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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

FOR THE QUARTERLY PERIOD ENDED JULY 31, 2004

OR

FOR THE TRANSITION PERIOD FROM              TO             

COMMISSION FILE NO.: 000-30326

VSOURCE, INC.

(Exact name of registrant as specified in its charter)

Registrant’s telephone number, including area code: (858) 551-2920

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 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  ¨

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PART I - FINANCIAL INFORMATION

Item 1. Financial Statements

VSOURCE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except shares and per share data)

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

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VSOURCE, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands, except shares and per share data)

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

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VSOURCE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands except share and per share data)

(Unaudited)

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

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VSOURCE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(Unaudited)

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

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VSOURCE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

1. Summary of Significant Accounting Policies

Basis of Presentation

The accompanying unaudited condensed consolidated financial statements of Vsource, Inc. (“Vsource” or the “Company”) as of July 31, 2004 and January 31, 2004 and for the three and six month periods ended July 31, 2004 and 2003, respectively, have been prepared on substantially the same basis as the Company’s annual consolidated financial statements and should be read in conjunction with the Company’s Annual Report on Form 10-K for the year ended January 31, 2004. In the opinion of management, the accompanying condensed consolidated financial statements reflect all adjustments of a normal recurring nature considered necessary to present fairly the financial information included herein. Certain prior period information has been reclassified to conform to the current period presentation.

The unaudited consolidated results for interim periods are not necessarily indicative of expected results for the full fiscal year.

Future Funding

The Company had an accumulated deficit of approximately $105.8 million as of July 31, 2004 that has been funded primarily through issuances of debt and equity securities. The Company has sustained operating losses since inception. During the six months ended July 31, 2004, the Company used net cash of $6.2 million from operating activities and generated $9.2 million in investing activities that resulted in an increase in cash of $3.0 million. The $9.2 million generated from investing activities was mainly as a result of the proceeds of $9.5 million from the Company’s sale of 39% of its interest in a former wholly owned subsidiary, Vsource Asia Berhad (“Vsource Asia”, formerly known as Vsource (Malaysia) Berhad) (see Note 8 for details).

As of July 31, 2004, the Company had a cash balance of $4.3 million. It has implemented cash conservation measures to reduce its operating losses and discontinued the non-profitable human capital management solutions segment by sale of Vsource (Texas) Inc. (“Vsource Texas”), a wholly owned subsidiary which was primarily engaged in this segment, for $46,000 (see Note 11 for details). Further, the Company is currently considering listing Vsource Asia on Malaysia’s MESDAQ Market in early 2005, which would raise additional funds. However, this listing, if completed following the consummation of the exchange offer and related transactions described in Note 12 below, will not generate funds for the Company. The Company’s management believes that the Company has adequate funding from its recent financings for it to continue in operation for at least 12 months. Therefore, the Company has prepared its financial statements on a going concern basis.

Use of Estimates

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

Concentration of Revenue/Credit Risk

For the three months ended July 31, 2004, one customer, Gateway Japan Inc. (“Gateway”), accounted for 38% of total revenue as compared to 64% for the same period last year. No other customer accounted for more than 10% of revenue during the three months ended July 31, 2004. As of January 31, 2004, the same customer, Gateway, accounted for 60% of the Company’s revenue. The revenue from Gateway has been declining as the installed base of Gateway’s customers in the Asia-Pacific region under warranty declines.

The Company believes that the resulting concentration of credit risk in accounts receivables is substantially mitigated by its ongoing credit evaluation process and the high level of creditworthiness of its customers. The Company performs ongoing credit evaluations of its customers and sets conditions and limits the amount of credit extended when deemed necessary. The Company generally does not require collateral from its customers. As of July 31, 2004, Gateway, accounted for 20% of accounts receivable. As of January 31, 2004, the same customer, Gateway, accounted for 48% of accounts receivable. In addition, as of July 31, 2004, the Company had a customer advance balance of $0.3 million from Gateway which is used to offset outstanding accounts receivable from Gateway at a monthly rate through October 2004.

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VSOURCE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

2. Restricted Cash

Restricted cash, current portion relates to cash held in trust for certain clients. Restricted cash, non current represents deposits with a bank to secure standby letters of credit established for the benefit of a customer and a vendor.

3. Other Current Assets

4. Net Profit /(Loss) Available to Common Shareholders

The following table is a calculation of net loss available to common shareholders:

$3.6 million was recorded as deemed dividend to preferred shareholders as a result of the amortization of beneficial conversion feature and the accretion of the redemption value on the Series 4-A convertible preferred stock in issue during the quarter ended July 31, 2004.

