VITRIA TECHNOLOGY INC - 10-Q Quarterly Report

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

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

The number of shares of Vitria’s common stock, $0.001 par value, outstanding as of April 30, 2003 was 130,456,928 shares.

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

The accompanying unaudited condensed consolidated financial statements have been prepared in accordance with generally accepted accounting principles for interim consolidated financial information and with the instructions for Form 10-Q and Article 10 of Regulation S-X. In the opinion of the management of Vitria Technology, Inc., these unaudited condensed consolidated financial statements include all adjustments, consisting only of normal recurring adjustments, which we consider necessary to fairly state Vitria’s financial position and the results of its operations and its cash flows. The balance sheet at December 31, 2002 has been derived from the audited consolidated financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. The accompanying condensed consolidated financial statements should be read in conjunction with the financial statements and notes thereto included in Vitria’s Annual Report on Form 10-K for the year ended December 31, 2002. The results of Vitria’s operations for any interim period are not necessarily indicative of the results of the operations for any other interim period or for a full fiscal year.

Certain prior period amounts have been reclassified to conform to the current period presentation. Such reclassifications did not change the previously reported operating loss or net loss amounts.

Vitria accounts for stock-based employee compensation arrangements using the intrinsic value method in accordance with the provisions of Accounting Principles Board Opinion No. 25 (APB 25), Accounting for Stock Issued to Employees, as amended by FASB Interpretation No. 44, Accounting for Certain Transactions Involving Stock Compensation, issued by the Financial Accounting Standards Board, and complies with the disclosure provisions of Statement of Financial Accounting Standards No. 123 (SFAS 123), Accounting for Stock-Based Compensation and SFAS No. 148, Accounting for Stock-based Compensation—Transition and Disclosure. Unearned compensation is amortized and expensed in accordance with Financial Accounting Standards Board Interpretation No. 28 using the multiple option approach.

Under APB 25 and related interpretations, unearned compensation is based on the difference, on the date of the grant, between the fair value of Vitria’s common stock and the exercise price. Under APB 25, no compensation expense is recognized in Vitria’s financial statements because the exercise price of Vitria’s employee stock options equals the market price of the underlying stock on the date of grant. Vitria has elected to follow APB 25 because the alternative fair value accounting provided for under SFAS 123 requires the use of option valuation models that were not developed for use in valuing employee stock options.

Pro forma information regarding net loss and net loss per share is required by SFAS 148. This information is required to be determined as if we had accounted for our employee stock options (including shares issued under our Employee Stock Purchase Plan, collectively called “stock based awards”), under the fair value method of that statement.

The fair value of our stock-based awards to employees in the table below was estimated using the Black-Scholes option-pricing model and the following weighted-average assumptions:

The Black-Scholes option-pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. Option valuation models require the input of highly subjective assumptions, including the expected volatility of the stock price. Because our stock based awards have characteristics significantly different from those of traded options and because changes in the subjective input assumptions can materially affect the fair value estimates, in the opinion of management, the existing models do not necessarily provide a reliable single measure of the fair value of our stock based awards.

The following table illustrates the effect on net loss and loss per share if we had applied the fair value recognition provisions of SFAS 123 to employee stock-based compensation, including shares issued under our stock option plans and Employee Stock Purchase Plan (collectively “options”). For purposes of pro forma disclosures, the estimated fair value of the options is assumed to be amortized to expense over the options’ vesting periods using the multiple option approach. Pro forma information follows (in thousands, except per share amounts):

During the three months ended March 31, 2003, stock-based compensation expense determined under the fair value based method resulted in a positive number in the above table or a reduction in expense. This is the result of adjustments to reverse previously recognized stock-based compensation expense on employee options forfeited prior to the employee earning the award. Forfeitures refer to awards that do not vest because service or employment requirements are not met. In accordance with SFAS 123, we based our initial estimate of stock-based compensation expense on the total number of options granted. Adjustments are made in the period of forfeiture to reverse previously recognized stock-based compensation expense associated with the unearned portion of a forfeited award.

Because the determination of fair value of all options granted prior to the time we became a public entity excludes volatility factors, the above results may not be representative of future periods.

Basic net loss per share is calculated by dividing net loss by the weighted-average number of shares of common stock outstanding. Basic net loss per share does not include shares subject to Vitria’s right of repurchase, which lapses ratably over the related vesting term. Diluted net loss per share is calculated by dividing net loss by the weighted-average number of shares of common stock outstanding plus shares of potential common stock. Shares of potential common stock are composed of shares of common stock subject to Vitria’s right of repurchase and shares of common stock issuable upon the exercise of stock options (using the treasury stock method). The calculation of diluted net loss per share excludes shares of potential common stock if their effect is anti-dilutive.

The following table sets forth the computation of basic and diluted net loss per share for the periods indicated (in thousands, except per share amounts):

The following table sets forth the weighted average potential shares of common stock that are not included in the diluted net loss per share calculation above because to do so would be anti-dilutive for the periods indicated (in thousands):

Comprehensive loss is comprised of net loss and other comprehensive income (loss) such as foreign currency translation gains (losses) and unrealized gains (losses) on available-for-sale marketable securities. Vitria’s total comprehensive loss was as follows (in thousands):

In accordance with Financial Accounting Standards No. 133 (SFAS No. 133), Accounting for Derivative Instruments and Hedging Activities, Vitria recognizes all of our derivative instruments as either assets or liabilities in the balance sheet at fair value. The accounting for changes in the fair value (i.e., unrealized gains or losses) of a derivative instrument depends on whether it has been designated and qualifies as part of a hedging relationship and on the type of hedging relationship. Derivatives that are not hedges must be adjusted to fair value through current earnings.

From time to time, we enter into foreign currency forward contracts to protect against a potential decline in value of assets and liabilities denominated in a currency other than the functional currency of Vitria or one of its subsidiaries. Gains and losses on these forward contracts as well as the offsetting losses and gains on the foreign denominated assets and liabilities are recognized in current earnings. There were no outstanding forward contracts at March 31, 2003.

In the year ended December 31, 2002 Vitria initiated actions to reduce our cost structure due to sustained negative economic conditions that have impacted our operations and resulted in lower than anticipated revenues. In April and August 2002 we reduced our workforce and consolidated our facilities. The restructuring actions in 2002 resulted in a reduction in workforce of approximately 285 employees or 33% of Vitria’s workforce measured as of the beginning of 2002 and affected all departments. Facilities in the United States and United Kingdom were consolidated and related leasehold improvement and equipment were written off. As a result of the restructuring actions, a charge of $19.5 million in the year ended December 31, 2002 was incurred. The restructuring charge included approximately $4.2 million of severance related charges and $15.4 million of committed excess facilities payments, which included $463,000 for the write-off of leasehold improvements and equipment in vacated buildings. As of March 31, 2003, $13.0 million of lease termination costs, net of anticipated sublease income, remains accrued from our 2002 restructuring actions and are expected to be fully utilized by fiscal 2013.

In the first quarter of 2003, we initiated actions to further reduce our cost structure. The plan was a combination of a reduction in workforce of approximately 100 employees, or 18% of the existing workforce, consolidations of facilities in the United States and United Kingdom and the associated disposal of leasehold improvements and equipment. The workforce reduction affected all functional areas and was largely completed in the quarter ended March 31, 2003. As a result of the restructuring plan, we incurred a charge of $14.0 million in the quarter ended March 31, 2003.

The 2003 restructuring charge included approximately $2.0 million of severance related charges, $9.8 million of committed excess facilities payments, and $2.2 million in write-offs of leasehold improvements and equipment. The severance related charges consist of one-time termination benefits recognized and measured at fair value at the date the plan was communicated to the employees. Most of the terminated employees had left Vitria by March 31, 2003 and the few remaining affected employees are expected to leave by May 31, 2003. The excess facilities payments were measured at fair value as of the cease-use date of the facilities using a discount rate of 6%. All excess facilities were vacated prior to March 31, 2003. The leasehold improvements and equipment write-offs, which were associated with vacating the excess facilities, were based on net book value as of the date of abandonment. As of March 31, 2003, $9.3 million of lease termination costs, net of anticipated sublease income, remains accrued from our restructuring actions in the first quarter of 2003 and are expected to be fully utilized by fiscal 2013.

The total accrued liability for lease termination costs of $22.4 million at March 31, 2003 is net of $10.7 million of estimated sublease income. A portion of this liability is based on the fair value treatment required by SFAS 146, which we adopted as of January 1, 2003 (see Note 7). Future minimum lease payments for vacated facilities totals $28.1 million at March 31, 2003.

