**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-Q**

 
| **(Mark One)**                                                                                                                                          |                                                                                               |
|---------------------------------------------------------------------------------------------------------------------------------------------------------|----------------------------------------------------------------------------------------------------|
|                                                                                                                                                    |                                                                                               |
| **ý**                                                                                                                                              | **QUARTERLY REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**  |
|                                                                                                                                                    |
| **For the Quarterly Period Ended September  30, 2003**                                                                                                  |
|                                                                                                                                                    |                                                                                               |
| **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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**SEGUESOFTWARE, INC.**

(Exact name of registrant as specified in itscharter)

 
| **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** |

 

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Indicate by check mark whether the registrant: (1) has filed allreports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such a shorterperiod that the registrant was required to file such reports) and (2) hasbeen subject to such filing requirements for the past 90 days. Yes ý  No o

 

The number of shares of Registrant’s Common Stock outstanding as ofNovember 3, 2003 was 9,778,598

 

 

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**SEGUESOFTWARE, INC.**

 

**FORM10-Q**

 

**FORTHE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2003**

 

**INDEX**

 
| PART I.   | FINANCIAL  INFORMATION                                                                                                       |
|-----------|------------------------------------------------------------------------------------------------------------------------------|
|      |                                                                                                                         |
| Item 1.   | Condensed  Consolidated Financial Statements:                                                                                |
|      |                                                                                                                         |
|      | Condensed  Consolidated Balance Sheets (unaudited) September 30, 2003 and  December 31, 2002                       |
|      |                                                                                                                         |
|      | Condensed  Consolidated Statements of Operations (unaudited) Three Months and Nine  Months Ended September 30, 2003 and 2002 |
|      |                                                                                                                         |
|      | Condensed  Consolidated Statements of Cash Flows (unaudited) Nine Months Ended September  30, 2003 and 2002                  |
|      |                                                                                                                         |
|      | Notes to  Condensed Consolidated Financial Statements (unaudited)                                                            |
|      |                                                                                                                         |
| Item 2.   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations                                  |
|      |                                                                                                                         |
| Item 3.   | Quantitative  and Qualitative Disclosures about Market Risk                                                                  |
|      |                                                                                                                         |
| Item 4.   | Controls  and Procedures                                                                                                     |
|      |                                                                                                                         |
| PART  II. | OTHER  INFORMATION                                                                                                           |
|      |                                                                                                                         |
| Item 1.   | Legal  Proceedings                                                                                                           |
|      |                                                                                                                         |
| Item 4.   | Submission  of Matters to a Vote of Security Holders                                                                         |
|      |                                                                                                                         |
| Item 5.   | Other  Information                                                                                                           |
|      |                                                                                                                         |
| Item 6.   | Exhibits  and Reports on Form 8-K                                                                                       |
|      |                                                                                                                         |
|      | Signatures                                                                                                                   |
|      |                                                                                                                         |
|      | Certifications                                                                                                               |

 

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**PART I****. FINANCIALINFORMATION**

 

**ITEM 1****. CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

 

**SEGUE SOFTWARE, INC.****CONDENSEDCONSOLIDATED BALANCE SHEETS****(INTHOUSANDS, EXCEPT PER SHARE DATA)**

 
|                                                                                                                                                      |   | **(Unaudited)**          |   | **(Audited)**           |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------------|--------|-------------------------|--------|
|                                                                                                                                                      |   | **September  30,  2003** |   | **December  31,  2002** |   |
| **ASSETS**                                                                                                                                                |   |                     |   |                    |   |
| Current assets:                                                                                                                                           |   |                     |   |                    |   |
| Cash and cash equivalents                                                                                                                                 |   | $                        | 6,187  |                    | $      | 5,335 |   |
| Accounts receivable, net of allowances of  $208 and $232, respectively                                                                                    |   | 4,472                    |   | 6,007                   |   |
| Other current assets                                                                                                                                      |   | 1,252                    |   | 967                     |   |
| Total current assets                                                                                                                                      |   | 11,911                   |   | 12,309                  |   |
|                                                                                                                                                      |   |                     |   |                    |   |
| Property and equipment, net                                                                                                                               |   | 1,276                    |   | 2,089                   |   |
| Goodwill, net                                                                                                                                             |   | 1,506                    |   | 1,506                   |   |
| Other assets                                                                                                                                              |   | 940                      |   | 1,291                   |   |
| Total assets                                                                                                                                              |   | $                        | 15,633 |                    | $      | 17,195 |   |
|                                                                                                                                                      |   |                     |   |                    |   |
| **LIABILITIES AND STOCKHOLDERS’ EQUITY**                                                                                                             |   |                     |   |                    |   |
| Current liabilities:                                                                                                                                      |   |                     |   |                    |   |
| Accounts payable                                                                                                                                          |   | $                        | 975    |                    | $      | 1,256 |   |
| Accrued compensation and benefits                                                                                                                         |   | 1,224                    |   | 1,163                   |   |
| Accrued lease obligations on excess space                                                                                                                 |   | 1,688                    |   | 2,145                   |   |
| Accrued expenses                                                                                                                                          |   | 1,019                    |   | 1,522                   |   |
| Deferred revenue                                                                                                                                          |   | 8,367                    |   | 8,408                   |   |
| Total current liabilities                                                                                                                                 |   | 13,273                   |   | 14,494                  |   |
|                                                                                                                                                      |   |                     |   |                    |   |
| Stockholders’ equity:                                                                                                                                |   |                     |   |                    |   |
| Preferred stock, par value $.01 per share;  9,000 shares authorized; 773 and 729 shares of Series B preferred stock  issued and outstanding, respectively |   | 2,269                    |   | 2,147                   |   |
| Common stock, par value $.01 per share;  30,000 shares authorized; 9,924 and 9,765 shares issued, respectively                                            |   | 100                      |   | 98                      |   |
| Additional paid-in capital                                                                                                                                |   | 58,272                   |   | 58,206                  |   |
| Cumulative translation adjustment                                                                                                                         |   | 205                      |   | 98                      |   |
| Accumulated deficit                                                                                                                                       |   | (57,886                  | )      | (57,248                 | )      |
|                                                                                                                                                      |   | 2,960                    |   | 3,301                   |   |
| Less treasury stock, at cost, 145 and 145  shares, respectively                                                                                           |   | (600                     | )      | (600                    | )      |
| Total stockholders’ equity                                                                                                                           |   | 2,360                    |   | 2,701                   |   |
| Total liabilities and stockholders’ equity                                                                                                           |   | $                        | 15,633 |                    | $      | 17,195 |   |

 

The accompanying notes are an integral partof the consolidated financial statements.

 

 

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**SEGUESOFTWARE, INC.****CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS****(INTHOUSANDS, EXCEPT PER SHARE DATA)****(UNAUDITED)**

 
|                                                            |   | **Three  Months Ended  September 30,** |   | **Nine  Months Ended  September 30,** |   |
|-----------------------------------------------------------------|--------|----------------------------------------|--------|---------------------------------------|--------|
|                                                            |   | **2003**                               |   | **2002**                              |   | **2003** |   | **2002** |   |
| Revenue:                                                        |   |                                   |   |                                  |   |   |   |   |   |
| Software                                                        |   | $                                      | 3,003  |                                  | $      | 3,754 |   | $ | 9,516 |   | $ | 9,583 |   |
| Services                                                        |   | 4,055                                  |   | 4,016                                 |   | 12,281 |   | 13,089 |   |
| Subtotal revenue                                                |   | 7,058                                  |   | 7,770                                 |   | 21,797 |   | 22,672 |   |
| Less vendor consideration to a customer                         |   | (41                                    | )      | (7                                    | )      | (136 | ) | (1,032 | ) |
| Net revenue                                                     |   | 7,017                                  |   | 7,763                                 |   | 21,661 |   | 21,640 |   |
|                                                            |   |                                   |   |                                  |   |   |   |   |   |
| Cost of revenue:                                                |   |                                   |   |                                  |   |   |   |   |   |
| Cost of software                                                |   | 109                                    |   | 193                                   |   | 284 |   | 596 |   |
| Cost of services                                                |   | 1,256                                  |   | 1,307                                 |   | 3,784 |   | 4,015 |   |
| Total cost of revenue                                           |   | 1,365                                  |   | 1,500                                 |   | 4,068 |   | 4,611 |   |
|                                                            |   |                                   |   |                                  |   |   |   |   |   |
| Gross margin                                                    |   | 5,652                                  |   | 6,263                                 |   | 17,593 |   | 17,029 |   |
|                                                            |   |                                   |   |                                  |   |   |   |   |   |
| Operating expenses:                                             |   |                                   |   |                                  |   |   |   |   |   |
| Sales and marketing                                             |   | 3,462                                  |   | 3,906                                 |   | 10,564 |   | 12,355 |   |
| Research and development                                        |   | 1,419                                  |   | 1,478                                 |   | 4,334 |   | 4,343 |   |
| General and administrative                                      |   | 912                                    |   | 1,434                                 |   | 3,263 |   | 4,215 |   |
| Restructuring charges                                           |   | —                                 |   | 373                                   |   | — |   | 1,203 |   |
| Total operating expenses                                        |   | 5,793                                  |   | 7,191                                 |   | 18,161 |   | 22,116 |   |
|                                                            |   |                                   |   |                                  |   |   |   |   |   |
| Loss from operations                                            |   | (141                                   | )      | (928                                  | )      | (568 | ) | (5,087 | ) |
| Interest Income                                                 |   | 11                                     |   | 31                                    |   | 38 |   | 74 |   |
| Loss before provision for income taxes                          |   | (130                                   | )      | (897                                  | )      | (530 | ) | (5,013 | ) |
| Provision (credit) for income taxes                             |   | (16                                    | )      | 48                                    |   | 108 |   | 123 |   |
| Net loss                                                        |   | (114                                   | )      | (945                                  | )      | (638 | ) | (5,136 | ) |
| Preferred stock dividend-in-kind                                |   | 79                                     |   | 58                                    |   | 201 |   | 112 |   |
| Net loss applicable to common shares                            |   | $                                      | (193   | )                                     | $      | (1,003 | ) | $ | (839 | ) | $ | (5,248 | ) |
|                                                            |   |                                   |   |                                  |   |   |   |   |   |
| Net loss per common share - basic and  diluted                  |   | $                                      | (0.02  | )                                     | $      | (0.10 | ) | $ | (0.09 | ) | $ | (0.55 | ) |
|                                                            |   |                                   |   |                                  |   |   |   |   |   |
| Weighted average common shares outstanding  - basic and diluted |   | 9,745                                  |   | 9,584                                 |   | 9,704 |   | 9,543 |   |

 

The accompanying notes are an integral partof the consolidated financial statements.

