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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION


Washington, D.C. 20549




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FORM 10-Q

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

For the transition period
from                     to

Commission file number 0-27794



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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



---

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

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

The number of shares of Registrants Common
Stock outstanding as of October 31, 2004 was 10,015,848.



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SEGUE SOFTWARE, INC.

FORM 10-Q

FOR THE QUARTERLY PERIOD ENDED
SEPTEMBER 30, 2004

INDEX

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



1



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##### Table of Contents






PART I.     FINANCIAL
INFORMATION

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

Some of the factors that might cause these
differences are discussed under the heading Risks and
Factors That May Affect Future Results beginning on
page 23. You should carefully review all of these factors,
and you should be aware that there might be other factors that
could cause these differences. These forward-looking statements
were based on information, plans and estimates at the date of
this report, and we do not promise to update any forward-looking
statements to reflect changes in underlying assumptions or
factors, new information, future events or other changes.

2



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

SEGUE SOFTWARE, INC.



CONDENSED CONSOLIDATED BALANCE
SHEETS


(In thousands except per share data)


|                                         |                                                                                                                                                                                                        |                                            |       |              |        |  |       |         |        | 
|---------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ | ------------------------------------------ | ----- | ------------ | ------ |  | ----- | ------- | ------ | 
|                                         |                                                                                                                                                                                                        | September 30,                              |       | December 31,
|                                         |                                                                                                                                                                                                        | 2004                                       |       | 2003        
|                                         |                                                                                                                                                                                                        |                                            |       |             
|                                         |                                                                                                                                                                                                        | (Unaudited)                                |       |             
|Current assets:                          |                                                                                                                                                                                                        |                                            |       |              |        |  |       |        
|                                         | Cash and cash equivalents                                                                                                                                                                              |                                            | $     | 9,922        |        |  | $     | 7,495   |       
|                                         | Accounts receivable, net of allowances of $211
    and $268, respectively                                                                                                                              |                                            |       | 5,257        |        |  |       | 5,607   |       
|                                         | Other current assets                                                                                                                                                                                   |                                            |       | 1,280        |        |  |       | 1,021   |       
|                                         |                                                                                                                                                                                                        |                                            |       |              |        |  |       |        
|                                         |                                                                                                                                                                                                        | Total current assets                       |       |              | 16,459 |  |       |         | 14,123 | 
|Property and equipment, net              |                                                                                                                                                                                                        |                                            | 714   |              |        |  | 1,069 |        
|Goodwill, net                            |                                                                                                                                                                                                        |                                            | 1,506 |              |        |  | 1,506 |        
|Other assets                             |                                                                                                                                                                                                        |                                            | 941   |              |        |  | 939   |        
|                                         |                                                                                                                                                                                                        |                                            |       |              |        |  |       |        
|                                         |                                                                                                                                                                                                        | Total assets                               |       | $            | 19,620 |  |       | $       | 17,637 | 
|                                         |                                                                                                                                                                                                        |                                            |       |              |        |  |       |        
|                                        
|LIABILITIES AND STOCKHOLDERS
    EQUITY
|Current liabilities:                     |                                                                                                                                                                                                        |                                            |       |              |        |  |       |        
|                                         | Accounts payable                                                                                                                                                                                       |                                            | $     | 671          |        |  | $     | 1,004   |       
|                                         | Accrued compensation and benefits                                                                                                                                                                      |                                            |       | 1,682        |        |  |       | 1,931   |       
|                                         | Accrued lease obligations on excess space                                                                                                                                                              |                                            |       | 1,191        |        |  |       | 1,554   |       
|                                         | Accrued expenses                                                                                                                                                                                       |                                            |       | 1,048        |        |  |       | 851     |       
|                                         | Deferred revenue                                                                                                                                                                                       |                                            |       | 9,494        |        |  |       | 9,015   |       
|                                         |                                                                                                                                                                                                        |                                            |       |              |        |  |       |        
|                                         |                                                                                                                                                                                                        | Total current liabilities                  |       |              | 14,086 |  |       |         | 14,355 | 
|Stockholders equity:                    |                                                                                                                                                                                                        |                                            |       |              |        |  |       |        
|                                         | Preferred stock, par value $.01 per share;
    9,000 shares authorized; 869 and 819 shares of
    Series B and 538 and 508 shares of Series C
    preferred stock issued and outstanding, respectively |                                            |       | 4,303        |        |  |       | 3,884   |       
|                                         | Common stock, par value $.01 per share;
    30,000 shares authorized; 10,160 and 9,926 shares
    issued, respectively                                                                                 |                                            |       | 102          |        |  |       | 100     |       
|                                         | Additional paid-in capital                                                                                                                                                                             |                                            |       | 58,311       |        |  |       | 58,160  |       
|                                         | Cumulative translation adjustment                                                                                                                                                                      |                                            |       | 294          |        |  |       | 309     |       
|                                         | Unearned compensation                                                                                                                                                                                  |                                            |       | (50          | )      |  |       |        |       
|                                         | Accumulated deficit                                                                                                                                                                                    |                                            |       | (56,826      | )      |  |       | (58,571 | )     
|                                         |                                                                                                                                                                                                        |                                            |       |              |        |  |       |        
|                                         |                                                                                                                                                                                                        |                                            | 6,134 |              |        |  | 3,882 |        
|Less treasury stock, at cost, 145 shares |                                                                                                                                                                                                        |                                            | (600  | )            |        |  | (600  | )      
|                                         |                                                                                                                                                                                                        |                                            |       |              |        |  |       |        
|                                         |                                                                                                                                                                                                        | Total stockholders equity                 |       |              | 5,534  |  |       |         | 3,282  | 
|                                         |                                                                                                                                                                                                        |                                            |       |              |        |  |       |        
|                                         |                                                                                                                                                                                                        | Total liabilities and stockholders equity |       | $            | 19,620 |  |       | $       | 17,637 | 
|                                         |                                                                                                                                                                                                        |                                            |       |              |        |  |       |        

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

3



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##### Table of Contents



SEGUE SOFTWARE, INC.



CONDENSED CONSOLIDATED STATEMENTS OF
OPERATIONS


(In thousands except per share data)


