** **

**UNITED STATES****SECURITIES AND EXCHANGECOMMISSION**

**Washington, D.C. 20549**

 

**Form 10-Q**

 

| **(Mark One)**                                                                                                                                               |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                         |
| ý**QUARTERLY  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE****SECURITIES EXCHANGE ACT OF 1934**                                                        |
|                                                                                                                                                         |
| **For the Quarterly Period Ended December 31, 2003**                                                                                                         |
|                                                                                                                                                         |
| **OR**                                                                                                                                                       |
|                                                                                                                                                         |
| o**TRANSITION  REPORT 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 the Act: |   |
|                                                         |   |   |
|                                                         | **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

 

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

 

The number of shares of the registrant’s common stock outstanding as ofJanuary 31, 2004, was 8,902,097.

 

 

----

 

NEON SYSTEMS, INC.

 

FORM 10-Q

 

FOR THE QUARTER ENDED DECEMBER31, 2003

 

INDEX

 
| PART I FINANCIAL INFORMATION |                                                                                        |
|------------------------------|---------------------------------------------------------------------------------------------|
|                         |                                                                                        |
| Item 1.                      | Financial Statements                                                                        |   |
|                         |                                                                                        |   |
|                         | Consolidated Balance Sheets  at December 31, 2003 and March 31, 2003                        |   |
|                         |                                                                                        |   |
|                         | Consolidated Statements of Operations for  the Three and Nine Months Ended                  |   |
|                         | December 31, 2003 and 2002.                                                                 |   |
|                         |                                                                                        |   |
|                         | Consolidated Statements of Cash Flows for  the Nine Months Ended December 31, 2003 and 2002 |   |
|                         |                                                                                        |   |
|                         | Condensed Notes to Consolidated Financial  Statements                                       |   |
|                         |                                                                                        |   |
| Item 2.                      | Management’s Discussion and Analysis of  Financial Condition and Results of Operations |   |
|                         |                                                                                        |   |
| Item 3.                      | Quantitative and Qualitative Disclosures  About Market Risk                                 |   |
|                         |                                                                                        |   |
| Item 4.                      | Controls and Procedures                                                                     |   |
|                         |                                                                                        |   |
| PART II. OTHER INFORMATION   |                                                                                        |
|                         |                                                                                        |   |
| Item 1.                      | Legal Proceedings                                                                           |   |
|                         |                                                                                        |   |
| Item 2.                      | Changes in Securities and Use of Proceeds                                                   |   |
|                         |                                                                                        |   |
| Item 3.                      | Defaults Upon Senior Securities                                                             |   |
|                         |                                                                                        |   |
| Item 4.                      | Submission of Matters to a Vote of Security  Holders                                        |   |
|                         |                                                                                        |   |
| Item 5.                      | Other Information – Risk Factors that May  Affect Future Results                       |   |
|                         |                                                                                        |   |
| Item 6.                      | Exhibits and Reports on Form 8-K                                                            |   |
|                         |                                                                                        |
|                         |                                                                                        |
| SIGNATURES                   |                                                                                        |

 

2

----

 

PART I - FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

 

NEON SYSTEMS, INC. ANDSUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS, EXCEPT SHAREAMOUNTS)

 
|                                                                                                                                                                      |   | **DECEMBER 31, 2003** |   | **MARCH 31, 2003** |   |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------|--------|--------------------|--------|
|                                                                                                                                                                      |   | **(UNAUDITED)**       |   |               |   |
| ASSETS                                                                                                                                                                    |   |                  |   |               |   |
|                                                                                                                                                                      |   |                  |   |               |   |
| CURRENT  ASSETS:                                                                                                                                                          |   |                  |   |               |   |
| Cash  and cash equivalents                                                                                                                                                |   | $                     | 20,213 |               | $      | 19,791 |   |
| Accounts  receivable, net                                                                                                                                                 |   | 3,305                 |   | 3,443              |   |
| Taxes  receivable                                                                                                                                                         |   | —                |   | 1,311              |   |
| Other current  assets                                                                                                                                                     |   | 519                   |   | 655                |   |
| Total current  assets                                                                                                                                                     |   | 24,037                |   | 25,200             |   |
|                                                                                                                                                                      |   |                  |   |               |   |
| Property and  equipment, net                                                                                                                                              |   | 518                   |   | 839                |   |
| Notes  receivable, net (related party, Note 7)                                                                                                                            |   | 7,760                 |   | 7,760              |   |
| Other assets                                                                                                                                                              |   | 100                   |   | 515                |   |
| Total assets                                                                                                                                                              |   | $                     | 32,415 |               | $      | 34,314 |   |
|                                                                                                                                                                      |   |                  |   |               |   |
| LIABILITIES & STOCKHOLDERS’ EQUITY                                                                                                                               |   |                  |   |               |   |
|                                                                                                                                                                      |   |                  |   |               |   |
| CURRENT  LIABILITIES:                                                                                                                                                     |   |                  |   |               |   |
| Accounts  payable                                                                                                                                                         |   | $                     | 304    |               | $      | 424 |   |
| Accrued  expenses                                                                                                                                                         |   | 1,397                 |   | 2,116              |   |
| Deferred  revenue                                                                                                                                                         |   | 5,269                 |   | 6,086              |   |
| Total current  liabilities                                                                                                                                                |   | 6,970                 |   | 8,626              |   |
|                                                                                                                                                                      |   |                  |   |               |   |
| Accrued  restructuring expenses – long term (Note 6)                                                                                                                 |   | 1,030                 |   | 1,297              |   |
| Total  liabilities                                                                                                                                                        |   | 8,000                 |   | 9,923              |   |
|                                                                                                                                                                      |   |                  |   |               |   |
| 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; 8,885,097 and 8,764,427 shares  issued and outstanding at December 31, 2003 and March 31, 2003, respectively |   | 98                    |   | 97                 |   |
| Additional  paid-in capital                                                                                                                                               |   | 51,677                |   | 51,585             |   |
| Treasury  stock, 913,400 shares at cost                                                                                                                                   |   | (2,649                | )      | (2,649             | )      |
| Accumulative  other comprehensive loss                                                                                                                                    |   | (426                  | )      | (473               | )      |
| Accumulated  deficit                                                                                                                                                      |   | (24,285               | )      | (24,169            | )      |
| Total  stockholders’ equity                                                                                                                                          |   | 24,415                |   | 24,391             |   |
| Commitments  and contingencies (Note 5)                                                                                                                                   |   |                  |   |               |   |
| Total  liabilities and stockholders’ equity                                                                                                                          |   | $                     | 32,415 |               | $      | 34,314 |   |

 

SEE ACCOMPANYING CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.

 

3

----

 

NEON SYSTEMS, INC. ANDSUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT PER SHAREAMOUNTS)

(UNAUDITED)

 
|                                                                                                          |   | **THREE MONTHS ENDED DECEMBER 31,** |   | **NINE MONTHS ENDED DECEMBER 31,** |   |
|---------------------------------------------------------------------------------------------------------------|--------|-------------------------------------|--------|------------------------------------|--------|
|                                                                                                          |   | **2003**                            |   | **2002**                           |   | **2003** |   | **2002** |   |
| Revenues:                                                                                                     |   |                                |   |                               |   |   |   |   |   |
| License                                                                                                       |   | $                                   | 1,157  |                               | $      | 2,233 |   | $ | 3,855 |   | $ | 5,582 |   |
| Maintenance                                                                                                   |   | 2,489                               |   | 2,363                              |   | 7,519 |   | 7,113 |   |
| Total revenues                                                                                                |   | 3,646                               |   | 4,596                              |   | 11,374 |   | 12,695 |   |
|                                                                                                          |   |                                |   |                               |   |   |   |   |   |
| Cost of  revenues:                                                                                            |   |                                |   |                               |   |   |   |   |   |
| Cost of  licenses                                                                                             |   | 1                                   |   | 5                                  |   | 84 |   | 270 |   |
| Cost of  maintenance                                                                                          |   | 342                                 |   | 475                                |   | 1,077 |   | 1,521 |   |
| Total cost of  revenues                                                                                       |   | 343                                 |   | 480                                |   | 1,161 |   | 1,791 |   |
|                                                                                                          |   |                                |   |                               |   |   |   |   |   |
| Gross profit                                                                                                  |   | 3,303                               |   | 4,116                              |   | 10,213 |   | 10,904 |   |
|                                                                                                          |   |                                |   |                               |   |   |   |   |   |
| Operating  expenses:                                                                                          |   |                                |   |                               |   |   |   |   |   |
| Sales and  marketing                                                                                          |   | 1,471                               |   | 2,912                              |   | 4,483 |   | 8,691 |   |
| Research and  development                                                                                     |   | 1,097                               |   | 985                                |   | 3,391 |   | 3,226 |   |
| General and  administrative                                                                                   |   | 934                                 |   | 1,325                              |   | 2,582 |   | 3,910 |   |
| Restructuring costs                                                                                           |   | 179                                 |   | —                             |   | 212 |   | 133 |   |
| Loss on  disposal                                                                                             |   | —                              |   | —                             |   | — |   | 687 |   |
| Total  operating expenses                                                                                     |   | 3,681                               |   | 5,222                              |   | 10,668 |   | 16,647 |   |
|                                                                                                          |   |                                |   |                               |   |   |   |   |   |
| Operating loss                                                                                                |   | (378                                | )      | (1,106                             | )      | (455 | ) | (5,743 | ) |
|                                                                                                          |   |                                |   |                               |   |   |   |   |   |
| Interest and  other income, net                                                                               |   | 60                                  |   | 79                                 |   | 231 |   | 332 |   |
| Equity loss in  affiliate                                                                                     |   | —                              |   | (1,004                             | )      | — |   | (3,187 | ) |
| Valuation  allowance of note receivable                                                                       |   | —                              |   | 105                                |   | — |   | (378 | ) |
| Loss  from continuing operations before income taxes and cumulative effect of  change in accounting principle |   | (318                                | )      | (1,926                             | )      | (224 | ) | (8,976 | ) |
|                                                                                                          |   |                                |   |                               |   |   |   |   |   |
| Provision for  income taxes                                                                                   |   | —                              |   | —                             |   | — |   | — |   |
| Loss  from continuing operations before cumulative effect of change in accounting  principle                  |   | (318                                | )      | (1,926                             | )      | (224 | ) | (8,976 | ) |
| Loss  from discontinued operations                                                                            |   | —                              |   | (476                               | )      | (244 | ) | (3,267 | ) |
| Gain on  disposal of discontinued operations                                                                  |   | 10                                  |   | —                             |   | 352 |   | — |   |
| Loss  before cumulative effect of change in accounting principle                                              |   | (308                                | )      | (2,402                             | )      | (116 | ) | (12,243 | ) |
| Cumulative  effect of change in accounting principle                                                          |   | —                              |   | —                             |   | — |   | (1,043 | ) |
| Net loss                                                                                                      |   | $                                   | (308   | )                                  | $      | (2,402 | ) | $ | (116 | ) | $ | (13,286 | ) |
|                                                                                                          |   |                                |   |                               |   |   |   |   |   |
| Loss per  common share —Basic:                                                                           |   |                                |   |                               |   |   |   |   |   |
| Loss from  continuing operations before cumulative effect of change in accounting  principle                  |   | $                                   | (0.03  | )                                  | $      | (0.23 | ) | $ | (0.02 | ) | $ | (1.03 | ) |
| Loss  from discontinued operations                                                                            |   | —                              |   | (0.05                              | )      | (0.03 | ) | (0.38 | ) |
| Gain  on disposal of discontinued operations                                                                  |   | —                              |   | —                             |   | 0.04 |   | — |   |
| Loss  before cumulative effect of change in accounting principle                                              |   | (0.03                               | )      | (0.28                              | )      | (0.01 | ) | (1.41 | ) |
| Cumulative  effect of change in accounting principle                                                          |   | —                              |   | —                             |   | — |   | (0.12 | ) |
| Net loss                                                                                                      |   | $                                   | (0.03  | )                                  | $      | (0.28 | ) | $ | (0.01 | ) | $ | (1.53 | ) |
|                                                                                                          |   |                                |   |                               |   |   |   |   |   |
| Loss per  common share —Diluted:                                                                         |   |                                |   |                               |   |   |   |   |   |
| Loss from  continuing operations before cumulative effect of change in accounting  principle                  |   | $                                   | (0.03  | )                                  | $      | (0.23 | ) | $ | (0.02 | ) | $ | (1.03 | ) |
| Loss  from discontinued operations                                                                            |   | —                              |   | (0.05                              | )      | (0.03 | ) | (0.38 | ) |
| Gain  on disposal of discontinued operations                                                                  |   | —                              |   | —                             |   | 0.04 |   | — |   |
| Loss before  cumulative effect of change in accounting principle                                              |   | (0.03                               | )      | (0.28                              | )      | (0.01 | ) | (1.41 | ) |
| Cumulative  effect of change in accounting principle                                                          |   | —                              |   | —                             |   | — |   | (0.12 | ) |
| Net loss                                                                                                      |   | $                                   | (0.03  | )                                  | $      | (0.28 | ) | $ | (0.01 | ) | $ | (1.53 | ) |
|                                                                                                          |   |                                |   |                               |   |   |   |   |   |
| Weighted  average shares outstanding:                                                                         |   |                                |   |                               |   |   |   |   |   |
| Basic                                                                                                         |   | 8,876                               |   | 8,734                              |   | 8,839 |   | 8,707 |   |
| Diluted                                                                                                       |   | 8,876                               |   | 8,734                              |   | 8,839 |   | 8,707 |   |

 

SEE ACCOMPANYING CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

4

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NEON SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(IN THOUSANDS)

(UNAUDITED)

 
|                                                                                      |   | **NINE MONTHS ENDED DECEMBER 31,** |   |
|-------------------------------------------------------------------------------------------|--------|------------------------------------|--------|
|                                                                                      |   | **2003**                           |   | **2002** |   |
| CASH FLOWS  FROM OPERATING ACTIVITIES:                                                    |   |                               |   |   |   |
| Net  loss                                                                                 |   | $                                  | (116   | ) | $ | (13,286 | ) |
| Adjustments to  reconcile net loss to net cash used in operating activities:              |   |                               |   |   |   |
| Depreciation  and amortization                                                            |   | 238                                |   | 258 |   |
| Loss from  discontinued operations                                                        |   | 244                                |   | 3,267 |   |
| Gain on  disposal of discontinued operations                                              |   | (352                               | )      | — |   |
| Cumulative  effect of change in accounting principle                                      |   | —                             |   | 1,043 |   |
| Non-cash  compensation expense                                                            |   | —                             |   | 349 |   |
| Equity loss in  affiliate                                                                 |   | —                             |   | 3,187 |   |
| Valuation  allowance of accounts receivable                                               |   | —                             |   | 169 |   |
| Valuation  allowance of note receivable                                                   |   | —                             |   | 378 |   |
| Loss on  Disposal                                                                         |   | —                             |   | 687 |   |
| Impairment of  fixed assets                                                               |   | 50                                 |   | — |   |
| Increase  (decrease) in cash resulting from changes in operating assets and  liabilities: |   |                               |   |   |   |
| Accounts  receivable                                                                      |   | (37                                | )      | 431 |   |
| Tax receivable                                                                            |   | 1,311                              |   | — |   |
| Other current  assets                                                                     |   | 369                                |   | 556 |   |
| Prepaid  royalty (related party, Note 7)                                                  |   | —                             |   | (1,756 | ) |
| Other assets                                                                              |   | 54                                 |   | 17 |   |
| Accrued  expenses                                                                         |   | (1,353                             | )      | (1,180 | ) |
| Accounts  payable                                                                         |   | (137                               | )      | (69 | ) |
| Deferred  revenue                                                                         |   | (686                               | )      | (2,084 | ) |
| Net cash used  in operating activities                                                    |   | (415                               | )      | (8,033 | ) |
|                                                                                      |   |                               |   |   |   |
| CASH FLOWS  FROM INVESTING ACTIVITIES:                                                    |   |                               |   |   |   |
| Advances  to Scalable Software (related party, Note 7)                                    |   | —                             |   | (3,362 | ) |
| Advances  to NESI (related party, Note 7)                                                 |   | —                             |   | (2,200 | ) |
| Purchases of  furniture and equipment                                                     |   | (57                                | )      | (319 | ) |
| Proceeds from  sale of business                                                           |   | 538                                |   | — |   |
|                                                                                      |   |                               |   |   |   |
| Net cash  provided by (used in) investing activities                                      |   | 481                                |   | (5,881 | ) |
|                                                                                      |   |                               |   |   |   |
| CASH FLOWS  FROM FINANCING ACTIVITIES:                                                    |   |                               |   |   |   |
| Proceeds from  exercises of stock options                                                 |   | 94                                 |   | 29 |   |
| Net cash  provided by financing activities                                                |   | 94                                 |   | 29 |   |
|                                                                                      |   |                               |   |   |   |
| Net cash flows  from discontinued operations                                              |   | 9                                  |   | (353 | ) |
|                                                                                      |   |                               |   |   |   |
| Net increase  (decrease) in cash and cash equivalents                                     |   | 169                                |   | (14,238 | ) |
| Effect of  exchange rate changes on cash                                                  |   | 253                                |   | (8 | ) |
| Cash and cash  equivalents at beginning of period                                         |   | 19,791                             |   | 34,506 |   |
|                                                                                      |   |                               |   |   |   |
| Cash and cash  equivalents at end of period                                               |   | $                                  | 20,213 |   | $ | 20,260 |   |
|                                                                                      |   |                               |   |   |   |
| Supplemental  disclosure of cash flow information:                                        |   |                               |   |   |   |
|                                                                                      |   |                               |   |   |   |
| Cash received  during the period for income tax refund                                    |   | $                                  | 1,420  |   | $ | — |   |
| Cash paid  during the period for interest                                                 |   | $                                  | — |   | $ | — |   |

 

SEE ACCOMPANYING CONDENSED NOTESTO CONSOLIDATED FINANCIAL STATEMENTS.

 

5

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NEON SYSTEMS, INC. ANDSUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIALSTATEMENTS

 

NOTE1—BASIS OF PRESENTATION

 

The accompanying unaudited consolidatedfinancial statements for NEON Systems, Inc. and its subsidiaries (collectively,“NEON”) have been prepared in accordance with accounting principles generallyaccepted in the United States of America for interim financial reporting and inaccordance with Regulation S-X of the Securities and Exchange Commission.Accordingly, they do not include all of the information and footnotes requiredby accounting principles generally accepted in the United States of America forcomplete financial statements. In the opinion of management, the unauditedconsolidated financial statements contained in this report reflect alladjustments, consisting of only normal recurring adjustments, considerednecessary for a fair presentation of the financial position and the results ofoperations for the interim periods presented. Operating results for interimperiods are not necessarily indicative of results for the full year. Theseunaudited consolidated financial statements, footnote disclosures and otherinformation should be read in conjunction with the financial statements and thenotes thereto included in NEON’s audited financial statements for the fiscalyear ended March 31, 2003, which are included in NEON’s Form 10-K for thefiscal year ended March 31, 2003. Certain prior period amounts have been reclassified to conform withcurrent period presentation.

 

NOTE 2—PER SHARE INFORMATION

 

In calculating earnings per shareinformation, NEON follows the provisions of Statement of Financial AccountingStandards (“SFAS”) No. 128, Earnings Per Share. Basic income (loss) per shareis computed by dividing net income (loss) applicable to common stockholders bythe weighted average number of shares of common stock outstanding during theperiod.  Diluted net income (loss) pershare is computed by dividing net income (loss) applicable to commonstockholders by the weighted average number of shares of common stockoutstanding, adjusted to reflect common stock equivalents, such as convertiblepreferred stock, stock options and warrants to purchase common stock, to theextent they are dilutive, less the number of shares that could have beenrepurchased with the exercise proceeds using the treasury stock method.  The Company reported net loss for thequarter ended December 31, 2003. Therefore, no potential common stock equivalents have been included inthe computation of any diluted per share amounts, in accordance with SFAS No. 128.