 

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**SEGUE SOFTWARE, INCCONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS(IN THOUSANDS)****(UNAUDITED)**

 
|                                                                                       |   | **Nine  months ended September 30,** |    |
|--------------------------------------------------------------------------------------------|--------|--------------------------------------|---------|
|                                                                                       |   | **2003**                             |    | **2002** |   |
| Increase (decrease) in cash and cash  equivalents                                          |   |                                 |    |   |   |
|                                                                                       |   |                                 |    |   |   |
| Cash flows from operating activities:                                                      |   |                                 |    |   |   |
| Net loss                                                                                   |   | $                                    | (638    | ) | $ | (5,136 | ) |
| Adjustments to reconcile net loss to net  cash provided by (used in) operating activities: |   |                                 |    |   |   |
| Depreciation and amortization                                                              |   | 1,037                                |    | 1,420 |   |
| Changes in operating assets and  liabilities:                                              |   |                                 |    |   |   |
| Accounts receivable                                                                        |   | 1,642                                |    | (232 | )  |
| Other current assets                                                                       |   | (262                                 | )       | 64 |   |
| Accounts payable                                                                           |   | (265                                 | )  | (978 | ) |
| Accrued expenses, lease obligations on  excess space, compensation, benefits and other     |   | (915                                 | )       | 651 |   |
| Deferred revenue                                                                           |   | (109                                 | )       | (214 | ) |
|                                                                                       |   |                                 |    |   |   |
| Net cash provided by (used in) operating  activities                                       |   | 490                                  |    | (4,425 | ) |
|                                                                                       |   |                                 |    |   |   |
| Cash flows from investing activities:                                                      |   |                                 |    |   |   |
| Additions to property and equipment                                                        |   | (197                                 | )       | (140 | ) |
| Maturities of short-term investments                                                       |   | —                               |    | 5,749 |   |
| Purchases of short-term investments                                                        |   | —                               |    | (800 | ) |
| Other, net                                                                                 |   | 352                                  |    | (98 | ) |
|                                                                                       |   |                                 |    |   |   |
| Net cash provided by investing activities                                                  |   | 155                                  |    | 4,711 |   |
|                                                                                       |   |                                 |    |   |   |
| Cash flows from financing activities:                                                      |   |                                 |    |   |   |
| Proceeds from exercise of stock options and  stock purchase plan                           |   | 190                                  |    | 201 |   |
| Proceeds from the issuance of convertible  preferred stock                                 |   | —                               |    | 2,000 |   |
|                                                                                       |   |                                 |    |   |   |
| Net cash provided by financing activities                                                  |   | 190                                  |    | 2,201 |   |
|                                                                                       |   |                                 |    |   |   |
| Effect of exchange rate changes on cash                                                    |   | 17                                   |    | 85 |   |
|                                                                                       |   |                                 |    |   |   |
| Net increase in cash and cash equivalents                                                  |   | 852                                  |    | 2,572 |   |
| Cash and cash equivalents, beginning of  period                                            |   | 5,335                                |    | 2,326 |   |
|                                                                                       |   |                                 |    |   |   |
| Cash and cash equivalents, end of period                                                   |   | $                                    | 6,187   |   | $ | 4,898 |   |
| Supplemental disclosure of non-cash  investing and financing transactions:                 |   |                                 |    |   |   |
| Cash paid for income taxes during the nine  months ended September 30                      |   | $                                    | 325     |   | $ | 144 |   |
|                                                                                            |        |                                      |         |  |  |  |  |  |

 

The accompanying notes are an integral partof the consolidated financial statements.

 

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**SEGUE SOFTWARE, INC.****NOTES****TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS****(UNAUDITED)**

 

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

 

The financial statements included herein have been prepared by Segue,without audit, pursuant to the rules and regulations of the Securities andExchange Commission. Certain information and note disclosures normally includedin financial statements prepared in accordance with generally accepted accountingprinciples have been condensed or omitted pursuant to such rules andregulations.  We believe that thedisclosures are adequate to make the information presented not misleading.  However, it is suggested that thesefinancial statements be read in conjunction with Segue’s audited financialstatements for the year ended December 31, 2002, included in its 2002Annual Report on Form 10-K.

 

This financial information reflects, in the opinion of management, alladjustments of a normal recurring nature necessary to present fairly theresults for the interim periods. Results of interim periods may not be indicative of results for the fullyear.

 

**2.****                                      LIQUIDITY**

 

The Company has incurred losses on an annual basis since it beganoperations, resulting in an accumulated deficit of approximately$57.9 million at September 30, 2003. As a result, the Company has used significant amounts of cash, cashequivalents and short-term investments to fund its operations.  However, the Company generated approximately$490,000 in positive cash flow from operations and  $852,000 in overall positive cash flow for the first nine monthsof 2003.

 

Segue management has taken significant steps to streamline itsoperations over the last two years and will continue to do so as the situationwarrants. These steps have included reducing headcount, infrastructure andother expenses and limiting capital expenditures.  The Company must increase revenue from the current levels forSegue to re-achieve profitability and sustain positive cash flow. Assuming thatthe Company can execute on current plans to grow revenue, Segue believes thereshould be sufficient cash to meet its forecasted working capital needs for atleast the next twelve months. Delays in the timing of future sales or saleslevels below management’s expectations may cause the Company to re-evaluate itscash position, adjust its operations and/or take other possible actions.

 

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

 

The effects of the steps taken by management have significantly reducedthe Company’s future expected cash outflow. On January 24, 2003, theCompany received approval from its landlord to restructure its corporateheadquarters’ sublease for approximately 33,000 square feet in its Lexingtonfacility.  Under the terms of theoriginal sublease and the restructured agreement, however, Segue was requiredto provide the landlord an initial letter of credit for $700,000. The cashsecurity of $770,000 (letter of credit plus 10%) that was posted is classifiedas restricted cash and is reflected in Other Assets on the Company’s balancesheet. This required letter of credit and the related cash collateral willreduce over time, by formula, to zero by August 2005.

 

The recoverability of a major portion of the recorded asset amountsshown in the accompanying balance sheet are dependent upon the continuedoperations of the Company, which in turn are dependent upon Segue’s ability tomaintain or increase sales and to succeed in its future operations. The financialstatements do not include any adjustments relating to the recoverability andclassification of recorded asset amounts, and classification and amounts ofliabilities that might be necessary should Segue be unable to continueoperations.

 

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

 

In November 2001, Emerging Issues Task Force (“EITF”) IssueNo. 01-9, “Accounting for Consideration Given by a Vendor to a Customer(Including a Reseller of the Vendor’s Products)” was issued. This EITF providesguidance with respect to the statement of operations classification,recognition and measurement of consideration given by a vendor to a customer orreseller. This EITF presumes any consideration to be an adjustment of theselling prices of the vendor’s products or services, which should be deductedfrom revenue when recognized in the vendor’s statement of operations, unlessthere is an identifiable and quantifiable benefit received for theconsideration. This EITF is effective for annual and interim periods beginningafter December 15, 2001. Upon adoption, financial statements for priorperiods presented for comparative purposes should be reclassified to complywith the requirements under the EITF. On January 1, 2002, the Companyadopted this EITF. During the quarter ended March 31, 2002, the Companycommitted to making a payment of $1.0 million to a customer, which wasmade in the second quarter of 2002. Under the provisions of EITF IssueNo. 01-9, this $1.0 million was considered to be a reduction inrevenue and is presented in the statement of operations as such. Per thecontract with the customer, this payment is a one-time expenditure.Furthermore, in accordance with EITF Issue No. 01-9, for the three andnine

 

5

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months ended September 30, 2003, we recorded approximately $41,000and $136,000 respectively, as an additional revenue reduction for amounts paidto resellers as referral fees for sales versus $7,000 and $1.0 million for thesame periods in 2002. There were no other material payments made by the Companyin this quarter or prior quarters that would be considered for reclassificationunder the guidance in EITF Issue No. 01-9.

 

On July 30, 2002, the Financial Accounting Standards Board(“FASB”) issued Statement of Financial Accounting Standards (“SFAS”)No. 146, “Accounting for Costs Associated with Exit or DisposalActivities” (“SFAS No. 146”). The standard requires companies to recognizecosts associated with exit or disposal activities when they are incurred ratherthan at the date of a commitment to an exit or disposal plan. Examples of costscovered by the standard include lease termination costs and certain employeeseverance costs that are associated with a restructuring, discontinuedoperation, plant closing, or other exit or disposal activity. Statement 146 isto be applied prospectively to exit or disposal activities initiated afterDecember 31, 2002.  The Company hasadopted the provisions of this FASB and did not have a material effect on theresults of operations.

 

In November 2002, the FASB issued Financial Interpretation Note(“FIN”) No. 45, or FIN 45, “Guarantor’s Accounting and DisclosureRequirements for Guarantees, Including Indirect Guarantees of Indebtedness ofOthers.” FIN 45 requires that upon issuance of a guarantee, a guarantor mustrecognize a liability for the fair value of an obligation assumed under aguarantee. FIN 45 also requires additional disclosures by a guarantor in itsinterim and annual financial statements about the obligations associated with guaranteesissued. The recognition provisions of FIN 45 are effective for any guaranteesissued or modified after December 31, 2002. The disclosure requirementsare effective for financial statements of interim or annual periods endingafter December 15, 2002.  Theadoption of FIN 45 did not have a material effect on the consolidated financialposition, results of operations or cash flows.

 

In December 2002, the FASB issued SFAS No. 148, “Accountingfor Stock-Based Compensation—Transition and Disclosure” (“SFAS No. 148”).The standard amends SFAS No. 123, “Accounting for Stock-BasedCompensation,” to provide alternative methods for voluntary transition toSFAS 123’s fair value method of accounting for stock-based employeecompensation (“the fair value method”). SFAS No. 148 also requiresdisclosure of the effects of an entity’s accounting policy with respect tostock-based employee compensation on reported net income (loss) and earnings(loss) per share in annual and interim financials statements. The transitionprovisions of SFAS No. 148 are effective in fiscal years beginning afterDecember 15, 2002. The Company is currently evaluating the transitionprovisions of SFAS No. 148 and has adopted the disclosure provisions ofSFAS No. 148.

