**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C.20549**

 

----

### ** **

**FORM 10-Q**

 

| **(Mark One)** |                                                                                               |
|----------------|----------------------------------------------------------------------------------------------------|
|           |                                                                                               |
| **ý**     | **QUARTERLY REPORT PURSUANT TO  SECTION 13 OR 15(d) OF THE SECURITIES  EXCHANGE ACT OF 1934** |

 

**For the Quarterly Period Ended September 30, 2002**

 

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

 

**For the transitionperiod from         to**

 

**Commission filenumber 0-27794**

 

----

 

| **SEGUE  SOFTWARE, INC.**                                                   |
|-----------------------------------------------------------------------------|
| (Exact name of registrant as specified in its charter)                      |
|                                                                        |   |   |
| **Delaware**                                                                |   | **95-4188982** |
| (State or other jurisdiction of incorporation or organization)              |   | (I.R.S. Employer Identification No.) |
|                                                                        |   |   |
| **201 Spring Street, Lexington, MA 02421**                                  |
| (Address of principal executive offices)                                    |
|                                                                        |   |   |
| Registrant’s telephone number, including area code: **(781) 402-1000** |

 

----

 

Indicate by check mark whetherthe registrant: (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such a shorter period that the registrant wasrequired to file such reports) and (2) has been subject to such filingrequirements for the past 90 days. Yes ý  No o

 

The number ofshares of Registrant’s Common Stock outstanding as of November 5, 2002 was9,618,315.

 

 

----

 

**SEGUESOFTWARE, INC.**

 

**FORM 10-Q**

 

**FOR THE QUARTERLYPERIOD ENDED SEPTEMBER 30, 2002**

 

**INDEX**

 
|       |                                                                                                                        | **Page** |
|------------|-----------------------------------------------------------------------------------------------------------------------------|----------|
| PART I.    | FINANCIAL INFORMATION                                                                                                       |     |
|       |                                                                                                                        |     |
| Item 1.    | Condensed Consolidated Financial  Statements:                                                                               |     |
|       |                                                                                                                        |     |
|       | Condensed  Consolidated Balance Sheets (unaudited) September 30, 2002 and  December 31, 2001                           | 3        |
|       |                                                                                                                        |     |
|       | Condensed Consolidated Statements of Operations (unaudited) Three  Months and Nine Months Ended September 30, 2002 and 2001 | 4        |
|       |                                                                                                                        |     |
|       | Condensed Consolidated Statements of Cash Flows (unaudited) Nine  Months Ended September 30, 2002 and 2001                  | 5        |
|       |                                                                                                                        |     |
|       | Notes to Condensed Consolidated Financial  Statements (unaudited)                                                           | 6        |
|       |                                                                                                                        |     |
| Item 2.    | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                                 | 12       |
|       |                                                                                                                        |     |
| Item 3.    | Quantitative and Qualitative Disclosures  about Market Risk                                                                 | 20       |
|       |                                                                                                                        |     |
| Item 4.    | Controls and Procedures                                                                                                     | 20       |
|       |                                                                                                                        |     |
| PART II.   | OTHER INFORMATION                                                                                                           | 21       |
|       |                                                                                                                        |     |
| Item  1.   | Legal  Proceedings                                                                                                          | 21       |
|       |                                                                                                                        |     |
| Item  4.   | Submission  of Matters to a Vote of Security Holders                                                                        | 21       |
|       |                                                                                                                        |     |
| Item 5.    | Other Information                                                                                                           | 21       |
|       |                                                                                                                        |     |
| Item 6.    | Exhibits and Reports on Form 8-K                                                                                       | 21       |
|       |                                                                                                                        |     |
| Signatures |                                                                                                                        | 21       |

 

2

----

 

**PARTI****. FINANCIAL INFORMATION**

 

**ITEM1****. CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

 

**SEGUE SOFTWARE, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(IN THOUSANDS, EXCEPTPER SHARE DATA)**

**(UNAUDITED)**

 
|                                                                                                                                                    |   | **September  30,  2002** |       | **December  31,  2001** |       |
|---------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|------------|-------------------------|------------|
| **ASSETS**                                                                                                                                              |   |                     | ** ** |                    | ** ** |
| Current  assets:                                                                                                                                        |   |                     |       |                    |       |
| Cash and cash  equivalents                                                                                                                              |   | $                        | 4,898      |                    | $          | 2,326 |   |
| Short-term  investments                                                                                                                                 |   | —                   |       | 4,949                   |       |
| Accounts  receivable, net of allowances of $264 and $594, respectively                                                                                  |   | 5,671                    |       | 5,332                   |       |
| Other current  assets                                                                                                                                   |   | 1,341                    |       | 1,384                   |       |
| Total current  assets                                                                                                                                   |   | 11,910                   |       | 13,991                  |       |
|                                                                                                                                                    |   |                     |       |                    |       |
| Property and  equipment, net                                                                                                                            |   | 2,499                    |       | 3,730                   |       |
| Goodwill, net                                                                                                                                           |   | 1,506                    |       | 1,506                   |       |
| Other assets                                                                                                                                            |   | 518                      |       | 417                     |       |
| Total assets                                                                                                                                            |   | $                        | 16,433     |                    | $          | 19,644 |   |
|                                                                                                                                                    |   |                     | ** ** |                    | ** ** |
| **LIABILITIES AND  STOCKHOLDERS’ EQUITY**                                                                                                          |   |                     | ** ** |                    | ** ** |
| Current  liabilities:                                                                                                                                   |   |                     |       |                    |       |
| Accounts  payable                                                                                                                                       |   | $                        | 938        |                    | $          | 1,903 |   |
| Accrued  compensation and benefits                                                                                                                      |   | 1,768                    |       | 1,184                   |       |
| Accrued lease  obligations on excess space                                                                                                              |   | 2,376                    |       | 2,405                   |       |
| Accrued  expenses                                                                                                                                       |   | 1,672                    |       | 1,601                   |       |
| Deferred  revenue                                                                                                                                       |   | 7,939                    |       | 8,072                   |       |
| Total current  liabilities                                                                                                                              |   | 14,693                   |       | 15,165                  |       |
|                                                                                                                                                    |   |                     |       |                    |       |
| Commitments  and contingencies (Note 10)                                                                                                                |   | —                   |       | —                  |       |
|                                                                                                                                                    |   |                     |       |                    |       |
| Stockholders’  equity:                                                                                                                             |   |                     |       |                    |       |
| Preferred stock, par value $.01 per share;  9,000 shares authorized; 688 and 0 shares issued and outstanding of Series B  preferred stock, respectively |   | 7                        |       | —                  |       |
| Common stock,  par value $.01 per share; 30,000 shares authorized; 9,764 and 9,599 shares  issued, respectively                                         |   | 98                       |       | 96                      |       |
| Additional  paid-in capital                                                                                                                             |   | 60,397                   |       | 58,150                  |       |
| Cumulative  translation adjustment                                                                                                                      |   | (2                       | )          | (197                    | )          |
| Accumulated  deficit                                                                                                                                    |   | (58,160                  | )          | (52,970                 | )          |
|                                                                                                                                                    |   | 2,340                    |       | 5,079                   |       |
| Less treasury  stock, at cost, 145 shares                                                                                                               |   | (600                     | )          | (600                    | )          |
| Total  stockholders’ equity                                                                                                                        |   | 1,740                    |       | 4,479                   |       |
| Total  liabilities and stockholders’ equity                                                                                                        |   | $                        | 16,433     |                    | $          | 19,644 |   |

 

The accompanying notes are an integral part of the consolidatedfinancial statements.

 

3

----

 

**SEGUE SOFTWARE, INC.**

**CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS**

**(IN THOUSANDS, EXCEPT PER SHARE DATA)**

**(UNAUDITED)**

 
|                                                            |   | **Three Months Ended  September 30,** |   | **Nine Months Ended  September 30,** |   |
|-----------------------------------------------------------------|--------|---------------------------------------|--------|--------------------------------------|--------|
|                                                            |   | **2002**                              |   | **2001**                             |   | **2002** |   | **2001** |   |
| Revenue:                                                        |   |                                  |   |                                 |   |   |   |   |   |
| Software                                                        |   | $                                     | 3,754  |                                 | $      | 3,655 |   | $ | 9,583 |   | $ | 12,834 |   |
| Services                                                        |   | 4,016                                 |   | 5,159                                |   | 13,089 |   | 17,570 |   |
| Subtotal  revenue                                               |   | 7,770                                 |   | 8,814                                |   | 22,672 |   | 30,404 |   |
| Adjustment  relating to payment to customers                    |   | (7                                    | )      | —                               |   | (1,032 | ) | — |   |
| Net revenue                                                     |   | 7,763                                 |   | 8,814                                |   | 21,640 |   | 30,404 |   |
|                                                            |   |                                  |   |                                 |   |   |   |   |   |
| Cost of  revenue:                                               |   |                                  |   |                                 |   |   |   |   |   |
| Cost of  software                                               |   | 193                                   |   | 95                                   |   | 596 |   | 492 |   |
| Cost of  services                                               |   | 1,307                                 |   | 1,711                                |   | 4,015 |   | 6,421 |   |
| Total cost  of revenue                                          |   | 1,500                                 |   | 1,806                                |   | 4,611 |   | 6,913 |   |
|                                                            |   |                                  |   |                                 |   |   |   |   |   |
| Gross margin                                                    |   | 6,263                                 |   | 7,008                                |   | 17,029 |   | 23,491 |   |
|                                                            |   |                                  |   |                                 |   |   |   |   |   |
| Operating  expenses:                                            |   |                                  |   |                                 |   |   |   |   |   |
| Sales and  marketing                                            |   | 3,906                                 |   | 5,491                                |   | 12,355 |   | 21,423 |   |
| Research and  development                                       |   | 1,478                                 |   | 1,925                                |   | 4,343 |   | 6,455 |   |
| General and  administrative                                     |   | 1,434                                 |   | 1,649                                |   | 4,215 |   | 6,235 |   |
| Amortization  of goodwill                                       |   | —                                |   | 376                                  |   | — |   | 1,129 |   |
| Restructuring  charges                                          |   | 373                                   |   | 1,964                                |   | 1,203 |   | 4,221 |   |
| Total  operating expenses                                       |   | 7,191                                 |   | 11,405                               |   | 22,116 |   | 39,463 |   |
|                                                            |   |                                  |   |                                 |   |   |   |   |   |
| Loss from  operations                                           |   | (928                                  | )      | (4,397                               | )      | (5,087 | ) | (15,972 | ) |
| Other  income, net                                              |   | 31                                    |   | 78                                   |   | 74 |   | 425 |   |
|                                                            |   |                                  |   |                                 |   |   |   |   |   |
| Loss before  provision for income taxes                         |   | (897                                  | )      | (4,319                               | )      | (5,013 | ) | (15,547 | ) |
| Provision  for income taxes                                     |   | 48                                    |   | 50                                   |   | 123 |   | 166 |   |
| Net loss                                                        |   | (945                                  | )      | (4,369                               | )      | (5,136 | ) | (15,713 | ) |
| Dividends on  preferred stock                                   |   | 58                                    |   | —                               |   | 112 |   | — |   |
|                                                            |   |                                  |   |                                 |   |   |   |   |   |
| Net loss  applicable to common shares                           |   | $                                     | (1,003 | )                                    | $      | (4,369 | ) | $ | (5,248 | ) | $ | (15,713 | ) |
|                                                            |   |                                  |   |                                 |   |   |   |   |   |
| Net loss per  common share - basic and diluted                  |   | $                                     | (0.10  | )                                    | $      | (0.46 | ) | $ | (0.55 | ) | $ | (1.67 | ) |
|                                                            |   |                                  |   |                                 |   |   |   |   |   |
| Weighted  average common shares outstanding - basic and diluted |   | 9,584                                 |   | 9,421                                |   | 9,543 |   | 9,388 |   |

 

The accompanying notes are an integral part of the consolidatedfinancial statements.

 

4

----

 

**SEGUE SOFTWARE, INC**

**CONDENSED CONSOLIDATED STATEMENTSOF CASH FLOWS**

**(IN THOUSANDS)**

**(UNAUDITED)**

 
|                                                                                       |   | **Nine  months ended September 30,** |    |
|--------------------------------------------------------------------------------------------|--------|--------------------------------------|---------|
|                                                                                       |   | **2002**                             |    | **2001** | ** ** |
| Increase (decrease) in cash                                                                |   |                                 |    |   |   |
|                                                                                       |   |                                 |    |   |   |
| Cash flows from operating activities:                                                      |   |                                 |    |   |   |
| Net loss                                                                                   |   | $                                    | (5,136  | ) | $ | (15,713 | ) |
| Adjustments to reconcile net loss to net  cash provided by (used in) operating activities: |   |                                 |    |   |   |
| Depreciation and amortization                                                              |   | 1,420                                |    | 3,031 |   |
| Changes in operating assets and  liabilities:                                              |   |                                 |    |   |   |
| Accounts receivable                                                                        |   | (232                                 | )  | 6,639 |   |
| Other current assets                                                                       |   | 64                                   |    | (120 | ) |
| Accounts payable                                                                           |   | (978                                 | )  | 439 |   |
| Accrued expenses, lease obligations on excess space, compensation, benefits and  other     |   | 651                                  |    | 340 |   |
| Deferred revenue                                                                           |   | (214                                 | )       | (3,332 | ) |
|                                                                                       |   |                                 |    |   |   |
| Net cash used in operating activities                                                      |   | (4,425                               | )       | (8,716 | ) |
|                                                                                       |   |                                 |    |   |   |
| Cash flows from investing activities:                                                      |   |                                 |    |   |   |
| Additions to property and equipment                                                        |   | (140                                 | )       | (425 | ) |
| Maturities of short-term investments                                                       |   | 5,749                                |    | 12,944 |   |
| Purchases of short-term investments                                                        |   | (800                                 | )       | (10,081 | ) |
| Other, net                                                                                 |   | (98                                  | )  | (177 | ) |
|                                                                                       |   |                                 |    |   |   |
| Net cash provided by investing activities                                                  |   | 4,711                                |    | 2,261 |   |
|                                                                                       |   |                                 |    |   |   |
| Cash flows from financing activities:                                                      |   |                                 |    |   |   |
| Proceeds from exercise of stock options and  stock purchase plan                           |   | 201                                  |    | 467 |   |
| Proceeds from the issuance of convertible  preferred stock                                 |   | 2,000                                |    | — |   |
|                                                                                       |   |                                 |    |   |   |
| Net cash provided by financing activities                                                  |   | 2,201                                |    | 467 |   |
|                                                                                       |   |                                 |    |   |   |
| Effect of exchange rate changes on cash                                                    |   | 85                                   |    | (13 | ) |
|                                                                                       |   |                                 |    |   |   |
| Net increase (decrease) in cash and cash  equivalents                                      |   | 2,572                                |    | (6,001 | ) |
| Cash and cash equivalents, beginning of  period                                            |   | 2,326                                |    | 9,379 |   |
|                                                                                       |   |                                 |    |   |   |
| Cash and cash equivalents, end of period                                                   |   | $                                    | 4,898   |   | $ | 3,378 |   |
|                                                                                            |        |                                      |         |  |  |  |  |  |

 

The accompanying notes are an integral part of the consolidatedfinancial statements.

 

5

----

 

**SEGUESOFTWARE, INC.**

**NOTES TO****CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

 

**1.****        BASISOF PRESENTATION**

 

The financialstatements included herein have been prepared by Segue, without audit, pursuantto the rules and regulations of the Securities and Exchange Commission. Certaininformation and footnote disclosures normally included in financial statementsprepared in accordance with generally accepted accounting principles have beencondensed or omitted pursuant to such rules and regulations.  We believe that the disclosures are adequateto make the information presented not misleading.  However, it is suggested that these financial statements be readin conjunction with Segue’s audited financial statements for the year endedDecember 31, 2001, included in its 2001 Annual Report on Form 10-K.

 

This financialinformation reflects, in the opinion of management, all adjustments of a normalrecurring nature necessary to present fairly the results for the interimperiods.  Results of interim periods maynot be indicative of results for the full year.

 

Certain prior year amounts have been reclassified to conform to thecurrent year presentation.  Thesereclassifications had no effect on the previously reported results ofoperations or retained earnings.  Inaccordance with a new Emerging Issues TaskForce (“EITF”) accounting pronouncement, which became effective January1, 2002, the Company has reclassified $111,000 and $421,000 of reimbursabletravel as services revenue and cost of service for the three and nine monthsended September 30, 2001, respectively, to be consistent with current yearpresentation.

 

**2.****        LIQUIDITY**

 

The Company has generally incurred losses since it began operations,which has resulted in an accumulated deficit of approximately$58.2 million at September 30, 2002. As a result, the Company has used significant amounts of cash, cashequivalents and short-term investments to fund its operations.  See note 10 to the financial statements forcommitments and contingencies.  Therecoverability of a major portion of the recorded asset amounts shown in theaccompanying balance sheet are dependent upon the continued operations ofSegue, which in turn are dependent upon Segue’s ability to increase sales andto succeed in its future operations. The financial statements do not include any adjustments relating to therecoverability and classification of recorded asset amounts, and classificationand amounts of liabilities that might be necessary should Segue be unable tocontinue operations.

 

Management hastaken significant steps to streamline its operations, as discussed in theaccompanying notes, and will continue to do so as the situation warrants.  These steps have included reducingheadcount, infrastructure and other expenses and limiting capitalexpenditures.  The Company must maintainrevenue at or above current levels to allow Segue to achieve and sustain profitability and to get to positive cash flow fromoperations, if it is to continue as a viable business. There are uncertaintiesas to whether or when this will occur.

 

In March 2002, the Company sold 666,667 shares of Preferred Stock toS-7 Associates LLC, a company managed and owned by the Chairman of Segue’sBoard of Directors, for $2.0 million. With this investment and assuming that Segue can executeon current plans to grow revenue, Segue believes there should be sufficientcash to meet its forecasted working capital needs in the near future.  Delays in the timing of future sales or saleslevels below management’s expectations may cause the Company to re-evaluate itscash position, adjust its operations and/or take other possible actions.

 

The effects ofthe steps taken by management have significantly reduced the Company’s cash outflow.  Furthermore, at the end ofSeptember 2002, the Company was in final negotiations to restructure its leasefor approximately 30,000 square feet in its Lexington facility.  If signed, the proposed restructured leasewould result in a positive cash impact of over $700,000 annually for the next 5years.  Under the terms of the originallease and this proposed agreement, however, Segue would be required to providethe landlord an initial letter of credit for $700,000. The cash security that will be posted will be classified as restrictedcash.  This required letter of creditwould be reduced over time, by formula, to zero by August 2005.

 

6

----

 

**3.****        RECENTACCOUNTING DEVELOPMENTS**

 

OnJuly 20, 2001, the Financial Accounting Standards Board (“FASB”) issued Statementof Financial Standards (“SFAS”) No. 141 “Business Combinations” (“SFASNo. 141”), and SFAS No. 142, “Goodwill and Intangible Assets” (“SFASNo. 142”).  SFAS No. 141 iseffective for all business combinations initiated after June 30, 2001.SFAS No. 142 is effective for fiscal years beginning afterDecember 15, 2001; however, certain provisions of this Statement apply togoodwill and other intangible assets acquired between July 1, 2001 and theeffective date of SFAS No. 142. Major provisions of these statements and their effective dates for Segueare as follows:

•                                          All business combinations initiated afterJune 30, 2001 must use the purchase method of accounting.

 

•                                          Intangible assets acquired in a businesscombination must be recorded separately from goodwill, if they arise fromcontractual or other legal rights or are separable from the acquired entity andcan be sold, transferred, licensed, rented or exchanged, either individually oras part of a related contract, asset or liability.

 

•                                          Goodwill and intangible assets with indefinitelives, acquired after June 30, 2001, are not amortized.  Effective January 1, 2002, allpreviously recognized but unamortized goodwill and intangible assets withindefinite lives will no longer be subject to amortization.

 

•                                          Effective January 1, 2002, goodwill andintangible assets with indefinite lives will be tested for impairment annuallyand whenever there is an impairment indicator.

 

•                                          All acquired goodwill must be assigned toreporting units for purposes of impairment testing and segment reporting.

 

Segue adoptedSFAS No. 142 effective January 2002. Segue continued to amortize goodwill recognized prior to July 1,2001, under its then current method until December 31, 2001, after whichdate the annual and quarterly goodwill amortization of $1.5 million and$377,000, respectively, ceased to be amortized.   Segue’s goodwill arose from an acquisition, for which Segueobtained its SilkPerformer product.  Itis to this component that the goodwill is attached for purposes of determiningfair value.  During the quarter endedJune 30, 2002, Segue performed an initial analysis of the transitional fairvalue of the goodwill.  No impairmentexisted at the time of this initial test. Segue will re-evaluate the fair value of the goodwill during Q42002.  Any future impairment loss thatmay occur would not exceed $1.5 million, which is the net amount ofgoodwill that is on the balance sheet at September 30, 2002.

 

In accordancewith the adoption of SFAS No. 142, the following table presents what the netloss and net loss per common share for each of the periods would have beenexclusive of the goodwill amortization.

 
|                                           |   | **For the  three months ended  September 30,** |   | **For the  nine months ended  September 30,** |   |
|------------------------------------------------|--------|-----------------------------------------------------|--------|----------------------------------------------------|--------|
|                                           |   | **2002**                                            |   | **2001**                                           |   | **2002** |   | **2001** |   |
| **In thousands,  except per share data**       |   |                                                |   |                                               |   |   |   |   |   |
|                                           |   |                                                |   |                                               |   |   |   |   |   |
| Reported net loss applicable to common  shares |   | $                                                   | (1,003 | )                                                  | $      | (4,369 | ) | $ | (5,248 | ) | $ | (15,713 | ) |
| Add back: Goodwill amortization                |   | —                                              |   | 376                                                |   | — |   | 1,129 |   |
| Adjusted net loss applicable to common  shares |   | $                                                   | (1,003 | )                                                  | $      | (3,993 | ) | $ | (5,248 | ) | $ | (14,584 | ) |
|                                           |   |                                                |   |                                               |   |   |   |   |   |
| Basic and diluted loss per common share:       |   |                                                |   |                                               |   |   |   |   |   |
| Reported net loss per common share             |   | $                                                   | (0.10  | )                                                  | $      | (0.46 | ) | $ | (0.55 | ) | $ | (1.67 | ) |
| Add back: Goodwill amortization                |   | —                                              |   | 0.04                                               |   | — |   | .12 |   |
| Adjusted net loss per common share             |   | $                                                   | (0.10  | )                                                  | $      | (0.42 | ) | $ | (0.55 | ) | $ | (1.55 | ) |

 

On October 3, 2001, the FASB issued SFAS No. 144, “Accountingfor the Impairment or Disposal of Long-Lived Assets”.  SFAS No. 144 addresses the accounting and reporting for theimpairment or disposal of long-lived assets. It replaces SFASNo. 121.  SFAS No. 144provides a single accounting model for the disposal of long-lived assets. Newcriteria must be met to classify the asset as an asset held-for-sale.  This statement also focuses on reporting theeffects of a disposal. This statement is effective for fiscal years beginningafter December 15, 2001.  TheCompany adopted this statement as of January 1, 2002 and does not expect thisadoption to have a material impact to the Company’s financial position orresults of operations.

 

InNovember 2001, Emerging Issues Task Force (“EITF”) Issue No. 01-9, “Accountingfor Consideration Given by a Vendor to a Customer (Including a Reseller of theVendor’s Products)” was issued.  This EITF provides guidance with respect tothe statement of operations classification, recognition and measurement ofconsideration given by a vendor to a customer or reseller.  This EITF presumes any consideration to bean adjustment of the selling prices of the vendor’s products or services, whichshould be deducted from revenue when recognized in the vendor’s statement ofoperations, unless there is an identifiable and quantifiable benefit receivedfor the consideration.  This EITF is effectivefor annual and interim periods beginning after December 15, 2001.  Upon adoption, financial statements forprior periods presented for comparative purposes should be reclassified tocomply with the requirements under the EITF.  In January 1, 2002, the Company adopted this EITF.  During the quarter ended March 31, 2002, theCompany committed to

 

7

----

 

making a payment of $1.0million to a customer, which was made in Q2 2002.  Under the provisions of EITF Issue No. 01-9, this $1.0 millionwas considered to be a reduction in revenue and is presented in the statementof operations as such.  Per the contractwith the customer, this payment is a one-time expenditure.  In accordance with EITF Issue No. 01-9, inthe third quarter ended September 30, 2002, we recorded approximately $7,000 asa revenue reduction for amounts paid to resellers as referral fees forsales.  There were no other materialpayments made by the Company in this quarter or prior quarters that would beconsidered for reclassification under the guidance in EITF Issue No. 01-9.

 

On July 30,2002, FASB issued SFAS No. 146, “Accounting for Costs Associated with Exit orDisposal Activities” (“SFAS No. 146”). The standard requires companies torecognize costs associated with exit or disposal activities when they areincurred rather than at the date of a commitment to an exit or disposal plan.Examples of costs covered by the standard include lease termination costs andcertain employee severance costs that are associated with a restructuring,discontinued operation, plant closing, or other exit or disposal activity.  Statement 146 is to be applied prospectivelyto exit or disposal activities initiated after December 31, 2002, at which timethe Company will adopt this SFAS.

 

**4.****        OTHERASSETS**

 

Included inother assets at September 30, 2002 and December 31, 2001 is the principalbalance of an interest bearing promissory note receivable of approximately$322,000 and $305,000, respectively, from Segue’s chief executive officer.Interest on the outstanding balance is to be calculated on a monthly basisusing the current prime rate as published in the Wall Street Journal.  Interest shall be payable on eachanniversary of the note, beginning on March 22, 2002.  The Compensation Committee of the Company’sboard of directors approved adding the interest due on the loan as of March 22,2002 to the principal balance.  Theborrower must use the proceeds from any Company paid bonus or gain on the saleof shares of stock underlying options issued by the Company to pay anyoutstanding balance on the note.  Thenote is payable in full on March 22, 2006 and is secured by a SecondMortgage and Security Agreement between Segue and its chief executive officer.  This note receivable is grandfathered underthe recently enacted Sarbanes-Oxley Act of 2002.

 

**5.****        EQUITYTRANSACTIONS**

 

On March 22, 2002, the Company and S-7 Associates LLC, a companymanaged and owned by the Chairman of Segue’s Board of Directors, Dr. JamesH. Simons (“S-7 Associates”), signed an agreement under which S-7 Associatespurchased 666,667 shares of the Company’s Series B Preferred Stock (“PreferredStock”) in consideration for a payment of $2.0 million.  The Preferred Stock is senior to the commonstock as to dividend and liquidation rights and is convertible at the option ofthe holder into shares of common stock of Segue at a conversion price of $3.00per share, subject to adjustment upon the occurrence of certaintransactions.  The holders of thePreferred Stock are entitled to vote together with the common stock on anas-converted basis, and in addition, are entitled to elect one director of theCompany as a separate class.  Dividendson the Preferred Stock are 12% per annum and will be paid-in-kind semiannually.  The Preferred Stock is callable at theoption of the Company on or after March 31, 2004 at 133% of its face value(“Liquidation Preference”).  If there isa sale of all or substantially all of the Company’s assets or equity, thePreferred Stock can either be redeemed at the Liquidation Preference orconverted to common stock. Pursuant to a registration rights agreement, theCompany has agreed, subject to certain limitations, to register, under theSecurities Act of 1933, the resale of common stock into which the PreferredStock may be converted.  Theregistration rights expire on March 22, 2007. Based on written confirmation from Nasdaq, the Company did not need toseek shareholder approval of this transaction.

 

On June 30,2002, 21,533 shares of Preferred Stock were issued as dividends on thePreferred Stock.  For the quarter endedSeptember 30, 2002, an additional 20,646 shares of Preferred Stock were earnedas dividends and will be issued on December 31, 2002.  Preferred Stock dividends earned for the three and nine monthsended September 30, 2002 resulted in an expense of approximately $58,000 and$112,000 respectively. The fair value of the Preferred Stock, on which thepreferred dividends are calculated, is estimated by management for the purposeof determining net loss applicable to common shares. These dividend amountsdiffer slightly from our October 29, 2002 results press release.

 

For the ninemonths ended September 30, 2002, a total of 26,995 options to purchase commonstock were exercised by employees and directors, and a total of 137,271 sharesof common stock was purchased and issued to employees under the Company’sEmployee Stock Purchase Plan.  Totalproceeds to Segue for the transactions were approximately $201,000.  For the nine months ended September 30,2001, a total of 3,733 options to purchase common stock were exercised byemployees and directors, and a total of 123,655 shares of common stock waspurchased and issued to employees under the Company’s Employee Stock PurchasePlan.  Total proceeds to Segue for thetransactions were approximately $467,000.

 

8

----

 

**6.             RESTRUCTURING CHARGES**

 

Over the past18 months, Segue has executed various restructuring plans aimed at reducing theexpenses of the Company.  As a result,Segue has recorded restructuring charges for severance, other employee-relatedcosts, and costs for estimated lease obligations associated with excess officefacilities in our Lexington and Los Gatos offices, net of estimated subleaseincome.  The following table summarizesthe restructuring actions and charges incurred by quarter.

 
| **Quarter** |   | **Severance  and  other employee  related costs** |      | **Number of  employees  terminated as part of  restructuring plan** |   | **%  Reduction  in  workforce** |   | **Cost of  estimated  facility obligations,  net of estimated  sublease income** |    | **Office for  which facility  costs accrued** |      | **Total  Restructuring  Charge** |    |
|-------------|--------|---------------------------------------------------|-----------|---------------------------------------------------------------------|--------|---------------------------------|--------|----------------------------------------------------------------------------------|---------|-----------------------------------------------|-----------|----------------------------------|---------|
|        |   |                                              |      |                                                                |   |                            |   |                                                                             |    |                                          |      |                             |    |
| Q3 2002     |   |                                              | —    |                                                                | — |                            | — |                                                                             | $       | 373,000                                       |      | Lexington                        |    | $ | 373,000 |   |
| Q2 2002     |   |                                              | —    |                                                                | — |                            | — |                                                                             |    | 147,000                                       |      | Lexington                        |    |   | 147,000 |   |
| Q1 2002     |   | $                                                 | 559,000   |                                                                | 12     |                            | 5%     |                                                                             | 124,000 |                                          | Lexington |                             | 683,000 |   |
| Total 02    |   | 559,000                                           |      | 12                                                                  |   |                            |   | 644,000                                                                          |    |                                          |      | 1,203,000                        |    |
|        |   |                                              |      |                                                                |   |                            |   |                                                                             |    |                                          |      |                             |    |
|        |   |                                              |      |                                                                |   |                            |   |                                                                             |    |                                          |      |                             |    |
| Q3 2001     |   | 485,000                                           |      | 42                                                                  |   | 14                              |   | 1,479,000                                                                        |    | Lexington                                     |      | 1,964,000                        |    |
| Q2 2001     |   | 859,000                                           |      | 73                                                                  |   | 20                              |   | 1,398,000                                                                        |    | Lexington  and  Los Gatos                     |      | 2,257,000                        |    |
| Q1 2001     |   | —                                            |      | —                                                              |   | —                          |   | —                                                                           |    | —                                        |      | —                           |    |
| Total 01    |   | 1,344,000                                         |      | 115                                                                 |   |                            |   | 2,877,000                                                                        |    |                                          |      | 4,221,000                        |    |
|        |   |                                              |      |                                                                |   |                            |   |                                                                             |    |                                          |      |                             |    |
| Total       |   | $                                                 | 1,903,000 |                                                                | 127    |                            |   |                                                                             | $       | 3,521,000                                     |      |                             |    | $ | 5,424,000 |   |
|             |        |                                                   |           |                                                                     |        |                                 |        |                                                                                  |         |                                               |           |                                  |         |  |  |  |  |  |

 

As of September 30, 2002, the Company still had approximately $233,000accrued for severance and other employee related costs associated with theabove restructuring actions.

 

During thethird quarter of 2002, the $373,000 that was accrued for restructuring reflectsan incremental estimated loss associated with excess space that the Companymade available in its Lexington facility, in anticipation of a restructuredlease transaction that the Company is currently negotiating.  At September 30, 2002, the accrual balancerelated to the obligations associated with all of the excess office space notedabove is approximately $2.4 million. This is comprised of an estimated $6.8 million for future rentobligations by Segue on unoccupied space, plus $295,000 in miscellaneous costsrelated to subleasing the space, less approximately $4.7 million ofestimated future reduced lease obligations.  This accrual balance reflects signed subleases for the Los Gatosspace and a small portion of space in our Lexington facility, but the balanceof the accrual is based on management’s estimates of terms associated with aproposed restructured lease for the Lexington facility that is not yetconsummated, but in final negotiations.   If this sublease is not signed or terms change in final negotiations,Segue may incur additional losses on this excess space.

 

**7.****        PROVISIONFOR INCOME TAXES**

 

Segue recordedprovisions for foreign and state income taxes of $48,000 and $123,000 for thethree and nine months ended September 30, 2002, respectively, and $50,000and $166,000 for the same periods last year. There was no tax benefit recordedfor losses generated in the U.S. in either period due to the uncertainty ofrealizing such benefits.

 

**8.****        NETLOSS PER COMMON SHARE**

 

The followingtable sets forth the computation of basic and diluted loss per share (inthousands, except per share data):

 
|                                                                       |   | **Three  months ended September 30,** |   | **Nine  months ended September 30,** |   |
|----------------------------------------------------------------------------|--------|---------------------------------------|--------|--------------------------------------|--------|
|                                                                       |   | **2002**                              |   | **2001**                             |   | **2002** |   | **2001** |   |
| Net loss applicable to common shares                                       |   | $                                     | (1,003 | )                                    | $      | (4,369 | ) | $ | (5,248 | ) | $ | (15,713 | ) |
| Weighted average shares used in net loss  per share—basic and diluted |   | 9,584                                 |   | 9,421                                |   | 9,543 |   | 9,388 |   |
| Net loss per common share—basic and diluted                           |   | $                                     | (0.10  | )                                    | $      | (0.46 | ) | $ | (0.55 | ) | $ | (1.67 | ) |

 

Excluded fromthe calculation of diluted earnings per share at September 30, 2002 and2001 were options to purchase 3,303,334 and 3,168,357 shares of common stock,respectively, and 688,200 and 0 shares of common stock issuable upon theconversion of preferred stock, respectively, because their inclusion would beanti-dilutive.

 

9

----

 

**9.             COMPREHENSIVELOSS**

 

SFASNo. 130, “Reporting Comprehensive Income” (“SFAS 130”) requires thereporting of comprehensive income in addition to net income fromoperations.  Comprehensive income is amore inclusive reporting methodology that includes disclosure of certainfinancial information that historically has not been recognized in thecalculation of net income.  To date,Segue’s comprehensive income items have consisted exclusively of foreigntranslation adjustments.  The followingtable sets forth the computation of comprehensive loss (in thousands):

 
|                            |   | **Three  months ended September 30,** |   | **Nine  months ended September 30,** |   |
|---------------------------------|--------|---------------------------------------|--------|--------------------------------------|--------|
|                            |   | **2002**                              |   | **2001**                             |   | **2002** |   | **2001** |   |
| Net loss                        |   | $                                     | (945   | )                                    | $      | (4,369 | ) | $ | (5,136 | ) | $ | (15,713 | ) |
| Foreign translation adjustments |   | (1                                    | )      | (42                                  | )      | 195 |   | (38 | ) |
| Comprehensive loss              |   | $                                     | (946   | )                                    | $      | (4,411 | ) | $ | (4,941 | ) | $ | (15,751 | ) |

 

**10.****     ****COMMITMENTS AND CONTINGENCIES**

 

At the end ofSeptember 2002, the Company was in active negotiations on a restructured leasefor approximately 30,000 square feet of its Lexington facility.  Under the provisions of Segue’s currentlease at its Lexington facility, Segue has an obligation to provide a securitydeposit to the landlord if Segue’s current assets, as defined in the lease, become less than $20.0 million, asevidenced by Segue’s annual audited financial statements as of eachDecember 31st.  As ofSeptember 30, 2002, current assets, as defined in the lease, were$10.6 million and at December 31, 2001 were $12.6 million.  The amount of the security deposit declinesby $350,000 for each year that passes from the commencement of the lease.  At September 30, 2002, the amount of thesecurity deposit required is approximately $1.1 million, which iscurrently under negotiation with the landlord. If Segue is able to complete the restructured lease, the landlord hasverbally agreed to reduce the required deposit to $700,000.  Under the terms of the agreement, the$700,000 would be in the form of a letter of credit.  The cash security that will be posted will be classified asrestricted cash.  This required letterof credit would be reduced over time, by formula, to zero by August 2005.

 

In January 2002, Segue entered into an agreement to be theexclusive external remote hosting application performance monitoring andscalability testing software provider to IBM Global Infrastructure and SystemsManagement Services (ISM), a division within IBM Global Services, for theinfrastructure used by ISM for this service for a period of three years throughDecember 31, 2004.  As part of thisagreement, the Company agreed to pay $1.0 million to IBM to be used tohelp fund the costs of deploying the remote monitoring infrastructure.  This amount was charged to earnings as areduction to revenue, based on EITF No. 01-9, in the first quarter of 2002 andthe payment was made in April 2002. Segue also agreed to provide certain amounts of training to IBMemployees at no charge.

 

In September2001, the Company signed a distribution agreement with T-Plan Ltd., of theUnited Kingdom.  Under the agreement,Segue will sell and market the T-Plan product that has been modified tointegrate with other Segue products, under the name SilkPlan, for which Seguewill pay T-Plan Ltd. a royalty for each unit sold.  Under the terms of the agreement, Segue mustpay T-Plan Ltd. a minimum quarterly royalty of $45,000 for the periodending March 31, 2002, $75,000 for the period ending June 30, 2002,and $100,000 for subsequent quarters. On October 1, 2002, both parties signed an amendment to the contractthat stated that beginning with the first quarter of 2003, the minimumroyalties would be renegotiated.  Eitherparty may cancel the agreement at any time by giving the other party writtennotice to that effect at least ninety days prior to such termination.  Other remaining royalty arrangements are notsignificant.

 

As of October15, 2001, the Company’s $1 million employer’s practices liability insurancepolicy expired.  Due to insurance marketconditions, the Company did not elect to acquire a new policy due to termsoffered, but purchased a one-year extended reporting provision that coveredclaims made during the period October 15, 2001 through October 15, 2002,arising from occurrences prior to October 15, 2001.  In March 2002, the Company purchased a new employer’s practicesliability insurance policy with an exclusion for claims made that were based onoccurrences before March 15, 2002. Based on the coverage under the extended reporting endorsement and thenew policy, the Company is self-insured for any claims made that are based onoccurrences between October 15, 2001 and March 15, 2002.  The Company is not aware of the assertion ofany claims based on occurrences during this period.

 

In the eventof a change of control or the sale of substantially all assets, the Company hascertain contractual obligations to executive officers, as well as, othernon-employee related contracts.  Thesepotential obligations, should a triggering event take place, are less than $2.0million.

 

As of September 30, 2002, Segue hadapproximately $1.7 million in net stockholder’s equity, which is below theNASDAQ’s minimum requirement of $2.5 million necessary to maintain our listingon the NASDAQ Small Cap Exchange. Management is currently in the process of developing a plan tore-establish net stockholder’s equity above the $2.5 million threshold.

 

10

----

 

**11.          SEGMENTREPORTING**

 

The Companyconsiders that it has the following reportable operating segments based ondifferences in products and services. Operating segments are defined as components of the enterprise aboutwhich separate financial information is available that is reviewed regularly bythe chief operating decision maker, or decision-making group, in deciding howto allocate resources and in assessing their performance. Software licenses substantiallyconsist of sales of our Silk product line. These operating segments are reviewed by management to the gross marginlevel.  The Company does not maintainand can not separate balance sheet information or full profit and lossinformation for these segments.  Thefollowing table sets forth the reportable operating segments (in thousands):

 
|                                          |   | **Three  months ended September 30,** |       | **Nine  months ended September 30,** |       |
|-----------------------------------------------|--------|---------------------------------------|------------|--------------------------------------|------------|
|                                          |   | **2002**                              |       | **2001**                             |       | **2002** |   | **2001** |   |
|                                          |   | **Revenue**                           | ** ** | **Gross  Margin**                    | ** ** | **Revenue** | ** ** | **Gross  Margin** | ** ** | **Revenue** | ** ** | **Gross  Margin** | ** ** | **Revenue** | ** ** | **Gross  Margin** | ** ** |
|                                          |   |                                  |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Software  licenses                            |   | $                                     | 3,754      |                                 | $          | 3,561 |   | $ | 3,655 |   | $ | 3,560 |   | $ | 9,583 |   | $ | 8,987 |   | $ | 12,834 |   | $ | 12,342 |   |
|                                          |   |                                  |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Training and  consulting                      |   | 761                                   |       | 194                                  |       | 1,738 |   | 686 |   | 3,113 |   | 1,136 |   | 6,652 |   | 2,648 |   |
| Maintenance                                   |   | 3,255                                 |       | 2,515                                |       | 3,421 |   | 2,762 |   | 9,976 |   | 7,938 |   | 10,918 |   | 8,501 |   |
|                                          |   |                                  |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total  services                               |   | 4,016                                 |       | 2,709                                |       | 5,159 |   | 3,448 |   | 13,089 |   | 9,074 |   | 17,570 |   | 11,149 |   |
|                                          |   |                                  |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Adjustment  relating to payment to a customer |   | (7                                    | )          | (7                                   | )          | — |   | — |   | (1,032 | ) | (1,032 | ) | — |   | — |   |
|                                          |   |                                  |       |                                 |       |   |   |   |   |   |   |   |   |   |   |   |   |
| Total  revenue                                |   | $                                     | 7,763      |                                 | $          | 6,263 |   | $ | 8,814 |   | $ | 7,008 |   | $ | 21,640 |   | $ | 17,029 |   | $ | 30,404 |   | $ | 23,491 |   |

 

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

 
|                           |   | **Total Revenue**                     |       |                                 |       |
|--------------------------------|--------|---------------------------------------|------------|--------------------------------------|------------|
|                           |   | **Three months ended  September 30,** |       | **Nine months ended  September 30,** |       | **Long Lived Assets  September 30,** |   |
|                           |   | **2002**                              | ** ** | **2001**                             | ** ** | **2002** | ** ** | **2001** |   | **2002** | ** ** | **2001** | ** ** |
|                           |   |                                  |       |                                 |       |   |   |   |   |   |   |   |   |
| United States                  |   | $                                     | 6,430      |                                 | $          | 7,770 |   | $ | 18,312 |   | $ | 26,434 |   | $ | 2,437 |   | $ | 3,831 |   |
| Foreign (substantially Europe) |   | 1,333                                 |       | 1,044                                |       | 3,328 |   | 3,970 |   | 580 |   | 869 |   |
|                           |   | $                                     | 7,763      |                                 | $          | 8,814 |   | $ | 21,640 |   | $ | 30,404 |   | $ | 3,017 |   | $ | 4,700 |   |

 

11

----

 

**ITEM2****. MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS**

 

**CRITICAL ACCOUNTING POLICIES**

 

Segue believes its most critical accountingpolicies are as follows:

 

**REVENUE RECOGNITION**—Segue’s revenue recognition policy follows theguidance prescribed in Statement of Position 97-2 (SOP 97-2) and Statement ofPosition 98-9 (SOP 98-9). These call for the residual method of revenue formulti-element arrangements when the vendor-specific objective evidence (VSOE)of the fair value does not exist for one of the delivered elements. Under theresidual method, the arrangement fee is recognized as follows: (1) thetotal fair value of the undelivered elements, as indicated by VSOE, is deferredand subsequently recognized in accordance with relevant sections of SOP 97-2and (2) the difference between the total arrangement fee and the amountdeferred for the undelivered elements is recognized as revenue related to the deliveredelements.

 

Segue reviews the methodology used todetermine VSOE of undelivered items semi-annually, or if warranted, on a morefrequent basis.  If the average VSOE issubstantially different from the standard VSOE, the Company adjusts thestandards to be more reflective of the actual VSOE. This change may result inmore or less revenue being recognized related to the initial delivery. To date,the difference between Segue’s standard VSOE and the actual VSOE has beenimmaterial.

 

**BAD DEBT RESERVE—**On a regular basis, Segue reviews its accountsreceivable aging to determine which accounts appear to be uncollectable andrecords an appropriate reserve. This determination is based on a completereview of all accounts greater than 60 days old and an estimate of defaultbased upon historical rates for all accounts less than 60 days old.

 

**RESTRUCTURINGCHARGES**—Anothercritical accounting policy relates to the recording of restructuring losses.Segue follows the guidance prescribed in EITF 94-3, “Liability Recognition forCertain Employee Termination Benefits and Other Costs to Exit an Activity(Including Certain Costs Incurred in a Restructuring)”. As such, Segue recordedas restructuring charges an estimated loss on unused leased space in ourLexington and Los Gatos facilities that resulted from workforce reductions.Refer to Note 6 in our Condensed Consolidated Financial Statements in thisForm 10-Q for additional information. These estimates were based on many factors that may be subject to changein the future including rental rates in the commercial office market and theestimated timeframe in which we expect to sublease the space or restructure thelease.   Segue obtained local realestate market data and consulted with its real estate advisor on these factorsto help determine an appropriate reserve for potential losses on the unusedspace. At September 30, 2002, the accrual balance related to theobligations associated with all of the excess office space is approximately$2.4 million.  This is comprised ofan estimated $6.8 million for future rent obligations by Segue onunoccupied space, plus $295,000 in miscellaneous costs related to subleasingthe space, less approximately $4.7 million of estimated future reducedlease obligations.  This accrual balancereflects signed subleases for the Los Gatos space and a small portion of spacein our Lexington facility, but the balance of the accrual is based onmanagement’s estimates of terms associated with a proposed restructured leasefor the Lexington facility that is not yet consummated, but in finalnegotiations.    If this sublease is notsigned or terms change in final negotiations, Segue may incur additional losseson this excess space.

 

12

----

 

**RESULTS OF OPERATIONS**

 

The followingtable sets forth certain unaudited quarterly results of operations expressed asa percentage of total revenue for the periods indicated:

 
|                                          |   | **Percentage  of Revenue for  Three Months Ended September 30,** |       | **Percentage  of Revenue for  Nine Months Ended September 30,** |       |
|-----------------------------------------------|--------|------------------------------------------------------------------|------------|-----------------------------------------------------------------|------------|
|                                          |   | **2002**                                                         | ** ** | **2001**                                                        | ** ** | **2002** | ** ** | **2001** |   |
|                                          |   |                                                             |       |                                                            |       |   |   |   |   |
| Revenue:                                      |   |                                                             |       |                                                            |       |   |   |   |   |
| Software                                      |   | 48.4                                                             | %          | 41.5                                                            | %          | 44.3 | % | 42.2 | % |
| Services                                      |   | 51.7                                                             |       | 58.5                                                            |       | 60.5 |   | 57.8 |   |
| Subtotal  revenue                             |   | 100.1                                                            |       | 100.0                                                           |       | 104.8 |   | 100.0 |   |
| Adjustment  relating to payment to a customer |   | (0.1                                                             | )          | —                                                          |       | (4.8 | ) | — |   |
| Net revenue                                   |   | 100.0                                                            |       | 100.0                                                           |       | 100.0 |   | 100.0 |   |
|                                          |   |                                                             |       |                                                            |       |   |   |   |   |
| Cost of  revenue:                             |   |                                                             |       |                                                            |       |   |   |   |   |
| Cost of  software                             |   | 2.5                                                              |       | 1.1                                                             |       | 2.8 |   | 1.6 |   |
| Cost of  services                             |   | 16.8                                                             |       | 19.4                                                            |       | 18.6 |   | 21.1 |   |
| Total cost  of revenue                        |   | 19.3                                                             |       | 20.5                                                            |       | 21.4 |   | 22.7 |   |
|                                          |   |                                                             |       |                                                            |       |   |   |   |   |
| Gross margin                                  |   | 80.7                                                             |       | 79.5                                                            |       | 78.6 |   | 77.3 |   |
|                                          |   |                                                             |       |                                                            |       |   |   |   |   |
| Operating  expenses:                          |   |                                                             |       |                                                            |       |   |   |   |   |
| Sales and  marketing                          |   | 50.3                                                             |       | 62.3                                                            |       | 57.1 |   | 70.5 |   |
| Research and  development                     |   | 19.1                                                             |       | 21.8                                                            |       | 20.1 |   | 21.2 |   |
| General and  administrative                   |   | 18.5                                                             |       | 18.7                                                            |       | 19.5 |   | 20.5 |   |
| Amortization  of goodwill                     |   | —                                                           |       | 4.3                                                             |       | — |   | 3.7 |   |
| Restructuring  and other charges              |   | 4.8                                                              |       | 22.3                                                            |       | 5.6 |   | 13.9 |   |
| Total  operating expenses                     |   | 92.7                                                             |       | 129.4                                                           |       | 102.3 |   | 129.8 |   |
|                                          |   |                                                             |       |                                                            |       |   |   |   |   |
| Loss from  operations                         |   | (12.0                                                            | )          | (49.9                                                           | )          | (23.7 | ) | (52.5 | ) |
| Other income  net                             |   | 0.4                                                              |       | .9                                                              |       | 0.3 |   | 1.4 |   |
| Loss before  provision for income taxes       |   | (11.6                                                            | )          | (49.0                                                           | )          | (23.4 | ) | (51.1 | ) |
| Provision  for income taxes                   |   | 0.6                                                              |       | 0.6                                                             |       | 0.6 |   | 0.5 |   |
|                                          |   |                                                             |       |                                                            |       |   |   |   |   |
| Net loss                                      |   | (12.2                                                            | )%         | (49.6                                                           | )%         | (24.0 | )% | (51.6 | )% |

 

**SOFTWARE REVENUE**

 

Software revenueincreased 3% to $3.8 million during the third quarter of 2002 from$3.7 million for the same period in 2001. For the nine months endedSeptember 30, 2002, software revenue decreased 25% to $9.6 million from $12.8million for the nine months ended September 30, 2001.  The major factor contributing to the increase in software revenuefor the three months ending September 30, 2002 was the closing of several largedeals, which significantly increased our average invoice size as compared tothe same period last year.   On a yearto date basis, the major reasons for the decline in software revenue ascompared to the same period in 2001, were the continued softness in theInformation Technology (“IT”) spending environment, longer time frames to closesales transactions and increased competition leading to greater discounts onsales.  The majority of Segue’s softwarelicense revenue comes from only two of its products, SilkTest andSilkPerformer.  International softwarerevenue accounted for 22%, or $833,000, and 20%, or $2.0 million, of totalsoftware revenue for the three and nine months ended September 30, 2002,respectively, as compared to 19%, or $690,000 and 20%, or $2.6 million for thesame periods in 2001.  The increase ininternational software revenue for the third quarter of 2002 versus the samequarter in 2001 can be attributed to the closing of a significant order inexcess of $400,000 in 2002.  On a yearto date basis, international software revenue has decreased in 2002, inabsolute dollars, due to the general slowdown in the European market andincreased competition.

 

13

----

 

**SERVICES REVENUE**

 

Servicesrevenue, which consists of training, consulting and maintenance, decreased 22%to $4.0 million during the third quarter of 2002 from $5.1 million inthe same quarter of 2001. For the nine months ended September 30, 2002,services revenue decreased 26% to $13.1 million, as compared to $17.6 millionfor the nine months ended September 30, 2001. As compared to the three and nine months ended September 30, 2001,training and consulting revenue decreased 56% and 53% for the same periods in2002, respectively.  The decrease intraining and consulting revenue in 2002, as compared to the same prior-yearperiods, was mostly due to slower sales of product, which is a major driver forthese services.  Additionally, theCompany has encountered some resistance from customers, who are unwilling tospend money for services in this tight spending environment.  For the three and nine months endedSeptember 30, 2002, recognized maintenance revenue decreased 5% and 9%respectively, as compared to the same periods in 2001.  The decrease in recognized maintenancerevenue was largely attributable to lower year to date sales of new softwarethat is sold with maintenance.

 

**COST OF SOFTWARE**

 

Cost ofsoftware increased 103% to $193,000 during the third quarter of 2002 from$95,000 in the same quarter of 2001. For the nine months ended September 30,2002, cost of software increased 21% to $596,000 from $492,000 in the sameperiod of 2001. As a percentage of software revenue, cost of software in thethird quarter of 2002 increased to 5%, up from 3% for the same period in2001.  For the nine months endedSeptember 30, 2002, cost of software as a percentage of software revenueincreased to 6% from 4% for the same period last year. The increase in cost ofsoftware, both in amount and as a percentage of software revenue, was primarilydue to the increase in royalties associated with the October 2001 agreementwith T-Plan Ltd, which requires Segue to pay minimum quarterly royalties forthe right to sell a modified version of T-Plan’s product, which Segue hascalled SilkPlan.  The increase in costof software in 2002 is partially offset by decreases in personnel related costsand lower allocated expenses that are due to the reduced headcount.

 

**COST OF SERVICES**

 

Cost ofservices decreased 24% to $1.3 million during the third quarter of 2002 from$1.7 million in the same quarter of 2001. For the nine months ended September 30, 2002, cost of services decreased37% to $4.0 million from $6.4 million in the same period in 2001.  Cost of services consists primarily of costsof providing customer technical support, training and consulting. During thethird quarter of 2002, cost of services as a percentage of services revenueremained at 33%, the same percentage as the similar quarter last year.  For the nine months ended September 30,2002, cost of services as a percentage of services revenue decreased to 31%from 37% in the corresponding prior-year period.  Cost of services as a percentage of services revenue may varybased on the profitability of individual consulting engagements and theutilization rate of in-house consultants versus outsourcing. Cost of trainingand consulting in the third quarter of 2002 decreased 46% to $567,000 from $1.1million for the same quarter of 2001. For the nine months ended September 30,2002, cost of training and consulting decreased 51% to $2.0 million as comparedto $4.0 million for the corresponding prior-year period. The decrease isprimarily attributable to lower personnel related expenses due to a lowervolume of engagements, also the result of the workforce reductions during thepast year, reductions in travel related expenses, as a result of a lower numberof training and consulting engagements, a reduction in outsourcing expenses andcost savings programs.  For the threemonths ended September 30, 2002, cost of maintenance increased 12% to $740,000from $659,000 as compared to the same period in 2001.  The increase in expense for the quarter is due to higher phoneand data line expenses for our Northern Ireland technical support center.  For the nine months ended September 30,2002, cost of maintenance decreased 16% to $2.0 million from $2.4 million forthe same period in 2001. The decreases are mainly in personnel related costs,which are the result of past reductions in workforce and further shifting ofsupport responsibilities to the global technical support center in NorthernIreland, where operating expenses are generally lower than in the UnitedStates, as well as a reduction in allocated expenses.  These reductions are offset by the increase in telephone and dataexpenses.

 

**SALES AND MARKETING**

 

Sales andmarketing expenses decreased 29% to $3.9 million during the third quarterof 2002 from $5.5 million in the third quarter of 2001.  For the nine months ended September 30,2002, sales and marketing expenses decreased 42% to $12.4 million from $21.4million in the corresponding prior-year period.  The main reasons for the decreases are lower personnel relatedcosts due to restructurings over the past year, less spending on marketingprograms, reduced commissions because of lower revenue and decreased travelrelated expenses.

 

14

----

 

**RESEARCH AND DEVELOPMENT**

 

Research anddevelopment expenses decreased 23% to $1.5 million during the third quarter of2002 from $1.9 million in the same quarter of 2001.  For the nine months ended September 30, 2002, research anddevelopment expenses decreased 33% to $4.3 million from $6.5 million in thecorresponding prior-year period.  Thedecreases are mainly in personnel related costs due to the workforce reductionsof the past year, including the closing of the development lab in Californiaduring 2001.

 

**GENERAL AND ADMINISTRATIVE**

 

General andadministrative expenses decreased 13% from $1.7 million for the thirdquarter of 2001 to $1.4 million for the quarter ended September 30, 2002.  For the nine months ended September 30,2002, general and administrative expenses decreased 32% to $4.2 million from$6.2 million in the corresponding prior-year period.  The decreases in expenses are a result of lower personnel relatedexpenses due to the restructuring actions in 2001, reduced consulting expensesthat were part of the cost savings plans, and a reduction in bad debtexpense.   Bad debt expense was higherin prior years due to the number of dot-com business failures.

 

**AMORTIZATION OF GOODWILL**

 

As required bySFAS No. 142, Segue discontinued the amortization of goodwill effective January1, 2002.  During the quarter endedSeptember 30, 2002, Segue performed an initial analysis of the transitionalfair value of the goodwill.  Noimpairment existed at the time of this initial test. Segue will re-evaluate thefair value of the goodwill during Q4 2002. Any future impairment loss that may occur would not exceed$1.5 million, which is the net amount of goodwill that is on the balancesheet at September 30, 2002.  For thethree and nine months ended September 30, 2001, amortization of goodwill was$376,000 and $1.1 million, respectively.

 

**RESTRUCTURINGCHARGES**

 

During thethird quarter of 2002, Segue recorded as restructuring charges $373,000 for anincrease in the estimate of the loss associated with excess office facilities.For the nine months ended September 30, 2002, the Company recordedrestructuring charges of $1.2 million, which included $559,000 for a reductionin the workforce of approximately 5% and approximately $644,000 forfacility-related costs, which included the accrual of estimated leaseobligations associated with the excess office facilities in our Lexingtonoffice, net of anticipated subleasing income. For the three months ended September 30, 2001, Segue recorded $2.0million for restructuring charges, including $485,000 for severance andemployee related costs associated with a reduction in force of approximately14% and $1.5 million for estimated lease obligations associated with the excessoffice facilities in our Lexington and Los Gatos offices, net of anticipatedsubleasing income.  For the nine monthsended September 30, 2001, Segue recorded restructuring charges of $4.2 million,which included $1.3 million for a total reduction in workforce of approximately32% and approximately $2.9 million for facility-related costs, which includedthe accrual of estimated lease obligations associated with the excess officefacilities in our Lexington and Los Gatos offices, net of anticipated subleasingincome.

 

**OTHER INCOME, NET**

 

Other income,net decreased 60% to $31,000 during the third quarter of 2002 from $78,000 inthe same quarter of 2001.  For the ninemonths ended September 30, 2002, net other income decreased 83% to $74,000 from$425,000 in the same period last year. Other income consists mainly of interest income on cash equivalents andshort-term investments.  The decrease ininterest income was primarily due to lower balances of cash equivalents andshort-term investments in 2002 in comparison to the same period in 2001, andlower interest rates on those investments.

 

**PROVISION FOR INCOME TAXES**

 

We recorded aprovision for foreign and state income taxes of $48,000 and $123,000 for thethree and nine months ended September 30, 2002, respectively, as compared to$50,000 and $166,000 for the same periods in 2001.  There was no tax benefit recorded for losses generated in the U.S. in any period due to the uncertainty of realizing such benefits.

 

15

----

 

**LIQUIDITY AND CAPITAL RESOURCES**

 

As ofSeptember 30, 2002, our principal sources of liquidity included cash, cashequivalents and short-term investments totaling $4.9 million, as compared to$7.3 million as of December 31, 2001.

 

During thefirst nine months of 2002, we used $4.4 million for operating activities,resulting from our net loss, adjusted for depreciation of fixed assets, as wellas decreases in accounts payable and deferred revenue, offset by increases inaccrued expenses and decreases in accounts receivable and other current assets.

 

Our investing activities generated cash of $4.7 million in thefirst nine months of 2002, which primarily came from maturing short-terminvestments. We continued to keep purchases of property and equipment lowduring the quarter.  In the future,Segue may need to make increased expenditures on property and equipment aspresent equipment ages.

 

We generatedfunds from financing activities of $2.2 million during the first nine months of2002.  $2.0 million of this is relatedto the issuance of convertible preferred stock, and the balance is from theissuance of stock under the employee stock purchase plan and the exercise ofstock options.

 

In 2001 and the first nine months of 2002, Segue had executed variousrestructuring actions, for which we had accrued severance, benefits andestimated lease obligations on excess office space, net of estimated subleasingincome.  During the first nine months of2002, we paid approximately $463,000 for the severance and termination benefitsassociated with all of the restructuring actions.  At September 30, 2002, we still had approximately $233,000accrued for severance and benefits associated with all of the restructuringactions.  During the first quarter of2002, we entered into a sublease with a private company for a small amount ofthe space in our Lexington office. The term of the sublease is from May 2002through October 2007, which is the end of Segue’s lease in Lexington.   At September 30, 2002, theaccrual balance related to the obligations associated with all of the excessoffice space is approximately $2.4 million.  This is comprised of an estimated $6.8 million for futurerent obligations by Segue on unoccupied space, plus $295,000 in miscellaneouscosts related to subleasing the space, less approximately $4.7 million ofestimated future reduced lease obligations. This accrual balance reflects signed subleases for the Los Gatos spaceand a small portion of space in our Lexington facility, but the balance of theaccrual is based on management’s estimates of terms associated with a proposedrestructured lease for the Lexington facility that is not yet consummated, butis in final negotiations.  If thissublease is not signed or terms change in final negotiations, Segue may incuradditional losses on this excess space.

 

In January 2002, Segue entered into an agreement to be theexclusive external remote hosting application performance monitoring andscalability testing software provider to IBM Global Infrastructure and SystemsManagement Services (ISM), a division within IBM Global Services, for theinfrastructure used by ISM for this service for a period of three years throughDecember 31, 2004. As part of this agreement, the Company agreed to pay$1.0 million to IBM to be used to help fund the costs of deploying theremote monitoring infrastructure.   Thisamount was paid in April 2002.

 

Under theprovision of Segue’s lease obligation at its Lexington facility, Segue has anobligation to provide a security deposit if Segue’s current assets, as defined in the lease, become less than$20.0 million, as evidenced by Segue’s annual audited financial statementsas of each December 31st. As of September 30, 2002, current assets, as defined in the lease, were$10.6 million and at December 31, 2001 were at $12.6 million.  The amount of the security deposit declinesby $350,000 for each year that passes from the commencement of the lease.  At September 30, 2002, the amount of thesecurity deposit required is approximately $1.1 million, which iscurrently under negotiation with the landlord.   If Segue is able to complete the restructured lease, thelandlord has verbally agreed to reduce the required deposit to $700,000.  Under the terms of the agreement, the$700,000 would be in the form of a letter of credit.  The cash security that will be posted will be classified asrestricted cash.  This required letterof credit would be reduced over time, by formula, to zero by August 2005.

 

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

 

We have historically had losses. This, accompanied by the currenteconomic downturn, the slowdown of IT capital spending and increasedcompetition, has resulted in lower sales volume, which has required Segue tocontinue utilizing cash and cash equivalents to fund operations.

 

16

----

 

Segue actively pursued additional financing to fund working capitalrequirements. On March 22, 2002, the Company and S-7 Associates LLC, acompany managed by the Chairman of Segue’s Board of Directors, Dr. JamesH. Simons (“S-7 Associates”), signed an agreement under which S-7 Associatespurchased 666,667 shares of the Company’s Series B Preferred Stock(“Preferred Stock”) in consideration for a payment of $2.0 million. ThePreferred Stock is senior to the common stock as to dividend and liquidationrights and is convertible at the option of the holder into shares of commonstock of Segue at a conversion price of $3.00 per share, subject to adjustmentupon the occurrence of certain transactions. The holders of the Preferred Stockare entitled to vote together with the common stock on an as-converted basis,and in addition, are entitled to elect one director of the Company as aseparate class. Dividends on the Preferred Stock are 12% per annum and will bepaid-in-kind semiannually. The Preferred Stock is callable on or afterMarch 31, 2004 at 133% of its face value (“Liquidation Preference”). Ifthere is a sale of all or substantially all of the Company’s assets or equity,the Preferred Stock can either be redeemed at the Liquidation Preference orconverted to common stock. Pursuant to a registration rights agreement, theCompany has agreed, subject to certain limitations, to register, under theSecurities Act of 1933, the resale of common stock into which the PreferredStock may be converted. The registration rights expire on March 22, 2007.

 

Management hastaken significant steps to streamline its operations and will continue to do soas the situation warrants.  These stepshave included reducing headcount, infrastructure and other expenses andlimiting capital expenditures.  TheCompany must maintain revenue at or above current levels to allow Segue to achieve and sustain profitability and to get topositive cash flow from operations, if it is to continue as a viable business.There are uncertainties as to whether or when this will occur.

 

The effects of the steps taken by management have significantly reducedthe Company’s cash out flow.  Assumingthat Segue can execute on current plans to grow revenue through itsrestructured sales program, its focus on enterprise customers, its newalliances with IBM and Allen Systems Group ("ASG") and itsintroduction and success of new and enhanced products, and the business climatefor IT spending does not worsen, we believe that with current cash and cashequivalents, that Segue has sufficient resources to meet its forecasted workingcapital requirements for the foreseeable future.  However, if Segue can not grow its revenue or the economyworsens, we may need to take other actions in order to fund our working capitalresource requirements.   These actionsmay possibly include further reductions in workforce, other cost reductions orraising additional capital.  At thistime, Segue has definitive no plans to take such actions.  If the Company needs additional financing,there is no assurance that Segue could raise definitive capital on termsacceptable to it.

 

If businesscontinues at the same rate as in the current quarter, management believes thatSegue should have sufficient cash for at least the next 12 months.

 

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

 

To date, inflation has not had a material impact on our financialresults.

 

**FACTORS THAT MAY AFFECT FUTURE RESULTS**

 

The Company’sbusiness is subject to many uncertainties and risks. This Form 10-Qcontains certain forward-looking statements within the meaning of the PrivateSecurities Reform Act of 1995.  TheCompany’s future results may differ materially from its current results andactual results could differ materially from those projected in theforward-looking statements as a result of certain risk factors, including butnot limited to those set forth below, other one-time events and other importantfactors disclosed previously and from time to time in Segue’s other filingswith the SEC.

 

***Ourquarterly results may fluctuate.***  Segue’squarterly revenue and operating results are difficult to predict and mayfluctuate significantly from quarter to quarter.  If our quarterly revenue or operating results fall below theexpectations of investors or public market analysts, the price of our commonstock could fall substantially.  Ourquarterly revenue may fluctuate significantly for several reasons, including:the timing and success of introductions of our new products or productenhancements or those of our competitors; uncertainty created by changes in themarket, including the decline in IT spending, and decline of the generalbusiness climate, which make it difficult to predict the size and timing ofindividual orders;  competition and pricing;customer order deferrals or reductions as a result of general businessconditions and budget freezes; ability to increase sales from enterprisecompanies; and general economic conditions. Substantial portions of Segue’soperating expenses are related to personnel, facilities and marketing and salesprograms.  The level of spending forsuch expenses cannot be adjusted quickly and is based, in significant part, onour expectations of future revenues.  Ifactual revenue levels are below management’s expectations, results ofoperations are likely to be adversely affected.  Furthermore, Segue has often recognized a substantial portion ofits product revenues in the last month of a quarter, with these revenues frequentlyconcentrated in the last weeks or days of a quarter.  As a result, product revenues in any quarter are substantiallydependent on orders booked and shipped in the latter part of that quarter andrevenues from any future quarter are not predictable with any significantdegree of accuracy.  Segue typicallydoes not experience order backlog. For these reasons, Segue believes thatquarter-to-quarter comparisons of its results of operations are not necessarilymeaningful and should not be relied upon as indications of future performance.

 

17

----

 

***Wemay not be profitable in the future.***  SinceSegue began operations, it has generally experienced losses.  Losses have resulted in an accumulateddeficit of approximately $58.2 million as of September 30, 2002.  For the first nine months of 2002, weexperienced significant revenue shortfalls from the same period in prior year.We initiated aggressive cost savings throughout 2001 and continued this in2002, in an effort to reduce expenses, enhance the possibility of breakeven,and conserve cash. These cost saving measures may not be effective, and are notnecessarily indicative of future operating results. Failure to achieveprofitability may adversely affect the market price of Segue’s common stock.

 

***Continueddecline in business conditions and Information Technology (IT) spending couldcause further decline in revenue.*** The levelof future IT spending in the marketplace remains very uncertain particularly inlight of the decline in the business climate throughout 2001 and 2002.  If IT spending continues to decline, Segue’srevenues could be further adversely impacted.

 

***Seguemay not derive substantial incremental revenue from its alliances and SilkElitePartner Program.***   In an effort to augmentproduct revenue derived from the efforts of its direct sales force, Segue hasfocused on expanding its key strategic alliances and on building a successfulSilkElite Partner Program. The SilkElite Partner Program focuses on resellers,consulting partners and distributors.  SilkElite Partners both resell Segue products and use Seguesoftware products in the delivery of consulting services.  The success of the expansion of keystrategic alliances and the SilkElite Partner Program is uncertain, facesstrong competition, and takes time and significant resources to develop.  Should Segue fail to generate substantialincremental revenue from its strategic alliances or its SilkElite PartnerProgram, the financial results and stock price could be adversely affected.

 

***Seguemay not generate substantial incremental revenue from the expanded relationshipwith IBM.***   Segue signed an expanded contract with IBMCorporation under which Segue is the exclusive external provider of softwarefor IBM Global Infrastructure and Systems Management Services’ new remoteinfrastructure analysis offering.  IBMwill use Segue’s recently introduced monitoring product, SilkVision andSegue’s enhanced scalability product, SilkPerformer V.  Segue invested significant resources in thealliance, including $1.0 million paid in April 2002, to accelerate theavailability of the new IBM service offering. Should the IBM service offering not be successful, Segue will notgenerate substantial incremental revenue and its business could be materiallyadversely affected.  In September 2002,Segue signed a contract with Tivoli, an IBM division, under which Tivoli hasthe right to integrate a Segue product into a certain Tivoli productsuite.  If Tivoli is not successful inthe integration and ultimate sale of the product suite, Segue will not generatesubstantial incremental revenue and its business could be materially adverselyaffected.

 

***Sellingproducts and services through alliances and partnerships may limit our controland interaction with end users of our products.***  As a result, our ability to forecast sales accurately, evaluatecustomer satisfaction and recognize emerging customer requirements may belimited.  Our ability to develop and maintaincustomer goodwill could also be affected. Finally, we will have to resolve potential channel selling conflictsamong our sales force and business partners in order to make the partnerprogram successful.

 

***Ourfuture success will depend on our ability to respond rapidly and effectively totechnological and other market changes, including the successful introductionof new and enhanced products.***   Thenature of the web-based automated software testing and e-business testingmarkets in which we compete is characterized by rapidly changing technology,rapidly evolving customer needs and desires, changes in industry standards andpractices and frequent releases of new product or enhancements bycompetitors.  To be competitive, Seguemust develop and introduce product enhancements and new products that addressthe increasingly sophisticated and varied needs of our existing and potentialcustomers.  SilkPerformer and SilkTestproducts accounted for over 90% of Segue’s product revenue for the first ninemonths of 2002 and fiscal 2001.  In late2001, we introduced our new web-based enterprise-monitoring product,SilkVision, and our enhanced scalability testing product SilkPerformer V.  Segue also announced an alliance tointegrate and resell a test management tool from T-Plan Ltd, that we namedSilkPlan.  In addition, Segue alsointroduced a Unicode multi-lingual testing capability for the Company’sregression testing tool, SilkTest International. Several of these products arebeing enhanced in 2002 to respond to market needs.   If these new products are not successful or if we fail to continueto develop and introduce new products and enhancements on a timely basis, ormaintain our level of product revenue from SilkPerformer and SilkTest, or failto generate substantial incremental revenue from our new products, our businessmay be materially adversely affected.

 

18

----

 

***Wemay face liquidity issues.***  We havetaken steps to conserve our cash, including significantly reducing headcount,infrastructure and other expenses, and limiting capital expenditures in orderto compensate in part for our recent decline in revenues, to improve ourliquidity and to achieve greater efficiencies. Segue believes that based on potential incremental revenue from itsstrategic alliances, including a new alliance with ASG, its SilkElite PartnerProgram, the expanded IBM relationship, and its new products and productenhancements, that future sales will be sufficient to allow us to continue as aviable business.  Revenue in the firstnine months of 2002 declined by approximately 29% from revenue in the sameperiod last year.  If future salesdecline below our current level, however, we may have to raise additionalfinancing to fund working capital needs. If we fail to maintain our current revenue level, or we are not successfulin raising additional financing on terms acceptable to us, we may not havesufficient working capital resources in the near future, and our business maybe materially adversely affected. Furthermore, at the end of September 2002, the Company was in finalnegotiations to restructure its lease for approximately 30,000 square feet inits Lexington facility.  If signed, theproposed restructured lease would result in a positive cash impact of over$700,000 annually for the next 5 years. Under the terms of the proposed agreement, however, Segue would berequired to provide the landlord an initial letter of credit for $700,000.   The cashsecurity that will be posted will be classified as restricted cash.  This required letter of credit would bereduced over time, by formula, to zero by August 2005.  Failure to consummate the restructured leasemay have a detrimental impact on our business.

 

***Wemay not be successful in restructuring our headquarters office lease.***  Segue hasreached an agreement in principle under which Segue will be released from itsobligation to the landlord for approximately 30,000 square feet, which will beleased by the landlord to a new tenant at current market rates.  If consummated, the transaction will have apositive cash effect in excess of $700,000 annually for the next 5 years.  If not consummated, it may take six totwelve months to find a replacement tenant in a very difficult commercial realestate market.  If these efforts are notsuccessful, Segue will not realize its estimated cost savings or the amount ofestimated future reduced lease obligations for the approximately 30,000 squarefeet in its Lexington facility(estimated to be $3.8 million at September 30, 2002) used in therestructuring reserve calculation, and real estate costs will continue toaffect cash flow.

 

***Wemay have difficulty managing organizational change and operating the businessefficiently with fewer resources.***   In 2001and 2002, Segue reorganized its sales force; appointed new leaders in itssupport services consulting and product development areas; appointed a new headof international sales; hired a new Vice President of Product Marketing, whowas recently terminated; hired a new Senior Vice President of Worldwide Sales,who was terminated in early 2002; terminated the Senior Vice President ofMarketing; eliminated the inside sales group in 2001 and re-formed a smallerinside sales group in 2002; created a new strategic alliance program; shiftedresearch and development resources; and consolidated several of its activitiesas a result of reduced headcount. During 2001, Segue reduced its headcount by approximately 37% and in thefirst nine months of 2002 further reduced headcount by an additional 5%.  The success of these organizational andother changes is uncertain and Segue’s ability to manage its businessefficiently or develop new products and upgrades with fewer resources couldadversely affect its business.

 

***Seguefaces significant competition from other software companies.*** The market for web-basedsoftware quality management and testing tools is evolving, intenselycompetitive and subject to rapid technological change.  We expect competition to intensify in thefuture.  Segue currently encounterscompetition from a number of public and private companies, including MercuryInteractive Corporation, Rational Software Corporation and CompuwareCorporation.  Many of our current andpotential competitors have longer operating histories, greater name recognition,larger installed customer bases, and significantly greater financial, technicaland marketing resources than we do and, therefore, they may be able to respondmore quickly to new or changing opportunities, technologies, standards orcustomer requirements or they may be able to devote greater resources to thepromotion and sale of their products than Segue.  An increase in competition could result in price reductions andloss of market share.  Such competitionand any resulting reduction in profitability could have a material adverseeffect on our business, operating results and financial condition.

 

***Segue’sbusiness could be adversely affected if its products contain errors.***  Software products as complex as ours may contain undetectederrors or “bugs”, which could result in product failures.  The occurrence of errors could result inloss of or delay in revenue, loss of market share, failure to achieve marketacceptance, diversion of development resources, significant repair andreplacement costs, injury to our reputation, or damage to our efforts to buildbrand awareness, any of which could have a material adverse effect on ourbusiness, operating results and financial condition.

