SEGUE SOFTWARE 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 a 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 þ No o

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

The number of shares of Registrant’s Common Stock outstanding as of October 31, 2004 was 10,015,848.

This Form 10-Q contains statements that are “forward-looking statements” under the Private Securities Litigation Reform Act of 1995. We may also make written or oral forward-looking statements in other documents we file with the SEC, in our annual report to stockholders, in press releases and other written materials, and in oral statements made by our officers, directors or employees. You can identify forward-looking statements by the use of the words “believe,” “expect,” “anticipate,” “intend,” “estimate,” “assume,” “outlook,” “will,” “should,” and other expressions which predict or indicate future events and trends and which do not relate to historical matters. You should not rely on forward-looking statements, because they involve known and unknown risks, uncertainties and other factors, some of which are beyond the control of the Company. These risks, uncertainties and other factors may cause the actual results, performance or achievements of the Company to be materially different from the anticipated future results, performance or achievements expressed or implied by the forward-looking statements.

Some of the factors that might cause these differences are discussed under the heading “Risks and Factors That May Affect Future Results” beginning on page 23. You should carefully review all of these factors, and you should be aware that there might be other factors that could cause these differences. These forward-looking statements were based on information, plans and estimates at the date of this report, and we do not promise to update any forward-looking statements to reflect changes in underlying assumptions or factors, new information, future events or other changes.

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


*	The assumed conversion of preferred shares into common shares is not included because their inclusion would be anti-dilutive for 2004.

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

The financial statements included herein have been prepared by Segue Software, Inc. (“Segue”, “We”, “Our” or “The Company”), without audit, pursuant to the rules and regulations of the Securities and Exchange Commission. Certain information and footnote disclosures normally included in financial statements prepared in accordance with generally accepted accounting principles have been condensed or omitted pursuant to such rules and regulations. We believe that the disclosures are adequate to make the information presented not misleading. However, it is suggested that these financial statements be read in conjunction with Segue’s audited financial statements for the year ended December 31, 2003, included in its 2003 Annual Report on Form 10-K.

This financial information reflects, in the opinion of our management, all adjustments of a normal recurring nature necessary to present fairly the results for the interim periods. Results of interim periods may not be indicative of results for the full year.

The Company has incurred losses on an annual basis since it began operations, resulting in an accumulated deficit of approximately $56.8 million at September 30, 2004. As a result, the Company has used significant amounts of cash, cash equivalents and short-term investments to fund its operations. However, the Company generated approximately $2.4 million in overall positive cash flow for the first nine months of 2004 versus $852,000 for the same period in 2003. For the quarter ended September 30, 2004, the Company generated approximately $691,000 in overall positive cash flow, which represents the eighth consecutive quarter of positive cash flow for the Company.

Segue management has taken significant steps to streamline its operations over the last three years and plans to continue to do so as the situation warrants. These steps, in the past, have included reducing headcount, infrastructure and other expenses and limiting capital expenditures. At a minimum, the Company must maintain revenue at or near the current levels for Segue to sustain profitability and positive cash flow. Assuming that Segue can execute on current plans to maintain or grow revenue, Segue believes there should be sufficient cash to meet its forecasted working capital needs for at least the next twelve months. Delays in the timing of future sales or sales levels below management’s expectations may cause the Company to re-evaluate its cash position, adjust its operations and/or take other actions.

Long-term cash requirements, other than for normal operating expenses, and for commitments including those detailed in Note 10, are anticipated for the development of new software products and enhancements of existing products, and the possible acquisition of software products or technologies complementary to our business.

The recoverability of a major portion of the recorded asset amounts shown in the accompanying balance sheet is dependent upon the continued operations of Segue, which in turn are dependent upon Segue’s ability to maintain or increase sales and to succeed in its future operations. The financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts, and classification and amounts of liabilities that might be necessary should Segue be unable to continue operations.

In December 2002, the FASB issued SFAS No. 148, “Accounting for Stock-Based Compensation — Transition and Disclosure” (“SFAS No. 148”). The standard amends SFAS No. 123, “Accounting for Stock-Based Compensation,” to provide alternative methods for voluntary transition to SFAS No. 123’s

fair value method of accounting for stock-based employee compensation (“the fair value method”). SFAS No. 148 also requires disclosure of the effects of an entity’s accounting policy with respect to stock-based employee compensation on reported net income (loss) and earnings (loss) per share in annual and interim financials statements. The transition provisions of SFAS No. 148 are effective in fiscal years beginning after December 15, 2002. The Company is currently evaluating the transition provisions of SFAS No. 148 and has adopted the disclosure provisions of SFAS No. 148.

SFAS No. 123, “Accounting for Stock-Based Compensation,” required the Company to elect either expense recognition under SFAS No. 123 or its disclosure-only alternative for stock-based employee compensation. The expense recognition provision encouraged by SFAS No. 123 requires fair-value based financial accounting to recognize compensation expense for employee stock compensation plans. The Company adopted SFAS No. 123 in 1997 and elected the disclosure-only alternative. Had compensation costs for the Company’s stock and stock option plans been determined based on the fair value at the grant dates for awards under those plans consistent with the methodology of SFAS No. 123, the Company’s net income (loss) and net income (loss) per share would have been adjusted to the pro forma amounts indicated below for the quarters and nine months ended September 30, (in thousands, except per share data):

In January 2003, the FASB issued FIN No. 46, “Consolidation of Variable Interest Entities.” In general, a variable interest entity is a corporation, partnership, trust, or any other legal structure used for business purposes that either (a) does not have equity investors with voting rights or (b) has equity investors that do not provide sufficient financial resources for the entity to support its activities. FIN No. 46 requires certain variable interest entities to be consolidated by the primary beneficiary of the entity if the investors 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. The consolidation requirements of FIN No. 46 apply immediately to variable interest entities created after January 31, 2003. The consolidation requirements apply to older entities in interim periods beginning after June 15, 2003. Certain of the disclosure requirements apply in all financial statements issued after January 31, 2003, regardless of when the variable interest entity was established. In December 2003, the FASB completed deliberations of proposed modifications to FIN 46 (Revised Interpretations) resulting in multiple effective dates based on the nature as well as the creation date of the variable interest entity. Because the Company currently has no investments in variable interest entities, the adoption of the provisions of FIN No. 46 did not have an impact on the consolidated results of operations or financial position.

In April 2003, FASB issued Statement of Financial Accounting Standard No. 149, “Amendment of Statement No. 133 on Derivative Instruments and Hedging Activities”. Statement No. 149 amends Statement No. 133 for decisions made (1) as part of the Derivatives Implementation Group process that effectively required amendments to Statement No. 133, (2) in connection with other Board projects dealing with financial instruments, and (3) in connection with implementation issues raised in relation to the application of the definition of a derivative. The Statement clarifies under what circumstances a contract with an initial net investment meets the characteristics of a derivative discussed in paragraph 6(b) of Statement No. 133, clarifies when a derivative contains a financing component, amends the definition of an underlying contract to conform it to language used in FASB Interpretation No. 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others”, and amends certain other existing pronouncements. Those changes are expected to result in more consistent reporting of contracts as either derivatives or hybrid instruments. This statement is effective for contracts entered into or modified after June 30, 2003 and for hedging relationships designated after June 30, 2003. The Company has not used hedging instruments; therefore the adoption of Statement No. 149 did not have a significant impact on either its financial position or results of operations.

In May 2003, FASB issued SFAS No. 150, “Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity”. Statement No. 150 establishes standards for how an issuer classifies and measures certain financial instruments with characteristics of both liabilities and equity. In addition, the Statement requires an issuer to classify certain instruments with specific characteristics described in it as liabilities. This Statement is effective for financial instruments entered into or modified after May 31, 2003, and otherwise is effective at the beginning of the first interim period beginning after June 15, 2003. The adoption of Statement No. 150 did not have a significant impact on either its financial position or results of operations.

In May 2003, EITF Issue No. 00-21, “Revenue Arrangements with Multiple Deliverables” was issued. This EITF provides guidance with respect to the accounting by a vendor for arrangements under which the vendor will perform multiple revenue generating activities. EITF No. 00-21 is effective for revenue arrangements entered into in fiscal periods after June 15, 2003. The adoption of EITF No. 00-21 did not have a significant impact on our financial position or results of operations.

On March 31, 2004, the Financial Accounting Standards Board (FASB) issued a proposed Statement, Share-Based Payment, that addresses the accounting for share-based awards to employees, including employee-stock-purchase-plans (ESPPs). The FASB formally proposed to require companies to recognize the fair value of stock options and other stock-based compensation to employees. The proposed Statement would eliminate the ability to account for share-based compensation transactions using APB Opinion No. 25, Accounting for Stock Issued to Employees, and generally would require instead, that such transactions, be accounted for using a fair-value-based method. The proposed requirements in the exposure draft would be effective for public companies as of the beginning of the first fiscal year beginning after December 15, 2004. At a meeting held in October 2004, the FASB decided to defer, for public companies, the effective date of the proposed statement from fiscal years beginning after December 15, 2004, to periods beginning after June 15, 2005. The Company currently accounts for its stock-based compensation plans in accordance with APB Opinion No. 25. Therefore, the eventual adoption of this proposed statement, if issued in final form by the FASB, will have a material effect on the Company’s consolidated financial statements.

