MICROMUSE INC, 10-K, 1998-12-29

MICROMUSE INC
10-K, 1998-12-29
PREPACKAGED SOFTWARE

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SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, D.C. 20549
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FORM 10-K
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[X] ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 (FEE REQUIRED)

FOR THE FISCAL YEAR ENDED SEPTEMBER 30, 1998

[ ] TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED)

FOR THE TRANSITION PERIOD FROM ____________ TO ____________ .

COMMISSION FILE NO. 000-23783
MICROMUSE INC.
(EXACT NAME OF REGISTRANT AS SPECIFIED IN ITS CHARTER)

<TABLE>
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DELAWARE 94-3288385
(STATE OR OTHER JURISDICTION OF (IRS EMPLOYER IDENTIFICATION NO.)
INCORPORATION OR ORGANIZATION)
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139 TOWNSEND STREET
SAN FRANCISCO, CALIFORNIA 94107
(415) 538-9090
(ADDRESS OF PRINCIPAL EXECUTIVE OFFICE, INCLUDING ZIP CODE, AND TELEPHONE
NUMBER)

SECURITIES REGISTERED PURSUANT TO SECTION 12(B) OF THE ACT: NONE
SECURITIES REGISTERED PURSUANT TO SECTION 12(G) OF THE ACT:
COMMON STOCK, $.01 PAR VALUE
(TITLE OF CLASS)

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein and will not be contained, to the
best of registrant's knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment to this
Form 10-K. [ ]

The aggregate market value of the Registrant's common stock, $.01 par
value, held by non-affiliates of the Registrant on November 30, 1998 was
approximately $309.9 million. As of November 30, 1998, there were 15,617,246
shares of Registrant's common stock, $.01 par value, outstanding.

DOCUMENTS INCORPORATED BY REFERENCE

Portions of Registrant's definitive proxy statement (the "Proxy Statement")
to be mailed to stockholders in connection with its 1999 annual meeting of
stockholders scheduled to be held on January 28, 1999, are incorporated by
reference into Part III of this report. Except as expressly incorporated by
reference, the Registrant's Proxy Statement shall not be deemed to be part of
this report.
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MICROMUSE INC.

TABLE OF CONTENTS

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PART I
Item 1. Business.................................................... 3
Item 2. Properties.................................................. 10
Item 3. Legal Proceedings........................................... 10
Item 4. Submission of Matters to a Vote of Security Holders......... 10
PART II
Item 5. Market for the Registrant's Common Equity and Related
Stockholder Matters......................................... 11
Item 6. Selected Financial Data..................................... 12
Item 7. Management's Discussion and Analysis of Financial Condition
and Results of Operations................................... 14
Item 7a. Quantitative and Qualitative Disclosures About Market Risk
Derivatives and Financial Instruments....................... 32
Item 8. Financial Statements and Supplementary Data................. 33
Item 9. Changes in and Disagreements With Accountants on Accounting
and Financial Disclosures................................... 49
PART III
Item 10. Directors and Executive Officers of the Registrant.......... 49
Item 11. Executive Compensation...................................... 50
Item 12. Security Ownership of Certain Beneficial Owners and
Management.................................................. 50
Item 13. Certain Relationships and Related Transactions.............. 50
PART IV
Item 14. Exhibits, Financial Statement Schedule, and Reports on Form
8-K......................................................... 50
Signatures............................................................ 51
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PART I

This document contains forward-looking statements that involve risks and
uncertainties. The Company's actual results may differ materially from the
results discussed in such forward-looking statements. Factors that might cause
such differences include, but are not limited to, fluctuations in customer
demand, the Company's ability to manage its growth, risks associated with
competition and risks identified in the Company's Securities and Exchange
Commission filings, including, but not limited to, those discussed elsewhere in
this Report under the caption "Risk Factors"

ITEM 1. BUSINESS

Micromuse develops, markets and supports a family of scalable, highly
configurable, rapidly deployable software solutions that enable Service Level
Management ("SLM") -- the effective monitoring and management of multiple
elements underlying an Information Technology infrastructure, including network
devices, computing systems and applications, and the mapping of these elements
to the business services they impact. The Company's Netcool product suite
collects, normalizes and consolidates high volumes of event information from
heterogeneous network management environments into an active database that
de-duplicates and correlates the resulting data in real-time, and then rapidly
distributes graphical views of the information to operators and administrators
responsible for monitoring service levels. Netcool's unique architecture allows
for the rapid, programmerless association of devices and specific attributes of
those devices to the business services they impact. This readily enables
administrators to create and modify their service views during systems
operations to monitor particular business services, rapidly identify which users
are affected by which network faults, pinpoint sources of network problems,
automate operator responses, facilitate problem resolution and report on the
results. The Company markets and distributes to customers through its own sales
force, OEMs, value-added resellers and systems integrators. The Company has
distribution agreements with Bay Networks, Cisco Systems, CTC (Itochu),
Datacraft, Ericsson Data Services, N.E.T., and Vanstar. As of September 30,
1998, the Company had over 200 customers operating in and serving a variety of
industries. Customers include AirTouch, America Online, AT&T Wireless, British
Telecommunications, Cable and Wireless, Cellular One, Deutsche Telekom, First
Data Resources, Genuity, GE Information Services, Global One, GTE
Internetworking, Merrill Lynch, MindSpring, Morgan Stanley, Netcom, Pacific
Bell, PSINet, Siemens, Southwestern Bell Internet Services, Unisource and
WorldCom/MFS/UUNet.

PRODUCTS AND TECHNOLOGY

Micromuse provides a suite of software products that enable SLM. The
Company's Netcool SLM solution includes Netcool/OMNIbus and its components for
event management, Netcool/Reporter for service level reporting, Netcool/Internet
Service Monitors for the proactive management of internet services, and
associated related technical services. Netcool/OMNIbus collects, consolidates,
de-duplicates and correlates information from a wide range of network management
platforms and devices and then presents user-configurable views of subsets of
network data. Netcool/Reporter uses this data to provide real-time and
historical reporting. Netcool/Internet Service Monitors collect response and
availability data from several frequently implemented Internet/Intranet services
and forward this information to Netcool/OMNIbus for integration with other
service data. Since customers can quickly associate each network element (a
network device, computing system or application) with a particular service,
Netcool products enable companies to efficiently set up, monitor, manage and
report on Service Level Agreements ("SLA"). Netcool/Reporter, currently in its
initial commercial release, has features and performance characteristics that
have had limited market appeal. See "Risk Factors -- Product Defects; Product
Liability."

Netcool/OMNIbus

Netcool/OMNIbus is based on a three-tier, client/server architecture and is
the core application of the product suite. Netcool/OMNIbus consists of four
components: Netcool/OMNIbus Probes, the Netcool/ OMNIbus ObjectServer,
Netcool/OMNIbus Desktops, and Netcool/OMNIbus Gateways. Probes collect event
information from existing network management systems, as well as event messages
from network devices, computing systems, applications or legacy systems. The
Probes then normalize and feed this event data into the ObjectServer, an
object-oriented, memory-resident active database. At the ObjectServer, the
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event data is de-duplicated, correlated and associated with other event data. By
manipulating the data in the ObjectServer through the Desktops, users can design
customized views of event data to monitor segments of the network or services
that span the entire network. Gateways permit data to be shared between multiple
ObjectServers for load balancing or fail-over facilities, exported to common
relational database management systems (Oracle or Sybase) for historical service
level views, or integrated with other applications such as Remedy's helpdesk
application.

Probes

Probes are the first tier of Netcool's three-tier architecture. Probes are
primarily passive software interfaces that collect network event data (including
messaged network data such as faults, alerts, and traps) from elements on the
network or from domain-based network management systems. These Probes can
collect information presented from either management platforms and devices
(e.g., HP OpenView, Cabletron SPECTRUM, Cisco StrataView Plus, and Newbridge
46020) and standard protocols such as screen oriented ASCII character streams,
application log files (e.g., syslog) TL1, SMNP, or any other method of
management information provision. They recognize Management Information Base
("MIB") information from switches and routers from leading vendors, including
Bay Networks, Cabletron, Cisco, 3Com and N.E.T. Probes use rules and lookup
tables to categorize and add information to events. As a result, network data
collected by the Probes is normalized into a common alert format and then passed
to the ObjectServer.

ObjectServer

The ObjectServer, which is the second tier of Netcool's three-tier
architecture, is a real-time, object-oriented, memory-resident, active database
which stores and manages all the collected network events. The ObjectServer
consolidates, associates and de-duplicates normalized data from the Probes,
converting events, such as faults and alarms, into event objects that can be
easily manipulated to create associations and filters. The active components of
the ObjectServer include its de-duplication capability and its ability to
correlate event objects with other event objects, make decisions on information,
automate operator responses and facilitate problem resolution. The ObjectServer,
which has been designed and optimized for handling large volumes of events
messages, can process hundreds of alarms per second and can collect data from
multiple Probes concurrently. The ObjectServer architecture also permits
multiple authenticated users to view all the events throughout the enterprise.
In addition, since one network fault can impact several locations in a
distributed environment and can therefore trigger multiple events, the
ObjectServer is designed to automatically de-duplicate repeated events so that
network operators can easily identify the root cause. The Company believes that
the ObjectServer architecture provides the Company with a competitive advantage
in both the speed with which it collects network events and the ability to
associate event information with the services it manages.

Desktops

A Desktop, the third tier in Netcool's three-tier architecture, is an
integrated suite of software tools designed for use by operators and
administrators to create filters, customize views of network event data, monitor
several services simultaneously, and automatically resolve service problems.
Network operators can quickly build filters by responding to simple onscreen
queries about user preferences. They can also associate events with services
through the use of simple "drag-and-drop" technology that automatically creates
the Boolean logic and SQL required to retrieve the data from the ObjectServer.
In this way, non-programmers can manipulate the data in the ObjectServer to
custom-design views of event data. In addition, each operator can use Desktops
to resolve element problems directly or automate responses to common network
problems when critical thresholds are reached.

Operators can use Desktops to monitor services through either EventLists,
the EventList Console or ObjectiveView. The EventList presents a configurable
spreadsheet-like view of the de-duplicated faults and acts as the primary
interface through which operators access problem resolution tools. The EventList
Console depicts a concise view of the EventLists for several services while the
ObjectiveView provides a graphical view of the network or services that depend
upon it. Administrators can use Desktops to configure the ObjectServer
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and the operator's desktop environments. Desktops run on multiple computing
platforms, including UNIX/ Motif, Microsoft Windows NT, or Web browsers via Java
applications.

Gateways

Gateways are interfaces to other Micromuse products or to third-party
applications that allow sharing of Netcool event data. For example, multiple
Netcool ObjectServers can share data using a Gateway to offer customers
load-balancing and fail-over facilities. In addition, event data can be exported
through Gateways to databases such as Oracle or Sybase for historical analysis
and reporting or to trouble-ticketing packages such as Remedy's help desk
application.

Netcool/Reporter

Netcool/Reporter is a Java-based application that generates reports on the
real-time and historical availability of network services, applications,
business processes or any customer-defined grouping of IT resources (both
physical and logical). Netcool/Reporter is designed to leverage archived data
from service profiles created within Netcool/OMNIbus, and to allow operators to
report on SLA compliance. Netcool/ Reporter can produce availability data in
several graphical formats, including spreadsheets, 2D or 3D charts, and billing
forms. Netcool/Reporter provides both Service Level Reports and generic reports.
Service Level Reports allow operators to define individualized service levels by
designing their own report metrics. They can also be tailored to precisely match
the service level availability criteria described by SLAs. Generic reports are
pre-configured reports that use event time and frequency categories as the
primary variables. Netcool/ Reporter, currently in its initial commercial
release, has features and performance characteristics that have had limited
market appeal. Although the Company is currently devoting significant management
and technical resources to improve the features and performance of
Netcool/Reporter, the Company does not expect significant revenue contribution
from Netcool/Reporter for the foreseeable future. To the extent such efforts
continue to require the allocation of a significant portion of the Company's
technical personnel resources, or if the performance and features of
Netcool/Reporter are not improved, the Company could continue to experience
delay in or failure of market acceptance of Netcool/Reporter, or damage to the
Company's reputation or relationships with its customers, any of which could
have a material adverse effect on the Company's business, operating results and
financial condition. See "Risk Factors -- Product Defects; Product Liability."

Netcool/Internet Service Monitors

Netcool/Internet Service Monitors, which became available on March 31,
1998, are software applications that collect and analyze real-time response and
availability data about internet services including HTTP (Web servers), FTP
(file transfer), SMTP and POP3 (e-mail), NNTP (news), DNS (directory services),
and RADIUS (dial-in security and accounting). Netcool/Internet Service Monitors
collect response and availability data, compare it with user-defined threshold
levels, and then forward fault information to Netcool/ OMNIbus when thresholds
are exceeded. The resulting information can be combined with other network fault
data to provide companies with detailed information about services that
incorporate Internet-based elements. Netcool/Internet Service Monitors can be
configured through the World Wide Web through an HTML interface and are designed
to integrate easily with networks managed by Netcool/OMNIbus.

SALES AND MARKETING

The Company markets its software and services primarily through its direct
sales organization in San Francisco; Atlanta; Boston; Chicago; Dallas; Los
Angeles; New York; Scottsdale, Arizona; Vienna, Virginia; Washington, D.C.;
London and Sydney. Additionally, the Company has a growing channel organization
and expects to generate an increasing percentage of total sales through its
OEMs, value-added resellers and systems integrators. As of September 30, 1998,
the Company's sales organization consisted of 42 individuals. Seven members of
the sales organization work exclusively with the OEMs, value-added resellers and
systems integrators in both a sales and a channel marketing capacity.

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Typically, the sales process will include an initial sales presentation, a
product demonstration; at times a proof of concept evaluation, a closing meeting
and a purchase process. The sales process typically takes 90 to 180 days.
Companies often purchase Netcool products to manage their internal data network
initially and upon its demonstrated effectiveness subsequently make additional
and larger purchases. A majority of the Company's sales are from repeat
customers who generally purchase additional software as their networks expand,
or as additional sites within a customer learn of the services provided by, and
the benefits of, Netcool.

The Company has a number of marketing programs designed to inform potential
customers about the capabilities and benefits of the Company's products. The
Company's marketing efforts include technical leadership, participation in
industry trade shows, technical conferences and technology seminars, preparation
of competitive analyses, sales training, publication of technical and
educational articles in industry journals and advertising. As of September 30,
1998, the Company's marketing organization employed 7 people.

Although the Company increased the size of its sales organization during
the year ended September 30, 1998, the Company experienced difficulty in
recruiting a sufficient number of qualified sales people during that period. If
the Company is to achieve significant revenue growth in the future, it must both
train successfully the members of its existing sales force and recruit
additional sales personnel. Competition for such persons is intense, and there
can be no assurance that the Company will be able to either retain and
adequately train its current sales force or attract qualified sales personnel in
the future. During the last fiscal year, the Company hired a Senior Vice
President, Sales, who is expected to be heavily involved, among other things, in
the recruitment of additional sales personnel. Consequently, the Company is
expected to have additional management capacity to assist in the recruitment of
additional sales personnel. If the Company is unable to hire such people on a
timely basis, the Company's business, operating results or financial condition
could be adversely affected. See "Risk Factors -- Need to Expand and Improve
Productivity of Sales Force, Technical Services and Customer Support
Organization."

To achieve significant growth in revenues in the future the Company must
continue to expand its network of distribution partners. The Company's network
of distribution partners currently includes VARs, systems integrators and OEM
partners, including Bay, Cisco, CTC (Itochu), Datacraft, Ericsson Data Services,
N.E.T., and Vanstar Corporation. Such partners license the Company's products at
a discount to list price for re-licensing and may provide training, support and
technical and customer services to the end users of the Company's products. At
times, members of the Company's technical services organization will assist a
channel partner with training and technical support. The Company offers a
comprehensive channel-partnering program consisting of training, certification,
technical support, priority communications regarding upcoming activities and
products, and joint sales and marketing activities. The Company also has a joint
marketing program with Concord Communications. There can be no assurance that
the Company will be able to continue to attract and retain VARs, systems
integrators and OEMs or that such organizations will be able to market and sell
the Company's products effectively. In addition, there can be no assurance that
the Company's existing or future channel partners will continue to represent the
Company's products. See "Risk Factors -- Need to Expand Distribution Channels;
Dependence on Third-Party Relationships."

Because the Company first sold its software in the United Kingdom and was
previously domiciled in London, sales of its software outside of the United
States (i.e., "international sales") have historically comprised a significant
portion of the Company's total revenue. International sales accounted for 39%,
48% and 55% of total revenues in fiscal 1998, 1997 and 1996, respectively. The
Company believes that a majority of these international sales were made to
customers in the United Kingdom and Europe. While the Company believes that
there are significant opportunities in the United Kingdom and Europe, it expects
international revenues from the United Kingdom and Europe as a percentage of
total revenues to decline in future quarters as the Company more fully exploits
opportunities in the United States and in the Pacific Rim. See "Risk
Factors -- Risks Associated with International Licensing and Operations."

TECHNICAL SERVICES

The Company's technical services organization provides customers with a
full range of support services including pre-sales demonstrations, evaluations,
implementations, consulting services, training and ongoing

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technical support. In addition, the technical services organization serves a
variety of internal functions, including drafting support and training
documentation, product management, product testing, research and development
related to specific customer industries. The Company believes that superior
technical services and support is critical to customer satisfaction and the
development of customer relationships. As of September 30, 1998, there were 46
individuals in the Company's technical services organization.

The recent growth of the Company and the expansion of the customer base of
Netcool have increased the demands on its technical services organization.
Competition for qualified technical personnel is intense. There can be no
assurance that the current resources in the Company's technical services
organization will be sufficient to manage any future growth in the Company's
business. Failure of the Company to expand its technical services organization
at least commensurate with the expansion in the installed base of Netcool
products would have a material adverse effect on the Company's business,
operating results and financial condition. See "Risk Factors -- Need to Expand
and Improve Productivity of Sales Force, Technical Services and Customer Support
Organization" and "-- Dependence on Key Personnel."

CUSTOMER SUPPORT

The customer support organization is responsible for providing ongoing
technical support for the Company's customers after implementation of the
product and for training the next generation of the Company's software engineers
and technical services personnel. Based on feedback by customers, the Company
believes that the quality and responsiveness of its customer support
organization provides it with a significant competitive advantage. As of
September 30, 1998, the Company employed 19 customer support personnel.

For an annual fee, a customer will receive toll-free telephone and email
support, as well as new releases of the Company's products. The Company offers
two support packages to its customers: 8 hours a day, 5 days a week support or
24 hours a day, 7 days a week support. While support personnel generally answer
the technical support calls and resolve most problems over the phone, Micromuse
will deploy any one of its 46 technical support personnel in the event that an
on-site visit is necessary.

RESEARCH AND DEVELOPMENT

The Company believes that its future success depends in large part on its
ability to continue to enhance existing products and develop new products that
maintain technological competitiveness and deliver rapid ROI to its customers.
The Company has historically developed and expects to continue to develop its
products in conjunction with its existing and potential customers. Extensive
product development input is obtained through customers, through the Company's
monitoring of end-user needs and changes in the marketplace and through
partnerships with leading research institutes such as Cambridge University
Centre for Communication Systems Research.

