**UNITEDSTATES****SECURITIES AND EXCHANGECOMMISSION**

**Washington,D.C. 20549**

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**FORM 10-Q**

 
| **(Mark One)**                                                                              |                                                                                                |
|---------------------------------------------------------------------------------------------|-----------------------------------------------------------------------------------------------------|
|                                                                                        |                                                                                                |
| **ý**                                                                                  | **QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934**  |
|                                                                                        |
| **For the Quarterly Period Ended June 30,  2003**                                           |
|                                                                                        |                                                                                                |
| **o**                                                                                       | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934** |
|                                                                                        |
| **For the transition period  from         to** |
|                                                                                        |
| **Commission file number 0-27794**                                                          |

 

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

 

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

 

The number of shares of Registrant’s Common Stock outstanding as ofAugust 4, 2003 was 9,716,740

 

 

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**SEGUESOFTWARE, INC.**

 

**FORM10-Q**

 

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

 

**INDEX**

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

 

2

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**PART I. FINANCIAL INFORMATION**

 

**ITEM 1. CONDENSEDCONSOLIDATED FINANCIAL STATEMENTS**

 

**SEGUESOFTWARE, INC.**

**CONDENSEDCONSOLIDATED BALANCE SHEETS**

**(INTHOUSANDS, EXCEPT PER SHARE DATA)**

 
|                                                                                                                                                      |   | **(Unaudited)**    |       |                    |       |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------------------|------------|-------------------------|------------|
|                                                                                                                                                      |   | **June 30,  2003** |       | **December  31,  2002** |       |
| **ASSETS**                                                                                                                                                |   |               | ** ** |                    | ** ** |
| Current assets:                                                                                                                                           |   |               |       |                    |       |
| Cash and cash equivalents                                                                                                                                 |   | $                  | 6,076      |                    | $          | 5,335 |   |
| Accounts receivable, net of allowances of  $213 and $232, respectively                                                                                    |   | 4,610              |       | 6,007                   |       |
| Other current assets                                                                                                                                      |   | 1,277              |       | 967                     |       |
| Total current assets                                                                                                                                      |   | 11,963             |       | 12,309                  |       |
|                                                                                                                                                      |   |               |       |                    |       |
| Property and equipment, net                                                                                                                               |   | 1,521              |       | 2,089                   |       |
| Goodwill, net                                                                                                                                             |   | 1,506              |       | 1,506                   |       |
| Other assets                                                                                                                                              |   | 964                |       | 1,291                   |       |
| Total assets                                                                                                                                              |   | $                  | 15,954     |                    | $          | 17,195 |   |
|                                                                                                                                                      |   |               |       |                    |       |
| **LIABILITIES AND  STOCKHOLDERS’ EQUITY**                                                                                                            |   |               | ** ** |                    | ** ** |
| Current liabilities:                                                                                                                                      |   |               |       |                    |       |
| Accounts payable                                                                                                                                          |   | $                  | 1,296      |                    | $          | 1,256 |   |
| Accrued compensation and benefits                                                                                                                         |   | 1,342              |       | 1,163                   |       |
| Accrued lease obligations on excess space                                                                                                                 |   | 1,760              |       | 2,145                   |       |
| Accrued expenses                                                                                                                                          |   | 1,023              |       | 1,522                   |       |
| Deferred revenue                                                                                                                                          |   | 8,096              |       | 8,408                   |       |
| Total current liabilities                                                                                                                                 |   | 13,517             |       | 14,494                  |       |
|                                                                                                                                                      |   |               |       |                    |       |
| Stockholders’ equity:                                                                                                                                |   |               |       |                    |       |
| Preferred stock, par value $.01 per share;  9,000 shares authorized; 773 and 729 shares of Series B preferred stock  issued and outstanding, respectively |   | 2,269              |       | 2,147                   |       |
| Common stock, par value $.01 per share;  30,000 shares authorized; 9,862 and 9,765 shares issued, respectively                                            |   | 99                 |       | 98                      |       |
| Additional paid-in capital                                                                                                                                |   | 58,179             |       | 58,206                  |       |
| Cumulative translation adjustment                                                                                                                         |   | 262                |       | 98                      |       |
| Accumulated deficit                                                                                                                                       |   | (57,772            | )          | (57,248                 | )          |
|                                                                                                                                                      |   | 3,037              |       | 3,301                   |       |
| Less treasury stock, at cost, 145 and 145  shares, respectively                                                                                           |   | (600               | )          | (600                    | )          |
| Total stockholders’ equity                                                                                                                           |   | 2,437              |       | 2,701                   |       |
| Total liabilities and stockholders’ equity                                                                                                           |   | $                  | 15,954     |                    | $          | 17,195 |   |

 

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

 

3

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**SEGUE SOFTWARE, INC.**

**CONDENSED CONSOLIDATED STATEMENTS OFOPERATIONS**

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

**(UNAUDITED)**

 
|                                                           |   | **Three Months Ended  June 30,** |   | **Six Months Ended  June 30,** |   |
|----------------------------------------------------------------|--------|----------------------------------|--------|--------------------------------|--------|
|                                                           |   | **2003**                         |   | **2002**                       |   | **2003** |   | **2002** |   |
| Revenue:                                                       |   |                             |   |                           |   |   |   |   |   |
| Software                                                       |   | $                                | 3,194  |                           | $      | 2,514 |   | $ | 6,513 |   | $ | 5,829 |   |
| Services                                                       |   | 4,042                            |   | 4,342                          |   | 8,226 |   | 9,073 |   |
| Subtotal revenue                                               |   | 7,236                            |   | 6,856                          |   | 14,739 |   | 14,902 |   |
| Less vendor consideration to a customer                        |   | (58                              | )      | (25                            | )      | (95 | ) | (1,025 | ) |
| Net revenue                                                    |   | 7,178                            |   | 6,831                          |   | 14,644 |   | 13,877 |   |
|                                                           |   |                             |   |                           |   |   |   |   |   |
| Cost of revenue:                                               |   |                             |   |                           |   |   |   |   |   |
| Cost of software                                               |   | 111                              |   | 173                            |   | 175 |   | 403 |   |
| Cost of services                                               |   | 1,219                            |   | 1,453                          |   | 2,528 |   | 2,708 |   |
| Total cost of revenue                                          |   | 1,330                            |   | 1,626                          |   | 2,703 |   | 3,111 |   |
|                                                           |   |                             |   |                           |   |   |   |   |   |
| Gross margin                                                   |   | 5,848                            |   | 5,205                          |   | 11,941 |   | 10,766 |   |
|                                                           |   |                             |   |                           |   |   |   |   |   |
| Operating expenses:                                            |   |                             |   |                           |   |   |   |   |   |
| Sales and marketing                                            |   | 3,543                            |   | 4,023                          |   | 7,102 |   | 8,449 |   |
| Research and development                                       |   | 1,457                            |   | 1,563                          |   | 2,915 |   | 2,865 |   |
| General and administrative                                     |   | 1,288                            |   | 1,303                          |   | 2,351 |   | 2,781 |   |
| Restructuring charges                                          |   | —                           |   | 147                            |   | — |   | 830 |   |
| Total operating expenses                                       |   | 6,288                            |   | 7,036                          |   | 12,368 |   | 14,925 |   |
|                                                           |   |                             |   |                           |   |   |   |   |   |
| Loss from operations                                           |   | (440                             | )      | (1,831                         | )      | (427 | ) | (4,159 | ) |
| Interest Income                                                |   | 14                               |   | 22                             |   | 27 |   | 43 |   |
| Loss before provision for income taxes                         |   | (426                             | )      | (1,809                         | )      | (400 | ) | (4,116 | ) |
| Provision for income taxes                                     |   | 27                               |   | 50                             |   | 124 |   | 75 |   |
| Net loss                                                       |   | (453                             | )      | (1,859                         | )      | (524 | ) | (4,191 | ) |
| Preferred stock dividend-in-kind                               |   | 68                               |   | 48                             |   | 122 |   | 54 |   |
| Net loss applicable to common shares                           |   | $                                | (521   | )                              | $      | (1,907 | ) | $ | (646 | ) | $ | (4,245 | ) |
|                                                           |   |                             |   |                           |   |   |   |   |   |
| Net loss per common share - basic and diluted                  |   | $                                | (0.05  | )                              | $      | (0.20 | ) | $ | (0.07 | ) | $ | (0.45 | ) |
|                                                           |   |                             |   |                           |   |   |   |   |   |
| Weighted average common shares outstanding - basic and diluted |   | 9,707                            |   | 9,552                          |   | 9,683 |   | 9,522 |   |