|                                                          |                                         |                    |                          |                   |       |       |       |       |       |       |        |        |        |        |        |        |        |        | 
|--------------------------------------------------------- | --------------------------------------- | ------------------ | ------------------------ | ----------------- | ----- | ----- | ----- | ----- | ----- | ----- | ------ | ------ | ------ | ------ | ------ | ------ | ------ | ------ | 
|                                                          |                                         |                    |                          |                  
|                                                          |                                         | Three months ended |                          | Nine months ended
|                                                          |                                         | September 30,      |                          | September 30,    
|                                                          |                                         |                    |                          |                  
|                                                          |                                         | 2004               |                          | 2003              |       | 2004  |       | 2003 
|                                                          |                                         |                    |                          |                   |       |       |       |      
|                                                          |                                         |                   
|                                                          |                                         | (Unaudited)       
|Revenue:                                                  |                                         |                    |                          |                   |       |       |       |       |       |       |        |        |        |        |        |       
|                                                          | Software                                |                    | $                        | 3,766             |       |       | $     | 3,003 |       |       | $      | 10,938 |        |        | $      | 9,516  |       
|                                                          | Services                                |                    |                          | 4,711             |       |       |       | 4,055 |       |       |        | 13,659 |        |        |        | 12,281 |       
|                                                          |                                         |                    |                          |                   |       |       |       |       |       |       |        |        |        |        |        |       
|                                                          |                                         | Gross revenue      |                          |                   | 8,477 |       |       |       | 7,058 |       |        |        | 24,597 |        |        |        | 21,797 |       
|                                                          | Less vendor consideration to a customer |                    |                          | (46               | )     |       |       | (41   | )     |       |        | (104   | )      |        |        | (136   | )     
|                                                          |                                         |                    |                          |                   |       |       |       |       |       |       |        |        |        |        |        |       
|                                                          |                                         |                    | Net revenue              |                   |       | 8,431 |       |       |       | 7,017 |        |        |        | 24,493 |        |        |        | 21,661 | 
|Cost of revenue:                                          |                                         |                    |                          |                   |       |       |       |       |       |       |        |        |        |        |        |       
|                                                          | Cost of software                        |                    |                          | 82                |       |       |       | 109   |       |       |        | 259    |        |        |        | 284    |       
|                                                          | Cost of services                        |                    |                          | 1,217             |       |       |       | 1,256 |       |       |        | 3,823  |        |        |        | 3,784  |       
|                                                          |                                         |                    |                          |                   |       |       |       |       |       |       |        |        |        |        |        |       
|                                                          |                                         |                    | Total cost of revenue    |                   |       | 1,299 |       |       |       | 1,365 |        |        |        | 4,082  |        |        |        | 4,068  | 
|                                                          |                                         |                    |                          |                   |       |       |       |       |       |       |        |        |        |        |        |       
|Gross margin                                              |                                         |                    | 7,132                    |                   |       |       | 5,652 |       |       |       | 20,411 |        |        |        | 17,593 |       
|Operating expenses:                                       |                                         |                    |                          |                   |       |       |       |       |       |       |        |        |        |        |        |       
|                                                          | Sales and marketing                     |                    |                          | 3,478             |       |       |       | 3,462 |       |       |        | 10,439 |        |        |        | 10,564 |       
|                                                          | Research and development                |                    |                          | 1,550             |       |       |       | 1,419 |       |       |        | 4,835  |        |        |        | 4,334  |       
|                                                          | General and administrative              |                    |                          | 1,176             |       |       |       | 912   |       |       |        | 3,404  |        |        |        | 3,263  |       
|                                                          |                                         |                    |                          |                   |       |       |       |       |       |       |        |        |        |        |        |       
|                                                          |                                         |                    | Total operating expenses |                   |       | 6,204 |       |       |       | 5,793 |        |        |        | 18,678 |        |        |        | 18,161 | 
|                                                          |                                         |                    |                          |                   |       |       |       |       |       |       |        |        |        |        |        |       
|Income (loss) from operations                             |                                         |                    | 928                      |                   |       |       | (141  | )     |       |       | 1,733  |        |        |        | (568   | )     
|Other income, net                                         |                                         |                    |                         |                   |       |       |      |       |       |       | 15     |        |        |        |       |       
|Interest income, net                                      |                                         |                    | 23                       |                   |       |       | 11    |       |       |       | 60     |        |        |        | 38     |       
|                                                          |                                         |                    |                          |                   |       |       |       |       |       |       |        |        |        |        |        |       
|Income (loss) before provision for income taxes           |                                         |                    | 951                      |                   |       |       | (130  | )     |       |       | 1,808  |        |        |        | (530   | )     
|Provision (benefit) for income taxes                      |                                         |                    | 61                       |                   |       |       | (16   | )     |       |       | 63     |        |        |        | 108    |       
|                                                          |                                         |                    |                          |                   |       |       |       |       |       |       |        |        |        |        |        |       
|Net income (loss)                                         |                                         |                    | 890                      |                   |       |       | (114  | )     |       |       | 1,745  |        |        |        | (638   | )     
|Preferred stock dividend-in-kind                          |                                         |                    | (187                     | )                 |       |       | (79   | )     |       |       | (527   | )      |        |        | (201   | )     
|                                                          |                                         |                    |                          |                   |       |       |       |       |       |       |        |        |        |        |        |       
|Net income (loss) applicable to common shares             |                                         | $                  | 703                      |                   |       | $     | (193  | )     |       | $     | 1,218  |        |        | $      | (839   | )     
|                                                          |                                         |                    |                          |                   |       |       |       |       |       |       |        |        |        |        |        |       
|Net income (loss) per common share 
    Basic            |                                         | $                  | 0.07                     |                   |       | $     | (0.02 | )     |       | $     | 0.12   |        |        | $      | (0.09  | )     
|Net income (loss) per common share 
    Diluted*         |                                         | $                  | 0.07                     |                   |       | $     | (0.02 | )     |       | $     | 0.11   |        |        | $      | (0.09  | )     
|Weighted average common shares
    outstanding  Basic    |                                         |                    | 9,962                    |                   |       |       | 9,745 |       |       |       | 9,827  |        |        |        | 9,704  |       
|Weighted average common shares
    outstanding  Diluted* |                                         |                    | 10,604                   |                   |       |       | 9,745 |       |       |       | 10,622 |        |        |        | 9,704  |       



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|  |                                                                                                                                               
|- | ----------------------------------------------------------------------------------------------------------------------------------------------
|* | The assumed conversion of preferred shares into
    common shares is not included because their inclusion would be
    anti-dilutive for 2004.

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

4



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##### Table of Contents



SEGUE SOFTWARE, INC



CONDENSED CONSOLIDATED STATEMENTS OF CASH
FLOWS


(In thousands)


(Unaudited)


|                                                                              |                                                                                                        |                                              |                                                                                           |       |     |      |       |      |       |       |  
|----------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------ | -------------------------------------------- | ----------------------------------------------------------------------------------------- | ----- | --- | ---- | ----- | ---- | ----- | ----- | -
|                                                                              |                                                                                                        |                                             
|                                                                              |                                                                                                        | Nine months ended                           
|                                                                              |                                                                                                        | September 30,                               
|                                                                              |                                                                                                        |                                             
|                                                                              |                                                                                                        | 2004                                         |                                                                                           | 2003 
|                                                                              |                                                                                                        |                                              |                                                                                           |      
|Increase (decrease) in cash and cash equivalents                              |                                                                                                        |                                              |                                                                                           |       |     |      |       |     
|Cash flows from operating activities:                                         |                                                                                                        |                                              |                                                                                           |       |     |      |       |     
|                                                                              | Net income (loss)                                                                                      |                                              | $                                                                                         | 1,745 |     |      | $     | (638 | )    
|                                                                              | Adjustments to reconcile net income (loss) to net
    cash provided by (used in) operating activities: |                                              |                                                                                           |       |     |      |       |      |      
|                                                                              |                                                                                                        | Depreciation and amortization                |                                                                                           |       | 578 |      |       |      | 1,037 |      
|                                                                              |                                                                                                        | Changes in operating assets and liabilities: |                                                                                           |       |     |      |       |      |       |      
|                                                                              |                                                                                                        |                                              | Accounts receivable                                                                       |       |     | 345  |       |      |       | 1,642 |  
|                                                                              |                                                                                                        |                                              | Other current assets                                                                      |       |     | (258 | )     |      |       | (262  | )
|                                                                              |                                                                                                        |                                              | Accounts payable                                                                          |       |     | (339 | )     |      |       | (265  | )
|                                                                              |                                                                                                        |                                              | Accrued expenses, lease obligations on excess
    space, compensation, benefits and other |       |     | (429 | )     |      |       | (915  | )
|                                                                              |                                                                                                        |                                              | Unearned compensation                                                                     |       |     | 17   |       |      |       |      |  
|                                                                              |                                                                                                        |                                              | Deferred revenue                                                                          |       |     | 479  |       |      |       | (109  | )
|                                                                              |                                                                                                        |                                              |                                                                                           |       |     |      |       |     
|Net cash provided by operating activities                                     |                                                                                                        |                                              | 2,138                                                                                     |       |     |      | 490   |     
|                                                                              |                                                                                                        |                                              |                                                                                           |       |     |      |       |     
|Cash flows from investing activities:                                         |                                                                                                        |                                              |                                                                                           |       |     |      |       |     
|                                                                              | Additions to property and equipment                                                                    |                                              |                                                                                           | (224  | )   |      |       | (197 | )    
|                                                                              | Other, net                                                                                             |                                              |                                                                                           | (3    | )   |      |       | 352  |      
|                                                                              |                                                                                                        |                                              |                                                                                           |       |     |      |       |     
|Net cash (used in) provided by investing
    activities                       |                                                                                                        |                                              | (227                                                                                      | )     |     |      | 155   |     
|                                                                              |                                                                                                        |                                              |                                                                                           |       |     |      |       |     
|Cash flows from financing activities:                                         |                                                                                                        |                                              |                                                                                           |       |     |      |       |     
|                                                                              | Proceeds from exercise of stock options and stock
    purchase plan                                    |                                              |                                                                                           | 505   |     |      |       | 190  |      
|                                                                              |                                                                                                        |                                              |                                                                                           |       |     |      |       |     
|Net cash provided by financing activities                                     |                                                                                                        |                                              | 505                                                                                       |       |     |      | 190   |     
|                                                                              |                                                                                                        |                                              |                                                                                           |       |     |      |       |     
|Effect of exchange rate changes on cash                                       |                                                                                                        |                                              | 11                                                                                        |       |     |      | 17    |     
|                                                                              |                                                                                                        |                                              |                                                                                           |       |     |      |       |     
|Net increase in cash and cash equivalents                                     |                                                                                                        |                                              | 2,427                                                                                     |       |     |      | 852   |     
|Cash and cash equivalents, beginning of period                                |                                                                                                        |                                              | 7,495                                                                                     |       |     |      | 5,335 |     
|                                                                              |                                                                                                        |                                              |                                                                                           |       |     |      |       |     
|Cash and cash equivalents, end of period                                      |                                                                                                        | $                                            | 9,922                                                                                     |       |     | $    | 6,187 |     
|                                                                              |                                                                                                        |                                              |                                                                                           |       |     |      |       |     
|Supplemental disclosure of non-cash investing and
    financing transactions: |                                                                                                        |                                              |                                                                                           |       |     |      |       |     
|                                                                              | Net cash paid for income taxes                                                                         |                                              | $                                                                                         | 35    |     |      | $     | 325  |      

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

5



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##### Table of Contents



SEGUE SOFTWARE, INC.



NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS


(Unaudited)



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

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

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



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

The Company has incurred losses on an annual
basis since it began operations, resulting in an accumulated
deficit of approximately $56.8 million at
September 30, 2004. As a result, the Company has used
significant amounts of cash, cash equivalents and short-term
investments to fund its operations. However, the Company
generated approximately $2.4 million in overall positive
cash flow for the first nine months of 2004 versus $852,000 for
the same period in 2003. For the quarter ended
September 30, 2004, the Company generated approximately
$691,000 in overall positive cash flow, which represents the
eighth consecutive quarter of positive cash flow for the Company.