The Company's research and development organization is composed of two
related engineering groups. The core technology group is responsible for the
enhancement of Netcool/OMNIbus, including its real-time technologies and the
exploration of new directions and applications of the Company's core
ObjectServer, Probe, Gateway and Desktop technologies. The application
development group is responsible for designing and developing off-the-shelf
products that leverage the technologies developed by the core technology group.
While both groups work closely with customers, the application development group
depends on customer contact and partnerships for the rapid development of new
SLM products. Both research and development groups work closely with the
Company's technical services organization and its marketing organization to
incorporate customer feedback and market requirements into their product
development agendas.

The Company has made and intends to continue to make substantial
investments in research and development. The Company's total expenses for
research and development for fiscal 1998, 1997 and 1996 were $5.5 million, $2.0
million and $1.6 million, respectively. Since the Company anticipates that it
will continue to commit substantial resources to research and development in the
future, product development expenses are expected to increase in absolute
dollars in future periods. To date, the Company's development efforts have

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not resulted in any capitalized software development costs. As of September 30,
1998, the Company's research and development organization consisted of 40
people.

The market for the Company's products is characterized by rapidly changing
technologies, evolving industry standards, changing regulatory environments,
frequent new product introductions and rapid changes in customer requirements.
The introduction or announcement of products by the Company or its competitors
embodying new technologies and the emergence of new industry standards and
practices can render existing products obsolete and unmarketable. As a result,
the life cycles of the Company's products are difficult to estimate. The
Company's future success will depend on its ability to enhance its existing
products and to develop and introduce, on a timely and cost-effective basis, new
products and product features that keep pace with technological developments and
emerging industry standards and that address the increasingly sophisticated
needs of its customers. There can be no assurance that the Company will be
successful in developing and marketing new products or product features that
respond to technological change or evolving industry standards, that the Company
will not experience difficulties that could delay or prevent the successful
development, introduction and marketing of these new products and features, or
that its new products or product features will adequately meet the requirements
of the marketplace and achieve market acceptance. In particular, the widespread
adoption of the TMN architecture for managing telecommunications networks would
force the Company to adapt its products to such standard, and there can be no
assurance that this could be done on a timely or cost-effective basis, if at
all. In addition, to the extent that any product upgrade or enhancement requires
extensive installation and configuration, current customers may postpone or
forgo the purchase of new versions of the Company's products. If the Company is
unable, for technological or other reasons, to develop and introduce
enhancements of existing products or new products in a timely manner, the
Company's business, operating results and financial condition will be materially
adversely affected. See "Risk Factors -- New Products and Rapid Technological
Change; Need to Manage Product Transitions; Dependence on Third-Party Software
Platforms." In addition, software products as complex as those offered by the
Company may contain defects or failures when introduced or when new versions or
enhancements are released. For example, Netcool/Reporter, currently in its
initial commercial release, has features and performance characteristics that
have had limited market appeal. Although the Company is currently devoting
significant management and technical resources to improve the features and
performance of Netcool/ Reporter, the Company does not expect significant
revenue contribution from Netcool/Reporter for the foreseeable future. To the
extent such efforts continue to require the allocation of a significant portion
of the Company's technical personnel resources, or if the performance and
features of Netcool/Reporter are not improved, the Company could continue to
experience delay in or failure of market acceptance of Netcool/ Reporter, or
damage to the Company's reputation or relationships with its customers, any of
which could have a material adverse effect on the Company's business, operating
results and financial condition. See "Risk Factors -- Product Defects; Product
Liability."

COMPETITION

The Company's products are designed for use in the evolving SLM and
enterprise network management markets. Competition in these markets is intense
and is characterized by rapidly changing technologies, new and evolving industry
standards, frequent new product introductions and rapid changes in customer
requirements. The Company's current and prospective competitors offer a variety
of solutions to address the SLM and enterprise network management markets and
generally fall within the following five categories: (i) customer's internal
design and development organizations that produce SLM and network management
applications for their particular needs, in some cases using multiple instances
of products from hardware and software vendors such as Sun, HP and Cabletron;
(ii) vendors of network and systems management frameworks including Computer
Associates and IBM; (iii) vendors of network and systems management applications
including HP, Sun and IBM; (iv) providers of specific market applications
including Boole & Babbage and several smaller software vendors; and (v) systems
integrators who primarily provide programming services to develop customer
specific applications including TCSI and OSI. In the future, as the Company
enters new markets, the Company expects that such markets will have additional,
market-specific competitors. In addition, because there are relatively low
barriers to entry in the software market, the Company expects additional
competition from other established and emerging companies. Increased competi-
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tion may result in price reductions, reduced gross margins and loss of market
share, any of which could materially adversely affect the Company's business,
operating results or financial condition.

Many of the Company's existing and potential customers continuously
evaluate whether to design and develop their own network operations support and
management applications or purchase them from outside vendors. These customers
internally design and develop their own software solutions for their particular
needs and therefore may be reluctant to purchase products offered by independent
vendors such as the Company. As a result, the Company must continuously educate
existing and prospective customers as to the advantages of the Company's
products versus internally developed network operations support and management
applications.

Many of the Company's current and potential competitors have longer
operating histories and have significantly greater financial, technical, sales,
marketing and other resources, as well as greater name recognition and a larger
customer base, than the Company. As a result, they may be able to respond more
quickly to new or emerging technologies and changes in customer requirements, or
to devote greater resources to the development, promotion, sale and support of
their products than the Company. Existing competitors could also increase their
market share by bundling products having management functionality offered by the
Company's products with their current applications. Moreover, the Company's
current and potential competitors may increase their share of the SLM market by
strategic alliances and/or the acquisition of competing companies. In addition,
network operating system vendors could introduce new, or upgrade and extend
existing, operating systems or environments that include management
functionality offered by the Company's products, which could render the
Company's products obsolete and unmarketable. There can be no assurance that the
Company will be able to compete successfully against current or future
competitors or that competitive pressures faced by the Company will not
materially adversely affect its business, operating results or financial
condition. See "Risk Factors -- Competition."

The principal competitive factors affecting the market for the Company's
software are price/performance, functionality and speed of implementation. The
Company currently believes it presently competes favorably with respect to each
of these factors. However, the Company's market is still evolving, and there can
be no assurance that the Company will be able to compete successfully against
current and future competitors and the failure to do so successfully will have a
material adverse effect upon the Company's business operating results and
financial condition.

INTELLECTUAL PROPERTY AND OTHER PROPRIETARY RIGHTS

The Company's success and ability to compete is dependent in significant
part upon its proprietary software technology. The Company relies on a
combination of trade secret, copyright and trademark laws, nondisclosure and
other contractual agreements and technical measures to protect its proprietary
rights. Despite the Company's efforts to protect its proprietary rights,
unauthorized parties may attempt to copy aspects of the Company's products or to
obtain and use information that the Company regards as proprietary. There can be
no assurance that the steps taken by the Company to protect its proprietary
technology will prevent misappropriation of such technology, and such
protections may not preclude competitors from developing products with
functionality or features similar to the Company's products. In addition,
effective copyright and trade secret protection may be unavailable or limited in
certain foreign countries. While the Company believes that its products and
trademarks do not infringe upon the proprietary rights of third parties, there
can be no assurance that the Company will not receive future communications from
third parties asserting that the Company's products infringe, or may infringe,
the proprietary rights of third parties. The Company expects that software
product developers will be increasingly subject to infringement claims as the
number of products and competitors in the Company's industry segment grows and
the functionality of products in different industry segments overlaps. Any such
claims, with or without merit, could be time-consuming, result in costly
litigation and diversion of technical and management personnel, cause product
shipment delays or require the Company to develop non-infringing technology or
enter into royalty or licensing agreements. Such royalty or licensing
agreements, if required, may not be available on terms acceptable to the Company
or at all. In the event of a successful claim of product infringement against
the Company and failure or inability of the Company to develop non-infringing
technology or license the infringed or similar
9
<PAGE> 10

technology, the Company's business, operating results or financial condition
could be materially adversely affected.

The Company relies on certain software that it licenses from third parties,
including software that is integrated with internally developed software and
used in the Company's products to perform key functions. There can be no
assurance that these third-party software licenses will continue to be available
to the Company on commercially reasonable terms or at all. Although the Company
believes that alternative software is available from other third-party
suppliers, the loss of or inability to maintain any of these software licenses
or the inability of the third parties to enhance in a timely and cost-effective
manner their products in response to changing customer needs, industry standards
or technological developments could result in delays or reductions in product
shipments by the Company until equivalent software could be developed internally
or identified, licensed and integrated, which would have a material adverse
effect on the Company's business, operating results and financial condition. See
"Risk Factors -- Dependence Upon Proprietary Technology; Risk of Third-Party
Claims of Infringement."

EMPLOYEES

As of September 30, 1998, the Company had 176 employees, including 40
engaged in research and development activities, 49 in sales and marketing, 46 in
technical services, 22 in administration and finance and 19 in customer support.
None of the Company's employees are represented by a collective bargaining
agreement, nor has the Company experienced work stoppages. The Company believes
that its relations with its employees are good.

The Company believes that its future success will depend in large part on
its ability to attract and retain highly-skilled managerial, sales, technical
services, customer support and product development personnel. The Company has at
times experienced and continues to experience difficulty in recruiting qualified
personnel. Competition for qualified personnel in the software industry is
intense, and there can be no assurance that the Company will be successful in
attracting and retaining such personnel. Failure to attract and retain key
personnel could materially adversely affect on the Company's business, operating
results or financial condition. See "Risk Factors -- Management of Growth; Need
to Improve Financial Systems and Controls," "-- Need to Expand and Improve
Productivity of Sales Force, Technical Services and Customer Support
Organization" and "-- Dependence on Key Personnel."

ITEM 2. PROPERTIES

The Company's headquarters are located in 11,235 square feet of office
space in San Francisco, under a lease that expires in April 2002. The Company's
principal product development operations are located in approximately 16,085
square feet of office space in London. Approximately 7,210 square feet of this
office space is leased pursuant to a lease that expires in December 2002. The
remaining 8,875 square feet of office space is leased pursuant to a lease that
expires in March 2007. The Company also maintains offices in New York City,
Chicago, Dallas and Sydney. The Company believes that its current facilities are
adequate for its needs through the next twelve months, and that, should it be
needed, suitable additional space will be available to accommodate expansion of
the Company's operations on commercially reasonable terms, although there can be
no assurance in this regard. See Note 10 of Notes to Consolidated Financial
Statements.

ITEM 3. LEGAL PROCEEDINGS

The Company is not a party to any material legal proceeding.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

There were no matters submitted to a vote of security holders during the
fourth quarter of the fiscal year ended September 30, 1998.

10
<PAGE> 11

PART II

ITEM 5. MARKET FOR THE REGISTRANT'S COMMON EQUITY AND RELATED STOCKHOLDER
MATTERS

PRICE RANGE OF COMMON STOCK

The Company's common stock has traded publicly on the Nasdaq National
Market since February 13, 1998 under the symbol "MUSE." The Company's initial
public offering price was $12.00 per share. The following table sets forth for
the periods indicated the high and low closing prices of the common stock. Prior
to the Company's initial public offering, there was no established public
trading market for the common stock.

<TABLE>
<CAPTION>
HIGH LOW
------ ------
<S> <C> <C>
Year ending September 30, 1998:
Fourth Quarter............................................ $41.13 $13.75
Third Quarter............................................. 40.81 21.50
Second Quarter (from February 13, 1998, the date trading
commenced)............................................. 26.63 18.88
</TABLE>

On November 30, 1998, the closing price of the common stock on the Nasdaq
National Market was $22.81 per share. As of September 30, 1998, there were
approximately 94 holders of record (not including beneficial holders of stock
held in street name) of the common stock.

DIVIDEND POLICY

The Company did not declare or pay any cash dividends on its capital stock
during fiscal 1998, 1997 and 1996 and does not expect to do so in the
foreseeable future. The Company anticipates that all future earnings, if any,
generated from operations will be retained by the Company to develop and expand
its business. Any future determination with respect to the payment of dividends
will be at the discretion of the Board of Directors and will depend upon, among
other things, the Company's operating results, financial condition and capital
requirements, the terms of then-existing indebtedness, general business
conditions and such other factors as the Board of Directors deems relevant.

11
<PAGE> 12

ITEM 6. SELECTED FINANCIAL DATA

CONSOLIDATED STATEMENTS OF OPERATIONS DATA:
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
------------------------------------------------
1998 1997 1996 1995 1994
------- ------- ------ ------ ------
<S> <C> <C> <C> <C> <C>
Revenues:
License................................... $22,432 $ 6,968 $3,374 $1,077 $ 111
Maintenance and services.................. 5,829 2,324 1,141 369 3
------- ------- ------ ------ ------
Total revenues.................... 28,261 9,292 4,515 1,446 114
Cost of revenues:
License................................... 1,320 523 311 163 61
Maintenance and services.................. 3,491 1,042 384 102 --
------- ------- ------ ------ ------
Total cost of revenues............ 4,811 1,565 695 265 61
------- ------- ------ ------ ------
Gross profit................................ 23,450 7,727 3,820 1,181 53
Operating expenses:
Sales and marketing....................... 15,710 8,970 1,768 728 30
Research and development.................. 5,535 2,042 1,582 708 318
General and administrative................ 4,521 4,244 996 584 236
------- ------- ------ ------ ------
Total operating expenses.......... 25,766 15,256 4,346 2,020 584
------- ------- ------ ------ ------
Loss from operations...................... (2,316) (7,529) (526) (839) (531)
Other income (expense):
Interest income........................... 1,840 64 8 -- --
Interest expense.......................... (312) (1,268) (212) (106) (68)
Other..................................... 100 (200) 25 -- --
------- ------- ------ ------ ------
Loss before income taxes.................. (688) (8,933) (705) (945) (599)
Income taxes................................ 150 -- 100 -- --
------- ------- ------ ------ ------
Loss from continuing operations........... (838) (8,933) (805) (945) (599)
Discontinued operations:
Income (loss) from discontinued
operations............................. -- (104) 569 711 335
Gain on disposition....................... -- 1,161 -- -- --
------- ------- ------ ------ ------
Net loss.................................. (838) (7,876) (236) (234) (264)
Accretion on redeemable convertible
preferred stock........................... (1,334) (755) -- -- --
------- ------- ------ ------ ------
Net loss applicable to holders of common
stock..................................... $(2,172) $(8,631) $ (236) $ (234) $ (264)
------- ------- ------ ------ ------
Basic and diluted per share data:
Loss from continuing operations applicable
to holders of common stock............. $ (0.07) $ (1.52) $(0.14) $(0.17) $(0.20)
Net loss applicable to holders of common
stock.................................. $ (0.18) $ (1.35) $(0.04) $(0.04) $(0.09)
Shares used in per share calculations..... 11,794 6,373 5,954 5,498 2,969
</TABLE>

12
<PAGE> 13

CONSOLIDATED BALANCE SHEET DATA:
(IN THOUSANDS)

<TABLE>
<CAPTION>
AS OF SEPTEMBER 30,
------------------------------------------------
1998 1997 1996 1995 1994
------- ------- ------ ------ ------
<S> <C> <C> <C> <C> <C>
Cash and cash equivalents................... $22,798 $13,741 $ 594 $ 12 $ 18
Working capital (deficiency)................ 58,193 13,181 (847) (383) (453)
Total assets................................ 80,644 22,740 9,107 5,767 4,492
Redeemable convertible preferred stock...... -- 22,865 -- -- --
Total stockholders' equity (deficit)........ 67,718 (7,234) (222) (203) 93
</TABLE>

QUARTERLY FINANCIAL DATA:
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

<TABLE>
<CAPTION>
1998 FOURTH QUARTER THIRD QUARTER SECOND QUARTER FIRST QUARTER
---- -------------- ------------- -------------- -------------
<S> <C> <C> <C> <C>
Revenues.............................. $9,644 $7,593 $6,195 $ 4,829
Gross profit.......................... 8,139 6,478 5,081 3,752
Income (loss) from operations......... 150 (357) (756) (1,353)
Net income (loss) applicable to
holders of common stock............. 900 161 (1,040) (2,193)
Diluted net income (loss) per share... $ 0.05 $ 0.01 $(0.10) $ (0.35)
</TABLE>

<TABLE>
<CAPTION>
1997 FOURTH QUARTER THIRD QUARTER SECOND QUARTER FIRST QUARTER
---- -------------- ------------- -------------- -------------
<S> <C> <C> <C> <C>
Revenues.............................. $ 3,671 $ 2,684 $ 1,711 $1,226
Gross profit.......................... 3,079 2,226 1,423 999
Loss from operations.................. (3,492) (798) (2,464) (775)
Net loss applicable to holders of
common stock........................ (3,249) (1,528) (2,985) (869)
Net loss per share.................... $ (0.50) $ (0.23) $ (0.49) $(0.13)
</TABLE>

13
<PAGE> 14

ITEM 7. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
OF OPERATIONS

The following discussion and analysis should be read in conjunction with
"Selected Financial Data" and the Company's Consolidated Financial Statements
and Notes thereto included elsewhere in this Form 10-K. This document contains
forward-looking statements that involve risks and uncertainties. The Company's
actual results may differ materially from the results discussed in such
forward-looking statements. Factors that might cause such differences include,
but are not limited to, fluctuations in customer demand, the Company's ability
to manage its growth, risks associated with competition and risks identified in
the Company's Securities and Exchange Commission filings, including, but not
limited to, those discussed elsewhere in this Report under the caption "Risk
Factors"

OVERVIEW

Micromuse develops, markets and supports a family of scalable, highly
configurable, rapidly deployable software solutions that enable service level
management ("SLM"). The Company was founded in 1989 in London, England, and
historically operated a systems integration business, reselling computer
hardware and software products and providing consulting services, principally
for managing networks. Leveraging its expertise in network management and using
funds generated from the systems integration business, the Company developed its
Netcool/OMNIbus software, which the Company began shipping in January 1995. In
March 1997, the Company was reorganized in Delaware and relocated its
headquarters from London to San Francisco. In connection with the
reorganization, the Company raised $4.9 million through the sale of equity
securities and arranged a $3.0 million credit facility. In September 1997, the
Company raised an additional $15.9 million through the sale of equity securities
and sold its systems integration business for approximately $400,000, net of
fees. In order to further the growth of the Netcool business, the Company
engaged in an initial public offering of common stock on February 12, 1998,
raising approximately $34.2 million, net of fees and expenses. With the proceeds
from the financings and the sale of the systems integration business, the
Company expanded operations and substantially increased development, sales and
administrative headcount for the Netcool business during the fifteen-month
period ended September 30, 1998, growing from 92 to 179 employees. On July 28,
1998, the Company engaged in a follow-on offering of common stock, raising
approximately $22.9 million, net of fees and expenses. To accommodate recent
growth and to compete effectively and manage future growth, if any, the Company
will be required to continue to implement and improve operational, financial and
management information systems, procedures and controls on a timely basis and to
expand, train, motivate and manage its work force. On March 31, 1998, the
Company announced the first customer shipment of Netcool/Reporter and
Netcool/Internet Service Monitors. Netcool/Reporter, currently in its initial
commercial release, has feature and performance characteristics that have had
limited market appeal.

