##### Table of Contents









UNITED STATES

SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549




---

FORM 10-Q

|                                                 |  |                                                                                             
|------------------------------------------------ |  | --------------------------------------------------------------------------------------------
|(Mark One)                                       |  |                                                                                             
|x                                                |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR
    15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 
|                                                
|For the Quarterly Period Ended June 30,
    2004
|                                                
|o                                                |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR
    15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

For the transition period
from                      to

Commission file number 0-27794



---

SEGUE SOFTWARE, INC.

(Exact name of registrant as specified in its
charter)


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

201 Spring Street, Lexington, MA
02421

(Address of principal executive
offices)


Registrants telephone number, including
area code: (781) 402-1000



---

Indicate by check mark whether the registrant:(1) has filed all reports
required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding
12 months (or for such a shorter period that the registrant
was required to file such reports) and (2) has been subject
to such filing requirements for the past
90 days.     Yes x     No o

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

The number of shares of Registrants Common
Stock outstanding as of August 2, 2004 was 9,930,423.



---






---










SEGUE SOFTWARE, INC.

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED JUNE 30,
2004

INDEX

|                                            |  |                                                                                                                              |  |      |    | 
|------------------------------------------- |  | ---------------------------------------------------------------------------------------------------------------------------- |  | ---- | -- | 
|                                            |  |                                                                                                                              |  | Page
|                                            |  |                                                                                                                              |  |     
|                                            |  | PART
    I.  FINANCIAL INFORMATION                                                                                           |  |      |    | 
|Item 1                                      |  | Condensed Consolidated
    Financial Statements:                                                                             |  |      | 3  | 
|                                            |  | Condensed Consolidated
    Balance Sheets (unaudited) June 30, 2004 and
    December 31, 2003                                |  |      | 3  | 
|                                            |  | Condensed Consolidated
    Statements of Operations (unaudited) Three Months and Six
    Months Ended June 30, 2004 and 2003 |  |      | 4  | 
|                                            |  | Condensed Consolidated
    Statements of Cash Flows (unaudited) Six Months Ended
    June 30, 2004 and 2003                  |  |      | 5  | 
|                                            |  | Notes to Condensed
    Consolidated Financial Statements (unaudited)                                                         |  |      | 6  | 
|Item 2                                      |  | Managements Discussion
    and Analysis of Financial Condition and Results of Operations                                    |  |      | 15 | 
|Item 3                                      |  | Quantitative and Qualitative
    Disclosures about Market Risk                                                               |  |      | 27 | 
|Item 4                                      |  | Controls and Procedures                                                                                                      |  |      | 27 | 
|                                            |  | PART II.  OTHER
    INFORMATION                                                                                              |  |      |    | 
|Item 1                                      |  | Legal Proceedings                                                                                                            |  |      | 28 | 
|Item 4                                      |  | Submission of Matters to a
    Vote of Security Holders                                                                      |  |      | 28 | 
|Item 5                                      |  | Other Information                                                                                                            |  |      | 29 | 
|Item 6                                      |  | Exhibits and Reports on
    Form 8-K                                                                                         |  |      | 29 | 
|                                            |  | Signatures                                                                                                                   |  |      | 30 | 
|                                            |  | Certifications                                                                                                               |  |      |    | 
|EX-31.1 SECTION 302 CERTIFICATION OF C.E.O.
|EX-31.2 SECTION 302 CERTIFICATION OF C.F.O.
|EX-32.1 SECTION 906 CERTIFICATION OF C.E.O.
|EX-32.2 SECTION 906 CERTIFICATION OF C.F.O.



1



---



##### Table of Contents






PART I.     FINANCIAL
INFORMATION

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

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

2



---



##### Table of Contents








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



SEGUE SOFTWARE, INC.

CONDENSED CONSOLIDATED BALANCE
SHEETS

(In thousands except per share data)


|                                                                   |                                                                                                                                                                                                        |                                            |       |              |        |  |       |         |        | 
|------------------------------------------------------------------ | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | ------------------------------------------ | ----- | ------------ | ------ |  | ----- | ------- | ------ | 
|                                                                   |                                                                                                                                                                                                        | June 30,                                   |       | December 31,
|                                                                   |                                                                                                                                                                                                        | 2004                                       |       | 2003        
|                                                                   |                                                                                                                                                                                                        |                                            |       |             
|                                                                   |                                                                                                                                                                                                        | (Unaudited)                                |       |             
|ASSETS                                                            
|Current assets:                                                    |                                                                                                                                                                                                        |                                            |       |              |        |  |       |        
|                                                                   | Cash                                                                                                                                                                                                   |                                            | $     | 9,231        |        |  | $     | 7,495   |       
|                                                                   | Accounts receivable, net of allowances of $209
    and $268, respectively                                                                                                                              |                                            |       | 4,913        |        |  |       | 5,607   |       
|                                                                   | Other current assets                                                                                                                                                                                   |                                            |       | 1,199        |        |  |       | 1,021   |       
|                                                                   |                                                                                                                                                                                                        |                                            |       |              |        |  |       |        
|                                                                   |                                                                                                                                                                                                        | Total current assets                       |       |              | 15,343 |  |       |         | 14,123 | 
|Property and equipment, net                                        |                                                                                                                                                                                                        |                                            | 776   |              |        |  | 1,069 |        
|Goodwill, net                                                      |                                                                                                                                                                                                        |                                            | 1,506 |              |        |  | 1,506 |        
|Other assets                                                       |                                                                                                                                                                                                        |                                            | 945   |              |        |  | 939   |        
|                                                                   |                                                                                                                                                                                                        |                                            |       |              |        |  |       |        
|                                                                   |                                                                                                                                                                                                        | Total assets                               |       | $            | 18,570 |  |       | $       | 17,637 | 
|                                                                   |                                                                                                                                                                                                        |                                            |       |              |        |  |       |        
|LIABILITIES AND STOCKHOLDERS
    EQUITY                          
|Current liabilities:                                               |                                                                                                                                                                                                        |                                            |       |              |        |  |       |        
|                                                                   | Accounts payable                                                                                                                                                                                       |                                            | $     | 746          |        |  | $     | 1,004   |       
|                                                                   | Accrued compensation and benefits                                                                                                                                                                      |                                            |       | 1,709        |        |  |       | 1,931   |       
|                                                                   | Accrued lease obligations on excess space                                                                                                                                                              |                                            |       | 1,318        |        |  |       | 1,554   |       
|                                                                   | Accrued expenses                                                                                                                                                                                       |                                            |       | 969          |        |  |       | 851     |       
|                                                                   | Deferred revenue                                                                                                                                                                                       |                                            |       | 9,443        |        |  |       | 9,015   |       
|                                                                   |                                                                                                                                                                                                        |                                            |       |              |        |  |       |        
|                                                                   |                                                                                                                                                                                                        | Total current liabilities                  |       |              | 14,185 |  |       |         | 14,355 | 
|Stockholders equity:                                              |                                                                                                                                                                                                        |                                            |       |              |        |  |       |        
|                                                                   | Preferred stock, par value $.01 per share; 9,000
    shares authorized; 869 and 819 shares of Series B and 538
    and 508 shares of Series C preferred stock issued and
    outstanding, respectively |                                            |       | 4,303        |        |  |       | 3,884   |       
|                                                                   | Common stock, par value $.01 per share; 30,000
    shares authorized; 10,075 and 9,926 shares issued, respectively                                                                                     |                                            |       | 101          |        |  |       | 100     |       
|                                                                   | Additional paid-in capital                                                                                                                                                                             |                                            |       | 58,087       |        |  |       | 58,160  |       
|                                                                   | Cumulative translation adjustment                                                                                                                                                                      |                                            |       | 265          |        |  |       | 309     |       
|                                                                   | Unearned compensation                                                                                                                                                                                  |                                            |       | (55          | )      |  |       |        |       
|                                                                   | Accumulated deficit                                                                                                                                                                                    |                                            |       | (57,716      | )      |  |       | (58,571 | )     
|                                                                   |                                                                                                                                                                                                        |                                            |       |              |        |  |       |        
|                                                                   |                                                                                                                                                                                                        |                                            | 4,985 |              |        |  | 3,882 |        
|Less treasury stock, at cost, 145 and 145 shares,
    respectively |                                                                                                                                                                                                        |                                            | (600  | )            |        |  | (600  | )      
|                                                                   |                                                                                                                                                                                                        |                                            |       |              |        |  |       |        
|                                                                   |                                                                                                                                                                                                        | Total stockholders equity                 |       |              | 4,385  |  |       |         | 3,282  | 
|                                                                   |                                                                                                                                                                                                        |                                            |       |              |        |  |       |        
|                                                                   |                                                                                                                                                                                                        | Total liabilities and stockholders equity |       | $            | 18,570 |  |       | $       | 17,637 | 
|                                                                   |                                                                                                                                                                                                        |                                            |       |              |        |  |       |        

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

3



---



##### Table of Contents






SEGUE SOFTWARE, INC.

