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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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Form 10-Q



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(Mark One)

|x | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ---------------------------------------------------------------------------------------



For the Quarterly Period Ended September 30, 2003



OR



| ̈ | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ----------------------------------------------------------------------------------------



For the transition period from  to



Commission File Number: 0-25457



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NEON Systems, Inc.

(Exact name of Registrant as specified in its charter)



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|Delaware                                 |  | 76-0345839         
|---------------------------------------- |  | -------------------
|(State or other jurisdiction of          |  | (I.R.S.Employer    
|incorporation or organization)           |  | Identification No.)
|                                         | 
|14100 Southwest Freeway, Suite 500,      |  |                    
|Sugar Land, Texas                        |  | 77478              
|(Address of principal executive offices) |  | (zip code)         



(281) 491-4200

(Registrants telephone number, including area code)



Securities registered pursuant to Section 12(b) of the Act:



|Title of Each Class |  | Name of each exchange on which registered
|------------------- |  | -----------------------------------------
|None                |  | None                                     



Securities
registered pursuant to Section 12(g) of the Act:

Common Stock, par value $0.01 per share

(Title of Class)



---



Indicate by check mark whether 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 Registrant was required to file such reports), and (2) has been subject to such filing
requirements for the past 90 days.    Yes  x    No ̈



The number of shares of the registrants common
stock outstanding as of October 31, 2003, was 8,878,297.



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



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##### Table of Contents

NEON SYSTEMS, INC.



FORM 10-Q



FOR THE QUARTER ENDED SEPTEMBER 30, 2003



INDEX



|                             |  |                                                                                                       |  | PAGE
|---------------------------- |  | ----------------------------------------------------------------------------------------------------- |  | ----
|                            
|PART I FINANCIAL INFORMATION
|                             |  |                                                                                                      
|Item 1.                      |  | Financial Statements                                                                                  |  |     
|                             |  |                                                                                                      
|                             |  | Consolidated Balance Sheets at September 30, 2003 and March 31, 2003                                  |  | 3   
|                             |  |                                                                                                      
|                             |  | Consolidated Statements of Operations for the Three and Six Months Ended September 30, 2003 and 2002. |  | 4   
|                             |  |                                                                                                      
|                             |  | Consolidated Statements of Cash Flows for the Six Months Ended September 30, 2003 and 2002            |  | 5   
|                             |  |                                                                                                      
|                             |  | Condensed Notes to Consolidated Financial Statements                                                  |  | 6   
|                             |  |                                                                                                      
|Item 2.                      |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                 |  | 12  
|                             |  |                                                                                                      
|Item 3.                      |  | Quantitative and Qualitative Disclosures About Market Risk                                            |  | 23  
|                             |  |                                                                                                      
|Item 4.                      |  | Controls and Procedures                                                                               |  | 23  
|                            
|PART II. OTHER INFORMATION  
|                             |  |                                                                                                      
|Item 1.                      |  | Legal Proceedings                                                                                     |  | 23  
|                             |  |                                                                                                      
|Item 2.                      |  | Defaults Upon Senior Securities                                                                       |  | 23  
|                             |  |                                                                                                      
|Item 3.                      |  | Submission of Matters to a Vote of Security Holders                                                   |  | 24  
|                             |  |                                                                                                      
|Item 4.                      |  | Other Information                                                                                     |  | 25  
|                             |  |                                                                                                      
|Item 5.                      |  | Exhibits and Reports on Form 8-K                                                                      |  | 27  
|                             | 
|SIGNATURES                   |  | 28                                                                                                   



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##### Table of Contents

PART I - FINANCIAL INFORMATION



ITEM 1. FINANCIAL STATEMENTS



NEON SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS, EXCEPT SHARE AMOUNTS)



|                                                                                                                                                                         |  | SEPTEMBER 30, 2003 |         |   | MARCH 31, 2003 |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | ------------------ | ------- | - | -------------- | -
|                                                                                                                                                                         |  | (UNAUDITED)        |         |   |                |  
|ASSETS                                                                                                                                                                   |  |                    |         |   |                |  
|CURRENT ASSETS:                                                                                                                                                          |  |                    |         |   |                |  
|Cash and cash equivalents                                                                                                                                                |  | $                  | 19,875  |   |                | $
|Accounts receivable, net                                                                                                                                                 |  |                    | 3,494   |   |                |  
|Taxes receivable                                                                                                                                                         |  |                    |        |   |                |  
|Other current assets                                                                                                                                                     |  |                    | 726     |   |                |  
|                                                                                                                                                                         |  |                    |         |   |                |  
|Total current assets                                                                                                                                                     |  |                    | 24,095  |   |                |  
|                                                                                                                                                                         |  |                    |         |   |                |  
|Property and equipment, net                                                                                                                                              |  |                    | 610     |   |                |  
|Notes receivable, net (related party, Note 7)                                                                                                                            |  |                    | 7,760   |   |                |  
|Other assets                                                                                                                                                             |  |                    | 45      |   |                |  
|                                                                                                                                                                         |  |                    |         |   |                |  
|Total assets                                                                                                                                                             |  | $                  | 32,510  |   |                | $
|                                                                                                                                                                         |  |                    |         |   |                |  
|LIABILITIES & STOCKHOLDERS EQUITY                                                                                                                                       |  |                    |         |   |                |  
|                                                                                                                                                                         |  |                   
|CURRENT LIABILITIES:                                                                                                                                                     |  |                    |         |   |                |  
|Accounts payable                                                                                                                                                         |  | $                  | 323     |   |                | $
|Accrued expenses                                                                                                                                                         |  |                    | 1,509   |   |                |  
|Deferred revenue                                                                                                                                                         |  |                    | 4,910   |   |                |  
|                                                                                                                                                                         |  |                    |         |   |                |  
|Total current liabilities                                                                                                                                                |  |                    | 6,742   |   |                |  
|                                                                                                                                                                         |  |                    |         |   |                |  
|Accrued restructuring expenses  long term (Note 6)                                                                                                                      |  |                    | 1,125   |   |                |  
|                                                                                                                                                                         |  |                    |         |   |                |  
|Total liabilities                                                                                                                                                        |  |                    | 7,867   |   |                |  
|                                                                                                                                                                         |  |                    |         |   |                |  
|STOCKHOLDERS EQUITY:                                                                                                                                                    |  |                    |         |   |                |  
|Preferred stock, $.01 par value. Authorized 10,000,000 shares; no shares issued and outstanding                                                                          |  |                    |        |   |                |  
|Common stock, $.01 par value. Authorized 30,000,000 shares; 8,860,622 and 8,764,427 shares issued and outstanding at September 30,
2003 and March 31, 2003, respectively |  |                    | 98      |   |                |  
|Additional paid-in capital                                                                                                                                               |  |                    | 51,638  |   |                |  
|Treasury stock, 913,400 shares at cost                                                                                                                                   |  |                    | (2,649  | ) |                |  
|Accumulative other comprehensive loss                                                                                                                                    |  |                    | (467    | ) |                |  
|Accumulated deficit                                                                                                                                                      |  |                    | (23,977 | ) |                |  
|                                                                                                                                                                         |  |                    |         |   |                |  
|Total stockholders equity                                                                                                                                               |  |                    | 24,643  |   |                |  
|                                                                                                                                                                         |  |                    |         |   |                |  
|Commitments and contingencies (Note 5)                                                                                                                                   |  |                    |         |   |                |  
|Total liabilities and stockholders equity                                                                                                                               |  | $                  | 32,510  |   |                | $
|                                                                                                                                                                         |  |                    |         |   |                |  



SEE ACCOMPANYING
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.



3



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##### Table of Contents

NEON SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

(UNAUDITED)



|                                                                                                                     |  | THREE MONTHS ENDED SEPTEMBER 30, |       |   | SIX MONTHS ENDED SEPTEMBER 30, |  
|-------------------------------------------------------------------------------------------------------------------- |  | -------------------------------- | ----- | - | ------------------------------ | -
|                                                                                                                     |  | 2003                             |       |   | 2002                           |  
|Revenues:                                                                                                            |  |                                  |       |   |                                |  
|License                                                                                                              |  | $                                | 1,138 |   |                                | $
|Maintenance                                                                                                          |  |                                  | 2,450 |   |                                |  
|                                                                                                                     |  |                                  |       |   |                                |  
|Total revenues                                                                                                       |  |                                  | 3,588 |   |                                |  
|Cost of revenues:                                                                                                    |  |                                  |       |   |                                |  
|Cost of licenses                                                                                                     |  |                                  |      |   |                                |  
|Cost of maintenance                                                                                                  |  |                                  | 361   |   |                                |  
|                                                                                                                     |  |                                  |       |   |                                |  
|Total cost of revenues                                                                                               |  |                                  | 361   |   |                                |  
|                                                                                                                     |  |                                  |       |   |                                |  
|Gross profit                                                                                                         |  |                                  | 3,227 |   |                                |  
|                                                                                                                     |  |                                  |       |   |                                |  
|Operating expenses:                                                                                                  |  |                                  |       |   |                                |  
|Sales and marketing                                                                                                  |  |                                  | 1,478 |   |                                |  
|Research and development                                                                                             |  |                                  | 981   |   |                                |  
|General and administrative                                                                                           |  |                                  | 868   |   |                                |  
|Restructuring costs                                                                                                  |  |                                  | 33    |   |                                |  
|Loss on disposal                                                                                                     |  |                                  |      |   |                                |  
|                                                                                                                     |  |                                  |       |   |                                |  
|Total operating expenses                                                                                             |  |                                  | 3,360 |   |                                |  
|                                                                                                                     |  |                                  |       |   |                                |  
|Operating loss                                                                                                       |  |                                  | (133  | ) |                                |  
|                                                                                                                     |  |                                  |       |   |                                |  
|Interest and other income, net                                                                                       |  |                                  | 117   |   |                                |  
|Equity loss in affiliate                                                                                             |  |                                  |      |   |                                |  
|Valuation allowance of note receivable                                                                               |  |                                  |      |   |                                |  
|                                                                                                                     |  |                                  |       |   |                                |  
|Income (loss) from continuing operations before income taxes and cumulative effect of change in accounting
principle |  |                                  | (16   | ) |                                |  
|                                                                                                                     |  |                                  |       |   |                                |  
|Provision for income taxes                                                                                           |  |                                  |      |   |                                |  
|                                                                                                                     |  |                                  |       |   |                                |  
|Income (loss) from continuing operations before cumulative effect of change in accounting principle                  |  |                                  | (16   | ) |                                |  
|Loss from discontinued operations                                                                                    |  |                                  |      |   |                                |  
|Gain on disposal of discontinued operations                                                                          |  |                                  | 53    |   |                                |  
|                                                                                                                     |  |                                  |       |   |                                |  
|Income (loss) before cumulative effect of change in accounting principle                                             |  |                                  | 37    |   |                                |  
|Cumulative effect of change in accounting principle                                                                  |  |                                  |      |   |                                |  
|                                                                                                                     |  |                                  |       |   |                                |  
|Net income (loss)                                                                                                    |  | $                                | 37    |   |                                | $
|                                                                                                                     |  |                                  |       |   |                                |  
|Earnings (loss) per common share Basic:                                                                             |  |                                  |       |   |                                |  
|Income (loss) from continuing operations before cumulative effect of change in accounting principle                  |  | $                                |      |   |                                | $
|                                                                                                                     |  |                                  |       |   |                                |  
|Loss from discontinued operations                                                                                    |  |                                  |      |   |                                |  
|Gain on disposal of discontinued operations                                                                          |  |                                  |      |   |                                |  
|                                                                                                                     |  |                                  |       |   |                                |  
|Income (loss) before cumulative effect of change in accounting principle                                             |  |                                  |      |   |                                |  
|Cumulative effect of change in accounting principle                                                                  |  |                                  |      |   |                                |  
|                                                                                                                     |  |                                  |       |   |                                |  
|Net income (loss)                                                                                                    |  | $                                |      |   |                                | $
|                                                                                                                     |  |                                  |       |   |                                |  
|Earnings (loss) per common share Diluted:                                                                           |  |                                  |       |   |                                |  
|Income (loss) from continuing operations before cumulative effect of change in accounting principle                  |  | $                                |      |   |                                | $
|                                                                                                                     |  |                                  |       |   |                                |  
|Loss from discontinued operations                                                                                    |  |                                  |      |   |                                |  
|Gain on disposal of discontinued operations                                                                          |  |                                  |      |   |                                |  
|                                                                                                                     |  |                                  |       |   |                                |  
|Income (loss) before cumulative effect of change in accounting principle                                             |  |                                  |      |   |                                |  
|Cumulative effect of change in accounting principle                                                                  |  |                                  |      |   |                                |  
|                                                                                                                     |  |                                  |       |   |                                |  
|Net income (loss)                                                                                                    |  | $                                |      |   |                                | $
|                                                                                                                     |  |                                  |       |   |                                |  
|Weighted average shares outstanding:                                                                                 |  |                                  |       |   |                                |  
|Basic                                                                                                                |  |                                  | 8,842 |   |                                |  
|                                                                                                                     |  |                                  |       |   |                                |  
|Diluted                                                                                                              |  |                                  | 8,842 |   |                                |  
|                                                                                                                     |  |                                  |       |   |                                |  