The Company's consolidated financial statements have been restated to
reflect the discontinuation of the operations associated with the Company's
systems integration business. In connection with such sale, the purchaser
indemnified the Company for work-in-process under existing contracts, warranty
claims under completed contracts and maintenance agreements, but retained
liability for completed contracts. See Note 2 of Notes to Consolidated Financial
Statements for information concerning this restatement.

As of September 30, 1998, Micromuse had licensed its Netcool products to
more than 200 customers worldwide. Micromuse licenses its software through its
direct sales force, OEMs and value-added resellers. License revenues from OEMs
and resellers combined accounted for approximately 26%, 11% and 8% of the
Company's total license revenues for fiscal 1998, 1997 and 1996, respectively.
The Company's ability to achieve significant additional revenue growth in the
future will depend substantially on its success in recruiting

14
<PAGE> 15

and training sufficient sales and technical services personnel, maintaining its
current distribution relationships and establishing additional relationships
with OEMs, resellers and systems integrators.

As a result of the Company's multinational operations and sales, the
Company's operating results are subject to significant fluctuations based upon
changes in the exchange rates of certain currencies, particularly the British
pound, in relation to the U.S. dollar. For example, while the Company's United
States headquarters are located in San Francisco, California, its principal
product development operations are located in London, England. As a result, a
substantial portion of the Company's costs and expenses are denominated in
currencies other than the U.S. dollar. For the fiscal years ended September 30,
1998 and 1997, license, maintenance and service revenues outside of the United
States accounted for 39% and 48% of the Company's total revenues, respectively.
See Note 8 of Notes to Consolidated Financial Statements. Although management
will continue to monitor the Company's exposure to currency fluctuations, there
can be no assurance that exchange rate fluctuations will not have a material
adverse effect on the Company's business and operating results.

Although the Company's revenues have increased in each of the last seven
quarters, after giving effect to the restatement of the financial statements due
to the sale of the systems integration business, the Company incurred net losses
in each quarter from inception through the quarter ended March 31, 1998, with
the exception of the quarter ended September 30, 1996, and had an accumulated
deficit of $11.4 million as of September 30, 1998. The Company's limited
operating history as a software developer, rapid expansion of operations and
headcount and the emerging nature of the market for SLM software make the
prediction of future operating results difficult. Accordingly, although the
Company has recently experienced revenue growth, such growth should not be
considered indicative of future revenue growth, if any, or of future operating
results. There can be no assurance that the Company's business strategies will
be successful or that the Company will be able to achieve profitability on a
quarterly or annual basis.

SUBSEQUENT EVENTS

In October 1998, the Company announced that Mr. Stephen A. Allott, the
Chief Financial Officer of the Company, was named President and appointed a
Director of the Company and that Mr. Christopher J. Dawes was no longer its
President and Chief Executive Officer. The Company has retained the services of
Heidrick & Struggles, an international executive search firm, to coordinate the
search for a President and Chief Executive Officer. In November 1998, Mr.
Christopher J. Dawes resigned as a Director.

In October 1998, the Board of Directors authorized the repurchase of up to
1.5 million shares, or approximately 9% of the Company's outstanding common
stock. The repurchased shares will be held as treasury stock and will be
available for general corporate purposes. As of November 30, 1998, the Company
had repurchased 500,000 shares of its outstanding common stock pursuant to the
repurchase program.

15
<PAGE> 16

RESULTS OF OPERATIONS

The following table sets forth certain items in the Company's consolidated
statement of operations as a percentage of total revenues, except as indicated:

<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
--------------------------
1998 1997 1996
------ ------ ------
<S> <C> <C> <C>
AS A PERCENTAGE OF TOTAL REVENUES:
Revenues:
License................................................... 79.4% 75.0% 74.7%
Maintenance and services.................................. 20.6% 25.0% 25.3%
----- ----- -----
Total revenues.................................... 100.0% 100.0% 100.0%
Cost of revenues:
License................................................... 4.7% 5.6% 6.9%
Maintenance and services.................................. 12.3% 11.2% 8.5%
----- ----- -----
Total cost of revenues............................ 17.0% 16.8% 15.4%
----- ----- -----
Gross profit................................................ 83.0% 83.2% 84.6%
----- ----- -----
Operating expenses:
Sales and marketing....................................... 55.6% 96.5% 39.2%
Research and development.................................. 19.6% 22.0% 35.0%
General and administrative................................ 16.0% 45.7% 22.1%
----- ----- -----
Total operating expenses.......................... 91.2% 164.2% 96.3%
----- ----- -----
Loss from operations...................................... (8.2)% (81.0)% (11.7)%
Other income (expense):
Interest income........................................... 6.5% 0.7% 0.2%
Interest expense.......................................... (1.1)% (13.6)% (4.7)%
Other..................................................... 0.4% (2.2)% 0.6%
----- ----- -----
Loss before income taxes.................................. (2.4)% (96.1)% (15.6)%
Income taxes................................................ 0.6% 0.0% 2.2%
----- ----- -----
Loss from continuing operations........................... (3.0)% (96.1)% (17.8)%
Discontinued operations:
Income (loss) from discontinued operations................ 0.0% (1.1)% 12.6%
Gain on disposition....................................... 0.0% 12.4% 0.0%
----- ----- -----
Net loss.......................................... (3.0)% (84.8)% (5.2)%
Accretion on redeemable convertible preferred stock......... (4.7)% (8.1)% 0.0%
----- ----- -----
Net loss applicable to holders of common stock.............. (7.7)% (92.9)% (5.2)%
===== ===== =====
AS A PERCENTAGE OF RELATED REVENUES:
Cost of license revenues.................................... 5.9% 7.5% 9.2%
Cost of maintenance and services revenues................... 59.9% 44.8% 33.7%
</TABLE>

Revenues

The Company's total revenues are derived from license revenues for its
Netcool family of products, as well as associated maintenance, consulting and
training services revenues. License revenues are recognized upon the acceptance
of a purchase order and shipment of the software provided the fee is fixed and
determinable, the arrangement does not involve significant customization of the
software and collection of the resulting receivable is probable. Allowances for
credit losses and for estimated future returns are provided for upon shipment.
Credit losses and returns to date have not been material. Maintenance revenues
from ongoing customer support and product upgrades are deferred and recognized
ratably over the term of the maintenance agreement, typically twelve months.
Payments for maintenance fees (on initial order or on renewal) are generally
made in advance and are nonrefundable. Revenues for consulting and training
services are

16
<PAGE> 17

recognized as the services are performed. See Note 1 of Notes to Consolidated
Financial Statements. The Company has recognized revenue, for all periods prior
to and including September 30, 1997, in accordance with the American Institute
of Certified Public Accountants ("AICPA") Statement of Position ("SOP") No. 91-1
entitled Software Revenue Recognition. For the fiscal year ended September 30,
1998, the Company has recognized revenue in accordance with AICPA SOP No. 97-2
entitled Software Revenue Recognition. There was no material change to the
Company's accounting for revenue as a result of the adoption of AICPA SOP No.
97-2.

The Company's total revenues increased to $28.3 million in fiscal 1998 from
$9.3 million in fiscal 1997 and $4.5 million in fiscal 1996. License revenues
increased to $22.4 million in fiscal 1998 from $7.0 million in fiscal 1997 and
$3.4 million in fiscal 1996, primarily as a result of an increase in the number
of product licenses sold and in average transaction size, reflecting the
increased acceptance of Netcool/OMNIbus and expansion of the Company's sales
organization. Maintenance and services revenues increased to $5.8 million in
fiscal 1998 from $2.3 million in fiscal 1997 and $1.1 million in fiscal 1996, as
a result of providing maintenance and services to a larger installed base in
each successive year. The percentage of the Company's total revenues
attributable to software was 79% in fiscal 1998 and 75% in both fiscal 1997 and
1996. Maintenance and services revenues accounted for 21% of total revenues in
fiscal 1998 and 25% in both fiscal 1997 and 1996.

Revenues from U.S. operations grew to 61% of total revenues in fiscal 1998
from 52% and 45% in fiscal 1997 and 1996, respectively, reflecting the Company's
expansion of U.S. operations. International revenues include all revenues other
than from the United States. See Note 8 of Notes to Consolidated Financial
Statements.

To date, the Company's revenues have resulted primarily from sales to the
telecommunications industry, ISPs and investment banks. License revenues from
telecommunications industry customers and ISPs combined accounted for 68%, 58%
and 34% of the Company's total license revenues in fiscal 1998, 1997 and 1996,
respectively. License revenues from investment banks accounted for 12%, 15% and
29% of total license revenues in fiscal 1998, 1997 and 1996, respectively. In
fiscal 1998 and 1997, entities affiliated with WorldCom accounted for 10% and
18% of the Company's total revenue, respectively. In addition, entities
affiliated with British Telecommunications accounted for 9% of the Company's
total revenues in both fiscal 1998 and 1997 and 14% in fiscal 1996.

Cost of Revenues

Cost of license revenues consists primarily of technology license fees paid
to third-party software vendors and the costs of software media, packaging and
production. Cost of license revenues decreased as a percentage of license
revenues to 6% in fiscal 1998 from 8% in fiscal 1997 and 9% in fiscal 1996, as a
result of economies of scale.

Cost of maintenance and service revenues consists primarily of
personnel-related costs incurred in providing maintenance, consulting and
training to customers. Cost of maintenance and service revenues increased as a
percentage of maintenance and service revenues to 60% in fiscal 1998 from 45% in
fiscal 1997 and 34% in fiscal 1996, principally due to increased personnel,
facilities and travel costs associated with growth in the customer support and
technical services organizations. The Company expects that the cost of
maintenance and services will continue to increase in dollar amounts in future
periods as the Company continues to hire additional customer support and
technical services personnel and expands its maintenance, consulting and
training activities.

Sales and Marketing Expenses

Sales and marketing expenses consist primarily of salaries, commissions and
bonuses earned by personnel engaged in sales, technical presales and marketing
activities, as well as the costs of trade shows, public relations, marketing
materials and other marketing activities. Sales and marketing expenses increased
to $15.7 million in fiscal 1998 from $9.0 million in fiscal 1997 and $1.8
million in fiscal 1996. The increases in both fiscal 1998 and fiscal 1997
reflected the hiring of additional personnel in connection with the building of
the Company's sales force. In addition, sales and marketing expenses increased
in fiscal 1997 due to increased
17
<PAGE> 18

technical staff and marketing personnel, compensation expense related to bonus
shares issued, increased facilities costs and costs associated with expanded
marketing activities. Sales and marketing expenses represented 56%, 97% and 39%
of total revenues in fiscal 1998, 1997 and 1996, respectively. The Company
expects that sales and marketing expenses will continue to increase in absolute
dollar amounts in future periods as the Company continues to hire additional
sales, technical services and marketing personnel, to increase marketing
activities and to build its indirect sales channel. See Note 5 of Notes to
Consolidated Financial Statements.

Research and Development Expenses

Research and development expenses consist primarily of salaries and other
personnel-related expenses and costs of computer systems and software
development tools. Research and development expenses increased to $5.5 million
in fiscal 1998 from $2.0 million in fiscal 1997 and $1.6 million in fiscal 1996.
The increase in research and development expenses in each year was primarily
attributable to increased personnel, additional facilities and an increase in
the computer systems and software development tools required by the additional
personnel. In addition to expanding its research and development facility in
London, the Company established a research and development team focused on
application development in its New York office in fiscal 1997. Research and
development expenses represented 20%, 22% and 35% of total revenues in fiscal
1998, 1997 and 1996, respectively. The decrease as a percentage of total
revenues was primarily due to growth in the Company's total revenues. The
Company anticipates that it will commit increasing resources to research and
development in future periods to enhance and extend its core technology and
product line and, as a result, expects that research and development expenses
will increase in absolute dollars in future periods. To date, all research and
development costs have been expensed as incurred. See Note 1 of Notes to
Consolidated Financial Statements.

General and Administrative Expenses

General and administrative expenses consist primarily of personnel costs
for administration, finance, information systems and human resources, as well as
professional fees. General and administrative expenses increased to $4.5 million
in fiscal 1998 from $4.2 million in fiscal 1997 and $996,000 in fiscal 1996.
These increases in each year were primarily due to increased staffing,
facilities costs and associated expenses necessary to manage and support the
Company's increased scale of operations and, in fiscal 1997, due to compensation
expenses related to bonus shares issued. General and administrative expenses as
a percentage of total revenues were 16% in fiscal 1998, 46% in fiscal 1997 and
22% in fiscal 1996. The decrease of general and administrative expenses as a
percentage of total revenues from fiscal 1997 to 1998 was primarily attributable
to the growth in total revenues and a reduction in professional fees related to
the reorganization in fiscal 1997. The increase in general and administrative
expenses as a percentage of total revenues from fiscal 1996 to fiscal 1997 was
primarily attributable to personnel-related costs and to the payment of
professional fees for various matters, associated with the transfer of the
Company's headquarters from London to San Francisco. The Company expects that
its general and administrative expenses will increase in absolute dollar amounts
as the Company expands its administrative staff, adds infrastructure and incurs
additional costs related both to the growth of its business and becoming a
public company, such as expenses related to directors' and officers' insurance,
investor relations programs and increased professional fees.

Other Income (Expense)

The change in other income (expense) from fiscal 1997 to fiscal 1998 was
primarily due to the interest earned on the proceeds raised from the Company's
public offerings in fiscal 1998, which offset imputed interest in fiscal 1997
related to the issuance of a warrant to purchase 1.5 million shares of Series A
preferred stock at a per share exercise price of $2.00. The increase in interest
expense from fiscal 1996 to fiscal 1997 was primarily attributable to the
imputed interest related to the issuance of a warrant to purchase shares of
Series A preferred stock issued in connection with the provision of a line of
credit to the Company. See Note 5 of Notes to Consolidated Financial Statements.

18
<PAGE> 19

Provision for Income Taxes

As of September 30, 1998, the Company had approximately $3.0 million and
$1.3 million of net operating loss carry-forwards for federal and state tax
purposes, respectively. The federal net operating loss carry-forwards expire
between 2013 and 2018, and the state net operating loss carry-forwards begin to
expire in 2003. Federal and state tax laws impose substantial restrictions on
the utilization of net operating loss carry-forwards in the event of an
"ownership change" as defined in Section 382 of the Internal Revenue Code. The
Company has not yet determined whether an ownership change occurred due to
significant stock transactions in each of the reporting years disclosed. If an
ownership change has occurred, utilization of the net operating loss
carry-forwards could be significantly reduced. Additionally, loss carry-forwards
of either Micromuse Inc. or Micromuse USA Inc. cannot be utilized against future
profits generated by the other company. As of September 30, 1998, the Company
also had approximately $3.7 million and $534,000 of loss carry-forwards in
England and Australia, respectively. The Company has provided a full valuation
allowance on the deferred tax asset, consisting primarily of net operating loss
carry-forwards, because of uncertainty regarding its realizability. See Note 6
of Notes to Consolidated Financial Statements.

Discontinued Operations

In July 1997, the Company adopted a formal plan to discontinue its Systems
Integration division based in England. In September 1997, the Company sold the
division for approximately $400,000 in cash, net of fees. The disposition of the
division has been accounted for as a discontinued operation in accordance with
Accounting Principles Board Opinion No. 30 and prior consolidated financial
statements have been restated to reflect the discontinuation of the Systems
Integration business. Revenue from discontinued operations was $15.7 million and
$14.0 million, respectively, in fiscal 1997 and 1996. The income (loss) from
discontinued operations of ($104,000) and $569,000 in fiscal 1997 and 1996,
respectively, represents the operation's operating income, net of taxes. The
gain on disposal of discontinued operations of $1.2 million in fiscal 1997
represents the gain on disposal of the operation including net income from
operations of $256,000 from the measurement date to the disposal date. See Note
2 of Notes to Consolidated Financial Statements.

LIQUIDITY AND CAPITAL RESOURCES

The Company has funded its operations to date primarily through the initial
and follow-on public offerings of its common stock, bank debt, private sales of
preferred equity securities totaling $20.8 million, cash generated from
discontinued operations and capital equipment lease lines. In April 1996, the
Company issued and sold notes convertible into Series A preferred stock in the
aggregate principal amount of $1.0 million. The notes were repaid without
conversion to Series A preferred stock. In March 1997, the Company sold shares
of Series B preferred stock for an aggregate of $4.9 million and entered into a
credit agreement (the "Credit Agreement") that provided the Company with a $3.0
million revolving credit line that terminated upon the closing of the Company's
initial public offering. In connection with the Credit Agreement, the Company
issued a warrant to purchase shares of Series A preferred stock for an aggregate
exercise price of $3.0 million that was exercised by means of a net issuance
immediately prior to the closing of the Company's initial public offering.
During fiscal 1997, the Company had borrowed and repaid a total of $1.0 million
under the Credit Agreement and there was no balance outstanding thereunder as of
September 30, 1998. In September 1997, the Company sold shares of Series C
preferred stock for an aggregate of $15.9 million. In November 1997, the Company
repurchased shares of common stock for $5.0 million. In February and July 1998,
the Company sold shares of common stock in its initial and follow-on public
offerings, generating net proceeds of $34.2 million and $22.9 million,
respectively. As of September 30, 1998, the Company had $22.8 million in cash
and cash equivalents and $47.0 million in marketable securities. See Notes 4 and
5 of Notes to Consolidated Financial Statements.

Net cash generated by operating activities in fiscal 1998 was primarily
attributable to an increase in deferred revenue as well as a decrease in the
related party loan, offset partially by the increase in accounts receivable and
the net loss of $838,000. The increase in deferred revenue, consisting primarily
of deferred maintenance revenues, reflects the Company's growing installed base
of customers. Net cash used in operating activities in fiscal 1997 was primarily
attributable to a net loss of $7.9 million. Net cash provided by operating
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activities in fiscal 1996 was primarily attributable to growth in accounts
payable and deferred revenue, as well as the non-cash nature of depreciation and
amortization, which more than offset a net loss and growth in accounts
receivable and prepaid expenses and other current assets.

Cash flows used in investing activities in fiscal 1998 was primarily due to
the purchase of investments while the net use in both fiscal 1997 and 1996 were
attributable to capital expenditures. In fiscal 1998, net cash generated by
financing activities was attributable to the Company's sale of common stock. Net
cash provided by financing activities was primarily attributable to proceeds
from the issuance of redeemable convertible preferred stock in fiscal 1997 and
to proceeds from a bank overdraft and short-term notes in fiscal 1996.

As of September 30, 1998, the Company's principal commitments consisted of
obligations under operating leases. See Note 10 of Notes to Consolidated
Financial Statements.

The Company believes that the current cash balances, its capital equipment
lease facility and the cash flows generated by operations, if any, will be
sufficient to meet its anticipated cash needs for working capital and capital
expenditures for the next twelve months. Thereafter, if cash generated from
operations is insufficient to satisfy the Company's liquidity requirements, the
Company may seek to sell additional equity or convertible debt securities, or
may seek to obtain credit facilities. The sale of additional equity or debt
securities could result in additional dilution to the Company's stockholders. A
portion of the Company's cash may be used to acquire or invest in complementary
businesses or products or to obtain the right to use complementary technologies.
From time to time, in the ordinary course of business, the Company evaluates
potential acquisitions of such businesses, products or technologies. The Company
has no current plans, agreements or commitments, and is not currently engaged in
any negotiations with respect to any such transaction.