CONDENSED CONSOLIDATED STATEMENTS OF
OPERATIONS

(In thousands except per share data)


|                                                          |                                         |                    |                          |                  |       |       |       |       |       |       |        |       |        |        |        |       |        |        | 
|--------------------------------------------------------- | --------------------------------------- | ------------------ | ------------------------ | ---------------- | ----- | ----- | ----- | ----- | ----- | ----- | ------ | ----- | ------ | ------ | ------ | ----- | ------ | ------ | 
|                                                          |                                         |                    |                          |                 
|                                                          |                                         | Three months ended |                          | Six months ended
|                                                          |                                         | June 30,           |                          | June 30,        
|                                                          |                                         |                    |                          |                 
|                                                          |                                         | 2004               |                          | 2003             |       | 2004  |       | 2003 
|                                                          |                                         |                    |                          |                  |       |       |       |      
|                                                          |                                         |                   
|                                                          |                                         | (Unaudited)       
|Revenue:                                                  |                                         |                    |                          |                  |       |       |       |       |       |       |        |       |        |        |        |      
|                                                          | Software                                |                    | $                        | 3,597            |       |       | $     | 3,194 |       |       | $      | 7,172 |        |        | $      | 6,513 |       
|                                                          | Services                                |                    |                          | 4,477            |       |       |       | 4,042 |       |       |        | 8,948 |        |        |        | 8,226 |       
|                                                          |                                         |                    |                          |                  |       |       |       |       |       |       |        |       |        |        |        |      
|                                                          |                                         | Gross revenue      |                          |                  | 8,074 |       |       |       | 7,236 |       |        |       | 16,120 |        |        |       | 14,739 |       
|                                                          | Less vendor consideration to a customer |                    |                          | (36              | )     |       |       | (58   | )     |       |        | (58   | )      |        |        | (95   | )     
|                                                          |                                         |                    |                          |                  |       |       |       |       |       |       |        |       |        |        |        |      
|                                                          |                                         |                    | Net revenue              |                  |       | 8,038 |       |       |       | 7,178 |        |       |        | 16,062 |        |       |        | 14,644 | 
|Cost of revenue:                                          |                                         |                    |                          |                  |       |       |       |       |       |       |        |       |        |        |        |      
|                                                          | Cost of software                        |                    |                          | 92               |       |       |       | 111   |       |       |        | 177   |        |        |        | 175   |       
|                                                          | Cost of services                        |                    |                          | 1,294            |       |       |       | 1,219 |       |       |        | 2,606 |        |        |        | 2,528 |       
|                                                          |                                         |                    |                          |                  |       |       |       |       |       |       |        |       |        |        |        |      
|                                                          |                                         |                    | Total cost of revenue    |                  |       | 1,386 |       |       |       | 1,330 |        |       |        | 2,783  |        |       |        | 2,703  | 
|                                                          |                                         |                    |                          |                  |       |       |       |       |       |       |        |       |        |        |        |      
|Gross margin                                              |                                         |                    | 6,652                    |                  |       |       | 5,848 |       |       |       | 13,279 |       |        |        | 11,941 |      
|Operating expenses:                                       |                                         |                    |                          |                  |       |       |       |       |       |       |        |       |        |        |        |      
|                                                          | Sales and marketing                     |                    |                          | 3,489            |       |       |       | 3,543 |       |       |        | 6,961 |        |        |        | 7,102 |       
|                                                          | Research and development                |                    |                          | 1,635            |       |       |       | 1,457 |       |       |        | 3,285 |        |        |        | 2,915 |       
|                                                          | General and administrative              |                    |                          | 1,046            |       |       |       | 1,288 |       |       |        | 2,228 |        |        |        | 2,351 |       
|                                                          |                                         |                    |                          |                  |       |       |       |       |       |       |        |       |        |        |        |      
|                                                          |                                         |                    | Total operating expenses |                  |       | 6,170 |       |       |       | 6,288 |        |       |        | 12,474 |        |       |        | 12,368 | 
|                                                          |                                         |                    |                          |                  |       |       |       |       |       |       |        |       |        |        |        |      
|Income (loss) from operations                             |                                         |                    | 482                      |                  |       |       | (440  | )     |       |       | 805    |       |        |        | (427   | )    
|Other income (expense)                                    |                                         |                    | (5                       | )                |       |       |      |       |       |       | 15     |       |        |        |       |      
|Interest income                                           |                                         |                    | 16                       |                  |       |       | 14    |       |       |       | 37     |       |        |        | 27     |      
|                                                          |                                         |                    |                          |                  |       |       |       |       |       |       |        |       |        |        |        |      
|Income (loss) before provision for income
    taxes       |                                         |                    | 493                      |                  |       |       | (426  | )     |       |       | 857    |       |        |        | (400   | )    
|Provision (benefit) for income taxes                      |                                         |                    | (24                      | )                |       |       | 27    |       |       |       | 2      |       |        |        | 124    |      
|                                                          |                                         |                    |                          |                  |       |       |       |       |       |       |        |       |        |        |        |      
|Net income (loss)                                         |                                         |                    | 517                      |                  |       |       | (453  | )     |       |       | 855    |       |        |        | (524   | )    
|Preferred stock dividend-in-kind                          |                                         |                    | (173                     | )                |       |       | (68   | )     |       |       | (340   | )     |        |        | (122   | )    
|                                                          |                                         |                    |                          |                  |       |       |       |       |       |       |        |       |        |        |        |      
|Net income (loss) applicable to common shares             |                                         | $                  | 344                      |                  |       | $     | (521  | )     |       | $     | 515    |       |        | $      | (646   | )    
|                                                          |                                         |                    |                          |                  |       |       |       |       |       |       |        |       |        |        |        |      
|Net income (loss) per common
    share  Basic            |                                         | $                  | 0.03                     |                  |       | $     | (0.05 | )     |       | $     | 0.05   |       |        | $      | (0.07  | )    
|Net income (loss) per common
    share  Diluted*         |                                         | $                  | 0.03                     |                  |       | $     | (0.05 | )     |       | $     | 0.05   |       |        | $      | (0.07  | )    
|Weighted average common shares
    outstanding  Basic    |                                         |                    | 9,906                    |                  |       |       | 9,707 |       |       |       | 9,869  |       |        |        | 9,683  |      
|Weighted average common shares
    outstanding  Diluted* |                                         |                    | 10,633                   |                  |       |       | 9,707 |       |       |       | 10,646 |       |        |        | 9,683  |      



---



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

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

4



---



##### Table of Contents






SEGUE SOFTWARE, INC

CONDENSED CONSOLIDATED STATEMENTS OF CASH
FLOWS

(In Thousands)


(Unaudited)


|                                                                              |                                                                                                            |                                              |                                                                                           |      |     |      |       |      |     |       |  
|----------------------------------------------------------------------------- | ---------------------------------------------------------------------------------------------------------- | -------------------------------------------- | ----------------------------------------------------------------------------------------- | ---- | --- | ---- | ----- | ---- | --- | ----- | -
|                                                                              |                                                                                                            |                                             
|                                                                              |                                                                                                            | Six months ended                            
|                                                                              |                                                                                                            | June 30,                                    
|                                                                              |                                                                                                            |                                             
|                                                                              |                                                                                                            | 2004                                         |                                                                                           | 2003
|                                                                              |                                                                                                            |                                              |                                                                                           |     
|Increase (decrease) in cash                                                   |                                                                                                            |                                              |                                                                                           |      |     |      |       |     
|Cash flows from operating activities:                                         |                                                                                                            |                                              |                                                                                           |      |     |      |       |     
|                                                                              | Net income (loss)                                                                                          |                                              | $                                                                                         | 855  |     |      | $     | (524 | )  
|                                                                              | Adjustments to reconcile net income
    (loss) to net cash provided by (used in) operating
    activities: |                                              |                                                                                           |      |     |      |       |      |    
|                                                                              |                                                                                                            | Depreciation and amortization                |                                                                                           |      | 437 |      |       |      | 773 |      
|                                                                              |                                                                                                            | Changes in operating assets and liabilities: |                                                                                           |      |     |      |       |      |     |      
|                                                                              |                                                                                                            |                                              | Accounts receivable                                                                       |      |     | 674  |       |      |     | 1,468 |  
|                                                                              |                                                                                                            |                                              | Other current assets                                                                      |      |     | (179 | )     |      |     | (290  | )
|                                                                              |                                                                                                            |                                              | Accounts payable                                                                          |      |     | (269 | )     |      |     | 35    |  
|                                                                              |                                                                                                            |                                              | Accrued expenses, lease obligations on excess
    space, compensation, benefits and other |      |     | (351 | )     |      |     | (667  | )
|                                                                              |                                                                                                            |                                              | Unearned compensation                                                                     |      |     | 13   |       |      |     |      |  
|                                                                              |                                                                                                            |                                              | Deferred revenue                                                                          |      |     | 439  |       |      |     | (354  | )
|                                                                              |                                                                                                            |                                              |                                                                                           |      |     |      |       |     
|Net cash provided by operating activities                                     |                                                                                                            |                                              | 1,619                                                                                     |      |     |      | 441   |     
|                                                                              |                                                                                                            |                                              |                                                                                           |      |     |      |       |     
|Cash flows from investing activities:                                         |                                                                                                            |                                              |                                                                                           |      |     |      |       |     
|                                                                              | Additions to property and equipment                                                                        |                                              |                                                                                           | (148 | )   |      |       | (151 | )  
|                                                                              | Other, net                                                                                                 |                                              |                                                                                           | (7   | )   |      |       | 329  |    
|                                                                              |                                                                                                            |                                              |                                                                                           |      |     |      |       |     
|Net cash (used in) provided by investing
    activities                       |                                                                                                            |                                              | (155                                                                                      | )    |     |      | 178   |     
|                                                                              |                                                                                                            |                                              |                                                                                           |      |     |      |       |     
|Cash flows from financing activities:                                         |                                                                                                            |                                              |                                                                                           |      |     |      |       |     
|                                                                              | Proceeds from exercise of stock options and stock
    purchase plan                                        |                                              |                                                                                           | 281  |     |      |       | 95   |    
|                                                                              |                                                                                                            |                                              |                                                                                           |      |     |      |       |     
|Net cash provided by financing activities                                     |                                                                                                            |                                              | 281                                                                                       |      |     |      | 95    |     
|                                                                              |                                                                                                            |                                              |                                                                                           |      |     |      |       |     
|Effect of exchange rate changes on cash                                       |                                                                                                            |                                              | (9                                                                                        | )    |     |      | 27    |     
|                                                                              |                                                                                                            |                                              |                                                                                           |      |     |      |       |     
|Net increase in cash and cash equivalents                                     |                                                                                                            |                                              | 1,736                                                                                     |      |     |      | 741   |     
|Cash and cash equivalents, beginning of period                                |                                                                                                            |                                              | 7,495                                                                                     |      |     |      | 5,335 |     
|                                                                              |                                                                                                            |                                              |                                                                                           |      |     |      |       |     
|Cash and cash equivalents, end of period                                      |                                                                                                            | $                                            | 9,231                                                                                     |      |     | $    | 6,076 |     
|                                                                              |                                                                                                            |                                              |                                                                                           |      |     |      |       |     
|Supplemental disclosure of non-cash investing and
    financing transactions: |                                                                                                            |                                              |                                                                                           |      |     |      |       |     
|                                                                              | Net cash paid (refunded) for income taxes
    during the six months ended June 30                          |                                              | $                                                                                         | (53  | )   |      |       | 354  |    