 

Earnings per share:

 
| **(In thousands, except per share date)**            |   | **THREE MONTHS ENDED  DECEMBER 31,** |   | **NINE MONTHS ENDED  DECEMBER 31,** |   |
|------------------------------------------------------|--------|--------------------------------------|--------|-------------------------------------|--------|
|                                                 |   | **2003**                             |   | **2002**                            |   | **2003** |   | **2002** |   |
| Net loss available for  common shareholders          |   | $                                    | (308   | )                                   | $      | (2,402 | ) | $ | (116 | ) | $ | (13,286 | ) |
|                                                 |   |                                 |   |                                |   |   |   |   |   |
| Weighted average  outstanding shares of common stock |   | 8,876                                |   | 8,734                               |   | 8,839 |   | 8,707 |   |
| Dilutive effect of employee stock options            |   | —                               |   | —                              |   | — |   | — |   |
| Common stock and common stock equivalents            |   | 8,876                                |   | 8,734                               |   | 8,839 |   | 8,707 |   |
|                                                 |   |                                 |   |                                |   |   |   |   |   |
| Loss per share:                                      |   |                                 |   |                                |   |   |   |   |   |
| Basic                                                |   | $                                    | (0.03  |                                | $      | (0.28 | ) | $ | (0.01 | ) | $ | (1.53 | ) |
| Diluted                                              |   | $                                    | (0.03  | )                                   | $      | (0.28 | ) | $ | (0.01 | ) | $ | (1.53 | ) |

 

At December 31, 2003, there wereoptions outstanding to purchase 2.7 million shares of common stock with aweighted-average exercise price of $6.29. All outstanding options were excluded from the calculation of dilutedloss per share for the three and nine months ended December 31, 2003 and 2002,as they were anti-dilutive.

 

6

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

 

NEON applies the intrinsic value-based methodof accounting prescribed by Accounting Principles Board (“APB”) Opinion No. 25,*Accounting For Stock Issued To Employees*,and related interpretations.  As such,compensation expense has generally only been recorded if the fair value of theunderlying stock on the date of grant exceeded the exercise price.  SFAS No. 123, *Accounting For Stock-Based Compensation*, establishedaccounting and disclosure requirements using a fair value-based method of accountingfor stock-based employee compensation plans. Alternatively, SFAS No. 123 allows entities to continue to apply theprovisions of APB Opinion No. 25 and provide pro forma net income and pro formaearnings per share disclosures for employee stock option grants made in 1996and future years as if the fair-value-based method defined in SFAS No. 123 hadbeen applied.  NEON has elected tocontinue to apply the provisions of APB Opinion No. 25 and provide the pro formadisclosure provisions of SFAS No. 123. The following table illustrates the effect on net income (loss) if thefair-value-based method had been applied to all outstanding and unvested awardsin each period (in thousands, except per share data):

 
|                                                                                                              |   | **THREE MONTHS ENDED  DECEMBER 31,** |       | **NINE MONTHS ENDED  DECEMBER 31,** |       |
|-------------------------------------------------------------------------------------------------------------------|--------|--------------------------------------|------------|-------------------------------------|------------|
|                                                                                                              |   | **2003**                             |       | **2002**                            |       | **2003** |   | **2002** |   |
|                                                                                                              |   |                                 | ** ** |                                | ** ** |   | ** ** |   | ** ** |
| Net  loss as reported                                                                                             |   | $                                    | (308       | )                                   | $          | (2,402 | ) | $ | (116 | ) | $ | (13,286 | ) |
| Add  stock-based employee compensation expense included in reported net loss                                      |   | —                               |       | —                              |       | — |   | 349 |   |
| Deduct  total stock-based employee compensation expense determined under  fair-value-based method for all rewards |   | 263                                  |       | 649                                 |       | 905 |   | 1,924 |   |
| Pro  forma net loss                                                                                               |   | $                                    | (571       | )                                   | $          | (3,051 | ) | $ | (1,021 | ) | $ | (14,861 | ) |
|                                                                                                              |   |                                 |       |                                |       |   |   |   |   |
| Basic loss per  share:                                                                                            |   |                                 |       |                                |       |   |   |   |   |
| As reported                                                                                                       |   | $                                    | (0.03      | )                                   | $          | (0.28 | ) | $ | (0.01 | ) | $ | (1.53 | ) |
| Pro forma                                                                                                         |   | $                                    | (0.06      | )                                   | $          | (0.35 | ) | $ | (0.12 | ) | $ | (1.71 | ) |
|                                                                                                              |   |                                 |       |                                |       |   |   |   |   |
| Diluted loss  per share:                                                                                          |   |                                 |       |                                |       |   |   |   |   |
| As reported                                                                                                       |   | $                                    | (0.03      | )                                   | $          | (0.28 | ) | $ | (0.01 | ) | $ | (1.53 | ) |
| Pro forma                                                                                                         |   | $                                    | (0.06      | )                                   | $          | (0.35 | ) | $ | (0.12 | ) | $ | (1.71 | ) |

 

NOTE 3—INCOME TAXES

 

NEON has recorded no income tax benefitrelated to the current year net loss as the net operating loss carry-forwardshave been fully reserved.  At March 31,2003, NEON had a net operating loss carry-forward for income tax purposes ofapproximately $17.3 million that is available to offset future taxable income.The net operating loss carry-forwards in the United Kingdom, Germany andAustralia carry forward indefinitely. The net operating loss carry-forward for the United States beginsexpiring in the tax year 2020.  Giventhe recent tax losses experienced by NEON, there can be no assurance that theoperations will generate taxable income in the future to utilize theselosses.  As of March 31, 2003 andDecember 31, 2003, the valuation allowance fully offsets the Company’s netdeferred tax assets.

 

NOTE 4—SEGMENT REPORTING

 

NEON considers its business activities to bein a single segment.  NEON did not haveany customers, individually or in aggregate that accounted for 10% or more ofconsolidated revenue during the nine-month periods ending December 31, 2003 andDecember 31, 2002.

 

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The table below summarizes revenues bygeographic region.

 
|                      |   | **THREE MONTHS ENDED DECEMBER  31,** |   | **NINE MONTHS ENDED DECEMBER 31,** |   |
|---------------------------|--------|--------------------------------------|--------|------------------------------------|--------|
|                      |   | **2003**                             |   | **2002**                           |   | **2003** |   | **2002** |   |
| Revenues:                 |   |                                 |   |                               |   |   |   |   |   |
| United States             |   | $                                    | 2,367  |                               | $      | 2,669 |   | $ | 7,605 |   | $ | 8,954 |   |
| United Kingdom            |   | 1,162                                |   | 1,705                              |   | 3,377 |   | 3,167 |   |
| Other                     |   | 117                                  |   | 222                                |   | 392 |   | 574 |   |
|                      |   | $                                    | 3,646  |                               | $      | 4,596 |   | $ | 11,374 |   | $ | 12,695 |   |
|                      |   |                                 |   |                               |   |   |   |   |   |
| Operating income  (loss): |   |                                 |   |                               |   |   |   |   |   |
| United States             |   | $                                    | (868   | )                                  | $      | (1,779 | ) | $ | (2,016 | ) | $ | (6,571 | ) |
| United Kingdom            |   | 598                                  |   | 807                                |   | 1,669 |   | 1,078 |   |
| Other                     |   | (108                                 | )      | (134                               | )      | (108 | ) | (250 | ) |
|                      |   | $                                    | (378   | )                                  | $      | (1,106 | ) | $ | (455 | ) | $ | (5,743 | ) |

 
|                  |   | **DECEMBER 31, 2003** |   | **MARCH 31, 2003** |   |
|-----------------------|--------|-----------------------|--------|--------------------|--------|
|                  |   |                  |   |               |   |
| Identifiable  Assets: |   |                  |   |               |   |
| United States         |   | $                     | 28,418 |               | $      | 30,842 |   |
| United Kingdom        |   | 3,433                 |   | 2,703              |   |
| Other                 |   | 564                   |   | 769                |   |
|                  |   | $                     | 32,415 |               | $      | 34,314 |   |

 

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. 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 appealed this decision, and NEONwill continue to defend this action. Aside from this action, NEON is not involved in any current claim orlegal action other than those arising in the ordinary course of business.

 

NOTE6—RESTRUCTURING CHARGES

 

During the three months ended December 31, 2003, NEON incurredrestructuring charges of $179,000.  Thecharges consist of severance and other costs related to the elimination ofdirect sales operations in two foreign locations.  During the nine months ended December 31, 2003, NEON incurredadditional charges resulting from the revision of facility cost estimates.  During the year ended March 31, 2003, NEONincurred restructuring charges of $3.0 million. The charges primarily relate tofuture losses due to the abandonment of leased facilities associated with acorporate reorganization as well as severance and non-cash stock compensationcosts related to the termination of the distribution agreement with NEONEnterprise Software, Inc. The Company has not been able to sublease a largeportion of the abandoned facilities and therefore, has accrued costs related tothis portion of the future lease commitments. If the Company is able tosublease additional portions of the facilities in the future, it may result inreversal of this accrual. During fiscal 2002, NEON also recorded losses fromlease commitments due to the abandonment of certain leased facilities.  All such costs have been reported asrestructuring costs in the Consolidated Statements of Operations.

 

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The following table provides a roll forward of the restructuringaccrual balance for the nine months ended December 31, 2003 (in thousands):

 
|                       |   |               |   | **Balance at********March 31,  2003** |   | **Amounts  Charged  to Expense** |   | **Net Amounts  Paid** |   | **Other** |   | **Balance at  December 31,  2003** |   |
|----------------------------|--------|--------------------|--------|--------------------------------------------|--------|---------------------------------------|--------|-----------------------|--------|-----------|--------|-----------------------------------------|--------|
| 2002 Restructuring Accrual |   | Facility closure   |   | $                                          | 62     |                                  | $      | 17                    |   | $         | 18     |                                    | $      | — |   | $ | 61 |   |
|                       |   |               |   |                                       |   |                                  |   |                  |   |      |   |                                    |   |
| 2003 Restructuring Accrual |   | Employee severance |   | 149                                        |   | —                                |   | 149                   |   | —    |   |                                    |   |
|                       |   | Facility closure   |   | 1,957                                      |   | 16                                    |   | 459                   |   | 68        |   | 1,582                                   |   |
|                       |   |               |   |                                       |   |                                  |   |                  |   |      |   |                                    |   |
| 2004 Restructuring Accrual |   | Employee severance |   | —                                     |   | 132                                   |   | 24                    |   | 3         |   | 111                                     |   |
|                       |   | Facility closure   |   | —                                     |   | 47                                    |   | —                |   | (5        | )      | 42                                      |   |
|                       |   |               |   |                                       |   |                                  |   |                  |   |      |   |                                    |   |
|                       |   | Totals             |   | $                                          | 2,168  |                                  | $      | 212                   |   | $         | 650    |                                    | $      | 66 |   | $ | 1,796 |   |

 

Of the $1.8 million balance at December 31, 2003, $1.6 million consistsof future cash payments for abandoned facilities that will be paid through2006. The remaining $153,000 consists primarily of severance cost to be paidthrough March 2004, as well as other office closure costs.  The current portion of this liability,$766,000, is included in accrued expenses. NEON doesnot expect to incur significant future costs in addition to those previouslyaccrued, related to these restructuring activities.