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VSOURCE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

5. Net Loss Per Share

Basic net loss per share is computed by dividing net loss by the weighted average shares of common stock outstanding during the period. Diluted net income per share is computed by dividing net income by the weighted average shares of common stock and potential common shares outstanding during the period. Potential common shares outstanding consist of dilutive shares issuable upon the exercise of outstanding options and warrants to purchase common stock as computed using the treasury stock method. Because the Company had a net loss available to common shareholders for the three and six-month periods ended July 31, 2004 and 2003, potential common shares outstanding are excluded from the computation of diluted net loss per share as their effect is anti-dilutive.

6. Comprehensive Loss

The difference between net loss and comprehensive loss for the Company arising from foreign currency translation adjustments is as follows:

7. Stock-Based Compensation

The Company applies Accounting Principles Board Opinion No. 25 (“APB 25”), “Accounting for Stock Issued to Employees” and related interpretations in accounting for its stock-based compensation plans. Accordingly, the Company records expense for employee stock compensation plans equal to the excess of the market price of the underlying Vsource shares at the date of grant over the exercise price of the stock-related award, if any (known as the intrinsic value). The intrinsic value of the stock-based compensation issued to employees as of the date of grant is amortized on a straight-line basis to compensation expense over the vesting period. In addition, no compensation expense is recorded for purchases under the Employee Stock Purchase Plan (the “Purchase Plan”) in accordance with APB Opinion No. 25 since the options were issued at market value at their respective dates of grants.

The following table summarizes the pro forma operating results of the Company had compensation cost for stock options granted under its stock option plans and for employee stock purchases under the Purchase Plan been determined in accordance with the fair value based method prescribed by Statement of Financial Accounting Standards No. 123, “Accounting for Stock-Based Compensation”.

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VSOURCE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

8. Gain on disposal of partial interest in Vsource Asia

The gain on disposal of partial interest of $7.6 million recorded during the three months ended April 30, 2004 was the result of the Company’s sale of 39% of its interest in a former wholly owned subsidiary, Vsource Asia. The sale was completed in March 2004, for which the Company received proceeds of approximately $9.5 million for the net assets of Vsource Asia of $1.6 million and incurred incidental costs of $0.3 million.

9. Commitments and Contingencies

Commitments

Operating Leases

The Company leases its operating facilities under non-cancelable operating leases that expire at various dates through 2007. Certain of these leases contain renewal options. As of July 31, 2004, future minimum lease commitments were as follows (in thousands):

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VSOURCE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Other Commitments

As of July 31, 2004, the Company had standby letters of credit with a maximum potential future payment of $0.6 million. These standby letters of credit are secured by way of a cash deposit, of an equivalent value, with the issuing banks.

Litigation

During the last quarter of 2004, the Company entered into a settlement agreement in connection with two lawsuits filed in October 2001 by holders of its Series 2-A convertible preferred stock. The settlement involved no admission of liability from the Company but required it to pay the plaintiffs’ attorneys’ fees and costs and issue warrants to purchase a total of 24,092 shares of its common stock at an exercise price of $14.20 each to the plaintiffs. Pursuant to the court’s order dated December 23, 2003, the cases were dismissed without prejudice to reopen within 30 days thereof if the settlement was not consummated. Final payment of attorneys’ fees and costs was made in July 2004, and consequently the Company and the plaintiffs have deemed the litigation dismissed with prejudice.

10. Segment Data

Currently, the Company’s business segments are organized into four solutions: (i) warranty solutions, including comprehensive warranty and after-sales service and support; (ii) human resource solutions, including payroll and expense claims processing; (iii) sales solutions; and (iv) Vsource Foundation Solutions, which are general business process outsourcing solutions, including customer relationship management, supply chain management and financial administration, delivered on a stand-alone basis rather than as components in an integrated solution.

The Company evaluates the performance of its segments based on revenues generated by each of its solutions and gross margin. Gross margin is calculated after cost of revenue charges directly attributable to the segment. Costs excluded from the segments primarily consist of selling, general and administrative expenses and other special charges including loss on impairment of long-lived assets, interest charges and amortization of beneficial conversion feature expense.

In July 2004, the Company discontinued its human capital management solutions through the disposal of its 100% interest in Vsource Texas, a former wholly owned subsidiary which was primarily engaged in providing such services. Prior periods comparatives for this segment were excluded in the presentation below and included as discontinued operations (see Note 11).