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

5



---



##### Table of Contents






SEGUE SOFTWARE, INC.

NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS

(Unaudited)



|   |                      
|-- | ---------------------
|1. | Basis of Presentation

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

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



|   |          
|-- | ---------
|2. | Liquidity

The Company has incurred losses on an annual
basis since it began operations, resulting in an accumulated
deficit of approximately $57.7 million at June 30,
2004. As a result, the Company has used significant amounts of
cash, cash equivalents and short-term investments to fund its
operations. However, the Company generated approximately
$1.7 million in overall positive cash flow for the first
six months of 2004 versus $741,000 for the same period in 2003.
For the quarter ended June 30, 2004, the Company generated
approximately $848,000 in overall positive cash flow, which
represents the seventh consecutive quarter of positive cash flow
for the Company.

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

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

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



|   |                               
|-- | ------------------------------
|3. | Recent Accounting Developments

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

6



---



##### Table of Contents



SEGUE SOFTWARE, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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

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



|                                                           |                                                                                                                             |                      |   |                    |   |      |   |        |   |  |   |       |   |  |   |        |  
|---------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------- | -------------------- | - | ------------------ | - | ---- | - | ------ | - |  | - | ----- | - |  | - | ------ | -
|                                                           |                                                                                                                             |                      |   |                   
|                                                           |                                                                                                                             | For the three months |   | For the six months
|                                                           |                                                                                                                             | ended June 30,       |   | ended June 30,    
|                                                           |                                                                                                                             |                      |   |                   
|                                                           |                                                                                                                             | 2004                 |   | 2003               |   | 2004 |   | 2003  
|                                                           |                                                                                                                             |                      |   |                    |   |      |   |       
|Net income (loss) applicable to common shares              |                                                                                                                             |                      |   |                    |   |      |   |        |   |  |   |       |   |  |   |       
|                                                           | As reported                                                                                                                 |                      | $ | 344                |   |      | $ | (521   | ) |  | $ | 515   |   |  | $ | (646   | )
|                                                           | Deduct: Total stock-based employee compensation
    expense determined under the fair value based method for all
    awards |                      |   | (427               | ) |      |   | (714   | ) |  |   | (906  | ) |  |   | (1,455 | )
|                                                           |                                                                                                                             |                      |   |                    |   |      |   |        |   |  |   |       |   |  |   |       
|                                                           | Pro forma                                                                                                                   |                      | $ | (83                | ) |      | $ | (1,235 | ) |  | $ | (391  | ) |  | $ | (2,101 | )
|                                                           |                                                                                                                             |                      |   |                    |   |      |   |        |   |  |   |       |   |  |   |       
|Net income (loss) per common share 
    basic and diluted |                                                                                                                             |                      |   |                    |   |      |   |        |   |  |   |       |   |  |   |       
|                                                           | As reported  basic                                                                                                         |                      | $ | 0.03               |   |      | $ | (0.05  | ) |  | $ | 0.05  |   |  | $ | (0.07  | )
|                                                           | As reported  diluted                                                                                                       |                      | $ | 0.03               |   |      | $ | (0.05  | ) |  | $ | 0.05  |   |  | $ | (0.07  | )
|                                                           | Pro forma  basic                                                                                                           |                      | $ | (0.01              | ) |      | $ | (0.13  | ) |  | $ | (0.04 | ) |  | $ | (0.22  | )
|                                                           | Pro forma  diluted                                                                                                         |                      | $ | (0.01              | ) |      | $ | (0.13  | ) |  | $ | (0.04 | ) |  | $ | (0.22  | )

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

7



---



##### Table of Contents



SEGUE SOFTWARE, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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

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

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

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



|   |             
|-- | ------------
|4. | Other Assets

Included in other assets at June 30, 2004
and December 31, 2003 is restricted cash of $770,000. This
amount represents the security for a letter of credit required
by our amended sublease for our Lexington headquarters. Our
obligation to maintain this letter of credit will reduce over
time, by formula, to zero by August 2005. Also included is
approximately $169,000 in refundable security deposits we have
paid for our various regional sales offices.

8



---



##### Table of Contents



SEGUE SOFTWARE, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|   |                    
|-- | -------------------
|5. | Equity Transactions

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

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

For the quarter ended June 30, 2004, an
additional 24,591 shares of our Series B Preferred Stock
and an additional 15,240 shares of our Series C Preferred
Stock were earned as dividends and were issued on June 30,
2004. The total number of shares of Series B Preferred
Stock and Series C Preferred Stock issued for the six
months ended June 30, 2004 totaled 49,180 and 30,474,
respectively. Our preferred stock dividends deemed earned for
the three months ended June 30, 2004 resulted in an expense
of approximately $173,000 versus $68,000 for the period ended
June 30, 2003. For the six-month period ended June 30,
2004, the expense related to dividends earned was approximately
$340,000 versus $122,000 for the same six-month period in 2003.

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

For the three months ended June 30, 2004,
there were options to purchase 39,617 shares of common stock
exercised by employees and no shares of common stock were
purchased and issued to employees under the Companys
Employee Stock Purchase Plan. Total proceeds to us from such
transactions were approximately $79,000. For the three months
ended June 30, 2003, there were 11,678 options to purchase
shares of common stock exercised by employees and no shares of
common stock were purchased and issued to employees under the
Companys Employee Stock Purchase Plan. Total proceeds to
us from such transactions were approximately $12,000. For the
six-months ended June 30, 2004, there were options to
purchase 98,842 shares of common stock exercised by employees
and 50,309 shares of common stock were purchased and issued to
employees under the Companys Employee Stock Purchase Plan.
Total proceeds to us from such transactions were approximately
$281,000. For the six-months ended June 30, 2003, there

9



---



##### Table of Contents



SEGUE SOFTWARE, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

were options to purchase 11,678 shares of common
stock exercised by employees and 84,809 shares of common stock
were purchased and issued to employees under the Companys
Employee Stock Purchase Plan. Total proceeds to us from such
transactions were approximately $95,000.

At June 30, 2004, the Company had three
stock-based employee compensation plans. (These plans are
described more fully in Note 5 of the Companys Annual
Report on Form 10-K.) The Company accounts for these plans
under the recognition and measurement principles of APB Opinion
No. 25, Accounting for Stock Issued to
Employees, and related interpretations. In general, most
options granted under those plans had an exercise price equal to
the market value of the underlying common stock on the date of
grant, resulting in no stock based compensation expense.
However, during the third quarter of 2003, a stock grant was
made for which the exercise price was slightly less than the
market value of the underlying common stock on the date of
grant. This resulted in a compensation expense of approximately
$4,000 for the quarter ended June 30, 2004. A balance of
approximately $55,000 in unearned compensation remains and it
will be amortized over the remaining vesting period of the grant
during the next 3 years.



|   |                      
|-- | ---------------------
|6. | Restructuring Charges

