 million available under the operating line of credit and $2.0 million available under the equipment line of credit.

      The following table summarizes our significant contractual obligations at March 31, 2006, which are comprised of capital and operating leases. These obligations are expected to have the following effects on our liquidity and cash flows in future periods: