##### Table of Contents









UNITED STATES

SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549




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FORM 10-Q

|                                                  |  |                                                                                             
|------------------------------------------------- |  | --------------------------------------------------------------------------------------------
|(Mark One)                                        |  |                                                                                             
|x                                                 |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR
    15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 
|                                                 
|For the Quarterly Period Ended March 31,
    2004
|                                                 
|o                                                 |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR
    15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period
from                     to

Commission file number 0-27794



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SEGUE SOFTWARE, INC.

(Exact name of registrant as specified in its
charter)


|                                |  |                    
|------------------------------- |  | -------------------
|Delaware                        |  | 95-4188982         
|(State or other jurisdiction of |  | (I.R.S. Employer   
|incorporation or organization)  |  | 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 whether the
registrant:(1) has filed all
reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding
12 months (or for such a shorter period that the registrant
was required to file such reports) and (2) has been subject
to such filing requirements for the past
90 days.     Yes x     No o

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

The number of shares of Registrants Common
Stock outstanding as of May 11, 2004 was 9,903,945.



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SEGUE SOFTWARE, INC.

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED MARCH 31,
2004

INDEX

|                                         |  |                                                                                                                |  |      |    | 
|---------------------------------------- |  | -------------------------------------------------------------------------------------------------------------- |  | ---- | -- | 
|                                         |  |                                                                                                                |  | Page
|                                         |  |                                                                                                                |  |     
|                                         |  | PART
    I.  FINANCIAL INFORMATION                                                                             |  |      |    | 
|Item 1                                   |  | Condensed Consolidated
    Financial Statements:                                                               |  |      | 2  | 
|                                         |  | Condensed Consolidated
    Balance Sheets (unaudited) March 31, 2004 and
    December 31, 2003                 |  |      | 2  | 
|                                         |  | Condensed Consolidated
    Statements of Operations (unaudited) Three months ended
    March 31, 2004 and 2003 |  |      | 3  | 
|                                         |  | Condensed Consolidated
    Statements of Cash Flows (unaudited) Three months ended
    March 31, 2004 and 2003 |  |      | 4  | 
|                                         |  | Notes to Condensed
    Consolidated Financial Statements (unaudited)                                           |  |      | 5  | 
|Item 2                                   |  | Managements Discussion
    and Analysis of Financial Condition and Results of Operations                      |  |      | 14 | 
|Item 3                                   |  | Quantitative and Qualitative
    Disclosures about Market Risk                                                 |  |      | 24 | 
|Item 4                                   |  | Controls and Procedures                                                                                        |  |      | 25 | 
|                                         |  | PART II.  OTHER
    INFORMATION                                                                                |  |      |    | 
|Item 1                                   |  | Legal Proceedings                                                                                              |  |      | 25 | 
|Item 4                                   |  | Submission of Matters to a
    Vote of Security Holders                                                        |  |      | 25 | 
|Item 5                                   |  | Other Information                                                                                              |  |      | 25 | 
|Item 6                                   |  | Exhibits and Reports on Form
    8-K                                                                           |  |      | 26 | 
|                                         |  | Signatures                                                                                                     |  |      | 27 | 
|Ex-31.1 Section 302 Certification of CEO
|Ex-31.2 Section 302 Certification of CFO
|Ex-32.1 Section 906 Certification of CEO
|Ex-32.2 Section 906 Certification of CFO



1



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##### Table of Contents






PART I.     FINANCIAL
INFORMATION






|        |                                                
|------- | -----------------------------------------------
|Item 1. | Condensed Consolidated Financial
    Statements



SEGUE SOFTWARE, INC.

CONDENSED CONSOLIDATED BALANCE
SHEETS

(In thousands except per share data)


|                                         |                                                                                                                                                                              |                                            |       |              |        |  |       |         |        | 
|---------------------------------------- | ---------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------------------------------ | ----- | ------------ | ------ |  | ----- | ------- | ------ | 
|                                         |                                                                                                                                                                              | March 31,                                  |       | December 31,
|                                         |                                                                                                                                                                              | 2004                                       |       | 2003        
|                                         |                                                                                                                                                                              |                                            |       |             
|                                         |                                                                                                                                                                              | (Unaudited)                                |       |             
|ASSETS                                  
|Current assets:                          |                                                                                                                                                                              |                                            |       |              |        |  |       |        
|                                         | Cash                                                                                                                                                                         |                                            | $     | 8,383        |        |  | $     | 7,495   |       
|                                         | Accounts receivable, net of allowances of $244
    and $268, respectively                                                                                                    |                                            |       | 5,053        |        |  |       | 5,607   |       
|                                         | Other current assets                                                                                                                                                         |                                            |       | 884          |        |  |       | 1,021   |       
|                                         |                                                                                                                                                                              |                                            |       |              |        |  |       |        
|                                         |                                                                                                                                                                              | Total current assets                       |       |              | 14,320 |  |       |         | 14,123 | 
|Property and equipment, net              |                                                                                                                                                                              |                                            | 917   |              |        |  | 1,069 |        
|Goodwill, net                            |                                                                                                                                                                              |                                            | 1,506 |              |        |  | 1,506 |        
|Other assets                             |                                                                                                                                                                              |                                            | 946   |              |        |  | 939   |        
|                                         |                                                                                                                                                                              |                                            |       |              |        |  |       |        
|                                         |                                                                                                                                                                              | Total assets                               |       | $            | 17,689 |  |       | $       | 17,637 | 
|                                         |                                                                                                                                                                              |                                            |       |              |        |  |       |        
|LIABILITIES AND STOCKHOLDERS
    EQUITY
|Current liabilities:                     |                                                                                                                                                                              |                                            |       |              |        |  |       |        
|                                         | Accounts payable                                                                                                                                                             |                                            | $     | 490          |        |  | $     | 1,004   |       
|                                         | Accrued compensation and benefits                                                                                                                                            |                                            |       | 1,499        |        |  |       | 1,931   |       
|                                         | Accrued lease obligations on excess space                                                                                                                                    |                                            |       | 1,444        |        |  |       | 1,554   |       
|                                         | Accrued expenses                                                                                                                                                             |                                            |       | 954          |        |  |       | 851     |       
|                                         | Deferred revenue                                                                                                                                                             |                                            |       | 9,504        |        |  |       | 9,015   |       
|                                         |                                                                                                                                                                              |                                            |       |              |        |  |       |        
|                                         |                                                                                                                                                                              | Total current liabilities                  |       |              | 13,891 |  |       |         | 14,355 | 
|Stockholders equity:                    |                                                                                                                                                                              |                                            |       |              |        |  |       |        
|                                         | Preferred stock, 9,000 shares authorized; 819 and
    819 shares of Series B and 508 and 508 shares of
    Series C preferred stock issued and outstanding,
    respectively |                                            |       | 3,963        |        |  |       | 3,884   |       
|                                         | Common stock, par value $.01 per share; 30,000
    shares authorized; 10,035 and 9,926 shares issued, respectively                                                           |                                            |       | 100          |        |  |       | 100     |       
|                                         | Additional paid-in capital                                                                                                                                                   |                                            |       | 58,349       |        |  |       | 58,160  |       
|                                         | Cumulative translation adjustment                                                                                                                                            |                                            |       | 278          |        |  |       | 309     |       
|                                         | Unearned compensation                                                                                                                                                        |                                            |       | (59          | )      |  |       |        |       
|                                         | Accumulated deficit                                                                                                                                                          |                                            |       | (58,233      | )      |  |       | (58,571 | )     
|                                         |                                                                                                                                                                              |                                            |       |              |        |  |       |        
|                                         |                                                                                                                                                                              |                                            | 4,398 |              |        |  | 3,882 |        
|Less treasury stock, at cost, 145 shares |                                                                                                                                                                              |                                            | (600  | )            |        |  | (600  | )      
|                                         |                                                                                                                                                                              |                                            |       |              |        |  |       |        
|                                         |                                                                                                                                                                              | Total stockholders equity                 |       |              | 3,798  |  |       |         | 3,282  | 
|                                         |                                                                                                                                                                              |                                            |       |              |        |  |       |        
|                                         |                                                                                                                                                                              | Total liabilities and stockholders equity |       | $            | 17,689 |  |       | $       | 17,637 | 
|                                         |                                                                                                                                                                              |                                            |       |              |        |  |       |        