YEAR 2000 COMPLIANCE AND EURO CONVERSION

A significant amount of the demand that the Company has experienced in
recent years for applications software may be generated by customers in the
process of replacing and upgrading applications in order to accommodate the
change in date to the Year 2000. Once such customers have completed their
preparations, the software industry and the Company may experience a significant
deceleration from the strong annual growth rates recently experienced in the
applications software marketplace.

Although the Company has designed and tested its products to be Year 2000
compliant, there can be no assurance that the Company's current products do not
contain undetected errors or defects associated with Year 2000 date functions
that may result in material costs to the Company. In addition, certain
components of the Company's products process timestamp information from
third-party applications or local operating systems. As a result, if such
third-party applications or local operating systems are not Year 2000 compliant,
the Company's products that process such timestamp information may not be Year
2000 compliant. The Company is currently evaluating Year 2000-related risks and
corrective actions in connection with such third-party applications and local
operating systems.

Some commentators have stated that a significant amount of litigation will
arise out of Year 2000 compliance issues, and the Company is aware of a growing
number of lawsuits against other software vendors. Because of the unprecedented
nature of such litigation, it is uncertain to what extent the Company may be
affected by it. In addition, in the Company's standard license agreements, the
Company warrants to licensees that its software routines and programs are Year
2000 compliant. If any of the Company's licensees experience Year 2000 problems,
such licensees could assert claims for damages against the Company. Any such
litigation could result in substantial costs and diversion of the Company's
resources even if ultimately decided in favor of the Company. With respect to
its internal information technology systems (including information technology-
based office facilities such as data and voice communications, and building
management and security systems), the Company is currently evaluating the
adoption of standard industry practices, as published by the British Standards
Institute, in preparing for the Year 2000 date change. The Company's Year 2000
internal readiness program primarily covers: taking inventory of hardware,
software and embedded systems, assessing business and customer satisfaction
risks associated with such systems, creating action plans to address known
risks, executing and monitoring action plans, and contingency planning. The
Company currently is conducting
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<PAGE> 21

(i) a review of its vendors and service providers to evaluate Year 2000
readiness and (ii) ongoing risk analysis. The Company expects to substantially
complete Year 2000 readiness preparations at the end of the first quarter of
calendar 1999 with respect to its core business and software systems and at the
end of the second quarter of calendar 1999 with respect to its hardware systems.
In each case, the Company expects to continue extensive testing through calendar
1999. The Company does not expect the total costs associated with preparing its
internal systems for the Year 2000 to exceed $350,000. Although the Company does
not currently believe that it will experience material disruptions in its
business associated with preparing its internal systems for the Year 2000, there
can be no assurances that the Company will not experience serious unanticipated
negative consequences and/or material costs caused by undetected errors or
defects in the technology used in its internal systems, which are composed of
third-party software, third-party hardware that contains embedded software and
the Company's own software products. The most reasonably likely worst case
scenarios would include: (i) corruption of data contained in the Company's
internal information systems, (ii) hardware failure and (iii) the failure of
infrastructure services provided by government agencies and other third parties
(e.g., electricity, phone service, water transport, internet services, etc.).
The Company is in the process of conducting its contingency planning for
high-risk areas at this time and is scheduled to commence contingency planning
for medium to low-risk areas in January 1999. The Company expects its
contingency plans to include, among other things, manual "work-arounds" for
software and hardware failures, as well as substitution of systems, if
necessary.

Various European countries have planned the introduction of a single
currency (known as the Euro) in January 1999. The introduction of the Euro may
result in complex conversion calculations. The Company is currently in the
process of conducting a review of its internal information systems to identify
systems that could be affected by such Year 2000 and Euro conversion
requirements. Further, to accommodate its recent growth, the Company will be
required to continue to implement and improve a variety of operational,
financial and management information systems, procedures and controls on a
timely basis. In particular, the Company will be required to improve its
accounting and financial reporting systems, which currently require substantial
management effort and will be required to implement a U.S.-based financial and
accounting system.

RISK FACTORS

In addition to the other information in this Report, the following risk
factors should be considered carefully in evaluating the Company and its
business. The following factors, in addition to the other information contained
in this Form 10-K, should be considered carefully in evaluating the Company and
its prospects. This Form 10-K (including without limitation the following Risk
Factors) contains forward-looking statements (within the meaning of Section 27A
of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of
1934) regarding the Company and its business, financial condition, results of
operations and prospects. Words such as "expects," "anticipates," "intends,"
"plans," "believes," "seeks," "estimates" and similar expressions or variations
of such words are intended to identify forward-looking statements, but are not
the exclusive means of identifying forward-looking statements in this Form 10-K.
Additionally, statements concerning future matters such as the development of
new products, enhancements or technologies, possible changes in legislation and
other statements regarding matters that are not historical are forward-looking
statements.

Although forward-looking statements in this Form 10-K reflect the good
faith judgment of the Company's management, such statements can only be based on
facts and factors currently known by the Company. Consequently, forward-looking
statements are inherently subject to risks and uncertainties, and actual results
and outcomes may differ materially from the results and outcomes discussed in
the forward-looking statements. Factors that could cause or contribute to such
differences in results and outcomes include, but are not limited to, those
discussed below and in "Management's Discussion and Analysis of Financial
Condition and Results of Operations" and "Business" as well as those discussed
elsewhere in this Form 10-K. Readers are urged not to place undue reliance on
these forward-looking statements, which speak only as of the date of the this
Form 10-K. The Company undertakes no obligation to revise or update any
forward-looking statements in order to reflect any event or circumstance that
may arise after the date of the Form 10-K.

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Limited Operating History as a Software Company; Uncertainty of Future
Operating Results

Although the Company began offering services for the network and systems
integration market in 1989, the Company first shipped its internally developed
software product, Netcool/OMNIbus, for the Service Level Management ("SLM")
market in January 1995. Accordingly, the Company has only a limited operating
history as a developer and provider of SLM software upon which an evaluation of
its business and prospects can be based. Since inception, the Company's software
business has incurred significant losses that were partially offset by profits
from the Company's systems integration business, which was divested in the
fourth quarter of fiscal 1997. Although the Company did not incur a net loss in
the fiscal quarter ended September 30, 1998, there can be no assurance that the
Company will be profitable in any period thereafter. The limited operating
history of the Company makes the prediction of future results of operations
difficult if not impossible, and the Company and its prospects must be
considered in light of the risks, costs and difficulties frequently encountered
by emerging companies, particularly companies in the competitive software
industry. Although the Company has achieved recent revenue growth, there can be
no assurance that the Company can generate substantial additional revenue growth
on a quarterly or annual basis, or that any revenue growth that is achieved can
be sustained. In addition, the Company has increased, and plans to increase
further, its operating expenses in order to develop new distribution channels,
increase its sales and marketing efforts, implement and improve its operational,
financial and management information systems, broaden its technical services and
customer support capabilities, fund higher levels of research and development
and expand its administrative resources in anticipation of future growth. To the
extent that increases in such expenses are not subsequently followed by
increased revenues, the Company's business, operating results and financial
condition would be materially adversely affected. In addition, in view of recent
revenue growth, the rapidly evolving nature of its business and markets and its
limited operating history in its current market, the Company believes that
period-to-period comparisons of financial results are not necessarily meaningful
and should not be relied upon as an indication of future performance. As of
September 30, 1998, the Company had accumulated net losses of $11.4 million. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations."

Variability of Quarterly Operating Results; Seasonality

The Company's quarterly operating results have fluctuated significantly in
the past, and will likely continue to fluctuate in the future, as a result of a
number of factors, many of which are outside the Company's control. These
factors include changes in the demand for the Company's software products and
services; the size and timing of specific sales; the timing of new hires; the
level of product and price competition that the Company encounters; changes in
the mix of, and lack of demand from, distribution channels through which
products are sold; the length of sales cycles; spending patterns and budgetary
resources of its customers on network management software solutions; the success
of the Company's new customer generation activities; introductions or
enhancements of products, or delays in the introductions or enhancements of
products, by the Company or its competitors; market acceptance of new products;
the Company's ability to anticipate and effectively adapt to developing markets
and rapidly changing technologies; the mix of products and services sold;
changes in the Company's sales incentives; changes in the renewal rate of
support agreements; the mix of international and domestic revenue; product life
cycles; software defects and other product quality problems; the Company's
ability to attract, retain and motivate qualified personnel; changes in the mix
of sales to new and existing customers; the extent of industry consolidation;
expansion of the Company's international operations; and general domestic and
international economic and political conditions. The timing of large individual
sales has been difficult for the Company to predict, and large individual sales
have, in some cases, occurred in quarters subsequent to those anticipated by the
Company. There can be no assurance that the loss or deferral of one or more
significant sales would not have a material adverse effect on the Company's
quarterly operating results. In addition, the Company's business has experienced
and may continue to experience significant seasonality. Historically, a
disproportionate amount of the Company's annual revenues have been generated by
sales of its products during the Company's fourth fiscal quarter. There can be
no assurance that this trend will not continue.

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<PAGE> 23

The Company typically realizes a significant portion of license revenue in
the last month of a quarter, frequently in the last weeks or even days of a
quarter. As a result, license revenue in any quarter is difficult to forecast
because it is substantially dependent on orders booked and shipped in that
quarter. Moreover, the Company's sales cycles, from initial evaluation to
delivery of software, vary substantially from customer to customer. In addition,
the Company's expense levels are based in part on its expectations of future
orders and sales, which, given the Company's limited operating history, are
extremely difficult to predict. A substantial portion of the Company's operating
expenses is related to personnel, facilities, and sales and marketing programs.
The level of spending for such expenses cannot be adjusted quickly and is,
therefore, relatively fixed in the short term. If revenue falls below the
Company's expectations in a particular quarter, the Company's operating results
could be materially adversely affected. See "-- Lengthy Sales Cycle."

Based on all of the foregoing, the Company believes that future revenue,
expenses and operating results are likely to vary significantly from
quarter-to-quarter. As a result, quarter-to-quarter comparisons of operating
results are not necessarily meaningful or indicative of future performance.
Furthermore, the Company believes it is possible that in some future quarter the
Company's operating results will be below the expectations of public market
analysts or investors. In such event, or in the event that adverse conditions
prevail, or are perceived to prevail, with respect to the Company's business or
generally, the market price of the Company's Common Stock would likely be
materially adversely affected. See "Selected Financial Data" and "Management's
Discussion and Analysis of Financial Condition and Results of Operations."

Management of Growth; Need to Improve Financial Systems and Controls

The Company has recently experienced a period of rapid revenue and customer
growth and a substantial expansion in the number of its personnel and in the
scope and the geographic area of its operations. The Company has grown from 138
employees on September 30, 1997 to 176 employees on September 30, 1998 and
currently plans to continue to recruit more staff. This growth has resulted in
new and increased responsibilities for management personnel and has placed and
continues to place a significant strain upon the Company's management, operating
and financial systems and resources. Moreover, members of the Company's
management team, including, without limitation, the Chief Financial Officer,
Senior Vice President, Sales and U.S. Controller have been in their current
positions with the Company for a limited period of time. To accommodate recent
growth, to compete effectively and manage future growth, if any, the Company
will be required to continue to implement and improve a variety of operational,
financial and management information systems, procedures and controls on a
timely basis and to expand, train, motivate and manage its work force. In
particular, the Company will be required to improve its accounting and financial
reporting systems, which currently require substantial management effort, and to
successfully manage an increasing number of relationships with customers,
suppliers and employees. These demands will require the addition of new
management personnel, and the Company currently is in the process of recruiting
individuals to fill important management positions such as Chief Executive
Officer, Vice President, Marketing, and managers for research and development
projects. Further, the Company will need to continue to develop a U.S.-based
financial and accounting system. The Company's future success will depend to a
significant extent on the recruitment and retention of these key personnel, the
implementation and improvement of operational, financial and management systems
and the ability of its current and future executive officers to operate
effectively, both independently and as a group. There can be no assurance that
the Company will be able to execute on a timely and cost-effective basis all
that is necessary to successfully manage any growth, and any failure to do so
could have a material adverse effect on the Company's business, operating
results or financial condition. See "Business -- Employees."

Need to Expand and Improve Productivity of Sales Force, Technical Services and
Customer Support Organization

To increase market penetration, the Company continues to hire sales
personnel. Based on the Company's experience, it takes at least six months, if
not longer, for a salesperson to become fully productive. Although the Company
increased the size of its sales organization during the year ended September 30,
1998, the Company experienced difficulty in recruiting a sufficient number of
qualified sales people during the period.

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There can be no assurance that the Company will be successful in recruiting
additional sales personnel or increasing the productivity of its sales
personnel, and the failure to do so could have a material adverse effect on the
Company's business, financial condition or results of operations. As a result of
the recent expansion of the installed base of Netcool/OMNIbus and the release of
the Company's Netcool/Reporter and Netcool/ Internet Service Monitors, the
demands on the Company's technical services and customer support resources have
grown rapidly. See "-- Product Defects; Product Liability." The Company believes
that a high level of technical services, training and customer support is
essential to maintaining its competitive position. The Company will be required
to significantly expand its technical services and customer support
organizations if it is to achieve significant additional revenue growth. In
addition, the Company has recently redeployed personnel from its discontinued
systems integration business and other newly hired personnel and the Company
expects that increased resources will be spent on training and transitioning
such personnel. Competition for additional qualified technical personnel to
perform the required functions is intense. There can be no assurance that the
Company's technical services and customer support resources will be sufficient
to manage any future growth in the Company's business, and any failure of the
Company to expand its technical services and customer support organizations
commensurate with any expansion of the installed base of Netcool/OMNIbus or
sales of Netcool/Reporter or Netcool/Internet Service Monitors would have a
material adverse effect on the Company's business, operating results and
financial condition. See "Business -- Technical Services" and "-- Customer
Support."

Need to Expand Distribution Channels; Dependence on Third-Party Relationships

A key element of the Company's business strategy is to develop
relationships with leading network equipment and telecommunications providers
and to expand the third-party channel of distribution. The Company is currently
investing, and plans to continue to invest, significant resources to develop
these relationships and channels of distribution, which could adversely affect
the Company's ability to generate profits. Third-party distributors accounted
for approximately 26% and 11% of the Company's total revenues in fiscal 1998 and
1997, respectively. There can be no assurance that the Company will be able to
attract additional distributors that will be able to market the Company's
products effectively. Many of the Company's agreements with third-party
distributors are nonexclusive, and many of the companies with which the Company
has agreements also have similar agreements with the Company's competitors or
potential competitors. The Company's third-party distributors have significantly
greater sales and marketing resources than the Company, and there can be no
assurance that their sales and marketing efforts will not conflict with the
Company's direct sales efforts. In addition, although sales through third-party
distributors result in reduced sales and marketing expense with respect to such
sales, the Company sells its products to third-party distributors at reduced
prices, resulting in lower gross margins on such third-party sales. The Company
believes that its success in penetrating markets for its SLM applications
depends substantially on its ability to maintain its current distribution
relationships, in particular, those with Cisco Systems ("Cisco") and Bay
Networks ("Bay"), to cultivate additional distribution relationships and to
cultivate alternative distribution relationships if distribution channels
change. There can be no assurance that network equipment and telecommunications
providers and distributors will not discontinue their relationships with the
Company, compete directly with the Company or form additional competing
arrangements with the Company's competitors or that the Company will be able to
expand its distribution relationships beyond what currently exists. See
"Business -- Sales and Marketing" and "Management's Discussion and Analysis of
Financial Condition and Results of Operations."

Emerging Service Level Management Market; Dependence on Telecommunication
Carriers and Other Service Providers; Demand for SLM Products

The market for the Company's products is in an early stage of development.
Although the rapid expansion and increasing complexity of computer networks in
recent years and the resulting emergence of SLAs has increased the demand for
SLM software products, the awareness of and the need for such products is a
recent development. Because the market for these products is only beginning to
develop, it is difficult to assess the size of this market, the appropriate
features and prices for products to address this market, the optimal
distribution strategy and the competitive environment that will develop. Failure
of the SLM market to
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<PAGE> 25

grow at anticipated rates or failure of the Company to properly assess and
address the demands from such market would have a material adverse effect on the
Company's business, operating results and financial condition. Historically, in
excess of 12% of the Company's software revenues have been derived from sales to
investment banks. However, as a result of the Company's strategy to focus on
telecommunications carriers, ISPs and other providers of managed networks, the
Company expects sales to investment banks to comprise a decreasing portion of
total revenues over the long-term. In excess of 45% of the Company's software
revenues to date have been derived from the sale of its products to
telecommunications carriers that deliver advanced communications services to
their customers. In addition, these providers are the central focus of the
Company's sales strategy. There can be no assurance that telecommunications
carriers and other service providers will be able to market their communications
services successfully, that SLM will gain widespread market acceptance or that
telecommunications carriers and other service providers will use the Company's
products in the deployment of their services. Delays in the introduction of
advanced services, such as network management outsourcing, failure of such
services to gain widespread market acceptance or the decision of
telecommunications carriers and other service providers not to use the Company's
products in the deployment of these services would have a material adverse
effect on the Company's business, operating results and financial condition.
There can be no assurance the Company will be able to penetrate these markets
further. See "Management's Discussion and Analysis of Financial Condition and
Results of Operations" and "Business -- Customers."

Competition

The Company's products are designed for use in the evolving SLM and
enterprise network management markets. Competition in these markets is intense
and is characterized by rapidly changing technologies, new and evolving industry
standards, frequent new product introductions and rapid changes in customer
requirements. The Company's current and prospective competitors offer a variety
of solutions to address the SLM and enterprise network management markets and
generally fall within the following five categories: (i) customer's internal
design and development organizations that produce SLM and network management
applications for their particular needs, in some cases using multiple instances
of products from hardware and software vendors such as Sun Microsystems, Inc.
("Sun"), Hewlett-Packard Company ("HP") and Cabletron Systems, Inc.
("Cabletron"); (ii) vendors of network and systems management frameworks
including Computer Associates International, Inc. ("CA") and International
Business Machines Corporation ("IBM"); (iii) vendors of network and systems
management applications including HP, Sun and IBM; (iv) providers of specific
market applications including Boole & Babbage, Inc. ("Boole & Babbage") and
several smaller software vendors; and (v) systems integrators which primarily
provide programming services to develop customer specific applications including
TCSI Corporation (formerly Teknekron Communications Systems, Inc.) and Objective
Systems Integrators, Inc. ("OSI"). In the future, as the Company enters new
markets, the Company expects that such markets will have additional,
market-specific competitors. In addition, because there are relatively low
barriers to entry in the software market, the Company expects additional
competition from other established and emerging companies. Increased competition
is likely to result in price reductions and may result in reduced gross margins
and loss of market share, any of which could materially adversely affect the
Company's business, operating results or financial condition.

