**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**Form 10-Q**

 

**(Mark One)**

 

**ý****  QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE****SECURITIES EXCHANGE ACT OF 1934**

 

**For the QuarterlyPeriod Ended June 30, 2004**

 

**OR**

 

**o****  TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THESECURITIES EXCHANGE ACT OF 1934**

 

**For the transition period from         to         **

 

**Commission File Number: 0-25457**

 

**NEON Systems, Inc.**

(Exact name of Registrant as specified in its charter)

 

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

 

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

 

Securities registered pursuant to Section 12(g) of theAct:

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

(Title of Class)

 

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

 

The number of shares of the registrant’s common stock outstanding as ofJuly 31, 2004, was 8,917,427.

 

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

Yes  o  No  ý

 

 

----

 

NEON SYSTEMS, INC.

 

FORM 10-Q

 

FOR THE QUARTER ENDED JUNE 30, 2004

 

INDEX

 
| ** **                    | ** **                                                                                  | **PAGE** |
|-------------------------------|---------------------------------------------------------------------------------------------|----------|
| PART I. FINANCIAL INFORMATION |                                                                                        |
|                          |                                                                                        |     |
| Item 1.                       | Financial Statements                                                                        |     |
|                          |                                                                                        |     |
|                          | Consolidated Balance Sheets  at June 30, 2004 and March 31, 2004                            | 3        |
|                          |                                                                                        |     |
|                          | Consolidated Statements of Operations for  the Three Months Ended June 30, 2004 and 2003    | 4        |
|                          |                                                                                        |     |
|                          | Consolidated Statements of Cash Flows for  the Three Months Ended June 30, 2004 and 2003    | 5        |
|                          |                                                                                        |     |
|                          | Condensed Notes to Consolidated Financial  Statements                                       | 6        |
|                          |                                                                                        |     |
| Item 2.                       | Management’s Discussion and Analysis of  Financial Condition and Results of Operations | 11       |
|                          |                                                                                        |     |
| Item 3.                       | Quantitative and Qualitative Disclosures  About Market Risk                                 | 16       |
|                          |                                                                                        |     |
| Item 4.                       | Controls and Procedures                                                                     | 17       |
|                          |                                                                                        |     |
| PART II. OTHER INFORMATION    |                                                                                        |
|                          |                                                                                        |     |
| Item 1.                       | Legal Proceedings                                                                           | 17       |
|                          |                                                                                        |     |
| Item 2.                       | Changes in Securities and Use of Proceeds                                                   | 17       |
|                          |                                                                                        |     |
| Item 3.                       | Defaults Upon Senior Securities                                                             | 17       |
|                          |                                                                                        |     |
| Item 4.                       | Submission of Matters to a Vote of Security  Holders                                        | 17       |
|                          |                                                                                        |     |
| Item 5.                       | Other Information                                                                           | 17       |
|                          |                                                                                        |     |
| Item 6.                       | Exhibits and Reports on Form 8-K                                                            | 19       |
|                          |                                                                                        |     |
| SIGNATURES                    | 20                                                                                          |

 

2

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PART I - FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

 

NEON SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS, EXCEPT SHARE AND PER SHAREAMOUNTS)

 
| ** **                                                                                                                                                            | ** ** | **JUNE 30, 2004** | ** ** | **MARCH 31, 2004** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|--------------------|------------|
| ** **                                                                                                                                                            | ** ** | **(UNAUDITED)**   | ** ** | ** **         | ** ** |
| ASSETS                                                                                                                                                                |       |              |       |               |       |
|                                                                                                                                                                  |       |              |       |               |       |
| CURRENT ASSETS:                                                                                                                                                       |       |              |       |               |       |
| Cash and cash equivalents                                                                                                                                             |       | $                 | 26,474     |               | $          | 20,899 |   |
| Accounts receivable, net                                                                                                                                              |       | 2,489             |       | 6,150              |       |
| Other current assets                                                                                                                                                  |       | 1,161             |       | 1,232              |       |
| Total current assets                                                                                                                                                  |       | 30,124            |       | 28,281             |       |
|                                                                                                                                                                  |       |              |       |               |       |
| Property and equipment, net                                                                                                                                           |       | 540               |       | 475                |       |
| Note receivable, net (Note 7)                                                                                                                                         |       | 4,260             |       | 7,760              |       |
| Purchased technology, net                                                                                                                                             |       | 399               |       | —             |       |
| Other assets                                                                                                                                                          |       | 487               |       | 341                |       |
| Total assets                                                                                                                                                          |       | $                 | 35,810     |               | $          | 36,857 |   |
|                                                                                                                                                                  |       |              |       |               |       |
| LIABILITIES & STOCKHOLDERS’ EQUITY                                                                                                                           |       |              |       |               |       |
|                                                                                                                                                                  |       |              |       |               |       |
| CURRENT LIABILITIES:                                                                                                                                                  |       |              |       |               |       |
| Accounts payable                                                                                                                                                      |       | $                 | 222        |               | $          | 298 |   |
| Accrued expenses                                                                                                                                                      |       | 1,366             |       | 2,733              |       |
| Deferred revenue                                                                                                                                                      |       | 6,563             |       | 7,540              |       |
| Total current liabilities                                                                                                                                             |       | 8,151             |       | 10,571             |       |
|                                                                                                                                                                  |       |              |       |               |       |
| Deferred revenue – long term                                                                                                                                     |       | 1,298             |       | 931                |       |
| Accrued restructuring expenses  – long term (Note 6)                                                                                                             |       | 932               |       | 898                |       |
| Total liabilities                                                                                                                                                     |       | 10,381            |       | 12,400             |       |
|                                                                                                                                                                  |       |              |       |               |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                            |       |              |       |               |       |
| Preferred stock, $.01 par  value. Authorized 10,000,000 shares; no shares issued and outstanding                                                                      |       | —            |       | —             |       |
| Common stock, $.01 par value.  Authorized 30,000,000 shares; 8,917,227 and 8,914,547 shares issued and  outstanding at June 30, 2004 and March 31, 2004, respectively |       | 98                |       | 98                 |       |
| Additional paid-in capital                                                                                                                                            |       | 51,703            |       | 51,696             |       |
| Treasury Stock, 913,400 shares  at cost                                                                                                                               |       | (2,649            | )          | (2,649             | )          |
| Accumulative other  comprehensive loss                                                                                                                                |       | (423              | )          | (421               | )          |
| Accumulated deficit                                                                                                                                                   |       | (23,300           | )          | (24,267            | )          |
| Total stockholders’ equity                                                                                                                                       |       | 25,429            |       | 24,457             |       |
| Commitments and contingencies  (Note 5)                                                                                                                               |       |              |       |               |       |
| Total liabilities and  stockholders’ equity                                                                                                                      |       | $                 | 35,810     |               | $          | 36,857 |   |

 

SEE ACCOMPANYING CONDENSED NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

 

3

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NEON SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