The facilities consolidation charges for all of our restructuring actions were calculated using management’s best estimates and were based upon the remaining future lease commitments for vacated facilities from the date of facility consolidation, net of estimated future sublease income. We have engaged brokers to locate tenants to sublease all of the excess facilities but to date we have not signed any sublease agreements. The estimated costs of vacating these leased facilities were based on market information and trend analyses, including information obtained from third-party real estate sources. Our ability to generate our estimated sublease income is highly dependent upon the existing economic conditions, particularly lease market conditions in certain geographies, at the time we negotiate the sublease arrangements with third parties. While the amount we have accrued is our best estimate, these estimates are subject to change and may require routine adjustment as conditions change through the implementation period. If macroeconomic conditions related to the commercial real estate market continue to worsen, we may be required to increase our estimated cost to exit certain facilities.

As of March 31, 2003, $23.0 million of restructuring costs remained accrued for payment in future periods, as follows (in thousands):

At March 31, 2003, $7.9 million related to restructuring activities remained in current liabilities and $15.1 million remained in long-term liabilities. Cash payments totaling approximately $23.0 million, primarily consisting of lease payments, will be made through 2013. The accrued severance balance of $566,000 is expected to be paid out by June 30, 2003.

In June 2002, the Financial Accounting Standard Board, or the FASB, issued Statement of Financial Accounting Standards No. 146 (SFAS 146), Accounting for Costs Associated with Exit or Disposal Activities. SFAS 146 eliminates the Emerging Issues Task Force Issue No. 94-3, Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring). Under SFAS 146, liabilities for costs associated with an exit or disposal activity are recognized when the liabilities are incurred, and fair value is the objective for initial measurement of the liabilities. SFAS 146 will be effective for exit or disposal activities that are initiated after December 31, 2002. The provisions of SFAS 146 are required to be applied prospectively after the adoption date to newly initiated exit activities, and may affect the timing of recognizing future restructuring costs, as well as the amounts recognized. Existing restructuring initiatives will not be affected by the adoption of this Statement. We adopted SFAS 146 as of January 1, 2003 which has resulted in the fair value treatment of our restructuring actions taken in the quarter ended March 31, 2003.

In November 2002, the FASB issued FASB Interpretation No. 45 (FIN 45), Guarantor’s Disclosure Requirements for Guarantees, Including Indirect Guarantees of Others. FIN 45 clarifies the guarantor’s requirements relating to the guarantor’s accounting for, and disclosure of, the issuance of certain types of guarantees and requires the guarantor to recognize at the inception of a guarantee a liability for the fair value of the guarantee obligation. FIN 45 also requires additional disclosures by a guarantor in its interim and annual financial statements about the obligation associated with guarantees issued. The provisions for the initial recognition and measurement of guarantees are effective on a prospective basis for guarantees that are issued or modified after December 31, 2002. The disclosure requirements are effective for financial statements of interim or annual periods ending after December 15, 2002. We have adopted the disclosure requirements for our financial statements as of December 31, 2002 and to date, the adoption of FIN 45 has not had a material effect on our operations or on our financial condition. See Note 11 in our Annual Report on Form 10-K for the year ended December 31, 2002 for additional information on our warranty and indemnification practices. During the three months ended March 31, 2003, we did not record any provisions for any guarantees.

In December 2002, the FASB issued Statement of Financial Accounting Standards No. 148 (SFAS 148), Accounting for Stock-Based Compensation—Transition and Disclosure. SFAS 148 amends Statement of Financial Accounting Standard No. 123 (SFAS 123), Accounting for Stock-Based Compensation, to provide alternative methods of transition for a voluntary change to the fair value method of accounting for stock-based employee compensation, and to require expanded and more prominent disclosure of the effects of an entity’s accounting policy with respect to stock-based employee compensation. While SFAS 148 does not amend SFAS 123 to require companies to account for employee stock options using the fair value method, the disclosure provisions of SFAS 148 are applicable to all companies with stock-based employee compensation, regardless of whether they account for that compensation using the fair value method of SFAS 123 or the intrinsic value method of APB 25. Since we account for our stock-based compensation under APB 25, and have no current plans on switching to SFAS 123, the impact of SFAS 148 will be limited to the interim reporting of the effects on net loss and loss per share if we accounted for stock-based compensation under SFAS 123.

In January 2003, the FASB issued Interpretation No. 46 (FIN 46), Consolidation of Variable Interest Entities, an Interpretation of ARB No. 51. FIN 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the equity investors in the entity do not have the characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 is effective for all new variable interest entities created or acquired after

January 31, 2003. For variable interest entities created or acquired prior to February 1, 2003, the provision of FIN 46 must be applied for the first interim or annual period beginning after June 15, 2003. We do not expect the adoption of FIN 46 will have a material effect on our operations results or financial condition.

On April 23, 2003, we received a letter from Nasdaq stating that we have failed to comply with the $1.00 per share minimum bid price required for continued listing on the Nasdaq National Market. Accordingly, our common stock is subject to delisting from the Nasdaq National Market. We have requested an oral hearing before a Nasdaq Listing Qualifications Panel to review the delisting determination. Although there can be no assurance that the Nasdaq Listing Qualifications Panel will grant our request for continued listing on the Nasdaq National Market, the hearing request will stay the delisting of our common stock pending the panel’s decision. Our oral hearing has been scheduled for May 29, 2003.

The information in this discussion 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 which are subject to the “safe harbor” created by those sections. These forward-looking statements are generally identified by words such as “expect,” “anticipate,” “intend,” “plan,” “believe,” “hope,” “assume,” “estimate” and other similar words and expressions. These forward-looking statements involve risks and uncertainties that could cause our actual results to differ materially from those in the forward-looking statements, including, without limitation, the risks outlined under “Business Risks” in this quarterly report on Form 10-Q. These business risks should be considered in evaluating our prospects and future financial performance. Although we believe that the expectations reflected in the forward-looking statements are reasonable, we cannot guarantee future results, levels of activity, performance or achievements.

Vitria is a leading provider of business process, integration, and management solutions. Our products and services enable corporations in healthcare, finance, telecommunications and other markets to gain greater real-time operational visibility and control of strategic business processes that are currently fragmented across multiple systems, manual processes and trading partner interactions. To accomplish this, we develop and deliver the BusinessWare^® business process integration software platform together with pre-built and configurable content to solve industry-specific problems, such as healthcare claims transaction management, straight-through processing in capital markets, telecommunications service provisioning, consolidated order management, and manufacturing and logistics. Vitria was incorporated in California in October 1994 and reincorporated in Delaware in July 1999.

Our flagship BusinessWare integration platform uses graphically modeled business process logic as the foundation for orchestrating complex, real-time interactions between dissimilar software applications, Web services, individuals, and trading partners over corporate networks and the Internet. By automating and measuring previously fragmented business processes from start to finish, our solutions are designed to:

Vitria combines technology leadership with industry domain expertise in healthcare, finance and telecommunications to improve strategic business processes across systems, people and trading partners. Through pre-built and specifically configured business process integration solutions that preserve and extend a company’s existing technology investments, Vitria solutions are designed to provide real-time visibility and streamlined control over processes and data to reduce costs, increase revenues, improve customer experience, and ensure regulatory compliance.

Vitria has developed years of intellectual property around automating industry-specific business processes in the healthcare, finance and telecommunications markets that can be either pre-built and pre-packaged in software and bundled with the BusinessWare platform, or used by Vitria’s professional services to rapidly design and configure solutions. This focus on business process solutions allows Vitria to concentrate its product development and marketing efforts on demonstrating the measurable business value of process integration to business executives, in addition to demonstrating the technical value of our platform to information technology professionals. Examples of business process integration problems that Vitria has developed solutions for include:

While each Vitria customer has unique aspects of their business processes, there are also many common elements to recurring business integration problems that lend themselves to a more standardized approach. A pre-built solutions approach is designed to satisfy customers’ desire for faster time-to-value, lower cost of implementation, and leveraging industry best practices. Pre-built solution components can include:

Because these solution components are built on our general-purpose BusinessWare integration platform, each is fully configurable to meet customers’ specific business and technology requirements.

Vitria’s Health Insurance Portability and Accountability Act, or HIPAA, Compliance solution is an example of a pre-built solution. It provides transaction and code set compliance with federal HIPAA regulations that provides a pre-built, re-usable foundation for other business process improvements such as claims transaction management. Vitria intends to develop more pre-built solutions, including co-developing pre-built solutions with select systems integrators.

BusinessWare unifies the five elements that we believe are essential for business process integration software, all in a single platform:

BusinessWare allows customers to solve their business problems using graphical models rather than developing custom programs. Rather than writing new software programs, business managers can create visual diagrams of business processes, called “process models,” using a point-and-click user interface. BusinessWare then translates these process models into software programs that automate the flow of information across a company’s underlying IT systems.

Once customers use BusinessWare to define their business process models and integrate the underlying IT systems, people and partners, BusinessWare automatically controls the flow of information across the IT systems as specified by the process models. BusinessWare continuously analyzes the customer’s business processes and can automatically change the processes in response to this analysis. This capability allows companies to transform the information flowing through their IT systems into “actionable intelligence” that enables business managers to optimize their business operations.

