**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**Form10-Q**

 

**(Mark One)**

 

ý**QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE**

#### **SECURITIES EXCHANGE ACT OF 1934**

 

**For the Quarterly Period Ended September 30, 2004**

 

## **OR**

 

o**TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE**

**SECURITIES EXCHANGE ACT OF 1934**

 

**For the transition periodfrom               to               **

 

**Commission File Number: 0-25457**

 

**NEON Systems, Inc.**

(Exact name of Registrant as specified in itscharter)

 
| **Delaware**                                                    | ** ** | **76-0345839**                      |
|-----------------------------------------------------------------|------------|-------------------------------------|
| (State or other jurisdiction of  incorporation or organization) | ** ** | (I.R.S.Employer Identification No.) |
|                                                            | ** ** | ** **                          |
| **14100 Southwest Freeway, Suite 500,  Sugar Land, Texas**      | ** ** | **77478**                           |
| (Address of principal executive offices)                        | ** ** | (zip code)                          |
|                                                            | ** ** |                                |
| **(281) 491-4200**                                              |
| (Registrant’s telephone number, including area  code)      |
|                                                            | ** ** |                                |
| Securities registered pursuant to Section 12(b)  of the Act:    |

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

 

Securities registered pursuant to Section 12(g) ofthe Act:

**Common Stock, par value $0.01per share**

(Title of Class)

 

Indicateby check mark whether Registrant (1) has filed all reports required to be filedby Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that Registrant was required tofile such reports), and (2) has been subject to such filing requirements forthe past 90 days.  Yes ý  No  o

 

The number of shares of theregistrant’s common stock outstanding as of October 28, 2004, was 9,324,209.

 

Indicate by check mark whetherthe registrant is an accelerated filer (as defined in Rule 12b-2 of theExchange Act).

Yes o  No ý

 

 

----

 

NEON SYSTEMS, INC.

 

FORM 10-Q

 

FOR THE QUARTER ENDED SEPTEMBER 30, 2004

 

INDEX

 
| PART I.                    | FINANCIAL INFORMATION                                                                                  |   |
|----------------------------|--------------------------------------------------------------------------------------------------------|--------|
|                       |                                                                                                   |   |
| Item 1.                    | Financial Statements                                                                                   |   |
|                       |                                                                                                   |   |
|                       | Consolidated Balance Sheets  at September 30, 2004 and March 31, 2004                                  |   |
|                       |                                                                                                   |   |
|                       | Consolidated  Statements of Operations for the Three and Six Months Ended September 30,  2004 and 2003 |   |
|                       |                                                                                                   |   |
|                       | Consolidated  Statements of Cash Flows for the Three and Six Months Ended September 30,  2004 and 2003 |   |
|                       |                                                                                                   |   |
|                       | Condensed  Notes to Consolidated Financial Statements                                                  |   |
|                       |                                                                                                   |   |
| Item  2.                   | Management’s  Discussion and Analysis of Financial Condition and Results of Operations            |   |
|                       |                                                                                                   |   |
| Item  3.                   | Quantitative  and Qualitative Disclosures About Market Risk                                            |   |
|                       |                                                                                                   |   |
| Item 4.                    | Controls and  Procedures                                                                               |   |
|                       |                                                                                                   |   |
| PART II. OTHER INFORMATION |                                                                                                   |
|                       |                                                                                                   |   |
| Item 1.                    | Legal Proceedings                                                                                      |   |
|                       |                                                                                                   |   |
| Item  2.                   | Unregistered  Sales of Equity Securities and Use of Proceeds                                      |   |
|                       |                                                                                                   |   |
| Item  3.                   | Defaults  Upon Senior Securities                                                                       |   |
|                       |                                                                                                   |   |
| Item  4.                   | Submission  of Matters to a Vote of Security Holders                                                   |   |
|                       |                                                                                                   |   |
| Item  5.                   | Other  Information                                                                                     |   |
|                       |                                                                                                   |   |
| Item 6.                    | Exhibits and  Reports on Form 8-K                                                                      |   |
|                       |                                                                                                   |   |
| SIGNATURES                 |                                                                                                   |

 

2

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PARTI - FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

 

NEON SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATEDBALANCE SHEETS

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)

 
| ** **                                                                                                                                                                  | ** ** | **SEPTEMBER 30, 2004** | ** ** | **MARCH 31, 2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|--------------------|------------|
| ** **                                                                                                                                                                  | ** ** | **(UNAUDITED)**        | ** ** | ** **         | ** ** |
| ASSETS                                                                                                                                                                      |       |                   |       |               |       |
|                                                                                                                                                                        |       |                   |       |               |       |
| CURRENT ASSETS:                                                                                                                                                             |       |                   |       |               |       |
| Cash and cash equivalents                                                                                                                                                   |       | $                      | 22,315     |               | $          | 20,899 |   |
| Accounts receivable, net                                                                                                                                                    |       | 4,368                  |       | 6,150              |       |
| Other current assets                                                                                                                                                        |       | 1,129                  |       | 1,232              |       |
| Total current assets                                                                                                                                                        |       | 27,812                 |       | 28,281             |       |
|                                                                                                                                                                        |       |                   |       |               |       |
| Property and equipment, net                                                                                                                                                 |       | 610                    |       | 475                |       |
| Note receivable, net (Note 7)                                                                                                                                               |       | 4,260                  |       | 7,760              |       |
| Acquired intangibles, net  (Note 10)                                                                                                                                        |       | 3,492                  |       | —             |       |
| Goodwill (Note 10)                                                                                                                                                          |       | 1,308                  |       | —             |       |
| Other assets                                                                                                                                                                |       | 390                    |       | 341                |       |
| Total assets                                                                                                                                                                |       | $                      | 37,872     |               | $          | 36,857 |   |
|                                                                                                                                                                        |       |                   |       |               |       |
| LIABILITIES &  STOCKHOLDERS’ EQUITY                                                                                                                                |       |                   |       |               |       |
|                                                                                                                                                                        |       |                   |       |               |       |
| CURRENT LIABILITIES:                                                                                                                                                        |       |                   |       |               |       |
| Accounts payable                                                                                                                                                            |       | $                      | 505        |               | $          | 298 |   |
| Accrued expenses and other                                                                                                                                                  |       | 1,414                  |       | 2,733              |       |
| Deferred revenue                                                                                                                                                            |       | 5,386                  |       | 7,540              |       |
| Total current liabilities                                                                                                                                                   |       | 7,305                  |       | 10,571             |       |
|                                                                                                                                                                        |       |                   |       |               |       |
| Long-term debt and capital  lease                                                                                                                                           |       | 69                     |       | —-            |       |
| Deferred revenue – long term                                                                                                                                           |       | 3,270                  |       | 931                |       |
| Accrued restructuring expenses  – long term (Note 6)                                                                                                                   |       | 903                    |       | 898                |       |
| Total liabilities                                                                                                                                                           |       | 11,547                 |       | 12,400             |       |
|                                                                                                                                                                        |       |                   |       |               |       |
| 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; 9,324,209 and 8,914,547 shares issued and outstanding at  September 30, 2004 and March 31, 2004, respectively |       | 102                    |       | 98                 |       |
| Additional paid-in capital                                                                                                                                                  |       | 53,168                 |       | 51,696             |       |
| Treasury stock, 913,400 shares  at cost                                                                                                                                     |       | (2,649                 | )          | (2,649             | )          |
| Accumulated other  comprehensive loss                                                                                                                                       |       | (430                   | )          | (421               | )          |
| Accumulated deficit                                                                                                                                                         |       | (23,866                | )          | (24,267            | )          |
| Total stockholders’ equity                                                                                                                                             |       | 26,325                 |       | 24,457             |       |
| Commitments and contingencies  (Note 5)                                                                                                                                     |       |                   |       |               |       |   |   |
| Total liabilities and  stockholders’ equity                                                                                                                            |       | $                      | 37,872     |               | $          | 36,857 |   |

 

SEE ACCOMPANYING CONDENSED NOTESTO CONSOLIDATED FINANCIAL STATEMENTS

 

3

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NEON SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATEDSTATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

