GENERAL

The Company does not provide forecasts of its future financial performance. However, from time to time, information provided by the Company or statements made by its employees may contain "forward looking" information that involves risks and uncertainties. In particular, statements contained in this Quarterly Report on Form 10-Q that are not historical facts may constitute forward looking statements and are made under the safe harbor provisions of The Private Securities Litigation Reform Act of 1995. The Company cautions readers not to place undue reliance on any such forward looking statements, which speak only as of the date they are made. The Company disclaims any obligation, except as specifically required by law and the rules of the Securities and Exchange Commission, to publicly update or revise any such statements to reflect any change in the Company's expectations or in events, conditions or circumstances on which any such statements may be based, or that may affect the likelihood that actual results will differ from those set forth in the forward looking statements. The Company's actual results of operations and financial condition have varied and may in the future vary significantly from those stated in any forward looking statements. Factors that may cause such differences include, without limitation, the risks, uncertainties and other information discussed in Item 1A of the Company's Annual Report on Form 10-K for the fiscal year ended September 30, 2011, as well as the accuracy of the Company's internal estimates of revenue and operating expense levels.

Datawatch is engaged in the design, development, manufacture, marketing, and support of business computer software primarily for the report analytics and business service management markets to allow organizations to access and analyze information in a more meaningful fashion.

The Company's principal product lines are Report Analytics Solutions (including Monarch, Monarch Data Pump, Monarch Enterprise Server, Monarch RMS, Datawatch Dashboards, Monarch Report Manager on Demand and iMergence) and Business Service Management Solutions (including Visual QSM and Visual HD). Included in the above categories are:

· Monarch, a desktop reporting and data analysis application that lets users extract and manipulate data from ASCII report files, PDF files or HTML files produced on any mainframe, midrange, client/server or PC system;

· Monarch Data Pump, a data replication and migration tool that offers a shortcut for populating and refreshing data marts and data warehouses, for migrating legacy data into new applications and for providing automated delivery of reports in a variety of formats, such as Excel, via email;

· Monarch Enterprise Server, an enterprise solution that provides web-enabled report storage, transformation and distribution including data analysis, visualization and MS Excel integration for easy to use and cost effective self-serve reporting and analytics;

· Monarch RMS, a web-based report analysis solution that integrates with any existing enterprise report management or content management archiving solution;

· Datawatch Dashboards, an interactive dashboard solution that provides a visual overview of operational performance as well as the ability to monitor specific business processes and events;

· Monarch Report Manager on Demand, a system for high-volume document capture, archiving, and online presentation;

· iMergence, an enterprise report mining system;

· Visual QSM, a fully internet-enabled IT service management solution that incorporates workflow and network management capabilities and provides web access to multiple databases via a standard browser; and

· Visual Help Desk or Visual HD, a web-based help desk and call center solution operating on the IBM Lotus Domino platform.

The Company offers its enterprise products through perpetual licenses, term licenses and subscription pricing models. Subscriptions automatically renew unless terminated with 90 days notice following the first year of the subscription term. The subscription arrangement includes software, maintenance and unspecified future upgrades including major version upgrades. The subscription renewal rate is the same as the initial subscription rate. During the three months ended December 31, 2011 and 2010, subscription revenues were approximately $67,000 and $74,000, respectively.

CRITICAL ACCOUNTING POLICIES

In the preparation of financial statements and other financial data, management applies certain accounting policies to transactions that, depending on choices made by management, can result in different outcomes. In order for a reader to understand the following information regarding the financial performance and condition of the Company, an understanding of those accounting policies is important. Certain of those policies are comparatively more important to the Company's financial results and condition than others. The policies that the Company believes are most important for a reader's understanding of the financial information provided in this report are described below.

· Revenue Recognition, Allowance for Bad Debts and Returns Reserve

· Income Taxes

· Capitalized Software Development Costs

· Valuation of Intangible Assets and Other Long-Lived Assets

· Accounting for Share-Based Compensation

During the three months ended December 31, 2011, there were no significant changes in the Company's critical accounting policies. See Note 1 to the Company's condensed consolidated financial statements included in this Quarterly Report on Form 10-Q and in its Annual Report on Form 10-K for the year ended September 30, 2011 for additional information about these critical accounting policies, as well as a description of the Company's other significant accounting policies.

