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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549
   FORM 10-Q  (Mark One)þ
    
    QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
OF THE SECURITIES EXCHANGE ACT OF 1934
 For the Quarterly Period Ended March 31, 2005 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   SEGUE SOFTWARE, INC. (Exact name of registrant as specified in its charter)
 Delaware
    
    95-4188982(State or other jurisdiction of
incorporation or organization)
    
    (I.R.S. Employer
Identification No.)
 201 Spring Street Lexington, MA 02421(Address of principal executive offices) Registrants telephone number, including area code: (781) 402-1000   Indicate by check mark whether the registrant:(1) has filed all reports required to be filed
by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or
for such a shorter period that the registrant was required to file such reports) and (2) has been
subject to such filing requirements for the past 90 days. Yes þ No £ Indicate by check mark whether the Registrant is an accelerated filer (as defined in Exchange
Act Rule 12b-2). Yes £ No þ The number of shares of Registrants Common Stock outstanding as of May 3, 2005 was
10,193,140.




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SEGUE SOFTWARE, INC. FORM 10-Q FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2005 INDEX  
 PagePART I. FINANCIAL INFORMATIONItem 1
    
    Condensed Consolidated Financial Statements:Condensed Consolidated Balance Sheets (unaudited) March 31, 2005 and December 31, 2004
    
    
    2Condensed Consolidated Statements of Operations (unaudited) Three months ended March 31, 2005 and 2004Condensed Consolidated Statements of Cash Flows (unaudited) Three months ended March 31, 2005 and 2004Notes to Condensed Consolidated Financial Statements (unaudited)
    
    
    3
4
5Item 2
    
    Managements Discussion and Analysis of Financial Condition and Results of Operations
    
    
    12Item 3
    
    Quantitative and Qualitative Disclosures about Market Risk
    
    
    22Item 4
    
    Controls and Procedures
    
    
    23PART II. OTHER INFORMATIONItem 1
    
    Legal Proceedings
    
    
    23Item 4
    
    Submission of Matters to a Vote of Security Holders
    
    
    23Item 5
    
    Other Information
    
    
    24Item 6
    
    Exhibits and Reports on Form 8-K
    
    
    24Signatures
    
    
    25Ex-31.1 Section 302 Certification of C.E.O.Ex-31.2 Section 302 Certification of C.F.O.Ex-32.1 Section 906 Certification of C.E.O.Ex-32.2 Section 906 Certification of C.F.O.
  1




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PART I.  FINANCIAL INFORMATION 
 Item 1.Condensed Consolidated Financial Statements SEGUE SOFTWARE, INC. 
 CONDENSED CONSOLIDATED BALANCE SHEETS
(In thousands except share data) March 31,
    
    
    December 31,2005
    
    
    2004(Unaudited)ASSETSCurrent assets:Cash and cash equivalents
    
    $
    11,524
    
    
    $
    11,028Short-term investments
    
    
    37
    
    
    
    Accounts receivable, net of allowances of $356 and $281, respectively
    
    
    6,710
    
    
    
    6,421Other current assets
    
    
    909
    
    
    
    1,013Total current assets
    
    
    19,180
    
    
    
    18,462Property and equipment, net
    
    
    739
    
    
    
    749Goodwill, net
    
    
    1,506
    
    
    
    1,506Other assets
    
    
    513
    
    
    
    604Total assets
    
    $
    21,938
    
    
    $
    21,321LIABILITIES AND STOCKHOLDERS EQUITYCurrent liabilities:Accounts payable
    
    $
    1,110
    
    
    $
    564Accrued compensation and benefits
    
    
    1,080
    
    
    
    1,602Accrued lease obligations on excess space
    
    
    954
    
    
    
    1,059Accrued expenses
    
    
    996
    
    
    
    1,134Deferred revenue
    
    
    10,477
    
    
    
    10,524Total current liabilities
    
    
    14,617
    
    
    
    14,883Stockholders equity:Preferred stock, 9,000 shares authorized; 921 and 921 shares of
Series B and 570 and 570 shares of Series C preferred stock issued
and outstanding, respectively
    
    
    4,726
    
    
    
    4,726Common stock, par value $.01 per share; 30,000 shares authorized;
10,331 and 10,195 shares issued, respectively
    
    
    103
    
    
    
    102Additional paid-in capital
    
    
    58,277
    
    
    
    57,959Cumulative translation adjustment
    
    
    357
    
    
    
    429Unearned stock-based compensation
    
    
    (42
    )
    
    
    (47
    )Accumulated deficit
    
    
    (55,500
    )
    
    
    (56,131
    )7,921
    
    
    
    7,038Less treasury stock, at cost, 145 shares
    
    
    (600
    )
    
    
    (600
    )Total stockholders equity
    
    
    7,321
    
    
    
    6,438Total liabilities and stockholders equity
    
    $
    21,938
    
    
    $
    21,321
 The accompanying notes are an integral part of the consolidated financial statements. 2




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SEGUE SOFTWARE, INC. 
 CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands except per share data) Three months endedMarch 31,2005
    
    
    2004(Unaudited)Revenue:Software
    
    $
    3,619
    
    
    $
    3,575Services
    
    
    4,843
    
    
    
    4,471Gross revenue
    
    
    8,462
    
    
    
    8,046Less vendor consideration to a customer
    
    
    (68
    )
    
    
    (22
    )Net revenue
    
    
    8,394
    
    
    
    8,024Cost of revenue:Cost of software
    
    
    110
    
    
    
    85Cost of services
    
    
    1,119
    
    
    
    1,312Total cost of revenue
    
    
    1,229
    
    
    
    1,397Gross margin
    
    
    7,165
    
    
    
    6,627Operating expenses:Sales and marketing
    
    
    3,507
    
    
    
    3,472Research and development
    
    
    1,848
    
    
    
    1,650General and administrative
    
    
    1,141
    
    
    
    1,182Total operating expenses
    
    
    6,496
    
    
    
    6,304Income from operations
    
    
    669
    
    
    
    323Other income, net
    
    
    
    
    
    
    20Interest income, net
    
    
    44
    
    
    
    21Income before provision for income taxes
    
    
    713
    
    
    
    364Provision for income taxes
    
    
    82
    
    
    
    26Net income
    
    
    631
    
    
    
    338Preferred stock dividend-in-kind
    
    
    269
    
    
    