SEE ACCOMPANYING
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



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NEON SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(IN THOUSANDS)

(UNAUDITED)



|                                                                                        |  | SIX MONTHS ENDED SEPTEMBER 30, |       
|--------------------------------------------------------------------------------------- |  | ------------------------------ | ------
|                                                                                        |  | 2003                           |       
|CASH FLOWS FROM OPERATING ACTIVITIES:                                                   |  |                                |       
|Net income (loss)                                                                       |  | $                              | 192   
|Adjustments to reconcile net income (loss) to net cash used in operating activities:    |  |                                |       
|Depreciation and amortization                                                           |  |                                | 127   
|Loss from discontinued operations                                                       |  |                                | 244   
|Gain on disposal of discontinued operations                                             |  |                                | (343  
|Cumulative effect of change in accounting principle                                     |  |                                |      
|Non-cash compensation expense                                                           |  |                                |      
|Equity loss in affiliate                                                                |  |                                |      
|Valuation allowance of note receivable                                                  |  |                                |       
|Loss on Disposal                                                                        |  |                                |      
|Impairment of fixed assets                                                              |  |                                | 46    
|Increase (decrease) in cash resulting from changes in operating assets and liabilities: |  |                                |       
|Accounts receivable                                                                     |  |                                | (328  
|Tax receivable                                                                          |  |                                | 1,311 
|Other current assets                                                                    |  |                                | 218   
|Prepaid royalty (related party, Note 7)                                                 |  |                                |      
|Other assets                                                                            |  |                                | 108   
|Accrued expenses                                                                        |  |                                | (1,049
|Accounts payable                                                                        |  |                                | (109  
|Deferred revenue                                                                        |  |                                | (935  
|                                                                                        |  |                                |       
|Net cash used in operating activities                                                   |  |                                | (518  
|                                                                                        |  |                                |       
|CASH FLOWS FROM INVESTING ACTIVITIES:                                                   |  |                                |       
|Advances to Scalable Software (related party, Note 7)                                   |  |                                |      
|Advances to NESI (related party, Note 7)                                                |  |                                |      
|Purchases of furniture and equipment                                                    |  |                                | (32   
|Proceeds from sale of business                                                          |  |                                | 461   
|                                                                                        |  |                                |       
|Net cash provided by (used in) investing activities                                     |  |                                | 429   
|                                                                                        |  |                                |       
|CASH FLOWS FROM FINANCING ACTIVITIES:                                                   |  |                                |       
|Proceeds from exercises of stock options                                                |  |                                | 54    
|                                                                                        |  |                                |       
|Net cash provided by financing activities                                               |  |                                | 54    
|                                                                                        |  |                                |       
|Net cash flows from discontinued operations                                             |  |                                | 9     
|                                                                                        |  |                                |       
|Net decrease in cash and cash equivalents                                               |  |                                | (26   
|Effect of exchange rate changes on cash                                                 |  |                                | 110   
|Cash and cash equivalents at beginning of period                                        |  |                                | 19,791
|                                                                                        |  |                                |       
|Cash and cash equivalents at end of period                                              |  | $                              | 19,875
|                                                                                        |  |                                |       
|Supplemental disclosure of cash flow information:                                       |  |                                |       
|Cash received during the period for income tax refund                                   |  | $                              | 1,420 
|                                                                                        |  |                                |       
|Cash paid during the period for interest                                                |  | $                              |      
|                                                                                        |  |                                |       



SEE ACCOMPANYING
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.



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##### Table of Contents

NEON SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



NOTE 1BASIS OF PRESENTATION



The accompanying unaudited consolidated financial statements for NEON
Systems, Inc. and its subsidiaries (collectively, NEON) have been prepared in accordance with accounting principles generally accepted in the United States of America for interim financial reporting and in accordance with Regulation S-X
of the Securities and Exchange Commission. Accordingly, they do not include all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion
of management, the unaudited consolidated financial statements contained in this report reflect all adjustments, consisting of only normal recurring adjustments, considered necessary for a fair presentation of the financial position and the results
of operations for the interim periods presented. Operating results for interim periods are not necessarily indicative of results for the full year. These unaudited consolidated financial statements, footnote disclosures and other information should
be read in conjunction with the financial statements and the notes thereto included in NEONs audited financial statements for the fiscal year ended March 31, 2003,which are included in NEONs Form 10-K for the fiscal year ended March 31,
2003.



NOTE 2PER SHARE INFORMATION



In calculating earnings per share information, NEON follows
the provisions of Statement of Financial Accounting Standards (SFAS) No. 128, Earnings Per Share. Basic income (loss) per share is computed by dividing net income (loss) applicable to common stockholders by the weighted average number of
shares of common stock outstanding during the period. Diluted net income (loss) per share is computed by dividing net income (loss) applicable to common stockholders by the weighted average number of shares of common stock outstanding, adjusted to
reflect common stock equivalents, such as convertible preferred stock, stock options and warrants to purchase common stock, to the extent they are dilutive, less the number of shares that could have been repurchased with the exercise proceeds using
the treasury stock method. Although the Company reported net income for the quarter ended September 30, 2003, the Company also had a loss from continuing operations. Therefore, no potential common stock equivalents have been included in the
computation of any diluted per share amounts, in accordance with SFAS No. 128.



Earnings per share:

(In thousands, except per share date)



|                                                    |  | THREE MONTHSENDEDSEPTEMBER 30, |       |      | SIX MONTHSENDEDSEPTEMBER 30, |       
|--------------------------------------------------- |  | ------------------------------ | ----- | ---- | ---------------------------- | ------
|                                                    |  | 2003                           |       | 2002 |                              |       
|Net income (loss) available for common shareholders |  | $                              | 37    |      | $                            | (6,250
|                                                    |  |                                |       |     
|Weighted average outstanding shares of common stock |  |                                | 8,842 |      |                              | 8,703 
|Dilutive effect of employee stock options           |  |                                |      |      |                              |      
|                                                    |  |                                |       |      |                              |       
|Common stock and common stock equivalents           |  |                                | 8,842 |      |                              | 8,703 
|                                                    |  |                                |       |      |                              |       
|Earnings (loss) per share:                          |  |                                |       |      |                              |       
|Basic                                               |  | $                              |      |      | $                            | (0.72 
|                                                    |  |                                |       |      |                              |       
|Diluted                                             |  | $                              |      |      | $                            | (0.72 
|                                                    |  |                                |       |      |                              |       



At September 30, 2003,
there were options outstanding to purchase 2.5 million shares of common stock with a weighted-average exercise price of $6.46. For the three months ended September 30, 2003, 2.5 million options were excluded from the computation of diluted earnings
per share, as NEON incurred a net loss from continuing operations for the period. For the six months ended September 30, 2003, 1.5 million options were excluded from the calculation of diluted earnings per share because the effect was anti-dilutive.
All outstanding options were excluded from the calculation of diluted loss per share for the three and six months ended September 30, 2002, as they were anti-dilutive.



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NEON SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



Employee Stock-Based Compensation



NEON applies the intrinsic value-based method of accounting prescribed by Accounting Principles Board (APB) Opinion No. 25, Accounting For Stock Issued To Employees, and related interpretations. As
such, compensation expense has been recorded on the date of grant only if the estimated value of the underlying stock exceeded the exercise price. SFAS No. 123, Accounting For Stock-Based Compensation, established accounting and disclosure
requirements using a fair value-based method of accounting for stock-based employee compensation plans. Alternatively, SFAS No. 123 allows entities to continue to apply the provisions of APB Opinion No. 25 and provide pro forma net income and pro
forma earnings per share disclosures for employee stock option grants made in 1996 and future years as if the fair-value-based method defined in SFAS No. 123 had been applied. NEON has elected to continue to apply the provisions of APB Opinion No.
25 and provide the pro forma disclosure provisions of SFAS No. 123. The following table illustrates the effect on net income (loss) if the fair-value-based method had been applied to all outstanding and unvested awards in each period (in thousands,
except per share data):



|                                                                                                                |  | THREE MONTHSENDEDSEPTEMBER 30, |       |   | SIX MONTHSENDEDSEPTEMBER 30, |  
|--------------------------------------------------------------------------------------------------------------- |  | ------------------------------ | ----- | - | ---------------------------- | -
|                                                                                                                |  | 2003                           |       |   | 2002                         |  
|Net income (loss) as reported                                                                                   |  | $                              | 37    |   |                              | $
|Add stock-based employee compensation expense included in reported net income (loss)                            |  |                                |      |   |                              |  
|Deduct total stock-based employee compensation expense determined under fair-value-based method for all rewards |  |                                | 232   |   |                              |  
|                                                                                                                |  |                                |       |   |                              |  
|Pro forma net loss                                                                                              |  | $                              | (195  | ) |                              | $
|                                                                                                                |  |                                |       |  
|Basic earnings (loss) per share:                                                                                |  |                                |       |   |                              |  
|As reported                                                                                                     |  | $                              |      |   |                              | $
|                                                                                                                |  |                                |       |   |                              |  
|Pro forma                                                                                                       |  | $                              | (0.02 | ) |                              | $
|                                                                                                                |  |                                |       |   |                              |  
|Diluted earnings (loss) per share:                                                                              |  |                                |       |   |                              |  
|As reported                                                                                                     |  | $                              |      |   |                              | $
|                                                                                                                |  |                                |       |   |                              |  
|Pro forma                                                                                                       |  | $                              | (0.02 | ) |                              | $
|                                                                                                                |  |                                |       |   |                              |  



NOTE
3INCOME TAXES



NEON has recorded no income tax provision
as the current year taxable income is offset by net operating loss carry-forwards that NEON had previously reserved. At March 31, 2003, NEON has a net operating loss carry-forward for income tax purposes of approximately $21.7 million that is
available to offset future taxable income. The net operating loss carry-forwards in the United Kingdom, Germany and Australia carry forward indefinitely. The net operating loss carry-forward for the United States begins expiring in the tax year
2020. Given the recent tax losses experienced by NEON, there can be no assurance that the operations will generate taxable income in the future to utilize these losses. As of March 31, 2003 and September 30, 2003, the valuation allowance fully
offsets the Companys net deferred tax assets.