RESULTS OF OPERATIONS

The following table sets forth certain statements of operations data as a percentage of total revenues for the periods indicated. The data has been derived from the unaudited condensed consolidated financial statements contained in this Quarterly Report on Form 10-Q. The operating results for any period should not be considered indicative of the results expected for any future period. This information should be read in conjunction with the Consolidated Financial Statements and Notes thereto included in the Company's Annual Report on Form 10-K for the fiscal year ended September 30, 2011.

                                                   Three Months Ended
                                                      December 31,
                                                    2011        2010
REVENUE:
Software licenses                                      67%         50%
Maintenance                                            27%         37%
Professional services                                   6%         13%
Total revenue                                         100%        100%

COSTS AND EXPENSES:
Cost of software licenses                               9%         13%
Cost of maintenance and services                       11%         16%
Sales and marketing                                    45%         30%
Engineering and product development                    10%         15%
General and administrative                             15%         21%
Total costs and expenses                               90%         95%

INCOME FROM OPERATIONS                                 10%          5%

Interest income and other income (expense), net         0%          1%

INCOME BEFORE INCOME TAXES                             10%          6%
Provision for income taxes                              0%          0%

NET INCOME                                             10%          6%

                Three Months Ended December 31, 2011 Compared to
                      Three Months Ended December 31, 2010

Total Revenues

The following table presents total revenue, total revenue increase (decrease)
and percentage change in total revenue for the three months ended December 31,
2011 and 2010:

                          Three Months Ended
                             December 31,            Increase       Percentage
                           2011          2010       (Decrease)        Change
                                    (In thousands)

Software licenses       $    4,208      $ 2,110     $     2,098             99%
Maintenance                  1,717        1,538             179             12%
Professional services          346          532            (186 )          -35%

Total revenue           $    6,271      $ 4,180     $     2,091             50%

Software license revenue for the three months ended December 31, 2011 was $4,208,000 or approximately 67% of total revenue, as compared to $2,110,000, or approximately 50% of total revenue for the three months ended December 31, 2010. The increase in software license revenue of $2,098,000 for the three months ended December 31, 2011 consists of a $2,092,000 increase in Report Analytics Solutions (including Monarch, Monarch Data Pump, Monarch Enterprise Server, Monarch RMS, Datawatch Dashboards, Monarch Report Manager on Demand and iMergence products) and a $6,000 increase in Business Service Management Solutions (including Visual QSM and Visual HD products). The Company attributes the increase in software license revenue to its new product positioning and the investments the Company has made in its sales and marketing organization which has resulted in increased enterprise license sales during the quarter. Additionally, included in software license revenue for the three months ended December 31, 2011 was an individual sale of the Company's Monarch Report Manager on Demand product for approximately $1.1 million to a significant customer. See additional details

related to this sale in "Concentration of Credit Risks and Major Customers" included in Note 1 to the Company's condensed consolidated financial statements. To the extent the Company has large contracts with single customers going forward, this may cause variability in financial results from period to period.

Maintenance revenue for the three months ended December 31, 2011 was $1,717,000 or approximately 27% of total revenue, as compared to $1,538,000, or approximately 37% of total revenue for the three months ended December 31, 2010. The increase in maintenance revenue of $179,000 consists of a $191,000 increase in Report Analytics Solutions (including Monarch, Monarch Data Pump, Monarch Enterprise Server, Monarch RMS, Datawatch Dashboards, Monarch Report Manager on Demand and iMergence products) offset by a $12,000 decrease in Business Service Management Solutions (including Visual QSM and Visual HD products). The increase in maintenance revenue is primarily attributable to increased maintenance on the Monarch product line.

Professional services revenue for the three months ended December 31, 2011 was $346,000 or approximately 6% of total revenue, as compared to $532,000, or approximately 13% of total revenue for the three months ended December 31, 2010. The decrease in professional services revenue of $186,000 consists of a $178,000 decrease in Report Analytics Solutions (including Monarch, Monarch Data Pump, Monarch Enterprise Server, Monarch RMS, Datawatch Dashboards, Monarch Report Manager on Demand and iMergence products) and an $8,000 decrease in Business Service Management Solutions (including Visual QSM and Visual HD products).