(UNAUDITED)

 
| ** **                                                    | ** ** | **THREE MONTHS ENDED SEPTEMBER  30,** | ** ** | **SIX MONTHS ENDED SEPTEMBER 30,** | ** ** |
|---------------------------------------------------------------|------------|---------------------------------------|------------|------------------------------------|------------|
| ** **                                                    | ** ** | **2004**                              | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues:                                                     |       |                                  |       |                               |       |   |   |   |   |
| License                                                       |       | $                                     | 1,186      |                               | $          | 1,138 |   | $ | 2,289 |   | $ | 2,698 |   |
| Maintenance                                                   |       | 2,570                                 |       | 2,450                              |       | 5,037 |   | 5,030 |   |
| Total revenues                                                |       | 3,756                                 |       | 3,588                              |       | 7,326 |   | 7,728 |   |
|                                                          |       |                                  |       |                               |       |   |   |   |   |
| Cost of revenues:                                             |       |                                  |       |                               |       |   |   |   |   |
| Cost of licenses                                              |       | 164                                   |       | —                             |       | 196 |   | 83 |   |
| Cost of maintenance                                           |       | 373                                   |       | 361                                |       | 736 |   | 735 |   |
| Total cost of revenues                                        |       | 537                                   |       | 361                                |       | 932 |   | 818 |   |
|                                                          |       |                                  |       |                               |       |   |   |   |   |
| Gross profit                                                  |       | 3,219                                 |       | 3,227                              |       | 6,394 |   | 6,910 |   |
|                                                          |       |                                  |       |                               |       |   |   |   |   |
| Operating expenses:                                           |       |                                  |       |                               |       |   |   |   |   |
| Sales and marketing                                           |       | 1,658                                 |       | 1,337                              |       | 3,241 |   | 3,012 |   |
| Research and development                                      |       | 1,294                                 |       | 1,122                              |       | 2,278 |   | 2,294 |   |
| General and administrative                                    |       | 902                                   |       | 901                                |       | 1,803 |   | 1,681 |   |
| Total operating expenses                                      |       | 3,854                                 |       | 3,360                              |       | 7,322 |   | 6,987 |   |
|                                                          |       |                                  |       |                               |       |   |   |   |   |
| Operating loss                                                |       | (635                                  | )          | (133                               | )          | (928 | ) | (77 | ) |
|                                                          |       |                                  |       |                               |       |   |   |   |   |
| Gain on sale of notes  receivable (Note 7)                    |       | —                                |       | —                             |       | 1,215 |   | — |   |
| Interest and other income, net                                |       | 69                                    |       | 117                                |       | 114 |   | 170 |   |
| Income (loss) from continuing  operations before income taxes |       | (566                                  | )          | (16                                | )          | 401 |   | 93 |   |
|                                                          |       |                                  |       |                               |       |   |   |   |   |
| Provision for income taxes                                    |       | —                                |       | —                             |       | — |   | — |   |
| Income (loss) from continuing  operations                     |       | (566                                  | )          | (16                                | )          | 401 |   | 93 |   |
| Gain from discontinued  operations, net                       |       | —                                |       | 53                                 |       | — |   | 99 |   |
| Net income (loss)                                             |       | $                                     | (566       | )                                  | $          | 37 |   | $ | 401 |   | $ | 192 |   |
|                                                          |       |                                  |       |                               |       |   |   |   |   |
| Earnings (loss) per common  share —Basic:                |       |                                  |       |                               |       |   |   |   |   |
| Income (loss) from continuing  operations                     |       | $                                     | (0.06      | )                                  | $          | — |   | $ | 0.04 |   | $ | 0.01 |   |
| Gain from discontinued  operations, net                       |       | —                                |       | —                             |       | — |   | 0.01 |   |
| Net income (loss)                                             |       | $                                     | (0.06      | )                                  | $          | — |   | $ | 0.04 |   | $ | 0.02 |   |
|                                                          |       |                                  |       |                               |       |   |   |   |   |
| Earnings (loss) per common  share —Diluted:              |       |                                  |       |                               |       |   |   |   |   |
| Income (loss) from continuing  operations                     |       | $                                     | (0.06      | )                                  | $          | — |   | $ | 0.04 |   | $ | 0.01 |   |
| Gain from discontinued  operations, net                       |       | —                                |       | —                             |       | — |   | 0.01 |   |
| Net income (loss)                                             |       | $                                     | (0.06      | )                                  | $          | — |   | $ | 0.04 |   | $ | 0.02 |   |
|                                                          |       |                                  |       |                               |       |   |   |   |   |
| Weighted average shares  outstanding:                         |       |                                  |       |                               |       |   |   |   |   |
| Basic                                                         |       | 9,266                                 |       | 8,842                              |       | 9,092 |   | 8,820 |   |
| Diluted                                                       |       | 9,266                                 |       | 8,842                              |       | 9,459 |   | 9,182 |   |

 

SEE ACCOMPANYING CONDENSED NOTESTO CONSOLIDATED FINANCIAL STATEMENTS

 

4

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NEON SYSTEMS, INC. ANDSUBSIDIARIES

CONSOLIDATEDSTATEMENTS OF CASH FLOWS

(IN THOUSANDS)

(UNAUDITED)

 
| ** **                                                                               | ** ** | **SIX MONTHS ENDED SEPTEMBER 30,** | ** ** |
|------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                               | ** ** | **2004**                           | ** ** | **2003** | ** ** |
| CASH FLOWS FROM OPERATING  ACTIVITIES:                                                   |       |                               |       |   |   |
| Net income                                                                               |       | $                                  | 401        |   | $ | 192 |   |
| Adjustments to reconcile net  income to net cash used in operating activities:           |       |                               |       |   |   |
| Depreciation                                                                             |       | 196                                |       | 127 |   |
| Amortization of acquired  intangibles                                                    |       | 193                                |       | — |   |
| Gain on sale of notes  receivable (Note 7)                                               |       | (1,215                             | )          | — |   |
| Gain from discontinued  operations, net                                                  |       | —                             |       | (99 | ) |
| Impairment of fixed assets                                                               |       | —                             |       | 46 |   |
| Increase (decrease) in cash  resulting from changes in operating assets and liabilities: |       |                               |       |   |   |
| Accounts receivable                                                                      |       | 1,927                              |       | (328 | ) |
| Tax receivable                                                                           |       | —                             |       | 1,311 |   |
| Other current assets                                                                     |       | 127                                |       | 218 |   |
| Other assets                                                                             |       | (64                                | )          | 108 |   |
| Accrued expenses                                                                         |       | (1,781                             | )          | (1,049 | ) |
| Accounts payable                                                                         |       | (127                               | )          | (109 | ) |
| Deferred revenue                                                                         |       | (109                               | )          | (935 | ) |
| Net cash used in operating  activities                                                   |       | (452                               | )          | (518 | ) |
|                                                                                     |       |                               |       |   |   |
| CASH FLOWS FROM INVESTING  ACTIVITIES:                                                   |       |                               |       |   |   |
| Purchases of furniture and  equipment                                                    |       | (190                               | )          | (32 | ) |
| Purchase of technology                                                                   |       | (264                               | )          | — |   |
| Acquisition, net of cash  acquired                                                       |       | (2,405                             | )          | — |   |
| Proceeds from sale of notes  receivable, net                                             |       | 4,715                              |       | — |   |
| Proceeds from sale of business                                                           |       | —                             |       | 461 |   |
|                                                                                     |       |                               |       |   |   |
| Net cash provided by investing  activities                                               |       | 1,856                              |       | 429 |   |
|                                                                                     |       |                               |       |   |   |
| CASH FLOWS FROM FINANCING  ACTIVITIES:                                                   |       |                               |       |   |   |
| Proceeds from exercises of  stock options                                                |       | 10                                 |       | 54 |   |
| Payments on capital lease                                                                |       | (7                                 | )          | — |   |
| Net cash provided by financing  activities                                               |       | 3                                  |       | 54 |   |
|                                                                                     |       |                               |       |   |   |
| Net cash flows from  discontinued operations                                             |       | —                             |       | 9 |   |
|                                                                                     |       |                               |       |   |   |
| Net increase (decrease) in  cash and cash equivalents                                    |       | 1,407                              |       | (26 | ) |
| Effect of exchange rate  changes on cash                                                 |       | 9                                  |       | 110 |   |
| Cash and cash equivalents at  beginning of period                                        |       | 20,899                             |       | 19,791 |   |
|                                                                                     |       |                               |       |   |   |
| Cash and cash equivalents at  end of period                                              |       | $                                  | 22,315     |   | $ | 19,875 |   |
|                                                                                     |       |                               |       |   |   |
| Supplemental disclosure of  cash flow information:                                       |       |                               |       |   |   |
|                                                                                     |       |                               |       |   |   |
| Cash (paid) received during  the period for income taxes                                 |       | $                                  | (40        | ) | $ | 1,420 |   |
| Cash paid during the period  for interest                                                |       | $                                  | —     |   | $ | — |   |

 

SEE ACCOMPANYING CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

5

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NEON SYSTEMS, INC. AND SUBSIDIARIES

CONDENSEDNOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

NOTE 1—BASIS OF PRESENTATION

 

The accompanying unauditedconsolidated financial statements for NEON Systems, Inc. and its subsidiaries(collectively, “NEON”) have been prepared in accordance with accountingprinciples generally accepted in the United States of America for interimfinancial reporting and in accordance with Regulation S-X of the Securities andExchange Commission. Accordingly, they do not include all of the informationand footnotes required by accounting principles generally accepted in theUnited States of America for complete financial statements. In the opinion ofmanagement, the unaudited consolidated financial statements contained in thisreport reflect all adjustments, consisting of only normal recurringadjustments, considered necessary for a fair presentation of the financialposition and the results of operations for the interim periods presented.Operating results for interim periods are not necessarily indicative of resultsfor the full year. These unaudited consolidated financial statements, footnote disclosuresand other information should be read in conjunction with the financialstatements and the notes thereto included in NEON’s audited consolidatedfinancial statements for the fiscal year ended March 31, 2004, which areincluded in NEON’s Form 10-K for the fiscal year ended March 31, 2004.  Certain prior period amounts have beenreclassified to conform to current period presentation.

 

NOTE 2—PER SHARE INFORMATION

 

In calculating earnings pershare information, NEON follows the provisions of Statement of FinancialAccounting Standards (“SFAS”) No. 128, *Earnings Per Share*.Basic earnings per share is computed by dividing net income applicable tocommon stockholders by the weighted average number of shares of common stockoutstanding during the period.  Dilutedearnings per share is computed by dividing net income applicable to commonstockholders by the weighted average number of shares of common stockoutstanding, adjusted to reflect common stock equivalents, such as convertiblepreferred stock, stock options and warrants to purchase common stock, to theextent they are dilutive, less the number of shares that could have beenrepurchased with the exercise proceeds using the treasury stock method.