(UNAUDITED)

 
| ** **                                             | ** ** | **THREE MONTHS ENDED JUNE 30,** | ** ** |
|--------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                             | ** ** | **2004**                        | ** ** | **2003** | ** ** |
| Revenues:                                              |       |                            |       |   |   |
| License                                                |       | $                               | 1,103      |   | $ | 1,560 |   |
| Maintenance                                            |       | 2,468                           |       | 2,580 |   |
| Total revenues                                         |       | 3,571                           |       | 4,140 |   |
|                                                   |       |                            |       |   |   |
| Cost of revenues:                                      |       |                            |       |   |   |
| Cost of licenses                                       |       | 32                              |       | 83 |   |
| Cost of maintenance                                    |       | 364                             |       | 374 |   |
| Total cost of revenues                                 |       | 396                             |       | 457 |   |
|                                                   |       |                            |       |   |   |
| Gross profit                                           |       | 3,175                           |       | 3,683 |   |
|                                                   |       |                            |       |   |   |
| Operating expenses:                                    |       |                            |       |   |   |
| Sales and marketing                                    |       | 1,555                           |       | 1,675 |   |
| Research and development                               |       | 983                             |       | 1,172 |   |
| General and administrative                             |       | 930                             |       | 780 |   |
| Total operating expenses                               |       | 3,468                           |       | 3,627 |   |
|                                                   |       |                            |       |   |   |
| Operating income (loss)                                |       | (293                            | )          | 56 |   |
|                                                   |       |                            |       |   |   |
| Interest and other income, net                         |       | 45                              |       | 53 |   |
| Gain on sale of notes  receivable (Note 7)             |       | 1,215                           |       | — |   |
| Income from continuing  operations before income taxes |       | 967                             |       | 109 |   |
|                                                   |       |                            |       |   |   |
| Provision for income taxes                             |       | —                          |       | — |   |
| Income from continuing  operations                     |       | 967                             |       | 109 |   |
|                                                   |       |                            |       |   |   |
| Gain from discontinued  operations, net (Note 8)       |       | —                          |       | 46 |   |
| Net income                                             |       | $                               | 967        |   | $ | 155 |   |
|                                                   |       |                            |       |   |   |
| Earnings per common share —Basic:                 |       |                            |       |   |   |
| Income from continuing  operations                     |       | $                               | 0.11       |   | $ | 0.01 |   |
| Gain from discontinued  operations, net                |       | —                          |       | 0.01 |   |
| Net income                                             |       | $                               | 0.11       |   | $ | 0.02 |   |
|                                                   |       |                            |       |   |   |
| Earnings per common share —Diluted:               |       |                            |       |   |   |
| Income from continuing  operations                     |       | $                               | 0.10       |   | $ | 0.01 |   |
| Gain from discontinued  operations, net                |       | —                          |       | 0.01 |   |
| Net income                                             |       | $                               | 0.10       |   | $ | 0.02 |   |
|                                                   |       |                            |       |   |   |
| Weighted average shares  outstanding:                  |       |                            |       |   |   |
| Basic                                                  |       | 8,915                           |       | 8,801 |   |
| Diluted                                                |       | 9,379                           |       | 9,058 |   |

 

SEE ACCOMPANYING CONDENSED NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

 

4

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NEON SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(IN THOUSANDS)

(UNAUDITED)

 
| ** **                                                                                   | ** ** | **THREE MONTHS ENDED JUNE 30,** | ** ** |
|----------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                   | ** ** | **2004**                        | ** ** | **2003** | ** ** |
| CASH FLOWS FROM OPERATING  ACTIVITIES:                                                       |       |                            |       |   |   |
| Net income                                                                                   |       | $                               | 967        |   | $ | 155 |   |
| Adjustments to reconcile net  income to net cash provided by (used in) operating activities: |       |                            |       |   |   |
| Depreciation and amortization                                                                |       | 131                             |       | 116 |   |
| Gain on sale of notes  receivable (Note 7)                                                   |       | (1,215                          | )          | — |   |
| Gain from discontinued  operations, net (Note 8)                                             |       | —                          |       | (46 | ) |
| Increase (decrease) in cash  resulting from changes in operating assets and liabilities:     |       |                            |       |   |   |
| Accounts receivable                                                                          |       | 3,641                           |       | 195 |   |
| Other current assets                                                                         |       | 70                              |       | 290 |   |
| Other assets                                                                                 |       | (136                            | )          | 10 |   |
| Accrued expenses                                                                             |       | (1,315                          | )          | (390 | ) |
| Accounts payable                                                                             |       | (76                             | )          | (60 | ) |
| Deferred revenue and other                                                                   |       | (593                            | )          | (1,034 | ) |
| Net cash provided by (used in)  operating activities                                         |       | 1,474                           |       | (764 | ) |
|                                                                                         |       |                            |       |   |   |
| CASH FLOWS FROM INVESTING  ACTIVITIES:                                                       |       |                            |       |   |   |
| Purchases of property and  equipment                                                         |       | (169                            | )          | (31 | ) |
| Purchase of technology                                                                       |       | (264                            | )          | — |   |
| Acquisition-related costs (Note  9)                                                          |       | (172                            | )          | — |   |
| Proceeds from sale of notes  receivable                                                      |       | 4,715                           |       | — |   |
| Proceeds from sale of business                                                               |       | —                          |       | 335 |   |
|                                                                                         |       |                            |       |   |   |
| Net cash provided by investing  activities                                                   |       | 4,110                           |       | 304 |   |
|                                                                                         |       |                            |       |   |   |
| CASH FLOWS FROM FINANCING  ACTIVITIES:                                                       |       |                            |       |   |   |
| Proceeds from exercises of  stock options                                                    |       | 7                               |       | 24 |   |
| Net cash provided by financing  activities                                                   |       | 7                               |       | 24 |   |
|                                                                                         |       |                            |       |   |   |
| Net cash flows from  discontinued operations                                                 |       | —                          |       | 9 |   |
|                                                                                         |       |                            |       |   |   |
| Net increase (decrease) in cash  and cash equivalents                                        |       | 5,591                           |       | (427 | ) |
| Effect of exchange rate changes  on cash                                                     |       | (16                             | )          | 1 |   |
| Cash and cash equivalents at  beginning of period                                            |       | 20,899                          |       | 19,791 |   |
|                                                                                         |       |                            |       |   |   |
| Cash and cash equivalents at  end of period                                                  |       | $                               | 26,474     |   | $ | 19,365 |   |
|                                                                                         |       |                            |       |   |   |
| Supplemental disclosure of cash  flow information:                                           |       |                            |       |   |   |
|                                                                                         |       |                            |       |   |   |
| Cash paid during the period for  income taxes                                                |       | $                               | —     |   | $ | — |   |
| Cash paid during the period for  interest                                                    |       | $                               | —     |   | $ | — |   |

 

SEE ACCOMPANYING CONDENSED NOTES TOCONSOLIDATED FINANCIAL STATEMENTS

 

5

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NEON SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIALSTATEMENTS

 

NOTE 1—BASIS OF PRESENTATION

 

The accompanying unaudited consolidated financial statements for NEONSystems, Inc. and its subsidiaries (collectively, “NEON”) have been prepared inaccordance with accounting principles generally accepted in the United Statesof America for interim financial reporting and in accordance with RegulationS-X of the Securities and Exchange Commission. Accordingly, they do not includeall of the information and footnotes required by accounting principlesgenerally accepted in the United States of America for complete financialstatements. In the opinion of management, the unaudited consolidated financialstatements contained in this report reflect all adjustments, consisting of onlynormal recurring adjustments, considered necessary for a fair presentation ofthe financial position and the results of operations for the interim periodspresented. Operating results for interim periods are not necessarily indicativeof results for the full year. These unaudited consolidated financialstatements, footnote disclosures and other information should be read inconjunction with the financial statements and the notes thereto included inNEON’s audited consolidated financial statements for the fiscal year endedMarch 31, 2004, which are included in NEON’s Form 10-K for the fiscal yearended March 31, 2004.  Certain priorperiod amounts have been reclassified to conform to current periodpresentation.

