<PAGE>

                                  UNITED STATES
                       SECURITIES AND EXCHANGE COMMISSION
                             Washington, D.C. 20549

                                    Form 10-Q

(Mark One)

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

                  For the Quarterly Period Ended June 30, 2002

                                       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 Identification No.)
 incorporation or organization)

  14100 Southwest Freeway, Suite 500,                      77478
            Sugar Land, Texas                            (zip code)
(Address of principal executive offices)

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

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

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

           Securities registered pursuant to Section 12(g) of the Act:
                     Common Stock, par value $0.01 per share
                                (Title of Class)

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

     The number of shares of the registrant's common stock outstanding as of
July 15, 2002, was 8,689,477.

<PAGE>

                               NEON SYSTEMS, INC.

                                    FORM 10-Q

                       FOR THE QUARTER ENDED JUNE 30, 2002

                                      INDEX
<TABLE>
<CAPTION>

                                                                                                               PAGE
<S>                                                                                                           <C>
PART I   FINANCIAL INFORMATION

Item 1.   Financial Statements

          Consolidated Balance Sheets at June 30, 2002 and March 31, 2002                                       3

          Consolidated Statements of Operations for the Three Months Ended June 30, 2002 and 2001               4

          Consolidated Statements of Cash Flows for the Three Months Ended June 30, 2002 and 2001               5

          Condensed Notes to Consolidated Financial Statements                                                  6

Item 2.   Management's Discussion and Analysis of Financial Condition and Results of Operations                13

Item 3.   Quantitative and Qualitative Disclosures About Market Risk                                           24

PART II. OTHER INFORMATION

Item 1.   Legal Proceedings                                                                                    24

Item 2.   Changes in Securities and Use of Proceeds                                                            24

Item 3.   Defaults Upon Senior Securities                                                                      25

Item 4.   Submission of Matters to a Vote of Security Holders                                                  25

Item 5.   Other Information                                                                                    25

Item 6.   Exhibits and Reports on Form 8-K                                                                     28

SIGNATURES                                                                                                     29


</TABLE>

                                       2

<PAGE>


PART I - FINANCIAL INFORMATION

    ITEM 1. FINANCIAL STATEMENTS

                       NEON SYSTEMS, INC. AND SUBSIDIARIES
                           CONSOLIDATED BALANCE SHEETS
                      (IN THOUSANDS, EXCEPT SHARE AMOUNTS)

<TABLE>
<CAPTION>


                                                                               JUNE 30, 2002       MARCH 31, 2002
                                                                          ---------------------  ----------------
                                                                               (UNAUDITED)
<S>                                                                       <C>                    <C>
                                     ASSETS

                  CURRENT ASSETS:
                     Cash and cash equivalents                               $    30,600           $     34,506
                     Accounts receivable, net                                      2,902                  4,650
                     Taxes receivable                                              1,066                  1,054
                     Deferred income taxes                                           608                    608
                     Prepaid royalty (related party, Note 7)                       2,950                  2,128
                     Other current assets                                            937                  1,005
                                                                             -----------            -----------
                        Total current assets                                      39,063                 43,951
                                                                             -----------            -----------

                  Property and equipment, net                                      2,139                  2,171
                  Note receivable, net (related party, Note 7)                     3,500                  3,702
                  Intangible assets, net                                           3,347                  3,713
                  Other assets                                                        53                     63
                                                                             -----------            -----------
                         Total assets                                        $    48,102            $    53,600
                                                                             ===========            ===========

                       LIABILITIES & STOCKHOLDERS' EQUITY

                  CURRENT LIABILITIES:
                     Accounts payable                                        $       418            $       297
                     Accrued expenses                                              1,411                  2,204
                     Deferred revenue                                              6,881                  8,174
                                                                             -----------            -----------
                        Total current liabilities                                  8,710                 10,675
                                                                             -----------            -----------

                  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; 8,684,477 and 8,674,953 shares
                    issued and outstanding at June 30, 2002 and
                    March 31, 2002, respectively                                      96                     96
                  Additional paid-in capital                                      51,236                 51,233
               Treasury Stock, 913,400 shares at cost                             (2,649)                (2,649)
                  Accumulative other comprehensive income (loss)                    (446)                  (475)
                  Unearned portion of deferred compensation                           --                    (26)
                  Accumulated deficit                                             (8,845)                (5,254)
                                                                             -----------            -----------
                         Total stockholders' equity                               39,392                 42,925
                  Commitments and contingencies (Note 5)
                                                                             -----------
                         Total liabilities and stockholders' equity          $    48,102            $    53,600
                                                                             ===========            ===========

</TABLE>

     SEE ACCOMPANYING CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.

                                       3




<PAGE>


                       NEON SYSTEMS, INC. AND SUBSIDIARIES
                      CONSOLIDATED STATEMENTS OF OPERATIONS
                    (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)
                                   (UNAUDITED)
<TABLE>
<CAPTION>

                                                                THREE MONTHS ENDED JUNE 30,
                                                         ------------------------------------------
                                                                2002                   2001
                                                         -------------------    -------------------
<S>                                                     <C>                     <C>
Revenues:
   License                                                     $     2,245            $     3,774
   Maintenance                                                       2,877                  2,423
                                                               -----------            -----------
     Total revenues                                                  5,122                  6,197

Cost of revenues:
   Cost of licenses                                                    549                    499
   Cost of maintenance                                                 567                    576
                                                               -----------            -----------
     Total cost of revenues                                          1,116                  1,075
                                                               -----------            -----------

Gross profit                                                         4,006                  5,122
                                                               -----------            -----------

Operating expenses:
  Sales and marketing                                                3,241                  4,109
  Research and development                                           1,579                  1,783
  General and administrative                                         1,239                  1,930
  Restructuring costs                                                 (138)                    --
  Amortization of goodwill                                              --                    120
                                                               -----------            -----------
   Total operating expenses                                          5,921                  7,942
                                                               -----------            -----------

Operating loss                                                      (1,915)                (2,820)

Interest and other income, net                                         142                    410
Equity loss in affiliate                                            (1,245)                    --
Valuation allowance on note receivable                                (573)                    --
                                                               -----------            -----------
  Loss before income taxes                                          (3,591)                (2,410)

Provision for income taxes                                              --                     --
                                                               -----------            -----------
   Net loss                                                    $    (3,591)           $    (2,410)
                                                               ===========            ===========

Net loss per share:
   Basic                                                       $     (0.41)           $     (0.25)
                                                               ===========            ===========
    Diluted                                                    $     (0.41)           $     (0.25)
                                                               ===========            ===========

Shares used in computing net loss per share:
   Basic                                                             8,682                  9,525
                                                               ===========            ===========
   Diluted                                                           8,682                  9,525
                                                               ===========            ===========
</TABLE>

      SEE ACCOMPANYING CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

                                       4


<PAGE>


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

<TABLE>
<CAPTION>

                                                                   THREE MONTHS ENDED JUNE 30,
                                                                   2002                   2001
                                                                  -------------     ----------------
<S>                                                               <C>               <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
  Net income (loss)                                               $     (3,591)          $    (2,410)
  Adjustments  to reconcile  net loss to net cash
    used in operating activities:
     Depreciation and amortization                                         538                   539
     Non-cash compensation expense                                          26                    97
     Amortization of goodwill                                               --                   120
    Equity loss in affiliate                                             1,245                    --
      Valuation allowance on note receivable                               573                    --
     Increase (decrease) in cash resulting from changes in
       operating assets and liabilities:
      Accounts receivable                                                1,893                 1,348
       Other current assets                                                 80                   370
       Prepaid royalty (related party, Note 7)                            (822)                 (588)
       Other assets                                                         12                    27
       Accrued expenses                                                   (835)               (1,523)
       Accounts payable                                                    113                  (617)
       Taxes payable                                                        --                    90
       Deferred revenue                                                 (1,428)                 (139)
                                                                  ------------           -----------
Net cash used in operating activities                                   (2,196)               (2,686)
                                                                  ------------           -----------

CASH FLOWS FROM INVESTING ACTIVITIES:
  Maturity of marketable securities                                         --                   819
  Investment in Enterworks                                                                    (2,000)
  Advances to Scalable Software (related party, Note 7)                 (1,616)                   --
  Purchases of furniture and equipment                                    (139)                 (260)
                                                                  ------------           -----------