 

Earnings per share:

(*In thousands, except per share data)*

 
| ** **                                          | ** ** | **THREE MONTHS ENDED  SEPTEMBER 30,** | ** ** | **SIX MONTHS ENDED  SEPTEMBER 30,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                          | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                          | ** ** | ** **                            | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income (loss) available for common shareholders |       | $                                     | (566       | )                                   | $          | 37 |   | $ | 401 |   | $ | 192 |   |
|                                                |       |                                  |       |                                |       |   |   |   |   |
| Weighted average outstanding shares of common stock |       | 9,266                                 |       | 8,842                               |       | 9,092 |   | 8,820 |   |
| Dilutive effect of stock options                    |       | —                                |       | —                              |       | 367 |   | 362 |   |
| Common stock and common stock equivalents           |       | 9,266                                 |       | 8,842                               |       | 9,459 |   | 9,182 |   |
|                                                |       |                                  |       |                                |       |   |   |   |   |
| Earnings (loss) per share:                          |       |                                  |       |                                |       |   |   |   |   |
| Basic                                               |       | $                                     | (0.06      | )                                   | $          | — |   | $ | 0.04 |   | $ | 0.02 |   |
| Diluted                                             |       | $                                     | (0.06      | )                                   | $          | — |   | $ | 0.04 |   | $ | 0.02 |   |

 

At September 30, 2004, therewere options outstanding to purchase 3.0 million shares of common stock with aweighted-average exercise price of $5.78. For the three and six months endedSeptember 30, 2004, 3.0 million and 2.2 million options were excluded from thecomputation of diluted earnings per share, respectively.  For the three and six months ended September30, 2003, 2.5 million and 1.5 million options, respectively, were excluded fromthe calculation of diluted loss per share, as they were anti-dilutive.

 

6

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NEON SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATEDFINANCIAL STATEMENTS

##### ** **

##### ***Employee Stock-Based Compensation***

 

NEON applies the intrinsicvalue-based method of accounting prescribed by Accounting Principles Board (“APB”)Opinion No. 25, *Accounting For Stock IssuedTo Employees*, and related interpretations.  As such, compensation expense has beenrecorded on the date of grant only if the fair value of the underlying stockexceeded the exercise price.  SFAS No.123, *Accounting For Stock-Based Compensation*,established accounting and disclosure requirements using a fair value-basedmethod of accounting for stock-based employee compensation plans.  Alternatively, SFAS No. 123 allows entitiesto continue to apply the provisions of APB Opinion No. 25 and provide pro formanet income and pro forma earnings per share disclosures for employee stockoption grants made in 1996 and future years as if the fair-value-based methoddefined in SFAS No. 123 had been applied. NEON has elected to continue to apply the provisions of APB Opinion No.25 and provide the pro forma disclosure provisions of SFAS No. 123.  The following table illustrates the effect onnet income if the fair-value-based method had been applied to all outstandingand unvested awards in each period (in thousands, except per share data):

 
| ** **                                                                                                       | ** ** | **THREE MONTHS ENDED SEPTEMBER  30,** | ** ** | **SIX MONTHS ENDED  SEPTEMBER 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|---------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                       | ** ** | **2004**                              | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                       | ** ** | ** **                            | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income (loss) as reported                                                                                    |       | $                                     | (566       | )                                   | $          | 37 |   | $ | 401 |   | $ | 192 |   |
| Deduct total stock-based  employee compensation expense determined under fair-value-based method for  all awards |       | 409                                   |       | 232                                 |       | 794 |   | 642 |   |
| Pro forma net loss                                                                                               |       | $                                     | (975       | )                                   | $          | (195 | ) | $ | (393 | ) | $ | (450 | ) |
|                                                                                                             |       |                                  |       |                                |       |   |   |   |   |
| Basic earnings (loss) per  share:                                                                                |       |                                  |       |                                |       |   |   |   |   |
| As reported                                                                                                      |       | $                                     | (0.06      | )                                   | $          | — |   | $ | 0.04 |   | $ | 0.02 |   |
| Pro forma                                                                                                        |       | $                                     | (0.11      | )                                   | $          | (0.02 | ) | $ | (0.04 | ) | $ | (0.05 | ) |
|                                                                                                             |       |                                  |       |                                |       |   |   |   |   |
| Diluted earnings (loss) per  share:                                                                              |       |                                  |       |                                |       |   |   |   |   |
| As reported                                                                                                      |       | $                                     | (0.06      | )                                   | $          | — |   | $ | 0.04 |   | $ | 0.02 |   |
| Pro forma                                                                                                        |       | $                                     | (0.11      | )                                   | $          | (0.02 | ) | $ | (0.04 | ) | $ | (0.05 | ) |

 

NOTE 3—INCOME TAXES

 

NEON has recorded no income taxprovision as the current year taxable income is offset by net operating losscarry-forwards that NEON had previously reserved.  At March 31, 2004, NEON had a net operatingloss carry-forward for income tax purposes of approximately $19.3 million thatis available to offset future taxable income. The net operating loss carry-forwardsin the United Kingdom, Germany and Australia carry forward indefinitely.  The net operating loss carry-forward for theUnited States begins expiring in the tax year 2020.  There can be no assurance that the operationswill generate taxable income in the future to utilize these losses.  As of September 30, 2004 and March 31, 2004,the valuation allowance fully offsets the Company’s net deferred tax assets.

 

NOTE 4—SEGMENT REPORTING

 

NEON considers its businessactivities to be in a single segment. During the three months ended September 30, 2004, one customer accountedfor 12% of consolidated revenue.  NEONdid not have any customers that accounted for 10% or more of consolidatedrevenue during the three months ended September 30, 2003, nor during the sixmonths ended September 30, 2004 and 2003.

 

7

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NEON SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

The table below summarizesrevenues by geographic region.

 
| ** **               | ** ** | **THREE MONTHS ENDED SEPTEMBER  30,** | ** ** | **SIX MONTHS ENDED SEPTEMBER 30,** | ** ** |
|--------------------------|------------|---------------------------------------|------------|------------------------------------|------------|
| ** **               | ** ** | **2004**                              | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues:                |       |                                  |       |                               |       |   |   |   |   |
| North America            |       | $                                     | 2,862      |                               | $          | 2,569 |   | $ | 5,414 |   | $ | 5,239 |   |
| United Kingdom           |       | 798                                   |       | 919                                |       | 1,725 |   | 2,215 |   |
| Other                    |       | 96                                    |       | 100                                |       | 187 |   | 274 |   |
|                     |       | $                                     | 3,756      |                               | $          | 3,588 |   | $ | 7,326 |   | $ | 7,728 |   |
|                     |       |                                  |       |                               |       |   |   |   |   |
| Operating income (loss): |       |                                  |       |                               |       |   |   |   |   |
| North America            |       | $                                     | (1,054     | )                                  | $          | (525 | ) | $ | (1,628 | ) | $ | (1,149 | ) |
| United Kingdom           |       | 363                                   |       | 443                                |       | 675 |   | 1,072 |   |
| Other                    |       | 56                                    |       | (51                                | )          | 25 |   | — |   |
|                     |       | $                                     | (635       | )                                  | $          | (133 | ) | $ | (928 | ) | $ | (77 | ) |

 
| ** **         | ** ** | **SEPTEMBER 30, 2004** | ** ** | **MARCH 31, 2004** | ** ** | ** ** | ** ** | ** ** | ** ** |
|--------------------|------------|------------------------|------------|--------------------|------------|------------|------------|------------|------------|
|               |       |                   |       |               |       |       |       |       |       |
| Long lived assets: |       |                   |       |               |       |       |       |       |       |
| North America      |       | $                      | 5,709      |               | $          | 705        |       |       |       |   |   |
| United Kingdom     |       | 91                     |       | 111                |       |       |       |       |       |
| Other              |       | —                 |       | —             |       |       |       |       |       |
|               |       | $                      | 5,800      |               | $          | 816        |       |       |       |   |   |

 

NOTE 5—COMMITMENTS AND CONTINGENCIES

 

On January 29, 2003, NEON received notification thatit had been sued in Fort Bend County, Texas for alleged tortious interferencewith contract, tortious interference with prospective business relations andunfair competition in a lawsuit styled Phoenix Network Technologies (Europe)Limited vs. NEON Systems, Inc. and Computer Associates International Inc., 400th District Court, Ft. BendCounty, Richmond, Texas, Cause Number 03-CV-127800. On October 27, 2003, thecourt granted NEON’s motion to dismiss the case.  Phoenix Network Technologies has appealedthis decision, and NEON is continuing to defend this action.  Aside from this action, NEON is not involvedin any current claim or legal action other than those arising in the ordinarycourse of business.

 

NOTE 6—RESTRUCTURINGEXPENSES

 

During prior periods, NEON recorded variousrestructuring charges related to future losses from leases of vacated facilitiesassociated with corporate reorganization. If, in the future, NEON is able to sublease or renegotiate the leasesrelated to these facilities, reversal of all or a portion of such accruedlosses may occur.