    167Net income applicable to common shares
    
    $
    362
    
    
    $
    171Net income per common share  Basic
    
    $
    0.04
    
    
    $
    0.02Net income per common share  Diluted*
    
    $
    0.03
    
    
    $
    0.02Weighted average common shares outstanding  Basic
    
    
    10,097
    
    
    
    9,832Weighted average common shares outstanding  Diluted*
    
    
    11,241
    
    
    
    10,571
   *
    
    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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SEGUE SOFTWARE, INC 
 CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands) Three months endedMarch 31,2005
    
    
    2004(Unaudited)Increase (decrease) in cash and cash equivalentsCash flows from operating activities:Net income
    
    $
    631
    
    
    $
    338Adjustments to reconcile net income to net cash provided by
(used in) operating activities:Depreciation and amortization
    
    
    117
    
    
    
    194Changes in operating assets and liabilities:Accounts receivable
    
    
    (356
    )
    
    
    547Other current assets
    
    
    98
    
    
    
    139Accounts payable
    
    
    545
    
    
    
    (523
    )Accrued expenses, lease obligations on excess space, compensation,
benefits and other
    
    
    (764
    )
    
    
    (449
    )Stock-based compensation
    
    
    4
    
    
    
    9Deferred revenue
    
    
    13
    
    
    
    490Net cash provided by operating activities
    
    
    288
    
    
    
    745Cash flows from investing activities:Additions to property and equipment
    
    
    (115
    )
    
    
    (43
    )Decreases (additions) to other assets
    
    
    91
    
    
    
    (7
    )Purchases of short-term investments
    
    
    (37
    )
    
    
    Net cash (used in) provided by investing activities
    
    
    (61
    )
    
    
    (50
    )Cash flows from financing activities:Proceeds from exercise of stock options and stock purchase plan
    
    
    319
    
    
    
    202Net cash provided by financing activities
    
    
    319
    
    
    
    202Effect of exchange rate changes on cash
    
    
    (50
    )
    
    
    (9
    )Net increase in cash and cash equivalents
    
    
    496
    
    
    
    888Cash and cash equivalents, beginning of period
    
    
    11,028
    
    
    
    7,495Cash and cash equivalents, end of period
    
    $
    11,524
    
    
    $
    8,383Supplemental disclosure of non-cash investing and financing transactions:Cash paid during the quarter for income taxes
    
    $
    22
    
    
    $
    36
 The accompanying notes are an integral part of the consolidated financial statements. 4




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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 accounting principles generally accepted in
the United States of America 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, 2004, included in its 2004 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 We recorded net income of approximately $631,000 for the three month period ended March 31,
2005. In addition, we recorded net income of approximately $2.5 million for the fiscal year ended
December 31, 2004. However, prior to the year ended December 31, 2004, the Company incurred losses
on an annual basis since it began operations. Due to the historical results, the Company has an
accumulated deficit of approximately $55.5 million at March 31, 2005. As a result, the Company has
used significant amounts of cash, cash equivalents and short-term investments to fund its
operations during the years prior to 2004. However, the Company generated approximately $496,000 in
overall positive cash flow for the three months ended March 31, 2005 and $3.5 million in overall
positive cash flow for the twelve months ended December 31, 2004. The cash and cash equivalents
balance at March 31, 2005 was $11.5 million versus $8.4 million at March 31, 2004. Segue management has taken significant steps to streamline its operations over the last
several 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. The
Company must maintain revenue at the current levels for Segue to maintain profitability and sustain
positive cash flow. Assuming that the Company can execute on its current plans, 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
possible 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 the Company, 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 On December 16, 2004, the Financial Accounting Standards Board (FASB) issued Statement 123R,
Share-Based Payment, that addresses the accounting for share-based awards to employees, including
employee-stock-purchase-plans (ESPPs). Statement 123R requires all entities to recognize the fair
value of stock options and other stock-based 5




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SEGUE SOFTWARE, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued) compensation to employees. The Statement eliminates the ability to account for share-based
compensation transactions using APB Opinion No. 25, Accounting for Stock Issued to Employees, and
generally requires instead, that such transactions, be accounted for using a fair-value-based
method. The requirements in Statement 123R were to be effective for public companies as of the
beginning of the first interim or annual period beginning after June 15, 2005. However, on April
14, 2005, the Securities and Exchange Commission (SEC) adopted a new rule amending the effective
date for Statement 123R, allowing public companies to adopt the rule at the beginning of their next
fiscal year after June 30, 2005. According to Statement 123R, an entity is also required to recognize compensation expense for
awards outstanding at the required effective date for which the requisite service has not been
rendered (such as awards that are unvested because service requirements have not been completed) as
the requisite service is subsequently rendered. The compensation expense will be based on the
grant date fair value of the award as was determined under Statement 123 for either recognition or
pro forma disclosures. The Company currently accounts for its stock-based compensation plans in
accordance with APB Opinion No. 25. Therefore, the adoption of Statement 123R will have a material
effect on the Companys consolidated financial statements. In addition, in March 2005, the SEC issued Staff Accounting Bulletin No. 107, Share-Based
Payment(SAB 107). SAB 107 provides supplemental implementation guidance on Statement 123R,
including guidance on valuation methods, classification of compensation expense, inventory
capitalization of share-based compensation cost, income tax effects, disclosures in Managements
Discussion and Analysis and several other issues. The Company is required to adopt Statement 123R
and SAB 107 in the first quarter of fiscal 2006. On December 21, 2004, the FASB issued FASB Staff Position 109-1, Application of FASB
Statement No. 109, Accounting for Income Taxes(SFAS No. 109), to the Tax Deduction on Qualified
Production Activities Provided by the American Jobs Creation Act of 2004 (The Act) (FSP 109-1).
FSP 109-1, which was effective upon issuance, states the deduction under this provision of the Act
should be accounted for as a special deduction in accordance with SFAS 109. The Company has not
yet quantified the benefit that may be realized from this provision of the Act. The Act also allows for an 85% dividends received deduction on the repatriation of certain
earnings of foreign subsidiaries. On December 21, 2004, the FASB issued FASB Staff Position 109-2,
Accounting and Disclosure Guidance for the Foreign Earnings Repatriation Provision within the
American Jobs Creation Act of 2004 (FSP 109-2). FSP 109-2, which was effective upon issuance,
allows companies time beyond the financial reporting period of enactment to evaluate the effect of
the Act on its plan for reinvestment or repatriation of foreign earnings for purposes of applying
SFAS No. 109. Additionally FSP 109-2 provides guidance regarding the required disclosures
surrounding a companys reinvestment or repatriation of foreign earnings. The Company continues to
evaluate this provision of the Act to determine the amount of foreign earnings to repatriate.
Currently the Company does not expect to repatriate foreign earnings. 4. Other Assets Included in other assets at March 31, 2005 and December 31, 2004 is restricted cash of
$440,000. 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. The amount of restricted cash included in other assets at March 31, 2004 was
$770,000. Also included in other assets at March 31, 2005 is approximately $64,000 for refundable
security deposits we have paid for our various regional sales offices. During the quarter ended
March 31, 2005, our security deposit of $112,000 for our former Los Gatos location was returned to
the Company. 6




