<PAGE>

                                 UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             WASHINGTON, D.C. 20549
                                _______________

                                   FORM 10-Q

              [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d)
                     OF THE SECURITIES EXCHANGE ACT OF 1934

                FOR THE QUARTERLY PERIOD ENDED December 31, 2001

                                       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


                               NEON SYSTEMS, INC.
             (Exact name of registrant as specified in its charter)


               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 office)

       Registrant's telephone number, including area code: (281) 491-4200

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

The number of shares of the registrant's common stock outstanding as of February
12, 2002 was 8,672,103.
<PAGE>

                              NEON SYSTEMS, INC.

                                   FORM 10-Q

                    FOR THE QUARTER ENDED December 31, 2001

                                     INDEX

<TABLE>
<CAPTION>
                                                                                                                           PAGE
                                                                                                                           ----
<S>                                                                                                                        <C>
PART I  FINANCIAL INFORMATION

Item 1.   Financial Statements

          Consolidated Balance Sheets at December 31, 2001 and
          March 31, 2001.............................................................................................         3

          Consolidated Statements of Operations for the Three and Nine
          Months Ended December 31, 2001 and 2000....................................................................         4

          Consolidated Statements of Cash Flows for the Nine Months Ended
          December 31, 2001 and 2000.................................................................................         5

          Condensed Notes to Consolidated Financial Statements.......................................................         6

Item 2.   Management's Discussion and Analysis of Financial Condition
          and Results of Operations..................................................................................         11

Item 3.   Quantitative and Qualitative Disclosures About Market Risk.................................................         17

PART II.  OTHER INFORMATION

Item 1.   Legal Proceedings..........................................................................................         18

Item 2.   Changes in Securities and Use of Proceeds..................................................................         18

Item 3.   Defaults Upon Senior Securities............................................................................         18

Item 4.   Submission of Matters to a Vote of Security Holders........................................................         18

Item 5.   Other Information..........................................................................................         18

Item 6.   Exhibits and Reports on Form 8-K...........................................................................         25

SIGNATURES...........................................................................................................         26
</TABLE>

                                       2
<PAGE>

PART I - FINANCIAL INFORMATION

  ITEM 1. FINANCIAL STATEMENTS

                      NEON SYSTEMS, INC. AND SUBSIDIARIES
                          CONSOLIDATED BALANCE SHEETS

<TABLE>
<CAPTION>
                                                                                     December 31, 2001         MARCH 31, 2001
                                                                                     -----------------         ---------------
                                                                                        (UNAUDITED)
                                         ASSETS
         <S>                                                                         <C>                       <C>
         CURRENT ASSETS:
            Cash and cash equivalents                                                   $38,850,747              $42,773,856
            Short-term investments                                                               --                  514,828
            Accounts receivable, net                                                      5,136,806                6,072,332
            Taxes receivable                                                              1,060,399                2,392,311
            Deferred income taxes                                                           750,644                  607,566
            Other current assets                                                          1,287,202                2,050,586
                                                                                        -----------              -----------
               Total current assets                                                      47,085,798               54,411,479
                                                                                        -----------              -----------

         Property and equipment, net                                                      2,164,840                2,103,764
         Note receivable                                                                  3,950,000                       --
         Long-term investments                                                                   --                  319,613
         Intangible assets, net                                                           4,197,888                5,652,857
         Other assets                                                                     2,145,304                  890,630
                                                                                        -----------              -----------
               Total assets                                                             $59,543,830              $63,378,343
                                                                                        ===========              ===========

              LIABILITIES & STOCKHOLDERS' EQUITY

         CURRENT LIABILITIES:
            Accounts payable                                                            $ 2,983,551              $ 1,385,541
            Accrued expenses                                                              2,460,192                5,197,674
            Deferred maintenance revenue                                                  6,133,752                7,481,593
                                                                                        -----------              -----------
               Total current liabilities                                                 11,577,495               14,064,808
                                                                                        -----------              -----------
         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; 8,661,283 and 9,516,804 shares
         issued and outstanding at December 31, 2001 and
         March 31, 2001, respectively                                                        95,775                   95,167
         Additional paid-in capital                                                      51,236,120               51,550,518
         Treasury stock, at cost                                                         (2,648,860)                      --
         Accumulative other comprehensive income (loss)                                    (464,415)                (423,574)
         Unearned portion of deferred compensation                                         (120,023)                (787,705)
         Retained earnings (deficit)                                                       (132,262)              (1,120,871)
                                                                                        -----------              -----------
               Total stockholders' equity                                                47,966,335               49,313,535
         Commitments and contingencies (Note 6)
                                                                                        -----------              -----------
               Total liabilities and stockholders' equity                               $59,543,830              $63,378,343
                                                                                        ===========              ===========
</TABLE>

    SEE ACCOMPANYING CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.

                                       3
<PAGE>

                      NEON SYSTEMS, INC. AND SUBSIDIARIES
                     CONSOLIDATED STATEMENTS OF OPERATIONS
                                  (UNAUDITED)

<TABLE>
<CAPTION>
                                                    THREE MONTHS ENDED DECEMBER 31,        NINE MONTHS ENDED DECEMBER 31,
                                                    ------------------------------        --------------------------------
                                                         2001             2000                2001               2000
                                                 ----------------------------------------------------------------------------
<S>                                              <C>                  <C>                 <C>                <C>
Revenues:
   License                                          $   2,857,458     $   4,230,981       $   9,231,654      $  13,168,644
   Maintenance                                          2,215,906         2,156,135           6,890,644          6,522,025
                                                    -------------     -------------       -------------      -------------
     Total revenues                                     5,073,364         6,387,116          16,122,298         19,690,669

Cost of revenues:
   Cost of licenses                                       395,643           839,079           1,510,233          2,089,003
   Cost of maintenance                                    464,096           583,746           1,509,432          1,739,886
                                                    -------------     -------------       -------------      -------------
     Total cost of revenues                               859,739         1,422,825           3,019,665          3,828,889
                                                    -------------     -------------       -------------      -------------

Gross profit                                            4,213,625         4,964,291          13,102,633         15,861,780
                                                    -------------     -------------       -------------      -------------

Operating expenses:
   Sales and marketing                                  2,725,763         3,900,957          10,041,128         11,234,371
   Research and development                             1,207,788         2,193,790           4,456,839          6,064,231
   General and administrative                           1,007,809         5,639,909           3,897,430          7,965,918
   Restructuring costs                                         --                --             908,000                 --
   Asset write-down charges                                    --                --             887,000                 --
   Amortization of acquisition-related costs              119,499           119,499             358,497            358,028
                                                    -------------     -------------       -------------      -------------
     Total operating expenses                           5,060,859        11,854,155          20,548,894         25,622,548
                                                    -------------     -------------       -------------      -------------

Operating income (loss)                                  (847,234)       (6,889,864)         (7,446,261)        (9,760,768)

Interest income                                           282,219           621,952           1,020,598          1,948,471
Interest expense                                             (153)           (1,871)               (555)            (6,140)
Gain from settlement of litigation                             --                --           9,259,815                 --
Valuation allowance of note receivable                 (2,000,000)               --          (2,000,000)                --
Other, net                                                  6,015                --              11,934              6,153
                                                    -------------     -------------       -------------      -------------
   Income (loss) before income taxes                   (2,559,153)       (6,269,783)            845,531         (7,812,284)
                                                    -------------     -------------       -------------      -------------

Benefit (provision) for income taxes                           --         1,096,931             143,078          1,524,931
                                                    -------------     -------------       -------------      -------------
   Net income (loss)                                $  (2,559,153)    $  (5,172,852)            988,609      $  (6,287,353)
                                                    =============     =============       =============      =============

Earnings (loss) per share:
   Basic                                            $       (0.27)    $       (0.55)      $        0.11      $       (0.67)
                                                    =============     =============       =============      =============

   Diluted                                          $       (0.27)    $       (0.55)      $        0.10      $       (0.67)
                                                    =============     =============       =============      =============

Shares used in computing earnings:
   per share
   Basic                                                9,525,667         9,490,669           9,380,287          9,405,295
                                                    =============     =============       =============      =============
   Diluted                                              9,525,667         9,490,669           9,937,200          9,405,295
                                                    =============     =============       =============      =============
</TABLE>

    SEE ACCOMPANYING CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.