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

2



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##### Table of Contents






SEGUE SOFTWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF
OPERATIONS

(In thousands except per share data)


|                                                          |                                         |                    |                          |       |       |       |       |       |       |       | 
|--------------------------------------------------------- | --------------------------------------- | ------------------ | ------------------------ | ----- | ----- | ----- | ----- | ----- | ----- | ----- | 
|                                                          |                                         |                   
|                                                          |                                         | Three months ended
|                                                          |                                         | March 31,         
|                                                          |                                         |                   
|                                                          |                                         | 2004               |                          | 2003 
|                                                          |                                         |                    |                          |      
|                                                          |                                         |                   
|                                                          |                                         | (Unaudited)       
|Revenue:                                                  |                                         |                    |                          |       |       |       |       |      
|                                                          | Software                                |                    | $                        | 3,575 |       |       | $     | 3,319 |      
|                                                          | Services                                |                    |                          | 4,471 |       |       |       | 4,184 |      
|                                                          |                                         |                    |                          |       |       |       |       |      
|                                                          |                                         | Gross revenue      |                          |       | 8,046 |       |       |       | 7,503 |      
|                                                          | Less vendor consideration to a customer |                    |                          | (22   | )     |       |       | (37   | )    
|                                                          |                                         |                    |                          |       |       |       |       |      
|                                                          |                                         |                    | Net revenue              |       |       | 8,024 |       |       |       | 7,466 | 
|Cost of revenue:                                          |                                         |                    |                          |       |       |       |       |      
|                                                          | Cost of software                        |                    |                          | 85    |       |       |       | 64    |      
|                                                          | Cost of services                        |                    |                          | 1,312 |       |       |       | 1,309 |      
|                                                          |                                         |                    |                          |       |       |       |       |      
|                                                          |                                         |                    | Total cost of revenue    |       |       | 1,397 |       |       |       | 1,373 | 
|                                                          |                                         |                    |                          |       |       |       |       |      
|Gross margin                                              |                                         |                    | 6,627                    |       |       |       | 6,093 |      
|Operating expenses:                                       |                                         |                    |                          |       |       |       |       |      
|                                                          | Sales and marketing                     |                    |                          | 3,472 |       |       |       | 3,559 |      
|                                                          | Research and development                |                    |                          | 1,650 |       |       |       | 1,458 |      
|                                                          | General and administrative              |                    |                          | 1,182 |       |       |       | 1,063 |      
|                                                          |                                         |                    |                          |       |       |       |       |      
|                                                          |                                         |                    | Total operating expenses |       |       | 6,304 |       |       |       | 6,080 | 
|                                                          |                                         |                    |                          |       |       |       |       |      
|Income from operations                                    |                                         |                    | 323                      |       |       |       | 13    |      
|Other income                                              |                                         |                    | 20                       |       |       |       |      |      
|Interest income                                           |                                         |                    | 21                       |       |       |       | 13    |      
|                                                          |                                         |                    |                          |       |       |       |       |      
|Income before provision for income taxes                  |                                         |                    | 364                      |       |       |       | 26    |      
|Provision for income taxes                                |                                         |                    | 26                       |       |       |       | 97    |      
|                                                          |                                         |                    |                          |       |       |       |       |      
|Net income (loss)                                         |                                         |                    | 338                      |       |       |       | (71   | )    
|Preferred stock dividend-in-kind                          |                                         |                    | 167                      |       |       |       | 54    |      
|                                                          |                                         |                    |                          |       |       |       |       |      
|Net income (loss) applicable to common shares             |                                         | $                  | 171                      |       |       | $     | (125  | )    
|                                                          |                                         |                    |                          |       |       |       |       |      
|Net income (loss) per common
    share  Basic            |                                         | $                  | 0.02                     |       |       | $     | (0.01 | )    
|Net income (loss) per common
    share  Diluted*         |                                         | $                  | 0.02                     |       |       | $     | (0.01 | )    
|Weighted average common shares
    outstanding  Basic    |                                         |                    | 9,832                    |       |       |       | 9,659 |      
|Weighted average common shares
    outstanding  Diluted* |                                         |                    | 10,571                   |       |       |       | 9,659 |      



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

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

3



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##### Table of Contents






SEGUE SOFTWARE, INC

CONDENSED CONSOLIDATED STATEMENTS OF CASH
FLOWS

(In Thousands)


(Unaudited)


|                                                                              |                                                                                               |                                              |                                                                                           |      |     |      |       |     |     |      |  
|----------------------------------------------------------------------------- | --------------------------------------------------------------------------------------------- | -------------------------------------------- | ----------------------------------------------------------------------------------------- | ---- | --- | ---- | ----- | --- | --- | ---- | -
|                                                                              |                                                                                               |                                             
|                                                                              |                                                                                               | Three months ended                          
|                                                                              |                                                                                               | March 31,                                   
|                                                                              |                                                                                               |                                             
|                                                                              |                                                                                               | 2004                                         |                                                                                           | 2003
|                                                                              |                                                                                               |                                              |                                                                                           |     
|Increase (decrease) in cash                                                   |                                                                                               |                                              |                                                                                           |      |     |      |       |    
|Cash flows from operating activities:                                         |                                                                                               |                                              |                                                                                           |      |     |      |       |    
|                                                                              | Net income (loss)                                                                             |                                              | $                                                                                         | 338  |     |      | $     | (71 | )  
|                                                                              | Adjustments to reconcile net loss to net cash
    provided by (used in) operating activities: |                                              |                                                                                           |      |     |      |       |     |    
|                                                                              |                                                                                               | Depreciation and amortization                |                                                                                           |      | 194 |      |       |     | 393 |     
|                                                                              |                                                                                               | Changes in operating assets and liabilities: |                                                                                           |      |     |      |       |     |     |     
|                                                                              |                                                                                               |                                              | Accounts receivable                                                                       |      |     | 547  |       |     |     | 904  |  
|                                                                              |                                                                                               |                                              | Other current assets                                                                      |      |     | 139  |       |     |     | 167  |  
|                                                                              |                                                                                               |                                              | Accounts payable                                                                          |      |     | (523 | )     |     |     | (532 | )
|                                                                              |                                                                                               |                                              | Accrued expenses, lease obligations on excess
    space, compensation, benefits and other |      |     | (449 | )     |     |     | (584 | )
|                                                                              |                                                                                               |                                              | Unearned compensation                                                                     |      |     | 9    |       |     |     |      |  
|                                                                              |                                                                                               |                                              | Deferred revenue                                                                          |      |     | 490  |       |     |     | 267  |  
|                                                                              |                                                                                               |                                              |                                                                                           |      |     |      |       |    
|Net cash provided by operating activities                                     |                                                                                               |                                              | 745                                                                                       |      |     |      | 544   |    
|                                                                              |                                                                                               |                                              |                                                                                           |      |     |      |       |    
|Cash flows from investing activities:                                         |                                                                                               |                                              |                                                                                           |      |     |      |       |    
|                                                                              | Additions to property and equipment                                                           |                                              |                                                                                           | (43  | )   |      |       | (45 | )  
|                                                                              | Other, net                                                                                    |                                              |                                                                                           | (7   | )   |      |       | 102 |    
|                                                                              |                                                                                               |                                              |                                                                                           |      |     |      |       |    
|Net cash (used in) provided by investing
    activities                       |                                                                                               |                                              | (50                                                                                       | )    |     |      | 57    |    
|                                                                              |                                                                                               |                                              |                                                                                           |      |     |      |       |    
|Cash flows from financing activities:                                         |                                                                                               |                                              |                                                                                           |      |     |      |       |    
|                                                                              | Proceeds from exercise of stock options and stock
    purchase plan                           |                                              |                                                                                           | 202  |     |      |       | 83  |    
|                                                                              |                                                                                               |                                              |                                                                                           |      |     |      |       |    
|Net cash provided by financing activities                                     |                                                                                               |                                              | 202                                                                                       |      |     |      | 83    |    
|                                                                              |                                                                                               |                                              |                                                                                           |      |     |      |       |    
|Effect of exchange rate changes on cash                                       |                                                                                               |                                              | (9                                                                                        | )    |     |      | (26   | )  
|                                                                              |                                                                                               |                                              |                                                                                           |      |     |      |       |    
|Net increase in cash and cash equivalents                                     |                                                                                               |                                              | 888                                                                                       |      |     |      | 658   |    
|Cash and cash equivalents, beginning of period                                |                                                                                               |                                              | 7,495                                                                                     |      |     |      | 5,335 |    
|                                                                              |                                                                                               |                                              |                                                                                           |      |     |      |       |    
|Cash and cash equivalents, end of period                                      |                                                                                               | $                                            | 8,383                                                                                     |      |     | $    | 5,993 |    
|                                                                              |                                                                                               |                                              |                                                                                           |      |     |      |       |    
|Supplemental disclosure of non-cash investing and
    financing transactions: |                                                                                               |                                              |                                                                                           |      |     |      |       |    
|                                                                              | Cash paid during the quarter for income taxes                                                 |                                              | $                                                                                         | 36   |     |      |       | 166 |    