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SEGUE SOFTWARE, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued) 5. Equity Transactions On October 21, 2003, we received $500,000 from the sale of 166,667 shares of our Series C
Preferred Stock (Preferred C Stock) to S-7 Associates LLC, a company managed and owned by the
Chairman of our Board of Directors, Dr. James H. Simons (S-7 Associates), and Howard Morgan, a
Segue Director. On November 24, 2003, we completed an additional preferred stock offering and
received $1,000,000 from the sale of 333,333 shares of Preferred C Stock to a private investor. The
Preferred C Stock is senior to the common stock as to dividend and liquidation rights and are
convertible at the option of the holder into shares of common stock of Segue at a conversion rate
of one share of common stock for one share of Preferred C Stock, subject to adjustment upon the
occurrence of certain transactions. Dividends on the Preferred C 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. Dividends paid to any holder on Preferred C Stock are restricted should they cause such
holder, among other things, to accumulate more than 20% of our voting power. If any holder of
Preferred C Stock should accumulate more than 20% of our voting power they are required to take
cash payments in lieu of dividends in kind. As of March 31, 2005 there were no such holders of our
Preferred C Stock. Beginning with the first quarter of 2004, the Company hired an independent third party, who
specializes in valuations, to establish the fair market value of its Preferred Stock, both Series B
and C, at the end of each quarter. Prior to that date the fair value of our Preferred Stock was
estimated by management. The Company will continue to engage this third party on a quarterly basis
for the purpose of establishing the fair market value of its Preferred Stock and in calculating the
amount of additional shares to be issued in lieu of cash payment dividends. We accrue for the
estimated value of the total Preferred Stock dividend-in-kind on a quarterly basis. Each sale and
issuance of our Preferred Stock was consummated in reliance on Regulation D under the Securities
Act of 1933, as amended. On December 27, 2004 the Company announced that its Board of Directors approved an amendment
to certain terms of the Companys Series B Preferred Stock, reducing the dividend payable on its
Series B Preferred Stock from 12% to 6% per year and extending the redemption date of its Series B
Preferred Stock to October 31, 2005, the earliest date at which the Company could redeem its stock.
The amendment to the terms of the Series B Preferred Stock is subject to approval by the Companys
stockholders at the next annual meeting, which is scheduled for June 6, 2005. The holder of the
Series B Preferred Stock, S-7 Associates LLC, a company managed and owned by Dr. James Simons,
Segues chairman, and Dr. James Simons have contractually agreed to vote all voting shares
controlled by them in favor of the amendment. If the amendment is approved by the Companys
stockholders, we expect that the reduced dividend rate would be in effect for the June 30, 2005
dividend on the Series B Preferred Stock. For the quarter ended March 31, 2005, an additional 27,629 shares of Series B Preferred Stock
and an additional 17,120 shares of Series C Preferred Stock were accrued as dividends and will be
issued on June 30, 2005. Our preferred stock dividends deemed earned for the three months ended
March 31, 2005 resulted in a preferred stock dividend-in-kind of approximately $269,000 versus
$167,000 for the period ended March 31, 2004. For the three months ended March 31, 2005, there were options to purchase 91,013 shares of
common stock exercised by employees, and a total of 44,802 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 $319,000. For the three months ended March 31, 2004, there
were options to purchase 59,225 shares of common stock exercised by employees or directors, 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. 7




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SEGUE SOFTWARE, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued) At March 31, 2005, 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, 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.
Due to the vesting of this grant, it resulted in a compensation expense of approximately $4,000 for
the quarter ended March 31, 2005. 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 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 has adopted the disclosure
provisions of SFAS No. 148. SFAS No. 123, Accounting for Stock-Based Compensation, required the Company to elect either
expense recognition under SFAS No. 123 or its disclosure-only alternative for stock-based employee
compensation. The expense recognition provision encouraged by SFAS No. 123 requires fair-value
based financial accounting to recognize compensation expense for employee stock compensation plans.
The Company adopted SFAS No. 123 in 1997 and elected the disclosure-only alternative. Had
compensation costs for the Companys stock and stock option plans been determined based on the fair
value at the grant dates for awards under those plans consistent with the methodology of SFAS No.
123, the Companys net income and net income 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 endedMarch 31,2005
    
    
    2004Net income applicable to common sharesAs reported
    
    $
    362
    
    
    $
    171Deduct: Total stock-based employee
compensation expense determined under the
fair value based method for all awards, net
of related tax effects
    
    
    (353
    )
    
    
    (479
    )Add: Stock-based employee compensation
expense included in reported net income, net
of related tax effects
    
    
    4
    
    
    
    10Pro forma
    
    $
    13
    
    
    $
    (298
    )Net income per common share  basic and dilutedAs reported  basic
    
    $
    0.04
    
    
    $
    0.02As reported  diluted
    
    $
    0.03
    
    
    $
    0.02Pro forma  basic
    
    $
    0.00
    
    
    $
    (0.03
    )Pro forma  diluted
    
    $
    0.00
    
    
    $
    (0.03
    )
 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, 8




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SEGUE SOFTWARE, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued) net of estimated sublease income. The Company had no restructuring activities during the
fiscal year ended December 31, 2004 and through the quarter ended March 31, 2005. At March 31, 2005, the accrual balance related to the obligations associated with all of the
excess office space noted above is approximately $954,000. This is comprised of an estimated $1.2
million for future rents payable by Segue on unoccupied space less approximately $258,000 of
estimated future sublease income. The Company made no estimate adjustments related to this accrual
for the period ended March 31, 2005. 7. Provision for Income Taxes Segue recorded provisions for foreign and state income taxes of $82,000 and $26,000 for the
three months ended March 31, 2005 and 2004, respectively. Income tax for these periods were
calculated taking into account the portion of taxable income that could be offset by net operating
loss carry-forwards. There was no long term tax benefit recorded for losses generated in the U.S.
in either period due to the uncertainty of realizing such benefits. 8. Net Income Per Common Share The following table sets forth the computation of basic and diluted income per share (in
thousands, except per share data): Three months endedMarch 31,2005
    