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

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

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



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

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

6



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##### Table of Contents



SEGUE SOFTWARE, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)

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

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

|                                                           |                                                                                                                             |                      |   |                     |   |      |   |       |   |  |   |        |   |  |   |        |  
|---------------------------------------------------------- | --------------------------------------------------------------------------------------------------------------------------- | -------------------- | - | ------------------- | - | ---- | - | ----- | - |  | - | ------ | - |  | - | ------ | -
|                                                           |                                                                                                                             |                      |   |                    
|                                                           |                                                                                                                             | For the three months |   | For the nine months
|                                                           |                                                                                                                             | ended September 30,  |   | ended September 30,
|                                                           |                                                                                                                             |                      |   |                    
|                                                           |                                                                                                                             | 2004                 |   | 2003                |   | 2004 |   | 2003 
|                                                           |                                                                                                                             |                      |   |                     |   |      |   |      
|Net income (loss) applicable to common shares              |                                                                                                                             |                      |   |                     |   |      |   |       |   |  |   |        |   |  |   |       
|                                                           | As reported                                                                                                                 |                      | $ | 703                 |   |      | $ | (193  | ) |  | $ | 1,218  |   |  | $ | (839   | )
|                                                           | Deduct: Total stock-based employee compensation
    expense determined under the fair value based method for all
    awards |                      |   | (400                | ) |      |   | (665  | ) |  |   | (1,306 | ) |  |   | (2,121 | )
|                                                           |                                                                                                                             |                      |   |                     |   |      |   |       |   |  |   |        |   |  |   |       
|                                                           | Pro forma                                                                                                                   |                      | $ | 303                 |   |      | $ | (858  | ) |  | $ | (88    | ) |  | $ | (2,960 | )
|                                                           |                                                                                                                             |                      |   |                     |   |      |   |       |   |  |   |        |   |  |   |       
|Net income (loss) per common share 
    basic and diluted |                                                                                                                             |                      |   |                     |   |      |   |       |   |  |   |        |   |  |   |       
|                                                           | As reported  basic                                                                                                         |                      | $ | 0.07                |   |      | $ | (0.02 | ) |  | $ | 0.12   |   |  | $ | (0.09  | )
|                                                           | As reported  diluted                                                                                                       |                      | $ | 0.07                |   |      | $ | (0.02 | ) |  | $ | 0.11   |   |  | $ | (0.09  | )
|                                                           | Pro forma  basic                                                                                                           |                      | $ | 0.03                |   |      | $ | (0.09 | ) |  | $ | (0.01  | ) |  | $ | (0.31  | )
|                                                           | Pro forma  diluted                                                                                                         |                      | $ | 0.03                |   |      | $ | (0.09 | ) |  | $ | (0.01  | ) |  | $ | (0.31  | )

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

7



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##### Table of Contents



SEGUE SOFTWARE, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)

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

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

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

On March 31, 2004, the Financial Accounting
Standards Board (FASB) issued a proposed Statement,
Share-Based Payment, that addresses the accounting for
share-based awards to employees, including
employee-stock-purchase-plans (ESPPs). The FASB formally
proposed to require companies to recognize the fair value of
stock options and other stock-based compensation to employees.
The proposed Statement would eliminate the ability to account
for share-based compensation transactions using APB Opinion
No. 25, Accounting for Stock Issued to Employees,
and generally would require instead, that such transactions, be
accounted for using a fair-value-based method. The proposed
requirements in the exposure draft would be effective for public
companies as of the beginning of the first fiscal year beginning
after December 15, 2004. At a meeting held in October 2004,
the FASB decided to defer, for public companies, the effective
date of the proposed statement from fiscal years beginning after
December 15, 2004, to periods beginning after June 15,
2005. The Company currently accounts for its stock-based
compensation plans in accordance with APB Opinion No. 25.
Therefore, the eventual adoption of this proposed statement, if
issued in final form by the FASB, will have a material effect on
the Companys consolidated financial statements.



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

Included in other assets at September 30,
2004 and December 31, 2003 is restricted cash of $770,000.
This amount represents the security for a letter of credit
required by our amended sublease for our Lexington headquarters.
The amount required to be maintained under this letter of credit
arrangement will

8



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##### Table of Contents



SEGUE SOFTWARE, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)

reduce over time, by formula, to zero by August
2005. Also included is approximately $153,000 in refundable
security deposits we have paid for our various regional sales
offices.



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

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

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

For the quarter ended September 30, 2004, an
additional 26,065 shares of our Series B Preferred
Stock and an additional 16,151 shares of our Series C
Preferred Stock were earned and will be issued on
December 31, 2004. The total number of shares of
Series B Preferred Stock and Series C Preferred Stock
earned for the nine months ended September 30, 2004 totaled
75,245 and 46,625, respectively, of which 49,180 shares of
Series B Preferred Stock and 30,474 shares of
Series C Preferred Stock were issued on June 30, 2004.
Our preferred stock dividends deemed earned for the three months
ended September 30, 2004 resulted in a reduction of net
income (increase in net loss) applicable to common shares of
approximately $187,000 versus $79,000 for the period ended
September 30, 2003. For the nine-month period ended
September 30, 2004, this amount was approximately $527,000
versus $201,000 for the same nine-month period in 2003.

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

For the three months ended September 30,
2004, there were options to purchase 45,399 shares of
common stock exercised by employees and 39,259 shares of
common stock were purchased and issued to employees under the
Companys Employee Stock Purchase Plan. Total proceeds to
us from such transactions were approximately $221,000. For the
three months ended September 30, 2003, there were

9



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##### Table of Contents



SEGUE SOFTWARE, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)

4,106 options to purchase shares of common stock
exercised by employees and 58,127 shares of common stock
were purchased and issued to employees under the Companys
Employee Stock Purchase Plan. Total proceeds to us from such
transactions were approximately $95,000. For the nine-months
ended September 30, 2004, there were options to
purchase 144,241 shares of common stock exercised by
employees and 89,658 shares of common stock were purchased
and issued to employees under the Companys Employee Stock
Purchase Plan. Total proceeds to us from such transactions were
approximately $505,000. For the nine-months ended
September 30, 2003, there were options to
purchase 15,784 shares of common stock exercised by
employees and 142,936 shares of common stock were purchased
and issued to employees under the Companys Employee Stock
Purchase Plan. Total proceeds to us from such transactions were
approximately $190,000.

At September 30, 2004, the Company had three
stock-based employee compensation plans. (These plans are
described more fully in Note 5 of the Companys Annual
Report on Form 10-K.) The Company accounts for these plans
under the recognition and measurement principles of APB Opinion
No. 25, Accounting for Stock Issued to
Employees, and related interpretations. In general, most
options granted under those plans had an exercise price equal to
the market value of the underlying common stock on the date of
grant, resulting in no stock based compensation expense.
However, during the third quarter of 2003, a stock grant was
made for which the exercise price was slightly less than the
market value of the underlying common stock on the date of
grant. This resulted in a compensation expense of approximately
$4,000 for the quarter ended September 30, 2004. A balance
of approximately $50,000 in unearned compensation remains and it
will be amortized over the remaining vesting period of the grant
during the next 3 years.



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

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

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

10



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##### Table of Contents



SEGUE SOFTWARE, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)

