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SECURITIES AND EXCHANGE COMMISSION
 
 WASHINGTON, D.C. 20549


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FORM 10-Q



(Mark One)

|                                                                                        |                                                                                                                                                    | 
|--------------------------------------------------------------------------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------- | 
|x                                                                                       | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
     OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED
     MARCH 31, 2000 OR
|                                                                                        |                                                                                                                                                   
|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 000-22647                                                       
|                                                                                        |                                                                                                                                                   
|PERITUS SOFTWARE SERVICES, INC.                                                        
|(Exact Name of Registrant as Specified in Its
     Charter)                            
|                                                                                        |                                                                                                                                                   
|Massachusetts                                                                           | 04-3126919                                                                                                                                        
|(State or Other Jurisdiction of Incorporation or
     Organization)                     | (I.R.S. Employer Identification No.)                                                                                                              
|                                                                                        |                                                                                                                                                   
|112 Turnpike Road, Suite 111, Westborough,
     Massachusetts                           | 01581-2860                                                                                                                                        
|(Address of Principal Executive
     Offices)                                           | (Zip Code)                                                                                                                                        
|                                                                                        |                                                                                                                                                   
|(508) 870-0963                                                                         
|(Registrant's Telephone Number, Including Area Code)                                   
|                                                                                        |                                                                                                                                                   
|Not Applicable                                                                         
|(Former Name, Former Address and Former Fiscal Year,
     If Changed Since Last Report)
|                                                                                        |                                                                                                                                                   

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 shorter period that the
   registrant was required to file such reports), and (2) has been subject to
   such filing requirements for the past 90 days. Yes x No o

Indicate
   the number of shares outstanding of each of the issuer's classes of common
   stock, as of the latest practicable date:

|Title of Class               | Shares outstanding
   at May 8, 2000
|---------------------------- | ------------------------------------
|Common Stock, $.01 par value | 27,319,903                          
|                             |                                     
|                            



PERITUS SOFTWARE SERVICES INC.
 
 FORM 10-Q
 
 FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2000

TABLE OF CONTENTS

|                                 |         |                                                                                              | Page
|-------------------------------- | ------- | -------------------------------------------------------------------------------------------- | ----
|Part I.
   Financial Information | 3      
|                                 |         |                                                                                              |     
|                                 | Item 1. | Financial Statements                                                                         |     
|                                 |         | Consolidated Balance Sheet as of March 31, 2000 and December
     31, 1999                   | 3   
|                                 |         | Consolidated Statement of Operations for the Three Months
     Ended March 31, 2000 and 1999 | 4   
|                                 |         | Consolidated Statement of Cash Flows for the Three Months
     Ended March 31, 2000 and 1999 | 5   
|                                 |         | Notes to Unaudited Consolidated Financial Statements                                         | 6   
|                                 | Item 2. | Management's Discussion and Analysis of Financial Condition
     and Results of Operations   | 9   
|                                 | Item 3. | Quantitative and Qualitative Disclosures about Market
     Risk                              | 17  
|                                 |         |                                                                                              |     
|Part II. Other Information       |        
|                                 |         |                                                                                              |     
|                                 | Item 1. | Legal Proceedings                                                                            | 19  
|                                 | Item 2. | Changes in Securities and Use of Proceeds                                                    | 19  
|                                 | Item 6. | Exhibits and Reports on Form 8-K                                                             | 19  
|                                 |         | Signatures                                                                                   | 20  

From time to time,
   information provided by the Company or statements made by its employees may
   contain ''forward-looking'' statements, as that term is defined in the
   Private Securities Litigation Reform Act of 1995. For this purpose, any
   statements contained herein that are not statements of historical fact may
   be deemed to be forward-looking statements. Without limiting the foregoing,
   the words ''believes'', ''anticipates'', ''plans'', ''expects'', and similar
   expressions are intended to identify forward-looking statements.

This Quarterly Report on
   Form 10-Q may contain forward looking statements which involve risks and
   uncertainties. The Company's actual results could differ materially from the
   results discussed in such statements. Certain factors that could cause such
   a difference include, without limitation, the risks specifically described
   in the Company's Annual Report on Form 10-K for the year ended December 31,
   1999 and other public documents filed by the Company with the Securities and
   Exchange Commission (the ''Commission''), which factors are incorporated
   herein by reference, the factors listed below in "Factors That May
   Affect Future Results" and other factors such as product or services
   demand and market acceptance risks, product development and services
   capacity, commercialization and technological difficulties, capacity and
   supply constraints or difficulties and the effect of general business or
   economic conditions. The Company's forward-looking statements do not reflect
   the impact of any future transactions or strategic alliances. From time to
   time, the Company may also provide oral or written forward-looking
   statements in other materials it releases to the public. The Company does
   not assume any obligation to update any of the forward-looking statements it
   makes.

2





PART I. FINANCIAL INFORMATION

|Item 1. |  | Financial Statements
|------- |  | --------------------

PERITUS SOFTWARE SERVICES, INC.

CONSOLIDATED BALANCE SHEET

(In thousands, except share-related data)

|ASSETS                                                                           | March 31,
   
   2000                                                                                                                                                                             |                            | December 31,
   
   1999 |      
|-------------------------------------------------------------------------------- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | -------------------------- | ------------------------ | -----
|                                                                                 |                                                                                                                                                                                                   |                            | (unaudited)              |      
|Current assets:                                                                  |                                                                                                                                                                                                   |                            |                          |      
|                                                                                 | Cash and cash equivalents                                                                                                                                                                         | $                          | 6,866                    |      
|                                                                                 | Accounts receivable, net of allowance for
     doubtful accounts of $25                                                                                                                           |                            | 306                      |      
|Costs and estimated earnings in excess of
     billings on uncompleted contracts |                                                                                                                                                                                                   | 190                        |                          |      
|Prepaid expenses and other current
     assets                                   |                                                                                                                                                                                                   | 176                        |                          |      
|                                                                                 |                                                                                                                                                                                                   |                            |                          |      
|                                                                                 |                                                                                                                                                                                                   | Total current assets       |                          | 7,538
|Property and equipment, net                                                      |                                                                                                                                                                                                   | 516                        |                          |      
|Intangible and other assets, net                                                 |                                                                                                                                                                                                   | 42                         |                          |      
|                                                                                 |                                                                                                                                                                                                   |                            |                          |      
|                                                                                 |                                                                                                                                                                                                   |                            | $                        | 8,096
|                                                                                 |                                                                                                                                                                                                   |                            |                          |      
|LIABILITIES AND STOCKHOLDERS'
     EQUITY                                        |                                                                                                                                                                                                   |                            |                          |      
|                                                                                 |                                                                                                                                                                                                   |                            |                          |      
|Current liabilities:                                                             |                                                                                                                                                                                                   |                            |                          |      
|                                                                                 | Current portion of capital lease
     obligations                                                                                                                                                 | $                          | 13                       |      
|                                                                                 | Accounts payable                                                                                                                                                                                  |                            | 47                       |      
|                                                                                 | Customer advances                                                                                                                                                                                 |                            | 296                      |      
|                                                                                 | Billings in excess of costs and estimated
     earnings on uncompleted contracts                                                                                                                  |                            | 197                      |      
|                                                                                 | Deferred revenue                                                                                                                                                                                  |                            | 127                      |      
|                                                                                 | Other accrued expenses and current
     liabilities                                                                                                                                               |                            | 805                      |      
|                                                                                 |                                                                                                                                                                                                   |                            |                          |      
|                                                                                 |                                                                                                                                                                                                   | Total current liabilities  |                          | 1,485
|Capital lease obligations                                                        |                                                                                                                                                                                                   | 21                         |                          |      
|                                                                                 |                                                                                                                                                                                                   |                            |                          |      
|                                                                                 |                                                                                                                                                                                                   | Total liabilities          |                          | 1,506
|                                                                                 |                                                                                                                                                                                                   |                            |                          |      
|Stockholders' equity:                                                            |                                                                                                                                                                                                   |                            |                          |      
|                                                                                 | Common stock, $.01 par value; 50,000,000
     shares authorized; 27,309,903 and
   
   17,173,975 shares issued and outstanding at March 31, 2000 and December 31,
     1999,
   
   respectively |                            | 273                      |      
|                                                                                 | Additional paid-in capital                                                                                                                                                                        |                            | 113,206                  |      
|                                                                                 | Accumulated deficit                                                                                                                                                                               |                            | (106,881                 | )    
|                                                                                 | Accumulated other comprehensive
     loss                                                                                                                                                         |                            | (8                       | )    
|                                                                                 |                                                                                                                                                                                                   |                            |                          |      
|                                                                                 |                                                                                                                                                                                                   | Total stockholders' equity |                          | 6,590
|                                                                                 |                                                                                                                                                                                                   |                            |                          |      
|                                                                                 |                                                                                                                                                                                                   |                            | $                        | 8,096
|                                                                                 |                                                                                                                                                                                                   |                            |                          |      

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



3



PERITUS SOFTWARE SERVICES, INC.