Included in other assets at September 30, 2004 and December 31, 2003 is restricted cash of $770,000. This amount represents the security for a letter of credit required by our amended sublease for our Lexington headquarters. The amount required to be maintained under this letter of credit arrangement will

reduce over time, by formula, to zero by August 2005. Also included is approximately $153,000 in refundable security deposits we have paid for our various regional sales offices.

On October 21, 2003, the Company received $500,000 from the sale of 166,667 shares of the Company’s Series C Preferred Stock to S-7 Associates, LLC, an entity controlled by James Simons, a Segue Director (“S-7 Associates”) and Howard Morgan, also a Segue Director. On November 25, 2003, the Company received $1,000,000 from the sale of 333,333 shares of the Company’s Series C Preferred Stock to a private investor. The Series C Preferred Stock is senior to the Company’s common stock as to dividend and liquidation rights and is convertible at the option of the holder into shares of our common stock at a conversion rate of one share of common for one share of Series C Preferred Stock, subject to adjustment upon the occurrence of certain transactions. The holders of the Series C Preferred Stock are entitled to vote together with the holders of our common stock on an as-converted basis. Dividends on the Series C Preferred Stock accrue at 12% per annum and are to be paid in additional shares of Preferred Stock or, in certain cases, in cash, semiannually on June 30 and December 31. The Series C Preferred Stock is redeemable at the option of the Company on or after October 31, 2005 at 133% of its face value (“Series C Preferred Liquidation Preference”). If there is a sale of all or substantially all of the Company’s assets or equity, the Series C Preferred Stock can either be redeemed at the Series C Preferred Liquidation Preference, at the holder’s request, or converted to our common stock. Pursuant to a registration rights agreement, the Company has agreed, subject to certain limitations, to register, under the Securities Act of 1933, the resale of common stock into which the Series C Preferred Stock may be converted. The registration rights expire on November 25, 2008.

Dividends paid to any holder on Series C Preferred Stock are restricted should they cause any holder, among other things, to accumulate more than 20% of our voting power. If any holder of Series C Preferred Stock should accumulate more than 20% of our voting power, such holder will be entitled to cash dividends in lieu of dividends in kind while holding 20% or more of our voting power.

For the quarter ended September 30, 2004, an additional 26,065 shares of our Series B Preferred Stock and an additional 16,151 shares of our Series C Preferred Stock were earned and will be issued on December 31, 2004. The total number of shares of Series B Preferred Stock and Series C Preferred Stock earned for the nine months ended September 30, 2004 totaled 75,245 and 46,625, respectively, of which 49,180 shares of Series B Preferred Stock and 30,474 shares of Series C Preferred Stock were issued on June 30, 2004. Our preferred stock dividends deemed earned for the three months ended September 30, 2004 resulted in a reduction of net income (increase in net loss) applicable to common shares of approximately $187,000 versus $79,000 for the period ended September 30, 2003. For the nine-month period ended September 30, 2004, this amount was approximately $527,000 versus $201,000 for the same nine-month period in 2003.

Prior to January 1, 2004, the fair value of our Preferred Stock, on which the preferred dividends were calculated, had been estimated by our management for the purpose of determining net loss applicable to common shares. Beginning with the first quarter of 2004, the Company hired an independent third party, who specializes in valuations, to establish the fair market value of its Preferred Stock at the end of each quarter. The Company will continue to engage this third party on a quarterly basis for the purpose of establishing the fair market value of its Preferred Stock and calculating the amount of the dividends earned.

For the three months ended September 30, 2004, there were options to purchase 45,399 shares of common stock exercised by employees and 39,259 shares of common stock were purchased and issued to employees under the Company’s Employee Stock Purchase Plan. Total proceeds to us from such transactions were approximately $221,000. For the three months ended September 30, 2003, there were

4,106 options to purchase shares of common stock exercised by employees and 58,127 shares of common stock were purchased and issued to employees under the Company’s Employee Stock Purchase Plan. Total proceeds to us from such transactions were approximately $95,000. For the nine-months ended September 30, 2004, there were options to purchase 144,241 shares of common stock exercised by employees and 89,658 shares of common stock were purchased and issued to employees under the Company’s Employee Stock Purchase Plan. Total proceeds to us from such transactions were approximately $505,000. For the nine-months ended September 30, 2003, there were options to purchase 15,784 shares of common stock exercised by employees and 142,936 shares of common stock were purchased and issued to employees under the Company’s Employee Stock Purchase Plan. Total proceeds to us from such transactions were approximately $190,000.

At September 30, 2004, the Company had three stock-based employee compensation plans. (These plans are described more fully in Note 5 of the Company’s Annual Report on Form 10-K.) The Company accounts for these plans under the recognition and measurement principles of APB Opinion No. 25, “Accounting for Stock Issued to Employees”, and related interpretations. In general, most options granted under those plans had an exercise price equal to the market value of the underlying common stock on the date of grant, resulting in no stock based compensation expense. However, during the third quarter of 2003, a stock grant was made for which the exercise price was slightly less than the market value of the underlying common stock on the date of grant. This resulted in a compensation expense of approximately $4,000 for the quarter ended September 30, 2004. A balance of approximately $50,000 in unearned compensation remains and it will be amortized over the remaining vesting period of the grant during the next 3 years.

Since April 1, 2001, Segue has executed various restructuring plans aimed at reducing the expenses of the Company. As a result, Segue has recorded restructuring charges for severance, other employee-related costs, and costs for estimated lease obligations associated with excess office facilities in our Lexington and Los Gatos offices, net of estimated sublease income. The following table summarizes the restructuring actions and charges incurred by quarter:

During the third quarter of 2004, the Company paid $119,000 of the amount accrued at December 31, 2003, leaving a balance of $248,000 at September, 2004 for the remaining severance and termination benefits associated with the restructuring actions from 2003.

At September 30, 2004, the accrual balance related to the obligations associated with all of the excess office space noted above is approximately $1.2 million. This is comprised of an estimated $1.5 million for future rents payable by Segue on unoccupied space less approximately $326,000 of estimated future sublease and operating expense income. The Company made no estimate adjustments related to this accrual for the period ended September 30, 2004.

The Company recorded provisions (benefits) for foreign and state income taxes of $61,000 and $63,000 for the three and nine months ended September 30, 2004, respectively, and ($16,000) and $108,000 for the same periods last year. The tax expense realized in the third quarter of 2004 was due in large part to a one time adjustment in state and local taxes in two states. No tax benefit for losses generated in the U.S. was recorded in either period due to the uncertainty of realizing such benefits.

The following table sets forth the computation of basic and diluted income (loss) per share (in thousands, except per share data):

Excluded from the calculation of diluted earnings per share for the three and nine months ended September 30, 2004 were 1,428,299 and 1,394,365 shares of common stock, respectively, that can be converted from preferred stock because their inclusion would be anti-dilutive. Excluded from the calculation of diluted earnings per share for the three and nine months ended September 30, 2003 were options to purchase 3,490,424 shares of common stock and 773,261 shares of common stock, as converted, issuable upon the conversion of preferred stock, respectively, because their inclusion would be anti-dilutive.

SFAS No. 130, “Reporting Comprehensive Income” (“SFAS 130”) requires the reporting of comprehensive income (loss) in addition to net income (loss) from operations. Comprehensive income (loss) is a more inclusive reporting methodology that includes disclosure of certain financial information that historically has not been recognized in the calculation of net income (loss). To date, Segue’s comprehensive income (loss) items have consisted exclusively of foreign translation adjustments. The following table sets forth the computation of comprehensive income (loss) (in thousands):

Various claims, charges and litigation have been asserted or commenced against Segue arising from or related to contractual or employee relations. Our management does not believe these claims will have a material adverse effect on the financial position or results of operations of Segue.

In August 1998, the Company moved its corporate headquarters to Lexington, Massachusetts under a non-cancelable operating sublease that expires on October 31, 2007. On January 24, 2003, the Company received approval to restructure its corporate headquarters sublease by returning approximately 33,000 square feet in its Lexington facility to the landlord. Pursuant to the terms of the restructuring,

Segue has posted an initial letter of credit for $700,000. The cash security of $770,000 (letter of credit plus 10%) that was posted is classified as restricted cash and is reflected in Other Assets on the Company’s balance sheet. The amount required to be maintained under this letter of credit arrangement will be reduced over time, to zero by August 2005. As a result of the restructuring, we reduced our office space from approximately 73,300 square feet to approximately 40,400 square feet with 3,000 square feet sub-subleased to a third party until the end of our sublease, leaving 37,400 square feet of space. We believe that we have more than adequate expansion space for growth in operations at the headquarters location for the foreseeable future. The Company had the right to terminate the sublease on September 30, 2004 for a fee of approximately $2.3 million, but declined to exercise this option.

The Company also leases certain United States and foreign offices and certain equipment under various operating leases with lease terms ranging from month-to-month up to five years. Several of these leases contain renewal options. The agreements generally require the payment of utilities, real estate taxes, insurance and repairs. Future minimum payments under the facilities and equipment leases, excluding the security deposit noted above, but including the obligation of the restructured sublease, with non-cancelable terms are as follows as of September 30, 2004 (in thousands):

Rent expense for the three and nine month period ended September 30, 2004 was $439,000 and $1.4 million, respectively, as compared to $543,000 and $1.5 million for the same periods in 2003.