                                       4
<PAGE>

                      NEON SYSTEMS, INC. AND SUBSIDIARIES
                     CONSOLIDATED STATEMENTS OF CASH FLOWS
                                  (UNAUDITED)

<TABLE>
<CAPTION>
                                                                  NINE MONTHS ENDED DECEMBER 31,
                                                                 --------------------------------
                                                                       2001             2000
                                                                    -----------      -----------
<S>                                                              <C>                 <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
 Net income                                                         $   988,609      $(6,287,353)
 Adjustments to reconcile net income to net
    cash provided by (used in) operating
    activities:
     Depreciation and amortization                                    1,971,064          963,802
     Deferred tax benefit (expense)                                    (143,078)          85,363
     Non-cash compensation expense                                      253,822        3,498,434
     Asset write-down charges                                           887,000               --
     Valuation allowance of note receivable                           2,000,000               --
 Increase (decrease) in cash resulting from changes in
       operating assets and liabilities:
       Accounts receivable                                              817,052        3,352,009
       Taxes receivable                                               1,331,912               --
       Other current assets                                             756,280         (568,735)
       Other assets                                                          --               --
       Accrued expenses                                              (2,747,390)       1,512,534
       Accounts payable                                              (1,053,354)         388,662
       Other non-current assets                                      (2,054,677)        (552,917)
       Taxes payable                                                         --       (1,737,465)
       Deferred maintenance revenue                                  (1,347,841)        (181,638)
                                                                    -----------      -----------
Net cash provided by operating activities                             1,659,399          472,696
                                                                    -----------      -----------
CASH FLOWS FROM INVESTING ACTIVITIES:
  Maturity (purchase) of marketable securities                          819,711       (3,625,056)
  Note receivable                                                    (5,950,000)              --
  Acquisition of intangibles                                                 --       (1,000,000)
  Purchases of furniture and equipment                                 (577,171)        (886,734)
                                                                    -----------      -----------

Net cash used in investing activities                                (5,707,460)      (5,511,790)
                                                                    -----------      -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
  Proceeds from exercises of stock options                              100,070          223,167
                                                                    -----------      -----------
Net cash provided by financing activities                               100,070          223,167
                                                                    -----------      -----------
Net decrease in cash and cash equivalents                            (3,947,991)      (4,815,927)
Effect of exchange rates on cash                                         24,882         (254,727)
Cash and cash equivalents at beginning of period                     42,773,856       37,120,342
                                                                    -----------      -----------

Cash and cash equivalents at end of period                          $38,850,747      $32,049,688
                                                                    ===========      ===========
Supplemental disclosure of cash flow information:

Cash paid during the period for income taxes                        $        --      $    77,005
                                                                    ===========      ===========
Cash paid during the period for interest                            $       555      $     6,140
                                                                    ===========      ===========
</TABLE>

    SEE ACCOMPANYING CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.

                                       5
<PAGE>

                      NEON SYSTEMS, INC. AND SUBSIDIARIES
             CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1--BASIS OF PRESENTATION

   The accompanying unaudited consolidated financial statements have been
prepared in accordance with generally accepted accounting principles 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 generally accepted accounting principles for complete
financial statements. In the opinion of management, the unaudited consolidated
financial statements contained in this report reflect all 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, 2001, which are included in NEON's Form 10-K for the fiscal
year ended March 31, 2001.

NOTE 2--PER SHARE INFORMATION

   In calculating earnings per share information, NEON follows the provisions of
Statement of Financial Accounting Standards No. 128, Earnings Per Share. Basic
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 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.

A reconciliation of the numerators and denominators of the basic and diluted per
share computation is as follows:

<TABLE>
<CAPTION>
                                           THREE MONTHS ENDED DECEMBER 31,   NINE MONTHS ENDED DECEMBER 31,
                                           -------------------------------   ------------------------------
                                                  2001             2000            2001             2000
                                           ----------------------------------------------------------------
<S>                                        <C>                 <C>              <C>             <C>
Net income (loss)                             $(2,559,153)     $(5,172,852)     $  988,609      $(6,287,353)
                                              ===========      ===========      ==========      ===========
Weighted average number of common
  shares outstanding during the period:
Basic                                           9,525,667        9,490,669       9,380,287        9,405,295
Dilutive stock options                                 --               --         556,913               --
                                              -----------      -----------      ----------      -----------
Diluted                                         9,525,667        9,490,669       9,937,200        9,405,295
                                              ===========      ===========      ==========      ===========
Income (loss) per common share:
  Basic                                       $     (0.27)     $     (0.55)     $     0.11      $     (0.67)
                                              ===========      ===========      ==========      ===========
  Diluted                                     $     (0.27)     $     (0.55)     $     0.10      $     (0.67)
                                              ===========      ===========      ==========      ===========
</TABLE>

   In the period April 1, 2001 through December 31, 2001, options to purchase
60,729 shares of common stock at exercise prices of $0.20 to $4.45 per share
were exercised. At December 31, 2001, there were options outstanding to purchase
2,051,932 shares of common stock with a weighted-average exercise price of
$9.07.

                                       6
<PAGE>

NOTE 3--MARKETABLE SECURITIES

   NEON considers all highly liquid investments with a maturity of three months
or less to be cash equivalents.

   NEON's investment policies are consistent with Financial Accounting Standards
Board ("FASB") Statement of Financial Accounting Standards ("SFAS") No. 115,
"Accounting for Certain Investments in Debt and Equity Securities," and NEON has
determined that its investment securities are to be classified as available-for-
sale.  Available-for-sale securities are carried at fair value, with the
unrealized gains and losses reported in stockholders' equity under the caption
"Accumulated other comprehensive income (loss)."  The cost of securities sold is
based on the specific identification method.  Interest and dividends on
securities classified as available-for-sale are included in interest income.

   The following is a summary of marketable securities classified as "available-
for-sale" securities as required by SFAS No. 115:

                                             DECEMBER 31, 2001  MARCH 31, 2001
                                             -----------------  --------------
               Debt Securities:
                 Cost                          $        --          $819,711
                 Gross unrealized losses                --            14,730
                                               -----------          --------
                     Estimated fair value      $        --          $834,441
                                               ===========          ========

NOTE 4--INCOME TAXES

   At December 31, 2001, NEON had a net operating loss carry-forward for income
tax purposes of approximately $3.5 million that is available to offset future
taxable income principally related to foreign tax jurisdictions. The net
operating loss carry-forwards in the United Kingdom, Germany and Australia carry
forward indefinitely. 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 December 31, 2001, NEON has recorded a
full valuation allowance for the deferred tax assets related to the future
benefits, if any, for these losses.

   The benefit for income taxes for the nine months ended December 31, 2001 and
2000, was $143,000, or 17% of pre-tax income and $1,525,000, or 20% of pre-tax
loss, respectively.   As NEON does not anticipate generating income for the year
ended March 31, 2002, no additional tax benefit was recorded in the quarter
ended December 31, 2001. The difference between the effective rate and the
statutory rate is primarily due to the impact of net operating losses for which
no benefit has been recognized for the nine months ended December 31, 2001 and
2000.

NOTE 5--SEGMENT REPORTING

   NEON considers its business activities to be in a single segment.  During the
three-month period ended December 31, 2001, NEON had one customer that
individually accounted for 24% of total revenues.  During the nine-month period
ended December 31, 2001, NEON had one customer that accounted for 13% of total
revenue.

   The table below summarizes revenues by geographic region.

<TABLE>
<CAPTION>
                                   THREE MONTHS ENDED DECEMBER 31,    NINE MONTHS ENDED DECEMBER 31,
                                   --------------------------------  --------------------------------
                                        2001              2000             2001             2000
    <S>                             <C>              <C>               <C>              <C>
    Revenues:
      United States                  $ 4,216,737       $ 5,769,649      $13,974,820      $17,425,714
      United Kingdom                     762,517           553,742        1,723,275        1,846,871
      Other                               94,110            63,725          424,203          418,084
                                     -----------       -----------      -----------      -----------
                                     $ 5,073,364       $ 6,387,116      $16,122,298      $19,690,669
                                     ===========       ===========      ===========      ===========
    Operating Income (Loss):
       United States                 $  (786,886)      $(6,238,133)     $(6,569,887)     $(8,225,899)
       United Kingdom                     34,528          (307,117)        (555,222)        (706,354)
       Other                             (94,876)         (344,614)        (321,152)        (828,515)
                                     -----------       -----------      -----------      -----------
                                     $  (847,234)      $(6,889,864)     $(7,446,261)     $(9,760,768)
                                     ===========       ===========      ===========      ===========
    Identifiable Assets:
        United States                $56,987,238       $55,641,755
        United Kingdom                 2,249,939         2,506,536
        Other                            306,653           958,632
                                     -----------       -----------
                                     $59,543,830       $59,106,923
                                     ===========       ===========
</TABLE>

                                       7
<PAGE>

NOTE 6--CONTINGENCIES

   NEON has resolved its litigation with New Era of Networks in a confidential
settlement that resolved all pending litigation between the parties.  NEON
received a cash payment of approximately $9.3 million, net of attorney fees, in
the fiscal quarter ending September 30, 2001, as a result of this settlement,
and is reporting such payment as a non-recurring item.   The litigation arose
from the fact that a number of organizations, including New Era of Networks,
Inc., were utilizing the name "Neon," alone and in combination with other words,
as a trademark, a tradename or both. New Era of Networks, which was recently
acquired by Sybase, Inc., is also a developer and distributor of middleware and
other software products. New Era of Networks had used the acronym "NEON" in its
business, was listed on the Nasdaq National Market under the symbol "NEON" and
had sought to obtain federal trademarks for products and services whose names
include the word "NEON." On December 24, 1998, New Era of Networks filed a
complaint against NEON in the United States District Court for the District of
Colorado seeking (a) a declaratory judgment that New Era of Networks' use of
certain trademarks, including "NEONET," does not infringe NEON's rights or
constitute unfair competition and (b) cancellation of NEON's federal trademark
registration for NEON. NEON filed an answer denying the material allegations of
that complaint. On February 11, 2000, the judge in the Colorado proceeding
advised the parties that the court intended to grant summary judgment for
cancellation of the federal trademark registration for the "NEON" mark.  On June
23, 1999, NEON sued New Era of Networks in District Court in Fort Bend County,
Texas, alleging that New Era of Networks' use of "NEON" was in violation of
Texas law concerning misappropriation of trade names. In this litigation, NEON
sought to enjoin New Era of Networks from using "NEON" as its "nickname," its
Nasdaq trading symbol, or in any other manner that is likely to result in
confusion in the marketplace or to dilute the meaning or value of NEON's name.
NEON's claims were based upon its prior and continuous use of "NEON" as its
corporate name.  On June 1, 2001, the jury in the Fort Bend County, Texas suit
returned a verdict in NEON's favor awarding NEON $14 million in actual damages
and $25 million in punitive damages. On June 26, 2001, the judge issued a final
judgment confirming the award of actual and punitive damages, and granted a
permanent injunction prohibiting New Era from referring to itself as "NEON" in
advertising, marketing or other public disclosures; from distributing software
that includes one or more occurrences of the "NEON" mark, and within specified
time periods to replace documentation, installed code, and advertising materials
that include any use of the mark "NEON."

