<PAGE>

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

                                    Form 10-Q

(Mark One)

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

                For the Quarterly Period Ended December 31, 2002

                                       OR

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

                        For the transition period from         to

                         Commission File Number: 0-25457

                               NEON Systems, Inc.
             (Exact name of registrant as specified in its charter)

                  Delaware                              76-0345839
       (State or other jurisdiction of     (I.R.S.# Employer Identification No.)
       incorporation or organization)

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

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

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

     Indicate by check mark whether the Registrant is an accelerated filer (as
defined in Rule 126-2 of the Exchange Act). Yes [_] No [X]


     The number of shares of the registrant's common stock outstanding as of
January 31, 2003, was 8,764,427.

<PAGE>

                               NEON SYSTEMS, INC.

                                    FORM 10-Q

                     FOR THE QUARTER ENDED DECEMBER 31, 2002

                                      INDEX

<TABLE>
<CAPTION>
                                                                                                                   PAGE
                                                                                                                   ----
<S>                                                                                                                <C>
PART I   FINANCIAL INFORMATION

Item 1.   Financial Statements

          Consolidated Balance Sheets at December 31, 2002 and March 31, 2002                                         3

          Consolidated Statements of Operations for the Three and Nine Months Ended December 31, 2002 and 2001        4

          Consolidated Statements of Cash Flows for the Nine Months Ended December 31, 2002 and 2001                  5

          Condensed Notes to Consolidated Financial Statements                                                        6

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

Item 3.   Quantitative and Qualitative Disclosures About Market Risk                                                 25

Item 4.   Controls and Procedures                                                                                    26

PART II. OTHER INFORMATION

Item 1.   Legal Proceedings                                                                                          26

Item 5.   Other Information                                                                                          26

Item 6.   Exhibits and Reports on Form 8-K                                                                           29

SIGNATURES                                                                                                           30
</TABLE>

                                       2

<PAGE>

PART I - FINANCIAL INFORMATION

    ITEM 1. FINANCIAL STATEMENTS


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

<TABLE>
<CAPTION>
                                                                  DECEMBER 31, 2002    MARCH 31, 2002
                                                                  -----------------    --------------
                                                                     (UNAUDITED)
<S>                                                               <C>                  <C>
                          ASSETS

       CURRENT ASSETS:
          Cash and cash equivalents                                  $    20,260          $    34,506
          Accounts receivable, net                                         3,999                4,650
          Taxes receivable                                                 1,074                1,054
          Deferred income taxes                                              608                  608
          Prepaid royalty (related party, Note 7)                              -                2,128
          Other current assets                                               497                1,005
                                                                     -----------          -----------
             Total current assets                                         26,438               43,951
                                                                     -----------          -----------

       Property and equipment, net                                         1,971                2,171
       Notes receivable, net (related parties, Note 7)                     7,760                3,702
       Intangible assets, net                                                550                3,713
       Other assets                                                           53                   63
                                                                     -----------          -----------
              Total assets                                           $    36,772          $    53,600
                                                                     ===========          ===========

            LIABILITIES & STOCKHOLDERS' EQUITY

       CURRENT LIABILITIES:
          Accounts payable                                           $       240          $       297
          Accrued expenses                                                 1,122                2,204
          Deferred revenue                                                 5,396                8,174
                                                                     -----------          -----------
             Total current liabilities                                     6,758               10,675
                                                                     -----------          -----------

       STOCKHOLDERS' EQUITY:
       Preferred stock, $.01 par value. Authorized
         10,000,000 shares; no shares issued and outstanding                   -                    -
       Common stock, $.01 par value. Authorized
         30,000,000 shares; 8,759,827 and 8,672,103 shares
         issued and outstanding at December 31, 2002 and
         March 31, 2002, respectively                                         96                   96
       Additional paid-in capital                                         51,584               51,233
       Treasury stock, 913,400 shares at cost                             (2,649)              (2,649)
       Accumulated other comprehensive loss                                 (477)                (475)
       Unearned portion of deferred compensation                               -                  (26)
       Accumulated deficit                                               (18,540)              (5,254)
                                                                     -----------          -----------
              Total stockholders' equity                                  30,014               42,925
       Commitments and contingencies (Note 5)
                                                                     -----------          -----------
              Total liabilities and stockholders' equity             $    36,772          $    53,600
                                                                     ===========          ===========
</TABLE>

     SEE ACCOMPANYING CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.

                                       3

<PAGE>


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

<TABLE>
<CAPTION>
                                             THREE MONTHS ENDED DECEMBER 31,   NINE MONTHS ENDED DECEMBER 31,
                                             -------------------------------   ------------------------------
                                                   2002           2001              2002           2001
                                             -------------------------------   ---------- -------------------
<S>                                          <C>            <C>                <C>             <C>
Revenues:
   License                                   $     2,320      $     2,857         $     5,840     $     9,232
   Maintenance                                     2,566            2,216               7,961           6,890
                                             -----------      -----------         -----------     -----------
    Total revenues                                 4,886            5,073              13,801          16,122

Cost of revenues:
   Cost of licenses                                  105              396               1,102           1,510
   Cost of maintenance                               475              464               1,521           1,509
                                             -----------      -----------         -----------     -----------
    Total cost of revenues                           580              860               2,623           3,019
                                             -----------      -----------         -----------     -----------

Gross profit                                       4,306            4,213              11,178          13,103
                                             -----------      -----------         -----------     -----------

Operating expenses:
  Sales and marketing                              3,272            2,726               9,771          10,041
  Research and development                         1,163            1,207               4,271           4,457
  General and administrative                       1,325            1,008               3,911           3,897
  Asset write-down charges                             -                -                   -             887
  Impairment of intangibles                            -                -               1,288               -
  Amortization of goodwill                             -              119                   -             359
  Restructuring costs                                128                                  261             908
  Loss on disposal                                     -                -                 687               -
                                             -----------      -----------         -----------     -----------
    Total operating expenses                       5,888            5,060              20,189          20,549
                                             -----------      -----------         -----------     -----------

Operating loss                                    (1,582)            (847)             (9,011)         (7,446)
Interest and other income, net                        79              288                 333           1,032
Gain from settlement of litigation                     -                -                   -           9,260
Equity loss in affiliate                          (1,004)               -              (3,187)              -
Valuation allowance on notes receivable              105           (2,000)               (378)         (2,000)
                                             -----------      -----------         ------------    -----------
    Income (loss) before income
     taxes and cumulative effect of change
     in accounting principle                      (2,402)          (2,559)            (12,243)            846
                                             -----------      -----------         -----------     -----------
Income tax benefit                                     -                -                   -             143
                                             -----------      -----------         -----------     -----------
Income (loss) before cumulative
  effect of change in accounting principle        (2,402)          (2,559)            (12,243)            989
Cumulative effect of change in
  accounting principle                                 -                -              (1,043)              -
                                             -----------      -----------         -----------     -----------
    Net income (loss)                        $    (2,402)     $    (2,559)        $   (13,286)    $       989
                                             ===========      ===========         ===========     ===========

Earnings (loss) per share - Basic:
Income (loss) before cumulative effect
  of change in accounting principle          $     (0.28)     $     (0.27)        $     (1.41)    $      0.11
Cumulative effect of change in
  accounting principle                                 -                -               (0.12)              -
                                             -----------      -----------         ------------    -----------
    Net income (loss)                        $     (0.28)     $     (0.27)        $     (1.53)    $      0.11
                                             ===========      ===========         ===========     ===========

Earnings (loss) per share - Diluted:
Income (loss) before cumulative effect
  of change in accounting principle          $     (0.28)     $     (0.27)        $     (1.41)    $      0.10
Cumulative effect of change in
  accounting principle                                 -                -               (0.12)              -
                                             -----------      -----------         -----------     -----------
    Net income (loss)                        $     (0.28)     $     (0.27)        $     (1.53)    $      0.10
                                             ===========      ===========         ===========     ===========
Shares used in computing earnings
 (loss)
    per share:
    Basic                                          8,734            9,526               8,707           9,380
                                             ===========      ===========         ===========     ===========
    Diluted                                        8,734            9,526               8,707           9,937
                                             ===========      ===========         ===========     ===========
</TABLE>

     SEE ACCOMPANYING CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.