NOTE 4SEGMENT REPORTING



NEON considers its
business activities to be in a single segment. NEON did not have any customers, individually or in aggregate that accounted for 10% or more of consolidated revenue during the six-month periods ending September 30, 2003 and September 30, 2002.



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##### Table of Contents

NEON SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



The table below summarizes revenues by geographic region.



|                         |  | THREE MONTHS ENDED SEPTEMBER 30, |       |   | SIX MONTHS ENDEDSEPTEMBER 30, |  
|------------------------ |  | -------------------------------- | ----- | - | ----------------------------- | -
|                         |  | 2003                             |       |   | 2002                          |  
|Revenues:                |  |                                  |       |   |                               |  
|North America            |  | $                                | 2,569 |   |                               | $
|United Kingdom           |  |                                  | 919   |   |                               |  
|Other                    |  |                                  | 100   |   |                               |  
|                         |  |                                  |       |   |                               |  
|                         |  | $                                | 3,588 |   |                               | $
|                         |  |                                  |       |   |                               |  
|Operating income (loss): |  |                                  |       |   |                               |  
|United States            |  | $                                | (525  | ) |                               | $
|United Kingdom           |  |                                  | 443   |   |                               |  
|Other                    |  |                                  | (51   | ) |                               |  
|                         |  |                                  |       |   |                               |  
|                         |  | $                                | (133  | ) |                               | $
|                         |  |                                  |       |   |                               |  



|                     |  |                   
|-------------------- |  | ------------------
|                     |  | SEPTEMBER 30, 2003
|Identifiable Assets: |  |                   
|United States        |  | $                 
|United Kingdom       |  |                   
|Other                |  |                   
|                     |  |                   
|                     |  | $                 
|                     |  |                   



NOTE
5COMMITMENTS AND CONTINGENCIES



On January 29, 2003,
NEON received notification that it had been sued in Fort Bend County, Texas for alleged tortious interference with contract, tortious interference with prospective business relations and unfair competition in a lawsuit styled Phoenix Network
Technologies (Europe) Limited vs. NEON Systems, Inc. and Computer Associates International Inc., 400thDistrict
Court, Ft. Bend County, Richmond, Texas, Cause Number 03-CV-127800. On October 27, 2003, the court granted NEONs motion to dismiss the case. NEON will continue to defend this action further if required. Aside from this action, NEON is not
involved in any current claim or legal action other than those arising in the ordinary course of business.



NOTE 6RESTRUCTURING CHARGES



During the year ended March 31, 2003, NEON incurred restructuring charges of $3.0 million. The charges primarily relate to future losses due to the abandonment of leased facilities associated with a corporate reorganization as well as
severance and non-cash stock compensation costs related to the termination of the distribution agreement with NEON Enterprise Software, Inc. The Company has not been able to sublease a large portion of the abandoned facilities and therefore, has
accrued costs related to this portion of the future lease commitments. If the Company is able to sublease additional portions of the facilities in the future, it may result in reversal of this accrual. During fiscal 2002, NEON recorded a
restructuring charge of $908,000. These charges also related to reductions in the Companys cost structure, including reductions in force resulting in severance charges of $570,000 and losses from lease commitments of $338,000 due to the
abandonment of certain leased facilities.



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NEON SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



The following table provides a roll forward of the restructuring accrual account for the six months
ended September 30, 2003 (in thousands):



|                           |  |                   |  | Balance atMarch 31, 2003 |       | Amounts Charged to Expense |   | Net Amounts Paid |  | Balance at September 30, 2003
|-------------------------- |  | ----------------- |  | ------------------------ | ----- | -------------------------- | - | ---------------- |  | -----------------------------
|2002 Restructuring Accrual |  | Facilityclosure   |  | $                        | 62    |                            | $ | 17               |  | $                            
|                           |  |                   |  |                          |      
|2003 Restructuring Accrual |  | Employeeseverance |  |                          | 149   |                            |   |                 |  |                              
|                           |  | Facilityclosure   |  |                          | 1,957 |                            |   | 16               |  |                              
|                           |  |                   |  |                          |       |                            |   |                  |  |                              
|                           |  | Totals            |  | $                        | 2,168 |                            | $ | 33               |  | $                            
|                           |  |                   |  |                          |       |                            |   |                  |  |                              



The $1.7 million
balance at September 30, 2003 consists of future cash payments for abandoned facilities that will be paid through 2006. The current portion of this liability, $599,000, is included in accrued expenses.



NOTE 7 RELATED PARTY TRANSACTIONS



Certain former members of NEONs Board of Directors and certain former
executive officers of NEON were shareholders and/or directors in other companies with which NEON currently has investments. Transactions between NEON and these other companies are described below. The directors and officers involved in such
transactions are no longer officers and directors of NEON. On March 6, 2003, Louis R. Woodhill resigned as a director and Chief Executive Officer of NEON. In June 2003, Jim Woodhill resigned as a director of NEON. At NEONs annual meeting of
stockholders on September 22, 2003, Mr. Moores, Mr. Noell, and Mr. Schaeffer did not stand for re-election and are no longer directors of NEON.



NEON Enterprise Software, Inc. (formerly Peregrine/Bridge Transfer Corporation)



NEON entered into a Termination and Customer Support Agreement (the Termination Agreement) on August 14, 2002, which
terminated a distribution agreement with Peregrine/Bridge Transfer Corporation, a database software company whose sole stockholder is an affiliate of John J. Moores, NEONs former Chairman of the Board of Directors. PBTC subsequently changed
its name to NEON Enterprise Software, Inc. (NESI).



NEON currently holds a consolidated promissory note payable to NEON in the aggregate principal amount of $3.6 million, bearing no interest to its due date of March 31, 2005. This consolidated promissory note is secured by all of the
intellectual property of NESI (NESI IP). NEON also currently holds a $3.0 million dollar convertible promissory note payable to NEON bearing no interest to its due date of March 31, 2005, which is also secured by the NESI IP. The $3.0
million convertible note is convertible by NEON, in its discretion, into equity in NESI at an agreed pre-cash valuation of $30.0 million dollars. Such conversion right will expire on the due date of the $3.0 million convertible note. On the Closing
of the transaction in August 2002, NEON recorded the notes receivable from NESI at their estimated net present value, which was calculated at $4.3 million in aggregate value. As a result of the Termination Agreement, NEON recorded a loss on disposal
of $687,000. NEON also evaluates the NESI IP on a quarterly basis to determine the notes net realizable value. Accordingly, NEON will adjust the carrying value of the note if the net realizable value is determined to be below the carrying
value. NEON management had an external valuation of the NESI IP performed as of March 31, 2003 and determined that no further impairment of the note was required. No changes have occurred since that date that NEON believes should require adjustment
of the carrying value.



Scalable Software, Inc.



Scalable Software, Inc., a Houston-based provider of
software solutions for IT portfolio management, is a company founded by Louis R. Woodhill, who served as NEONs Chief Executive Officer until March 2003. Several former members of NEONs Board of Directors, including Louis R. Woodhill,
John J. Moores, Peter Schaeffer, Charles E. Noell III and Jim Woodhill, had or have a financial interest in Scalable Software.



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CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



In June 2002, NEON obtained a two-year option to acquire Scalable Software as outlined in the
Agreement and Plan of Merger dated June 26, 2002. In connection with this Option, NEON agreed to provide bridge financing of up to $5.5 million (subsequently increased to $6.0 million in October 2002), in addition to $3.5 million previously loaned
to Scalable Software that was secured by personal guarantees from John J. Moores, Louis R. Woodhill and Jim Woodhill. The aggregate financing has a 36-month term and does not bear interest during the term of the two-year option to acquire Scalable
Software, which option expires June 26, 2004. After the expiration of the option, the loan will bear interest at the prime rate plus two percentage points. In addition to the personal guarantees of John J. Moores, Louis R. Woodhill and Jim Woodhill
for the initial $3.5 million loaned to Scalable Software, the $6.0 million loan is secured by all of the intellectual property rights of Scalable Software. As of January 2003, Scalable had exhausted its credit facility with NEON. Scalable has asked
for and received waivers of NEONs right of first refusal with respect to additional venture capital bridge financing and has closed a private placement of Convertible Preferred Stock.



During the period in which NEON was advancing funds to Scalable Software,
NEON accounted for its investment in Scalable Software using the modified equity method of accounting. Under this method of accounting, NEON recognized 100% of Scalable Softwares losses to the extent of advances made in excess of the
guaranteed amount. At September 30, 2003, NEON had made total advances of $9.5 million to Scalable Software (including $6.0 million of unguaranteed advances) and recognized cumulative losses of $5.6 million, of which $3.5 million were recorded
during fiscal 2003. No losses have been recognized in fiscal year 2004 since NEON has no further obligation to advance funds to Scalable Software. Due to the uncertainties regarding NEONs ultimate ability to recover any unguaranteed advances
to Scalable Software, NEON has determined that it should not record the carrying value of its net advance to Scalable Software above the guaranteed amount of $3.5 million.



NOTE 8  IMPAIRMENT OF INTANGIBLES



NEON adopted SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets, effective April 1, 2002. SFAS No.
141 requires that the purchase method of accounting be used for all business combinations initiated or completed after June 30, 2001, and specifies criteria for the recognition and reporting of intangible assets apart from goodwill. Under SFAS No.
142, NEON no longer amortizes goodwill and intangible assets with indefinite useful lives, but instead will test those assets for impairment at least annually. SFAS No. 142 also requires that intangible assets with definite useful lives be amortized
over such lives to their estimated residual values. As of the date of adoption of SFAS Nos. 141 and 142, the Companys unamortized goodwill in the amount of $1.2 million, was subject to transition provisions of SFAS Nos. 141 and 142.



Under the transition provision of SFAS No. 142, NEON tested
the goodwill balances associated with the September 1999 acquisition of Beyond Software, Inc. (BSI) for impairment by comparing the fair value of BSI to its carrying value. Fair value was determined after considering changes in
operational strategies and plans, as well as assumptions regarding the potential future cash flows from the acquired assets. As a result, NEON determined that the carrying value of the goodwill related to the BSI acquisition had been impaired by
$1.0 million, which is shown as a cumulative effect of a change in accounting principle as of April 1, 2002. This impairment charge resulted in a net carrying value of $150,000, which was subsequently written off to impairment charges as of March
31, 2003.