CONSOLIDATED STATEMENT OF OPERATIONS

(In thousands, except per share related data)

(unaudited)

|                                     |                              |                          |        | Three Months
   
   Ended
   
   March 31, |       
|------------------------------------ | ---------------------------- | ------------------------ | ------ | ------------------------------------------ | ------
|
|
|Revenue:                             |                              |                          |        |                                            |       
|                                     | Outsourcing services         |                          | 809    |                                            | $     
|                                     | License                      |                          | 644    |                                            |       
|                                     | Other services               |                          | 112    |                                            |       
|                                     |                              |                          |        |                                            |       
|                                     |                              | Total revenue            |        | 1,565                                      |       
|                                     |                              |                          |        |                                            |       
|Cost of revenue:                     |                              |                          |        |                                            |       
|                                     | Cost of outsourcing services |                          | 510    |                                            |       
|                                     | Cost of license              |                          |       |                                            |       
|                                     | Cost of other services       |                          | 70     |                                            |       
|                                     |                              |                          |        |                                            |       
|                                     |                              | Total cost of revenue    |        | 580                                        |       
|                                     |                              |                          |        |                                            |       
|Gross profit                         |                              | 985                      |        |                                            | 1,620 
|                                     |                              |                          |        |                                            |       
|Operating expenses:                  |                              |                          |        |                                            |       
|                                     | Sales and marketing          |                          | 57     |                                            |       
|                                     | Research and development     |                          | 325    |                                            |       
|                                     | General and administrative   |                          | 472    |                                            |       
|                                     | Restructuring charge         |                          |       |                                            |       
|                                     | Gain on sale of assets       |                          | (24    | )                                          |       
|                                     |                              |                          |        |                                            |       
|                                     |                              | Total operating expenses |        | 830                                        |       
|                                     |                              |                          |        |                                            |       
|Profit (Loss) from operations        |                              | 155                      |        |                                            | (1,967
|Interest income, net                 |                              | 35                       |        |                                            | 8     
|Cost of strategic investment         |                              | (4,000                   | )      |                                            |      
|                                     |                              |                          |        |                                            |       
|                                     | Net loss                     | $                        | (3,810 | )                                          | $     
|                                     |                              |                          |        |                                            |       
|Net loss per share:                  |                              |                          |        |                                            |       
|                                     | Basic                        | $                        | (0.19  | )                                          | $     
|                                     |                              |                          |        |                                            |       
|                                     | Diluted                      | $                        | (0.19  | )                                          | $     
|                                     |                              |                          |        |                                            |       
|Weighted average shares outstanding: |                              |                          |        |                                            |       
|                                     | Basic                        |                          | 19,708 |                                            |       
|                                     |                              |                          |        |                                            |       
|                                     | Diluted                      |                          | 19,708 |                                            |       
|                                     |                              |                          |        |                                            |       

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

4

PERITUS SOFTWARE SERVICES, INC.

CONSOLIDATED STATEMENT OF CASH FLOWS

(In thousands)

(Unaudited)

|                                                            |                                                                                                 | Three Months Ended
   
   March 31,                                                 |                                                          
|----------------------------------------------------------- | ----------------------------------------------------------------------------------------------- | ----------------------------------------------------------------------------------- | ---------------------------------------------------------
|
|Increase (Decrease) in Cash and Cash
     Equivalents       |                                                                                                 |                                                                                     |                                                          
|Cash flows from operating activities:                      
|                                                            | Net loss                                                                                        | $                                                                                   | (3,810                                                   
|                                                            | Adjustments to reconcile net loss to net cash
     provided by (used for) operating activities:
|                                                            | Depreciation and amortization                                                                   |                                                                                     | 153                                                      
|                                                            | Gain on asset sale                                                                              |                                                                                     | (24                                                      
|                                                            | Cost of strategic investment                                                                    |                                                                                     | 4,000                                                    
|                                                            | Changes in assets and
     liabilities:                                                        
|                                                            |                                                                                                 | Accounts receivable                                                                 |                                                          
|                                                            |                                                                                                 | Costs and estimated earnings in excess of
     billings on uncompleted contracts    |                                                          
|                                                            |                                                                                                 | Prepaid expenses and other current assets                                           |                                                          
|                                                            |                                                                                                 | Other assets                                                                        |                                                          
|                                                            |                                                                                                 | Accounts payable                                                                    |                                                          
|                                                            |                                                                                                 | Customer advances                                                                   |                                                          
|                                                            |                                                                                                 | Billings in excess of costs and estimated
     earnings on uncompleted contracts    |                                                          
|                                                            |                                                                                                 | Deferred revenue                                                                    |                                                          
|                                                            |                                                                                                 | Other accrued expenses and current
     liabilities excluding accrued restructuring
|                                                            | (323                                                                                            | )                                                                                   |                                                          
|                                                            |                                                                                                 | Accrued restructuring                                                               |                                                          
|                                                            |                                                                                                 |                                                                                     |                                                          
|                                                            |                                                                                                 |                                                                                     | Net cash provided by (used for) operating
     activities
|                                                            |                                                                                                 |                                                                                     |                                                          
|Cash flows from investing activities:                      
|                                                            | Sale (purchase) of short-term investments                                                       |                                                                                     |                                                         
|                                                            | Proceeds from sale of property and
     equipment                                               |                                                                                     | 57                                                       
|                                                            | Purchases of property and equipment                                                             |                                                                                     |                                                         
|                                                            |                                                                                                 |                                                                                     |                                                          
|                                                            |                                                                                                 |                                                                                     | Net cash provided by (used for) investing
     activities
|                                                            |                                                                                                 |                                                                                     |                                                          
|Cash flows from financing activities:                      
|                                                            | Restricted cash                                                                                 |                                                                                     |                                                         
|                                                            | Principal payments on long-term debt                                                            |                                                                                     |                                                         
|                                                            | Principal payments on capital lease
     obligations                                            |                                                                                     | (4                                                       
|                                                            | Proceeds from exercise of stock options                                                         |                                                                                     | 28                                                       
|                                                            | Proceeds from issuance of common stock, net of
     issuance costs                              |                                                                                     | 4,000                                                    
|                                                            |                                                                                                 |                                                                                     |                                                          
|                                                            |                                                                                                 | Net cash provided by financing activities                                           |                                                          
|                                                            |                                                                                                 |                                                                                     |                                                          
|Effects of exchange rates on cash and cash
     equivalents |                                                                                                 |                                                                                    |                                                          
|                                                            |                                                                                                 |                                                                                     |                                                          
|Net increase (decrease) in cash and cash
     equivalents   |                                                                                                 | 4,391                                                                               |                                                          
|Cash and cash equivalents, beginning of
     period         |                                                                                                 | 2,475                                                                               |                                                          
|                                                            |                                                                                                 |                                                                                     |                                                          
|Cash and cash equivalents, end of period                    | $                                                                                               | 6,866                                                                               |                                                          
|                                                            |                                                                                                 |                                                                                     |                                                          
|Supplemental disclosure of cash flows:                     
|                                                            | Cash paid for income
     taxes                                                                 | $                                                                                   |                                                         
|                                                            | Cash paid for interest                                                                          |                                                                                     |                                                         

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

5



PERITUS SOFTWARE SERVICES, INC.

NOTES TO UNAUDITED CONSOLIDATED FINANCIAL STATEMENTS



1. Basis of Presentation and Current Financial
   Condition

The accompanying
   unaudited consolidated financial statements include the accounts of Peritus
   Software Services, Inc. and its subsidiaries (the ''Company'') and have been
   prepared by the Company without audit in accordance with the Company's
   accounting policies, as described in the Company's Annual Report on Form
   10-K for the year ended December 31, 1999, as filed with the Securities and
   Exchange Commission (''SEC''). In the opinion of management, the
   accompanying unaudited consolidated financial statements contain all
   adjustments, and consist only of those of a normal recurring nature,
   necessary for a fair presentation of the Company's financial position,
   results of operations and cash flows at the dates and for the periods
   indicated. While the Company believes that the disclosures presented are
   adequate to make the information not misleading, these financial statements
   should be read in conjunction with the consolidated financial statements and
   related notes included in the Company's 1999 Annual Report on Form 10-K. The
   operating results for the three months ended March 31, 2000 are not
   necessarily indicative of the results to be expected for the full year
   ending December 31, 2000.

The Company's
   consolidated financial statements have been presented on the basis that it
   is a going concern, which contemplates continuity of operations, realization
   of assets and the satisfaction of liabilities in the ordinary course of
   business. The Company experienced a net loss of $3,810,000 for the quarter
   ended March 31, 2000, and net losses of $2,583,000 and $26,673,000 in the
   years ended December 31, 1999 and 1998, respectively.