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

|         |  |                |         |                       |  |           |    |                       |  |                  |   |               |  |  |         |  |  |  |           |  |  |   |           | 
|-------- |  | -------------- | ------- | --------------------- |  | --------- | -- | --------------------- |  | ---------------- | - | ------------- |  |  | ------- |  |  |  | --------- |  |  | - | --------- | 
|         |  |                |         | Number of             |  | %         |    | Cost of estimated     |  |                  |   |              
|         |  | Severance and  |         | employees             |  | Reduction |    | facility obligations, |  | Office for which |   | Total        
|         |  | other employee |         | terminated as part    |  | in        |    | net of estimated      |  | facility costs   |   | Restructuring
|Quarter  |  | related costs  |         | of restructuring plan |  | workforce |    | sublease income       |  | accrued          |   | Charge       
|         |  |                |         |                       |  |           |    |                       |  |                  |   |              
|Q2 2004  |  |                |        |                       |  |           |   |                       |  |                  |  |               |  |  |        |  |  |  |          |  |  |   |          | 
|Q1 2004  |  |                |        |                       |  |           |   |                       |  |                  |  |               |  |  |        |  |  |  |          |  |  |   |          | 
|         |  |                |         |                       |  |           |    |                       |  |                  |   |               |  |  |         |  |  |  |           |  |  |   |           | 
|Total 04 |  |                |        |                       |  |           |   |                       |  |                  |  |               |  |  |        |  |  |  |           |  |  |   |          | 
|         |  |                |         |                       |  |           |    |                       |  |                  |   |               |  |  |         |  |  |  |           |  |  |   |           | 
|Q4 2003  |  | $              | 725,000 |                       |  |           | 8  |                       |  |                  | 4 |               |  |  |        |  |  |  |          |  |  | $ | 725,000   | 
|Q3 2003  |  |                |        |                       |  |           |   |                       |  |                  |  |               |  |  |        |  |  |  |          |  |  |   |          | 
|Q2 2003  |  |                |        |                       |  |           |   |                       |  |                  |  |               |  |  |        |  |  |  |          |  |  |   |          | 
|Q1 2003  |  |                |        |                       |  |           |   |                       |  |                  |  |               |  |  |        |  |  |  |          |  |  |   |          | 
|         |  |                |         |                       |  |           |    |                       |  |                  |   |               |  |  |         |  |  |  |           |  |  |   |           | 
|Total 03 |  |                | 725,000 |                       |  |           | 8  |                       |  |                  | 4 |               |  |  |        |  |  |  |          |  |  |   | 725,000   | 
|         |  |                |         |                       |  |           |    |                       |  |                  |   |               |  |  |         |  |  |  |           |  |  |   |           | 
|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 | 
|         |  |                |         |                       |  |           |    |                       |  |                  |   |               |  |  |         |  |  |  |           |  |  |   |           | 

10



---



##### Table of Contents



SEGUE SOFTWARE, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

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

During the second quarter of 2004, we paid
$127,000 of the amount accrued at December 31, 2003,
leaving a balance of $367,000 at June 30, 2004 for the
remaining severance and termination benefits associated with the
restructuring actions from 2003.

At June 30, 2004, the accrual balance
related to the obligations associated with all of the excess
office space noted above is approximately $1.3 million.
This is comprised of an estimated $1.7 million for future
rents payable by Segue on unoccupied space less approximately
$417,000 of estimated future sublease and operating expense
income. The Company made no estimate adjustments related to this
accrual for the period ended June 30, 2004.



|   |                           
|-- | --------------------------
|7. | Provision for Income Taxes

We recorded provisions (benefits) for
foreign and state income taxes of ($24,000) and $2,000 for the
three and six months ended June 30, 2004, respectively, and
$27,000 and $124,000 for the same periods last year. The tax
credit we realized in the second quarter of 2004 was due to a
research and development tax credit refund in Austria for prior
years. We recorded no tax benefit for losses generated in the
U.S. in either period due to the uncertainty of realizing such
benefits.



|   |                                   
|-- | ----------------------------------
|8. | Net Income (Loss) Per Common Share

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

|                                                                          |  |                    |        |                  |  |      |       |      |  |   |        |  |  |   |       |  
|------------------------------------------------------------------------- |  | ------------------ | ------ | ---------------- |  | ---- | ----- | ---- |  | - | ------ |  |  | - | ----- | -
|                                                                          |  |                    |        |                 
|                                                                          |  | Three months ended |        | Six months ended
|                                                                          |  | June 30,           |        | June 30,        
|                                                                          |  |                    |        |                 
|                                                                          |  | 2004               |        | 2003             |  | 2004 |       | 2003
|                                                                          |  |                    |        |                  |  |      |       |     
|Net income (loss) applicable to common shares                             |  | $                  | 344    |                  |  | $    | (521  | )    |  | $ | 515    |  |  | $ | (646  | )
|Weighted average shares used in net income (loss)
    per share  basic   |  |                    | 9,906  |                  |  |      | 9,707 |      |  |   | 9,869  |  |  |   | 9,683 |  
|Weighted average shares used in net income (loss)
    per share  diluted |  |                    | 10,633 |                  |  |      | 9,707 |      |  |   | 10,646 |  |  |   | 9,683 |  
|Net income (loss) per common share 
    basic                            |  | $                  | 0.03   |                  |  | $    | (0.05 | )    |  | $ | 0.05   |  |  | $ | (0.07 | )
|Net income (loss) per common share 
    diluted                          |  | $                  | 0.03   |                  |  | $    | (0.05 | )    |  | $ | 0.05   |  |  | $ | (0.07 | )

Excluded from the calculation of diluted earnings
per share for the three and six months ended June 30, 2004
were 1,387,496 and 1,387,278 shares of common stock,
respectively, that can be converted from preferred stock because
their inclusion would be anti-dilutive. Excluded from the
calculation of diluted earnings per share for the three and six
months ended June 30, 2003 were options to

11



---



##### Table of Contents



SEGUE SOFTWARE, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

purchase 3,433,163 shares of common
stock and 773,261 shares of common stock, as converted,
issuable upon the conversion of preferred stock, respectively,
because their inclusion would be anti-dilutive.



|   |                            
|-- | ---------------------------
|9. | Comprehensive Income (Loss)

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

|                                |  |                |     |                |  |      |      |      |  |   |     |   |  |   |      |  
|------------------------------- |  | -------------- | --- | -------------- |  | ---- | ---- | ---- |  | - | --- | - |  | - | ---- | -
|                                |  |                |     |               
|                                |  | Three months   |     | Six months    
|                                |  | ended June 30, |     | ended June 30,
|                                |  |                |     |               
|                                |  | 2004           |     | 2003           |  | 2004 |      | 2003
|                                |  |                |     |                |  |      |      |     
|Net income (loss)               |  | $              | 517 |                |  | $    | (453 | )    |  | $ | 855 |   |  | $ | (524 | )
|Foreign translation adjustments |  |                | (13 | )              |  |      | 140  |      |  |   | (44 | ) |  |   | 164  |  
|Comprehensive income (loss)     |  | $              | 504 |                |  | $    | (313 | )    |  | $ | 811 |   |  | $ | (360 | )



|    |                              
|--- | -----------------------------
|10. | Commitments and Contingencies



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

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



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

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

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

The Company also leases certain United States and
foreign offices and certain equipment under various operating
leases with lease terms ranging from month-to-month up to five
years. Several of these leases contain renewal options. The
agreements generally require the payment of utilities, real
estate taxes, insurance and repairs. Future minimum payments
under the facilities and equipment leases, excluding the

12



---



##### Table of Contents



SEGUE SOFTWARE, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)

security deposit noted above, but including the
obligation of the restructured sublease, with non-cancelable
terms are as follows as of June 30, 2004 (in thousands):

|                       |       |            |       |          |  |        |      |      |   |   |       |       | 
|---------------------- | ----- | ---------- | ----- | -------- |  | ------ | ---- | ---- | - | - | ----- | ----- | 
|                       |       | Gross      |       | Sublease |  | Net   
|                       |       | Commitment |       | Income   |  | Amount
|                       |       |            |       |          |  |       
|2004 (balance of year) |       | $          | 1,276 |          |  | $      | (168 | )    |   | $ | 1,108 |      
|2005                   |       |            | 1,823 |          |  |        | (67  | )    |   |   | 1,756 |      
|2006                   |       |            | 1,640 |          |  |        | (70  | )    |   |   | 1,570 |      
|2007                   |       |            | 1,377 |          |  |        | (60  | )    |   |   | 1,317 |      
|2008                   |       |            | 58    |          |  |        | 0    |      |   |   | 58    |      
|Thereafter             |       |            | 15    |          |  |        | 0    |      |   |   | 15    |      
|                       |       |            |       |          |  |        |      |      |   |   |       |      
|                       | Total |            | $     | 6,189    |  |        | $    | (365 | ) |   | $     | 5,825 | 
|                       |       |            |       |          |  |        |      |      |   |   |       |      

Rent expense for the three and six month period
ended June 30,2004 was $470,000 and $945,000, respectively,
as compared to $466,000 and $986,000 for the same periods in
2003.



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

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

On April 14, 2003, an amendment was signed
that stated an advance payment of $50,000 per quarter would
be made to T-Plan Ltd. These advance payments would be credited
against the actual royalties earned during the period. However,
beginning January 14, 2004, in the event that the
cumulative prepaid royalties are more than $100,000 in excess of
the cumulative actual royalties earned, then the Company would
have no obligations to make further advance royalty payments
until the cumulative actual royalties are equal to the
cumulative advance royalties. As of June 30, 2004, the
prepaid royalty balance to T-Plan Ltd. stood at approximately
$71,000. Either party may cancel the agreement at any time by
giving the other party written notice to that effect at least
ninety days prior to such termination. In the event of a
termination of the contract, Segue will receive a refund if
advance royalty payments should exceed actual cumulative
royalties. Segue has other minor royalty agreements for third
party embedded software in Segues products.