 

8

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The following table provides a roll-forward of therestructuring accrual account for the six months ended September 30, 2004 (inthousands):

 
| ** **                 | ** ** | ** **         | ** ** | **Balance at  March 31,  2004** | ** ** | **Reduction of  Expense** | ** ** | **Net  Amounts  Paid** | ** ** | **Other** | ** ** | **Balance at  September 30,  2004** | ** ** |
|----------------------------|------------|--------------------|------------|-------------------------------------------|------------|---------------------------|------------|------------------------|------------|-----------|------------|------------------------------------------|------------|
|                       |       |               |       |                                      |       |                      |       |                   |       |      |       |                                     |       |
| 2002 Restructuring Accrual |       | Facility closure   |       | $                                         | 54         |                      | $          | —                 |       | $         | (11        | )                                        | $          | — |   | $ | 43 |   |
|                       |       |               |       |                                      |       |                      |       |                   |       |      |       |                                     |       |
| 2003 Restructuring Accrual |       | Facility closure   |       | 1,462                                     |       | (196                      | )          | (215                   | )          | (16       | )          | 1,035                                    |       |
|                       |       |               |       |                                      |       |                      |       |                   |       |      |       |                                     |       |
| 2004 Restructuring Accrual |       | Employee severance |       | 35                                        |       | —                    |       | (35                    | )          | —    |       | —                                   |       |
|                       |       | Facility closure   |       | 3                                         |       | —                    |       | (3                     | )          | —    |       | —                                   |       |
|                       |       |               |       |                                      |       |                      |       |                   |       |      |       |                                     |       |
|                       |       | Totals             |       | $                                         | 1,554      |                      | $          | (196                   | )          | $         | (264       | )                                        | $          | (16 | ) | $ | 1,078 |   |

 

The $1.1 million balance at September 30, 2004consists of future cash payments for vacated facilities that will be paidthrough 2006. The current portion of this liability, $175,000, is included inaccrued expenses.

 

During the six months ended September 30, 2004, NEONrenegotiated lease and sublease agreements associated with a vacated property.  Renegotiation resulted in a decrease in the accruedliability of $196,000, of which $82,000 was recorded in the three months endedSeptember 30, 2004.  These amounts are reportedin general and administrative expenses in the consolidated statement ofoperations in the applicable periods.

 

Other adjustments relate primarily to the effect ofcurrency translation on foreign balances.

 

NOTE 7—RELATED PARTY TRANSACTIONS

 

Certain former members of NEON’s Board of Directorsand certain former executive officers of NEON were shareholders and/ordirectors in other companies with which NEON has investments.  Transactions between NEON and these othercompanies are described below. The directors and officers involved in suchtransactions are no longer officers and directors of NEON.

 

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

 

NEON entered into a Termination and Customer SupportAgreement on August 14, 2002, which terminated a distribution agreement withPeregrine/Bridge Transfer Corporation (PBTC), a database software company whosesole stockholder is an affiliate of John J. Moores, NEON’s former Chairman ofthe Board of Directors. PBTC subsequently changed its name to NEON EnterpriseSoftware, Inc. (“NESI”).

 

NEON currently holds a consolidated promissory notereceivable from NESI in the aggregate principal amount of $3.6 million, bearingno interest to its due date of March 31, 2005. This consolidated promissorynote is secured by all of the intellectual property of NESI (“NESI IP”). NEONalso currently holds a $3.0 million convertible promissory note receivable fromNESI bearing no interest to its due date of March 31, 2005, which is alsosecured by the NESI IP. The $3.0 million convertible note is convertible byNEON, in its discretion, into equity in NESI at an agreed pre-cash valuation of$30.0 million.   Such conversion right willexpire on the due date of the $3.0 million convertible note. On the closing ofthe transaction in August 2002, NEON recorded the notes receivable from NESI attheir estimated net present value, which was calculated at $4.3 million inaggregate value. NEON will adjust the carrying value of the note if the netrealizable value is determined to be below the carrying value. NEON had anexternal valuation of the NESI IP performed as of March 31, 2004 and determinedthat no further impairment of the notes was required.  NEON also evaluates the NESI IP on aquarterly basis to determine the notes’ net realizable value. NEON is not awareof any changes that have occurred that would result in an adjustment to thecarrying value.

 

9

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*Scalable Software, Inc.*

 

On June 9, 2004, NEON entered into a Note PurchaseAgreement with JMI Services, Inc., the largest shareholder of Scalable, to sellthe $3.5 million guaranteed note and the $6.0 million secured note issued byScalable to NEON for a cash price of $4.8 million.  A gain of $1.2 million resulted from the cashproceeds in excess of the recorded combined book value of the notes and directselling expenses.  JMI Services is anaffiliate of John J. Moores, NEON’s largest shareholder.  The proposed sale of the Scalable notes wasreviewed by NEON’s Board of Directors, including fully independent members.  The board requested and received a fairnessopinion from Avail Consulting, Inc., a Houston, Texas based independentvaluation and financial consultant, stating that the transaction was fair tothe stockholders of NEON from a financial standpoint and recommending that theBoard accept the purchase offer made by JMI Services, Inc.  Closing of the transaction occurred on June17, 2004.

 

NOTE 8 –DISCOUNTINUED OPERATIONS

 

On June 20, 2003, NEON entered into an Asset PurchaseAgreement with a third party software vendor to sell its iWave product lineassets.  As a result of the transaction,NEON recorded a gain on the sale of $343,000, net of closing expenses, duringthe six months ended September 30, 2003.  Total revenues for the three months ended June 30, 2003 were$194,000.  Operating losses associatedwith the iWave product line were classified as discontinued operations.  Operating loss for the three months ended June30, 2003 was $244,000.

 

NOTE 9 – BUSINESSCOMBINATIONS

 

On July 14, 2004,NEON acquired 100% interest in InnerAccess Technologies, Inc. (InnerAccess), acompany incorporated under the laws of the province of Quebec, Canada.  InnerAccess develops, markets and licensesweb services technology and provides services related to the integration ofmainframe data sources with modern distributed computing systems.  NEON paid the InnerAccess Shareholders atotal of $2.4 million dollars in cash and issued 407,000 shares of NEONrestricted common stock to the amalgamated entity, of which 406,000 have beentransferred to the shareholders of InnerAccess in consideration for theacquisition.  All issuances and transfersof NEON common stock were exempt from SEC registration requirements underRegulation S.  These shares are includedin the weighted average shares outstanding for the respective periods.

 

In addition, NEONhas assumed certain special warrants of InnerAccess, which, on a convertedbasis, represent the right to acquire an additional 19,894 shares of NEONcommon stock at a cash exercise price equal to $9.50 per share.  In connection with the issuance of the sharesof NEON common stock, NEON has also agreed to enter into a registration rightsagreement with each former InnerAccess Shareholder in the form attached asExhibit 4.1 to our Form 8-K filed with the SEC on July 29, 2004.  Such Registration Rights Agreement grants toeach such former InnerAccess Shareholder a right to piggyback on any publicoffering of NEON shares of common stock during the one year period followingthe closing of the acquisition of InnerAccess by NEON.

 

**PurchasePrice:**

 

NEONpaid an estimated preliminary total purchase price of approximately$4.5 million for 100% of the outstanding common stock of InnerAccess. Thefair value of the NEON Systems, Inc. (“NEON”) restricted common stockissued of $1.5 million was based on the average market price of NEONcommon stock for the period beginning two trading days before and ending twotrading days after June 1, 2004, the announcement date of the acquisition.The estimated preliminary total purchase price for the acquisition is asfollows (in thousands):

 

| Cash                                         |   | $     | 2,400  |   |
|----------------------------------------------|--------|-------|--------|--------|
| Fair value of NEON common stock to be issued |   | 1,466 |   |
| Estimated direct acquisition costs           |   | 611   |   |
| Total estimated purchase price               |   | $     | 4,477  |   |

 

Thefinal purchase price is dependent on the actual final direct acquisition costs.

 

10

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**CondensedBalance Sheet:**

 

Underthe purchase method of accounting, the total estimated purchase price has beenallocated to the tangible and intangible assets acquired and liabilitiesassumed on the basis of their respective estimated fair values on the date ofacquisition. The valuation of the identifiable intangible assets acquiredreflects management’s estimates based on, among other factors, a valuation ofthe intangible assets prepared by an independent third party.  Based on the estimated purchase price and thepreliminary valuations, the preliminary purchase price allocation, subject tochange pending completion of final analysis, is as follows (in thousands): 

 

| Cash                                         |   | $      | 259    |   |
|----------------------------------------------|--------|--------|--------|--------|
| Tangible assets                              |   | 567    |   |
| Amortizable intangible assets:               |   |   |   |
| Core technology                              |   | 2,600  |   |
| Maintenance contracts/customer relationships |   | 660    |   |
| Goodwill                                     |   | 1,308  |   |
| Total assets acquired                        |   | 5,394  |   |
| Liabilities assumed                          |   | 917    |   |
| Net assets acquired                          |   | $      | 4,477  |   |

 

Approximately$3.3 million has been allocated to amortizable intangible assetsconsisting of existing technology, maintenance contracts and customerrelationships. A preliminary estimate of $1.3 million has been allocatedto goodwill. Goodwill represents the excess of the purchase price over the fairvalue of the net tangible and amortizable intangible assets acquired.