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

4



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##### Table of Contents






SEGUE SOFTWARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

(Unaudited)

1.     Basis of
Presentation

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

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

2.     Liquidity

The Company has incurred losses on an annual
basis since it began operations, resulting in an accumulated
deficit of approximately $58.2 million at March 31,
2004. As a result, the Company has used significant amounts of
cash, cash equivalents and short-term investments to fund its
operations. However, the Company generated approximately
$888,000 in overall positive cash flow for the quarter ended
March 31, 2004 versus $658,000 in overall positive cash
flow for the quarter ended March 31, 2003. The first
quarter of 2004 represented the sixth consecutive quarter of
positive cash flow for the Company.

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

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

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

3.     Recent
Accounting Developments

In December 2002, the FASB issued SFAS
No. 148, Accounting for Stock-Based
Compensation  Transition and Disclosure
(SFAS No. 148). The standard amends SFAS
No. 123, Accounting for Stock-Based
Compensation, to provide alternative methods for voluntary
transition to SFAS 123s fair value method of accounting
for stock-based employee compensation (the fair value
method). SFAS

5



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##### Table of Contents



SEGUE SOFTWARE, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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

SFAS No. 123, Accounting for
Stock-Based Compensation, required the Company to elect
either expense recognition under SFAS No. 123 or its
disclosure-only alternative for stock-based employee
compensation. The expense recognition provision encouraged by
SFAS No. 123 requires fair-value based financial accounting
to recognize compensation expense for employee stock
compensation plans. The Company adopted SFAS No. 123 in
1997 and elected the disclosure-only alternative. Had
compensation costs for the Companys stock and stock option
plans been determined based on the fair value at the grant dates
for awards under those plans consistent with the methodology of
SFAS No. 123, the Companys net loss and net loss per
share would have been adjusted to the pro forma amounts
indicated below for the quarters ended March 31, (in
thousands, except per share data):

|                                                           |                                                                                                                                                         |                    |   |       |   |  |   |       |  
|---------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------------ | - | ----- | - |  | - | ----- | -
|                                                           |                                                                                                                                                         |                   
|                                                           |                                                                                                                                                         | Three months ended
|                                                           |                                                                                                                                                         | March 31,         
|                                                           |                                                                                                                                                         |                   
|                                                           |                                                                                                                                                         | 2004               |   | 2003 
|                                                           |                                                                                                                                                         |                    |   |      
|Net income (loss) applicable to common shares              |                                                                                                                                                         |                    |   |       |   |  |   |      
|                                                           | As reported                                                                                                                                             |                    | $ | 171   |   |  | $ | (125  | )
|                                                           | Deduct: Total stock-based employee compensation
    expense determined under the fair value based method for all
    awards, net of related tax effects |                    |   | (479  | ) |  |   | (742  | )
|                                                           |                                                                                                                                                         |                    |   |       |   |  |   |      
|                                                           | Pro forma                                                                                                                                               |                    | $ | (308  | ) |  | $ | (867  | )
|                                                           |                                                                                                                                                         |                    |   |       |   |  |   |      
|Net income (loss) per common share 
    basic and diluted |                                                                                                                                                         |                    |   |       |   |  |   |      
|                                                           | As reported  basic                                                                                                                                     |                    | $ | 0.02  |   |  | $ | (0.01 | )
|                                                           | As reported  diluted                                                                                                                                   |                    | $ | 0.02  |   |  | $ | (0.01 | )
|                                                           | Pro forma  basic                                                                                                                                       |                    | $ | (0.03 | ) |  | $ | (0.09 | )
|                                                           | Pro forma  diluted                                                                                                                                     |                    | $ | (0.03 | ) |  | $ | (0.09 | )

In January 2003, the FASB issued FIN
No. 46, Consolidation of Variable Interest
Entities. In general, a variable interest entity is a
corporation, partnership, trust, or any other legal structure
used for business purposes that either (a) does not have
equity investors with voting rights or (b) has equity
investors that do not provide sufficient financial resources for
the entity to support its activities. FIN No. 46 requires
certain variable interest entities to be consolidated by the
primary beneficiary of the entity if the investors do not have
the characteristics of a controlling financial interest or do
not have sufficient equity at risk for the entity to finance its
activities without additional subordinated financial support
from other parties. The consolidation requirements of FIN
No. 46 apply immediately to variable interest entities
created after January 31, 2003. The consolidation
requirements apply to older entities in interim periods
beginning after June 15, 2003. Certain of the disclosure
requirements apply in all financial statements issued after
January 31, 2003, regardless of when the variable interest
entity was established. In December 2003, the FASB
completed deliberations of proposed modifications to FIN 46
(Revised Interpretations) resulting in multiple effective dates
based on the nature as well as the creation date of the variable
interest entity. Because the Company currently has no
investments in variable interest entities, the adoption of the
provisions of FIN No. 46 did not have an impact on the
consolidated results of operations or financial position.

In April 2003, FASB issued Statement of
Financial Accounting Standard No. 149, Amendment of
Statement 133 on Derivative Instruments and Hedging
Activities. Statement No. 149 amends Statement

6



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##### Table of Contents



SEGUE SOFTWARE, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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

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

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

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

4.     Other
Assets

Included in other assets at March 31, 2004
and March 31, 2003 is restricted cash of $770,000. This
amount represents the security for a letter of credit required
by our sublease for our Lexington headquarters. This required
letter of credit will reduce over time, by formula, to zero by
August 2005. Also included is approximately $169,000 for
refundable security deposits we have paid for our various
regional sales offices.

7



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##### Table of Contents



SEGUE SOFTWARE, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

5.     Equity
Transactions

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

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

For the quarter ended March 31, 2004, an
additional 24,589 shares of Series B Preferred Stock and an
additional 15,234 shares of Series C Preferred Stock were
earned as dividends and will be issued on June 30, 2004.
Our preferred stock dividends deemed earned for the three months
ended March 31, 2004 resulted in an expense of
approximately $167,000 versus $54,000 for the period ended
March 31, 2003.

Until December 31, 2003, the fair value of
our preferred stock, on which the preferred dividends are
calculated, had been estimated by management for the purpose of
determining net loss applicable to common shares. During the
first quarter of 2004, the Company hired an independent third
party, who specializes in valuations, to establish the fair
market value of its preferred stock. The Company will engage
this third party on a quarterly basis for the purpose of
establishing the fair market value of its preferred stock and
calculating the expense of the dividends earned.

For the three months ended March 31, 2004,
there were options to purchase 59,225 shares of common stock
exercised by employees, and a total of 50,309 shares of common
stock were purchased and issued to employees under the
Companys Employee Stock Purchase Plan. Total proceeds to
Segue for the transactions were approximately $202,000. For the
three months ended March 31, 2003, there were no options to
purchase shares of common stock exercised by employees or
directors, and a total of 84,809 shares of common stock were
purchased and issued to employees under the Companys
Employee Stock Purchase Plan. Total proceeds to Segue for the
transactions were approximately $83,000.