    
    2004Net income applicable to common shares
    
    $
    362
    
    
    $
    171Weighted average shares used in net income per share  basic
    
    
    10,097
    
    
    
    9,832Incremental common shares issuable under employee stock option plans
    
    
    1,144
    
    
    
    739Weighted average shares used in net income per share  diluted
    
    
    11,241
    
    
    
    10,571Net income per common share  basic
    
    $
    0.04
    
    
    $
    0.02Net income per common share  diluted
    
    $
    0.03
    
    
    $
    0.02
 Excluded from the calculation of diluted earnings per share for the three months ended March
31, 2005 and 2004 were 1,513,999 and 1,347,667, respectively shares of common stock that can be
converted from preferred stock because their inclusion would be anti-dilutive. 9. Other Comprehensive Income SFAS No. 130, Reporting Comprehensive Income (SFAS 130) requires the reporting of
comprehensive income in addition to net income 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 other
comprehensive income items have consisted exclusively of foreign translation adjustments. The
following table sets forth the computation of other comprehensive income (in thousands): Three monthsendedMarch 31,2005
    
    
    2004Net income
    
    $
    631
    
    
    $
    338Foreign translation adjustments
    
    
    (72
    )
    
    
    (31
    )Other comprehensive income
    
    $
    559
    
    
    $
    307
 9




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SEGUE SOFTWARE, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued) 10. Commitments and Contingencies Legal Proceedings Various minor claims have been asserted against Segue. Management does not believe these
claims will have a material adverse effect on the financial position or results of operations of
Segue. 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 posted an initial letter of credit for $700,000. The cash security of $770,000 (letter of
credit plus 10%) that was posted was reduced to $440,000 and is classified as restricted cash and
is reflected in Other Assets on the Companys balance sheet at March 31, 2005. This required letter
of credit will further reduce over time, by formula, 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. During January 2005, the Company entered into a five-year lease for a branch sales office in
San Mateo, California, which consists of approximately 3,434 square feet. This office replaces our
Los Gatos and San Francisco sales offices, for which the lease expired for both locations during
the first quarter of 2005. 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.
Certain 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, 2005 (in
thousands): Gross
    
    
    Sublease
    
    
    NetCommitment
    
    
    Income
    
    
    Amount2005
    
    $
    1,403
    
    
    $
    (73
    )
    
    $
    1,3302006
    
    
    1,725
    
    
    
    (100
    )
    
    
    1,6252007
    
    
    1,460
    
    
    
    (85
    )
    
    
    1,3752008
    
    
    144
    
    
    
    0
    
    
    
    1442009
    
    
    95
    
    
    
    0
    
    
    
    95Thereafter
    
    
    22
    
    
    
    0
    
    
    
    22Total
    
    $
    4,849
    
    
    $
    (258
    )
    
    $
    4,591
 Rent expense for the quarters ended March 31, 2005 and 2004 totaled $409,000 and $475,000,
respectively. Royalty Commitments The Company has participated in royalty arrangements with third parties. 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 10




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SEGUE SOFTWARE, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS  (Continued) which Segue will pay T-Plan Ltd., a royalty for each unit sold based on a percentage of price.
On March 31, 2005, we had a remaining prepaid balance of $50,000 associated with T-Plan
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 are 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 less than $1.7
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 endedMarch 31, 2005
    
    
    March 31, 2004Revenue
    
    
    Gross Margin
    
    
    Revenue
    
    
    Gross MarginSoftware licenses
    
    $
    3,619
    
    
    $
    3,509
    
    
    $
    3,575
    
    
    $
    3,490Training and consulting
    
    
    501
    
    
    
    48
    
    
    
    732
    
    
    
    161Maintenance
    
    
    4,342
    
    
    
    3,676
    
    
    
    3,739
    
    
    
    2,998Total services
    
    
    4,843
    
    
    
    3,724
    
    
    
    4,471
    
    
    
    3,159Less vendor consideration to a customer
    
    
    (68
    )
    
    
    (68
    )
    
    
    (22
    )
    
    
    (22
    )Total
    
    $
    8,394
    
    
    $
    7,165
    
    
    $
    8,024
    
    
    $
    6,627
 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 forThree Months
    
    
    Long Lived Assets AtEnded March 31,
    
    
    March 31,2005
    
    
    2004
    
    
    2005
    
    
    2004United States
    
    $
    6,866
    
    
    $
    6,573
    
    
    $
    1,045
    
    
    $
    1,580Foreign
    
    
    1,528
    
    
    
    1,451
    
    
    
    207
    
    
    