|            |  |                |           |                       |  |           |     |                       |  |                  |    |               |  |   |           |  |  |  |               |  |  |   |           | 
|----------- |  | -------------- | --------- | --------------------- |  | --------- | --- | --------------------- |  | ---------------- | -- | ------------- |  | - | --------- |  |  |  | ------------- |  |  | - | --------- | 
|            |  |                |           | Number of             |  | %         |     | Cost of estimated     |  |                  |    |              
|            |  | Severance and  |           | employees             |  | Reduction |     | facility obligations, |  | Office for which |    | Total        
|            |  | other employee |           | terminated as part    |  | in        |     | net of estimated      |  | facility costs   |    | Restructuring
|Quarter     |  | related costs  |           | of restructuring plan |  | workforce |     | sublease income       |  | accrued          |    | Charge       
|            |  |                |           |                       |  |           |     |                       |  |                  |    |              
|Q4 2002     |  |                |          |                       |  |           |    |                       |  |                  |   |               |  |   |          |  |  |  |              |  |  |   |          | 
|Q3 2002     |  |                |          |                       |  |           |    |                       |  |                  |   |               |  |   | 373,000   |  |  |  | Lexington     |  |  |   | 373,000   | 
|Q2 2002     |  |                |          |                       |  |           |    |                       |  |                  |   |               |  |   | 147,000   |  |  |  | Lexington     |  |  |   | 147,000   | 
|Q1 2002     |  |                | 559,000   |                       |  |           | 12  |                       |  |                  | 5  |               |  |   | 124,000   |  |  |  | Lexington     |  |  |   | 683,000   | 
|            |  |                |           |                       |  |           |     |                       |  |                  |    |               |  |   |           |  |  |  |               |  |  |   |           | 
|Total 02    |  |                | 559,000   |                       |  |           | 12  |                       |  |                  |    |               |  |   | 644,000   |  |  |  |               |  |  |   | 1,203,000 | 
|            |  |                |           |                       |  |           |     |                       |  |                  |    |               |  |   |           |  |  |  |               |  |  |   |           | 
|Q4 2001     |  |                |          |                       |  |           |    |                       |  |                  |   |               |  |   |          |  |  |  |              |  |  |   |          | 
|Q3 2001     |  |                | 485,000   |                       |  |           | 42  |                       |  |                  | 14 |               |  |   | 1,479,000 |  |  |  | Lexington     |  |  |   | 1,964,000 | 
|            |  |                |           |                       |  |           |     |                       |  |                  |    |               |  |   |           |  |  |  | Lexington and |  |  |   |           | 
|Q2 2001     |  |                | 859,000   |                       |  |           | 73  |                       |  |                  | 20 |               |  |   | 1,398,000 |  |  |  | Los Gatos     |  |  |   | 2,257,000 | 
|Q1 2001     |  |                |          |                       |  |           |    |                       |  |                  |   |               |  |   |          |  |  |  |              |  |  |   |          | 
|            |  |                |           |                       |  |           |     |                       |  |                  |    |               |  |   |           |  |  |  |               |  |  |   |           | 
|Total 01    |  |                | 1,344,000 |                       |  |           | 115 |                       |  |                  |    |               |  |   | 2,877,000 |  |  |  |               |  |  |   | 4,221,000 | 
|            |  |                |           |                       |  |           |     |                       |  |                  |    |               |  |   |           |  |  |  |               |  |  |   |           | 
|Grand Total |  | $              | 2,628,000 |                       |  |           | 135 |                       |  |                  |    |               |  | $ | 3,521,000 |  |  |  |               |  |  | $ | 6,149,000 | 
|            |  |                |           |                       |  |           |     |                       |  |                  |    |               |  |   |           |  |  |  |               |  |  |   |           | 

During the third quarter of 2004, the Company
paid $119,000 of the amount accrued at December 31, 2003,
leaving a balance of $248,000 at September, 2004 for the
remaining severance and termination benefits associated with the
restructuring actions from 2003.

At September 30, 2004, the accrual balance
related to the obligations associated with all of the excess
office space noted above is approximately $1.2 million.
This is comprised of an estimated $1.5 million for future
rents payable by Segue on unoccupied space less approximately
$326,000 of estimated future sublease and operating expense
income. The Company made no estimate adjustments related to this
accrual for the period ended September 30, 2004.



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

The Company recorded provisions (benefits) for
foreign and state income taxes of $61,000 and $63,000 for the
three and nine months ended September 30, 2004,
respectively, and ($16,000) and $108,000 for the same periods
last year. The tax expense realized in the third quarter of 2004
was due in large part to a one time adjustment in state and
local taxes in two states. No tax benefit for losses generated
in the U.S. was recorded in either period due to the
uncertainty of realizing such benefits.

11



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##### Table of Contents



SEGUE SOFTWARE, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)



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

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

|                                                                          |  |                    |        |                   |  |      |       |      |  |   |        |  |  |   |       |  
|------------------------------------------------------------------------- |  | ------------------ | ------ | ----------------- |  | ---- | ----- | ---- |  | - | ------ |  |  | - | ----- | -
|                                                                          |  |                    |        |                  
|                                                                          |  | Three months ended |        | Nine months ended
|                                                                          |  | September 30,      |        | September 30,    
|                                                                          |  |                    |        |                  
|                                                                          |  | 2004               |        | 2003              |  | 2004 |       | 2003
|                                                                          |  |                    |        |                   |  |      |       |     
|Net income (loss) applicable to common shares                             |  | $                  | 703    |                   |  | $    | (193  | )    |  | $ | 1,218  |  |  | $ | (839  | )
|Weighted average shares used in net income (loss)
    per share  basic   |  |                    | 9,962  |                   |  |      | 9,745 |      |  |   | 9,827  |  |  |   | 9,704 |  
|Weighted average shares used in net income (loss)
    per share  diluted |  |                    | 10,604 |                   |  |      | 9,745 |      |  |   | 10,622 |  |  |   | 9,704 |  
|Net income (loss) per common share 
    basic                            |  | $                  | 0.07   |                   |  | $    | (0.02 | )    |  | $ | 0.12   |  |  | $ | (0.09 | )
|Net income (loss) per common share 
    diluted                          |  | $                  | 0.07   |                   |  | $    | (0.02 | )    |  | $ | 0.11   |  |  | $ | (0.09 | )

Excluded from the calculation of diluted earnings
per share for the three and nine months ended September 30,
2004 were 1,428,299 and 1,394,365 shares of common stock,
respectively, that can be converted from preferred stock because
their inclusion would be anti-dilutive. Excluded from the
calculation of diluted earnings per share for the three and nine
months ended September 30, 2003 were options to
purchase 3,490,424 shares of common stock and
773,261 shares of common stock, as converted, issuable upon
the conversion of preferred stock, respectively, because their
inclusion would be anti-dilutive.



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

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

|                                |  |                    |     |                   |  |      |      |      |  |   |       |   |  |   |      |  
|------------------------------- |  | ------------------ | --- | ----------------- |  | ---- | ---- | ---- |  | - | ----- | - |  | - | ---- | -
|                                |  |                    |     |                  
|                                |  | Three months ended |     | Nine months ended
|                                |  | September 30,      |     | September 30,    
|                                |  |                    |     |                  
|                                |  | 2004               |     | 2003              |  | 2004 |      | 2003
|                                |  |                    |     |                   |  |      |      |     
|Net income (loss)               |  | $                  | 890 |                   |  | $    | (114 | )    |  | $ | 1,745 |   |  | $ | (638 | )
|Foreign translation adjustments |  |                    | 29  |                   |  |      | (57  | )    |  |   | (15   | ) |  |   | 107  |  
|Comprehensive income (loss)     |  | $                  | 919 |                   |  | $    | (171 | )    |  | $ | 1,730 |   |  | $ | (531 | )



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



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

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



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

In August 1998, the Company moved its corporate
headquarters to Lexington, Massachusetts under a non-cancelable
operating sublease that expires on October 31, 2007. On
January 24, 2003, the Company received approval to
restructure its corporate headquarters sublease by returning
approximately 33,000 square feet in its Lexington facility
to the landlord. Pursuant to the terms of the restructuring,

12



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##### Table of Contents



SEGUE SOFTWARE, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)

Segue has posted an initial letter of credit for
$700,000. The cash security of $770,000 (letter of credit plus
10%) that was posted is classified as restricted cash and is
reflected in Other Assets on the Companys balance sheet.
The amount required to be maintained under this letter of credit
arrangement will be reduced over time, to zero by August 2005.
As a result of the restructuring, we reduced our office space
from approximately 73,300 square feet to approximately
40,400 square feet with 3,000 square feet
sub-subleased to a third party until the end of our sublease,
leaving 37,400 square feet of space. We believe that we
have more than adequate expansion space for growth in operations
at the headquarters location for the foreseeable future. The
Company had the right to terminate the sublease on
September 30, 2004 for a fee of approximately
$2.3 million, but declined to exercise this option.

The Company also leases certain United States and
foreign offices and certain equipment under various operating
leases with lease terms ranging from month-to-month up to five
years. Several of these leases contain renewal options. The
agreements generally require the payment of utilities, real
estate taxes, insurance and repairs. Future minimum payments
under the facilities and equipment leases, excluding the
security deposit noted above, but including the obligation of
the restructured sublease, with non-cancelable terms are as
follows as of September 30, 2004 (in thousands):

|                       |       |            |       |          |  |        |     |      |   |   |       |       | 
|---------------------- | ----- | ---------- | ----- | -------- |  | ------ | --- | ---- | - | - | ----- | ----- | 
|                       |       | Gross      |       | Sublease |  | Net   
|                       |       | Commitment |       | Income   |  | Amount
|                       |       |            |       |          |  |       
|2004 (balance of year) |       | $          | 638   |          |  | $      | (85 | )    |   | $ | 553   |      
|2005                   |       |            | 1,825 |          |  |        | (67 | )    |   |   | 1,758 |      
|2006                   |       |            | 1,640 |          |  |        | (70 | )    |   |   | 1,570 |      
|2007                   |       |            | 1,377 |          |  |        | (60 | )    |   |   | 1,317 |      
|2008                   |       |            | 58    |          |  |        | 0   |      |   |   | 58    |      
|Thereafter             |       |            | 15    |          |  |        | 0   |      |   |   | 15    |      
|                       |       |            |       |          |  |        |     |      |   |   |       |      
|                       | Total |            | $     | 5,553    |  |        | $   | (282 | ) |   | $     | 5,271 | 
|                       |       |            |       |          |  |        |     |      |   |   |       |      

Rent expense for the three and nine month period
ended September 30, 2004 was $439,000 and
$1.4 million, respectively, as compared to $543,000 and
$1.5 million for the same periods in 2003.



