**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

 

**Form 10-Q**

 

**(Mark One)**

 

**ý****QUARTERLY REPORT PURSUANT TO SECTION 13 OR15(d) OF THE****SECURITIESEXCHANGE ACT OF 1934**

 

**For the Quarterly Period Ended September 30,2005**

 

**OR**

 

**o****TRANSITION REPORT PURSUANT TO SECTION 13 OR15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

** **

**For the transition period from                 to                 **

 

**CommissionFile Number: 0-25457**

** **

**NEON Systems, Inc.**

(Exact name ofRegistrant as specified in its charter)

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

 

**(281)491-4200**

(Registrant’s telephonenumber, including area code)

 

Indicateby check mark whether Registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934during the preceding 12 months (or for such shorter period that Registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.  Yes ý  No  o

 

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

Yes  o No ý

 

Indicate by check mark whetherthe registrant is a shell company (as defined in Rule 12b-2 of theExchange Act).

Yes  o No ý

 

The number of shares of the registrant’s commonstock outstanding as of November 10, 2005, was 9,558,198

 

 

----

 

NEON SYSTEMS, INC.

 

FORM 10-Q

 

FOR THE QUARTER ENDED SEPTEMBER 30, 2005

 

INDEX

 
| PART I.                    | FINANCIAL INFORMATION                                                                                                 |   |
|---------------------------------|-----------------------------------------------------------------------------------------------------------------------|--------|
|                            |                                                                                                                  |   |
| Item 1.                         | Financial Statements                                                                                                  |   |
|                            |                                                                                                                  |   |
|                            | Condensed Consolidated  Balance Sheets at September 30, 2005 and March 31, 2005                             |   |
|                            |                                                                                                                  |   |
|                            | Condensed Consolidated  Statements of Operations for the Three and Six Months Ended September 30,  2005 and 2004 |   |
|                            |                                                                                                                  |   |
|                            | Condensed Consolidated  Statements of Cash Flows for the Six Months Ended September 30, 2005 and  2004           |   |
|                            |                                                                                                                  |   |
|                            | Condensed Notes to the  Condensed 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                                                                                                     |   |
|                            |                                                                                                                  |   |
| SIGNATURES                      |                                                                                                                  |

 

2

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PART I - FINANCIALINFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

 

NEON SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED CONSOLIDATED BALANCESHEETS

(IN THOUSANDS, EXCEPT SHARE AND PER SHAREAMOUNTS)

 
| ** **                                                                                                                                                                            | ** ** | **SEPTEMBER 30,  2005** | ** ** | **MARCH 31,  2005** | ** ** |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------------|------------|--------------------------|------------|
| ** **                                                                                                                                                                            | ** ** | **(UNAUDITED)**              | ** ** | ** **               | ** ** |
| ASSETS                                                                                                                                                                                |       |                         |       |                     |       |
|                                                                                                                                                                                  |       |                         |       |                     |       |
| CURRENT ASSETS:                                                                                                                                                                       |       |                         |       |                     |       |
| Cash  and cash equivalents                                                                                                                                                            |       | $                            | 16,465     |                     | $          | 13,317 |   |
| Accounts  receivable, net                                                                                                                                                             |       | 4,753                        |       | 5,056                    |       |
| Notes  receivable, net                                                                                                                                                                |       | —                       |       | 4,260                    |       |
| Prepaid  and other current assets                                                                                                                                                     |       | 994                          |       | 1,112                    |       |
| Total  current assets                                                                                                                                                                 |       | 22,212                       |       | 23,745                   |       |
|                                                                                                                                                                                  |       |                         |       |                     |       |
| Property  and equipment, net                                                                                                                                                          |       | 642                          |       | 725                      |       |
| Acquired  intangibles, net                                                                                                                                                            |       | 7,447                        |       | 8,386                    |       |
| Goodwill                                                                                                                                                                              |       | 9,594                        |       | 9,594                    |       |
| Other  assets                                                                                                                                                                         |       | 538                          |       | 550                      |       |
| Total  assets                                                                                                                                                                         |       | $                            | 40,433     |                     | $          | 43,000 |   |
|                                                                                                                                                                                  |       |                         |       |                     |       |
| LIABILITIES &  STOCKHOLDERS’ EQUITY                                                                                                                                     |       |                         |       |                     |       |
|                                                                                                                                                                                  |       |                         |       |                     |       |
| CURRENT LIABILITIES:                                                                                                                                                                  |       |                         |       |                     |       |
| Accounts  payable and accrued liabilities                                                                                                                                             |       | $                            | 1,811      |                     | $          | 3,359 |   |
| Deferred  revenue                                                                                                                                                                     |       | 7,081                        |       | 7,485                    |       |
| Total  current liabilities                                                                                                                                                            |       | 8,892                        |       | 10,844                   |       |
|                                                                                                                                                                                  |       |                         |       |                     |       |
| Non-current Liabilities:                                                                                                                                                              |       |                         |       |                     |       |
| Accrued  liabilities                                                                                                                                                                  |       | 594                          |       | 678                      |       |
| Deferred  revenue                                                                                                                                                                     |       | 3,737                        |       | 4,138                    |       |
| Deferred  income taxes                                                                                                                                                                |       | 478                          |       | 493                      |       |
| Total  liabilities                                                                                                                                                                    |       | 13,701                       |       | 16,153                   |       |
|                                                                                                                                                                                  |       |                         |       |                     |       |
| 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; 9,558,198 and 9,499,544  shares issued and outstanding at September 30, 2005 and March 31,  2005, respectively |       | 105                          |       | 104                      |       |
| Additional  paid-in capital                                                                                                                                                           |       | 54,829                       |       | 54,708                   |       |
| Treasury  stock, 913,400 shares at cost                                                                                                                                               |       | (2,649                       | )          | (2,649                   | )          |
| Accumulated  other comprehensive loss                                                                                                                                                 |       | (378                         | )          | (418                     | )          |
| Accumulated  deficit                                                                                                                                                                  |       | (25,175                      | )          | (24,898                  | )          |
| Total  stockholders’ equity                                                                                                                                                      |       | 26,732                       |       | 26,847                   |       |
| Commitments and contingencies  (Note 6)                                                                                                                                               |       |                         |       |                     |       |
|                                                                                                                                                                                  |       |                         |       |                     |       |
| Total  liabilities and stockholders’ equity                                                                                                                                      |       | $                            | 40,433     |                     | $          | 43,000 |   |

 

SEE ACCOMPANYING CONDENSED NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS

 

3

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NEON SYSTEMS, INC. AND SUBSIDIARIES

CONDENSEDCONSOLIDATED STATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

(UNAUDITED)

 
| ** **                                 | ** ** | **THREE  MONTHS ENDED  SEPTEMBER 30,** | ** ** | **SIX  MONTHS ENDED  SEPTEMBER 30,** | ** ** |
|--------------------------------------------|------------|---------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                 | ** ** | **2005**                                    | ** ** | **2004**                                  | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues:                                  |       |                                        |       |                                      |       |   |   |   |   |
| License                                    |       | $                                           | 2,860      |                                      | $          | 1,186 |   | $ | 3,846 |   | $ | 2,289 |   |
| Maintenance                                |       | 2,891                                       |       | 2,497                                     |       | 5,911 |   | 4,916 |   |
| Service                                    |       | 192                                         |       | 73                                        |       | 478 |   | 121 |   |
| Total  revenues                            |       | 5,943                                       |       | 3,756                                     |       | 10,235 |   | 7,326 |   |
|                                       |       |                                        |       |                                      |       |   |   |   |   |
| Cost  of revenues:                         |       |                                        |       |                                      |       |   |   |   |   |
| Cost  of license                           |       | 477                                         |       | 164                                       |       | 953 |   | 196 |   |
| Cost  of maintenance                       |       | 344                                         |       | 373                                       |       | 655 |   | 736 |   |
| Cost  of service                           |       | 80                                          |       | —                                    |       | 186 |   | — |   |
| Total  cost of revenues                    |       | 901                                         |       | 537                                       |       | 1,794 |   | 932 |   |
|                                       |       |                                        |       |                                      |       |   |   |   |   |
| Gross  profit                              |       | 5,042                                       |       | 3,219                                     |       | 8,441 |   | 6,394 |   |
|                                       |       |                                        |       |                                      |       |   |   |   |   |
| Operating  expenses:                       |       |                                        |       |                                      |       |   |   |   |   |
| Sales  and marketing                       |       | 2,319                                       |       | 1,658                                     |       | 4,486 |   | 3,241 |   |
| Research  and development                  |       | 1,302                                       |       | 1,294                                     |       | 2,662 |   | 2,278 |   |
| General  and administrative                |       | 997                                         |       | 902                                       |       | 2,091 |   | 1,803 |   |
| Total  operating expenses                  |       | 4,618                                       |       | 3,854                                     |       | 9,239 |   | 7,322 |   |
|                                       |       |                                        |       |                                      |       |   |   |   |   |
| Operating  income (loss)                   |       | 424                                         |       | (635                                      | )          | (798 | ) | (928 | ) |
|                                       |       |                                        |       |                                      |       |   |   |   |   |
| Gain  on sale of notes receivable          |       | 250                                         |       | —                                    |       | 336 |   | 1,215 |   |
| Interest  and other income, net            |       | 117                                         |       | 69                                        |       | 265 |   | 114 |   |
|                                       |       |                                        |       |                                      |       |   |   |   |   |
| Income  (loss) before income taxes         |       | 791                                         |       | (566                                      | )          | (197 | ) | 401 |   |
| Income  taxes                              |       | 67                                          |       | —                                    |       | 80 |   | — |   |
| Net  income (loss)                         |       | $                                           | 724        |                                      | $          | (566 | ) | $ | (277 | ) | $ | 401 |   |
|                                       |       |                                        |       |                                      |       |   |   |   |   |
| Earnings  per common share — basic:   |       |                                        |       |                                      |       |   |   |   |   |
| Net  income (loss)                         |       | $                                           | 0.08       |                                      | $          | (0.06 | ) | $ | (0.03 | ) | $ | 0.04 |   |
|                                       |       |                                        |       |                                      |       |   |   |   |   |
| Earnings  per common share — diluted: |       |                                        |       |                                      |       |   |   |   |   |
| Net  income (loss)                         |       | $                                           | 0.07       |                                      | $          | (0.06 | ) | $ | (0.03 | ) | $ | 0.04 |   |
|                                       |       |                                        |       |                                      |       |   |   |   |   |
| Weighted  average shares outstanding:      |       |                                        |       |                                      |       |   |   |   |   |
| Basic                                      |       | 9,558                                       |       | 9,266                                     |       | 9,534 |   | 9,092 |   |
| Diluted                                    |       | 9,660                                       |       | 9,266                                     |       | 9,534 |   | 9,459 |   |

 

SEE ACCOMPANYING CONDENSED NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS

 

4

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NEON SYSTEMS, INC. AND SUBSIDIARIES

CONDENSEDCONSOLIDATED STATEMENTS OF CASH FLOWS

(IN THOUSANDS)