At March 31, 2004, the Company had three
stock-based employee compensation plans. (These plans are
described more fully in Note 5 of the Companys Annual
Report on Form 10-K.) The Company accounts for these plans under
the recognition and measurement principles of APB Opinion
No. 25, Accounting for Stock Issued to
Employees, and related interpretations. In general, no
stock-based employee compensation cost is reflected in net
income, as most options granted under those plans had an
exercise price equal to the market value of the underlying
common stock on the date of grant. However,

8



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##### Table of Contents



SEGUE SOFTWARE, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

during the third quarter of 2003, a stock grant
was made for which the exercise price was slightly less than the
market value of the underlying common stock on the date of
grant. This resulted in a compensation expense of approximately
$10,000 for the quarter ended March 31, 2004.

6.     Restructuring
Charges

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

|         |  |                |           |                       |  |           |     |                       |  |                |    |               |  |   |           |  |  |  |               |  |  |   |           | 
|-------- |  | -------------- | --------- | --------------------- |  | --------- | --- | --------------------- |  | -------------- | -- | ------------- |  | - | --------- |  |  |  | ------------- |  |  | - | --------- | 
|         |  |                |           | Number of             |  | %         |     | Cost of estimated     |  |                |    |              
|         |  | Severance and  |           | employees             |  | Reduction |     | facility obligations, |  | Office for     |    | Total        
|         |  | other employee |           | terminated as part    |  | in        |     | net of estimated      |  | which facility |    | Restructuring
|Quarter  |  | related costs  |           | of restructuring plan |  | workforce |     | sublease income       |  | costs accrued  |    | Charge       
|         |  |                |           |                       |  |           |     |                       |  |                |    |              
|Q1 2004  |  |                |          |                       |  |           |    |                       |  |                |   |               |  |   |          |  |  |  |              |  |  |   |          | 
|         |  |                |           |                       |  |           |     |                       |  |                |    |               |  |   |           |  |  |  |               |  |  |   |           | 
|Total 04 |  |                |          |                       |  |           |    |                       |  |                |   |               |  |   |          |  |  |  |               |  |  |   |          | 
|         |  |                |           |                       |  |           |     |                       |  |                |    |               |  |   |           |  |  |  |               |  |  |   |           | 
|        
|Q4 2003  |  | $              | 725,000   |                       |  |           | 8   |                       |  |                | 4  |               |  |   |          |  |  |  |              |  |  | $ | 725,000   | 
|Q3 2003  |  |                |          |                       |  |           |    |                       |  |                |   |               |  |   |          |  |  |  |              |  |  |   |          | 
|Q2 2003  |  |                |          |                       |  |           |    |                       |  |                |   |               |  |   |          |  |  |  |              |  |  |   |          | 
|Q1 2003  |  |                |          |                       |  |           |    |                       |  |                |   |               |  |   |          |  |  |  |              |  |  |   |          | 
|         |  |                |           |                       |  |           |     |                       |  |                |    |               |  |   |           |  |  |  |               |  |  |   |           | 
|Total 03 |  |                | 725,000   |                       |  |           | 8   |                       |  |                | 4  |               |  |   |          |  |  |  |              |  |  |   | 725,000   | 
|         |  |                |           |                       |  |           |     |                       |  |                |    |               |  |   |           |  |  |  |               |  |  |   |           | 
|        
|Q4 2002  |  |                |          |                       |  |           |    |                       |  |                |   |               |  |   |          |  |  |  |              |  |  |   |          | 
|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 | 
|         |  |                |           |                       |  |           |     |                       |  |                |    |               |  |   |           |  |  |  |               |  |  |   |           | 
|        
|Q4 2001  |  |                |          |                       |  |           |    |                       |  |                |   |               |  |   |          |  |  |  |              |  |  |   |          | 
|Q3 2001  |  |                | 485,000   |                       |  |           | 42  |                       |  |                | 14 |               |  |   | 1,479,000 |  |  |  | Lexington     |  |  |   | 1,964,000 | 
|         |  |                |           |                       |  |           |     |                       |  |                |    |               |  |   |           |  |  |  | Lexington and |  |  |   |           | 
|Q2 2001  |  |                | 859,000   |                       |  |           | 73  |                       |  |                | 20 |               |  |   | 1,398,000 |  |  |  | Los Gatos     |  |  |   | 2,257,000 | 
|Q1 2001  |  |                |          |                       |  |           |    |                       |  |                |   |               |  |   |          |  |  |  |              |  |  |   |          | 
|         |  |                |           |                       |  |           |     |                       |  |                |    |               |  |   |           |  |  |  |               |  |  |   |           | 
|Total 01 |  |                | 1,344,000 |                       |  |           | 115 |                       |  |                |    |               |  |   | 2,877,000 |  |  |  |               |  |  |   | 4,221,000 | 
|         |  |                |           |                       |  |           |     |                       |  |                |    |               |  |   |           |  |  |  |               |  |  |   |           | 
|        
|Total    |  | $              | 2,628,000 |                       |  |           | 135 |                       |  |                |    |               |  | $ | 3,521,000 |  |  |  |               |  |  | $ | 6,149,000 | 
|         |  |                |           |                       |  |           |     |                       |  |                |    |               |  |   |           |  |  |  |               |  |  |   |           | 

During the first quarter of 2004, we paid
$231,000 of the amount accrued at December 31, 2003,
leaving a balance of $494,000 for the remaining severance and
termination benefits associated with the restructuring actions
from 2003.

At March 31, 2004, the accrual balance
related to the obligations associated with all of the excess
office space noted above is approximately $1.4 million.
This is comprised of an estimated $1.9 million for future
rents payable by Segue on unoccupied space less approximately
$515,000 of estimated future sublease income. The Company made
no estimate adjustments related to this accrual for the period
ended March 31, 2004.

9



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##### Table of Contents



SEGUE SOFTWARE, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

7.     Provision for
Income Taxes

Segue recorded provisions for foreign and state
income taxes of $26,000 and $97,000 for the three months ended
March 31, 2004 and 2003, respectively. There was no tax
benefit recorded for losses generated in the U.S. in either
period due to the uncertainty of realizing such benefits.

8.     Net Income
(Loss) Per Common Share

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

|                                                                          |  |                    |        |      |  |   |       |  
|------------------------------------------------------------------------- |  | ------------------ | ------ | ---- |  | - | ----- | -
|                                                                          |  |                   
|                                                                          |  | Three months ended
|                                                                          |  | March 31,         
|                                                                          |  |                   
|                                                                          |  | 2004               |        | 2003
|                                                                          |  |                    |        |     
|Net income (loss) applicable to common shares                             |  | $                  | 171    |      |  | $ | (125  | )
|Weighted average shares used in net income
    (loss) per share  basic   |  |                    | 9,832  |      |  |   | 9,659 |  
|Weighted average shares used in net income
    (loss) per share  diluted |  |                    | 10,571 |      |  |   | 9,659 |  
|Net income (loss) per common
    share  basic                            |  | $                  | 0.02   |      |  | $ | (0.01 | )
|Net income (loss) per common
    share  diluted                          |  | $                  | 0.02   |      |  | $ | (0.01 | )

Excluded from the calculation of diluted earnings
per share for the three months ended March 31, 2004 were
1,327,537 shares of common stock that can be converted from
preferred stock because their inclusion would be anti-dilutive.
Excluded from the calculation of diluted earnings per share for
the three months ended March 31, 2003 were options to
purchase 3,135,961 shares of common stock and 729,492 shares of
common stock that can be converted from convertible preferred
stock because their inclusion would be anti-dilutive.