Net cash used in investing activities                                   (1,755)               (1,441)
                                                                  ------------           -----------
CASH FLOWS FROM FINANCING ACTIVITIES:
  Proceeds from exercises of stock options                                   3                    27
                                                                  ------------           -----------
Net cash used in financing activities                                        3                    27
                                                                  ------------           -----------
Net decrease in cash and cash equivalents                               (3,948)               (4,100)
Effect of exchange rate changes on cash                                     42                   (41)
Cash and cash equivalents at beginning of period                        34,506                42,774
                                                                  ------------           -----------
Cash and cash equivalents at end of period                        $     30,600           $    38,633
                                                                  ============           ===========
Supplemental disclosure of cash flow information:

Cash paid during the period for income taxes                      $         --           $        --
                                                                  ============           ===========
Cash paid during the period for interest                          $         --           $        --
                                                                  ============           ===========
</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 for NEON
Systems, Inc. and its subsidiaries (collectively, "NEON") have been prepared in
accordance with accounting principles generally accepted in the United States of
America for interim financial reporting and in accordance with Regulation S-X of
the Securities and Exchange Commission. Accordingly, they do not include all of
the information and footnotes required by accounting principles generally
accepted in the United States of America for complete financial statements. In
the opinion of management, the unaudited consolidated financial statements
contained in this report reflect all adjustments, consisting of only normal
recurring adjustments, considered necessary for a fair presentation of the
financial position and the results of operations for the interim periods
presented. Operating results for interim periods are not necessarily indicative
of results for the full year. These unaudited consolidated financial statements,
footnote disclosures and other information should be read in conjunction with
the financial statements and the notes thereto included in NEON's audited
financial statements for the fiscal year ended March 31, 2002 which are included
in NEON's Form 10-K for the fiscal year ended March 31, 2002.

NOTE 2--PER SHARE INFORMATION

    In calculating earnings per share information, NEON follows the provisions
of Statement of Financial Accounting Standards ("SFAS") No. 128, Earnings Per
Share. Basic loss per share is computed by dividing net loss applicable to
common stockholders by the weighted average number of shares of common stock
outstanding during the period. Diluted net loss per share is computed by
dividing net 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:

                                              THREE MONTHS ENDED JUNE 30,
                                             ----------------------------
                                               2002               2001
                                             --------          ----------
 Net income (loss)                           $(3,591)           $(2,410)
                                             =======            =======
  Weighted average number of common shares
  outstanding during the period:
 Basic                                         8,682              9,525
 Dilutive stock options                           --                 --
                                             -------            -------
 Diluted                                       8,682              9,525
                                             =======            =======
 Income (loss) per common share:
   Basic                                     $ (0.41)           $ (0.25)
                                             =======            =======
   Diluted                                   $ (0.41)           $ (0.25)
                                             =======            =======

    In the period April 1, 2002 through June 30, 2002 options to purchase 16,374
shares of common stock at an exercise price of $0.20 per share were exercised.
At June 30, 2002, there were options outstanding to purchase 2,634,580 shares of
common stock with a weighted-average exercise price of $8.53. These options were
excluded from the calculation of diluted loss per share for the three months
ended June 30, 2002, as they were anti-dilutive.

NOTE 3--INCOME TAXES

    NEON has a net operating loss carry-forward for income tax purposes of
approximately $7.2 million that is available to offset future taxable income, if
any. The net operating loss carry-forwards in the United Kingdom, Germany and
Australia carry forward indefinitely. The net operating loss carry-forward for
the United States begins expiring in the tax year 2020. Given the recent tax
losses experienced by NEON, there can be no assurance that the operations will
generate taxable income in the

                                       6


<PAGE>


future to utilize these losses, therefore, as of June 30, 2002, NEON has
recorded a full valuation allowance for the deferred tax assets related to the
future benefits, if any, for these loss caryforwards.

NOTE 4--SEGMENT REPORTING

    NEON considers its business activities to be in a single segment. During the
three-month period ended June 30, 2001, NEON had one customer that individually
accounted for 17% of total revenue. NEON did not have any customers that
individually accounted for more than 10% of total revenue during the three-month
period ended June 30, 2002.

    The table below summarizes revenues by geographic region.

                                             THREE MONTHS ENDED JUNE 30,
                                   -------------------------------------------
                                          2002                   2001
                                   -------------------    --------------------
    Revenues:
    North America                        $    3,853             $    5,541
    United Kingdom                              956                    452
    Other                                       313                    204
                                         ----------             ----------
                                         $    5,122             $    6,197
                                         ==========             ==========
     Operating Income (Loss):
       United States                     $   (2,265)            $   (2,062)
       United Kingdom                           268                   (592)
       Other                                     82                   (166)
                                         ----------             ----------
                                         $   (1,915)            $   (2,820)
                                         ==========             ==========

                                     June 30, 2002          March 31, 2002
                                   -------------------    --------------------
     Identifiable Assets:
        United States                    $   44,356             $   49,698
        United Kingdom                        2,657                  3,365
        Other                                 1,089                    537
                                         ----------             ----------
                                         $   48,102             $   53,600
                                         ==========             ==========

NOTE 5--CONTINGENCIES

    NEON is involved in various 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 6--RESTRUCTURING CHARGES

    During the year ended March 31, 2002, NEON recorded restructuring charges of
$908,000, which related to reductions in force and the abandonment of leased
facilities as a result of a corporate reorganization. These restructuring
expenses included severance costs of $570,000 and losses from lease commitments
of $338,000. As of March 31, 2002, NEON has paid all severance related
restructuring costs. In May, 2002, NEON subleased its previously abandoned
leased facilities. As a result, NEON reduced its previously recorded
restructuring charges by $138,000 during the three-months ended June 30, 2002.
As of June 30, 2002, cumulative cash paid for leasing expenses totaled $114,000
and NEON included the remaining net lease liability of $86,000 in accrued
liabilities.

NOTE 7 --RELATED PARTY TRANSACTIONS

    Members of NEON's Board of Directors and certain executive officers of NEON
are shareholders and/or directors in other companies with which NEON has
business relationships. Transactions between NEON and these other companies are
described below.

                                       7


<PAGE>

Peregrine/Bridge Transfer Corporation

     NEON entered into a distribution agreement with Peregrine/Bridge Transfer
Corporation ("PBTC"), a database software company, in January 1996. In December
1998, NEON amended its distribution agreement with Peregrine/Bridge Transfer
Corporation under which PBTC granted NEON an exclusive, worldwide license to
market and sublicense PBTC's only products, its Enterprise Subsystem Management
products. The amended distribution agreement has an initial term through March
31, 2004. The agreement also 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 PBTC 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 PBTC products. NEON incurred royalty expense of $172,000 and
$94,000 for the three months ended June 30, 2002 and 2001, respectively to PBTC.

     The amended distribution agreement also provides that PBTC will reimburse
NEON for the amount of unearned royalty advances when the agreement terminates
in 2004. The balance of the unearned advance payments was $3.0 million at June
30, 2002, an increase of $822,000 from March 31, 2002. Management believes that
while the current and reasonably foreseeable business prospects for revenue
received by NEON from licenses and maintenance for PBTC products are expected to
be sufficient to offset the unearned advance payments as of June 30, 2002, these
revenues may not be sufficient to meet the aggregate future minimum royalties to
be paid by NEON to PBTC. As a result, the balance of unearned advance payments
may increase substantially by the time the distribution agreement terminates.
PBTC's sole source of income is the royalty payments made by NEON and PBTC has a
substantial negative net worth. As a result, PBTC may be unable to repay any
unearned advances at the termination of the agreement in 2004.

     NEON also has a services agreement with PBTC pursuant to which PBTC
reimburses NEON for PBTC's share of the general and administrative expenses
supplied to it by NEON. Such amounts are presented as a reduction of general and
administrative expenses in the accompanying consolidated financial statements.
NEON revised the services agreement with PBTC in October 2001, as a result of
which PBTC's monthly payment to NEON declined from $30,000 per month to $5,000
per month and NEON's services were reduced.

     On July 2, 2002, the independent directors of NEON authorized the officers
of NEON to review the distributor relationship with PBTC and to negotiate a
termination of the distribution relationship. On July 24, 2002, the independent
directors of NEON approved a letter of intent with proposed terms for a
termination of the distribution agreement, which letter of intent was executed
by PBTC and NEON on such date.

     Pursuant to the provisions of the letter of intent and after the review and
approval of the independent directors of NEON and the ratification by the full
Board of Directors on August 12, 2002, NEON and PBTC entered into a Termination
and Customer Support Agreement dated August 14, 2002 pursuant to which the
distribution agreement, the Services Agreement, and all other agreements between
NEON and PBTC were terminated effective as of August 1, 2002.