                                       4

<PAGE>

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

<TABLE>
<CAPTION>
                                                                          NINE MONTHS ENDED DECEMBER 31,
                                                                            2002                 2001
                                                                    --------------------   -----------------
<S>                                                                 <C>                    <C>
CASH FLOWS FROM OPERATING ACTIVITIES:

Net income (loss)                                                    $    (13,286)              $       989
Adjustments to reconcile net income (loss) to net cash
    used in operating activities:
     Depreciation and amortization                                          1,355                     1,971
     Cumulative effect of change in accounting principle                    1,043                         -
     Non-cash compensation expense                                            349                       253
     Deferred tax benefit                                                       -                      (143)
     Asset write-down charges                                                   -                       887
     Impairment of intangibles                                              1,288                         -
     Equity loss in affiliate                                               3,187                         -
     Valuation allowance on accounts receivable                               169                         -
     Valuation allowance on note receivable                                   378                     2,000
     Loss on disposal                                                         687                         -
     Increase (decrease) in cash resulting from
       changes in operating assets and liabilities:
      Accounts receivable                                                     832                       817
      Tax receivable                                                            -                     1,332
      Other current assets                                                    556                       756
      Prepaid royalty (related party, Note 7)                              (1,756)                        -
      Other assets                                                             17                         -
      Accrued expenses                                                     (1,180)                   (2,747)
      Accounts payable                                                        (69)                   (1,053)
      Other non-current assets                                                  -                    (2,055)
      Deferred revenue                                                     (1,956)                   (1,348)
                                                                     ------------               -----------
Net cash (used in) provided by operating activities                        (8,386)                    1,659
                                                                     ------------               -----------

CASH FLOWS FROM INVESTING ACTIVITIES:
  Maturity of marketable securities                                             -                       820
  Advances to Scalable Software (related party, Note 7)                    (3,362)                   (3,950)
  Advances to PBTC (related party, Note 7)                                 (2,200)                        -
  Advances to Enterworks                                                        -                    (2,000)
  Purchases of furniture and equipment                                       (319)                     (577)
                                                                     ------------               -----------

Net cash used in investing activities                                      (5,881)                   (5,707)
                                                                     ------------               -----------

CASH FLOWS FROM FINANCING ACTIVITIES:
  Proceeds from exercises of stock options                                     29                       100
                                                                     ------------               -----------
Net cash provided by financing activities                                      29                       100
                                                                     ------------               -----------

Net decrease in cash and cash equivalents                                 (14,238)                   (3,948)
Effect of exchange rate changes on cash                                        (8)                       25
Cash and cash equivalents at beginning of period                           34,506                    42,774
                                                                     ------------               -----------

Cash and cash equivalents at end of period                           $     20,260               $    38,851
                                                                     ============               ===========

Supplemental disclosure of cash flow information:

Cash paid during the period for income taxes                         $          -               $         -
                                                                     ============               ===========
Cash paid during the period for interest                             $          -               $         1
                                                                     ============               ===========
</TABLE>

     SEE ACCOMPANYING CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.

                                       5

<PAGE>

                       NEON SYSTEMS, INC. AND SUBSIDIARIES
              CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1--BASIS OF PRESENTATION

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

NOTE 2--PER SHARE INFORMATION

     In calculating earnings per share information, NEON follows the provisions
of Statement of Financial Accounting Standards ("SFAS") No. 128, Earnings Per
Share. Basic income (loss) per share is computed by dividing net income (loss)
by the weighted average number of shares of common stock outstanding during the
period. Diluted net income (loss) per share is computed by dividing net income
(loss) by the weighted average number of shares of common stock outstanding,
adjusted to reflect common stock equivalents, such as convertible preferred
stock, stock options and warrants to purchase common stock, to the extent they
are dilutive, less the number of shares that could have been repurchased with
the exercise proceeds using the treasury stock method.

     A reconciliation of the numerators and denominators of the basic and
diluted per share computation is as follows:

<TABLE>
<CAPTION>
                                            THREE MONTHS ENDED DECEMBER 31,      NINE MONTHS ENDED DECEMBER 31,
                                          ---------------------------------      ------------------------------
                                               2002               2001             2002                  2001
                                          -----------------------------------------------------------------------
<S>                                       <C>                   <C>              <C>                 <C>
 Net income (loss)                         $     (2,402)        $     (2,559)    $    (13,286)       $     989
                                           ============         ============     ============        =========

 Weighted average number of common
   shares outstanding during the period:
 Basic                                            8,734                9,526            8,707            9,380
 Dilutive stock options                               -                    -                -              557
                                           ------------         ------------     ------------        ---------
 Diluted                                          8,734                9,526            8,707            9,937
                                           ============         ============     ============        =========

 Income (loss) per common share:
   Basic                                   $      (0.28)        $      (0.27)    $      (1.53)       $    0.11
                                           ============         ============     ============        =========
   Diluted                                 $      (0.28)        $      (0.27)    $      (1.53)       $    0.10
                                           ============         ============     ============        =========
</TABLE>

     In the period April 1, 2002 through December 31, 2002 options to purchase
87,724 shares of common stock at exercise prices between $0.20 to $1.80 per
share were exercised. At December 31, 2002, there were options outstanding to
purchase 3,139,676 shares of common stock with a weighted-average exercise price
of $7.30. These options were excluded from the calculation of diluted loss per
share for the three and nine months ended December 31, 2002, as they were
anti-dilutive.

NOTE 3--INCOME TAXES

     As of March 31, 2002 NEON had a net operating loss carry-forward for income
tax purposes of approximately $5.4 million that is available to offset future
taxable income, if any. The net operating loss carry-forwards in the United
Kingdom, Germany and Australia carry forward indefinitely. The net operating
loss carry-forward for the United States begins expiring in the tax year 2020.
Given the recent tax losses experienced by NEON, there can be no assurance that
the operations will generate taxable income in the future to utilize these
losses; therefore, as of December 31, 2002, NEON has recorded a full valuation
allowance for the deferred tax assets related to the future benefits, if any,
for these loss carry-forwards. Management currently believes that it is more
likely than not that the Company will have sufficient future taxable income to
allow it to realize the net deferred tax asset recorded as of December 31, 2002.

                                       6

<PAGE>

NOTE 4--SEGMENT REPORTING

     NEON considers its business activities to be in a single segment. During
the three-month period ended December 31, 2002, NEON had one customer that
individually accounted for 14% of total revenue. During the nine-month period
ended December 31, 2002, NEON did not have any customers that individually
accounted for more than 10% of total revenue. During the three-month and
nine-month periods ended December 31, 2001, NEON had a different customer that
accounted for 24% and 13% of total revenue, respectively.

    The table below summarizes revenues by geographic region.

<TABLE>
<CAPTION>
                                    THREE MONTHS ENDED DECEMBER 31,     NINE MONTHS ENDED DECEMBER 31,
                                  -----------------------------------  --------------------------------
                                        2002                2001           2002               2001
<S>                               <C>                    <C>            <C>                <C>
          Revenues:
            United States           $    2,842           $    4,217     $    9,662         $   13,975
            United Kingdom               1,792                  762          3,454              1,723
            Other                          252                   94            685                424
                                    ----------           ----------     ----------         ----------
                                    $    4,886           $    5,073     $   13,801         $   16,122
                                    ==========           ==========     ==========         ==========

          Operating Loss:
            United States           $   (2,281)          $     (787)    $   (9,931)        $   (6,570)
            United Kingdom                 803                   35          1,060               (555)
            Other                         (104)                 (95)          (140)              (321)
                                    ----------           ----------     ----------         ----------
                                    $   (1,582)          $     (847)    $   (9,011)        $   (7,446)
                                    ==========           ==========     ==========         ==========

          Identifiable Assets:
            United States           $   33,253           $   56,987
            United Kingdom               2,644                2,250
            Other                          875                  307
                                    ----------           ----------
                                    $   36,772           $   59,544
                                    ==========           ==========
</TABLE>

NOTE 5--CONTINGENCIES

     NEON is involved in various claims and legal actions arising in the
ordinary course of business. In the opinion of management, the ultimate
dispositions of any of these matters will not have a material adverse effect on
NEON's consolidated financial position, results of operations or liquidity. On
January 29, 2003, NEON received notification that it had been sued in Fort Bend
County, Texas in a lawsuit styled Phoenix Network Technologies (Europe) Limited
vs. NEON Systems, Inc. and Computer Associates International Inc., 400th
District Court, Ft. Bend County, Richmond Texas, Cause Number 03-CV-127800.
Phoenix Network Technologies (Europe) Limited was a distributor of the Solve:
Diplomat software products prior to NEON's acquisition of the Solve: Diplomat
assets from Sterling Software. The lawsuit alleges interference with such
distributor relationship among other claims. NEON has not yet evaluated the
claim raised in such case but do not currently believe that the ultimate
disposition of such case will have a material adverse effect on our consolidated
financial position, results of operations or liquidity.

NOTE 6--RESTRUCTURING CHARGES

     During the year ended March 31, 2002, NEON recorded restructuring charges
of $908,000, which related to reductions in force and the abandonment of leased
facilities as a result of a corporate reorganization. These restructuring
expenses included severance costs of $570,000 and losses from lease commitments
of $338,000. As of March 31, 2002, NEON has paid all severance related
restructuring costs. In May 2002, NEON subleased its previously abandoned leased
facilities, and as a result, NEON reduced its previously recorded restructuring
charges by $138,000. As of December 31, 2002, cumulative cash paid for leasing
expenses totaled $132,000 and NEON included the remaining net lease liability of
$68,000 in accrued liabilities.

    NEON incurred restructuring charges of $261,000 during the nine months ended
December 31, 2002. This represents $271,000 related to the termination of NEON's
distribution agreement with PBTC and $128,000 related to reducing the scope of
the iWave product operations. The charges primarily represented non-cash stock
compensation costs resulting from the extension of stock options for several
employees. This amount was offset by a $138,000 reduction to an outstanding
restructuring accrual for abandoned facilities, as those facilities were
subleased during the period. Future annual benefits resulting from cost
reductions related to PBTC and iWave are estimated at $2.3 million and $688,000,
respectively.

NOTE 7--RELATED PARTY TRANSACTIONS

     Members of NEON's Board of Directors and certain executive officers of NEON
are shareholders and/or directors in other companies with which NEON has
business relationships. See "Risk Factors - Some Members of Our Board of
Directors and Management May have Conflicts of Interest and/or Are Interested
Parties to Certain Transactions of NEON." Transactions between NEON and these
other companies are described below.