    283Total
    
    $
    8,394
    
    
    $
    8,024
    
    
    $
    1,252
    
    
    $
    1,863
 11




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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 quality optimization solutions for both Web-based and
enterprise client/server applications. We also provide product related training and consulting
services. This summary provides an overview of the most significant aspects of our operations
during the three month period ending March 31, 2005. Details of the matters addressed in this
summary are provided elsewhere in this document and, in particular, in the sections immediately
following. Thus far in 2005, we continue to focus on our three strategic business objectives: profitable
revenue growth, market-driven product innovations and a focus on selective partnerships and
alliances. Our first quarter 2005 financial results demonstrate continued alignment with our
strategic objectives and show growth in both the areas of revenue and profitability. For the first quarter of 2005, total revenue grew 5% to $8.4 million as compared to $8.0
million during the same period last year. Our income from operations for the first quarter of 2005
was $669,000, up from $323,000 for the same period in 2004. The difference between operating
income and our reported net income applicable to common shares is primarily the result of preferred
dividends. We view operating income (results before preferred dividends) as a better reflection of
Segues business results for the reason that the preferred dividend is a non-cash,
non-operating-transaction. Total operating expenses and cost of sales combined, totaled $7.7
million for both the first quarter of 2005 and 2004. Our total worldwide headcount at March 31,
2005 and March 31, 2004 stood at 185 and 190, respectively. On the balance sheet, we reported a cash and cash equivalent balance of $11.5 million at March
31, 2005, up from a reported $11.0 million at December 31, 2004 and $8.4 million one year ago.
Deferred revenue stood at $10.5 million at March 31, 2005 which remained unchanged from December
31, 2004 and up from $9.5 million at March 31, 2004. We also reported positive cash flow from
operations of $288,000 in the first quarter of 2005 as compared to $745,000 positive cash flow
reported the same period in 2004. We had no off-balance sheet contingency debt and continue to
have no debt on our balance sheet. 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. Our critical accounting policies are those that affect our financial statements materially and
involve a significant level of judgment by management: Revenue Recognition The Company follows the guidance in Statement of Position (SOP) 97-2,
Software Revenue Recognition, as amended by SOP 98-9, in recognizing revenue on software
transactions. Such revenue is recognized upon the delivery of the software, provided persuasive
evidence of an arrangement exists, fees are considered fixed and determinable and a collection of
the receivable is considered probable. The revenue recognized for each separate undelivered
element of a multiple-element software contract is based upon vendor-specific objective evidence
(VSOE) of fair value, which is based upon the price the customer is required to pay when the
element is sold separately. Revenue allocated by 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 12




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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. The Companys 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, the Company follows
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. The Company determines 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. The Company determines 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, Segue reviews its accounts receivable aging to
determine which accounts appear to be uncollectible and records 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,
Segue has 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. Segue did not execute a restructuring plan in the year ended December 31, 2004 and the
quarter ended March 31, 2005 and thus incurred no related charges for severance and other
employee-related costs during the year ended December 31, 2004 and the quarter ended March 31,
2005. 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.
Segue obtained local real estate market data and consulted with its real estate advisor on these
factors to help determine an appropriate reserve for potential losses on the unused space. During
the fourth quarter of 2002, Segue was able to reach an agreement in principle with its landlord to
restructure the sublease for our Lexington facility. A formal agreement was consummated on January
24, 2003. At March 31, 2005, 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 $954,000.
This is comprised of an estimated $1.2 million for future rents payable by Segue on unoccupied
space less approximately $258,000 of estimated future sublease income. Segue is 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
Segues 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, Segue performs 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 13




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the Companys consolidated balance sheet. During the fourth quarter of 2004, Segue performed
an analysis of the transitional fair value of the goodwill on the Companys balance sheet. The
analysis demonstrated that no impairment existed at December 31, 2004 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, 2005. 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. On December 27, 2004 the Company announced that its Board of Directors approved an amendment
to certain terms of the Companys Series B Preferred Stock, reducing the dividend payable on its
Series B Preferred Stock from 12% to 6% per year and extending the redemption date of its Series B
Preferred Stock to October 31, 2005, the earliest date at which the Company could redeem its
stock. The amendment to the terms of the Series B Preferred Stock is subject to approval by the
Companys stockholders at their next annual meeting, which is scheduled for June 6, 2005. The
holder of the Series B Preferred Stock, S-7 Associates LLC, a company managed and owned by Dr.
James Simons, Segues chairman, and all other voting shares of Dr. James Simons have agreed to vote
in favor of the amendment. If the amendment is approved by the Companys stockholders, we expect
that the reduced dividend rate would be in effect for the June 30, 2005 dividend on the Series B
Preferred Stock. 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. Commencing in 2004, the Company hired an independent third party on a quarterly basis,
who specializes in valuations, to establish the fair market value of the Preferred Stock. The
Company will continue to engage this third party on a quarterly basis for the purpose of
establishing the fair market value of the Preferred Stock and calculating the expense of the
dividends earned. The Company reflects the estimated value of the Preferred Stock dividend-in-kind on a
quarterly basis as a reduction in the net income (increase in net loss) applicable to common
shares. Dividends paid to any holder on Series C Preferred Stock are restricted should they cause such
holder, among other things, to accumulate more than 20% of our voting power. If any holder of
Series C Preferred Stock should accumulate more than 20% of our voting power, such holder will be
paid cash payments in lieu of dividends in kind while holding at least 20% of our voting power. Deferred Tax Valuation Allowance- We have established a full valuation allowance to
reduce our deferred tax assets to the amount that is more likely than not to be realized. Deferred
tax assets and liabilities are determined based on the difference between the financial statement
and tax bases of assets and liabilities using the enacted tax rates in effect for the year in which
the differences are expected to affect taxable income. Valuation allowances are established when
necessary to reduce deferred tax assets to the amounts expected to be realized. While we have considered potential future taxable income and ongoing prudent and feasible tax
planning strategies in assessing the need for the full valuation allowance, in the event that we
were to determine that we 14




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would be able to realize our deferred tax assets in the future, an adjustment to the deferred tax
asset would increase net profit in the period such determination was made. Subsequently, we would
recognize tax expense in subsequent periods at amounts approximating the statutory rate. We
recently turned profitable, and if we continue to be profitable in the future, the deferred tax
valuation allowance may be adjusted accordingly. 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 ofRevenue for theThree monthsended March 31,2005
    
    
    2004Revenue:Software
    
    
    43.1
    %
    
    
    44.6
    %Services
    
    
    57.7
    
    
    
    55.7Gross revenue
    
    
    100.8
    
    
    
    100.3Less vendor consideration to a customer
    
    
    (0.8
    )
    
    
    (0.3
    )Net revenue
    
    
    100.0
    
    
    
    100.0Cost of revenue:Cost of software
    
    
    1.3
    
    
    
    1.1Cost of services
    
    
    13.3
    
    
    
    16.3Total cost of revenue
    
    
    14.6
    
    
    
    17.4Gross margin
    
    
    85.4
    
    
    
    82.6Operating expenses:Sales and marketing
    
    
    41.8
    
    
    
    43.3Research and development
    
    
    22.0
    
    
    
    20.6General and administrative
    
    
    13.6
    
    
    
    14.7Total operating expenses
    
    
    77.4
    
    
    
    78.6Income from operations
    
    
    8.0
    
    
    
    4.0Other income, net
    
    
    0.0
    
    
    
    0.2Interest income, net
    
    
    0.5
    
    
    