(UNAUDITED)

 
| ** **                                                                            | ** ** | **SIX  MONTHS ENDED SEPTEMBER 30,** | ** ** |
|---------------------------------------------------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                            | ** ** | **2005**                                 | ** ** | **2004** | ** ** |
| CASH  FLOWS FROM OPERATING ACTIVITIES:                                                |       |                                     |       |   |   |
| Net  income (loss)                                                                    |       | $                                        | (277       | ) | $ | 401 |   |
| Adjustments  to reconcile net income (loss) to net cash used in operating activities: |       |                                     |       |   |   |
| Depreciation                                                                          |       | 183                                      |       | 196 |   |
| Amortization  of acquired intangibles                                                 |       | 939                                      |       | 193 |   |
| Gain  on sale of notes receivable                                                     |       | (336                                     | )          | (1,215 | ) |
| Gain  on sale of assets                                                               |       | (55                                      | )          | — |   |
| Deferred  tax expense                                                                 |       | 50                                       |       | — |   |
| Increase  (decrease) in cash resulting from changes in:                               |       |                                     |       |   |   |
| Accounts  receivable                                                                  |       | 236                                      |       | 1,927 |   |
| Prepaid  and other assets                                                             |       | 37                                       |       | 63 |   |
| Accounts  payable and accrued liabilities                                             |       | (1,516                                   | )          | (1,908 | ) |
| Deferred  revenue and other                                                           |       | (607                                     | )          | (109 | ) |
|                                                                                  |       |                                     |       |   |   |
| Net  cash used in operating activities                                                |       | (1,346                                   | )          | (452 | ) |
|                                                                                  |       |                                     |       |   |   |
| CASH  FLOWS FROM INVESTING ACTIVITIES:                                                |       |                                     |       |   |   |
| Purchase  of assets, net of sales proceeds                                            |       | (93                                      | )          | (190 | ) |
| Purchase  of technology                                                               |       | —                                   |       | (264 | ) |
| Acquisitions,  net of cash acquired                                                   |       | —                                   |       | (2,412 | ) |
| Proceeds  from sale of notes receivable, net                                          |       | 4,596                                    |       | 4,715 |   |
| Other  investment costs, net                                                          |       | (40                                      | )          | — |   |
|                                                                                  |       |                                     |       |   |   |
| Net  cash provided by investing activities                                            |       | 4,463                                    |       | 1,849 |   |
|                                                                                  |       |                                     |       |   |   |
| CASH  FLOWS FROM FINANCING ACTIVITIES:                                                |       |                                     |       |   |   |
| Proceeds  from exercises of stock options                                             |       | 122                                      |       | 10 |   |
|                                                                                  |       |                                     |       |   |   |
| Net  cash provided by financing activities                                            |       | 122                                      |       | 10 |   |
|                                                                                  |       |                                     |       |   |   |
| Net  increase in cash and cash equivalents                                            |       | 3,239                                    |       | 1,407 |   |
| Effect  of exchange rates on cash                                                     |       | (91                                      | )          | 9 |   |
| Cash  and cash equivalents at beginning of period                                     |       | 13,317                                   |       | 20,899 |   |
|                                                                                  |       |                                     |       |   |   |
| Cash  and cash equivalents at end of period                                           |       | $                                        | 16,465     |   | $ | 22,315 |   |
|                                                                                  |       |                                     |       |   |   |
|                                                                                  |       |                                     |       |   |   |
| Cash  paid for income taxes                                                           |       | $                                        | —     |   | $ | 40 |   |

 

SEE ACCOMPANYING CONDENSED NOTES TO CONDENSED CONSOLIDATEDFINANCIAL STATEMENTS

 

5

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NEON SYSTEMS, INC. AND SUBSIDIARIES

CONDENSEDNOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

NOTE 1—BASIS OF PRESENTATION

 

The accompanying unaudited condensedconsolidated financial statements for NEON Systems, Inc. and itssubsidiaries (collectively, “NEON”) have been prepared in accordance with U.S. generallyaccepted accounting principles for interim financial reporting and inaccordance with Regulation S-X of the Securities and Exchange Commission.Accordingly, they do not include all of the information and footnotes requiredby U.S. generally accepted accounting principles for complete financialstatements. In the opinion of management, the unaudited condensed consolidatedfinancial statements contained in this report reflect all adjustments,consisting of only normal recurring adjustments, considered necessary for afair presentation of the financial position and the results of operations forthe interim periods presented. Operating results for interim periods are notnecessarily indicative of results for the full year. These unaudited condensed consolidatedfinancial statements, footnote disclosures and other information should be readin conjunction with the financial statements and the notes thereto included inNEON’s audited consolidated financial statements for the fiscal year ended March 31,2005, which are included in NEON’s Form 10-K for the fiscal year ended March 31,2005.  Certain prior period amounts havebeen reclassified to conform to current period presentation.

 

NOTE 2—PER SHARE INFORMATION

 

##### ***SignificantAccounting Policy***

 

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 date)*

 
| ** **                                           | ** ** | **THREE  MONTHS ENDED****SEPTEMBER 30,** | ** ** | **SIX  MONTHS ENDED****SEPTEMBER 30,** | ** ** |
|------------------------------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                           | ** ** | **2005**                                      | ** ** | **2004**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                           | ** ** | ** **                                    | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income (loss), as  reported                      |       | $                                             | 724        |                                        | $          | (566 | ) | $ | (277 | ) | $ | 401 |   |
|                                                 |       |                                          |       |                                        |       |   |   |   |   |   |   |   |   |
| Weighted average  outstanding shares of common stock |       | 9,558                                         |       | 9,266                                       |       | 9,534 |   | 9,092 |   |
| Dilutive effect of  employee stock options           |       | 102                                           |       | —                                      |       | — |   | 367 |   |
| Common stock and common  stock equivalents           |       | 9,660                                         |       | 9,266                                       |       | 9,534 |   | 9,459 |   |
|                                                 |       |                                          |       |                                        |       |   |   |   |   |
| Earnings per share:                                  |       |                                          |       |                                        |       |   |   |   |   |
| Basic                                                |       | $                                             | 0.08       |                                        | $          | (0.06 | ) | $ | (0.03 | ) | $ | 0.04 |   |
| Diluted                                              |       | $                                             | 0.07       |                                        | $          | (0.06 | ) | $ | (0.03 | ) | $ | 0.04 |   |

 

At September 30,2005 and 2004, there were options outstanding to purchase 3.0 million shares ofcommon stock with a weighted-average exercise price of $5.32 and $5.78,respectively. For the three months ended September 30, 2005 and 2004, 2.3 millionand 3.0 million options, respectively, were excluded from the computation ofdiluted earnings per share because the effect was anti-dilutive. For thesix months ended September 30, 2005 and 2004, 3.0 and 2.2 million options, respectively, were excluded fromthe computation of diluted earnings per share.

 

6

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Also excluded from thecomputation of diluted earnings per share for the three and six months ended September 30,2005 was a warrant to acquire up to 1.1 million shares of NEON common stock ata price of $4.80 per share.  This warrant was issued in conjunction withthe acquisition of ClientSoft, Inc. (ClientSoft).

 

##### ***EmployeeStock-Based Compensation***

##### ** **

NEON applies the intrinsicvalue-based method of accounting prescribed by Accounting Principles Board (“APB”)Opinion No. 25, *Accounting For StockIssued To Employees*, and related interpretations.  As such, compensation expense has beenrecorded on the date of grant only if the estimated value of the underlyingstock exceeded 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 allowsentities to continue to apply the provisions of APB Opinion No. 25 andprovide pro forma net income and pro forma earnings per share disclosures foremployee stock option grants made in 1996 and future years as if thefair-value-based method defined in SFAS No. 123 had been applied.  NEON has elected to continue to apply theprovisions of APB Opinion No. 25 and provide the pro forma disclosureprovisions of SFAS No. 123, as amended by SFAS No. 148, *Accounting for Stock-Based Compensation—Transitionand Disclosure—an amendment of FASB Statement 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,** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|
| ** **                                                                                                       | ** ** | **2005**                                   | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                                       | ** ** | ** **                                 | ** ** | ** **                               | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net  income (loss), as reported                                                                                  |       | $                                          | 724        |                                     | $          | (566 | ) | $ | (277 | ) | $ | 401 |   |
| Deduct  total stock-based employee compensation expense determined under  fair-value-based method for all awards |       | 355                                        |       | 409                                      |       | 686 |   | 794 |   |
| Pro  forma net income (loss)                                                                                     |       | $                                          | 369        |                                     | $          | (975 | ) | $ | (963 | ) | $ | (393 | ) |
|                                                                                                             |       |                                       |       |                                     |       |   |   |   |   |
| Basic  earnings (loss) per share:                                                                                |       |                                       |       |                                     |       |   |   |   |   |
| As  reported                                                                                                     |       | $                                          | 0.08       |                                     | $          | (0.06 | ) | $ | (0.03 | ) | $ | 0.04 |   |
| Pro  forma                                                                                                       |       | $                                          | 0.04       |                                     | $          | (0.11 | ) | $ | (0.10 | ) | $ | (0.04 | ) |
|                                                                                                             |       |                                       |       |                                     |       |   |   |   |   |
| Diluted  earnings (loss) per share:                                                                              |       |                                       |       |                                     |       |   |   |   |   |
| As  reported                                                                                                     |       | $                                          | 0.07       |                                     | $          | (0.06 | ) | $ | (0.03 | ) | $ | 0.04 |   |
| Pro  forma                                                                                                       |       | $                                          | 0.04       |                                     | $          | (0.11 | ) | $ | (0.10 | ) | $ | (0.04 | ) |

 

NOTE 3—INCOME TAXES

 

As of March 31, 2005, NEONhas a net operating loss carry-forward for income tax purposes of $23.4 millionthat is available to offset future taxable income, if any. The estimated netoperating loss carry-forward consists of $19.8 million in the United States, $1.3million in the United Kingdom, $600,000 in Canada and $1.7 million in Germany.The net operating loss carry-forwards in the United Kingdom and Germany carryforward indefinitely. The net operating loss carry-forwards for the UnitedStates and Canada begin expiring in 2020 and 2008, respectively.  Additionally, NEON has a United States losscarryforward of $4.8 million available to offset future capital gains.

 

In assessing the realizabilityof net deferred tax assets in each taxation jurisdiction, management considerswhether it is more likely than not that some portion or all of the deferred taxassets will not be realized.  Thisassessment may result in recording a valuation allowance.  Due to the Company’s history of operatinglosses, as of September 30, 2005 and 2004, management determined that itwas not more likely than not that the Company would be able to realize thebenefits of its net deferred tax assets in the United States, the UnitedKingdom and Germany. Therefore, management has recorded a valuation allowanceto fully reserve the net deferred tax assets in these countries.

 

7

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As of September 30, 2005,NEON has deferred tax assets and liabilities related primarily to net operatingloss carryforwards in Canada, as well as deductible goodwill and non-deductibleacquired intangibles resulting from the acquisitions of businesses in the U.S.and Canada.  Income tax expense for theperiods is as follows:

 
| ** **   | ** ** | **THREE  MONTHS ENDED SEPTEMBER 30,** | ** ** | **SIX  MONTHS ENDED****SEPTEMBER 30,** | ** ** |
|--------------|------------|--------------------------------------------|------------|---------------------------------------------|------------|
| ** **   | ** ** | **2005**                                   | ** ** | **2004**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **   | ** ** | ** **                                 | ** ** | ** **                                  | ** ** | ** ** | ** ** | ** ** | ** ** |
| Income taxes |       |                                       |       |                                        |       |   |   |   |   |
| Current      |       | 30                                         |       | —                                      |       | 30 |   | — |   |
| Deferred     |       | 37                                         |       | —                                      |       | 50 |   | — |   |
| Total        |       | $                                          | 67         |                                        | $          | — |   | $ | 80 |   | $ | — |   |
|              |            |                                            |            |                                             |            |  |  |  |  |  |  |  |  |

 

NOTE 4—SEGMENT REPORTING

 

NEON considers its businessactivities to be in a single segment.  Forthe three months ended September 30, 2005, NEON had one customer thataccounted for 13% of total consolidated revenues.  Additionally, this customer accounted for 34%of outstanding accounts receivable at September 30, 2005. For the threemonths ended September 30, 2004, NEON had one customer that accounted for12% of total consolidated revenues.  NEONdid not have any customers that accounted for 10% or more of consolidatedrevenue during the six month periods ended September 30, 2005 or 2004.