 

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

 

4

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**SEGUESOFTWARE, INC**

**CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS**

**(INTHOUSANDS)**

**(UNAUDITED)**

 
|                                                                                       |   | **Six months  ended June 30,** |   |
|--------------------------------------------------------------------------------------------|--------|--------------------------------|--------|
|                                                                                       |   | **2003**                       |   | **2002** |   |
| Increase (decrease) in cash                                                                |   |                           |   |   |   |
|                                                                                       |   |                           |   |   |   |
| Cash flows from operating activities:                                                      |   |                           |   |   |   |
| Net loss                                                                                   |   | $                              | (524   | ) | $ | (4,191 | ) |
| Adjustments to reconcile net loss to net  cash provided by (used in) operating activities: |   |                           |   |   |   |
| Depreciation and amortization                                                              |   | 773                            |   | 971 |   |
| Changes in operating assets and  liabilities:                                              |   |                           |   |   |   |
| Accounts receivable                                                                        |   | 1,468                          |   | 1,539 |   |
| Other current assets                                                                       |   | (290                           | )      | 58 |   |
| Accounts payable                                                                           |   | 35                             |   | (713 | ) |
| Accrued expenses, lease obligations on  excess space, compensation, benefits and other     |   | (667                           | )      | 380 |   |
| Deferred revenue                                                                           |   | (354                           | )      | (916 | ) |
|                                                                                       |   |                           |   |   |   |
| Net cash provided by (used in) operating  activities                                       |   | 441                            |   | (2,872 | ) |
|                                                                                       |   |                           |   |   |   |
| Cash flows from investing activities:                                                      |   |                           |   |   |   |
| Additions to property and equipment                                                        |   | (151                           | )      | (123 | ) |
| Maturities of short-term investments                                                       |   | —                         |   | 5,749 |   |
| Purchases of short-term investments                                                        |   | —                         |   | (800 | ) |
| Other, net                                                                                 |   | 329                            |   | (99 | ) |
|                                                                                       |   |                           |   |   |   |
| Net cash provided by investing activities                                                  |   | 178                            |   | 4,727 |   |
|                                                                                       |   |                           |   |   |   |
| Cash flows from financing activities:                                                      |   |                           |   |   |   |
| Proceeds from exercise of stock options and  stock purchase plan                           |   | 95                             |   | 143 |   |
| Proceeds from the issuance of convertible  preferred stock                                 |   | —                         |   | 2,000 |   |
|                                                                                       |   |                           |   |   |   |
| Net cash provided by financing activities                                                  |   | 95                             |   | 2,143 |   |
|                                                                                       |   |                           |   |   |   |
| Effect of exchange rate changes on cash                                                    |   | 27                             |   | 77 |   |
|                                                                                       |   |                           |   |   |   |
| Net increase (decrease) in cash and cash  equivalents                                      |   | 741                            |   | 4,075 |   |
| Cash and cash equivalents, beginning of  period                                            |   | 5,335                          |   | 2,326 |   |
|                                                                                       |   |                           |   |   |   |
| Cash and cash equivalents, end of period                                                   |   | $                              | 6,076  |   | $ | 6,401 |   |
| Supplemental disclosure of non-cash investing  and financing transactions:                 |   |                           |   |   |   |
| Cash paid for income taxes during the six  months ended June 30                            |   | $                              | 354    |   | 45 |   |

 

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

 

5

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**SEGUESOFTWARE, INC.**

**NOTESTO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS**

**(UNAUDITED)**

 

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

 

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

 

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

 

**2.****                                      LIQUIDITY**

 

The Company has incurred losses on an annual basis since it beganoperations, resulting in an accumulated deficit of approximately$57.8 million at June 30, 2003.  Asa result, the Company has used significant amounts of cash, cash equivalentsand short-term investments to fund its operations.  However, the Company generated approximately $441,000 in positivecash flow from operations and  $741,000in overall positive cash flow for the first six months of 2003.

 

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

 

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

 

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

 

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

 

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

 

InNovember 2001, Emerging Issues Task Force (“EITF”) Issue No. 01-9,“Accounting for Consideration Given by a Vendor to a Customer (Including aReseller of the Vendor’s Products)” was issued. This EITF provides guidancewith respect to the statement of operations classification, recognition andmeasurement of consideration given by a vendor to a customer or reseller. ThisEITF presumes any consideration to be an adjustment of the selling prices ofthe vendor’s products or services, which should be deducted from revenue whenrecognized in the vendor’s statement of operations, unless there is an identifiableand quantifiable benefit received for the consideration. This EITF is effectivefor annual and interim periods beginning after December 15, 2001. Uponadoption, financial statements for prior periods presented for comparativepurposes should be reclassified to comply with the requirements under the EITF.In January 1, 2002, the Company adopted this EITF. During the quarterended March 31, 2002, the Company committed to making a payment of$1.0 million to a customer, which was made in Q2 2002. Under theprovisions of EITF Issue No. 01-9, this

 

6

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$1.0 million was considered to be a reduction in revenue and ispresented in the statement of operations as such. Per the contract with thecustomer, this payment is a one-time expenditure. Furthermore, in accordancewith EITF Issue No. 01-9, for the three and six months ended June 30,2003, we recorded approximately $58,000 and $95,000 respectively, as anadditional revenue reduction for amounts paid to resellers as referral fees forsales versus $25,000 and $1.0 million for the same periods in 2002. There wereno other material payments made by the Company in this quarter or priorquarters that would be considered for reclassification under the guidance inEITF Issue No. 01-9.

 

On July 30, 2002, FASB issued SFAS No. 146, “Accounting forCosts Associated with Exit or Disposal Activities” (“SFAS No. 146”). Thestandard requires companies to recognize costs associated with exit or disposalactivities when they are incurred rather than at the date of a commitment to anexit or disposal plan. Examples of costs covered by the standard include leasetermination costs and certain employee severance costs that are associated witha restructuring, discontinued operation, plant closing, or other exit ordisposal activity. Statement 146 is to be applied prospectively to exit ordisposal activities initiated after December 31, 2002.  The Company has adopted the provisions ofthis FASB.

 

In November 2002, the FASB issued Interpretation No. 45, orFIN 45, “Guarantor’s Accounting and Disclosure Requirements for Guarantees,Including Indirect Guarantees of Indebtedness of Others.” FIN 45 requires thatupon issuance of a guarantee, a guarantor must recognize a liability for thefair value of an obligation assumed under a guarantee. FIN 45 also requiresadditional disclosures by a guarantor in its interim and annual financialstatements about the obligations associated with guarantees issued. Therecognition provisions of FIN 45 are effective for any guarantees issued ormodified after December 31, 2002. The disclosure requirements areeffective for financial statements of interim or annual periods ending afterDecember 15, 2002.  The adoption ofFIN 45 will not have a material effect on the consolidated financial position,results of operations or cash flows.

 

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

 

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

 
|                                                                                                                  |   | **For the  three months ended  June 30,** |   | **For the  six months ended  June 30,** |   |
|-----------------------------------------------------------------------------------------------------------------------|--------|------------------------------------------------|--------|----------------------------------------------|--------|
|                                                                                                                  |   | **2003**                                       |   | **2002**                                     |   | **2003** |   | **2002** |   |
|                                                                                                                  |   |                                           |   |                                         |   |   |   |   |   |
| Net loss applicable to common shares                                                                                  |   |                                           |   |                                         |   |   |   |   |   |
| As reported                                                                                                           |   | $                                              | (521   | )                                            | $      | (1,907 | ) | $ | (646 | ) | $ | (4,245 | ) |
| Deduct: Total stock-based employee  compensation expense determined under the fair value based method for all  awards |   | (714                                           | )      | (885                                         | )      | (1,455 | ) | (1,746 | ) |
| Pro forma                                                                                                             |   | $                                              | (1,235 | )                                            | $      | (2,792 | ) | $ | (2,101 | ) | $ | (5,991 | ) |
| Net loss per common share — basic and  diluted                                                                   |   |                                           |   |                                         |   |   |   |   |   |
| As reported                                                                                                           |   | $                                              | (0.05  | )                                            | $      | (0.20 | ) | $ | (0.07 | ) | $ | (0.45 | ) |
| Pro forma                                                                                                             |   | $                                              | (0.13  | )                                            | $      | (0.29 | ) | $ | (0.22 | ) | $ | (0.63 | ) |

 

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In January 2003, the FASB issued FIN No. 46, “Consolidationof Variable Interest Entities.” In general, a variable interest entity is acorporation, partnership, trust, or any other legal structure used for businesspurposes that either (a) does not have equity investors with voting rightsor (b) has equity investors that do not provide sufficient financial resourcesfor the entity to support its activities. FIN No. 46 requires certainvariable interest entities to be consolidated by the primary beneficiary of theentity if the investors do not have the characteristics of a controllingfinancial interest or do not have sufficient equity at risk for the entity tofinance its activities without additional subordinated financial support fromother parties. The consolidation requirements of FIN No. 46 applyimmediately to variable interest entities created after January 31, 2003.The consolidation requirements apply to older entities in interim periodsbeginning after June 15, 2003. Certain of the disclosure requirementsapply in all financial statements issued after January 31, 2003,regardless of when the variable interest entity was established. Because theCompany currently has no investments in variable interest entities, theadoption of the provisions of FIN No. 46 will not have a material impacton the consolidated results of operations or financial position.