The following table sets forth summary information by segment for the three- and six- month periods ended July 31, 2004 and 2003 (in thousands):

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VSOURCE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

A reconciliation of consolidated segment gross margin to consolidated loss for the three- and six- month periods ended July 31, 2004 and 2003 is as follows (in thousands):

11. Discontinued operations

On July 1, 2004, the Company discontinued its non-profitable human capital management solutions through the disposal of 100% of its interest in Vsource Texas, a wholly owned subsidiary which was primarily engaged in providing such services. The human capital management solutions were launched in October 2003.

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VSOURCE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Loss from discontinued operation consisted of losses incurred by the discontinued operation prior to the disposal and the loss on disposal of interest in Vsource Texas, the details of which are as follows (in thousands):

The loss on disposal was calculated based on the difference of the purchase price to the net assets of the subsidiary at the date of disposal. The $46,000 purchase price is receivable in the form of a promissory note and was based on the excess of assets over liabilities, including certain long term lease and other contractual commitments totaling approximately $87,000, as measured at June 1, 2004. The note is due in twelve equal monthly installments starting on August 15, 2004, bearing interest at 3% per annum. No incidental costs were incurred.

The detailed calculation of the loss was as follows (in thousands) :

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VSOURCE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

Summarized net assets of the discontinued operations of human capital management solutions were as follows:-

12. Subsequent event

On September 1, 2004, the Company announced that it intended to initiate an exchange offer under which holders of its Series 1-A, 2-A and 4-A convertible preferred stock could exchange their preferred stock for the shares of a new wholly-owned special purpose vehicle (SPV) holding Vsource’s 61.2% interest in its operating subsidiary, Vsource Asia. The exchange offer is subject to various conditions. The Company also announced that it had been informed by Symphony House Berhad, a Malaysian company which holds 30.3% of Vsource Asia, that Symphony House would simultaneously be making a cash offer of $15.8 million for all of the shares of the SPV, which will be subject to several conditions.

The exchange ratios to be offered to preferred stockholders in the exchange are (a) each share of Series 1-A convertible preferred stock can be exchanged for 6.639 shares of the SPV; (b) each share of Series 2-A convertible preferred stock can be exchanged for 17.818 shares of the SPV; and (c) each share of Series 4-A convertible preferred stock can be exchanged for 5,059.217 shares of the SPV.

These ratios were set so that if all of the Company’s preferred stock is exchanged in the exchange offer, substantially all of the shares of the SPV, and therefore all of the Company’s interest in Vsource Asia, will be issued to the holders of preferred stock. Holders of record of Vsource’s preferred stock as of August 10, 2004, will be eligible to participate in the exchange offer.

Completion of the exchange offer and related transactions would result in a sale of substantially all of the assets of the Company and would result in a change in the Company’s capital structure. After the exchange offer is completed, the Company will not retain any ownership in Vsource Asia and the Company’s primary asset will be the cash which it will retain. The Company will have only a limited staff and limited operations. The amount of cash which the Company will retain will depend on how many shares of the SPV are sold by preferred stockholders to Symphony House and how many are sold by the Company to Symphony House. If all shares

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VSOURCE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(Unaudited)

of preferred stock are exchanged for SPV shares, then the Company will not receive any proceeds from the Symphony House purchase offer and anticipates that it will have approximately $3.0 million of cash and cash equivalents on hand. Following completion of the exchange offer, the Company will primarily be focused on managing its remaining liabilities, continuing to provide certain consulting services to third parties and support services to Vsource Asia, and determining how to utilize its remaining resources. Senior management and the Board of Directors of the Company have decided to defer any decisions regarding its future activities and the use of its cash resources until after the exchange offer has been completed.

The Company intends to complete the exchange offer and related transactions on October 31, 2004 or soon thereafter.

The exchange offer and related transactions were approved on August 31, 2004 by written consent of shareholders holding a majority of the outstanding voting stock of the Company, and an information statement explaining the matters voted upon and describing the terms of the exchange offer and related transactions was filed with the Securities and Exchange Commission on September 1, 2004, on a Schedule 14(c), and also mailed to all shareholders of the Company.