Our discussion and analysis of our financial condition and results of operations are based upon our consolidated financial statements, which have been prepared in accordance with accounting principles generally accepted in the United States. The preparation of these financial statements requires us to make estimates and judgments that affect the reported amounts of assets, liabilities, revenues and expenses, and related disclosures. We evaluate our estimates, on an on-going basis, including those related to revenue recognition, allowances for doubtful accounts, goodwill and purchased intangibles—impairment assessments and restructuring charges. We base our estimates on historical experience and on various other assumptions that are believed to be reasonable under the circumstances, the results of which form the basis for making judgments about the carrying values of assets and liabilities that are not readily apparent from other sources. Actual results may differ from these estimates under different assumptions or conditions.

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

We derive revenues from software licenses to end users for BusinessWare and other products and related services, which include maintenance and support, consulting and training services. In accordance with the provisions of Statement of Position 97-2, Software Revenue Recognition, as amended, we record revenue from software licenses when a license agreement is signed by both parties, the fee is fixed or determinable, collection of the fee is probable and delivery of the product has occurred. For electronic delivery, the product is considered to have been delivered when the access code to download the software from the Internet has been provided to the customer. If an element of the agreement has not been delivered, revenue for the element is deferred based on vendor-specific objective evidence of fair value. If vendor-specific objective evidence of fair value does not exist for the undelivered element, all revenue is deferred until sufficient objective evidence exists or all elements have been delivered. We treat all arrangements with payment terms longer than normal not to be fixed or determinable. Our normal payment terms currently range from “net 30 days” to “net 90 days” for domestic and international customers, respectively. Revenue is generally deferred for those agreements which exceed our normal payment terms and are therefore assessed as not being fixed or determinable. Revenue under these agreements is recognized as payments become due unless collectibility concerns exist, in which case revenue is deferred until payments are received. Our assessment of collectibility is particularly critical in determining whether revenue should be recognized in the current market environment. If collectibility is not considered probable, revenue is recognized when the fee is collected. Revenue on arrangements with customers who are not the ultimate users, primarily third-party systems integrators, is not recognized until evidence of a sell-through arrangement to an end user has been received.

Service and other revenues include product maintenance, consulting, and training. Customers who license BusinessWare normally purchase maintenance contracts. These contracts provide unspecified software upgrades and technical support over a specified term, which is typically twelve months. Maintenance contracts are usually paid in advance, and revenues from these contracts are recognized ratably over the term of the contract. A majority of our customers use third-party system integrators to implement our products. Customers typically purchase additional consulting services from us to support their implementation activities. These consulting services are generally sold on a time and materials basis and recognized as the services are performed. We also offer training services which are sold on a per student or per class basis and recognized as the classes are attended.

Payments received in advance of revenue recognition are recorded as deferred revenue. When the software license arrangement requires us to provide consulting services for significant production, customization or modification of the software, or when the customer considers these services essential to the functionality of the

software product, both the product license revenue and consulting services revenue are recognized in accordance with the provision of Statement of Position 81-1, Accounting for Performance of Construction Type and Certain Production Type Contracts. We recognize revenue from these arrangements using the percentage of completion method based on cost inputs and, therefore, both product license and consulting services revenue are recognized as work progresses. These arrangements have not been common and, therefore, the significant majority of the Company’s license revenue in the past three years has been recognized under SOP 97-2.

We maintain allowances for doubtful accounts for estimated losses resulting from the inability of our customers to deliver required payments to us. These allowances are established through analysis of the credit worthiness of each customer, which is based on credit reports from third parties, analysis of published or publicly available financial information and customer specific experience including payment practices and history. If the financial condition of our customers were to deteriorate, resulting in an impairment of their ability to make payments, additional allowances may be required. When we believe a collectibility issue exists with respect to a specific receivable, we record an allowance to reduce that receivable to the amount that we believe is collectible.

During the first quarter of 2003, we recorded $14.0 million of restructuring charges related to the realignment of our business operations. In addition, we recorded $19.5 million in restructuring charges related to the realignment of our business operations in 2002. As of March 31, 2003, we have $23.0 million in accrued restructuring expenses, consisting primarily of lease payments, to be made through 2013. Only costs resulting from a restructuring plan that are not associated with, or that do not benefit activities that will be continued, are eligible for recognition as liabilities at the commitment date. These charges represent expenses incurred in connection with certain cost reduction programs that we have undertaken, and consist primarily of the cost of involuntary termination benefits and remaining contractual lease payments and other costs associated with closed facilities, net of anticipated sublease income.

The charges for facility closure costs require the extensive use of estimates, including estimates and assumptions related to future maintenance costs, our ability to secure sub-tenants and anticipated sublease income to be received in the future. If we fail to make accurate estimates or to complete planned activities in a timely manner, we might record additional charges or reverse previous charges in the future. Such additional charges or reversals will be recorded to the restructuring charges line in our statement of operations in the period in which additional information becomes available to indicate our estimates should be adjusted. Minimum future lease payments due for abandoned properties totals $28.1 million at March 31, 2003.

The following table sets forth the results of operations for the three months ended March 31, 2003 and 2002, expressed as a percentage of total revenues.

We recognized approximately 26% of our revenues from customers outside the United States in the three months ended March 31, 2003 compared to 28% in the three months ended March 31, 2002. For the next quarter, we believe international revenues will remain at approximately the same percentage of total revenues as the three months ended March 31, 2003.

Sales to our ten largest customers accounted for 51% of total revenues in the three months ended March 31, 2003. Sales to our ten largest customers accounted for 38% of total revenues in the three months ended March 31, 2002. Two customers accounted for 19% and 13% of our total revenues in the three months ended March 31, 2003. No customer accounted for more than 10% of total revenues in the three months ended March 31, 2002. We expect that revenues from a limited number of customers will continue to account for a large percentage of total revenues in future quarters. Therefore, the loss or delay of individual orders could have a significant impact on revenues. Our ability to attract new customers will depend on a variety of factors, including the reliability, security, scalability and the overall cost-effectiveness of our products.

To date we have not experienced significant seasonality of revenue. Future results may be affected by the fiscal or quarterly budget cycles of our customers.

License. License revenues increased 6% to $10.5 million in the three months ended March 31, 2003 from $10.0 million in the three months ended March 31, 2002. We believe that this slight year over year increase is a result of the general slowdown in information technology spending in our target markets, which has made it more difficult for us to grow our revenues.

Service and other. Service and other revenues decreased 18% to $12.1 million in the three months ended March 31, 2003 from $14.7 million in the three months ended March 31, 2002. The decrease is primarily due to a decrease in consulting revenues as projects initiated in prior quarters were completed.

Included in deferred revenue as of March 31, 2003 is approximately $750,000 of unrecognized revenues from Government grants which are subject to outstanding audits with the Government. We expect some of these audits will be resolved in 2003 which may result in repaying some amount to the Government and/or recognition of certain deferred Government grant revenues.

License. Cost of license revenues consists of royalty payments to third parties for technology incorporated into our products. Cost of license revenues decreased to $94,000 in the three months ended March 31, 2003 from $455,000 in the three months ended March 31, 2002. This fluctuation is due to the buying patterns of our customers, as cost of license revenues is dependent upon which products our customers purchase, and which of those purchased products have third-party technology incorporated into them.

Service and other. Cost of service and other revenues consists of salaries, facility costs, travel expenses and third party consultant fees incurred in providing customer support, training and implementation related services. Cost of service and other revenues decreased 23% from $9.2 million in the three months ended March 31, 2002 to $7.0 million in the three months ended March 31, 2003. This decrease is primarily due to a decrease of $2.5 million in salary and benefit expenses arising from our workforce reductions in 2002 and the first three months of 2003. For the next quarter, we expect that cost of service and other will decrease slightly as a result of further efforts to control costs.

Sales and marketing. Sales and marketing expenses consist of salaries, commissions, field office expenses, travel and entertainment, and promotional expenses. Sales and marketing expenses decreased 49% from $25.7 million in the three months ended March 31, 2002 to $13.0 million in the three months ended March 31, 2003. This decrease was primarily due to lower salary and benefit expenses of $8.0 million, lower commission expenses of $613,000, reduced travel expenses of $968,000 and reduced facilities costs of $666,000 arising from our workforce reductions and facility closures, as well as related decreases in most other expense areas as a result of our cost containment efforts. For the next quarter, we expect that sales and marketing expenses will decrease slightly as a result of the reduction in workforce and further efforts to control costs.

Research and development. Research and development expenses include costs associated with the development of new products, enhancements to existing products, and quality assurance activities. These costs consist primarily of employee salaries, benefits, and the cost of consulting resources that supplement the internal development team. Research and development expenses decreased 45% from $9.5 million in the three months ended March 31, 2002 to $5.3 million in the three months ended March 31, 2003. This decrease was primarily due to a decrease of $3.6 million in salary expenses arising from our workforce reductions and a reduction of $207,000 in the use of outside consultants, as well as related decreases in most other expense areas as a result of our cost containment efforts. For the next quarter, we expect that research and development expenses will decrease slightly as a result of the reduction in workforce and further efforts to control costs.