 

**Pro FormaInformation:**

 

The following proforma information presents the consolidated operating results of NEON as if theacquisition had occurred at the beginning of the fiscal period presented:

 
| ** **                           | ** ** | **Three Months Ended,** | ** ** | **Six Months Ended,** | ** ** |
|--------------------------------------|------------|-------------------------|------------|-----------------------|------------|
| **Results  of Operations:**          | ** ** | **9/30/04**             | ** ** | **9/30/03**           | ** ** | **9/30/04** | ** ** | **9/30/03** | ** ** |
|                                 |       |                    |       |                  |       |   |   |   |   |
| Total revenues                       |       | $                       | 3,779      |                  | $          | 3,985 |   | $ | 7,748 |   | $ | 8,485 |   |
|                                 |       |                    |       |                  |       |   |   |   |   |
| Net loss                             |       | (816                    | )          | (199                  | )          | (199 | ) | (316 | ) |
|                                 |       |                    |       |                  |       |   |   |   |   |
| Earning per share:                   |       |                    |       |                  |       |   |   |   |   |
| Basic                                |       | $                       | (0.09      | )                     | $          | (0.02 | ) | $ | (0.02 | ) | $ | (0.03 | ) |
| Diluted                              |       | $                       | (0.09      | )                     | $          | (0.02 | ) | $ | (0.02 | ) | $ | (0.03 | ) |
|                                 |       |                    |       |                  |       |   |   |   |   |
| Weighted-average shares outstanding: |       |                    |       |                  |       |   |   |   |   |
| Basic                                |       | 9,324                   |       | 9,248                 |       | 9,322 |   | 9,226 |   |
| Diluted                              |       | 9,324                   |       | 9,248                 |       | 9,322 |   | 9,226 |   |

 

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NOTE 10 – GOODWILL ANDINTANGIBLE ASSETS

 

**Goodwill:**

 

In accordance withStatement of Financial Accounting Standards No. 142, *Goodwill andOther Intangible Assets* (FAS 142), purchase price in excess of thefair values of acquired tangible and amortizable intangible net assets has beenclassified as goodwill. The value of recorded goodwill is subject to finalization of the preliminary purchaseprice and allocation. The acquired goodwill, although not subject to regularamortization, will be assessed for impairment on an annual basis, or sooner iffactors indicate such is necessary. Aggregate goodwill acquired in theInnerAccess transaction was $1.3 million. NEON reports one operating segment, and that operating segment has beenidentified as the reporting unit for the purposes of assessing futureimpairment of the acquired InnerAccess goodwill.  No impairments of the InnerAccess goodwillhave occurred to date.

 

**Acquired Intangibles:**

 

The components of identifiableintangible assets acquired in the InnerAccess transaction are as follows (inthousands):

 
| ** **                                   | ** ** | **As of September 30, 2004** | ** ** |
|----------------------------------------------|------------|------------------------------|------------|
| ** **                                   | ** ** | **Gross Carrying Amount**    | ** ** | **Accumulated Amortization** | ** ** | **Net Carrying Value** | ** ** |
| Intangible assets:                           |       |                         |       |   |   |   |   |
| Core technology                              |       | $                            | 2,600      |   | $ | 112 |   | $ | 2,488 |   |
| Maintenance contracts/customer relationships |       | 660                          |       | 28 |   | 632 |   |
| Total                                        |       | $                            | 3,260      |   | $ | 140 |   | $ | 3,120 |   |

 

Theseidentifiable intangible assets are amortized using the straight-line methodover an estimated five year life.  Nosignificant residual value is estimated for the intangible assets. Amortizationexpense for the three months ended September 30, 2004 was $140,000.

 

Inaddition to those intangible assets acquired by business combination, NEONacquired certain software code at a cost of $426,000 in April 2004.  The asset, net of accumulated amortization,is classified as purchased technology in the accompanying unauditedconsolidated balance sheet, and has been assigned a useful life of fouryears.  Amortization expense, calculatedon a straight-line basis, is presented as cost of license in the accompanyingunaudited consolidated statements of operations and represented $27,000 and $54,000for the three and six months ended September 30, 2004, respectively.

 

**NOTE 11 – Significant RevenueDeferral**

 

In March 2004, NEON entered into a four year enterprise license andmaintenance agreement with one of its largest customers. The contract providesservices through March 31, 2008 and has an aggregate value of $2,900,000. Allsoftware products licensed by the customer were delivered by October 1,2004.  Since vendor specific objectiveevidence could not be determined for the maintenance portion of the contract,NEON will amortize the contract value on a straight-line basis over theremaining term of the agreement, beginning on October 1, 2004, in accordance withNEON’s revenue recognition policy.  SeeCritical Accounting Policies*– Revenue RecognitionPolicies*.

 

ITEM 2.  MANAGEMENT’SDISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

 

The following discussion and analysis should be readin conjunction with NEON’s consolidated financial statements and the relatednotes thereto included in this report on Form 10-Q. The discussion and analysiscontains forward-looking statements within the meaning of Section 27A of theSecurities Act of 1933 and Section 21E of the Securities Exchange Act of1934.  These statements are based on ourcurrent expectations and entail various risks and uncertainties such as our plans, objectives, expectations andintentions.  Our actual resultscould differ materially from those projected in the forward-looking statementsas a result of various factors, including those set forth below in Part II, Item 5 under “Factors that May AffectFuture Results.”  In some cases, you canidentify forward-looking statements by terminology such as “may,” “will,” “should,”“expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,”“continue,” or the negative of these terms or other comparable terms.

 

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OVERVIEW

 

NEON Systems, Inc. (“NEON”) is a leading provider ofenterprise-class mainframe integration software.  NEON develops, markets and supports a unifiedmainframe integration platform that supports a broad range of requirements formodern Service-Oriented Architectures and emerging Event-Driven Architectures.NEON’s Shadow technology providesflexible, industry standard interfaces to enable highly secure and scalablemainframe integration, allowing organizations to reduce total cost of ownership and risk associated with mainframeintegration, while streamlining the number of incumbent technologies needed forsuch integration.

 

In July 2004, NEON closed its acquisition ofInnerAccess Technologies, Inc., a Quebec corporation that develops mainframeintegration software products with particular specialization in web servicesfor mainframe integration and integration of IDMS databases.

 

##### ***Business Environment***

 

NEON derives revenue from software licenses andmaintenance services. License fees, which are graduated and based upon variousindustry standard measures of product usage such as mainframe potentialcapacity, CPUs, and users, are generally due upon license grant and include aone-year maintenance period. The sales process typically takes between six andnine months. After the initial year of license, NEON provides ongoingmaintenance 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 technologicalchange, could materially adversely affect our business, operating results andfinancial condition.

 

In mid-2000, the mainframe software market began toweaken as the global economies entered a recessionary period.  Prior to 2000, many of NEON’s customers wereexperiencing consistent growth of their mainframe systems and, as a result,they purchased additional software capacity in anticipation of continued growthat rates consistent with history. Additionally, during this time frame, thecompetitive landscape for NEON’s product also began to intensify.

 

During fiscal 2003, NEON began restructuring thecompany to concentrate on its core mainframe integration business, which hashistorically accounted for the majority of its revenues. NEON divested itsnon-core products and reduced the size of its sales, marketing andadministrative organizations. During this period NEON also began to develop newmainframe integration products as well as identify other adjacent market products,technologies and companies, which were complementary to NEON’s existing productportfolio.

 

Many of NEON’s customers remain cautious about theircapital spending. Although general economic conditions have improved, NEON isstill uncertain as to future spending patterns of its customers. NEON believesthat period-to-period comparisons of our revenue and operating results shouldnot be relied upon as indications of our future performance. Further, NEON doesnot believe that its historical growth rates in prior years are necessarilyrepresentative of its future growth potential.

 

*****Related Party Transactions*****

 

Certain former members of NEON’s Board of Directorsand certain former executive officers of NEON were shareholders and/ordirectors in other companies with which NEON has investments.  Transactions between NEON and these othercompanies are described below. The directors and officers involved in suchtransactions are no longer officers and directors of NEON.

 

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

 

NEON entered into a Termination and Customer SupportAgreement on August 14, 2002, which terminated a distribution agreement withPeregrine/Bridge Transfer Corporation (PBTC), a database software company whosesole stockholder is an affiliate of John J. Moores, NEON’s former Chairman ofthe Board of Directors. PBTC subsequently changed its name to NEON EnterpriseSoftware, Inc. (“NESI”).

 

NEON currently holds a consolidated promissory notereceivable from NESI in the aggregate principal amount of $3.6 million, bearingno interest to its due date of March 31, 2005. This consolidated promissorynote is secured by all of the intellectual property of NESI (“NESI IP”). NEONalso currently holds a $3.0 million convertible promissory note receivable from

 

13

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NESI bearing no interestto its due date of March 31, 2005, which is also secured by the NESI IP. The$3.0 million convertible note is convertible by NEON, in its discretion, intoequity in NESI at an agreed pre-cash valuation of $30.0 million.  Such conversion right will expire on the duedate of the $3.0 million convertible note. On the closing of the transaction inAugust 2002, NEON recorded the notes receivable from NESI at their estimatednet present value, which was calculated at $4.3 million in aggregate value.NEON will adjust the carrying value of the notes if the net realizable value isdetermined to be below the carrying value. NEON had an external valuation ofits notes receivable due from NESI as of March 31, 2004 and determined that nofurther impairment of the notes was required.  NEON also evaluates the NESI IP on a quarterly basis to determine thenotes’ net realizable value. NEON is not aware of any changes that haveoccurred that would result in an adjustment of the carrying value.