 

In April 2003, the Financial Accounting Standards Board issuedStatement of Financial Accounting Standard No. 149,**“Amendment of Statement 133 on Derivative Instruments andHedging Activities”.  Statement No. 149amends Statement 133 for decisions made (1) as part of the DerivativesImplementation Group process that effectively required amendments toStatement 133, (2) in connection with other Board projects dealing withfinancial instruments, and (3) in connection with implementation issues raisedin relation to the application of the definition of a derivative. The Statementclarifies under what circumstances a contract with an initial net investmentmeets the characteristics of a derivative discussed in paragraph 6(b) ofStatement 133, clarifies when a derivative contains a financing component,amends the definition of an underlying to conform it to language used in FASBInterpretation No.45,**“Guarantor’sAccounting and Disclosure Requirements for Guarantees, Including IndirectGuarantees of Indebtedness of Others”, and amends certain other existingpronouncements. Those changes will result in more consistent reporting ofcontract as either derivatives or hybrid instruments. This statement iseffective for contracts entered into or modified after June 30, 2003 and forhedging relationships designated after June 30, 2003. As a general rule, theCompany does not using hedging instruments, therefore management does notexpect that the adoption of Statement No. 149 will have a significant impact oneither its financial position or results of operations.

 

In May2003, the Financial Accounting Standards Board issued Statement of FinancialAccounting Standard No. 150,**“Accountingfor Certain Financial Instruments with Characteristics of Both Liabilities andEquity”.  Statement No. 150 establishesstandards for how an issuer classifies and measures certain financialinstruments with characteristics of both liabilities and equity. In addition,the Statement requires an issuer to classify certain instruments with specific characteristicsdescribed in it as liabilities. This Statement is effective for financialinstruments entered into or modified after May 31, 2003, and otherwise iseffective at the beginning of the first interim period beginning after June 15,2003. Management does not expect that the adoption of Statement No. 150 willhave a significant impact on either its financial position or results ofoperations.

 

**4.****                                      OTHERASSETS**

 

Included in other assets at June 30, 2003 is restricted cash of$770,000. This amount represents the security for a letter of credit requiredby our sublease for our Lexington headquarters. This required letter of creditwill reduce over time, by formula, to zero by August 2005. Also includedin the total is $194,000 for the security deposits on several of our otheroffice leases.  During the quarter endedJune 30, 2003, the balance on an interest bearing promissory note receivable ofapproximately $225,000 from Segue’s former chief executive officer was paid infull, including all interest due.

 

**5. ****                                EQUITYTRANSACTIONS**

 

On March 22, 2002, the Company and S-7 Associates LLC, a companymanaged and owned by the Chairman of Segue’s Board of Directors, Dr. JamesH. Simons (“S-7 Associates”), signed an agreement under which S-7 Associatespurchased 666,667 shares of the Company’s Series B Preferred Stock (“PreferredStock”) in consideration for a payment of $2.0 million.  The Preferred Stock is senior to the commonstock as to dividend and liquidation rights and is convertible at the option ofthe holder into shares of common stock of Segue at a conversion rate of oneshare of preferred for one share of common, subject to adjustment upon theoccurrence of certain transactions.  Theholders of the Preferred Stock are entitled to vote together with the commonstock on an as-converted basis, and in addition, are entitled to elect onedirector of the Company as a separate class. Dividends on the Preferred Stock accrue at 12% per annum and are to bepaid in additional shares of preferred stock semiannually.  The Preferred Stock is callable at theoption of the Company on or after March 31, 2004 at 133% of its face value(“Liquidation Preference”).  If there isa sale of all or substantially all of the Company’s assets or equity, thePreferred Stock can either be redeemed at the Liquidation Preference orconverted to common stock. Pursuant to a registration rights agreement, theCompany has agreed, subject to certain limitations, to register, under theSecurities Act of 1933, the resale of common stock into which the PreferredStock may be converted.  Theregistration rights expire on March 22, 2007.

 

8

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For the quarter ended June 30, 2003, an additional 21,885 shares ofPreferred Stock were earned as dividends. For the six months ended June 30, 2003, a total of 43,769 shares wereearned as dividends and were issued as shares of Preferred Stock on June 30,2003.  Preferred Stock dividends earnedfor the three and six months ended June 30, 2003 resulted in an expense ofapproximately $68,000 and $122,000 respectively versus $48,000 and $54,000 forthe same periods in 2002. The fair value of the Preferred Stock, on which thepreferred dividends are calculated, is estimated by management for the purposeof determining net loss applicable to common shares.

 

For the three months ended June 30, 2003, there were 11,678 options topurchase common stock exercised by employees and no shares of common stock werepurchased and issued to employees under the Company’s Employee Stock PurchasePlan.  Total proceeds to Segue for thetransactions were approximately $12,000. For the three months ended June 30, 2002, there were options to purchase15,537 shares of common stock exercised by employees and a director, and noshares of common stock were purchased and issued to employees under theCompany’s Employee Stock Purchase Plan. Total proceeds to Segue for the transactions were approximately$16,000.  For the six months ended June30, 2003, there were a total of 11,678 options to purchase common stockexercised by employees and 84,809 shares of common stock were purchased andissued to employees under the Company’s Employee Stock Purchase Plan.  Total proceeds to Segue for the transactionswere approximately $95,000.  For the sixmonths ended June 30, 2002, there were a total of 25,537 options to purchasecommon stock exercised by employees and directors, and 78,816 shares of commonstock were purchased and issued to employees under the Company’s Employee StockPurchase Plan.  Total proceeds to Seguefor the transactions were approximately $143,000.

 

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

 

**6. ****                                RESTRUCTURINGCHARGES**

 