General and administrative. General and administrative expenses consist of salaries for administrative, executive and finance personnel, information systems costs, outside professional service fees and our provision for doubtful accounts. General and administrative expenses decreased 34% from $5.9 million in the three months ended March 31, 2002 to $3.9 million in the three months ended March 31, 2003. This decrease was primarily attributable to a decrease of $1.0 million in salaries and benefit expenses as a result of our workforce reductions in 2002 and the first three months of 2003, a reduction of $520,000 in the use of outside consultants, as well as related decreases in most other expense areas as a result of our cost containment efforts. For the next quarter, we expect that general and administrative expenses will decrease slightly as a result of the reduction in workforce and further efforts to control costs.

Stock-based compensation. Total stock-based compensation expenses were $153,000 for the three months ended March 31, 2003 and $1.0 million for the three months ended March 31, 2002. Stocked based compensation includes the amortization of unearned employee stock-based compensation on options issued to employees prior to Vitria completing its initial public offering in September 1999 and is being amortized over a five-year vesting period. In the quarter ended March 31, 2002, we recorded $695,000 in additional non-cash stock-based compensation expense as a result of vesting modifications made to option grants for certain key executives who left Vitria during that quarter. We expect to recognize employee stock-based compensation expenses of approximately $127,000, $84,000 and $63,000 for the periods ending June 30, 2003, September 30, 2003 and December 31, 2003, respectively. This unearned compensation expense will be reduced in future periods to the extent that options are terminated prior to vesting.

Amortization of purchased intangible assets. Amortization of purchased intangible assets associated with the acquisition of XMLSolutions in April 2001 resulted in charges to earnings of $518,000 for the three months ended March 31, 2002. In the fourth quarter of 2002, we reduced the carrying value of all of our intangible assets associated with this purchase to zero. Therefore there was no amortization of intangible assets in the three months ended March 31, 2003.

Restructuring charges. In the year ended December 31, 2002 Vitria initiated actions to reduce our cost structure due to sustained negative economic conditions that have impacted our operations and resulted in lower than anticipated revenues. In April and August 2002 we reduced our workforce and consolidated our facilities. The restructuring actions in 2002 resulted in a reduction in workforce of approximately 285 employees or 33% of Vitria’s workforce measured as of the beginning of 2002 and affected all departments. Facilities in the United States and United Kingdom were consolidated and related leasehold improvement and equipment were written off. As a result of the restructuring actions, a charge of $19.5 million in the year ended December 31, 2002 was incurred. The restructuring charge included approximately $4.2 million of severance related charges and $15.4 million of committed excess facilities payments, which included $463,000 for the write-off of leasehold improvements and equipment in vacated buildings. As of March 31, 2003, $13.0 million of lease termination costs, net of anticipated sublease income, remains accrued from our 2002 restructuring actions and are expected to be fully utilized by fiscal 2013.

We expect to achieve annualized cost savings of approximately $38 million from our restructuring actions initiated in the year ended December 31, 2002 and an additional $14.0 million from our restructuring actions initiated in the three months ended March 31, 2003.

Interest income and other income, net. Interest and other income, net, decreased $436,000, or 68%, from $641,000 in the three months ended March 31, 2002 to $205,000 in the three months ended March 31, 2003. The decrease is primarily attributable to a charge of $300,000 in the period ended March 31, 2003 associated with an other-than-temporary decline in value of our equity investment in a private company. Lower interest income due to lower cash and investment balances, as well as losses due to fluctuations in foreign currencies on foreign denominated assets and liabilities also attributed to the decrease.

We recorded an income tax provision of $65,000 for the three-month period ended March 31, 2003. The provision relates to income taxes currently payable on income generated in non-U.S. tax jurisdictions, state income taxes, and foreign withholding taxes incurred on software license revenue. We recorded an income tax provision of $191,000 for the three-month period ended March 31, 2002. The 2002 provision relates to income taxes payable on income generated in non-U.S. jurisdictions, state income taxes, and foreign withholding taxes incurred on software license revenue.

As of March 31, 2003, we had approximately $102.5 million of cash, cash equivalents and short-term investments, and $15.3 million of long-term liabilities, compared to approximately $147.1 million of cash, cash equivalents and short-term investments with no long-term liabilities at March 31, 2002.

Net cash used in operating activities decreased $4.5 million, or 42%, in the three months ended March 31, 2003 compared to the three months ended March 31, 2002. This decrease was primarily due to a decrease in our net loss, an increase in accounts receivable, an increase in deferred revenue, and the addition of accrued restructuring expenses.

Net cash provided by (used in) investing activities increased $3.4 million, or 153%, in the three months ended March 31, 2003 compared to the three months ended March 31, 2002. This increase in the current period was primarily due the fact that we sold more investments than we purchased to fund our operations, as compared to the prior period when we purchased more investments than we sold.

Net cash provided by (used in) financing activities decreased $245,000, or 100%, in the three months ended March 31, 2003 as compared to the three months ended March 31, 2002. Net cash provided by (used in) financing activities in both the current and prior periods was primarily from the issuance of common stock offset by the repurchases of terminated employees’ stock options which had been exercised prior to vesting.

During the three months ended March 31, 2003, our net accounts receivable balance increased $7.0 million from $15.1 million at December 31, 2002 to $22.1 million at March 31, 2003. The reason for the increase was due to the timing of cash receipts. We received a $5.0 million cash payment from a customer early in April 2003. At March 31, 2003, our gross accounts receivable balance is $24.9 million with an allowance for doubtful accounts of $2.8 million.

During the three months ended March 31, 2003, our deferred revenue balance increased $1.8 million from $13.4 million at December 31, 2002 to $15.2 million at March 31, 2003. The primary reason for this increase in deferred revenue is an increase in support renewals.

At March 31, 2003, we had contractual obligations and commercial commitments of approximately $31.6 million as shown in the table below. The table below (in thousands) excludes obligations related to accounts payable and accrued liabilities incurred in the ordinary course of business.

Operating lease commitments shown above include $28.1 million of operating lease commitments under leases for vacated facilities which were recorded as accrued restructuring expenses in the accompanying balance sheet as of March 31, 2003. We do not have any material commercial commitments under lines of credit, standby lines of credit, standby repurchase obligations or other such arrangements.

At March 31, 2003, Vitria did not have any off-balance sheet arrangements or relationships with unconsolidated entities or financial partnerships, such as entities often referred to as structured finance or special purpose entities, which are typically established for the purpose of facilitating off-balance sheet arrangements or other contractually narrow or limited purposes.

We have a $15.0 million revolving line of credit agreement with Silicon Valley Bank. Interest on outstanding borrowings accrues at the bank’s prime rate of interest. The facility is secured by all of Vitria’s assets. The agreement includes restrictive covenants which require us to maintain, among other things, a minimum cash, cash equivalents, and short-term investments balance of $90.0 million. The line of credit serves as collateral for letters of credit and other commitments, even though these items do not constitute draws on the line of credit. Available advances under the line of credit are reduced by the amount of outstanding letters of credit and other commitments.

As of March 31, 2003, we had not borrowed against this line of credit. In connection with the line of credit agreement, we have outstanding letters of credit of approximately $13.5 million related to certain office leases at March 31, 2003.

In July 2002, our Board of Directors announced a stock repurchase program under which we may repurchase up to an aggregate of five million shares of our common stock through July 2003. Under the program the repurchases will be made from time to time on the open market at prevailing market prices or in negotiated transactions off the market. The repurchases will be funded from available working capital. As of March 31, 2003, 496,000 shares had been repurchased in the open market at a total cost of approximately $496,000. No shares were repurchased during the three months ended March 31, 2003.

Estimated future uses of cash over the next twelve months are primarily to fund operations and to a lesser extent to fund capital expenditures. For the next twelve months, we expect to fund these uses from available cash balances, cash generated from operations, if any, and interest on available cash and investment balances. Our ability to generate cash from operations is dependent upon our ability to sell our products and services and generate revenue, as well as our ability to manage our operating costs. In turn, our ability to sell our products is dependent upon both the economic climate and the competitive factors of the marketplace in which we operate.

In the past, we have invested significantly in our operations. Over the next fiscal year, we expect that operating expenses will decrease in absolute dollars due to restructuring actions and other cost reduction efforts. However, we anticipate that operating expenses and planned capital expenditures will continue to constitute a material use of our cash resources. We expect our capital expenditures in fiscal year 2003 to be at approximately the same level of spending as in fiscal year 2002. The lease for our headquarters building in Sunnyvale expires in August 2003; if we were to move to a different location, we could incur up to $1.0 million in leasehold improvements and moving expense in 2003. Our actual expenses could be higher. In addition, we may utilize cash resources to fund acquisitions or investments in other businesses, technologies or products lines. We believe that our available cash, cash equivalents and short-term investments will be sufficient to meet our working capital and operating expense requirements for at least the next twelve months. At some point in the future we may require additional funds to support our working capital and operating expense requirements or for other purposes and may seek to raise these additional funds through public or private debt or equity financings. If we need to seek additional financing, there is no assurance that this additional financing will be available, or if available, will be on reasonable terms and not dilutive to our stockholders.