 

*Scalable Software, Inc.*

 

On June 9, 2004, NEON entered into a Note PurchaseAgreement with JMI Services, Inc., the largest shareholder of Scalable, to sellthe $3.5 million guaranteed note and the $6.0 million secured note issued byScalable to NEON for a cash price of $4.8 million.  A gain of $1.2 million resulted from the cashproceeds in excess of the recorded combined book value of the notes and directselling expenses.  JMI Services is anaffiliate of John J. Moores, NEON’s largest shareholder.  The proposed sale of the Scalable notes wasreviewed by NEON’s Board of Directors, including fully independentmembers.  The board requested andreceived a fairness opinion from Avail Consulting, Inc., a Houston, Texas basedindependent valuation and financial consultant, stating that the transactionwas fair to the stockholders of NEON from a financial standpoint andrecommending that the Board accept the purchase offer made by JMI Services,Inc.  Closing of the transaction occurredon June 17, 2004.

 

*****Critical Accounting Policies*****

 

The following is a discussion of the accountingpolicies that NEON believes (1) are most important to the portrayal of itsfinancial condition and results of operations and (2) require our mostdifficult, subjective or complex judgments, often as a result of the need tomake 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 inOctober 1997 by the American Institute of Certified Public Accountants (AICPA)and was amended by Statement of Position 98-4 (SOP 98-4) and Statement ofPosition 98-9 (SOP 98-9). NEON adopted SOP 97-2 effective July 1, 1997, SOP98-4 effective March 31, 1998 and SOP 98-9 effective April 1, 1999. NEONbelieves its current revenue recognition policies and practices are consistentwith SOP 97-2, SOP 98-4 and SOP 98-9. Revenues from software license sales arerecognized when all of the following conditions are met: a non-cancelablelicense agreement has been obtained, the product has been delivered; there areno material uncertainties regarding customer acceptance; collection of thereceivable is probable; no other significant vendor obligations exist; andvendor-specific objective evidence exists to allocate the total fee to at leasteach undelivered element of the arrangement. Vendor-specific objective evidenceis based on the price generally charged when an element is sold separately. Allelements of each order are valued at the time of revenue recognition. NEON willdefer license revenue for all delivered elements associated with a salesarrangement, if vendor-specific objective evidence cannot be established foreach undelivered element. License revenues generally include softwaremaintenance agreements for the first year following the date of sale. In suchcases, revenues are allocated between license and maintenance revenues based onthe residual method provided by SOP 98-9. Deferred revenue is generally basedon vendor-specific objective evidence of the fair value of maintenance with theremaining portion of the total arrangement value allocated to licenserevenues.  If vendor-specific objectiveevidence cannot be established for deferred revenue, then the value of thesales arrangement is amortized ratably on a straight-line basis over thecontract term. Revenues from first-year maintenance agreements and separatelypriced software maintenance agreements for subsequent years are deferred andrecognized ratably on a straight-line basis over the maintenance period. NEONalso markets and sells its products through independent distributors andresellers. License and maintenance revenues from these transactions are recognizedas above, when sold to the ultimate end user and all of the above conditionsare met.

 

***Capitalized Software Costs***

 

NEON follows SFAS No. 86, *Accounting for the Costs of Computer Software to be Sold, Leased orOtherwise Marketed*. Research and development expenditures have beencharged to operating expenses as incurred. No internal software developmentcosts have been capitalized to date, as theimpact on the financial statements would be insignificant because the timebetween a product meeting the definition of technological feasibility andreadiness for market is very short.   The costs of acquired software technology arecapitalized and amortized over their useful lives.

 

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***Allowance for Doubtful Accounts Receivable***

##### ** **

##### **As a part of its normal accounting procedures, NEONevaluates outstanding accounts receivable to estimate whether they will becollected. This is a subjective process that involves making judgments aboutour customers’ ability and willingness to pay these accounts. An allowance fordoubtful accounts is recorded as an offset to accounts receivable in order topresent a net balance that NEON believe will be collected. In estimating theappropriate balance for this allowance, NEON considers (1) specific reservesfor accounts NEON believes may prove to be uncollectible and (2) additionalreserves, based on historical collections, for the remainder of our accounts.Additions to the allowance for doubtful accounts are charged to operatingexpenses, and deductions from the allowance are recorded when specific accountsreceivable are written off as uncollectible or when actual experience differsfrom management’s original estimate. If NEON’s estimate of uncollectibleaccounts should prove to be inaccurate at some future date, the results ofoperations for the period could be materially affected by any necessarycorrection to the allowance for doubtful accounts.**

 

***Deferred Income Taxes***

 

NEON records deferred income tax assets andliabilities on its balance sheet related to events that impact its financialstatements and tax returns in different periods. In order to compute thesedeferred tax balances, NEON first analyzes the differences between the bookbasis and tax basis of its assets and liabilities (referred to as “temporarydifferences”). These temporary differences are then multiplied by current taxrates to arrive at the balances for the deferred income tax assets andliabilities. If deferred tax assets exceed deferred tax liabilities, NEON mustestimate whether those net deferred asset amounts will be realized in thefuture. A valuation allowance is then provided for the net deferred assetamounts that are not likely to be realized.

 

The change in NEON’s net deferred income tax balancesduring a period results in a deferred income tax provision or benefit in itsstatement of operations. If NEON’s expectations about the future taxconsequences of past events should prove to be inaccurate, the balances of itsdeferred income tax assets and liabilities could require significantadjustments in future periods. Such adjustments could cause a material effecton NEON’s results of operations for the period of the adjustment.

 

RESULTS OF OPERATIONS

 

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

 
| ** **                                                    | ** ** | **THREE MONTHS ENDED SEPTEMEBER 30,** | ** ** | **SIX MONTHS ENDED SEPTEMBER 30,** | ** ** |
|---------------------------------------------------------------|------------|---------------------------------------|------------|------------------------------------|------------|
| ** **                                                    | ** ** | **2004**                              | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues:                                                     |       |                                  |       |                               |       |   |   |   |   |
| License                                                       |       | 31.6                                  | %          | 31.7                               | %          | 31.2 | % | 34.9 | % |
| Maintenance                                                   |       | 68.4                                  |       | 68.3                               |       | 68.8 |   | 65.1 |   |
| Total revenues                                                |       | 100.0                                 |       | 100.0                              |       | 100.0 |   | 100.0 |   |
|                                                          |       |                                  |       |                               |       |   |   |   |   |
| Cost of revenues:                                             |       |                                  |       |                               |       |   |   |   |   |
| Cost of licenses                                              |       | 4.4                                   |       | —                             |       | 2.7 |   | 1.1 |   |
| Cost of maintenance                                           |       | 9.9                                   |       | 10.1                               |       | 10.0 |   | 9.5 |   |
| Total cost of revenues                                        |       | 14.3                                  |       | 10.1                               |       | 12.7 |   | 10.6 |   |
|                                                          |       |                                  |       |                               |       |   |   |   |   |
| Gross profit                                                  |       | 85.7                                  |       | 89.9                               |       | 87.3 |   | 89.4 |   |
|                                                          |       |                                  |       |                               |       |   |   |   |   |
| Operating expenses:                                           |       |                                  |       |                               |       |   |   |   |   |
| Sales and marketing                                           |       | 44.1                                  |       | 37.3                               |       | 44.2 |   | 39.0 |   |
| Research and development                                      |       | 34.5                                  |       | 31.3                               |       | 31.1 |   | 29.7 |   |
| General and administrative                                    |       | 24.0                                  |       | 25.1                               |       | 24.6 |   | 21.8 |   |
| Total operating expenses                                      |       | 102.6                                 |       | 93.6                               |       | 99.9 |   | 90.4 |   |
|                                                          |       |                                  |       |                               |       |   |   |   |   |
| Operating loss                                                |       | (16.9                                 | )          | (3.7                               | )          | (12.7 | ) | (1.0 | ) |
| Gain on sale of notes  receivable (Note 7)                    |       | —                                |       | —                             |       | 16.6 |   | — |   |
| Interest and other income, net                                |       | 1.8                                   |       | 3.3                                |       | 1.6 |   | 2.2 |   |
|                                                          |       |                                  |       |                               |       |   |   |   |   |
| Income (loss) from continuing  operations before income taxes |       | (15.1                                 | )          | (0.4                               | )          | 5.5 |   | 1.2 |   |
| Provision for income taxes                                    |       | —                                |       | —                             |       | — |   | — |   |
|                                                          |       |                                  |       |                               |       |   |   |   |   |
| Loss from continuing  operations                              |       | (15.1                                 | )          | (0.4                               | )          | 5.5 |   | 1.2 |   |
| Gain from discontinued operations,  net                       |       | —                                |       | 1.5                                |       | — |   | 1.3 |   |
| Net income (loss)                                             |       | (15.1                                 | )%         | 1.0                                | %          | 5.5 | % | 2.5 | % |

 

15

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THREE MONTHS ENDED SEPTEMBER 30, 2004 COMPARED TOTHREE MONTHS ENDED SEPTEMBER 30, 2003

 

REVENUES

 

License revenues for the threemonths ended September 30, 2004 were $1.2 million, an increase of $48,000 from$1.1 million for the three months ended September 30, 2003. The increase wasdue to the acquisition of InnerAccess during the period, although this increasewas offset by a reduction in license revenue in the United Kingdom.

 

In March 2004, NEON entered intoa four year enterprise license and maintenance agreement with one of itslargest customers. The contract provides services through March 31, 2008 andhas an aggregate value of $2,900,000. All software products licensed by thecustomer were delivered by October 1, 2004. Since vendor-specific objective evidence could not be determined for themaintenance portion of the contract, NEON will amortize the contract value on astraight-line basis over the remaining term of the agreement, beginning onOctober 1, 2004, in accordance with NEON’s revenue recognition policy.  See Critical Accounting Policies*– Revenue Recognition Policies*.