 

NOTE2—PER SHARE INFORMATION

 

In calculating earnings per share information, NEON follows theprovisions of Statement of Financial Accounting Standards (“SFAS”) No. 128,Earnings Per Share. Basic earnings per share is computed by dividing net incomeapplicable to common stockholders by the weighted average number of shares ofcommon stock outstanding during the period. Diluted earnings per share is computed by dividing net income applicableto common stockholders 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.

 

Earningsper share:

(*In thousands, except per share date)*

 
| ** **                                           | ** ** | **THREE MONTHS ENDED JUNE 30,** | ** ** |
|------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                           | ** ** | **2004**                        | ** ** | **2003** | ** ** |
| ** **                                           | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Net income available for common shareholders         |       | $                               | 967        |   | $ | 155 |   |
|                                                 |       |                            |       |   |   |
| Weighted average outstanding shares of  common stock |       | 8,915                           |       | 8,801 |   |
| Dilutive effect of employee stock options            |       | 464                             |       | 257 |   |
| Common stock and common stock equivalents            |       | 9,379                           |       | 9,058 |   |
|                                                 |       |                            |       |   |   |
| Earnings per share:                                  |       |                            |       |   |   |
| Basic                                                |       | $                               | 0.11       |   | $ | 0.02 |   |
| Diluted                                              |       | $                               | 0.10       |   | $ | 0.02 |   |

 

At June 30, 2004 and 2003, there were optionsoutstanding to purchase 2.8 million shares of common stock with aweighted-average exercise price of $6.00 and $8.96, respectively. For the threemonths ended June 30, 2004 and 2003, 1.4 million and 1.8 million, respectively,were excluded from the calculation of diluted earnings per share because theeffect was anti-dilutive.

 

6

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***Employee Stock-Based Compensation***

 

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

 
| ** **                                                                                                       | ** ** | **THREE MONTHS ENDED JUNE 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                       | ** ** | **2004**                        | ** ** | **2003** | ** ** |
| ** **                                                                                                       | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Net income as reported                                                                                           |       | $                               | 967        |   | $ | 155 |   |
| Deduct total stock-based  employee compensation expense determined under fair-value-based method for  all awards |       | (385                            | )          | (410 | ) |
| Pro forma net income (loss)                                                                                      |       | $                               | 582        |   | $ | (255 | ) |
|                                                                                                             |       |                            |       |   |   |
| Basic earnings (loss) per  share:                                                                                |       |                            |       |   |   |
| As reported                                                                                                      |       | $                               | 0.11       |   | $ | 0.02 |   |
| Pro forma                                                                                                        |       | $                               | 0.07       |   | $ | (0.03 | ) |
|                                                                                                             |       |                            |       |   |   |
| Diluted earnings (loss) per  share:                                                                              |       |                            |       |   |   |
| As reported                                                                                                      |       | $                               | 0.10       |   | $ | 0.02 |   |
| Pro forma                                                                                                        |       | $                               | 0.06       |   | $ | (0.03 | ) |

 

NOTE3—INCOME TAXES

 

NEON has recorded no income tax provision asthe current year taxable income is offset by net operating loss carry-forwardsthat NEON had previously reserved.  AtMarch 31, 2004, NEON has a net operating loss carry-forward for income taxpurposes of approximately $19.3 million that is available to offset futuretaxable income. The net operating loss carry-forwards in the United Kingdom,Germany and Australia carry forward indefinitely.  The net operating loss carry-forward for theUnited States begins expiring in the tax year 2020.  There can be no assurance that the operationswill generate taxable income in the future to utilize these losses.  As of June 30, 2004 and March 31, 2004, thevaluation allowance fully offsets the Company’s net deferred tax assets.

 

NOTE4—SEGMENT REPORTING

 

NEON considers its business activities to be in a single segment.  NEON did not have any customers, individuallyor in aggregate that accounted for 10% or more of consolidated revenue duringthe three-month periods ending June 30, 2004 and June 30, 2003.

 

7

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The table below summarizes revenues by geographic region.

 
| ** **               | ** ** | **THREE MONTHS ENDED JUNE 30,** | ** ** |
|--------------------------|------------|---------------------------------|------------|
| ** **               | ** ** | **2004**                        | ** ** | **2003** | ** ** |
| Revenues:                |       |                            |       |   |   |
| North America            |       | $                               | 2,551      |   | $ | 2,670 |   |
| United Kingdom           |       | 928                             |       | 1,296 |   |
| Other                    |       | 92                              |       | 174 |   |
|                     |       | $                               | 3,571      |   | $ | 4,140 |   |
|                     |       |                            |       |   |   |
| Operating income (loss): |       |                            |       |   |   |
| United States            |       | $                               | (574       | ) | $ | (624 | ) |
| United Kingdom           |       | 313                             |       | 629 |   |
| Other                    |       | (32                             | )          | 51 |   |
|                     |       | $                               | (293       | ) | $ | 56 |   |

 
| ** **           | ** ** | **JUNE 30, 2004** | ** ** | **MARCH 31, 2004** |   |
|----------------------|------------|-------------------|------------|--------------------|--------|
|                 |       |              |       |               |   |
| Identifiable Assets: |       |              |       |               |   |
| United States        |       | $                 | 32,499     |               | $      | 33,258 |   |
| United Kingdom       |       | 3,185             |       | 3,302              |   |
| Other                |       | 126               |       | 297                |   |
|                 |       | $                 | 35,810     |               | $      | 36,857 |   |

 

NOTE 5—COMMITMENTS AND CONTINGENCIES

 

On January 29, 2003, NEON received notification that it had been suedin Fort Bend County, Texas for alleged tortious interference with contract,tortious interference with prospective business relations and unfaircompetition in a lawsuit styled Phoenix Network Technologies (Europe) Limitedvs. NEON Systems, Inc. and Computer Associates International Inc., 400th District Court, Ft. Bend County,Richmond, Texas, Cause Number 03-CV-127800. On October 27, 2003, the courtgranted NEON’s motion to dismiss the case. Phoenix Network Technologies has appealed this decision, and NEON iscontinuing to defend this action.  Asidefrom this action, NEON is not involved in any current claim or legal actionother than those arising in the ordinary course of business.

 

NOTE 6—RESTRUCTURINGCHARGES

 

During prior periods, NEON recorded various restructuring chargesrelated to future losses due to the abandonment of leased facilities andemployee severance associated with corporate reorganizations.  If, in the future, NEON is able to subleaseor renegotiate the leases related to these abandoned facilities, reversal ofall or a portion of such accrued losses may occur.