     Upon the closing of the Termination and Customer Support Agreement on
August 14, 2002, PBTC's right to receive from NEON, and NEON's corresponding
obligation to pay to PBTC, the advance royalty payments described in the
distribution agreement terminated. Additionally, NEON's option to purchase PBTC
and right of first refusal under the distribution agreement also terminated. The
Termination and Customer Support Agreement also provided that the outstanding
unearned royalty advance of $3,884,028 as of July 31, 2002 was converted into
(i) a $3.0 million dollar convertible promissory note payable to NEON bearing no
interest to its due date of March 31, 2005 which promissory note is secured by
all of the intellectual property of PBTC ("PBTC IP") and (ii) the remaining
balance of $884,028 was consolidated into a second loan as described below. The
$3.0 million convertible note is convertible by NEON, in its discretion, into
equity in PBTC at an agreed pre-cash valuation of PBTC of $30.0 million dollars.
Such conversion right will expire on the due date of the $3.0 million
convertible note.

     Pursuant to the terms of the Termination and Customer Support Agreement and
in consideration of NEON's assignment to PBTC of license and maintenance
agreements related to the PBTC software products, NEON's grant to PBTC of a
license to use the "NEON" trademark in connection with the marketing of the PBTC
software products, and NEON's agreement to provide PBTC with certain
administrative services, PBTC agreed to pay to NEON $500,000, which amount was
consolidated in the consolidated promissory note described below.

                                       8

<PAGE>

     The Termination and Customer Support Agreement provides that, in
consideration of PBTC's consent to terminate its existing agreements with NEON,
NEON paid PBTC a final cash advance of $2.2 million, which amount will be
consolidated with the $884,028 remaining balance of the outstanding unearned
royalty advance under the distribution agreement and the $500,000 payment with
respect to the transfer of rights described above and represented by the
consolidated promissory note payable to NEON in the aggregate principal amount
of $3,584,028, bearing no interest to its due date of March 31, 2005. This
consolidated promissory note is also secured by the PBTC IP. NEON does not
expect to recognize any gain or loss in its consolidated financial statements
for the three months ended September 30, 2002, as a result of this transaction.

     Pursuant to the Termination and Customer Support Agreement and an
assignment agreement executed in connection with the closing of the Termination
and Customer Support Agreement and effective as of August 1, 2002, PBTC was
assigned all of NEON's rights and obligations under any customer license and
maintenance agreements related to the PBTC software products previously marketed
by NEON, including customer support obligations. In addition, the terms of the
Termination and Customer Support Agreement provide that PBTC will offer
employment to certain sales and support personnel of NEON that are assigned to
market and support the PBTC software products. The Termination and Customer
Support Agreement also contemplated the resignation of Wayne E. Webb Jr. as
Senior Vice President and General Counsel of NEON, effective as of August 1,
2002, to focus on his role as President and CEO of PBTC.

     At the closing of the Termination and Customer Support Agreement,
Skunkware, Inc., PBTC's sole stockholder, entered into a Subordination Agreement
whereby all of the promissory notes described above from PBTC to NEON were made
senior in priority to all other indebtedness from PBTC to Skunkware. Pursuant to
the terms of the convertible promissory note and the consolidated promissory
note, PBTC has agreed to preserve and maintain the senior status of its
indebtedness to NEON and pursuant to the Security Agreement agreed to not issue
any additional debt unless such debt does not encumber the PBTC IP.

     In further consideration of PBTC entering into the Termination and Customer
Support Agreement, NEON agreed to provide PBTC with administrative, accounting
and legal services pursuant to the terms of a new services agreement. Such
services will be provided by NEON at no cost to PBTC, other than reimbursement
of reasonable business expenses, for the initial twelve-month period beginning
August 1, 2002. After the initial twelve-month period of the services agreement,
PBTC may elect to receive the services, at its option, for up to an additional
twelve months for a fee of $10,000 per month, plus reimbursement of reasonable
business expenses. At the end of such additional term, or in the event PBTC does
not elect to continue receiving the services described above for the additional
term, at the end of the initial term, NEON shall have no further obligations
under the services agreement.

    Additionally, in connection with the closing of the Termination and Customer
Support Agreement on August 14, 2002, NEON and PBTC entered into a license and
distribution Agreement whereby PBTC agreed to market and distribute NEON's 24x7
software product. The NEON 24x7 software product was developed by PBTC as an OEM
software product using the Shadow source and object code under a remarketing
agreement dated January 25, 2000. This remarketing agreement provided that NEON
would distribute the NEON 24x7 software product under the terms of the
distribution agreement.

     Additionally, in connection with the closing of the Termination and
Customer Support Agreement on August 14, 2002, NEON and PBTC entered into a
trademark license agreement granting PBTC a license to use the "NEON(R)"
registered trademark in its marketing of the NEON 24x7 and the PBTC software
products. Under the terms of this agreement, NEON granted PBTC the option to
acquire the "NEON(R)" trademarks in the event that NEON discontinues its use of
such marks.

     NEON interlocks with Peregrine/Bridge Transfer Corporation. John J. Moores,
Charles E. Noell, III and Norris van den Berg, directors of NEON, also serve as
directors of PBTC. Wayne E. Webb, Jr., Senior Vice President and General Counsel
of NEON, served as the Vice President and General Counsel of PBTC until February
of 2002, when he was appointed its President and CEO. On June 1, 2001, Mr. Webb
was appointed President and Chief Executive Officer of NEON Systems, Inc., an
office he held until Mr. Louis Woodhill assumed those positions on October 15,
2001. On August 1, 2002 and in connection with the closing of the Termination
and Customer Support Agreement described above, Mr. Webb resigned from his
position as Senior Vice President and General Counsel of NEON. Through his
interest in Skunkware, Inc., John J. Moores, Chairman of the NEON Board of
Directors, beneficially owns approximately 90% of PBTC. Through their interests
in Skunkware, Inc., each of Messrs. Noell, van den Berg and Webb beneficially
own approximately 1% of PBTC. Additionally, Messrs. Noell, Moores and van den
Berg serve as directors of Skunkware, Inc.

Scalable Software, Inc.

     Scalable Software, Inc., a Houston-based provider of software solutions for
IT portfolio management, is a company founded by Louis R. Woodhill, NEON's Chief
Executive Officer. Several members of NEON's Board of Directors, including Louis
R.

                                       9

<PAGE>


    Woodhill, have a financial interest in Scalable Software. The percentage
beneficial ownership of the NEON directors and executive officers that have a
financial interest in Scalable Software is set forth below:

                                                Ownership
                  Name                          Percentage
                  ----                          ----------
    Jim Woodhill                                   24.3%
    John J. Moores (and affilitates)               23.8%
    Louis R. Woodhill                              16.7%
    Charles E. Noell (and affilitates)             15.1%
    Peter Schaeffer                                 1.5%
                                                   -----
       Total                                       81.4%
                                                   =====

    On July 17, 2001, NEON announced that it had entered into a letter of intent
to acquire Scalable Software, Inc. Louis R. Woodhill, is also a director, and
the President and Chief Executive Officer of Scalable Software. In connection
with the letter of intent, NEON and Scalable Software entered into a Promissory
Note dated July 17, 2001, which provided bridge financing to Scalable in a
maximum amount of $3.0 million with a maturity date of December 31, 2001,
secured by the personal guarantees of John J. Moores, Louis R. Woodhill and Jim
Woodhill. On November 13, 2001, the promissory note was amended to increase the
maximum lending limit to $3.5 million with an original maturity date of March
31, 2002, with such increased amount also being guaranteed by Messrs. Moores,
Woodhill and Woodhill.

    Due to the interests in Scalable Software of several members of NEON's Board
of Directors, the Board of Directors concluded that it would be appropriate to
create a Special Committee comprised solely of directors who had no interest in
Scalable Software to review the terms of the proposed acquisition. After
thorough consideration and discussion by the Special Committee and its advisors,
the Special Committee proposed that the payment of the consideration for the
proposed acquisition be structured as an earn out, in which the NEON stock to be
used as consideration would be placed in escrow subject to release to the
Scalable Software shareholders upon Scalable Software's attainment of specified
revenue and profitability goals. This proposal was unacceptable to Scalable
Software's management and its Board of Directors and was rejected. The status of
the proposed acquisition was then discussed at a special meeting of NEON's Board
of Directors in December 2001. After thorough consideration and discussion and
upon endorsement by the Special Committee, NEON's Board of Directors approved
modifications to the proposed terms and conditions for the acquisition such that
the transaction would be structured as an option to acquire Scalable Software as
discussed below. In addition, NEON also announced on December 21, 2001, that
Louis R. Woodhill, its President and Chief Executive Officer, and Jim Woodhill
had been appointed to the Board of Directors of NEON. As of June 2002, Louis R.
Woodhill and Jim Woodhill's status as Scalable Software shareholders, directors
and officers remains unchanged.