On March 27, 2000,
   Rocket Software, Inc. ("Rocket"), a privately held company,
   invested $4,000,000 in the Company in exchange for 10,000,000 shares ($.40
   per share) of restricted common stock (37% of outstanding stock after the
   investment). The Company granted Rocket certain registration rights with
   respect to the shares. The Company recorded a $4,000,000 non-cash charge
   related to the investment in the quarter ended March 31, 2000. The charge
   represented the difference between the quoted market price on the commitment
   date and the price paid by Rocket. Under certain sections of the Internal
   Revenue Code, a change in ownership of greater than 50% within a three-year
   period places an annual limitation on the Company's ability to utilize its
   existing net operating loss and research and development tax credit
   carry-forwards. The investment by Rocket triggered the limitation. Based on
   the Company's current forecasted cash expenditures, its cash on hand prior
   to the Rocket investment and the $4,000,000 invested by Rocket, the Company
   expects to have sufficient cash to finance its operations through the year
   2000. The Company's future beyond the year 2000 is dependent upon its
   ability to achieve a break-even cash flow or raise additional financing.
   There can be no assurances that the Company will be able to do so.

2. Legal Proceedings

The Company and certain
   of its officers and directors were named as defendants in purported class
   action lawsuits filed in the United States District Court for the District
   of Massachusetts by Robert Downey on April 1, 1998, by Scott Cohen on April
   7, 1998, by Timothy Bonnett on April 9, 1998, by Peter Lindsay on April 17,
   1998, by Harry Teague on April 21, 1998, by Jesse Wijntjes on April 29,
   1998, by H. Vance Johnson and H. Vance Johnson as Trustee for the I.O.R.D.
   Profit-Sharing Plan on May 6, 1998, by John B. Howard, M.D. on May 21, 1998
   and by Helen Lee on May 28, 1998 (collectively, the "complaints").
   The complaints principally alleged that the defendants violated federal
   securities laws by making false and misleading statements and by failing to
   disclose material information concerning the Company's December 1997
   acquisition of substantially all of the assets and assumption of certain
   liabilities of the Millennium Dynamics, Inc. ("MDI") business from
   American Premier Underwriters, Inc., thereby allegedly causing the value of
   the Company's common stock to be artificially inflated during the purported
   class periods. In addition, the Howard complaint alleged violation of
   federal securities laws as a result of the Company's purported failure to
   disclose material information in connection with the Company's initial
   public offering on July 2, 1997, and also named Montgomery Securities, Inc.,
   Wessels, Arnold & Henderson, and H.C. Wainwright & Co., Inc. as
   defendants. The complaints further alleged that certain officers and/or
   directors of the Company sold stock in the open market during the class
   periods and sought unspecified damages.

On or about June
   1, 1998, all of the named plaintiffs and additional purported class members
   filed a motion for the appointment of several of those individuals as lead
   plaintiffs, for approval of lead and liaison plaintiffs' counsel and for
   consolidation of the actions. The Court granted the motion on June 18,
   1998.

On January 8, 1999, the plaintiffs
   filed a Consolidated Amended Complaint applicable to all previously filed
   actions. The Consolidated Amended Complaint alleged a class period of
   October 22, 1997 through October 26, 1998 and principally claimed that the
   Company and three of its former officers violated federal securities law by
   purportedly making false and misleading statements (or omitting material
   information) concerning the MDI acquisition and the Company's revenue during
   the proposed class period, thereby allegedly causing the value of the
   Company's common stock to be artificially inflated. Previously stated claims
   against the Company and its underwriters alleging violations of the federal
   securities laws as a result of purportedly inadequate or incorrect
   disclosure in connection with the Company's initial public offering were not
   included in the Consolidated Amended Complaint. The Company and the
   individual defendants filed motions to dismiss the Consolidated Amended
   Complaint on March 5, 1999. Oral arguments on the motions were held on April
   21, 1999 and the Court granted the Company's and the individual defendants'
   motions to dismiss the Consolidated Amended Complaint pursuant to an order
   dated June 1, 1999. The plaintiffs appealed the Court's order of dismissal.
   The Company contested the appeal and supported the Court's order of
   dismissal. In December, 1999, the parties agreed to settle the lawsuit. The
   Company received final approval on February 28, 2000 from the Court of the
   settlement of the action. The $2.8 million settlement became effective and
   the appeal period expired on March 29, 2000. The settlement was funded
   entirely by the Company's directors and officers liability insurer and the
   Company and the individual defendants received a full release and dismissal
   of all claims brought by the class during the class period.

On or about April
   28, 1999, the Company filed a lawsuit in the United States District Court
   for the District of Massachusetts against Micah Technology Services, Inc.
   and Affiliated Computer Services, Inc. (collectively, "Micah").
   The lawsuit principally alleges that Micah breached its contract with the
   Company by failing to pay for services performed by the Company under such
   contract. The lawsuit further alleges that since Micah was unjustly enriched
   by the services performed by the Company, the Company is entitled to
   recovery based on quantum meruit, and that Micah engaged in unfair and/or
   deceptive trade practices or acts in violation of Massachusetts General Laws
   ("M.G.L.") Chapter 93A by allowing the Company to perform services
   when Micah did not pay for such services. The lawsuit seeks unspecified
   damages on the breach of contract and quantum meruit claims and double or
   triple damages on the Chapter 93A claim. Micah has denied the Company's
   allegations and has filed a counterclaim against the Company principally
   alleging fraud, negligent misrepresentations, breach of contract and that
   the Company engaged in unfair and/or deceptive trade practices or acts in
   violation of M.G.L. Chapter 93A by its misrepresentations and breach of
   contract. The Company denied the allegations contained in Micah's
   counterclaim and intends to contest the counterclaim vigorously. The parties
   are still in the initial discovery phase of the litigation. A non-binding
   mediation hearing was held on March 17, 2000 and no settlement was
   reached.

On April 13,
   2000, without admitting or denying any findings, the Company consented to
   the issuance of an administrative cease and desist Order with the Securities
   and Exchange Commission concerning its previously announced revenue
   restatements in the first and second quarters of 1998, the third quarter of
   1997 and the year ended December 31, 1997. The Order requires the Company to
   cease and desist from committing future violations of the public company
   reporting, record keeping and internal control provisions of the Securities
   Exchange Act of 1934.

In addition
   to the matters noted above, the Company is from time to time subject to
   legal proceedings and claims which arise in the normal course of its
   business. In the opinion of management, the amount of ultimate liability
   with respect to these other actions, currently known, will not have a
   material adverse effect on the Company's financial position or results of
   operations.

6

3. Comprehensive Income (Loss)

Comprehensive income is
   defined as the change in equity of a business enterprise during a period
   from transactions and other events and circumstances from non-owner sources.
   It includes all changes in equity during a period except those resulting
   from investments by owners and distributions to owners.

For the three months
   ended March 31, 2000 and 1999, the Company's comprehensive loss consisted of
   the following:

|                       | Three Months
   
   Ended March 31, |           
|---------------------- | ----------------------------------- | ----------
|                       | 2000                                |           
|Net loss               | $                                   | (3,810,000
|Translation adjustment |                                     |          
|                       |                                     |           
|                       | $                                   | (3,810,000
|                       |                                     |           

4. Recently Issued Accounting Standards

In March 2000, the
   Financial Accounting Standard Board ("FASB") issued FASB
   Interpretation No. 44, "Accounting for Certain Transactions Involving
   Stock Compensation, -an interpretation of APB Opinion 25" ("FIN
   44"). FIN 44 clarifies the application of APB No. 25 and, among other
   issues, clarifies the following: the definition of an employee for purposes
   of applying APB Opinion No. 25; the criteria for determining whether a plan
   qualifies as a non-compensatory plan; the accounting consequence of various
   modifications to the terms of previously fixed stock options or awards; and
   the accounting for an exchange of stock compensation awards in a business
   combination. FIN 44 is effective July 1, 2000, but certain conclusions in
   FIN 44 cover specific events that occurred after either December 15, 1998 or
   January 12, 2000. At this time, the Company does not expect the application
   of FIN 44 to have a material impact on its financial position or results of
   operations.

5. Segment, Geographic, and Product
   Information

The Company operates in
   one reportable segment under SFAS No. 131, "Disclosures about Segments
   of an Enterprise and Related Information," due to its centralized
   structure and single industry segment: software maintenance, tools and
   services. The Company currently derives its revenue from software
   maintenance outsourcing services, software and methodology licensing and
   other services.

Information by geographic area for the three months
   ended at March 31, 2000 and 1999 is summarized below (in thousands):



|               | Outsourcing Services |         | License Revenue |         | Other Services Revenue |         | Long-lived |   
|-------------- | -------------------- | ------- | --------------- | ------- | ---------------------- | ------- | ---------- | --
|
|March 31, 2000 |                      |         |                 |         |                        |         |            |   
|United States  |                      | $   809 |                 |        |                        | $   644 |            |  
|Foreign        |                      |        |                 |        |                        |        |            |  
|               |                      |         |                 |         |                        |         |            |   
|               |                      | $   809 |                 |        |                        | $   644 |            |  
|               |                      |         |                 |         |                        |         |            |   
|March 31, 1999 |                     
|United States  |                      | $1,853  |                 |        |                        | $1,359  |            |  
|Foreign        |                      |        |                 |        |                        |        |            |  
|               |                      |         |                 |         |                        |         |            |   
|               |                      | $1,853  |                 | $      |                        | $1,359  |            | -
|               |                      |         |                 |         |                        |         |            |   



7

The geographic
   classification of revenue is determined based on the country in which the
   legal entity providing the services is located. Revenue from no single
   foreign country was greater than 10% of the consolidated revenues of the
   Company in the quarters ended March 31, 2000 and 1999.