 

8

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The following table provides a roll-forward of the restructuringaccrual account for the three months ended June 30, 2004 (in thousands):

 
| ** **                 | ** ** | ** **          | ** ** | **Balance at  March 31,  2004** | ** ** | **Amounts  Charged  to Expense** | ** ** | **Net  Amounts  Paid** | ** ** | **Other** | ** ** | **Balance at  June 30,  2004** | ** ** |
|----------------------------|------------|---------------------|------------|-------------------------------------------|------------|---------------------------------------|------------|------------------------|------------|-----------|------------|------------------------------------------|------------|
|                       |       |                |       |                                      |       |                                  |       |                   |       |      |       |                                     |       |
| 2002 Restructuring Accrual |       | Facility  closure   |       | $                                         | 54         |                                  | $          | —                 |       | $         | (5         | )                                        | $          | — |   | $ | 49 |   |
|                       |       |                |       |                                      |       |                                  |       |                   |       |      |       |                                     |       |
| 2003 Restructuring Accrual |       | Facility  closure   |       | 1,462                                     |       | (114                                  | )          | (122                   | )          | (12       | )          | 1,214                                    |       |
|                       |       |                |       |                                      |       |                                  |       |                   |       |      |       |                                     |       |
| 2004 Restructuring Accrual |       | Employee  severance |       | 35                                        |       | —                                |       | (35                    | )          | —    |       | —                                   |       |
|                       |       | Facility  closure   |       | 3                                         |       | —                                |       | (3                     | )          | —    |       | —                                   |       |
|                       |       |                |       |                                      |       |                                  |       |                   |       |      |       |                                     |       |
|                       |       | Totals              |       | $                                         | 1,554      |                                  | $          | (114                   | )          | $         | (165       | )                                        | $          | (12 | ) | $ | 1,263 |   |

 

The $1.3 million balance at June 30, 2004 consists of future cashpayments for abandoned facilities that will be paid through 2006. The currentportion of this liability, $331,000, is included in accrued expenses.

 

During the three months ended June 30, 2004, NEON renegotiated anabandoned lease that had been previously accrued, resulting in a decrease ofthe liability by $114,000, which is reported in general and administrativeexpenses in the consolidated statement of operations.

 

Other adjustments relate primarily to the effect of currencytranslation on foreign balances.

 

NOTE 7—RELATED PARTY TRANSACTIONS

 

Certain former members of NEON’s Board of Directors and certain formerexecutive officers of NEON were shareholders and/or directors in othercompanies with which NEON has investments. Transactions between NEON and these other companies are described below.The directors and officers involved in such transactions are no longer officersand directors of NEON.

 

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

 

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

 

NEON currently holds a consolidated promissory note receivable  from NESI in the aggregate principal amountof $3.6 million, bearing no interest to its due date of March 31, 2005. Thisconsolidated promissory note is secured by all of the intellectual property ofNESI (“NESI IP”). NEON also currently holds a $3.0 million convertiblepromissory note receivable from NESI bearing no interest to its due date ofMarch 31, 2005, which is also secured by the NESI IP. The $3.0 millionconvertible note is convertible by NEON, in its discretion, into equity in NESIat an agreed pre-cash valuation of $30.0 million dollars. Such conversion rightwill expire on the due date of the $3.0 million convertible note. On theclosing of the transaction in August 2002, NEON recorded the notes receivablefrom NESI at their estimated net present value, which was calculated at $4.3million in aggregate value. NEON will adjust the carrying value of the note ifthe net realizable value is determined to be below the carrying value. NEON hadan external valuation of the NESI IP performed as of March 31, 2004 anddetermined that no further impairment of the notes were required.  NEON also evaluates the NESI IP on aquarterly basis to determine the notes’ net realizable value. NEON is not awareof any changes that have occurred which would result in an adjustment to the carrying value.

 

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*Scalable Software, Inc.*

 

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

 

In June 2002, NEON obtained a two-year option to acquire Scalable asoutlined in the Agreement and Plan of Merger dated June 26, 2002. In connectionwith this Option, NEON agreed to provide bridge financing of up to $5.5 million(subsequently increased to $6.0 million in October 2002), in addition to $3.5million previously loaned to Scalable that was secured by personal guaranteesfrom John J. Moores, Louis R. Woodhill and Jim Woodhill. The aggregatefinancing had a 36-month term and did not bear interest during the term of thetwo-year option to acquire Scalable, which expires June 26, 2004. After theexpiration of the option, the loan was scheduled to bear interest at the primerate plus two percentage points to its due date of June 26, 2005 and thereafteron any unpaid principal and interest amounts outstanding. In addition to thepersonal guarantees of John J. Moores, Louis R. Woodhill and Jim Woodhill forthe initial $3.5 million loaned to Scalable, the $6.0 million loan was securedby all of the intellectual property rights of Scalable. In January 2003,Scalable exhausted its credit facility with NEON. Scalable has asked for andreceived waivers of NEON’s right of first refusal with respect to additionalventure capital bridge financing.

 

On June 9, 2004, NEON entered into a Note Purchase Agreement with JMIServices, Inc., the largest shareholder of Scalable, to sell the $3.5 millionguaranteed note and the $6.0 million secured note issued by Scalable to NEONfor an aggregate cash purchase price of $4.8 million.  JMI Services is an affiliate of John J.Moores, NEON’s largest shareholder.  Theproposed purchase of the Scalable notes was reviewed by NEON’s fullyindependent Board of Directors.  Theboard requested and received a fairness opinion from Avail Consulting, Inc., aHouston, Texas based independent valuation and financial consultant, statingthat the transaction was fair to the stockholders of NEON from a financialstandpoint and their recommendation that the Board accept the cash purchaseoffer made by JMI Services, Inc.  Closingof the transaction occurred on June 17, 2004.

 

NEON recorded the carrying value of its net advance to Scalable at theguaranteed amount of $3.5 million.  As aresult of the sale of the notes during the three months ended June 30, 2004,NEON recorded a net gain of $1.2 million, consisting of proceeds in excess ofthe recorded net book value and direct selling costs.

 

NOTE 8 –  DISCONTINUED OPERATIONS

 

On June 20, 2003,NEON divested of its iWave product line assets. As a result of the transaction, NEON recorded a gain on the sale of$290,000, net of closing expenses, during the three months ended June 30,2003.  Total revenues attributed to theiWave product line for the three months ended June 30, 2003 were $194,000.  Operating losses associated with the iWaveproduct line of $244,000 for the three months ended June 30, 2003 were offsetagainst the gain on disposal of the discontinued operations in the consolidated statements of operations.