    0.3Income before provision for income taxes
    
    
    8.5
    
    
    
    4.5Provision for income taxes
    
    
    1.0
    
    
    
    0.3Net income
    
    
    7.5
    %
    
    
    4.2
    %
 Software Revenue Software revenue results from the granting of perpetual and time-based licenses for the use of
Segue products. We license our software through our direct sales force, inside sales, international
distributors, business partners, and resellers. Software revenue remained flat at $3.6 million for
the three month period ended March 31, 2005 as compared to the three month period ended March 31,
2004. The software license revenue for the three month period ended March 31, 2005 over the same
period last year was effected by $400,000 in software licenses that were received on December 31,
2003, but not delivered or recognized until January 2004. International product sales represented
24% and 26% of our total product sales in the three month period ended March 31, 2005 and 2004,
respectively. The total dollar amount of international product sales decreased by approximately
$44,000 or 5%. Software revenue growths depends upon our ability to successfully generate and fulfill
software license orders, generate incremental revenue from our business partnerships and strategic
alliances, attract and retain skilled personnel, deliver timely new products and enhancements and
continued market growth. Performance could also be affected by the market acceptance of our new and
enhanced products and increased competition. It is difficult to determine if we will be able to
continue to grow software revenue in the future. 15




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Services Revenue Services revenue consists of revenue from maintenance, training and consulting. Service
revenue increased 7%, or $300,000, to $4.8 million during the three month period ended March 31,
2005 as compared to $4.5 million in the three month period ended March 31, 2004. Maintenance
revenue increased 16%, or $600,000, to $4.3 million during the three month period ended March 31,
2005 as compared to $3.7 million in the three month period ended March 31, 2004. This increase was
primarily attributable to an increase in renewals of existing maintenance contracts over a larger
base of licenses as compared to 2004. Training and consulting revenue decreased 32%, or $231,000,
to $501,000 during the three month period ended March 31, 2005 as compared to $732,000 in the three
month period ended March 31, 2004. This decrease was primarily due to a reduction in performed
domestic consulting and training engagements. However, actual training and consulting orders
received for the quarter ended March 31, 2005 totaled $737,000 as compared to $558,000 in orders
received for the period ended March 31, 2004. It is difficult to determine if we will be able to continue 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 Vendor considerations to a customer consist of the Companys commitment to making referral fee
payments to several vendors, resellers, and distributors. Under EITF Issue No. 01-9, Accounting
for Consideration Given by a Vendor to a Customer (Including a Reseller of Vendors Products),
these payments are considered to be a reduction of revenue and are presented in our statement of
operations as such for 2005 and 2004. Vendor considerations to a customer increased 209%, or
$46,000, to $68,000 during the three month period ended March 31, 2005 as compared to $22,000 in
the three month period ended March 31, 2004. This increase, while large in terms of percentage,
but relatively small in terms of dollars, is primarily attributed to several large deals to which a
referral fee applied. Cost of Software Cost of software includes documentation, product packaging and shipping, product media,
employee costs for processing and distribution, amortization of capitalized technology and
royalties due to third parties for their software that we embed in our products. Cost of software
increased 29%, or $25,000, to $110,000 during the three month period ended March 31, 2005 as
compared to $85,000 in the three month period ended March 31, 2004. As a percent of software
revenues, cost of software was 3% in 2005 as compared to 2% in 2004. This increase is attributed
to a $35,000 increase in royalty expense due primarily to increased sales of products covered under
an OEM agreement. Cost of Services Cost of services consists principally of salaries and benefits for our customer service and
technical support staff, which staff provides services under maintenance contracts and for our
training and consulting staff, as well as third party consulting fees and the cost of materials and
facilities used for training customers. Cost of services as a percentage of services revenue varies
based on the profitability of individual consulting engagements and the utilization rate of
in-house consultants versus the use of higher cost outside contract consultants. Cost of services
decreased 15%, or $200,000, to $1.1 million during the three month period ended March 31, 2005 as
compared to $1.3 million in the three month period ended March 31, 2004. The decrease in cost of
services primarily came from a decrease of $118,000 in training and consulting costs and a decrease
of $75,000 for cost of maintenance as described in greater details below. As a percent of service
revenue, cost of services was 23% in 2005 as compared to 29% in 2004. Cost of training and consulting decreased 21%, or $118,000, to $453,000 during the three month
period ended March 31, 2005 as compared to $571,000 in the three month period ended March 31, 2004.
This decrease was primarily attributed to a decrease of $70,000 in personnel related costs due to
a reduced number of employees and a decrease of $25,000 in travel cost as a result of the reduced
number of domestic consulting and training 16