8



Item 2. Management's Discussion And Analysis Of Financial Condition And
   Results Of Operations

Overview and Current Financial Condition

Peritus
   Software Services, Inc. ("Peritus" or the "Company") was
   incorporated in Massachusetts in August 1991. The Company provides solutions
   consisting of software products and services that enable organizations to
   improve the productivity, quality and effectiveness of their information
   technology, systems maintenance, or "software evolution"
   functions. The Company derives its revenue from software maintenance
   outsourcing services, software and methodology licensing and other services.

In the
   second half of 1998 and in 1999, the overall market for the year 2000 tools
   and services of Peritus contracted dramatically, resulting in substantial
   financial losses. In response, the Company substantially reduced its
   workforce in September and December of 1998 and again in April of 1999.
   During the second and third quarters of 1999, the Company also settled its
   leases for its facilities in Cincinnati, Ohio, Lisle, Illinois and
   Billerica, Massachusetts and took other efforts to reduce its fixed costs.
   As a result of the Company's degraded financial condition, the Company began
   encountering major obstacles in obtaining new outsourcing business. Since
   most outsourcing engagements are multi-year and involve critical
   applications, prospective new clients, although interested in the
   capabilities and technology of the Company, were reluctant or unwilling to
   commit to contracts. Despite the significant reduction in the overall cost
   structure as a result of the foregoing actions, the Company was unable to
   achieve a cash flow break-even position in the year ended December 31,
   1999.

On March
   27, 2000, Rocket Software, Inc. ("Rocket"), a privately held
   company, invested $4,000,000 in the Company in exchange for 10,000,000
   shares ($.40 per share) of restricted common stock (37% of outstanding stock
   after the investment). The Company granted Rocket certain registration
   rights with respect to the shares. Based on the Company's current forecasted
   cash expenditures, its cash on hand prior to the Rocket investment and the
   $4,000,000 invested by Rocket, the Company expects to have sufficient cash
   to finance its operations through the year 2000. The Company's future beyond
   the year 2000 is dependent upon its ability to achieve a break-even cash
   flow or raise additional financing. There can be no assurances that the
   Company will be able to do so.

The
   Company's current strategy is to continue to service its existing
   outsourcing customers and to renew expiring contracts. At the same time, the
   Company is pursuing new business through the licensing of, and associated
   consulting and training for, its outsourcing methodology (technology
   transfer services) and SAM Relay and SAM Workbench tools. The Company
   anticipates using the proceeds from the Rocket investment to fund additional
   investments in sales and marketing, research and development (particularly
   the enhancement of the Company's SAM Workbench tool) and other general
   corporate purposes. The Company also plans to develop other service
   offerings.

Three Months Ended March 31, 2000 Compared To Three
   Months Ended March 31, 1999

Revenue

Total
   revenue decreased 66.5% to $1,565,000 in the three months ended March 31,
   2000 from $4,667,000 in the three months ended March 31, 1999. This decrease
   in revenue was primarily due to a decrease in other services and outsourcing
   revenues and, to a lesser extent, in the licensing of the Company's software
   products and tools.

The Company anticipates that total revenue
   for the year 2000 will be substantially below the level achieved in 1999.

Outsourcing Services.Outsourcing services revenue decreased 56.3%
   to $809,000 in the three months ended March 31, 2000 from $1,853,000 in the
   three months ended March 31, 1999. As a percentage of total revenue,
   outsourcing services revenue increased to 51.7% in the three months ended
   March 31, 2000 from 39.7% for the three months ended March 31, 1999. The
   increase in outsourcing services revenue as a percentage of total revenue
   reflects the decreased contribution of other services revenue to total
   revenue during the three months ended March 31, 2000 when compared to the
   same period in the prior year. The decrease in outsourcing services revenue
   in absolute dollars in the three months ended March 31, 2000, compared to
   March 31, 1999, was attributable to recording lower amounts of revenue under
   existing outsourcing engagements due to reduced workload or contract
   terminations. During the first quarter of 2000, a contract with one client
   reached the end of its term and was not renewed. During the first quarter of
   2000, outsourcing services revenue
 attributable to the client was $216,000. The Company did not sign any new
   outsourcing contracts during the first quarter of 2000.

License.License revenue decreased 52.6% to $644,000 in the three
   months ended March 31, 2000, or 41.2% of total revenue, compared to
   $1,359,000, or 29.1% of total revenue, in the three months ended March 31,
   1999. The decrease in license revenue for 2000 in absolute dollars was
   primarily attributable to a decrease in year 2000 related licensed revenue
   from end users and value added integrators. The Company will continue to
   pursue licenses of its outsourcing technology and SAM Relay and SAM
   Workbench tools and future revenue is dependent on the success of such
   efforts. The $644,000 of license revenue in the quarter ended March 31, 2000
   was attributable to paid-up license revenue from two customers.

Other
   Services.Other services revenue decreased 92.3% to $112,000in
   the three months ended March 31, 2000 from $1,455,000 in the three months
   ended March 31, 1999. As a percentage of total revenue, other services
   revenue decreased to 7.2% in the three months ended March 31, 2000 from
   31.2% in the three months ended March 31, 1999. The decrease in other
   services revenue in absolute dollars was primarily attributable to a
   decrease in direct delivery, consulting and client support services relating
   to the Company's year 2000 products and services. Future revenue from other
   services is dependent on the Company's success in licensing its methodology,
   and its SAM Workbench and SAM Relay tools, which would generate maintenance,
   consulting and training revenue. Future revenue from other services is also
   dependent on the development of other successful offerings.

Cost of Revenue

Cost
   of Outsourcing Services Revenue.Cost of outsourcing services revenue
   consists primarily of salaries, benefits and overhead costs associated with
   delivering outsourcing services to clients. The cost of outsourcing services
   revenue decreased 73.5% to $510,000 in the three months ended March 31, 2000
   from $1,923,000 for the three months ended March 31, 1999. Cost of
   outsourcing services revenue as a percentage of outsourcing services revenue
   decreased to 63.0% in the three months ended March 31, 2000 from 103.8% in
   the three months ended March 31, 1999. Costs in 1999 were negatively
   impacted by expenditures in anticipation of and to generate new business
   that did not materialize. In addition, the Company incurred costs in
   connection with an agreement with Micah Technology Services, Inc.
   ("Micah") for which it received no payments. The Company has filed
   a lawsuit against Micah to attempt to recover amounts due under such
   agreement. See "Part II-Item 1. Legal Proceedings."

Cost
   of License Revenue.Cost of license revenue consists primarily of
   amortization of expense of intangibles related to the acquisition of
   Millennium Dynamics, Inc. ("MDI") and salaries, benefits and
   related overhead costs associated with license-related materials packaging
   and freight. Cost of license revenue was $0 in the three months ended March
   31, 2000. Cost of license revenue was $96,000, or 7.1% of license revenue,
   in the three months ended March 31, 1999. The decrease in cost of license
   revenue was primarily related to the termination (in the fourth quarter of
   1999) of amoritization expense of intangibles related to the MDI
   acquisition.

Cost
   of Other Services Revenue.Cost of other services revenue consists
   primarily of salaries, benefits and related overhead costs associated with
   delivering other services to clients. Cost of other services revenue
   decreased 93.2% to $70,000 in the three months ended March 31, 2000 from
   $1,028,000 in the three months ended March 31, 1999. Cost of other services
   revenue as a percentage of other services revenue decreased to 62.5% in the
   three months ended March 31, 2000 from 70.7% in the three months ended March
   31, 1999. Costs decreased in absolute dollars in the three months ended
   March 31, 2000 due to reduced staffing for the Company's client support,
   training and consulting organizations related to fewer customers for the
   Company's year 2000 products and services, including year 2000 renovations
   and renovation quality evaluation ("RQE") services.

Operating Expenses

Sales
   and Marketing.Sales and marketing expenses consist primarily of
   salaries, commissions and related overhead costs for sales and marketing
   personnel; sales referral fees to third parties; advertising programs; and
   other promotional activities. Sales and marketing expenses decreased 94.6%
   to $57,000 in the three months ended March 31, 2000 from $1,050,000 in the
   three months ended March 31, 1999. As a percentage of total revenue, sales
   and marketing expenses decreased to 3.6% in the three months ended March 31,
   2000 from 22.5% in the three months ended March 31, 1999.
 The decrease in expenses in absolute dollars and as a percentage of revenue
   was primarily attributable to dramatically reduced staffing, commissions and
   promotional activities. The Company plans to increase its sales resources
   and marketing efforts in the future.