 

NOTE 9 –  SUBSEQUENT EVENTS

 

On July 15,2004, NEON closed its acquisition of InnerAccess Technologies, Inc., a companyincorporated under the laws of the province of Quebec, Canada.  InnerAccess is a company which develops,markets and licenses web services technology and provides services related tothe integration of mainframe data sources with modern distributed computingsystems.  In connection with theacquisition, NEON and InnerAccess entered into a Combination Agreement, whichprovided for the amalgamation of InnerAccess, three single purpose entitiesholding the majority of the shares of InnerAccess (the “PrincipalShareholders”), and NEON’s wholly-owned subsidiary, NEON Systems Canada Inc.(the “Amalgamated Entity”).  Inconnection with the amalgamation, the shareholders of InnerAccess (“InnerAccessShareholders”) exchanged their shares of the capital stock of InnerAccess for(i) class A redeemable shares of the Amalgamated Entity which entitled suchInnerAccess Shareholders to receive $0.174 per share redeemed by theAmalgamated Entity and (ii) class B redeemable shares of the Amalgamated Entitywhich entitled such InnerAccess Shareholder to receive 0.02952 of a share of

 

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NEON common stock per share redeemed by theAmalgamated Entity.  Upon the fullredemption of the redeemable preferred shares, NEON will have paid theInnerAccess Shareholders a total of $2.4 million dollars in cash purchase priceand issued 407,123 shares of NEON common stock in consideration for theacquisition of InnerAccess by NEON.

 

In addition,NEON has assumed certain special warrants of InnerAccess, which (on a convertedbasis) represent the right to acquire an additional 19,894 shares of NEONcommon stock at a cash exercise price equal to $9.50 per share.  In connection with the issuance of the sharesof NEON common stock, NEON entered into a registration rights agreement witheach former InnerAccess Shareholder. Such Registration Rights Agreement grants to each such formerInnerAccess Shareholder a right to piggyback on any public offering of NEONshares of common stock during the one year period following the closing of theacquisition of InnerAccess  by NEON.

 

TheAmalgamated Entity now has offices in Quebec City, Quebec, Canada and inToronto, Ontario, Canada.   In connectionwith the acquisition, the President and CEO of InnerAccess, Jean-Daniel Bégin,became NEON’s Vice President of Product Management and became an executiveofficer of NEON.

 

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

 

The followingdiscussion and analysis should be read in conjunction with NEON’s consolidatedfinancial statements and the related notes thereto included in this report onForm 10-Q. The discussion and analysis contains forward-looking statementswithin the meaning of Section 27A of the Securities Act of 1933 and Section 21Eof the Securities Exchange Act of 1934. These statements are based on our current expectations and entailvarious risks and uncertainties such as ourplans, objectives, expectations and intentions. Our actual results could differ materially from those projectedin the forward-looking statements as a result of various factors, includingthose set forth below in Part II, Item 5under “Factors that May Affect Future Results.” In some cases, you can identify forward-looking statements byterminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,”“believes,” “estimates,” “predicts,” “potential,” “continue,” or the negativeof these terms or other comparable terms.

 

OVERVIEW

 

NEON Systems, Inc. (“NEON”) is a leading provider of enterprise-classmainframe integration software.  NEONdevelops, markets and supports a unified mainframe integration platform thatsupports a broad range of requirements for modern Service-OrientedArchitectures and emerging Event-Driven Architectures. NEON’s Shadow technologyprovides flexible,industry standard interfaces to enable highly secure and scalable mainframeintegration, allowing organizations to reduce total cost of ownership and risk associated with mainframeintegration, while streamlining the number of incumbent technologies needed forsuch integration.

 

In July 2004, NEON closed its acquisition of InnerAccess Technologies,a Quebec corporation which develops mainframe integration software productswith particular specialization in web services for mainframe integration andintegration of IDMS databases.

 

***Business Environment***

 

NEON derives revenue from software licenses and maintenance services.License fees, which are graduated and based upon various industry standardmeasures of product usage such as mainframe potential capacity, CPUs, andusers, are generally due upon license grant and include a one-year maintenanceperiod. The sales process typically takes between six and nine months. Afterthe initial year of license, NEON provides ongoing maintenance services, whichinclude technical support and product enhancements, for an annual fee. Anyfactors adversely affecting the pricing of, demand for, or market acceptanceof, our products, such as competition or technological change, could materiallyadversely affect our business, operating results and financial condition.

 

In mid-2000, the mainframe software market began to weaken as theglobal economies entered a recessionary period. Prior to 2000, many of NEON’s customers were experiencing consistentgrowth of their mainframe systems and, as a result, 

 

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they purchased additionalsoftware capacity in anticipation of continued growth at rates consistent withhistory. Additionally, during this time frame, the competitive landscape forNEON’s product also began to intensify.

 

During fiscal 2003, NEON began restructuring the company to concentrateon its core mainframe integration business, which has historically accountedfor the majority of its revenues. NEON divested its non-core products and reduced the size of its sales, marketing andadministrative organizations. During this period NEON also began to develop newmainframe integration products as well as identify other adjacent marketproducts, technologies and companies which were complementary to NEON’sexisting product portfolio.

 

Many of NEON’s customers remain cautious about their capital spending.Although general economic conditions have improved, NEON is still uncertain asto future spending patterns of its customers. NEON believes thatperiod-to-period comparisons of our revenue and operating results should not berelied upon as indications of our future performance. Further, NEON does notbelieve that its historical growth rates in prior years are necessarilyrepresentative of its future growth potential.

 

***Related Party Transactions***

 

Certain former members of NEON’s Board of Directors and certain formerexecutive officers of NEON were shareholders and/or directors in othercompanies with which NEON has investments. Transactions between NEON and these other companies are described below.The directors and officers involved in such transactions are no longer officersand directors of NEON.

 

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

 

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

 

NEON currently holds a consolidated promissory note receivable fromNESI in the aggregate principal amount of $3.6 million, bearing no interest toits due date of March 31, 2005. This consolidated promissory note is secured byall of the intellectual property of NESI (“NESI IP”). NEON also currently holdsa $3.0 million convertible promissory note receivable from NESI bearing nointerest to its due date of March 31, 2005, which is also secured by the NESIIP. The $3.0 million convertible note is convertible by NEON, in its discretion,into equity in NESI at an agreed pre-cash valuation of $30.0 million dollars.Such conversion right will expire on the due date of the $3.0 millionconvertible note. On the closing of the transaction in August 2002, NEONrecorded the notes receivable from NESI at their estimated net present value,which was calculated at $4.3 million in aggregate value. NEON will adjust thecarrying value of the note if the net realizable value is determined to bebelow the carrying value. NEON had an external valuation of its notesreceivable due from NESI as of March 31, 2004 and determined that no furtherimpairment of the notes were required.  NEON also evaluates the NESI IP on a quarterly basis to determine thenotes’ net realizable value. NEON is not aware of any changes that haveoccurred which would result in an adjustment of the carrying value.

 

*Scalable Software, Inc.*

 

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

 

In June 2002, NEON obtained a two-year option to acquire Scalable asoutlined in the Agreement and Plan of Merger dated June 26, 2002. In connectionwith this Option, NEON agreed to provide bridge financing of up to $5.5 million(subsequently increased to $6.0 million in October 2002), in addition to $3.5million previously loaned to Scalable that was secured by personal guaranteesfrom John J. Moores, Louis R. Woodhill and Jim Woodhill. The aggregatefinancing had a 36-month term and did not bear interest during the term of thetwo-year option to acquire Scalable, which expires June 26, 2004. After theexpiration of the option, the loan was scheduled to bear interest at the primerate plus two percentage points to its due date of June 26, 2005 and thereafteron any unpaid principal and interest amounts outstanding. In addition to thepersonal guarantees

 

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of John J. Moores, Louis R.Woodhill and Jim Woodhill for the initial $3.5 million loaned to Scalable, the$6.0 million loan was secured by all of the intellectual property rights ofScalable. As of January 2003, Scalable had exhausted its credit facility withNEON. Scalable has asked for and received waivers of NEON’s right of first refusalwith respect to additional venture capital bridge financing.