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



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

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

13



---



##### Table of Contents



SEGUE SOFTWARE, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS  (Continued)



|    |                  
|--- | -----------------
|11. | Segment Reporting

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

|                                        |                |                             |       |                           |  |         |       |        |  |         |       |        |  |         |       |        |  |   |       |        |  |   |       |        |  |   |       |        |  |   |       |        | 
|--------------------------------------- | -------------- | --------------------------- | ----- | ------------------------- |  | ------- | ----- | ------ |  | ------- | ----- | ------ |  | ------- | ----- | ------ |  | - | ----- | ------ |  | - | ----- | ------ |  | - | ----- | ------ |  | - | ----- | ------ | 
|                                        |                |                             |       |                          
|                                        |                | Three months ended June 30, |       | Six months ended June 30,
|                                        |                |                             |       |                          
|                                        |                |                             |       |                           |  |         |       |       
|                                        |                | 2004                        |       | 2003                      |  | 2004    |       | 2003  
|                                        |                |                             |       |                           |  |         |       |       
|                                        |                |                             |       | Gross                     |  |         |       | Gross  |  |         |       | Gross  |  |         |       | Gross 
|                                        |                | Revenue                     |       | Margin                    |  | Revenue |       | Margin |  | Revenue |       | Margin |  | Revenue |       | Margin
|                                        |                |                             |       |                           |  |         |       |        |  |         |       |        |  |         |       |       
|Software licenses                       |                | $                           | 3,597 |                           |  | $       | 3,505 |        |  | $       | 3,194 |        |  | $       | 3,083 |        |  | $ | 7,172 |        |  | $ | 6,995 |        |  | $ | 6,513 |        |  | $ | 6,338 |       
|Training and consulting                 |                |                             | 705   |                           |  |         | 193   |        |  |         | 610   |        |  |         | 32    |        |  |   | 1,437 |        |  |   | 354   |        |  |   | 1,540 |        |  |   | 344   |       
|Maintenance                             |                |                             | 3,772 |                           |  |         | 2,990 |        |  |         | 3,432 |        |  |         | 2,791 |        |  |   | 7,511 |        |  |   | 5,988 |        |  |   | 6,686 |        |  |   | 5,354 |       
|                                        |                |                             |       |                           |  |         |       |        |  |         |       |        |  |         |       |        |  |   |       |        |  |   |       |        |  |   |       |        |  |   |       |       
|                                        | Total services |                             |       | 4,477                     |  |         |       | 3,183  |  |         |       | 4,042  |  |         |       | 2,823  |  |   |       | 8,948  |  |   |       | 6,342  |  |   |       | 8,226  |  |   |       | 5,698  | 
|Less vendor consideration to a customer |                |                             | (36   | )                         |  |         | (36   | )      |  |         | (58   | )      |  |         | (58   | )      |  |   | (58   | )      |  |   | (58   | )      |  |   | (95   | )      |  |   | (95   | )     
|                                        |                |                             |       |                           |  |         |       |        |  |         |       |        |  |         |       |        |  |   |       |        |  |   |       |        |  |   |       |        |  |   |       |       
|                                        | Total          |                             | $     | 8,038                     |  |         | $     | 6,652  |  |         | $     | 7,178  |  |         | $     | 5,848  |  |   | $     | 16,062 |  |   | $     | 13,279 |  |   | $     | 14,644 |  |   | $     | 11,941 | 
|                                        |                |                             |       |                           |  |         |       |        |  |         |       |        |  |         |       |        |  |   |       |        |  |   |       |        |  |   |       |        |  |   |       |       

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

|              |  |                    |       |                  |  |                   |       |      |  |      |        |      |  |   |        |  |  |   |       |  |  |   |       | 
|------------- |  | ------------------ | ----- | ---------------- |  | ----------------- | ----- | ---- |  | ---- | ------ | ---- |  | - | ------ |  |  | - | ----- |  |  | - | ----- | 
|              |  |                    |       |                  |  |                  
|              |  | Total Net Revenue  |       |                  |  |                  
|              |  |                    |       |                  |  |                  
|              |  |                    |       |                  |  |                  
|              |  | Three months ended |       | Six months ended |  | Long Lived Assets
|              |  | June 30,           |       | June 30,         |  | June 30,         
|              |  |                    |       |                  |  |                  
|              |  | 2004               |       | 2003             |  | 2004              |       | 2003 |  | 2004 |        | 2003
|              |  |                    |       |                  |  |                   |       |      |  |      |        |     
|United States |  | $                  | 6,609 |                  |  | $                 | 6,079 |      |  | $    | 13,182 |      |  | $ | 11,887 |  |  | $ | 1,478 |  |  | $ | 2,066 | 
|Foreign       |  |                    | 1,429 |                  |  |                   | 1,099 |      |  |      | 2,880  |      |  |   | 2,757  |  |  |   | 243   |  |  |   | 419   | 
|              |  |                    |       |                  |  |                   |       |      |  |      |        |      |  |   |        |  |  |   |       |  |  |   |       | 
|              |  | $                  | 8,038 |                  |  | $                 | 7,178 |      |  | $    | 16,062 |      |  | $ | 14,644 |  |  | $ | 1,721 |  |  | $ | 2,485 | 

14



---



##### Table of Contents








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

Overview

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

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

During the second quarter and six months ended
June 30, 2004, we achieved profitability while growing
revenue and focusing on our new strategic objectives. Total
revenue grew 11% to $8.0 million for the quarter ended
June 30, 2004 as compared to $7.2 million during the
same period last year. Total revenue grew for the year by 10% to
$16.1 million for the six months ended June 30, 2004
as compared to $14.6 million for the same period in 2003.
We reported a net income applicable to common shares of
$344,000, or $0.03 basic and fully diluted income per share for
the quarter ended June 30, 2004. This compares to a net
loss applicable to common shares of $521,000, or a $0.05 loss
per share, for the same period last year. For the six months
ended June 30, 2004, we reported net income applicable to
common shares of $515,000, or $0.05 basic and fully diluted
income per share, compared to $646,000 net loss applicable
to common shares, or $0.07 loss per share, for the same period
during 2003. Total operating expenses and cost of sales
combined, totaled $7.6 million for the second quarter of
2004, which remained relatively flat compared with the same
period in 2003. For the first six months of 2004, total
operating expenses and cost of sales combined, totaled
$15.3 million, compared to $15.1 million in 2003. Our
total worldwide headcount at June 30 of 2004 and 2003 stood
at 180 and 201, respectively.

At June 30, 2004, our reported cash and cash
equivalent balance was $9.2 million, compared to
$7.5 million at December 31, 2003 and
$6.1 million at June 30, 2003. We reported positive
cash flow from operations of $1.6 million in the first six
months of 2004, compared to $441,000 positive cash flow during
the first six months of 2003. Deferred revenue increased to
$9.4 million for the quarter ended June 30, 2004,
compared to $8.1 million for the quarter ended
June 30, 2003. We continue to have no debt on our balance
sheet and have no off-balance sheet contingency debt.

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

Critical Accounting Policies

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

15



---



##### Table of Contents



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

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

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

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

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

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

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

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

16



---



##### Table of Contents



market data and consulted with our real estate
advisor on these factors to help determine an appropriate
reserve for potential losses on the unused space. During the
fourth quarter of 2002, Segue was able to reach an agreement in
principle with its landlord to restructure the sublease for our
Lexington facility. A formal agreement was consummated on
January 24, 2003. At June 30, 2004, the accrual
balance related to the obligations associated with all of the
excess office space in both the Lexington and Los Gatos
facilities is approximately $1.3 million. This is comprised
of an estimated $1.7 million for future rents payable by
Segue on unoccupied space less approximately $417,000 of
estimated future sublease and operating expense income. We are
under a restructured sublease for the Lexington facility until
October 2007.