The Company has participated in royalty arrangements with third parties and, as revenues from the related products are recognized, the Company records the related royalty expense. In September 2001, the Company signed a distribution agreement with T-Plan Ltd., of the United Kingdom. Under the agreement, Segue will sell and market the T-Plan product that has been modified to integrate with other Segue products, under the name SilkPlan Pro, for which Segue will pay T-Plan Ltd., a royalty for each unit sold based on a percentage of price. Under the terms of the agreement, Segue paid T-Plan Ltd., a minimum quarterly royalty through December 31, 2002.

On April 14, 2003, an amendment was signed that stated an advance payment of $50,000 per quarter would be made to T-Plan Ltd. These advance payments would be credited against the actual royalties earned during the period. However, beginning January 14, 2004, in the event that the cumulative prepaid royalties are more than $100,000 in excess of the cumulative actual royalties earned, then the Company would have no obligations to make further advance royalty payments until the cumulative actual royalties are equal to the cumulative advance royalties. As of September 30, 2004, the prepaid royalty balance to T-Plan Ltd. stood at approximately $69,000. Either party may cancel the agreement at any time by giving the other party written notice to that effect at least ninety days prior to such termination. In the event of a termination of the contract, Segue will receive a refund if advance royalty payments should exceed actual

cumulative royalties. Segue has other minor royalty agreements for third party embedded software in Segue’s products.

In addition to the arrangements described above, Segue has entered into other arrangements with third party resellers, distributors and partners that require Segue to pay a referral fee for leads that may be generated by these other parties. None of these arrangements calls for guaranteed minimum payments.

In the event of a change of control or the sale of substantially all assets, the Company has certain contractual obligations to executive officers, as well as, other non-employee related contracts. These potential obligations, should a triggering event take place, are approximately $1.6 million.

The Company considers that it has the following reportable operating segments based on differences in products and services. Operating segments are defined as components of the enterprise about which separate financial information is available that is reviewed regularly by the chief operating decision maker, or decision-making group, in deciding how to allocate resources and in assessing their performance. Software licenses substantially consist of sales of our Silk product line. These operating segments are reviewed only to the gross margin level. The following table sets forth the reportable operating segments (in thousands):

The following table presents revenue and long-lived asset information by geographic area as of and for the quarters and nine months ended September 30 (in thousands):

We develop, market and support software quality optimization solutions for both Web-based and enterprise client/server applications. We also provide product related training and consulting services. This summary provides an overview of the most significant aspects of our operations during the quarter and nine months ended September 30, 2004. Details of the matters addressed in this summary are provided elsewhere in this document and, in particular, in the sections immediately following.

For the quarter ended September 30, 2004, our operating results continued to reflect financial improvement over 2003. During September 2003, we saw the arrival of a new Chief Executive Officer (“CEO”) who brought a new strategy to Segue. In January 2004, our new CEO hired a new Executive Vice President of Worldwide Sales and Marketing and a Chief Marketing Officer to further strengthen our restructured senior management team.

During the third quarter and nine months ended September 30, 2004, we achieved profitability while growing revenue and focusing on our new strategic objectives: profitable revenue growth, market-driven product innovations and maximizing selective partnerships and alliances. Total revenue grew 20% to $8.4 million for the quarter ended September 30, 2004 as compared to $7.0 million during the same period last year. This represents the third consecutive quarter with profitable revenue growth over the same period in 2003. Total revenue for the year ended September 30, 2004 was $24.5 million, up 13% from $21.8 million for the same period in 2003. We reported a net income applicable to common shares of $703,000, or $0.07 basic and fully diluted income per share for the quarter ended September 30, 2004. This compares to a net loss applicable to common shares of $193,000 or a $0.02 loss per share, for the same period last year. For the nine months ended September 30, 2004, we reported net income applicable to common shares of $1.2 million, or $0.12 basic and $0.11 fully diluted income per share, compared to $839,000 net loss applicable to common shares, or $0.09 loss per share, for the same period during 2003. Total operating expenses and cost of sales combined, totaled $7.5 million for the third quarter of 2004, compared to $7.2 million for the same period in 2003. For the first nine months of 2004, total operating expenses and cost of sales combined, totaled $22.8 million. This represents a 3% increase over the $22.2 million total operating expenses and cost of sales combined as reported in the first three-quarters of 2003. Our total worldwide headcount at September 30, 2004 and 2003 stood at 184 and 194, respectively.

At September 30, 2004, our reported cash and cash equivalent balance was $9.9 million, compared to $7.5 million at December 31, 2003 and $6.2 million at September 30, 2003. We reported positive cash flow from operations of $2.1 million in the first nine months of 2004, compared to $490,000 positive cash flow during the first nine months of 2003. Deferred revenue increased to $9.5 million for the quarter ended September 30, 2004, compared to $8.4 million for the quarter ended September 30, 2003. We continue to have no debt on our balance sheet and have no off-balance sheet contingency debt.

Over the last three years, we have been able to reduce our net loss through a streamlining of the organization, which included restructurings, consolidations, process improvements, office closings and general improved cost control. In 2004, we are continuing to improve and grow the business by focusing on our three strategic priorities: profitable revenue growth, market-driven product innovations; and a focus on selective partnerships and alliances.

The preparation of financial statements in accordance with accounting principles generally accepted in the United States of America requires that management make a number of assumptions and estimates that affect the reported amounts of assets, liabilities, revenues and expenses in our consolidated financial statements and accompanying notes. Management bases its estimates on historical experience and various other assumptions believed to be reasonable. Although these estimates are based on management’s best knowledge of current events and actions that may impact the Company in the future, actual results may differ from these estimates and assumptions.

Our critical accounting policies are those that affect our financial statements materially and involve a significant level of judgment by management:

Revenue Recognition — We follow the guidance in Statement of Position (“SOP”) 97-2, “Software Revenue Recognition”, as amended by SOP 98-9, in recognizing revenue on software transactions. SOP 97-2 requires that revenue allocated to software products, specified upgrades and enhancements is recognized upon delivery of the related products, upgrades or enhancements. Revenue allocated by vendor specific objective evidence (“VSOE”) to post contract customer support (maintenance) is recognized ratably over the term of the support, and revenue allocated by VSOE to service elements (training and consulting) is recognized as the services are performed. The residual method of revenue recognition is used for multi-element arrangements when the VSOE of the fair value does not exist for one or more of the delivered elements. Under the residual method, the arrangement fee is recognized as follows: (1) the total fair value of the undelivered elements, as indicated by VSOE, is deferred and subsequently recognized in accordance with relevant sections of SOP 97-2 and (2) the difference between the total arrangement fee and the amount deferred for the undelivered elements is recognized as revenue related to the delivered elements.

We recognize revenue from software licenses upon the receipt of a signed purchase order contract; product delivery; assessment that collection is probable; and the other revenue recognition criteria of SOP 97-2 are met. Our software products do not require significant modification, customization or installation and are generally sold on a permanent license basis.

Post contract customer support (maintenance) and service revenue (training and consulting) that is not yet earned is included in deferred revenue.

With respect to the determination of VSOE for multi-element arrangements, we follow the guidance within paragraph 10 of SOP 97-2. The Company uses the residual method of revenue recognition as provided for in paragraph 12 of SOP 97-2, as amended by SOP 98-9. The Company does a thorough review of the VSOE for maintenance, training and consulting semi-annually. In all instances the VSOE is defined as the objective, verifiable price when the same item is sold separately. We determine VSOE for post-contract support (maintenance) using a consistent percentage of list price method for product categories, which approximates the maintenance renewal rates and is considered to be substantive. We determine the VSOE for training classes and consulting services using objective verifiable evidence of these items when sold separately.

Bad Debt Reserve — On a quarterly basis, we review our accounts receivable aging to determine which accounts appear to be uncollectible and record an appropriate reserve. This determination is based on a complete review of all accounts greater than 60 days old and an estimate of default based upon historical rates for all accounts less than 60 days old.

Restructuring and Impairment Charges — Another critical accounting policy relates to the recording of restructuring losses. Through 2002, Segue followed the guidance prescribed in EITF 94-3, “Liability Recognition for Certain Employee Termination Benefits and Other Costs to Exit an Activity (Including Certain Costs Incurred in a Restructuring)”. Effective from January 1, 2003, Segue follows the guidance prescribed in Statement of Financial Accounting Standard (“SFAS”) No. 146, “Accounting for Costs Associated with Exit or Disposal Activities”. As such, since April 2001, we recorded total restructuring charges of $6.1 million, which includes $2.6 million for severance and other employee related costs and $3.5 million for the cost of unused space in our Lexington and Los Gatos offices, net of estimated sublease income, that resulted from workforce reductions. Refer to Note 6 in our Consolidated Financial Statements in this Form 10-Q for additional information. During the fourth quarter of 2003, we executed a restructuring plan and incurred charges of approximately $725,000 for severance and other employee-related costs for the termination of eight employees, including three senior vice presidents.