 

***We must hire andretain skilled personnel in a difficult economic environment.***  Qualified personnel remain in demand throughoutthe software industry.  Our successdepends in large part upon our ability to attract, train, motivate and retainhighly skilled employees, particularly sales and marketing personnel, softwareengineers and other senior personnel. The failure to attract and retain the highly skilled personnel that areintegral to our direct sales, product development, service and support teamsmay limit the rate at which we can generate sales and develop new products orproduct enhancements.  Our ability toattract and retain our qualified staff may be further impacted by our financialresults.  All of this could have amaterial adverse effect on our business, operating results and financialcondition.

 

19

----

 

***Weface many risks associated with international business activities.***  We derived approximately 15% of totalrevenue from international customers in the first nine months of 2002.  The international market for softwareproducts is highly competitive and we expect to face substantial competition inthis market from established and emerging companies.  Segue faces many risks associated with international businessactivities 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 localrequirements, trade restrictions, changes in tariffs and taxes, difficulties instaffing and managing international operations, longer accounts receivablepayment cycles and the burdens of complying with a wide variety of foreign lawsand regulations.  To the extent we areunable to continue to expand international sales in a timely and cost-effectivemanner, our business could be materially adversely affected.

 

***Segue’ssuccess depends on our ability to protect our software and other proprietarytechnology**.***  The unauthorized reproduction or othermisappropriation of our proprietary technology could enable third parties tobenefit from Segue’s technology without paying us for it.  This could have a material adverse effect onour business, operating results and financial condition.  Although we have taken steps to protect ourproprietary technology, these efforts may be inadequate.  We currently rely on a combination ofpatent, trademark, copyright and trade secret laws and contractual provisionsto protect our proprietary rights in our products.  Currently, we have three issued patents, a fourth pending andseveral at various stages to be filed with the Patent Office.  There can be no assurance that these patentswould be upheld if challenged. Moreover, the laws of other countries in which we market our products mayafford little or no effective protection of our intellectual property.  If we resort to legal proceedings to enforceour intellectual property rights, the proceedings could be burdensome andexpensive and could involve a high degree of risk.  If we were to discover that any of Segue products violated thirdparty proprietary rights, or protect our trade secrets, there can be noassurance that we would be able to obtain licenses on commercially reasonableterms to continue licensing our software without substantial reengineering orthat any effort to undertake such reengineering would be successful.  Any claim of infringement could cause Segueto incur substantial costs defending against the claim, even if the claim isinvalid, and could distract management resources from our business.  Furthermore, a party making such a claimcould secure a judgment that requires us to pay substantial damages or resultin an injunction.  Any of these eventscould have a material adverse effect on our business, operating results andfinancial condition.

 

**ITEM3****. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUTMARKET RISK**

 

The followingdiscussion about our market risk disclosures involves forward-lookingstatements.  Actual results could differmaterially from those discussed in the forward-looking statements.  We are exposed to market risk related tochanges in interest rates and foreign currency exchange rates.  We do not use derivative financialinstruments for speculative or trading purposes.

 

INTEREST RATE RISK.  Segue isexposed to market risk from changes in interest rates primarily through itsinvesting activities.  In addition, ourability to finance future transactions may be impacted if we are unable toobtain appropriate financing at acceptable rates.  Our investing strategy to manage interest rate and marketexposure is to invest in short-term, highly secure and liquid investments.  We maintain a portfolio of highly liquidcash equivalents and short-term investments (primarily in high-grade corporatecommercial paper). As of September 30, 2002, we had no short-term investments,only cash and cash equivalents.

 

FOREIGNCURRENCY RISK.  Segue faces exposure tomovements in foreign currency exchange rates. These exposures may change over time as business practices evolve andcould have a material adverse effect on our business, financial condition andresults of operations.  We do not usederivative financial instruments or other financial instruments to hedgeeconomic exposures or for trading. Historically, our primary exposures have been related to the operationsof our foreign subsidiaries.  During thefirst nine months of 2002, we incurred expenses of approximately $166,000related to foreign currency.  Theexpense effect of foreign currency for the first nine months in 2001 wasapproximately $190,000.  As of September30, 2002, the cumulative translation of foreign currency changes recordedagainst stockholders’ equity was $2,000. On January 1, 2002, the Euro became the local currency for two ofour operating subsidiaries, Austria and Germany.  We anticipate that the impact of the Euro will have a largereffect than in the past, as we will have both transactions and translationrelated to this currency.

 

### **ITEM 4**.  CONTROLS AND PROCEDURES

 

**EVALUATION OF DISCLOSURE CONTROLS ANDPROCEDURES -** As required by new Rule 13a-15 under theSecurities Exchange Act of 1934, within the 90 days prior to the date of thisreport, the Company carried out an evaluation under the supervision and withthe participation of the Company’s management, including the Company’s ChiefExecutive Officer and Chief Financial Officer, of the effectiveness of thedesign and operation of the Company’s disclosure controls and procedures.  Based upon that evaluation, the ChiefExecutive Officer and Chief Financial Officer concluded that the Company’sdisclosure controls and procedures are effective to ensure that informationrequired to be disclosed by the Company in the reports it files or submitsunder the Exchange Act is recorded, processed, summarized and reported, withinthe time periods specified in the Securities and Exchange Commission’s rulesand forms.  In connection with the newrules, we currently are in the process of further reviewing and documenting ourdisclosure controls and procedures, including our internal controls andprocedures for financial reporting, and may from time to time make changesaimed at enhancing their effectiveness and to ensure that our systems evolvewith our business.

 

**CHANGESIN INTERNAL CONTROLS** - None.

 

20

----

 

**PARTII****. OTHERINFORMATION**

 

**ITEM 1. LEGAL PROCEEDINGS**

 

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

 

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

 

Not applicable.

 

**ITEM 5. OTHER INFORMATION**

 

Not applicable.

 

**ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K**

 
| (a)    | Exhibits                  |
|--------|---------------------------|
|   | None.                     |
|   |                      |
| (b)    | Reports on  Form 8-K |
|   | None.                     |

 

### **SIGNATURES**

 

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

 

Date: November 14, 2002.

 
|   | **SEGUE SOFTWARE, INC.** |
|--------|--------------------------|
|   |                     |   |
|   |                     |   |
|   | By:                      | /s/ STEPHEN  B. BUTLER |   |
|   |                     |   |
|   |                     | Stephen B.  Butler |
|   |                     | Chief  Executive Officer, President and Director |
|   |                     |   |
|   | By:                      | /s/ DOUGLAS  ZACCARO |   |
|   |                     |   |
|   |                     | Douglas  Zaccaro |
|   |                     | Chief  Financial Officer and Treasurer |

 

21

----

 

**CERTIFICATIONS**

 

Ladiesand Gentlemen:

 

I, Stephen B. Butler, Chief Executive Officerof the Company, hereby certify that:

 

1.             I have reviewed this quarterly report on Form 10-Q of Segue Software,Inc.;

 

2.             Based on my knowledge, thisquarterly report does not contain any untrue statement of a material fact oromit to state a material fact necessary to make that statements made, in lightof the circumstances under which such statements were made, not misleading withrespect to the period covered by this quarterly report;

 

3.             Based on my knowledge, thefinancial statements, and other financial information included in thisquarterly report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, andfor, the period presented in this quarterly report;

 

4.             The registrant’s other certifyingofficer and I are responsible for establishing and maintaining disclosurecontrols and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14)for the registrant and we have:

 

a)        designed such disclosurecontrols and procedures to ensure that material information relating to theregistrant, including its consolidated subsidiaries, is made known to us byothers within those entities, particularly during the period in which thisquarterly report is being prepared;

b)        evaluated theeffectiveness of the registrant’s disclosure controls and procedures as of adate within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”); and

c)        presented in thisquarterly report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5.             The registrant’s other certifyingofficer and I have disclosed, based on our most recent evaluation, to theregistrant’s auditors and the audit committee of the registrant’s board ofdirectors:

 

a)        all significant deficiencies in thedesign or operation of internal controls which could adversely affect theregistrant’s ability to record, process, summarize and report financial dataand have identified for the registrant’s auditors any material weaknesses in internalcontrols; and

b)        any fraud, whether ornot material, that involves management or other employees who have asignificant role in the registrant’s internal controls; and

 

6.             The registrant’s other certifyingofficer and I have indicated in this quarterly report whether or not there weresignificant changes in internal controls or in other factors that couldsignificantly affect internal controls subsequent to the date of our mostrecent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 

 

 
| Date:  November 14, 2002 | /s/  STEPHEN B. BUTLER |                                             |
|-------------------------------|-----------------------------|--------------------------------------------------|
|                          | Name:                       | Stephen B.  Butler                               |
|                          | Title:                      | Chief  Executive Officer, President and Director |
|                               |                             |                                                  |  |

 

22

----

 

**CERTIFICATIONS**

 

Ladiesand Gentlemen:

 

I, Douglas Zaccaro, Chief Financial Officerand Treasurer of the Company, hereby certify that:

 

1.             I have reviewed this quarterly report on Form 10-Q of Segue Software,Inc.;

 

2.             Based on my knowledge, thisquarterly report does not contain any untrue statement of a material fact oromit to state a material fact necessary to make that statements made, in lightof the circumstances under which such statements were made, not misleading withrespect to the period covered by this quarterly report;

 

3.             Based on my knowledge, thefinancial statements, and other financial information included in thisquarterly report, fairly present in all material respects the financialcondition, results of operations and cash flows of the registrant as of, and for,the period presented in this quarterly report;

 

4.             The registrant’s other certifyingofficer and I are responsible for establishing and maintaining disclosurecontrols and procedures (as defined in Exchange Act Rules 13a-14 and 15d-14)for the registrant and we have:

 

a)        designed such disclosure controls andprocedures to ensure that material information relating to the registrant,including its consolidated subsidiaries, is made known to us by others withinthose entities, particularly during the period in which this quarterly reportis being prepared;

b)        evaluated theeffectiveness of the registrant’s disclosure controls and procedures as of adate within 90 days prior to the filing date of this quarterly report (the“Evaluation Date”); and

c)        presented in thisquarterly report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5.             The registrant’s other certifyingofficer and I have disclosed, based on our most recent evaluation, to theregistrant’s auditors and the audit committee of the registrant’s board ofdirectors (or persons performing the equivalent functions):

 

a)        all significant deficiencies in thedesign or operation of internal controls which could adversely affect theregistrant’s ability to record, process, summarize and report financial dataand have identified for the registrant’s auditors any material weaknesses ininternal controls; and

b)        any fraud, whether ornot material, that involves management or other employees who have asignificant role in the registrant’s internal controls; and

 

6.             The registrant’s other certifyingofficer and I have indicated in this quarterly report whether or not there weresignificant changes in internal controls or in other factors that couldsignificantly affect internal controls subsequent to the date of our mostrecent evaluation, including any corrective actions with regard to significantdeficiencies and material weaknesses.

 

 

 
| Date:  November 14, 2002 | /s/ DOUGLAS  ZACCARO |                                  |
|-------------------------------|----------------------|---------------------------------------|
|                          | Name:                | Douglas  Zaccaro                      |
|                          | Title:               | Chief Financial Officer and Treasurer |
|                               |                      |                                       |  |

 

23

----