    NEON has obtained a two-year option to acquire Scalable Software as outlined
in the Agreement and Plan of Merger dated June 26, 2002. In connection with this
Option, NEON agreed to provide bridge financing of up to $5.5 million, in
addition to the $3.5 million previously loaned to Scalable Software that is
secured by personal guarantees from John J. Moores, Louis R. Woodhill and Jim
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 J. Moores,
Louis R. Woodhill and Jim Woodhill for the initial $3.5 million loaned to
Scalable Software, the $5.5 million loan will be secured by all of the
intellectual property rights of Scalable Software. NEON may exercise the option
to acquire Scalable Software at any time during the two-year term, subject to
provisions that require NEON to exercise its option within a 30-day window under
certain circumstances or forfeit the option. If NEON exercises the option and
acquires Scalable Software, each of the approximately 19,400,000 outstanding
shares of common stock of Scalable Software will be converted into approximately
0.135 of a share of NEON common stock and outstanding options and warrants to
purchase approximately 3,000,000 shares of common stock of Scalable Software
will become options and warrants to purchase common stock of NEON on the same
conversion basis. If Scalable Software incurs more indebtedness for borrowed
money or issues more equity, the exchange ratio will be reduced. Prior to NEON
exercising the option to acquire Scalable Software, a Special Committee would be
appointed to review the negotiated terms of the proposed acquisition and NEON
would seek to obtain a fairness opinion regarding the transaction from a
financial advisory firm. The acquisition of Scalable Software will also require
approval of the stockholders of NEON and the NEON Board of Directors.

    Scalable Software may exhaust its line of credit from NEON before it is able
to generate cash from operations sufficient to sustain its operations. In that
event, and if Scalable Software is unable to secure additional financing, it
could become the


                                       10

<PAGE>

subject of bankruptcy proceedings. If Scalable Software is subject to bankruptcy
proceedings, it is possible that the security interests held by NEON in the
intellectual property of Scalable Software could be set aside, and NEON could be
an unsecured creditor with respect to the $5.5 million loan.

     As noted above, certain member's of NEON's board of directors and executive
officers also serve as directors and executive officers of Scalable Software and
claim beneficial ownership of approximately 81% of Scalable's common stock. In
addition, NEON has an option to acquire all of the outstanding shares of
Scalable Software and is currently providing Scalable's primary financing for
its operations. Therefore, NEON recognizes 100% of Scalable Software's losses to
the extent of advances made in excess of the guaranteed amount. At June 30,
2002, NEON had made total advances of $7.4 million to Scalable Software
(including $3.9 million of unguaranteed advances) and recognized cumulative
losses of $3.3 million. Due to the uncertainities regarding NEON's ultimate
ability to recover any unguaranteed advances to Scalable Software, NEON will not
record the carrying value of its net advance to Scalable Software in excess of
the guaranteed amount. Accordingly, for the three months ended June 30, 2002,
NEON recorded a valuation allowance of $573,000 against the Scalable note
receivable.

Sheer Genius Software, Inc.

    On January 3, 2002, NEON entered into a services agreement with Sheer Genius
Software, Inc. of Austin, Texas, a company owned by Jim Woodhill. Also, JMI
Services, Inc., a private company owned by John J. Moores, NEON's Chairman, is a
creditor of Sheer Genius, holding a promissory note dated August 31, 2001 in the
amount of $200,000. 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 initial project
description was six months and the maximum aggregate fees were $480,000. This
agreement was recently amended to extend the contract period for an additional
three months with additional maximum aggregate fees of $300,000. While NEON is
currently Sheer Genius' sole source of income, it is free to solicit other
customers. 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. 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.

NOTE 8 - IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS

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

    SFAS No. 142 required NEON to perform a transitional goodwill impairment
evaluation as of the date of adoption. To accomplish this, NEON identified its
reporting units and determined 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 April 1, 2002. NEON has until
September 30, 2002 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 NEON must perform the second step
of the transitional impairment test. In the second step, NEON must compare the
implied fair value of the reporting unit's goodwill, determined by allocating
the reporting unit's fair value to all of it 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 March 31, 2003. Any
transitional impairment loss will be recognized as the cumulative effect of a
change in accounting principle in NEON's statement of earnings.

    As of June 30, 2002, NEON had unamortized goodwill in the amount of
$1,193,000 subject to the transition provisions of SFAS Nos. 141 and 142. The
adoption of the SFAS No. 142 resulted in the elimination of approximately
$480,000 of goodwill amortization, annually, subsequent to March 31, 2002.
Amortization expense related to goodwill for the three months ended June 30,
2001 was $120,000. Due to the extensive effort needed to comply with adopting
SFAS No. 142, it is not practical to


                                       11

<PAGE>


reasonably estimate whether any transitional impairment losses will be required
to be recognized as the cumulative effect of a change in accounting principle
and the impact on NEON's financial statements at the date of this report.


                                       12

<PAGE>

The pro forma effects of the adoption of SFAS 142 on net loss and loss per share
for NEON for the three months ended June 30, 2001 is as follows:

                                                       THREE MONTHS ENDED
                                                         JUNE 30, 2001
                                                       ------------------
    Net loss as reported                                     $   (2,410)
    Add back: Amortization of goodwill                              120
                                                             ----------
          Adjusted loss income                               $   (2,290)
                                                             ==========
    Basic and diluted loss per share, as reported            $    (0.25)
    Add back: Amortization of goodwill                             0.01
                                                             ----------
       Pro forma loss per share                              $    (0.24)
                                                             ==========


     NEON adopted SFAS No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets," effective April 1, 2002. 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
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 adoption of SFAS No. 144 did
not have a material impact of NEON's consolidated financial statements.

     In April 2002, the FASB issued SFAS No. 145 "Rescission of FASB Statements
No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections." SFAS No. 145 rescinds FASB Statement No. 4, "Reporting Gains and
Losses from Extinguishment of Debt," and an amendment of that Statement, FASB
Statement No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund
Requirements." SFAS No. 145 also rescinds FASB Statement No. 44, "Accounting for
Intangible Assets of Motor Carriers" and amends FASB Statement No. 13,
"Accounting for Leases." SFAS No. 145 also amends other existing authoritative
pronouncements to make various technical corrections, clarify meanings, or
describe their applicability under changed conditions. SFAS No. 145 will be
effective for fiscal years beginning after May 15, 2002. NEON does not
anticipate that the adoption of SFAS No. 145 will have a material impact of
NEON's consolidated financial statements.

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

ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS
        OF OPERATIONS

    The following discussion and analysis should be read in conjunction with
NEON's consolidated financial statements and the related notes thereto included
in this report on Form 10-Q. The discussion and analysis contains
forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These
statements are based on our current expectations and entail various risks and
uncertainties such as our plans, objectives, expectations and intentions. Our
actual results could differ materially from those projected in the
forward-looking statements as a result of various factors, including those set
forth below in Part II, Item 5 under "Factors that May Affect Future Results."


                                       13

<PAGE>

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 Systems, Inc. and its subsidiaries (collectively, "NEON") develops,
markets and supports software products for the IBM mainframe platform. NEON's
primary product group, the Shadow branded products, provide access and
integration of IBM mainframe data and applications from standard application
client environments, including the Internet and client/server systems. In
addition, NEON markets and supports NEON branded products that provide enhanced
availability, recoverability and control for the IBM IMS database management
system and allows more rapid deployment of CICS applications in the IBM CICSPlex
environment. NEON's iWave branded products integrate helpdesk, network
management, database management and systems management applications across
mainframe and distributed systems environments. The sales mix between NEON's
various product lines may vary significantly from period to period. NEON was
incorporated in May 1993 and is a successor by merger to NEON Systems, Inc., an
Illinois corporation, which was incorporated in June 1991.

    NEON derives revenue from software licenses and maintenance services.
Historically, NEON's 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 upon 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. During the three-month
period ended June 30, 2002, NEON did not have any customers that individually
accounted more than 10% of total revenue. During the three-month period ended
June 30, 2001 NEON had one customer that accounted for 17% of total revenue.

    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 annual revenue to
generate operating profits. There can be no assurance in future quarters that we
will achieve or sustain revenue growth and/or return to profitability. As a
result, management believes that its cash resources may decline as a result of
continuing losses from operations, the advance royalty payments made to PBTC and
incremental costs associated with the acquisition and operation of Scalable
Software. See "Related Party Transactions" below and in Note 7 to NEON's
financial statements.