The estimate for the $3.5 million loss on unused space was based on information that was available at that time. Factors that were included were anticipated rental rates in the local commercial office market and the estimated timeframe in which we expected to sublease the space. We obtained local real estate

market data and consulted with our real estate advisor on these factors to help determine an appropriate reserve for potential losses on the unused space. During the fourth quarter of 2002, Segue was able to reach an agreement in principle with its landlord to restructure the sublease for our Lexington facility. A formal agreement was consummated on January 24, 2003. At September 30, 2004, the accrual balance related to the obligations associated with all of the excess office space in both the Lexington and Los Gatos facilities is approximately $1.2 million. This is comprised of an estimated $1.5 million for future rents payable by Segue on unoccupied space less approximately $326,000 of estimated future sublease and operating expense income. We are under a restructured sublease for the Lexington facility until October 2007.

Goodwill — As required by SFAS No. 142, “Goodwill and Other Intangible Assets”, Segue discontinued the amortization of goodwill effective January 1, 2002. Goodwill represents the excess of cost over the fair value of the net assets of businesses acquired. Goodwill resulted from our acquisition of SQLBench in December 1997 and was being amortized using the straight-line method over five years. As further required by SFAS No. 142, we perform an analysis of the transitional fair value of the goodwill annually during the fourth quarter and will adjust the value of the goodwill should the calculated transitional fair value of the goodwill be less than that reported on our consolidated balance sheet. During the year ended December 31, 2002, Segue performed an initial analysis of the transitional fair value of the goodwill and re-evaluated the fair value of the goodwill during the fourth quarter of 2002. The analysis demonstrated that no impairment existed at December 31, 2002 and no adjustment was made. We re-evaluated the fair value of the goodwill during the fourth quarter of 2003. The analysis demonstrated that no impairment existed at December 31, 2003 and no adjustment was made. Any future impairment loss that may occur would not exceed $1.5 million, which is the net amount of goodwill that is on the consolidated balance sheet at September 30, 2004.

Preferred Stock Dividend-In-Kind — On March 22, 2002, the Company and S-7 Associates signed an agreement under which S-7 Associates purchased 666,667 shares of the Company’s Series B Preferred Stock (“Preferred B Stock”) in consideration for a payment of $2.0 million. On October 21, 2003, we received $500,000 from the sale of 166,667 shares of the Company’s Series C Preferred Stock (together with the Preferred B Stock, the “Preferred Stock”) to S-7 Associates and also Dr. Howard Morgan, a Segue Director. On November 25, 2003, we completed an additional Preferred Stock offering and received $1,000,000 from the sale of 333,333 shares of Series C Preferred Stock to a private investor, further raising our net stockholders’ equity position and strengthening our listing status on Nasdaq’s Small Cap Market Exchange. The Preferred Stock is senior to the common stock as to dividend and liquidation rights and is convertible at the option of the holder into shares of our common stock at a conversion rate of one share of Preferred Stock for one share of common, subject to adjustment upon the occurrence of certain transactions including future stock and warrant issuances at an exercise price of less than $3 per share. Dividends on the Preferred Stock accrue at 12% per annum and are to be paid in additional shares of Preferred Stock or, in certain cases, cash, semiannually on June 30 and December 31.

Prior to January 1, 2004, management had estimated the value of a share of Preferred Stock to be equal to 140% of the average stock price for the Company’s common stock for the period in question. During 2004, the Company hired an independent third party on a quarterly basis, who specializes in valuations, to establish the fair market value of the Preferred Stock. The Company will continue to engage this third party on a quarterly basis for the purpose of establishing the fair market value of the Preferred Stock and calculating the expense of the dividends earned.

The Company reflects the estimated value of the Preferred Stock dividend-in-kind on a quarterly basis as a reduction in the net income (increase in net loss) applicable to common shares.

Dividends paid to any holder on Series C Preferred Stock are restricted should they cause such holder, among other things, to accumulate more than 20% of our voting power. If any holder of Series C Preferred Stock should accumulate more than 20% of our voting power, such holder will be paid cash payments in lieu of dividends in kind while holding at least 20% of our voting power.

The following table sets forth certain unaudited quarterly results of operations expressed as a percentage of total revenue for the periods indicated:

Software revenue results from the granting of perpetual and time-based licenses for the use of Segue products. We license our software through our direct sales force, inside sales, international distributors, business partners, and resellers.

Software revenue was $3.8 million for the quarter ended September 30, 2004 as compared to $3.0 million for the quarter ended September 30, 2003, an increase of 25%. This increase of $800,000 in software revenue was primarily attributable to an increase in product sales in our European markets. Software revenue was $10.9 million for the nine months ended September 30, 2004 as compared to $9.5 million for the nine months ended September 30, 2003, an increase of 15%. This increase of $1.4 million in software revenue was primarily attributable to $400,000 in software licenses that were received on December 31, 2003, but not delivered until January 2004 (as disclosed in our Annual Report on Form 10-K for the fiscal year ended December 31, 2003). The increase was also attributed to the number of overall product deals and as previously mentioned, an increase in European sales during the third quarter of 2004.

International software revenue represented $1.2 million, or 32%, and $691,000, or 23%, of total product sales for the quarter ended September 30, 2004 and 2003, respectively. The total dollar amount of international software revenue increased by approximately $509,000 or 73%. This increase was primarily attributable to several large product deals from our Germany sales operation. International software revenue represented $3.1 million, or 28%, and $2.5 million, or 26% of total product sales for the nine months ended September 30, 2004 and 2003, respectively.

Our software revenue growth depends upon our ability to successfully generate and fulfill software license orders, generate incremental revenue from our business partnerships and strategic alliances, attract and retain skilled personnel, deliver timely new products and enhancements and continued market growth. Performance could also be affected by the market acceptance of our new and enhanced products and increased competition. It is difficult to determine when and if we will be able to grow software revenue in the future.

Services revenue consists of revenue from maintenance, training and consulting. Services revenue was $4.7 million for the quarter ended September 30, 2004 as compared to $4.1 million for the quarter ended September 30, 2003, an increase of 15%. Service revenue was $13.7 million for the nine months ended September 30, 2004 as compared to $12.3 million for the nine months ended September 30, 2003, an increase of 11%.

Maintenance revenue was $3.9 million for the quarter ended September 30, 2004 as compared to $3.6 million for the quarter ended September 30, 2003, an increase of 8%. The increase of $300,000 in maintenance revenue was primarily attributable to an increase in renewals of existing maintenance contracts due to a larger base of licenses. Recognized maintenance revenue is being amortized over the contract period, which is predominately a 12-month period. Maintenance revenue was $11.4 million for the nine months ended September 30, 2004 as compared to $10.3 million for the nine months ended September 30, 2003, an increase of 11%. The increase of $1.1 million was also attributable to an increase in renewals of existing maintenance contracts over a larger base of licenses compared to 2003.

Training and consulting revenue was $829,000 for the quarter ended September 30, 2004 as compared to $478,000 for the quarter ended September 30, 2003, an increase of 73%. The increase in training and consulting revenue of $351,000 was primarily due to an increase in bookings of domestic consulting and training engagements. Training and consulting revenue was $2.3 million for the nine months ended September 30, 2004, compared to $2.0 million for the nine months ended September 30, 2003, an increase of 15%. The increase of $300,000 was primarily attributed to an increase of bookings of domestic consulting and training engagements. Additionally, we continue to see an increase in customers using on-line training which the Company began offering in 2002 and has proven to be successful. On-line instructor monitored training allows our customers a flexible option in which to realize the full value of training while keeping expenses, such as tuition, travel and lodging, to a minimum.

It is difficult to determine when and if we will be able to grow training and consulting revenue in the future or if we will be able to renew maintenance contracts at the same level as we have done in the past.

The Company committed to making payments to several vendors, resellers, and distributors of $46,000 for the quarter ended September 30, 2004, compared to $41,000 for the quarter ended September 30, 2003. The increase of $5,000 is primarily attributed to an increase in the number of deals to which a referral fee applied. The Company committed to making payments to several vendors, resellers, and distributors of $104,000 for the nine months ended September 30, 2004, compared to $136,000 for the nine months ended September 30, 2003. The decrease of $32,000 is primarily attributed to a reduction in the number of deals to which a referral fee applied.

Under EITF Issue No. 01-9, “Accounting for Consideration Given by a Vendor to a Customer (Including a Reseller of Vendor’s Products)”, these payments are considered to be a reduction of revenue and are presented in our statement of operations as such for 2004 and 2003.

Cost of software includes documentation, product packaging, product media, employment costs for processing and distribution, amortization of capitalized technology and royalties due to third parties for their software that we embed in our products. Cost of software was $82,000 for the quarter ended September 30, 2004, or 2% of software revenue as compared to $109,000 for the quarter ended September 30, 2003, or 4% of software revenue. The decrease of $27,000 was primarily attributable to a decrease of $25,000 in other fulfillment costs.

Cost of software was $259,000 for the nine months ended September 30, 2004, or 2% of software revenue as compared to $284,000 for the nine months ended September 30, 2003, or 3% of software revenue. The decrease of $25,000 was primarily attributed to a decrease of $15,000 in royalty expense and a decrease of $27,000 in other fulfillment costs, offset by an increase of $21,000 in personnel related costs.