We believe our success requires expanding our customer base and continuing to enhance our BusinessWare products. We intend to continue to invest selectively in sales, marketing and research and development and expect to incur operating losses for at least the first half of 2003. Our revenues, operating results and cash flows depend upon the volume and timing of customer orders and payments and the date of product delivery. Historically, a substantial portion of revenues in a given quarter have been recorded in the third month of that quarter, with a concentration of these revenues in the last two weeks of the third month. We expect this trend to continue and, therefore, any failure or delay in the closing of orders would have a material adverse effect on our quarterly operating results and cash flows. Since our operating expenses are based on anticipated revenues and because a high percentage of these expenses are relatively fixed, a delay in the recognition of revenue from one or more license transactions could cause significant variations in operating results from quarter to quarter and cause unexpected results. Revenues from contracts that do not meet our revenue recognition policy requirements for which we have been paid or have a valid receivable are recorded as deferred revenues. While a portion of our revenues each quarter is recognized from deferred revenue, our quarterly performance will depend primarily upon entering into new contracts to generate revenues for that quarter. New contracts may not result in revenue during the quarter in which the contract was signed, and we may not be able to predict accurately when revenues from these contracts will be recognized. Our future operating results and cash flows will depend on many factors, including the following:

As a result of these factors, we believe that period-to-period comparisons of our results of operations are not necessarily meaningful and should not be relied upon as indications of future performance. It is likely that in some future quarter our operating results will be below the expectations of public market analysts and investors. In this event, the price of our common stock would likely decline.

The following discussion about our risk management activities includes “forward-looking statements” that involve risks and uncertainties. Actual results could differ materially from those projected in the forward-looking statements for the reasons described under the caption “Risks Associated with Vitria’s Business and Future Operating Results.”

Our exposure to market risk for changes in interest rates relates to our investment portfolio, which consists of short-term money market instruments and debt securities with maturities between 90 days and one year. We do not use derivative financial instruments in our investment portfolio. We place our investments with high credit quality issuers and, by policy, we limit the amount of credit exposure to any one issuer.

We mitigate default risk by investing in high credit quality securities and by monitoring the credit rating of investment issuers. The portfolio includes only marketable securities with active secondary or resale markets to ensure portfolio liquidity. These securities are generally classified as available for sale, and consequently, are recorded on the balance sheet at fair value with unrealized gains or losses reported, as a separate component of stockholders’ equity, net of tax. Unrealized gains and losses at March 31, 2003 were not material.

We have no cash flow exposure due to rate changes for cash equivalents and cash investments as all of these investments are at fixed interest rates.

There has been no material change in our interest rate exposure since March 31, 2003.

As a global concern, we face exposure to adverse movements in foreign currency exchange rates. These exposures may change over time as business practices evolve and could have a material adverse impact on our financial position and results of operations. Historically, our primary exposures have related to non-U.S. dollar-denominated currencies, customer receivables, and inter-company receivables or payables with our foreign subsidiaries. Additionally, we provide funding to our foreign subsidiaries in Europe, Asia Pacific and Latin America.

In order to reduce the effect of foreign currency fluctuations, from time to time, we utilize foreign currency forward exchange contracts (forward contracts) to hedge certain foreign currency transaction exposures outstanding during the period. The gains and losses on the forward contracts help to mitigate the gains and losses on our outstanding foreign currency transactions. We do not enter into forward contracts for trading purposes. All foreign

currency transactions and all outstanding forward contracts are marked-to-market at the end of the period with unrealized gains and losses included in other income, net.

Our operating results fluctuate significantly and an unanticipated decline in revenue may disappoint securities analysts or investors and result in a decline in our stock price.

Our quarterly operating results have fluctuated significantly in the past and may vary significantly in the future. If our operating results are below the expectations of securities analysts or investors, our stock price is likely to decline. Period-to-period comparisons of our historical results of operations are not necessarily a good predictor of our future performance.

Our revenues and operating results depend upon the volume and timing of customer orders and payments and the date of product delivery. Historically, a substantial portion of revenues in a given quarter have been recorded in the third month of that quarter, with a concentration of these revenues in the last two weeks of the third month. We expect this trend to continue and, therefore, any failure or delay in the closing of orders would have a material adverse effect on our quarterly operating results. Since our operating expenses are based on anticipated revenues and because a high percentage of these expenses are relatively fixed, a delay in the recognition of revenue from one or more license transactions could cause significant variations in operating results from quarter to quarter and cause unexpected results.

Our quarterly results depend primarily upon entering into new or follow-on contracts to generate revenues for that quarter. New contracts may not result in revenue in the quarter in which the contract was signed, and we may not be able to predict accurately when revenues from these contracts will be recognized. Our operating results are also dependent upon our ability to manage our cost structure.

We have incurred substantial operating losses since inception and we cannot guarantee that we will become profitable in the future.

We have incurred substantial losses since inception as we funded the development of our products and the growth of our organization. We have an accumulated deficit of $191.6 million as of March 31, 2003. Since the beginning of 2002, we have reduced our workforce by a total of 385 employees and consolidated certain facilities as part of our restructuring plan. As a result of these actions, we incurred a restructuring charge of $19.5 million in 2002 and $14.0 million in the first quarter of 2003. Despite these recent measures in order to remain competitive we intend to continue investing heavily in sales, marketing and research and development. As a result, we are likely to continue report future operating losses and cannot guarantee whether we will report net income in the future.

Our operating results are substantially dependent on license revenues from our BusinessWare product and our business could be materially harmed by factors that adversely affect the pricing and demand for BusinessWare.

Since 1998, a majority of our total revenues has been derived from licensing our BusinessWare product and applications built using that product. We expect that will continue to be the case. Accordingly, our future operating results will depend on the demand for BusinessWare by existing and future customers, including new and enhanced releases that are subsequently introduced. If our competitors release new products that are superior to BusinessWare in performance or price, or we fail to enhance BusinessWare and introduce new products in a timely manner, demand for

our product may decline. A decline in demand for BusinessWare as a result of competition, technological change or other factors would significantly reduce our revenues.

Failure to raise additional capital or generate the significant capital necessary to expand our operations and invest in new products could reduce our ability to compete and result in lower revenues.

During the three months ended March 31, 2003, we had a net loss of $20.7 million and our operating activities used $15.3 million of cash. As of March 31, 2003, we had approximately $102.5 million in cash and cash equivalents and short-term investments, and $15.3 million in long-term liabilities. We may need to raise additional funds, and we cannot be certain that we will be able to obtain additional financing on favorable terms, or at all. If we need additional capital and cannot raise it on acceptable terms, we may not be able to, among other things:

Our failure to do any of these things could result in lower revenues and could seriously harm our business.

The challenging economic environment in the United States and abroad, and especially the continued reluctance of companies to make significant expenditures on information technology, could reduce demand for our products and cause our revenues to continue to decline.

The downturn in the U.S. and the world economy may cause a further decline in capital allocations for software purchases. The delay in capital expenditures may cause a decrease in sales, may cause an increase in our accounts receivable and may make collection of license and support payments from our customers more difficult. Over approximately the past two years, we have experienced a general slow-down in the level of capital spending by some of our customers due to the general economic downturn, which has resulted in lower revenues. This slow-down in capital spending, if sustained in future periods, could result in reduced sales or the postponement of sales to our customers. There can be no assurance that the level of spending on information technology in general, or on business integration software by our customers and potential customers, will increase or remain at current levels in future periods. Lower spending on information technology could result in reduced license sales to our customers, reduced overall revenues, diminished margin levels, and could impair our operating results in future periods.

In addition, international events threaten to deepen and prolong the challenging economic environment. Terrorism and the threat thereof, as well as actual or threatened war or hostilities in various regions, could cause companies further to delay or moderate their capital expenditures, thereby potentially harming our financial performance.

We experience long and variable sales cycles, which could have a negative impact on our results of operations for any given quarter.

Our product is often used by our customers to deploy mission-critical solutions used throughout their organization. Customers generally consider a wide range of issues before committing to purchase our products, including product benefits, ability to operate with existing and future computer systems, ability to accommodate increased transaction volume and product reliability. Many customers will be addressing these issues for the first time. As a result, we or other parties, including system integrators, must educate potential customers on the use and benefits

of our product and services. In addition, the purchase of our products generally involves a significant commitment of capital and other resources by a customer. This commitment often requires significant technical review, assessment of competitive products, and approval at a number of management levels within the customer’s organization. Because of these issues, our sales cycle has ranged from six to nine months, and in some cases even longer, and it is very difficult to predict whether and when any particular license transaction might be completed. In addition, the downturn in the U.S. economy has caused some customers to increase budgetary controls or require additional management approvals within the customers’ organization prior to committing to significant capital purchases, either of which could result in an increased sales cycle.