Symphony has also informed the Company that prior to announcing its cash offer, it had entered into an agreement with several holders of the Company’s preferred stock to purchase the Vsource common stock and certain warrants to purchase Vsource common stock held by such holders. Symphony is purchasing these additional securities to assist these preferred stockholders in qualifying to treat the exchange offer as a sale for U.S. income tax purposes and to encourage these preferred stockholders to participate in the transaction. Certain of these holders are officers and directors or major shareholders of the Company. The purchase price will be $0.50 per share for common stock and $0.25 per warrant held by such shareholders. If this purchase of the common stock and warrants is completed, Symphony will hold approximately 32.0% of the Company’s outstanding common stock at completion (assuming that all of the preferred stock is exchanged for SPV shares) and 50.3% on a fully diluted basis (assuming that the warrants purchased will be exercised according to their terms on or after April 1, 2005 and assuming that no additional shares of the Company are issued prior to such exercise).

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Item 2. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

The following discussion and analysis of our financial condition and results of operations should be read in conjunction with the condensed consolidated financial statements and the related notes appearing elsewhere herein.

FORWARD LOOKING STATEMENTS

The discussion in this Form 10-Q contains forward-looking statements. All forward-looking statements included in this document are based on information available to us on the date hereof. We assume no obligation to update any such forward-looking statements. Our actual results in future periods could differ materially from those indicated in such forward-looking statements. Factors that could cause or contribute to such differences include, but are not limited to, our heavy reliance on a few major clients, a potential requirement to redeem our Series 4-A convertible preferred stock if we fail to meet certain conditions by March 31, 2006, the new and unproven market for business process outsourcing services internationally, long cycles for sales of our solutions, complexities involved in implementing and integrating our services, fluctuations in revenues and operating results, economic and infrastructure disruptions, dependence on a small number of vendors and service providers, management of acquisitions, litigation, competition and other risks discussed in our Annual Report on Form 10-K for the fiscal year ended January 31, 2004, under the heading “Risk Factors” and the risks discussed in our other Securities and Exchange Commission filings.

RECENT DEVELOPMENTS

On September 1, 2004, we announced that we intended to initiate an exchange offer under which holders of our Series 1-A, 2-A and 4-A convertible preferred stock could exchange their preferred stock for the shares of a new wholly-owned special purpose vehicle (SPV) holding our 61.2% interest in our operating subsidiary, Vsource Asia Berhad. The exchange offer is subject to various conditions. We also announced that we had been informed by Symphony House Berhad, a Malaysian company which holds 30.3% of Vsource Asia, that Symphony House would simultaneously be making a cash offer of $15.8 million for all of the shares of the SPV, which will be subject to several conditions.

The exchange ratios to be offered to preferred stockholders in the exchange are: (a) each share of Series 1-A convertible preferred stock can be exchanged for 6.639 shares of the SPV; (b) each share of Series 2-A convertible preferred stock can be exchanged for 17.818 shares of the SPV; and (c) each share of Series 4-A convertible preferred stock can be exchanged for 5,059.217 shares of the SPV.

These ratios were set so that if all of our preferred stock is exchanged in the exchange offer, substantially all of the shares of the SPV, and therefore all of our interest in Vsource Asia, will be issued to the holders of preferred stock. Holders of record of our preferred stock as of August 10, 2004, will be eligible to participate in the exchange offer.

Completion of the exchange offer and related transactions would result in a sale of substantially all of our assets and would result in a change in our capital structure. After the exchange offer is completed, we will not retain any ownership in Vsource Asia and our primary asset will be the cash which we will retain. We will have only a limited staff and limited operations. The amount of cash which we will retain will depend on how many shares of the SPV are sold by preferred stockholders to Symphony House and how many are sold by us to Symphony House. If all shares of preferred stock are exchanged for SPV shares, then we will not receive any proceeds from the Symphony House purchase offer and we anticipate that we will have approximately $3.0 million of cash and cash equivalents on hand. Following completion of the exchange offer, we will primarily be focused on managing our remaining liabilities, continuing to provide certain consulting services to third parties and support services to Vsource Asia, and determining how to utilize our remaining resources. Senior management and the Board of Directors of Vsource have decided to defer any decisions regarding our future activities and the use of our cash resources until after the exchange offer has been completed.

We intend to complete the exchange offer and related transactions on October 31, 2004 or soon thereafter.

The exchange offer and related transactions were approved on August 31, 2004 by written consent of shareholders holding a majority of the outstanding voting stock of Vsource, and an information statement explaining

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the matters voted upon and describing the terms of the exchange offer and related transactions was filed with the Securities and Exchange Commission on September 1, 2004, on a Schedule 14(c), and also mailed to all shareholders of Vsource. The information statement is available free of charge at www.sec.gov.