Cost of services consists principally of salaries and benefits for our customer service and technical support staff, which staff provides services under maintenance contracts, and for our training and consulting staff, as well as third party consulting fees and the cost of materials and facilities used for training customers. Cost of services as a percentage of services revenue varies based on the profitability of individual consulting engagements and the utilization rate of in-house consultants versus the use of higher cost outside contract consultants. Cost of services was $1.2 million for the quarter ended September 30, 2004, or 26% of service revenue, compared to $1.3 million for the quarter ended September 30, 2003, or 31% of service revenue. Cost of services was $3.8 million for the nine months ended September 30, 2004, or 28% of service revenue, compared to $3.8 million for the nine months ended September 30, 2003, or 31% of service revenue.

Cost of training and consulting was $529,000 for the quarter ended September 30, 2004, or 11% of service revenue, compared to $595,000 for the quarter ended September 30, 2003, or 15% of service revenue. The decrease in cost of training and consulting of $66,000 was primarily attributed to a decrease of $99,000 in personnel related costs and a decrease of $50,000 in allocated facility costs due to lower headcount, partially offset by an increase of $63,000 in outsourced consulting expense and an increase of $24,000 in travel costs. Cost of training and consulting was $1.6 million for the nine months ended September 30, 2004, or 12% of service revenue as compared to $1.8 million for the nine months ended September 30, 2003, or 15% of service revenue. The decrease in cost of training and consulting of $200,000 was primarily attributed to a decrease in personnel related cost of $182,000 and a decrease of $115,000 in allocated facility costs due to a lower headcount and an overall reduction in facility costs to be allocated. These decreases were partially offset by an increase of $53,000 in travel costs and an increase of $67,000 in outsourced consulting expense.

Cost of maintenance was $688,000 for the quarter ended September 30, 2004, or 15% of service revenues as compared to $661,000 for the quarter ended September 30, 2003, or 16% of service revenues. The increase in cost of maintenance of $27,000 was primarily attributed to an increase of $57,000 associated with the exchange rate translation in the European market of our foreign technical support operations, offset with a decrease of $13,000 in personnel related costs and $16,000 in depreciation expense associated with more fully depreciated assets. Cost of maintenance was $2.2 million for the nine months ended September 30, 2004, or 16% of net revenues, compared to $2.0 million for the nine months ended September 30, 2003, or 16% of net revenues. The increase in cost of maintenance of $200,000 was primarily attributed to an increase of $81,000 in personnel costs due to higher wages and an increase of $183,000 associated with the exchange rate translation in the European market of our foreign technical

Sales and marketing expenses consist primarily of salaries and benefits, commissions, travel costs, promotional marketing programs and allocated facility costs. Marketing programs include advertising, public relations, direct mail programs, seminars and trade shows. Total sales and marketing expenses was $3.5 million for the quarter ended September 30, 2004, or 41% of net revenue, compared to $3.5 million for the quarter ended September 30, 2003, or 49% of net revenue. Total sales and marketing expenses was $10.4 million for the nine months ended September 30, 2004, or 43% of net revenue, compared to $10.6 million for the nine months ended September 30, 2003, or 49% of net revenue.

Sales expense was $2.8 million for the quarter ended September 30, 2004, or 33% of net revenue, compared to $3.2 million for the quarter ended September 30, 2003, or 46% of net revenue. The decrease in total sales expense of $400,000 was primarily attributed to a decrease of $265,000 in personnel related costs and a decrease of $45,000 in travel costs due to a lower number of employees and a decrease of $216,000 in allocated facility costs which consist mostly of a reduction in rent and depreciation, partially offset by an increase of $201,000 in the exchange rate translation effect in the European market of our foreign sales operations expenses. Sales expense was $8.5 million for the nine months ended September 30, 2004, or 35% of net revenue, compared to $9.5 million for the nine months ended September 30, 2003, or 44% of net revenue. The decrease in sales expense of $1.0 million was primarily attributed to a decrease of $651,000 in personnel related costs and a decrease of $385,000 in allocated facility costs due to a reduced number of employees, a decrease of $74,000 in legal expense and a decrease of $110,000 in travel costs. These decreases were partially offset by an increase of $337,000 in the exchange rate translation effect in the European market of our foreign sales operations.

Marketing expense was $689,000 for the quarter ended September 30, 2004, or 8% of net revenue, compared to $314,000 for the quarter ended September 30, 2003, or 4% of net revenue. The increase of $375,000 was primarily attributed to an increase of $132,000 in personnel related costs due to a higher number of employees and an increase of $26,000 from the incentive bonus program for employees not on a commission plan that was reinstituted by the Company at the beginning of the second quarter of 2004, an increase of $165,000 in marketing programs, and an increase of $18,000 in travel related costs. Marketing expense was $1.9 million for the nine months ended September 30, 2004, or 8% of net revenue, compared to $1.0 million for the nine months ended September 30, 2003, or 5% of net revenue. The increase of $900,000 was primarily attributed to an increase of $553,000 in personnel cost and an increase of $75,000 in allocated facility cost due to a higher number of employees, an increase of $70,000 from the incentive bonus program, and an increase of $71,000 in marketing programs, and an increase of $72,000 in travel related costs.

We plan to continue to tightly control the level of expenses for marketing programs, but further reductions to these may have an adverse effect on our business by not creating enough leads to generate incremental sales revenue.

We anticipate that sales and marketing expenses will continue to be a large percent of total expenses for Segue, although their percent to total revenue may vary in the future, as we try to grow revenue faster than expenses.

Research and development expenses consist primarily of salaries and benefits and allocated facility costs. To date, all of Segue’s internal costs for research and development have been charged to operations as incurred, since amounts of software development costs qualifying for capitalization have been insignificant. Research and development expense was $1.6 million for the quarter ended September 30, 2004, or 18% of net revenue as compared to $1.4 million for the quarter ended September 30, 2003, or 20% of net revenue. The increase of $200,000 was primarily attributable to an increase of $70,000 in the

exchange rate translation effect of our foreign research and development lab expenses due to the stronger Euro, an increase of $57,000 associated with an incentive bonus program that was reinstituted by the Company at the beginning of the second quarter of 2004 for all non-commissioned employees, and an increase of $35,000 in personnel related costs, partially offset by a decrease of $26,000 in depreciation expense.

Research and development expense was $4.8 million for the nine months ended September 30, 2004, or 20% of net revenue as compared to $4.3 million for the nine months ended September 30, 2003, or 20% of net revenue. The increase of $500,000 was primarily attributable to an increase of $318,000 in personnel related costs due to higher base salaries in Austria and from the incentive bonus program, and an increase of $255,000 in the exchange rate translation of our foreign research and development lab expenses due to the stronger Euro. These increases were partially offset by a decrease of $91,000 in depreciation resulting from more fully depreciated assets.

General and administrative expenses consist primarily of salaries and benefits for executive, finance, legal, information technology, human resources and administrative personnel, professional fees, system support costs, allocated facility costs and other general corporate expenses. General and administrative expense was $1.2 million for the quarter ended September 30, 2004, or 14% of net revenue as compared to $912,000 for the quarter ended September 30, 2003, or 13% of net revenue. The increase of $288,000 was primarily attributed to an increase of $144,000 in personnel related costs due to an increased number of employees and expense associated with an incentive bonus program, an increase of $82,000 in legal and audit expense, an increase of $108,000 in the foreign currency translation expense, and an increase of $61,000 in travel and other administrative costs. These increases were offset by a decrease of $100,000 in bad debt and a decrease of $31,000 in depreciation and telephone expense.

General and administrative expense was $3.4 million for the nine months ended September 30, 2004, or 14% of net revenue, compared to $3.3 million for the nine months ended September 30, 2003, or 15% of net revenue. The decrease of $100,000 was primarily attributable to a decrease of $153,000 in recruiting charges that were mainly incurred during the CEO search in 2003, a decrease of $138,000 in bad debt expense, a decrease of $118,000 in allocated facility related costs, and a decrease of $74,000 in the foreign currency translation expense. These decreases were offset by an increase of $212,000 in personnel related costs due to an increase in number of employees and expense associated with an incentive bonus program, an increase of $358,000 in legal and audit costs, and an increase of $40,000 in travel.

Other income consists primarily of interest income from cash and cash equivalents. Other income was $23,000 for the quarter ended September 30, 2004 as compared to $11,000 for the quarter ended September 30, 2003. The increase of $12,000 was primarily attributed to interest income on higher balances of cash and cash equivalents in 2004 in comparison to the same period in 2003.

Other income was $75,000 for the nine months ended September 30, 2004 compared to $38,000 for the nine months ended September 30, 2003. The increase of $37,000 is primarily due to other income we had of $20,000 during the first quarter of 2004, which was related to the settlement of a minor sublease issue.

The Company had no interest expense for both the quarters ended and nine months ended September 30, 2004 and 2003. Segue carries no debt.

Segue recorded a provision (benefit) for foreign and state income taxes of $61,000 and ($16,000) for the quarter ended September 30, 2004 and 2003, respectively. The decrease of $76,000 was primarily attributed to the Company realizing a tax adjustment of about $70,000 in its United Kingdom subsidiary

that resulted in a positive impact to earnings during the quarter ended September 30, 2003. Provision for foreign and state income taxes was $63,000 for the nine months ended September 30, 2004 as compared to $108,000 for the nine months ended September 30, 2003. The decrease of $45,000 is primarily due to adjustments in foreign tax provision in the nine months of 2003.