Many of the Company's existing and potential customers continuously
evaluate whether to design and develop their own network operations support and
management applications or purchase them from outside vendors. Sometimes these
customers internally design and develop their own software solutions for their
particular needs and therefore may be reluctant to purchase products offered by
independent vendors such as the Company. As a result, the Company must
continuously educate existing and prospective customers as to the advantages of
the Company's products versus internally developed network operations support
and management applications.

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or emerging technologies and changes in customer requirements than the Company.
Existing competitors could also increase their market share by bundling products
having management functionality offered by the Company's products with their
current applications. Moreover, the Company's current and potential competitors
may increase their share of the SLM market by strategic alliances and/or the
acquisition of competing companies. In addition, network operating system
vendors could introduce new or upgrade and extend existing operating systems or
environments that include management functionality offered by the Company's
products, which could render the Company's products obsolete and unmarketable.
There can be no assurance that the Company will be able to compete successfully
against current or future competitors or that competitive pressures faced by the
Company will not materially adversely affect its business, operating results or
financial condition. See "Business -- Competition."

Product Defects; Product Liability

Software products as internally complex as Netcool/OMNIbus,
Netcool/Reporter and Netcool/Internet Service Monitors frequently contain errors
or defects, especially when first introduced or when new versions or
enhancements are released. Despite extensive product testing by the Company, the
Company has in the past released versions of Netcool/OMNIbus with defects and
has discovered software errors in certain of its products after their
introduction. For example, version 3.0 of Netcool/OMNIbus, released in 1996, had
a number of material defects. Netcool/Reporter, currently in its initial
release, has features and performance characteristics that have had limited
market appeal. Although the Company is currently devoting significant management
and technical resources to improve the features and performance of
Netcool/Reporter, the Company does not expect significant revenue contribution
from Netcool/Reporter for the foreseeable future. To the extent such efforts
continue to require the allocation of a significant portion of the Company's
technical personnel resources, or if the performance and features of
Netcool/Reporter are not improved, the Company could continue to experience
delays in or failure of market acceptance of Netcool/Reporter, or damage to the
Company's reputation or relationships with its customers, any of which could
have a material adverse effect on the Company's business, operating results or
financial condition. See "-- Need to Expand and Improve Productivity of Sales
Force, Technical Services and Customer Support Organization." Additionally,
there can be no assurance that, despite testing by the Company and by current
and potential customers, defects and errors will not be found in new versions or
enhancements of the Company's products after commencement of commercial
shipments which could have a material adverse effect upon the Company's
business, operating results or financial condition.

Since the Company's products are used by its customers to monitor and
address network problems and avoid failures of the network to support critical
business functions, any design defects, software errors, misuse of the Company's
products, incorrect data from network elements or other potential problems
within or out of the Company's control that may arise from the use of the
Company's products could result in financial or other damages to the Company's
customers. Such customers could seek damages from the Company for any such
losses, which, if successful, could have a material adverse effect on the
Company's business, operating results or financial condition. Although the
Company maintains product liability insurance, there can be no assurance that
such insurance will adequately cover, if at all, any such claims. Further,
although the Company's license agreements with its customers typically contain
provisions designed to limit the Company's exposure to potential claims as well
as any liabilities arising from such claims, such provisions may not effectively
protect the Company against such claims and the liability and costs associated
therewith. Accordingly, any such claim could have a material adverse effect upon
the Company's business, results of operations or financial condition. See
"Business -- Products and Technology" and "-- Research and Development."

Lengthy Sales Cycle

The Company's software is generally used for division- or enterprise-wide,
business-critical purposes and involves significant capital commitments by
customers. Potential customers generally commit significant resources to an
evaluation of available enterprise software and require the Company to expend
substantial time, effort and money educating them about the value of the
Company's solutions. Sales of the Company's

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software products often require an extensive sales effort throughout a
customer's organization because decisions to license such software generally
involve the evaluation of the software by a significant number of customer
personnel in various functional and geographic areas, each often having specific
and conflicting requirements. A variety of factors, including actions by
competitors and other factors over which the Company has little or no control,
may cause potential customers to favor a particular supplier or to delay or
forego a purchase. As a result of these and other factors, the sales cycle for
the Company's products is long, typically about three to six months. As a result
of the length of the sales cycle for its software products, the Company's
ability to forecast the timing and amount of specific sales is limited, and the
delay or failure to complete one or more large license transactions could have a
material adverse effect on the Company's business, operating results or
financial condition and cause the Company's operating results to vary
significantly from quarter to quarter. See "-- Variability of Quarterly
Operating Results; Seasonality," and "Business -- Sales and Marketing."

Dependence on Key Personnel

The Company's success is substantially dependent upon a limited number of
key management, sales, product development, technical services and customer
support personnel. The loss of the services of one or more of such key employees
could have a material adverse effect on the Company's business, financial
condition or results of operations. The Company does not have employment
contracts with any of its key personnel. In addition, the Company's success will
be dependent upon its continuing ability to attract, train and retain additional
highly qualified management, sales, product development, technical services and
customer support personnel. The Company has at times and continues to experience
difficulty in recruiting qualified personnel. Because the Company faces intense
competition in its recruiting activities, there can be no assurance that the
Company will be able to attract and/or retain qualified personnel. Failure to
attract and retain the necessary qualified personnel on a timely basis could
have a material adverse effect on the Company's business, operating results or
financial condition. See "Management's Discussion and Analysis of Financial
Condition and Results of Operations."

Product Concentration

Other than discontinued operations, all of the Company's revenues have been
derived from licenses for its Netcool family of products and related
maintenance, training and consulting services. The Company currently expects
that Netcool/OMNIbus-related revenues will continue to account for all or
substantially all of the Company's revenues beyond fiscal 1998 and for the
foreseeable future thereafter. Therefore, the Company's future operating
results, particularly in the near term, are significantly dependent upon the
continued market acceptance of Netcool/OMNIbus, improvements to Netcool/OMNIbus
and new and enhanced Netcool/ OMNIbus applications. There can be no assurance
that Netcool/OMNIbus will continue to achieve market acceptance or that the
Company will be successful in developing, introducing or marketing improvements
to Netcool/OMNIbus or new or enhanced Netcool/OMNIbus applications. The life
cycles of Netcool/ OMNIbus, including the Netcool/OMNIbus applications, are
difficult to estimate due in large part to the recent emergence of many of the
Company's markets, the effect of future product enhancements and competition. A
decline in the demand for Netcool/OMNIbus as a result of competition,
technological change or other factors would have a material adverse effect on
the Company's business, operating results and financial condition. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations," "Business -- Products and Technology" and "-- Research and
Development."

Sales Concentration

To date, a significant portion of the Company's revenues in any particular
period has been attributable to a limited number of customers. In fiscal 1998
and 1997, entities affiliated with WorldCom accounted for 10% and 18% of the
Company's total revenue, respectively. In addition, entities affiliated with
British Telecommunications accounted for 9% of the Company's total revenues in
both fiscal 1998 and 1997 and 14% in fiscal 1996. The Company expects that it
will continue to be dependent upon a limited number of customers for a
significant portion of its revenues in future periods. As a result of this
concentration of sales, the Company's

27
<PAGE> 28

business, operating results or financial condition could be materially adversely
affected by the failure of anticipated orders from significant customers to
materialize or by deferrals or cancellations of orders by significant customers.
In addition, there can be no assurance that revenue from customers that have
accounted for significant revenues in past periods, individually or as a group,
will continue, or if continued, will reach or exceed historical levels in any
future period. The terms of the Company's agreements with its customers
typically contain a one-time license fee and a prepayment of one year of
maintenance fees. The maintenance agreement is renewable annually at the option
of the customer and there are no minimum payment obligations or obligations to
license additional software. Therefore, there can be no assurance that any of
the Company's current customers will generate significant revenues in future
periods. For example, pre-existing customers may be part of, or become part of,
large organizations that standardize using a competitive product. See
"Management's Discussion and Analysis of Financial Condition and Results of
Operations" and "Business -- Sales and Marketing."

Risks Associated With International Licensing and Operations

License, maintenance and service revenue outside of the United States
accounted for 39%, 48% and 55% of the Company's total revenue in fiscal 1998,
1997 and 1996. The Company expects that international license, maintenance and
consulting revenue will continue to account for a significant portion of its
total revenue in future periods. Currency exchange fluctuations in countries in
which the Company licenses its products or conducts operations historically have
had, and in the future could continue to have, a material adverse effect on the
Company's business, operating results or financial condition by resulting in
pricing levels that are not competitive or expense levels that adversely impact
profitability. In such event, gains and losses on the conversion to United
States dollars of accounts receivable and accounts payable arising from
international operations may contribute to fluctuations in the Company's
operating results. The Company intends to enter into additional international
markets and to continue to expand its operations outside of the United States by
expanding its direct sale force and pursuing additional strategic relationships.
Such expansion will require significant management attention and expenditure of
significant financial resources and could adversely affect the Company's ability
to generate profits. To the extent that the Company is unable to establish
additional foreign operations in a timely manner, the Company's growth, if any,
in international sales will be limited, and the Company's business, operating
results or financial condition could be materially adversely affected. The
Company maintains a significant portion of its operations, including the bulk of
its software development operations, in the United Kingdom. The Company's
international operations and revenue involve a number of inherent risks,
including longer receivables collection periods and greater difficulty in
accounts receivable collection, difficulty in staffing and managing foreign
operations, an even lengthier sales cycle than with domestic customers, the
impact of possible recessionary environments in economies outside the United
States, unexpected changes in regulatory requirements, including a slowdown in
the rate of privatization of telecommunications service providers, reduced
protection for intellectual property rights in some countries and tariffs and
other trade barriers. There can be no assurance that the Company will be able to
sustain or increase revenue derived from international licensing and service or
that the foregoing factors will not have a material adverse effect on the
Company's future international license, service and other revenue, and,
consequently, on the Company's business, operating results or financial
condition. The Company pays the expenses of its international operations in
local currencies and does not currently engage in hedging transactions with
respect to such obligations. In addition, sales in Europe and certain other
parts of the world typically are adversely affected in the quarter ending
September 30, as many customers reduce their business activities during the
summer months. If the Company's international sales become a greater component
of total revenue, these seasonal factors may have a more pronounced effect on
the Company's operating results. See "Management's Discussion and Analysis of
Financial Condition and Results of Operations," "Business -- Customers" and
"-- Sales and Marketing."

New Products and Rapid Technological Change; Need to Manage Product
Transitions; Dependence on Third-Party Software Platforms

in customer requirements. The introduction or announcement of products by the
Company or its competitors embodying new technologies and the emergence of new
industry standards and practices can render existing products obsolete and
unmarketable. As a result, the life cycles of the Company's products are
difficult to estimate. The Company's future success will depend on its ability
to enhance its existing products and to develop and introduce, on a timely and
cost-effective basis, new products and product features that keep pace with
technological developments and emerging industry standards and address the
increasingly sophisticated needs of its customers. Historically, the Company has
used its close working relationship with large customers to define its product
development direction. There can be no assurance that the Company will be
successful in developing and marketing new products or product features that
respond to technological change or evolving industry standards, that the Company
will not experience difficulties that could delay or prevent the successful
development, introduction and marketing of these new products and features, or
that its new products or product features will adequately meet the requirements
of the marketplace and achieve market acceptance. In particular, the widespread
adoption of the Telecommunications Management Network ("TMN") architecture for
managing telecommunications networks would force the Company to adapt its
products to such standard, and there can be no assurance that this could be done
on a timely or cost-effective basis, if at all. In addition, to the extent that
any product upgrade or enhancement requires extensive installation and
configuration, current customers may postpone or forgo the purchase of new
versions of the Company's products. If the Company is unable, for technological
or other reasons, to develop and introduce enhancements of existing products or
new products in a timely manner, the Company's business, operating results and
financial condition will be materially adversely affected. In addition, there
can be no assurance that the introduction or announcement of new product
offerings by the Company or one or more of its competitors will not cause
customers to defer licensing of existing Company products. Any such deferment of
purchases could have a material adverse effect on the Company's business,
operating results or financial condition.

The Company's products are designed to operate on a variety of hardware and
software platforms employed by its customers in their networks. The Company must
continually modify and enhance its products to keep pace with changes in
hardware and software platforms and database technology. As a result,
uncertainties related to the timing and nature of new product announcements,
introductions or modifications by systems vendors, particularly Sun, IBM, HP,
Cabletron and Cisco and by vendors of relational database software, particularly
Oracle Corporation ("Oracle") and Sybase, Inc. ("Sybase"), could materially
adversely impact the Company's business, operating results or financial
condition. For example, the Company is currently modifying certain of its
products to operate with the Microsoft Windows NT operating system. The failure
of the Company's products to operate effectively across the various existing and
evolving versions of hardware and software platforms and database environments
employed by customers could have a material adverse effect on the Company's
business, operating results or financial condition. See "Business -- Research
and Development."

Dependence Upon Proprietary Technology; Risk of Third-Party Claims of
Infringement

consuming, result in costly litigation and diversion of technical and management
personnel, cause product shipment delays or require the Company to develop
non-infringing technology or enter into royalty or licensing agreements. Such
royalty or licensing agreements, if required, may not be available on terms
acceptable to the Company or at all. In the event of a successful claim of
product infringement against the Company and failure or inability of the Company
to develop non-infringing technology or license the infringed or similar
technology, the Company's business, operating results or financial condition
could be materially adversely affected. See "Business -- Intellectual Property
and Other Proprietary Rights."

Risks Associated With Third-Party Licenses

The Company relies on certain software that it licenses from third parties,
including software that is integrated with internally developed software and
used in the Company's products to perform key functions. There can be no
assurance that these third-party software licenses will continue to be available
to the Company on commercially reasonable terms or at all. Although the Company
believes that alternative software is available from other third-party
suppliers, the loss of or inability to maintain any of these software licenses
or the inability of the third parties to enhance in a timely and cost-effective
manner their products in response to changing customer needs, industry standards
or technological developments could result in delays or reductions in product
shipments by the Company until equivalent software could be developed internally
or identified, licensed and integrated, which would have a material adverse
effect on the Company's business, operating results and financial condition. See
"Business -- Intellectual Property and Other Proprietary Rights."

Year 2000 Compliance and Euro Conversion

quarter of calendar 1999 with respect to its core business and software systems
and at the end of the second quarter of calendar 1999 with respect to its
hardware systems. In each case, the Company expects to continue extensive
testing through calendar 1999. The Company does not expect the total costs
associated with preparing its internal systems for the Year 2000 to exceed
$350,000. Although the Company does not currently believe that it will
experience material disruptions in its business associated with preparing its
internal systems for the Year 2000, there can be no assurances that the Company
will not experience serious unanticipated negative consequences and/or material
costs caused by undetected errors or defects in the technology used in its
internal systems, which are composed of third-party software, third-party
hardware that contains embedded software and the Company's own software
products. The most reasonably likely worst case scenarios would include: (i)
corruption of data contained in the Company's internal information systems, (ii)
hardware failure and (iii) the failure of infrastructure services provided by
government agencies and other third parties (e.g., electricity, phone service,
water transport, internet services, etc.). The Company is in the process of
conducting its contingency planning for high-risk areas at this time and is
scheduled to commence contingency planning for medium to low-risk areas in
January 1999. The Company expects its contingency plans to include, among other
things, manual "work-arounds" for software and hardware failures, as well as
substitution of systems, if necessary.

Volatility of Stock Price

The market price of the Common Stock has been and is likely to continue to
be highly volatile and may be significantly affected by factors such as actual
or anticipated fluctuations in the Company's operating results, announcements of
technological innovations, new products or new contracts by the Company or its
competitors, developments with respect to copyrights or proprietary rights,
adoption of new accounting standards affecting the software industry, general
market conditions and other factors. In addition, the stock market has from time
to time experienced significant price and volume fluctuations that have
particularly affected the market price for the common stock of technology
companies. These types of broad market fluctuations may adversely affect the
market price of the Company's Common Stock. In the past, following periods of
volatility in the market price of a company's securities, securities class
action litigation has often been initiated against such company. Such litigation
could result in substantial costs and a diversion of management's attention and
resources that could have a material adverse effect upon the Company's business,
operating results or financial condition. See "Price Range of Common Stock."

General Economic and Market Conditions

Segments of the software industry have experienced significant economic
downturns characterized by decreased product demand, price erosion, work
slowdowns and layoffs. The Company's operations may in the future experience
substantial fluctuations from period to period as a consequence of general
economic conditions affecting the timing of orders from major customers and
other factors affecting capital spending. Although the Company has a diverse
client base, it has targeted certain vertical markets. Therefore, any economic
downturns in general or in the targeted vertical segments in particular would
have a material adverse effect on the Company's business, operating results and
financial condition.

Anti-takeover Effects of Certificate of Incorporation; Bylaws and Delaware Law

Certain provisions of the Company's Restated Certificate of Incorporation
and Bylaws and certain provisions of Delaware law could delay or make difficult
a merger, tender offer or proxy contest involving the
31
<PAGE> 32

Company. The authorized but unissued capital stock of the Company includes 5.0
million shares of preferred stock. The Board of Directors is authorized to
provide for the issuance of such preferred stock in one or more series and to
fix the designations, preferences, powers and relative, participating, optional
or other rights and restrictions thereof. Accordingly, the Company may in the
future issue a series of preferred stock, without further stockholder approval,
that will have preference over the Common Stock with respect to the payment of
dividends and upon liquidation, dissolution or winding-up of the Company. See
"Description of Capital Stock -- Preferred Stock." Further, Section 203 of the
General Corporation Law of the State of Delaware (as amended from time to time,
the "DGCL"), which is applicable to the Company, prohibits certain business
combinations with certain stockholders for a period of three years after they
acquire 15% or more of the outstanding voting stock of a corporation. In
addition, the Restated Certificate of Incorporation provides that the Board of
Directors is divided into two classes of directors with each class serving a
staggered two-year term. The classification of the Board of Directors has the
effect of generally requiring at least two annual stockholder meetings, instead
of one, to replace a majority of the Board members. Any of the foregoing could
adversely affect holders of the Common Stock or discourage or make difficult any
attempt to obtain control of the Company. See "Description of Capital
Stock -- Anti-takeover Effects of Provisions of the Certificate of
Incorporation, Bylaws and Delaware Law."

ITEM 7A.QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK DERIVATIVES
AND FINANCIAL INSTRUMENTS

FOREIGN CURRENCY HEDGING INSTRUMENTS

The Company transacts business in various foreign currencies. Accordingly,
the Company is subject to exposure from adverse movements in foreign currency
exchange rates. This exposure is primarily related to local currency denominated
revenues and operating expenses in the U.K. However, as of September 30, 1998,
the Company had no hedging contracts outstanding.

The Company currently does not use financial instruments to hedge local
currency denominated operating expenses in the U.K. Instead, the Company
believes that a natural hedge exists, in that local currency revenues will
substantially offset the local currency denominated operating expenses. The
Company assesses the need to utilize financial instruments to hedge currency
exposures on an ongoing basis.

The Company does not use derivative financial instruments for speculative
trading purposes, nor does the Company hedge its foreign currency exposure in a
manner that entirely offsets the effects of changes in foreign exchange rates.
The Company regularly reviews its hedging program and may as part of this review
determine at any time to change its hedging program.