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

 
| **Quarter** |   | **Severance  and  other employee  related costs** |      | **Number of  employees  terminated as part of  restructuring plan** |   | **%  Reduction  in  workforce** |   | **Cost of  estimated  facility obligations,  net of estimated  sublease income** |    | **Office for  which facility  costs accrued** |      | **Total  Restructuring  Charge** |    |
|-------------|--------|---------------------------------------------------|-----------|---------------------------------------------------------------------|--------|---------------------------------|--------|----------------------------------------------------------------------------------|---------|-----------------------------------------------|-----------|----------------------------------|---------|
|        |   |                                              |      |                                                                |   |                            |   |                                                                             |    |                                          |      |                             |    |
| Q2 2003     |   | —                                            |      | —                                                              |   | —                          |   | —                                                                           |    | —                                        |      | —                           |    |
| Q1 2003     |   | —                                            |      | —                                                              |   | —                          |   | —                                                                           |    | —                                        |      | —                           |    |
| Total 03    |   | —                                            |      | —                                                              |   |                            |   | —                                                                           |    | —                                        |      | —                           |    |
|        |   |                                              |      |                                                                |   |                            |   |                                                                             |    |                                          |      |                             |    |
| Q4 2002     |   | —                                            |      | —                                                              |   | —                          |   | —                                                                           |    | —                                        |      | —                           |    |
| Q3 2002     |   | —                                            |      | —                                                              |   | —                          |   | $                                                                                | 373,000 |                                          | Lexington |                             | $       | 373,000 |   |
| Q2 2002     |   | —                                            |      | —                                                              |   | —                          |   | 147,000                                                                          |    | Lexington                                     |      | 147,000                          |    |
| Q1 2002     |   | $                                                 | 559,000   |                                                                | 12     |                            | 5      |                                                                             | 124,000 |                                          | Lexington |                             | 683,000 |   |
| Total 02    |   | 559,000                                           |      | 12                                                                  |   |                            |   | 644,000                                                                          |    |                                          |      | 1,203,000                        |    |
|        |   |                                              |      |                                                                |   |                            |   |                                                                             |    |                                          |      |                             |    |
| Q4 2001     |   | —                                            |      | —                                                              |   | —                          |   | —                                                                           |    | —                                        |      | —                           |    |
| Q3 2001     |   | 485,000                                           |      | 42                                                                  |   | 14                              |   | 1,479,000                                                                        |    | Lexington                                     |      | 1,964,000                        |    |
| Q2 2001     |   | 859,000                                           |      | 73                                                                  |   | 20                              |   | 1,398,000                                                                        |    | Lexington and Los Gatos                       |      | 2,257,000                        |    |
| Q1 2001     |   | —                                            |      | —                                                              |   | —                          |   | —                                                                           |    | —                                        |      | —                           |    |
| Total 01    |   | 1,344,000                                         |      | 115                                                                 |   |                            |   | 2,877,000                                                                        |    |                                          |      | 4,221,000                        |    |
|        |   |                                              |      |                                                                |   |                            |   |                                                                             |    |                                          |      |                             |    |
| Total       |   | $                                                 | 1,903,000 |                                                                | 127    |                            |   |                                                                             | $       | 3,521,000                                     |      |                             |    | $ | 5,424,000 |   |

 

9

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

 

At June 30, 2003, the accrual balance related to the obligationsassociated with all of the excess office space noted above is approximately$1.8 million.  This is comprised ofan estimated $2.5 million for future rents payable by Segue on unoccupiedspace, plus $25,000 in miscellaneous costs related to subleasing the space,less approximately $757,000 of estimated future sublease income.  The Company made no material estimateadjustments related to this accrual for the period ended June 30, 2003.

 

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

 

Segue recorded provisions for foreign and state income taxes of $27,000and $124,000 for the three and six months ended June 30, 2003,respectively, and $50,000 and $75,000 for the same periods last year. There wasno tax benefit recorded for losses generated in the U.S. in either period dueto the uncertainty of realizing such benefits.

 

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

 

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

 
|                                                                              |   | **Three  months ended June 30,** |   | **Six months  ended June 30,** |   |
|-----------------------------------------------------------------------------------|--------|----------------------------------|--------|--------------------------------|--------|
|                                                                              |   | **2003**                         |   | **2002**                       |   | **2003** |   | **2002** |   |
| Net loss applicable to common shares                                              |   | $                                | (521   | )                              | $      | (1,907 | ) | $ | (646 | ) | $ | (4,245 | ) |
| Weighted average common shares used in net  loss per share—basic and diluted |   | 9,707                            |   | 9,552                          |   | 9,683 |   | 9,522 |   |
| Net loss per common share—basic and diluted                                  |   | $                                | (0.05  | )                              | $      | (0.20 | ) | $ | (0.07 | ) | $ | (0.45 | ) |

 

Excluded from the calculation of diluted earnings per share for thethree and six months ended June 30, 2003 and 2002 were options to purchase3,433,163 and 3,444,641 shares of common stock, respectively, and 773,261 and688,200 shares of common stock issuable upon the conversion of preferred stock,respectively, because their inclusion would be anti-dilutive.

 

**9.****                                      COMPREHENSIVELOSS**

 

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

 
|                            |   | **Three  months ended June 30,** |   | **Six months  ended June 30,** |   |
|---------------------------------|--------|----------------------------------|--------|--------------------------------|--------|
|                            |   | **2003**                         |   | **2002**                       |   | **2003** |   | **2002** |   |
| Net loss                        |   | $                                | (453   | )                              | $      | (1,859 | ) | $ | (524 | ) | $ | (4,191 | ) |
| Foreign translation adjustments |   | 140                              |   | 99                             |   | 164 |   | 196 |   |
| Comprehensive loss              |   | $                                | (313   | )                              | $      | (1,760 | ) | $ | (360 | ) | $ | (3,995 | ) |

 

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

 

In March 2003, Segue amended the distribution agreement it had signedin September 2001 with T-Plan Ltd. of the United Kingdom.  Under the revised agreement, Segue willcontinue to sell and market the T-Plan product that has been modified tointegrate with other Segue products, under the name SilkPlan Pro; Segue willpay T-Plan Ltd. a royalty for each unit sold. However, under the revised terms, Segue will no longer pay T-Plan Ltd. aminimum royalty in each quarter. Effective April 1, 2003, the Company will make advance royalty paymentsof $50,000 per quarter each year through the year 2005.  These advance royalty payments will be creditedagainst the actual royalties due on a cumulative basis until the termination ofthe contract.  Advance royalty paymentswill cease should the cumulative advance payments exceed actual royalties bymore than $100,000.  Either party maycancel the agreement at any time by giving the other party written notice tothat effect at least ninety days prior to such termination.  In the event of a termination of thecontract, Segue will receive a refund if advance royalty payments should exceedactual cumulative royalties.  Otherremaining royalty arrangements are not significant.

 

In the event of a change of control or the sale of substantially allassets, the Company has certain contractual obligations to executive officers,as well as, other non-employee related contracts. These potential obligations,should a triggering event take place, are less than $2.0 million.

 

10

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

 

As of June 30, 2003, Segue had slightly more than $2.4 million in netstockholder’s equity, which is below the NASDAQ’s minimum requirement of $2.5million necessary to maintain our listing on the NASDAQ Small CapExchange.  Management is currently inthe process of developing a plan to re-establish net stockholder’s equity abovethe $2.5 million threshold.

 

**11.****                               SEGMENTREPORTING**

 

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

 
|                                    |   | **Three  months ended June 30,** |   | **Six months  ended June 30,** |   |
|-----------------------------------------|--------|----------------------------------|--------|--------------------------------|--------|
|                                    |   | **2003**                         |   | **2002**                       |   | **2003** |   | **2002** |   |
|                                    |   | **Revenue**                      |   | **Gross  Margin**              |   | **Revenue** |   | **Gross  Margin** |   | **Revenue** |   | **Gross  Margin** |   | **Revenue** |   | **Gross  Margin** |   |
|                                    |   |                             |   |                           |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Software licenses                       |   | $                                | 3,194  |                           | $      | 3,083 |   | $ | 2,514 |   | $ | 2,341 |   | $ | 6,513 |   | $ | 6,338 |   | $ | 5,829 |   | $ | 5,426 |   |
|                                    |   |                             |   |                           |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Training and consulting                 |   | 610                              |   | 32                             |   | 1,050 |   | 331 |   | 1,540 |   | 344 |   | 2,352 |   | 942 |   |
| Maintenance                             |   | 3,432                            |   | 2,791                          |   | 3,292 |   | 2,558 |   | 6,686 |   | 5,354 |   | 6,721 |   | 5,423 |   |
|                                    |   |                             |   |                           |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total services                          |   | 4,042                            |   | 2,823                          |   | 4,342 |   | 2,889 |   | 8,226 |   | 5,698 |   | 9,073 |   | 6,365 |   |
|                                    |   |                             |   |                           |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Less vendor consideration to a customer |   | (58                              | )      | (58                            | )      | (25 | ) | (25 | ) | (95 | ) | (95 | ) | (1,025 | ) | (1,025 | ) |
|                                    |   |                             |   |                           |   |   |   |   |   |   |   |   |   |   |   |   |   |
| Total                                   |   | $                                | 7,178  |                           | $      | 5,848 |   | $ | 6,831 |   | $ | 5,205 |   | $ | 14,644 |   | $ | 11,941 |   | $ | 13,877 |   | $ | 10,766 |   |

 

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

 
|          |   | **Total Net Revenue**            |   |                           |   |
|---------------|--------|----------------------------------|--------|--------------------------------|--------|
|          |   | **Three months ended  June 30,** |   | **Six months ended  June 30,** |   | **Long Lived Assets  June 30,** |   |
|          |   | **2003**                         |   | **2002**                       |   | **2003** |   | **2002** |   | **2003** |   | **2002** |   |
|          |   |                             |   |                           |   |   |   |   |   |   |   |   |   |
| United States |   | $                                | 6,079  |                           | $      | 5,863 |   | $ | 11,887 |   | $ | 11,882 |   | $ | 2,066 |   | $ | 2,778 |   |
| Foreign       |   | 1,099                            |   | 968                            |   | 2,757 |   | 1,995 |   | 419 |   | 666 |   |
|          |   | $                                | 7,178  |                           | $      | 6,831 |   | $ | 14,644 |   | $ | 13,877 |   | $ | 2,485 |   | $ | 3,444 |   |

 

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

 

**CRITICAL ACCOUNTINGPOLICIES**

 

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

 

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

 

11

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**REVENUERECOGNITION**—Segue’s revenue recognition policy followsthe guidance prescribed in Statement of Position 97-2 (SOP 97-2) and Statementof Position 98-9 (SOP 98-9). These call for the residual method of revenue formulti-element arrangements when the vendor-specific objective evidence (VSOE)of the fair value does not exist for one 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 byVSOE, is deferred and subsequently recognized in accordance with relevantsections of SOP 97-2 and (2) the difference between the total arrangementfee and the amount deferred for the undelivered elements is recognized asrevenue related to the delivered elements.