9.     Comprehensive
Income (Loss)

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

|                                |  |              |     |      |  |   |     |  
|------------------------------- |  | ------------ | --- | ---- |  | - | --- | -
|                                |  |             
|                                |  | Three months
|                                |  | ended       
|                                |  | March 31,   
|                                |  |             
|                                |  | 2004         |     | 2003
|                                |  |              |     |     
|Net income (loss)               |  | $            | 338 |      |  | $ | (71 | )
|Foreign translation adjustments |  |              | 31  |      |  |   | 24  |  
|                                |  |              |     |      |  |   |     |  
|Comprehensive income (loss)     |  | $            | 307 |      |  | $ | (47 | )

10.     Commitments
and Contingencies



| |                  
| | -----------------
| | Legal Proceedings

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

10



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##### Table of Contents



SEGUE SOFTWARE, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



| |                  
| | -----------------
| | Lease Commitments

In August 1998, the Company moved its
corporate headquarters to Lexington, Massachusetts under a
non-cancelable operating sublease that expires in 2007. On
January 24, 2003, the Company received approval to
restructure its corporate headquarters sublease by returning
approximately 33,000 square feet in its Lexington facility to
the landlord. Pursuant to the terms of the restructuring, Segue
has posted an initial letter of credit for $700,000. The cash
security of $770,000 (letter of credit plus 10%) that was posted
is classified as restricted cash and is reflected in Other
Assets on the Companys balance sheet. This required letter
of credit will be reduced over time, to zero by
August 2005. As a result of the restructuring, we reduced
our office space from approximately 73,300 square feet to
approximately 40,400 square feet with 3,000 square feet
sub-subleased to a third party until the end of our sublease,
leaving 37,400 square feet of space. We believe that we have
more than adequate expansion space for growth in operations at
the headquarters location for the foreseeable future. The
Company has the right to terminate the sublease on
September 30, 2004 for a fee of approximately
$2.3 million.

In May 2001, the Company entered into a
five-year lease for a branch sales office consisting of
approximately 3,800 square feet in Irving, Texas. This office
replaced an executive suite arrangement that Segue had been
using. In September 2003, the Company paid $29,000 to the
landlord in order to exercise the early termination clause in
the Companys lease agreement. By making the payment, the
Companys lease on 3,801 square feet will now terminate on
June 30, 2004 as opposed to the original termination date
of June 30, 2006.

The Company also leases certain United States and
foreign sales offices and certain equipment under various
operating leases with lease terms ranging from month-to-month up
to five years. Several of these leases contain renewal options.
The agreements generally require the payment of utilities, real
estate taxes, insurance and repairs. Future minimum payments
under the facilities and equipment leases, excluding the
security deposit noted above, but including the obligation of
the restructured sublease, with non-cancelable terms are as
follows as of March 31, 2004 (in thousands):

|                       |       |            |       |          |  |        |      |      |   |   |       |       | 
|---------------------- | ----- | ---------- | ----- | -------- |  | ------ | ---- | ---- | - | - | ----- | ----- | 
|                       |       | Gross      |       | Sublease |  | Net   
|                       |       | Commitment |       | Income   |  | Amount
|                       |       |            |       |          |  |       
|2004 (balance of year) |       | $          | 1,837 |          |  | $      | (271 | )    |   | $ | 1,566 |      
|2005                   |       |            | 1,687 |          |  |        | (97  | )    |   |   | 1,590 |      
|2006                   |       |            | 1,643 |          |  |        | (100 | )    |   |   | 1,543 |      
|2007                   |       |            | 1,379 |          |  |        | (85  | )    |   |   | 1,294 |      
|2008                   |       |            | 61    |          |  |        | 0    |      |   |   | 61    |      
|Thereafter             |       |            | 61    |          |  |        | 0    |      |   |   | 61    |      
|                       |       |            |       |          |  |        |      |      |   |   |       |      
|                       | Total |            | $     | 6,668    |  |        | $    | (553 | ) |   | $     | 6,115 | 
|                       |       |            |       |          |  |        |      |      |   |   |       |      

Rent expense for the quarters ended
March 31, 2004 and 2003 totaled $475,000 and $520,000,
respectively.



| |                    
| | -------------------
| | Royalty Commitments

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

11



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##### Table of Contents



SEGUE SOFTWARE, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

On April 14, 2003, an amendment was signed
that stated an advance payment of $50,000 per quarter would be
made to T-Plan Ltd. These advance payments would be credited
against the actual royalties earned during the period. However,
beginning January 14, 2004, in the event that the
cumulative prepaid royalties are more than $100,000 in excess of
the cumulative actual royalties earned, then the Company would
have no obligations to make further advance royalty payments
until the cumulative actual royalties are equal to the
cumulative advance royalties. Subsequent to March 31, 2004,
the cumulative advance payments exceeded actual royalties by
more than $100,000. Either party may cancel the agreement at any
time by giving the other party written notice to that effect at
least ninety days prior to such termination. In the event of a
termination of the contract, Segue will receive a refund if
advance royalty payments should exceed actual cumulative
royalties. Segue has other minor royalty agreements for third
party imbedded software in Segues products.

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



| |              
| | -------------
| | Contingencies

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

11.     Segment
Reporting

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

|                                        |                |                    |       |                    |  |         |       |              |  |   |       |       |  |   |       |       | 
|--------------------------------------- | -------------- | ------------------ | ----- | ------------------ |  | ------- | ----- | ------------ |  | - | ----- | ----- |  | - | ----- | ----- | 
|                                        |                |                    |       |                   
|                                        |                | Three months ended |       | Three months ended
|                                        |                | March 31, 2004     |       | March 31, 2003    
|                                        |                |                    |       |                   
|                                        |                | Revenue            |       | Gross Margin       |  | Revenue |       | Gross Margin
|                                        |                |                    |       |                    |  |         |       |             
|Software licenses                       |                | $                  | 3,575 |                    |  | $       | 3,490 |              |  | $ | 3,319 |       |  | $ | 3,255 |      
|Training and consulting                 |                |                    | 732   |                    |  |         | 161   |              |  |   | 930   |       |  |   | 312   |      
|Maintenance                             |                |                    | 3,739 |                    |  |         | 2,998 |              |  |   | 3,254 |       |  |   | 2,563 |      
|                                        |                |                    |       |                    |  |         |       |              |  |   |       |       |  |   |       |      
|                                        | Total services |                    |       | 4,471              |  |         |       | 3,159        |  |   |       | 4,184 |  |   |       | 2,875 | 
|Less vendor consideration to a customer |                |                    | (22   | )                  |  |         | (22   | )            |  |   | (37   | )     |  |   | (37   | )    
|                                        |                |                    |       |                    |  |         |       |              |  |   |       |       |  |   |       |      
|                                        | Total          |                    | $     | 8,024              |  |         | $     | 6,627        |  |   | $     | 7,466 |  |   | $     | 6,093 | 
|                                        |                |                    |       |                    |  |         |       |              |  |   |       |       |  |   |       |      

12



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##### Table of Contents



SEGUE SOFTWARE, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

The following table presents revenue and
long-lived asset information by geographic area as of and for
the quarters ended March 31 (in thousands):

|              |       |                   |       |                      |  |      |       |       |  |   |       |       |  |   |       |       | 
|------------- | ----- | ----------------- | ----- | -------------------- |  | ---- | ----- | ----- |  | - | ----- | ----- |  | - | ----- | ----- | 
|              |       |                   |       |                      |  |     
|              |       | Total Revenue for |       |                     
|              |       | Three Months      |       | Long Lived Assets At
|              |       | Ended March 31,   |       | March 31,           
|              |       |                   |       |                     
|              |       | 2004              |       | 2003                 |  | 2004 |       | 2003 
|              |       |                   |       |                      |  |      |       |      
|United States |       | $                 | 6,573 |                      |  | $    | 5,808 |       |  | $ | 1,580 |       |  | $ | 2,495 |      
|Foreign       |       |                   | 1,451 |                      |  |      | 1,658 |       |  |   | 283   |       |  |   | 439   |      
|              |       |                   |       |                      |  |      |       |       |  |   |       |       |  |   |       |      
|              | Total |                   | $     | 8,024                |  |      | $     | 7,466 |  |   | $     | 1,863 |  |   | $     | 2,934 | 
|              |       |                   |       |                      |  |      |       |       |  |   |       |       |  |   |       |      

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|        |                                                                                          
|------- | -----------------------------------------------------------------------------------------
|Item 2. | Managements Discussion and Analysis
    of Financial Condition and Results of Operations

Overview

We develop, market and support software products
and provide related professional services for the management and
testing of e-business applications. This summary provides an
overview of the most significant aspects of our operations
during the quarter ended March 31, 2004. Details of the
matters addressed in this summary are provided elsewhere in this
document and, in particular, in the sections immediately
following.