FIXED INCOME INVESTMENTS

The Company's exposure to market risks for changes in interest rates relate
primarily to investments in debt securities issued by U.S. government agencies
and corporate debt securities. The Company places its investments with high
credit quality issuers and, by policy, limits the amount of t credit exposure to
any one issuer.

The Company's general policy is to limit the risk of principal loss and
ensure the safety of invested funds by limiting market and credit risk. All
highly liquid investments with a maturity of three months or less at the date of
purchase are considered to be cash equivalents; investments with maturities
between three months or less are considered cash equivalents; investments with
maturities between three and twelve months are considered to be short-term
investments; investments with maturities in excess of twelve months are
considered to be long-term investments. The weighted average pre-tax interest
rate on the investment portfolio is approximately 5.61%. The Company does not
expect any material loss with respect to its investment portfolio.

32
<PAGE> 33

ITEM 8. FINANCIAL STATEMENTS AND SUPPLEMENTARY DATA

CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

ASSETS

<TABLE>
<CAPTION>
AS OF SEPTEMBER 30,
-------------------
1998 1997
-------- -------
<S> <C> <C>
Current assets:
Cash and cash equivalents................................. $ 22,798 $13,741
Short-term investments.................................... 40,452 --
Accounts receivable....................................... 6,495 4,461
Prepaid expenses and other current assets................. 1,289 935
Related party loan........................................ 85 1,153
-------- -------
Total current assets.............................. 71,119 20,290
Property and equipment, net............................... 2,968 2,450
Long-term investments..................................... 6,557 --
-------- -------
$ 80,644 $22,740
======== =======
LIABILITIES AND STOCKHOLDERS' EQUITY (DEFICIT)
Current liabilities:
Accounts payable.......................................... $ 2,073 $ 2,654
Accrued expenses.......................................... 3,327 3,133
Deferred revenues......................................... 7,526 1,322
-------- -------
Total current liabilities......................... 12,926 7,109
Commitments and contingencies
Redeemable convertible preferred stock; $0.01 par value;
5,988 shares authorized; 4,488 shares issued and
outstanding at September 30, 1997......................... -- 22,865
Stockholders' equity (deficit):
Preferred stock; $0.01 par value; 5,000 shares authorized;
no shares issued and outstanding....................... -- --
Common stock; $0.01 par value; 60,000 shares authorized;
16,049 and 6,706 shares outstanding as of September 30,
1998 and 1997, respectively............................ 160 67
Additional paid-in capital................................ 79,159 2,390
Treasury stock, at cost: 120 shares at September 30,
1997................................................... -- (300)
Deferred compensation..................................... (159) (215)
Cumulative translation adjustment......................... (42) 52
Accumulated deficit....................................... (11,400) (9,228)
-------- -------
Total stockholders' equity (deficit).............. 67,718 (7,234)
-------- -------
$ 80,644 $22,740
======== =======
</TABLE>

See Accompanying Notes to Consolidated Financial Statements.
33
<PAGE> 34

CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
----------------------------
1998 1997 1996
---- ---- ----
<S> <C> <C> <C>
Revenues:
License................................................... $22,432 $ 6,968 $3,374
Maintenance and services.................................. 5,829 2,324 1,141
------- ------- ------
Total revenues.................................... 28,261 9,292 4,515
Cost of revenues:
License................................................... 1,320 523 311
Maintenance and services.................................. 3,491 1,042 384
------- ------- ------
Total cost of revenues............................ 4,811 1,565 695
------- ------- ------
Gross profit................................................ 23,450 7,727 3,820
Operating expenses:
Sales and marketing....................................... 15,710 8,970 1,768
Research and development.................................. 5,535 2,042 1,582
General and administrative................................ 4,521 4,244 996
------- ------- ------
Total operating expenses.......................... 25,766 15,256 4,346
------- ------- ------
Loss from operations...................................... (2,316) (7,529) (526)
Other income (expense):
Interest income........................................... 1,840 64 8
Interest expense.......................................... (312) (1,268) (212)
Other..................................................... 100 (200) 25
------- ------- ------
Loss before income taxes.................................. (688) (8,933) (705)
Income taxes................................................ 150 -- 100
------- ------- ------
Loss from continuing operations........................... (838) (8,933) (805)
Discontinued operations:
Income (loss) from discontinued operations................ -- (104) 569
Gain on disposition....................................... -- 1,161 --
------- ------- ------
Net loss.................................................. (838) (7,876) (236)
Accretion on redeemable convertible preferred stock......... (1,334) (755) --
------- ------- ------
Net loss applicable to holders of common stock.............. $(2,172) $(8,631) $ (236)
======= ======= ======
Basic and diluted per share data:
Loss from continuing operations applicable to holders of
common stock........................................... $ (0.07) $ (1.52) $(0.14)
Net loss applicable to holders of common stock............ $ (0.18) $ (1.35) $(0.04)
Shares used in per share calculations..................... 11,794 6,373 5,954
</TABLE>

See Accompanying Notes to Consolidated Financial Statements.
34
<PAGE> 35

CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (DEFICIT)
(IN THOUSANDS)
<TABLE>
<CAPTION>

COMMON STOCK ADDITIONAL TREASURY STOCK DEFERRED CUMULATIVE
--------------- PAID-IN ---------------- STOCK TRANSLATION ACCUMULATED
SHARES AMOUNT CAPITAL SHARES AMOUNT COMPENSATION ADJUSTMENT DEFICIT
------ ------ ---------- ------ ------- ------------ ----------- -----------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Balance as of September 30,
1995........................... 5,937 $ 59 $ 95 -- $ -- $ -- $ 4 $ (361)
Issuance of common stock......... 163 2 2 -- -- -- -- --
Deferred compensation related to
grants of stock options........ -- -- 167 -- -- (167) -- --
Amortization of deferred employee
compensation................... -- -- -- -- -- 167 -- --
Foreign currency translation
adjustment..................... -- -- -- -- -- -- 46 --
Net loss......................... -- -- -- -- -- -- -- (236)
------ ---- ------- ---- ------- ----- ---- --------
Balance as of September 30,
1996........................... 6,100 61 264 -- -- -- 50 (597)
Bonus shares issued.............. 450 5 1,138 -- -- -- -- --
Stock options exercised.......... 36 -- 130 -- -- -- -- --
Compensation expense related to
stock transfer................. -- -- 210 -- -- -- -- --
Treasury stock purchased......... -- -- -- (120) (300) -- -- --
Issuance of common stock......... 120 1 419 -- -- -- -- --
Deferred compensation related to
grants of stock options........ -- -- 229 -- -- (229) -- --
Amortization of deferred employee
compensation................... -- -- -- -- -- 14 -- --
Foreign currency translation
adjustment..................... -- -- -- -- -- -- 2 --
Net loss......................... -- -- -- -- -- -- -- (7,876)
Accretion on redeemable
convertible preferred stock.... -- -- -- -- -- -- -- (755)
------ ---- ------- ---- ------- ----- ---- --------
Balance as of September 30,
1997........................... 6,706 67 2,390 (120) (300) (215) 52 (9,228)
Stock options exercised.......... 120 1 261 -- -- -- -- --
Issuance of common stock under
stock purchase plan............ 62 1 628 -- -- -- -- --
Issuance of common stock in
public offerings, net of
related costs.................. 3,332 33 51,739 898 5,300 -- -- --
Treasury stock purchased......... -- -- -- (778) (5,000) -- -- --
Conversion of Series B and C
preferred stock................ 4,488 45 22,566 -- -- -- -- --
Exercise of Series A warrants.... 1,341 13 1,575 -- -- -- -- --
Amortization of deferred employee
compensation................... -- -- -- -- -- 56 -- --
Foreign currency translation
adjustment..................... -- -- -- -- -- -- (94) --
Net loss......................... -- -- -- -- -- -- -- (838)
Accretion on redeemable
convertible preferred stock.... -- -- -- -- -- -- -- (1,334)
------ ---- ------- ---- ------- ----- ---- --------
Balance as of September 30,
1998........................... 16,049 $160 $79,159 -- $ -- $(159) $(42) $(11,400)
------ ---- ------- ---- ------- ----- ---- --------

<CAPTION>
TOTAL
STOCKHOLDERS'
EQUITY
(DEFICIT)
-------------
<S> <C>
Balance as of September 30,
1995........................... $ (203)
Issuance of common stock......... 4
Deferred compensation related to
grants of stock options........ --
Amortization of deferred employee
compensation................... 167
Foreign currency translation
adjustment..................... 46
Net loss......................... (236)
-------
Balance as of September 30,
1996........................... (222)
Bonus shares issued.............. 1,143
Stock options exercised.......... 130
Compensation expense related to
stock transfer................. 210
Treasury stock purchased......... (300)
Issuance of common stock......... 420
Deferred compensation related to
grants of stock options........ --
Amortization of deferred employee
compensation................... 14
Foreign currency translation
adjustment..................... 2
Net loss......................... (7,876)
Accretion on redeemable
convertible preferred stock.... (755)
-------
Balance as of September 30,
1997........................... (7,234)
Stock options exercised.......... 262
Issuance of common stock under
stock purchase plan............ 629
Issuance of common stock in
public offerings, net of
related costs.................. 57,072
Treasury stock purchased......... (5,000)
Conversion of Series B and C
preferred stock................ 22,611
Exercise of Series A warrants.... 1,588
Amortization of deferred employee
compensation................... 56
Foreign currency translation
adjustment..................... (94)
Net loss......................... (838)
Accretion on redeemable
convertible preferred stock.... (1,334)
-------
Balance as of September 30,
1998........................... $67,718
-------
</TABLE>

See Accompanying Notes to Consolidated Financial Statements.
35
<PAGE> 36

CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)

<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
------------------------------
1998 1997 1996
-------- ------- -------
<S> <C> <C> <C>
Cash flows from operating activities:
Net loss.................................................. $ (838) $(7,876) $ (236)
Adjustments to reconcile net loss to net cash provided by
(used in) operating activities:
Depreciation and amortization.......................... 1,201 669 603
Loss on disposal of assets............................. -- 51 242
Debt issuance costs.................................... -- 1,350 --
Amortization of deferred employee compensation......... 56 14 167
Compensation expense related to stock transfers........ -- 330 --
Compensation expense related to bonus shares issued.... -- 1,143 --
Changes in operating assets and liabilities:
Accounts receivable.................................. (2,034) 1,221 (2,495)
Inventories.......................................... -- 399 (53)
Prepaid expenses and other current assets............ (354) 315 (294)
Related party loan................................... 1,068 (994) (127)
Accounts payable..................................... (581) (1,394) 1,806
Accrued expenses..................................... 194 2,162 149
Deferred revenues.................................... 6,204 150 548
Long-term taxes payable.............................. -- -- (22)
-------- ------- -------
Cash provided by (used in) operating activities... 4,916 (2,460) 288
-------- ------- -------
Cash flows from investing activities:
Capital expenditures...................................... (1,719) (2,147) (602)
Purchase of investments................................... (57,831) -- --
Proceeds from the sale of investments..................... 10,822 -- --
-------- ------- -------
Cash used in investing activities...................... (48,728) (2,147) (602)
-------- ------- -------
Cash flows from financing activities:
Bank overdraft............................................ -- (1,351) 677
Proceeds from short-term notes............................ -- 2,500 951
Payment of short-term notes............................... -- (3,775) --
Payment of long-term notes................................ -- (268) (205)
Payment of capital lease obligations...................... -- (244) (577)
Proceeds from issuance of common stock, net............... 57,963 430 4
Purchase of treasury stock................................ (5,000) (300) --
Proceeds from issuance of redeemable convertible preferred
stock.................................................. -- 20,760 --
-------- ------- -------
Cash provided by financing activities.................. 52,963 17,752 850
-------- ------- -------
Effects of exchange rate changes on cash and cash
equivalents............................................... (94) 2 46
-------- ------- -------
Net increase in cash and cash equivalents................... 9,057 13,147 582
Cash and cash equivalents at beginning of year.............. 13,741 594 12
-------- ------- -------
Cash and cash equivalents at end of year.................... $ 22,798 $13,741 $ 594
-------- ------- -------
Supplemental disclosures of cash flow information:
Cash paid during the year - interest...................... $ 36 $ 154 $ 159
Noncash financing activities:
Accretion of redeemable convertible preferred stock.... $ 1,334 $ 755 $ --
Exercise of warrants to purchase redeemable convertible
Series A preferred stock for common stock............ $ 1,588 $ -- $ --
Conversion of redeemable convertible Series B and C
preferred stock to common stock...................... $ 22,611 $ -- $ --
</TABLE>

See Accompanying Notes to Consolidated Financial Statements.
36
<PAGE> 37

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1. DESCRIPTION OF BUSINESS AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES

Description of Business

Micromuse Inc. and its subsidiaries (the "Company") develops, markets and
supports a family of scaleable, highly configurable, rapidly deployable,
software solutions for the effective monitoring and management of multiple
elements underlying an enterprise's information technology infrastructure. The
Company maintains its U.S. headquarters in California and its European
headquarters in London, England.

Micromuse plc was incorporated in England in 1989 and operated in the
United States through its subsidiary, Micromuse USA Inc., a Texas corporation.
In 1997, Micromuse plc became a subsidiary of Micromuse Inc., a Delaware
corporation. The Company entered into a stock exchange agreement with the
stockholders of the English corporation in March 1997. The Company's Board of
Directors approved an exchange of one share in the English corporation for
5.9365 shares in the Delaware corporation. The Certificate of Incorporation of
the Delaware corporation authorized 60.0 million shares of common stock at $0.01
par value per share and approximately 6.0 million shares of preferred stock at
$0.01 par value per share. The accompanying consolidated financial statements
have been retroactively restated to give effect to the reorganization and
exchange of common stock.

Principles of Consolidation

The accompanying consolidated financial statements include the accounts of
the Company and its subsidiaries. All significant intercompany balances and
transactions have been eliminated.

Use of Estimates

The preparation of consolidated financial statements in conformity with
generally accepted accounting principles requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities at the date of the consolidated
financial statements and the reported amounts of revenues and expenses during
the reporting period. Actual results could differ from these estimates.

Cash Equivalents

The Company considers all highly liquid instruments with a purchased
maturity of 90 days or less to be cash equivalents.

Concentration of Credit Risk

Financial instruments that potentially expose the Company to credit risk
consist of cash and cash equivalents, investments and accounts receivable. At
September 30, 1998, the Company had deposits in excess of insured amounts of
approximately $6.7 million and had invested $5.0 million in money market funds,
$41.5 million in debt securities issued by U.S. government agencies and $16.3
million in corporate debt securities. Trade receivables potentially subject the
Company to concentrations of credit risk. The Company closely monitors
extensions of credit and has not experienced significant credit losses in the
past. Credit losses have been provided for in the consolidated financial
statements and have been within management's expectations.

Fair Value of Financial Instruments

The fair value of cash and cash equivalents, investments, accounts
receivable, accounts payable and the redeemable convertible preferred stock
approximates their respective carrying amounts defined as the amount at which
the instrument could be exchanged in a current transaction between willing
parties.

37
<PAGE> 38
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

Investments

The Company has invested in certain equity securities that are categorized
as held-to-maturity. The fair value of these investments, which are accounted
for using the amortized cost-basis of accounting, approximates their respective
carrying value defined as the amount at which the instrument could be exchanged
in a current transaction between willing parties.

Property and Equipment

Property and equipment are recorded at cost less accumulated depreciation.
Depreciation is calculated using the straight-line method over the estimated
useful lives of the assets, typically three years for equipment and furniture.
Leasehold improvements are amortized over the shorter of the estimated useful
lives of the respective assets or the lease term.

Revenue Recognition

License revenues are recognized upon the acceptance of a purchase order and
shipment of the software provided the fee is fixed and determinable, the
arrangement does not involve significant customization of the software and
collection of the resulting receivable is probable. Allowances for credit losses
and for estimated future returns are provided for upon shipment. Credit losses
and returns to date have not been material. Maintenance revenues from ongoing
customer support and product upgrades are deferred and recognized ratably over
the term of the maintenance agreement, typically twelve months. Payments for
maintenance fees (on initial order or on renewal) are generally made in advance
and are nonrefundable. Revenues for consulting and training services are
recognized as the services are performed. In October 1997, the American
Institute of Certified Public Accountants issued Statement of Position No. 97-2,
Software Revenue Recognition ("SOP 97-2.") SOP 97-2 generally requires revenue
earned on software arrangements involving multiple elements, such as software
products, upgrades, enhancements, post-contract customer support, installation
and training, to be allocated to each element based on the relative fair values
of the elements. The fair value of an element must be based on evidence that is
specific to the vendor. The revenue allocated to software products, including
specified upgrades or enhancements, generally is recognized upon delivery of the
products. The revenue allocated to post-contract customer support generally is
recognized ratably over the term of the support, and revenue allocated to
service elements generally is recognized as the services are performed. If
evidence of the fair value for all element arrangement does not exist, all
revenue from the arrangement is deferred until such evidence exists or until all
elements are delivered. SOP 97-2 was adopted effective October 1, 1997. There
was no material change to the Company's accounting for revenue as a result of
the adoption of SOP 97-2.

Research and Development Cost

In accordance with the Financial Accounting Standards Board's (the "FASB")
Statement of Financial Accounting Standard ("SFAS") No. 86, "Accounting for the
Costs of Computer Software to Be Sold, Leased, or Otherwise Marketed,"
development costs related to software products are expensed as incurred until
the technological feasibility of the product has been established. Technological
feasibility in the Company's circumstances occurs when a working model is
completed. After technological feasibility is established, additional costs
would be capitalized. The Company believes its process for developing software
is essentially completed concurrent with the establishment of technological
feasibility, and, accordingly, no research and development costs have been
capitalized to date.

Income Taxes

Income taxes are recorded using the asset and liability method. Deferred
tax assets and liabilities are recognized for the future tax consequences
attributable to differences between the financial statement carrying amount of
existing assets and liabilities and their respective tax bases. Deferred tax
assets and liabilities are

38
<PAGE> 39
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

measured using enacted tax rates expected to apply to taxable income in the
years in which the temporary differences are expected to be recovered or
settled. The measurement of deferred tax assets is reduced, if necessary, by a
valuation allowance for any tax benefits that are not expected to be realized.

Stock-Based Compensation

The Company accounts for its stock-based compensation arrangements using
the intrinsic value method. As such, compensation expense is recorded when on
the date of grant the fair value of the underlying common stock exceeds the
exercise price for stock options or the purchase price for issuance or sales of
common stock.

Foreign Currency Translation

The functional currency of the Company's foreign subsidiaries is the local
currency. The Company translates the assets and liabilities of its foreign
subsidiaries to U.S. dollars at the rates of exchange in effect at the end of
the year. Revenues and expenses are translated at the average rates of exchange
for the year. Translation adjustments and the effects of exchange rate changes
on intercompany transactions of a long-term investment nature are included in
stockholders' equity (deficit) in the consolidated balance sheets. Gains and
losses resulting from foreign currency transactions denominated in a currency
other than the functional currency are included in income and have not been
significant to the Company's consolidated operating results in any year.