Because a small number of customers have in the past accounted for a substantial portion of our revenues, our revenues could decline due to the loss or delay of a single customer order.

Our ten largest transactions accounted for 51% of total revenues in the three months ended March 31, 2003. Our license agreements do not generally provide for ongoing license payments. Therefore, we expect that revenues from a limited number of customers will continue to account for a significant percentage of total revenues in future quarters. Our ability to attract new customers will depend on a variety of factors, including the reliability, security, scalability, breadth and depth of our products, and cost-effectiveness of our products. The loss or delay of individual orders could have a significant impact on revenues and operating results. Our failure to add new customers that make significant purchases of our product and services would reduce our future revenues.

If we are not successful in developing industry specific solutions based on BusinessWare, our ability to increase future revenues could be harmed.

We have developed and intend to continue to develop solutions based on BusinessWare which incorporate business processes, connectivity and document transformations specific to the needs of particular industries, including telecommunications, financial services and healthcare industries. This presents technical and sales challenges and requires collaboration with third parties, including system integrators and standard organizations, and the commitment of significant resources. Specific industries may experience economic downturns or regulatory changes that may result in delayed spending decisions by customers or require changes to our products. If we are not successful in developing these targeted solutions or these solutions do not achieve market acceptance, our ability to increase future revenues could be harmed.

To date we have concentrated our sales and marketing efforts toward companies in the telecommunications, financial services and healthcare industries. Customers in these new vertical markets are likely to have different requirements and may require us to change our product design or features, sales methods, support capabilities or pricing policies. If we fail to successfully address these new vertical markets we may experience decreased sales in future periods.

Our products may not achieve market acceptance, which could cause our revenues to decline.

Deployment of our products requires interoperability with a variety of software applications and systems and, in some cases, the ability to process a high number of transactions per second. If our products fail to satisfy these demanding technological objectives, our customers will be dissatisfied and we may be unable to generate future sales. Failure to establish a significant base of customer references will significantly reduce our ability to license our product to additional customers.

We are currently not in compliance with the Nasdaq National Market’s listing criterion requiring us to maintain a minimum bid price of $1.00, and our common stock could be delisted from the Nasdaq National Market.

On April 23, 2003, we received a letter from Nasdaq advising us that our common stock had not met Nasdaq’s

minimum bid price requirement of $1.00 for approximately 210 consecutive trading days and that, our common stock would be delisted from the Nasdaq National Market. We have requested an oral hearing before a Nasdaq Listing Qualifications Panel to review the delisting determination. Although there can be no assurance that the Nasdaq Listing Qualifications Panel will grant our request for continued listing on the National Market, the hearing request will stay the delisting of our common stock pending the panel’s decision. Our oral hearing has been scheduled for May 29, 2003.

On April 22, 2003 we filed with the SEC a definitive proxy statement in connection with our Annual Meeting of Stockholders to be held on May 16, 2003 seeking authorization from our stockholders to allow the Board of Directors to implement a reverse stock split with a ratio in the range of 2-to-1 to 6-to-1. If such authorization is granted, the Board could choose to implement a reverse stock split. While there is no guarantee that our stock price would continue to trade above $1.00 for any period of time, a reverse stock split could allow us to forestall, at least temporarily, a delisting action by Nasdaq.

Alternatively, upon our request and at the discretion of Nasdaq, we could seek to have our common stock transferred to the Nasdaq SmallCap Market. Transferring to the Nasdaq SmallCap Market would provide us with an additional grace period to satisfy the minimum bid price requirement; however, we would nevertheless be subject to certain adverse consequences described below. In addition, in such event we would still be required to satisfy various listing maintenance standards for our common stock to be quoted on the Nasdaq SmallCap Market, including the minimum bid price requirement after expiration of any grace periods. If we fail to meet such standards, our common stock would likely be delisted from the Nasdaq SmallCap Market and trade on the over-the-counter bulletin board, commonly referred to as the “pink sheets.” Such alternatives are generally considered as less efficient markets and would seriously impair the liquidity of our common stock and limit our potential to raise future capital through the sale of our common stock, which could materially harm our business.

If we are delisted from the Nasdaq National Market, we will face a variety of legal and other consequences that will likely negatively affect us including, without limitation, the following:

Our markets are highly competitive and, if we do not compete effectively, we may suffer price reductions, reduced gross margins and loss of market share.

The market for our products is intensely competitive, evolving and subject to rapid technological change. The intensity of competition is expected to increase in the future. Increased competition is likely to result in price reductions, reduced gross margins and loss of market share, any one of which could significantly reduce our future revenues. Our current competitors include BEA, IBM Corporation, IONA, Microsoft Corporation, Mercator Software,

Sybase, SeeBeyond Technology, Tibco Software, and webMethods. In the future, some of these companies may expand their products to provide or enhance existing business process management, business analysis and monitoring, and business vocabulary management functionality. These or other competitors may merge to attempt the creation of a more competitive entity, or one that offers a broader solution than we provide. In addition, “in-house” information technology departments of potential customers have developed or may develop systems that provide for some or all of the functionality of our products. We expect that internally developed application integration and process automation efforts will continue to be a principal source of competition for the foreseeable future. In particular, it can be difficult to sell our product to a potential customer whose internal development group has already made large investments in and progress towards completion of systems that our product is intended to replace. Finally, we also face or may soon face direct and indirect competition from major enterprise software developers that offer integration products as a complement to their other enterprise software products. These companies may also modify their applications to be more easily integrated with other applications through web services or other means. Some of these vendors include JD Edwards, Oracle, PeopleSoft, Siebel Systems and SAP AG.

Many of our competitors have more resources and broader customer and partner relationships than we do. In addition, many of these competitors have extensive knowledge of our industry. Current and potential competitors have established or may establish cooperative relationships among themselves or with third-parties to offer a single solution and increase the ability of their products to address customer needs. Although we believe that our solutions generally compete favorably with respect to these factors, our market is relatively new and is evolving rapidly. We may not be able to maintain our competitive position against current and potential competitors, especially those with significantly greater resources.

Our revenues will likely decline if we do not develop and maintain successful relationships with system integrators.

System integrators install and deploy our products and those of our competitors, and perform custom integration of systems and applications. Some system integrators engage in joint marketing and sales efforts with us. If these relationships fail, we will have to devote substantially more resources to the sales and marketing, and implementation and support of our product than we would otherwise have to, and our efforts may not be as effective as those of the system integrators. In many cases, these parties have extensive relationships with our existing and potential customers and influence the decisions of these customers. We rely upon these firms for recommendations of our product during the evaluation stage of the purchasing process, as well as for implementation and customer support services. A number of our competitors have strong relationships with these system integrators and, as a result, these system integrators may recommend competitors’ products and services. In addition, a number of our competitors have relationships with a greater number of these system integrators and, therefore, have access to a broader base of enterprise customers. Our failure to establish or maintain these relationships would significantly harm our ability to license and successfully implement our software product. In addition, we rely on the industry expertise and reach of these firms. Therefore, this failure would also harm our ability to develop industry-specific products. We are currently investing, and plan to continue to invest, significant resources to develop and maintain these relationships. Our operating results could be harmed if these efforts do not generate license and service revenues necessary to offset this investment.

The cost and difficulty in implementing our product could significantly harm our reputation with customers, diminishing our ability to license additional products to our customers.

Our products are often purchased as part of large projects undertaken by our customers. These projects are complex, time consuming and expensive. Failure by customers to successfully deploy our products, or the failure by us or third-party consultants to ensure customer satisfaction, could damage our reputation with existing and future customers and reduce future revenues. In many cases, our customers must interact with, modify, or replace significant elements of their existing computer systems. The costs of our products and services represent only a portion of the related hardware, software, development, training and consulting costs. The significant involvement of third parties,

including system integrators, reduces the control we have over the implementation of our products and the quality of customer service provided to organizations which license our software.

If our products do not operate with the many hardware and software platforms used by our customers, our business may fail.

We currently serve a customer base with a wide variety of constantly changing hardware, packaged software applications and networking platforms. If our products fail to gain broad market acceptance, due to their inability to support a variety of these platforms, our operating results may suffer. Our business depends, among others, on the following factors:

If we fail to introduce new versions and releases of our products in a timely manner, our revenues may decline.

We may fail to introduce or deliver new products on a timely basis, if at all. In the past, we have experienced delays in the commencement of commercial shipments of our BusinessWare products. To date, these delays have not had a material impact on our revenues. If new releases or products are delayed or do not achieve market acceptance, we could experience a delay or loss of revenues and cause customer dissatisfaction. In addition, customers may delay purchases of our products in anticipation of future releases. If customers defer material orders in anticipation of new releases or new product introductions, our revenues may decline.

Our products rely on third-party programming tools and applications. If we lose access to these tools and applications, or are unable to modify our products in response to changes in these tools and applications, our revenues could decline.