                                       7

<PAGE>

Peregrine/Bridge Transfer Corporation

     In January 1996, NEON entered into a distribution agreement with
Peregrine/Bridge Transfer Corporation ("PBTC"), a database software company
whose sole stockholder is an affiliate of John J. Moores, NEON's Chairman of the
Board of Directors. The distribution agreement had an initial term through
January 1, 1998 and could be automatically renewed for successive one-year
terms. The agreement also provided that NEON pay royalties to PBTC for the
license of products and for maintenance and support and upgrade services equal
to 50% of the revenues received by NEON for NEON's distribution of PBTC's only
products, its Enterprise Subsystem Management products. In December 1998, NEON
amended its distribution agreement with PBTC and PBTC granted NEON an exclusive,
worldwide license to market and sublicense PBTC's Enterprise Subsystem
Management products in exchange for NEON's agreement to extend the term of the
agreement through March 31, 2004 and pay PBTC a minimum advance royalty of
$250,000 per quarter during fiscal year 2000, $500,000 per quarter during fiscal
year 2001, $750,000 per quarter during fiscal year 2002, $1,000,000 per quarter
during fiscal year 2003, and $1,250,000 per quarter during fiscal year 2004, for
an aggregate payment of $15 million. Such advance royalty payments have
historically been recorded by NEON as a prepaid expense and offset by 50% of
NEON's sales of PBTC products. The amended distribution agreement also provided
that PBTC would reimburse NEON for the amount of any unearned royalty advances
when the agreement terminated in 2004.

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

     On June 30, 2002, the balance of the unearned advance payments was $3.0
million, an increase of $822,000 from March 31, 2002. Management believed that
while the then-current and reasonably foreseeable business prospects for revenue
received by NEON from licenses and maintenance for PBTC products was expected to
be sufficient to offset the unearned advance royalty payments as of June 30,
2002, these revenues did not appear to be sufficient to meet the aggregate
future minimum royalties required to be paid by NEON to PBTC over the term of
the distribution agreement. As a result, the balance of unearned advance royalty
payments was projected to increase substantially by the time the distribution
agreement would terminate on March 31, 2004. On June 30, 2002, PBTC's sole
source of income was the royalty payments made by NEON and PBTC had a
substantial negative net worth. As a result, NEON's Board had concerns regarding
PBTC's ability to repay any balance of unearned advances at the termination of
the agreement in 2004.

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

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

     Upon the closing of the Termination and Customer Support Agreement on
August 14, 2002, PBTC's right to receive from NEON, and NEON's corresponding
obligation to pay to PBTC, the advance royalty payments described in the
distribution agreement terminated. Additionally, NEON's option to purchase PBTC
and right of first refusal under the distribution agreement also terminated. The
Termination and Customer Support Agreement provides that, in consideration of
PBTC's consent to terminate its existing agreements with NEON, NEON paid PBTC a
final cash advance of $2.2 million, which amount has been consolidated with
$884,028 of the outstanding unearned royalty advance under the distribution
agreement as of July 31, 2002 and the $500,000 payment with respect to the
transfer of rights described below and represented by the consolidated
promissory note payable to NEON in the aggregate principal amount of $3,584,028,
bearing no interest to its due date of March 31, 2005. This consolidated
promissory note is secured by all of the intellectual property of PBTC ("PBTC
IP"). The Termination and Customer Support Agreement also provided that the
remaining outstanding unearned royalty advance of $3.0 million as of July 31,
2002 was converted into a $3.0 million dollar convertible promissory note
payable to NEON bearing no interest to its due date of March 31, 2005, which is
also secured by the PBTC IP. The $3.0 million convertible note is convertible by
NEON, in its discretion, into equity in PBTC at an agreed pre-cash valuation of
$30.0 million dollars. Such

                                       8

<PAGE>

conversion right will expire on the due date of the $3.0 million convertible
note. Upon closing, NEON recorded the notes receivable from PBTC at their
estimated net present value, which was calculated at $4.3 million in aggregate.
As a result of the termination agreement, NEON recorded a loss on disposal of
$687,000. NEON also evaluates the PBTC IP on a quarterly basis to determine the
note's net realizable value, as it is secured by the PBTC IP. Accordingly, NEON
will adjust the carrying value of the note if the net realizable value is
determined to be below the carrying value.

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

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

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

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

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

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

                                       9

<PAGE>

Scalable Software, Inc.

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

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

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

     Due to the interests in Scalable Software of several members of NEON's
Board of Directors, the Board of Directors concluded that it would be
appropriate to create a Special Committee comprised solely of independent
directors who had no interest in Scalable Software to review the terms of the
proposed acquisition. After thorough consideration and discussion by the Special
Committee and its advisors, the Special Committee proposed that the payment of
the consideration for the proposed acquisition be structured as an earn out, in
which the NEON stock to be used as consideration would be placed in escrow
subject to release to the Scalable Software shareholders upon Scalable
Software's attainment of specified revenue and profitability goals. This
proposal was unacceptable to Scalable Software's management and its Board of
Directors and was rejected. The status of the proposed acquisition was then
discussed at a special meeting of NEON's Board of Directors in December 2001.
After thorough consideration and discussion and upon endorsement by the Special
Committee, NEON's Board of Directors approved modifications to the proposed
terms and conditions for the acquisition such that the transaction would be
structured as an option to acquire Scalable Software as discussed below. In
addition, NEON also announced on December 21, 2001, that Louis R. Woodhill, its
President and Chief Executive Officer, and Jim Woodhill had been appointed to
the Board of Directors of NEON. As of December 31, 2002, there has been no
change to the status of the directors and officers of NEON who are listed as
shareholders, directors or officers of Scalable Software above.

     NEON obtained a two-year option to acquire Scalable Software as outlined in
the Agreement and Plan of Merger dated June 26, 2002. In connection with this
Option, NEON agreed to provide bridge financing of up to $5.5 million, in
addition to the $3.5 million previously loaned to Scalable Software that is
secured by personal guarantees from John J. Moores, Louis R. Woodhill and Jim
Woodhill. The aggregate financing has a 36-month term and will not bear interest
during the term of the two-year option to acquire Scalable Software. After the
expiration of the option, the loan will bear interest at the prime rate plus two
percentage points. In addition to the personal guarantees of John J. Moores,
Louis R. Woodhill and Jim Woodhill for the initial $3.5 million loaned to
Scalable Software, the $5.5 million loan will be secured by all of the
intellectual property rights of Scalable Software. NEON may exercise the option
to acquire Scalable Software at any time during the two-year term, subject to
provisions that require NEON to exercise its option within a 30-day window under
certain circumstances or forfeit the option. If NEON exercises the option and
acquires Scalable Software, each of the approximately 19,400,000 outstanding
shares of common stock of Scalable Software will be converted into approximately
0.135 of a share of NEON common stock and outstanding options and warrants to
purchase approximately 3,000,000 shares of common stock of Scalable Software
will become options and warrants to purchase common stock of NEON on the same
conversion basis. If Scalable Software incurs more indebtedness for borrowed
money or issues more equity, the exchange ratio will be adjusted accordingly.
Prior to NEON exercising the option to acquire Scalable Software, a Special
Committee would be appointed to review the negotiated terms of the proposed
acquisition and NEON would seek to obtain a fairness opinion regarding the
transaction from a financial advisory

                                       10

<PAGE>

firm. The acquisition of Scalable Software will also require approval of the
stockholders of NEON and the NEON Board of Directors.

     On October 16, 2002, the Board of Directors reviewed the progress of
Scalable Software with respect to the timing of its anticipated break-even
quarter and determined that Scalable Software may require an additional infusion
of at least $500,000 in additional capital to meet its projections. In the
interest of preserving NEON's investment, the Special Committee approved an
increase in the aggregate borrowing limit under the $5.5 million loan to an
aggregate principal amount of $6.0 million, an increase of $500,000 in Scalable
Software's aggregate borrowing limits under its line of credit with NEON. Such
increase was memorialized in an amendment to the relevant promissory notes and
security agreements on December 23, 2002, and will be subject in all respects to
the current terms and conditions of the $5.5 million loan. It has been
management's belief that Scalable Software might exhaust its line of credit from
NEON before it was able to generate cash from operations sufficient to sustain
its operations. As of the date of this filing, Scalable has exhausted its credit
facility with NEON. If Scalable Software is unable to secure additional
financing, it is management's belief that Scalable Software could become the
subject of bankruptcy proceedings. If Scalable Software is subject to bankruptcy
proceedings, it is possible that the security interests held by NEON in the
intellectual property of Scalable Software might be set aside, and in such event
NEON could be treated as an unsecured creditor with respect to the $6.0 million
loan.

     As noted above, certain members of NEON's board of directors and executive
officers also serve as directors and executive officers of Scalable Software and
claim beneficial ownership of approximately 81% of Scalable's common stock. In
addition, NEON has an option to acquire all of the outstanding shares of
Scalable Software and is currently providing Scalable's primary financing for
its operations. Therefore, NEON determined that it has effective control of
Scalable Software and began accounting for its investment in Scalable Software
using the modified equity method of accounting. Under this method of accounting,
NEON recognizes 100% of Scalable Software's losses to the extent of advances
made in excess of the guaranteed amount. At December 31, 2002, NEON had made
total advances of $9.2 million to Scalable Software (including $5.7 million of
unguaranteed advances) and recognized cumulative losses of $5.3 million, of
which $3.2 million was recorded during the nine-months ended December 31, 2002.
In addition, due to the uncertainties regarding NEON's ultimate ability to
recover any unguaranteed advances to Scalable Software, NEON will not record the
carrying value of its net advance to Scalable Software above the guaranteed
amount. Accordingly, for the nine months ended December 31, 2002, NEON recorded
a valuation allowance of $378,000 against the Scalable note receivable, reducing
the carrying value of the note receivable to the $3.5 million guaranteed amount.

     Sheer Genius Software, Inc.