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NEON SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



The pro-forma effects of the adoption of SFAS No. 142 on net income (loss) per share for NEON for the
six months ended September 30, 2002 is as follows (in thousands, except per share data):



|                                                              |  | SIX MONTHS ENDEDSEPTEMBER 30, 2002 |        
|------------------------------------------------------------- |  | ---------------------------------- | -------
|Net loss as reported                                          |  | $                                  | (10,884
|Add back: Cumulative effect of change in accounting principle |  |                                    | 1,043  
|                                                              |  |                                    |        
|Adjusted net loss                                             |  | $                                  | (9,841 
|                                                              |  |                                    |        
|Loss per shareBasic and diluted:                             |  |                                    |        
|Loss per share, as reported                                   |  | $                                  | (1.25  
|                                                              |  |                                    |        
|Add back: Cumulative effect of change in accounting principle |  | $                                  | 0.12   
|                                                              |  |                                    |        
|Pro forma loss per share                                      |  | $                                  | (1.13  
|                                                              |  |                                    |        



There has been no
effect of adoption recognized in subsequent periods.



NOTE 9  IMPACT OF
RECENTLY ISSUED ACCOUNTING STANDARDS



In June 2001, FASB
issued SFAS No. 143, Accounting for Asset Retirement Obligations. SFAS No. 143 requires that the fair value of an asset retirement obligation be recorded as a liability in the period in which it incurs a legal obligation associated with the
retirement of tangible long-lived assets that result from the acquisition, construction, development, and/or normal use of the assets. Subsequent to the initial measurement of the asset retirement obligation, the obligation will be adjusted at the
end of each period to reflect the passage of time and changes in the estimated future cash flows underlying the obligation. NEON adopted SFAS No. 143 on April 1, 2003. The adoption of SFAS No. 143 did not have a material effect on the NEONs
consolidated financial statements.



In April 2002, the FASB
issued SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical Corrections. SFAS No. 145 rescinds FASB Statement No. 4, Reporting Gains and Losses from Extinguishment of Debt,
and an amendment of that Statement, FASB Statement No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund Requirements. SFAS No. 145 also rescinds FASB Statement No. 44, Accounting for Intangible Assets of Motor Carriers and
amends FASB Statement No. 13, Accounting for Leases. SFAS No. 145 also amends other existing authoritative pronouncements to make various technical corrections, clarify meanings, or describe their applicability under changed conditions. The
adoption of SFAS No. 145 on April 1, 2003 did not have a material impact on NEONs consolidated financial statements.



In June 2002, the FASB issued SFAS No. 146, Accounting for Costs Associated with Exit or Disposal Activities. SFAS No. 146 addresses financial
accounting and reporting for costs associated with exit or disposal activities and nullifies EITF Issue 94-3, Liability Recognition for Certain Employee Termination Benefit and Other Costs to Exit an Activity (in Certain Costs Incurred in a
Restructuring). SFAS No. 146 is effective for exit or disposal of activities that are initiated after December 31, 2002. NEON adopted the requirements of SFAS No. 146 as of January 1, 2003.



In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based
Compensation-Transition and Disclosure, a amendment of FASB Statement No. 123. SFAS No. 148 amends FASB Statement No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for an entity that
voluntarily changes to the fair value based method of accounting for stock-based employee compensation. It also amends the disclosure provisions of that Statement to require prominent disclosure about the effects on reported net income of an
entitys accounting policy decisions with respect to stock-based employee compensation. SFAS No. 148 also amends APB Opinion No. 28, Interim Financial Reporting, to require disclosure about those effects in interim financial information.
NEON adopted the disclosure requirements of SFAS No. 148 and these disclosures are included in the notes to NEONs consolidated financial statements.



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CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



In November 2002, the FASB issued Interpretation No. 45, Guarantors Accounting and
Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, an interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No. 34. This interpretation clarifies the requirements
for a guarantors accounting for and disclosures of certain guarantees issued and outstanding. This Interpretation also incorporates without reconsideration the guidance in FASB Interpretation No. 34, Disclosure of Indirect Guarantees of
Indebtedness of Others, which is being superseded. The adoption of SFAS No. 145 on April 1, 2003 did not have a material impact on NEONs consolidated financial statements.



In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of
ARB No. 51. This Interpretation addresses the consolidation by business enterprises of variable interest entities as defined in the Interpretation. The Interpretation applies immediately to variable interests in variable interest entities
created after January 31, 2003, and as of December 31, 2003 to variable interests in variable interest entities obtained before January 31, 2003. Management is continuing to evaluate the impact that application of this Interpretation will have as of
December 31, 2003 on NEONs consolidated financial statements.



In April 2003, the FASB issued Statement of Financial Accounting Standard No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging Activities. This statement amends and clarifies financial accounting and reporting
for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging activities under SFAS Statement No. 133, Accounting for Derivative Instruments and Hedging
Activities. This Statement is effective for contracts entered into or modified after June 30, 2003. The adoption of this Statement did not have a material effect on the results of operations or financial position of the Company.



On May 15, 2003, the Financial Accounting Standards Board issued Statement
No. 150, Accounting for Certain Financial Instruments with Characteristics of Both Liabilities and Equity.The Statement requires issuers to classify as liabilities (or assets in some circumstance) three classes of freestanding financial
instruments that embody obligations for the issuer. NEON adopted the provisions of the Statement on July 1, 2003. The adoption of SFAS No. 150 did not have a material effect on NEONs financial statements.



NOTE 10  DISCONTINUED OPERATIONS



On June 20, 2003, NEON entered into an Asset Purchase Agreement with a third
party software vendor to sell its iWave product line assets. As a result of the transaction, NEON recorded a gain on the sale of $343,000, net of closing expenses, during the six months ended September 30, 2003. Total revenues attributed to the
iWave product line for the three and six months ended September 30, 2002 were $393,000 and $817,000, respectively. Total revenue for the three months ended June 30, 2003 was $194,000. Operating losses associated with the iWave product line were
classified as discontinued operations and represented $2.3 million and $2.8 million for the three and six months ended September 30, 2002, respectively. Operating loss for the three months ended June 30, 2003 was $244,000.



|ITEM 2. |  | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|------- |  | -------------------------------------------------------------------------------------



The following discussion and analysis should be read in conjunction with NEONs consolidated financial statements and
the related notes thereto included in this report on Form 10-Q. The discussion and analysis contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934.
These statements are based on our current expectations and entail various risks and uncertainties such as our plans, objectives, expectations and intentions. Our actual results could differ materially from those projected in the forward-looking
statements as a result of various factors, including those set forth below in Part II, Item 4 under Risk Factors that May Affect Future Results. In some cases, you can identify forward-looking statements by terminology such as
may, will, should, expects, plans, anticipates, believes, estimates, predicts, potential, continue, or the negative
of these terms or other comparable terms.



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NEON SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



OVERVIEW



NEON develops, markets and supports software products for the IBM mainframe platform. NEON was incorporated in May 1993 and is a successor by merger to
NEON Systems, Inc., an Illinois corporation, which was incorporated in June 1991. NEONs Shadow products provide access and integration of IBM mainframe data and applications from standard application client environments, including the
Internet, application platforms, and client/server systems. NEONs product mix in the past three fiscal years has consisted of NEONs Shadow branded products, its iWave products, and the Enterprise Subsystem Management (ESM)
products owned by NEON Enterprise Software, Inc. (formerly Peregrine/Bridge Transfer Corporation, hereafter NESI) and distributed by NEON. Over the last two fiscal years, NEONs Shadow products accounted for the majority of its
sales mix, representing 88% and 79% of NEONs sales for fiscal 2003 and 2002, respectively. During fiscal year 2003, NEON phased out its ESM and iWave product lines. In August 2002, NEON terminated its distribution agreement with NESI,
effectively exiting the ESM market. SeeManagements Discussion and AnalysisRelated Party Transactions and Note 7 to NEONs consolidated financial statements. On June 20, 2003, NEON entered into an Asset Purchase
Agreement with a third party software vendor to sell the iWave product line assets. See Note 10 to NEONs consolidated financial statements.



NEON derives revenue from software licenses and maintenance services. License fees, which are based upon the number and capacity of servers as well as the
number of client users, are generally due upon license grant and include a one-year maintenance period. The sales process typically takes between six and nine months. After the initial year of license, NEON provides ongoing maintenance services,
which include technical support and product enhancements, for an annual fee. Any factors adversely affecting the pricing of, demand for, or market acceptance of, our products, such as competition or technological change, could materially adversely
affect our business, operating results and financial condition. In fiscal 2003 and 2002, maintenance revenues represented 58% and 44% of total revenues, respectively. Maintenance revenues are expected to continue to increase as a percentage of total
revenues in the future. During fiscal 2003, NEON did not have any customers that individually accounted for 10% or more of total revenue. In fiscal 2002 NEON had one customer that accounted for 10% of total revenue.



Since its inception, NEON has incurred substantial costs to develop our
technology and products, to recruit and train personnel for our engineering, sales and marketing and technical support departments, and to establish an administrative organization. Accordingly, NEON may need to increase its annual revenue to
generate operating profits. There can be no assurance that NEON will achieve or sustain revenue growth and/or return to profitability in future quarters. As a result, management believes that it is possible that its cash resources may decline as a
result of continuing losses from operations and incremental costs associated with financing and acquisition.



NEON conducts its business in the United Kingdom and Germany through two wholly owned consolidated subsidiaries, and revenues from these subsidiaries are
denominated in local currencies. In connection with these foreign operations, NEON is exposed to foreign currency fluctuations for its net working capital positions. At September 30, 2003, NEON had no material commitments that would be satisfied in
currencies other than U.S. dollars. In other international markets, NEON conducts substantially all of its business through independent third-party distributors. Revenues derived from third-party distributors are generally denominated in U.S.
dollars. Revenues recognized from sales to customers outside North America, primarily in Europe, represented approximately 28% and 14% in fiscal 2003 and 2002, respectively. Foreign currency fluctuations have not had a significant impact on
NEONs revenues or operating results. Management does not currently have an active foreign exchange hedging program; however, NEON may implement a program to mitigate foreign currency transaction risk in the future.



In view of the rapidly changing nature of our business and the current
weakness in the mainframe software market, NEON believes that period-to-period comparisons of our revenue and operating results are not necessarily meaningful and should not be relied upon as indications of our future performance. Further, NEON does
not believe that its historical growth rates are necessarily representative of its future growth potential.



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NEON SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



RELATED PARTY TRANSACTIONS



Certain former members of NEONs Board of Directors and certain former executive officers of NEON were shareholders
and/or directors in other companies with which NEON had investments or currently transacts business. Transactions between NEON and these other companies are described below. The directors and officers involved in such transactions are no longer
officers and directors of NEON. On March 6, 2003, Louis R. Woodhill resigned as a director and Chief Executive Officer of NEON. In June 2003, Jim Woodhill resigned as a director of NEON. At NEONs annual meeting of stockholders on September 22,
2003, Mr. Moores, Mr. Noell, and Mr. Schaeffer did not stand for re-election and are no longer directors of NEON.