 

SFAS No. 123, “Accounting for Stock-Based Compensation,” requiredthe Company to elect either expense recognition under SFAS No. 123 or itsdisclosure-only alternative for stock-based employee compensation. The expenserecognition provision encouraged by SFAS No. 123 requires fair-value basedfinancial accounting to recognize compensation expense for employee stockcompensation plans. The Company adopted SFAS No. 123 in 1997 and electedthe disclosure-only alternative. Had compensation costs for the Company’s stockand stock option plans been determined based on the fair value at the grantdates for awards under those plans consistent with the methodology of SFASNo. 123, the Company’s net loss and net loss per share would have beenadjusted to the pro forma amounts indicated below for the periods endedSeptember 30, (in thousands, except per share data):

 
|                                                                                                                  |   | **For the  three months ended  September 30,** |   | **For the  nine months ended  September 30,** |   |
|-----------------------------------------------------------------------------------------------------------------------|--------|-----------------------------------------------------|--------|----------------------------------------------------|--------|
|                                                                                                                  |   | **2003**                                            |   | **2002**                                           |   | **2003** |   | **2002** |   |
|                                                                                                                  |   |                                                |   |                                               |   |   |   |   |   |
| Net loss applicable to common shares                                                                                  |   |                                                |   |                                               |   |   |   |   |   |
| As reported                                                                                                           |   | $                                                   | (193   | )                                                  | $      | (1,003 | ) | $ | (839 | ) | $ | (5,248 | ) |
| Deduct: Total stock-based employee  compensation expense determined under the fair value based method for all  awards |   | (665                                                | )      | (814                                               | )      | (2,121 | ) | (2,560 | ) |
| Pro forma                                                                                                             |   | $                                                   | (858   | )                                                  | $      | (1,817 | ) | $ | (2,960 | ) | $ | (7,808 | ) |
| Net loss per common share — basic and  diluted                                                                   |   |                                                |   |                                               |   |   |   |   |   |
| As reported                                                                                                           |   | $                                                   | (0.02  | )                                                  | $      | (0.10 | ) | $ | (0.09 | ) | $ | (0.55 | ) |
| Pro forma                                                                                                             |   | $                                                   | (0.09  | )                                                  | $      | (0.19 | ) | $ | (0.31 | ) | $ | (0.82 | ) |

 

In January 2003, the FASB issued FIN No. 46, “Consolidationof Variable Interest Entities.” In general, a variable interest entity is acorporation, partnership, trust, or any other legal structure used for businesspurposes that either (a) does not have equity investors with voting rightsor (b) has equity investors that do not provide sufficient financialresources for the entity to support its activities. FIN No. 46 requirescertain variable interest entities to be consolidated by the primarybeneficiary of the entity if the investors do not have the characteristics of acontrolling financial interest or do not have sufficient equity at risk for theentity to finance its activities without additional subordinated financialsupport from other parties. The consolidation requirements of FIN No. 46apply immediately to variable interest entities created after January 31,2003. The consolidation requirements apply to older entities in interim periodsbeginning after June 15, 2003. This requirement has been delayed untilSeptember 15, 2003.  Certain of thedisclosure requirements apply in all financial statements issued afterJanuary 31, 2003, regardless of when the variable interest entity wasestablished. Because the Company currently has no investments in variableinterest entities, the adoption of the provisions of FIN No. 46 did nothave an impact on the consolidated results of operations or financial position.

 

6

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In April 2003, FASB issued Statement of Financial Accounting StandardNo. 149,**“Amendment of Statement133 on Derivative Instruments and Hedging Activities”.  Statement No. 149 amends Statement 133 fordecisions made (1) as part of the Derivatives Implementation Group process thateffectively required amendments to Statement 133, (2) in connection withother Board projects dealing with financial instruments, and (3) in connectionwith implementation issues raised in relation to the application of thedefinition of a derivative. The Statement clarifies under what circumstances acontract with an initial net investment meets the characteristics of aderivative discussed in paragraph 6(b) of Statement 133, clarifies when aderivative contains a financing component, amends the definition of anunderlying contract to conform it to language used in FASB InterpretationNo.45,**“Guarantor’s Accountingand Disclosure Requirements for Guarantees, Including Indirect Guarantees ofIndebtedness of Others”, and amends certain other existing pronouncements.Those changes will result in more consistent reporting of contract as eitherderivatives or hybrid instruments. This statement is effective for contractsentered into or modified after June 30, 2003 and for hedging relationshipsdesignated after June 30, 2003.  TheCompany has not used hedging instruments; therefore the adoption of StatementNo. 149 did not have a significant impact on either its financial position orresults of operations.

 

In May2003, FASB issued SFAS No. 150,**“Accountingfor Certain Financial Instruments with Characteristics of Both Liabilities andEquity”.  Statement No. 150 establishesstandards for how an issuer classifies and measures certain financialinstruments with characteristics of both liabilities and equity. In addition,the Statement requires an issuer to classify certain instruments with specificcharacteristics described in it as liabilities. This Statement is effective forfinancial instruments entered into or modified after May 31, 2003, andotherwise is effective at the beginning of the first interim period beginningafter June 15, 2003. The adoption of Statement No. 150 did not have asignificant impact on either its financial position or results of operations.

 

In May 2003, EITF Issue No. 00-21, “RevenueArrangements with Multiple Deliverables” was issued. This EITF providesguidance with respect to the accounting by a vendor for arrangements underwhich the vendor will perform multiple revenue generating activities.  EITF 00-21 is effective for revenuearrangements entered into in fiscal periods after June 15, 2003.  Management does not expect that the adoptionof EITF 00-21 will have a significant impact on either its financial positionor results of operations.

 

**4.****                                      OTHERASSETS**

 

Included in other assets at September 30, 2003 is restricted cashof $770,000. This amount represents the security for a letter of creditrequired by our sublease for our Lexington headquarters. This required letterof credit will reduce over time, by formula, to zero by August 2005. Alsoincluded in the total is $170,000 for the security deposits on several of ourother office leases.

 

**5.  ****                                EQUITYTRANSACTIONS**

 

On March 22, 2002, the Company and S-7 Associates, LLC, a companymanaged and owned by the Chairman of Segue’s Board of Directors, Dr. JamesH. Simons (“S-7 Associates”), signed an agreement under which S-7 Associatespurchased 666,667 shares of the Company’s Series B Preferred Stock (“PreferredB Stock”) in consideration for a payment of $2.0 million.  The Preferred Stock is senior to the commonstock as to dividend and liquidation rights and is convertible at the option ofthe holder into shares of common stock of Segue at a conversion rate of oneshare of preferred for one share of common, subject to adjustment upon theoccurrence of certain transactions.  Theholders of the Preferred B Stock are entitled to vote together with the commonstock on an as-converted basis, and in addition, are entitled to elect onedirector of the Company as a separate class. Dividends on the Preferred B Stock accrue at 12% per annum and are to bepaid in additional shares of preferred stock semiannually on June 30 andDecember 31.  The Preferred B Stock iscallable at the option of the Company on or after March 31, 2004 at 133%of its face value (“Preferred B Liquidation Preference”).  If there is a sale of all or substantiallyall of the Company’s assets or equity, the Preferred B Stock can either beredeemed at the Preferred B Liquidation Preference or converted to commonstock. 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 Preferred B Stock may beconverted.  The registration rightsexpire on March 22, 2007.

 

For the quarter ended September 30, 2003, an additional 23,197 sharesof Preferred B Stock were earned and accrued as dividends.  For the nine months ended September 30,2003, a total of 66,966 shares were earned and accrued as dividends of which43,769 were issued as shares of Preferred B Stock on June 30, 2003.  The dividends earned during the quarter endedSeptember 30, 2003 will be issued as shares of Preferred B Stock on December31, 2003.  Preferred B Stock dividendsearned for the three and nine months ended September 30, 2003 resulted in adividend expense based on GAAP of approximately $79,000 and $201,000respectively versus $58,000 and $112,000 for the same periods in 2002. The fairvalue of the Preferred B Stock, on which the preferred dividends arecalculated, is estimated by management for the purpose of determining net lossapplicable to common shares.

 

Subsequent to September 30, 2003, on October 21, 2003, the Companyreceived $500,000 from the sale of 166,667 shares of the Company’s Series CPreferred Stock (“Preferred C Stock”) to S-7 Associates, and Howard Morgan, aSegue Director.  The Preferred C Stockis senior to the common stock as to dividend and liquidation rights and isconvertible at the option of the holder into shares of common stock of Segue ata conversion rate of one share of preferred for one share of common, subject toadjustment upon the occurrence of certain transactions.  The holders of the Preferred C Stock areentitled to vote together with the common stock on an as-converted basis.  Dividends on the Preferred C Stock accrue at12% per annum and are to be paid in additional shares of preferred stock or, incertain cases, in cash, semiannually on June 30 and December 31.    The Preferred Stock is callable at theoption of the Company on or after October 31, 2005 at 133% of its facevalue (“Preferred C Liquidation Preference”). If there is a sale of all or substantially all of the Company’s assetsor equity, the Preferred C Stock can either be redeemed at the Preferred CLiquidation Preference or converted to common stock. Pursuant to a registrationrights agreement, the Company has agreed, subject to certain limitations, toregister, under the Securities Act of 1933, the resale of common stock intowhich the Preferred C Stock may be converted. The registration rights expire on October 21, 2008.

 

7

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For the three months ended September 30, 2003, there were 4,106 optionsto purchase common stock exercised by employees and 58,127 shares of commonstock were purchased and issued to employees under the Company’s Employee StockPurchase Plan.  Total proceeds to Seguefor both transactions were approximately $95,000.  For the three months ended September 30, 2002, there were optionsto purchase 1,458 shares of common stock exercised by employees and 58,455shares of common stock were purchased and issued to employees under theCompany’s Employee Stock Purchase Plan. Total proceeds to Segue for both transactions were approximately$59,000.  For the nine months endedSeptember 30, 2003, there were a total of 15,784 options to purchase commonstock exercised by employees and 142,936 shares of common stock were purchasedand issued to employees under the Company’s Employee Stock Purchase Plan.  Total proceeds to Segue for the transactionsfor the nine months ended September 30, 2003 were approximately $190,000.  For the nine months ended September 30,2002, there were a total of 26,995 options to purchase common stock exercisedby employees and directors, and 137,271 shares of common stock were purchasedand issued to employees under the Company’s Employee Stock Purchase Plan.  Total proceeds to Segue for the transactionsfor the nine months ended September 30, 2002 were approximately $201,000.

 

At September 30, 2003, the Company has 3 stock-based employeecompensation plans.  (These plans aredescribed more fully in Note 5 of the Company’s Annual 10-K Report.)  The Company accounts for these plans underthe recognition and measurement principles of APB Opinion No. 25,“Accounting for Stock Issued to Employees”, and related interpretations. Nostock-based employee compensation cost is reflected in net income, as alloptions granted under those plans had an exercise price equal to or greaterthan the market value of the underlying common stock on the date of grant.