    NEON conducts its business in the United Kingdom and Germany through two
wholly owned consolidated subsidiaries. Revenues from these subsidiaries are
denominated in local currencies. In connection with these foreign operations,
NEON is exposed to foreign currency fluctuations for its net working capital
positions. At that date, NEON had no material commitments that would be
satisfied in currencies other than U.S. dollars. In other international markets,
NEON conducts substantially all of its business through independent third-party
distributors. Revenues derived from third-party distributors are denominated in
U.S. dollars. Revenues recognized from sales to customers outside North America,
primarily in Europe, represented approximately 25% and 11% for the three months
ended June 30, 2002 and 2001, respectively. Foreign currency fluctuations have
not had a significant impact on NEON's revenues or operating results. Management
does not currently have an active foreign exchange hedging program; however,
NEON may implement a program to mitigate foreign currency transaction risk in
the future.

    In view of the rapidly changing nature of our business and the current
weakness in the mainframe software market, 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.

Related Party Transactions

     Members of NEON's Board of Directors and certain executive officers of NEON
are shareholders and/or directors in other companies with which NEON has
business relationships. See "Risk Factors - Some Members of Our Board of
Directors and


                                       14

<PAGE>

    Management May have Conflicts of Interest and/or Are Interested Parties to
Certain Transactions of NEON." Transactions between NEON and these other
companies are described below.

Peregrine/Bridge Transfer Corporation

     NEON entered into a distribution agreement with Peregrine/Bridge Transfer
Corporation ("PBTC"), a database software company, in January 1996. In December
1998, NEON amended its distribution agreement with Peregrine/Bridge Transfer
Corporation under which PBTC granted NEON an exclusive, worldwide license to
market and sublicense PBTC's only products, its Enterprise Subsystem Management
products. The amended distribution agreement has an initial term through March
31, 2004. The agreement also 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 PBTC 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 PBTC products. NEON incurred royalty expense of $172,000 and
$94,000 for the three months ended June 30, 2002 and 2001, respectively to PBTC.

     The amended distribution agreement also provides that PBTC will reimburse
NEON for the amount of unearned royalty advances when the agreement terminates
in 2004. The balance of the unearned advance payments was $3.0 million at June
30, 2002, an increase of $822,000 from March 31, 2002. Management believes that
while the current and reasonably foreseeable business prospects for revenue
received by NEON from licenses and maintenance for PBTC products are expected to
be sufficient to offset the unearned advance payments as of June 30, 2002, these
revenues may not be sufficient to meet the aggregate future minimum royalties to
be paid by NEON to PBTC. As a result, the balance of unearned advance payments
may increase substantially by the time the distribution agreement terminates.
PBTC's sole source of income is the royalty payments made by NEON and PBTC has a
substantial negative net worth. As a result, PBTC may be unable to repay any
unearned advances at the termination of the agreement in 2004.

     NEON also has a services agreement with PBTC pursuant to which PBTC
reimburses NEON for PBTC's share of the general and administrative expenses
supplied to it by NEON. Such amounts are presented as a reduction of general and
administrative expenses in the accompanying consolidated financial statements.
NEON revised the services agreement with PBTC in October 2001, as a result of
which PBTC's monthly payment to NEON declined from $30,000 per month to $5,000
per month and NEON's services were reduced.

     On July 2, 2002, the independent directors of NEON authorized the officers
of NEON to review the distributor relationship with PBTC and to negotiate a
termination of the distribution relationship. On July 24, 2002, the independent
directors of NEON approved a letter of intent with proposed terms for a
termination of the distribution agreement, which letter of intent was executed
by PBTC and NEON on such date.

     Pursuant to the provisions of the letter of intent and after the review and
approval of the independent directors of NEON and the ratification by the full
Board of Directors on August 12, 2002, NEON and PBTC entered into a Termination
and Customer Support Agreement dated August 14, 2002 pursuant to which the
distribution agreement, the Services Agreement, and all other agreements between
NEON and PBTC were terminated effective as of August 1, 2002 consolidated in the
consolidated promissory note described below.

     Upon the closing of the Termination and Customer Support Agreement on
August 14, 2002, PBTC's right to receive from NEON, and NEON's corresponding
obligation to pay to PBTC, the advance royalty payments described in the
distribution agreement terminated. Additionally, NEON's option to purchase PBTC
and right of first refusal under the distribution agreement also terminated. The
Termination and Customer Support Agreement also provided that the outstanding
unearned royalty advance of $3,884,028 as of July 31, 2002 was converted into
(i) a $3.0 million dollar convertible promissory note payable to NEON bearing no
interest to its due date of March 31, 2005 which promissory note is secured by
all of the intellectual property of PBTC ("PBTC IP") and (ii) the remaining
balance of $884,028 was consolidated into a second loan as described below. The
$3.0 million convertible note is convertible by NEON, in its discretion, into
equity in PBTC at an agreed pre-cash valuation of PBTC of $30.0 million dollars.
Such conversion right will expire on the due date of the $3.0 million
convertible note.
                                       15

<PAGE>


     The Termination and Customer Support Agreement provides that, in
consideration of PBTC's consent to terminate its existing agreements with NEON,
NEON paid PBTC a final cash advance of $2.2 million, which amount will be
consolidated with the $884,028 remaining balance of the outstanding unearned
royalty advance under the distribution agreement and the $500,000 payment with
respect to the transfer of rights described above and represented by the
consolidated promissory note payable to NEON in the aggregate principal amount
of $3,584,028, bearing no interest to its due date of March 31, 2005. This
consolidated promissory note is also secured by the PBTC IP. NEON does not
expect to recognize any gain or loss in its consolidated financial statements
for the three months ended September 30, 2002, as a result of this transaction.

     Pursuant to the Termination and Customer Support Agreement and an
assignment agreement executed in connection with the closing of the Termination
and Customer Support Agreement and effective as of August 1, 2002, PBTC was
assigned all of NEON's rights and obligations under any customer license and
maintenance agreements related to the PBTC software products previously marketed
by NEON, including customer support obligations. In addition, the terms of the
Termination and Customer Support Agreement provide that PBTC will offer
employment to certain sales and support personnel of NEON that are assigned to
market and support the PBTC software products. The Termination and Customer
Support Agreement also contemplated the resignation of Wayne E. Webb Jr. as
Senior Vice President and General Counsel of NEON, effective as of August 1,
2002, to focus on his role as President and CEO of PBTC.

     At the closing of the Termination and Customer Support Agreement,
Skunkware, Inc., PBTC's sole stockholder, entered into a Subordination Agreement
whereby all of the promissory notes described above from PBTC to NEON were made
senior in priority to all other indebtedness from PBTC to Skunkware. Pursuant to
the terms of the convertible promissory note and the consolidated promissory
note, PBTC has agreed to preserve and maintain the senior status of its
indebtedness to NEON and pursuant to the Security Agreement agreed to not issue
any additional debt unless such debt does not encumber the PBTC IP.

     In further consideration of PBTC entering into the Termination and Customer
Support Agreement, NEON agreed to provide PBTC with administrative, accounting
and legal services pursuant to the terms of a new services agreement. Such
services will be provided by NEON at no cost to PBTC, other than reimbursement
of reasonable business expenses, for the initial twelve-month period beginning
August 1, 2002. After the initial twelve-month period of the services agreement,
PBTC may elect to receive the services, at its option, for up to an additional
twelve months for a fee of $10,000 per month, plus reimbursement of reasonable
business expenses. At the end of such additional term, or in the event PBTC does
not elect to continue receiving the services described above for the additional
term, at the end of the initial term, NEON shall have no further obligations
under the services agreement.

    Additionally, in connection with the closing of the Termination and Customer
Support Agreement on August 14, 2002, NEON and PBTC entered into a license and
distribution Agreement whereby PBTC agreed to market and distribute NEON's 24x7
software product. The NEON 24x7 software product was developed by PBTC as an OEM
software product using the Shadow source and object code under a remarketing
agreement dated January 25, 2000. This remarketing agreement provided that NEON
would distribute the NEON 24x7 software product under the terms of the
distribution agreement.

     Additionally, in connection with the closing of the Termination and
Customer Support Agreement on August 14, 2002, NEON and PBTC entered into a
trademark license agreement granting PBTC a license to use the "NEON(R)"
registered trademark in its marketing of the NEON 24x7 and the PBTC software
products. Under the terms of this agreement, NEON granted PBTC the option to
acquire the "NEON(R)" trademarks in the event that NEON discontinues its use of
such marks.