 

Segue does a thorough review of the VSOE of undelivered itemssemi-annually. If the average actual VSOE is substantially different from thestandard VSOE, the Company adjusts the standards to be more reflective of theactual VSOE. This change may result in more or less revenue being recognizedrelated to the initial delivery. To date, the difference between Segue’sstandard VSOE and the actual VSOE has been immaterial and no adjustments havebeen made.

 

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

 

**RESTRUCTURINGAND IMPAIRMENT CHARGES**—Another critical accountingpolicy relates to the recording of restructuring losses. Segue followed theguidance prescribed in EITF 94-3, “Liability Recognition for Certain EmployeeTermination Benefits and Other Costs to Exit an Activity (Including CertainCosts Incurred in a Restructuring)”. As such, since April 2001, Segue hasrecorded total restructuring charges of $5.4 million, which includes $3.5million for the cost of unused space in our Lexington and Los Gatos offices,net of estimated sublease income, that resulted from workforce reductions.Refer to Note 6 in our Consolidated

Financial Statements in this Form 10-Q for additional information.This estimate for the loss on unused space was based on information that wasavailable at that time. Factors that were included were anticipated rentalrates in the local commercial office market and the estimated timeframe inwhich we expected to sublease the space. Segue obtained local real estatemarket data and consulted with its real estate advisor on these factors to helpdetermine an appropriate reserve for potential losses on the unused space.During the fourth quarter of 2002, Segue was able to reach an agreement inprinciple with its landlord to restructure the sublease for our Lexingtonfacility. A formal agreement was consummated on January 24, 2003.  There were no restructuring charges for thesecond quarter of 2003.  At June 30,2003, the accrual balance related to the obligations associated with all of theexcess office space in both the Lexington and Los Gatos facilities isapproximately $1.8 million.  Thisis comprised of an estimated $2.5 million for future rents payable bySegue on unoccupied space, plus $25,000 in miscellaneous costs related tosubleasing the space, less approximately $757,000 of estimated future subleaseincome.  Segue is under a restructuredsublease for the Lexington facility until October 2007.

 

**GOODWILL-**As required by SFAS No. 142, “Goodwill and OtherIntangible Assets”, Segue discontinued the amortization of goodwill effectiveJanuary 1, 2002. Goodwill represents the excess of cost over the fairvalue of the net assets of businesses acquired. Goodwill resulted from Segue’sacquisition of SQLBench in December 1997 and was being amortized using thestraight-line method over five years. During the year ended December 31, 2002, Segue performed an initialanalysis of the transitional fair value of the goodwill and re-evaluated thefair value of the goodwill during the fourth quarter of 2002. The analysisdemonstrated that no impairment existed at December 31, 2002 and noadjustment was made. Segue will re-evaluate the fair value of the goodwillduring the fourth quarter of 2003. Any future impairment loss that may occurwould not exceed $1.5 million, which is the net amount of goodwill that ison the consolidated balance sheet at June 30, 2003.

 

**PREFERRED STOCK DIVIDEND-IN-KIND -**OnMarch 22, 2002, the Company and S-7 Associates LLC, a company managed andowned by the Chairman of Segue’s Board of Directors, Dr. James H. Simons(“S-7 Associates”), signed an agreement under which S-7 Associates purchased666,667 shares of the Company’s Series B Preferred Stock (“Preferred Stock”) inconsideration for a payment of $2.0 million.  The Preferred Stock is senior to the common stock as to dividendand liquidation rights and is convertible at the option of the holder intoshares of common stock of Segue at a conversion rate of one share of preferredfor one share of common, subject to adjustment upon the occurrence of certaintransactions.  Dividends on thePreferred Stock accrue at 12% per annum and are to be paid in additional sharesof preferred stock semiannually. Management has estimated the value of a share of preferred stock to beequal to 140% of the average stock price for the Company’s common stock for theperiod in question.  The Company accruesfor the estimated value of the preferred stock dividend-in-kind on a quarterlybasis.

 

12

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**RESULTS OF OPERATIONS**

 

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

 
|                                    |   | **Percentage  of Revenue for  Three Months Ended June 30,** |   | **Percentage  of Revenue for  Six Months Ended June 30,** |   |
|-----------------------------------------|--------|-------------------------------------------------------------|--------|-----------------------------------------------------------|--------|
|                                    |   | **2003**                                                    |   | **2002**                                                  |   | **2003** |   | **2002** |   |
|                                    |   |                                                        |   |                                                      |   |   |   |   |   |
| Revenue:                                |   |                                                        |   |                                                      |   |   |   |   |   |
| Software                                |   | 44.5                                                        | %      | 36.8                                                      | %      | 44.4 | % | 42.0 | % |
| Services                                |   | 56.3                                                        |   | 63.6                                                      |   | 56.2 |   | 65.4 |   |
| Subtotal revenue                        |   | 100.8                                                       |   | 100.4                                                     |   | 100.6 |   | 107.4 |   |
| Less vendor consideration to a customer |   | (0.8                                                        | )      | (0.4                                                      | )      | (0.6 | ) | (7.4 | ) |
| Net revenue                             |   | 100.0                                                       |   | 100.0                                                     |   | 100.0 |   | 100.0 |   |
|                                    |   |                                                        |   |                                                      |   |   |   |   |   |
| Cost of revenue:                        |   |                                                        |   |                                                      |   |   |   |   |   |
| Cost of software                        |   | 1.5                                                         |   | 2.5                                                       |   | 1.2 |   | 2.9 |   |
| Cost of services                        |   | 17.0                                                        |   | 21.3                                                      |   | 17.3 |   | 19.5 |   |
| Total cost of revenue                   |   | 18.5                                                        |   | 23.8                                                      |   | 18.5 |   | 22.4 |   |
|                                    |   |                                                        |   |                                                      |   |   |   |   |   |
| Gross margin                            |   | 81.5                                                        |   | 76.2                                                      |   | 81.5 |   | 77.6 |   |
|                                    |   |                                                        |   |                                                      |   |   |   |   |   |
| Operating expenses:                     |   |                                                        |   |                                                      |   |   |   |   |   |
| Sales and marketing                     |   | 49.4                                                        |   | 58.9                                                      |   | 48.5 |   | 60.9 |   |
| Research and development                |   | 20.3                                                        |   | 22.9                                                      |   | 19.9 |   | 20.7 |   |
| General and administrative              |   | 17.9                                                        |   | 19.1                                                      |   | 16.1 |   | 20.0 |   |
| Restructuring and other charges         |   | —                                                      |   | 2.1                                                       |   | — |   | 6.0 |   |
| Total operating expenses                |   | 87.6                                                        |   | 103.0                                                     |   | 84.5 |   | 107.6 |   |
|                                    |   |                                                        |   |                                                      |   |   |   |   |   |
| Loss from operations                    |   | (6.1                                                        | )      | (26.8                                                     | )      | (3.0 | ) | (30.0 | ) |
| Interest Income                         |   | 0.2                                                         |   | 0.3                                                       |   | 0.2 |   | 0.3 |   |
| Loss before provision for income taxes  |   | (5.9                                                        | )      | (26.5                                                     | )      | (2.8 | ) | (29.7 | ) |
| Provision for income taxes              |   | 0.4                                                         |   | 0.7                                                       |   | 0.8 |   | 0.5 |   |
| Net loss                                |   | (6.3                                                        | )%     | (27.2                                                     | )%     | (3.6 | )% | (30.2 | )% |

 

**SOFTWARE REVENUE**

 

Software revenue increased 27% to $3.2 million during the secondquarter of 2003 from $2.5 million for the same period in 2002. For the sixmonths ended June 30, 2003, software revenue increased 12% to $6.5 million from$5.8 million for the six months ended June 30, 2002.  The overall factor contributing to the increase in softwarerevenue for the three months ending June 30, 2003 was due to theincrease in average deal size as compared to the same period in 2002.  On a year to date basis, the major reasonsfor the increase in software revenue as compared to the same period in 2002,was the closing of several large deals early in 2003, which significantlyincreased our average invoice size and an increase in international sales.  International software revenue accounted for21%, or $665,000, and 27%, or $1.8 million, of total software revenue for thethree and six months ended June 30, 2003, respectively, as compared to 21%, or$521,000 and 19%, or $1.1 million for the same periods in 2002.  The increase in international softwarerevenue, in absolute dollars, was due to stronger performance by Europeanresellers and distributors.