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

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

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

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

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

17



---



##### Table of Contents



Results of Operations

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

|                                                |                                         |                          |      |                |       |      |      |      |       |  |      |      |       |  |      |      |       | 
|----------------------------------------------- | --------------------------------------- | ------------------------ | ---- | -------------- | ----- | ---- | ---- | ---- | ----- |  | ---- | ---- | ----- |  | ---- | ---- | ----- | 
|                                                |                                         |                          |      |               
|                                                |                                         | Percentage of            |      | Percentage of 
|                                                |                                         | Revenue for              |      | Revenue for   
|                                                |                                         | Three Months             |      | Six Months    
|                                                |                                         | Ended June 30,           |      | Ended June 30,
|                                                |                                         |                          |      |               
|                                                |                                         | 2004                     |      | 2003           |       | 2004 |      | 2003
|                                                |                                         |                          |      |                |       |      |      |     
|Revenue:                                        |                                         |                          |      |                |       |      |      |      |       |  |      |      |       |  |      |     
|                                                | Software                                |                          |      | 44.7           | %     |      |      | 44.5 | %     |  |      | 44.7 | %     |  |      | 44.4 | %    
|                                                | Services                                |                          |      | 55.7           |       |      |      | 56.3 |       |  |      | 55.7 |       |  |      | 56.2 |      
|                                                |                                         |                          |      |                |       |      |      |      |       |  |      |      |       |  |      |     
|                                                |                                         | Gross revenue            |      |                | 100.4 |      |      |      | 100.8 |  |      |      | 100.4 |  |      |      | 100.6 | 
|                                                | Less vendor consideration to a customer |                          |      | (0.4           | )     |      |      | (0.8 | )     |  |      | (0.4 | )     |  |      | (0.6 | )    
|                                                |                                         |                          |      |                |       |      |      |      |       |  |      |      |       |  |      |     
|                                                |                                         | Net revenue              |      |                | 100.0 |      |      |      | 100.0 |  |      |      | 100.0 |  |      |      | 100.0 | 
|Cost of revenue:                                |                                         |                          |      |                |       |      |      |      |       |  |      |      |       |  |      |     
|                                                | Cost of software                        |                          |      | 1.1            |       |      |      | 1.5  |       |  |      | 1.1  |       |  |      | 1.2  |      
|                                                | Cost of services                        |                          |      | 16.1           |       |      |      | 17.0 |       |  |      | 16.2 |       |  |      | 17.3 |      
|                                                |                                         |                          |      |                |       |      |      |      |       |  |      |      |       |  |      |     
|                                                |                                         | Total cost of revenue    |      |                | 17.2  |      |      |      | 18.5  |  |      |      | 17.3  |  |      |      | 18.5  | 
|Gross margin                                    |                                         |                          | 82.8 |                |       |      | 81.5 |      |       |  | 82.7 |      |       |  | 81.5 |     
|Operating expenses:                             |                                         |                          |      |                |       |      |      |      |       |  |      |      |       |  |      |     
|                                                | Sales and marketing                     |                          |      | 43.4           |       |      |      | 49.4 |       |  |      | 43.3 |       |  |      | 48.5 |      
|                                                | Research and development                |                          |      | 20.3           |       |      |      | 20.3 |       |  |      | 20.5 |       |  |      | 19.9 |      
|                                                | General and administrative              |                          |      | 13.0           |       |      |      | 17.9 |       |  |      | 13.9 |       |  |      | 16.1 |      
|                                                |                                         |                          |      |                |       |      |      |      |       |  |      |      |       |  |      |     
|                                                |                                         | Total operating expenses |      |                | 76.7  |      |      |      | 87.6  |  |      |      | 77.7  |  |      |      | 84.5  | 
|Income (loss) from operations                   |                                         |                          | 6.1  |                |       |      | (6.1 | )    |       |  | 5.0  |      |       |  | (3.0 | )   
|Other income (expense), net                     |                                         |                          | (0.1 | )              |       |      |     |      |       |  | 0.1  |      |       |  |     |     
|Interest income, net                            |                                         |                          | 0.2  |                |       |      | 0.2  |      |       |  | 0.2  |      |       |  | 0.2  |     
|                                                |                                         |                          |      |                |       |      |      |      |       |  |      |      |       |  |      |     
|Income (loss) before provision for income taxes |                                         |                          | 6.2  |                |       |      | (5.9 | )    |       |  | 5.3  |      |       |  | (2.8 | )   
|Provision for income taxes                      |                                         |                          | (0.3 | )              |       |      | 0.4  |      |       |  | 0.0  |      |       |  | 0.8  |     
|                                                |                                         |                          |      |                |       |      |      |      |       |  |      |      |       |  |      |     
|Net income (loss)                               |                                         |                          | 6.5  | %              |       |      | (6.3 | )%   |       |  | 5.3  | %    |       |  | (3.6 | )%  
|                                                |                                         |                          |      |                |       |      |      |      |       |  |      |      |       |  |      |     

Software Revenue

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

Software revenue was $3.6 million for the
quarter ended June 30, 2004 as compared to
$3.2 million for the quarter ended June 30, 2003, an
increase of 13%. This increase of $400,000 in software revenue
was primarily attributable to an increase in product sales in
our European markets. Software revenue was $7.2 million for
the six months ended June 30, 2004 as compared to
$6.5 million for the six months ended June 30, 2003,
an increase of 11%. This increase of $700,000 in software
revenue was primarily attributable to $400,000 in software
licenses that were received on December 31, 2003, but not
delivered until January 2004 (as disclosed in our Annual Report
on Form 10-K for the fiscal year ended December 31,
2003), an increase in the number of overall product deals and as
previously mentioned, an increase in European sales during the
second quarter of 2004.

International software revenue represented
$953,000, or 27%, and $665,000, or 21%, of total product sales
for the quarter ended June 30, 2004 and 2003, respectively.
The total dollar amount of international

18



---



##### Table of Contents



software revenue increased by approximately
$288,000 or 43%. This increase was primarily attributable to
several large product deals from our Germany sales operation.
International software revenue represented $1.9 million, or
26%, and $1.8 million, or 27% of total product sales for
the six months ended June 30, 2004 and 2003, respectively.


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

Services Revenue

Services revenue consists of revenue from
maintenance, training and consulting. Services revenue was
$4.5 million for the quarter ended June 30, 2004 as
compared to $4.0 million for the quarter ended
June 30, 2003, an increase of 13%. Service revenue was
$9.0 million for the six months ended June 30, 2004 as
compared to $8.2 million for the six months ended
June 30, 2003, an increase of 10%.

Maintenance revenue was $3.8 million for the
quarter ended June 30, 2004 as compared to
$3.4 million for the quarter ended June 30, 2003, an
increase of 12%. The increase of $400,000 in maintenance revenue
was primarily attributable to an increase in renewals of
existing maintenance contracts due to a larger base of licenses.
Recognized maintenance revenue is being amortized over the
contract period, which is predominately a 12-month period.
Maintenance revenue was $7.5 million for the six months
ended June 30, 2004 as compared to $6.7 million for
the six months ended June 30, 2003, an increase of 12%. The
increase of $800,000 was attributable to an increase in renewals
of existing maintenance contracts over a larger base of licenses
compared to 2003.

Training and consulting revenue was $705,000 for
the quarter ended June 30, 2004 as compared to $610,000 for
the quarter ended June 30, 2003, a increase of 16%. The
increase in training and consulting revenue of $95,000 was
primarily due to an increase in bookings of consulting
engagements. Training and consulting revenue was
$1.4 million for the six months ended June 30, 2004,
compared to $1.5 million for the six months ended
June 30, 2003, a decrease of 7%. The decrease of $103,000
was primarily attributed to the continued difficult economic
conditions in 2004, which caused a decrease in bookings and
delivery of training and consulting engagements. Additionally,
we continue to see an increase in customers using on-line
training which the Company began offering in 2002 and has proven
to be successful. On-line instructor monitored training allows
our customers a flexible option in which to realize the full
value of training while keeping expenses, such as tuition,
travel and lodging, to a minimum.

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

Vendor Consideration to a Customer

The Company committed to making payments to
several vendors, resellers, and distributors of $36,000 for the
quarter ended June 30, 2004, compared to $58,000 for the
quarter ended June 30, 2003. The decrease of $22,000 is
primarily attributed to a reduction in the number of deals to
which a referral fee applied.

The Company committed to making payments to
several vendors, resellers, and distributors of $58,000 for the
six months ended June 30, 2004, compared to $95,000 for the
six months ended June 30, 2003. The decrease of $37,000 is
primarily attributed to a reduction in the number of deals to
which a referral fee applied.

Under EITF Issue No. 01-9, these payments
are considered to be a reduction of revenue and are presented in
our statement of operations as such for 2004 and 2003.

19



---



##### Table of Contents



Cost of Software

Cost of software includes documentation, product
packaging, product media, employment costs for processing and
distribution, amortization of capitalized technology and
royalties due to third parties for their software that we embed
in our products. Cost of software was $92,000 for the quarter
ended June 30, 2004, or 3% of software revenue as compared
to $111,000 for the quarter ended June 30, 2003, or 3% of
software revenue. The decrease of $19,000 was primarily
attributable to a decrease of $12,000 in royalty expense and a
decrease of $6,000 in other fulfillment costs.

Cost of software was $177,000 for the six months
ended June 30, 2004, or 2% of software revenue as compared
to $175,000 for the six months ended June 30, 2003, or 3%
of software revenue.

Cost of Services

Cost of services consists principally of salaries
and benefits for our customer service and technical support
staff, which staff provides services under maintenance
contracts, and for our training and consulting staff, as well as
third party consulting fees and the cost of materials and
facilities used for training customers. Cost of services as a
percentage of services revenue varies based on the profitability
of individual consulting engagements and the utilization rate of
in-house consultants versus the use of higher cost outside
contract consultants. Cost of services was $1.3 million for
the quarter ended June 30, 2004, or 29% of service revenue,
compared to $1.2 million for the quarter ended
June 30, 2003, or 30% of service revenue. Cost of services
was $2.6 million for the six months ended June 30,
2004, or 29% of service revenue, compared to $2.5 million
for the six months ended June 30, 2003, or 31% of service
revenue.

Cost of training and consulting was $512,000 for
the quarter ended June 30, 2004, or 6% of net revenue,
compared to $578,000 for the quarter ended June 30, 2003,
or 8% of net revenue. The decrease in cost of training and
consulting of $66,000 was primarily attributed to a decrease of
$51,000 in personnel related costs and a decrease of $32,000 in
allocated facility costs due to lower headcount, partially
offset by an increase of $16,000 in outsourced consulting
expense. Cost of training and consulting was $1.1 million
for the six months ended June 30, 2004, or 14% of net
revenue as compared to $1.2 million for the six months
ended June 30, 2003, or 17% of net revenue. The decrease in
cost of training and consulting of $100,000 was primarily
attributed to a decrease in personnel related cost of $83,000
and a decrease of $65,000 in allocated facility costs due to a
lower headcount. These decreases were partially offset by an
increase of $29,000 in travel costs.

Cost of maintenance was $782,000 for the quarter
ended June 30, 2004, or 10% of net revenues as compared to
$641,000 for the quarter ended June 30, 2003, or 9% of net
revenues. The increase in cost of maintenance of $141,000 was
primarily attributed to an increase of $69,000 in personnel
costs due to higher wages, an increase of $59,000 associated
with the exchange rate translation in the European market of our
foreign technical support operations and an increase of $28,000
from an incentive bonus program that was reinstituted by the
Company at the beginning of the second quarter of 2004 for all
non-commissioned employees. Cost of maintenance was
$1.5 million for the six months ended June 30, 2004,
or 19% of net revenues, compared to $1.3 million for the
six months ended June 30, 2003, or 18% of net revenues. The
increase in cost of maintenance of $200,000 was primarily
attributed to an increase of $57,000 in personnel costs due to
higher wages, an increase of $126,000 associated with the
exchange rate translation in the European market of our foreign
technical support operations and an increase of $28,000 from the
incentive bonus program that was reinstituted by the Company at
the beginning of the second quarter of 2004 for all
non-commissioned employees.