   NEON is involved in various other claims and legal actions arising in the
ordinary course of business.  In the opinion of management, the ultimate
dispositions of any of these matters will not have a material adverse effect on
NEON's consolidated financial position, results of operations or liquidity.

NOTE 7 - RESTRUCTURING CHARGES AND ASSET WRITE-DOWN CHARGES

   During the nine-month period ended December 31, 2001, the Company recorded a
restructuring charge of $908,000.  These charges related to reductions in the
Company's cost structure and corporate reorganization, including reductions in
force, and abandonment of leased facilities. These restructuring costs included
severance costs of $570,000 and losses from lease commitments of $338,000.  Cash
paid for severance costs and leasing expenses during the nine months ended
December 31, 2001 totaled $515,000 and $13,000, respectively.  As of December
31, 2001, the Company has included in accrued liabilities $380,000 related to
lease commitments included in the restructuring charge.

   NEON has recorded non-cash charges of $887,000 during the nine months ended
December 31, 2001 related to the write-down of pre-paid royalties and other
assets.

NOTE 8 - LONG TERM INVESTMENTS AND NOTES RECEIVABLE

     NEON made an advance on a note receivable to Enterworks Software, Inc. of
$2 million.  The Enterworks Software loan is a Demand 10% Convertible Promissory
Note and was issued under a Convertible Promissory Note and Warrant Agreement
dated March 1, 2001 in a second round of financing for Enterworks.  The loan
accrues interest at 10% per annum and matures on demand made by the holders
representing at least 50% of the outstanding principal amount of the Demand
Notes.

                                       8
<PAGE>

     During the quarter ended September 30, 2001, NEON announced that it had
entered into a non-binding term sheet to acquire Scalable Software, Inc., a
privately held Houston-based provider of client effectiveness management tools
for Windows networks.  The term sheet provides that each of the approximately
19,400,000 outstanding shares of common stock of Scalable Software would be
converted into approximately 0.135 of a share of NEON's common stock and that
outstanding options and warrants to purchase approximately 2,800,000 shares of
common stock of Scalable Software would become options and warrants to purchase
common stock of NEON on the same conversion basis.

     In connection with the transaction, NEON originally provided Scalable
Software with bridge financing of up to $3 million that was guaranteed by Louis
R. Woodhill, NEON's Chief Executive Officer, James R. Woodhill and John Moores,
NEON's Chairman of the Board. On November 13, 2001, the Promissory Note was
amended to increase the maximum aggregate lending limit from $3 million to $3.5
million.

     On December 21, 2001, NEON announced that it had entered into a non-binding
term sheet to be granted a two-year option to acquire Scalable Software.  This
term sheet reflected a revision by NEON and Scalable Software of NEON's
previously announced plan to acquire Scalable Software.  In connection with the
option to acquire Scalable Software, NEON agreed to provide bridge financing of
up to $9.0 million, of which $3.5 million is secured by personal guarantees from
John Moores, Louis R. Woodhill and James R. Woodhill.  The aggregate financing
has a 36-month term and will not bear interest during the term of the two-year
option to acquire Scalable Software.  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 Moores, Louis R. Woodhill and James
R. Woodhill for the initial $3.5 million loaned to Scalable Software, the
aggregate loan amount will be secured by all of the intellectual property rights
of Scalable Software. As of December 31, 2001, $3.95 million of the bridge
financing had been drawn upon by Scalable Software, and is reflected as a note
receivable. Due to Neon's significant influence over Scalable, the Company will
account for this investment under the modified equity accounting method in
future periods.

   In the fiscal quarter ended December 31, 2001, NEON recorded a reserve of $2
million as a valuation allowance against its long-term investments and notes
receivable.

NOTE 9 - TREASURY STOCK PURCHASE

     NEON purchased 913,400 shares of its outstanding common stock in a
transaction arising from an unsolicited offer.  The shares were purchased at a
purchase price of $2.90 per share for a total aggregate purchase price of
$2,648,860.  The shares purchased amounted to approximately 9.5% of NEON's then
outstanding 9,577,533 shares of common stock.  The transaction trade date was
December 21, 2001 and the transaction settlement date was December 27, 2001.
The Company recorded the transaction on the trade date and as such has recorded
a balance in accounts payable at December 31, 2001 in the amount of $2,648,860.
The cash was remitted on January 3, 2002.

NOTE 10 --RELATED PARTY TRANSACTIONS

     NEON entered into a distributor agreement with Peregrine/Bridge Transfer
Corporation, a database software company, in January 1996. In December 1998,
NEON amended its distributor agreement with Peregrine/Bridge Transfer
Corporation whereby Peregrine/Bridge Transfer Corporation has granted the
Company an exclusive, worldwide license to market and sublicense Enterprise
Subsystem Management products, with the exception of limited co-marketing rights
held by IBM relating to one of Peregrine/Bridge Transfer Corporation's
Enterprise Subsystem Management products. The amended distributor agreement has
an initial term through March 31, 2004. The distributor agreement provides that
NEON pay royalties for the license of products and for maintenance and support
and upgrade services equal to 50% of the revenues received by NEON.  The terms
of this agreement provide that Neon will pay Peregrine/Bridge Transfer
Corporation a minimum advance royalty of $250,000 per quarter during fiscal year
2000, $500,000 per quarter during fiscal year 2001, $750,000 per quarter during
fiscal year 2002, $1,000,000 per quarter during fiscal year 2003 and $1,250,000
per quarter during fiscal year 2004, for an aggregate payment of $15 million.
This royalty payment is recorded as a prepaid expense and offset by 50% of
Neon's sales of Peregrine/Bridge Transfer Corporation products.   NEON charged
royalty expense of $332,000 and $1,588,000 for the nine months ended December
31, 2001 and 2000, respectively to Peregrine/Bridge Transfer Corporation.

     NEON also has a services agreement with Peregrine/Bridge Transfer
Corporation pursuant to which Peregrine/ Bridge Transfer Corporation reimburses
NEON for Peregrine/Bridge Transfer Corporation's share of the general and
administrative

                                       9
<PAGE>

expenses supplied to it by NEON and for the time spent by NEON's management
developing and implementing Peregrine/Bridge Transfer Corporation's product
development and market strategy. Such amounts are presented as a reduction of
general and administrative expenses in the accompanying consolidated financial
statements. Pursuant to a revised services agreement with Peregrine/Bridge
Transfer Corporation, beginning in October 2001, Peregrine/Bridge Transfer
Corporation pays NEON $5,000 per month under the services agreement and such
amounts are included as a reduction of general and administrative expenses in
the accompanying statements of operations. Due to the timing of cash payments
between the two parties related to the distributor agreement and the services
agreement described above, NEON has accounts receivable(payable)-related party
of $180,000 and nil, as of December 31, 2001 and March 31, 2001, respectively.

     NEON and Peregrine/Bridge Transfer Corporation have certain common
directors. In addition, the controlling stockholder of Peregrine/Bridge Transfer
Corporation's sole shareholder, Skunkware, Inc., is NEON's chairman of the Board
of Directors.

     On January 3, 2002, NEON entered into a Services Agreement with Sheer
Genius Software, Inc. of Austin, Texas, a company owned by or affiliated with
James R. Woodhill, one of NEON's directors and the brother of NEON's Chief
Executive Officer, Louis R. Woodhill.  Under the first Project Description
negotiated for such Services Agreement, Sheer Genius will provide development
services to NEON on a budgeted time and materials basis and will deliver fixed
deliverables, consisting primarily of developed source code.  The term of the
Project Description is six months and the maximum aggregate fees will be
$480,000.  Under the Services Agreement, all intellectual property created by
Sheer Genius in the course of performing the Services shall be owned by NEON.
Additionally, Sheer Genius will receive a license back of such intellectual
property for limited use in the development by Sheer Genius of software that
does not compete with software distributed by NEON.  Also, JMI Services, Inc.,
an entity owned by John Moores, NEON's Chairman, is a creditor of Sheer Genius,
holding a promissory note dated August 31, 2001 in the amount of $200,000. The
Board of Directors reviewed the terms of the Services Agreement and Project
Description and approved such agreements following disclosure of the interest of
its officers and directors associated with Sheer Genius.