Costs and Operating Expenses

The following table presents costs of sales and operating expenses, increase
(decrease) in costs of sales and operating expenses and percentage changes in
costs of sales and operating expenses for the three months ended December 31,
2011 and 2010:

                                        Three Months Ended
                                           December 31,            Increase       Percentage
                                         2011          2010       (Decrease)        Change
                                                  (In thousands)

Cost of software licenses             $      575      $   545     $        30              6%
Cost of maintenance and services             668          680             (12 )           -2%
Sales and marketing                        2,801        1,226           1,575            129%
Engineering and product development          628          635              (7 )           -1%
General and administrative                   967          877              90             10%

Total costs and operating expenses    $    5,639      $ 3,963     $     1,676             42%

The increase in cost of software licenses and subscriptions of $30,000, or approximately 6%, is primarily due to an increase in royalty costs associated with higher sales of the Company's Monarch product line offset by lower software amortization costs associated with previously acquired software.

The decrease in cost of maintenance and services of $12,000, or approximately 2%, is primarily due to lower use of external consultants during the three months ended December 31, 2011 as compared to the same period last year.

The increase in sales and marketing expenses of $1,575,000, or approximately 129%, is due to increased promotional, lead generation and consulting costs as well as higher wages and employee-related costs, including share-based compensation, attributable to increased headcount as compared to the same period last year.

The decrease in engineering and product development expenses of $7,000, or approximately 1%, is primarily attributable to lower external consulting costs as well as lower employee-related costs as compared to the same period last year.

The increase in general and administrative expenses of $90,000, or 10%, is primarily attributable to higher professional services, legal and consulting costs and employee-related costs which were partially offset by lower bad debt and depreciation expense.

Interest income and other income (expense) includes primarily the following two components: interest income and gains (losses) on foreign currency transactions. Interest income for the three months ended December 31, 2011 and 2010 was $2,000 and $1,000, respectively. Gain (loss) on foreign currency transactions for the three months ended December 31, 2011 was a gain of approximately $7,000 as compared to $22,000 for the three months ended December 31, 2010. The foreign currency gains for the three months ended December 31, 2011 and 2010 were primarily attributable to the repayment of intercompany loans between the Australian and UK subsidiaries.

Income tax expense for the three months ended December 31, 2011 was $38,000 as compared to $11,000 for the three months ended December 31, 2010. Income tax expense for the three months ended December 31, 2011 includes $19,000 related to estimated state taxes and $13,000 related to estimated federal alternative minimum taxes. Income tax expense for the three months ended December 31, 2010 includes $5,000 related to estimated alternative minimum taxes. Income tax expense for both periods also includes a $6,000 provision for uncertain tax positions relative to foreign taxes. At December 31, 2011, the Company had U.S. federal tax loss carryforwards of approximately $6.4 million which expire at various dates through and until 2031 as well as significant state and foreign net operating loss carryforwards.

Net income for the three months ended December 31, 2011 was $603,000 as compared to $229,000 for the three months ended December 31, 2010.

OFF BALANCE SHEET ARRANGEMENTS, CONTRACTUAL OBLIGATIONS AND CONTINGENT LIABILITIES AND COMMITMENTS

The Company leases various facilities and equipment in the U.S. and overseas under non-cancelable operating leases that expire through 2016. The lease agreements generally provide for the payment of minimum annual rentals, pro rata share of taxes, and maintenance expenses. Rental expense for all operating leases was approximately $113,000 and $82,000 for the three months ended December 31, 2011 and 2010, respectively.

As of December 31, 2011, the Company's contractual obligations include minimum rental commitments under non-cancelable operating leases and other liabilities related to uncertain tax positions as follows (in thousands):

                                                 Less than                                       More than
Contractual Obligations:           Total          1 Year         1-3 Years       3-5 Years        5 Years

  Operating Lease Obligations    $      954     $       320     $       380     $       254     $         -

  Other Liabilities              $      181     $         -     $         -     $         -     $       181

The Company is also obligated to pay royalties ranging from 7% to 50% on revenue generated by the sale of certain licensed software products. Royalty expense included in cost of software licenses was approximately $511,000 and $339,000, respectively, for the three months ended December 31, 2011 and 2010. The Company is not obligated to pay any minimum amounts for royalties.

The Company's software products are sold under warranty against certain defects in material and workmanship for a period of 30 days from the date of purchase. If necessary, the Company would provide for the estimated cost of warranties based on specific warranty claims and claim history. However, the Company has never incurred significant expense under its product or service warranties. As a result, the Company believes its exposure related to these warranty agreements is minimal. Accordingly, there are no liabilities recorded for warranty claims as of December 31, 2011.