Sales and Marketing

Sales and marketing expenses consist primarily of
salaries and benefits, commissions, travel costs, promotional
marketing programs and allocated facility costs. Marketing
programs include advertising, public relations, direct mail
programs, seminars and trade shows. Total sales and marketing
expenses was $3.5 million for the quarter ended
June 30, 2004, or 43% of net revenue, compared to
$3.5 million for the quarter ended June 30, 2003, or
49% of net revenue. Total sales and marketing expenses was
$7.0 million

20



---



##### Table of Contents



for the six months ended June 30, 2004, or
43% of net revenue, compared to $7.1 million for the six
months ended June 30, 2003, or 49% of net revenue.


Sales expense was $2.9 million for the
quarter ended June 30, 2004, or 36% of net revenue,
compared to $3.2 million for the quarter ended
June 30, 2003, or 45% of net revenue. The decrease in total
sales expense of $300,000 was primarily attributed to a decrease
of $246,000 in personnel related costs and a decrease of
$138,000 in allocated facility costs due to a reduced number of
employees. These decreases were partially offset by an increase
of $80,000 in commission due to higher sales and an increase of
$43,000 in the exchange rate translation effect in the European
market of our foreign sales operations. Sales expense was
$5.8 million for the six months ended June 30, 2004,
or 36% of net revenue, compared to $6.4 million for the six
months ended June 30, 2003, or 44% of net revenue. The
decrease in sales expense of $600,000 was primarily attributed
to a decrease of $415,000 in personnel related costs and a
decrease of $169,000 in allocated facility costs due to a
reduced number of employees, a decrease of $77,000 in legal
expense and a decrease of $65,000 in travel costs. These
decreases were partially offset by an increase of $135,000 in
the exchange rate translation effect in the European market of
our foreign sales operations.

Marketing expense was $642,000 for the quarter
ended June 30, 2004, or 8% of net revenue, compared to
$389,000 for the quarter ended June 30, 2003, or 5% of net
revenue. The increase of $253,000 was primarily attributed to an
increase of $198,000 in personnel related costs due to a higher
number of employees and an increase of $31,000 from an incentive
bonus program that was reinstituted by the Company at the
beginning of the second quarter of 2004 for all non-commissioned
employees. Marketing expense was $1.2 million for the six
months ended June 30, 2004, or 15% of net revenue, compared
to $714,000 for the six months ended June 30, 2003, or 10%
of net revenue. The increase of $486,000 was primarily
attributed to an increase of $403,000 in personnel cost and an
increase of $57,000 in allocated facility cost due to a higher
number of employees and a increase of $43,000 from an incentive
bonus program that was reinstituted by the Company at the
beginning of the second quarter of 2004 for all non-commissioned
employees. These increase were partially offset by a decrease of
$94,000 in marketing programs.

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

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

Research and Development

Research and development expenses consist
primarily of salaries and benefits and allocated facility costs.
To date, all of Segues internal costs for research and
development have been charged to operations as incurred, since
amounts of software development costs qualifying for
capitalization have been insignificant. Research and development
expense was $1.6 million for the quarter ended
June 30, 2004, or 20% of net revenue as compared to
$1.5 million for the quarter ended June 30, 2003, or
20% of net revenue. The increase of $100,000 was primarily
attributable to an increase of $66,000 in personnel related
costs due to an increased number of employees, an increase of
$55,000 in the exchange rate translation effect of our foreign
research and development lab expenses due to the stronger Euro,
and an increase of $80,000 from an incentive bonus program that
was reinstituted by the Company at the beginning of the second
quarter of 2004 for all non-commissioned employees. These
increases were partially offset by a decrease of $32,000 in
depreciation resulting from more fully depreciated assets and a
decrease of $24,000 in travel expenses.

Research and development expense was
$3.3 million for the six months ended June 30, 2004,
or 21% of net revenue as compared to $2.9 million for the
six months ended June 30, 2003, or 20% of net revenue. The
increase of $400,000 was primarily attributable to an increase
of $146,000 in personnel

21



---



##### Table of Contents



related costs due to increased vacation expense
and higher base salaries in Austria an increase of $185,000 in
the exchange rate translation of our foreign research and
development lab expenses due to the stronger Euro, an increase
of $39,000 in telephone expense and an increase of $80,000 from
an incentive bonus program that was reinstituted by the Company
at the beginning of the second quarter of 2004 for all
non-commissioned employees. These increases were partially
offset by a decrease of $66,000 in depreciation resulting from
more fully depreciated assets.


General and Administrative

General and administrative expenses consist
primarily of salaries and benefits for executive, finance,
legal, information technology, human resources and
administrative personnel, professional fees, system support
costs, allocated facility costs and other general corporate
expenses. General and administrative expense was
$1.0 million for the quarter ended June 30, 2004, or
13% of net revenue as compared to $1.3 million for the
quarter ended June 30, 2003, or 18% of net revenue. The
decrease of $300,000 was primarily attributed to a decrease of
$143,000 in the foreign currency translation expense and a
decrease of $190,000 in recruiting charges that were mainly
incurred during the CEO search in 2003. These decreases were
offset by an increase of $67,000 from an incentive bonus program
that was reinstituted by the Company at the beginning of the
second quarter of 2004 for all non-commissioned employees.

General and administrative expense was
$2.2 million for the six months ended June 30, 2004,
or 14% of net revenue, compared to $2.4 million for the six
months ended June 30, 2003, or 16% of net revenue. The
decrease of $200,000 was primarily attributable to a decrease of
$182,000 in the foreign currency translation expense, a decrease
of $167,000 in recruiting charges that were mainly incurred
during the CEO search in 2003, a decrease of $63,000 in
depreciation expense associated with fully depreciated assets,
and a decrease of $38,000 in bad debt cost. These decreases were
partially offset by an increase of $260,000 in legal expense due
to the absence of our internal legal counsel during most of the
first quarter of 2004 and an increase of $112,000 in bonus
expense as a result of a contracted executive bonus and an
incentive bonus program that was reinstituted by the Company at
the beginning of the second quarter of 2004 for all
non-commissioned employees.

Other Income, Net

Other income consists primarily of interest
income from cash, cash equivalents and short-term investments.
Other income was $11,000 for the quarter ended June 30,
2004 as compared to $14,000 for the quarter ended June 30,
2003.

Other income was $52,000 for the six months ended
June 30, 2004 compared to $27,000 for the six months ended
June 30, 2003. The increase of $25,000 is primarily due to
other income we had of $20,000 during the first quarter of 2004,
which was related to the settlement of a minor sublease issue.

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

Provision for Income Taxes

Segue recorded a provision for foreign and state
income taxes of $57,000 offset by a tax refund of $81,000 for
the quarter ended June 30, 2004. This compares to $27,000
provision for foreign and state income taxes the quarter ended
June 30, 2003. Provision for foreign and state income taxes
was $2,000 for the six months ended June 30, 2004 as
compared to $124,000 for the six months ended June 30,
2003. The decrease of $122,000 is primarily due to adjustments
in foreign tax provision in the six months of 2003.

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

22



---



##### Table of Contents



tax assets have been fully reserved. Management
re-evaluates the positive and negative evidence on a quarterly
basis.


Liquidity and Capital Resources

As of June 30, 2004, our principal sources
of liquidity included cash and cash equivalents totaling
$9.2 million.

Our operating activities generated cash of
$1.6 million during the first six months of 2004, compared
to $441,000 of cash generated in the same period in 2003. Cash
generated in 2004 resulted from the net income, adjusted for
depreciation of property and equipment and the increase in
deferred revenue and other current assets, and the decrease in
accounts receivable offset by a decrease in accounts payable and
accrued expenses.

Our investing activities utilized cash of
$155,000 in the first six months of 2004, as compared to
$178,000 cash generated during the first six months of 2003.
Cash used in 2004 was the result of the purchase of some
replacement computers and equipment. In the future, we may need
to make increased expenditures on property and equipment as
present equipment ages.

Our financing activities generated cash of
$281,000 and $95,000 during the first six months of 2004 and
2003, respectively. Cash generated from financing activities in
the first six months of 2004 was generated primarily from the
exercise of employee stock options and the issuance of stock
under the Employee Stock Purchase Plan. Cash generated in the
first six months of 2003 was primarily generated from the
issuance of stock under the Employee Stock Purchase Plan.

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

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

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

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

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

Risks and Factors That May Affect Future
Results

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

23



---



##### Table of Contents



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

We may not be profitable in the
future.Since we began operations, we
have generally experienced losses. Losses have resulted in an
accumulated deficit of approximately $57.7 million as of
June 30, 2004. In the second quarter of 2004, we reported
our second consecutive quarter of net income, which totaled
$517,000 for the period. In the first quarter of 2004, we
reported net income of $338,000. It is uncertain whether we can
maintain profitability in the future.