 

**6.****                                      RESTRUCTURINGCHARGES**

 

Since April 1, 2001, Segue has executed various restructuring plansaimed 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 associatedwith excess office facilities in our Lexington and Los Gatos offices, net ofestimated sublease income.  Thefollowing table summarizes the restructuring actions and charges incurred byquarter:

 
| **Quarter** |   | **Severance  and  other employee  related costs** |      | **Number of  employees  terminated as part of  restructuring plan** |   | **%  Reduction  in  workforce** |   | **Cost of  estimated  facility obligations,  net of estimated  sublease income** |    | **Office for  which facility  costs accrued** |      | **Total  Restructuring  Charge** |    |
|-------------|--------|---------------------------------------------------|-----------|---------------------------------------------------------------------|--------|---------------------------------|--------|----------------------------------------------------------------------------------|---------|-----------------------------------------------|-----------|----------------------------------|---------|
|        |   |                                              |      |                                                                |   |                            |   |                                                                             |    |                                          |      |                             |    |
| Q3  2003    |   | —                                            |      | —                                                              |   | —                          |   | —                                                                           |    | —                                        |      | —                           |    |
| Q2  2003    |   | —                                            |      | —                                                              |   | —                          |   | —                                                                           |    | —                                        |      | —                           |    |
| Q1  2003    |   | —                                            |      | —                                                              |   | —                          |   | —                                                                           |    | —                                        |      | —                           |    |
| Total  03   |   | —                                            |      | —                                                              |   |                            |   | —                                                                           |    |                                          |      | —                           |    |
|        |   |                                              |      |                                                                |   |                            |   |                                                                             |    |                                          |      |                             |    |
| 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                        |    |
| Q2 2001     |   | 859,000                                           |      | 73                                                                  |   | 20                              |   | 1,398,000                                                                        |    | Lexington and Los Gatos                       |      | 2,257,000                        |    |
| Q1 2001     |   | —                                            |      | —                                                              |   | —                          |   | —                                                                           |    | —                                        |      | —                           |    |
| Total 01    |   | 1,344,000                                         |      | 115                                                                 |   |                            |   | 2,877,000                                                                        |    |                                          |      | 4,221,000                        |    |
|        |   |                                              |      |                                                                |   |                            |   |                                                                             |    |                                          |      |                             |    |
| Total       |   | $                                                 | 1,903,000 |                                                                | 127    |                            |   |                                                                             | $       | 3,521,000                                     |      |                             |    | $ | 5,424,000 |   |

 

During the first quarter of 2003, we paid the entire $82,000 accrued atDecember 31, 2002 for the remaining severance and termination benefitsassociated with the restructuring actions from 2002.  At March 31, 2003, we had fulfilled all our liabilities relatedto severance and other employee related costs associated with all of therestructuring actions noted above.

 

8

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At September 30, 2003, the accrual balance related to the obligationsassociated with all of the excess office space noted above is approximately$1.7 million.  This is comprised ofan estimated $2.4 million for future rents payable by Segue on unoccupiedspace, plus $25,000 in miscellaneous costs related to subleasing the space,less approximately $683,000 of estimated future sublease income.  Upon review, the Company made no materialestimate adjustments related to this accrual for the period ended September 30,2003.

 

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

 

Segue recorded a (refund) provision for foreign and state income taxesof ($16,000) and $108,000 for the three and nine months endedSeptember 30, 2003, respectively, and $48,000 and $123,000 for the sameperiods last year.   During the quarterended September 30, 2003, the Company realized a tax adjustment of about$70,000 in its United Kingdom subsidiary that resulted in a positive impact toearnings.  There was no tax benefitrecorded for losses generated in the U.S. in either period due to theuncertainty of realizing such benefits.

 

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

 

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

 
|                                                                              |   | **Three  months ended September 30,** |   | **Nine  months ended September 30,** |   |
|-----------------------------------------------------------------------------------|--------|---------------------------------------|--------|--------------------------------------|--------|
|                                                                              |   | **2003**                              |   | **2002**                             |   | **2003** |   | **2002** |   |
| Net loss applicable to common shares                                              |   | $                                     | (193   | )                                    | $      | (1,003 | ) | $ | (839 | ) | $ | (5,248 | ) |
| Weighted average common shares used in net  loss per share—basic and diluted |   | 9,745                                 |   | 9,584                                |   | 9,704 |   | 9,543 |   |
| Net loss per common share—basic and diluted                                  |   | $                                     | (0.02  | )                                    | $      | (0.10 | ) | $ | (0.09 | ) | $ | (0.55 | ) |

 

Excluded from the calculation of diluted earnings per share for thethree and nine months ended September 30, 2003 and 2002 were options topurchase 3,490,424 and 3,262,238 shares of common stock, respectively, and773,261 and 688,200 shares of common stock issuable upon the conversion ofPreferred B Stock, respectively, because their inclusion would beanti-dilutive.

 

**9.****                                      COMPREHENSIVELOSS**

 

SFAS No. 130, “Reporting Comprehensive Income” (“SFAS 130”)requires the reporting of comprehensive income in addition to net income fromoperations.  Comprehensive income is amore inclusive reporting methodology that includes disclosure of certainfinancial information that historically has not been recognized in thecalculation of net income.  To date,Segue’s comprehensive income items have consisted exclusively of foreigntranslation adjustments.  The followingtable sets forth the computation of comprehensive loss (in thousands):

 
|                            |   | **Three  months ended September 30,** |    | **Nine  months ended September 30,** |    |
|---------------------------------|--------|---------------------------------------|---------|--------------------------------------|---------|
|                            |   | **2003**                              |    | **2002**                             |    | **2003** |   | **2002** |   |
| Net loss                        |   | $                                     | (114    | )                                    | $       | (945 | ) | $ | (638 | ) | $ | (5,136 | ) |
| Foreign translation adjustments |   | (57                                   | )  | (1                                   | )  | 107 |   | 195 |   |
| Comprehensive loss              |   | $                                     | (171    | )                                    | $       | (946 | ) | $ | (531 | ) | $ | (4,941 | ) |

 

**10.****                               COMMITMENTSAND CONTINGENCIES**

 

In September 2003, the Company paid $29,000 to the landlord of itsDallas office in order to exercise the early termination clause in theCompany’s lease agreement.  By makingthe payment, the Company’s lease on 3,801 square feet will now terminate onJune 30, 2004 as opposed to the original termination date of June 30,2006.  The early termination of thislease will result in over $100,000 in net rent expense reductions through June30, 2006.

 

  In March 2003, Segue amendedthe distribution agreement it had signed in September 2001 with T-Plan Ltd. ofthe United Kingdom.  Under the revisedagreement, Segue will continue to sell and market the T-Plan product that hasbeen modified to integrate with other Segue products, under the name SilkPlanPro; Segue will pay T-Plan Ltd. a royalty for each unit sold.  However, under the revised terms, Segue willno longer pay T-Plan Ltd. a minimum royalty in each quarter.  Effective April 1, 2003, the Company willmake advance royalty payments of $50,000 per quarter each year through the year2005.  These advance royalty paymentswill be credited against the actual royalties due on a cumulative basis untilthe termination of the contract. Advance royalty payments will cease should the cumulative advancepayments exceed actual royalties by more than $100,000 after January 15,2004.  As of September 30, 2003, advancepayments did not exceed actual royalties by more than $100,000.  Either party may cancel the agreement at anytime by giving the other party written notice to that effect at least ninetydays prior to such termination.  In theevent of a termination of the contract, Segue will receive a refund if advanceroyalty payments should exceed actual cumulative royalties.  Other remaining royalty arrangements are notsignificant.

 

In the event of a change of control or the sale of substantially allassets, the Company has certain contractual obligations to

 

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executive officers, as well as, other non-employee related contracts.These potential obligations, should a triggering event take place, are lessthan $2.0 million.

 

Various claims, charges and litigation have been asserted or commencedagainst Segue arising from or related to contractual or employee relations.Management does not believe these claims will have a material adverse effect onthe financial position or results of operations of Segue.

 

As of September 30, 2003, Segue had approximately $2.4 million in netstockholders’ equity, which is below the NASDAQ’s minimum requirement of $2.5million necessary to maintain our continued listing on the NASDAQ Small CapExchange.  On October 21, 2003, theCompany completed a $500,000 preferred stock investment, which enabled theCompany to comply with the NASDAQ continued listing requirements.

 

In 2002, Segue signed an expanded contract with IBM Corporation underwhich Segue was the exclusive external provider of software for IBM GlobalInfrastructure and Systems Management Services’ (IGSSMS) new remoteinfrastructure analysis offering. *** ***Inthe first quarter of 2003, IBM’s IGSSMS advised Segue that it would no longerbe offering the remote monitoring service, which was powered by Segue’sSilkVision software.  The Company hadinvested $1.0 million to accelerate the implementation of this service.  In September of 2003, Segue received$175,000 from IBM as a proposed termination fee for the contract.   The $175,000 was included as an accruedexpense on the Company’s balance sheet at September 30, 2003 until the offercould be reviewed further.   In October2003, after reviewing the offer, Segue signed and accepted the terms of thecontract cancellation.  Under the termsof the agreement, Segue will keep the $175,000 and both parties are released ofany further obligations under the contract. The $175,000 will be recognized as a favorable adjustment to “vendorconsideration to a customer” in the fourth quarter of 2003.

 

**11.****                               SEGMENTREPORTING**

 

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

 
|                                    |   | **Three  months ended September 30,** |   | **Nine  months ended September 30,** |   |
|-----------------------------------------|--------|---------------------------------------|--------|--------------------------------------|--------|
|                                    |   | **2003**                              |   | **2002**                             |   | **2003** |   | **2002** |   |
|                                    |   | **Revenue**                           |   | **Gross  Margin**                    |   | **Revenue** |   | **Gross  Margin** |   | **Revenue** |   | **Gross  Margin** |   | **Revenue** |   | **Gross  Margin** |   |
|                                    |   |                                  |   |                                 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Software licenses                       |   | $                                     | 3,003  |                                 | $      | 2,894 |   | $ | 3,754 |   | $ | 3,561 |   | $ | 9,516 |   | $ | 9,232 |   | $ | 9,583 |   | $ | 8,987 |   |
|                                    |   |                                  |   |                                 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Training and consulting                 |   | 478                                   |   | (117                                 | )      | 761 |   | 194 |   | 2,018 |   | 227 |   | 3,113 |   | 1,136 |   |
| Maintenance                             |   | 3,577                                 |   | 2,916                                |   | 3,255 |   | 2,515 |   | 10,263 |   | 8,270 |   | 9,976 |   | 7,938 |   |
|                                    |   |                                  |   |                                 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total services                          |   | 4,055                                 |   | 2,799                                |   | 4,016 |   | 2,709 |   | 12,281 |   | 8,497 |   | 13,089 |   | 9,074 |   |
|                                    |   |                                  |   |                                 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Less vendor consideration to a customer |   | (41                                   | )      | (41                                  | )      | (7 | ) | (7 | ) | (136 | ) | (136 | ) | (1,032 | ) | (1,032 | ) |
|                                    |   |                                  |   |                                 |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total                                   |   | $                                     | 7,017  |                                 | $      | 5,652 |   | $ | 7,763 |   | $ | 6,263 |   | $ | 21,661 |   | $ | 17,593 |   | $ | 21,640 |   | $ | 17,029 |   |