Our operating results for the quarter ended
March 31, 2004 reflect continued financial improvement over
2003 while undergoing a dramatic change in corporate leadership,
vision and strategic direction. During September 2003, we
saw the arrival of a new Chief Executive Officer
(CEO) who brought a new vision and strategy to
Segue. In January 2004, our new CEO hired a new Executive
Vice President of Worldwide Sales and Marketing and a Chief
Marketing Officer to further strengthen our restructured senior
management team.

During the first quarter of 2004, we achieved
profitability while growing revenue and focusing on our new
strategic objectives. Total revenue grew 7% to $8.0 million
for the quarter ended March 31, 2004 compared to
$7.5 million during the same period last year and 6% growth
compared to $7.6 million during the fourth quarter of 2003.
We reported a net income applicable to common shares of
$171,000, or $0.02 basic and fully diluted income per share for
the first quarter ended March 31, 2004. This compares to a
net loss applicable to common shares of $125,000, or a $0.01
loss per share, for the same period last year. Total operating
expenses and cost of sales combined, totaled $7.7 million for
the first quarter of 2004, compared to $7.5 million for the
first quarter of 2003. Our total worldwide headcount at
March 31 of 2004 and 2003 stood at 190 and 201,
respectively.

At March 31, 2004, our reported cash and
cash equivalent balance was $8.4 million, compared to
$7.5 million at December 31, 2003 and
$6.0 million at March 31, 2003. We reported positive
cash flow from operations of $745,000 in the first quarter of
2004, compared to $544,000 positive cash flow during the first
quarter of 2003. Deferred revenue increased to $9.5 million
for the quarter ended March 31, 2004, compared to
$8.7 million for the quarter ended March 31, 2003.
This represents the third consecutive quarterly increase in
deferred revenue and is primarily due to an increase in deferred
maintenance revenue, as demonstrated by our very strong
renewals. We continue to have no debt on our balance sheet.

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

Critical Accounting Policies

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

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

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

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

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

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

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

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

The estimate for the $3.5 million loss on
unused space was based on information that was available at that
time. Factors that were included were anticipated rental rates
in the local commercial office market and the estimated
timeframe in which we expected to sublease the space. We
obtained local real estate market data and consulted with its
real estate advisor on these factors to help determine an
appropriate

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reserve for potential losses on the unused space.
During the fourth quarter of 2002, Segue was able to reach an
agreement in principle with its landlord to restructure the
sublease for our Lexington facility. A formal agreement was
consummated on January 24, 2003. At March 31, 2004,
the accrual balance related to the obligations associated with
all of the excess office space in both the Lexington and Los
Gatos facilities is approximately $1.4 million. This is
comprised of an estimated $1.9 million for future rents
payable by Segue on unoccupied space less approximately $515,000
of estimated future sublease income. We are under a restructured
sublease for the Lexington facility until October 2007.


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

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

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

The Company accrues for the estimated value of
the preferred stock dividend-in-kind on a quarterly basis.

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

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Results of Operations

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

|                                         |                                         |                          |      |      |       |  |      |      |       | 
|---------------------------------------- | --------------------------------------- | ------------------------ | ---- | ---- | ----- |  | ---- | ---- | ----- | 
|                                         |                                         |                         
|                                         |                                         | Percentage of           
|                                         |                                         | Revenue for the         
|                                         |                                         | Three months            
|                                         |                                         | ended March 31,         
|                                         |                                         |                         
|                                         |                                         | 2004                     |      | 2003
|                                         |                                         |                          |      |     
|Revenue:                                 |                                         |                          |      |      |       |  |      |     
|                                         | Software                                |                          |      | 44.6 | %     |  |      | 44.5 | %    
|                                         | Services                                |                          |      | 55.7 |       |  |      | 56.0 |      
|                                         |                                         |                          |      |      |       |  |      |     
|                                         |                                         | Gross revenue            |      |      | 100.3 |  |      |      | 100.5 | 
|                                         | Less vendor consideration to a customer |                          |      | (0.3 | )     |  |      | (0.5 | )    
|                                         |                                         |                          |      |      |       |  |      |     
|                                         |                                         | Net revenue              |      |      | 100.0 |  |      |      | 100.0 | 
|Cost of revenue:                         |                                         |                          |      |      |       |  |      |     
|                                         | Cost of software                        |                          |      | 1.1  |       |  |      | 0.9  |      
|                                         | Cost of services                        |                          |      | 16.3 |       |  |      | 17.5 |      
|                                         |                                         |                          |      |      |       |  |      |     
|                                         |                                         | Total cost of revenue    |      |      | 17.4  |  |      |      | 18.4  | 
|                                         |                                         |                          |      |      |       |  |      |     
|Gross margin                             |                                         |                          | 82.6 |      |       |  | 81.6 |     
|Operating expenses:                      |                                         |                          |      |      |       |  |      |     
|                                         | Sales and marketing                     |                          |      | 43.3 |       |  |      | 47.7 |      
|                                         | Research and development                |                          |      | 20.6 |       |  |      | 19.5 |      
|                                         | General and administrative              |                          |      | 14.7 |       |  |      | 14.2 |      
|                                         |                                         |                          |      |      |       |  |      |     
|                                         |                                         | Total operating expenses |      |      | 78.6  |  |      |      | 81.4  | 
|                                         |                                         |                          |      |      |       |  |      |     
|Income from operations                   |                                         |                          | 4.0  |      |       |  | 0.2  |     
|Other income, net                        |                                         |                          | 0.2  |      |       |  | 0.0  |     
|Interest income, net                     |                                         |                          | 0.3  |      |       |  | 0.2  |     
|                                         |                                         |                          |      |      |       |  |      |     
|Income before provision for income taxes |                                         |                          | 4.5  |      |       |  | 0.4  |     
|Provision for income taxes               |                                         |                          | 0.3  |      |       |  | 1.3  |     
|                                         |                                         |                          |      |      |       |  |      |     
|Net income (loss)                        |                                         |                          | 4.2  | %    |       |  | (0.9 | )%  
|                                         |                                         |                          |      |      |       |  |      |     

Software Revenue

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

Software revenue was $3.6 million for the
quarter ended March 31, 2004, compared to $3.3 million
for the quarter ended March 31, 2003, an increase of 9%.
The increase in software revenue of $300,000 was primarily
attributable to $400,000 in software licenses that were received
on December 31, 2003, but not delivered until
January 2004 (as disclosed in our 2003 Annual Report on
Form 10-K). Our international product sales represented 26%, or
$918,000, and 33%, or $1.1 million, of total product sales
for the quarters ended March 31, 2004 and 2003,
respectively. The total dollar amount of our international
product sales decreased by approximately $182,000 or 16%. This
decrease was primarily due to several large deals received
during the first quarter of 2003 from our European sales
operations.

Our software revenue growth depends upon our
ability to successfully generate and fulfill software license
orders, generate incremental revenue from our business
partnerships and strategic alliances, attract

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and retain skilled personnel, deliver timely new
products and enhancements and continued market growth.
Performance could also be affected by the market acceptance of
our new and enhanced products and increased competition. It is
difficult to determine when and if we will be able to grow
software revenue in the future.


Services Revenue

Our services revenue consists of revenue from
maintenance, training and consulting. Our services revenue was
$4.5 million for the quarter ended March 31, 2004, compared
to $4.2 million for the quarter ended March 31, 2003,
an increase of 7%.

Our maintenance revenue was $3.7 million for
the quarter ended March 31, 2004, compared to
$3.3 million for the quarter ended March 31, 2003, an
increase of 12%. The increase of $400,000 in maintenance revenue
was primarily attributable to an increase in renewals of
existing maintenance contracts due to a larger base of installed
licenses. Recognized maintenance revenue is being amortized over
the contract period, which is predominately a 12-month period.

Training and consulting revenue was $732,000 for
the quarter ended March 31, 2004, compared to $930,000 for the
quarter ended March 31, 2003, a decrease of 21%. The
decrease in training and consulting revenue of $198,000 was
primarily due to the continued difficult economic conditions in
2004, which caused a decrease in bookings and delivery of
training and consulting engagements. Additionally, we continue
to see an increase in customers using on-line training which the
Company began offering in 2002 and has proven to be successful.
On-line instructor monitored training allows our customers a
flexible option in which to realize the full value of training
while keeping expenses, such as travel and lodging, to a minimum.