Research and Development. Research and development expenses
   consist primarily of salaries, benefits and related overhead costs for
   engineering and technical personnel and outside engineering consulting
   services associated with developing new products and enhancing existing
   products. Research and development expenses decreased 30.9% to $325,000 in
   the three months ended March 31, 2000 from $470,000 in the three months
   ended March 31, 1999. As a percentage of total revenue, research and
   development expenses increased to 20.8% in the three months ended March 31,
   2000 from 10.1% in the three months ended March 31, 1999. The decrease in
   research and development expenses in absolute dollars was primarily
   attributable to reduced staffing. The Company plans to continue maintenance
   of and enhancements to its existing products (particularly the enhancement
   of the Company's SAM Workbench tool) and may selectively develop new
   products or services.

General and Administrative. General and administrative expenses
   consist primarily of salaries and related costs for the finance and
   accounting, human resources, legal services, information systems and other
   administrative departments of the Company, as well as contracted legal and
   accounting services. General and administrative expenses decreased 73.4% to
   $472,000 in the three months ended March 31, 2000 from $1,776,000 in the
   three months ended March 31, 1999. As a percentage of total revenue, general
   and administrative expenses decreased to 30.2% in the three months ended
   March 31, 2000 from 38.1% in the three months ended March 31, 1999. The
   decrease in general and administrative expenses in absolute dollars was
   primarily due to the reductions in staffing, the cost of excess space, and
   legal and accounting fees incurred in the three months ended March 31, 2000.

Restructuring
   Charge

On March 29,
   1999, the Company announced its intention to restructure and recorded a
   charge of $291,000 consisting of severance payments associated with the
   termination of 40 employees. The Company had no restructuring charges in the
   three months ended March 31, 2000.

Gain on the Sale of Assets

The gain on the sale of assets in the quarter ended
   March 31, 2000 represented the excess of the sales proceeds over the net
   book value of the fixed assets of the Company's India subsidiary that were
   sold during the quarter.

Cost of Strategic Investment

On March 27,
   2000, Rocket, a privately held company, invested $4,000,000 in the Company
   in exchange for 10,000,000 shares ($.40 per share) of restricted common
   stock (37% of outstanding stock after the investment). The Company recorded
   a non-cash charge of $4,000,000 for the cost of this strategic investment
   equal to the difference between the purchase price per share of $0.40 and
   the market price per share of $0.80 on March 27, 2000.

Interest Income
   (Expense), Net

Interest
   income and expense consists primarily of interest income from cash balances,
   partially offset by interest expense on debt. The Company had interest
   income, net, of $35,000 in the three months ended March 31, 2000 compared to
   interest income, net, of $8,000 in the three months ended March 31, 1999.
   This change in interest income (expense), net, was primarily attributable to
   increased interest income from higher interest bearing balances and higher
   bank rates as well as lower interest expense.

Provision for Income
   Taxes

The
   Company's income tax provision was zero in each of the three months ended
   March 31, 2000 and 1999. The Company did not record a tax provision or
   benefit in either period due to losses incurred.

Liquidity and Capital Resources

The Company has financed
   its operations and capital expenditures primarily with the proceeds from
   sales of the Company's convertible preferred stock and common stock,
   borrowings, and advance payments for services from clients. The Company's
   cash balances were $6,866,000 and $2,475,000 at March 31, 2000 and December
   31, 1999, respectively. The Company's working capital was $6,053,000 and
   $1,640,000 at March 31, 2000 and December 31, 1999, respectively.

11

The Company's operating
   activities provided cash of $310,000 and used cash of $63,000 during the
   three months ended March 31, 2000 and 1999, respectively. The cash provided
   during the three months ended March 31, 2000 was primarily caused by a net
   loss of $3,810,000 (less the non-cash cost of the strategic investment of
   $4,000,000 by Rocket, depreciation and amortization expense of $153,000, and
   the gain from the sale of assets of $24,000). Other sources were a decrease
   in accounts receivable of $226,000, a decrease in costs and estimated
   earnings in excess of billings on uncompleted contracts of $91,000, a
   decrease in prepaid expenses and other current assets of $72,000, an
   increase in accounts payable of $36,000, and a decrease in other assets of
   $13,000. These amounts were partially offset by a decrease in other accrued
   liabilities of $323,000, a decrease in deferred revenue of $68,000, and a
   decrease in billings in excess of costs and estimated earnings on
   uncompleted contracts of $56,000.

The Company's investing
   activities provided cash of $57,000 and used cash of $577,000 during the
   three months ended March 31, 2000 and 1999, respectively. Proceeds from the
   sale of property and equipment in the three months ended March 31, 2000
   consisted of the proceeds from the sale of the remaining assets of the
   Company's India subsidiary.

The Company's financing
   activities provided cash of $4,024,000 and $270,000 during the three months
   ended March 31, 2000 and 1999, respectively. Financing activities in the
   three months ended March 31, 2000 primarily reflect an increase from the
   proceeds of issuance of new common stock of $4,000,000 and the exercise of
   stock options of $28,000, partially offset by payments on capital lease
   obligations of $4,000.

The Company has an
   accounts receivable purchase agreement with a lender to permit borrowing
   against certain acceptable receivables at a rate of 80% of the face amount
   of such receivables up to a maximum of $4,000,000. In exchange for such
   agreement, the Company granted the lender security interest on substantially
   all of its assets. There were no borrowings outstanding under the agreement
   at March 31, 2000.

On March 27, 2000,
   Rocket, a privately held company, invested $4,000,000 in the Company in
   exchange for 10,000,000 shares ($.40 per share) of restricted common stock
   (37% of outstanding stock after the investment). The Company granted Rocket
   certain registration rights with respect to the shares. Based on the
   Company's current forecasted cash expenditures, its cash on hand prior to
   the Rocket investment and the $4,000,000 invested by Rocket, the Company
   expects to have sufficient cash to finance its operations through the year
   2000. The Company's future beyond the year 2000 is dependent upon its
   ability to achieve a breakeven cash flow or raise additional financing.
   There can be no assurances that the Company will be able to do so.

To date, the Company has
   not invested in derivative securities or any other financial instruments
   that involve a high level of complexity or risk. Excess cash has been, and
   the Company contemplates that it will continue to be, invested in
   interest-bearing, investment grade securities.

Foreign Currency

Assets and liabilities of
   the Company's majority-owned foreign subsidiary are translated into U.S.
   dollars at exchange rates in effect at the balance sheet date. Income and
   expense items are translated at average exchange rates for the period.
   Accumulated net translation adjustments are included in stockholders'
   equity.

Inflation

To date, inflation has
   not had a material impact on the Company's results of operations.

Recently Issued Accounting Standards

In March 2000, the
   Financial Accounting Standard Board ("FASB") issued FASB
   Interpretation No. 44, "Accounting for Certain Transactions Involving
   Stock Compensation, -an interpretation of APB Opinion 25" ("FIN
   44"). FIN 44 clarifies the application of APB No. 25 and, among other
   issues, clarifies the following: the definition of an employee for purposes
   of applying APB Opinion No. 25; the criteria for determining whether a plan
   qualifies as a non-compensatory plan; the accounting consequence of various
   modifications to the terms of previously fixed stock options or awards; and
   the accounting for an exchange of stock compensation awards in a business
   combination. FIN 44 is effective July 1, 2000, but certain conclusions in
   FIN 44 cover specific events that occurred after either December 15, 1998 or
   January 12,
 2000. At this time, the Company does not expect the application of FIN 44 to
   have a material impact on its financial position or results of
   operations.

Factors That May Affect Future Results

Failure to Achieve Cash
   Flow Breakeven/Strategic Initiatives

The Company's ability to achieve a cash flow breakeven
   position is critical for achieving financial stability. There can be no
   assurance that the Company will achieve a cash flow breakeven position in
   the future.

Financing

There can
   be no assurance that the Company will be able to obtain additional funds in
   the future through equity and/or debt financings or borrow against its
   accounts receivable financing agreement.

Over the Counter Listing

Trading
   of the common stock is conducted in the over-the-counter market which could
   make it more difficult for an investor to dispose of, or obtain accurate
   quotations as to the market value of, the common stock. In addition, there
   are additional sales practice requirements on broker-dealers who sell such
   securities to persons other than established customers and accredited
   investors. For transactions covered by this rule, the broker-dealer must
   make a special suitability determination for the purchaser and must have
   received the purchaser's written consent to the transaction prior to sale.
   In addition, if the trading price of the common stock is below $5.00 per
   share, trading in the common stock would also be subject to the requirements
   of certain rules promulgated under the Securities Exchange Act of 1934,
   which require additional disclosure by broker-dealers in connection with any
   trades involving a stock defined as a penny stock (generally any non-NASDAQ
   equity security that has a market price of less than $5.00 per share,
   subject to certain exceptions). Such rules require the delivery, prior to
   any penny stock transaction, of a disclosure schedule explaining the penny
   stock market and the risks associate therewith, and impose various sales
   practice requirements on broker-dealers who sell penny stocks to persons
   other than established customers and accredited investors (generally
   institutions). For these types of transactions, the broker-dealer must make
   a special suitability determination for the purchaser and have received the
   purchaser's written consent to the transaction prior to sale. The additional
   burdens imposed upon broker-dealers by such requirements may discourage
   broker-dealers from effecting transactions in the common stock, which could
   severely limit the market liquidity of the common stock and the ability of
   purchasers in this offering to sell the common stock in the secondary
   market.