 

Otheradjustments to the balance for the nine months ended December 31, 2003 relateprimarily to the effect of currency translation 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 currently has investments. Transactions between NEONand these other companies are described below. The directors and officersinvolved in such transactions are no longer officers and directors of NEON.  On March 6, 2003, Louis R. Woodhill resigned as a director and ChiefExecutive Officer of NEON.  In June2003, Jim Woodhill resigned as a director of NEON.  At NEON’s annual meeting of stockholders on September 22, 2003,Mr. Moores, Mr. Noell, and Mr. Schaeffer did not stand for re-election and areno longer directors of NEON.

 

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

 

NEON entered into a Termination and Customer Support Agreement (theTermination Agreement) on August 14, 2002, which terminated a distributionagreement with Peregrine/Bridge Transfer Corporation, a database softwarecompany whose sole stockholder is an affiliate of John J. Moores, NEON’s formerChairman of the Board of Directors. PBTC subsequently changed its name to NEONEnterprise Software, Inc. (“NESI”).

 

NEON currently holds a consolidated promissory note payable to NEON inthe aggregate principal amount of $3.6 million, bearing no interest to its duedate of March 31, 2005. This consolidated promissory note is secured by all ofthe intellectual property of NESI (“NESI IP”). NEON also currently holds a $3.0million dollar convertible promissory note payable to NEON bearing no interestto its due date of March 31, 2005, which is also secured by the NESI IP. The$3.0 million convertible note is convertible by NEON, in its discretion, intoequity in NESI at an agreed pre-cash valuation of $30.0 million dollars. Suchconversion right will expire on the due date of the $3.0 million convertiblenote. On the Closing of the transaction in August 2002, NEON recorded the notesreceivable from NESI at their estimated net present value, which was calculatedat $4.3 million in aggregate value. As a result of the Termination Agreement,NEON recorded a loss on disposal of $687,000. NEON also evaluates the NESI IP on a quarterly basis to determine thenote’s net realizable value. Accordingly, NEON will adjust the carrying valueof the note if the net realizable value is determined to be below the carryingvalue. NEON management had an

 

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external valuation of the NESI IP performed as of March 31, 2003 anddetermined that no further impairment of the note was required.   No changes have occurred since that datethat NEON believes should require adjustment of the carrying value.

 

*Scalable Software, Inc.*

 

Scalable Software, Inc., a Houston-based provider of software solutionsfor IT portfolio management, is a company founded by Louis R. Woodhill, whoserved as NEON’s Chief Executive Officer until March 2003. Several formermembers of NEON’s Board of Directors, including Louis R. Woodhill, John J.Moores, Peter Schaeffer, Charles E. Noell III and Jim Woodhill, had or have afinancial interest in Scalable Software.

 

In June 2002, NEON obtained a two-year option to acquire ScalableSoftware as outlined in the Agreement and Plan of Merger dated June 26, 2002.In connection with this Option, NEON agreed to provide bridge financing of upto $5.5 million (subsequently increased to $6.0 million in October 2002), inaddition to $3.5 million previously loaned to Scalable Software that wassecured by personal guarantees from John J. Moores, Louis R. Woodhill and JimWoodhill. The aggregate financing has a 36-month term and does not bearinterest during the term of the two-year option to acquire Scalable Software,which option expires June 26, 2004. After the expiration of the option, theloan will bear interest at the prime rate plus two percentage points to its duedate of June 26, 2005 and thereafter on any unpaid principal and interestamount outstanding. In addition to the personal guarantees of John J. Moores,Louis R. Woodhill and Jim Woodhill for the initial $3.5 million loaned toScalable Software, the $6.0 million loan is secured by all of the intellectualproperty rights of Scalable Software. As of January 2003, Scalable hadexhausted its credit facility with NEON. Scalable has asked for and receivedwaivers of NEON’s right of first refusal with respect to additional venturecapital bridge financing and has closed a private placement of ConvertiblePreferred Stock.

 

During the period in which NEON was advancing funds to ScalableSoftware, NEON accounted for its investment in Scalable Software using themodified equity method of accounting. Under this method of accounting, NEONrecognized 100% of Scalable Software’s losses to the extent of advances made inexcess of the guaranteed amount. At December 31, 2003, NEON had made totaladvances of $9.5 million to Scalable Software (including $6.0 million ofunguaranteed advances) and recognized cumulative losses of $5.6 million, ofwhich $3.5 million were recorded during fiscal 2003. No losses have beenrecognized in fiscal year 2004 since NEON has no further obligation to advancefunds to Scalable Software.  Due to theuncertainties regarding NEON’s ultimate ability to recover any unguaranteedadvances to Scalable Software, NEON has determined that it should not recordthe carrying value of its net advance to Scalable Software above the guaranteedamount of $3.5 million.

 

NOTE 8 – IMPAIRMENT OF INTANGIBLES

 

NEON adopted SFAS No. 141, *BusinessCombinations*, and SFAS No. 142, *Goodwilland Other Intangible Assets*, effective April 1, 2002. SFAS No.141 requires that the purchase method of accounting be used for all businesscombinations initiated or completed after June 30, 2001, and specifies criteriafor the recognition and reporting of intangible assets apart from goodwill.Under SFAS No. 142, NEON no longer amortizes goodwill and intangible assetswith indefinite useful lives, but instead will test those assets for impairmentat least annually. SFAS No. 142 also requires that intangible assets withdefinite useful lives be amortized over such lives to their estimated residualvalues. As of the date of adoption of SFAS Nos. 141 and 142, the Company’sunamortized goodwill in the amount of $1.2 million, was subject to transitionprovisions of SFAS Nos. 141 and 142.

 

Under the transition provision of SFAS No. 142, NEON tested thegoodwill balances associated with the September 1999 acquisition of BeyondSoftware, Inc. (“BSI”) for impairment by comparing the fair value of BSI to itscarrying value. Fair value was determined after considering changes inoperational strategies and plans, as well as assumptions regarding thepotential future cash flows from the acquired assets. As a result, NEONdetermined that the carrying value of the goodwill related to the BSIacquisition had been impaired by $1.0 million, which is shown as a cumulativeeffect of a change in accounting principle as of April 1, 2002. This impairmentcharge resulted in a net carrying value of $150,000, which was subsequentlywritten off to impairment charges as of March 31, 2003.

 

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The pro-forma effects of the adoption of SFAS No. 142 on net loss pershare for NEON for the nine months ended December 31, 2002 is as follows (inthousands, except per share data):

 
|                                                           |   | **NINE MONTHS ENDED  DECEMBER 31, 2002** |       |
|----------------------------------------------------------------|--------|------------------------------------------|------------|
|                                                           |   |                                     | ** ** |
| Net loss as reported                                           |   | $                                        | (13,286    | ) |
| Add back: Cumulative  effect of change in accounting Principle |   | 1,043                                    |       |
| Adjusted net loss                                              |   | $                                        | (12,243    | ) |
|                                                           |   |                                     |       |
| Loss per share—Basic and diluted:                         |   |                                     |       |
| Loss per share, as reported                                    |   | $                                        | (1.53      | ) |
| Add back: Cumulative effect of change in  accounting Principle |   | $                                        | 0.12       |   |
|                                                           |   |                                     |       |
| Pro forma loss per share                                       |   | $                                        | (1.41      | ) |

 

There has been no effect of adoption recognized insubsequent periods.

 

NOTE 9 – IMPACT OFRECENTLY ISSUED ACCOUNTING STANDARDS

 

In June 2001, FASB issued SFAS No. 143, *Accounting for Asset Retirement Obligations.* SFAS No. 143requires that the fair value of an asset retirement obligation be recorded as aliability in the period in which it incurs a legal obligation associated withthe retirement of tangible long-lived assets that result from the acquisition,construction, development, and/or normal use of the assets. Subsequent to theinitial measurement of the asset retirement obligation, the obligation will beadjusted at the end of each period to reflect the passage of time and changesin the estimated future cash flows underlying the obligation. NEON adopted SFASNo. 143 on April 1, 2003. The adoption of SFAS No. 143 did not have a materialeffect on the NEON’s consolidated financial statements.

 

In April 2002, the FASB issued SFAS No. 145, *Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASBStatement No. 13, and Technical Corrections.* SFAS No. 145 rescindsFASB Statement No. 4, *Reporting Gains andLosses from Extinguishment of Debt*, and an amendment of thatStatement, FASB Statement No. 64, *Extinguishmentsof Debt Made to Satisfy Sinking-Fund Requirements*. SFAS No. 145 alsorescinds FASB Statement No. 44, *Accountingfor Intangible Assets of Motor Carriers* and amends FASB StatementNo. 13, *Accounting for Leases*.SFAS No. 145 also amends other existing authoritative pronouncements to makevarious technical corrections, clarify meanings, or describe theirapplicability under changed conditions. The adoption of SFAS No. 145 on April1, 2003 did not have a material impact on NEON’s consolidated financial statements.

 

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

 

In December 2002, the FASB issued SFAS No. 148, *Accounting for Stock-Based Compensation-Transitionand Disclosure*, a amendment of FASB Statement No. 123. SFAS No. 148amends FASB Statement No. 123, *Accountingfor Stock-Based Compensation*, to provide alternative methods oftransition for an entity that voluntarily changes to the fair value basedmethod of accounting for stock-based employee compensation. It also amends thedisclosure provisions of that Statement to require

 

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prominent disclosure about the effects on reported net income of anentity’s accounting policy decisions with respect to stock-based employeecompensation. SFAS No. 148 also amends APB Opinion No. 28, *Interim Financial Reporting*, to requiredisclosure about those effects in interim financial information. NEON adoptedthe disclosure requirements of SFAS No. 148 and these disclosures are includedin the notes to NEON’s consolidated financial statements.

 

In November 2002, the FASB issued Interpretation No. 45, *Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness of Others*,an interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASBInterpretation No. 34. This interpretation clarifies the requirements for aguarantor’s accounting for and disclosures of certain guarantees issued andoutstanding. This Interpretation also incorporates without reconsideration theguidance in FASB Interpretation No. 34, *Disclosureof Indirect Guarantees of Indebtedness of Others*, which is beingsuperseded. The adoption of SFAS No. 145 on April 1, 2003 did not have amaterial impact on NEON’s consolidated financial statements.