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

Vendor Consideration to a Customer

We committed to making payments to several
vendors, resellers, and distributors for orders referred to us,
by them, of $22,000 for the quarter ended March 31, 2004,
compared to $37,000 for the quarter ended March 31, 2003.
Under EITF Issue No. 01-9, these payments are considered to
be a reduction of revenue and are presented in our statement of
operations as such.

Cost of Software

Our cost of software includes documentation,
product packaging, product media, employment costs for
processing and distribution, amortization of capitalized
technology and royalties due to third parties for their software
that we embed in our products. Our cost of software was $85,000
for the quarter ended March 31, 2004, or 2% of software
revenues, compared to $64,000 for the quarter ended
March 31, 2003, or 2% of software revenues. The increase of
$21,000 was primarily attributable to an increase in
personnel-related costs.

Cost of Services

Our cost of services consists principally of
salaries and benefits for our customer service and technical
support staff, which staff provides services under maintenance
contracts, and for our training and consulting staff, as well as
third party consulting fees and the cost of materials and
facilities used for training customers. Cost of services as a
percentage of our services revenue varies based on the
profitability of individual consulting engagements and the
utilization rate of in-house consultants versus the use of
higher cost outside contract consultants. Our cost of services
was $1.3 million for the quarter ended March 31, 2004,
or 29% of service revenue, compared to $1.3 million for the
quarter ended March 31, 2003, or 31% of service revenue.

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Our cost of training and consulting was $571,000
for the quarter ended March 31, 2004, or 7% of total net
revenue, compared to $618,000 for the quarter ended
March 31, 2003, or 8% of total net revenue. The decrease in
cost of training and consulting of $47,000 was primarily
attributed to a decrease of $30,000 in personnel related costs
due to lower headcount and a decrease of $21,000 in outsourced
consulting expense. The decrease in cost of training and
consulting for the quarter ended March 31, 2004 of $47,000
is significantly less than the $197,000 million reduction
in training and consulting revenue due to the fact that the
majority of these costs are related to personnel and are
relatively fixed, resulting in a significant decrease in gross
margin percentage.

Our cost of maintenance was $741,000 for the
quarter ended March 31, 2004, or 9% of total net revenues,
compared to $691,000 for the quarter ended March 31, 2003, or 9%
of net revenues. The increase of $50,000 was primarily due a
$68,000 increase associated with the exchange rate translation
in the European market of our foreign technical support
operations.

Sales and Marketing

Our sales and marketing expenses consist
primarily of salaries and benefits, commissions, travel costs,
promotional marketing programs and allocated facility costs. Our
marketing programs include advertising, public relations, direct
mail programs, seminars and trade shows. Our total sales and
marketing expenses were $3.5 million for the quarter ended
March 31, 2004, or 43% of net revenue, compared to
$3.6 million for the quarter ended March 31, 2003, or
48% of net revenue.

Our sales expense was $2.9 million for the
quarter ended March 31, 2004, or 36% of net revenue,
compared to $3.2 million for the quarter ended
March 31, 2003, or 43% of net revenue. The decrease in
total sales expense of $300,000 was due to a decrease of
$251,000 in personnel related costs and allocated facility costs
due to a reduced number of employees, a decrease of $71,000 in
travel costs and a decrease of $71,000 in legal expense,
partially offset by an increase of $92,000 in the exchange rate
translation in the European market of our foreign sales
operations.

Our marketing expense was $554,000 for the
quarter ended March 31, 2004, or 7% of net revenue,
compared to $325,000 for the quarter ended March 31, 2003,
or 4% of net revenue. The increase of $229,000 was primarily
attributed to an increase of $236,000 in personnel related costs
and an increase of $33,000 in allocated facility costs due to an
increased number of marketing employees. These increases were
partially offset by a decrease of $63,000 in marketing programs.
Segue will continue to tightly control the level of expenses for
marketing programs, but further reductions to these may have an
adverse effect on our business by not creating enough leads to
generate sales revenue.

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

Research and Development

Our research and development expenses consist
primarily of salaries and benefits and allocated facility costs.
To date, all of our internal costs for research and development
have been charged to operations as incurred, since amounts of
software development costs qualifying for capitalization have
been insignificant. Our research and development expense was
$1.7 million for the quarter ended March 31, 2004, or
21% of net revenue, compared to $1.5 million for the
quarter ended March 31, 2003, or 20% of net revenue. The
increase of $200,000 was primarily attributable to an increase
of $32,000 in consulting and temporary personnel costs, an
increase of $16,000 in telephone expense and an increase of
$130,000 in the exchange rate translation of our foreign
research and development lab expenses due to the stronger Euro.

General and Administrative

Our general and administrative expenses consist
primarily of salaries and benefits for executive, finance,
legal, information technology, human resources and
administrative personnel, professional fees,

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system support costs, allocated facility costs
and other general corporate expenses. General and administrative
expense was $1.2 million for the quarter ended
March 31, 2004, or 15% of net revenue, compared to
$1.1 million for the quarter ended March 31, 2003, or
15% of net revenue. The increase of $100,000 was primarily
attributed to an increase of $232,000 in outside legal expense
due to the absence of our internal legal counsel and an increase
of $46,000 due to higher personnel related costs. These
increases were partially offset by a decrease of $49,000 in bad
debt, a decrease of $61,000 in allocated facility costs, and a
decrease of $39,000 in the foreign currency transaction expense.


Restructuring Charges

There were no restructuring charges for the
quarters ended March 31, 2004 and 2003.

Other Income, Net

Our other income was $41,000 for the quarter
ended March 31, 2004, compared to $13,000 for the quarter
ended March 31, 2003. Other income consists primarily of
interest income from cash, cash equivalents and short-term
investments. However, during the first quarter of 2004, we had
other income of $20,000, which was related to the settlement of
a minor sublease issue.

We had no interest expense for both quarters
ended March 31, 2004 and 2003, and we carry no debt.

Provision for Income Taxes

We recorded a provision for foreign and state
income taxes of $26,000 for the quarter ended March 31,
2004, compared to $97,000 for the quarter ended March 31,
2003. The decrease of $71,000 was primarily due to an adjustment
in foreign tax provisions recorded in 2003. We received no tax
benefit for losses generated in the United States in any period
due to the uncertainty of realizing such benefits. Management
has evaluated the positive and negative evidence impacting the
ability to realize its deferred tax assets. Based on the weight
of the available evidence, it is more likely than not that all
of the deferred tax assets will not be realized and,
accordingly, the deferred tax assets have been fully reserved.
Management re-evaluates the positive and negative evidence on a
quarterly basis.

Liquidity and Capital Resources

As of March 31, 2004, our principal sources
of liquidity included cash and cash equivalents totaling
$8.4 million.

Our operating activities generated cash of
$745,000 during the first three months of 2004, compared to
$544,000 of cash generated in the same period in 2003. Cash
generated in 2004 resulted from the net income, adjusted for
depreciation of property and equipment and the increase in
deferred revenue, offset by a decrease in accounts receivable
and other current assets, and a decrease in accounts payable and
accrued expenses.

Our investing activities utilized cash of $50,000
in the first quarter of 2004, as compared to $57,000 generated
in the first quarter of 2003. Cash used in 2004 was the result
of the purchase of some replacement computers. In the future, we
may need to make increased expenditures on property and
equipment as present equipment ages.

Our financing activities generated cash of
$202,000 and $83,000 during the first quarter of 2004 and 2003,
respectively. Cash generated from financing activities in the
first quarter of 2004 was generated primarily from the exercise
of employee stock options and the issuance of stock under the
Employee Stock Purchase Plan. Cash generated in the first
quarter of 2003 was generated primarily from the issuance of
stock under the Employee Stock Purchase Plan.

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

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

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

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

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

Risks and Factors That May Affect Future
Results

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

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

We may not be profitable in the future.Since we began operations, we have
generally experienced losses. Losses have resulted in an
accumulated deficit of approximately $58.2 million as of
March 31, 2004. In the fourth quarter of 2002, we reported
net income of $857,000, but in each of the quarters of 2003 we
reported net losses of $71,000, $453,000, $114,000 and $685,000,
respectively. In the first quarter of 2004, we reported net
income of $338,000. It is uncertain whether we can maintain
profitability in the future.