 

The following table presents revenue and long-lived asset informationby geographic area as of and for the quarters and nine months ended September30 (in thousands):

 
|          |   | **Total Net Revenue**                 |   |                                 |   |
|---------------|--------|---------------------------------------|--------|--------------------------------------|--------|
|          |   | **Three months ended  September 30,** |   | **Nine months ended  September 30,** |   | **Long Lived Assets  September 30,** |   |
|          |   | **2003**                              |   | **2002**                             |   | **2003** |   | **2002** |   | **2003** |   | **2002** |   |
|          |   |                                  |   |                                 |   |   |   |   |   |   |   |   |   |
| United States |   | $                                     | 5,909  |                                 | $      | 6,430 |   | $ | 17,796 |   | $ | 18,312 |   | $ | 1,866 |   | $ | 2,437 |   |
| Foreign       |   | 1,108                                 |   | 1,333                                |   | 3,865 |   | 3,328 |   | 350 |   | 580 |   |
|          |   | $                                     | 7,017  |                                 | $      | 7,763 |   | $ | 21,661 |   | $ | 21,640 |   | $ | 2,216 |   | $ | 3,017 |   |

 

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**ITEM 2****.  MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**CRITICAL ACCOUNTINGPOLICIES**

 

The preparation of financial statements in accordance with accountingprinciples generally accepted in the U.S. requires that management make anumber of assumptions and estimates that affect the reported amounts of assets,liabilities, revenues and expenses in our consolidated financial statements andaccompanying notes. Management bases its estimates on historical experience andvarious other assumptions believed to be reasonable. Although these estimatesare based on management’s best knowledge of current events and actions that mayimpact the Company in the future, actual results may differ from theseestimates and assumptions.

 

Our critical accounting policies are those that affect our financialstatements materially and involve a significant level of judgment bymanagement:

 

**REVENUERECOGNITION**—TheCompany follows the guidance in Statement of Position (“SOP”) 97-2, “SoftwareRevenue Recognition”, as amended by SOP 98-9, in recognizing revenue onsoftware transactions. SOP 97-2 requires that revenue allocated to softwareproducts, specified upgrades and enhancements is recognized upon delivery ofthe related products, upgrades or enhancements. Revenue allocated by vendorspecific objective evidence (“VSOE”) to post contract customer support(maintenance) is recognized ratably over the term of the support, and revenueallocated by VSOE to service elements (training and consulting) is recognizedas the services are performed. The residual method of revenue recognition isused for multi-element arrangements when the VSOE of the fair value doesnot exist for one of the delivered elements. Under the residual method, thearrangement fee is recognized as follows: (1) the total fair value of theundelivered elements, as indicated by VSOE, is deferred and subsequentlyrecognized in accordance with relevant sections of SOP 97-2 and (2) thedifference between the total arrangement fee and the amount deferred for theundelivered elements is recognized as revenue related to the deliveredelements.

 

The Company recognizes revenuefrom software licenses upon the receipt of a signed purchase order contract;product delivery; assessment that collection is probable; and the other revenuerecognition criteria of SOP 97-2 are met. The Company’s softwareproducts do not require significant modification or customization.

 

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

 

With respect to the determination of VSOE formulti-element arrangements, the Company follows the guidance within paragraph10 of SOP 97-2.  The Company uses theresidual method of revenue recognition as provided for in paragraph 12 of SOP97-2, as amended by SOP 98-9.  TheCompany does a thorough review of the VSOE for maintenance, training andconsulting semi-annually.  In allinstances the VSOE is defined as the objective, verifiable price when the sameitem is sold separately.  The Companydetermines VSOE for post-contract support (maintenance) using a consistentpercentage of list price method for product categories which approximates themaintenance renewal rates and is considered to be substantive.  The Company determines the VSOE for trainingclasses and consulting services using objective verifiable evidence of theseitems when sold separately.

 

 

**BADDEBT RESERVE**—On a quarterly basis, Segue reviews itsaccounts receivable aging to determine which accounts appear to beuncollectible and records an appropriate reserve. This determination is basedon a complete review of all accounts greater than 60 days old and anestimate of default based upon historical rates for all accounts less than60 days old.

 

**RESTRUCTURINGAND IMPAIRMENT CHARGES**—Another critical accountingpolicy relates to the recording of restructuring losses. Segue followed theguidance prescribed in EITF 94-3, “Liability Recognition for Certain EmployeeTermination Benefits and Other Costs to Exit an Activity (Including CertainCosts Incurred in a Restructuring)”. As such, since April 2001, Segue hasrecorded total restructuring charges of $5.4 million, which includes $3.5million 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.This estimate for the loss on unused space was based on information that wasavailable at that time. Factors that were included were anticipated rentalrates in the local commercial office market and the estimated timeframe inwhich we expected to sublease the space. Segue obtained local real estatemarket data and consulted with its real estate advisor on these factors to helpdetermine an appropriate reserve for potential losses on the unused space.During the fourth quarter of 2002, Segue was able to reach an agreement inprinciple with its landlord to restructure the sublease for our Lexingtonfacility. A formal agreement was consummated on January 24, 2003.  There were no restructuring charges for thethird quarter of 2003.  At September 30,2003, the accrual balance related to the obligations associated with all of theexcess office space in both the Lexington and Los Gatos facilities isapproximately $1.7 million.  Thisis comprised of an estimated $2.4 million for future rents payable bySegue on unoccupied space, plus $25,000 in miscellaneous costs related to subleasingthe space, less approximately $683,000 of estimated future subleaseincome.  Segue is under a restructuredsublease for the Lexington facility until October 2007.  Segue now follows the guidance prescribed inSFAS 146 effective from January 1, 2003, but there have been no significantexit

 

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activities since that date.

 

**GOODWILL-**As required by SFAS No. 142, “Goodwill andOther Intangible Assets”, Segue discontinued the amortization of goodwilleffective January 1, 2002. Goodwill represents the excess of cost over thefair value of the net assets of businesses acquired. Goodwill resulted fromSegue’s acquisition of SQLBench in December 1997 and was being amortizedusing the straight-line method over five years.  During the year ended December 31, 2002, Segue performed aninitial analysis of the transitional fair value of the goodwill andre-evaluated the fair value of the goodwill during the fourth quarter of 2002.The analysis demonstrated that no impairment existed at December 31, 2002and no adjustment was made. Segue will re-evaluate the fair value of thegoodwill during the fourth quarter of 2003. Any future impairment loss that mayoccur would not exceed $1.5 million, which is the net amount of goodwillthat is on the consolidated balance sheet at September 30, 2003.

 

**PREFERRED STOCK DIVIDEND-IN-KIND -**OnMarch 22, 2002, the Company and S-7 Associates LLC, a company managed andowned by the Chairman of Segue’s Board of Directors, Dr. James H. Simons(“S-7 Associates”), signed an agreement under which S-7 Associates purchased666,667 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, the Company received $500,000 from the saleof 166,667 shares of the Company’s Series C Preferred Stock (“Preferred CStock” and, together with the Preferred B Stock, the “Preferred Stock”) to S-7Associates, and Howard Morgan, a Segue Director.  The Preferred B Stock and the Preferred C Stock are senior to thecommon stock as to dividend and liquidation rights and are convertible at theoption of the holder into shares of common stock of Segue at a conversion rateof one share of Preferred Stock for one share of common, subject to adjustmentupon the occurrence of certain transactions. Dividends on the Preferred Stock accrue at 12% per annum and are to bepaid in additional shares of preferred stock or, in certain cases, cash,semiannually on June 30 and December 31. Management has estimated the value of a share of preferred stock to beequal to 140% of the average stock price for the Company’s common stock for theperiod in question.  The Company accruesfor the estimated value of the preferred stock dividend-in-kind on a quarterlybasis.

 

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**RESULTS OF OPERATIONS**

 

The following table sets forth certain unaudited quarterly results ofoperations expressed as a percentage of total revenue for the periodsindicated:

 
|                                    |   | **Percentage  of Revenue for  Three Months Ended September 30,** |    | **Percentage  of Revenue for  Nine Months Ended September 30,** |   |
|-----------------------------------------|--------|------------------------------------------------------------------|---------|-----------------------------------------------------------------|--------|
|                                    |   | **2003**                                                         |    | **2002**                                                        |   | **2003** |   | **2002** |   |
|                                    |   |                                                             |    |                                                            |   |   |   |   |   |
| Revenue:                                |   |                                                             |    |                                                            |   |   |   |   |   |
| Software                                |   | 42.8                                                             | %       | 48.4                                                            | %      | 43.9 | % | 44.3 | % |
| Services                                |   | 57.8                                                             |    | 51.7                                                            |   | 56.7 |   | 60.5 |   |
| Subtotal revenue                        |   | 100.6                                                            |    | 100.1                                                           |   | 100.6 |   | 104.8 |   |
| Less vendor consideration to a customer |   | (0.6                                                             | )       | (0.1                                                            | )      | (0.6 | ) | (4.8 | ) |
| Net revenue                             |   | 100.0                                                            |    | 100.0                                                           |   | 100.0 |   | 100.0 |   |
|                                    |   |                                                             |    |                                                            |   |   |   |   |   |
| Cost of revenue:                        |   |                                                             |    |                                                            |   |   |   |   |   |
| Cost of software                        |   | 1.6                                                              |    | 2.5                                                             |   | 1.3 |   | 2.8 |   |
| Cost of services                        |   | 17.9                                                             |    | 16.8                                                            |   | 17.5 |   | 18.6 |   |
| Total cost of revenue                   |   | 19.5                                                             |    | 19.3                                                            |   | 18.8 |   | 21.4 |   |
|                                    |   |                                                             |    |                                                            |   |   |   |   |   |
| Gross margin                            |   | 80.5                                                             |    | 80.7                                                            |   | 81.2 |   | 78.6 |   |
|                                    |   |                                                             |    |                                                            |   |   |   |   |   |
| Operating expenses:                     |   |                                                             |    |                                                            |   |   |   |   |   |
| Sales and marketing                     |   | 49.3                                                             |    | 50.3                                                            |   | 48.8 |   | 57.1 |   |
| Research and development                |   | 20.2                                                             |    | 19.1                                                            |   | 20.0 |   | 20.1 |   |
| General and administrative              |   | 13.0                                                             |    | 18.5                                                            |   | 15.1 |   | 19.5 |   |
| Restructuring charges                   |   | —                                                           |    | 4.8                                                             |   | — |   | 5.6 |   |
| Total operating expenses                |   | 82.5                                                             |    | 92.7                                                            |   | 83.9 |   | 102.3 |   |
|                                    |   |                                                             |    |                                                            |   |   |   |   |   |
| Loss from operations                    |   | (2.0                                                             | )       | (12.0                                                           | )      | (2.7 | ) | (23.7 | ) |
| Interest Income                         |   | 0.2                                                              |    | 0.4                                                             |   | 0.2 |   | 0.3 |   |
| Loss before provision for income taxes  |   | (1.8                                                             | )       | (11.6                                                           | )      | (2.5 | ) | (23.4 | ) |
| Provision for income taxes              |   | (0.2                                                             | )  | 0.6                                                             |   | 0.5 |   | 0.6 |   |
|                                    |   |                                                             |    |                                                            |   |   |   |   |   |
| Net loss                                |   | (1.6                                                             | )%      | (12.2                                                           | )%     | (3.0 | )% | (24.0 | )% |