Risk of Current Strategy

In the
   past, the Company generated significant revenues from marketing and selling
   products and services that addressed the year 2000 problem. The demand for
   such products and services has ended and the Company no longer actively
   markets and sells year 2000 products and services. The Company's current
   strategy is to continue to service its existing outsourcing customers and to
   renew expiring contracts. At the same time, the Company is pursuing new
   business through the licensing of, and associated consulting and training
   for, its outsourcing methodology (technology transfer services) and SAM
   Relay and SAM Workbench tools. The Company plans to continue maintenance of
   and enhancements to its existing products (particularly the enhancements of
   the Company's SAM Workbench tool) and may selectively develop new products
   or services. The Company is planning to increase its sales resources and
   marketing efforts in the future. There can be no assurance that this current
   strategy will generate revenues sufficient for the Company to achieve a cash
   flow breakeven position.

Potential Fluctuations in
   Quarterly Performance

The
   Company's revenue and operating results have varied significantly in the
   past and are likely to vary significantly from quarter to quarter in the
   future. The Company's quarterly operating results may continue to fluctuate
   due to a number of factors, including the timing, size and nature of the
   Company's individual outsourcing, technology transfer,
 insourcing and licensing transactions; unforeseen difficulties in performing
   such transactions; the performance of the Company's value added integrators
   and distributors; the timing of the introduction and the market acceptance
   of new services, products or product enhancements by the Company or its
   competitors; the relative proportions of revenue derived from license fees
   and professional services; changes in the Company's operating expenses;
   personnel changes; foreign currency exchange rates and fluctuations in
   economic and financial market conditions.

The
   timing, size and nature of individual outsourcing, technology transfer,
   insourcing and licensing transactions are important factors in the Company's
   quarterly operating results. Many such transactions involve large dollar
   amounts, and the sales cycle for these transactions is often lengthy and
   unpredictable. In addition, the sales cycle associated with these
   transactions is subject to a number of uncertainties, including clients'
   budgetary constraints, the timing of clients' budget cycles and clients'
   internal approval processes. There can be no assurance that the Company will
   be successful in closing such large transactions on a timely basis or at
   all. Most of the Company's outsourcing engagements are performed on a
   fixed-price basis and, therefore, the Company bears the risk of cost
   overruns and inflation. A significant percentage of the Company's revenue
   derived from these engagements is recognized on the percentage-of-completion
   method, which requires revenue to be recorded over the term of a client
   contract. A loss is recorded at the time when current estimates of project
   costs exceed unrecognized revenue. The Company's operating results may be
   adversely affected by inaccurate estimates of contract completion costs.

The
   Company's expense levels are based, in part, on its expectations as to
   future revenue and are fixed, to a large extent, in the short term. As a
   result, the Company has been and may continue to be unable to adjust
   spending in a timely manner to compensate for any further unexpected revenue
   shortfall. Accordingly, any significant shortfall in revenue, in addition to
   those already experienced in relation to the Company's expectations, would
   have an immediate and material adverse effect on the Company's business,
   financial condition and results of operations.

Due to
   all of the foregoing factors, the Company believes that period-to-period
   comparisons of its operating results are not necessarily meaningful and that
   such comparisons cannot be relied upon as indicators of future performance.
   There can be no assurance that future revenue and operating results will not
   continue to vary substantially. It is also possible that in a quarter the
   Company's operating results will be below the expectations of public market
   analysts and investors. In either case, the price of the Company's Common
   Stock has been and could continue to be materially adversely affected.

Need to Develop
   Additional Products and Services

In the
   past, the Company generated significant revenue from, and devoted
   significant resources to, products and services that address the year 2000
   problem. The demand for such products and services has ended and the Company
   no longer actively markets and sells year 2000 products and services. The
   Company's current strategy is to continue to service its existing
   outsourcing customers and to renew expiring contracts. At the same time, the
   Company is pursuing new business through the licensing of and associated
   consulting and training for, its outsourcing methodology (technology
   transfer services) and SAM Relay and SAM Workbench tools. The Company plans
   to continue maintenance of and enhancements to its existing products
   (particularly the enhancements of the Company's SAM Workbench Tool) and may
   selectively develop new products or services. There can be no assurance that
   the Company will be able to grow or maintain its outsourcing business or
   sell its other products or services. The failure to diversify, develop and
   sell additional products and services (and/or sell existing products or
   services) would have a material adverse effect on the Company's business,
   financial condition and results of operations.

Concentration of
   Clients

The
   Company's revenue is highly concentrated among a small number of clients.
   During the year ended December 31, 1999, revenue from three clients
   accounted for 40.5% of the year's revenue, with one client representing
   21.7%. The contracts for two of these three clients (representing 18.8% of
   the revenue for the year ended December 31, 1999) terminated in November
   1999 and March 2000. During the quarter ended March 31, 2000, $644,000 of
   license revenue was attributable to paid-up license revenue from two
   customers. The loss of, or a significant reduction in revenue from, any of
   the Company's major clients could have a material adverse impact on the
   Company's business, financial condition and results of operations. In
   addition, with such a large percentage of the Company's revenue attributable
   to a small number of clients, the loss of one or more major clients could
   have a material adverse impact on the Company's liquidity.



14

Competition

The
   market for the Company's products and services is intensely competitive and
   is characterized by rapid changes in technology and user needs and the
   frequent introduction of new products. In addition, the Company faces
   competition in the software maintenance outsourcing services market and the
   software maintenance tools market. A number of the Company's competitors are
   more established, benefit from greater name recognition and have
   substantially greater financial, technical and marketing resources than
   those of the Company. As a result, there can be no assurance that the
   Company's products and services, will compete effectively with those of
   their respective competitors.

Competitive Market for
   Technical Personnel

The
   Company depends, to a significant extent, on its ability to attract, train,
   motivate and retain highly skilled software professionals, particularly
   project managers, software engineers and other senior technical personnel.
   The Company believes that there is a shortage of, and significant
   competition for, software development professionals with the skills and
   experience necessary to perform the services offered by the Company. The
   Company's ability to develop new products and services, maintain and renew
   existing engagements and obtain new business depends, in large part, on its
   ability to hire and retain technical personnel with the IT and other skills
   that keep pace with continuing changes in software evolution, industry
   standards and technologies, client preferences and the Company's business
   strategy. The inability to hire additional qualified personnel could impair
   the Company's ability to satisfy its client base and to develop new products
   and services, requiring an increase in the level of responsibility for both
   existing and new personnel. There can be no assurance that the Company will
   be successful in retaining current or future employees.

Fixed-Price, Fixed-Time
   Contracts

Part of
   the Company's business is to offer its outsourcing and technology transfer
   services on fixed-price, fixed-time frame contracts, rather than contracts
   in which payment to the Company is determined solely on a time-and-materials
   basis. These contracts are terminable by either party generally upon prior
   written notice. Although the Company uses its proprietary tools and
   methodologies and its past project experience to reduce the risks associated
   with estimating, planning and performing the fixed-price projects, the
   Company's standard outsourcing and technology transfer agreements provide
   for a fixed-fee based on projected reductions in a client's maintenance
   costs and increases in a client's maintenance productivity. The Company's
   failure to estimate accurately the resources, costs and time required for a
   project or its failure to complete its contractual obligations within the
   time frame committed could have a material adverse effect on the Company's
   business, financial condition and results of operations.

Potential for Contract
   Liability

The
   Company's products and services relating to software maintenance, involve
   key aspects of its clients' computer systems. A failure in a client's system
   could result in a claim for substantial damages against the Company,
   regardless of the Company's responsibility for such failure. The Company
   attempts to limit contractually its liability for damages arising from
   negligent acts, errors, mistakes or omissions in rendering its products and
   services. Despite this precaution, there can be no assurance that the
   limitations of liability set forth in its contracts would be enforceable or
   would otherwise protect the Company from liability for damages.
   Additionally, the Company maintains general liability insurance coverage,
   including coverage for errors and omissions. However, there can be no
   assurance that such coverage will continue to be available on acceptable
   terms, or will be available in sufficient amounts to cover one or more large
   claims, or that the insurer will not disclaim coverage as to any future
   claim. The successful assertion of one or more large claims against the
   Company that exceed available insurance coverage or changes in the Company's
   insurance policies, including premium increases or the imposition of large
   deductible or co-insurance requirements, could have a material adverse
   effect on the Company's business, financial
 condition and results of operations. Furthermore, litigation, regardless of
   its outcome, could result in substantial cost to the Company and divert
   management's attention from the Company's operations. Any contract liability
   claim or litigation against the Company could, therefore, have a material
   adverse effect on the Company's business, financial conditions and results
   of operations.