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

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

On April 14, 2003, an amendment was signed
that stated an advance payment of $50,000 per quarter would
be made to T-Plan Ltd. These advance payments would be credited
against the actual royalties earned during the period. However,
beginning January 14, 2004, in the event that the
cumulative prepaid royalties are more than $100,000 in excess of
the cumulative actual royalties earned, then the Company would
have no obligations to make further advance royalty payments
until the cumulative actual royalties are equal to the
cumulative advance royalties. As of September 30, 2004, the
prepaid royalty balance to T-Plan Ltd. stood at approximately
$69,000. Either party may cancel the agreement at any time by
giving the other party written notice to that effect at least
ninety days prior to such termination. In the event of a
termination of the contract, Segue will receive a refund if
advance royalty payments should exceed actual

13



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##### Table of Contents



SEGUE SOFTWARE, INC.


NOTES TO CONDENSED CONSOLIDATED FINANCIAL
STATEMENTS   (Continued)

cumulative royalties. Segue has other minor
royalty agreements for third party embedded software in
Segues products.

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



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

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



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

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

|                                        |                |                                  |       |                                 |  |         |       |        |  |         |       |        |  |         |       |        |  |   |        |        |  |   |        |        |  |   |        |        |  |   |       |        | 
|--------------------------------------- | -------------- | -------------------------------- | ----- | ------------------------------- |  | ------- | ----- | ------ |  | ------- | ----- | ------ |  | ------- | ----- | ------ |  | - | ------ | ------ |  | - | ------ | ------ |  | - | ------ | ------ |  | - | ----- | ------ | 
|                                        |                |                                  |       |                                
|                                        |                | Three months ended September 30, |       | Nine months ended September 30,
|                                        |                |                                  |       |                                
|                                        |                |                                  |       |                                 |  |         |       |       
|                                        |                | 2004                             |       | 2003                            |  | 2004    |       | 2003  
|                                        |                |                                  |       |                                 |  |         |       |       
|                                        |                |                                  |       | Gross                           |  |         |       | Gross  |  |         |       | Gross  |  |         |       | Gross 
|                                        |                | Revenue                          |       | Margin                          |  | Revenue |       | Margin |  | Revenue |       | Margin |  | Revenue |       | Margin
|                                        |                |                                  |       |                                 |  |         |       |        |  |         |       |        |  |         |       |       
|Software licenses                       |                | $                                | 3,766 |                                 |  | $       | 3,684 |        |  | $       | 3,003 |        |  | $       | 2,894 |        |  | $ | 10,938 |        |  | $ | 10,679 |        |  | $ | 9,516  |        |  | $ | 9,232 |       
|Training and consulting                 |                |                                  | 829   |                                 |  |         | 300   |        |  |         | 478   |        |  |         | (117  | )      |  |   | 2,266  |        |  |   | 654    |        |  |   | 2,018  |        |  |   | 227   |       
|Maintenance                             |                |                                  | 3,882 |                                 |  |         | 3,194 |        |  |         | 3,577 |        |  |         | 2,916 |        |  |   | 11,393 |        |  |   | 9,182  |        |  |   | 10,263 |        |  |   | 8,270 |       
|                                        |                |                                  |       |                                 |  |         |       |        |  |         |       |        |  |         |       |        |  |   |        |        |  |   |        |        |  |   |        |        |  |   |       |       
|                                        | Total services |                                  |       | 4,711                           |  |         |       | 3,494  |  |         |       | 4,055  |  |         |       | 2,799  |  |   |        | 13,659 |  |   |        | 9,836  |  |   |        | 12,281 |  |   |       | 8,497  | 
|Less vendor consideration to a customer |                |                                  | (46   | )                               |  |         | (46   | )      |  |         | (41   | )      |  |         | (41   | )      |  |   | (104   | )      |  |   | (104   | )      |  |   | (136   | )      |  |   | (136  | )     
|                                        |                |                                  |       |                                 |  |         |       |        |  |         |       |        |  |         |       |        |  |   |        |        |  |   |        |        |  |   |        |        |  |   |       |       
|                                        | Total          |                                  | $     | 8,431                           |  |         | $     | 7,132  |  |         | $     | 7,017  |  |         | $     | 5,652  |  |   | $      | 24,493 |  |   | $      | 20,411 |  |   | $      | 21,661 |  |   | $     | 17,593 | 
|                                        |                |                                  |       |                                 |  |         |       |        |  |         |       |        |  |         |       |        |  |   |        |        |  |   |        |        |  |   |        |        |  |   |       |       

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

|              |  |                    |       |                   |  |                   |       |      |  |      |        |      |  |   |        |  |  |   |       |  |  |   |       | 
|------------- |  | ------------------ | ----- | ----------------- |  | ----------------- | ----- | ---- |  | ---- | ------ | ---- |  | - | ------ |  |  | - | ----- |  |  | - | ----- | 
|              |  |                    |       |                   |  |                  
|              |  | Total Net Revenue  |       |                   |  |                  
|              |  |                    |       |                   |  |                  
|              |  |                    |       |                   |  |                  
|              |  | Three months ended |       | Nine months ended |  | Long Lived Assets
|              |  | September 30,      |       | September 30,     |  | September 30,    
|              |  |                    |       |                   |  |                  
|              |  | 2004               |       | 2003              |  | 2004              |       | 2003 |  | 2004 |        | 2003
|              |  |                    |       |                   |  |                   |       |      |  |      |        |     
|United States |  | $                  | 6,636 |                   |  | $                 | 5,909 |      |  | $    | 19,818 |      |  | $ | 17,796 |  |  | $ | 1,417 |  |  | $ | 1,866 | 
|Foreign       |  |                    | 1,795 |                   |  |                   | 1,108 |      |  |      | 4,675  |      |  |   | 3,865  |  |  |   | 238   |  |  |   | 350   | 
|              |  |                    |       |                   |  |                   |       |      |  |      |        |      |  |   |        |  |  |   |       |  |  |   |       | 
|              |  | $                  | 8,431 |                   |  | $                 | 7,017 |      |  | $    | 24,493 |      |  | $ | 21,661 |  |  | $ | 1,655 |  |  | $ | 2,216 | 

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##### Table of Contents








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

Overview

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

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

During the third quarter and nine months ended
September 30, 2004, we achieved profitability while growing
revenue and focusing on our new strategic objectives: profitable
revenue growth, market-driven product innovations and maximizing
selective partnerships and alliances. Total revenue grew 20% to
$8.4 million for the quarter ended September 30, 2004
as compared to $7.0 million during the same period last
year. This represents the third consecutive quarter with
profitable revenue growth over the same period in 2003. Total
revenue for the year ended September 30, 2004 was
$24.5 million, up 13% from $21.8 million for the same
period in 2003. We reported a net income applicable to common
shares of $703,000, or $0.07 basic and fully diluted income per
share for the quarter ended September 30, 2004. This
compares to a net loss applicable to common shares of $193,000
or a $0.02 loss per share, for the same period last year. For
the nine months ended September 30, 2004, we reported net
income applicable to common shares of $1.2 million, or
$0.12 basic and $0.11 fully diluted income per share, compared
to $839,000 net loss applicable to common shares, or $0.09
loss per share, for the same period during 2003. Total operating
expenses and cost of sales combined, totaled $7.5 million
for the third quarter of 2004, compared to $7.2 million for
the same period in 2003. For the first nine months of 2004,
total operating expenses and cost of sales combined, totaled
$22.8 million. This represents a 3% increase over the
$22.2 million total operating expenses and cost of sales
combined as reported in the first three-quarters of 2003. Our
total worldwide headcount at September 30, 2004 and 2003
stood at 184 and 194, respectively.

At September 30, 2004, our reported cash and
cash equivalent balance was $9.9 million, compared to
$7.5 million at December 31, 2003 and
$6.2 million at September 30, 2003. We reported
positive cash flow from operations of $2.1 million in the
first nine months of 2004, compared to $490,000 positive cash
flow during the first nine months of 2003. Deferred revenue
increased to $9.5 million for the quarter ended
September 30, 2004, compared to $8.4 million for the
quarter ended September 30, 2003. We continue to have no
debt on our balance sheet and have no off-balance sheet
contingency debt.

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

Critical Accounting Policies

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

15



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##### Table of Contents



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

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

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

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

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

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

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

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

16



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##### Table of Contents



market data and consulted with our real estate
advisor on these factors to help determine an appropriate
reserve for potential losses on the unused space. During the
fourth quarter of 2002, Segue was able to reach an agreement in
principle with its landlord to restructure the sublease for our
Lexington facility. A formal agreement was consummated on
January 24, 2003. At September 30, 2004, the accrual
balance related to the obligations associated with all of the
excess office space in both the Lexington and Los Gatos
facilities is approximately $1.2 million. This is comprised
of an estimated $1.5 million for future rents payable by
Segue on unoccupied space less approximately $326,000 of
estimated future sublease and operating expense income. We are
under a restructured sublease for the Lexington facility until
October 2007.


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

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

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

The Company reflects the estimated value of the
Preferred Stock dividend-in-kind on a quarterly basis as a
reduction in the net income (increase in net loss) applicable to
common shares.