     NEON interlocks with Peregrine/Bridge Transfer Corporation. John J. Moores,
Charles E. Noell, III and Norris van den Berg, directors of NEON, also serve as
directors of PBTC. Wayne E. Webb, Jr., Senior Vice President and General Counsel
of NEON, served as the Vice President and General Counsel of PBTC until February
of 2002, when he was appointed its President and CEO. On June 1, 2001, Mr. Webb
was appointed President and Chief Executive Officer of NEON Systems, Inc., an
office he held until Mr. Louis Woodhill assumed those positions on October 15,
2001. On August 1, 2002 and in connection with the closing of the Termination
and Customer Support Agreement described above, Mr. Webb resigned from his
position as Senior Vice President and General Counsel of NEON. Through his
interest in Skunkware, Inc., John J. Moores, Chairman of the NEON Board of
Directors, beneficially owns approximately 90% of PBTC. Through their interests
in Skunkware, Inc., each of Messrs. Noell, van den Berg and Webb beneficially
own approximately 1% of PBTC. Additionally, Messrs. Noell, Moores and van den
Berg serve as directors of Skunkware, Inc.


                                       16

<PAGE>

Scalable Software, Inc.

    Scalable Software, Inc., a Houston-based provider of software solutions for
IT portfolio management, is a company founded by Louis R. Woodhill, NEON's Chief
Executive Officer. Several members of NEON's Board of Directors, including Louis
R. Woodhill, have a financial interest in Scalable Software. The percentage
beneficial ownership of the NEON directors and executive officers that have a
financial interest in Scalable Software is set forth below:

                                                            Ownership
                               Name                         Percentage
                               ----                         ----------
                 Jim Woodhill                                  24.3%
                 John J. Moores (and affilitates)              23.8%
                 Louis R. Woodhill                             16.7%
                 Charles E. Noell (and affilitates)            15.1%
                 Peter Schaeffer                                1.5%
                                                               -----
                    Total                                      81.4%
                                                               =====

    On July 17, 2001, NEON announced that it had entered into a letter of intent
to acquire Scalable Software, Inc. Louis R. Woodhill, is also a director, and
the President and Chief Executive Officer of Scalable Software. In connection
with the letter of intent, NEON and Scalable Software entered into a Promissory
Note dated July 17, 2001, which provided bridge financing to Scalable in a
maximum amount of $3.0 million with a maturity date of December 31, 2001,
secured by the personal guarantees of John J. Moores, Louis R. Woodhill and Jim
Woodhill. On November 13, 2001, the promissory note was amended to increase the
maximum lending limit to $3.5 million with an original maturity date of March
31, 2002, with such increased amount also being guaranteed by Messrs. Moores,
Woodhill and Woodhill.

    Due to the interests in Scalable Software of several members of NEON's Board
of Directors, the Board of Directors concluded that it would be appropriate to
create a Special Committee comprised solely of directors who had no interest in
Scalable Software to review the terms of the proposed acquisition. After
thorough consideration and discussion by the Special Committee and its advisors,
the Special Committee proposed that the payment of the consideration for the
proposed acquisition be structured as an earn out, in which the NEON stock to be
used as consideration would be placed in escrow subject to release to the
Scalable Software shareholders upon Scalable Software's attainment of specified
revenue and profitability goals. This proposal was unacceptable to Scalable
Software's management and its Board of Directors and was rejected. The status of
the proposed acquisition was then discussed at a special meeting of NEON's Board
of Directors in December 2001. After thorough consideration and discussion and
upon endorsement by the Special Committee, NEON's Board of Directors approved
modifications to the proposed terms and conditions for the acquisition such that
the transaction would be structured as an option to acquire Scalable Software as
discussed below. In addition, NEON also announced on December 21, 2001, that
Louis R. Woodhill, its President and Chief Executive Officer, and Jim Woodhill
had been appointed to the Board of Directors of NEON. As of June 2002, Louis R.
Woodhill and Jim Woodhill's status as Scalable Software shareholders, directors
and officers remains unchanged.

    NEON has obtained a two-year option to acquire Scalable Software as outlined
in the Agreement and Plan of Merger dated June 26, 2002. In connection with this
Option, NEON agreed to provide bridge financing of up to $5.5 million, in
addition to the $3.5 million previously loaned to Scalable Software that is
secured by personal guarantees from John J. Moores, Louis R. Woodhill and Jim
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 J. Moores,
Louis R. Woodhill and Jim Woodhill for the initial $3.5 million loaned to
Scalable Software, the $5.5 million loan will be secured by all of the
intellectual property rights of Scalable Software. NEON may exercise the option
to acquire Scalable Software at any time during the two-year term, subject to
provisions that require NEON to exercise its option within a 30-day window under
certain circumstances or forfeit the option. If NEON exercises the option and
acquires Scalable Software, each of the approximately 19,400,000 outstanding
shares of common stock of Scalable Software will be converted into approximately
0.135 of a share of NEON common stock and outstanding options and warrants to
purchase approximately 3,000,000 shares of common stock of Scalable Software
will become options and warrants to purchase common stock of NEON on the same
conversion basis. If Scalable Software incurs more indebtedness for borrowed
money or issues more equity, the exchange ratio will be reduced. Prior to NEON
exercising the option to acquire Scalable Software, a Special Committee would be
appointed to review the negotiated terms of the proposed acquisition and NEON
would seek to obtain a fairness opinion regarding the transaction from a
financial advisory firm. The acquisition of Scalable Software will also require
approval of the stockholders of NEON and the NEON Board of Directors.


                                       17

<PAGE>

    Scalable Software may exhaust its line of credit from NEON before it is able
to generate cash from operations sufficient to sustain its operations. In that
event, and if Scalable Software is unable to secure additional financing, it
could become the subject of bankruptcy proceedings. If Scalable Software is
subject to bankruptcy proceedings, it is possible that the security interests
held by NEON in the intellectual property of Scalable Software could be set
aside, and NEON could be an unsecured creditor with respect to the $5.5 million
loan.

     As noted above, certain member's of NEON's board of directors and executive
officers also serve as directors and executive officers of Scalable Software and
claim beneficial ownership of approximately 81% of Scalable's common stock. In
addition, NEON has an option to acquire all of the outstanding shares of
Scalable Software and is currently providing Scalable's primary financing for
its operations. Therefore, NEON recognizes 100% of Scalable Software's losses to
the extent of advances made in excess of the guaranteed amount. At June 30,
2002, NEON had made total advances of $7.4 million to Scalable Software
(including $3.9 million of unguaranteed advances) and recognized cumulative
losses of $3.3 million. Due to the uncertainties regarding NEON's ultimate
ability to recover any unguaranteed advances to Scalable Software, NEON will not
record the carrying value of its net advance to Scalable Software in excess of
guaranteed amount. Accordingly, for the three months ended June 30, 2002, NEON
recorded a valuation allowance of $573,000 against the Scalable note receivable
to write-down the outstanding balance of the note to the guaranteed amount.

Sheer Genius Software, Inc.

    On January 3, 2002, NEON entered into a services agreement with Sheer Genius
Software, Inc. of Austin, Texas, a company owned by Jim Woodhill. Also, JMI
Services, Inc., a private company owned by John J. Moores, NEON's Chairman, is a
creditor of Sheer Genius, holding a promissory note dated August 31, 2001 in the
amount of $200,000. 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 initial project
description was six months and the maximum aggregate fees were $480,000. This
agreement was recently amended to extend the contract period for an additional
three months with additional maximum aggregate fees of $300,000. While NEON is
currently Sheer Genius' sole source of income, it is free to solicit other
customers. 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. 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.

Critical Accounting Policies

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

Revenue Recognition Policies

    Statement of Position 97-2, "Software Revenue Recognition" (SOP 97-2), was
issued in October 1997 by the American Institute of Certified Public Accountants
(AICPA) and was amended by Statement of Position 98-4 (SOP 98-4) and Statement
of Position 98-9 (SOP 98-9). NEON adopted SOP 97-2 effective July 1, 1997, SOP
98-4 effective March 31, 1998 and SOP 98-9 effective April 1, 1999. NEON
believes its current revenue recognition policies and practices are consistent
with SOP 97-2, SOP 98-4 and SOP 98-9. Revenues from software license sales are
recognized when all of the following conditions are met: a non-cancelable
license agreement has been 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 vendor-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


                                       18

<PAGE>

independent distributors and resellers. License and maintenance revenues from
these transactions are recognized when sold to the ultimate end user and all of
the above conditions are met.