There was no tax benefit for losses generated in the United States in any period due to the uncertainty of realizing such benefits. Management has evaluated the positive and negative evidence impacting the ability to realize its deferred tax assets. Based on the weight of the available evidence, it is more likely than not that all of the deferred tax assets will not be realized and, accordingly, the deferred tax assets have been fully reserved. Management re-evaluates the positive and negative evidence on a quarterly basis.

As of September 30, 2004, our principal sources of liquidity included cash and cash equivalents totaling $9.9 million.

Our operating activities generated cash of $2.1 million during the first nine months of 2004, compared to $490,000 of cash generated in the same period in 2003. Cash generated in 2004 resulted from the net income, adjusted for depreciation of property and equipment and the increase in deferred revenue and other current assets, and the decrease in accounts receivable offset by a decrease in accounts payable and accrued expenses.

Our investing activities utilized cash of $227,000 in the first nine months of 2004, as compared to $155,000 cash generated during the first nine months of 2003. Cash used in 2004 was the result of the purchase of some replacement computers and equipment. In the future, we may need to make increased expenditures on property and equipment as our present equipment ages.

Our financing activities generated cash of $522,000 and $190,000 during the first nine months of 2004 and 2003, respectively. Cash generated from financing activities in the first nine months of 2004 was generated primarily from the exercise of employee stock options and the issuance of stock under the Employee Stock Purchase Plan. Cash generated in the first nine months of 2003 was primarily generated from the issuance of stock under the Employee Stock Purchase Plan.

Long-term cash requirements, other than for normal operating expenses and those described above are anticipated for the development of new software products and enhancements of existing products, and the possible acquisition of software products or technologies complementary to our business.

We have reduced our workforce and overhead expenses as described above and curtailed capital spending and other uses of cash. But, in order to achieve and sustain profitability and to continue positive cash flow from operations, we must maintain or grow our current revenue level.

Assuming that we can execute our current plans to maintain or grow revenue through our restructured sales program, our focus on enterprise customers, and our introduction and success of new and enhanced products, and the business climate for IT spending does not worsen, we believe that with the funding described above, plus current cash and cash equivalents, we will have sufficient resources to meet our working capital and debt requirements for at least the next twelve months. However, if we are not able to maintain current business levels or the economy worsens, we may need to take other actions in order to fund our working capital requirements.

Additionally, the financial statements do not include any adjustments relating to the recoverability and classification of recorded asset amounts, and classification and amounts of liabilities that might be necessary should Segue be unable to continue funding its operations.

Set forth below are certain risk factors that could harm our business prospects, results of operations and financial condition. You should carefully read the following risk factors, together with the financial statements, related notes and other information contained in this Form 10-Q. This Form 10-Q contains forward-looking statements that contain risks and uncertainties. Please refer to the discussion of “Forward-Looking Statements” on page 1 of our Annual Report filed on Form 10-K and on page 3 of this Quarterly Report on Form 10-Q in connection with your consideration of the risk factors and other important factors that may affect future results described below.

Our quarterly results may fluctuate. Our quarterly revenue and operating results are difficult to predict and may fluctuate significantly from quarter to quarter. If our quarterly revenue or operating results fall below the expectations of investors or public market analysts, the price of our common stock could fall substantially. Our quarterly revenue may fluctuate significantly for several reasons, including: the timing and success of introductions of our new products or product enhancements or those of our competitors; decline of the general business climate, including the uncertainty of IT spending; competition and pricing; customer order deferrals or reductions in the size of individual orders as a result of general business conditions; ability to increase sales from enterprise companies; and general economic conditions. Substantial portions of our operating expenses are related to personnel, facilities and marketing and sales programs. The level of spending for such expenses can not be adjusted quickly and is based, in significant part, on our expectations of future revenues. If actual revenue levels are below management’s expectations, results of operations are likely to be adversely affected. Furthermore, we have often recognized a substantial portion of our product license revenues in the last month of a quarter, with these revenues frequently concentrated in the last weeks or days of a quarter. As a result, product license revenues in any quarter are substantially dependent on orders booked and shipped in the latter part of that quarter and revenues for any future quarter are not predictable with any significant degree of accuracy. We typically do not experience order backlog. For these reasons, we believe that quarter-to-quarter comparisons of our results of operations are not necessarily meaningful and should not be relied upon as indications of future performance.

We may not be profitable in the future. Since we began operations, we have generally experienced losses. Losses have resulted in an accumulated deficit of approximately $56.8 million as of September 30, 2004. In the third quarter of 2004, we reported our third consecutive quarter of net income, which totaled $703,000 for the period. We reported net income of $1.2 million for the nine months ended September 30, 2004. It is uncertain whether we can maintain profitability in the future.

For the quarter ended September 30, 2004, we had total revenue of $8.4 million versus $7.0 million for the quarter ended September 30, 2003. Further, for the nine months ended September 30, 2004, we had total revenue of $24.5 million versus $21.7 million for the same nine months in 2003. During 2001, 2002 and 2003, we initiated aggressive cost saving measures in an effort to reduce expenses, enhance the possibility of profitability, and conserve cash, and we have sustained these measures through September 30, 2004. Despite these cost saving measures, our future profitability remains uncertain because of, among other items, the uncertainty of our revenue from quarter to quarter. Failure to achieve profitability may adversely affect the market price of our common stock.

Business conditions and Information Technology (IT) spending could cause further decline in revenue. The level of future IT spending remains very uncertain particularly in light of the decline in the business climate throughout 2002, 2003 and into 2004. The decline in IT spending over this two and one half year period has negatively impacted our profitability. If IT spending does not increase, our revenues could be further adversely impacted.

We may not derive substantial incremental revenue from our alliances and SilkElite Partner Program. In an effort to augment product revenue derived from the efforts of our direct sales force, we have focused on expanding our key strategic alliances and on building a successful SilkElite Partner Program. We have built alliances with PeopleSoft, Keynote Systems, Borland Software and Microsoft.

The SilkElite Partners Program focuses on resellers, consulting partners and distributors. SilkElite Partners resell our products, refer business to Segue and use our software products in the delivery of consulting services. The success of the key strategic alliances and the SilkElite Program is uncertain, faces strong competition, and takes time and significant resources to develop. Should we fail to generate substantial incremental revenue from our strategic alliances or our SilkElite Program, our financial results and stock price could be adversely affected. The SilkElite Partner Program accounted for 14% of total revenue for the three-month period ended September 30, 2004 versus 14% for the same period ended September 30, 2003. For the nine-month period ended September 30, 2004, The SilkElite Partner Program accounted for 15% of total revenue versus 14% for the nine-month period ended September 30, 2003.

The effect of the change in the IBM relationship is uncertain. In 2002, we signed an expanded contract with IBM Corporation under which we were the exclusive external provider of software for IBM Global Infrastructure and Systems Management Services’ (IGSSMS) new remote infrastructure analysis offering. In the first quarter of 2003, IBM’s IGSSMS advised us that it would no longer be offering the remote monitoring service, which was powered by our SilkVision software. We paid $1.0 million to accelerate the implementation of this service. In October 2003, we negotiated the termination of this portion of the IBM contract and the return of $175,000 of the investment not spent by IBM in the deployment of this service. In addition, in the second quarter of 2003, IBM Tivoli advised us of the cancellation of the royalty contract signed by both companies in September of 2002. Tivoli was expected to integrate our SilkTest software into a larger Tivoli product suite, and we were to have received a royalty each time Tivoli sold its product suite. IBM acquired Rational Software in February 2003 and accordingly, IBM Tivoli has decided to use a Rational Software testing tool in place of our tool. We had the potential to receive up to $2.5 million in remaining royalties over the next several years. The impact of these events on the remaining IBM relationship and future revenue is uncertain and may adversely affect our future results.

Our future success will depend on our ability to respond rapidly and effectively to technological and other market changes, including the successful introduction of new and enhanced products. The nature of the automated software testing, performance management and application monitoring markets in which we compete is characterized by rapidly changing technology, rapidly evolving customer needs and desires, changes in industry standards and practices and frequent releases of new product or enhancements by competitors. To be competitive, we must develop and introduce product enhancements and new products that address the increasingly sophisticated and varied needs of our existing and potential customers. For the nine months ended September 30, 2004, over 93% of our product revenues were generated from our SilkPerformer and SilkTest products, as compared with over 90% in same period last year. During the first nine months of 2004, we released SilkPerformer 6.5, the newest version of our enterprise-class load and stress-testing tool, SilkTest 7.0, our newest version of functional testing with add-on support available to test .NET applications, SilkCentral Performance Manager, the Company’s newest offering for monitoring software applications from the end-user perspective and SilkCentral Test Manager 7.0, a comprehensive solution for the overall management of application quality prior to deployment. If these new products are not successful or if we fail to continue to develop and introduce new products and enhancements on a timely basis, or maintain our level of product revenue from SilkPerformer and SilkTest, or fail to generate substantial incremental revenue from our new products, our business may be materially adversely affected.