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

17



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##### Table of Contents



Results of Operations

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

|                                                |                                         |                          |      |               |       |      |      |      |       |  |      |      |       |  |      |      |       | 
|----------------------------------------------- | --------------------------------------- | ------------------------ | ---- | ------------- | ----- | ---- | ---- | ---- | ----- |  | ---- | ---- | ----- |  | ---- | ---- | ----- | 
|                                                |                                         |                          |      |              
|                                                |                                         | Percentage of            |      | Percentage of
|                                                |                                         | Revenue for              |      | Revenue for  
|                                                |                                         | Three Months             |      | Nine months  
|                                                |                                         | Ended                    |      | Ended        
|                                                |                                         | September 30,            |      | September 30,
|                                                |                                         |                          |      |              
|                                                |                                         | 2004                     |      | 2003          |       | 2004 |      | 2003
|                                                |                                         |                          |      |               |       |      |      |     
|Revenue:                                        |                                         |                          |      |               |       |      |      |      |       |  |      |      |       |  |      |     
|                                                | Software                                |                          |      | 44.7          | %     |      |      | 42.8 | %     |  |      | 44.7 | %     |  |      | 43.9 | %    
|                                                | Services                                |                          |      | 55.9          |       |      |      | 57.8 |       |  |      | 55.8 |       |  |      | 56.7 |      
|                                                |                                         |                          |      |               |       |      |      |      |       |  |      |      |       |  |      |     
|                                                |                                         | Gross revenue            |      |               | 100.6 |      |      |      | 100.6 |  |      |      | 100.5 |  |      |      | 100.6 | 
|                                                | Less vendor consideration to a customer |                          |      | (0.6          | )     |      |      | (0.6 | )     |  |      | (0.5 | )     |  |      | (0.6 | )    
|                                                |                                         |                          |      |               |       |      |      |      |       |  |      |      |       |  |      |     
|                                                |                                         | Net revenue              |      |               | 100.0 |      |      |      | 100.0 |  |      |      | 100.0 |  |      |      | 100.0 | 
|Cost of revenue:                                |                                         |                          |      |               |       |      |      |      |       |  |      |      |       |  |      |     
|                                                | Cost of software                        |                          |      | 1.0           |       |      |      | 1.6  |       |  |      | 1.1  |       |  |      | 1.3  |      
|                                                | Cost of services                        |                          |      | 14.4          |       |      |      | 17.9 |       |  |      | 15.6 |       |  |      | 17.5 |      
|                                                |                                         |                          |      |               |       |      |      |      |       |  |      |      |       |  |      |     
|                                                |                                         | Total cost of revenue    |      |               | 15.4  |      |      |      | 19.5  |  |      |      | 16.7  |  |      |      | 18.8  | 
|Gross margin                                    |                                         |                          | 84.6 |               |       |      | 80.5 |      |       |  | 83.3 |      |       |  | 81.2 |     
|Operating expenses:                             |                                         |                          |      |               |       |      |      |      |       |  |      |      |       |  |      |     
|                                                | Sales and marketing                     |                          |      | 41.3          |       |      |      | 49.3 |       |  |      | 42.6 |       |  |      | 48.8 |      
|                                                | Research and development                |                          |      | 18.4          |       |      |      | 20.2 |       |  |      | 19.7 |       |  |      | 20.0 |      
|                                                | General and administrative              |                          |      | 13.9          |       |      |      | 13.0 |       |  |      | 13.9 |       |  |      | 15.1 |      
|                                                |                                         |                          |      |               |       |      |      |      |       |  |      |      |       |  |      |     
|                                                |                                         | Total operating expenses |      |               | 73.6  |      |      |      | 82.5  |  |      |      | 76.2  |  |      |      | 83.9  | 
|Income (loss) from operations                   |                                         |                          | 11.0 |               |       |      | (2.0 | )    |       |  | 7.1  |      |       |  | (2.7 | )   
|Other income, net                               |                                         |                          |     |               |       |      |     |      |       |  | 0.1  |      |       |  |     |     
|Interest income, net                            |                                         |                          | 0.3  |               |       |      | 0.2  |      |       |  | 0.2  |      |       |  | 0.2  |     
|                                                |                                         |                          |      |               |       |      |      |      |       |  |      |      |       |  |      |     
|Income (loss) before provision for income taxes |                                         |                          | 11.3 |               |       |      | (1.8 | )    |       |  | 7.4  |      |       |  | (2.5 | )   
|Provision (benefit) for income taxes            |                                         |                          | 0.7  |               |       |      | (0.2 | )    |       |  | 0.3  |      |       |  | 0.5  |     
|                                                |                                         |                          |      |               |       |      |      |      |       |  |      |      |       |  |      |     
|Net income (loss)                               |                                         |                          | 10.6 | %             |       |      | (1.6 | )%   |       |  | 7.1  | %    |       |  | (3.0 | )%  
|                                                |                                         |                          |      |               |       |      |      |      |       |  |      |      |       |  |      |     

Software Revenue

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

Software revenue was $3.8 million for the
quarter ended September 30, 2004 as compared to
$3.0 million for the quarter ended September 30, 2003,
an increase of 25%. This increase of $800,000 in software
revenue was primarily attributable to an increase in product
sales in our European markets. Software revenue was
$10.9 million for the nine months ended September 30,
2004 as compared to $9.5 million for the nine months ended
September 30, 2003, an increase of 15%. This increase of
$1.4 million in software revenue was primarily attributable
to $400,000 in software licenses that were received on
December 31, 2003, but not delivered until January 2004 (as
disclosed in our Annual Report on Form 10-K for the fiscal
year ended December 31, 2003). The increase was also
attributed to the number of overall product deals and as
previously mentioned, an increase in European sales during the
third quarter of 2004.

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International software revenue represented
$1.2 million, or 32%, and $691,000, or 23%, of total
product sales for the quarter ended September 30, 2004 and
2003, respectively. The total dollar amount of international
software revenue increased by approximately $509,000 or 73%.
This increase was primarily attributable to several large
product deals from our Germany sales operation. International
software revenue represented $3.1 million, or 28%, and
$2.5 million, or 26% of total product sales for the nine
months ended September 30, 2004 and 2003, respectively.

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

Services Revenue

Services revenue consists of revenue from
maintenance, training and consulting. Services revenue was
$4.7 million for the quarter ended September 30, 2004
as compared to $4.1 million for the quarter ended
September 30, 2003, an increase of 15%. Service revenue was
$13.7 million for the nine months ended September 30,
2004 as compared to $12.3 million for the nine months ended
September 30, 2003, an increase of 11%.

Maintenance revenue was $3.9 million for the
quarter ended September 30, 2004 as compared to
$3.6 million for the quarter ended September 30, 2003,
an increase of 8%. The increase of $300,000 in maintenance
revenue was primarily attributable to an increase in renewals of
existing maintenance contracts due to a larger base of licenses.
Recognized maintenance revenue is being amortized over the
contract period, which is predominately a 12-month period.
Maintenance revenue was $11.4 million for the nine months
ended September 30, 2004 as compared to $10.3 million
for the nine months ended September 30, 2003, an increase
of 11%. The increase of $1.1 million was also attributable
to an increase in renewals of existing maintenance contracts
over a larger base of licenses compared to 2003.

Training and consulting revenue was $829,000 for
the quarter ended September 30, 2004 as compared to
$478,000 for the quarter ended September 30, 2003, an
increase of 73%. The increase in training and consulting revenue
of $351,000 was primarily due to an increase in bookings of
domestic consulting and training engagements. Training and
consulting revenue was $2.3 million for the nine months
ended September 30, 2004, compared to $2.0 million for
the nine months ended September 30, 2003, an increase of
15%. The increase of $300,000 was primarily attributed to an
increase of bookings of domestic consulting and training
engagements. Additionally, we continue to see an increase in
customers using on-line training which the Company began
offering in 2002 and has proven to be successful. On-line
instructor monitored training allows our customers a flexible
option in which to realize the full value of training while
keeping expenses, such as tuition, travel and lodging, to a
minimum.

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

Vendor Consideration to a Customer

The Company committed to making payments to
several vendors, resellers, and distributors of $46,000 for the
quarter ended September 30, 2004, compared to $41,000 for
the quarter ended September 30, 2003. The increase of
$5,000 is primarily attributed to an increase in the number of
deals to which a referral fee applied. The Company committed to
making payments to several vendors, resellers, and distributors
of $104,000 for the nine months ended September 30, 2004,
compared to $136,000 for the nine months ended
September 30, 2003. The decrease of $32,000 is primarily
attributed to a reduction in the number of deals to which a
referral fee applied.

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Under EITF Issue No. 01-9, Accounting
for Consideration Given by a Vendor to a Customer (Including a
Reseller of Vendors Products), these payments are
considered to be a reduction of revenue and are presented in our
statement of operations as such for 2004 and 2003.

Cost of Software

Cost of software includes documentation, product
packaging, product media, employment costs for processing and
distribution, amortization of capitalized technology and
royalties due to third parties for their software that we embed
in our products. Cost of software was $82,000 for the quarter
ended September 30, 2004, or 2% of software revenue as
compared to $109,000 for the quarter ended September 30,
2003, or 4% of software revenue. The decrease of $27,000 was
primarily attributable to a decrease of $25,000 in other
fulfillment costs.