 

The tables below summarizerevenues and identifiable assets by geographic region (in thousands).

 
| ** **                | ** ** | **THREE  MONTHS ENDED SEPTEMBER 30,** | ** ** | **SIX  MONTHS ENDED SEPTEMBER 30,** | ** ** |
|---------------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|
| ** **                | ** ** | **2005**                                   | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues:                 |       |                                       |       |                                     |       |   |   |   |   |
| North  America            |       | $                                          | 4,640      |                                     | $          | 2,862 |   | $ | 8,151 |   | $ | 5,414 |   |
| United  Kingdom           |       | 1,303                                      |       | 798                                      |       | 2,070 |   | 1,725 |   |
| Other                     |       | —                                     |       | 96                                       |       | 14 |   | 187 |   |
|                      |       | $                                          | 5,943      |                                     | $          | 3,756 |   | $ | 10,235 |   | $ | 7,326 |   |
|                      |       |                                       |       |                                     |       |   |   |   |   |
| Operating  income (loss): |       |                                       |       |                                     |       |   |   |   |   |
| North  America            |       | $                                          | (398       | )                                        | $          | (1,054 | ) | $ | (1,771 | ) | $ | (1,628 | ) |
| United  Kingdom           |       | 822                                        |       | 363                                      |       | 959 |   | 675 |   |
| Other                     |       | —                                     |       | 56                                       |       | 14 |   | 25 |   |
|                      |       | $                                          | 424        |                                     | $          | (635 | ) | $ | (798 | ) | $ | (928 | ) |
|                      |       |                                       |       |                                     |       |   |   |   |   |
| ** **                | ** ** | **SEPTEMBER 30,  2005**               | ** ** | **MARCH 31,  2005**                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Identifiable Assets:      |       |                                       |       |                                     |       |   |   |   |   |
| North  America            |       | $                                          | 17,907     |                                     | $          | 18,916 |   |   |   |   |   |
| United  Kingdom           |       | 314                                        |       | 339                                      |       |   |   |   |   |
|                      |       | $                                          | 18,221     |                                     | $          | 19,255 |   |   |   |   |   |

 

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NOTE 5— COMPREHENSIVE INCOME (LOSS)

 

The components of comprehensive income (loss) are asfollows (in thousands):

 
| ** **                               | ** ** | **THREE  MONTHS ENDED****SEPTEMBER 30,** | ** ** | **SIX  MONTHS ENDED****SEPTEMBER 30,** | ** ** |
|------------------------------------------|------------|-----------------------------------------------|------------|---------------------------------------------|------------|
| ** **                               | ** ** | **2005**                                      | ** ** | **2004**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net  income (loss)                       |       | $                                             | 724        |                                        | $          | (566 | ) | $ | (277 | ) | $ | 401 |   |
|                                     |       |                                          |       |                                        |       |   |   |   |   |
| Other  comprehensive income (loss):      |       |                                          |       |                                        |       |   |   |   |   |
| Foreign  currency translation adjustment |       | 7                                             |       | (7                                          | )          | 40 |   | (9 | ) |
| Comprehensive  income (loss)             |       | $                                             | 731        |                                        | $          | (573 | ) | $ | (237 | ) | $ | 392 |   |

 

NOTE 6—LITIGATION

 

On January 29, 2003, NEON received notificationthat it had been sued in Fort Bend County, Texas for alleged tortiousinterference with contract, tortious interference with prospective businessrelations and unfair competition in a lawsuit styled Phoenix NetworkTechnologies (Europe) Limited vs. NEON Systems, Inc. and ComputerAssociates International Inc., 400th District Court, Ft. Bend County, Richmond, Texas, CauseNumber 03-CV-127800. On October 27, 2003, the court granted NEON’s motion todismiss the case.  Phoenix NetworkTechnologies (“PNTE”) appealed this decision to the First District Court ofAppeals of Texas.  On August 25,2005, the district court affirmed the lower court’s decision to dismiss thecase.  Subsequently, PNTE has appealedsuch decision, and NEON will continue to defend this action.  Aside from these actions, NEON is notinvolved in any material current claim or legal action other than those arisingin the ordinary course of business.

 

NOTE 7—RESTRUCTURING CHARGES AND OTHER EXIT ACTIVITIES

 

During fiscal 2005, NEON recorded employee severance liabilitiesrelated to streamlining the organization after the acquisitions of InnerAccessTechnologies Inc. (InnerAccess) and ClientSoft. Additionally, during the threemonths ended September 30, 2005, NEON initiated severance activities thatwere charged to Sales and marketing expense in the accompanying unaudited condensedconsolidated statement of operations. The related balances and changes in balances are reflected in the tablebelow.

 

During periods prior to fiscal 2004, NEON recordedcosts associated with vacated facility leases and employee severance related tocorporate reorganization. NEON has not been able to sublease a portion of thevacated facilities for the duration of the lease commitments, and therefore, hasaccrued costs related to the unused portions of the future lease commitments.Securing new subleases of all or of a portion of these facilities orrenegotiation of existing leases in the future may result in complete orpartial reversal of this accrual.

 

The following table provides a roll-forward of the relatedaccrual balances for the six months ended September 30, 2005 and 2004 (inthousands):

 

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| ** **                       | ** ** | **Vacated  Facilities** | ** ** | **Severance  and Other** | ** ** | **Total** | ** ** |
|----------------------------------|------------|-------------------------|------------|--------------------------|------------|-----------|------------|
|                             |       |                    |       |                     |       |      |       |
| Balance March 31,  2005     |       | 782                     |       | 230                      |       | 1,012     |       |
| Charges (reversals)              |       | (105                    | )          | —                   |       | (105      | )          |
| Amounts paid                     |       | (77                     | )          | (230                     | )          | (307      | )          |
| Other adjustments                |       | (7                      | )          | —                   |       | (7        | )          |
| Balance September 30,  2005 |       | $                       | 593        |                     | —     |      | $          | 593 |   |
|                             |       |                    |       |                     |       |      |       |
| Balance March 31,  2004     |       | $                       | 1,516      |                     | $          | 38        |       | $ | 1,554 |   |
| Charges (reversals)              |       | (196                    | )          | —                   |       | (196      | )          |
| Amounts paid                     |       | (226                    | )          | (38                      | )          | (264      | )          |
| Other adjustments                |       | (16                     | )          | —                   |       | (16       | )          |
| Balance September 30,  2004 |       | $                       | 1,078      |                     | $          | —    |       | $ | 1,078 |   |
|                                  |            |                         |            |                          |            |           |            |  |  |  |  |

 

The balance at September 30, 2005 consists offuture cash payments for vacated facilities that will be paid through 2010. Ofthe total liability, $44,000 and $549,000 are reflected in current andnon-current accrued liabilities in the condensed consolidated balance sheet,respectively.  NEON does not expect to incur significantfuture costs in addition to those previously accrued, related to theseactivities.

 

Other adjustments to thebalance for the six months ended September 30, 2005 and 2004 relateprimarily to the effects of accretion of the present value of accrued leaseobligations as well as currency translation on foreign balances.

 

NOTE 8—RELATED PARTYTRANSACTIONS

 

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 had investments.  Transactions between NEON and these othercompanies are described below. The previous directors and officers involved insuch transactions 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 agreementwith Peregrine/Bridge Transfer Corporation, a database software company whosesole stockholder is an affiliate of John J. Moores, NEON’s largest shareholderand its former Chairman of the Board of Directors. PBTC subsequently changedits name to NEON Enterprise Software, Inc. (“NESI”).

 

In connection with the closing of the Termination andCustomer Support Agreement in August 2002, NESI issued two promissorynotes to NEON in the aggregate principal amount of $6.6 million, each securedby all of the intellectual property of NESI (“NESI IP”). On the closing of thetransaction in August 2002, NEON recorded the notes receivable from NESIat the estimated fair value, which was calculated at $4.3 million.

 

On April 15, 2005, NEON sold the notes issued byNESI to John J. Moores.  Mr. Moorespaid NEON $4.4 million on April 15, 2005 and issued a personal promissorynote in the amount of $2.2 million to NEON. Such promissory note will bear interest of 4.0% per annum and will bepayable at a rate of $250,000 per quarter.  NEON recorded a gain on sale of $336,000 for the six months ended September 30,2005, based on net proceeds of the cash payment in excess of the recorded valueof the notes.  Due to uncertaintyassociated with the related party nature of the unsecured promissory note, NEONwill recognize gain on sale in the consolidated statement of operations only ascash proceeds are received.

 

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*Scalable Software, Inc.*

 

Scalable Software, Inc. (“Scalable Software”), aHouston-based provider of software solutions for IT portfolio management, is acompany founded by Louis R. Woodhill, who served as NEON’s Chief ExecutiveOfficer from October 2001 until March 2003. Several former members ofNEON’s Board of Directors, including Louis R. Woodhill, John J. Moores, Peter Schaeffer,Charles E. Noell III and Jim Woodhill, had or have a financial interest inScalable Software.

 

In June 2002, NEON obtained a two-year option toacquire Scalable Software as outlined in the Agreement and Plan of Merger datedJune 26, 2002. In connection with this Option, NEON provided $6.0 millionin bridge financing to Scalable Software during fiscal 2002 and 2003, inaddition to $3.5 million previously loaned to Scalable Software that wassecured by personal guarantees from John J. Moores, Louis R. Woodhill and JimWoodhill. The aggregate financing had a 36-month term and did not bear interestduring the term of the two-year option to acquire Scalable Software, whichexpired June 26, 2004.

 

On June 9, 2004, NEON entered into a NotePurchase Agreement with JMI Services, Inc., the largest shareholder ofScalable Software, to sell the $3.5 million guaranteed note and the $6.0million secured note issued by Scalable Software to NEON for a cash purchaseprice of $4.8 million.  JMI Services is an affiliate of John J. Moores,NEON’s largest shareholder.  During the six months ended September 30,2004, NEON recognized a gain of $1.2 million as a result of net cash proceedsin excess of the recorded book value of the notes. The proposed sale of theScalable Software notes was reviewed and approved by the Special Committee ofthe Board of Directors, consisting of “independent” and disinteresteddirectors, and finally by the full Board of Directors, no member of which wasan interested or related party of either JMI Services, Inc. or ScalableSoftware.  The Board requested and received a fairness opinion from AvailConsulting, Inc., a Houston, Texas based independent valuation andfinancial consultant, stating that the transaction was fair to the stockholdersof NEON from a financial standpoint and recommending that the Board accept thepurchase offer made by JMI Services, Inc.  Based on such fairnessopinion, consideration of possible decline in the value of the underlyingsecurity for the secured note and the potential expense of collection effortswhen the notes matured in June 2005, the Board approved the sale of the ScalableSoftware Notes to JMI Services, Inc. The transaction closed on June 17, 2004.