For the quarter ended June 30, 2004, we had
total revenue of $8.0 million versus $7.2 million for
the quarter ended June 30, 2003. Further, for the six
months ended June 30, 2004, we had total revenue of
$16.1 million versus $14.6 million for the same six
months in 2003. During 2001, 2002 and 2003, we initiated
aggressive cost saving measures in an effort to reduce expenses,
enhance the possibility of profitability, and conserve cash, and
we have sustained these measures through June 30, 2004.
Despite these cost saving measures, our future profitability
remains uncertain because of, among other items, the uncertainty
of our revenue from quarter to quarter. Failure to achieve
profitability may adversely affect the market price of our
common stock.

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

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

The SilkElite Partners Program focuses on
resellers, consulting partners and distributors. SilkElite
Partners resell our products, refer business to Segue and use
our software products in the delivery of consulting services.
The success of the key strategic alliances and the SilkElite
Program is uncertain, faces strong competition, and takes time
and significant resources to develop. Should we fail to generate
substantial incremental revenue from our strategic alliances or
our SilkElite Program, our financial results and stock price
could be adversely affected. The SilkElite Partner Program
accounted for 15% of total revenue for the period ended
June 30, 2004 versus 10% for the period ended June 30,
2003. For the six-month period ended June 30, 2004, The
SilkElite Partner Program accounted for 14% of total revenue
versus 11% for the six-month period ended June 30, 2003.

24



---



##### Table of Contents



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

Our future success will depend on our ability
to respond rapidly and effectively to technological and other
market changes, including the successful introduction of new and
enhanced products.The nature of the
automated software testing, performance management and
application monitoring markets in which we compete is
characterized by rapidly changing technology, rapidly evolving
customer needs and desires, changes in industry standards and
practices and frequent releases of new product or enhancements
by competitors. To be competitive, we must develop and introduce
product enhancements and new products that address the
increasingly sophisticated and varied needs of our existing and
potential customers. For the six months ended June 30,
2004, over 93% of our product revenues were generated from our
SilkPerformer and SilkTest products, as compared with over 87%
in same period last year. During the first six months of 2004,
we released SilkPerformer 6.5, the newest version of our
enterprise-class load and stress-testing tool, SilkTest 7.0, our
newest version of functional testing with add-on support
available to test .NET applications, SilkCentral Performance
Manager, the Companys newest offering for monitoring
software applications from the end-user perspective and
SilkCentral Test Manager 7.0, a comprehensive solution for the
overall management of application quality prior to deployment.
If these new products are not successful or if we fail to
continue to develop and introduce new products and enhancements
on a timely basis, or maintain our level of product revenue from
SilkPerformer and SilkTest, or fail to generate substantial
incremental revenue from our new products, our business may be
materially adversely affected.

We may face liquidity
issues.We have taken steps to
conserve our use of cash, including significantly reducing
headcount, infrastructure and other expenses, and limiting
capital expenditures in order to improve our liquidity and to
achieve greater efficiencies. We believe that based on expense
savings and the stability of our revenue in the last year, that
future sales at or above current levels should be sufficient to
allow us to continue as a viable business. For the three-month
period ended June 30, 2004, we generated $848,000 in
positive cash flow, the Companys seventh consecutive
quarter of cash balance growth. For the six-month period ended
June 30, 2004, we have generated a total of
$1.7 million in positive cash flow. Total net revenue of
$8.0 million for the three-month period ended June 30,
2004 was improved from the $7.2 million reported for the
same period last year. If we fail to maintain or grow revenue
levels we may have to raise additional financing to fund working
capital needs. If we fail to generate substantial incremental
revenue, or we are not successful in raising additional
financing on terms acceptable to us, we may not have sufficient
working capital resources and our business may be materially
adversely affected.

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

We cannot assure a liquid market for our
stock.In 2002, we were informed by
NASDAQ that we were not in compliance with certain listing
requirements for continued listing on their National Market

25



---



##### Table of Contents



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


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

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

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

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

We face many risks associated with
international business activities.We
derived approximately 18% of total revenue from international
customers in the three-month period ended June 30, 2004, as
compared with 15% in the same period last year. For the
six-month period ended June 30, 2004, we derived
approximately 18% of total revenue from international customers
versus 19% for the same six-month period last year. The
international market for software products is highly competitive
and we expect to face substantial competition in this market
from established and emerging companies. We face many risks
associated with international business activities including
currency fluctuations, imposition of government controls, export
license requirements, restrictions on the export of critical
technology, political and economic instability, tailoring of
products to local requirements, trade restrictions, changes in
tariffs and taxes, difficulties in staffing and managing
international operations, longer accounts receivable payment
cycles and the burdens of complying with a wide variety of
foreign laws and regulations. In particular, currency
fluctuations can have a significant impact on our foreign
operating expenses. Continued growth of international sales is
important to our growth and the stability. To the extent we are
unable to continue to

26



---



##### Table of Contents



expand international sales in a timely and
cost-effective manner, our business could be materially
adversely affected.


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






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

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

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

Foreign Currency
Risk.We face exposure to movements in
foreign currency exchange rates. These exposures may change over
time as business practices evolve and could have a material
adverse effect on our business, financial condition and results
of operations. We do not use derivative financial instruments or
other financial instruments to hedge economic exposures or for
trading. Historically, our primary currency exposures have been
related to the operations of our foreign subsidiaries. During
the three and six months ended June 30, 2004, we incurred
transaction and re-measurement gains of approximately $13,000
and $32,000 related to foreign currency, respectively. For the
three and six month period ended June 30, 2003, the expense
effect of foreign currency was approximately $130,000 and
$150,000, respectively. As of June 30, 2004, the cumulative
translation of foreign currency changes recorded in
stockholders equity was $265,000.






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

Evaluation of Disclosure Controls and
Procedures

As required by new Rule 13a-15 under the
Securities Exchange Act of 1934, as of June 30, 2004 we
carried out an evaluation under the supervision and with the
participation of our management, including our Chief Executive
Officer and Chief Financial Officer, of the effectiveness of the
design and operation of our disclosure controls and procedures.
In designing and evaluating our disclosure controls and
procedures, we and our management recognize that any controls
and procedures, no matter how well designed and operated, can
provide only reasonable assurance of achieving the desired
control objectives, and our

27



---



##### Table of Contents



management necessarily was required to apply its
judgment in evaluating and implementing possible controls and
procedures. Based upon that evaluation, our Chief Executive
Officer and Chief Financial Officer concluded that, as of the
date of completion of the evaluation, our disclosure controls
and procedures were reasonably effective to ensure that material
information required to be disclosed by us in the reports we
file or submit under the Exchange Act is recorded, processed,
summarized and reported, within the time periods specified in
the Securities and Exchange Commissions rules and forms.
In connection with the new rules, we will continue to review and
document our disclosure controls and procedures, including our
internal controls and procedures for financial reporting, on an
ongoing basis, and may from time to time make changes aimed at
enhancing their effectiveness and to ensure that our systems
evolve with our business.


Changes in Internal Controls over Financial
Reporting

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




PART II.     OTHER
INFORMATION






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

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






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

The 2004 Annual Meeting of Stockholders of Segue
Software, Inc. (the Annual Meeting) was held on
June 7, 2004.

At the Annual Meeting, the following individuals
were elected to Segues Board of Directors, constituting
all members of Segues Board of Directors:

|                      |  |           |           |                |  |  |         | 
|--------------------- |  | --------- | --------- | -------------- |  |  | ------- | 
|                      |  | Votes For |           | Votes Withheld
|                      |  |           |           |               
|Joseph K. Krivickas   |  |           | 8,330,277 |                |  |  | 186,403 | 
|John R. Levine        |  |           | 8,443,284 |                |  |  | 73,396  | 
|Howard L. Morgan      |  |           | 8,300,677 |                |  |  | 216,003 | 
|Robert W. Powers, Jr. |  |           | 8,443,284 |                |  |  | 73,396  | 
|Jyoti Prakash         |  |           | 8,042,130 |                |  |  | 474,550 | 
|James H. Simons       |  |           | 8,300,677 |                |  |  | 216,003 | 

The following additional proposals were
considered at the Annual Meeting:

|                                                                                                                                                                                                                    |  |       |           |         |  |          |         |  |  |  |        | 
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ----- | --------- | ------- |  | -------- | ------- |  |  |  | ------ | 
|                                                                                                                                                                                                                    |  | Votes |           | Votes   |  | Votes   
|                                                                                                                                                                                                                    |  | For   |           | Against |  | Withheld
|                                                                                                                                                                                                                    |  |       |           |         |  |         
|Ratification of the amendment to the
    Companys 1996 Employee Stock Purchase Plan increasing the
    number of shares of Common Stock available for purchase by
    eligible employees of the Company by 200,000 |  |       | 3,652,845 |         |  |          | 118,845 |  |  |  | 550    | 
|Ratification of the appointment of Grant Thornton
    LLP as independent public accountants for the fiscal year ending
    December 31, 2004                                                                        |  |       | 8,432,120 |         |  |          | 74,560  |  |  |  | 10,000 | 

28



---



##### Table of Contents








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

Edmund F. Kelly did not stand for re-election as
a director of the Company due to competing demands on his time.

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






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

(a) Exhibits

The following documents are filed as Exhibits to
this report:

|     |  |                                                                                                                                                           
|---- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------
|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 April 28, 2004
    regarding a press release announcing that Segue Software had
    reported its financial results for the first quarter ended
    March 31, 2004.

29



---



##### Table of Contents






SIGNATURES

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

Date: August 12, 2004



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



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

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



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

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

30