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engagements during the period. Cost of maintenance decreased 10%, or $75,000, to $666,000
during the three month period ended March 31, 2005 as compared to $741,000 in the three month
period ended March 31, 2004. The decrease is primarily attributed to a decrease of $68,000 in
personnel related cost due to a reduced number of employees and a decrease of $37,000 in
depreciation expense as a result of more fully depreciated assets in 2005. Theses decreases were
partially offset by an increase of $40,000 in exchange rate translation in the European market of
our foreign technical support operations. Sales and Marketing Sales and marketing expenses consist primarily of salaries and benefits, commissions, travel
costs, promotional marketing programs and allocated facility costs. Marketing programs include
advertising, public relations, direct mail programs, seminars and trade shows. Total sales and
marketing expense remained flat at $3.5 million during the three month period ended March 31, 2005
as compared to the three month period ended March 31, 2004. As a percent of net revenue, total
sales and marketing expense was 42% for 2005 as compared to 43% for 2004. Sales expense decreased
3%, or $100,000, to $2.8 million during the three month period ended March 31, 2005 as compared to
$2.9 million in the three month period ended March 31, 2004. This decrease was primarily due to a
decrease of $90,000 in personnel-related costs due to a reduced number of employees, a decrease of
$76,000 in rent expense due to the closing of our San Francisco and Los Gatos California offices, a
decrease of $44,000 in depreciation expense resulting from more fully depreciated assets in 2005,
and a decrease of $22,000 in travel related costs. These decreases were partially offset by an
increase of $156,000 in commission expense due to increased revenues and exceptional performance by
several sales teams that exceeded their quotas. Marketing expense increased 24%, or $132,000, to $686,000 during the three month period ended
March 31, 2005 as compared to $554,000 in the three month period ended March 31, 2004. This
increase was primarily attributed to an increase of $184,000 in marketing campaigns partially
offset by a decrease of $30,000 in personnel related cost due to a reduced number of employees. We
plan to make investments in this area, but will continue to tightly control the level of expenses
for marketing programs, but further reductions to these programs may have an adverse effect on our
business by not creating enough leads to generate incremental sales revenue. We anticipate that sales and marketing expenses will continue to be a large percent of total
expenses for Segue, although their percent to total revenue may vary in the future, as we try to
continue to grow revenue. Research and Development Research and development expenses consist primarily of salaries, benefits, and allocated
facility costs. To date, all of Segues internal costs for research and development have been
charged to operations as incurred, since amounts of software development costs qualifying for
capitalization have been insignificant. Research and development expense increased 12%, or
$200,000, to approximately $1.9 million during the three month period ended March 31, 2005 as
compared to $1.7 million in the three month period ended March 31, 2004. The increase was
primarily attributed to an increase of $177,000 in outsourced consulting expense and an increase of
$49,000 due to rate valuation of the U.S. dollar to the Euro, as a substantial portion of our
research and development expenses were from our Austrian subsidiary. The planned increase in
outsourced consulting expenses was a result of our meeting the requirements of the Companys
accelerated product development plan for 2005. General and Administrative General and administrative expenses consist primarily of salaries and benefits for executive,
finance, legal, information technology, human resources and administrative personnel, professional
fees, system support costs, allocated facility costs and other general corporate expenses. General
and administrative expense decreased 8%, or $100,000, to $1.1 million during the three month period
ended March 31, 2005 as compared to $1.2 million in the three month period ended March 31, 2004.
This decrease was primarily attributable to a reduction of $207,000 in outside legal expense due to
a high level of legal contracts effort and the absence of our internal legal counsel in the first quarter of 2004. This decrease was 17




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partially offset by an increase of $86,000 in bad debt expense and an increase of $35,000 in
personnel related costs due to an increased number of employees. Restructuring Charges There were no restructuring charges recorded during the three month period ended March 31,
2005 and March 31, 2004. During the first quarter of 2004, we paid $231,000 of the restructuring
costs accrued at December 31, 2003, which left a balance of $494,000 for the remaining accrued
severance and termination benefits associated with the restructuring actions from 2003 which was
reflected on our consolidated balance sheet. Interest and Other Income (Expense) Interest and other income and expense consist primarily of interest earned on cash, cash
equivalents and short-term investment balances. Interest and other income, net increased 7%, or
$3,000, to $44,000 during the three month period ended March 31, 2005 as compared to $41,000 in the
three month period ended March 31, 2004. This increase is primarily attributed to an increase of
$23,000 in interest income on higher balances of cash and cash equivalents in the first quarter of
2005 in comparison to the same period last year, partially offset by a decrease of $20,000 in other
income which was related to the settlement of a minor sublease issue during the first quarter of
2004. The Company had no interest expense for the three month period ended March 31, 2005 and March
31, 2004. Segue carries no debt. Provision for Income Taxes Provisions for federal, foreign and state income taxes increased 215%, or $56,000, to $82,000
during the three month period ended March 31, 2005 as compared to $26,000 in the three month period
ended March 31, 2004. The increase was primarily attributed to foreign tax provisions. There was no long term tax benefit for prior losses generated in the United States 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. Tax provisions for the current periods reflect the
utilization of net operating loss carry-forwards. Liquidity and Capital Resources At March 31, 2005, our principal sources of liquidity consisted of $11.5 million of cash and
cash equivalents, compared to $8.4 million at March 31, 2004 and $11.0 million at December 31,
2004. An additional $770,000 of restricted cash was posted in late 2002 as security for the letter
of credit related to our restructured sublease for our Lexington headquarters and will reduce, by
formula, to zero by August 2005. This restricted cash is shown in other assets on our balance
sheet and was reduced in December 2004 to $440,000 and remains on the balance sheet at March 31,
2005 as compared to $770,000 at March 31, 2004. Our operating activities generated cash of $288,000 during the three month period ended March
31, 2005 as compared to $745,000 in the three month period ended March 31, 2004. In the first
quarter of 2005, cash generated primarily resulted from our net income of $631,000 during the
period and the positive impact of non-cash items such as depreciation and amortization expense and
the increase in deferred revenue and accounts payable and the decrease in other current assets,
offset by a decrease in accrued expenses and an increase in accounts receivable. Cash generated in
the first quarter of 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. 18




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Our investing activities utilized cash of $61,000 during the three month period ended March
31, 2005 as compared to cash utilized of $50,000 in the three month period ended March 31, 2004.
Cash used in the first quarter of 2005 and 2004 primarily came from the result of the purchase of
replacement computers, equipment and an upgrade the Companys e-mail system. In the future, we may
need to make increased expenditures on property and equipment as present equipment ages. Our financing activities generated cash of $319,000 during the three month period ended March
31, 2005 as compared to $202,000 in the three month period ended March 31, 2004. Cash generated in
the first quarter of 2005 and 2004, primarily came from the issuance of common stock under our
employee stock option and stock purchase plans. The average stock price of the Companys common
stock was $6.04 for the quarter ended March 31, 2005 as compared to $3.68 for the same period last
year and thus resulted in more employees exercising their stock options. Long-term cash requirements, other than for normal operating expenses and those described
above are anticipated for the development of new software products and enhancements of existing
products, and the possible acquisition of software products or technologies complementary to our
business. We have reduced our workforce and overhead expenses and minimized capital spending and other
uses of cash. However, in order to sustain profitability and to continue positive cash flow from
operations, we must maintain or increase our revenue from current levels. Assuming that we can execute our current plans to maintain or grow revenue through our
restructured sales program, our focus on enterprise customers, and our introduction and success of
new and enhanced products, and the business climate for IT spending does not worsen, we believe
that with the funding provided by operations 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 in our 2004 Annual Report 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 results may fluctuate.Our revenue and operating results are difficult to predict and may
fluctuate significantly from quarter to quarter. If our revenue or operating results fall below the
expectations of investors or public market analysts, the price of our common stock could fall
substantially. Our 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; changes in 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 19