 

Maintenance revenues for thethree months ended September 30, 2004 were $2.6 million, an increase of$120,000 over the three months ended September 30, 2003.  The increase is primary attributable to theacquisition of InnerAccess and its customer base.

 

COST OF REVENUES

 

Cost of license revenues for thethree months ended September 30, 2004 were $164,000, or 14% of licenserevenues, and primarily represented amortization of acquired product technology,primarily associated with the InnerAccess acquisition. NEON did not incur costof license revenue during the three months ended September 30, 2003.

 

Cost of maintenance revenuesincludes personnel and other customer support costs. Cost of maintenancerevenues for the three months ended September 30, 2004 were $373,000 or 15% ofmaintenance revenues, as compared to $361,000, or 15% of maintenance revenues,for the three months ended September 30, 2003. Cost of maintenance revenue as apercentage of maintenance revenue remained consistent in both periods.

 

OPERATING EXPENSES

 

Sales and marketing expenses includepersonnel costs, sales commissions and travel expenses of sales, presalessupport and marketing personnel, along with trade show participation and otherpromotional expenses. Sales and marketing expenses for the three months endedSeptember 30, 2004 were $1.7 million, an increase of $321,000 from $1.3 millionfor the three months ended September 30, 2003. The increase was primarily dueto greater personnel costs associated with growth in the sales force andincreased marketing activities.

 

Research and developmentexpenses primarily include personnel costs associated with NEON’s productdevelopment staff. Research and development expenses for the three months endedSeptember 30, 2004 were $1.3 million, an increase of $172,000 from $1.1 millionfor the three months ended September 30, 2003. The increase in research and development is primarily due to the acquisitionof InnerAccess, as well as increased costs associated with contracteddevelopment activities.

 

General and administrativeexpenses include personnel and other costs associated with NEON’s executive,financial, legal and administrative functions. General and administrativeexpenses for the three months ended September 30, 2004 were $902,000, versus$901,000 for the three months ended September 30, 2003. General andadministrative expenses increased during the period as a result of the InnerAccessacquisition, although the increase was offset by a reduction in previouslyaccrued future lease obligations related to vacated facilities, as a result of therenegotiation of NEON’s corporate office lease.

 

Interest and other income forthe three months ended September 30, 2004 and 2003 was $69,000 and $117,000,respectively.

 

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No provision for income taxeswas recorded for the three months ended September 30, 2004 due to the net lossfor the period.  No provision for incometaxes was recorded for the three months ended September 30, 2003, as thetaxable income was offset by net operating loss carry-forwards that NEON hadpreviously reserved.  As of March 31,2004, NEON had a net operating loss carry-forward for income tax purposes ofapproximately $19.3 million that is available to offset future taxable income,if any. The net operating loss carry-forwards in the United Kingdom, Germanyand Australia carry forward indefinitely. The net operating loss carry-forward for the United States beginsexpiring in the tax year 2020.  There canbe no assurance that the operations will generate taxable income in the futureto utilize these losses.  Therefore, asof September 30, 2004 and March 31, 2004, NEON has recorded a full valuationallowance for the deferred tax assets related to the future benefits, if any,for these loss carryforwards.

 

SIX MONTHS ENDED SEPTEMBER 30, 2004 COMPARED TOSIX MONTHS ENDED SEPTEMBER 30, 2003

 

REVENUES

 

License revenues for the sixmonths ended September 30, 2004 were $2.3 million, a decrease of $409,000 from$2.7 million for the six months ended September 30, 2003. The decrease inlicense revenue was primarily due to a reduction in license revenue in theUnited Kingdom.

 

In March 2004, NEON entered intoa four year enterprise license and maintenance agreement with one of itslargest customers. The contract provides services through March 31, 2008 andhas an aggregate value of $2,900,000. All software products licensed by thecustomer were delivered by October 1, 2004. Since vendor-specific objective evidence could not be determined for themaintenance portion of the contract, NEON will amortize the contract value on astraight-line basis over the remaining term of the agreement, beginning onOctober 1, 2004, in accordance with NEON’s revenue recognition policy.  See Critical Accounting Policies*– Revenue Recognition Policies*.

 

Maintenance revenues for the sixmonths ended September 30, 2004 and 2003 were $5.0 million.  Maintenance revenues were consistent duringboth periods, however during fiscal 2004 maintenance revenues increased as ofresult of the InnerAccess acquisition, although the increase was offset by a reductionin recurring maintenance revenue as NEON received certain one-time maintenancepayments during fiscal 2003, which related to prior years.

 

COST OF REVENUES

 

Cost of license revenuesprimarily consists of amortization of purchased technology and royalty paymentsto third parties. Cost of license revenues for the six months ended September30, 2004 were $196,000, or 9% of license revenues, as compared to $83,000, or3% of license revenues, for the six months ended September 30, 2003. Theincrease in cost of license revenues related primarily to the amortization oftechnology acquired during the fiscal 2005.

 

Cost of maintenance revenuesincludes personnel and other customer support costs. Cost of maintenancerevenues for the six months ended September 30, 2004 were $736,000, or 15% ofmaintenance revenues, as compared to $735,000, or 15% of maintenance revenues,for the six months ended September 30, 2003. Cost of maintenance revenue as apercentage of maintenance revenue remained consistent in both periods.

 

OPERATING EXPENSES

 

Sales and marketing expensesinclude personnel costs, sales commissions and travel expenses of sales,presales support and marketing personnel, along with other promotionalexpenses. Sales and marketing expenses for the six months ended September 30,2004 were $3.2 million, an increase of $229,000 from $3.0 million for the sixmonths ended September 30, 2003. The increase was primarily due to greaterpersonnel costs associated with growth in the sales force and increasedmarketing activities.

 

Research and developmentexpenses primarily include personnel costs associated with NEON’s productdevelopment staff. Research and development expenses for the six months endedSeptember 30, 2004 and 2003 were $2.3 million. Research and development expenses increased during the period primarily dueto the acquisition of InnerAccess, although these expenses were offset byreductions in personnel related costs.

 

General and administrativeexpenses include personnel and other costs associated with NEON’s executive,financial, legal and administrative functions. General and administrativeexpenses for the six months ended September 30, 2004 were $1.8 million, an 

 

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increaseof $122,000 from $1.7 million for the six months ended September 30, 2003. Theincrease was primarily related to the acquisition of InnerAccess and greaterpersonnel costs, although the increase was offset by a reduction in previouslyaccrued future lease obligations related to vacated facilities, as a result ofthe renegotiation of NEON’s corporate office lease.

 

Interest and other income forthe six months ended September 30, 2004 was $114,000 as compared to $170,000for the six months ended September 30, 2003. Interest and other income in theprior period included interest received on an income tax receivable collectedduring the quarter, which was offset by lower cash balances combined with adecline in short-term interest rates.

 

On June 20, 2003, NEON entered into an Asset PurchaseAgreement with a third party software vendor to sell its iWave product lineassets.  As a result of the transaction,NEON recorded a gain on the sale of $343,000, net of closing expenses duringthe six months ended September 30, 2003. Total revenues attributed to the iWave product line for the six monthsended September 30, 2003 were $194,000. Operating losses associated with the iWave product line were classifiedas discontinued operations and represented $244,000 for the six months endedSeptember 30, 2003.

 

During the three months endedJune 30, 2004, NEON recognized a gain on sale of the notes receivable fromScalable Software (see Related Party Transactions).  The gain of $1.2 million resulted from netcash proceeds of $4.7 million, which was in excess of the recorded net book valueof $3.5 million.

 

No provision for income taxeswas recorded for the six months ended September 30, 2004 or 2003, as thecurrent year taxable income is offset by net operating loss carry-forwards thatNEON had previously reserved.  At March31, 2004, NEON has a net operating loss carry-forward for income tax purposesof approximately $19.3 million that is available to offset future taxable income,if any. The net operating loss carry-forwards in the United Kingdom, Germanyand Australia carry forward indefinitely. The net operating loss carry-forward for the United States beginsexpiring in the tax year 2020.  Given therecent tax losses experienced by NEON, there can be no assurance that theoperations will generate taxable income in the future to utilize these losses,therefore, as of September 30, 2004, NEON has recorded a full valuationallowance for the deferred tax assets related to the future benefits, if any,for these loss carry forwards.

 

LIQUIDITY AND CAPITAL RESOURCES

 

NEON’s cash and cash equivalentsat September 30, 2004 were $22.3 million, an increase of $1.4 million from$20.9 million at March 31, 2004. This increase was due primarily to the sale ofthe notes receivable from Scalable Software (See Related Party Transactions)and collection of account receivables, offset by funds used in the purchase ofInnerAccess.

 

Net cash used in operatingactivities was $452,000, versus $518,000 for the six months ended September 30,2004 and 2003, respectively.  Net cashused in operating activities for the six months ended September 30, 2004resulted primarily from a decrease in deferred revenue and settlement of accountspayable and accrued liabilities in excess of receivables collections.  The net cash used in operating activitiesduring the six months ended September 30, 2003, resulted primarily from areduction in deferred revenue.

 

During the six months endedSeptember 30, 2004, net cash provided by investing activities was $1.9 million,primarily resulting from the proceeds from the sale of the notes receivablefrom Scalable Software in excess of cash used to acquire InnerAccess.  Net cash provided by investing activitiesduring the six months ended September 30, 2003 was $429,000, primarily due tothe sale of the iWave product line.