NEON Enterprise Software, Inc. (formerly Peregrine/Bridge Transfer Corporation)



In January 1996, NEON entered into a Termination and Customer Support Agreement on August 14, 2002, which terminated a
distribution agreement with Peregrine/Bridge Transfer Corporation, a database software company whose sole stockholder is an affiliate of John J. Moores, NEONs former Chairman of the Board of Directors. PBTC subsequently changed its name to
NEON Enterprise Software, Inc. (NESI).



NEON
currently holds a consolidated promissory note payable to NEON in the aggregate principal amount of $3.6 million, bearing no interest to its due date of March 31, 2005. This consolidated promissory note is secured by all of the intellectual property
of NESI (NESI IP). NEON also currently holds a $3.0 million dollar convertible promissory note payable to NEON bearing no interest to its due date of March 31, 2005, which is also secured by the NESI IP. The $3.0 million convertible note
is convertible by NEON, in its discretion, into equity in NESI at an agreed pre-cash valuation of $30.0 million dollars. Such conversion right will expire on the due date of the $3.0 million convertible note. On the Closing of the transaction in
August 2002, NEON recorded the notes receivable from NESI at their estimated net present value, which was calculated at $4.3 million in aggregate value. As a result of the Termination Agreement, NEON recorded a loss on disposal of $687,000. NEON
also evaluates the NESI IP on a quarterly basis to determine the notes net realizable value. Accordingly, NEON will adjust the carrying value of the note if the net realizable value is determined to be below the carrying value. NEON management
had an external valuation of the NESI IP performed as of March 31, 2003 and determined that no further impairment of the note was required. No changes have occurred since that date that NEON believes should require adjustment of the carrying value.



Scalable Software, Inc.



Scalable Software, Inc., a Houston-based provider of software solutions for
IT portfolio management, is a company founded by Louis R. Woodhill, who served as NEONs Chief Executive Officer until March 2003. Several former members of NEONs Board of Directors, including Louis R. Woodhill, John J. Moores, Peter
Schaeffer, Charles E. Noell III and Jim Woodhill, had or have a financial interest in Scalable Software.



In June 2002, NEON obtained a two-year option to acquire Scalable Software as outlined in the Agreement and Plan of Merger dated June 26, 2002. In
connection with this Option, NEON agreed to provide bridge financing of up to $5.5 million (subsequently increased to $6.0 million in October 2002), in addition to $3.5 million previously loaned to Scalable Software that was secured by personal
guarantees from John J. Moores, Louis R. Woodhill and Jim Woodhill. The aggregate financing has a 36-month term and does not bear interest during the term of the two-year option to acquire Scalable Software, which expires June 26, 2004. After the
expiration of the option, the loan will bear interest at the prime rate plus two percentage points. In addition to the personal guarantees of John J. Moores, Louis R. Woodhill and Jim Woodhill for the initial $3.5 million loaned to Scalable
Software, the $6.0 million loan is secured by all of the intellectual property rights of Scalable Software. As of January 2003, Scalable had exhausted its credit facility with NEON. Scalable has asked for and received waivers of NEONs right of
first refusal with respect to additional venture capital bridge financing and NEON believes that Scalable has closed a private placement of Convertible Preferred Stock.



During the period in which NEON was advancing funds to Scalable Software, NEON accounted for its investment in Scalable
Software using the modified equity method of accounting. Under this method of accounting, NEON recognized 100% of Scalable Softwares losses to the extent of advances made in excess of the guaranteed amount. At September 30, 2003, NEON had made
total advances of $9.5 million to Scalable Software (including $6.0 million of unguaranteed advances) and recognized cumulative losses of $5.6 million, of which $3.5 million were recorded during fiscal 2003. No losses have been recognized in fiscal
year 2004 since NEON has no further obligation to advance funds to Scalable Software. Due to the uncertainties regarding NEONs ultimate ability to recover any unguaranteed advances to Scalable Software, NEON has determined that it should not
record the carrying value of its net advance to Scalable Software above the guaranteed amount of $3.5 million.





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##### Table of Contents

NEON SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Critical Accounting Policies



The following is a discussion of the accounting policies that NEON believes (1) are most important to the portrayal of its
financial condition and results of operations and (2) require our most difficult, subjective or complex judgments, often as a result of the need to make estimates about the effect of matters that are inherently uncertain.



Revenue Recognition Policies



Statement of Position 97-2, Software Revenue Recognition (SOP 97-2),
was issued in October 1997 by the American Institute of Certified Public Accountants (AICPA) and was amended by Statement of Position 98-4 (SOP 98-4) and Statement of Position 98-9 (SOP 98-9). NEON adopted SOP 97-2 effective July 1, 1997, SOP 98-4
effective March 31, 1998 and SOP 98-9 effective April 1, 1999. NEON believes its current revenue recognition policies and practices are consistent with SOP 97-2, SOP 98-4 and SOP 98-9. Revenues from software license sales are recognized when all of
the following conditions are met: a non-cancelable license agreement has been obtained, the product has been delivered; there are no material uncertainties regarding customer acceptance; collection of the receivable is probable; no other significant
vendor obligations exist; and vendor-specific objective evidence exists to allocate the total fee to elements of the arrangement. Vendor-specific objective evidence is based on the price generally charged when an element is sold separately. All
elements of each order are valued at the time of revenue recognition. License revenues generally include software maintenance agreements for the first year following the date of sale. In such cases, revenues are allocated between licenses fees and
maintenance revenues based on vendor-specific objective evidence. Revenues from first-year maintenance agreements and separately priced software maintenance agreements for subsequent years are deferred and recognized ratably on a straight-line basis
over the maintenance period. NEON also markets and sells its products through independent distributors and resellers. License and maintenance revenues from these transactions are recognized as above, when sold to the ultimate end user and all of the
above conditions are met.



Capitalized Software Costs



NEON follows SFAS No. 86, Accounting for the Costs of Computer
Software to be Sold, Leased or Otherwise Marketed. Research and development expenditures have been charged to operations as incurred. No such costs have been capitalized to date.



Allowance for Doubtful Accounts Receivable



As a part of its normal accounting procedures, NEON evaluates outstanding accounts receivable to estimate whether they will
be collected. This is a subjective process that involves making judgments about our customers ability and willingness to pay these accounts. An allowance for doubtful accounts is recorded as an offset to accounts receivable in order to present
a net balance that we believe will be collected. In estimating the appropriate balance for this allowance, we consider (1) specific reserves for accounts we believe may prove to be uncollectible and (2) additional reserves, based on historical
collections, for the remainder of our accounts. Additions to the allowance for doubtful accounts are charged to operating expenses, and deductions from the allowance are recorded when specific accounts receivable are written off as uncollectible or
when actual



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NEON SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



experience differs from managements estimate. If NEONs estimate of uncollectible accounts should prove to be inaccurate at some future date, the
results of operations for the period could be materially affected by any necessary correction to the allowance for doubtful accounts.



Deferred Income Taxes



NEON records deferred income tax assets and liabilities on its balance sheet related to events that impact its financial statements and tax returns in
different periods. In order to compute these deferred tax balances, NEON first analyzes the differences between the book basis and tax basis of its assets and liabilities (referred to as temporary differences). These temporary
differences are then multiplied by current tax rates to arrive at the balances for the deferred income tax assets and liabilities. If deferred tax assets exceed deferred tax liabilities, NEON must estimate whether those net deferred asset amounts
will be realized in the future. A valuation allowance is then provided for the net deferred asset amounts that are not likely to be realized.



The change in NEONs net deferred income tax balances during a period results in a deferred income tax provision or benefit in its statement of
operations. If NEONs expectations about the future tax consequences of past events should prove to be inaccurate, the balances of its deferred income tax assets and liabilities could require significant adjustments in future periods. Such
adjustments could cause a material effect on NEONs results of operations for the period of the adjustment.



Accounting for Advances to Scalable Software



During the period in which NEON was advancing funds to Scalable Software, NEON accounted for its investment in Scalable Software using the modified equity
method of accounting. Under this method of accounting, NEON recognized 100% of Scalable Softwares losses to the extent of advances made in excess of the guaranteed amount. At September 30, 2003, NEON had made total advances of $9.5 million to
Scalable Software (including $6.0 million of unguaranteed advances) and recognized cumulative losses of $5.6 million, of which $3.5 million were recorded during fiscal 2003. No losses have been recognized in fiscal year 2004 since NEON has no
further obligation to advance funds to Scalable Software. Due to the uncertainties regarding NEONs ultimate ability to recover any unguaranteed advances to Scalable Software, NEON has determined that it should not record the carrying value of
its net advance to Scalable Software above the guaranteed amount of $3.5 million.





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NEON SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



RESULTS OF OPERATIONS



The following table sets forth, for the periods illustrated, certain statement of operations data expressed as a percentage of total revenues:



|                                                                                                                     |  | THREE MONTHSENDEDSEPTEMEBER 30, |   |  | SIX MONTHSENDEDSEPTEMBER 30, |   
|-------------------------------------------------------------------------------------------------------------------- |  | ------------------------------- | - |  | ---------------------------- | --
|                                                                                                                     |  | 2003                            |   |  | 2002                         |   
|Revenues:                                                                                                            |  |                                 |   |  |                              |   
|License                                                                                                              |  | 31.7                            | % |  | 34.1                         | % 
|Maintenance                                                                                                          |  | 68.3                            |   |  | 65.9                         |   
|                                                                                                                     |  |                                 |   |  |                              |   
|Total revenues                                                                                                       |  | 100.0                           |   |  | 100.0                        |   
|Cost of revenues:                                                                                                    |  |                                 |   |  |                              |   
|Cost of licenses                                                                                                     |  |                                |   |  | 2.4                          |   
|Cost of maintenance                                                                                                  |  | 10.1                            |   |  | 14.1                         |   
|                                                                                                                     |  |                                 |   |  |                              |   
|Total cost of revenues                                                                                               |  | 10.1                            |   |  | 16.5                         |   
|                                                                                                                     |  |                                 |   |  |                              |   
|Gross profit                                                                                                         |  | 89.9                            |   |  | 83.5                         |   
|Operating expenses:                                                                                                  |  |                                 |   |  |                              |   
|Sales and marketing                                                                                                  |  | 41.2                            |   |  | 80.9                         |   
|Research and development                                                                                             |  | 27.3                            |   |  | 30.3                         |   
|General and administrative                                                                                           |  | 24.2                            |   |  | 39.6                         |   
|Restructuring costs                                                                                                  |  | 0.9                             |   |  | 8.0                          |   
|Loss on disposal                                                                                                     |  |                                |   |  | 20.2                         |   
|                                                                                                                     |  |                                 |   |  |                              |   
|Total operating expenses                                                                                             |  | 93.6                            |   |  | 179.0                        |   
|                                                                                                                     |  |                                 |   |  |                              |   
|Operating loss                                                                                                       |  | (3.7                            | ) |  | (95.5                        | ) 
|Interest and other income, net                                                                                       |  | 3.3                             |   |  | 3.3                          |   
|Equity loss in affiliate                                                                                             |  |                                |   |  | (27.6                        | ) 
|Valuation allowance of note receivable                                                                               |  |                                |   |  | 2.7                          |   
|                                                                                                                     |  |                                 |   |  |                              |   
|Income (loss) from continuing operations before income taxes and cumulative effect of change in accounting
principle |  | (0.4                            | ) |  | (117.1                       | ) 
|Provision for income taxes                                                                                           |  |                                |   |  |                             |   
|                                                                                                                     |  |                                 |   |  |                              |   
|Income (loss) from continuing operations before cumulative effect of change in accounting principle                  |  | (0.4                            | ) |  | (117.1                       | ) 
|                                                                                                                     |  |                                 |   |  |                              |   
|Loss on discontinued operations                                                                                      |  |                                |   |  | (66.6                        | ) 
|Gain on disposal of discontinued operations                                                                          |  | 1.5                             |   |  |                             |   
|                                                                                                                     |  |                                 |   |  |                              |   
|Income (loss) before cumulative effect of change in accounting principle                                             |  | 1.0                             |   |  | (183.8                       | ) 
|Cumulative effect of change in accounting principle                                                                  |  |                                |   |  |                             |   
|                                                                                                                     |  |                                 |   |  |                              |   
|Net income (loss)                                                                                                    |  | 1.0                             | % |  | (183.8                       | )%
|                                                                                                                     |  |                                 |   |  |                              |   