 

In January 2003, the FASB issued Interpretation No. 46, *Consolidation of Variable Interest Entities, aninterpretation of ARB No. 51.* This Interpretation addresses theconsolidation by business enterprises of variable interest entities as defined inthe Interpretation. The Interpretation, as revised in December 2003 for partialdeferral, applies immediately to variable interests in variable interestentities created after January 31, 2003, for periods ending after December 15,2003 to special purpose entities obtained before February 1, 2003 and forperiods ending after March 15, 2003 to variable interests in other variableinterest entities obtained before February 1, 2003. Management is continuing toevaluate the impact that application of this Interpretation may have on NEON’sconsolidated financial statements.

 

In April 2003, the FASB issued Statement of Financial AccountingStandard No. 149, *Amendment of Statement 133on Derivative Instruments and Hedging Activities*. This statementamends and clarifies financial accounting and reporting for derivativeinstruments, including certain derivative instruments embedded in othercontracts (collectively referred to as derivatives) and for hedging activitiesunder SFAS Statement No. 133, *Accounting forDerivative Instruments and Hedging Activities*. This Statement iseffective for contracts entered into or modified after June 30, 2003. Theadoption of this Statement did not have a material effect on the results ofoperations or financial position of the Company.

 

On May 15, 2003, the Financial Accounting Standards Board issuedStatement No. 150, *Accounting for CertainFinancial Instruments with Characteristics of Both Liabilities and Equity.*TheStatement requires issuers to classify as liabilities (or assets in somecircumstance) three classes of freestanding financial instruments that embodyobligations for the issuer. NEON adopted the provisions of the Statement onJuly 1, 2003. The adoption of SFAS No. 150 did not have a material effect onNEON’s financial statements.

 

InDecember 2003 the SEC issued Staff Accounting Bulletin No. 104 (SAB 104), *Revenue Recognition*.  The bulletin clarifies certain issuesaddressed in SAB 101 and EITF Issue No. 00-21, *Accountingfor Revenue Arrangements with Multiple Deliverables*.  The adoption of SAB 104 did not have amaterial effect on NEON’s financial statements.

 

NOTE 10 –  DISCONTINUED OPERATIONS

 

On June 20, 2003, NEON entered into an Asset PurchaseAgreement with a third party software vendor to sell its iWave product lineassets.  As a result of the transaction,NEON recorded a gain on the sale of $352,000, net of closing expenses, duringthe nine months ended December 31, 2003. Total revenues attributed to the iWave product line for the three andnine months ended December 31, 2002 were $290,000 and $1.1 million,respectively.  Total revenue for thethree months ended June 30, 2003 was $194,000. Operating losses associated with the iWave product line were classifiedas discontinued operations and represented $348,000 and $3.1 million for thethree and nine months ended December 31, 2002, respectively.  Operating loss for the three months endedJune 30, 2003 was $244,000.

 

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

 

The following discussion and analysis should be read in conjunctionwith NEON’s consolidated financial statements and the related notes theretoincluded in this report on Form 10-Q. The discussion and analysis containsforward-looking statements within the meaning of Section 27A of the SecuritiesAct of 1933 and Section 21E of 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 thoseprojected in the forward-looking statements as a result of various factors,including those set forth below in Part II,Item 4 under “Risk Factors that May Affect Future Results.”  In some cases, you can identifyforward-looking statements by terminology such as “may,” “will,” “should,”“expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,”“potential,” “continue,” or the negative of these terms or other comparableterms.

 

OVERVIEW

 

NEON develops, markets and supports software products for the IBMmainframe platform. NEON was incorporated in May 1993 and is a successor bymerger to NEON Systems, Inc., an Illinois corporation, which was incorporatedin June 1991. NEON’s Shadow products provide access and integration of IBMmainframe data and applications from standard application client environments,including the Internet, application platforms, and client/server systems. NEON’sproduct mix in the past three fiscal years has consisted of NEON’s Shadowbranded products, its iWave products, and the Enterprise Subsystem Management(“ESM”) products. The ESM products are owned by NEON Enterprise Software, Inc.(formerly Peregrine/Bridge Transfer Corporation, hereafter “NESI”) and weredistributed by NEON. Over the last two fiscal years, NEON’s Shadow productsaccounted for the majority of its sales mix, representing 88% and 79% of NEON’ssales for fiscal 2003 and 2002, respectively. During fiscal year 2003, NEONphased out its ESM and iWave product lines. In August 2002, NEON terminated itsdistribution agreement with NESI, effectively exiting the ESM market.  *See**Management’s Discussion and Analysis—RelatedParty Transactions and Note 7 to NEON’s consolidated financial statements*.On June 20, 2003, NEON entered into an Asset Purchase Agreement with a thirdparty software vendor to sell the iWave product line assets. *See Note 10 to NEON’s consolidated financialstatements.*

 

NEON derives revenue from software licenses and maintenance services.License fees, which are based upon the number and capacity of servers as wellas the number of client users, are generally due upon license grant and includea one-year maintenance period. The sales process typically takes between sixand nine months. After the initial year of license, NEON provides ongoingmaintenance services, which include technical support and product enhancements,for an annual fee. Any factors adversely affecting the pricing of, demand for,or market acceptance of, our products, such as competition or technologicalchange, could materially adversely affect our business, operating results andfinancial condition. In fiscal 2003 and 2002, maintenance revenues represented58% and 44% of total revenues, respectively. Maintenance revenues are expectedto continue to increase as a percentage of total revenues in the future. Duringfiscal 2003, NEON did not have any customers that individually accounted for10% or more of total revenue. In fiscal 2002 NEON had one customer thataccounted for 10% of total revenue.

 

Since its inception, NEON has incurred substantial costs to develop ourtechnology and products, to recruit and train personnel for our engineering,sales and marketing and technical support departments, and to establish anadministrative organization. Accordingly, NEON may need to increase its annualrevenue to generate operating profits. There can be no assurance that NEON willachieve or sustain revenue growth and/or return to profitability in futurequarters. As a result, management believes that it is possible that NEON’s cashresources may decline as a result of continuing losses from operations andincremental costs associated with financing and acquisition*.*

 

NEON conducts its business in the United Kingdom and Germany throughtwo wholly owned consolidated subsidiaries, and revenues from thesesubsidiaries are denominated in local currencies. In connection with theseforeign operations, NEON is exposed to foreign currency fluctuations for itsnet working capital positions. During the three months ended December 31, 2003,NEON restructured German operations, further reducing its exposure to currencyfluctuations.  At December 31, 2003,NEON had an operating lease for office facilities denominated in British poundsterling.  There were no other materialcommitments to be satisfied in currencies other than U.S. dollars. In otherinternational markets, NEON conducts substantially all of its business throughindependent third-party distributors. Revenues derived from third-partydistributors are generally

 

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denominated in U.S. dollars. Revenues recognized from sales tocustomers outside North America, primarily in Europe, represented approximately28% and 14% in fiscal 2003 and 2002, respectively. Foreign currencyfluctuations have not had a significant impact on NEON’s revenues or operatingresults. Management does not currently have an active foreign exchange hedgingprogram; however, NEON may implement a program to mitigate foreign currencytransaction risk in the future.

 

In view of the rapidly changing nature of our business and the currentweakness in the mainframe software market, NEON believes that period-to-periodcomparisons of our revenue and operating results are not necessarily meaningfuland should not be relied upon as indications of our future performance.Further, NEON does not believe that its historical growth rates 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 had investments or currently transacts business.  Transactions between NEON and these othercompanies are described below. The directors and officers involved in suchtransactions are no longer officers and directors of NEON.  On March 6, 2003, Louis R. Woodhill resigned as a director and Chief ExecutiveOfficer of NEON. In June 2003, Jim Woodhill resigned as a director ofNEON.  At NEON’s annual meeting ofstockholders on September 22, 2003, Mr. Moores, Mr. Noell, and Mr. Schaefferdid not stand for re-election and are no longer directors of NEON.

 

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

 

In January 1996, NEON entered into a Termination and Customer SupportAgreement on August 14, 2002, which terminated a distribution agreement withPeregrine/Bridge Transfer Corporation, a database software company whose solestockholder is an affiliate of John J. Moores, NEON’s former Chairman of theBoard of Directors. PBTC subsequently changed its name to NEON EnterpriseSoftware, Inc. (“NESI”).

 

NEON currently holds a consolidated promissory note payable to NEON inthe aggregate principal amount of $3.6 million, bearing no interest to its duedate of March 31, 2005. This consolidated promissory note is secured by all ofthe intellectual property of NESI (“NESI IP”). NEON also currently holds a $3.0million dollar convertible promissory note payable to NEON bearing no interestto its due date of March 31, 2005, which is also secured by the NESI IP. The$3.0 million convertible note is convertible by NEON, in its discretion, intoequity in NESI at an agreed pre-cash valuation of $30.0 million dollars. Suchconversion right will expire on the due date of the $3.0 million convertiblenote. On the Closing of the transaction in August 2002, NEON recorded the notesreceivable from NESI at their estimated net present value, which was calculatedat $4.3 million in aggregate value. As a result of the Termination Agreement,NEON recorded a loss on disposal of $687,000. NEON also evaluates the NESI IP on a quarterly basis to determine thenote’s net realizable value. Accordingly, NEON will adjust the carrying valueof the note if the net realizable value is determined to be below the carryingvalue. NEON management had an external valuation of the NESI IP performed as ofMarch 31, 2003 and determined that no further impairment of the note wasrequired.   No changes have occurredsince that date that NEON believes should require adjustment of the carryingvalue.

 

*Scalable Software, Inc.*

 

Scalable Software, Inc., a Houston-based provider of software solutionsfor IT portfolio management, is a company founded by Louis R. Woodhill, whoserved as NEON’s Chief Executive Officer until March 2003. Several formermembers of NEON’s Board of Directors, including Louis R. Woodhill, John J.Moores, Peter Schaeffer, Charles E. Noell III and Jim Woodhill, had or have afinancial interest in Scalable Software.

 

In June 2002, NEON obtained a two-year option to acquire ScalableSoftware as outlined in the Agreement and Plan of Merger dated June 26, 2002.In connection with this Option, NEON agreed to provide bridge financing of upto $5.5 million (subsequently increased to $6.0 million in October 2002), inaddition to $3.5 million previously loaned to Scalable Software that wassecured by personal guarantees from John J. Moores, Louis R. Woodhill and JimWoodhill. The aggregate financing has a 36-month term and does not bearinterest during the term of the two-year option to acquire Scalable Software,which expires June 26, 2004. After the expiration of the option, the loan willbear interest at the prime rate plus two percentage points to its due date ofJune 26, 2005 and thereafter on any unpaid principal and interest amountsoutstanding. In addition to the personal guarantees of John J. Moores, Louis R.Woodhill and Jim Woodhill for the initial $3.5 million loaned to ScalableSoftware, the $6.0 million loan is secured by all of the intellectual propertyrights of Scalable Software. As of January 2003,

 

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Scalable had exhausted its credit facility with NEON. Scalable hasasked for and received waivers of NEON’s right of first refusal with respect toadditional venture capital bridge financing and NEON believes that Scalable hasclosed a private placement of Convertible Preferred Stock.