 

NEON’s net cash provided byfinancing activities was $3,000 and $54,000 for the six months ended September30, 2004 and 2003, respectively. The net cash provided by financing activitiesfor the six months ended September 30, 2004 represents proceeds from theexercise of employee stock options, less payments on a capital lease forequipment acquired from InnerAccess.  Forthe six months ended September 30, 2003, net cash flow from financingactivities consisted of proceeds from exercise of stock options.

 

NEON’s future liquidity andcapital requirements will depend upon numerous factors, including the costsassociated with potential future business and product acquisitions, the costsand timing of expansion of product development efforts and the success of thesedevelopment efforts, the costs and timing of expansion of sales and marketingactivities, the extent to which our existing and new products gain marketacceptance, market developments, the costs involved in maintaining andenforcing intellectual property rights, the level and timing of licenserevenue, and other factors. NEON believes that its current balance of 

 

18

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cashand cash equivalents will be sufficient to meet its working capital, fundingcommitments and anticipated capital expenditure requirements for at least thenext 12 months. NEON may require additional funds to support its workingcapital requirements or for other purposes and may seek to raise additionalfunds through public or private equity financing or from other sources. Therecan be no assurance that additional financing will be available at all, or ifavailable, that such financing will be obtainable on terms acceptable to NEON,or that any additional financing will not be dilutive.

 

ITEM 3.                       QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK

 

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

 

The majority of NEON’s foreigncurrency transactions are denominated in the British pounds sterling, which isthe functional currency of NEON Systems (UK) Ltd. As these sales contracts aredenominated and settled in the functional currency, risks associated withcurrency fluctuations are minimized to foreign currency translationadjustments. NEON does not currently hedge against foreign currency translationrisks and believes that foreign currency exchange risk is not significant toits operations.  As a result of NEON’sacquisition of InnerAccess Technologies, Inc. in July 2004, additional risksassociated with currency fluctuations between Canadian dollar and US dollarsmay occur.

 

NEON adheres to a conservativeinvestment policy, whereby its principal concern is the preservation of liquidfunds while maximizing its yield on such assets. Cash and cash equivalentsapproximated $22.3 million at September 30, 2004 and were invested in varioustypes of investment grade short-term commercial paper and moneysecurities.  NEON believes that anear-term change in interest rates would not materially affect its financialposition, results of operations or net cash flows for fiscal year 2005.

 

ITEM 4.   CONTROLS AND PROCEDURES

 

As of the end of the periodcovered by this Quarterly Report on Form 10-Q, NEON carried out an evaluation,under the supervision and with the participation of NEON’s management,including the Chief Executive Officer and Chief Financial Officer, of theeffectiveness of the design and operation of NEON’s disclosure controls andprocedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of1934).  Based upon that evaluation, theChief Executive Officer and Chief Financial Officer concluded that NEON’sdisclosure controls and procedures are effective in ensuring that materialinformation is accumulated and communicated to management, and made known tothe Chief Executive Officer and Chief Financial Officer, on a timely basis toallow disclosure as required in this Quarterly Report on Form 10-Q.  There have been no changes in our internalcontrols over financial reporting during the three months ended September 30,2004 that have materially affected, or are reasonably likely to materiallyaffect, our internal control over financial reporting..

 

PARTII - OTHER INFORMATION

 

ITEM 1.      LEGAL PROCEEDINGS - On January 29, 2003, NEON receivednotification that it had been sued in Fort Bend County, Texas for allegedtortious interference with contract, tortious interference with prospectivebusiness relations and unfair competition in a lawsuit styled Phoenix NetworkTechnologies (Europe) Limited vs. NEON Systems, Inc. and Computer AssociatesInternational Inc., 400thDistrict Court, Ft. Bend County, Richmond, Texas, Cause Number 03-CV-127800. OnOctober 27, 2003, the court granted NEON’s motion to dismiss the case.  Phoenix Network Technologies has appealedthis decision, and NEON is continuing to defend this action.  Aside from this action, NEON is not involvedin any current material claim or legal action other than those arising in theordinary course of business.

 

ITEM 2.                       UNREGISTERED SALES OF EQUITYSECURITIES AND USE OF PROCEEDS

 

On July 14, 2004,NEON acquired 100% interest in InnerAccess Technologies, Inc. (InnerAccess), acompany incorporated under the laws of the province of Quebec, Canada.  InnerAccess develops, markets and licensesweb services technology and provides services related to the integration ofmainframe data sources with modern distributed computing systems.  NEON paid the InnerAccess Shareholders atotal of $2.4 million dollars in cash and issued 407,000 shares of NEONrestricted common stock to the amalgamated entity, of which 406,000 have beentransferred to the shareholders of InnerAccess in consideration for the

 

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acquisition.  All issuances and transfers of NEON commonstock were exempt from SEC registration requirements under Regulation S.  These shares are included in the weightedaverage shares outstanding for the respective periods.

 

In addition, NEONhas assumed certain special warrants of InnerAccess, which, on a convertedbasis, represent the right to acquire an additional 19,894 shares of NEONcommon stock at a cash exercise price equal to $9.50 per share.  In connection with the issuance of the sharesof NEON common stock, NEON has also agreed to enter into a registration rightsagreement with each former InnerAccess Shareholder in the form attached asExhibit 4.1 to our Form 8-K filed with the SEC on July 29, 2004.  Such Registration Rights Agreement grants toeach such former InnerAccess Shareholder a right to piggyback on any publicoffering of NEON shares of common stock during the one year period followingthe closing of the acquisition of InnerAccess by NEON.

 

ITEM 3.                       DEFAULTS UPON SENIOR SECURITIES -Not applicable.

 

ITEM 4.        SUBMISSION OF MATTERSTO A VOTE OF SECURITY HOLDERS

 

On September 20, 2004, NEONconvened its Annual Meeting of Stockholders for the fiscal year ended March 31,2004.  As of the record date of July 21,2004, there were approximately 8,917,227 million shares issued andoutstanding.  At the Annual Meeting,which was held at NEON’s headquarters in Sugar Land, Texas on September 20,2004, the following matters were submitted to the stockholders for a vote andwere approved by the vote reflected below each such proposal (percentagesreflect percentage of total outstanding common stock):

 

•                  **Election of five directors to serve on the Board ofDirectors**

 

At the annual meeting of stockholders held onSeptember 20, 2004, the following five directors were elected as directors forterms expiring at the annual meeting to be held in 2005:  George Ellis, Richard Holcomb, Mark J.Cresswell, Dave F. Cary, and Loretta Cross.

 

The voting results were as follows:

(In thousands)

 
| **Nominee**     | ** ** | **Votes For** | ** ** | **(%)** | ** ** | **Votes Withheld** | ** ** | **(%)** | ** ** |
|-----------------|------------|---------------|------------|---------|------------|--------------------|------------|---------|------------|
|            |       |          |       |    |       |               |       |    |       |
| George Ellis    |       | 8,462,803     |       | 94.9    | %          | 23,037             |       | .03     | %          |
| Richard Holcomb |       | 8,457,503     |       | 94.8    | %          | 28,337             |       | .03     | %          |
| Mark Cresswell  |       | 8,356,603     |       | 93.7    | %          | 129,237            |       | 1.5     | %          |
| Dave F. Cary    |       | 8,462,803     |       | 94.9    | %          | 23,037             |       | .03     | %          |
| Loretta Cross   |       | 8,459,603     |       | 94.8    | %          | 26,237             |       | .03     | %          |

 

•                  **Ratification of KPMG LLP as independent auditors forthe fiscal year ending March 31, 2005**

 

The Audit Committee of the Board of Directors selectedKPMG LLP as the Company’s independent public accountants for the fiscal yearending March 31, 2005. KPMG LLP has audited the Company’s financial statementssince its initial public offering in fiscal 1999.

 

At the Annual Meeting of Stockholders on September 20,2004, the stockholders ratified the Board’s selection of KPMG as NEON’sindependent auditors, casting 8,482,028 million votes in favor of theratification (95.1%) and 3,100 votes against ratification (.03%), with 712abstentions (.01%).

 

Effective upon the adjournment of the Annual Meetingof Stockholders, the compensation arrangements for independent directors waschanged to an annual fee of $20,000 for each director, a $10,000 annual fee forthe lead independent director, a $5,000 annual fee for each Committee Chairman,a $1,000 Board Meeting Fee, and a $500 Committee Meeting fee.

 

20

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ITEM 5.        OTHER INFORMATION –  None

 

ITEM 6.        EXHIBITS AND REPORTSON FORM 8-K

 

(a)                            EXHIBITS

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

 

(b)                         REPORTSON FORM 8-K

 

Form 8-K filed with theSecurities and Exchange Commission on July 29, 2004 regarding the acquisitionof InnerAccess Technologies, Inc.

 

Form 8-K filed with theSecurities and Exchange Commission on August 16, 2004 regarding the earningsconference call and press release.

 

Form 8-K/A filed with theSecurities and Exchange Commission on September 27, 2004 regarding financialstatements and pro forma financial statements related to NEON Systems Inc.’sacquisition of InnerAccess Technologies, Inc.

 

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SIGNATURES

 

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

 
|   | NEON SYSTEMS, INC.                           |
|--------|----------------------------------------------|
|   |                                         |
| Date:  | November 15, 2004                            |   | /s/ Brian D. Helman |   |
|   | Chief Financial Officer                      |
|   | (principal financial and accounting officer) |
|   |                                         |
|   |                                         |
| Date:  | November 15, 2004                            |   | /s/ Mark J. Cresswell |   |
|   | President and Chief Executive Officer        |
|   | (principal executive officer)                |

 

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