Symphony has also informed us that prior to announcing its cash offer, it had entered into an agreement with several holders of Vsource preferred stock to purchase the Vsource common stock and certain warrants to purchase Vsource common stock held by such holders. Symphony is purchasing these additional securities to assist these preferred stockholders in qualifying to treat the exchange offer as a sale for U.S. income tax purposes and to encourage these preferred stockholders to participate in the transaction. Certain of these holders are officers and directors or major shareholders of Vsource. The purchase price will be $0.50 per share for common stock and $0.25 per warrant held by such shareholders. If this purchase of the common stock and warrants is completed, Symphony will hold approximately 32.0% of our outstanding common stock at completion (assuming that all of the preferred stock is exchanged for SPV shares) and 50.3% on a fully diluted basis (assuming that the warrants purchased will be exercised according to their terms on or after April 1, 2005 and assuming that no additional shares of Vsource are issued prior to such exercise).

OVERVIEW

OUR FISCAL YEAR ENDS ON JANUARY 31 OF THE FOLLOWING CALENDAR YEAR. UNLESS OTHERWISE INDICATED, REFERENCES TO “2005” AND “2004” RELATE TO THE FISCAL YEARS ENDED JANUARY 31, 2005 AND 2004, RESPECTIVELY, RATHER THAN CALENDAR YEARS.

For the quarter ended July 31, 2004, our revenues decreased by 16% to $4.1 million from $4.8 million for the same year-ago period. For the six months ended July 31, 2004, our revenues decreased by 8% to $8.7 million from $9.5 million during the same year-ago period. However, excluding revenue of $0.3 million from Team America, Inc. from the same year-ago periods, which we subsequently wrote off as bad debt following Team America’s Chapter 11 proceedings, the decline in our revenues would have been less pronounced, decreasing to 9% and 5%, respectively, for the second quarter and first half of 2005 compared to the same periods in 2004. Our primary source of revenues was fees earned from delivering business process outsourcing solutions such as warranty solutions, human resource solutions and Vsource Foundation Solutions. We also derived revenues from the sales of products through our sales solutions.

The principal cause of the decrease in revenue was a 40% decline in warranty solutions revenues during the second quarter and first half of 2005 compared to the same periods in 2004. Warranty solutions, which continued to constitute our largest line of business, declined from $3.0 million in the second quarter of 2004 to $1.8 million in the first quarter of 2005. Our warranty solutions revenue was primarily derived from a three-year support services agreement (the “Support Services Agreement”) to support the warranty obligations of Gateway Japan Inc. (“Gateway”) with respect to its installed base of end users in the Asia-Pacific region. Because Gateway terminated its operations in the region in 2001 and therefore is not selling any new products in Asia, revenues from the Support Services Agreement have been declining and are expected to continue to decline as the installed base of end users who will be covered by Gateway’s warranties declines over time. We also experienced declines of 48% and 32%, respectively, in sales solution revenue during the second quarter and first half of 2005 compared to the same year-ago periods.

The declines in revenues from our warranty solutions and sales solutions were partially offset by increases in revenues from our human resource solutions and Vsource Foundation Solutions, which collectively increased by 88% during the second quarter and first half of 2005 compared to the same periods a year earlier. Excluding $0.3 million of human resource solutions revenue attributable to TEAM America in 2004, which we subsequently wrote off, the collective increase would have been 192% and 204%, respectively, during the second quarter and first half of 2005 compared to the same year-ago periods. These increases reflected several factors:

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Our operating loss decreased by 18% from $1.7 million during the second quarter of 2004 to $1.4 million in the second quarter of 2005, and by 25% from $3.1 million during the first half of 2004 to $2.4 million during the first half of 2005. This decrease was primarily attributable to a 25% and 27% reduction, respectively, in selling, general and administrative related costs during the second quarter and first half of 2005 compared to the same year-ago periods. However, this was offset in part by the 16% and 8% drops in revenue during the second quarter and first half of 2005, respectively, compared to the same periods a year earlier. Excluding $0.3 million of human resource solutions revenue and $0.1 million cost of revenue attributable to Team America in the second quarter and first half of 2004, however, we would have reduced our operating loss by 29% during the second quarter of 2005 and by 31% during the first half of 2005, compared to the same year-ago periods.

RESULTS OF OPERATIONS (All amounts in thousands)