 

During the period in which NEON was advancing funds to ScalableSoftware, NEON accounted for its investment in Scalable Software using themodified equity method of accounting. Under this method of accounting, NEONrecognized 100%

of Scalable Software’s losses to the extent of advances made in excessof the guaranteed amount. At December 31, 2003, NEON had made total advances of$9.5 million to Scalable Software (including $6.0 million of unguaranteedadvances) and recognized cumulative losses of $5.6 million, of which $3.5million were recorded during fiscal 2003. No losses have been recognized infiscal year 2004 since NEON has no further obligation to advance funds toScalable Software.  Due to theuncertainties regarding NEON’s ultimate ability to recover any unguaranteedadvances to Scalable Software, NEON has determined that it should not recordthe carrying value of its net advance to Scalable Software above the guaranteedamount of $3.5 million.

 

*****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 elements 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. License revenues generally includesoftware maintenance agreements for the first year following the date of sale.In such cases, revenues are allocated between licenses fees and maintenancerevenues based on vendor-specific objective evidence. Revenues from first-yearmaintenance agreements and separately priced software maintenance agreementsfor subsequent years are deferred and recognized ratably on a straight-linebasis over the maintenance period. NEON also markets and sells its productsthrough independent distributors and resellers. License and maintenancerevenues from these transactions are recognized as above, when sold to theultimate end user and all of the above conditions are met.

 

***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 operations asincurred. No such costs have been capitalized to date.

 

***Allowance for Doubtful Accounts Receivable***

 

##### **As a part of its normal accounting procedures, NEONevaluates outstanding accounts receivable to estimate whether they will becollected. This is a subjective process that involves making judgments aboutour customers’ ability and willingness to pay these accounts. An allowance fordoubtful accounts is recorded as an offset to accounts receivable in order topresent a net balance that we believe will be collected. In estimating theappropriate balance for this allowance, we consider (1) specific reserves foraccounts we believe may prove to be uncollectible and (2) additional reserves,based on historical collections, for the remainder of our accounts. Additionsto the allowance for doubtful accounts are charged to operating expenses, anddeductions from the allowance are recorded when specific accounts receivableare written off as uncollectible or when actual experience differs frommanagement’s estimate. If NEON’s estimate of uncollectible accounts shouldprove to be inaccurate at**

 

##### **15**

##### ****

 

##### **somefuture date, the results of operations for the period could be materiallyaffected by any necessary correction to the allowance for doubtful accounts.**

 

***Deferred Income Taxes***

 

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

 

The change in NEON’s net deferred income tax 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 tax assets andliabilities could require significant adjustments in future periods. Suchadjustments could cause a material effect on NEON’s results of operations forthe period of the adjustment.

 

***Accounting for Advances to Scalable Software***

 

During the period in which NEON was advancing funds to ScalableSoftware, NEON accounted for its investment in Scalable Software using themodified equity method of accounting. Under this method of accounting, NEONrecognized 100%

of Scalable Software’s losses to the extent of advances made in excessof the guaranteed amount. At December 31, 2003, NEON had made total advances of$9.5 million to Scalable Software (including $6.0 million of unguaranteedadvances) and recognized cumulative losses of $5.6 million, of which $3.5million were recorded during fiscal 2003. No losses have been recognized infiscal year 2004 since NEON has no further obligation to advance funds toScalable Software.  Due to theuncertainties regarding NEON’s ultimate ability to recover any unguaranteedadvances to Scalable Software, NEON has determined that it should not recordthe carrying value of its net advance to Scalable Software above the guaranteedamount of $3.5 million.

 

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RESULTS OF OPERATIONS

 

The following table sets forth, for theperiods illustrated, certain statement of operations data expressed as apercentage of total revenues:

 
|                                                                                                          |   | **THREE  MONTHS ENDED DECEMBER 31,** |   | **NINE  MONTHS ENDED DECEMBER 31,** |   |
|---------------------------------------------------------------------------------------------------------------|--------|--------------------------------------|--------|-------------------------------------|--------|
|                                                                                                          |   | **2003**                             |   | **2002**                            |   | **2003** |   | **2002** |   |
| Revenues:                                                                                                     |   |                                 |   |                                |   |   |   |   |   |
| License                                                                                                       |   | 32                                   | %      | 49                                  | %      | 34 | % | 44 | % |
| Maintenance                                                                                                   |   | 68                                   |   | 51                                  |   | 66 |   | 56 |   |
| Total revenues                                                                                                |   | 100                                  |   | 100                                 |   | 100 |   | 100 |   |
|                                                                                                          |   |                                 |   |                                |   |   |   |   |   |
| Cost of  revenues:                                                                                            |   |                                 |   |                                |   |   |   |   |   |
| Cost of  licenses                                                                                             |   | —                               |   | —                              |   | — |   | 2 |   |
| Cost of  maintenance                                                                                          |   | 9                                    |   | 10                                  |   | 10 |   | 12 |   |
| Total cost of  revenues                                                                                       |   | 9                                    |   | 10                                  |   | 10 |   | 14 |   |
|                                                                                                          |   |                                 |   |                                |   |   |   |   |   |
| Gross profit                                                                                                  |   | 91                                   |   | 90                                  |   | 90 |   | 86 |   |
|                                                                                                          |   |                                 |   |                                |   |   |   |   |   |
| Operating  expenses:                                                                                          |   |                                 |   |                                |   |   |   |   |   |
| Sales and  marketing                                                                                          |   | 40                                   |   | 63                                  |   | 39 |   | 69 |   |
| Research and  development                                                                                     |   | 30                                   |   | 22                                  |   | 30 |   | 25 |   |
| General and  administrative                                                                                   |   | 26                                   |   | 29                                  |   | 23 |   | 31 |   |
| Restructuring  costs                                                                                          |   | 5                                    |   | —                              |   | 2 |   | 1 |   |
| Loss on  disposal                                                                                             |   | —                               |   | —                              |   | — |   | 5 |   |
| Total  operating expenses                                                                                     |   | 101                                  |   | 114                                 |   | 94 |   | 131 |   |
|                                                                                                          |   |                                 |   |                                |   |   |   |   |   |
| Operating loss                                                                                                |   | (10                                  | )      | (24                                 | )      | (4 | ) | (45 | ) |
|                                                                                                          |   |                                 |   |                                |   |   |   |   |   |
| Interest and  other income, net                                                                               |   | 2                                    |   | 2                                   |   | 2 |   | 2 |   |
| Equity loss in  affiliate                                                                                     |   | —                               |   | (22                                 | )      | — |   | (25 | ) |
| Valuation  allowance of note receivable                                                                       |   | —                               |   | 2                                   |   | — |   | (3 | ) |
|                                                                                                          |   |                                 |   |                                |   |   |   |   |   |
| Loss from  continuing operations before income taxes and cumulative effect of change in  accounting principle |   | (8                                   | )      | (42                                 | )      | (2 | ) | (71 | ) |
| Provision for  income taxes                                                                                   |   | —                               |   | —                              |   | — |   | — |   |
|                                                                                                          |   |                                 |   |                                |   |   |   |   |   |
| Loss from  continuing operations before cumulative effect of change in accounting  principle                  |   | (8                                   | )      | (42                                 | )      | (2 | ) | (71 | ) |
| Loss on  discontinued operations                                                                              |   | —                               |   | (10                                 | )      | (2 | ) | (26 | ) |
| Gain on  disposal of discontinued operations                                                                  |   | —                               |   | —                              |   | 3 |   | — |   |
| Loss before  cumulative effect of change in accounting principle                                              |   | (8                                   | )      | (52                                 | )      | (1 | ) | (97 | ) |
| Cumulative  effect of change in accounting principle                                                          |   | —                               |   | —                              |   | — |   | (8 | ) |
| Net loss                                                                                                      |   | (8                                   | )%     | (52                                 | )%     | (1 | )% | (105 | )% |

 

THREE MONTHS ENDED DECEMBER 31, 2003 COMPARED TOTHREE MONTHS ENDED DECEMBER 31, 2002

 

REVENUES

 

License revenues for the three months endedDecember 31, 2003 were $1.2 million, a decrease of $1.0 from $2.2 million forthe three months ended December 31, 2002. The reduction in license revenue wasprimarily due to a lower volume of large dollar value license transactionsduring the period.

 

Maintenance revenues for the three monthsended December 31, 2003 were $2.5 million, an increase of $126,000 from $2.4million for the three months ended December 31, 2002.  The increase in maintenance revenue was due to cumulative growthof NEON’s installed customer base combined with increases in maintenancerenewal fees.

 

COST OF REVENUES

 

Cost of license revenues primarily consistsof royalty payments to third parties. NEON did not incur significant cost oflicense revenues during the three months ended December 31, 2003 and 2002,respectively.

 

Cost of maintenance revenues includespersonnel and other customer support costs. Cost of maintenance revenues forthe three months ended December 31, 2003 were $342,000, or 14% of maintenancerevenues, as compared to $475,000, or 20% of

 

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maintenance revenues, for the three monthsended December 31, 2002. The reduction in cost of maintenance revenue as apercentage of maintenance revenue was due to the cumulative growth in NEON’sinstalled customer base and increases in maintenance renewal fees combined withconsolidation of the technical support staff.

 

OPERATING EXPENSES

 

Sales and marketing expenses includepersonnel costs, sales commissions and travel expenses of sales, presalessupport and marketing personnel, along with other promotional expenses. Salesand marketing expenses for the three months ended December 31, 2003 were $1.5million, a decrease of $1.4 million from $2.9 million for the three monthsended December 31, 2002. The reduction was primarily due to lower personnel andpromotional costs as a result of a reorganization of the NEON sales department.

 

Research and development expenses primarilyinclude personnel costs associated with NEON’s product development staff.Research and development expenses for the three months ended December 31, 2003and 2002 remained consistent at $1.1 million and $1.0 million, respectively.

 

General and administrative expenses includepersonnel and other costs associated with NEON’s executive, financial, legaland administrative functions. General and administrative expenses for the threemonths ended December 31, 2003 were $934,000, a decrease of $391,000 from $1.3million for the three months ended December 31, 2002. The decrease wasprimarily related to a reduction in administrative personnel.