 

NOTE 9—GOODWILL AND ACQUIREDINTANGIBLE ASSETS

 

**Goodwill:**

 

In accordance with SFAS No. 141, *Business Combinations*, purchase price inexcess of the fair values of acquired tangible and identifiable intangible netassets has been classified as goodwill.  The acquired goodwill will beassessed for impairment on an annual basis, or sooner if factors indicate suchis necessary.  Goodwill acquired in the InnerAccess and ClientSofttransactions was $2.1 million and $7.5 million, respectively.  The $7.5million of goodwill related to the ClientSoft acquisition is expected to bedeductible for tax purposes.  NEON reports one operating segment, and thatoperating segment has been identified as the reporting unit for the purpose ofassessing impairment of the acquired goodwill. NEON assessed all goodwill for impairment under the provisions of SFAS No. 142,*Goodwill and Intangible Assets*, at July 2005.  No goodwill impairment loss was required.

 

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**Intangible Assets:**

 

The components of identifiable intangible assetsacquired in the InnerAccess and ClientSoft transactions are as follows (inthousands):

 
|                                          |       | **As of September 30, 2005** | ** ** |
|-----------------------------------------------|------------|-----------------------------------|------------|
| ** **                                    | ** ** | **Gross Carrying  Amount**        | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying Value** | ** ** |
| InnerAccess:                                  |       |                              |       |   |   |   |   |
| Core technology                               |       | $                                 | 2,600      |   | $ | (633 | ) | $ | 1,967 |   |
| Maintenance  contracts/customer relationships |       | 660                               |       | (159 | ) | 501 |   |
| Total                                         |       | $                                 | 3,260      |   | $ | (792 | ) | $ | 2,468 |   |
|                                          |       |                              |       |   |   |   |   |
| ClientSoft:                                   |       |                              |       |   |   |   |   |
| Core technology                               |       | $                                 | 4,500      |   | $ | (713 | ) | $ | 3,787 |   |
| Maintenance  contracts/customer relationships |       | 1,100                             |       | (174 | ) | 926 |   |
| Total                                         |       | $                                 | 5,600      |   | $ | (887 | ) | $ | 4,713 |   |
|                                          |       |                              |       |   |   |   |   |
| Total intangibles                             |       | $                                 | 8,860      |   | $ | (1,679 | ) | $ | 7,181 |   |
|                                          |       |                              |       |   |   |   |   |
|                                          |       | **As of March 31, 2005**     | ** ** |
| ** **                                    | ** ** | **Gross Carrying  Amount**        | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying Value** | ** ** |
| InnerAccess:                                  |       |                              |       |   |   |   |   |
| Core technology                               |       | $                                 | 2,600      |   | $ | (372 | ) | $ | 2,228 |   |
| Maintenance  contracts/customer relationships |       | 660                               |       | (94 | ) | 566 |   |
| Total                                         |       | $                                 | 3,260      |   | $ | (466 | ) | $ | 2,794 |   |
|                                          |       |                              |       |   |   |   |   |
| ClientSoft:                                   |       |                              |       |   |   |   |   |
| Core technology                               |       | $                                 | 4,500      |   | $ | (263 | ) | $ | 4,237 |   |
| Maintenance  contracts/customer relationships |       | 1,100                             |       | (64 | ) | 1,036 |   |
| Total                                         |       | $                                 | 5,600      |   | $ | (327 | ) | $ | 5,273 |   |
|                                          |       |                              |       |   |   |   |   |
| Total intangibles                             |       | $                                 | 8,860      |   | $ | (793 | ) | $ | 8,067 |   |

 

These identifiable intangible assets are amortizedusing the straight-line method over an estimated five-year life. No significantresidual value is estimated for the intangible assets.

 

In addition to those intangible assets acquired bybusiness combination, NEON acquired certain software code at a cost of $426,000in April 2004.  The asset, net of accumulated amortization of $160,000and $106,000 as of September 30, 2005 and March 31, 2005,respectively, is classified as acquired intangibles in the accompanyingunaudited condensed consolidated balance sheet, and has been assigned a usefullife of four years.

 

Total amortization expense for the six months ended September 30,2005 and 2004 was $939,000 and $193,000, respectively, and is presented as Costof license in the accompanying unaudited condensed consolidated statements ofoperations.

 

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The expected annual amortization expense for the fullcurrent fiscal year and fiscal years following is as follows (in thousands):

 
| ** **           | ** ** | **2006** | ** ** | **2007** | ** ** | **2008** | ** ** | **2009** | ** ** | **2010** | ** ** | **Thereafter** | ** ** | **Totals** | ** ** |
|----------------------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------|------------|----------------|------------|------------|------------|
| Amortization expense |       | $        | 1,878      |     | $          | 1,878    |       | $        | 1,878      |     | $          | 1,772          |       | $          | 980        |   | $ | — |   | $ | 8,386 |   |
|                      |            |          |            |          |            |          |            |          |            |          |            |                |            |            |            |  |  |  |  |  |  |  |

 

NOTE 10—IMPACT OF RECENTLY ISSUED ACCOUNTINGSTANDARDS

 

In December 2004, the Financial AccountingStandards Board (FASB) issued SFAS No. 123, as revised*,Share-based Payment* (SFAS 123(R)).  The implementation of SFAS123(R) is effective for SEC filings for the first interim period of the firstfiscal year beginning after June 15, 2005.  SFAS 123(R) requires thatcompensation cost for all share-based employee payments be recognized in thestatement of operations based on grant date fair values of the awards, adjustedto reflect actual forfeitures and the outcome of certain other conditions. Thefair value is generally not re-measured, except in limited circumstances, or ifthe award is subsequently modified.  SFAS 123(R) will require NEON toestimate the fair value of stock-based awards and recognize expense in thestatement of operations as the related services are provided. This will changecurrent practice as, upon adoption, NEON must cease using the intrinsic valuemethod of accounting, currently permitted by APB 25 that resulted in no expensefor most of the Company’s stock option awards.

 

NEON will adopt the provisions of SFAS 123(R) as of April 1,2006, which will require NEON to recognize compensation expense in futureperiods as stock options granted prior to adoption of SFAS 123(R) continue tovest over time. Adoption of SFAS 123(R) will likely have a material impact onthe results of operations.  However, the impact of adoption will depend onlevels of share-based payments granted in the future.  The Companycurrently uses the Black-Scholes option pricing model to value itsawards.  Selection of a different valuation model could result in adifferent fair value measure than that determined by the previously usedpricing model.

 

In May 2005, the FASB issued SFAS No. 154, *Accounting Changes and Error Corrections—a replacement of APB Opinion No. 20and FASB Statement No. 3*(SFAS 154)*.*  SFAS 154 changes the accounting and reportingrequirements for a change in accounting principle, requiring retrospectiveapplication to prior period financial statements of changes in accountingprinciple as if that principle had always been used, unless it is impracticableto determine either the period-specific effects or the cumulative effect of thechange.  SFAS 154 applies to allvoluntary changes in accounting principle and redefines “restatement” as therevising of previously issued financial statements to reflect the correction ofan error.

 

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

 

Thefollowing discussion and analysis should be read in conjunction with NEON’s condensedconsolidated financial statements and the related notes thereto included inthis report on Form 10-Q. The discussion and analysis containsforward-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 in our Form 10-Kfor the fiscal year ended March 31, 2005 filed with the SecuritiesExchange Commission on June 29, 2005.  In some cases, you can identifyforward-looking statements by terminology such as “may,” “will,” “should,” “expects,”“plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “continue,”or the negative of these terms or other comparable terms.

 

**Overview**

** **

NEONSystems, Inc. (“NEON”) is a leading provider of enterprise-class mainframeintegration software.  NEON develops,markets and supports a unified mainframe integration platform for modernService-Oriented Architectures and emerging Event-

 

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Driven Architectures. NEON’s Shadow technology provides flexible,industry standard interfaces to enable highly secure and scalable mainframeintegration, thereby enabling organizations to reduce their total costs ofownership and risk associated with mainframe integration.

 

NEONinitially developed its mainframe integration adapters under the Shadow brandto provide ODBC access to IBM mainframe data and databases. NEON hascontinually expanded its mainframe integration product suite, but prior tofiscal 2003, the Company also marketed and sold products outside of themainframe integration market. In fiscal 2003, NEON began restructuring thecompany to concentrate on its core mainframe integration business, which hashistorically accounted for the majority of its revenues. In August 2002,NEON terminated the distribution agreement for its Enterprise SubsystemManagement (“ESM”) products, owned by NEON Enterprise Software, Inc.(formerly Peregrine/Bridge Transfer Corporation, hereafter “NESI”). In January 2003,NEON discontinued its financing obligation to Scalable Software, Inc., aprovider of IT portfolio management software, which NEON received the option toacquire in June 2002.  Finally, in June 2003, NEON sold itsiWave division. See  *Management’s Discussion and Analysis—Related PartyTransactions.*

 

In September 2004,NEON brought to market an event-based mainframe integration solution, now knownas Shadow z/Events, which introduced Event-Driven Architectures to mainframeintegration customers.  In July 2004,NEON acquired InnerAccess Technologies, Inc. (“InnerAccess”), gaining amainframe web services product and substantial experience in supportingComputer Associates’ CA-IDMS database access to the mainframe.  After the integration of InnerAccess andrelease of NEON’s Shadow z/Services product, NEON acquired substantially all ofthe assets of ClientSoft, Inc. (“ClientSoft”), in December of2004.  ClientSoft’s ServiceBuildertechnology was then-recognized by major industry analysts as a leadingtechnology for standards based mainframe web services.  See * Acquisition Activity.*

 

As aresult of the above acquisitions, combined with its internal developmentefforts, NEON now offers customers a unified mainframe integration platformthat supports a broad range of requirements for modern Service-OrientedArchitectures and emerging Event-Driven Architectures.

 

NEONwas formed as an Illinois corporation in 1991 and reincorporated in Delaware in1993.

 

*BusinessEnvironment*

 

NEON derives revenue from softwarelicenses, maintenance and professional services. License fees, which aregraduated and based upon various industry standard measures of product usagesuch as mainframe potential processing capacity, CPUs, and users, are generallydue upon license grant and require a one-year maintenance period. The salesprocess typically takes between six and nine months. After the initial year ofrequired maintenance, NEON provides optional ongoing maintenance services,which include technical support and product enhancements, for an annual fee.Any factors adversely affecting the pricing of, demand for, or marketacceptance of, our products, such as competition or technological change, couldmaterially adversely affect our business, operating results and financialcondition.

 

In mid-2000, we believe that themainframe software market began to weaken as the global economies entered arecessionary 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 beganrestructuring the company to concentrate on its core mainframe integrationbusiness, which has historically accounted for the majority of itsrevenues.  NEON divested its non-core products and reduced the size of itssales, marketing and administrative organizations. During this period NEON alsobegan to develop new mainframe integration products, such as Shadow z/Events,as well as identify other adjacent market products, technologies and companies,which were complementary to NEON’s existing product portfolio.