     On December 21, 2001, the Board of Directors appointed Louis R. Woodhill
and James R. Woodhill to fill open positions as directors on the NEON Board of
Directors.  Louis R. Woodhill was also hired by NEON as its President and Chief
Executive Officer as of October 15, 2001.  Louis R. Woodhill also maintains a
position as the President and Chief Executive Officer of Scalable Software, Inc.
On December 21, 2001, NEON announced that it had entered into a non-binding term
sheet to be granted a two-year option to acquire Scalable Software.  This term
sheet reflected a revision by NEON and Scalable Software of NEON's previously
announced plan to acquire Scalable Software.  In connection with the option to
acquire Scalable Software, NEON has agreed to provide bridge financing of up to
$9.0 million, of which $3.5 million is secured by personal guarantees from John
Moores, Louis R. Woodhill and James R. Woodhill.  The aggregate financing has a
36-month term and will not bear interest during the term of the two-year option
to acquire Scalable Software.  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 on the initial $3.5 million loaned to Scalable Software, the
aggregate loan amount will be secured by all of the intellectual property rights
of Scalable Software. As of December 31, 2001, $3.95 million of the bridge
financing had been drawn upon by Scalable Software, and is reflected as a note
receivable.    Louis R. Woodhill, James R. Woodhill and John Moores are all
investors and directors of Scalable Software.   Additionally, NEON directors
Charles E. Noell III and Peter Schaeffer are also involved as investors and
directors of Scalable Software. The Board of Directors reviewed the terms of the
term sheet between NEON and Scalable Software and approved such term sheet
following disclosure of the interests of its officers and directors associated
with Scalable Software.

NOTE 11 - IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS

   In July 2001, the FASB issued SFAS No. 141, "Business Combinations", and SFAS
No. 142, "Goodwill and Other Intangible Assets."  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,
beginning April 1, 2002, the Company will no longer amortize goodwill and
intangible assets with indefinite useful lives, but instead will test those
assets for impairment at least annually.  SFAS No. 142 will also require that
intangible assets with definite useful lives be amortized over such lives to
their estimated residual values.

   The Company is required to adopt SFAS No. 141 immediately and SFAS No. 142
effective April 1, 2002.  Furthermore, any goodwill or any intangible asset
determined to have an indefinite useful life that is acquired in a purchase
business combination completed after June 30, 2001 will not be amortized, but
will continue to be evaluated for impairment in

                                       10
<PAGE>

accordance with the appropriate pre-SFAS No. 142 accounting literature. Goodwill
and intangible assets acquired in business combinations completed before July 1,
2001 will continue to be amortized through March 31, 2002. SFAS No. 142 will
require the Company to perform a transitional goodwill impairment evaluation as
of the date of adoption. To accomplish this the Company must identify its
reporting units and determine the carrying value of each reporting unit by
assigning the assets and liabilities, including the existing goodwill and
intangible assets, to those reporting units as of the date of adoption. The
Company will then have up to six months from the date of adoption to determine
the fair value of each reporting unit and compare it to the reporting unit's
carrying amount. To the extent a reporting unit's carrying amount exceeds its
fair value, an indication exists that the reporting unit's goodwill may be
impaired and the Company must perform the second step of the transitional
impairment test. In the second step, the Company must compare the implied fair
value of the reporting unit's goodwill, determined by allocating the reporting
unit's fair value to all of its assets (recognized and unrecognized) and
liabilities in a manner similar to a purchase price allocation in accordance
with SFAS No. 141, to its carrying amount, both of which would be measured as of
the date of adoption. This second step is required to be completed as soon as
possible, but no later than the end of the year of adoption. Any transitional
impairment loss will be recognized as the cumulative effect of a change in
accounting principle in the Company's statement of earnings.

   As of the date of adoption, the Company expects to have unamortized goodwill
in the amount of $1,193,000, which will be subject to transition provisions of
SFAS Nos. 141 and 142. Amortization expense related to goodwill was $358,000 and
$477,000, for the nine months ended December 31, 2001 and the year ended March
31, 2001, respectively. Management has completed an evaluation of the effects of
SFAS Nos. 141 and 142 and believes that it will not have a material effect on
the Company's consolidated financial statements.

   In October 2001, the FASB issued SFAS No. 144, Accounting for the Impairment
or Disposal of Long-Lived Assets. SFAS No. 144 supersedes No. 121, Accounting
for the Impairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed
Of, but retains many of its fundamental provisions. SFAS No. 144 also clarifies
certain measurement and classification issued from SFAS No. 121. In addition,
SFAS No. 144 supersedes the accounting and reporting provisions for the disposal
of a business segment as found in Accounting Principles Board Opinion No. 30,
Reporting the Results of Operations--Reporting the Effects of Disposal of a
Segment of a Business and Extraordinary, Unusual and Infrequently Occurring
Events and Transactions. SFAS No. 144 retains the basic requirements in APB
Opinion No. 30 to separately report discontinued operations, and broadens the
scope of such requirement to include more types of disposal transactions. The
scope of SFAS No. 144 excludes goodwill. The provisions of SFAS No. 144 are
effective for fiscal years beginning after December 15, 2002, and are to be
applied prospectively. NEON will adopt the requirements of SFAS No. 144 as of
April 2002.

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 our
condensed 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 5 under "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.

OVERVIEW

   NEON develops, markets and supports software products that allow our
customers to leverage their existing investment in legacy mainframe systems by
integrating or renewing legacy data sources with distributed or Internet
applications. In legacy environments, NEON also generates revenue by offering
Enterprise Subsystem Management software products that help mainframe database
administrators backup, recover, reorganize and manage IMS databases. NEON also
develops, markets and supports integration software that allows customers to
integrate helpdesk systems either with other helpdesk systems, network system
management products or asset management products.

   NEON was incorporated in May 1993 and is a successor by merger to NEON
Systems, Inc., an Illinois corporation that was incorporated in June 1991.

                                       11
<PAGE>

   NEON derives revenue from software licenses and maintenance services.
Historically, the NEON Shadow product line has generated substantially all of
NEON's revenue. License fees, which are based upon the number and capacity of
servers as well as the number of client users are generally due net 30 days from
the license grant and include a one-year maintenance period. The sales process
typically takes approximately 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.

   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 signed; 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, or if
not yet sold separately, is established by authorized management. 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 NEON specific 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 foreign
distributors.  License and maintenance revenues from these transactions are
recognized when all of the above conditions are met.

   NEON follows SFAS No. 86, "Accounting for the Cost of Computer Software to be
Sold, Leased or Otherwise Marketed." Research and development expenditures in
general have been charged to operations as incurred and any amounts which were
capitalized have been immaterial.

   Since NEON's inception, we have 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. We anticipate that our operating expenses will
increase in the future as we increase our sales and marketing operations,
develop new distribution channels, fund greater levels of research and
development, broaden our technical support and improve our operational and
financial systems. Accordingly, we will need to increase our quarterly revenue
to generate operating profits. In addition, a significant portion of our
quarterly revenue is historically recorded at the end of each quarter.
Consequently, it is difficult for us to predict future operating results and,
accordingly, there can be no assurance in future quarters that we will achieve
or sustain revenue growth and/or return to profitability.

   In the nine months ended December 31, 2001 and 2000, revenue outside of North
America was approximately 13% and 12%, respectively, of our total revenue. We
expect international revenue to increase as a percentage of total revenue in the
future as compared to the period ended December 31, 2001. A majority of NEON's
sales are generally denominated in United States dollars and as a result our
current exposure to foreign exchange fluctuations is currently limited. As our
international sales and operations expand, we anticipate that our exposure to
foreign currency fluctuations will increase.

   In view of the rapidly changing nature of our business and the current
weakness in the mainframe software market, we believe 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,
we do not believe that historical growth rates are necessarily representative of
our future growth potential.

   For a discussion of related party transactions to which NEON is a party, see
Note 10 of the "Condensed Notes to Consolidated Financial Statements," which is
incorporated by reference in this Management's Discussion and Analysis of
Financial Condition and Results of Operations.

                                       12
<PAGE>

RESULTS OF OPERATIONS

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

<TABLE>
<CAPTION>
                                                     THREE MONTHS ENDED DECEMBER 31,    NINE MONTHS ENDED DECEMBER 31,
                                                     -------------------------------    ------------------------------
                                                           2001             2000             2001             2000
                                                           ----             ----             ----             ----
<S>                                                  <C>                    <C>         <C>                   <C>
     Revenues:
        License                                              56%              66%              57%              67%
        Maintenance                                          44               34               43               33
                                                           ----             ----             ----             ----
           Total revenues                                   100              100              100              100
     Cost of revenues:
        Cost of licenses                                      8               13               10               10
        Cost of maintenance                                   9                9                9                9
                                                           ----             ----             ----             ----
           Total cost of revenues                            17               22               19               19
                                                           ----             ----             ----             ----
     Gross profit                                            83               78               81               81
     Operating expenses:
        Sales and marketing                                  54               61               62               57
        Research and development                             24               34               28               31
        General and administrative                           20               88               24               40
        Restructuring costs                                  --               --                6               --
        Asset write-down charges                             --               --                5               --
        Amortization of acquisition related costs             2                2                2                2

           Total operating expenses                         100              186              127              130
                                                           ----             ----             ----             ----
     Operating income (loss)                                (17)            (108)             (46)             (50)
     Interest and other, net                                  6               10                6               10
     Gain from settlement of litigation                      --               --               57               --
     Valuation allowance note receivable                    (39)              --              (12)              --
                                                           ----             ----             ----             ----
     Income (loss) before income taxes                      (50)             (98)               5              (40)
     Benefit for income taxes                                --               17                1                8
                                                           ----             ----             ----             ----
     Net income (loss)                                      (50)%            (81)%              6 %            (32)%
                                                           ====             ====             ====             ====
</TABLE>

THREE MONTHS ENDED DECEMBER 31, 2001 COMPARED TO THREE MONTHS ENDED DECEMBER 31,
2000

REVENUES

  Total revenues. NEON's revenues decreased $1.3 million or 21% from $6.4
million for the three months ended December 31, 2000 to $5.1 million for the
three months ended December 31, 2001. This reduction in total revenue was due to
an overall weakness in the mainframe software market that resulted in a decrease
in the amount of licenses sold during the three months ended December 31, 2001.
During the three-month period ended December 31, 2000, NEON had two customers
that individually accounted for 17% and 19%, respectively, of total revenue.
During the three-month period ended December 31, 2001, NEON had one customer
that accounted for 24% of total revenue.