THREE MONTHS ENDED SEPTEMBER 30, 2003
COMPARED TO THREE MONTHS ENDED SEPTEMBER 30, 2002



REVENUES



License revenues for the three months ended September 30, 2003 were $1.1
million, a decrease of $21,000 from $1.2 million for the three months ended September 30, 2002. ESM products accounted for $236,000 in license revenue during the three months ended September 30, 2002. Excluding ESM products, sales of NEONs
Shadow products increased slightly as a result of greater sales through OEM channels.



Maintenance revenues for the three months ended September 30, 2003 and 2002 were $2.5 million, an increase of $208,000 from $2.2 million. Maintenance revenue attributed to ESM products accounted for $88,000 during the
three months ended September 30, 2002. The net increase in maintenance revenue was due to cumulative growth of NEONs installed customer base combined with increases in maintenance renewal fees.



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##### Table of Contents

NEON SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



COST OF REVENUES



Cost of license revenues primarily consists of royalty payments to third parties. Cost of license revenues for the three months ended September 30, 2002
were $82,000, or 7% of license revenues. NEON did not incur costs of license revenue during the three months ended September 30, 2003. The decrease in the cost of license revenues as a percentage of license revenue was due to the termination of
product royalty payments to NESI, see Related Party Transactions.



Cost of maintenance revenues includes personnel and other customer support costs. Cost of maintenance revenues for the three months ended September 30, 2003 were $361,000, or 15% of maintenance revenues, as compared
to $479,000, or 21% of maintenance revenues, for the three months ended September 30, 2002. The reduction in cost of maintenance revenue as a percentage of maintenance revenue was due to the cumulative growth in NEONs installed customer base
and increases in maintenance renewal fees combined with consolidation of the technical support staff.



OPERATING EXPENSES



Sales and
marketing expenses include personnel costs, sales commissions and travel expenses of sales, presales support and marketing personnel, along with other promotional expenses. Sales and marketing expenses for the three months ended September 30, 2003
were $1.5 million, a decrease of $1.3 million from $2.8 million for the three months ended September 30, 2002. The reduction was primarily due to lower personnel and promotional costs, which resulted from the termination of the distribution
agreement for ESM products and refocusing the sales activities of the Shadow product line.



Research and development expenses primarily include personnel costs associated with NEONs product development staff. Research and development expenses for the three months ended September 30, 2003 and 2002 were
$1.0 million.



General and administrative expenses include
personnel and other costs associated with NEONs executive, financial, legal and administrative functions. General and administrative expenses for the three months ended September 30, 2003 were $868,000, a decrease of $478,000 from $1.3 million
for the three months ended September 30, 2002. The decrease was primarily related to a reduction in administrative personnel.



NEON incurred restructuring charges of $271,000 during the three months ended September 30, 2002 related to termination of its distribution agreement with
NESI. The charges primarily represented non-cash stock compensation costs resulting from the extension of stock options for severed employees. NEON incurred restructuring charges of $33,000 during the three months ended September 30, 2003 due to the
adjustment of certain restructuring accruals for abandoned facilities.



As a result of the termination of prior agreements with NESI on August 14, 2002, NEON recorded a loss on disposal of $687,000 during the three months ended September 30, 2002.



Interest and other income for the three months ended September 30, 2003 was $117,000 as compared to $111,000 for the three
months ended September 30, 2002. Interest and other income in the current period includes interest received on an income tax receivable collected during the quarter, which was offset by lower cash balances combined with a decline in short-term
interest rates.



One June 20, 2003, NEON entered into an Asset
Purchase Agreement with a third party software vendor to sell its iWave product line assets. Total revenues attributed to the iWave product line for the three months ended September 30, 2002 were $393,000. Operating losses associated with the iWave
product line were classified as discontinued operations and represented $2.3 million for the three months ended September 30, 2002.



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NEON SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



During the three months ended September 30, 2002, NEON performed impairment tests on its intangible
assets related to the iWave intellectual property. As a result, NEON recorded impairment charges of $1.3 million during the period. Such impairment charges are included in the loss from discontinued operations.



NEON accounts for its investment in Scalable Software using the modified
equity method of accounting. Under this method, NEON recognizes 100% of Scalable Softwares income or loss to the extent of advances made in excess of the guaranteed amount. For the three months ended September 30, 2002 NEON recorded equity in
loss of $939,000. NEON also recorded a valuation allowance against the Scalable note receivable to write-down the outstanding balance of the note to the guaranteed amount. NEON is no longer advancing funds to Scalable, therefore equity income or
loss was not recognized for the three months ended September 30, 2003. The note receivable from Scalable Software is recorded at the amount guaranteed by certain individuals. See Related Party Transactions and Note 7 to NEONs
consolidated financial statements.



No provision for income
taxes was recorded for the three months ended September 30, 2003, as the current year taxable income is offset by net operating loss carry-forwards that NEON had previously reserved. No provision for income tax was recorded for the three months
ended September 30, 2002, as NEON had a pre-tax loss for the period of $6.3 million. At March 31, 2003, NEON has a net operating loss carry-forward for income tax purposes of approximately $21.7 million that is available to offset future taxable
income, if any. The net operating loss carry-forwards in the United Kingdom, Germany and Australia carry forward indefinitely. The net operating loss carry-forward for the United States begins expiring in the tax year 2020. Given the recent tax
losses experienced by NEON, there can be no assurance that the operations will generate taxable income in the future to utilize these losses, therefore, as of September 30, 2003, NEON has recorded a full valuation allowance for the deferred tax
assets related to the future benefits, if any, for these loss carryforwards.



SIX MONTHS ENDED SEPTEMBER 30, 2003 COMPARED TO SIX MONTHS ENDED SEPTEMBER 30, 2002



REVENUES



License revenues for
the six months ended September 30, 2003 were $2.7 million, a decrease of $651,000 from $3.3 million for the six months ended September 30, 2002. The reduction in license revenue was primarily due to the termination of the distribution agreement for
ESM products, which accounted for $575,000 in license revenue during the six months ended September 30, 2002.



Maintenance revenues for the six months ended September 30, 2003 were $5.0 million, an increase of $280,000 from $4.8 million for the six months ended
September 30, 2002. ESM products accounted for $323,000 in maintenance revenue during the six months ended September 30, 2003. The net increase in maintenance revenue was due to cumulative growth of NEONs installed customer base combined with
increases in maintenance renewal fees.



COST OF REVENUES



Cost of license revenues primarily consists of royalty payments to third
parties. Cost of license revenues for the six months ended September 30, 2003 were $83,000, or 3% of license revenues, as compared to $265,000, or 8% of license revenues, for the six months ended September 30, 2002. The decrease in the cost of
license revenues as a percentage of license revenue was due to the termination of product royalty payments to NESI, see Related Party Transactions.



Cost of maintenance revenues includes personnel and other customer support costs. Cost of maintenance revenues for the six months ended September 30,
2003 were $735,000, or 15% of maintenance revenues, as compared to $1.0 million, or 22% of maintenance revenues, for the six months ended September 30, 2002. The reduction in cost of maintenance revenue as a percentage of maintenance revenue was due
to the cumulative growth in NEONs installed customer base and increases in maintenance renewal fees combined with consolidation of the technical support staff.



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NEON SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



OPERATING EXPENSES



Sales and marketing expenses include personnel costs, sales commissions and travel expenses of sales, presales support and marketing personnel, along with
other promotional expenses. Sales and marketing expenses for the six months ended September 30, 2003 were $3.3 million, a decrease of $2.7 million from $6.0 million for the six months ended September 30, 2002. The reduction was primarily due to
lower personnel and promotional costs, which resulted from the termination of the distribution agreement for ESM products and refocusing the sales activities of the Shadow product line.



Research and development expenses primarily include personnel costs associated with NEONs product development staff.
Research and development expenses for the six months ended September 30, 2003 and 2002 were $2.0 million



General and administrative expenses include personnel and other costs associated with NEONs executive, financial, legal and administrative
functions. General and administrative expenses for the six months ended September 30, 2003 were $1.6 million, a decrease of $1.0 million from $2.6 million for the six months ended September 30, 2002. The decrease was primarily related to a reduction
in administrative personnel.



NEON incurred restructuring
charges of $133,000 during the six months ended September 30, 2002. Of this, $271,000 related to the termination of NEONs distribution agreement with NESI. The charges primarily represented non-cash stock compensation costs resulting from the
extension of stock options for severed employees. This amount was offset by a $138,000 reduction to an outstanding restructuring accrual for abandoned facilities, as those facilities were subleased during the period. NEON incurred restructuring
charges of $33,000 during the three months ended September 30, 2003 due to the adjustment of certain restructuring accruals for abandoned facilities.



As a result of terminating prior agreements with NESI on August 14, 2002, NEON recorded a loss on disposal of $687,000 during the six months ended
September 30, 2002.



Interest and other income for the six
months ended September 30, 2003 was $170,000 as compared to $253,000 for the six months ended September 30, 2002. Interest and other income in the current period includes interest received on an income tax receivable collected during the quarter,
which was offset by lower cash balances combined with a decline in short-term interest rates.



On June 20, 2003, NEON entered into an Asset Purchase Agreement with a third party software vendor to sell its iWave product line assets. As a result of the transaction, NEON recorded a gain on the sale of $343,000,
net of closing expenses during the six months ended September 30, 2003. Total revenues attributed to the iWave product line for the six months ended September 30, 2003 and 2002 were $194,000 and $817,000, respectively. Operating losses associated
with the iWave product line were classified as discontinued operations and represented $244,000 and $2.8 million for the six months ended September 30, 2003 and 2002, respectively.



During the three months ended September 30, 2002, NEON performed impairment tests on its intangible assets related to the
iWave intellectual property. As a result, NEON recorded impairment charges of $1.3 million during the period. Such impairment charges are included in the loss from discontinued operations.