We may face liquidity issues. We have taken steps to conserve our use of cash, including significantly reducing headcount, infrastructure and other expenses, and limiting capital expenditures in order to improve our liquidity and to achieve greater efficiencies. We believe that based on expense savings and the stability of our revenue in the last year, that future sales at or above current levels should be sufficient to allow us to continue as a viable business. For the three-month period ended September 30, 2004, we generated $691,000 in positive cash flow, the Company’s eighth consecutive quarter of cash balance growth. For the nine-month period ended September 30, 2004, we have generated a total of $2.4 million in positive cash flow. Total net revenue of $8.4 million for the three-month period ended September 30, 2004 was improved from the $7.0 million reported for the same period last year. If we fail to maintain or grow revenue levels we may have to raise additional financing to fund working capital

needs. If we fail to generate substantial incremental revenue, or we are not successful in raising additional financing on terms acceptable to us, we may not have sufficient working capital resources and our business may be materially adversely affected.

Our new management structure could adversely impact its business. In the second quarter of 2003, our Chief Executive Officer resigned, and in the third quarter, we hired a new Chief Executive Officer. In addition, in the first quarter of 2004 we added two new members to our sales and marketing management team. The effect of this new management structure on our business and employees is uncertain.

We cannot assure a liquid market for our stock. In 2002, we were informed by NASDAQ that we were not in compliance with certain listing requirements for continued listing on their National Market exchange. We were able to take steps to meet the initial listing requirements of the NASDAQ Small Cap Market Exchange. However, continued compliance with the listing requirements of the NASDAQ Small Cap Market Exchange, and thus a liquid market for our common stock, are closely related to our financial performance. Our future business may not be sufficient to assure continued listing on the NASDAQ Small Cap Market Exchange.

We may have difficulty operating the business efficiently with fewer resources. Since 2000, we have reduced headcount by approximately 50% and implemented several cost reduction initiatives, including reduced marketing and sales expenses. We were able to achieve increased productivity with fewer resources. Our ability to further increase our current productivity, as well as sustain current performance with fewer resources, is uncertain.

We face significant competition from other software companies. The market for web-based software quality management and testing and monitoring tools is intensely competitive and subject to rapid technological change. We expect competition to intensify even further in the future. We currently encounter competition from a number of public and private companies, including Mercury Interactive Corporation, Rational Software Corporation (now part of IBM), Compuware Corporation and Empirix. Many of our current and potential competitors have longer operating histories, greater name recognition, larger installed customer bases, and significantly greater financial, technical and marketing resources than we do. Therefore, our competitors may be able to respond more quickly to new or changing opportunities, technologies, standards or customer requirements or may be able to devote greater resources to the promotion and sale of their products than we can. An increase in competition could result in price reductions and loss of market share. Such competition and any resulting reduction in profitability could have a material adverse effect on our business, operating results and financial condition.

Our business could be adversely affected if our products contain errors. Software products, as complex as ours, may contain undetected errors or “bugs” which result in product failures. The occurrence of errors could result in loss of or delay in revenue, loss of market share, failure to achieve market acceptance, diversion of development resources, significant repair and replacement costs, injury to our reputation, or damage to our efforts to build brand awareness, any of which could have a material adverse effect on our business, operating results and financial condition.

We must hire and retain skilled personnel in a difficult economic environment. Qualified personnel remain in demand throughout the software industry. Our success depends in large part upon our ability to attract, train, motivate and retain highly skilled employees, particularly sales and marketing personnel, software engineers and other senior personnel. The failure to attract and retain the highly skilled personnel that are integral to our direct sales, product development, service and support teams may limit the rate at which we can generate sales and develop new products or product enhancements. Our ability to retain our qualified staff may be further impacted by our financial results during 2004 or in the future. All of this could have a material adverse effect on our business, operating results and financial condition.

We face many risks associated with international business activities. We derived approximately 21% of total revenue from international customers in the three-month period ended September 30, 2004, as compared with 16% in the same period last year. For the nine-month period ended September 30, 2004, we derived approximately 19% of total revenue from international customers versus 18% for the same nine-

month period last year. The international market for software products is highly competitive and we expect to face substantial competition in this market from established and emerging companies. We face many risks associated with international business activities including currency fluctuations, imposition of government controls, export license requirements, restrictions on the export of critical technology, political and economic instability, tailoring of products to local requirements, trade restrictions,

changes in tariffs and taxes, difficulties in staffing and managing international operations, longer accounts receivable payment cycles and the burdens of complying with a wide variety of foreign laws and regulations. In particular, currency fluctuations can have a significant impact on our foreign operating expenses. Continued growth of international sales is important to our growth and the stability. To the extent we are unable to continue to expand international sales in a timely and cost-effective manner, our business could be materially adversely affected.

Our success depends on our ability to protect our software and other proprietary technology. The unauthorized reproduction or other misappropriation of our proprietary technology could enable third parties to benefit from our technology without paying us for it. This could have a material adverse effect on our business, operating results and financial condition. Although we have taken steps to protect our proprietary technology, these efforts may be inadequate. We currently rely on a combination of patent, trademark, copyright and trade secret laws and contractual provisions to protect our proprietary rights in our products. Currently, we have three issued patents and four are pending. There can be no assurance that these patents would be upheld if challenged. Moreover, the laws of other countries in which we market our products may afford little or no effective protection of our intellectual property. If we were to discover that any of our products violated third party proprietary rights, there can be no assurance that we would be able to obtain licenses on commercially reasonable terms to continue licensing our software without substantial reengineering or that any effort to undertake such reengineering would be successful. Any claim of infringement could cause us to incur substantial costs defending against the claim, even if the claim is invalid, and could distract management resources from our business. Furthermore, a party making such a claim could secure a judgment that requires us to pay substantial damages or result in an injunction. Any of these events could have a material adverse effect on our business, operating results and financial condition.

The following discussion about our market risk disclosures involves forward-looking statements. Actual results could differ materially from those discussed in the forward-looking statements. We are exposed to market risk related to changes in interest rates and foreign currency exchange rates. We do not use derivative financial instruments for speculative or trading purposes.

Interest Rate Risk. We are exposed to market risk from changes in interest rates primarily through our investing and borrowing activities. In addition, our ability to finance future transactions may be impacted if we are unable to obtain appropriate financing at acceptable rates. Our investing strategy to manage interest rate exposure and market risk is to invest in short-term, highly secured and liquid investments. We maintain a portfolio of highly liquid cash equivalents.

Foreign Currency Risk. We face exposure to movements in foreign currency exchange rates. These exposures may change over time as business practices evolve and could have a material adverse effect on our business, financial condition and results of operations. We do not use derivative financial instruments or other financial instruments to hedge economic exposures or for trading. Historically, our primary currency exposures have been related to the operations of our foreign subsidiaries. During the three and nine months ended September 30, 2004, we incurred transaction and re-measurement losses of approximately $39,000 and $7,000 related to foreign currency, respectively. For the three and nine month period ended September 30, 2003, the effect of foreign currency was a re-measurement gain of approximately $70,000 and a re-measurement expense of approximately $81,000, respectively. As of September 30, 2004, the cumulative translation of foreign currency changes recorded in stockholders’ equity was $294,000.

As required by new Rule 13a-15 under the Securities Exchange Act of 1934, as of September 30, 2004 we carried out an evaluation under the supervision and with the participation of our management, including our Chief Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of our disclosure controls and procedures. In designing and evaluating our disclosure controls and procedures, we and our management recognize that any controls and procedures, no matter how well designed and operated, can provide only reasonable assurance of achieving the desired control objectives, and our management necessarily was required to apply its judgment in evaluating and implementing possible controls and procedures. Based upon that evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of the date of completion of the evaluation, our disclosure controls and procedures were reasonably effective to ensure that material information required to be disclosed by us in the reports we file or submit under the Exchange Act is recorded, processed, summarized and reported, within the time periods specified in the Securities and Exchange Commission’s rules and forms. In connection with the new rules, we will continue to review and document our disclosure controls and procedures, including our internal controls and procedures for financial reporting, on an ongoing basis, and may from time to time make changes aimed at enhancing their effectiveness and to ensure that our systems evolve with our business.

There was no change in our internal control over financial reporting that occurred during the period covered by this Quarterly Report on Form 10-Q that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

There are no pending lawsuits which management believes will have a material adverse affect on the financial position or results of operations of Segue.

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.


(Mark One)
þ		QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the Quarterly Period Ended September 30, 2004

o		TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934


Delaware		95-4188982
(State or other jurisdiction of incorporation or organization)		(I.R.S. Employer Identification No.)