  License. License revenues decreased $1.3 million or 32% from $4.2 million for
the three months ended December 31, 2000 to $2.9 million for the three months
ended December 31, 2001. This reduction in license revenue was due to an overall
weakness in the mainframe software market that resulted in a decrease in the
amount of licenses sold during the three months ended December 31, 2001.
Additionally, license revenues for the three-month period ended December 31,
2000 included $1.1 million attributable to a two-year software distribution
agreement with BMC Software entered into in October 1999, in connection with
NEON's settlement of a lawsuit originally filed by BMC Software.  The final
quarterly payment under such distribution agreement occurred in the fiscal
quarter ended September 30, 2001.

  Maintenance. Maintenance revenues increased $60,000 or 3% from $2.1 million
for the three months ended December 31, 2000 to $2.2 million for the three
months ended December 31, 2001. This increase resulted primarily from the
increase in NEON's cumulative installed base of customers.

COST OF REVENUES

  Cost of licenses. Cost of license revenues includes costs of product licenses,
such as product manuals, distribution and

                                       13
<PAGE>

media costs for NEON's software products, as well as royalty payments to third
parties related to license revenues. Cost of license revenues decreased $443,000
or 53% from $839,000, or 20% of license revenues, for the three months ended
December 31, 2000 to $396,000, or 14% of license revenues, for the three months
ended December 31, 2001. The decrease in the absolute dollar cost of license
revenue was primarily attributable to a decrease in the total dollar amount of
license revenue generated during the three-month period ended December 31, 2001
due to current market conditions generally affecting software sales in our
industry, partially offset by $365,000 in amortization cost of the iWave
intellectual property. The percentage decreases in the cost of license revenue
is the result of a lower percentage of the product mix having associated royalty
cost for the period ended December 31, 2001.

  Cost of maintenance. Cost of maintenance revenues includes personnel and other
costs related to NEON's customer support department. Cost of maintenance
revenues decreased $120,000 or 21% from $584,000, or 27% of maintenance
revenues, for the three months ended December 31, 2000 to $464,000, or 21% of
maintenance revenues, for the three months ended December 31, 2001. The decrease
in the cost of maintenance revenue as a percentage of maintenance revenue was
due primarily to the decrease in the total dollar amount of purchases of
computer supplies and software, as well as a reduction in telecommunications
costs, necessary to provide maintenance support to our maintenance customer base
during the three-month period ended December 31, 2001.

OPERATING EXPENSES

  Sales and marketing. Sales and marketing expenses include salaries,
commissions, bonuses, benefits and travel expenses of sales, presales support
and marketing personnel, together with trade show participation and other
promotional expenses. These expenses decreased $1.2 million or 30% from $3.9
million, or 61% of total revenues, for the three months ended December 31, 2000
to $2.7 million, or 54% of total revenues, for the three months ended December
31, 2001. The dollar decrease includes a reduction in commissions and marketing
program costs due to the reduction in revenue.

  Research and development. Research and development expenses include salaries,
bonuses and benefits for product development and product documentation personnel
and the computer hardware, software and telecommunication expenses associated
with these personnel. Research and development expenses decreased $1.0 million
or 45% from $2.2 million, or 34% of total revenues, for the three months ended
December 31, 2000 to $1.2 million, or 24% of total revenues, for the three
months ended December 31, 2001. The dollar decrease includes a decrease in
compensation costs due to improved efficiency in utilization of personnel and  a
decrease in the related computer hardware and software expenses related to
research and development staffing.  We expect research and development expenses
to increase in absolute dollar amounts as we continue to expand our existing
product line and develop new products.

  General and administrative. General and administrative expenses include
salaries, personnel and related costs for NEON's executive, financial, legal and
administrative staff. General and administrative expenses decreased $132,000 or
12% from $1.1 million, excluding $4.5 million from nonrecurring charges, or 18%
of total revenues, for the three months ended December 31, 2000 to $1.0 million,
or 20% of total revenues, for the three months ended December 31, 2001. NEON
anticipates that general and administrative expenses will increase in absolute
dollars as we continue to upgrade and improve our internal systems.

  Amortization of acquisition related costs. In September 1999 we acquired
various software products and miscellaneous assets from Beyond Software Inc., a
privately held company based in Santa Clara, California, for $1.87 million, plus
the assumption of certain liabilities. The transaction resulted in goodwill of
approximately $2.4 million, which is being amortized on a straight-line basis
over five years. Amortization expense related to this transaction was $119,000,
which was recognized in both the three months ended December 31, 2000 and 2001.

  Interest and other income, net. Interest income decreased for the three months
ended December 31, 2001 compared to the three months ended December 31, 2000 by
$334,000 due to lower interest rates and available investable cash balances
during the three months ended December 31, 2001.

  Benefit for income taxes. At December 31, 2001, NEON had a net operating loss
carry-forward for income tax purposes of approximately $3.5 million that is
available to offset future taxable income principally related to foreign tax
jurisdictions. The net operating loss carry-forwards in the United Kingdom,
Germany and Australia carry forward indefinitely.  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 December
31, 2001, NEON has recorded a full valuation allowance for the deferred tax

                                       14
<PAGE>

assets related to the future benefits, if any, for these losses.

  The benefit for income taxes for the three-months ended December 31, 2001 and
2000 was nil, or 0% of pre-tax loss and $1.1 million or 17% of pre-tax loss,
respectively. As NEON does not anticipate generating income for the year ended
March 31, 2002, no tax benefit is recorded in the interim financial statements.
The difference between the effective rate and the statutory rate is primarily
due to the impact of net operating losses for which no benefit has been
recognized for the three months ended December 31, 2001 and 2000.

NINE MONTHS ENDED DECEMBER 31, 2001 COMPARED TO NINE MONTHS ENDED DECEMBER 31,
2000

REVENUES

  Total revenues. NEON's revenues decreased $3.6 million or 18% from $19.7
million for the nine months ended December 31, 2000 to $16.1 million for the
nine months ended December 31, 2001. This reduction in total revenue was due to
an overall weakness in the mainframe software market that resulted in a decrease
in the amount of licenses sold during the nine months ended December 31, 2001.
During the nine-month period ended December 31, 2000, NEON had two customers
that represented 11% and 16% of total revenues, respectively. During the nine-
month period ended December 31, 2001, NEON had 2 customers that represented 13%
and 8% of total revenues, respectively.

  License. License revenues decreased $3.9 million or 30% from $13.2 million for
the nine months ended December 31, 2000 to $9.2 million for the nine months
ended December 31, 2001. This reduction in license revenue was due to an overall
weakness in the mainframe software market that resulted in a decrease in the
amount of licenses sold during the nine months ended December 31, 2001. License
revenues for the nine months ended December 31, 2000 includes $3.2 million
attributable to a two-year software distribution agreement with BMC Software
entered into in October 1999, in connection with NEON's settlement of a lawsuit
originally filed by BMC Software.  License revenues for the nine months ended
December 31, 2001 includes only $2.2 million attributable to such distribution
agreement, which agreement expired as of the end of September 2001.  The final
payment under such two-year distribution agreement occurred in the fiscal
quarter ended September 30, 2001.

  Maintenance. Maintenance revenues increased $369,000 or 6% from $6.5 million
for the nine months ended December 31, 2000 to $6.9 million for the nine months
ended December 31, 2001. This increase resulted primarily from the increase in
NEON's cumulative installed base of customers.

COST OF REVENUES

  Cost of licenses. Cost of license revenues includes costs of product licenses,
such as product manuals, distribution and media costs for NEON's software
products, as well as royalty payments to third parties related to license
revenues. Cost of license revenues decreased $579,000 or 28% from $2.1 million,
or 16% of license revenues, for the nine months ended December 31, 2000 to $1.5
million, or 16% of license revenues for the nine months ended December 31,
2001.  The decrease in the absolute dollar cost of license revenue was primarily
attributable to a decrease in the total dollar amount of license revenue
generated during the nine-month period December 31, 2001 due to current market
conditions generally affecting software sales in our industry, partially offset
by $1.1 million in amortization cost of the iWave intellectual property.

  Cost of maintenance. Cost of maintenance revenues includes personnel and other
costs related to NEON's customer support department. Cost of maintenance
revenues decreased $230,000 or 13% from $1.7 million or 27% of maintenance
revenues for the nine months ended December 31, 2000 to $1.5 million or 22% of
maintenance revenues for the nine months ended December 31, 2001.  The decrease
in the cost of maintenance revenue as a percentage of maintenance revenue was
due primarily to a decrease in the total dollar amount of purchases of computer
supplies and software, as well as a reduction in telecommunications costs,
necessary to provide maintenance support to our maintenance customer base during
the three-month period ended December 31, 2001.

OPERATING EXPENSES

  Sales and marketing. Sales and marketing expenses include salaries,
commissions, bonuses, benefits and travel expenses of

                                       15
<PAGE>

sales, presales support and marketing personnel, together with trade show
participation and other promotional expenses. These expenses decreased $1.2
million or 11% from $11.2 million, or 57% of total revenues, for the nine months
ended December 31, 2000 to $10.0 million, or 62% of total revenues, for the nine
months ended December 31, 2001. The dollar decrease includes a reduction in
commissions and marketing program costs due to the reduction in revenue.