Our programs utilize Java programming technology provided by Sun Microsystems. We also depend upon access to the interfaces, known as “APIs,” used for communication between external software products and packaged application software. Our access to APIs of third-party applications are controlled by the providers of these applications. If the application provider denies or delays our access to APIs, our business may be harmed. Some application providers may become competitors or establish alliances with our competitors, increasing the likelihood that we would not be granted access to their APIs. We also license technology related to the connectivity of our product to third-party database and other applications and we incorporate some third-party technology into our product offerings. Loss of the ability to use this technology, delays in upgrades, failure of these third parties to support these technologies, or other difficulties with our third-party technology partners could lead to delays in product shipment and could cause our revenues to decline.

We could suffer losses and negative publicity if new versions and releases of our products contain errors or defects.

Our products and their interactions with customers’ software applications and IT systems are complex and, accordingly, there may be undetected errors or failures when products are introduced or as new versions are released. We have in the past discovered software errors in our new releases and new products after their introduction which has resulted in additional research and development expenses. To date, these additional expenses have not been material. We may in the future discover errors in new releases or new products after the commencement of commercial shipments. Since many customers are using our products for mission-critical business operations, any of these occurrences could seriously harm our business and generate negative publicity.

If we fail to attract and retain qualified personnel, our ability to compete will be harmed.

We depend on the continued service of our key technical, sales and senior management personnel. None of these persons are bound by an employment agreement. The loss of senior management or other key research, development, sales and marketing personnel could have a material adverse effect on our future operating results. In addition, we must attract, retain and motivate highly skilled employees. We face significant competition for individuals with the skills required to develop, market and support our products and services. We cannot assure that we will be able to recruit and retain sufficient numbers of these highly skilled employees.

If we fail to adequately protect our proprietary rights, we may lose these rights and our business may be seriously harmed.

We depend upon our ability to develop and protect our proprietary technology and intellectual property rights to distinguish our products from our competitor’s products. The use by others of our proprietary rights could materially harm our business. We rely on a combination of copyright, patent, trademark and trade secret laws, as well as confidentiality agreements and licensing arrangements, to establish and protect our proprietary rights. Despite our efforts to protect our proprietary rights, existing laws afford only limited protection. Attempts may be made to copy or reverse engineer aspects of our products or to obtain and use information that we regard as proprietary. Accordingly, there can be no assurance that we will be able to protect our proprietary rights against unauthorized third party copying or use. Furthermore, policing the unauthorized use of our products is difficult, and expensive litigation may be necessary in the future to enforce our intellectual property rights.

Our products could infringe the intellectual property rights of others causing costly litigation and the loss of significant rights.

Software developers in our market will increasingly be subject to infringement claims as the number of products in different software industry segments overlap. Any claims, with or without merit, could be time-consuming, result in costly litigation, prevent product shipment or cause delays, or require us to enter into royalty or licensing agreements, any of which could harm our business. Patent litigation in particular has complex technical issues and inherent uncertainties. In the event an infringement claim against us is successful and we cannot obtain a license on acceptable terms or license a substitute technology or redesign our product to avoid infringement, our business would be harmed. Furthermore, former employers of our current and future employees may assert that our employees have improperly disclosed to us or are using confidential or proprietary information.

Our significant international operations may fail to generate significant product revenues or contribute to our drive toward profitability, which could result in slower revenue growth and harm our business.

We have opened international offices in countries including the United Kingdom, Japan, Germany, France, Italy, Brazil, Taiwan, Korea, Mexico, Singapore, Canada, Australia and Spain, and we may establish additional international offices. During 2002, 35% of our revenue was derived from international markets. We anticipate devoting significant resources and management attention to expanding international opportunities. There are a number of challenges to establishing operations outside of the United States and we may be unable to successfully generate significant international revenues. If we fail to successfully establish our products in international markets, we could

experience slower revenue growth and our business could be harmed. It may be difficult to protect our intellectual property in certain international jurisdictions.

We are at risk of securities class action litigation due to our expected stock price volatility.

In the past, securities class action litigation has often been brought against a company following a decline in the market price of its securities. This risk is especially acute for us because technology companies have experienced greater than average stock price volatility in recent years and, as a result, have been subject to, on average, a greater number of securities class action claims than companies in other industries. In November 2001 and in February 2003, Vitria and certain of our officers and directors were named as defendants in a class action shareholder complaints. This litigation could result in substantial costs and divert management’s attention and resources, and could seriously harm our business. See Part II Item 1 “Legal Proceedings” for more information regarding this litigation.

We have implemented anti-takeover provisions which could discourage or prevent a takeover, even if an acquisition would be beneficial to our stockholders.

Provisions of our amended and restated certificate of incorporation and bylaws, as well as provisions of Delaware law, could make it more difficult for a third party to acquire us, even if doing so would be beneficial to our stockholders. These provisions include:

Section 203 of the Delaware General Corporations Law and the terms of our stock option plans may also discourage, delay or prevent a change in control of Vitria. In addition, as of March 31, 2003, our executive officers, directors and their affiliates beneficially own approximately 36% of our outstanding common stock. This could have the effect of delaying or preventing a change of control of Vitria and may make some transactions difficult or impossible without the support of these stockholders.

Under the supervision and with the participation of our management, including our chief executive officer and chief financial officer, we have evaluated the effectiveness of the design and operation of our disclosure controls and procedures pursuant to the Securities Exchange Act Rule 13a-14 within 90 days of the filing date of this quarterly report. Based on their evaluation, our principal executive officer and principal financial officer have

concluded that these controls and procedures are effective. There were no significant changes in our internal controls or in other factors that could significantly affect these controls subsequent to the date of evaluation.

Our management, including our chief executive officer and chief financial officer, does not expect that our disclosure controls and procedures or our internal controls will prevent all error and all fraud. A control system, no matter how well conceived and operated, can provide only reasonable, not absolute, assurance that the objectives of the control system are met. Further, the design of a control system must reflect the fact that there are resource constraints, and the benefits of controls must be considered relative to their costs. Because of the inherent limitations in all control systems, no evaluation of controls can provide absolute assurance that all control issues and instances of fraud, if any, within Vitria have been detected. These inherent limitations include the realities that judgments in decision-making can be faulty, and that breakdowns can occur because of simple error or mistake. Additionally, controls can be circumvented by the individual acts of some persons, by collusion of two or more people, or by management override of the control. The design of any system of controls also is based in part upon certain assumptions about the likelihood of future events, and there can be no assurance that any design will succeed in achieving its stated goals under all potential future conditions; over time, control may become inadequate because of changes in conditions, or the degree of compliance with the policies or procedures may deteriorate. Because of the inherent limitations in a cost-effective control system, misstatements due to error or fraud may occur and not be detected.

In November 2001, Vitria and certain of its officers and directors were named as defendants in a class action shareholder complaint filed in the United States District Court for the Southern District of New York, and captioned Kideys, et al., v. Vitria Technology, Inc., et al., Case No. 01-CV-10092. The plaintiffs allege that Vitria, certain of its officers and directors and the underwriters of its initial public offering, or IPO, violated federal securities laws because Vitria’s IPO registration statement and prospectus contained untrue statements of material fact or omitted material facts regarding the compensation to be received by, and the stock allocation practices of, the IPO underwriters. The plaintiffs seek unspecified monetary damages and other relief. Similar complaints were filed in the same court beginning in January 2001 against numerous public companies that first sold their common stock since the mid-1990s. . All of these IPO-related lawsuits were consolidated for pretrial purposes before United States Judge Shira Scheindlin of the Southern District of New York. Defendants filed a global motion to dismiss the IPO-related lawsuits on July 15, 2002. Subsequent settlement discussions between the parties have resulted in an agreement by the plaintiffs to dismiss the named individual officers and directors of Vitria who were named as defendants in the IPO-related lawsuit. Judge Scheindlin entered a court order detailing this dismissal on October 9, 2002. On February 19, 2003, Judge Scheindlin issued a ruling denying in part and granting in part the Defendants’ motions to dismiss. We intend to defend this lawsuit vigorously.

In February 2003, Vitria and certain of our officers and directors were named as defendants in a class action shareholder complaint filed in the United States District Court for the Southern District of Florida, captioned Liu v. Credit Suisse First Boston Corporation (“CSFB”), et al., Case No. 03-20459. In the complaint, the plaintiffs allege that CSFB knowingly conspired with dozens of issuers, including Vitria, to conduct initial public offerings based on misinformation about our future prospects and the proper pricing of their shares, in violation of the anti-fraud provisions of section 10(b) of the Securities Exchange Act of 1934. The plaintiffs seek unspecified monetary damages and other relief. Neither Vitria nor our individual officers and directors have yet been served with the complaint. We intend to defend this lawsuit vigorously.

With the exception of the above lawsuits, we are not currently party to any other material pending legal proceedings, except routine legal proceedings arising in the ordinary course of and incidental to our business. We do not believe that these other proceedings, individually or collectively, will harm our business.