 

NEON’s strategy was to expand itsproduct offerings through internal product development and acquisitions. NEONsought to create a unified platform for mainframe integration, which could meetall of the requirements of modern Service-Oriented Architectures and EventDriven Architectures.  In furtherance of this goal, NEON acquiredInnerAccess in July 2004, adding a nascent web services product to itsproduct portfolio.  NEON released its Shadow z/Services product in September 2004,which is based on InnerAccess’ technology.  In December 2004, NEONcontinued its market consolidation by acquiring substantially all of the assetsof ClientSoft, a developer of mainframe integration and web services.ClientSoft was considered a technology

 

14

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leader by certain industryanalysts in the mainframe web services market.  NEON continues to evaluateadditional product and company acquisitions to further support its strategy.

 

Notwithstanding the expansion ofNEON’s product offerings and positioning with industry analysts, many of NEON’scustomers remain cautious about their capital spending. Although generaleconomic conditions have improved, NEON is still uncertain as to futurespending patterns of its customers and the market conditions of the mainframeintegration market. NEON believes that period-to-period comparisons of ourrevenue and operating results should not be relied upon as indications of ourfuture performance. Further, NEON does not believe that its historical growthrates in prior years are necessarily representative of its future growthpotential.

 

**AcquisitionActivity**

 

*Summary*

 

During fiscal 2005, NEON acquiredone company and substantially all of the assets of another company, in aneffort to expand its product portfolio. The following table summarizes theassigned values for each acquisition.

 
| ** **           | ** ** | **Acquired Net Assets**       | ** ** |
|----------------------|------------|-------------------------------|------------|
| ** **           | ** ** | **(in thousands)**            | ** ** |
| **Acquired  Entity** | ** ** | **Cash and  Tangible Assets** | ** ** | **Amortizable  Tangible Assets** | ** ** | **Goodwill** | ** ** | **Less:  Liabilities** | ** ** | **Total  Net Assets** | ** ** |
| InnerAccess          |       | $                             | 826        |   | $ | 3,260 |   | $ | 2,066 |   | $ | 1,676 |   | $ | 4,476 |   |
| ClientSoft           |       | 89                            |       | 5,600 |   | 7,528 |   | 569 |   | 12,648 |   |
|                 |       | $                             | 915        |   | $ | 8,860 |   | $ | 9,594 |   | $ | 2,245 |   | $ | 17,124 |   |

 

The amortizable intangibles relateprimarily to acquired software technology, as well as maintenance contracts andcustomer relationships.  All amounts arebeing amortized over five years on a straight-line basis.  Goodwill will be tested annually forimpairment in accordance with United States GAAP.

 

*InnerAccessTechnologies, Inc.*

 

On July 14, 2004,NEON acquired 100% interest in InnerAccess Technologies, Inc., a companyincorporated under the laws of the province of Quebec, Canada.  InnerAccess developed, marketed and licensedweb services technology and provided services related to the integration ofmainframe data sources with modern distributed computing systems.  NEON paid the InnerAccess shareholders atotal of $2.4 million in cash and issued 407,000 shares of NEON restrictedcommon stock.  The results of operationsof the acquired entity are included in the consolidated results of operationsof NEON from the date of acquisition.

 

*ClientSoft, Inc.*

 

On December 13,2004, NEON acquired substantially all of the assets, and assumed certainliabilities, of ClientSoft, Inc. for a cash purchase price of$10.5 million and the issuance to ClientSoft of a warrant to acquire up to1,125,000 shares of NEON common stock at an exercise price of $4.80 per share.ClientSoft developed, marketed and licensed web services technology andprovided services related to the integration of mainframe data sources withmodern distributed computing systems. The assets acquired by NEON includedintellectual property, contracts and equipment and other tangible personalproperty. The liabilities assumed by NEON related to future customer support.  The results of operations of the acquiredentity are included in the consolidated results of operations of NEON from thedate of acquisition.

 

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

*** ***

Certainformer members of NEON’s Board of Directors and certain former executiveofficers of NEON were shareholders and/or directors in other companies withwhich NEON had investments.  Transactionsbetween NEON and these other companies are described below. The directors andofficers involved in such transactions are no longer officers and directors ofNEON.

 

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

 

NEONentered into a Termination and Customer Support Agreement on August 14,2002, which terminated a distribution agreement with Peregrine/Bridge TransferCorporation, a database software company whose sole stockholder is an affiliateof John J. Moores, NEON’s largest shareholder and its former Chairman of theBoard of Directors. PBTC subsequently changed its name to NEON EnterpriseSoftware, Inc. (“NESI”).

 

Inconnection with the closing of the Termination and Customer Support Agreementin August 2002, NESI issued two promissory notes to NEON in the aggregateprincipal amount of $6.6 million, each secured by all of the intellectualproperty of NESI (“NESI IP”). On the closing of the transaction in August 2002,NEON recorded the notes receivable from NESI at the estimated fair value, whichwas calculated at $4.3 million.

 

On April 15,2005, NEON sold the notes issued to NESI to John J. Moores.  Mr. Moores paid NEON $4.4 million on April 15,2005 and issued a personal promissory note in the amount of $2.2 million toNEON.  Such promissory note will bearinterest of 4.0% per annum and will be payable at a rate of $250,000 perquarter. NEON recorded a gain on sale of $336,000 for the six months ended September 30,2005, based on net proceeds of the cash payment in excess of the recorded valueof the notes.  Due to uncertaintyassociated with the related party nature of the unsecured promissory note, NEONwill recognize gain on sale as cash proceeds are received.

 

*Scalable Software, Inc.*

 

ScalableSoftware, Inc. (Scalable Software), a Houston-based provider of softwaresolutions for IT portfolio management, is a company founded by Louis R.Woodhill, who served as NEON’s Chief Executive Officer from October 2001until March 2003. Several former members of NEON’s Board of Directors,including Louis R. Woodhill, John J. Moores, Peter Schaeffer, Charles E. NoellIII and Jim Woodhill, had or have a financial interest in Scalable Software.

 

In June 2002,NEON obtained a two-year option to acquire Scalable Software as outlined in theAgreement and Plan of Merger dated June 26, 2002. In connection with thisOption, NEON provided $6.0 million in bridge financing to Scalable Softwareduring fiscal 2002 and 2003, in addition to $3.5 million previously loaned toScalable Software that was secured by personal guarantees from John J. Moores,Louis R. Woodhill and Jim Woodhill. The aggregate financing had a 36-month termand did not bear interest during the term of the two-year option to acquireScalable Software, which expired June 26, 2004.

 

On June 9, 2004, NEON entered into a NotePurchase Agreement with JMI Services, Inc., the largest shareholder ofScalable Software, to sell the $3.5 million guaranteed note and the $6.0 millionsecured note issued by Scalable Software to NEON for a cash purchase price of$4.8 million.  During the six months ended September 30, 2004 NEONrecognized a gain of $1.2 million as a result of net cash proceeds in excess ofthe recorded book value of the notes. JMI Services is an affiliate of John J.Moores, NEON’s largest shareholder.  The proposed sale of the ScalableSoftware notes was reviewed and approved by the Special Committee of the Boardof Directors, consisting of “independent” and disinterested directors, andfinally by the full Board of Directors, no member of which was an interested orrelated party of either JMI Services, Inc. or Scalable Software.  TheBoard requested and received a fairness opinion from Avail Consulting, Inc.,a Houston, Texas based independent valuation and financial consultant, statingthat the transaction was fair to the stockholders of NEON from a financialstandpoint and recommending that the Board accept the purchase offer made byJMI Services, Inc.  Based on such fairness opinion, consideration ofpossible decline in the value of the underlying security for the secured noteand the potential expense of collection efforts when the notes matured in June 2005,the Board approved the sale of the NESI Notes to JMI Services, Inc.Closing of the transaction occurred on June 17, 2004.

 

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

*** ***

Thefollowing is a discussion of the accounting policies that NEON believes are (1) mostimportant to the portrayal of its financial condition and results of operationsand (2) require our most difficult, subjective or complex judgments, oftenas a result of the need to make estimates about the effect of matters that areinherently uncertain.

 

***RevenueRecognition Policies***

*** ***

Statement of Position(SOP) 97-2, *Software Revenue Recognition*, was issuedin October 1997 by the American Institute of Certified Public Accountants(AICPA) and was amended by Statement of Position 98-4 and Statement of Position98-9. NEON adopted SOP 97-2 effective July 1, 1997, SOP 98-4 effective March 31,1998 and SOP 98-9 effective April 1, 1999. NEON believes its currentrevenue recognition policies and practices are consistent with SOP 97-2, SOP 98-4and SOP 98-9. Revenues

 

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from software license sales are recognized when all of the followingconditions are met: a non-cancelable license agreement has been obtained, theproduct has been delivered; there are no material uncertainties regardingcustomer acceptance; collection of the receivable is probable; no othersignificant vendor obligations exist; and vendor-specific objective evidenceexists to allocate the total fee to each element of the arrangement.Vendor-specific objective evidence is based on the price generally charged whenan element is sold separately. All elements of each order are valued at thetime of revenue recognition. NEON will defer license revenue for all deliveredelements associated with a sales arrangement, if vendor-specific objectiveevidence cannot be established for each undelivered element. License salesgenerally include software maintenance agreements for the first year followingthe date of sale. In such cases, revenues are allocated between license andmaintenance revenues based on the residual method provided by SOP 98-9.Deferred revenue is generally based on vendor-specific objective evidence ofthe fair value of maintenance with the remaining portion of the totalarrangement value allocated to license revenues.  If vendor-specificobjective evidence cannot be established for deferred revenue, then the valueof the sales 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. NEON also provides consulting services, which are recognized as theservices are performed. Consulting services primarily consist of implementationservices related to our products. NEON’s consulting services do not include thecustomization of its underlying software code.

 

***CapitalizedSoftware Costs***

*** ***

NEONfollows Statement of Financial Accounting Standards (SFAS) No. 86, *Accounting for the Costs of Computer Software to beSold, Leased or Otherwise Marketed*. Research and developmentexpenditures have been charged to operating expenses as incurred. No such costshave 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.

 

***Allowancefor 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 believes will be collected. In estimating theappropriate balance for this allowance, NEON considers specific accountsreceivable as well as historical write-off experience to determine itsallowance for doubtful accounts. Additions to the allowance for doubtful accounts are charged tooperating expenses, and deductions from the allowance are recorded whenspecific accounts receivable are written off as uncollectible or when actualexperience differs from management’s original estimate. If NEON’s estimate ofuncollectible accounts should prove to be inaccurate at some future date, theresults of operations for the period could be materially affected by anynecessary correction to the allowance for doubtful accounts.**

##### ** **

***Goodwill and Acquired Intangible Assets***

** **

Inaccordance with SFAS No. 141, *Business Combinations*,the cost of an acquired entity is allocated to assets acquired and liabilitiesassumed with any excess of the fair values of tangible and amortizable intangiblenet assets acquired recognized as goodwill. Value is assigned to amortizableintangible assets based on estimated fair values, if those assets arise fromcontractual or legal obligations or are otherwise separable from goodwill.  The original purchase price allocation may beadjusted within the allocation period for changes related to pre-acquisitioncontingencies as better information becomes available.  In accordance with SFAS No.142, *Goodwill and Other Intangible Assets*, each acquired goodwilland identifiable intangible asset must be assigned to a reporting unit of NEONfor the purpose of assessing the possibility of impairment.  Assessments are performed on an annual basisor more often if events or changes in circumstances indicate that the carryingvalue may not be recoverable.  Theimpairment of goodwill requires that judgments and estimates be made bymanagement, including those regarding the value of the reporting unit.  Impairment testing is performed using atwo-step process.  The first steprequires assessing whether a potential impairment has occurred by comparing thefair value of the assigned reporting unit with its carrying amount, includinggoodwill.  The second step requiresmeasuring any potential impairment identified by allocating the assessed fairvalue to the assets and liabilities of the reporting unit, excludinggoodwill.  Any excess fair value iscompared to the recorded value of goodwill to measure the impairment.