Cost of software was $259,000 for the nine months
ended September 30, 2004, or 2% of software revenue as
compared to $284,000 for the nine months ended
September 30, 2003, or 3% of software revenue. The decrease
of $25,000 was primarily attributed to a decrease of $15,000 in
royalty expense and a decrease of $27,000 in other fulfillment
costs, offset by an increase of $21,000 in personnel related
costs.

Cost of Services

Cost of services consists principally of salaries
and benefits for our customer service and technical support
staff, which staff provides services under maintenance
contracts, and for our training and consulting staff, as well as
third party consulting fees and the cost of materials and
facilities used for training customers. Cost of services as a
percentage of services revenue varies based on the profitability
of individual consulting engagements and the utilization rate of
in-house consultants versus the use of higher cost outside
contract consultants. Cost of services was $1.2 million for
the quarter ended September 30, 2004, or 26% of service
revenue, compared to $1.3 million for the quarter ended
September 30, 2003, or 31% of service revenue. Cost of
services was $3.8 million for the nine months ended
September 30, 2004, or 28% of service revenue, compared to
$3.8 million for the nine months ended September 30,
2003, or 31% of service revenue.

Cost of training and consulting was $529,000 for
the quarter ended September 30, 2004, or 11% of service
revenue, compared to $595,000 for the quarter ended
September 30, 2003, or 15% of service revenue. The decrease
in cost of training and consulting of $66,000 was primarily
attributed to a decrease of $99,000 in personnel related costs
and a decrease of $50,000 in allocated facility costs due to
lower headcount, partially offset by an increase of $63,000 in
outsourced consulting expense and an increase of $24,000 in
travel costs. Cost of training and consulting was
$1.6 million for the nine months ended September 30,
2004, or 12% of service revenue as compared to $1.8 million
for the nine months ended September 30, 2003, or 15% of
service revenue. The decrease in cost of training and consulting
of $200,000 was primarily attributed to a decrease in personnel
related cost of $182,000 and a decrease of $115,000 in allocated
facility costs due to a lower headcount and an overall reduction
in facility costs to be allocated. These decreases were
partially offset by an increase of $53,000 in travel costs and
an increase of $67,000 in outsourced consulting expense.

Cost of maintenance was $688,000 for the quarter
ended September 30, 2004, or 15% of service revenues as
compared to $661,000 for the quarter ended September 30,
2003, or 16% of service revenues. The increase in cost of
maintenance of $27,000 was primarily attributed to an increase
of $57,000 associated with the exchange rate translation in the
European market of our foreign technical support operations,
offset with a decrease of $13,000 in personnel related costs and
$16,000 in depreciation expense associated with more fully
depreciated assets. Cost of maintenance was $2.2 million
for the nine months ended September 30, 2004, or 16% of net
revenues, compared to $2.0 million for the nine months
ended September 30, 2003, or 16% of net revenues. The
increase in cost of maintenance of $200,000 was primarily
attributed to an increase of $81,000 in personnel costs due to
higher wages and an increase of $183,000 associated with the
exchange rate translation in the European market of our foreign
technical

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support operations, offset by a decrease of
$17,000 in travel costs and a decrease of $23,000 in
depreciation expense.


Sales and Marketing

Sales and marketing expenses consist primarily of
salaries and benefits, commissions, travel costs, promotional
marketing programs and allocated facility costs. Marketing
programs include advertising, public relations, direct mail
programs, seminars and trade shows. Total sales and marketing
expenses was $3.5 million for the quarter ended
September 30, 2004, or 41% of net revenue, compared to
$3.5 million for the quarter ended September 30, 2003,
or 49% of net revenue. Total sales and marketing expenses was
$10.4 million for the nine months ended September 30,
2004, or 43% of net revenue, compared to $10.6 million for
the nine months ended September 30, 2003, or 49% of net
revenue.

Sales expense was $2.8 million for the
quarter ended September 30, 2004, or 33% of net revenue,
compared to $3.2 million for the quarter ended
September 30, 2003, or 46% of net revenue. The decrease in
total sales expense of $400,000 was primarily attributed to a
decrease of $265,000 in personnel related costs and a decrease
of $45,000 in travel costs due to a lower number of employees
and a decrease of $216,000 in allocated facility costs which
consist mostly of a reduction in rent and depreciation,
partially offset by an increase of $201,000 in the exchange rate
translation effect in the European market of our foreign sales
operations expenses. Sales expense was $8.5 million for the
nine months ended September 30, 2004, or 35% of net
revenue, compared to $9.5 million for the nine months ended
September 30, 2003, or 44% of net revenue. The decrease in
sales expense of $1.0 million was primarily attributed to a
decrease of $651,000 in personnel related costs and a decrease
of $385,000 in allocated facility costs due to a reduced number
of employees, a decrease of $74,000 in legal expense and a
decrease of $110,000 in travel costs. These decreases were
partially offset by an increase of $337,000 in the exchange rate
translation effect in the European market of our foreign sales
operations.

Marketing expense was $689,000 for the quarter
ended September 30, 2004, or 8% of net revenue, compared to
$314,000 for the quarter ended September 30, 2003, or 4% of
net revenue. The increase of $375,000 was primarily attributed
to an increase of $132,000 in personnel related costs due to a
higher number of employees and an increase of $26,000 from the
incentive bonus program for employees not on a commission plan
that was reinstituted by the Company at the beginning of the
second quarter of 2004, an increase of $165,000 in marketing
programs, and an increase of $18,000 in travel related costs.
Marketing expense was $1.9 million for the nine months
ended September 30, 2004, or 8% of net revenue, compared to
$1.0 million for the nine months ended September 30,
2003, or 5% of net revenue. The increase of $900,000 was
primarily attributed to an increase of $553,000 in personnel
cost and an increase of $75,000 in allocated facility cost due
to a higher number of employees, an increase of $70,000 from the
incentive bonus program, and an increase of $71,000 in marketing
programs, and an increase of $72,000 in travel related costs.

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

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

Research and Development

Research and development expenses consist
primarily of salaries and benefits and allocated facility costs.
To date, all of Segues internal costs for research and
development have been charged to operations as incurred, since
amounts of software development costs qualifying for
capitalization have been insignificant. Research and development
expense was $1.6 million for the quarter ended
September 30, 2004, or 18% of net revenue as compared to
$1.4 million for the quarter ended September 30, 2003,
or 20% of net revenue. The increase of $200,000 was primarily
attributable to an increase of $70,000 in the

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exchange rate translation effect of our foreign
research and development lab expenses due to the stronger Euro,
an increase of $57,000 associated with an incentive bonus
program that was reinstituted by the Company at the beginning of
the second quarter of 2004 for all non-commissioned employees,
and an increase of $35,000 in personnel related costs, partially
offset by a decrease of $26,000 in depreciation expense.


Research and development expense was
$4.8 million for the nine months ended September 30,
2004, or 20% of net revenue as compared to $4.3 million for
the nine months ended September 30, 2003, or 20% of net
revenue. The increase of $500,000 was primarily attributable to
an increase of $318,000 in personnel related costs due to higher
base salaries in Austria and from the incentive bonus program,
and an increase of $255,000 in the exchange rate translation of
our foreign research and development lab expenses due to the
stronger Euro. These increases were partially offset by a
decrease of $91,000 in depreciation resulting from more fully
depreciated assets.

General and Administrative

General and administrative expenses consist
primarily of salaries and benefits for executive, finance,
legal, information technology, human resources and
administrative personnel, professional fees, system support
costs, allocated facility costs and other general corporate
expenses. General and administrative expense was
$1.2 million for the quarter ended September 30, 2004,
or 14% of net revenue as compared to $912,000 for the quarter
ended September 30, 2003, or 13% of net revenue. The
increase of $288,000 was primarily attributed to an increase of
$144,000 in personnel related costs due to an increased number
of employees and expense associated with an incentive bonus
program, an increase of $82,000 in legal and audit expense, an
increase of $108,000 in the foreign currency translation
expense, and an increase of $61,000 in travel and other
administrative costs. These increases were offset by a decrease
of $100,000 in bad debt and a decrease of $31,000 in
depreciation and telephone expense.

General and administrative expense was
$3.4 million for the nine months ended September 30,
2004, or 14% of net revenue, compared to $3.3 million for
the nine months ended September 30, 2003, or 15% of net
revenue. The decrease of $100,000 was primarily attributable to
a decrease of $153,000 in recruiting charges that were mainly
incurred during the CEO search in 2003, a decrease of $138,000
in bad debt expense, a decrease of $118,000 in allocated
facility related costs, and a decrease of $74,000 in the foreign
currency translation expense. These decreases were offset by an
increase of $212,000 in personnel related costs due to an
increase in number of employees and expense associated with an
incentive bonus program, an increase of $358,000 in legal and
audit costs, and an increase of $40,000 in travel.

Other Income, Net

Other income consists primarily of interest
income from cash and cash equivalents. Other income was $23,000
for the quarter ended September 30, 2004 as compared to
$11,000 for the quarter ended September 30, 2003. The
increase of $12,000 was primarily attributed to interest income
on higher balances of cash and cash equivalents in 2004 in
comparison to the same period in 2003.