NEON accounts for its investment in Scalable Software using the modified
equity method of accounting. Under this method, NEON recognized 100% of Scalable Softwares income or loss to the extent of advances made in excess of the guaranteed amount. For the six months ended September 30, 2002 NEON recorded equity in
loss of $2.2 million. NEON also recorded a valuation allowance of $482,000 for the six months ended September 30, 2002 against the Scalable note receivable to write-down the outstanding balance of the note to the guaranteed amount. NEON is no longer
advancing funds to Scalable, therefore an equity loss was not recognized for the six months ended September 30, 2003. The note receivable from Scalable Software is recorded at the amount guaranteed by certain individuals. See Related Party
Transactions and Note 7 to NEONs financial statements.



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NEON SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



No provision for income taxes was recorded for the six months ended September 30, 2003 as the current
year taxable income is offset by net operating loss carry-forwards that NEON had previously reserved. No provision for income tax was recorded for the six months ended September 30, 2002, as NEON had a pre-tax loss for the period of $9.8 million. At
March 31, 2003, NEON has a net operating loss carry-forward for income tax purposes of approximately $21.7 million that is available to offset future taxable income, if any. The net operating loss carry-forwards in the United Kingdom, Germany and
Australia carry forward indefinitely. The net operating loss carry-forward for the United States begins expiring in the tax year 2020. Given the recent tax losses experienced by NEON, there can be no assurance that the operations will generate
taxable income in the future to utilize these losses, therefore, as of September 30, 2003, NEON has recorded a full valuation allowance for the deferred tax assets related to the future benefits, if any, for these loss carryforwards.



Under the transition provision of SFAS No. 142, NEON tested the goodwill
balances associated with the September 1999 acquisition of Beyond Software, Inc. (BSI) for impairment by comparing the fair value of BSI to its carrying value. Fair value was determined after considering changes in operational strategies
and plans, as well as assumptions regarding the potential future cash flows from the acquired assets. As a result, NEON determined that the carrying value of the goodwill related to the BSI acquisition had been impaired by $1.0 million, which is
shown as a cumulative effect of a change in accounting principle as of April 1, 2002. This impairment charge resulted in a net carrying value of $150,000, which was further impaired and written off by March 31, 2003.



LIQUIDITY AND CAPITAL RESOURCES



NEONs cash and cash equivalents at September 30, 2003 were $19.9
million, an increase of $84,000 from $19.8 million at March 31, 2003.



Net cash used in operating activities was $518,000 and $6.3 million for the six months ended September 30, 2003 and 2002, respectively. The net cash used in operating activities for the six months ended September 30, 2003 resulted primarily
from a reduction in deferred revenue, which resulted from the sale of the iWave product line and related customer contracts. The net cash used in operating activities for the six months ended September 30, 2002, resulted primarily from NEONs
net operating loss.



During the six months ended September 30,
2003, net cash provided by investing activities was $429,000, primarily as a result from the proceeds from the sale of the iWave product line. Net cash used in investing activities during the six months ended September 30, 2002 was $4.9 million,
primarily due to advances to Scalable Software (see Related Party Transactions).



NEONs net cash provided by financing activities was $54,000 and $19,000 for the six months ended September 30, 2003 and 2002, respectively. The net cash provided by financing activities in both periods
represents proceeds from the exercise of employee stock options.



NEONs future liquidity and capital requirements will depend upon numerous factors, including the costs and timing of expansion of product development efforts and the success of these development efforts, the costs and timing of
expansion of sales and marketing activities, the extent to which our existing and new products gain market acceptance, market developments, the costs involved in maintaining and enforcing intellectual property rights, the level and timing of license
revenue, and other factors. NEON believes that its current balance of cash and cash equivalents will be sufficient to meet its working capital, and anticipated capital expenditure requirements for at least the next 12 months. Thereafter, NEON may
require additional funds to support its working capital requirements or for other purposes and may seek to raise additional funds through public or private equity financing or from other sources. There can be no assurance that additional financing
will be available at all, or if available, that such financing will be obtainable on terms acceptable to NEON, or that any additional financing will not be dilutive.



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NEON SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



New Accounting Pronouncements



In June 2001, FASB issued SFAS No. 143, Accounting for Asset Retirement Obligations. SFAS No. 143 requires that the
fair value of an asset retirement obligation be recorded as a liability in the period in which it incurs a legal obligation associated with the retirement of tangible long-lived assets that result from the acquisition, construction, development,
and/or normal use of the assets. Subsequent to the initial measurement of the asset retirement obligation, the obligation will be adjusted at the end of each period to reflect the passage of time and changes in the estimated future cash flows
underlying the obligation. NEON adopted SFAS No. 143 on April 1, 2003. The adoption of SFAS No. 143 did not have a material effect on the NEONs consolidated financial statements.



In April 2002, the FASB issued SFAS No. 145, Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASB Statement
No. 13, and Technical Corrections. SFAS No. 145 rescinds FASB Statement No. 4, Reporting Gains and Losses from Extinguishment of Debt, and an amendment of that Statement, FASB Statement No. 64, Extinguishments of Debt Made to Satisfy Sinking-Fund
Requirements. SFAS No. 145 also rescinds FASB Statement No. 44, Accounting for Intangible Assets of Motor Carriers and amends FASB Statement No. 13, Accounting for Leases. SFAS No. 145 also amends other existing authoritative pronouncements to make
various technical corrections, clarify meanings, or describe their applicability under changed conditions. The adoption of SFAS No. 145 on April 1, 2003 did not have a material impact on NEONs consolidated financial statements.



In June 2002, the FASB issued SFAS No. 146, Accounting for Costs
Associated with Exit or Disposal Activities. SFAS No. 146 addresses financial accounting and reporting for costs associated with exit or disposal activities and nullifies EITF Issue 94-3, Liability Recognition for Certain Employee Termination
Benefit and Other Costs to Exit an Activity (in Certain Costs Incurred in a Restructuring). SFAS No. 146 is effective for exit or disposal of activities that are initiated after December 31, 2002. NEON adopted the requirements of SFAS No. 146 as
of January 1, 2003.



In December 2002, the FASB issued SFAS No.
148, Accounting for Stock-Based Compensation-Transition and Disclosure, a amendment of FASB Statement No. 123. SFAS No. 148 amends FASB Statement No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of
transition for an entity that voluntarily changes to the fair value based method of accounting for stock-based employee compensation. It also amends the disclosure provisions of that Statement to require prominent disclosure about the effects on
reported net income of an entitys accounting policy decisions with respect to stock-based employee compensation. SFAS No. 148 also amends APB Opinion No. 28, Interim Financial Reporting, to require disclosure about those effects in
interim financial information. NEON adopted the disclosure requirements of SFAS No. 148 and these disclosures are included in the notes to NEONs consolidated financial statements.



In November 2002, the FASB issued Interpretation No. 45, Guarantors Accounting and Disclosure Requirements for
Guarantees, Including Indirect Guarantees of Indebtedness of Others, an interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No. 34. This interpretation clarifies the requirements for a guarantors
accounting for and disclosures of certain guarantees issued and outstanding. This Interpretation also incorporates without reconsideration the guidance in FASB Interpretation No. 34, Disclosure of Indirect Guarantees of Indebtedness of
Others, which is being superseded. The adoption of SFAS No. 145 on April 1, 2003 did not have a material impact on NEONs consolidated financial statements.



In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of
ARB No. 51. This Interpretation addresses the consolidation by business enterprises of variable interest entities as defined in the Interpretation. The Interpretation applies immediately to variable interests in variable interest entities
created after January 31, 2003, and as of December 31, 2003 to variable interests in variable interest entities obtained before January 31, 2003. Management is continuing to evaluate the impact that application of this Interpretation will have as of
December 31, 2003 on NEONs consolidated financial statements.



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NEON SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



In April 2003, the FASB issued Statement of Financial Accounting Standard No. 149, Amendment of
Statement 133 on Derivative Instruments and Hedging Activities. This statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively
referred to as derivatives) and for hedging activities under SFAS Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. This Statement is effective for contracts entered into or modified after June 30, 2003. The
adoption of this Statement did not have a material effect on the results of operations or financial position of the Company.



On May 15, 2003, the Financial Accounting Standards Board issued Statement No. 150, Accounting for Certain Financial Instruments with Characteristics
of Both Liabilities and Equity.The Statement requires issuers to classify as liabilities (or assets in some circumstance) three classes of freestanding financial instruments that embody obligations for the issuer. NEON adopted the provisions of
the Statement on July 1, 2003. The adoption of SFAS No. 150 did not have a material effect on NEONs financial statements.



|ITEM 3. |  | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
|------- |  | ----------------------------------------------------------



NEON is exposed to a variety of risks, including foreign currency exchange rate fluctuations and changes in the market value of its investments.



The majority of NEONs foreign currency transactions are
denominated in the British pound sterling, which is the functional currency of NEON Systems (UK) Ltd. As sales contracts are denominated and settled in the functional currency, risks associated with currency fluctuations are minimized to foreign
currency translation adjustments. NEON does not currently hedge against foreign currency translation risks and believes that foreign currency exchange risk is not significant to its operations.



NEON adheres to a conservative investment policy, whereby its principal
concern is the preservation of liquid funds while maximizing its yield on such assets. Cash and cash equivalents approximated $20.0 million at September 30, 2003, and were invested in various types of high-grade commercial paper and money
securities. NEON believes that a near-term change in interest rates would not materially affect its financial position, results of operations or net cash flows for fiscal year 2004.



|ITEM 4. |  | CONTROLS AND PROCEDURES
|------- |  | -----------------------



As of the end of the period covered by this Quarterly Report on Form 10-Q, NEON carried out an evaluation, under the supervision and with the
participation of NEONs management, including the Principal Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of NEONs disclosure controls and procedures (as defined in Rule 13a-15(e) of the
Securities Exchange Act of 1934). Based upon that evaluation, the Principal Executive Officer and Chief Financial Officer concluded that NEONs disclosure controls and procedures are effective in ensuring that material information is
accumulated and communicated to management, and made known to the Principal Executive Officer and Chief Financial Officer, on a timely basis to allow disclosure as required in this Quarterly Report on Form 10-Q. There have been no significant
changes in NEONs internal controls or in other factors that could significantly affect internal controls subsequent to the date NEON carried out its evaluation.



PART II - OTHER INFORMATION



|ITEM 1. |  | LEGAL PROCEEDINGS - Please see the discussion in Part I, Note 5 of the Condensed Notes to Consolidated Financial Statements, which is incorporated by reference in this
Part II, Item 1.
|------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|ITEM 2. |  | DEFAULTS UPON SENIOR SECURITIES  Not applicable.
|------- |  | -------------------------------------------------



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|ITEM 3. |  | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS
|------- |  | ---------------------------------------------------



On September 22, 2003, NEON convened its Annual Meeting of Stockholders for the fiscal year ended March 31, 2003. As of the record date of July 25, 2003,
there were approximately 8,825,945 million shares issued and outstanding. At the Annual Meeting, which was held at NEONs headquarters in Sugar Land, Texas on September 22, 2003, the following matters were submitted to the stockholders for a
vote and were approved by the vote reflected below each such proposal (percentages reflect percentage of total outstanding common stock):



| |  | Amendment and Restatement of Certificate of Incorporation
| | - | ---------------------------------------------------------



Article 5 of our Amended and Restated Certificate of Incorporation provides that there will be a staggered Board of Directors with three classes of
directors, to be elected for three-year terms. On August 11, 2003, our Board of Directors unanimously adopted resolutions proposing, declaring advisable, and recommending that our stockholders authorize the amendment and restatement of our Amended
and Restated Certificate of Incorporation in the form of an Amended and Restated Certificate of Incorporation included with the Proxy Statement filed with the SEC on August 11, 2003, to revise our Amended and Restated Certificate of Incorporation to
eliminate the requirement of a staggered board consisting of three classes of directors in connection with the Boards recommendation that we reduce the size of our Board to five members, to consist of four independent members and one
management member.