Per Share Data

Basic net income (loss) per share is calculated using the weighted-average
number of common shares outstanding during the period. Diluted net income (loss)
per share is calculated using the weighted-average number of common shares
outstanding during the period and, when dilutive, the weighted average number of
potential common shares from the assumed conversion of the redeemable
convertible preferred stock and the exercise of outstanding options to purchase
common stock using the treasury stock method. Excluded from the computation of
the diluted loss per share for the years ended September 30, 1998, 1997 and 1996
were approximately 4.5 million shares of redeemable convertible preferred stock
and options to acquire 1.5 million, 1.3 million and 575,379 shares of common
stock, respectively, with a weighted average exercise price of $4.78, $2.38 and
$2.43 per share, respectively, because their effect would be anti-dilutive.

Recent Accounting Pronouncements

In June 1997, the FASB issued SFAS No. 130, "Reporting Comprehensive
Income." SFAS No. 130 establishes standards for reporting and displaying
comprehensive income and its components in the consolidated financial
statements. It does not, however, require a specific format for the statement,
but requires the Company to display an amount representing total comprehensive
income for the period in that financial statement. The Company is in the process
of determining its preferred format. This statement is effective for fiscal
years beginning after December 15, 1997.

In June 1997, the FASB issued SFAS No. 131, "Disclosures about Segments of
an Enterprise and Related Information." SFAS No. 131 establishes standards for
the way public business enterprises report information about operating segments
in annual financial statements and requires those enterprises to report selected
information about operating segments in interim financial reports issued to
stockholders. SFAS No. 131 is effective for financial statements for periods
beginning after December 31, 1997. The Company has not yet determined whether it
has any separately reportable business segments.

In June 1998, the FASB issued SFAS No. 133, "Accounting for Derivative
Instruments and Hedging Activities." SFAS No. 133 addresses the accounting for
derivative instruments, including certain derivative instruments embedded in
other contracts. Under SFAS No. 133, entities are required to carry all
derivative instruments in the balance sheet at fair value. The accounting for
changes in the fair value of a derivative instrument depends on whether it has
been designated and qualifies as part of a hedging relationship and, if so,
39
<PAGE> 40
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

the reason for holding it. The Company must adopt SFAS No. 133 by October 1,
1999. The Company does not anticipate that SFAS No. 133 will have an effect on
its financial statements.

In March 1998, the American Institute of Certified Public Accountants
issued Statement of Position No. 98-1, Accounting for the Costs of Computer
Software Developed or Obtained for Internal Use ("SOP 98-1"). This SOP applies
to software that is acquired or developed solely for an entity's internal use
and requires the capitalization of qualifying costs in software application
development activities, which include design, coding, installation hardware and
testing. Capitalization of qualifying costs incurred in development stage
activities begins when the entity has committed to fund a particular internal
computer software project and the entity considers it probable that the
committed software will be used to perform the intended function, provided that
the entity has completed the preliminary project stage activities. Preliminary
project stage activities include the conceptual formulation and evaluation of
alternatives and the determination of the existence of needed technology.
Qualifying capitalizable computer software costs include the external direct
costs of materials and services and the payroll related costs of employees who
are directly involved with the internal project. All other costs related to the
project are expensed as incurred.

SOP 98-1 will be effective for internal use computer software costs
incurred in future years commencing with the Company's fiscal year beginning
October 1, 1999. The Company has followed an accounting policy of expensing as
incurred all costs related to software developed for internal use and intends to
continue this policy until the effective date of SOP 98-1. The Company has not
yet determined whether the adoption of SOP 98-1 will have a material effect on
the Company's financial position or results of operations.

NOTE 2. DISCONTINUED OPERATIONS

In July 1997, the Company adopted a formal plan to discontinue its Systems
Integration division based in England. In September 1997, the Company sold the
division for approximately $400,000 in cash, net of fees. The disposition of the
division has been accounted for as a discontinued operation in accordance with
APB Opinion No. 30 and prior period consolidated financial statements have been
restated to reflect the discontinuation of the Systems Integration business.
Revenue from discontinued operations was $15.7 million and $14.0 million,
respectively in fiscal 1997 and 1996. The income (loss) from discontinued
operations of ($104,000) and $569,000 in fiscal 1997 and 1996, respectively,
represents the operation's operating income. The gain on disposal of
discontinued operations of $1.2 million in fiscal 1997 represents the gain on
disposal of the operation including net income from operations of $256,000 from
the measurement date to the disposal date.

In accordance with the agreement for the sale of the Systems Integration
division, the Company was released from all obligations to perform any services
except as explicitly specified by the contract.

40
<PAGE> 41
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 3. BALANCE SHEET COMPONENTS

<TABLE>
<CAPTION>
AS OF SEPTEMBER 30,
--------------------
1998 1997
-------- --------
<S> <C> <C>
Property and equipment (In thousands):
Computer equipment........................................ $ 4,450 $ 2,819
Furniture and fixtures.................................... 1,096 959
Leasehold improvements.................................... 138 115
Other..................................................... 350 482
------- -------
6,034 4,375
Accumulated depreciation.................................. (3,066) (1,925)
------- -------
$ 2,968 $ 2,450
======= =======
Accrued expenses (In thousands):
Payroll and commission related............................ $ 1,693 $ 996
Other..................................................... 1,634 2,137
------- -------
$ 3,327 $ 3,133
======= =======
</TABLE>

NOTE 4. RELATED PARTY TRANSACTIONS

In July 1997, the Company repurchased, from a stockholder who was an
officer and a director, 120,000 shares of common stock at $2.50 per share for a
total price of $300,000.

In November 1997, the Company repurchased, from a stockholder who was an
officer and a director, 777,605 shares of common stock at $6.43 per share for a
total price of $5.0 million. The stockholder used a portion of the proceeds to
repay an interest-free loan from the Company.

NOTE 5. REDEEMABLE CONVERTIBLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY
(DEFICIT)

Redeemable Convertible Preferred Stock

Redeemable convertible preferred stock as of September 30, 1997, was
comprised of the following:

<TABLE>
<CAPTION>
SHARES ISSUED
AND OUTSTANDING CARRYING VALUE
--------------- --------------
<S> <C> <C>
Series A......................................... -- $ 1,468,000
Series B......................................... 2,000,000 5,333,000
Series C......................................... 2,488,336 16,064,000
--------- -----------
4,488,336 $22,865,000
========= ===========
</TABLE>

Holders of Series A, B and C preferred stock were permitted to convert all
or part of their shares at any time after the date of issuance into such number
of common stock as is determined by dividing $2.00, $2.50 and $6.43,
respectively, by the conversion price in effect at the time. Conversion was
automatic upon the closing of an Initial Public Offering ("IPO") of the
Company's common stock, with respect to Series A and B, at a price of not less
than $6.86 per share and with aggregate proceeds of not less than $10 million
and with respect to Series C, at a price not less than $9.65 per share if such
public offering occurred on or before September 8, 1998, and $12.86 per share
thereafter, and with aggregate proceeds of not less than $10 million or by
written consent or agreement of the holders of two-thirds of the outstanding
shares of Series A, B and C voting together as a single class.

The holders of the Series A, B and C preferred stock were entitled to
receive non-cumulative dividends of $0.20, $0.25, and $0.643 per share per
annum, respectively, when, and if, declared by the Board of Directors.

Upon the occurrence of a liquidation event, such as a dissolution of the
Company or a merger or sale of assets, the holders of Series A, B and C
preferred stock were entitled to receive in preference to holders of
41
<PAGE> 42
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

common stock an amount equal to the original issuance price and an amount equal
to declared but unpaid dividends and, thereafter, share any remaining proceeds
on a pro rata basis with the holders of common stock based on the number of
shares of common stock held by each, assuming full conversion of Series A, B and
C preferred stock.

The Company was required to redeem the Series A, B and C preferred stock at
the option of the holders of preferred stock after March 6, 2002, subject to
reasonable financial stability considerations, payable quarterly thereafter
until satisfied. The holders of preferred stock were entitled to a redemption
price per share equal to the original issuance price, plus an annually
compounded 15% cumulative rate of return thereon. The Company accrued the 15%
rate of return to the redemption date. The amount accrued as of September 30,
1997, is included in the carrying value of the redeemable convertible preferred
stock.

A $3.0 million line of credit was made available to the Company in March
1997. Interest under the line of credit was at no more than prime plus 2% and
funds drawn were to be used to finance an acquisition or other vehicle of growth
as approved by the Board of Directors. The $3.0 million line of credit was
available as of September 30, 1997. If exercised, the line of credit became due
and payable upon the earliest of a qualified public offering, a qualified
acquisition, or expiration of the Series A warrant issued in conjunction with
the line of credit. During fiscal 1997, the Company drew down $1.0 million,
which was repaid as of September 30, 1997. The warrant expired on the earlier of
March 2002, or the closing date of a public offering, merger, or acquisition of
the Company. The warrant issued in conjunction with the line of credit allowed
the holder to purchase 1.5 million shares of the Series A preferred stock at an
exercise price of $2.00 per share. The warrant was initially recorded at fair
value of $1.4 million, which was included in the carrying value of the Series A
preferred stock and treated as a debt issuance cost. This cost was amortized to
interest expense over the period from the date of issuance to the anticipated
date of the initial public offering, which resulted in a non-cash interest
charge of $300,000 and $1.1 million in fiscal 1998 and 1997, respectively. Under
the terms of the initial public offering, all the outstanding shares of Series B
and Series C preferred stock were converted into 2.0 million shares and 2.4
million shares of common stock, respectively, upon the closing of the IPO. In
addition, a warrant to purchase Series A preferred stock was converted into 1.5
million shares of common stock.

Common Stock

In March 1997, approximately 450,000 shares of common stock were issued to
stockholders as bonuses. The Company recorded compensation expense of
approximately $1.1 million for the fair market value of such shares. During
fiscal 1997, the principal stockholders transferred shares of common stock to
certain employees. The Company recorded compensation expense of $210,000 for the
difference between the fair market value and the transfer price of the common
stock.

In February 1998, the Company raised $34.2 million of net proceeds from the
sale of 3.2 million shares of the Company's common stock pursuant to its IPO.

In July 1998, the Company raised $22.9 million of net proceeds from the
sale of 1.0 million shares of the Company's common stock pursuant to a follow-on
public offering.

Treasury Stock

In July 1997, the Company repurchased, from a stockholder who is an officer
and a director, 120,000 shares of common stock at $2.50 per share for a total
price of $300,000.

In November 1997, the Company repurchased, from a stockholder who is an
officer and a director, 777,605 shares of common stock at $6.43 per share for a
total price of $5.0 million. The stockholder used a portion of the proceeds to
repay an interest-free loan from the Company.

42
<PAGE> 43
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

Stock Option Plan

Under the Company's 1997 Stock Option/Stock Issuance Plan (the "Plan"),
options to purchase up to an aggregate of approximately 2.5 million shares of
common stock may be granted to employees, officers, directors and consultants.
Because the warrant to purchase 1.5 million shares of Series A was exercised
upon the IPO, options to purchase an additional 166,666 shares of common stock
were reserved under the Plan. The Plan provides for the issuance of incentive
and non-statutory options that must be granted at an exercise price not less
than 100% and 85% of the fair market value of the common stock on the date of
grant, respectively (110% if the person to whom the option is granted is a 10%
stockholder). Incentive options may only be granted to employees. Options
generally vest over four years from the date of grant. The options expire
between five and ten years from the grant date, and any vested options must
normally be exercised within three months after termination of employment. The
Plan is administered by the Company's Board of Directors.

A summary of the status of the Company's options under the plan is as
follows:

<TABLE>
<CAPTION>
OUTSTANDING OPTIONS
-------------------------------------------
WEIGHTED- WEIGHTED-
NUMBER OF AVERAGE AVERAGE FAIR
SHARES EXERCISE PRICE VALUE
--------- -------------- ------------
<S> <C> <C> <C>
Balance as of September 30, 1995................. 476,083 $ 2.41 $ --
Granted at greater than market value............. 212,266 3.21 0.10
Granted at market value.......................... 70,765 2.31 0.36
Granted at less than market value................ 133,915 1.06 1.43
Canceled......................................... (317,650) 2.31 --
--------- ------ -----
Balance as of September 30, 1996................. 575,379 2.43 --
Granted at greater than market value............. 269,992 2.50 1.25
Granted at market value.......................... 640,856 2.55 0.43
Exercised........................................ (36,320) 3.50 --
Canceled......................................... (137,821) 3.31 --
--------- ------ -----
Balance as of September 30, 1997................. 1,312,086 2.38 --
Granted at market value.......................... 465,924 10.86 6.76
Exercised........................................ (119,324) 2.06 --
Canceled......................................... (178,295) 4.88 --
--------- ------ -----
Balance as of September 30, 1998................. 1,480,391 $ 4.78 $ --
========= ====== =====
</TABLE>

As of September 30, 1998 and 1997, 502,094 and 267,687 shares, with
weighted-average exercise prices of $2.46 and $1.97, were fully vested and
exercisable, respectively. As of September 30, 1998, 876,965 shares were
available for grant. The following table summarizes information concerning
outstanding and exercisable options under the plan outstanding as of September
30, 1998:

<TABLE>
<CAPTION>
OUTSTANDING
-------------------------------------- EXERCISABLE
WEIGHTED- WEIGHTED- --------------------------
RANGE OF AVERAGE AVERAGE WEIGHTED-
EXERCISE NUMBER OF REMAINING LIFE EXERCISE NUMBER AVERAGE
PRICES SHARES (IN YEARS) PRICE OF SHARES EXERCISE PRICE
-------- --------- -------------- --------- --------- --------------
<S> <C> <C> <C> <C> <C>
$0.03 - $ 2.50 995,240 6.63 $ 2.29 421,656 $ 2.03
$3.64 - $ 8.00 400,551 7.13 7.27 79,438 4.44
$8.50 - $41.13 84,600 8.99 22.24 1,000 22.50
--------- -------
1,480,391 6.90 $ 4.78 502,094 $ 2.46
========= =======
</TABLE>

The Company uses the intrinsic value-based method to account for all of its
employee stock-based compensation plans. Accordingly, no compensation cost has
been recognized for its stock options in the

43
<PAGE> 44
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

accompanying consolidated financial statements because the fair value of the
underlying common stock equals or exceeds the exercise price of the stock
options at the date of grant, except with respect to certain options issued in
1996 and during fiscal 1997. The Company has recorded deferred stock
compensation expense of $167,000 and $229,000 for the difference at the grant
date between the exercise price and the fair value of the common stock
underlying the options issued in September 1996 and fiscal 1997, respectively.
The $167,000 was amortized in fiscal 1996 as the options were fully vested upon
issuance and $14,000 and $56,000 of the $229,000 was amortized in fiscal 1997
and 1998, respectively, as the options vest over four years.

Had compensation cost for the Company's stock options been determined in a
manner consistent with SFAS No. 123, Accounting for Stock-Based Compensation,
the Company's net loss would have increased by approximately $733,000 and
$47,000 for fiscal 1998 and 1997, and the loss per share would have been $0.25
and $1.36 for fiscal 1998 and 1997, respectively.

The per share weighted-average fair value of stock options granted during
1998 and 1997 was $6.76 and $0.67, on the date of grant using the Black-Scholes
pricing model and minimum value method, respectively, with the following
weighted assumptions: 1998 -- expected dividend yield of 0.0%, risk-free
interest rate of 5.6%, expected volatility of 80%, expected forfeiture rate of
25% and expected life of four years; 1997 -- expected dividend yield of 0.0%,
risk-free interest rate of 6.28%, and expected life of three years.

The per share weighted-average fair value of Employee Stock Purchase Plan
shares granted during fiscal 1998 was $4.88, calculated using the Black-Scholes
pricing model with the following weighted assumptions used are: expected
dividend yield of 0.0%, risk-free interest rate of 5.2%, expected volatility of
80%, and expected life of 0.5 years.

In July 1997, 120,000 shares were issued to two directors at $2.50 per
share, under the Plan. The Company has recorded stock compensation expense of
$120,000, for the difference between the issuance price and the fair market
value of the common stock.

1998 Employee Stock Purchase Plan

In January 1998, the Board of Directors adopted the Company's 1998 Employee
Stock Purchase Plan (the "ESPP") to provide employees of the Company with an
opportunity to purchase common stock through payroll deductions. Under the ESPP
300,000 shares of common stock have been reserved for issuance. The ESPP became
effective at the time of the IPO. All full-time regular employees who are
employed by the Company are eligible to participate in the ESPP after completing
a three-month waiting period.

Eligible employees may contribute up to 15% of their total cash
compensation to the ESPP. Amounts withheld are applied at the end of every
six-month accumulation period to purchase shares of common stock, but not more
than 1,250 shares per accumulation period. The value of the common stock
(determined as of the beginning of the offering period) that may be purchased by
any participant in a calendar year is limited to $25,000. Participants may
withdraw their contributions at any time before stock is purchased.

The purchase price is equal to 85% of the lower of (a) the market price of
common stock immediately before the beginning of the applicable offering period
or (b) the market price of common stock at the time of the purchase. In general,
each offering period is 24 months long, but a new offering period begins every
six months. Thus, up to four overlapping offering periods may be in effect at
the same time. An offering period continues to apply to a participant for the
full 24 months, unless the market price of common stock is lower when a
subsequent offering period begins. In that event, the subsequent offering period
automatically becomes the applicable period for purposes of determining the
purchase price. The first accumulation and offering periods commenced on
February 13, 1998, the effective date of the IPO. The first accumulation period
ended on July 31, 1998, and the first offering period will end on January 31,
2000. A total of 61,596 shares of the Company's common stock were issued under
the ESPP in fiscal 1998 at a price of $10.20 per share.

44
<PAGE> 45
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 6. INCOME TAXES

The provision for income taxes was as follows (in thousands):

<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
--------------------------
1998 1997 1996
------ ------ ------
<S> <C> <C> <C>
Current:
Federal................................................... $ 83 $ -- $ 85
State..................................................... 67 -- 15
---- ---- ----
Foreign................................................... -- -- --
---- ---- ----
Total Current..................................... $150 $ -- $100
==== ==== ====
</TABLE>

As of September 30, 1998, the Company had approximately $3.0 million and
$1.3 million of net operating loss carry-forwards for federal and state
purposes, respectively. The federal net operating loss carry-forwards expire
between 2013 and 2018. The state net operating loss carry-forwards expire
primarily in 2003. The difference between the federal and state net operating
loss carry-forwards is due primarily to a 50% limitation on net operating loss
carry-forwards for California purposes. As of September 30, 1998, the Company
also had approximately $3.7 million and $534,000 of loss carry-forwards in
England and Australia, respectively. The loss carry-forwards of the English
company can be carried forward indefinitely. The Australian loss carry-forwards
can also be carried forward indefinitely, subject to certain restrictions.