Other income was $75,000 for the nine months
ended September 30, 2004 compared to $38,000 for the nine
months ended September 30, 2003. The increase of $37,000 is
primarily due to other income we had of $20,000 during the first
quarter of 2004, which was related to the settlement of a minor
sublease issue.

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

Provision (benefit) for Income
Taxes

Segue recorded a provision (benefit) for
foreign and state income taxes of $61,000 and ($16,000) for the
quarter ended September 30, 2004 and 2003, respectively.
The decrease of $76,000 was primarily attributed to the Company
realizing a tax adjustment of about $70,000 in its United
Kingdom subsidiary

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that resulted in a positive impact to earnings
during the quarter ended September 30, 2003. Provision for
foreign and state income taxes was $63,000 for the nine months
ended September 30, 2004 as compared to $108,000 for the
nine months ended September 30, 2003. The decrease of
$45,000 is primarily due to adjustments in foreign tax provision
in the nine months of 2003.


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

Liquidity and Capital Resources

As of September 30, 2004, our principal
sources of liquidity included cash and cash equivalents totaling
$9.9 million.

Our operating activities generated cash of
$2.1 million during the first nine months of 2004, compared
to $490,000 of cash generated in the same period in 2003. Cash
generated in 2004 resulted from the net income, adjusted for
depreciation of property and equipment and the increase in
deferred revenue and other current assets, and the decrease in
accounts receivable offset by a decrease in accounts payable and
accrued expenses.

Our investing activities utilized cash of
$227,000 in the first nine months of 2004, as compared to
$155,000 cash generated during the first nine months of 2003.
Cash used in 2004 was the result of the purchase of some
replacement computers and equipment. In the future, we may need
to make increased expenditures on property and equipment as our
present equipment ages.

Our financing activities generated cash of
$522,000 and $190,000 during the first nine months of 2004 and
2003, respectively. Cash generated from financing activities in
the first nine months of 2004 was generated primarily from the
exercise of employee stock options and the issuance of stock
under the Employee Stock Purchase Plan. Cash generated in the
first nine months of 2003 was primarily generated from the
issuance of stock under the Employee Stock Purchase Plan.

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

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

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

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

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

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Risks and Factors That May Affect Future
Results

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

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

We may not be profitable in the
future.Since we began operations, we
have generally experienced losses. Losses have resulted in an
accumulated deficit of approximately $56.8 million as of
September 30, 2004. In the third quarter of 2004, we
reported our third consecutive quarter of net income, which
totaled $703,000 for the period. We reported net income of
$1.2 million for the nine months ended September 30,
2004. It is uncertain whether we can maintain profitability in
the future.

For the quarter ended September 30, 2004, we
had total revenue of $8.4 million versus $7.0 million
for the quarter ended September 30, 2003. Further, for the
nine months ended September 30, 2004, we had total revenue
of $24.5 million versus $21.7 million for the same
nine months in 2003. During 2001, 2002 and 2003, we initiated
aggressive cost saving measures in an effort to reduce expenses,
enhance the possibility of profitability, and conserve cash, and
we have sustained these measures through September 30,
2004. Despite these cost saving measures, our future
profitability remains uncertain because of, among other items,
the uncertainty of our revenue from quarter to quarter. Failure
to achieve profitability may adversely affect the market price
of our common stock.

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

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

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

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

Our future success will depend on our ability
to respond rapidly and effectively to technological and other
market changes, including the successful introduction of new and
enhanced products.The nature of the
automated software testing, performance management and
application monitoring markets in which we compete is
characterized by rapidly changing technology, rapidly evolving
customer needs and desires, changes in industry standards and
practices and frequent releases of new product or enhancements
by competitors. To be competitive, we must develop and introduce
product enhancements and new products that address the
increasingly sophisticated and varied needs of our existing and
potential customers. For the nine months ended
September 30, 2004, over 93% of our product revenues were
generated from our SilkPerformer and SilkTest products, as
compared with over 90% in same period last year. During the
first nine months of 2004, we released SilkPerformer 6.5, the
newest version of our enterprise-class load and stress-testing
tool, SilkTest 7.0, our newest version of functional testing
with add-on support available to test .NET applications,
SilkCentral Performance Manager, the Companys newest
offering for monitoring software applications from the end-user
perspective and SilkCentral Test Manager 7.0, a comprehensive
solution for the overall management of application quality prior
to deployment. If these new products are not successful or if we
fail to continue to develop and introduce new products and
enhancements on a timely basis, or maintain our level of product
revenue from SilkPerformer and SilkTest, or fail to generate
substantial incremental revenue from our new products, our
business may be materially adversely affected.

We may face liquidity
issues.We have taken steps to
conserve our use of cash, including significantly reducing
headcount, infrastructure and other expenses, and limiting
capital expenditures in order to improve our liquidity and to
achieve greater efficiencies. We believe that based on expense
savings and the stability of our revenue in the last year, that
future sales at or above current levels should be sufficient to
allow us to continue as a viable business. For the three-month
period ended September 30, 2004, we generated $691,000 in
positive cash flow, the Companys eighth consecutive
quarter of cash balance growth. For the nine-month period ended
September 30, 2004, we have generated a total of
$2.4 million in positive cash flow. Total net revenue of
$8.4 million for the three-month period ended
September 30, 2004 was improved from the $7.0 million
reported for the same period last year. If we fail to maintain
or grow revenue levels we may have to raise additional financing
to fund working capital

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needs. If we fail to generate substantial
incremental revenue, or we are not successful in raising
additional financing on terms acceptable to us, we may not have
sufficient working capital resources and our business may be
materially adversely affected.


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

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

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

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

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

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

We face many risks associated with
international business activities.We
derived approximately 21% of total revenue from international
customers in the three-month period ended September 30,
2004, as compared with 16% in the same period last year. For the
nine-month period ended September 30, 2004, we derived
approximately 19% of total revenue from international customers
versus 18% for the same nine-

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month period last year. The international market
for software products is highly competitive and we expect to
face substantial competition in this market from established and
emerging companies. We face many risks associated with
international business activities including currency
fluctuations, imposition of government controls, export license
requirements, restrictions on the export of critical technology,
political and economic instability, tailoring of products to
local requirements, trade restrictions,


changes in tariffs and taxes, difficulties in
staffing and managing international operations, longer accounts
receivable payment cycles and the burdens of complying with a
wide variety of foreign laws and regulations. In particular,
currency fluctuations can have a significant impact on our
foreign operating expenses. Continued growth of international
sales is important to our growth and the stability. To the
extent we are unable to continue to expand international sales
in a timely and cost-effective manner, our business could be
materially adversely affected.


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






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

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

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

Foreign Currency
Risk.We face exposure to movements in
foreign currency exchange rates. These exposures may change over
time as business practices evolve and could have a material
adverse effect on our business, financial condition and results
of operations. We do not use derivative financial instruments or
other financial instruments to hedge economic exposures or for
trading. Historically, our primary currency exposures have been
related to the operations of our foreign subsidiaries. During
the three and nine months ended September 30, 2004, we
incurred transaction and re-measurement losses of approximately
$39,000 and $7,000 related to foreign currency, respectively.
For the three and nine month period ended
September 30, 2003, the effect of foreign currency was a
re-measurement gain of approximately $70,000 and a
re-measurement expense of approximately $81,000, respectively.
As of September 30, 2004, the cumulative translation of
foreign currency changes recorded in stockholders equity
was $294,000.

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

Evaluation of Disclosure Controls and
Procedures

As required by new Rule 13a-15 under the
Securities Exchange Act of 1934, as of September 30, 2004
we carried out an evaluation under the supervision and with the
participation of our management, including our Chief Executive
Officer and Chief Financial Officer, of the effectiveness of the
design and operation of our disclosure controls and procedures.
In designing and evaluating our disclosure controls and
procedures, we and our management recognize that any controls
and procedures, no matter how well designed and operated, can
provide only reasonable assurance of achieving the desired
control objectives, and our management necessarily was required
to apply its judgment in evaluating and implementing possible
controls and procedures. Based upon that evaluation, our Chief
Executive Officer and Chief Financial Officer concluded that, as
of the date of completion of the evaluation, our disclosure
controls and procedures were reasonably effective to ensure that
material information required to be disclosed by us in the
reports we file or submit under the Exchange Act is recorded,
processed, summarized and reported, within the time periods
specified in the Securities and Exchange Commissions rules
and forms. In connection with the new rules, we will continue to
review and document our disclosure controls and procedures,
including our internal controls and procedures for financial
reporting, on an ongoing basis, and may from time to time make
changes aimed at enhancing their effectiveness and to ensure
that our systems evolve with our business.

Changes in Internal Controls over Financial
Reporting

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




PART II.     OTHER
INFORMATION






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

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






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

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






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

There were no other matters requiring disclosure
on this Form 10-Q.






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

(a) Exhibits

The following documents are filed as Exhibits to
this report:

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

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SIGNATURES

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

Date: November 12, 2004



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



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

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



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

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

29