For the quarter ended March 31, 2004, we had
total revenue of $8.0 million versus $7.5 million for the
quarter ended March 31, 2003. Further, for the fiscal year
ended December 31, 2003, we had total

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revenue of $29.2 million versus
$29.7 million in the fiscal year ended December 31,
2002. During 2001, 2002 and 2003, we initiated aggressive cost
saving measures in an effort to reduce expenses, enhance the
possibility of profitability, and conserve cash, and we have
sustained these measures through March 31, 2004. Despite
these cost saving measures, our future profitability remains
uncertain because of, among other items, the uncertainty of our
revenue from quarter to quarter. Failure to achieve
profitability may adversely affect the market price of our
common stock.


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

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

The SilkElite Partners Program focuses on
resellers, consulting partners and distributors. SilkElite
Partners resell our products, refer business to Segue and use
our software products in the delivery of consulting services.
The success of the key strategic alliances and the SilkElite
Program is uncertain, faces strong competition, and takes time
and significant resources to develop. Should we fail to generate
substantial incremental revenue from our strategic alliances or
our SilkElite Program, our financial results and stock price
could be adversely affected. The SilkElite Partner Program
accounted for 13% of total revenue for the period ended
March 31, 2004 versus 16% for the period ended
March 31, 2003.

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

Our future success will depend on our ability
to respond rapidly and effectively to technological and other
market changes, including the successful introduction of new and
enhanced products.The nature of the
automated software testing, performance management and
application monitoring markets in which we compete is
characterized by rapidly changing technology, rapidly evolving
customer needs and desires, changes in industry standards and
practices and frequent releases of new product or enhancements
by competitors. To be competitive, we must develop and introduce
product enhancements and new products that address the
increasingly sophisticated and varied needs of our existing and
potential customers. For the period ended March 31, 2004,
over 91% of our product revenues were generated from our
SilkPerformer and SilkTest products, as compared with over 85%
in same period last year. During the quarter ended
September 30, 2003, we released SilkVision 2.5, the newest
version of our powerful Web-based enterprise monitoring
software, and SilkPerformer 6.0, the newest version of our
enterprise-class load and stress-testing tool. During the fourth
quarter of 2003, we released SilkTest 6.5, our newest version of
functional testing with add-on support available to test .NET
applications. If these new products are not

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successful or if we fail to continue to develop
and introduce new products and enhancements on a timely basis,
or maintain our level of product revenue from SilkPerformer and
SilkTest, or fail to generate substantial incremental revenue
from our new products, our business may be materially adversely
affected.


We may face liquidity issues.We have taken steps to conserve our
use of cash, including significantly reducing headcount,
infrastructure and other expenses, and limiting capital
expenditures in order to improve our liquidity and to achieve
greater efficiencies. We believe that based on expense savings
and the stability of our revenue in the last year, that future
sales at or above current levels should be sufficient to allow
us to continue as a viable business. For the three-month period
ended March 31, 2004, we generated $888,000 in positive
cash flow, the Companys sixth consecutive quarter of cash
balance growth. Total net revenue of $8.0 million for such
period was improved from the $7.5 million reported for the
same period last year. If we fail to maintain or grow revenue
levels we may have to raise additional financing to fund working
capital needs. If we fail to generate substantial incremental
revenue, or we are not successful in raising additional
financing on terms acceptable to us, we may not have sufficient
working capital resources and our business may be materially
adversely affected.

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

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

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

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

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

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

We face many risks associated with
international business activities.We
derived approximately 18% of total revenue from international
customers in the three-month period ended March 31, 2004,
as compared with 22% in the same period last year. The
international market for software products is highly competitive
and we expect to face substantial competition in this market
from established and emerging companies. We face many risks
associated with international business activities including
currency fluctuations, imposition of government controls, export
license requirements, restrictions on the export of critical
technology, political and economic instability, tailoring of
products to local requirements, trade restrictions, changes in
tariffs and taxes, difficulties in staffing and managing
international operations, longer accounts receivable payment
cycles and the burdens of complying with a wide variety of
foreign laws and regulations. In particular, currency
fluctuations can have a significant impact on our foreign
operating expenses. Continued growth of international sales is
important to our growth and the stability. To the extent we are
unable to continue to expand international sales in a timely and
cost-effective manner, our business could be materially
adversely affected.

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






|        |                                                               
|------- | --------------------------------------------------------------
|Item 3. | Quantitative and Qualitative Disclosures
    About Market Risk

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

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

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Foreign Currency Risk.We face exposure to movements in
foreign currency exchange rates. These exposures may change over
time as business practices evolve and could have a material
adverse effect on our business, financial condition and results
of operations. We do not use derivative financial instruments or
other financial instruments to hedge economic exposures or for
trading. Historically, our primary currency exposures have been
related to the operations of our foreign subsidiaries. During
the quarter ended March 31, 2004, we incurred transaction
and re-measurement gains of approximately $19,000 related to
foreign currency. The expense effect of foreign currency for the
first three months of 2003 was approximately $20,000. As of
March 31, 2004, the cumulative translation of foreign
currency changes recorded in stockholders equity was
$278,000.






|        |                        
|------- | -----------------------
|Item 4. | Controls and Procedures

Evaluation of Disclosure Controls and
Procedures

As required by new Rule 13a-15 under the
Securities Exchange Act of 1934, as of March 31, 2004 we
carried out an evaluation under the supervision and with the
participation of our management, including our Chief Executive
Officer and Chief Financial Officer, of the effectiveness of the
design and operation of our disclosure controls and procedures.
In designing and evaluating our disclosure controls and
procedures, we and our management recognize that any controls
and procedures, no matter how well designed and operated, can
provide only reasonable assurance of achieving the desired
control objectives, and our management necessarily was required
to apply its judgment in evaluating and implementing possible
controls and procedures. Based upon that evaluation, our Chief
Executive Officer and Chief Financial Officer concluded that, as
of the date of completion of the evaluation, our disclosure
controls and procedures were reasonably effective to ensure that
material information required to be disclosed by us in the
reports we file or submit under the Exchange Act is recorded,
processed, summarized and reported, within the time periods
specified in the Securities and Exchange Commissions rules
and forms. In connection with the new rules, we will continue to
review and document our disclosure controls and procedures,
including our internal controls and procedures for financial
reporting, on an ongoing basis, and may from time to time make
changes aimed at enhancing their effectiveness and to ensure
that our systems evolve with our business.

Changes in Internal Controls over Financial
Reporting

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




PART II.     OTHER
INFORMATION






|        |                  
|------- | -----------------
|Item 1. | Legal Proceedings

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






|        |                                                        
|------- | -------------------------------------------------------
|Item 4. | Submission of Matters to a Vote of Security
    Holders

There were no submissions of matters to a vote of
security holders.






|        |                  
|------- | -----------------
|Item 5. | Other Information

On January 12, 2004, Andre Pino joined Segue
as Chief Marketing Officer. On January 20, 2004, Joseph
Friscia joined Segue as Executive Vice President Sales and
Marketing. Both such officers were appointed to our executive
management team and will report directly to our Chief Executive
Officer, Joseph Krivickas.

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No material changes have been made to the
procedure by which our stockholders may recommend nominees for
election to our Board of Directors.






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

(a) Exhibits

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

(b) Reports on Form 8-K



| |   |                                                                                                                                                                  
| | - | -----------------------------------------------------------------------------------------------------------------------------------------------------------------
| |  | A Form 8-K was filed on February 5,
    2004 regarding the financial results of Segue Software, Inc. for
    the fiscal quarter and year ended December 31, 2003.

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SIGNATURES

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

Date: May 14, 2004



| |                     
| | --------------------
| | SEGUE SOFTWARE, INC.



| |     |                        
| | --- | -----------------------
| | By: | /s/ JOSEPH K. KRIVICKAS

| |                        
| | -----------------------
| |                        
| | Joseph K. Krivickas    
| | Chief Executive Officer



| |     |                    
| | --- | -------------------
| | By: | /s/ DOUGLAS ZACCARO

| |                        
| | -----------------------
| |                        
| | Douglas Zaccaro        
| | Chief Financial Officer

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