 

**SERVICES REVENUE**

 

Services revenue decreased 7% to $4.0 million during the secondquarter of 2003 from $4.3 million in the same quarter of 2002. For the sixmonths ended June 30, 2003, services revenue decreased 10% to $8.2 million, ascompared to $9.1 million for the six months ended June 30, 2002.  As compared to the three and six monthsended June 30, 2002, training and consulting revenue decreased 42% and 35% forthe same periods in 2003, respectively. The decrease in training and consulting revenue in 2003, as compared tothe same prior-year periods, is primarily attributable to the continueddifficult economic conditions in 2003, which caused a decrease in bookings anddelivery of training and consulting engagements.  Additionally, we continue to see an increase in customers usingon-line training, which allows them to realize the full value of training whilekeeping expenses to a minimum.  For thethree months ended June 30, 2003, recognized maintenance revenue increased 4%from the same period in 2002.  Theincrease in recognized maintenance revenue was largely attributable toincreased product sales and a continued higher renewal rate in the period

 

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as compared to 2002.  For thefirst half of 2003, recognized maintenance revenue essentially remainedunchanged from the same period in 2002.

 

**ADJUSTMENT RELATINGTO PAYMENT TO A CUSTOMER**

 

Inthe three and six months ended June 30, 2003, the Company made payments ofapproximately $58,000 and $95,000 to several resellers for referral fees, ascompared to $25,000 and $1.0 million in the same period of 2002.  Under EITF Issue No. 01-9, these paymentswere considered to be a reduction in revenue and are presented in the statementof operations as such.  In January 2002,the Company made a one-time payment of $1.0 million to IBM.  There were no other material payments madeby the Company in the second quarter of 2003 or prior quarters that would beconsidered for reclassification under the guidance inEITF Issue No. 01-9.

 

**COST OF SOFTWARE**

 

Cost of software decreased 36% to $111,000 during the second quarter of2003 from $173,000 in the same quarter of 2002. For the six months endedJune 30, 2003, cost of software decreased 57% to $175,000 from$403,000 in the same period of 2002. As a percentage of software revenue, costof software decreased to 3% from 7% in both the three months and six monthsended June 30, 2003 as compared to the same periods in 2002.  The decrease in cost of software, both inamount and as a percentage of software revenue, was primarily due to reducedpersonnel and facility related expenses and a reduction in royalties andreseller commissions.

Furthermore, more software orders are being delivered electronically,reducing the use of media, manuals and packaging.

 

**COST OF SERVICES**

 

Cost of services decreased 20% to $1.2 million and 7% to $2.5 millionfor the three months and six months ended June 30, 2003, as compared to $1.5million and $2.7 million for the same periods in 2002.  Cost of services consists primarily of costsof providing customer technical support, training and consulting. During thesecond quarter of 2003, cost of services as a percentage of services revenuedecreased to 30% from 33% in the same quarter last year.  For the six months ended June 30, 2003, costof services as a percentage of services revenue increased to 31% from 30% inthe corresponding prior-year period. Cost of services as a percentage of services revenue may vary based onthe profitability of individual consulting engagements and the utilization rateof in-house consultants. For the second quarter of 2003, cost of training andconsulting decreased 20% to $578,000 from $719,000 for the same quarter of2002. For the six months ended June 30, 2003, cost of training and consultingdecreased 14% to $1.2 million as compared to $1.4 million for the correspondingprior-year period. The decrease is primarily attributable to lower personnelrelated expenses, reduced outsourced consulting expenses and lower telephoneexpense.  For the three months endedJune 30, 2003, cost of maintenance decreased 13% to $641,000 from $734,000 forthe same period in 2002.  For the firsthalf of 2003, cost of maintenance remained relatively unchanged at $1.3 millionfrom the same period in 2002.  Thedecreases are mainly in allocated rent, telephone and depreciation, whichrepresent further shifting of support responsibilities to the global technicalsupport center in Northern Ireland, where operating expenses are generallylower.

 

# **SALES AND MARKETING**

 

Sales and marketing expenses decreased 13% to $3.5 million duringthe second quarter of 2003 from $4.0 million in the second quarter of2002.  For the six months ended June 30,2003, sales and marketing expenses decreased 15% to $7.1 million from $8.4million in the corresponding prior-year period.  The main reasons for the decreases are lower personnel andfacility related costs due to the restructurings during 2002 and less travelrelated expenses, partially offset by increased commissions because of higherrevenue.

 

**RESEARCH ANDDEVELOPMENT**

 

Research and development expenses decreased 6% to $1.5 million duringthe second quarter of 2003 from $1.6 million in the same quarter of 2002.  For the six months ended June 30, 2003,research and development expenses remained relatively unchanged at $2.9 millionfrom the same period in 2002.  Thedecrease is mainly related to a reduction in personnel and facility related costsassociated with the restructuring in 2002, partially offset by the exchangerate translation in the European market on the expenses of our foreignoperations.

 

**GENERAL ANDADMINISTRATIVE**

 

General and administrative expenses remained unchanged at $1.3 millionduring the second quarter of 2003 as compared to the same period in 2002.  For the six months ended June 30, 2003,general and administrative expenses decreased 14% to $2.4 million from $2.8million in the corresponding prior-year period.  The decrease in expenses are a result of lower personnel relatedand allocated expenses due to the restructuring actions in 2002 and reducedlegal expenses.  The overall decrease ingeneral and administrative expense was partially offset by recruitment chargesincurred relating to the CEO search and for bad debt expense in the first sixmonths of 2003 as compared to $196,000 recoveries of bad debt in the sameperiod in 2002.

 

14

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**RESTRUCTURING CHARGES**

 

For the three and six months ended June 30, 2003, there were norestructuring charges recorded.  Duringthe second quarter of 2002, Segue recorded as restructuring charges $147,000for an increase in the estimate of the loss associated with excess officefacilities. For the six months ended June 30, 2002, the Company recordedrestructuring charges of $830,000, which included $559,000 for a reduction inworkforce of approximately 5% and approximately $271,000 for facility-relatedcosts, which included the accrual of estimated lease obligations associatedwith the excess office facilities in our Lexington office, net of anticipatedsubleasing income.

 

**OTHER INCOME, NET**

 

Other income, net decreased 36% to $14,000 during the second quarter of2003 from $22,000 in the same quarter of 2002. For the six months ended June 30, 2003, net other income decreased 37%to $27,000 from $43,000 in the same period last year.  Other income consists mainly of interest income on cashequivalents and short-term investments. The decrease in interest income was primarily due to lower balances ofcash equivalents and short-term investments in 2003 in comparison to the sameperiod in 2002, and lower interest rates on those investments.

 

**PROVISION FOR INCOMETAXES**

 

We recorded a provision for foreign and state income taxes of $27,000and $124,000 for the three and six months ended June 30, 2003, respectively, ascompared to $50,000 and $75,000 for the same periods in 2002.  There was no tax benefit recorded for lossesgenerated in the U. S. in any period due to the uncertainty of realizing suchbenefits.  The increase in taxes was dueto adjustments in foreign tax provisions in the six months of 2003 as comparedto the same period in 2002.