 

Thedetermination of the value of amortizable intangible assets acquired involvescertain judgments and estimates that are

 

17

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subject to change over time based on internal and externalfactors.  These judgments can include,but are not limited to the cash flows that an asset is expected to generate inthe future and the appropriate cost of capital of similar investments.  The value of an amortizable intangible assetis amortized to expense in the statement of operations on a straight-line basisover the estimated useful life.  Theestimated useful life is determined by management considering, among otherthings, expected use, any applicable legal provisions, expected technologicaldevelopment, expected demand and other company-specific, economic or otherexternal factors.

 

***DeferredIncome Taxes***

*** ***

NEONrecords deferred income tax assets and liabilities on its balance sheet relatedto events that impact its financial statements and tax returns in differentperiods, analyzed by taxation jurisdiction. In order to compute these deferredtax balances, NEON first analyzes the differences between the book basis andtax basis of its assets and liabilities (referred to as “temporary differences”).These temporary differences are then multiplied by current tax rates to arriveat the balances for the deferred income tax assets and liabilities. NEON mustassess whether deferred income tax asset amounts will be realized in thefuture. This assessment requires management to make certain estimates about taxplanning strategies, the expected future timing of the reversal of temporarydifferences and future taxable income.  Avaluation allowance is then provided for deferred asset amounts that areestimated by management as not being more likely than not to be realized.

 

Thechange in NEON’s net deferred income tax balances during a period, results in adeferred income tax provision or benefit in its statement of operations. IfNEON’s expectations about the future tax consequences of past events shouldprove to be inaccurate or management should change these estimates, thebalances of NEON’s deferred income tax assets and liabilities could requiresignificant adjustments in future periods. Such adjustments could cause amaterial effect on NEON’s results of operations for the period of the adjustment.

 

RESULTSOF OPERATIONS

 

The following table sets forth, for the periodsillustrated, certain statement of operations data expressed as a percentage oftotal revenues:

 
| ** **                        | ** ** | **THREE MONTHS ENDED  SEPTEMBER 30,** | ** ** | **SIX MONTHS ENDED  SEPTEMBER 30,** | ** ** |
|-----------------------------------|------------|--------------------------------------------|------------|------------------------------------------|------------|
| ** **                        | ** ** | **2005**                                   | ** ** | **2004**                                 | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenues:                         |       |                                       |       |                                     |       |   |   |   |   |
| License                           |       | 48.1                                       | %          | 31.6                                     | %          | 37.6 | % | 31.2 | % |
| Maintenance                       |       | 48.6                                       |       | 66.5                                     |       | 57.8 |   | 67.1 |   |
| Service                           |       | 3.2                                        |       | 1.9                                      |       | 4.7 |   | 1.7 |   |
| Total revenues                    |       | 100.0                                      |       | 100.0                                    |       | 100.0 |   | 100.0 |   |
|                              |       |                                       |       |                                     |       |   |   |   |   |
| Cost of revenues:                 |       |                                       |       |                                     |       |   |   |   |   |
| Cost of license                   |       | 8.0                                        |       | 4.4                                      |       | 9.3 |   | 2.7 |   |
| Cost of maintenance               |       | 5.8                                        |       | 9.9                                      |       | 6.4 |   | 10.0 |   |
| Cost of service                   |       | 1.3                                        |       | —                                   |       | 1.8 |   | — |   |
| Total cost of revenues            |       | 15.2                                       |       | 14.3                                     |       | 17.5 |   | 12.7 |   |
|                              |       |                                       |       |                                     |       |   |   |   |   |
| Gross profit                      |       | 84.8                                       |       | 85.7                                     |       | 82.5 |   | 87.3 |   |
|                              |       |                                       |       |                                     |       |   |   |   |   |
| Operating expenses:               |       |                                       |       |                                     |       |   |   |   |   |
| Sales and marketing               |       | 39.0                                       |       | 44.1                                     |       | 43.8 |   | 44.2 |   |
| Research and development          |       | 21.9                                       |       | 34.5                                     | ** ** | 26.0 |   | 31.1 |   |
| General and administrative        |       | 16.8                                       |       | 24.0                                     |       | 20.4 |   | 24.6 |   |
| Total operating expenses          |       | 77.7                                       |       | 102.6                                    | ** ** | 90.3 |   | 99.9 |   |
|                              |       |                                       |       |                                     |       |   |   |   |   |
| Operating income (loss)           |       | 7.1                                        |       | (16.9                                    | )          | (7.8 | ) | (12.7 | ) |
|                              |       |                                       |       |                                     |       |   |   |   |   |
| Gain on sale of notes receivable  |       | 4.2                                        |       | —                                   |       | 3.3 |   | 16.6 |   |
| Interest and other income, net    |       | 2.0                                        |       | 1.8                                      |       | 2.6 |   | 1.6 |   |
|                              |       |                                       |       |                                     |       |   |   |   |   |
| Income (loss) before income taxes |       | 13.3                                       |       | (15.1                                    | )          | (1.9 | ) | 5.5 |   |
| Income taxes                      |       | 1.1                                        |       | —                                   |       | .8 |   | — |   |
| Net income (loss)                 |       | 12.2                                       | %          | (15.1                                    | )%         | (2.7 | )% | 5.5 | % |

 

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THREE MONTHS ENDED SEPTEMBER 30, 2005 COMPARED TOTHREE MONTHS ENDED SEPTEMBER 30, 2004

 

REVENUES

 

License revenues for the three months ended September 30,2005 were $2.9 million, an increase of $1.7 million from $1.2 million for thethree months ended September 30, 2004. The increase was due to acombination of greater sales of NEON’s z/Direct products to its installedcustomer base as well as additional sales of its z/Services products, obtainedthrough the acquisitions of InnerAccess and ClientSoft in fiscal 2005.  During the three months ended September 30,2005, license revenue from one customer constituted 25% of total licenserevenues.  During the three months endedSeptember 30, 2004, license revenues from another customer constituted 32% oftotal license revenues.

 

Maintenance revenues for the three months ended September 30,2005 were $2.9 million, an increase of $394,000 over $2.5 million for the threemonths ended September 30, 2004.  Theincrease primarily resulted from the acquisitions of ClientSoft and InnerAccessduring fiscal 2005.

 

Service revenues for the three months ended September 30,2005 and 2004 were $192,000 and $73,000, respectively, as a result of newprofessional services offerings associated with the acquisition of ClientSoftin December 2004.

 

COST OF REVENUES

 

Cost of license revenues primarily consist ofamortization of acquired product technology. For the three months ended September 30,2005 and 2004 cost of license revenues were $477,000, or 17% of licenserevenues, and $164,000, or 14% of license revenues. The increase in costof license revenues was due primarily to the acquisition of ClientSoft duringfiscal 2005 and the related amortization of acquired technology.

 

Cost of maintenance revenues includes personnel andother customer support costs. Cost of maintenance revenues for the three monthsended September 30, 2005 were $344,000 or 12% of maintenance revenues, ascompared to $373,000, or 15% of maintenance revenues, for the three monthsended September 30, 2004. Cost of maintenance revenue as a percentage ofmaintenance revenue decreased as a result of the greater maintenance revenue,combined with the consolidation of NEON’s technical support staff.

 

Cost of service revenue primarily represents personnelcosts associated with providing professional services to customers.  Cost of service for the three months ended September 30,2005 was $80,000, or 42% of service revenues. NEON did not recognize cost of service revenue for the six months endedSeptember, 2004, as it did not offer substantial professional services duringsuch period. The increase in cost of service revenue was due to the growth inthe number of professional service hours delivered during the period.

 

OPERATINGEXPENSES

 

Sales and marketing expenses include personnel costs,sales commissions, travel and promotional expenses. Sales and marketingexpenses for the three months ended September 30, 2005 were $2.3 million,an increase of $661,000 from $1.7 million for the three months ended September 30,2004. The increase was primarily due to expansion of NEON’s direct sales forceas a result of the ClientSoft acquisition.

 

Research and development expenses primarily includepersonnel costs associated with NEON’s product development staff. Research anddevelopment expenses for the three months ended September 30, 2005 and2004 were $1.3 million, remaining consistent in both periods.

 

General and administrative expenses include personneland other costs associated with NEON’s executive, financial, legal andadministrative functions. General and administrative expenses for the threemonths ended September 30, 2005 were $997,000, versus $902,000 for thethree months ended September 30, 2004. General and administrative expensesincreased during the period as a result of the InnerAccess and ClientSoft acquisitions.During the three months ended September 30, 2005 and 2004, general and administrativeexpenses included a reduction in previously accrued future lease obligations forvacated facilities. During the three months ended September 30, 2005 and2004, NEON recognized reductions of such accruals of

 

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$106,000 and $82,000, respectively, related to anew subleases in the United Kingdom during each period.

 

During the three months ended September 30, 2005,NEON recognized a gain on sale of notes receivable of $250,000 from theinstallment proceeds received from John J. Moores related to the sale of theNESI notes (see Related Party Transactions).

 

Interest and other income for the three months ended September 30,2005 and 2004 was $117,000 and $69,000, respectively.   The increasewas primarily a result of greater average short-term interest rates received oncash equivalent investments during the period.

 

During the three months ended September 30, 2005,NEON recognized $67,000 of income tax expense, of which $37,000 consisted of deferredtaxes primarily related to acquired goodwill and intangible assets.  No provision for income taxes was recordedfor the three months ended September 30, 2004, as the taxable income wasoffset by net operating loss carry-forwards that NEON had previously reserved.

 

As of March 31, 2005, NEON has a net operating losscarry-forward for income tax purposes of approximately $23.4 million that isavailable to offset future taxable income, if any. The net operating losscarry-forward consists of approximately $19.8 million in the United States, $1.3million in the United Kingdom, $600,000 in Canada and $1.7 million in Germany.The net operating loss carry-forwards in the United Kingdom and Germany carryforward indefinitely. The net operating loss carry-forwards for the UnitedStates and Canada begin expiring in 2020 and 2008, respectively.  Additionally, NEON has a United States losscarryforward of $4.8 million available to offset future capital gains.  NEON has recorded a full valuation allowanceagainst the loss carryforwards in the United States, United Kingdom andGermany.  The deferred tax assetsresulting from loss carryforwards in Canada are offset by deferred taxliabilities at September 30, 2005.

 

SIX MONTHS ENDED SEPTEMBER 30, 2005 COMPARED TO SIXMONTHS ENDED SEPTEMBER 30, 2004

 

REVENUES (see additional three month analysis above)

 

License revenues for the six months ended September 30,2005 were $3.8, an increase of $1.6 million from $2.3 million for the sixmonths ended September 30, 2004. The increase was due to greater sales ofits z/Services products obtained through the acquisition of ClientSoft andInnerAccess during fiscal 2005, combined with greater sales of NEON’s z/Directproducts to its installed customer base.