     On January 3, 2002, NEON entered into a services agreement with Sheer
Genius Software, Inc. of Austin, Texas, a company owned by Jim Woodhill. Also,
JMI Services, Inc., a private company owned by John J. Moores, NEON's Chairman,
is a creditor of Sheer Genius, holding a promissory note dated August 31, 2001
in the amount of $200,000. Under the first project description negotiated for
such services agreement, Sheer Genius provided development services to NEON on a
budgeted time and materials basis and delivered fixed deliverables consisting
primarily of developed source code. The term of the initial project description
was six months and the aggregate fees were $480,000. This agreement was extended
by the Board for an additional three months with additional aggregate fees of
$300,000. On October 16, 2002, the Board determined that the Services Agreement
with Sheer Genius should be extended on a month-to-month basis. All fees under
this arrangement are expensed as incurred and included in research and
development. While NEON is currently Sheer Genius' sole source of income, it is
free to solicit other customers. Under the services agreement, all intellectual
property created by Sheer Genius in the course of performing the services is
owned by NEON. Sheer Genius will receive a license back of such intellectual
property for limited use in the development by Sheer Genius of software that
does not compete with software distributed by NEON. The Board of Directors
reviewed the terms of the services agreement and project description and
approved such agreements following disclosure of the interest of its officers
and directors associated with Sheer Genius. As of December 31, 2002, NEON has
paid Sheer Genius Software services fees in an aggregate amount of $973,000.

NOTE 8 - IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS

     NEON adopted SFAS No. 141, "Business Combinations", and SFAS No. 142,
"Goodwill and Other Intangible Assets," effective April 1, 2002. SFAS No. 141
requires that the purchase method of accounting be used for all business
combinations initiated or completed after June 30, 2001, and specifies criteria
for the recognition and reporting of intangible assets apart from goodwill.
Under SFAS No. 142, NEON no longer amortizes goodwill and intangible assets with
indefinite useful lives,

                                       11

<PAGE>

but instead test these assets for impairment at least annually. SFAS No. 142
also requires that intangible assets with definite useful lives be amortized
over such lives to their estimated residual values.

    Under the transition provisions of SFAS No. 142, NEON tested the goodwill
balances associated with the September 1999 acquisition of Beyond Software, Inc.
("BSI") for impairment by comparing the fair value of BSI to its carrying value.
Fair value was determined after considering changes in operational strategies
and plans, as well as assumptions regarding the potential future cash flows from
the acquired assets. As a result, NEON determined that the carrying value of the
goodwill related to the BSI acquisition had been impaired by $1.0 million, which
is shown as a cumulative effect of a change in accounting principle as of April
1, 2002. This impairment charge resulted in a net carrying value of $150,000 at
December 31, 2002.

    The pro forma effects of the adoption of SFAS No. 142 on net income (loss)
and income (loss) per share for NEON for the three and nine months ended
December 31, 2002 and 2001 is as follows:

<TABLE>
<CAPTION>
                                            THREE MONTHS          THREE MONTHS           NINE MONTHS           NINE MONTHS
                                               ENDED                 ENDED                  ENDED                 ENDED
                                         DECEMBER 31, 2002     DECEMBER 31, 2001      DECEMBER 31, 2002     DECEMBER 31, 2001
                                         ------------------------------------------------------------------------------------
<S>                                      <C>                   <C>                    <C>                   <C>
 Net income (loss) as reported                $    (2,402)        $      (2,559)          $    (13,286)         $        989
 Add  back: Cumulative effect of change
     in accounting principle                            -                     -                  1,043                     -
 Add back: Amortization of goodwill                     -                   119                      -                   359
                                              -----------         -------------           ------------          ------------
       Adjusted net income (loss)             $    (2,402)        $      (2,440)          $    (12,243)         $      1,348
                                              ===========         =============           ============          ============

 Income (loss) per share - Basic:
   Income (loss) per share, as reported       $     (0.28)        $       (0.27)          $      (1.53)         $       0.11
   Add back: Cumulative effect of change
     in accounting principle                            -                     -                   0.12                     -
   Add back: Amortization of goodwill                   -                  0.01                      -                  0.04
                                              -----------         -------------           ------------          ------------
   Pro forma income (loss) per share          $     (0.28)         $      (0.26)          $      (1.41)         $       0.15
                                              ===========         =============           ============          ============

 Income (loss) per share - Diluted:
   Income (loss) per share as reported        $     (0.28)         $      (0.27)          $      (1.53)         $       0.10
   Add  back: Cumulative effect of change
     in accounting principle                            -                     -                   0.12                     -
   Add back: Amortization of goodwill                   -                  0.01                      -                  0.04
                                              -----------          ------------           ------------          ------------
   Pro forma income (loss) per share          $     (0.28)         $      (0.26)          $      (1.41)         $       0.14
                                              ===========          ============           ============          ============
</TABLE>

     NEON adopted SFAS No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets," effective April 1, 2002. SFAS No. 144 supersedes SFAS No.
121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of," but retains many of its fundamental provisions. SFAS
No. 144 clarifies certain measurement and classification issues from SFAS No.
121. In addition, SFAS No. 144 supersedes the accounting and reporting
provisions for the disposal of a business segment as found in Accounting
Principles Board Opinion No. 30, "Reporting the Results of Operations--Reporting
the Effects of Disposal of a Segment of a Business and Extraordinary, Unusual
and Infrequently Occurring Events and Transactions." SFAS No. 144 retains the
basic requirements in APB Opinion No. 30 to separately report discontinued
operations, and broadens the scope of such requirement to include more types of
disposal transactions. The scope of SFAS No. 144 excludes goodwill. The adoption
of SFAS No. 144 did not have a material impact on NEON's consolidated financial
statements.

     In April 2002, the FASB issued SFAS No. 145 "Rescission of FASB Statements
No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections." SFAS No. 145 rescinds FASB Statement No. 4, "Reporting Gains and
Losses from Extinguishment of Debt," and an amendment of that Statement, FASB
Statement No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund
Requirements." SFAS No. 145 also rescinds FASB Statement No. 44, "Accounting for
Intangible Assets of Motor Carriers" and amends FASB Statement No. 13,
"Accounting for Leases." SFAS No. 145 also amends other existing authoritative
pronouncements to make various technical corrections, clarify meanings, or
describe their applicability under changed conditions. SFAS No. 145 will be
effective for the fiscal year beginning April 1, 2003. NEON does not anticipate
that the adoption of SFAS No. 145 will have a material impact on NEON's
consolidated financial statements.

                                       12

<PAGE>

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

     In December 2002, the FASB issued SFAS No. 148 "Accounting for Stock-Based
Compensation-Transition and Disclosure, an amendment of FASB Statement No. 123".
SFAS No. 148 amends FASB Statement No. 123, "Accounting for Stock-Based
Compensation," to provide alternative methods of transition for an entity that
voluntarily changes to the fair value based method of accounting for stock-based
employee compensation. It also amends the disclosure provisions of that
Statement to require prominent disclosure about the effects on reported net
income of an entity's accounting policy decisions with respect to stock-based
employee compensation. SFAS No. 148 also amends APB Opinion No. 28, "Interim
Financial Reporting," to require disclosure about those effects in interim
financial information. The revised disclosure requirements of SFAS No. 148 will
be required in the Company's annual report for the year ended March 31, 2003.
Should NEON choose to adopt the fair value based method of accounting provided
for in SFAS No. 123, the alternative methods of transition provided by SFAS No.
148 would be applicable for NEON's year ended March 31, 2003. NEON does not
anticipate that the adoption of SFAS No. 148 will have a material impact on
NEON's consolidated financial statements.

     In November 2002, the FASB issued Interpretation No. 45 "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others", an interpretation of FASB Statements No.
5, 57, and 107 and rescission of FASB Interpretation No. 34. This interpretation
clarifies the requirements for a guarantor's accounting for and disclosures of
certain guarantees issued and outstanding. This Interpretation also incorporates
without reconsideration the guidance in FASB Interpretation No. 34 "Disclosure
of Indirect Guarantees of Indebtedness of Others", which is being superseded.
Interpretation No. 45 will be effective for the fiscal year beginning April 1,
2003. NEON does not anticipate that the adoption of FASB Interpretation No. 45
will have a material impact on NEON's consolidated financial statements.

NOTE 9 - IMPAIRMENT OF INTANGIBLES

    As a result of changes to NEON's estimate of future cash flows attributable
to NEON's iWave products acquired from Sterling Software in October 2000, NEON
performed impairment tests on these assets in accordance with SFAS No. 144,
"Accounting for the Impairment or Disposal of Long-Lived Assets." SFAS No. 144
requires that certain identifiable intangibles be reviewed for impairment
whenever events or changes in circumstances indicate that the carrying amount of
an asset may not be recoverable. If the estimated future cash flows expected to
result from the use of the asset are less than the carrying amount of the asset,
an impairment loss is recognized. NEON recorded an impairment charge of $1.3
million during the nine months ended December 31, 2002, associated with the
intellectual property acquired from Sterling Software. As a result of the
impairment, the carrying value was reduced to $500,000 at September 30, 2002.

    In addition, under SFAS No. 142, NEON determined that fair value of goodwill
related to the BSI acquisition was approximately $150,000. The carrying value of
goodwill related to the BSI acquisition at June 30, 2002 was $1.2 million, and
as a result, NEON recorded an impairment charge of $1.0 million upon the
adoption of SFAS No. 142 as of April 1, 2002.