Capitalized Software Costs

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

Allowance for Doubtful Accounts Receivable

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

Deferred Income Taxes

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

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

Accounting for Advances to Scalable Software

    As discussed more fully in "Related Party Transactions" above, certain
members of NEON's board of directors and executive officers also serve as
directors and executive officers of Scalable Software and claim beneficial
ownership of approximately 81% of Scalable's common stock. In addition, NEON has
an option to acquire all of the outstanding shares of Scalable Software and is
currently providing Scalable's primary financing for its operations. Therefore,
NEON determined that it has effective control of Scalable Software and began
accounting for its investment in Scalable Software using the modified equity
method of accounting. Under this method of accounting, NEON recognizes 100% of
Scalable Software's losses to the extent of its advances made to Scalable
Software in excess of the amounts guaranteed by Messrs. Moores, Woodhill and
Woodhill.

Advance Payments to PBTC

    As discussed more fully in "Related Party Transactions" above, as part of a
distribution agreement with PBTC, NEON makes advance royalty payments to PBTC.
PBTC earns such advance payments as NEON recognizes license and maintenance
revenues related to its distribution of the PBTC products. At the termination of
the agreement, PBTC is to reimburse NEON for any unearned royalty advances. In
determining whether the unearned advance payments to PBTC may be realized and
recovered, management considers the future revenue anticipated to be generated
from the license and maintenance of PBTC products, as well as PBTC's ability and
intent to reimburse any unearned royalty advances.


                                       19

<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:

                                         THREE MONTHS ENDED JUNE 30,
                                         ---------------------------
                                          2002                 2001
                                         -----                ------
Revenues:
   License                                 44%                  61%
   Maintenance                             56                   39
                                          ---                  ---
      Total revenues                      100                  100
Cost of revenues:
   Cost of licenses                        11                    8
   Cost of maintenance                     11                    9
                                          ---                  ---
      Total cost of revenues               22                   17
                                          ---                  ---
Gross profit                               78                   83
Operating expenses:
   Sales and marketing                     63                   66
   Research and development                31                   29
   General and administrative              24                   31
   Restructuring costs                     (3)                  --
   Amortization of goodwill                --                    2
                                          ---                  ---
      Total operating expenses            115                  128
                                          ---                  ---
Operating loss                            (37)                 (46)
Interest and other, net                     2                    7
Equity loss in affiliate                  (24)                  --
Valuation allowance on note receivable    (11)                  --
Loss before income taxes                  (70)                 (39)
                                          ---                  ---
Provision for income taxes                 --                   --
                                          ---                  ---
Net loss                                  (70)%                (39)%
                                          ===                  ===



                                       20

<PAGE>

THREE MONTHS ENDED JUNE 30, 2002 COMPARED TO THREE MONTHS ENDED JUNE 30, 2001

REVENUES

    License revenues for the three months ended June 30, 2002 were $2.2 million,
a decrease of $1.6 million from $3.8 million for the three months ended June 30,
2001. The reduction in license revenue was primarily due to the expiration of 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. NEON recognized $1.1 million in license revenue for the
three-month period ended June 30, 2001 under the agreement. The overall weakness
in the mainframe software market also contributed to the decline in license
revenues.

    Maintenance revenues for the three months ended June 30, 2002 were $2.9
million, an increase of $454,000 from $2.4 million for the three months ended
June 30, 2001. The increase primarily resulted from the growth of NEON's
cumulative installed customer base.

COST OF REVENUES

    Cost of license revenues primarily consists of royalty payments to third
parties, as well as other direct product costs such as product manuals and
distribution and media costs associated with NEON's software products. Cost of
license revenues for the three months ended June 30, 2002 were $549,000, or 24%
of license revenues, as compared to $499,000, or 13% of license revenues, for
the three months ended June 30, 2001. The increase in the cost of license
revenues as a percentage of license revenue was due to greater product royalty
payments to PBTC as the contribution of PBTC's Enterprise Subsystem Management
products increased in proportion to NEON's total license revenues.

    Cost of maintenance revenues includes personnel and other customer support
costs. Cost of maintenance revenues for the three months ended June 30, 2002
were $567,000, or 20% of maintenance revenues, as compared to $576,000, or 24%
of maintenance revenues, for the three months ended June 30, 2001. The reduction
in cost of maintenance revenue as a percentage of maintenance revenue was due to
the cumulative growth in NEON's customer base and annual increases in
maintenance fees.

OPERATING EXPENSES

    Sales and marketing expenses include personnel costs, sales commissions and
travel expenses of sales, presales support and marketing personnel, along with
trade show participation and other promotional expenses. Sales and marketing
expenses for the three months ended June 30, 2002 were $3.2 million, a decrease
of $868,000 from $4.1 million for the three months ended June 30, 2001. The
reduction was primarily due to lower personnel costs associated with a headcount
reduction during the three months ended June 30, 2001, combined with lower
promotional marketing costs, as NEON reduced the scope of its iWave product
operations and refocused its marketing efforts to emphasize its Shadow product
line. NEON expects sales and marketing expenses to increase as it continues to
expand its sales channel and global footprint.

    Research and development expenses primarily include personnel costs
associated with NEON's product development staff. Research and development
expenses for the three months ended June 30, 2002 were $1.6 million, a decrease
$204,000 from $1.8 million for the three months ended June 30, 2001. The
decrease was primarily attributed to the reduction in scope of NEON's iWave
product operations, which resulted in the closure of its North Carolina facility
in June 2001. This reduction was partially offset by $200,000 in contract
development fees paid to Sheer Genius Software, Inc., see "Related Party
Transactions." NEON expects research and development expenses to increase as it
continues to expand its existing product lines and develop new products.

    General and administrative expenses include personnel and other costs
associated with NEON's executive, financial, legal and administrative functions.
General and administrative expenses for the three months ended June 30, 2002
were $1.2 million, a decrease of $691,000 from $1.9 million for the three months
ended June 30, 2001. Excluding severance costs of $1.1 million related to the
departure of certain executives during the three months ended June 30, 2001,
general and administrative expenses increased by $409,000. The increase was
primarily related to greater compensation expenses associated with the
transition of new executive management.

     In September 1999, NEON 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


                                       21

<PAGE>


transaction resulted in goodwill of approximately $2.4 million, which was being
amortized on a straight-line basis over five years. Amortization expense related
to this transaction of $120,000 was recognized in the three months ended June
30, 2001. Effective April 1, 2002, NEON adopted SFAS No. 141, "Business
Combinations", and SFAS No. 142, "Goodwill and Other Intangible Assets." Under
SFAS No. 142, NEON no longer amortizes goodwill and intangible assets with
indefinite useful lives but instead will test those assets for impairment at
least annually, see "New Accounting Pronouncements."

    Interest and other income for the three months ended June 30, 2002 was
$142,000 as compared to $410,000 for the three months ended June 30, 2001. The
reduction in interest income was primarily due to lower available cash balances
combined with a decline in interest rates.

    As previously discussed, NEON accounts for its investment in Scalable
Software using the modified equity method of accounting. Under this method, NEON
recognizes 100% of Scalable Software's income or loss to the extent of advances
made in excess of the guaranteed amount. For the three months ended June 30,
2002 NEON recorded an equity in loss of $1.2 million. NEON also recorded a
valuation allowance of $573,000 for the three months ended June 30, 2002 against
the Scalable note receivable to write-down the outstanding balance of the note
to the guaranteed amount. See "Related Party Transactions" and Note 7 to NEON's
financial statements.

    No provision for income taxes was recorded for the three months ended June
30, 2002 and 2001 as NEON had pre-tax losses for the periods of $3.0 million and
$2.4 million, respectively. At June 30, 2002, NEON has a net operating loss
carry-forward for income tax purposes of approximately $7.2 million that is
available to offset future taxable income, if any. The net operating loss
carry-forwards in the United Kingdom, Germany and Australia carry forward
indefinitely. The net operating loss carry-forward for the United States begins
expiring in the tax year 2020. Given the recent tax losses experienced by NEON,
there can be no assurance that the operations will generate taxable income in
the future to utilize these losses, therefore, as of June 30, 2002, NEON has
recorded a full valuation allowance for the deferred tax assets related to the
future benefits, if any, for these loss carryforwards.

LIQUIDITY AND CAPITAL RESOURCES

    NEON's cash and cash equivalents at June 30, 2002 were $30.6 million, a
decline of $3.9 million from $34.5 million at March 31, 2002. This decrease was
due primarily to a net operating loss of $1.9 million for the three months ended
June 30, 2002, and an advance on a note receivable to Scalable Software, Inc. of
$1.6 million during the period.

    Net cash used in operating activities was $2.2 million and $2.7 million for
the three months ended June 30, 2002 and 2001, respectively and resulted
primarily from NEON's net operating losses.