 

Maintenance revenues for the six months ended September 30,2005 were $5.9 million, an increase of $995,000 from 4.9 million for the sixmonths ended September 30, 2004. The increase primarily resulted from the acquisitionsof ClientSoft and InnerAccess during fiscal 2005.

 

Service revenues for the six months ended September 30,2005 and 2004 were $478,000 and $121,000, respectively, as a result of newprofessional services offerings associated with the acquisition of ClientSoftin December 2004.

 

COST OF REVENUES (see additional three month analysisabove)

 

Cost of license revenues primarily representsamortization of acquired intangible assets. For the six months ended September 30,2005 and 2004 cost of license revenues were $953,000 and $196,000,respectively. The increase in cost of license revenues was primarily due to amortizationof the technology acquired from InnerAccess and ClientSoft during fiscal 2005.

 

Cost of maintenance revenues includes personnel andother customer support costs. Cost of maintenance revenues for the six monthsended September 30, 2005 were $655,000, or 11% of maintenance revenues, ascompared to $736,000, or 15% of maintenance revenues, for the six months ended September 30,2004.  The decrease in cost ofmaintenance as a percentage of maintenance revenue was primarily due to theincrease in maintenance revenue, combined with the consolidation of thetechnical support staff after the acquisitions of InnerAccess and ClientSoft.

 

Cost of service revenue primarily represents personnelcosts associated with providing professional services to customers.  Cost of service for the six months ended September 30,2005 was $186,000, or 39% of service revenues.  NEON did not recognize cost of service revenuefor the six months ended September, 2004. The increase in cost of servicerevenue was due to the growth in the number of professional service hoursdelivered during the period.

 

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OPERATINGEXPENSES (see additional three month analysis above)

 

Sales and marketing expenses include personnel costs,sales commissions, travel and promotional expenses. Sales and marketingexpenses for the six months ended September 30, 2005 were $4.5 million, anincrease of $1.2 million from $3.2 million for the six months ended September 30,2004. The increase was primarily due to expansion of NEON’s direct sales forceas a result of the ClientSoft acquisition.

 

Research and development expenses primarily includepersonnel costs associated with NEON’s product development staff. Research anddevelopment expenses for the six months ended September 30, 2005 were $2.7million, an increase of $384,000 from $2.3 million for the six months ended September 30,2004.  The increase in research anddevelopment is primarily due to the expansion of the research and developmentstaff as a result of the ClientSoft and InnerAccess acquisitions during fiscal2005.

 

General and administrative expenses include personneland other costs associated with NEON’s executive, financial, legal andadministrative functions. General and administrative expenses for the sixmonths ended September 30, 2005 were $2.1 million, an increase of $288,000from $1.8 million for the six months ended September 30, 2004. Theincrease was due primarily to the acquisitions of ClientSoft and InnerAccessduring fiscal 2005. Each of the six months ended September 30, 2005 and2004, included an approximate $106,000 reduction of previously accrued futurelease obligations for vacated facilities as a result of the renegotiation orsublease of two of NEON’s leases.

 

During the six months ended September 30, 2005,NEON recognized a $336,000 gain on the sale of notes receivable from NESIresulting from total net proceeds of $4.6 million, in excess of the $4.3million recorded net book value.

 

Duringthe six months ended September 30, 2004, NEON sold its notes receivablefrom Scalable Software for $4.7 million, net of direct costs, and recognized again on the sale of $1.2 million.

 

Interest and other income for the six months ended September 30,2005 and 2004 was $265,000 and $114,000, respectively.   The increase was primarily a result ofgreater average short-term interest rates received on cash equivalentinvestments during the period.

 

During the six months ended September 30, 2005, NEONrecognized $80,000 of income taxes, of which $50,000 consisted of deferred taxesprimarily related to acquired goodwill and intangible assets.  No provision for income taxes was recordedfor the six months ended September 30, 2004, as the taxable income wasoffset by net operating loss carry-forwards that NEON had previously reserved.

 

As of March 31, 2005, NEON has a net operating losscarry-forward for income tax purposes of approximately $23.4 million that isavailable to offset future taxable income, if any. The net operating losscarry-forward consists of approximately $19.8 million in the United States, $1.3million in the United Kingdom, $600,000 in Canada and $1.7 million in Germany.The net operating loss carry-forwards in the United Kingdom and Germany carryforward indefinitely. The net operating loss carry-forwards for the UnitedStates and Canada begin expiring in 2020 and 2008, respectively.  Additionally, NEON has a United States losscarryforward of $4.8 million available to offset future capital gains.  NEON has recorded a full valuation allowanceagainst the loss carryforwards in the United States, United Kingdom andGermany.  The deferred tax assetsresulting from loss carryforwards in Canada are offset by deferred taxliabilities at September 30, 2005.

 

LIQUIDITYAND CAPITAL RESOURCES

 

NEON’s cash and cash equivalents at September 30,2005 were $16.5 million, an increase of $3.1 million from $13.3 million at March 31,2005. This increase was due primarily to the sale of the notes receivable from NESI.

 

Net cash used in operating activities was $1.3 millionfor the six months ended September 30, 2005, versus $452,000 for the sixmonths ended September 30, 2004.  Netcash used in operating activities for the six months ended September 30,2005 included a reduction of $1.5 million in accounts payable and accruedexpenses as well as a $607,000 decline in deferred revenue. The net cash usedin operating activities during the six months ended September 30, 2004,resulted primarily from the operating loss in excess of non-cash expenses.

 

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During the six months ended September 30, 2005, netcash provided by investing activities was $4.5 million, which was primarily attributableto the proceeds from the sale of the NESI notes receivable to John J. Moores.  Net cash provided by investing activitiesduring the six months ended September 30, 2004 was $1.8 million and was primarilydue to the sale of the notes receivable from Scalable Software to JMI Services inexcess of cash used to acquire InnerAccess.

 

NEON’s net cash provided by financing activities was $122,000and $10,000 for the six months ended September 30, 2005 and 2004,respectively. The net cash provided by financing activities in both periods representsproceeds from the exercise of employee stock options.

 

NEON’sfuture liquidity and capital requirements will depend upon numerous factors,including the costs associated with potential future business and productacquisitions, the sales of multi-year maintenance and support contracts tocustomers, the costs of the expansion of product development, sales andmarketing efforts and the success of these efforts, the extent to which ourexisting and new products gain market acceptance, the level and timing oflicense revenue and other factors. NEON believes that its current balance ofcash and cash equivalents will be sufficient to meet its working capital,funding commitments and anticipated capital expenditure requirements for atleast the next 12 months. NEON may require additional funds to support itsworking capital requirements or for other purposes and may seek to raiseadditional funds through public or private equity financing or from othersources. There can be no assurance that additional financing will be availableat all, or if available, that such financing will be obtainable on termsacceptable to NEON, or that any additional financing will not be dilutive.

 

**OtherMatters**

 

Section 408 of theSarbanes-Oxley Act of 2002 requires that the staff of the Securities andExchange Commission (the “SEC Staff”) review the filings of all reportingcompanies not less frequently than once every three years. In accordance withthat requirement, the SEC Staff recently reviewed the Company’s periodic reportsand issued a letter (the “Comment Letter”) on September 2, 2005 commenting oncertain aspects of the Company’s Annual Report on Form 10-K for the yearended March 31, 2005 and Quarterly Report on Form 10-Q for the quarterended June 30, 2005. Among the comments, the SEC Staff asked the Company toprovide support for its position that the sale of the Scalable and NESI notesreceivables were not capital transactions. The SEC Staff also asked the Companyto provide support for its assessment that the Company was not the primarybeneficiary of Scalable and NESI under FIN 46(R). The Company has carefullyanalyzed the relevant generally accepted accounting principles and believes ithas correctly accounted for the transactions. The Company provided a detailed responseby letter on October 7, 2005. The SEC Staff is evaluating the Company’sresponse. The accounting matters are complex and require the Company’sjudgment, and there can be no certainty that the SEC Staff ultimately willagree with our position. Certain of the matters reviewed by the SEC Staffpertain to transactions which may be material to the financial statements.

 

**New Accounting Pronouncements**

 

In December 2004, the Financial AccountingStandards Board (FASB) issued SFAS No. 123, as revised*, Share-basedPayment* (SFAS 123(R)).  The implementation of SFAS 123(R) iseffective for SEC filings for the first interim period of the first fiscal yearbeginning after June 15, 2005.  SFAS 123(R) requires thatcompensation cost for all share-based employee payments be recognized in thestatement of operations based on grant date fair values of the awards, adjustedto reflect actual forfeitures and the outcome of certain other conditions. Thefair value is generally not re-measured, except in limited circumstances, or ifthe award is subsequently modified.  SFAS 123(R) will require NEON toestimate the fair value of stock-based awards and recognize expense in thestatement of operations as the related services are provided. This will changecurrent practice as, upon adoption, NEON must cease using the intrinsic valuemethod of accounting, currently permitted by APB 25 that resulted in no expensefor most of the Company’s stock option awards.

 

NEON will adopt the provisions of SFAS 123(R) as of April 1,2006, which will require NEON to recognize compensation expense in futureperiods as stock options granted prior to adoption of SFAS 123(R) continue tovest over time. Adoption of SFAS 123(R) will likely have a material impact onthe results of operations.  However, the impact of adoption will depend onlevels of share-based payments granted in the future.  The Companycurrently uses the Black-Scholes option pricing model to value itsawards.  Selection of a different valuation model could result in a differentfair value measure than that determined by the previously used pricing model.

 

In May 2005, the FASB issued SFAS No. 154, *Accounting Changes and Error Corrections—a replacement of APB Opinion No. 20and FASB Statement No. 3* (SFAS 154)*.*  SFAS 154 changes the accounting and reportingrequirements for a change in accounting principle, requiring retrospectiveapplication to prior period financial statements of changes in accountingprinciple as if that principle had always been used, unless it is impracticableto determine either the period-specific effects or the cumulative effect of thechange.  SFAS 154 applies to allvoluntary changes in accounting principle and redefines “restatement” as therevising of previously issued financial statements to reflect the correction ofan error.