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

     The following discussion and analysis should be read in conjunction with
NEON's consolidated financial statements and the related notes thereto included
in this report on Form 10-Q. The discussion and analysis contains
forward-looking statements within the meaning of Section 27A of the Securities
Act of 1933 and Section 21E of the Securities Exchange Act of 1934. These
statements are based on our current expectations and entail various risks and
uncertainties such as our plans, objectives, expectations and intentions. Our
actual results could differ materially from those projected in the
forward-looking statements as a result of various factors, including those set
forth below in Part II, Item 5 under "Factors that May Affect Future Results."
In some cases, you can identify forward-looking statements by terminology such
as "may," "will," "should," "expects," "plans," "anticipates," "believes,"
"estimates," "predicts," "potential," "continue," or the negative of these terms
or other comparable terms.

                                       13

<PAGE>

OVERVIEW

     NEON Systems, Inc. and its subsidiaries (collectively, "NEON") develop,
market and support software products for the IBM mainframe platform. NEON was
incorporated in May 1993 and is a successor by merger to NEON Systems, Inc., an
Illinois corporation, which was incorporated in June 1991. NEON's primary
product group, the Shadow branded products, provide access and integration of
IBM mainframe data and applications from standard application client
environments, including the Internet and client/server systems. Historically,
NEON's sales mix primarily consisted of Shadow products. NEON's iWave branded
products integrate helpdesk, network management, database management and systems
management applications across mainframe and distributed systems environments.
On October 31, 2002, NEON reduced the scope of its iWave operations and is
evaluating various strategic alternatives to maximize the value of that
division.

     NEON derives revenue from software licenses and maintenance services.
License fees, which are based upon the number and capacity of servers as well as
the number of client users, are generally due upon license grant and include a
one-year maintenance period. The sales process typically takes approximately
nine months. After the initial year of license, NEON provides ongoing
maintenance services, which include technical support and product enhancements,
for an annual fee. Any factors adversely affecting the pricing of, demand for,
or market acceptance of, our products, such as competition or technological
change, could materially adversely affect our business, operating results and
financial condition. During the three-month period ended December 31, 2002, NEON
had one customer that individually accounted for 14% of total revenue. During
the three-month period ended December 31, 2001 NEON had one customer that
accounted for 24% of total revenue.

     Since its inception, NEON has incurred substantial costs to develop our
technology and products, to recruit and train personnel for our engineering,
sales and marketing and technical support departments, and to establish an
administrative organization. Accordingly, NEON will need to increase its annual
revenue to generate operating profits. There can be no assurance in future
quarters that NEON will achieve or sustain revenue growth and/or return to
profitability. As a result, management believes that its cash resources may
decline as a result of continuing losses from operations and incremental costs
associated with the financing and acquisition, as well as losses from operations
of Scalable Software. See "Related Party Transactions" below and in Note 7 to
NEON's financial statements.

     NEON conducts business in the United Kingdom and Germany through two wholly
owned consolidated subsidiaries and revenues from these subsidiaries are
denominated in local currencies. In connection with these foreign operations,
NEON is exposed to foreign currency fluctuations for its net working capital
positions. NEON has no material commitments that would be satisfied in
currencies other than U.S. dollars. In other international markets, NEON
conducts substantially all of its business through independent third-party
distributors. Revenues derived from third-party distributors are denominated in
U.S. dollars. Revenues recognized from sales to customers outside North America,
primarily in Europe, represented approximately 30% and 13% for the nine months
ended December 31, 2002 and 2001, respectively. Foreign currency fluctuations
have not had a significant impact on NEON's revenues or operating results.
Management does not currently have an active foreign exchange hedging program;
however, NEON may implement a program to mitigate foreign currency transaction
risk in the future.

     In view of the rapidly changing nature of our business and the current
weakness in the mainframe software market, NEON believes that period-to-period
comparisons of our revenue and operating results are not necessarily meaningful
and should not be relied upon as indications of our future performance. Further,
NEON does not believe that its historical growth rates are necessarily
representative of its future growth potential.

Related Party Transactions

     Members of NEON's Board of Directors and certain executive officers of NEON
are shareholders and/or directors in other companies with which NEON has
business relationships. See "Risk Factors - Some Members of Our Board of
Directors and Management May have Conflicts of Interest and/or Are Interested
Parties to Certain Transactions of NEON." Transactions between NEON and these
other companies are described below.

Peregrine/Bridge Transfer Corporation

     In January 1996, NEON entered into a distribution agreement with
Peregrine/Bridge Transfer Corporation ("PBTC"), a database software company
whose sole stockholder is an affiliate of John J. Moores, NEON's Chairman of the
Board of Directors. The distribution agreement had an initial term through
January 1, 1998 and could be automatically renewed for successive one-year
terms. The agreement also provided that NEON pay royalties to PBTC for the
license of products and for

                                       14

<PAGE>

maintenance and support and upgrade services equal to 50% of the revenues
received by NEON for NEON's distribution of PBTC's only products, its Enterprise
Subsystem Management products. In December 1998, NEON amended its distribution
agreement with PBTC and PBTC granted NEON an exclusive, worldwide license to
market and sublicense PBTC's Enterprise Subsystem Management products in
exchange for NEON's agreement to extend the term of the agreement through March
31, 2004 and pay PBTC a minimum advance royalty of $250,000 per quarter during
fiscal year 2000, $500,000 per quarter during fiscal year 2001, $750,000 per
quarter during fiscal year 2002, $1,000,000 per quarter during fiscal year 2003,
and $1,250,000 per quarter during fiscal year 2004, for an aggregate payment of
$15 million. Such advance royalty payments have historically been recorded by
NEON as a prepaid expense and offset by 50% of NEON's sales of PBTC products.
The amended distribution agreement also provided that PBTC would reimburse NEON
for the amount of any unearned royalty advances when the agreement terminated in
2004.

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

     On June 30, 2002, the balance of the unearned advance payments was $3.0
million, an increase of $822,000 from March 31, 2002. Management believed that
while the then-current and reasonably foreseeable business prospects for revenue
received by NEON from licenses and maintenance for PBTC products was expected to
be sufficient to offset the unearned advance royalty payments as of June 30,
2002, these revenues did not appear to be sufficient to meet the aggregate
future minimum royalties required to be paid by NEON to PBTC over the term of
the distribution agreement. As a result, the balance of unearned advance royalty
payments was projected to increase substantially by the time the distribution
agreement would terminate on March 31, 2004. On June 30, 2002, PBTC's sole
source of income was the royalty payments made by NEON and PBTC had a
substantial negative net worth. As a result, NEON's Board had concerns regarding
PBTC's ability to repay any balance of unearned advances at the termination of
the agreement in 2004.

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

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

     Upon the closing of the Termination and Customer Support Agreement on
August 14, 2002, PBTC's right to receive from NEON, and NEON's corresponding
obligation to pay to PBTC, the advance royalty payments described in the
distribution agreement terminated. Additionally, NEON's option to purchase PBTC
and right of first refusal under the distribution agreement also terminated. The
Termination and Customer Support Agreement provides that, in consideration of
PBTC's consent to terminate its existing agreements with NEON, NEON paid PBTC a
final cash advance of $2.2 million, which amount has been consolidated with
$884,028 of the outstanding unearned royalty advance under the distribution
agreement as of July 31, 2002 and the $500,000 payment with respect to the
transfer of rights described below and represented by the consolidated
promissory note payable to NEON in the aggregate principal amount of $3,584,028,
bearing no interest to its due date of March 31, 2005. This consolidated
promissory note is secured by all of the intellectual property of PBTC ("PBTC
IP"). The Termination and Customer Support Agreement also provided that the
remaining outstanding unearned royalty advance of $3.0 million as of July 31,
2002 was converted into a $3.0 million dollar convertible promissory note
payable to NEON bearing no interest to its due date of March 31, 2005, which is
also secured by the PBTC IP. The $3.0 million convertible note is convertible by
NEON, in its discretion, into equity in PBTC at an agreed pre-cash valuation of
$30.0 million dollars. Such conversion right will expire on the due date of the
$3.0 million convertible note. Upon closing, NEON recorded the notes receivable
from PBTC at their estimated net present value, which was calculated at $4.3
million in aggregate. As a result of the termination agreement, NEON recorded a
loss on disposal of $687,000. NEON also evaluates the PBTC IP on a quarterly
basis to determine the note's net realizable value, as it is secured by the PBTC
IP. Accordingly, NEON will adjust the carrying value of the note if the net
realizable value is determined to be below the carrying value.

                                       15

<PAGE>

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

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

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

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

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

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

                                       16

<PAGE>

Scalable Software, Inc.

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

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

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

     Due to the interests in Scalable Software of several members of NEON's
Board of Directors, the Board of Directors concluded that it would be
appropriate to create a Special Committee comprised solely of independent
directors who had no interest in Scalable Software to review the terms of the
proposed acquisition. After thorough consideration and discussion by the Special
Committee and its advisors, the Special Committee proposed that the payment of
the consideration for the proposed acquisition be structured as an earn out, in
which the NEON stock to be used as consideration would be placed in escrow
subject to release to the Scalable Software shareholders upon Scalable
Software's attainment of specified revenue and profitability goals. This
proposal was unacceptable to Scalable Software's management and its Board of
Directors and was rejected. The status of the proposed acquisition was then
discussed at a special meeting of NEON's Board of Directors in December 2001.
After thorough consideration and discussion and upon endorsement by the Special
Committee, NEON's Board of Directors approved modifications to the proposed
terms and conditions for the acquisition such that the transaction would be
structured as an option to acquire Scalable Software as discussed below. In
addition, NEON also announced on December 21, 2001, that Louis R. Woodhill, its
President and Chief Executive Officer, and Jim Woodhill had been appointed to
the Board of Directors of NEON. As of December 31, 2002, there has been no
change to the status of the directors and officers of NEON who are listed as
shareholders, directors or officers of Scalable Software above.