The Company enters into indemnification agreements in the ordinary course of business. Pursuant to these agreements, the Company generally agrees to indemnify, hold harmless, and reimburse the indemnified party for losses suffered or incurred by the indemnified party, generally its customers, in connection with any patent, copyright or other intellectual property infringement claim by any third party with respect to the Company's products. The term of these indemnification agreements is generally perpetual. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited. The Company has never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the Company believes its exposure related to these agreements is minimal. Accordingly, the Company has no liabilities recorded for these potential obligations as of December 31, 2011.

Certain of the Company's agreements also provide for the performance of services at customer sites. These agreements may contain indemnification clauses, whereby the Company will indemnify the customer from any and all damages, losses, judgments, costs and expenses for acts of its employees or subcontractors resulting in bodily injury or property damage. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company has general and umbrella insurance policies that would enable it to recover a portion of any amounts paid. The Company has never incurred costs to defend lawsuits or settle claims related to these indemnification agreements. As a result, the Company believes its exposure related to these agreements is minimal. Accordingly, the Company has no liabilities recorded for these potential obligations as of December 31, 2011.

As permitted under Delaware law, the Company has agreements with its directors whereby the Company will indemnify them for certain events or occurrences while the director is, or was, serving at the Company's request in such capacity. The term of the director indemnification period is for the later of ten years after the date that the director ceases to serve in such capacity or the final termination of proceedings against the director as outlined in the indemnification agreement. The maximum potential amount of future payments the Company could be required to make under these indemnification agreements is unlimited; however, the Company's director and officer insurance policy would enable it to recover a portion of any future amounts paid. As a result of its insurance policy coverage, the Company believes its exposure related to these indemnification agreements is minimal. The Company has no liabilities recorded for these potential obligations as of December 31, 2011.

LIQUIDITY AND CAPITAL RESOURCES

Management believes that its current cash balances and cash generated from operations will be sufficient to meet the Company's cash needs for working capital and anticipated capital expenditures for at least the next twelve months. At December 31, 2011, the Company had $9,651,000 of cash and equivalents, an increase of $1,267,000 from September 30, 2011.

At December 31, 2011, the Company had working capital of approximately $6,093,000 as compared to $5,423,000 at September 30, 2011. The Company expects cash flows from operations to remain positive as it anticipates profitability in the future. However, if the Company's cash flow from operations were to decline significantly, it may need to consider reductions to its operating expenses. The Company does not anticipate additional cash requirements to fund significant growth. However, if the Company were to acquire complementary technology or businesses, the cost of any such acquisition may require the Company to seek additional debt or equity financing to fund such requirements. There can be no assurance that the Company will be able to issue additional equity or obtain a new credit facility at attractive prices or rates, or at all.

The Company had net income of approximately $603,000 for the three months ended December 31, 2011 as compared to net income of approximately $229,000 for the three months ended December 31, 2010. During the three months ended December 31, 2011 and 2010, approximately $1,419,000 and $468,000, respectively, of cash was provided by the Company's operations. During the three months ended December 31, 2011, the main source of cash from operations was net income adjusted for share-based compensation expense as well as increases in deferred revenue and accounts payable, accrued expenses and other liabilities.

Net cash used in investing activities for the three months ended December 31, 2011 of $116,000 is primarily related to the purchase of property and equipment, capitalized software development costs and an increase in other assets.

Net cash provided by financing activities for the three months ended December 31, 2011 of $6,000 is related to proceeds from the exercise of stock options.

An existing agreement between Datawatch and Math Strategies grants the Company exclusive worldwide rights to use and distribute through April 30, 2015 certain intellectual property owned by Math Strategies and incorporated by the Company in its Monarch, Monarch Data Pump and certain other products. The Company has also entered into an Option Purchase Agreement with Math Strategies giving the Company the option to purchase these intellectual property rights for a formula price based on a multiple of the aggregate royalties paid to Math Strategies by the Company for the four fiscal quarters preceding the exercise of the option. The option, if exercised, would provide the Company with increased flexibility to utilize the purchased technology in the future.

Management believes that the Company's current operations have not been materially impacted by the effects of inflation.