 

**SOFTWARE REVENUE**

Software revenue decreased 21% to $3.0 million during the thirdquarter of 2003 from $3.8 million for the same period in 2002. For thenine months ended September 30, 2003, software revenue decreased 1% to $9.5million from $9.6 million for the nine months ended September 30, 2002.  The main factor contributing to the decreasein software revenue for the three months ending September 30, 2003was the closing of several large deals in 2002, which significantly increasedthe average invoice size as compared to 2003. International software revenue accounted for 23%, or $691,000, and 26%,or $2.5 million, of total software revenue for the three and nine months endedSeptember 30, 2003, respectively, as compared to 22%, or $833,000 and 20%, or$2.0 million for the same periods in 2002. The increase in international software revenue on a year to date basis,in absolute dollars, was due to stronger performance by European resellers anddistributors earlier this year.

 

**SERVICES REVENUE**

Services revenue, which consists of training, consulting andmaintenance, increased 2% to $4.1 million during the third quarter of 2003 from$4.0 million in the same quarter of 2002. For the nine months ended September30, 2003, services revenue decreased 6% to $12.3 million, as compared to $13.1million for the nine months ended September 30, 2002.  Refer to Note 11 in our Consolidated Financial Statements inthis Form 10-Q for additional information.

Training and consulting revenue was $478,000 for thethree months ended September 30, 2003 compared to $761,000 for the three monthsended September 30, 2002, a decrease of 37%. Training and consulting revenue was $2.0 million for the nine monthsended September 30, 2003 compared to $3.1 million for the nine months endedSeptember 30, 2002, a decrease of 35%. The decrease in training and consulting revenue in 2003, as compared tothe same prior-year periods, is primarily attributable to the continueddifficult economic conditions in 2003, which caused a decrease in bookings anddelivery of training and consulting engagements.  Additionally, we continue to see an increase in customers usingon-line training, which allows them to realize the full value of training whilekeeping expenses to a minimum.

 

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Recognized maintenance revenue was $3.6 million for the three monthsended September 30, 2003 compared to $3.3 million for the three months endedSeptember 30, 2002, an increase of 10%. The increase in recognized maintenance revenue was primarily attributedto a continued higher renewal rate in the period as compared to 2002.Recognized maintenance revenue was $10.3 million for the nine months endedSeptember 30, 2003 compared to $10.0 million for the nine months endedSeptember 30, 2002, an increase of 3%. The increase in recognized maintenance revenue was primarily attributedto a continued higher renewal rate in the period as compared to 2002.

 

**VENDOR CONSIDERATIONTO A CUSTOMER**

Inthe three and nine months ended September 30, 2003, the Company made paymentsof approximately $41,000 and $136,000 to several resellers for referral fees,as compared to $7,000 and $1.0 million in the same period of 2002.  Under EITF Issue No. 01-9, these paymentswere considered to be a reduction in revenue and are presented in the statementof operations as such.  In January 2002,the Company made a one-time payment of $1.0 million to IBM.  There were no other material payments madeby the Company in the third quarter of 2003 or prior quarters that would beconsidered for reclassification under the guidance inEITF Issue No. 01-9.

 

**COST OF SOFTWARE**

Cost ofsoftware decreased 44% to $109,000 during the third quarter of 2003, or 4% ofsoftware revenue, compared to $193,000 in the third quarter of 2002, or 5% ofsoftware revenue. This decrease was primarily attributed to a decrease inroyalty expense.  For the nine monthsended September 30, 2003, cost of software decreased 52% to $284,000,or 3% of software revenue, from $596,000 in the same period of 2002, or 6% ofsoftware revenue.  This decreasein cost of software was mainly attributed to a decrease of $109,000 in royaltyexpense, lower personnel related expense of $64,000 and lower facility relatedexpenses of $50,000 as a result of the restructuring actions in 2002.

 

**COST OF SERVICES**

Cost of services consists primarily of costs of providing customertechnical support, training and consulting. Cost of services for the three months ending September 30, 2003 remainedrelatively unchanged at $1.3 million as compared to the same period in2002.  For the nine months endedSeptember 30, 2003, cost of services decreased 5% to $3.8 million from $4.0million in the nine months ending September 30, 2002.  As a percentage of service revenue, cost of services was at 31%for both the three months and nine months ending September 30, 2003, ascompared to 33% and 31% in the same periods in 2002.  Cost of services as a percentage of services revenue may varybased on the profitability of individual consulting engagements and theutilization rate of in-house consultants.

For the third quarter of 2003, cost of training and consultingincreased 5% to $595,000 from $567,000 for the same quarter of 2002. For thenine months ended September 30, 2003, cost of training and consulting decreased10% to $1.8 million as compared to $2.0 million for the correspondingprior-year period. The decrease is primarily attributable to a decrease inoutsourced consulting expense of $94,000 and a decrease in facility relatedcost of $126,000 as a result of the restructuring actions in 2002.

For the three months ended September 30, 2003, cost of maintenancedecreased 11% to $661,000 from $740,000 for the same period in 2002.  The decrease in cost of maintenance isprimarily attributed to facility related costs, which represent furthershifting of support responsibilities to the global technical support center inNorthern Ireland, where operating expenses are generally lower.  For the nine months of 2003, cost ofmaintenance remained relatively unchanged at $2.0 million from the same periodin 2002.

 

# **SALES AND MARKETING**

Sales and marketing expenses decreased 10% to $3.5 million duringthe third quarter of 2003 from $3.9 million in the third quarter of2002.  The decrease in sales andmarketing expense was primarily attributable to a decrease in personnel relatedcosts of $454,000 due to a reduced number of employees and lower commissionsearned on lower revenue, and a decrease in travel expense of $49,000, partiallyoffset by an increase in marketing programs of $91,000.  For the nine months ended September 30,2003, sales and marketing expenses decreased 15% to $10.6 million from $12.4million in the corresponding prior-year period.  The main reasons for the decrease are attributed to a decrease intravel expense of $248,000 and a decrease in both personnel related cost of$1.2 million and facility related cost of $497,000 associated with therestructuring actions in 2002. These decreases in sales and marketing expenseswere offset by an increase in legal cost of $88,000 and an increase inmarketing programs of $51,000.

 

**RESEARCH ANDDEVELOPMENT**

Research and development expenses decreased 7% to $1.4 million duringthe third quarter of 2003 from $1.5 million in the same quarter of 2002.  The decrease in research and developmentexpenses were attributed to a decrease in personnel related costs and facilityrelated costs associated with the restructuring actions in 2002 of $97,000 and$52,000, respectively.  These decreaseswere partially offset by the increase of $100,000 in exchange rate translationin the European market of our foreign research and development operations. Forthe nine months ended September 30, 2003, research and development expensesremained relatively unchanged at $4.3 million compared to the same period in2002.

 

**GENERAL ANDADMINISTRATIVE**

General and administrative expenses decreased 35% to $912,000 duringthe third quarter of 2003 as compared to $1.4 million in the same period in2002.  The decrease was attributable tolower personnel related costs of $89,000, lower legal expenses of $349,000 due to the settlement ofseveral employment issues and the completed sub-lease negotiations, and reducedforeign currency

 

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transaction expense of $70,000. For the nine months ended September 30, 2003, general and administrativeexpenses decreased 21% to $3.3 million from $4.2 million in the first nine months of 2002.  The decrease in expenses for the nine monthsending September 30, 2003 are attributable to the lower personnel relatedexpenses of $373,000 due to reduced headcount, lower legal expense of $459,000due to the settlement of several employment issues and completed sub-leasenegotiations in 2002, lower facility related expenses of $354,000 due torestructuring of excess office space in 2002 and a reduction in foreigncurrency transaction expense of $85,000. The overall decrease in general and administrative expense was partiallyoffset by an increase of $221,000 in bad debt and an $174,000 in recruitmentcharges incurred relating to the CEO search.

 

**RESTRUCTURING CHARGES**

For the three and nine months ended September 30, 2003, there were norestructuring charges recorded.  Duringthe third quarter of 2002, Segue recorded as restructuring charges $373,000 foran increase in the estimate of the loss associated with excess officefacilities. For the nine months ended September 30, 2002, the Company recordedrestructuring charges of $1.2 million, which included $559,000 for a reductionin workforce of approximately 5% and approximately $644,000 forfacility-related costs, which included the accrual of estimated leaseobligations associated with the excess office facilities in our Lexingtonoffice, net of anticipated subleasing income.

 

**OTHER INCOME, NET**

Other income, net decreased 65% to $11,000 during the third quarter of2003 from $31,000 in the same quarter of 2002. For the nine months ended September 30, 2003, net other income decreased49% to $38,000 from $74,000 in the same period last year.  Other income consists mainly of interestincome on cash equivalents and short-term investments.  The decrease in interest income wasprimarily due to lower balances of cash equivalents and short-term investmentsin 2003 in comparison to the same period in 2002, and lower interest rates onthose investments.

 

**PROVISION FOR INCOMETAXES**

We recorded a provision (refund) for foreign and state income taxes of($16,000) and $108,000 for the three and nine months ended September 30, 2003,respectively, as compared to $48,000 and $123,000 for the same periods in 2002.  During the quarter ended September 30, 2003,the Company realized a tax adjustment of about $70,000 in its United Kingdomsubsidiary that resulted in a positive impact to earnings. There was no taxbenefit recorded for losses generated in the U. S. in any period due to theuncertainty of realizing such benefits.

 

**LIQUIDITY AND CAPITALRESOURCES**

As of September 30, 2003, our principal sources of liquidity includedcash and cash equivalents totaling $6.2 million, as compared to$5.3 million as of December 31, 2002.