     NEON obtained a two-year option to acquire Scalable Software as outlined in
the Agreement and Plan of Merger dated June 26, 2002. In connection with this
Option, NEON agreed to provide bridge financing of up to $5.5 million, in
addition to the $3.5 million previously loaned to Scalable Software that is
secured by personal guarantees from John J. Moores, Louis R. Woodhill and Jim
Woodhill. The aggregate financing has a 36-month term and will not bear interest
during the term of the two-year option to acquire Scalable Software. After the
expiration of the option, the loan will bear interest at the prime rate plus two
percentage points. In addition to the personal guarantees of John J. Moores,
Louis R. Woodhill and Jim Woodhill for the initial $3.5 million loaned to
Scalable Software, the $5.5 million loan will be secured by all of the
intellectual property rights of Scalable Software. NEON may exercise the option
to acquire Scalable Software at any time during the two-year term, subject to
provisions that require NEON to exercise its option within a 31-day window under
certain circumstances or forfeit the option. If NEON exercises the option and
acquires Scalable Software, each of the approximately 19,400,000 outstanding
shares of common stock of Scalable Software will be converted into approximately
0.135 of a share of NEON common stock and outstanding options and warrants to
purchase approximately 3,000,000 shares of common stock of Scalable Software
will become options and warrants to purchase common stock of NEON on the same
conversion basis. If Scalable Software incurs more indebtedness for borrowed
money or issues more equity, the exchange ratio will be adjusted accordingly.
Prior to NEON exercising the option to acquire Scalable Software, a Special
Committee would be appointed to review the negotiated terms of the proposed
acquisition and NEON would seek to obtain a fairness opinion regarding the
transaction from a financial advisory

                                       17

<PAGE>

firm. The acquisition of Scalable Software will also require approval of the
stockholders of NEON and the NEON Board of Directors.

     On October 16, 2002, the Board of Directors reviewed the progress of
Scalable Software with respect to the timing of its anticipated break-even
quarter and determined that Scalable Software may require an additional infusion
of at least $500,000 in additional capital to meet its projections. In the
interest of preserving NEON's investment, the Special Committee approved an
increase in the aggregate borrowing limit under the $5.5 million loan to an
aggregate principal amount of $6.0 million, an increase of $500,000 in Scalable
Software's aggregate borrowing limits under its line of credit with NEON. Such
increase was memorialized in an amendment to the relevant promissory notes and
security agreements on December 23, 2002, and will be subject in all respect to
the current terms and conditions of the $5.5 million loan. It has been
management's belief that Scalable Software may exhaust its line of credit from
NEON before it is able to generate cash from operations sufficient to sustain
its operations. As of the date of this filing, Scalable has exhausted its credit
facility with NEON. If Scalable Software is unable to secure additional
financing, it is management's belief that Scalable Software could become the
subject of bankruptcy proceedings. If Scalable Software is subject to bankruptcy
proceedings, it is possible that the security interests held by NEON in the
intellectual property of Scalable Software might be set aside, and in such event
NEON could be treated as an unsecured creditor with respect to the $6.0 million
loan.

     As noted above, certain members of NEON's board of directors and executive
officers also serve as directors and executive officers of Scalable Software and
claim beneficial ownership of approximately 81% of Scalable's common stock. In
addition, NEON has an option to acquire all of the outstanding shares of
Scalable Software and is currently providing Scalable's primary financing for
its operations. Therefore, NEON determined that it has effective control of
Scalable Software and began accounting for its investment in Scalable Software
using the modified equity method of accounting. Under this method of accounting,
NEON recognizes 100% of Scalable Software's losses to the extent of advances
made in excess of the guaranteed amount. At December 31, 2002, NEON had made
total advances of $9.2 million to Scalable Software (including $5.7 million of
unguaranteed advances) and recognized cumulative losses of $5.3 million, of
which $3.2 million was recorded during the nine-months ended December 31, 2002.
In addition, due to the uncertainties regarding NEON's ultimate ability to
recover any unguaranteed advances to Scalable Software, NEON will not record the
carrying value of its net advance to Scalable Software above the guaranteed
amount. Accordingly, for the nine months ended December 31, 2002, NEON recorded
a valuation allowance of $378,000 against the Scalable note receivable, reducing
the carrying value of the note receivable to the $3.5 million guaranteed amount.

Sheer Genius Software, Inc.

     On January 3, 2002, NEON entered into a services agreement with Sheer
Genius Software, Inc. of Austin, Texas, a company owned by Jim Woodhill. Also,
JMI Services, Inc., a private company owned by John J. Moores, NEON's Chairman,
is a creditor of Sheer Genius, holding a promissory note dated August 31, 2001
in the amount of $200,000. Under the first project description negotiated for
such services agreement, Sheer Genius provided development services to NEON on a
budgeted time and materials basis and delivered fixed deliverables consisting
primarily of developed source code. The term of the initial project description
was six months and the aggregate fees were $480,000. This agreement was extended
by the Board for an additional three months with additional aggregate fees of
$300,000. On October 16, 2002, the Board determined that the Services Agreement
with Sheer Genius should be extended on a month-to-month basis. All fees under
this arrangement are expensed as incurred and included in research and
development. While NEON is currently Sheer Genius' sole source of income, it is
free to solicit other customers. Under the services agreement, all intellectual
property created by Sheer Genius in the course of performing the services is
owned by NEON. Sheer Genius will receive a license back of such intellectual
property for limited use in the development by Sheer Genius of software that
does not compete with software distributed by NEON. The Board of Directors
reviewed the terms of the services agreement and project description and
approved such agreements following disclosure of the interest of its officers
and directors associated with Sheer Genius. As of December 31, 2002, NEON has
paid Sheer Genius Software services fees in an aggregate amount of $973,000.

Critical Accounting Policies

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

                                       18

<PAGE>

Revenue Recognition Policies

     Statement of Position 97-2, "Software Revenue Recognition" (SOP 97-2), was
issued in October 1997 by the American Institute of Certified Public Accountants
(AICPA) and was amended by Statement of Position 98-4 (SOP 98-4) and Statement
of Position 98-9 (SOP 98-9). NEON adopted SOP 97-2 effective July 1, 1997, SOP
98-4 effective March 31, 1998 and SOP 98-9 effective April 1, 1999. NEON
believes its current revenue recognition policies and practices are consistent
with SOP 97-2, SOP 98-4 and SOP 98-9. Revenues from software license sales are
recognized when all of the following conditions are met: a non-cancelable
license agreement has been signed; the product has been delivered; there are no
material uncertainties regarding customer acceptance; collection of the
receivable is probable; no other significant vendor obligations exist; and
vendor-specific objective evidence exists to allocate the total fee to elements
of the arrangement. Vendor-specific objective evidence is based on the price
generally charged when an element is sold separately. All elements of each order
are valued at the time of revenue recognition. License revenues generally
include software maintenance agreements for the first year following the date of
sale. In such cases, revenues are allocated between licenses fees and
maintenance revenues based on vendor-specific objective evidence. Revenues from
first-year maintenance agreements and separately priced software maintenance
agreements for subsequent years are deferred and recognized ratably on a
straight-line basis over the maintenance period. NEON also markets and sells its
products through independent distributors and resellers. License and maintenance
revenues from these transactions are recognized when sold to the ultimate end
user and all of the above conditions are met.

Capitalized Software Costs

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

Allowance for Doubtful Accounts Receivable

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

Deferred Income Taxes

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

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

Accounting for Advances to Scalable Software

     As discussed more fully in "Related Party Transactions" above, certain
members of NEON's board of directors and executive officers also serve as
directors and executive officers of Scalable Software and claim beneficial
ownership of approximately 81% of Scalable's common stock. In addition, NEON has
an option to acquire all of the outstanding shares of

                                       19

<PAGE>

Scalable Software and is currently providing Scalable's primary financing for
its operations. Therefore, NEON determined that it has effective control of
Scalable Software and began accounting for its investment in Scalable Software
using the modified equity method of accounting. Under this method of accounting,
NEON recognizes 100% of Scalable Software's losses to the extent of its advances
made to Scalable Software in excess of the amounts guaranteed by Messrs. Moores,
Woodhill and Woodhill.

RESULTS OF OPERATIONS

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

<TABLE>
<CAPTION>
                                                THREE MONTHS ENDED DECEMBER 31,      NINE MONTHS ENDED DECEMBER 31,
                                                -------------------------------      ------------------------------
                                                  2002                 2001           2002                   2001
                                                  ----                 ----           ----                   ----
<S>                                             <C>                   <C>            <C>                    <C>
   Revenues:
       License                                     47%                   56%            42%                    57%
       Maintenance                                 53                    44             58                     43
                                                  ---                   ---            ---                    ---
          Total revenues                          100                   100            100                    100
    Cost of revenues:
       Cost of licenses                             2                     8              8                     10
       Cost of maintenance                         10                     9             11                      9
                                                  ---                   ---            ---                    ---
          Total cost of revenues                   12                    17             19                     19
                                                  ---                   ---            ---                    ---
    Gross profit                                   88                    83             81                     81
    Operating expenses:
       Sales and marketing                         67                    54             71                     62
       Research and development                    23                    24             31                     28
       General and administrative                  27                    20             28                     24
       Asset write-down charges                     -                     -              -                      5
       Impairment of intangibles                    -                     -              9                      -
       Amortization of acquisition
        related costs                               -                     2              -                      2
       Restructuring costs                          3                     -              2                      6
       Loss on disposals                            -                     -              5                      -
                                                  ---                   ---            ---                    ---
          Total operating expenses                120                   100            146                    127
                                                  ---                   ---            ---                    ---
    Operating loss                                (32)                  (17)           (65)                   (46)
    Interest and other, net                         2                     6              2                      6
    Gain from settlement of lawsuit                 -                     -              -                     57
    Equity loss in affiliate                      (21)                                 (23)                     -
    Valuation allowance on notes receivable         2                   (39)            (3)                   (12)
                                                  ---                   ---            ---                    ---
    Income (loss) before income taxes and
      cumulative effect of change in
      accounting principle                        (49)                  (50)           (89)                     5
    Income tax benefit                              -                     -              -                      1
                                                  ---                   ---            ---                    ---
    Income (loss) before cumulative effect of
       change in accounting principle             (49)                  (50)           (89)                     6
    Cumulative effect of change in
       accounting principle                         -                     -             (7)                     -
                                                  ---                   ---            ---                    ---
    Net income (loss)                             (49)%                 (50)%          (96)%                    6%
                                                  ===                   ===            ====                   ===
</TABLE>