		Page

PART I. FINANCIAL INFORMATION
Item 1	Condensed Consolidated Financial Statements:		3
	Condensed Consolidated Balance Sheets (unaudited) September 30, 2004 and December 31, 2003		3
	Condensed Consolidated Statements of Operations (unaudited) Three Months and Nine Months Ended September 30, 2004 and 2003		4
	Condensed Consolidated Statements of Cash Flows (unaudited) Nine Months Ended September 30, 2004 and 2003		5
	Notes to Condensed Consolidated Financial Statements (unaudited)		6
Item 2	Management’s Discussion and Analysis of Financial Condition and Results of Operations		15
Item 3	Quantitative and Qualitative Disclosures about Market Risk		27
Item 4	Controls and Procedures		28

PART II. OTHER INFORMATION
Item 1	Legal Proceedings		28
Item 4	Submission of Matters to a Vote of Security Holders		28
Item 5	Other Information		28
Item 6	Exhibits and Reports on Form 8-K		28
	Signatures		29
	Certifications
EX-31.1 SECTION 302 CERTIFICATION OF C.E.O.
EX-31.2 SECTION 302 CERTIFICATION OF C.F.O.
EX-32.1 SECTION 906 CERTIFICATION OF C.E.O.
EX-32.2 SECTION 906 CERTIFICATION OF C.F.O.


			September 30,			December 31,
			2004			2003

			(Unaudited)
Current assets:
	Cash and cash equivalents		$	9,922		$	7,495
	Accounts receivable, net of allowances of $211 and $268, respectively			5,257			5,607
	Other current assets			1,280			1,021

		Total current assets		16,459			14,123
Property and equipment, net				714			1,069
Goodwill, net				1,506			1,506
Other assets				941			939

		Total assets	$	19,620		$	17,637


LIABILITIES AND STOCKHOLDERS’ EQUITY
Current liabilities:
	Accounts payable		$	671		$	1,004
	Accrued compensation and benefits			1,682			1,931
	Accrued lease obligations on excess space			1,191			1,554
	Accrued expenses			1,048			851
	Deferred revenue			9,494			9,015

		Total current liabilities		14,086			14,355
Stockholders’ equity:
	Preferred stock, par value $.01 per share; 9,000 shares authorized; 869 and 819 shares of Series B and 538 and 508 shares of Series C preferred stock issued and outstanding, respectively			4,303			3,884
	Common stock, par value $.01 per share; 30,000 shares authorized; 10,160 and 9,926 shares issued, respectively			102			100
	Additional paid-in capital			58,311			58,160
	Cumulative translation adjustment			294			309
	Unearned compensation			(50	)		—
	Accumulated deficit			(56,826	)		(58,571	)

				6,134			3,882
Less treasury stock, at cost, 145 shares				(600	)		(600	)

		Total stockholders’ equity		5,534			3,282

		Total liabilities and stockholders’ equity	$	19,620		$	17,637



				Three months ended						Nine months ended
				September 30,						September 30,

				2004			2003			2004			2003


				(Unaudited)
Revenue:
	Software			$	3,766		$	3,003		$	10,938		$	9,516
	Services				4,711			4,055			13,659			12,281

		Gross revenue			8,477			7,058			24,597			21,797
	Less vendor consideration to a customer				(46	)		(41	)		(104	)		(136	)

			Net revenue		8,431			7,017			24,493			21,661
Cost of revenue:
	Cost of software				82			109			259			284
	Cost of services				1,217			1,256			3,823			3,784

			Total cost of revenue		1,299			1,365			4,082			4,068

Gross margin					7,132			5,652			20,411			17,593
Operating expenses:
	Sales and marketing				3,478			3,462			10,439			10,564
	Research and development				1,550			1,419			4,835			4,334
	General and administrative				1,176			912			3,404			3,263

			Total operating expenses		6,204			5,793			18,678			18,161

Income (loss) from operations					928			(141	)		1,733			(568	)
Other income, net					—			—			15			—
Interest income, net					23			11			60			38

Income (loss) before provision for income taxes					951			(130	)		1,808			(530	)
Provision (benefit) for income taxes					61			(16	)		63			108

Net income (loss)					890			(114	)		1,745			(638	)
Preferred stock dividend-in-kind					(187	)		(79	)		(527	)		(201	)

Net income (loss) applicable to common shares				$	703		$	(193	)	$	1,218		$	(839	)

Net income (loss) per common share — Basic				$	0.07		$	(0.02	)	$	0.12		$	(0.09	)
Net income (loss) per common share — Diluted*				$	0.07		$	(0.02	)	$	0.11		$	(0.09	)
Weighted average common shares outstanding — Basic					9,962			9,745			9,827			9,704
Weighted average common shares outstanding — Diluted*					10,604			9,745			10,622			9,704

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Item 1.	*Condensed Consolidated Financial Statements*



		For the three months						For the nine months
		ended September 30,						ended September 30,

		2004			2003			2004			2003

Net income (loss) applicable to common shares
	As reported	$	703		$	(193	)	$	1,218		$	(839	)
	Deduct: Total stock-based employee compensation expense determined under the fair value based method for all awards		(400	)		(665	)		(1,306	)		(2,121	)

	Pro forma	$	303		$	(858	)	$	(88	)	$	(2,960	)

Net income (loss) per common share — basic and diluted
	As reported — basic	$	0.07		$	(0.02	)	$	0.12		$	(0.09	)
	As reported — diluted	$	0.07		$	(0.02	)	$	0.11		$	(0.09	)
	Pro forma — basic	$	0.03		$	(0.09	)	$	(0.01	)	$	(0.31	)
	Pro forma — diluted	$	0.03		$	(0.09	)	$	(0.01	)	$	(0.31	)


			Number of		%		Cost of estimated
	Severance and		employees		Reduction		facility obligations,		Office for which		Total
	other employee		terminated as part		in		net of estimated		facility costs		Restructuring
Quarter	related costs		of restructuring plan		workforce		sublease income		accrued		Charge

Q3 2004		—		—		—		—		—		—
Q2 2004		—		—		—		—		—		—
Q1 2004		—		—		—		—		—		—

Total 04		—		—		—		—				—

Q4 2003	$	725,000		8		4		—		—	$	725,000
Q3 2003		—		—		—		—		—		—
Q2 2003		—		—		—		—		—		—
Q1 2003		—		—		—		—		—		—

Total 03		725,000		8		4		—		—		725,000


		Gross		Sublease			Net
		Commitment		Income			Amount

2004 (balance of year)		$	638	$	(85	)	$	553
2005			1,825		(67	)		1,758
2006			1,640		(70	)		1,570
2007			1,377		(60	)		1,317
2008			58		0			58
Thereafter			15		0			15

	Total	$	5,553	$	(282	)	$	5,271



		Three months ended September 30,												Nine months ended September 30,


		2004						2003						2004						2003

					Gross						Gross						Gross						Gross
		Revenue			Margin			Revenue			Margin			Revenue			Margin			Revenue			Margin

Software licenses		$	3,766		$	3,684		$	3,003		$	2,894		$	10,938		$	10,679		$	9,516		$	9,232
Training and consulting			829			300			478			(117	)		2,266			654			2,018			227
Maintenance			3,882			3,194			3,577			2,916			11,393			9,182			10,263			8,270

	Total services		4,711			3,494			4,055			2,799			13,659			9,836			12,281			8,497
Less vendor consideration to a customer			(46	)		(46	)		(41	)		(41	)		(104	)		(104	)		(136	)		(136	)

	Total	$	8,431		$	7,132		$	7,017		$	5,652		$	24,493		$	20,411		$	21,661		$	17,593



	Total Net Revenue


	Three months ended				Nine months ended				Long Lived Assets
	September 30,				September 30,				September 30,

	2004		2003		2004		2003		2004		2003

United States	$	6,636	$	5,909	$	19,818	$	17,796	$	1,417	$	1,866
Foreign		1,795		1,108		4,675		3,865		238		350

	$	8,431	$	7,017	$	24,493	$	21,661	$	1,655	$	2,216


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



			Percentage of						Percentage of
			Revenue for						Revenue for
			Three Months						Nine months
			Ended						Ended
			September 30,						September 30,

			2004			2003			2004			2003

Revenue:
	Software			44.7	%		42.8	%		44.7	%		43.9	%
	Services			55.9			57.8			55.8			56.7

		Gross revenue		100.6			100.6			100.5			100.6
	Less vendor consideration to a customer			(0.6	)		(0.6	)		(0.5	)		(0.6	)

		Net revenue		100.0			100.0			100.0			100.0
Cost of revenue:
	Cost of software			1.0			1.6			1.1			1.3
	Cost of services			14.4			17.9			15.6			17.5

		Total cost of revenue		15.4			19.5			16.7			18.8
Gross margin				84.6			80.5			83.3			81.2
Operating expenses:
	Sales and marketing			41.3			49.3			42.6			48.8
	Research and development			18.4			20.2			19.7			20.0
	General and administrative			13.9			13.0			13.9			15.1

		Total operating expenses		73.6			82.5			76.2			83.9
Income (loss) from operations				11.0			(2.0	)		7.1			(2.7	)
Other income, net				—			—			0.1			—
Interest income, net				0.3			0.2			0.2			0.2

Income (loss) before provision for income taxes				11.3			(1.8	)		7.4			(2.5	)
Provision (benefit) for income taxes				0.7			(0.2	)		0.3			0.5

Net income (loss)				10.6	%		(1.6	)%		7.1	%		(3.0	)%


Item 3.	*Quantitative and Qualitative Disclosures About Market Risk*


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


1.	Basis of Presentation


2.	Liquidity


3.	Recent Accounting Developments


4.	Other Assets


31.1		Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
31.2		Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1		Certification of Chief Executive Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.
32.2		Certification of Chief Financial Officer pursuant to 18 U.S.C. Section 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.