The tax effects of temporary differences that give rise to significant
portions of deferred tax assets are presented below (in thousands):

<TABLE>
<CAPTION>
AS OF SEPTEMBER 30,
--------------------
1998 1997
-------- --------
<S> <C> <C>
Various accruals and reserves not deductible for tax
purposes.................................................. $ 521 $ 498
Net operating loss carry-forwards........................... 2,448 1,525
Property and equipment...................................... 109 124
Other....................................................... 177 25
AMT credit carry-forwards................................... 58 --
------- -------
Total deferred tax assets......................... 3,313 2,172
Valuation allowance......................................... (3,313) (2,172)
------- -------
Net deferred tax assets........................... $ -- $ --
======= =======
</TABLE>

Income (loss) before income taxes is comprised as follows (in thousands):

<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
-----------------------------
1998 1997 1996
------- ------- -------
<S> <C> <C> <C>
United States......................................... $ 517 $(4,931) $ 725
International......................................... (1,355) (4,002) (1,530)
------- ------- -------
Total....................................... $ (838) $(8,933) $ (805)
======= ======= =======
</TABLE>

Federal and state tax laws impose substantial restrictions on the
utilization of net operating loss carry-forwards in the event of an "ownership
change," as defined in Section 382 of the Internal Revenue Code. The Company has
not yet determined whether an ownership change occurred due to significant stock
transactions in each of the reporting years disclosed. If an ownership change
has occurred, utilization of the net operating loss carry-forwards could be
significantly reduced. Additionally, loss carry-forwards of either Micromuse
Inc. or Micromuse USA Inc. cannot be utilized against future profits generated
by the other company.

45
<PAGE> 46
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

Total income tax expense from continuing operations differs from expected
income tax expense (computed by applying the U.S. federal corporate income tax
rate of 34% to profit (loss) before taxes), as follows (in thousands):

<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
-------------------------
1998 1997 1996
----- ------- -----
<S> <C> <C> <C>
Income tax expense (benefit) at federal statutory rate... $(234) $(2,532) $(240)
State income taxes, net of federal income tax benefit.... 44 -- 10
Permanent differences.................................... 56 -- --
Unutilized losses........................................ 284 2,514 345
Change in beginning of year valuation allowance.......... -- -- (16)
Other.................................................... -- 18 1
----- ------- -----
$ 150 $ -- $ 100
===== ======= =====
</TABLE>

NOTE 7. DEFINED CONTRIBUTION PLAN

In February 1998, the Company adopted a defined contribution plan (the
"Plan") in the United States pursuant to Section 401(k) of the Internal Revenue
Code (the "Code"). All eligible full and part-time employees of the Company who
meet certain age requirements may participate in the Plan. Participants may
contribute up to 20% of their pre-tax compensation, but not in excess of the
maximum allowable under the Code. The Plan allows for discretionary
contributions by the Company. Such matching contributions vest based on the
participant's length of service. In addition, the Company may make
profit-sharing contributions at the discretion of the Board of Directors. The
Company made no contributions during fiscal 1998.

NOTE 8. GEOGRAPHIC INFORMATION

The Company markets its products primarily from its operations in the
United States. International sales are primarily to customers in France, Germany
and the United Kingdom. Information regarding operations in different geographic
regions is as follows (in thousands):

<TABLE>
<CAPTION>
YEAR ENDED SEPTEMBER 30,
-----------------------------
1998 1997 1996
------- ------- -------
<S> <C> <C> <C>
Revenues:
United States..................................... $17,242 $ 4,810 $ 2,030
International..................................... 11,019 4,482 2,485
------- ------- -------
Total..................................... $28,261 $ 9,292 $ 4,515
======= ======= =======
Income (loss) from continuing operations:
United States..................................... $ 517 $(4,931) $ 725
International..................................... (1,355) (4,002) (1,530)
------- ------- -------
Total..................................... $ (838) $(8,933) $ (805)
======= ======= =======
</TABLE>

<TABLE>
<CAPTION>
AS OF SEPTEMBER 30,
-----------------------------
1998 1997 1996
------- ------- -------
<S> <C> <C> <C>
Identifiable assets:
United States..................................... $71,377 $15,398 $ 1,467
International..................................... 9,267 7,342 1,540
Assets related to discontinued operations......... -- -- 6,100
------- ------- -------
Total..................................... $80,644 $22,740 $ 9,107
======= ======= =======
</TABLE>

Intercompany transfers between geographic areas are accounted for using the
transfer prices in effect for subsidiaries.

46
<PAGE> 47
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS (CONTINUED)

NOTE 9. MAJOR CUSTOMERS

A summary of the net revenues from major customers that exceed 10% of total
revenues during each of the years in the three-year period ended September 30,
1998, and the amount due from these customers as of September 30, 1998, follows:

<TABLE>
<CAPTION>
ACCOUNTS
1998 1997 1996 RECEIVABLE
---- ---- ---- ----------
<S> <C> <C> <C> <C>
Customer 1........................................... 10% 18% -- $815,468
Customer 2........................................... 9% 9% 14% 285,184
</TABLE>

NOTE 10. COMMITMENTS

The Company leases its facilities and certain equipment under
non-cancelable operating leases. The lease agreements expire at various dates
during the next 10 years.

Rent expense was approximately $907,925, $538,000 and $215,000 for the
years ended September 30, 1998, 1997 and 1996, respectively. Future minimum
lease payments under non-cancelable operating leases will be approximately $1.6
million, $1.3 million, $1.1 million, $715,338, $496,934 and $1.2 million for
each of the years in the five-year period and thereafter, respectively.

NOTE 11. SUBSEQUENT EVENTS

In October 1998, the Board of Directors authorized the repurchase of up to
1.5 million shares, or approximately 9% percent of the Company's outstanding
common stock. The repurchased shares will be held as treasury stock and will be
available for general corporate purposes. As of November 30, 1998, the Company
had repurchased 500,000 shares of its outstanding common stock pursuant to the
repurchase program.

47
<PAGE> 48

INDEPENDENT AUDITORS' REPORT

The Board of Directors
Micromuse Inc.

We have audited the accompanying consolidated balance sheets of Micromuse
Inc. and subsidiaries as of September 30, 1998 and 1997, and the related
consolidated statements of operations, stockholders' equity (deficit), and cash
flows for each of the years in the three-year period ended September 30, 1998.
These consolidated financial statements are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits.

We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above
present fairly, in all material respects, the financial position of Micromuse
Inc. and subsidiaries as of September 30, 1998 and 1997, and the results of
their operations and their cash flows for each of the years in the three-year
period ended September 30, 1998, in conformity with generally accepted
accounting principles.

KPMG Peat Marwick LLP
Mountain View, California
October 27, 1998

48
<PAGE> 49

ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURES

None.

PART III

ITEM 10. DIRECTORS AND EXECUTIVE OFFICERS OF THE REGISTRANT

The following table provides certain information regarding the executive
officers of the Company as of September 30, 1998:

<TABLE>
<CAPTION>
NAME AGE POSITION
---- --- --------
<S> <C> <C>
Christopher J. Dawes........... 38 President, Chief Executive Officer and
Chairman of the Board of Directors
Stephen A. Allott.............. 40 Chief Financial Officer
David N. Dorrance.............. 37 Senior Vice President, Sales
Peter Shearan.................. 34 Senior Vice President, Technical Services
Timothy J. Tokarsky............ 34 Vice President, Business Development
Mark J. Peach.................. 39 Vice President, Core Technology
Helen M. Fairclough............ 36 Vice President, Operations
</TABLE>

Christopher J. Dawes served as President and Chief Executive Officer since
the Company's inception through October 1998. Mr. Dawes also served as the
Company's Chairman of the Board of Directors since its inception through
November 1998. Mr. Dawes has also been a director of Micromuse plc, a subsidiary
of the Company ("Micromuse plc") since its inception. Prior to co-founding the
Company, Mr. Dawes served as Sales Manager at Computer Associates International,
Inc. ("Computer Associates") from June 1988 to September 1989. Mr. Dawes is a
graduate of Electrical and Electronic Engineering from the University of
Adelaide, South Australia.

Stephen A. Allott was appointed the Company's President and Director in
October 1998. Mr. Allott served as Chief Financial Officer since July 1998. Mr.
Allott served as the Company's Senior Vice President, Finance from September
1997 to July 1998. From June 1997 to September 1997, Mr. Allott served as Vice
President, Global Telco Industry. From April 1996 to September 1997, Mr. Allott
served as Managing Director, Micromuse Europe. From September 1995 to April 1996
he served as the Company's Business Development Director. Mr. Allott has also
been a director of Micromuse plc since March 1996. Prior to joining the Company,
Mr. Allott served as a strategy consultant with McKinsey & Company from
September 1990 to September 1995. From May 1988 to September 1990, Mr. Allott
served as United Kingdom legal counsel for Sun Microsystems, UK. Mr. Allott
received his M.A., Law from Trinity College, Cambridge and was called to the
English Bar at Gray's Inn.

David N. Dorrance has served as the Company's Senior Vice President, Sales
since June 1997. Prior to joining the Company, Mr. Dorrance served as Head of
United Kingdom Oracle Applications Group for Deloitte & Touche Consulting Group
from March 1996 to June 1997. From September 1993 to May 1995, Mr. Dorrance
served as a sales manager at Sybase, Inc. ("Sybase"). From November 1989 to
September 1993, Mr. Dorrance served as Director N.A. Sales and as a director of
SQL Solutions following its acquisition by Sybase. Mr. Dorrance received his
B.S. in Computer Science from the University of California at Santa Barbara and
an M.S. in Economics from the University of Oxford.

Peter Shearan has served as the Company's Senior Vice President, Technical
Services since April 1998. From February 1996 to March 1998, Mr. Shearan served
as the Company's Vice President, Technical Services. From November 1995 to
February 1996, Mr. Shearan served as Senior Consultant in the Company's Netcool
Business Development department. Prior to joining the Company, Mr. Shearan
served as a systems manager for British Telecommunications from June 1984 to
November 1995. Mr. Shearan received his Qualifications in Computer Science from
Southbank University, London.

49
<PAGE> 50

Timothy J. Tokarsky has served as the Company's Vice President, Application
Development since February 1997. Prior to joining the Company, Mr. Tokarsky
served as Vice President Distributed Systems Management for Merrill Lynch & Co.,
Inc. from June 1995 to February 1997. From January 1994 to June 1995, Mr.
Tokarsky served as Architect, Global Distributed Systems Monitoring for Goldman
Sachs & Co. From May 1993 to January 1994, Mr. Tokarsky served as a system
administrator for Standard and Poor's Rating Services. From October 1992 to May
1993, Mr. Tokarsky served as a system administrator for First Boston Corp. Mr.
Tokarsky received his B.Sc. in Geophysics from McGill University.

Mark J. Peach has served as the Company's Vice President, Core Technology
since December 1996. From June 1994 to December 1996, Mr. Peach served as an
original architect and developer of Netcool/ OMNIbus. Prior to joining the
Company, Mr. Peach served as Principal PreSales Engineer for Sun Microsystems,
Inc. and SunConnect from December 1989 to May 1994. Mr. Peach received his B.Sc.
in Mathematical Engineering from Loughborough University.

Helen M. Fairclough has served as the Company's Vice President, Operations
since November 1995. From June 1994 to November 1995, Ms. Fairclough served as
the Company's Manager, Operations. Prior to joining the Company, Ms. Fairclough
served as Business Operations Manager for Cap Gemini, PLC from October 1991 to
June 1994. Ms. Fairclough received her B.Sc. in Resource Sciences/Geology from
Kingston University and is a Member of The Chartered Institute of Secretaries
and Administrators.

The information regarding Directors who are nominated for re-election
required by Item 10 is incorporated herein by reference from the section
entitled "Proposal No. 1 -- Election of Directors" of the Proxy Statement.

ITEM 11. EXECUTIVE COMPENSATION

The information required by Item 11 is incorporated herein by reference
from the section entitled "Executive Compensation" of the Proxy Statement.

ITEM 12. SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT

The information required by Item 12 is incorporated herein by reference
from the section entitled "Security Ownership of Certain Beneficial Owners and
Management" of the Proxy Statement.

ITEM 13. CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS

The information required by Item 13 is incorporated herein by reference
from the section entitled "Certain Relationships and Related Transactions" of
the Proxy Statement.

PART IV

ITEM 14. EXHIBITS, FINANCIAL STATEMENTS SCHEDULE, AND REPORTS ON FORM 8-K

(a)(1) FINANCIAL STATEMENTS

See the Consolidated Statements beginning on page 33 of this Form 10-K.

(2) FINANCIAL STATEMENT SCHEDULE

See the Financial Statement Schedule at page 52 of this Form 10-K.

(3) EXHIBITS

See Exhibit Index at page 53 of this Form 10-K.

(b) Current report on Form 8-K dated December 3, 1998.

(d) See the Consolidated Financial Statements beginning on page 33 and Financial
Statement Schedule at page 52 of this Form 10-K.

50
<PAGE> 51

SIGNATURES

Pursuant to the requirements of the Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed on
its behalf by the undersigned, thereunto duly authorized.

MICROMUSE INC.

By: /s/ STEPHEN A. ALLOTT
------------------------------------
Stephen A. Allott
Director, President and Chief
Financial Officer
(Principal Executive and Financial
Officer)
Date: December 29, 1998

Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons, on behalf of the
Registrant in the capacities indicated:

<TABLE>
<CAPTION>
NAME TITLE DATE
---- ----- ----
<S> <C> <C>

/s/ STEPHEN A. ALLOTT Director, President and December 29, 1998
- ----------------------------------------------------- Chief Financial Officer
(Stephen A. Allott) (Principal Executive and
Financial Officer)

/s/ ANGELA DAWES Director December 29, 1998
- -----------------------------------------------------
(Angela Dawes)

/s/ MICHAEL E.W. JACKSON Director December 29, 1998
- -----------------------------------------------------
(Michael E.W. Jackson)

/s/ DAVID C. SCHWAB Director December 29, 1998
- -----------------------------------------------------
(David C. Schwab)
</TABLE>

51
<PAGE> 52

SCHEDULE II

VALUATION AND QUALIFYING ACCOUNTS
YEAR ENDED SEPTEMBER 30, 1998, 1997 AND 1996
(IN THOUSANDS)

<TABLE>
<CAPTION>
BALANCE AT CHARGED TO BALANCE AT
BEGINNING COSTS AND END OF
DESCRIPTION OF PERIOD EXPENSES DEDUCTIONS PERIOD
----------- ---------- ---------- ---------- ----------
<S> <C> <C> <C> <C>
Year Ended September 30, 1998
Allowance for doubtful accounts and returns... $ -- $178 $(25) $153
Year Ended September 30, 1997
Allowance for doubtful accounts and returns... -- -- -- --
Year Ended September 30, 1996
Allowance for doubtful accounts and returns... -- -- -- --
</TABLE>
<PAGE> 53

EXHIBIT INDEX

<TABLE>
<CAPTION>
EXHIBIT
NUMBER DESCRIPTION
- ------- -----------
<C> <S>
2.1+ Agreement for the sale of the systems integration business
of Micromuse plc by and among Micromuse plc, Horizon Open
Systems (UK) Limited and Horizon Computer Services Limited,
dated as of September 16, 1997.
3.1++ Restated Certificate of Incorporation of the Registrant, as
amended to date.
3.2++ Amended and Restated Bylaws of the Registrant.
4.1++ Reference is made to Exhibits 3.1, 3.2 and 10.4.
4.2+ Specimen Common Stock certificate.
10.1+ Form of Indemnity Agreement entered into between the
Registrant and its directors and officers.
10.2+ 1997 Stock Option/Stock Issuance Plan and forms of
agreements thereunder.
10.3+ 1997 Employee Stock Purchase Plan.
10.4+ Amended and Restated Investors' Rights Agreement by and
among the Registrant and certain stockholders of the
Registrant, dated as of September 8, 1997.
10.5+ Office lease dated as of March 25, 1997, by and between the
Registrant and SOMA Partners, L.P.
10.6+ Office lease dated as of March 3, 1997, by and between
Micromuse plc, Marldown Limited and Christopher J. Dawes.
10.7+ Office lease dated as of March 3, 1993, by and between
Micromuse plc, Guildquote Limited and Christopher J. Dawes.
10.8+ Agreement for the sale of the systems integration business
of Micromuse plc dated as of September 16, 1997. Reference
is made to Exhibit 2.1.
21.1+ Subsidiaries of the Registrant.
23.1 Report on Schedule and Consent of Independent Auditors
27.1 Financial Data Schedule
</TABLE>

- ---------------
+ Incorporated by reference from the exhibit of the same number in the
Registrant's Registration Statement on Form S-1 (Registration No. 333-42177)
as filed with the SEC on February 12, 1998.

++ Incorporated by reference from the exhibit of the same number in the
Registrant's Registration Statement on Form S-1 (Registration No. 333-58975)
as filed with the SEC on July 28, 1998.

<PAGE> 1

EXHIBIT 23.1

REPORT ON SCHEDULE AND CONSENT OF INDEPENDENT AUDITORS

The Board of Directors
Micromuse Inc. and subsidiaries:

The audits referred to in our report dated October 27, 1998, included the
related financial statement schedule as of September 30, 1998, and for each of
the years in the three-year period ended September 30, 1998, included in the
annual report on Form 10-K of Micromuse Inc. This financial statement schedule
is the responsibility of the Company's management. Our responsibility is to
express an opinion on this financial statement schedule based on our audits. In
our opinion, such financial statement schedule, when considered in relation to
the basic consolidated financial statements taken as a whole, presents fairly in
all material respects the information set forth therein.

We consent to incorporation by reference in the registration statement No.
333-46649 on Form S-8 of Micromuse Inc. and subsidiaries of our report dated
October 27, 1998, relating to the consolidated balance sheets of Micromuse Inc.
and subsidiaries as of September 30, 1998 and 1997, and the related consolidated
statements of operations, stockholders' equity (deficit) and cash flows for each
of the years in the three-year period ended September 30, 1998, and related
schedule, which reports appear in the September 30, 1998, annual report on Form
10-K of Micromuse Inc.

KPMG Peat Marwick LLP
Mountain View, California
December 28, 1998

<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
CONSOLIDATED BALANCE SHEETS AND THE CONSOLIDATED STATEMENTS OF OPERATIONS FOUND
ON PAGES 35 AND 36 OF THIS FORM 10-K AND IS QUALIFIED IN ITS ENTIRETY BY
REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000

<S> <C>
<PERIOD-TYPE> 12-MOS
<FISCAL-YEAR-END> SEP-30-1998
<PERIOD-START> OCT-01-1997
<PERIOD-END> SEP-30-1998
<CASH> 22,798
<SECURITIES> 47,009
<RECEIVABLES> 6,648
<ALLOWANCES> 153
<INVENTORY> 0
<CURRENT-ASSETS> 71,119
<PP&E> 6,034
<DEPRECIATION> 3,066
<TOTAL-ASSETS> 80,644
<CURRENT-LIABILITIES> 12,926
<BONDS> 0
0
0
<COMMON> 79,319
<OTHER-SE> (11,600)
<TOTAL-LIABILITY-AND-EQUITY> 80,644
<SALES> 22,432
<TOTAL-REVENUES> 28,261
<CGS> 1,320
<TOTAL-COSTS> 30,577
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 178
<INTEREST-EXPENSE> 312
<INCOME-PRETAX> (688)
<INCOME-TAX> 150
<INCOME-CONTINUING> (838)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (2,172)
<EPS-PRIMARY> (0.18)
<EPS-DILUTED> (0.18)

</TABLE>