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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.For the quarter ended March 31, 2005, we reported net
income of approximately $631,000 as compared to $338,000 for the same period last year. Prior to
the fiscal year ended December 31, 2004, we generally experienced losses. Prior losses have
resulted in an accumulated deficit of approximately $55.5 million as of March 31, 2005. It is
uncertain whether we can maintain profitability in the future. For the quarter ended March 31, 2005, we had total revenue of $8.4 million versus $8.0 million
in the quarter ended March 31, 2004. We continue to aggressively monitor our expenses and conserve
cash. Despite these cost control measures, our future profitability remains uncertain because of,
among other items, the uncertainty of our revenue from quarter to quarter. Failure to maintain
profitability may adversely affect the market price of our common stock. Business conditions and Information Technology (IT) spending could cause a decline in revenue.
The level of future IT spending remains uncertain. This is particularly true in light of the
changes in the general business climate in recent years. If IT spending does not increase, our
ability to generate revenues may be diminished and, as a result, may 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. To date, we have established alliances with PeopleSoft, Keynote Systems,
Borland Software and Microsoft. In an effort to further enhance the success of the SilkElite Partner Program, we hired a new
Vice President of Channel Sales and Strategic Partnerships in late 2004. The effect of this new
position on our SilkElite Partner Program remains uncertain. The SilkElite Partners Program focuses on resellers, consulting partners and distributors.
SilkElite Partners resell our products, refer business to us and use our software products in the
delivery of consulting services. The SilkElite Partner Program accounted for 18% of total revenue
for the quarter ended March 31, 2005 versus 13% for the quarter ended March 31, 2004. The success
of our strategic alliances and the SilkElite Program is uncertain, however, and such success 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 may be adversely affected. 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 feel we need to
develop and introduce product enhancements and new products that address the increasingly
sophisticated and varied needs of our existing and potential customers. For the fiscal quarter
ended March 31, 2005, over 86% of our product revenues were generated from our SilkPerformer and
SilkTest products, as compared with over 92% in same period last year. During the quarter ended
March 31, 2005, we released our Software Quality 20




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Optimization for SAP solution that enables SAP users to optimize the quality of and obtain
greater business value from SAP applications. During the fourth quarter of 2004, we released
SilkCentral Performance Manager 2.7, the newest version of our application performance management
software for monitoring production behavior of applications. SilkCentral Performance Manager
provided about 6% of our product revenue in the quarter ended March 31, 2005. If these new
products are not successful, if we fail to continue to develop and introduce new products and
enhancements on a timely basis, or if we fail to maintain our level of product revenue from
SilkPerformer and SilkTest our business and the results of our operations may be adversely
affected. We may face liquidity issues.We have taken steps to conserve our use of cash, including
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 continued growth of our revenue, future sales at or above current levels should be
sufficient to allow us to continue our positive cash flow. For the quarter ended March 31, 2005, we
generated $496,000 in overall positive cash flow. Our total net revenue of $8.4 million for the
period ended March 31, 2005 was approximately 5% greater than for the same period last year. If we
fail to maintain or grow revenue, we may have to raise additional financing to fund working capital
needs. If we fail to generate substantial incremental revenue, or if 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 adversely affected. Our stock price may be volatile.The market price of our common stock is subject to
significant fluctuations. The market price of our common stock may be significantly affected by
the announcement of new products, product enhancements or technological innovation by us or our
competitors, changes in our or our competitors results of operations, changes in revenue, revenue
growth rates and revenue mix, changes in earnings estimates by market analysts and general market
conditions or market conditions specific to particular industries. In addition, the capital
stocks of technology stocks in general have experienced wide fluctuations in prices, which
sometimes have been unrelated to their operating performance. The market price of our common stock
could be adversely affected by such fluctuations. 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, IBM-Rational, 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
may 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
may have a material adverse effect on our business, operating results and financial condition. We must hire and retain skilled personnel in a difficult economic environment.Qualified
personnel remain in demand throughout the software industry. Our success depends in large part upon
our ability to attract, train, motivate and retain highly skilled employees, particularly sales and
marketing personnel, software engineers and other senior personnel. The failure to attract and
retain the highly skilled personnel that are integral to our direct sales, product development,
service and support teams may limit the rate at which we can generate sales and develop new
products or product enhancements. Our ability to retain our qualified staff may be further impacted
by our 21




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financial results during 2005 or in the future. All of this may have a material adverse effect
on our business, operating results and financial condition. Our earnings may be adversely affected by the new accounting treatment for stock options and
we may be forced to change our employee compensation and benefits practices.On December 16, 2004,
the Financial Accounting Standards Board (FASB) issued Statement 123R, Share-Based Payment, that
addresses the accounting for share-based awards to employees, including
employee-stock-purchase-plans (ESPPs). Statement 123R requires entities to recognize the fair
value of stock options and other stock-based compensation to employees. The Statement eliminates
the ability to account for share-based compensation transactions using APB Opinion No. 25,
Accounting for Stock Issued to Employees, and generally requires instead, that such transactions,
be accounted for using a fair-value-based method. The requirements in Statement 123R are effective
for public companies as of the beginning of their next fiscal year, which will be in the first
quarter of 2006. Therefore, the adoption of Statement 123R will have a material effect on the
Companys consolidated financial statements. Also, we may consider changing our employee
compensation and benefits practices in a manner that may adversely impact our ability to retain
existing employees and attract qualified candidates. We face many risks associated with international business activities.We derived
approximately 18% of total revenue from international customers in the quarter ended March 31,
2005, as compared with 18% 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 may 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 five
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 may 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. 22




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INTEREST RATE RISK.Segue is 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 United States Government treasury bills). FOREIGN CURRENCY RISK.Segue faces 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. We incurred transaction and re-measurement gains of $33,000 related to foreign
currency for the three month period ended March 31, 2005 as compared to a gain of $19,000 in the
three month period ended March 31, 2004. As of March 31, 2005, the cumulative translation of
foreign currency changes recorded in stockholders equity was $357,000. 
 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, 2005
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 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 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. 23




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Item 5.Other Information There were no other matters requiring disclosure on this Form 10-Q. 
 Item 6.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.
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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 13, 2005 SEGUE SOFTWARE, INC.By:
    
    /s/   JOSEPH K. KRIVICKASJoseph K. KrivickasChief Executive OfficerBy:
    
    /s/   DOUGLAS ZACCARODouglas ZaccaroChief Financial Officer
 25