 

**LIQUIDITY AND CAPITALRESOURCES**

 

As of June 30, 2003, our principal sources of liquidity included cash,cash equivalents and short-term investments totaling $6.1 million, ascompared to $5.3 million as of December 31, 2002.

 

Our operating activities generated cash of $441,000 during the firstsix months of 2003 compared to $2.9 million cash utilized in the same period in2002.  Cash generated from operatingactivities in 2003 resulted from our net loss, adjusted for depreciation offixed assets, as well as increases in other current assets and accountspayable, offset by decreases in accounts receivable and decreases in accruedexpenses and deferred revenue.

 

Our investingactivities generated cash of $178,000 and $4.7 million in the first six monthsof 2003 and 2002, respectively.  Cashgenerated in 2003 came from a decrease in other assets partially offset bypurchases in property and equipment, as compared to 2002, which primarily camefrom maturing short-term investments. We continued to keep purchases of property and equipment low during thequarter.  In the future, Segue may needto make increased expenditures on property and equipment as present equipmentages.

 

We generated funds from financing activities of $95,000 during thefirst half of 2003, as compared to $2.1 million during the same period in2002.  Cash generated from financingactivities in 2003 was primarily generated from the sale of stock under theemployee stock purchase plan, while the first six months of 2002 also included$2.0 million from the issuance of convertible preferred stock.

 

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

 

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

 

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

 

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

 

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from the current level.

 

Assuming that Segue can execute on current plans to increase revenuethrough its restructured sales program, its focus on enterprise customers, andits introduction and success of new and enhanced products, and the businessclimate for IT spending does not worsen, we believe that with the fundingdescribed above, plus current cash and cash equivalents, Segue will havesufficient resources to meet its working capital and debt requirements for atleast the next twelve months. However, if we are not able to increase currentbusiness levels or the economy worsens, we may need to take other actions inorder to fund our working capital requirements.

 

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

 

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

 

**FACTORS THAT MAYAFFECT FUTURE RESULTS**

 

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

 

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

 

***We may not beprofitable in the future.***  Since Segue began operations, it hasgenerally experienced losses. Losses have resulted in an accumulated deficit ofapproximately $57.8 million as of June 30, 2003. In the fourth quarter of2002, Segue reported net income of $857,000, but in the first quarter of 2003the Company reported a net loss of $71,000, and in the second quarter of 2003,Segue reported a net loss of $453,000. It is uncertain whether the Company can return to profitability in thefuture. For the period ended June 30, 2003, the Company had total revenue of$7.2 million verses $6.8 million in the same period last year.  During 2001 and 2002, Segue initiatedaggressive cost saving measures in an effort to reduce expenses, enhance thepossibility of profitability, and conserve cash, and the Company has sustainedthese measures in 2003. Despite these cost saving measures, the Company’sfuture profitability remains uncertain. Failure to achieve profitability mayadversely affect the market price of Segue’s common stock.

 

***Continued decline inbusiness conditions and Information Technology (IT) spending could causefurther decline in revenue.***  The level of future IT spending remains veryuncertain particularly in light of the continued decline in the businessclimate throughout 2002 and early 2003. If IT spending does not increase,Segue’s revenues could be further adversely impacted.

 

***Segue may not derivesubstantial incremental revenue from its alliances and SilkElite PartnerProgram.*** In an effort to augment product revenue derived from the efforts of itsdirect sales force, Segue has focused on expanding its key strategic alliancesand on building a successful SilkElite Partner Program. Segue has builtalliances with PeopleSoft, Allen Systems Group, Microsoft and IBM.  The SilkElite Partners Program focuses onresellers, consulting partners and distributors. SilkElite Partners both resellSegue products and use Segue software products in the delivery of consultingservices. The success of the key strategic alliances and the SilkElite Programis uncertain, faces strong competition, and takes time and significantresources to develop. Should Segue fail to generate substantial incrementalrevenue from its strategic alliances or its SilkElite Program, the financialresults and stock price could be adversely affected.

 

***The effect of thechange in the IBM relationship is uncertain.*** In 2002, Segue signed an expanded contractwith IBM Corporation

 

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under which Segue was the exclusive external provider of software forIBM Global Infrastructure and Systems Management Services’ (IGSSMS) new remoteinfrastructure analysis offering. *** ***Inthe first quarter of 2003, IBM’s IGSSMS advised Segue that it would no longerbe offering the remote monitoring service, which was powered by Segue’sSilkVision software.  The Company hadinvested $1.0 million to accelerate the implementation of this service.  Segue is negotiating the termination of thisportion of the IBM contract, and the return of the amount of the investment notspent by IBM in the deployment of this service.  The amount of any return is uncertain and there is no obligationto do so.  In addition, in the secondquarter of 2003, IBM Tivoli advised Segue of the cancellation of the royaltycontract signed by both companies in September of 2002.  Tivoli was expected to integrate Segue’sSilkTest software into a larger Tivoli product suite, and Segue was to havereceived a royalty each time Tivoli sold its product suite.  IBM acquired Rational Software in February2003 and accordingly, IBM Tivoli has decided to use a Rational Software testingtool in place of Segue’s tool.  Seguehad the potential to receive up to $2.5 million in royalties over the nextseveral years.  The impact of theseevents on the remaining IBM relationship and future revenue is uncertain.

 

***Our future successwill depend on our ability to respond rapidly and effectively to technologicaland other market changes, including the successful introduction of new andenhanced products.***  The nature of the automated software testing, performancemanagement and application monitoring markets in which we compete ischaracterized by rapidly changing technology, rapidly evolving customer needsand desires, changes in industry standards and practices and frequent releasesof new product or enhancements by competitors. To be competitive, Segue mustdevelop and introduce product enhancements and new products that address theincreasingly sophisticated and varied needs of our existing and potentialcustomers. For the first six months of 2003, over 87% of Segue’s productrevenues were generated from its SilkPerformer and SilkTest products comparedto over 96% in same period last year. During the quarter ended June 30, 2003, Segue released SilkVision 2.0,the newest version of its powerful Web-based enterprise monitoringsoftware.  The Company anticipatesreleasing further product enhancements in 2003.  If these new products are not successful or if we fail tocontinue to develop and introduce new products and enhancements on a timelybasis, or maintain our level of product revenue from SilkPerformer andSilkTest, or fail to generate substantial incremental revenue from our newproducts, our business may be materially adversely affected.

 

***We may faceliquidity issues.*** We have taken steps to conserve our use of cash, including significantlyreducing headcount, infrastructure and other expenses, and limiting capital expendituresin order to compensate in part for our recent decline in revenues, to improveour liquidity and to achieve greater efficiencies. Segue believes that based onexpense savings and the stability of its revenue in the last year, that futuresales at or above current levels should be sufficient to allow us to continueas a viable business. For the six months ended June 30, 2003, the Companygenerated $741,000 in positive cash flow. Total gross revenue in the firstquarter 2003 declined by approximately 7% from the same prior year period, butincreased by approximately 6% in the second quarter of 2003 over the sameperiod last year. If the Company fails to maintain or grow revenue levels wemay have to raise additional financing to fund working capital needs. If wefail to generate substantial incremental revenue, or we are not successful inraising additional financing on terms acceptable to Segue, we may not havesufficient working capital resources and our business may be materiallyadversely affected.

 

***The Company’sinterim management structure could adversely impact its business.***  In the second quarter of 2003, the Company’sChief Executive Officer resigned.  TheCompany is actively recruiting a replacement Chief Executive Officer with theassistance of Korn/Ferry, an international executive search firm.  Two members of senior management arecurrently serving as Co-Chief Executive Officers.  The effect of this interim management structure on the Company’sbusiness and employees is uncertain.

 

***We cannot assure aliquid market for our stock.***  In 2002, Segue was informed by NASDAQ thatthe company was not in compliance with certain listing requirements forcontinued listing on their National Market exchange.  Segue was able to take steps to meet the initial listingrequirements of the NASDAQ Small Cap Market Exchange.  As of June 30, 2003, Segue had slightly more than $2.4 million innet stockholder’s equity, which is below the NASDAQ’s minimum requirement of$2.5 million necessary to maintain our listing on the NASDAQ Small CapExchange.  Management is currently inthe process of developing a plan to re-establish net stockholder’s equity abovethe $2.5 million threshold.  Continuedcompliance with the listing requirements of the NASDAQ Small Cap Market Exchange,and thus a liquid market for our common stock, are closely related to thefinancial performance of the Company. The Company’s future business may not besufficient to assure continued listing on the NASDAQ Small Cap Market Exchange.