 

During the three months ended December 31,2003, NEON incurred restructuring charges of $179,000 related to theelimination of direct sales operations in two foreign locations.  NEON plans to replace these with distributorrelationships.   No such charges wereincurred during the three months ended December 31, 2002.

 

Interest and other income for the three monthsended December 31, 2003 was $60,000 as compared to $79,000 for the three monthsended December 31, 2002. The decrease is due primarily to a decline inshort-term interest rates.

 

One June 20, 2003, NEON entered into an Asset PurchaseAgreement with a third party software vendor to sell its iWave product lineassets.  Total revenues attributed tothe iWave product line for the three months ended December 31, 2002 were$290,000.  Operating losses associatedwith the iWave product line were classified as discontinued operations andrepresented $476,000 for the three months ended December 31, 2002.

 

NEON accounts for its investment in Scalable Software using themodified equity method of accounting. Under this method, NEON recognizes 100%of Scalable Software’s income or loss to the extent of advances made in excessof the guaranteed amount. For the three months ended December 31, 2002 NEONrecorded equity in loss of $1.0 million. NEON also recorded a valuationallowance against the Scalable note receivable to write-down the outstandingbalance of the note to the guaranteed amount. NEON is no longer advancing funds to Scalable, therefore equity incomeor loss was not recognized for the three months ended December 31, 2003.  The note receivable from Scalable Softwareis recorded at the amount guaranteed by certain individuals.  See “Related Party Transactions” and Note 7to NEON’s consolidated financial statements.

 

No provision for income tax was recorded forthe three months ended December 31, 2003 or 2002, as NEON incurred pretaxlosses.  At March 31, 2003, NEON has anet operating loss carry-forward for income tax purposes of approximately $17.3million that is available to offset future taxable income, if any. The netoperating 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.  Given the recent tax lossesexperienced by NEON, there can be no assurance that the operations willgenerate taxable income in the future to utilize these losses, therefore, as ofDecember 31, 2003, NEON has recorded a full valuation allowance for thedeferred tax assets related to the future benefits, if any, for these losscarryforwards.

 

NINE MONTHS ENDED DECEMBER 31, 2003 COMPARED TONINE MONTHS ENDED DECEMBER 31, 2002

 

REVENUES

 

License revenues for the nine months endedDecember 31, 2003 were $3.9 million, a decrease of $1.7 million from

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$5.6 millionfor the nine months ended December 31, 2002. The reduction in license revenuewas due to the termination of the distribution agreement for ESM products,which accounted for $575,000 in license revenue during the nine months endedDecember 31, 2002, as well as a lower volume of large dollar value licensetransactions during the period.

##### ** **

Maintenance revenues for the nine monthsended December 31, 2003 were $7.5 million, an increase of $406,000 from $7.1million for the nine months ended December 31, 2002. ESM products accounted for$323,000 in maintenance revenue during the nine months ended December 31,2003.  The increase in maintenancerevenue was due to cumulative growth of NEON’s installed customer base combinedwith increases in maintenance renewal fees.

 

COST OF REVENUES

 

Cost of license revenues primarily consistsof royalty payments to third parties. Cost of license revenues for the ninemonths ended December 31, 2003 were $84,000, or 2% of license revenues, ascompared to $270,000, or 5% of license revenues, for the nine months endedDecember 31, 2002. The decrease in the cost of license revenues as a percentageof license revenue was due to the termination of product royalty payments toNESI, see “Related Party Transactions”.

 

Cost of maintenance revenues includespersonnel and other customer support costs. Cost of maintenance revenues forthe nine months ended December 31, 2003 were $1.1 million, or 14% ofmaintenance revenues, as compared to $1.5 million, or 21% of maintenancerevenues, for the nine months ended December 31, 2002. The reduction in cost ofmaintenance revenue as a percentage of maintenance revenue was due to thecumulative growth in NEON’s installed customer base and increases inmaintenance renewal fees combined with consolidation of the technical supportstaff.

##### ** **

OPERATING EXPENSES

 

Sales and marketing expenses includepersonnel costs, sales commissions and travel expenses of sales, presalessupport and marketing personnel, along with other promotional expenses. Salesand marketing expenses for the nine months ended December 31, 2003 were $4.5million, a decrease of $4.2 million from $8.7 million for the nine months endedDecember 31, 2002. The reduction was primarily due to lower personnel andpromotional costs, which resulted from the termination of the distributionagreement for ESM products and the reorganization of the Shadow salesdepartment.

 

Research and development expenses primarilyinclude personnel costs associated with NEON’s product development staff.Research and development expenses for the nine months ended December 31, 2003and 2002 were relatively consistent, accounting for $3.4 million and $3.2million, respectively.

 

General and administrative expenses includepersonnel and other costs associated with NEON’s executive, financial, legaland administrative functions. General and administrative expenses for the ninemonths ended December 31, 2003 were $2.6 million, a decrease of $1.3 millionfrom $3.9 million for the nine months ended December 31, 2002. The decrease wasprimarily related to a reduction in administrative personnel.

 

During the nine months ended December 31,2003, NEON incurred $212,000 of restructuring charges.  These charges primarily relate to employeeseverance costs associated with the elimination of direct sales operations intwo foreign locations.  NEON plans toreplace these with distributorship relationships NEON incurred restructuringcharges of $133,000 during the nine months ended December 31, 2002.  This represents $271,000 related to thetermination of NEON’s distribution agreement with NESI. The charges primarilyrepresented non-cash stock compensation costs resulting from the extension ofstock options for severed employees. This amount was offset by a $138,000 reduction to an outstandingrestructuring accrual for abandoned facilities, as those facilities weresubleased during the period.

 

As a result of terminating prior agreementswith NESI on August 14, 2002, NEON recorded a loss on disposal of $687,000during the nine months ended December 31, 2002.

 

Interest and other income for the nine monthsended December 31, 2003 was $231,000 as compared to $332,000 for the ninemonths ended December 31, 2002. For the nine months ended December 31, 2003,interest and other income includes interest received on an income taxreceivable collected during the period. This income was offset by lower interest income as a result of areduction in NEON’s average cash balances combined with a decline in short-terminterest rates.

 

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On June 20, 2003, NEON entered into an Asset PurchaseAgreement with a third party software vendor to sell its iWave product lineassets.  As a result of the transaction,NEON recorded a gain on the sale of $352,000, net of closing expenses duringthe nine months ended December 31, 2003. Total revenues attributed to the iWave product line for the nine monthsended December 31, 2003 and 2002 were $194,000 and $1.1 million, respectively.  Operating losses associated with the iWaveproduct line were classified as discontinued operations and represented$244,000 and $3.3 million for the nine months ended December 31, 2003 and 2002,respectively.

 

During the nine months ended December 31, 2002, NEONperformed impairment tests on its intangible assets related to the iWaveintellectual property.  As a result,NEON recorded impairment charges of $1.3 million during the period.  Such impairment charges are included in theloss from discontinued operations.

 

NEON accounts for its investment in Scalable Software using themodified equity method of accounting. Under this method, NEON recognized 100%of Scalable Software’s income or loss to the extent of advances made in excessof the guaranteed amount. For the nine months ended December 31, 2002 NEONrecorded equity in loss of $3.2 million. NEON also recorded a valuationallowance of $378,000 for the nine months ended December 31, 2002 against theScalable note receivable to write-down the outstanding balance of the note tothe guaranteed amount.  NEON is nolonger advancing funds to Scalable, therefore an equity loss was not recognizedfor the nine months ended December 31, 2003. The note receivable from Scalable

Software is recorded at the amount guaranteed by certainindividuals.  See “Related PartyTransactions” and Note 7 to NEON’s financial statements.

 

No provision for income taxes was recordedfor the nine months ended December 31, 2003 or 2002 as NEON incurred pretaxlosses.   At March 31, 2003, NEON has anet operating loss carry-forward for income tax purposes of approximately $17.3million that is available to offset future taxable income, if any. The netoperating 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.  Given the recent tax lossesexperienced by NEON, there can be no assurance that the operations willgenerate taxable income in the future to utilize these losses, therefore, as ofDecember 31, 2003, NEON has recorded a full valuation allowance for thedeferred tax assets related to the future benefits, if any, for these losscarryforwards.

 

Under the transition provision of SFAS No.142, NEON tested the goodwill balances associated with the September 1999acquisition of Beyond Software, Inc. (“BSI”) for impairment by comparing thefair value of BSI to its carrying value. Fair value was determined after considering changes in operational strategiesand plans, as well as assumptions regarding the potential future cash flowsfrom the acquired assets.  As a result,NEON determined that the carrying value of the goodwill related to the BSIacquisition had been impaired by $1.0 million, which is shown as a cumulativeeffect of a change in accounting principle as of April 1, 2002.  This impairment charge resulted in a netcarrying value of $150,000, which was further impaired and written off by March31, 2003.

 

LIQUIDITY AND CAPITAL RESOURCES

 

NEON’s cash and cash equivalents at December31, 2003 were $20.2 million, an increase of $422,000 from $19.8 million atMarch 31, 2003.

 

Net cash used in operating activities was$415,000 and $8.0 million for the nine months ended December 31, 2003 and 2002,respectively.  The net cash used inoperating activities in both periods was primarily due to NEON’s net operatingloss.

 

During the nine months ended December 31,2003, net cash provided by investing activities was $481,000, primarily as aresult from the proceeds from the sale of the iWave product line.  Net cash used in investing activities duringthe nine months ended December 31, 2002 was $5.9 million, primarily due toadvances to Scalable Software and NESI (see “Related Party Transactions”).

 

NEON’s net cash provided by financingactivities was $94,000 and $29,000 for the nine months ended December 31, 2003and 2002, respectively. The net cash provided by financing activities in bothperiods represents proceeds from the exercise of employee stock options.

 

NEON’s future liquidity and capital requirementswill depend upon numerous factors, including the costs and timing of expansionof product development efforts and the success of these development efforts,the costs and timing of expansion of

 

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sales and marketing activities, the extent towhich our existing and new products gain market acceptance, marketdevelopments, the costs involved in maintaining and enforcing intellectualproperty rights, the level and timing of license revenue, and other factors.NEON believes that its current balance of cash and cash equivalents will besufficient to meet its working capital, and anticipated capital expenditurerequirements for at least the next 12 months. Thereafter, NEON may requireadditional funds to support its working capital requirements or for otherpurposes and may seek to raise additional funds through public or privateequity financing or from other sources. There can be no assurance thatadditional financing will

be available at all, or if available, thatsuch financing will be obtainable on terms acceptable to NEON, or that anyadditional financing will not be dilutive.