At the Annual Meeting of Stockholders on
September 22, 2003, the stockholders approved the amendment and restatement of NEONs amended and restated certificate of incorporation, casting 8,439,834 million votes in favor of the amendment and restatement (95.6%) and 30,425 votes against
the amendment and restatement (.3%), with 3,350 abstentions (.04%). The Amended and Restated Certificate of Incorporation was filed with the State of Delaware on October 31, 2003.



| |  | Election of five directors to serve on the Board of Directors
| | - | -------------------------------------------------------------



At the annual meeting of stockholders held on September 22, 2003, the following five directors were elected as directors for terms expiring at the annual
meeting to be held in 2004: George Ellis, Richard Holcomb, Mark J. Cresswell, Dave F. Cary, and Loretta Cross.



The voting results were as follows:

(In
thousands)



|Nominee         |  | Votes For |  | (%)  |   |  | Votes Withheld |  | (%) |  
|--------------- |  | --------- |  | ---- | - |  | -------------- |  | --- | -
|George Ellis    |  | 8,468,259 |  | 95.9 | % |  | 5,350          |  | .01 | %
|Richard Holcomb |  | 8,464,959 |  | 95.9 | % |  | 8,650          |  | .01 | %
|Mark Cresswell  |  | 8,311,783 |  | 94.2 | % |  | 161,826        |  | 1.8 | %
|Dave F. Cary    |  | 8,468,259 |  | 95.9 | % |  | 5,350          |  | .01 | %
|Loretta Cross   |  | 8,468,259 |  | 95.9 | % |  | 5,350          |  | .01 | %



| |  | Ratification of KPMG LLP as independent auditors for the fiscal year ending March 31, 2004
| | - | ------------------------------------------------------------------------------------------



The Audit Committee of the Board of Directors selected KPMG LLP as the Companys independent public accountants for the
fiscal year ending March 31, 2004. KPMG LLP has audited the Companys financial statements since its initial public offering in fiscal 1999.



At the Annual Meeting of Stockholders on September 22, 2003, the stockholders ratified the Boards selection of KPMG as NEONs independent
auditors, casting 8,467,959 million votes in favor of the ratification (95.9%) and 4,700 votes against ratification (.05%), with 950 abstentions (.01%).



Effective upon the adjournment of the Annual Meeting of Stockholders, the compensation arrangements for independent directors was changed to an annual fee
of $20,000 for each director, a $10,000 annual fee for the lead independent director, a $5,000 annual fee for each Committee Chairman, a $1,000 Board Meeting Fee, and a $500 Committee Meeting fee. Such change was approved by the disinterested
directors of the Board of Directors on July 25, 2003.



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|ITEM 4. |  | OTHER INFORMATION 
|------- |  | -------------------



RISK FACTORS THAT MAY AFFECT FUTURE RESULTS



This report on Form 10-Q, including Managements Discussion and Analysis of Financial Condition and Results of Operations, contains forward-looking statements and other prospective information relating to future
events. These forward-looking statements and other information are subject to certain risks and uncertainties that could cause results to differ materially from historical results or anticipated results, including the following:



Our Stock Price May Fluctuate And Be Impacted By A Number Of Internal And External
Factors



| |  | Our stock price has fluctuated and is subject to wide swings in price based on a number of factors, including our quarterly operating results, which may vary significantly from
quarter to quarter.
| | - | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Our future operating
results may vary significantly from quarter to quarter due to a variety of factors, many of which are outside our control. Therefore, it is likely that in one or more future quarters our results may fall below the expectations of securities analysts
and investors. We operate with virtually no order backlog because our products are shipped and revenues are recognized shortly after orders are received. In addition, the amount of revenues associated with sales of our software can vary
significantly. In various quarters in the past, we have derived a significant portion of our software license revenues from a small number of relatively large sales. An inability to close one or more large sales that we had targeted to close in a
particular period could materially adversely affect our operating results for that period. Moreover, we typically realize a majority of our software license revenues in the last month of a quarter. As a result, minor delays in the timing of customer
orders can shift a sale from its contemplated quarter of completion to a subsequent quarter and cause significant variability in our operating results for any particular period. Accordingly, we believe that period-to-period comparisons of our
operating results are not necessarily a meaningful indication of future performance. Although we generally do not give guidance as to future operating results, if our quarterly results do not meet investors expectations, the trading price of
our common stock will likely decline.



| |  | The Availability Of Significant Amounts Of Our Common Stock For Sale Could Adversely Affect Its Market Price
| | - | ------------------------------------------------------------------------------------------------------------



If our stockholders sell substantial amounts of our common stock in the
public market, the market price of our common stock could fall. A substantial number of sales, or the perception that such sales might occur, also might make it more difficult for us to sell equity or equity-related securities in the future at a
time and price that we deem appropriate.



Reduced Customer Reliance Upon
Mainframe Computers Could Adversely Affect Our Business



We are dependent upon the continued use and acceptance of mainframe computers in a computing environment increasingly based on distributed platforms, including client/server and Internet-based computing networks. Decreased use of the
mainframe or in the growth of demand for Web-based and client/server applications accessing mainframe data and transactions could have a material adverse effect on our business, operating results and financial condition. We now derive our revenues
solely from our Shadow products. Our continued success depends on a number of factors, including:



| |  | Continued use of the mainframe as a central repository of mission-critical data and transactions;
| | - | -------------------------------------------------------------------------------------------------



| |  | Growth in business demands for access to the data, applications and transactions residing on mainframe computers from Web-based and client/server applications; and
| | - | -------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  | Continued market acceptance of the Shadow products and enhancements to these products.
| | - | --------------------------------------------------------------------------------------



Loss of Key Software Developers Could Adversely Affect Our Business



Our success is dependent upon the continued service and skills of our key
software developers. The loss of the services of any of these key software developers could have a negative impact on our business because of their unique skills, years of industry experience and the difficulty of promptly finding qualified
replacement personnel. We do not intend to maintain key-man life insurance policies covering any of our employees. Significant competition exists for employees with the skills required to develop the software products and perform the
maintenance services that we offer, and we may not be able to continue to retain sufficient numbers of highly skilled employees.



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We May Lose Market Share And Be Required To Reduce Prices As A Result Of Competition From Our Existing Competitors,
Other Vendors And Information Systems Departments Of Customers



We compete in markets that are intensely competitive and feature rapidly changing technology and evolving standards. Our competitors may be able to respond more quickly than we can to new or emerging technologies and changes in customer
requirements. Competitive pressures could reduce our market share or require us to reduce the price of our products, either of which could have a material adverse effect on our business, operating results and financial condition.



Rapid Technological Change Could Render Our Products Obsolete



Our markets are characterized by rapid technological change, frequent new
product introductions and enhancements, uncertain product life cycles, changes in customer requirements and evolving industry standards. The introduction of new products embodying new technologies and the emergence of new industry standards could
render our existing products obsolete which would have a material adverse effect on our business, operating results and financial condition. Our future success will depend upon our ability to continue to develop and introduce a variety of new
products and product enhancements to address the increasingly sophisticated needs of our customers. We may experience delays in releasing new products and product enhancements in the future. Material delays in introducing new products or product
enhancements may cause customers to forego purchases of our products and purchase those of our competitors.



We May Be Unable To Enforce Or Defend Our Ownership And Use Of Proprietary Technology



Our success depends to a significant degree upon our proprietary technology. We rely on a combination of trademark, trade secret and copyright law, and
contractual restrictions and passwords to protect our proprietary technology. However, these measures provide only limited protection, and we may not be able to detect unauthorized use or take appropriate steps to enforce our intellectual property
rights, particularly in foreign countries where the laws may not protect our proprietary rights as fully as in the United States. Companies in the software industry have experienced substantial litigation regarding intellectual property. Any
litigation to enforce our intellectual property rights would be expensive and time-consuming, would divert management resources and may not be adequate to protect our business. We could be subject to claims that we have infringed the intellectual
property rights of others. In addition, we may be required to indemnify our distribution partners and end-users for similar claims made against them. Any claims against us could require us to spend significant time and money in litigation, pay
damages, develop new intellectual property or acquire licenses to intellectual property that is the subject of the infringement claims. These licenses, if required, may not be available on acceptable terms. As a result, intellectual property claims
against us could have a material adverse effect on our business, operating results and financial condition.



Our Products May Contain Undetected Software Errors, Which Could Adversely Affect Our Business



Our software products and the software products that we sell for others are
complex and may contain undetected errors. These undetected errors could result in adverse publicity, loss of revenues, delay in market acceptance or claims against us by customers, all of which could have a material adverse effect on our business,
operating results and financial condition. Despite testing, we cannot be certain that errors will not be found in our products. Liability claims could require us to spend significant time and money in litigation or to pay significant damages. As a
result, any such claims, whether or not successful, could have a material adverse effect on our reputation and business, operating results and financial condition.





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|ITEM 5. |  | EXHIBITS AND REPORTS ON FORM 8-K
|------- |  | --------------------------------



| | (a) | EXHIBITS
| | --- | --------



|Exhibit Number |  | Description                                                                                                                                                                                                 
|-------------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------
|               | 
|31.1           |  | Certification of Mark J. Cresswell, principal executive officer of NEON Systems, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                            
|               | 
|31.2           |  | Certification of Brian D. Helman, principal financial and accounting officer of NEON Systems, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                               
|               | 
|32.1           |  | Certification of Mark J. Cresswell, principal executive officer of NEON Systems, Inc. pursuant to 18 U.S.C. SECTION 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley
Act of 2002.             
|               | 
|32.2           |  | Certification of Brian D. Helman, principal financial and accounting officer of NEON Systems, Inc. pursuant to 18 U.S.C. SECTION 1350, as adopted pursuant to Section 906 of the
Sarbanes-Oxley Act of 2002.



| | (b) | REPORTS ON FORM 8-K
| | --- | -------------------



None



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SIGNATURES



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





|                        |  | NEON SYSTEMS, INC.                          
|----------------------- |  | --------------------------------------------
|                        | 
|Date: November 14, 2003 |  | /s/ Brian D. Helman                         
|                        |  | Chief Financial Officer                     
|                        |  | (principal financial and accounting officer)
|                        | 
|Date: November 14, 2003 |  | /s/ Mark J. Cresswell                       
|                        |  | President and Chief Operating Officer       
|                        |  | (principal executive officer)               



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