Software Errors or Bugs

The
   Company's software products and tools are highly complex and sophisticated
   and could from time to time contain design defects or software errors that
   could be difficult to detect and correct. Errors, bugs or viruses may result
   in loss of or delay in market acceptance, a failure in a client's system or
   loss or corruption of client data. Although the Company has not experienced
   material adverse effects resulting from any software defects or errors,
   there can be no assurance that, despite testing by the Company and its
   clients, errors will not be found in new products, which errors could have a
   material adverse effect upon the Company's business, financial condition and
   results of operations.

Limited Protection of
   Proprietary Rights

The
   Company relies on a combination of patent, copyright, trademark and trade
   secret laws and license agreements to establish and protect its rights in
   its software products and proprietary technology. In addition, the Company
   currently requires its employees and consultants to enter into nondisclosure
   and assignment of invention agreements to limit use of, access to and
   distribution of its proprietary information. There can be no assurance that
   the Company's means of protecting its proprietary rights in the United
   States or abroad will be adequate. The laws of some foreign countries may
   not protect the Company's proprietary rights as fully or in the same manner
   as do the laws of the United States. Also, despite the steps taken by the
   Company to protect its proprietary rights, it may be possible for
   unauthorized third parties to copy aspects of the Company's products,
   reverse engineer, develop similar technology independently or obtain and use
   information that the Company regards as proprietary. Furthermore, there can
   be no assurance that others will not develop technologies similar or
   superior to the Company's technology or design around the proprietary rights
   owned by the Company.

The
   Company has entered into license agreements with clients that allow these
   clients access to and use of the Company's AutoEnhancer/2000, Vantage YR
   2000 software, SAM Relay and RQE Tools source code for certain purposes.
   Access to the Company's source code may increase the likelihood of
   misappropriation or misuse by third parties.

There can
   be no assurance that any patent will be issued pursuant to any pending
   patent applications or that, if granted, such patents would survive a legal
   challenge to their validity or provide meaningful or significant protection
   to the Company. In addition, the Company may decide to abandon a patent
   application if, among other things, it determines that continued prosecution
   of an application would be too costly, the technologies, processes or
   methodologies are not critical to the Company's business in the foreseeable
   future or it is unlikely that a patent will issue with regard to a
   particular application. Certain of the Company's technology incorporated in
   some of its products may infringe on patents held by others. Any
   infringement claim or litigation against the Company could have a material
   adverse effect on the Company's business, financial condition and results of
   operations.

The
   Company maintains trademarks and service marks to identify its various
   service offerings, products and software. Although the Company has
   registered certain trademarks and service marks with the United States
   Patent and Trademark Office ("PTO") and has several trademark and
   service mark applications pending in the United States and foreign
   jurisdictions, not all of the applications have been granted and, even if
   granted, there can be no assurance that a particular trademark or service
   mark will survive a legal challenge to its validity or provide meaningful or
   significant protection to the Company. In addition, the Company has
   abandoned the applications of certain trademarks or service marks that it
   believes are not critical to its business in the future. In some cases,
   entities other than the Company are using certai

16

different manner than a third party. There may be some
   risk of infringement claims against the Company in the event that a service
   or product of the Company is too similar to that of another entity that is
   using a similar mark.

Dependence on Third-Party
   Technology

The
   Company's proprietary software is currently designed, and may in the future
   be designed, to work on or in conjunction with certain third-party hardware
   and/or software products. If any of these current or future third-party
   vendors were to discontinue making their products available to the Company
   or to licensees of the Company's software or to increase materially the cost
   to the Company or its licensees to acquire, license or purchase the
   third-party vendors' products, or if a material problem were to arise in
   connection with the ability of the Company to design its software to
   properly use or operate with third-party hardware and/or software products,
   the Company would be required to redesign its software to function with or
   on alternative third-party products or attempt to develop internally a
   replacement for the third-party products. In such an event, interruptions in
   the availability or functioning of the Company's software and delays in the
   introduction of new products and services may occur until equivalent
   technology is obtained. There can be no assurance that an alternative source
   of suitable technology would be available or that the Company would be able
   to develop an alternative product in sufficient time or at a reasonable
   cost. The failure of the Company to obtain or develop alternative
   technologies or products on a timely basis and at a reasonable cost could
   have a material adverse effect on the Company's business, financial
   condition and results of operations.



Rapid Technological
   Change

The
   market for the Company's products and services is characterized by rapidly
   changing technology, evolving industry standards and new product
   introductions and enhancements that may render existing products obsolete.
   As a result, the Company's market position could erode further due to
   unforeseen changes in the features and functionality of competing products.
   The process of developing products and services such as those offered by the
   Company is extremely complex and is expected to become increasingly complex
   and expensive in the future with the introduction of new platforms and
   technologies. There can be no assurance that the Company will develop any
   new products or services in a timely fashion or that the Company's current
   or future products or services will satisfy the needs of its target
   market.

Potential Adverse
   Effects of Anti-Takeover Provisions; Possible Issuance of Preferred Stock

The
   Company's Amended and Restated Articles of Organization and Amended and
   Restated By-laws contain provisions that may make it more difficult for a
   third party to acquire, or discourage acquisition bids for, the Company. For
   instance, the Company's Amended and Restated By-laws provide that special
   meetings of stockholders may be called only by the President, the Board of
   Directors or the holders of at least 80% of the voting securities of the
   Company. In addition, the Massachusetts General Laws provide that
   stockholders may take action without a meeting only by the unanimous written
   consent of all stockholders. The Company's Board of Directors is also
   divided into three classes, as nearly equal in size as possible, with
   staggered three-year terms. The Company is also subject to an anti-takeover
   provision of the Massachusetts General Laws which prohibits, subject to
   certain exceptions, a holder of 5% or more of the outstanding voting stock
   of the Company from engaging in certain activities with the Company,
   including a merger, stock or asset sale. The foregoing provisions could
   limit the price that certain investors might be willing to pay in the future
   for shares of the Company's Common Stock. In addition, shares of the
   Company's Preferred Stock may be issued in the future without further
   stockholder approval and upon such terms and conditions, and having such
   rights, privileges and preferences, as the Board of Directors may determine.
   The rights of the holders of Common Stock will be subject to, and may be
   adversely affected by, the rights of any holders of Preferred Stock that may
   be issued in the future. The issuance of Preferred Stock, while providing
   desirable flexibility in connection with possible acquisitions and other
   corporate purposes, could have the effect of making it more difficult for a
   third party to acquire, or discouraging a third party from acquiring, a
   majority of the outstanding voting stock of the Company.

Year 2000 Matters

To date, the Company
   has not experienced any material problems with its internal computer systems
   relating to the inability of such systems to recognize appropriate dates
   associated with the year 2000. The Company is also not aware of any material
   year 2000 problems experienced by customers that have licensed the Company's
   products or have received its services, or vendors that have provided
   products or services to the Company. Accordingly, the Company does not
   presently anticipate incurring material expenses or damages or experiencing
   any material operational disruptions as a result of any year 2000 problems.
   However, there can be no assurance that the Company may not experience
   unanticipated expenses or damages or be adversely impacted by any year 2000
   problems.



Item 3. Quantitative and Qualitative Disclosures About Market Risk

17

As of
   March 31, 2000, the Company was exposed to market risks which primarily
   included changes in U.S. interest rates. The Company maintains a significant
   portion of its cash and cash equivalents in financial instruments with
   purchased maturities of three months or less. These financial instruments
   are subject to interest rate risk and will decline in value if interest
   rates increase. Due to the short duration of these financial instruments, an
   immediate increase in interest rates would not have a material effect of the
   Company's financial condition or results of operations.

18

PART II. OTHER INFORMATION

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

The Company and certain
   of its officers and directors were named as defendants in purported class
   action lawsuits filed in the United States District Court for the District
   of Massachusetts by Robert Downey on April 1, 1998, by Scott Cohen on April
   7, 1998, by Timothy Bonnett on April 9, 1998, by Peter Lindsay on April 17,
   1998, by Harry Teague on April 21, 1998, by Jesse Wijntjes on April 29,
   1998, by H. Vance Johnson and H. Vance Johnson as Trustee for the I.O.R.D.
   Profit-Sharing Plan on May 6, 1998, by John B. Howard, M.D. on May 21, 1998
   and by Helen Lee on May 28, 1998 (collectively, the "complaints").
   The complaints principally alleged that the defendants violated federal
   securities laws by making false and misleading statements and by failing to
   disclose material information concerning the Company's December 1997
   acquisition of substantially all of the assets and assumption of certain
   liabilities of the Millennium Dynamics, Inc. business from American Premier
   Underwriters, Inc., thereby allegedly causing the value of the Company's
   common stock to be artificially inflated during the purported class periods.
   In addition, the Howard complaint alleged violation of federal securities
   laws as a result of the Company's purported failure to disclose material
   information in connection with the Company's initial public offering on July
   2, 1997, and also named Montgomery Securities, Inc., Wessels, Arnold &
   Henderson, and H.C. Wainwright & Co., Inc. as defendants. The complaints
   further alleged that certain officers and/or directors of the Company sold
   stock in the open market during the class periods and sought unspecified
   damages.