 

**NewAccounting Pronouncements**

 

In June 2001, FASB issued SFAS No. 143, *Accounting for Asset Retirement Obligations.* SFAS No. 143requires that the fair value of an asset retirement obligation be recorded as aliability in the period in which it incurs a legal obligation associated withthe retirement of tangible long-lived assets that result from the acquisition,construction, development, and/or normal use of the assets. Subsequent to theinitial measurement of the asset retirement obligation, the obligation will beadjusted at the end

of each period to reflect the passage of time and changes in theestimated future cash flows underlying the obligation. NEON adopted SFAS No.143 on April 1, 2003. The adoption of SFAS No. 143 did not have a materialeffect on the NEON’s consolidated financial statements.

 

In April 2002, the FASB issued SFAS No. 145, *Rescission of FASB Statements No. 4, 44, and 64, Amendment of FASBStatement No. 13, and Technical Corrections*. SFAS No. 145 rescindsFASB Statement No. 4, *Reporting Gains andLosses from Extinguishment of Debt*, and an amendment of thatStatement, FASB Statement No. 64, *Extinguishmentsof Debt Made to Satisfy Sinking-Fund Requirements*. SFAS No. 145 alsorescinds FASB Statement No. 44, *Accountingfor Intangible Assets of Motor Carriers* and amends FASB StatementNo. 13, *Accounting for Leases*.SFAS No. 145 also amends other existing authoritative pronouncements to makevarious technical corrections, clarify meanings, or describe theirapplicability under changed conditions. The adoption of SFAS No. 145 on April1, 2003 did not have a material impact on NEON’s consolidated financial statements.

 

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

 

In December 2002, the FASB issued SFAS No. 148, *Accounting for Stock-Based Compensation-Transitionand Disclosure*, a amendment of FASB Statement No. 123. SFAS No. 148amends FASB Statement No. 123, *Accountingfor Stock-Based Compensation*, to provide alternative methods oftransition for an entity that voluntarily changes to the fair value basedmethod of accounting for stock-based employee compensation. It also amends thedisclosure provisions of that Statement to require prominent disclosure aboutthe effects on reported net income of an entity’s accounting policy decisionswith respect to stock-based employee compensation. SFAS No. 148 also amends APBOpinion No. 28, *Interim Financial Reporting*,to require disclosure about those effects in interim financial information.NEON adopted the disclosure requirements of SFAS No. 148 and these disclosuresare included in the notes to NEON’s consolidated financial statements.

 

In November 2002, the FASB issued Interpretation No. 45, *Guarantor’s Accounting and Disclosure Requirementsfor Guarantees, Including Indirect Guarantees of Indebtedness of Others*,an interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASBInterpretation No. 34. This interpretation clarifies the requirements for aguarantor’s accounting for and disclosures of certain guarantees issued andoutstanding. This Interpretation also incorporates without reconsideration theguidance in FASB Interpretation No. 34, *Disclosureof Indirect Guarantees of Indebtedness of Others*, which is beingsuperseded. The adoption of SFAS No. 145 on April 1, 2003 did not have amaterial impact on NEON’s consolidated financial statements.

 

In January 2003, the FASB issued Interpretation No. 46, *Consolidation of Variable Interest Entities, aninterpretation of ARB No. 51.* This Interpretation addresses theconsolidation by business enterprises of variable interest entities as definedin the Interpretation. The Interpretation as revised in December 2003 forpartial deferral, applies immediately to variable interests in variableinterest entities created after January 31, 2003, to special purpose entitiesobtained before February 1, 2003 and for periods ending after March 15, 2003 tovariable interests in other variable interest entities obtained before February1, 2003.

 

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Management is continuing to evaluate the impact that application ofthis Interpretation may have on NEON’s consolidated financial statements.

 

In April 2003, the FASB issued Statement of Financial AccountingStandard No. 149, *Amendment of Statement 133on Derivative Instruments and Hedging Activities*. This statementamends and clarifies financial accounting and reporting for derivativeinstruments, including certain derivative instruments embedded in othercontracts (collectively referred to as derivatives) and for hedging activitiesunder SFAS Statement No. 133, *Accounting forDerivative Instruments and Hedging Activities*. This Statement iseffective for contracts entered into or modified after June 30, 2003. Theadoption of this Statement did not have a material effect on the results ofoperations or financial position of the Company.

 

On May 15, 2003, the Financial Accounting Standards Board issuedStatement No. 150, *Accounting for CertainFinancial Instruments with Characteristics of Both Liabilities and Equity.*TheStatement requires issuers to classify as liabilities (or assets in somecircumstance) three classes of freestanding financial instruments that embodyobligations for the issuer. NEON adopted the provisions of the Statement onJuly 1, 2003. The adoption of SFAS No. 150 did not have a material effect onNEON’s financial statements.

 

InDecember 2003 the SEC issued Staff Accounting Bulletin No. 104 (SAB 104), *Revenue Recognition*.  The bulletin clarifies certain issuesaddressed in SAB 101 and EITF Issue No. 00-21, *Accountingfor Revenue Arrangements with Multiple Deliverables*.  The adoption of SAB 104 did not have amaterial effect on NEON’s financial statements.

 

ITEM 3.                             QUANTITATIVEAND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

 

NEON is exposed to a variety of risks,including foreign currency exchange rate fluctuations and changes in the marketvalue of its investments.

 

The majority of NEON’s foreign currencytransactions are denominated in the British pound sterling, which is thefunctional currency of NEON Systems (UK) Ltd. As these sales contracts aredenominated and settled in the functional currency, risks associated withcurrency fluctuations are minimized to foreign currency translationadjustments. NEON does not currently hedge against foreign currency translationrisks and believes that foreign currency exchange risk is not significant toits operations.

 

Cash equivalents approximated $15.0 millionat December 31, 2003, and were invested in various types of high-gradecommercial paper and money securities. NEON believes that a near-term change in interest rates would notmaterially affect its financial position, results of operations or net cashflows for fiscal year 2004.

 

ITEM 4.          CONTROLSAND PROCEDURES

 

As of the end of the period covered by thisQuarterly Report on Form 10-Q, NEON carried out an evaluation, under thesupervision and with the participation of NEON’s management, including thePrincipal Executive Officer and Chief Financial Officer, of the effectivenessof the design and operation of NEON’s disclosure controls and procedures (asdefined in Rule 13a-15(e) of the Securities Exchange Act of 1934).  Based upon that evaluation, the PrincipalExecutive Officer and Chief Financial Officer concluded that NEON’s disclosurecontrols and procedures are effective in ensuring that material information isaccumulated and communicated to management, and made known to the PrincipalExecutive Officer and Chief Financial Officer, on a timely basis to allowdisclosure as required in this Quarterly Report on Form 10-Q.  There have been no significant changes inNEON’s internal controls or in other factors that could significantly affectinternal controls subsequent to the date NEON carried out its evaluation.

 

PART II - OTHER INFORMATION

 

ITEM 1.                        LEGALPROCEEDINGS - Please see the discussion in Part I, Note 5 of the “CondensedNotes to Consolidated Financial Statements,” which is incorporated by referencein this Part II, Item 1.

 

ITEM 2.                        CHANGESIN SECURITIES AND USE OF PROCEEDS - None

 

ITEM 3.                        DEFAULTSUPON SENIOR SECURITIES -None.

 

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ITEM 4.                        SUBMISSIONOF MATTERS TO A VOTE OF SECURITY HOLDERS – None

 

ITEM 5.                        OTHERINFORMATION –  **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, contains forward-lookingstatements and other prospective information relating to future events. Theseforward-looking statements and other information are subject to certain risksand uncertainties that could cause results to differ materially from historicalresults or anticipated results, including the following:

 

***Our Stock Price MayFluctuate And Be Impacted By A Number Of Internal And External Factors***

 

•             *Our stock price has fluctuated and is subject to wideswings in price based on a number of factors, including our quarterly operatingresults, which may vary significantly 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 securities analysts and investors. We operatewith virtually no order backlog because our products are shipped and revenuesare recognized shortly after orders are received. In addition, the amount ofrevenues associated with sales of our software can vary significantly. Invarious quarters in the past, we have derived a significant portion of oursoftware license revenues from a small number of relatively large sales. Aninability to close one or more large sales that we had targeted to close in aparticular period could materially adversely affect our operating results forthat period. Moreover, we typically realize a majority of our software licenserevenues in the last month of a quarter. As a result, minor delays in thetiming of customer orders can shift a sale from its contemplated quarter ofcompletion to a subsequent quarter and cause significant variability in ouroperating results for any particular period. Accordingly, we believe thatperiod-to-period comparisons of our operating results are not necessarily ameaningful indication of future performance. Although we generally do not giveguidance as to future operating results, if our quarterly results do not meetinvestors’ expectations, the trading price of our common stock will likelydecline.

 

*•**             The Availability Of Significant Amounts OfOur Common Stock 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 CustomerReliance Upon Mainframe Computers 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 themainframe as a central repository of mission-critical data and transactions;

 

•             Growth in businessdemands for access to the data, applications and transactions residing onmainframe computers from Web-based and client/server applications; and

 

•             Continued marketacceptance of the Shadow products and enhancements to these products.

 

***Loss of Key SoftwareDevelopers Could Adversely 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.

 

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***We May Lose MarketShare And Be Required To Reduce Prices As A Result Of Competition From OurExisting Competitors, Other Vendors And Information Systems Departments OfCustomers***

 

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 TechnologicalChange Could Render Our Products 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 product enhancements in the future.Material delays in introducing new products or product enhancements may causecustomers to forego purchases of our products and purchase those of ourcompetitors.

 

***We May Be Unable ToEnforce Or Defend Our Ownership 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 MayContain Undetected Software Errors, 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.

 

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ITEM 6.                             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)                           REPORTS ON FORM 8-K

 

None

 

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SIGNATURES

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, the registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.

 
|   | NEON SYSTEMS, INC.                            |
|--------|-----------------------------------------------|
|   |                                          |
| Date:  | February 17, 2004                             |   | /s/ Brian D. Helman |   |
|   | Chief Financial Officer                       |
|   | (principal financial and accounting  officer) |
|   |
|   |
| Date:  | February 17, 2004                             |   | /s/ Mark J. Cresswell |   |
|   | President and Chief Operating Officer         |
|   | (principal executive officer)                 |

 

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