 

Our operating activities generated cash of $490,000 during the firstnine months of 2003 compared to $4.4 million cash utilized in the same periodin 2002.  Cash generated from operatingactivities in 2003 resulted from our net loss, adjusted for depreciation offixed assets, as well as increases in other current assets, offset by decreasesin accounts receivable, accounts payable, accrued expenses and deferredrevenue.

 

Our investingactivities generated cash of $155,000 and $4.7 million in the first nine monthsof 2003 and 2002, respectively.  Cashgenerated in 2003 came from a decrease in other assets partially offset bypurchases in property and equipment, as compared to 2002, which primarily camefrom maturing short-term investments. We continued to keep purchases of property and equipment low during thequarter.  In the future, Segue may needto make increased expenditures on property and equipment as present equipmentages.

 

We generated funds from financing activities of $190,000 during thefirst nine months of 2003, as compared to $2.2 million during the same periodin 2002.  Cash generated from financingactivities in 2003 was primarily generated from the sale of stock under theemployee stock purchase plan, while the first nine months of 2002 also included$2.0 million from the issuance of convertible preferred stock.

 

We have historically had annual losses. This, accompanied by thecontinued economic downturn in 2003 and the slowdown of Information Technologycapital spending, has resulted in lower sales volume, which has required Segueto continue utilizing significant amounts of cash and cash equivalents to fundoperations.

 

However, the effects of the steps taken by management havesignificantly reduced the Company’s future expected cash outflow. Furthermore,on January 24, 2003, the Company received approval to restructure itscorporate headquarters sublease by returning approximately 33,000 square feetin its Lexington facility to the landlord. Pursuant to the terms of the restructuring Segue has posted an initialletter of credit for $700,000. The cash security of $770,000 (letter of creditplus 10%) that was posted is classified as restricted cash and is reflected inOther Assets on the Company’s balance sheet. This required letter of creditwill reduce over time, by formula, to zero by August 2005.

 

Long-term cash requirements, other than for normal operating expensesand those described previously, are anticipated for

 

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the development of new software products and enhancements of existingproducts, and for the possible acquisition of software products or technologiescomplementary to our business.

 

We have reduced our workforce and overhead expenses as described aboveand curtailed capital spending and other uses of cash. But, in order to achieveand sustain profitability and to continue positive cash flow from operations,the Company must increase revenue from the current level.

 

Assuming that the Company can execute on current plans to increaserevenue through its restructured sales program, its focus on enterprisecustomers, and its introduction and success of new and enhanced products, andthe business climate for IT spending does not worsen, we believe that with thefunding described above, plus current cash and cash equivalents, Segue willhave sufficient resources to meet its working capital and debt requirements forat least the next twelve months. However, if we are not able to increasecurrent business levels or the economy worsens, we may need to take otheractions in order to fund our working capital requirements.

 

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

 

On October 21, 2003, subsequent to September 30, 2003, the Companycompleted a preferred stock offering of 166,667 shares of Preferred C Stock toS-7 Associates and Howard Morgan and received $500,000 as proceed from suchoffering.

 

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

 

**FACTORS THAT MAYAFFECT FUTURE RESULTS**

 

The Company’s business is subject to many uncertainties and risks. ThisForm 10-Q also contains certain forward-looking statements within themeaning of the Private Securities Reform Act of 1995. The Company’s futureresults may differ materially from its current results and actual results coulddiffer materially from those projected in the forward looking statements as aresult of certain risk factors, including but not limited to those set forthbelow, other one-time events and other important factors disclosed previouslyand from time to time in Segue’s other filings with the SEC.

 

***Our quarterlyresults may fluctuate.***  Segue’s quarterly revenue and operating results are difficult topredict and may fluctuate significantly from quarter to quarter. If ourquarterly revenue or operating results fall below the expectations of investorsor public market analysts, the price of our common stock could fallsubstantially. Our quarterly revenue may fluctuate significantly for severalreasons, including: the timing and success of introductions of our new productsor product enhancements or those of our competitors; decline of the generalbusiness climate, including uncertainty of IT spending; competition andpricing; customer order deferrals or reductions in the size of individualorders as a result of general business conditions; ability to increase salesfrom enterprise companies; and general economic conditions.  Substantial portions of Segue’s operatingexpenses are related to personnel, facilities and marketing and sales programs.The level of spending for such expenses can not be adjusted quickly and isbased, in significant part, on our expectations of future revenues. If actualrevenue levels are below management’s expectations, results of operations arelikely to be adversely affected. Furthermore, Segue has often recognized asubstantial portion of its product revenues in the last month of a quarter,with these revenues frequently concentrated in the last weeks or days of aquarter. As a result, product revenues in any quarter are substantiallydependent on orders booked and shipped in the latter part of that quarter andrevenues from any future quarter are not predictable with any significantdegree of accuracy. Segue typically does not experience order backlog. Forthese reasons, Segue believes that quarter-to-quarter comparisons of itsresults of operations are not necessarily meaningful and should not be reliedupon as indications of future performance.

 

***We may not beprofitable in the future.***  Since Segue began operations, it hasgenerally experienced losses. Losses have resulted in an accumulated deficit ofapproximately $57.9 million as of September 30, 2003. In the fourthquarter of 2002, Segue reported net income of $857,000, but in the firstquarter of 2003 the Company reported a net loss of $71,000, in the secondquarter of 2003, Segue reported a net loss of $453,000, and in the thirdquarter of 2003, Segue reported a net loss of $114,000.  It is uncertain whether the Company canreturn to profitability in the future. For the period ended September 30, 2003,the Company had total revenue of $7.0 million versus $7.8 million in the sameperiod last year.  During 2001 and 2002,Segue initiated aggressive cost saving measures in an effort to reduceexpenses, enhance the possibility of profitability, and conserve cash, and theCompany has sustained these measures through the third quarter of 2003. Despitethese cost saving measures, the Company’s future profitability remainsuncertain because of, among other items, the uncertainty of our revenue from quarterto quarter. Failure to achieve profitability may adversely affect the marketprice of Segue’s common stock.

 

***Business conditionsand Information Technology (IT) spending could cause further decline inrevenue.*** The level of future IT spending remains very uncertain particularly inlight of the decline in the business climate throughout 2002 and through 2003.If IT spending does not increase, Segue’s revenues could be further adverselyimpacted.

 

***Segue may not derivesubstantial incremental revenue from its alliances and SilkElite PartnerProgram.*** In an effort to augment product revenue derived from the efforts of itsdirect sales force, Segue has focused on expanding its key strategic alliancesand on building a successful SilkElite Partner Program. Segue has builtalliances with PeopleSoft, Allen Systems Group, Microsoft and IBM.

 

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The SilkElite Partners Program focuses on resellers, consultingpartners and distributors. SilkElite Partners both resell Segue products anduse Segue software products in the delivery of consulting services. The successof the key strategic alliances and the SilkElite Program is uncertain, facesstrong competition, and takes time and significant resources to develop. ShouldSegue fail to generate substantial incremental revenue from its strategicalliances or its SilkElite Program, the Company’s financial results and stockprice could be adversely affected.

 

***The effect of thechange in the IBM relationship is uncertain.*** In 2002, Segue signed an expanded contractwith IBM Corporation under which Segue was the exclusive external provider ofsoftware for IBM Global Infrastructure and Systems Management Services’(IGSSMS) new remote infrastructure analysis offering. *** ***In the first quarter of 2003, IBM’s IGSSMS advisedSegue that it would no longer be offering the remote monitoring service, whichwas powered by Segue’s SilkVision software. The Company had invested $1.0 million to accelerate the implementationof this service.  In October 2003, Seguenegotiated the termination of this portion of the IBM contract and the returnof $175,000 of the investment not spent by IBM in the deployment of thisservice.  In addition, in the secondquarter of 2003, IBM Tivoli advised Segue of the cancellation of the royaltycontract signed by both companies in September of 2002.  Tivoli was expected to integrate Segue’sSilkTest software into a larger Tivoli product suite, and Segue was to havereceived a royalty each time Tivoli sold its product suite.  IBM acquired Rational Software in February2003 and accordingly, IBM Tivoli has decided to use a Rational Software testingtool in place of Segue’s tool.  Seguehad the potential to receive up to $2.5 million in royalties over the nextseveral years.  The impact of theseevents on the remaining IBM relationship and future revenue is uncertain.

 

***Our future successwill depend on our ability to respond rapidly and effectively to technologicaland other market changes, including the successful introduction of new andenhanced products.***  The nature of the automated software testing, performancemanagement and application monitoring markets in which we compete ischaracterized by rapidly changing technology, rapidly evolving customer needsand desires, changes in industry standards and practices and frequent releasesof new product or enhancements by competitors. To be competitive, Segue mustdevelop and introduce product enhancements and new products that address theincreasingly sophisticated and varied needs of our existing and potentialcustomers. For the first nine months of 2003, over 90% of Segue’s productrevenues were generated from its SilkPerformer and SilkTest products comparedto over 96% in same period last year. During the quarter ended September 30, 2003, Segue released SilkVision2.5, the newest version of its powerful Web-based enterprise monitoringsoftware, and SilkPerformer 6.0, the newest version of its enterprise-classload and stress-testing tool.  TheCompany anticipates releasing further product enhancements in the fourthquarter of 2003.  If these new productsare not successful or if we fail to continue to develop and introduce newproducts and enhancements on a timely basis, or maintain our level of productrevenue from SilkPerformer and SilkTest, or fail to generate substantialincremental revenue from our new products, our business may be materiallyadversely affected.

 

***We may faceliquidity issues.*** We have taken steps to conserve our use of cash, including significantlyreducing headcount, infrastructure and other expenses, and limiting capitalexpenditures in order to compensate in part for our recent decline in revenues,to improve our liquidity and to achieve greater efficiencies. Segue believesthat based on expense savings and the stability of its revenue in the lastyear, that future sales at or above current levels should be sufficient toallow us to continue as a viable business. For the nine months ended September30, 2003, the Company generated $852,000 in positive cash flow and hasexperienced four consecutive quarters of positive growth in its cash balance.Total net revenue of $21.6 million for the first nine months of 2003 wasessentially the same as the first nine months of 2002.  If the Company fails to maintain or growrevenue levels we may have to raise additional financing to fund workingcapital needs. If we fail to generate substantial incremental revenue, or weare not successful in raising additional financing on terms acceptable toSegue, we may not have sufficient working capital resources and our businessmay be materially adversely affected.

 

***The Company’s newmanagement structure could adversely impact its business.***  In the second quarter of 2003, the Company’sChief Executive Officer resigned, and in the third quarter, the Company hired areplacement Chief Executive Officer. The effect of this new managementstructure on the Company’s business and employees is uncertain.