 

On June 9, 2004, NEON entered into a Note Purchase Agreement with JMIServices, Inc., the largest shareholder of Scalable, to sell the $3.5 millionguaranteed note and the $6.0 million secured note issued by Scalable to NEON inconnection with NEON’s financing obligations for an aggregate cash purchaseprice of $4.8 million.  JMI Services isan affiliate of John J. Moores, NEON’s largest shareholder. The proposedpurchase of the Scalable notes was reviewed by NEON’s fully independent Boardof Directors.  The board requested andreceived a fairness opinion from Avail Consulting, Inc., a Houston, Texas basedindependent valuation and financial consultant, stating that the transactionwas fair to the stockholders of NEON from a financial standpoint. NEON alsoengaged Avail Consulting to perform a valuation on both notes receivable fromScalable. The value received by JMI Services exceeded the estimated fair valueof both notes, as determined by Avail Consulting.  Closing of the transaction occurred on June17, 2004.

 

NEON recorded the carrying value of its net advance to Scalable at theguaranteed amount of $3.5 million.  As aresult of the sale of the notes during the three months ended June 30, 2004,NEON recorded a net gain of $1.2 million, consisting of proceeds in excess ofthe recorded net book value and direct selling costs.

 

***Critical Accounting Policies***

 

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

 

***Revenue Recognition Policies***

 

Statement of Position 97-2, *SoftwareRevenue Recognition* (SOP 97-2), was issued in October 1997 by theAmerican Institute of Certified Public Accountants (AICPA) and was amended byStatement of Position 98-4 (SOP 98-4) and Statement of Position 98-9 (SOP98-9). NEON adopted SOP 97-2 effective July 1, 1997, SOP 98-4 effective March31, 1998 and SOP 98-9 effective April 1, 1999. NEON believes its currentrevenue recognition policies and practices are consistent with SOP 97-2, SOP98-4 and SOP 98-9. Revenues from software license sales are recognized when allof the following conditions are met: a non-cancelable license agreement hasbeen obtained, the product has been delivered; there are no materialuncertainties regarding customer acceptance; collection of the receivable isprobable; no other significant vendor obligations exist; and vendor-specificobjective evidence exists to allocate the total fee to each element of thearrangement. Vendor-specific objective evidence is based on the price generallycharged when an element is sold separately. All elements of each order arevalued at the time of revenue recognition. NEON will defer license revenue forall delivered elements associated with a sales arrangement, if vendor-specificobjective evidence cannot be established for each undelivered element. Licenserevenues generally include software maintenance agreements for the first yearfollowing the date of sale. In such cases, revenues are allocated betweenlicense and maintenance revenues based on the residual method provided by SOP98-9. Deferred revenue is generally based on vendor-specific objective evidenceof the fair value of maintenance with the remaining portion of the totalarrangement value allocated to license revenues.  Revenues from first-year maintenanceagreements and separately priced software maintenance agreements for subsequentyears are deferred and recognized ratably on a straight-line basis over themaintenance period. NEON also markets and sells its products throughindependent distributors and resellers. License and maintenance revenues fromthese transactions are recognized as above, when sold to the ultimate end userand all of the above conditions are met.

 

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***Capitalized Software Costs***

 

NEON follows SFAS No. 86, *Accountingfor the Costs of Computer Software to be Sold, Leased or Otherwise Marketed*.Research and development expenditures have been charged to operating expensesas incurred. No such costs have been capitalized to date, as the impact on the financial statements wouldbe insignificant because the time between a product meeting the definition oftechnological feasibility and readiness for market is very short.

 

***Allowance for Doubtful Accounts Receivable***

 

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

 

***Deferred Income Taxes***

 

NEON records deferred income tax assets and liabilities on its balancesheet related to events that impact its financial statements and tax returns indifferent periods. In order to compute these deferred tax balances, NEON firstanalyzes the differences between the book basis and tax basis of its assets andliabilities (referred to as “temporary differences”). These temporarydifferences are then multiplied by current tax rates to arrive at the balancesfor the deferred income tax assets and liabilities. If deferred tax assetsexceed deferred tax liabilities, NEON must estimate whether those net deferredasset amounts will be realized in the future. A valuation allowance is thenprovided for the net deferred asset amounts that are not likely to be realized.

 

The change in NEON’s net deferred income tax balances during a periodresults in a deferred income tax provision or benefit in its statement ofoperations. If NEON’s expectations about the future tax consequences of pastevents should prove to be inaccurate, the balances of its deferred income taxassets and liabilities could require significant adjustments in future periods.Such adjustments could cause a material effect on NEON’s results of operationsfor the period of the adjustment.

 

RESULTSOF OPERATIONS

 

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

 
| ** **                                             | ** ** | **THREE MONTHS ENDED JUNE 30,** | ** ** |
|--------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                             | ** ** | **2004**                        | ** ** | **2003** | ** ** |
| Revenues:                                              |       |                            |       |   |   |
| License                                                |       | 30.9                            | %          | 37.7 | % |
| Maintenance                                            |       | 69.1                            |       | 62.3 |   |
| Total revenues                                         |       | 100.0                           |       | 100.0 |   |
|                                                   |       |                            |       |   |   |
| Cost of revenues:                                      |       |                            |       |   |   |
| Cost of licenses                                       |       | 0.9                             |       | 2.0 |   |
| Cost of maintenance                                    |       | 10.2                            |       | 9.0 |   |
| Total cost of revenues                                 |       | 11.1                            |       | 11.0 |   |
|                                                   |       |                            |       |   |   |
| Gross profit                                           |       | 88.9                            |       | 89.0 |   |
|                                                   |       |                            |       |   |   |
| Operating expenses:                                    |       |                            |       |   |   |
| Sales and marketing                                    |       | 43.5                            |       | 40.5 |   |
| Research and development                               |       | 27.5                            |       | 28.3 |   |
| General and administrative                             |       | 26.0                            |       | 18.8 |   |
| Total operating expenses                               |       | 97.0                            |       | 87.6 |   |
|                                                   |       |                            |       |   |   |
| Operating income (loss)                                |       | (8.1                            | )          | 1.4 |   |
| Interest and other income, net                         |       | 1.3                             |       | 1.3 |   |
| Gain on sale of notes  receivable                      |       | 34.0                            |       | — |   |
|                                                   |       |                            |       |   |   |
| Income from continuing  operations before income taxes |       | 27.2                            |       | 2.7 |   |
|                                                   |       |                            |       |   |   |
| Provision for income taxes                             |       | —                          |       | — |   |
| Income from continuing  operations                     |       | 27.2                            |       | 2.7 |   |
|                                                   |       |                            |       |   |   |
| Gain on disposal of  discontinued operations, net      |       | —                          |       | 1.1 |   |
| Net income                                             |       | 27.2                            | %          | 3.8 | % |

 

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THREE MONTHS ENDED JUNE 30, 2004 COMPARED TO THREE MONTHS ENDED JUNE 30,2003

 

REVENUES

 

License revenues for the three months ended June 30, 2004 were $1.1million, a decrease of $457,000 from $1.6 million for the three months endedJune 30, 2003. The decline in license revenue was primarily due to a reductionin the quantity of license transactions in both the United States and UnitedKingdom.