 

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**Tabular Disclosure of ContractualObligations**

 

The following table presents NEON’s contractual cashobligations for the full fiscal year periods beginning April 1, 2005:

 
| ** **                                                                    | ** ** | **Payments Due by Period** | ** ** |
|-------------------------------------------------------------------------------|------------|----------------------------|------------|
| ** **                                                                    | ** ** | **Total  Due**             | ** ** | **Fiscal  2006** | ** ** | **1-3 Years** | ** ** | **4-5 Years** | ** ** | **> 5 Years** | ** ** |
|                                                                          |       |                       |       |   |   |   |   |   |   |   |   |
| Long-term debt  obligations                                                   |       | $                          | 19         |   | $ | 19 |   | $ | — |   | $ | — |   | $ | — |   |
| Operating lease  obligations (1)                                              |       | 4,706                      |       | 1,124 |   | 1,989 |   | 1,593 |   | — |   |
| Purchase  obligations                                                         |       | —                     |       | — |   | — |   | — |   | — |   |
| Other long-term  liabilities reflected on the balance sheet under US GAAP (2) |       | 184                        |       | 88 |   | 96 |   | — |   | — |   |
|                                                                          |       |                       |       |   |   |   |   |   |   |   |   |
| Total                                                                         |       | $                          | 4,909      |   | $ | 1,231 |   | $ | 2,085 |   | $ | 1,593 |   | $ | — |   |

 

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(1)          Leases of office space and equipment

(2)          Contractual payments under software licenses for internal developmentuse

 

**Factors That May AffectFuture Operating Results**

 

Thisreport on Form 10-Q, including Management’s Discussion and Analysis ofFinancial Condition and Results of Operations, contains forward-lookingstatements and other prospective information relating to future events. Theseforward-looking statements and other information are subject to certain risksand uncertainties that could cause results to differ materially from historicalresults or anticipated results, including the following:

 

***Our Stock Price May Fluctuate And Be Impacted By ANumber Of Internal And External Factors***

 

•                  *Ourstock price has fluctuated and is subject to wide swings in price based on anumber of factors, including our quarterly operating results, which may varysignificantly from quarter to quarter.*

 

Ourfuture operating results may vary significantly from quarter to quarter due toa variety of factors, many of which are outside our control. Therefore, it islikely that in one or more future quarters our results may fall below theexpectations of securities analysts and investors. We operate with virtually noorder backlog because our products are shipped and revenues are recognizedshortly after orders are received. In addition, the amount of revenuesassociated with sales of our software can vary significantly. In variousquarters in the past, we have derived a significant portion of our softwarelicense revenues from a small number of relatively large sales. An inability toclose one or more large sales that we had targeted to close in a particularperiod could materially adversely affect our operating results for that period.Moreover, we typically realize a majority of our software license revenues inthe last month of a quarter. As a result, minor delays in the timing ofcustomer orders can shift a sale from its contemplated quarter of completion toa subsequent quarter and cause significant variability in our operating resultsfor any particular period. Accordingly, we believe that period-to-periodcomparisons of our operating results are not necessarily a meaningfulindication of future performance. Although we generally do not give guidance asto future operating results, if our quarterly results do not meet investors’expectations, the trading price of our common stock will likely decline.

 

*•**                  The AvailabilityOf Significant Amounts Of Our Common Stock For Sale Could Adversely Affect ItsMarket Price*

 

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

 

***Reduced Customer Reliance Upon Mainframe Computers CouldAdversely Affect Our Business***

 

We aredependent upon the continued use and acceptance of mainframe computers in acomputing environment increasingly based on distributed platforms, includingclient/server and Internet-based computing networks. Decreased use of themainframe or in the growth of demand for Web-based and client/serverapplications accessing mainframe data and transactions could have a

 

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material adverse effect on our business, operating results andfinancial condition. We now derive our revenues solely from our Shadowproducts. Our continued success depends on a number of factors, including:

 

•                  Continueduse of the mainframe as a central repository of mission-critical data andtransactions;

 

•                  Growthin business demands for access to the data, applications and transactionsresiding on mainframe computers from Web-based and client/server applications;and

 

•                  Continuedmarket acceptance of the Shadow products and enhancements to these products.

 

***Loss of Key Software Developers Could Adversely Affect OurBusiness***

 

Oursuccess is dependent upon the continued service and skills of our key softwaredevelopers. The loss of the services of any of these key software developerscould have a negative impact on our business because of their unique skills,years of industry experience, and the difficulty of promptly finding qualifiedreplacement personnel. We do not intend to maintain “key-man” life insurancepolicies covering any of our employees. Significant competition exists foremployees with the skills required to develop the software products and performthe maintenance services that we offer, and we may not be able to continue toretain sufficient numbers of highly skilled employees.

 

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

 

Wecompete in markets that are intensely competitive and feature rapidly changingtechnology and evolving standards. Our competitors may be able to respond morequickly than we can to new or emerging technologies and changes in customerrequirements. Competitive pressures could reduce our market share or require usto reduce the price of our products, either of which could have a materialadverse effect on our business, operating results and financial condition.

 

***Rapid Technological Change Could Render Our ProductsObsolete***

 

Ourmarkets are characterized by rapid technological change, frequent new productintroductions and enhancements, uncertain product life cycles, changes incustomer requirements and evolving industry standards. The introduction of newproducts embodying new technologies and the emergence of new industry standardscould render our existing products obsolete which would have a material adverseeffect on our business, operating results and financial condition. Our futuresuccess will depend upon our ability to continue to develop and introduce avariety of new products and product enhancements to address the increasinglysophisticated needs of our customers. We may experience delays in releasing newproducts and product enhancements in the future. Material delays in introducingnew products or product enhancements may cause customers to forego purchases ofour products and purchase those of our competitors.

 

***We May Be Unable To Enforce Or Defend Our Ownership AndUse Of Proprietary Technology***

 

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

 

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

 

Oursoftware products and the software products that we sell for others are complexand may contain undetected errors. These undetected errors could result inadverse publicity, loss of revenues, delay in market acceptance or claimsagainst us by customers, all of which could have a material adverse effect onour business, operating results and financial condition. Despite testing, wecannot be certain that errors will not be found in our products. Liabilityclaims could require us to spend significant

 

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time and money in litigation or to pay significant damages. As aresult, any such claims, whether or not successful, could have a materialadverse effect on our reputation and business, operating results and financialcondition.

 

ITEM 3.     QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK

 

NEON is exposed to a variety of risks, including foreigncurrency exchange rate fluctuations and changes in the market value of itsinvestments.

 

Themajority of NEON’s foreign currency transactions are denominated in the Britishpounds sterling, the functional currency of NEON Systems (UK) Ltd. As theBritish pound sterling transactions are denominated and settled in thefunctional currency, risks associated with currency fluctuations are minimizedto foreign currency translation adjustments. During fiscal 2005, 29% of NEON’ssales were denominated in other currencies. NEON does not currently hedge against these foreign currency transactionrisks and believes that foreign currency exchange risk is not significant toits operations, as the related accounts receivable are generally collectedwithin a short time-frame.  As a resultof the acquisition of InnerAccess Technologies, Inc. in July 2004,NEON is exposed to operating expenses denominated in the Canadian dollar thatare funded in U.S. dollars from U.S. operations.  Sales transactions related to the technologyacquired from InnerAccess are generally denominated in U.S. dollars.

 

NEON adheres to a conservative investment policy,whereby its principal concern is the preservation of liquid funds whilemaximizing its yield on such assets. Cash and cash equivalents approximated $16.5million at September 30, 2005, and were invested in different types of investment-gradecommercial paper and money securities. NEON believes that a near-term change in interest rates would notmaterially affect its financial position, results of operations or net cashflows for fiscal year 2006.

 

ITEM4.   CONTROLS AND PROCEDURES

 

Our management has evaluated, with the participation of our principalexecutive and financial officers, the effectiveness of our disclosure controlsand procedures (as defined in Rule 13a-15(e) of the SecuritiesExchange Act of 1934) as of the end of the period covered by this report, andhas concluded that our disclosure controls and procedures are effective toprovide reasonable assurance that information required to be disclosed by us inthe reports that we file or submit under the Exchange Act is recorded,processed, summarized and reported, within the time periods specified in theSecurities and Exchange Commission’s rules and forms.  There has been no change in our internalcontrol over financial reporting during the six months ended September 30, 2005that has materially affected, or is reasonably likely to materially affect, ourinternal control over financial reporting.

 

PART II - OTHER INFORMATION

 

ITEM 1.                             LEGALPROCEEDINGS - See disclosure from prior periods regarding Phoenix NetworkTechnologies (Europe) Limited vs. NEON Systems, Inc. and ComputerAssociates International Inc., 400thDistrict Court, Ft. Bend County, Richmond, Texas, Cause Number 03-CV-127800.Aside from this action, NEON is not involved in any current material claim orlegal action other than those arising in the ordinary course of business.

 

ITEM 2.                             UNREGISTERED SALES OFSECURITIES AND USE OF PROCEEDS – Not applicable

 

ITEM 3.                             DEFAULTS UPON SENIOR SECURITIES -Not applicable.

 

ITEM 4.                             SUBMISSIONOF MATTERS TO VOTE OF SECURITY HOLDERS

 

On September 19, 2005, NEON convened its AnnualMeeting of Stockholders for the fiscal year ended March 31, 2005.  As of the record date of August 11,2005, there were approximately 8,644,798 million shares issued and outstanding.  At the Annual Meeting, which was held at NEON’sheadquarters in Sugar Land, Texas on September 19, 2005, the followingmatters were submitted to the stockholders for a vote and were approved by thevote reflected below each such proposal (percentages reflect percentage oftotal outstanding common stock):

 

•                  **Election of five directors toserve on the Board of Directors**

 

At the annual meeting of stockholders held on September 19,2005, the following five directors were elected as directors for

 

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terms expiring at the annual meeting to he held in2006:  George Ellis, Richard Holcomb,Mark J. Cresswell, David F. Cary, Loretta Cross and William Wilson.

 

Thevoting results were as follows:

(Inthousands)

 
| **Nominee**     | ** ** | **Votes For** | ** ** | **(%)** | ** ** | **Votes Withheld** | ** ** | **(%)** | ** ** |
|-----------------|------------|---------------|------------|---------|------------|--------------------|------------|---------|------------|
|            |       |          |       |    |       |               |       |    |       |
| George Ellis    |       | 8,591,308     |       | 99.4    | %          | 25,325             |       | .03     | %          |
| Richard Holcomb |       | 8,592,008     |       | 99.4    | %          | 24,625             |       | .03     | %          |
| Mark Cresswell  |       | 8,567,108     |       | 99.1    | %          | 49,525             |       | .06     | %          |
| David F. Cary   |       | 8,567,208     |       | 99.10   | %          | 49,425             |       | .06     | %          |
| Loretta Cross   |       | 8,559,008     |       | 99.0    | %          | 57,625             |       | .07     | %          |
| William Wilson  |       | 8,566,208     |       | 99.0    | %          | 50,425             |       | .06     | %          |

 

•                  **Ratification of KPMG LLP as independent registeredpublic accounting firm for the fiscal year ending March 31, 2006**

 

TheAudit Committee of the Board of Directors selected KPMG LLP as the Company’sindependent registered public accounting firm for the fiscal year ending March 31,2006. KPMG LLP has audited the Company’s financial statements since its initialpublic offering in fiscal 1999.

 

At theAnnual Meeting of Stockholders on September 19, 2005, the stockholdersratified the Board’s selection of KPMG as NEON’s independent registered publicaccounting firm, casting 8,581,087 million votes in favor of the ratification(95.3%) and 35,062 votes against ratification (.04%), with 484 abstentions(.01%).

 

ITEM 5.                             OTHERINFORMATION - None

 

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ITEM 6.                             EXHIBITS

 

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. |

 

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SIGNATURES

 

Pursuant to the requirements of the Securities ExchangeAct of 1934, the registrant has duly caused this report to be signed on itsbehalf by the undersigned thereunto duly authorized.

 
|                         | NEON SYSTEMS, INC.                           |   |
|------------------------------|----------------------------------------------|--------|
|                         |                                         |   |
| Date: November 14, 2005 | /s/ Brian D. Helman                          |   |
|                         | Chief Financial Officer                      |   |
|                         | (principal financial and accounting officer) |   |
|                         |                                         |   |
|                         |                                         |   |
| Date: November 14, 2005 | /s/ Mark Cresswell                           |   |
|                         | President and Chief Executive Officer        |   |
|                         | (principal executive officer)                |   |

 

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