  Research and development. Research and development expenses include salaries,
bonuses and benefits for product development and product documentation personnel
and the computer hardware, software and telecommunication expenses associated
with these personnel. Research and development expenses decreased $1.6 million
or 27% from $6.1 million, or 31% of total revenues, for the nine months ended
December 31, 2000 to $4.5 million, or 28% of total revenues, for the nine months
ended December 31, 2001. The dollar decrease includes a decrease in compensation
costs due to improved efficiency in utilization of personnel and the related
computer hardware, software and telecommunication expenses related to research
and development staffing.  The increase in percentage of total revenue is
primarily due to a reduction in total revenue generated in the nine months ended
December 31, 2001. We expect research and development expenses to increase in
absolute dollar amounts as we continue to expand our existing product line and
develop new products.

  General and administrative. General and administrative expenses include
salaries, personnel and related costs for NEON's executive, financial, legal and
administrative staff. General and administrative expenses increased $432,000 or
12% from $3.5 million, excluding $4.5 million from nonrecurring charges, or 18%
of total revenues, for the nine months ended December 31, 2000, to $3.9 million,
or 24% of total revenues, for the nine months ended December 31, 2001. NEON
anticipates that general and administrative expenses will increase in absolute
dollars as we continue to upgrade and improve our internal systems.

  Amortization of acquisition related costs. In September 1999 we acquired
various software products and miscellaneous assets from Beyond Software Inc., a
privately held company based in Santa Clara, California, for $1.87 million, plus
the assumption of certain liabilities. The transaction resulted in goodwill of
approximately $2.4 million, which is being amortized on a straight-line basis
over five years. Amortization expense related to this transaction of $358,000
was recognized in both the nine months ended December 31, 2000 and 2001.

  Interest and other income, net. Interest income decreased for the nine months
ended December 31, 2001 compared to the nine months ended December 31, 2000 by
$916,000 due to lower interest rates and lower available investable cash
balances during the nine months ended December 31, 2001.

  Benefit for income taxes.  The benefit for income taxes for the nine months
ended December 31, 2001 and 2000, was $143,000, or 17% of pre-tax income and
$1,525,000, or 20% of pre-tax loss, respectively.  As NEON does not anticipate
generating income for the year ended March 31, 2002, no additional tax benefit
was recorded in the quarter ended December 31, 2001. The difference between the
effective rate and the statutory rate is primarily due to the impact of net
operating losses for which no benefit has been recognized for the nine months
ended December 31, 2001 and 2000.

LIQUIDITY AND CAPITAL RESOURCES

     NEON's cash and cash equivalent balance decreased to $39 million at
December 31, 2001 from $43 million at March 31, 2001. This decrease was due
primarily to an operating loss of $7.4 million for the nine months ended
December 31, 2001, an advance on a note receivable to Enterworks Software, Inc.
of $2 million and an advance on a note receivable to Scalable Software, Inc. of
$3.95 million, partially offset by the $9.3 million settlement, net of
attorney fees, of the New Era law suit.   The Enterworks Software loan is a
Demand 10% Convertible Promissory Note and was issued under a Convertible
Promissory Note and Warrant Agreement dated March 1, 2001 in a second round of
financing for Enterworks, Inc. The loan accrues interest at 10% per annum and
matures on demand made by the holders representing at least 50% of the
outstanding principal amount of the Demand Notes. The Scalable Software
Promissory Note dated July 17, 2001 permitted advances up to an aggregate
principal amount of $3 million dollars and is guaranteed by Louis Woodhill,
James R. Woodhill and John Moores. The Scalable Software Promissory Note accrued
interest at 7% per annum, paid quarterly, and matured on December 31, 2001. On
November 13, 2001, the Promissory Note was amended to increase the maximum
aggregate lending limit from $3.0 million to $3.5 million. On December 21, 2001,
NEON announced that it had entered into a non-binding term sheet to be granted a
two-year option to acquire Scalable Software, Inc. This term sheet reflected a
revision by NEON and Scalable Software of NEON's previously announced plan to
acquire Scalable Software. In connection with the option to acquire

                                       16
<PAGE>

Scalable Software, NEON agreed to provide bridge financing of up to $9.0
million, of which $3.5 million is secured by personal guarantees from John
Moores, Louis R. Woodhill and James R. Woodhill. The aggregate financing has a
36-month term and will not bear interest during the term of the two-year option
to acquire Scalable Software. 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 Moores, Louis R. Woodhill and James R. Woodhill for
the initial $3.5 million loaned to Scalable Software, the aggregate loan amount
will be secured by all of the intellectual property rights of Scalable Software.
As of December 31, 2001, $3.95 million of the bridge financing had been drawn
upon by Scalable Software, and is reflected as a note receivable.

  Net cash provided by operating activities was $1.7 million in the nine months
ended December 31, 2001, while the net cash provided by operating activities was
$473,000 in the nine months ended December 31, 2000. The net cash provided by
operating activities during the nine months ended December 31, 2001 was due
primarily to the $9.3 million settlement, net of attorney fees, of the New Era
lawsuit, partially offset by an operating loss of $7.4 million for the nine
months ended December 31, 2001.

  Net cash used by NEON in investing activities was $5.7 million and $5.5
million in the nine months ended December 31, 2001 and 2000, respectively.
Purchases of marketable securities totaling $3.6 million and $887,000 in
purchases of property and equipment were the principal uses of investing funds
in the nine months ended December 31, 2000. The principal investing uses in the
nine months ended December 31, 2001 were an advance on a note receivable to
Enterworks Software, Inc. of $2 million, an advance on a note receivable to
Scalable Software, Inc. of $3.95 million and $577,000 in purchases of property
and equipment partially offset by the maturity of $820,000 in marketable
securities. As of December 31, 2001, NEON had no material commitment for capital
expenditures.

  NEON's net cash provided by financing activities was $100,000 and $223,000 in
the nine months ended December 31, 2001 and 2000, respectively. The net cash
provided by financing activities in both periods are proceeds from the exercise
of employee stock options.

  We intend to invest strategically in the development of new products and
enhancements to our existing products. Our 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. We
believe that our current cash and investment balances and any cash generated
from operations will be sufficient to meet our operating and capital
requirements for at least the next 12 months. However, it is possible that we
may require additional financing within this period. We have no current plans,
and we are not currently negotiating, to obtain additional financing. The
factors described in this paragraph will affect our future capital requirements
and the adequacy of our available funds. We may be required to raise additional
funds through public or private financing, strategic relationships or other
arrangements. We cannot ensure that such funding, if needed, will be available
to us on terms attractive to us, or at all. Furthermore, any additional equity
financing may be dilutive to stockholders, and debt financing, if available, may
involve restrictive covenants. Strategic arrangements, if necessary to raise
additional funds, may require us to relinquish our rights to certain of our
technologies or products. If we fail to raise capital when needed, our failure
could have a negative impact on our operating results and financial condition.

   In the fiscal quarter ended December 31, 2001, NEON recorded a reserve of $2
million as a valuation allowance against its long-term investments and notes
receivable.

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 $39 million at December 31, 2001,
and $33 million was invested in different types of highly liquid commercial
paper with maturity dates ranging from 28 days to 45 days. NEON believes that a
near-term change in interest rates would not materially affect its financial
position, results of operations

                                       17
<PAGE>

or net cash flows for fiscal year 2002.

PART II - OTHER INFORMATION

ITEM 1.   LEGAL PROCEEDINGS - Please see the discussion in Part I, Note 6 of the
"Condensed Notes to Consolidated Financial Statements," which is incorporated by
reference in this Part II, Item 1.

ITEM 2.   CHANGES IN SECURITIES AND USE OF PROCEEDS - In March 1999, NEON
completed the initial public offering of its common stock (the "IPO"). In the
IPO, NEON issued and sold 3,041,000 shares for an aggregate price to the public
of $45,615,000, and a sole selling stockholder sold 64,000 shares of common
stock for an aggregate offering price of $960,000. The IPO was a firm commitment
underwriting, and the managing underwriters of the IPO were Donaldson, Lufkin &
Jenrette Securities Corporation, Hambrecht & Quist LLC and the CIBC Oppenheimer
Corp. The underwriting discount incurred by NEON relating to the IPO was
$3,193,050. Net offering proceeds received by NEON from the IPO were
approximately $41.2 million. Approximately $1.0 million of the proceeds received
by NEON from the IPO were used to repay existing indebtedness and $1.9 million
was used in connection with the September 1999 acquisition of the assets of
Beyond Software Inc. An additional $4.5 million was paid to Computer Associates,
Inc. through December 2000 to pay certain software product royalties and to
purchase certain software products and intellectual property rights.
Additionally, $2.0 million was loaned to Enterworks Software, Inc. as bridge
financing in June 2001.  In connection with NEON's entering into a Letter of
Intent on July 17, 2001, to acquire Scalable Software, Inc., Scalable executed a
promissory note that permits them to borrow up to $3,000,000 from NEON.  On
November 13, 2001, the promissory note was amended to increase the maximum
lending limit to $3,500,000.  On December 21, 2001, NEON announced that it had
entered into a non-binding term sheet to be granted a two-year option to acquire
Scalable Software, Inc.  This term sheet reflected a revision by NEON and
Scalable Software of NEON's previously announced plan to acquire Scalable
Software.  In connection with the option to acquire Scalable Software, NEON has
agreed to provide bridge financing of up to $5.5 million, in addition to the
$3.5 million previously loaned to Scalable Software that is secured by personal
guarantees from John Moores, Louis R. Woodhill and James Woodhill.  The
aggregate financing has a 36-month term and will not bear interest during the
term of the two-year option to acquire Scalable Software.  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 Moores, Louis R.
Woodhill and James R. Woodhill for the initial $3.5 million loaned to Scalable
Software, the aggregate loan amount will be secured by all of the intellectual
property rights of Scalable Software. As of December 31, 2001, $3.95 million of
the bridge financing had been drawn upon by Scalable Software, and is reflected
as a note receivable. January 2, 2002, NEON announced that it had purchased
913,400 shares of its outstanding common stock in a transaction arising from an
unsolicited offer. The transaction occurred December 21, 2001 at a purchase
price of $2.90 per share for a total aggregate purchase price of $2,648,860. The
shares purchased amounted to approximately 9.5% of NEON's then outstanding
9,577,533 shares of common stock, which after the purchase totaled 8,664,133
shares. The remainder of the proceeds from the IPO has been invested in
interest-bearing, investment-grade securities.