On or about June 1, 1998, all of the named plaintiffs
   and additional purported class members filed a motion for the appointment of
   several of those individuals as lead plaintiffs, for approval of lead and
   liaison plaintiffs' counsel and for consolidation of the actions. The Court
   granted the motion on June 18, 1998.

On January 8, 1999, the plaintiffs
   filed a Consolidated Amended Complaint applicable to all previously filed
   actions. The Consolidated Amended Complaint alleged a class period of
   October 22, 1997 through October 26, 1998 and principally claimed that the
   Company and three of its former officers violated federal securities law by
   purportedly making false and misleading statements (or omitting material
   information) concerning the MDI acquisition and the Company's revenue during
   the proposed class period, thereby allegedly causing the value of the
   Company's common stock to be artificially inflated. Previously stated claims
   against the Company and its underwriters alleging violations of the federal
   securities laws as a result of purportedly inadequate or incorrect
   disclosure in connection with the Company's initial public offering were not
   included in the Consolidated Amended Complaint. The Company and the
   individual defendants filed motions to dismiss the Consolidated Amended
   Complaint on March 5, 1999. Oral arguments on the motions were held on April
   21, 1999 and the Court granted the Company's and the individual defendants'
   motions to dismiss the Consolidated Amended Complaint pursuant to an order
   dated June 1, 1999. The plaintiffs appealed the Court's order of dismissal.
   The Company contested the appeal and supported the Court's order of
   dismissal. In December, 1999, the parties agreed to settle the lawsuit. The
   Company received final approval on February 28, 2000 from the Court of the
   settlement of the action. The $2.8 million settlement became effective and
   the appeal period expired on March 29, 2000. The settlement was funded
   entirely by the Company's directors and officers liability insurer and the
   Company and the individual defendants received a full release and dismissal
   of all claims brought by the class during the class period.

On or about April 28,
   1999, the Company filed a lawsuit in the United States District Court for
   the District of Massachusetts against Micah Technology Services, Inc. and
   Affiliated Computer Services, Inc. (collectively, "Micah"). The
   lawsuit principally alleges that Micah breached its contract with the
   Company by failing to pay for services performed by the Company under such
   contract. The lawsuit further alleges that since Micah was unjustly enriched
   by the services performed by the Company, the Company is entitled to
   recovery based on quantum meruit, and that Micah engaged in unfair and/or
   deceptive trade practices or acts in violation of Massachusetts General Laws
   ("M.G.L.") Chapter 93A by allowing the Company to perform services
   when Micah did not pay for such services. The lawsuit seeks unspecified
   damages on the breach of contract and quantum meruit claims and double or
   triple damages on the Chapter 93A claim. Micah has denied the Company's
   allegations and has filed a counterclaim against the Company principally
   alleging fraud, negligent misrepresentations, breach of contract and that
   the Company engaged in unfair and/or deceptive trade practices or acts in
   violation of M.G.L. Chapter 93A by its misrepresentations and breach of
   contract. The Company denied the allegations contained in Micah's
   counterclaim and intends to contest the counterclaim vigorously. The parties
   are in the initial discovery phase of the litigation. A non-binding
   mediation hearing was held on March 17, 2000 and no settlement was
   reached.

On April 13,
   2000, without admitting or denying any findings, the Company consented to
   the issuance of an administrative cease and desist Order with the Securities
   and Exchange Commission concerning its previously announced revenue
   restatements in the first and second quarters of 1998, the third quarter of
   1997 and the year ended December 31, 1997. The Order requires the Company to
   cease and desist from committing future violations of the public company
   reporting, record keeping and internal control provisions of the Securities
   Exchange Act of 1934.

In addition
   to the matters noted above, the Company is from time to time subject to
   legal proceedings and claims which arise in the normal course of its
   business. In the opinion of management, the amount of ultimate liability
   with respect to these other actions, currently known, will not have a
   material adverse effect on the Company's financial position or results of
   operations.

|Item 2. |  | Changes in Securities and Use of Proceeds
|------- |  | -----------------------------------------

On March 27, 2000, the Company
   issued and sold 10,000,000 shares of Peritus common stock, $.01 par value
   per share, to Rocket Software, Inc. for $4,000,000 in cash. These shares
   were offered and sold in reliance upon Rule 506 under the Securities Act of
   1933, as amended, relating to sales by an issuer not involving a public
   offering. Rocket Software represented to the Company, among other things,
   that it is an "accredited investor" as defined in Rule 501(a)
   under the Securities Act. On April 4, 2000, the Company filed a Notice of
   Sale of Securities Pursuant to Regulation D on Form D with the Securities
   and Exchange Commission. No underwriters were involved in the sale of these
   shares.

|Item 6. |  | Exhibits And Reports On Form 8-K
|------- |  | --------------------------------

(a) Exhibits:

> Documents listed below,
>    except for documents identified by footnotes, are being filed as exhibits
>    herewith. Documents identified by footnotes, if any, are not being filed
>    herewith and, pursuant to Rule 12b-32 of the General Rules and Regulations
>    promulgated by the Commission under the Securities Exchange Act of 1934 (the
>    ''Exchange Act''), reference is made to such documents as previously filed
>    as exhibits with the Commission. The Company's file number under the
>    Exchange Act is 000-22647.
> 
>  Exhibit
>      10.1
>    
>    1997 Director Stock Option Plan as Amended and
>      Restated10.2(1)
>    
>    Addendum to Employment Agreement between the Company
>      and John Giordano
>    
>    dated January 21, 2000.10.3(1)
>    
>    Amended Employment Agreement between the Company and
>      John Giordano datedJanuary 21, 2000.10.4(1)
>    
>    Asset Purchase Agreement dated as of January 31,
>      2000, as amended, by and among Peritus Software  Services
>      (India) Private Limited, LTP (India) Pvt. Ltd. and Lisle Technology
>      Partners L.L.C.10.5(1)
>    
>    Common Stock Purchase Agreement dated as of March 27,
>      2000 by and between the Company and Rocket Software,
>      Inc.10.6(1)
>    
>    Registration Rights Agreement dated as of March 27,
>      2000 by and between
>    
>    the Company and Rocket Software, Inc.Exhibit 27
>    
>    Financial Data Schedule(1)
>    
>    Incorporated by reference to the Registrant's Annual
>      Report on Form 10-K dated
>    
>    March 30, 2000

(b) Reports
   on Form 8-K:

A Current
   Report Form 8-K dated March 27, 2000 was filed by the Company on March 29,
   2000. The Company reported under item 5 (Other Events) that Rocket Software,
   Inc. ("Rocket"), a privately held software company, invested
   $4,000,000 in Peritus. Under terms of the agreement, Rocket invested
   $4,000,000 in cash in exchange for 10,000,000 restricted shares of Peritus
   common stock ($0.40 per share). The shares represented approximately 37% of
   the total shares outstanding after the investment and the Company granted
   Rocket certain registration rights with respect to the shares.

19

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.

Dated: May 15, 2000

| | Peritus Software Services, Inc.                                                                                                   
| | ----------------------------------------------------------------------------------------------------------------------------------
| |                                                                                                                                   
| | By:   /s/ John D. Giordano                                                                                                        
| |                                                                                                                                   
| | John D. Giordano
   
   President, Chief Executive Officer and Chief
   
   Financial Officer
   
   (Principal Financial Officer)
| |                                                                                                                                   
| |                                                                                                                                   
| | Peritus Software Services, Inc.                                                                                                   
| |                                                                                                                                   
| | By:   /s/ Patrick Manning                                                                                                         
| |                                                                                                                                   
| | Patrick Manning
   
   Corporate Controller
   
   (Principal Accounting Officer)                                                 
| |                                                                                                                                   



20

Peritus Software Services, Inc.FORM 10-QFor the Quarterly Period Ended March 31, 2000Exhibit Index

|Exhibit No. |                         | Description                                                                                                                                                                                                  
|----------- | ----------------------- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|10.1        |                         | 1997 Director Stock Option Plan as Amended and
     Restated                                                                                                                                                 
|10.2(1)     |                         | Addendum to Employment Agreement between the Company
     and John Giordano dated January 21, 2000.                                                                                                          
|10.3(1)     |                         | Amended Employment Agreement between the Company and
     John Giordano datedJanuary 21, 2000.                                                                                                               
|10.4(1)     |                         | Asset Purchase Agreement dated as of January 31,
     2000, as amended, by and among Peritus Software  Services
     (India) Private Limited, LTP (India) Pvt. Ltd. and Lisle Technology
     Partners L.L.C.
|10.5(1)     |                         | Common Stock Purchase Agreement dated as of March 27,
     2000 by and between the Company and Rocket Software,
     Inc.                                                                                    
|10.6(1)     |                         | Registration Rights Agreement dated as of March 27,
     2000 by and between the Company and Rocket Software, Inc.                                                                                           
|27          | Financial Data Schedule
|(1)         |                         | Incorporated by reference to the Registrant's Annual
     Report on Form 10-K dated March 30, 2000