 

***We may have difficultyoperating the business efficiently with fewer resources.***  Since 2000, Segue has reduced headcount byapproximately 50% and implemented several cost reduction initiatives, includingreduced marketing and sales expenses. Segue was able to achieve increasedproductivity with fewer resources. Segue’s ability to further increase itscurrent productivity, as well as sustain current performance with fewerresources, is uncertain.

 

***Segue facessignificant competition from other software companies.***  The market for web-based software qualitymanagement and testing and monitoring tools is intensely competitive andsubject to rapid technological change. We expect competition to intensify evenfurther in the future. Segue currently encounters competition from a number ofpublic and private companies, including Mercury Interactive Corporation,Rational Software Corporation (now part of IBM), Compuware Corporation andEmpirix. Many of our current and potential competitors have longer operatinghistories, greater name recognition, larger installed customer bases, andsignificantly greater financial, technical and marketing resources than we do.Therefore, they may be able to respond more quickly to new or changingopportunities, technologies, standards or customer requirements or may be ableto devote greater resources to the promotion

 

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and sale of their products than we can. An increase in competitioncould result in price reductions and loss of market share. Such competition andany resulting reduction in profitability could have a material adverse effecton our business, operating results and financial condition.

 

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

 

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

 

***We face many risksassociated with international business activities.***  We derived approximately 19% of totalrevenue from international customers in the first six months of 2003, comparedto 14% in the first six months of 2002. The international market for software products is highly competitive andwe expect to face substantial competition in this market from established andemerging companies. Segue faces many risks associated with internationalbusiness activities including currency fluctuations, imposition of governmentcontrols, export license requirements, restrictions on the export of criticaltechnology, political and economic instability, tailoring of products to localrequirements, trade restrictions, changes in tariffs and taxes, difficulties instaffing and managing international operations, longer accounts receivablepayment cycles and the burdens of complying with a wide variety of foreign lawsand regulations. Continued growth of international sales is important to growthand the stability of Segue. To the extent we are unable to continue to expandinternational sales in a timely and cost-effective manner, our business couldbe materially adversely affected.

 

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

 

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

 

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

 

*INTEREST RATE RISK.*  Segue is exposed to market risk from changes in interest ratesprimarily through its investing and borrowing activities. In addition, ourability to finance future transactions may be impacted if we are unable toobtain appropriate financing at acceptable rates. Our investing strategy tomanage interest rate exposure is to invest in short-term, highly secured andliquid investments. We maintain a portfolio of highly liquid cash equivalentsand short-term investments (primarily in high-grade  commercial paper).  As ofJune 30, 2003, we had no short-term investments, only cash and cashequivalents.

 

*FOREIGN CURRENCY RISK.*  Segue faces exposure to movements in foreigncurrency exchange rates. These exposures may change over time as businesspractices evolve and could have a material adverse effect on our business,financial condition and results of operations. We do not use derivativefinancial instruments or other financial instruments to hedge economicexposures or for trading. Historically, our primary currency exposures havebeen related to the operations of our foreign subsidiaries. For the three andsix month period ended June 30, 2003, we incurred transaction andre-measurement expenses of approximately $130,000 and $150,000 respectively,versus $4,000 and $165,000 for the same periods in 2002.  As of June 30, 2003, the cumulativetranslation of foreign currency changes recorded in stockholders’ equity was$262,000.

 

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# **ITEM 4**. CONTROLS AND PROCEDURES

 

### **Evaluationof Disclosure Controls and Procedures**

 

As required by new Rule 13a-15 under the Securities Exchange Actof 1934, within the 90 days prior to the date of this report, we carriedout an evaluation under the supervision and with the participation of ourmanagement, including our Acting Co-Chief Executive Officers and ChiefFinancial Officer, of the effectiveness of the design and operation of ourdisclosure controls and procedures. In designing and evaluating our disclosurecontrols and procedures, we and our management recognize that any controls andprocedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving the desired control objectives, and ourmanagement necessarily was required to apply its judgment in evaluating andimplementing possible controls and procedures. Based upon that evaluation, ourActing Co-Chief Executive Officers and Chief Financial Officer concluded that,as of the date of completion of the evaluation, our disclosure controls andprocedures were reasonably effective to ensure that information required to bedisclosed by us in the reports we file or submit under the Exchange Act isrecorded, processed, summarized and reported, within the time periods specifiedin the Securities and Exchange Commission’s rules and forms. In connection withthe new rules, we will continue to review and document our disclosure controlsand procedures, including our internal controls and procedures for financialreporting, on an ongoing basis, and may from time to time make changes aimed atenhancing their effectiveness and to ensure that our systems evolve with ourbusiness. Since the date of this evaluation we have had no changes in, oraffecting, our disclosure controls and procedures.

 

### **Changesin Internal Controls**

 

There were no significant changes in our internal controls or to ourknowledge, in other factors that could significantly affect these controlssubsequent to the date of the evaluation referenced above.

### ** **

### **PART II. OTHERINFORMATION**

 

**ITEM 1. LEGAL PROCEEDINGS**

 

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

 

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

 

The 2003 Annual Meeting of Stockholders of Segue Software, Inc. (the“Annual Meeting”) was held on June 6, 2003.

 

At the Annual Meeting, the following individuals were elected toSegue’s Board of Directors, constituting all members of Segue’s Board ofDirectors:

 
|                  |   | **Votes For** |   | **Votes  Withheld** |   |
|-----------------------|--------|---------------|--------|---------------------|--------|
| Edmund F. Kelly       |   | 7,948,323     |   | 1,010,886           |   |
| John R. Levine        |   | 7,948,323     |   | 1,010,886           |   |
| Howard L. Morgan      |   | 7,872,723     |   | 1,086,486           |   |
| Robert W. Powers, Jr. |   | 7,948,323     |   | 1,010,886           |   |
| Jyoti Prakash         |   | 7,804,038     |   | 1,155,171           |   |
| James H. Simons       |   | 7,873,723     |   | 1,085,486           |   |

 

The following additional proposals were considered at the AnnualMeeting:

 
|                                                                                                                                                                                                             |   | **Votes  For** |   | **Votes  Against** |   | **Votes  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 100,000. |   | 7,692,130      |   | 1,250,735          |   | 16,344              |   |
| Ratification of the appointment of Grant  Thornton LLP as independent public accountants for the fiscal year ending  December 31, 2003                                                                           |   | 7,907,387      |   | 1,033,708          |   | 18,114              |   |

 

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**ITEM 5. OTHER INFORMATION**

 

On May 5, 2003, the Company announced thatStephen B. Butler resigned as chief executive officer, president and directorto take a position with a private company in the electronic design automationmarket.  The Company has initiated asearch process for a new chief executive officer and has hired an executivesearch firm to assist in the process. Until a successor chief executive officer is named, the board ofdirectors has elected Samuel J. Gallo, senior vice president and generalcounsel, and Douglas Zaccaro, senior vice president, chief financial officer,and treasurer as acting co-chief executive officers.  Mr. Butler did not stand for re-election to the Board at theCompany’s June 6, 2003, annual meeting.

 

As of the date of this report, the Companywas still in the process of searching for a successor to Mr. Butler.

 

**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 Acting Co-Chief Executive Officer pursuant to  Section 302 of the Sarbanes-Oxley Act of 2002.                                                                             |
|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                                                       |
| 31.2   | Certification of Acting Co-Chief Executive Officer and Chief  Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                 |
|   |                                                                                                                                                                                       |
| 32.1   | Certification of Acting Co-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 Acting Co-Chief Executive Officer and 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 23, 2003 regarding a press releaseannouncing that Segue Software had reported its financial results for the firstquarter ended March 31, 2003.

 

 

### **SIGNATURES**

 

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

 

Date: August 12, 2003.

 
|   | **SEGUE SOFTWARE,  INC.** |
|--------|---------------------------|
|   |                      |   |
|   | By:                       | /s/ DOUGLAS ZACCARO |   |
|   |                      |   |
|   |                      | Douglas Zaccaro |
|   |                      | Acting Co-Chief Executive Officer and Chief Financial Officer of the  Company |
|   |                      |   |
|   | By:                       | /s/ SAMUEL J. GALLO |   |
|   |                      |   |
|   |                      | Samuel J. Gallo |
|   |                      | Acting Co-Chief Executive Officer of the Company |

 

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