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES - Not Applicable.

ITEM 4.  SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS - Not applicable.

ITEM 5.  OTHER INFORMATION -

ANNUAL MEETING AND STOCKHOLDER PROPOSALS - The Annual Meeting for NEON is
ordinarily conducted between August and September of each year.  This annual
meeting for the fiscal year ended 2001 has been delayed beyond such customary
date by a period exceeding thirty (30) days.  Therefore, NEON is re-opening the
period for submission of stockholder proposals beyond the previous date of March
23, 2001.  All stockholder proposals to be considered for inclusion in the proxy
statement for the fiscal year ended March 31, 2001 must be submitted in writing
prior to February 21, 2002 to James Bradford Poynter, Secretary, NEON Systems,
Inc., 14100 Southwest Freeway, Suite 500, Sugar Land, Texas 77478.

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 MANAGEMENT IS IN TRANSITION, WHICH COULD ADVERSELY AFFECT OUR BUSINESS

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<PAGE>

  In June 2001, Steve Odom, our then-President, Chief Operating Officer and
Chief Financial Officer, resigned. Immediately after Mr. Odom's resignation,
John Moores, Chairman of our Board of Directors, became our interim Chief
Executive Officer and Wayne Webb, our vice president and general counsel, became
our interim President. On June 28, 2001, James Bradford Poynter was hired by
NEON as its Chief Financial Officer.  On October 17, 2001, NEON announced that
the Board of Directors had hired Louis R. Woodhill as NEON's Chief Executive
Officer and President. Until we were able to hire a permanent Chief Executive
Officer and President, our business was disrupted, and our management resources
were diverted from the development of our business. In addition, since Mr.
Woodhill is still the Chief Executive Officer and President of Scalable
Software, Inc., the failure to close the proposed acquisition by NEON of
Scalable Software, Inc. may result in additional uncertainty with respect to the
continued management of NEON, which events could materially adversely affect our
business, operating results and financial condition.

SOME MEMBERS OF OUR BOARD OF DIRECTORS AND MANAGEMENT MAY HAVE CONFLICTS OF
INTERESTS AND/OR ARE INTERESTED PARTIES TO CERTAIN TRANSACTIONS OF NEON

     On January 3, 2002, NEON entered into a Services Agreement with Sheer
Genius Software, Inc. of Austin, Texas, a company owned by or affiliated with
James R. Woodhill, one of NEON's directors and the brother of NEON's Chief
Executive Officer, Louis R. Woodhill.  Under the first Project Description
negotiated for such Services Agreement, Sheer Genius will provide development
services to NEON on a budgeted time and materials basis and will deliver fixed
deliverables, consisting primarily of developed source code.  The term of the
Project Description is six months and the maximum aggregate fees will be
$480,000.  Under the Services Agreement, all intellectual property created by
Sheer Genius in the course of performing the Services shall be owned by NEON.
Additionally, Sheer Genius will receive a license back of such intellectual
property for limited use in the development by Sheer Genius of software that
does not compete with software distributed by NEON.  Also, JMI Services, Inc.,
an entity owned by John Moores, NEON's Chairman, is a creditor of Sheer Genius,
holding a promissory note dated August 31, 2001 in the amount of $200,000. The
Board of Directors reviewed the terms of the Services Agreement and Project
Description and unanimously approved such agreements following disclosure of the
interest of its officers and directors associated with Sheer Genius.

     On December 21, 2001, the Board of Directors appointed Louis R. Woodhill
and James R. Woodhill to fill open positions as directors on the NEON Board of
Directors.  Louis R. Woodhill was also hired by NEON as its President and Chief
Executive Officer as of October 15, 2001.  Louis R. Woodhill also maintains a
position as the President and Chief Executive Officer of Scalable Software, Inc.
On December 21, 2001, NEON announced that it had entered into a non-binding term
sheet to be granted a two-year option to acquire Scalable Software.  This term
sheet reflected a revision by NEON and Scalable Software of NEON's previously
announced plan to acquire Scalable Software.  In connection with the option to
acquire Scalable Software, NEON has agreed to provide bridge financing of up to
$9.0 million, of which $3.5 million is secured by personal guarantees from John
Moores, Louis R. Woodhill and James R. Woodhill.  The aggregate financing has a
36-month term and will not bear interest during the term of the two-year option
to acquire Scalable Software.  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 on the initial $3.5 million loaned to Scalable Software, the
aggregate loan amount will be secured by all of the intellectual property rights
of Scalable Software. As of December 31, 2001, $3.95 million of the bridge
financing had been drawn upon by Scalable Software, and is reflected as a note
receivable.    Louis R. Woodhill, James R. Woodhill and John Moores are all
investors and directors of Scalable Software.   Additionally, NEON directors
Charles E. Noell III and Peter Schaeffer are also involved as investors and/or
directors of Scalable Software.  The Board of Directors reviewed the terms of
the term sheet between NEON and Scalable Software and unanimously approved such
term sheet following disclosure of the interests of its officers and directors
associated with Scalable Software.

     Although NEON believes that each of the above transactions was an arms-
length transaction, the possibility of conflicts of interest between the
interests of the NEON stockholders and the stockholders and/or employees of
Scalable Software may arise due to the interlocking nature of the Boards of
Directors of NEON and Scalable Software, as well as due to the dual executive
management positions currently held by Louis R. Woodhill.

BECAUSE OUR EXPENSES ARE LARGELY FIXED, AN UNEXPECTED REVENUE SHORTFALL MAY
ADVERSELY AFFECT OUR BUSINESS

  Our expense levels are based primarily on our estimates of future revenues and
are largely fixed. We also intend to hire additional personnel to support
additional growth of our business. We may be unable to adjust spending rapidly
enough to

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<PAGE>

compensate for any unexpected revenue shortfall. Accordingly, any significant
shortfall in revenues in relation to our planned expenditures would reduce, and
possibly eliminate, any operating income or increase our operating loss, and
could materially adversely affect our business, operating results and financial
condition.

BECAUSE WE CANNOT ACCURATELY PREDICT THE AMOUNT AND TIMING OF INDIVIDUAL SALES,
OUR QUARTERLY OPERATING RESULTS MAY VARY SIGNIFICANTLY; THIS MAY ADVERSELY
IMPACT OUR STOCK PRICE

  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. Further, we believe that period-to-period comparisons
of our operating results are not necessarily a meaningful indication of future
performance. If our quarterly results do not meet investors' expectations, the
trading price of our common stock would likely decline.

SEASONAL TRENDS IN SALES OF OUR PRODUCTS MAY AFFECT INVESTORS' EXPECTATIONS
REGARDING OUR FINANCIAL PERFORMANCE AND ADVERSELY AFFECT OUR STOCK PRICE

  Historically, our revenues have tended to be strongest in the third and fourth
quarters of our fiscal year and to decrease slightly in our first fiscal
quarter. The expectations of investors who rely on our third or fourth quarter
results in a given year may be adversely impacted if this seasonal trend
continues. We believe that our seasonality is due in part to the calendar year
budgeting cycles of many of our customers, our employee recognition policies
which tend to reward our sales personnel for achieving fiscal year-end rather
than quarterly revenue quotas, and the timing of our hiring of sales force
personnel. In future periods, we expect that this seasonal trend will continue
to cause first fiscal quarter license revenues to decrease from the level
achieved in the preceding quarter.

BECAUSE A SIGNIFICANT PERCENTAGE OF OUR REVENUES ARE DERIVED FROM OUR SHADOW
PRODUCT LINE, DECREASED DEMAND FOR THESE PRODUCTS COULD ADVERSELY AFFECT OUR
BUSINESS

  The Shadow product line represented 89%, 88%, and 94% of our revenues in
fiscal 1999, 2000 and 2001, respectively, for the nine months ended December 31,
2001.   We anticipate that these products will account for a substantial amount
of our revenues for the foreseeable future. Consequently, our future success
will depend on continued market acceptance of the Shadow product line and
enhancements to these products. Competition, technological change or other
factors could reduce demand for, or market acceptance of, these products and
could have a material adverse effect on our business, operating results and
financial condition.