 

Maintenance revenues for the three months ended June 30, 2004 were $2.5million, a decrease of $112,000 from $2.6 million for the three months endedJune 30, 2003. The decrease primarily resulted from the receipt of certainmaintenance payments during the three months ended June 30, 2003 that relatedto prior periods.

 

COST OF REVENUES

 

Cost of license revenues for the three months ended June 30, 2004 were$32,000, or 2.9% of license revenues, and primarily represented amortization ofproduct technology that was acquired in April 2004. Cost of license revenuesfor the three months ended June 30, 2003 were $83,000, or 5.3% of licenserevenues, and primarily attributed to royalty payments.

 

Cost of maintenance revenues includes personnel and other customersupport costs. Cost of maintenance revenues for the three months ended June 30,2004 were $364,000, or 14.7% of maintenance revenues, as compared to $374,000,or 14.5% of maintenance revenues, for the three months ended June 30, 2003.

 

OPERATINGEXPENSES

 

Sales and marketing expenses includepersonnel costs, sales commissions and travel expenses of sales, presalessupport and marketing personnel, along with trade show participation and otherpromotional expenses. Sales and marketing expenses for the three months endedJune 30, 2004 were $1.6 million, a decrease of $120,000 from $1.7 million forthe three months ended June 30, 2003. The reduction was primarily due to lowerpersonnel costs.

 

Research and development expenses primarilyinclude personnel costs associated with NEON’s product development staff.Research and development expenses for the three months ended June 30, 2004 were$1.0 million, a decrease of $189,000 from $1.2 million for the three monthsended June 30, 2003.  The decrease inresearch and development is primarily due to a reduction in costs associatedwith contract development.

 

General and administrative expenses include personnel and other costsassociated with NEON’s executive, financial, legal and administrativefunctions. General and administrative expenses for the three months ended June30, 2004 were $930,000, an increase of $150,000 from $780,000 for the threemonths ended June 30, 2003. The increase was primarily related to greaterpersonnel costs.

 

Interest and other income for the three months ended June 30, 2004 and2003 was $45,000 and $53,000, respectively.

 

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During the three months ended June 30, 2004, NEON recognized a gain onsale of the notes receivable from Scalable Software (see Related PartyTransactions).  The gain of $1.2 millionresulted from net cash proceeds of $4.7 million in excess of the recorded netbook value of $3.5 million for the notes.

 

On June 20, 2003,NEON divest of its iWave product line assets. As a result of the transaction, NEON recorded a gain on the sale of$290,000, after closing expenses, during the three months ended June 30,2003.  Total revenues attributed to theiWave product line for the three months ended June 30, 2003 were $194,000.  Operating losses associated with the iWaveproduct line of $244,000 for the three months ended June 30, 2003 were offsetagainst the gain on disposal of the discontinued operations in the consolidatedfinancial statements.

 

No provision for income taxes was recordedfor the three months ended June 30, 2004 and 2003, as the taxable income isoffset by net operating loss carry-forwards that NEON had previouslyreserved.  As of March 31, 2004, NEON hada net operating loss carry-forward for income tax purposes of approximately$19.3 million that is available to offset future taxable income, if any. Thenet operating loss carry-forwards in the United Kingdom, Germany and Australiacarry forward indefinitely.  The netoperating loss carry-forward for the United States begins expiring in the taxyear 2020.  There can be no assurancethat the operations will generate taxable income in the future to utilize theselosses.  Therefore, as of June 30, 2004and March 31, 2004, NEON has recorded a full valuation allowance for thedeferred tax assets related to the future benefits, if any, for these loss carryforwards.

 

LIQUIDITYAND CAPITAL RESOURCES

 

NEON’s cash and cash equivalents at June 30, 2004 were $26.5 million,an increase of $5.6 million from $20.9 million at March 31, 2004. This increasewas due primarily to the sale of the notes receivable from Scalable Software(See Related Party Transactions) and collection of account receivables.

 

Net cash provided by operating activities was $1.5 million, versus$764,000 used in operations for the three months ended June 30, 2004 and 2003,respectively.  Net cash provided byoperating activities for the three months ended June 30, 2004 resultedprimarily from collection of receivables, less reduction of certain accruedliabilities.  The net cash used inoperating activities during the three months ended June 30, 2003, resultedprimarily from a reduction in deferred revenue.

 

During the three months ended June 30, 2004, net cash provided byinvesting activities was $4.1 million, primarily resulting from the proceedsfrom the sale of the notes receivable from Scalable Software.  Net cash provided by investing activitiesduring the three months ended June 30, 2003 was $304,000, primarily due to thesale of the iWave product line.

 

NEON’s net cash provided by financing activities was $7,000 and $24,000for the three months ended June 30, 2004 and 2003, respectively. The net cashprovided by financing activities in both periods represents proceeds from theexercise of employee stock options.

 

NEON’s future liquidity and capitalrequirements will depend upon numerous factors, including the costs associatedwith potential future business and product acquisitions, the costs and timingof expansion of product development efforts and the success of thesedevelopment efforts, the costs and timing of expansion of sales and marketingactivities, the extent to which our existing and new products gain marketacceptance, market developments, the costs involved in maintaining andenforcing intellectual property rights, the level and timing of licenserevenue, and other factors. NEON believes that its current balance of cash andcash equivalents will be sufficient to meet its working capital, fundingcommitments and anticipated capital expenditure requirements for at least thenext 12 months. NEON may require additional funds to support its workingcapital requirements or for other purposes and may seek to raise additionalfunds through public or private equity financing or from other sources. Therecan be no assurance that additional financing will be available at all, or ifavailable, that such financing will be obtainable on terms acceptable to NEON,or that any additional financing will not be dilutive.

 

ITEM 3.                             QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

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

 

The majority of NEON’s foreign currency transactions are denominated inthe British pounds sterling, which is the 

 

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functionalcurrency of NEON Systems (UK) Ltd. As these sales contracts are denominated andsettled in the functional currency, risks associated with currency fluctuationsare minimized to foreign currency translation adjustments. NEON does notcurrently hedge against foreign currency translation risks and believes thatforeign currency exchange risk is not significant to its operations.  As a result of NEON’s acquisition ofInnerAccess Technologies, Inc. in July 2004, additional risks associated withcurrency fluctuations between Canadian dollar and US dollars may occur.

 

NEON adheres to a conservative investment policy, whereby its principalconcern is the preservation of liquid funds while maximizing its yield on suchassets. Cash and cash equivalents approximated $26 million at June 30, 2004,and were invested in different types of commercial paper and moneysecurities.  NEON believes that anear-term change in interest rates would not materially affect its financial position,results of operations or net cash flows for fiscal year 2005.