Consistent with Section 10A(i)(2) of the Securities Exchange Act of 1934, as added by Section 202 of the Sarbanes-Oxley Act of 2002, Vitria is responsible for disclosing the nature of the non-audit services approved by our Audit Committee during a quarter to be performed by Ernst & Young LLP, our independent auditor. Non-audit services are services other than those provided by Ernst & Young LLP in connection with an audit or a review of Vitria’s financial statements. During the first quarter of 2003 our Audit Committee approved Vitria to utilize non-audit services performed by Ernst & Young LLP as listed below:

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

By:

/s/ JOMEI CHANG, PH.D.

JoMei Chang, Ph.D.

Chief Executive Officer

By:

/s/ JEFFREY J. BAIRSTOW

Jeffrey J. Bairstow

Chief Financial Officer

		Page
PART I:	FINANCIAL INFORMATION

Item 1.	Condensed Consolidated Financial Statements and Notes

	Condensed Consolidated Balance Sheets at March 31, 2003 and December 31, 2002	3

	Condensed Consolidated Statements of Operations for the three months ended March 31, 2003 and 2002	4

	Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2003 and 2002	5

	Notes to the Condensed Consolidated Financial Statements	6

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	13

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	26

Item 4.	Controls and Procedures	34

PART II:	OTHER INFORMATION

Item 1.	Legal Proceedings	36

Item 2.	Changes in Securities and Uses of Proceeds	36

Item 3.	Defaults Upon Senior Securities	36

Item 4.	Submission of Matters to a Vote of Security Holders	36

Item 5.	Other Information	37

Item 6.	Exhibits and Reports on Form 8-K	37

Signature		38

Certifications		39

	March 31, 2003			December 31, 2002
	(unaudited)			(Note 1)
Assets
Current Assets:
Cash and cash equivalents	$	28,515		$	42,427
Short-term investments		73,971			75,436
Accounts receivable, net		22,088			15,108
Other current assets		3,048			3,111

Total current assets		127,622			136,082
Property and equipment, net		5,524			9,179
Other assets		1,085			1,363

Total assets	$	134,231		$	146,624

Liabilities and Stockholders’ Equity
Current Liabilities:
Accounts payable	$	2,124		$	2,264
Accrued payroll and related		5,668			6,157
Other accrued liabilities		6,559			8,715
Accrued restructuring expenses		7,852			4,258
Deferred revenue		15,166			13,430

Total current liabilities		37,369			34,824
Long-Term Liabilities:
Accrued restructuring expenses		15,096			8,936
Other long-term liabilities		195			916

Total long-term liabilities		15,291			9,852
Commitments and Contingencies
Stockholders’ Equity:
Common Stock		131			131
Additional paid-in capital		273,312			273,320
Unearned stock-based compensation		(357	)		(517	)
Notes receivable from stockholders		(193	)		(193	)
Accumulated other comprehensive income		806			620
Accumulated deficit		(191,632	)		(170,917	)
Treasury stock, at cost		(496	)		(496	)

Total stockholders’ equity		81,571			101,948

Total liabilities and stockholders’ equity	$	134,231		$	146,624

	Three Months Ended March 31,
	2003			2002
Revenues
License	$	10,549		$	9,954
Service and other		12,056			14,695

Total revenues		22,605			24,649
Cost of revenues
License		94			455
Service and other		7,015			9,154

Total cost of revenues		7,109			9,609
Operating expenses
Sales and marketing		13,020			25,699
Research and development		5,271			9,508
General and administrative		3,899			5,924
Stock-based compensation		153			1,009
Amortization of intangible assets		—			518
Restructuring charges		14,008			—

Total operating expenses		36,351			42,658

Loss from operations		(20,855	)		(27,618	)
Interest income		422			964
Other income, net		(217	)		(323	)

Net loss before income taxes		(20,650	)		(26,977	)
Provision for income taxes		65			191

Net loss	$	(20,715	)	$	(27,168	)

Basic and diluted net loss per share	$	(0.16	)	$	(0.21	)

Weighted average shares used in calculating basic and diluted net loss per share		130,119			128,495

	Three Months Ended March 31,
	2003			2002
Operating activities:
Net loss	$	(20,715	)	$	(27,168	)
Adjustments to reconcile net loss to net cash used in operating activities:
Amortization of intangible assets		—			518
Loss on write-down of equity investments		300			39
Loss on disposal of fixed assets		2,380			—
Depreciation		1,539			1,759
Stock-based compensation		153			1,009
Changes in assets & liabilities:
Accounts receivable		(6,980	)		20,559
Other current assets		63			(171	)
Other assets		(22	)		(187	)
Accounts payable		(140	)		(942	)
Accrued liabilities		(2,645	)		(2,447	)
Accrued restructuring charges		9,754			—
Deferred revenue		1,736			(3,768	)
Other long term liabilities		(721	)		—

Net cash used in operating activities		(15,298	)		(10,799	)

Investing activities:
Purchases of property and equipment		(264	)		(853	)
Purchases of investments		(16,550	)		(71,194	)
Maturities of investments		18,000			69,788

Net cash provided by (used in) investing activities		1,186			(2,259	)

Financing activities:
Issuance of common stock, net		(1	)		244

Net cash provided by financing activities		(1	)		244

Effect of exchange rates on changes on cash and cash equivalents		201			475

Net decrease in cash and cash equivalents		(13,912	)		(12,339	)
Cash and cash equivalents at beginning of period		42,427			60,479

Cash and cash equivalents at end of period	$	28,515		$	48,140

	Three Months Ended March 31,
	2003		2002
Risk-free interest rates	3.23	%	3.30	%
Expected lives (in years)	5		5
Dividend yield	0	%	0	%
Expected volatility	82	%	140	%

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	Three Months Ended,
	March 31, 2003			March 31, 2002
Net loss, as reported	$	(20,715	)	$	(27,168	)
Add: stock-based employee compensation expense included in reported net loss		153			1,009
Deduct: total stock-based compensation expense determined under the fair value based method for all awards		41			(196	)

Pro forma net loss	$	(20,521	)	$	(26,355	)

Net loss per share as reported	$	(0.16	)	$	(0.21	)

Pro forma net loss per share	$	(0.16	)	$	(0.21	)

Total shares used in calculation		130,119			128,495

	Three Months Ended
	March 31, 2003			March 31, 2002
Numerator for basic and diluted net loss per share:
Net loss	$	(20,715	)	$	(27,168	)

Denominator for basic and diluted net loss per share:
Weighted average shares of common stock outstanding		130,424			130,268
Less shares subject to repurchase		(305	)		(1,323	)

Denominator for basic and diluted net loss per share		130,119			128,945

Basic and diluted net loss per share	$	(0.16	)	$	(0.21	)

Restructuring Provision	Facilities consolidation			Severance			Total
Fiscal year 2002 actions	$	15,358		$	4,158		$	19,516
Cash payments		(2,592	)		(4,014	)		(6,606	)
Fixed asset write-offs		(463	)		—			(463	)
Reclassification of deferred rent		747			—			747

Balance at December 31, 2002	$	13,050		$	144		$	13,194

Fiscal year 2003 actions	$	12,726		$	1,951		$	14,677
Cash payments		(1,166	)		(1,529	)		(2,695	)
Fixed asset write-offs		(2,251	)		—			(2,251	)

Balance at March 31, 2003	$	22,359		$	566		$	22,925

	Three Months Ended March 31,						Percent Change
	2003			2002			Percent Change
	(in thousands)
Cash, cash equivalents and short term investments	$	102,486		$	147,092		(30	)%
Net cash used in operating activities		(15,298	)		(10,799	)	42	%
Net cash provided by (used in) investing activities		1,186			(2,259	)	(153	)%
Net cash provided by (used in) financing activities		(1	)		244		(100	)%

	Year ending March 31,												Total minimum lease payment
	2003		2004		2005		2006		2007		2008 and thereafter		Total minimum lease payment
Operating Leases	$	6,523	$	6,970	$	6,602	$	4,731	$	2,173	$	4,392	$	31,391
Capital Leases		65		95		70		—		—		—		230

Total	$	6,588	$	7,065	$	6,672	$	4,731	$	2,173	$	4,392	$	31,621

	Fair Value		2003 Weighted Average Interest Rate		Fair Value		2002 Weighted Average Interest Rate
Cash and cash equivalents	$	28,515	1.25	%	$	48,140	1.80	%
Short-term investments		73,971	1.71	%		116,308	2.58	%

Total cash and investment securities	$	102,486			$	164,448

99.1		Certification of Chief Executive Officer pursuant to Section 906 of the Public Company Reform and Investor Protection Act of 2002.

99.2		Certification of Chief Financial Officer pursuant to Section 906 of the Public Company Reform and Investor Protection Act of 2002.

	Vitria Technology, Inc.

Date: May 14, 2003	By:	/s/ JEFFREY J. BAIRSTOW
		Jeffrey J. Bairstow Chief Financial Officer