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
derive our revenues primarily from our Shadow products, and, to a lesser extent,
from our Enterprise Subsystem Management products that backup, recover,
reorganize and manage IMS databases, and our helpdesk integration software
products that allow customers to integrate helpdesk systems either with other
helpdesk systems, network system management products or asset management
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;

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<PAGE>

  .  Growth in business demands for access to the data, applications and
     transactions residing on mainframe computers from Web-based and
     client/server applications; and
  .  Growth in business demands to integrate helpdesk systems, and/or to
     integrate helpdesk systems with network system management or asset
     management software products.

LOSS OF AN EXECUTIVE OFFICER OR OUR PRODUCT AUTHORS COULD ADVERSELY AFFECT OUR
BUSINESS

  Our success is dependent upon the continued service and skills of our
executive officers and our product authors, none of which is bound by an
employment agreement. If we lose the services of any of these key personnel, it
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 author the 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.

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.

  Our potential field of competitors continues to expand as both organizations
and vendors recognize the need for products such as our legacy system
integration products that permit users to access mainframe-based data and
applications for integration with distributed applications. Our Shadow products
compete principally with products, known as middleware software, that provide
the connection between a client application and a server application, a database
or a transaction processing system.  Currently middleware software products are
also provided by established vendors such as IBM and Information Builders, and
to a lesser extent by Attachmate, IONA Technologies, and New Era of
Networks/Sybase. Our Enterprise Subsystem Management products face significant
competition from BMC Software and IBM. We expect to experience increased
competition from current and potential competitors, many of which have
significantly greater financial, technical, marketing and other resources than
we do. We may also face competition from:

  - Other business application software vendors who may internally develop, or
    attain through acquisitions and partnerships, middleware and enterprise
    subsystem management and enterprise security solutions;

  - Internal development efforts by corporate information technology
    departments; and

  - New entrants to the middleware, enterprise subsystem management, or helpdesk
    integration markets.

WE MAY NOT HAVE THE RESOURCES TO SUCCESSFULLY MANAGE ADDITIONAL GROWTH

  Any prospective growth will placed significant demands on management as well
as on our administrative, operational and financial resources. Our inability to
sustain or manage any additional growth could have a material adverse effect on
our business, operating results and financial condition. In addition, expansion
of our existing international operations and entry into additional international
markets will require significant management attention and financial resources.
To manage any additional growth, we must:

  - Expand our sales, marketing and customer support organizations;

  - Invest in the development of enhancements to existing products and new
    products that meet changing customer needs;

  - Further develop our technical expertise so that we can influence and respond
    to emerging industry standards; and

                                       21
<PAGE>

  - Improve our operational processes and management controls.

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.

LOSS OF CODE-SHARING OR DISTRIBUTOR RIGHTS COULD DIVERT OUR RESOURCES FROM NEW
PRODUCT DEVELOPMENT

  We have code-sharing arrangements with third parties under which we have
obtained and used some source code in the development of some of our software
products. If any of these agreements are terminated, we could be required to
discontinue our use of the acquired code, and we would have to spend time and
software development resources to replace that code. Any diversion of these
resources could delay our development of new products or product enhancements.
In addition, we license several of our Enterprise Subsystem Management products
from Peregrine/Bridge Transfer Corporation pursuant to a distributor agreement
with an initial term through March 31, 2004. The license may be terminated by
either party in the event of default. The termination of the distributor
agreement could have a material adverse effect on our business, operating
results and financial condition.

OUR PLANNED EXPANSION OF OUR INTERNATIONAL OPERATIONS MAY MAKE US MORE
SUSCEPTIBLE TO GLOBAL ECONOMIC FACTORS, FOREIGN TAX LAW ISSUES AND BUSINESS
PRACTICES AND CURRENCY FLUCTUATIONS

  We currently have limited experience in developing local versions of our
products and marketing and distributing our products internationally. We plan to
expand our current international operations and to establish additional
facilities and marketing relationships in additional regions. We have
established direct telesales subsidiary offices in Germany, Australia and the
United Kingdom to market and sell our products in Europe and Australia. We have
distributors in Europe, Latin America and the Pacific Rim to market and sell our
products in those regions. We plan to expand our current international
operations and to establish additional facilities and marketing relationships in
additional regions. Our international operations are subject to particular
risks, including:

  - Impact of recessions in economies outside the United States;

                                       22
<PAGE>

  - Difficulty in accounts receivable collection and longer collection periods;

  - Cost of enforcement of contractual obligations;

  - Difficulties and costs of managing foreign operations;

  - Limited protection for intellectual property rights in some countries;

  - Currency exchange rate fluctuations;

  - Political and economic instability; and

  - Potentially adverse tax consequences.

  Our international revenues are generally denominated in local currencies. We
do not currently engage in currency hedging activities; however, we may
implement a program to mitigate foreign currency transaction risk in the future.
Future fluctuations in currency exchange rates may adversely affect our revenues
from international sales.

USE OF OUR NAME BY OTHERS MAY CAUSE CONFUSION IN THE MARKET

  Notwithstanding the settlement of our litigation with New Era of Networks that
was previously disclosed in the Form 10-Q for the fiscal quarter ended September
30, 2001, there are no guarantees that other organizations may not use or
continue to use the name "Neon" alone and in combination with other words, as a
trademark, a trade name or both.  In such event, such use may be confusing or
misleading and may result in confusion of NEON's goods and services in the
marketplace and may also result in further litigation, which may cause NEON to
incur additional legal expenses as well as cause executive management to be
distracted from the business operations of NEON.

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. We have previously
discovered software errors in certain of the products that we have developed or
sold. Despite testing, we cannot be certain that errors will not be found in
current versions, new versions or enhancements of our products after
commencement of commercial shipments.

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<PAGE>

THE COMPLEX TECHNOLOGY OF OUR PRODUCTS SUBJECTS US TO LIABILITY CLAIMS

  Because our products provide critical database access, integration and
management functions, we may face significant liability claims if our customers
believe that our products have failed to perform their intended functions.
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.

AS A TECHNOLOGY COMPANY, OUR COMMON STOCK MAY BE SUBJECT TO ERRATIC PRICE
FLUCTUATIONS

  From time to time, the stock market experiences significant price and volume
fluctuations, which may affect the market price of our common stock for reasons
unrelated to our performance. Recently, such volatility has particularly
impacted the stock prices of publicly-traded technology companies. In the past,
securities class action litigation has been instituted against a company
following periods of volatility in the market price of a company's securities.
If similar litigation were instituted against us, it could result in substantial
costs and a diversion of our management's attention and resources, which could
have an adverse effect on our business. In addition, the market price of our
common stock may be subject to significant fluctuations in response to numerous
factors, including:

  - Variations in our annual or quarterly financial results or those of our
    competitors;

  - Changes by financial research analysts in their estimates of our earnings or
    our failure to meet such estimates;

  - Conditions in the economy in general or in the software and other technology
    industries;

  - Announcements of key developments by competitors;

  - Loss of key personnel;

  - Unfavorable publicity affecting our industry or us;

  - Adverse legal events affecting us; and

  - Sales of NEON common stock by stockholders.

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. We granted registration rights to two
of our stockholders, Peter Schaeffer and JMI Equity Fund, L.P. Those rights
enabled these stockholders to require that we register, at NEON's expense,
resales of their shares of common stock. Mr. Schaeffer and the individuals and
entities to which JMI Equity Fund, L.P. has distributed its shares of our common
stock beneficially own, in the aggregate, approximately 4.1 million shares of
our common stock. If they sell a large portion of their shares on the open
market and at one time, our market price per share may decline.

OUR OFFICERS AND DIRECTORS CONTROL NEON, AND THESE OFFICERS AND DIRECTORS COULD
CONTROL MATTERS SUBMITTED TO OUR STOCKHOLDERS

  At present, our executive officers and directors and entities affiliated with
them beneficially own approximately 61.8% of our outstanding common stock. As a
result, these stockholders, if they act together, could control most matters
submitted to our stockholders for a vote, including the election of directors.

PROVISIONS OF OUR CHARTER AND BYLAWS AND DELAWARE LAW COULD DETER TAKEOVER
ATTEMPTS

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     Provisions of our certificate of incorporation and bylaws as well as
Delaware law could make it more difficult for a third party to acquire us, even
if doing so would be beneficial to our stockholders. We are subject to the
provisions of Delaware law which restrict certain business combinations with
interested stockholders, which may have the effect of inhibiting a non-
negotiated merger or other business combinations.

ITEM 6.  EXHIBITS AND REPORTS ON FORM 8-K

         (a)  EXHIBIT 99 - Term Sheet dated December 21, 2001 by and between
              NEON and Scalable Software, Inc. granting NEON a two-year option
              to acquire Scalable Software, Inc.

         (b)  REPORTS ON FORM 8-K -

               1.   Form 8-K dated September 7, 2001 and filed with the
                    Securities Exchange Commission on October 9, 2001 to report
                    preliminary second quarter results and highlights; and
               2.   Form 8-K dated December 21, 2001 and filed with the
                    Securities Exchange Commission on December 26, 2001 to
                    report that NEON had entered into a non-binding term sheet
                    to be granted a two-year option to acquire Scalable
                    Software, Inc. and the appointment of two directors; and
               3.   Form 8-K dated December 21, 2001 and filed with the
                    Securities Exchange Commission on January 3, 2002 to report
                    that NEON had repurchased 913,400 shares of its common stock
                    in an unsolicited broker transaction.

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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:  February 13, 2002           /s/ JAMES BRADFORD POYNTER
                                   -------------------------------------
                                   Chief Financial Officer
                                   (Principal financial officer)

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