 

ITEM4.          CONTROLS AND PROCEDURES

 

As of the end of the period covered by this Quarterly Report on Form10-Q, NEON carried out an evaluation, under the supervision and with theparticipation of NEON’s management, including the Chief Executive Officer andChief Financial Officer, of the effectiveness of the design and operation ofNEON’s disclosure controls and procedures (as defined in Rule 13a-15(e) of theSecurities Exchange Act of 1934).  Basedupon that evaluation, the Chief Executive Officer and Chief Financial Officerconcluded that NEON’s disclosure controls and procedures are effective inensuring that material information is accumulated and communicated tomanagement, and made known to the Chief Executive Officer and Chief FinancialOfficer, on a timely basis to allow disclosure as required in this QuarterlyReport on Form 10-Q.  There have been nosignificant changes in NEON’s internal controls or in other factors which couldsignificantly affect internal controls subsequent to the date NEON carried outits evaluation.

 

PART II - OTHER INFORMATION

 

ITEM 1.          LEGAL PROCEEDINGS- On January 29, 2003, NEON received notification that it had been sued in FortBend County, Texas for alleged tortious interference with contract, tortiousinterference with prospective business relations and unfair competition in alawsuit styled Phoenix Network Technologies (Europe) Limited vs. NEON Systems,Inc. and Computer Associates International Inc., 400th District Court, Ft. BendCounty, Richmond, Texas, Cause Number 03-CV-127800. On October 27, 2003, thecourt granted NEON’s motion to dismiss the case.  Phoenix Network Technologies has appealedthis decision, and NEON is continuing to defend this action.  Aside from this action, NEON is not involvedin any current material claim or legal action other than those arising in theordinary course of business.

 

ITEM 2.                             CHANGES IN SECURITIES ANDUSE OF PROCEEDS - None

 

ITEM 3.                             DEFAULTS UPON SENIORSECURITIES  - Not applicable.

 

ITEM 4.          SUBMISSION OF MATTERSTO VOTE OFSECURITY HOLDERS – Not applicable.

 

ITEM5.          OTHER INFORMATION –

 

**RISK FACTORS THAT MAY AFFECT FUTURE RESULTS**

 

This report on Form 10-Q, including Management’s Discussion andAnalysis of Financial Condition and Results of Operations, containsforward-looking statements and other prospective information relating to futureevents. These forward-looking statements and other information are subject tocertain risks and uncertainties that could cause results to differ materiallyfrom historical results or anticipated results, including the following:

 

***Our Stock Price May Fluctuate And Be ImpactedBy A Number Of Internal And External Factors***

 

*•**                  Our stock pricehas fluctuated and is subject to wide swings in price based on a number offactors, including our quarterly operating results, which may varysignificantly from quarter to quarter.*

 

Our future operating results may vary significantly from quarter toquarter due to a variety of factors, many of which are outside our control.Therefore, it is likely that in one or more future quarters our results mayfall below the expectations of

 

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securities analysts andinvestors. We operate with virtually no order backlog because our products areshipped and revenues are recognized shortly after orders are received. Inaddition, the amount of revenues associated with sales of our software can varysignificantly. In various quarters in the past, we have derived a significantportion of our software license revenues from a small number of relativelylarge sales. An inability to close one or more large sales that we had targetedto close in a particular period could materially adversely affect our operatingresults for that period. Moreover, we typically realize a majority of oursoftware license revenues in the last month of a quarter. As a result, minordelays in the timing of customer orders can shift a sale from its contemplatedquarter of completion to a subsequent quarter and cause significant variabilityin our operating results for any particular period. Accordingly, we believethat period-to-period comparisons of our operating results are not necessarilya meaningful indication of future performance. Although we generally do notgive guidance as to future operating results, if our quarterly results do notmeet investors’ expectations, the trading price of our common stock will likelydecline.

 

•                  *The Availability Of Significant Amounts Of Our CommonStock For Sale Could Adversely Affect Its Market Price*

 

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

 

***Reduced Customer Reliance Upon MainframeComputers Could Adversely Affect Our Business***

 

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

 

•      Continued use of the mainframe as acentral repository of mission-critical data and transactions;

 

•                  Growth inbusiness demands for access to the data, applications and transactions residingon mainframe computers from Web-based and client/server applications; and

 

•      Continued market acceptance of the Shadowproducts and enhancements to these products.

 

***Loss of Key Software Developers CouldAdversely Affect Our Business***

 

Our success is dependent upon the continued service and skills of ourkey software developers. The loss of the services of any of these key softwaredevelopers could have a negative impact on our business because of their uniqueskills, years of industry experience, and the difficulty of promptly findingqualified replacement personnel. We do not intend to maintain “key-man” lifeinsurance policies covering any of our employees. Significant competitionexists for employees with the skills required to develop the software productsand perform the maintenance services that we offer, and we may not be able tocontinue to retain sufficient numbers of highly skilled employees.

 

***We May Lose Market Share And Be Required ToReduce Prices As A Result Of Competition From Our Existing Competitors, OtherVendors And Information Systems Departments Of Customers***

 

We compete in markets that are intensely competitive and featurerapidly changing technology and evolving standards. Our competitors may be ableto respond more quickly than we can to new or emerging technologies and changesin customer requirements. Competitive pressures could reduce our market shareor require us to reduce the price of our products, either of which could have amaterial adverse effect on our business, operating results and financialcondition.

 

***Rapid Technological Change Could Render OurProducts Obsolete***

 

Our markets are characterized by rapid technological change, frequentnew product introductions and enhancements, uncertain product life cycles,changes in customer requirements and evolving industry standards. Theintroduction of new products embodying new technologies and the emergence ofnew industry standards could render our existing products obsolete which wouldhave a material adverse effect on our business, operating results and financialcondition. Our future success will depend upon our ability to continue todevelop and introduce a variety of new products and product enhancements toaddress the increasingly sophisticated needs of our customers. We mayexperience delays in releasing new products and

 

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product enhancements in thefuture. Material delays in introducing new products or product enhancements maycause customers to forego purchases of our products and purchase those of ourcompetitors.

 

***We May Be Unable To Enforce Or Defend OurOwnership And Use Of Proprietary Technology***

 

Our success depends to a significant degree upon our proprietarytechnology. We rely on a combination of trademark, trade secret and copyrightlaw, and contractual restrictions and passwords to protect our proprietarytechnology. However, these measures provide only limited protection, and we maynot be able to 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 SoftwareErrors, Which Could Adversely Affect Our Business***

 

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

 

ITEM6.          EXHIBITS AND REPORTS ON FORM 8-K

 

(a)                            EXHIBITS

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

 

(b)                            REPORTSON FORM 8-K

 

None

 

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SIGNATURES

 

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

 

 
|   |            |                                         |   | NEON SYSTEMS, INC.    |   |
|--------|-----------------|----------------------------------------------|--------|-----------------------|--------|
|   |            |                                         |   |                  |   |
|   |            |                                         |   |                  |   |
| Date:  | August 16, 2004 |                                         |   | /s/ Brian D. Helman   |   |
|   |            | Chief Financial Officer                      |
|   |            | (principal financial and accounting officer) |
|   |            |                                         |
|   |            |                                         |
| Date:  | August 16, 2004 |                                         |   | /s/ Mark J. Cresswell |   |
|   |            | President and Chief Executive Officer        |
|   |            | (principal executive officer)                |

 

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