    Net cash used in investing activities was $1.8 million and $1.4 million for
the three months ended June 30, 2002 and 2001, respectively. For the three
months ended June 30, 2002, net cash used in investing activities represents
advances on a note receivable to Scalable Software, Inc. of $1.6 million (see
Related Party Transactions) and purchases of property and equipment of $139,000.
The principal investing uses in the three months ended June 30, 2001 were an
advance on a note receivable to Enterworks Software, Inc. of $2 million,
$260,000 in purchases of property and equipment partially offset by the maturity
of $800,000 in marketable securities. As of June 30, 2001, NEON had no material
commitment for capital expenditures.

    NEON's net cash provided by financing activities was $3,000 and $27,000 for
the three months ended June 30, 2002 and 2001, respectively. The net cash
provided by financing activities in both periods represents proceeds from the
exercise of employee stock options.

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


                                       22

<PAGE>

New Accounting Pronouncements

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

    SFAS No. 142 required NEON to perform a transitional goodwill impairment
evaluation as of the date of adoption. To accomplish this, NEON identified its
reporting units and determined 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 April 1, 2002. NEON has until
September 30, 2002 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 NEON must perform the second step
of the transitional impairment test. In the second step, NEON must compare the
implied fair value of the reporting unit's goodwill, determined by allocating
the reporting unit's fair value to all of it 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 March 31, 2003. Any
transitional impairment loss will be recognized as the cumulative effect of a
change in accounting principle in NEON's statement of earnings.

    As of June 30, 2002, NEON had unamortized goodwill in the amount of
$1,193,000 subject to the transition provisions of Statements 141 and 142. The
adoption of the Statement 142 resulted in the elimination of approximately
$480,000 of goodwill amortization, annually, subsequent to March 31, 2002.
Amortization expense related to goodwill was $120,000 for the three months ended
June 30, 2001. Because of the extensive effort needed to comply with adopting
Statement 142, it is not practical to reasonably estimate whether any
transitional impairment losses will be required to be recognized as the
cumulative effect of a change in accounting principle and the impact on NEON's
financial statements at the date of this report.

     NEON adopted SFAS No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets," effective April 1, 2002. 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
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 adoption of SFAS 144 did not
have a material impact of NEON's consolidated financial statements.

     In April 2002, the FASB issued SFAS No. 145 "Rescission of FASB Statements
No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections." SFAS No. 145 rescinds FASB Statement No. 4, "Reporting Gains and
Losses from Extinguishment of Debt," and an amendment of that Statement, FASB
Statement No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund
Requirements." SFAS No. 145 also rescinds FASB Statement No. 44, "Accounting for
Intangible Assets of Motor Carriers" and amends FASB Statement No. 13,
"Accounting for Leases." SFAS No. 145 also amends other existing authoritative
pronouncements to make various technical corrections, clarify meanings, or
describe their applicability under changed conditions. SFAS No. 145 will be
effective for fiscal years beginning after May 15, 2002. NEON does not
anticipate that the adoption of SFAS No. 145 will have a material impact of
NEON's consolidated financial statements.

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

                                       23

<PAGE>

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 $30.6 million at June 30, 2002,
and were invested in different types of commercial paper and money securities.
NEON believes that a near-term change in interest rates would not materially
affect its financial position, results of operations or net cash flows for
fiscal year 2003.

                          PART II - OTHER INFORMATION

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

ITEM 2. 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. NEON has obtained a two-year option to acquire
Scalable Software as outlined in the Agreement and Plan of Merger dated June 26,
2002. 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 J. 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 June 30, 2002, $7.4 million of the bridge financing had been
drawn upon by Scalable Software, and is reflected as a note receivable. On
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


                                       24

<PAGE>



$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 -

FACTORS THAT MAY AFFECT FUTURE RESULTS

RISK FACTORS

    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:

Some Members Of Our Board Of Directors And Management May Have Conflicts Of
Interests And/Or Are Interested Parties To Certain Transactions Of NEON

    Members of our Board of Directors and our Executive Officers are
shareholders, directors and/or officers in other companies, some of which are
identified and discussed in Management's Discussions and Analysis of Financial
Condition and Results of Operations section on "Related Party Transactions" and
Note 7 to NEON's Condensed Notes to Consolidated Financial Statements herein.
These companies include Peregrine/Bridge Transfer Corporation. Scalable
Software, Inc. and Sheer Genius Software, Inc.

    Such relationships may give rise to conflicts of interest resulting from the
balancing of such officer/director's duties to NEON's stockholders and their
corresponding duties to the stockholders of any company in which they also hold
positions as directors (or officers), especially in the context of business
negotiations between NEON and such other company. In any event where an officer
or director has a conflict of interest, the Board of Directors has reviewed such
conflict and fully discussed the interests of the directors and/or officers
involved. On any votes related thereto, the interested party has abstained.
Notwithstanding such procedures, NEON may face the threat of shareholder claims
based solely on the mere appearance of conflicts of interest in any related
party business transaction.

Uncertainty Regarding Management May Adversely Affect Our Business

    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. In June 2002, Mr. Poynter resigned and NEON immediately
appointed Brian D. Helman as it Chief Financial Officer. Such continuous change
in management may cause uncertainties concerning NEON's future direction and
results. In addition, since Mr. Woodhill is still the Chief Executive Officer
and President of Scalable Software, the failure of NEON to exercise its option
to acquire Scalable Software may result in additional uncertainty with respect
to his continued management of NEON, which uncertainty could materially
adversely affect our business, operating results and financial condition.

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

    As of June 3, 2002, our common stock began trading on the Nasdaq Stock
Market under the ticker symbol "NEON". Previously, we had traded under the
ticker symbol "NESY". In previous years our stock price has fluctuated and
continues to be subject to wide swings in price based on a number of factors
including the following:


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    Our future operating results may vary significantly from quarter to quarter
due to a variety of factors, many of which are outside our control. In addition,
the amount of revenues associated with sales of our software can vary
significantly. Therefore, it is likely that in one or more future quarters our
results may fall below the expectations of securities analysts and investors.
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 will likely decline.

Seasonal Trends In Sales Of Our Products May Affect Investors' Expectations
Regarding Our Financial Performance

    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 88%, 75%, and 86% of our revenues in
fiscal 2000, 2001 and 2002, respectively. 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.

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 4.3
million shares, or approximately 50%, 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.

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 reduced 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:

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

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

     o    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



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<PAGE>

          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.

     o    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.

     o    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.

     o    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 distribution
          agreement with an initial term through March 31, 2004. The license may
          be terminated by either party in the event of default. Termination of
          the agreement could have a material adverse effect on our business,
          operating results and financial condition.

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

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


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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 53.8% 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

    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) EXHIBITS

 10.1   Termination and Customer Support Agreement dated August 14, 2002
        between NEON Systems, Inc. and Peregrine/Bridge Transfer
        Corporation

 10.2   $3,000,000 Convertible Promissory Note dated August 14, 2002
        between Peregrine/Bridge Transfer Corporation, as Maker, and NEON
        Systems, Inc., as Payee

 10.3   $3,584,028 Consolidated Promissory Note dated August 14, 2002
        between Peregrine/Bridge Transfer Corporation, as Maker, and NEON
        Systems, Inc., as Payee

 10.4   Security Agreement dated August 14, 2002 between NEON Systems,
        Inc. and Peregrine/Bridge Transfer Corporation

 10.5   Subordination Agreement dated August 14, 2002 between Skunkware,
        Inc. and NEON Systems, Inc.

 10.6   Trademark License Agreement dated August 14, 2002 between NEON
        Systems, Inc. and Peregrine/Bridge Transfer Corporation

 10.7   License and Distribution Agreement dated August 14, 2002 between
        NEON Systems, Inc. and Peregrine/Bridge Transfer Corporation

 10.8   Services Agreement dated August 14, 2002 between NEON Systems,
        Inc. and Peregrine/Bridge Transfer Corporation

 10.9   Assignment Agreement dated August 14, 2002 between NEON Systems,
        Inc. and Peregrine/Bridge Transfer Corporation

 99.1   Certification of Louis R. Woodhill, Chief Executive Officer of
        NEON Systems, Inc., pursuant to 18 U.S.C. SECTION 1350, as adopted
        pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

 99.2   Certification of Brian D. Helman, Chief Financial Officer of NEON
        Systems, Inc., pursuant to 18 U.S.C. SECTION 1350, as adopted
        pursuant to Section 906 of the Sarbanes-Oxley Act of 2002

       (b) REPORTS ON FORM 8-K

       A Current Report on Form 8-K was filed on July 3, 2002, which
       included a copy of a press release announcing the appointment of a
       new Chief Financial Officer.

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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:  August 14, 2002                  /s/ Brian D. Helman
                                        ----------------------------------------
                                        Chief Financial Officer
                                        (Principal financial officer)





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