THREE MONTHS ENDED DECEMBER 31, 2002 COMPARED TO THREE MONTHS ENDED DECEMBER 31,
2001

REVENUES

     License revenues for the three months ended December 31, 2002 were $2.3
million, a decrease of $538,000 from $2.9 million for the three months ended
December 31, 2001. The reduction in license revenue was primarily due to an
overall weakness in the mainframe software market, the divestiture of our
Enterprise Subsystem Management product distributor relationship with PBTC in
August 2002, and the restructuring of our iWave division, resulting in a
decrease in the amount of licenses sold.

     Maintenance revenues for the three months ended December 31, 2002 were $2.6
million, an increase of $350,000 from $2.2 million for the three months ended
December 31, 2001. The increase primarily resulted from increases in maintenance
renewal fees reflected as a percentage of current license fees, as well as
growth of NEON's cumulative installed customer base.

COST OF REVENUES

     Cost of license revenues primarily consist of amortization charges
associated with acquired product technology, royalty

                                       20

<PAGE>

payments to third parties, as well as other direct product costs such as product
manuals and distribution and media costs associated with NEON's software
products. Cost of license revenues for the three months ended December 31, 2002
were $105,000, or 5% of license revenues, as compared to $396,000, or 14% of
license revenues, for the three months ended December 31, 2001. The decrease in
cost of license revenues as a percentage of license revenue was primarily due to
lower product royalty payments associated with the termination of the PBTC
distribution agreement in August 2002 (see "Related Party Transactions").

     Cost of maintenance revenues includes personnel and other customer support
costs. Cost of maintenance revenues for the three months ended December 31, 2002
represented $475,000, or 19% of maintenance revenues for the three months ended
December 31, 2002, as compared to $464,000, or 21% of maintenance revenues, for
the three months ended December 31, 2001.

OPERATING EXPENSES

     Sales and marketing expenses include personnel costs, sales commissions and
travel expenses of sales, presales support and marketing personnel, along with
trade show participation and other promotional expenses. Sales and marketing
expenses for the three months ended December 31, 2002 and 2001 were $3.3 million
and $2.7 million, respectively. Sales and marketing expenses increased $546,000
as NEON continues to expand its sales channels and global footprint.

     Research and development expenses primarily include personnel costs
associated with NEON's product development staff. Research and development
expenses for the three months ended December 31, 2002 and 2001 were consistent
at approximately $1.2 million. Research and development may increase as NEON
continues to expand its existing product lines and develop new products.

     General and administrative expenses include personnel and other costs
associated with NEON's executive, financial, legal and administrative functions.
General and administrative expenses for the three months ended December 31, 2002
were $1.3 million, an increase of $317,000 from $1.0 million for the three
months ended December 31, 2001. The increase was primarily related to greater
compensation costs associated with the transition of new executive management.

     NEON incurred restructuring charges of $128,000 during the three months
ended December 31, 2002 related to a reduction in force as a result of reducing
the scope of the iWave product operations.

     Interest and other income for the three months ended December 31, 2002 was
$79,000 as compared to $288,000 for the three months ended December 31, 2001.
The reduction in interest income was due to lower available cash balances
combined with a decline in interest rates.

     As previously discussed, NEON accounts for its investment in Scalable
Software using the modified equity method of accounting. Under this method, NEON
recognizes 100% of Scalable Software's income or loss to the extent of advances
made in excess of the guaranteed amount. For the three months ended December 31,
2002 NEON recorded an equity loss of $1.0 million. NEON records the note
receivable from Scalable at the guaranteed amount. During the three months ended
December 31, 2002, NEON reduced the valuation against the note by $105,000 to
increase the carrying value of the note to the guaranteed amount of $3.5
million. See "Related Party Transactions" and Note 7 to NEON's financial
statements.

     No provision for income taxes was recorded for the three months ended
December 31, 2002 as NEON had pre-tax losses of $2.4million. As of March 31,
2002 NEON had a net operating loss carry-forward for income tax purposes of
approximately $5.4 million that is available to offset future taxable income, if
any. The net operating loss carry-forwards in the United Kingdom, Germany and
Australia carry forward indefinitely. The net operating loss carry-forward for
the United States begins expiring in the tax year 2020. Given the recent tax
losses experienced by NEON, there can be no assurance that operations will
generate taxable income in the future to utilize these losses, therefore, as of
December 31, 2002, NEON has recorded a full valuation allowance for the deferred
tax assets related to the future benefits, if any, for these loss
carry-forwards.

                                       21

<PAGE>

NINE MONTHS ENDED DECEMBER 31, 2002 COMPARED TO NINE MONTHS ENDED DECEMBER 31,
2001

REVENUES

     License revenues for the nine months ended December 31, 2002 were $5.8
million, a decrease of $3.4 million from $9.2 million for the nine months ended
December 31, 2001. The reduction in license revenue was primarily due to the
expiration of a two-year software distribution agreement with BMC Software
entered into in October 1999, in connection with NEON's settlement of a lawsuit
originally filed by BMC Software. NEON recognized $2.2 million in license
revenue for the nine-month period ended December 31, 2001 under the BMC
distribution agreement. The final payment under the BMC distribution agreement
occurred in the fiscal quarter ended September 30, 2001. The decline in license
revenue was also due to the termination of the Enterprise Subsystem Management
product division in August 2002 as well as the reduction in scope of the
operations of the iWave product division and the overall weakness in the
mainframe software market.

     Maintenance revenues for the nine months ended December 31, 2002 were $8.0
million, an increase of $1.1 million from $6.9 million for the nine months ended
December 31, 2001. The increase primarily resulted from annual increases in
maintenance renewal fees reflected as a percentage of current license fees and
growth of NEON's cumulative installed customer base.

COST OF REVENUES

     Cost of license revenues primarily consists of amortization charges
associated with acquired product technology, royalty payments to third parties,
as well as other direct product costs such as product manuals and distribution
and media costs associated with NEON's software products. Cost of license
revenues for the nine months ended December 31, 2002 were $1.1, or 19% of
license revenues, as compared to $1.5 million, or 16% of license revenues, for
the nine months ended December 31, 2001. The increase in cost of license
revenues as a percentage of license revenue was primarily due to lower license
revenue as amortization charges for purchased product technology were consistent
between both periods. Excluding amortization charges, cost of license revenues
as a percentage of total revenues decreased due to lower product royalty
payments associated with the termination of the PBTC distribution agreement in
August 2002, see "Related Party Transactions."

     Cost of maintenance revenues includes personnel and other customer support
costs. Cost of maintenance revenues for the nine months ended December 31, 2002
were $1.5 million, or 19% of maintenance revenues, as compared to $1.5 million,
or 22% of maintenance revenues, for the nine months ended December 31, 2001. The
decrease in cost of maintenance revenue as a percentage of maintenance revenue
was due to the cumulative growth in NEON's customer base and annual increases in
maintenance fees.

OPERATING EXPENSES

     Sales and marketing expenses include personnel costs, sales commissions and
travel expenses of sales, presales support and marketing personnel, along with
trade show participation and other promotional expenses. Sales and marketing
expenses for the nine months ended December 31, 2002 were $9.8 million, a
decrease of $270,000 from $10.0 million for the nine months ended December 31,
2001. The reduction was primarily due to lower personnel costs associated with
the divesture of NEON's Enterprise Subsystem Management product division and the
downsizing of its iWave division. On January 15, 2002, NEON reduced its direct
sales operation in a headcount reduction-in-force of its Shadow North American
sales division.

     Research and development expenses primarily include personnel costs
associated with NEON's product development staff. Research and development
expenses for the nine months ended December 31, 2002 were $4.3 million, a
decrease of $186,000 from $4.5 million for the nine months ended December 31,
2001. The decrease was primarily attributed to the reduction in scope of NEON's
iWave product operations, which resulted in the closure of its North Carolina
facility in June 2001. This reduction was partially offset by contract
development fees paid to Sheer Genius Software, Inc., see "Related Party
Transactions." Research and development may increase as NEON continues to expand
its existing product lines and develop new products.

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<PAGE>

     General and administrative expenses include personnel and other costs
associated with NEON's executive, financial, legal and administrative functions.
General and administrative expenses for the nine months ended December 31, 2002
and December 31, 2001 were $3.9 million. Excluding severance costs of $1.1
million related to the departure of certain executives during the three months
ended June 30, 2001, general and administrative expenses increased by $1.1
million. The increase was primarily related to greater compensation costs
associated with the transition of new executive management, including severance,
recruiting and relocation costs, as well as the reclassification of certain IT
infrastructure expenses.

     NEON recorded non-cash charges of $887,000 during the nine months ended
December 31, 2001 related to the write-down of pre-paid royalties and other
assets.