 

***We cannot assure aliquid market for our stock.***  In 2002, Segue was informed by NASDAQ thatthe company was not in compliance with certain listing requirements forcontinued listing on their National Market exchange.  Segue was able to take steps to meet the initial listingrequirements of the NASDAQ Small Cap Market Exchange.  As of September 30, 2003, Segue had slightly less than $2.4million in net stockholders’ equity, which is below the NASDAQ’s minimumrequirement of $2.5 million necessary to maintain our continued listing on theNASDAQ Small Cap Exchange.  On October21, 2003, the Company completed a preferred stock offering and received$500,000 from the sale of 166,667 shares of Preferred C Stock to S-7Associates, and Howard Morgan, a Segue Director.  As a result of this transaction and the pro-forma balance sheetthat was filed with the SEC on Form 8-K on October 22, 2003, NASDAQ notifiedthe Company that it was once again in compliance with the minimum requirementof $2.5 million in net stockholders’ equity necessary to maintain our listingon the NASDAQ Small Cap Exchange.  Continuedcompliance with the listing requirements of the NASDAQ Small Cap MarketExchange, and thus a liquid market for our common stock, are closely related tothe financial performance of the Company. The Company’s future business may notbe sufficient to assure continued listing on the NASDAQ Small Cap MarketExchange.

 

***We may havedifficulty operating the business efficiently with fewer resources.***  Since 2000, Segue has reduced headcount by

 

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approximately 50% and implemented several cost reduction initiatives,including reduced marketing and sales expenses. Segue was able to achieveincreased productivity with fewer resources. Segue’s ability to furtherincrease its current productivity, as well as sustain current performance withfewer resources, is uncertain.

 

***Segue facessignificant competition from other software companies.***  The market for web-based software qualitymanagement and testing and monitoring tools is intensely competitive andsubject to rapid technological change. We expect competition to intensify evenfurther in the future. Segue currently encounters competition from a number ofpublic and private companies, including Mercury Interactive Corporation,Rational Software Corporation (now part of IBM), Compuware Corporation andEmpirix. Many of our current and potential competitors have longer operatinghistories, greater name recognition, larger installed customer bases, andsignificantly greater financial, technical and marketing resources than we do.Therefore, they may be able to respond more quickly to new or changingopportunities, technologies, standards or customer requirements or may be ableto devote greater resources to the promotion and sale of their products than wecan. An increase in competition could result in price reductions and loss ofmarket share. Such competition and any resulting reduction in profitabilitycould have a material adverse effect on our business, operating results andfinancial condition.

 

***Segue’s businesscould be adversely affected if its products contain errors.***  Software products as complex as ours maycontain undetected errors or “bugs” which result in product failures. Theoccurrence of errors could result in loss of or delay in revenue, loss ofmarket share, failure to achieve market acceptance, diversion of developmentresources, significant repair and replacement costs, injury to our reputation,or damage to our efforts to build brand awareness, any of which could have amaterial adverse effect on our business, operating results and financialcondition.

 

***We must hire andretain skilled personnel in a difficult economic environment.***  Qualified personnel remain in demandthroughout the software industry. Our success depends in large part upon ourability to attract, train, motivate and retain highly skilled employees,particularly sales and marketing personnel, software engineers and other seniorpersonnel. The failure to attract and retain the highly skilled personnel thatare integral to our direct sales, product development, service and supportteams may limit the rate at which we can generate sales and develop newproducts or product enhancements. Our ability to retain our qualified staff maybe further impacted by our financial results during 2003. All of this couldhave a material adverse effect on our business, operating results and financialcondition.

 

***We face many risksassociated with international business activities.***  We derived approximately 18% of totalrevenue from international customers in the first nine months of 2003, comparedto 15% in the first nine months of 2002. The international market for software products is highly competitive andwe expect to face substantial competition in this market from established andemerging companies. Segue faces many risks associated with internationalbusiness activities including currency fluctuations, imposition of governmentcontrols, export license requirements, restrictions on the export of criticaltechnology, political and economic instability, tailoring of products to localrequirements, trade restrictions, changes in tariffs and taxes, difficulties instaffing and managing international operations, longer accounts receivablepayment cycles and the burdens of complying with a wide variety of foreign lawsand regulations. Continued growth of international sales is important to growthand the stability of Segue. To the extent we are unable to continue to expandinternational sales in a timely and cost-effective manner, our business couldbe materially adversely affected.

 

***Segue’s successdepends on our ability to protect our software and other proprietarytechnology.*** The unauthorized reproduction or othermisappropriation of our proprietary technology could enable third parties tobenefit from Segue’s technology without paying us for it. This could have amaterial adverse effect on our business, operating results and financialcondition. 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 toprotect our proprietary rights in our products. Currently, we have three issuedpatents and four are pending. There can be no assurance that these patentswould be upheld if challenged. Moreover, the laws of other countries in whichwe market our products may afford little or no effective protection of ourintellectual property. If we were to discover that any of Segue’s productsviolated third party proprietary rights, there can be no assurance that wewould be able to obtain licenses on commercially reasonable terms to continuelicensing our software without substantial reengineering or that any effort toundertake such reengineering would be successful. Any claim of infringementcould cause Segue to incur substantial costs defending against the claim, evenif the claim is invalid, and could distract management resources from ourbusiness. Furthermore, a party making such a claim could secure a judgment thatrequires us to pay substantial damages or result in an injunction. Any of theseevents could have a material adverse effect on our business, operating resultsand financial condition.

 

**ITEM 3****.  QUANTITATIVE AND QUALITATIVE DISCLOSURESABOUT MARKET RISK**

 

The following discussion about our market risk disclosures involvesforward-looking statements. Actual results could differ materially from thosediscussed in the forward-looking statements. We are exposed to market riskrelated to changes in interest rates and foreign currency exchange rates. We donot use derivative financial instruments for speculative or trading purposes.

 

*INTEREST RATE RISK.*  Segue is exposed to market risk from changes in interest ratesprimarily through its investing and borrowing activities. In addition, ourability to finance future transactions may be impacted if we are unable toobtain appropriate

 

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financing at acceptable rates. Our investing strategy to manageinterest rate exposure is to invest in short-term, highly secured and liquidinvestments. We maintain a portfolio of highly liquid cash equivalents andsometimes short-term investments (primarily in high-grade commercialpaper).  As of September 30, 2003, wehad no short-term investments, only cash and cash equivalents.

 

*FOREIGN CURRENCY RISK.*  Segue faces exposure to movements in foreigncurrency exchange rates. These exposures may change over time as businesspractices evolve and could have a material adverse effect on our business,financial condition and results of operations. We do not use derivativefinancial instruments or other financial instruments to hedge economicexposures or for trading. Historically, our primary currency exposures havebeen related to the operations of our foreign subsidiaries. For the three monthperiod ended September 30, 2003, we incurred a transaction and re-measurementgain of approximately $70,000 compared to an expense of approximately $1,000for the period ended September 30, 2002. For the nine months ended September 30, 2003, the Company incurred atransaction and re-measurement expense of approximately $81,000 versus anexpense of approximately $166,000 in the same period last year.  As of September 30, 2003, the cumulativetranslation of foreign currency changes recorded in stockholders’ equity was$205,000.

 

 

# **ITEM 4**. CONTROLS AND PROCEDURES

 

**Evaluationof Disclosure Controls and Procedures**

 

As required by new Rule 13a-15 under the Securities Exchange Actof 1934, as of September 30, 2003 we carried out an evaluation under thesupervision and with the participation of our management, including our ChiefExecutive Officer and Chief Financial Officer, of the effectiveness of thedesign and operation of our disclosure controls and procedures. In designingand evaluating our disclosure controls and procedures, we and our managementrecognize that any controls and procedures, no matter how well designed andoperated, can provide only reasonable assurance of achieving the desiredcontrol objectives, and our management necessarily was required to apply itsjudgment in evaluating and implementing possible controls and procedures. Basedupon that evaluation, our Chief Executive Officer and Chief Financial Officerconcluded that, as of the date of completion of the evaluation, our disclosurecontrols and procedures were reasonably effective to ensure that informationrequired to be disclosed by us in the reports we file or submit under theExchange Act is recorded, processed, summarized and reported, within the timeperiods specified in the Securities and Exchange Commission’s rules and forms.In connection with the new rules, we will continue to review and document ourdisclosure controls and procedures, including our internal controls and proceduresfor financial reporting, on an ongoing basis, and may from time to time makechanges aimed at enhancing their effectiveness and to ensure that our systemsevolve with our business. 

 

### **Changesin Internal Controls over Financial Reporting**

 

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

### ** **

### **PART II**. OTHER INFORMATION

 

**ITEM 1****. LEGALPROCEEDINGS**

 

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

 

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

 

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

 

 

**ITEM 5****. OTHERINFORMATION**

 

On May 5, 2003, the Company announced thatStephen B. Butler resigned as chief executive officer, president and directorto take a position with a private company in the electronic design automationmarket.  The Company initiated a searchprocess for a new chief executive officer and hired an executive search firm toassist in the process.  Until asuccessor chief executive officer was named, the board of directors electedSamuel J. Gallo, senior vice president and general counsel, and DouglasZaccaro, senior vice president, chief financial officer, and treasurer asacting co-chief executive officers.  Mr.Butler did not stand for re-election to the Board at the Company’s June 6,2003, annual meeting.

 

On September 3, 2003, the Company announcedthat Joseph K. Krivickas was appointed chief executive officer, president anddirector to lead the Company through. Mr. Gallo and Mr. Zaccaro both

 

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relinquished the title of acting co-chiefexecutive officer. Mr. Gallo reassumed the position of senior vice presidentand general counsel and Mr. Zaccaro reassumed the position of senior vicepresident, chief financial officer and treasurer.

 

On October 21, 2003, subsequent to September 30 2003, the Companycompleted a preferred stock offering of 166,667 shares of Preferred C Stock toS-7 Associates and Howard Morgan and received $500,000 as proceed from such offering.

 

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

 

(a)  Exhibits

 

The following documents are filed as Exhibits to this report:

 
|   3.4 | Certificate of Designation of Series C Preferred Stock.                                                                                              |
|-----------------|------------------------------------------------------------------------------------------------------------------------------------------------------|
|            |                                                                                                                                                 |
| 10.25           | Series C Preferred Stock Purchase Agreement, dated October 21, 2003,  by and among the registrant, S-7 Associates, LLC, and Howard Morgan.           |
|            |                                                                                                                                                 |
| 10.26           | Registration Rights Agreement, dated October 21, 2003, by and among  the registrant, S-7 Associates, LLC, and Howard Morgan.                         |
|            |                                                                                                                                                 |
| 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 July 23, 2003 regarding a press releaseannouncing that Segue Software had reported its financial results for the firstquarter and six months ended June 30, 2003.

 

 

### **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 theundersigned thereunto duly authorized.

 

Date: November 13, 2003.

 
|   | **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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