     During the nine months ended December 31, 2002, NEON performed impairment
tests on its intangible assets related to the intellectual property acquired
from Sterling Software in October 2000. In September 2002, NEON adjusted the
estimated future cash flows attributable to these assets due to lower than
expected operating performance and changes in the future operating strategies
related to this product. As a result, NEON determined that the carrying value of
the intangibles was impaired. NEON recorded impairment charges of $1.3 million
in September 2002, related to intellectual property acquired from Sterling
Software. See Note 9 to NEON's financial statements.

     NEON incurred restructuring charges of $261,000 during the nine months
ended December 31, 2002. This represents $271,000 related to the termination of
NEON's distribution agreement with PBTC and $128,000 related to reducing the
scope of the iWave product operations. The charges primarily represented
non-cash stock compensation costs resulting from the extension of stock options
for severed employees. This amount was offset by a $138,000 reduction to an
outstanding restructuring accrual for abandoned facilities, as those facilities
were subleased during the period. During the nine-month period ended December
31, 2001, NEON recorded a restructuring charge of $908,000. These charges
related to reductions in the Company's cost structure and corporate
reorganization, including reductions in force resulting in severance charges of
$570,000 and losses from lease commitments of $338,000 due to the abandonment of
certain leased facilities.

     Interest and other income for the nine months ended December 31, 2002 was
$333,000 as compared to $1.0 million for the nine months ended December 31,
2001. The reduction in interest income was due to lower available cash balances
combined with a decline in interest rates.

     During the nine months ending December 31, 2001, NEON resolved its
trademark litigation with New Era of Networks, and as a result NEON received a
cash payment of approximately $9.3 million, net of attorney fees.

     As previously discussed, NEON accounts for its investment in Scalable
Software using the modified equity method of accounting. Under this method, NEON
recognizes 100% of Scalable Software's income or loss to the extent of advances
made in excess of the guaranteed amount. For the nine months ended December 31,
2002 NEON recorded an equity loss of $3.2 million. NEON also recorded a
valuation allowance of $378,000 during the nine months ended December 31, 2002
against the Scalable note receivable to write-down the outstanding balance of
the note to the guaranteed amount. See "Related Party Transactions" and Note 7
to NEON's financial statements.

     No provision for income taxes was recorded for the nine months ended
December 31, 2002 as NEON had pre-tax losses of $12.2 million. A tax benefit of
$143,000 or 17% of pre-tax loss was recorded for the nine months ending December
31, 2001. As of March 31, 2002 NEON had a net operating loss carry-forward for
income tax purposes of approximately $5.4 million that is available to offset
future taxable income, if any. The net operating loss carry-forwards in the
United Kingdom, Germany and Australia carry forward indefinitely. The net
operating loss carry-forward for the United States begins expiring in the tax
year 2020. Given the recent tax losses experienced by NEON, there can be no
assurance that the operations will generate taxable income in the future to
utilize these losses, therefore, as of December 31, 2002, NEON has recorded a
full valuation allowance for the deferred tax assets related to the future
benefits, if any, for these loss carryforwards.

     Under the transition provision of SFAS No. 142, NEON tested the goodwill
balances associated with the September 1999 acquisition of Beyond Software, Inc.
("BSI") for impairment by comparing the fair value of BSI to its carrying value.
Fair value was determined after considering changes in operational strategies
and plans, as well as assumptions regarding the potential future cash flows from
the acquired assets. As a result, NEON determined that the carrying value of the
goodwill related to the BSI acquisition had been impaired by $1.0 million, which
is shown as a cumulative effect of a change in accounting principle as of April
1, 2002. This impairment charge resulted in a net carrying value of $150,000 at
December 31, 2002.

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<PAGE>

LIQUIDITY AND CAPITAL RESOURCES

     NEON's cash and cash equivalents at December 31, 2002 were $20.3 million, a
decline of $14.2 million from $34.5 million at March 31, 2002. This decrease was
due primarily to a net operating loss of $9.0 million for the nine months ended
December 31, 2002, and advances on a note receivable to PBTC of $2.2 million and
advances to Scalable Software, Inc. of $3.4 million (see "Related Party
Transactions").

     Net cash used in operating activities for the nine months ended December
31, 2002 was $8.4 million and was primarily due to NEON's net operating losses.
For the nine months ended December 31, 2001 net cash provided by operating
activities was $1.7 million and resulted from NEON's $9.3 million trademark
settlement, net of attorney fees, with New Era of Networks, offset by $7.4
million in operating losses.

     Net cash used in investing activities was $5.9 million and $5.7 million for
the nine months ended December 31, 2002 and 2001, respectively. For the nine
months ended December 31, 2002, net cash used in investing activities represents
advances on a note receivable to Scalable Software of $3.4 million, an advance
on a note receivable to PBTC of $2.2 million and purchases of property and
equipment of $319,000. The principal investing uses in the nine months ended
December 31, 2001 were an advance on a note receivable to Scalable Software of
$4.0 million, an advance on a note receivable to Enterworks Software, Inc. of
$2.0 million, and $577,000 in purchases of property and equipment partially
offset by the maturity of $820,000 in marketable securities. As of December 31,
2002, NEON had no material commitment for capital expenditures. As of December
31, 2002, Scalable had additional funding available of $338,000.

     NEON's net cash provided by financing activities was $29,000 and $100,000
for the nine months ended December 31, 2002 and 2001, respectively. The net cash
provided by financing activities in both periods represents proceeds from the
exercise of employee stock options.

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

New Accounting Pronouncements

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

     Under the transition provision of SFAS No. 142, NEON tested the goodwill
balances associated with the September 1999 acquisition of Beyond Software, Inc.
("BSI") for impairment by comparing the fair value of BSI to its carrying value.
Fair value was determined after considering changes in operational strategies
and plans, as well as assumptions regarding the potential future cash flows from
the acquired assets. As a result, NEON determined that the carrying value of the
goodwill related to the BSI acquisition had been impaired by $1.0 million, which
is shown as a cumulative effect of a change in accounting principle as of April
1, 2002. This impairment charge resulted in a net carrying value of $150,000 at
December 31, 2002.

     NEON adopted SFAS No. 144, "Accounting for the Impairment or Disposal of
Long-Lived Assets," effective April 1, 2002. SFAS No. 144 supersedes SFAS No.
121, "Accounting for the Impairment of Long-Lived Assets and for Long-Lived
Assets to Be Disposed Of," but retains many of its fundamental provisions. SFAS
No. 144 clarifies certain measurement and

                                       24

<PAGE>

classifications issues from SFAS No. 121. In addition, SFAS No. 144 supersedes
the accounting and reporting provisions for the disposal of a business segment
as found in Accounting Principles Board Opinion No. 30, "Reporting the Results
of Operations--Reporting the Effects of Disposal of a Segment of a Business and
Extraordinary, Unusual and Infrequently Occurring Events and Transactions." SFAS
No. 144 retains the basic requirements in APB Opinion No. 30 to separately
report discontinued operations, and broadens the scope of such requirement to
include more types of disposal transactions. The scope of SFAS No. 144 excludes
goodwill. The adoption of SFAS No. 144 did not have a material impact on NEON's
consolidated financial statements.

     In April 2002, the FASB issued SFAS No. 145 "Rescission of FASB Statements
No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections." SFAS No. 145 rescinds FASB Statement No. 4, "Reporting Gains and
Losses from Extinguishment of Debt," and an amendment of that Statement, FASB
Statement No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund
Requirements." SFAS No. 145 also rescinds FASB Statement No. 44, "Accounting for
Intangible Assets of Motor Carriers" and amends FASB Statement No. 13,
"Accounting for Leases." SFAS No. 145 also amends other existing authoritative
pronouncements to make various technical corrections, clarify meanings, or
describe their applicability under changed conditions. SFAS No. 145 will be
effective for the fiscal year beginning April 1, 2003. NEON does not anticipate
that the adoption of SFAS No. 145 will 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 associated with exit or disposal activities
and nullifies EITF Issue 94-3, "Liability Recognition for Certain Employee
Termination Benefit and Other Costs to Exit an Activity (in Certain Costs
Incurred in a Restructuring)." SFAS No. 146 is effective for exit or disposal of
activities that are initiated after December 31, 2002. NEON will adopt the
requirements of SFAS No. 146 as of January 1, 2003.

     In December 2002, the FASB issued SFAS No. 148 "Accounting for Stock-Based
Compensation-Transition and Disclosure, an amendment of FASB Statement No. 123".
SFAS No. 148 amends FASB Statement No. 123, "Accounting for Stock-Based
Compensation," to provide alternative methods of transition for an entity that
voluntarily changes to the fair value based method of accounting for stock-based
employee compensation. It also amends the disclosure provisions of that
Statement to require prominent disclosure about the effects on reported net
income of an entity's accounting policy decisions with respect to stock-based
employee compensation. SFAS No. 148 also amends APB Opinion No. 28, "Interim
Financial Reporting," to require disclosure about those effects in interim
financial information. The revised disclosure requirements of SFAS No. 148 will
be required in the Company's annual report for the year ended March 31, 2003.
Should NEON choose to adopt the fair value based method of accounting provided
for in SFAS No. 123, the alternative methods of transition provided by SFAS No.
148 would be applicable for NEON's year ended March 31, 2003. NEON does not
anticipate that the adoption of SFAS No. 148 will have a material impact on
NEON's consolidated financial statements.

     In November 2002, the FASB issued Interpretation No. 45 "Guarantor's
Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others", an interpretation of FASB Statements No.
5, 57, and 107 and rescission of FASB Interpretation No. 34. This interpretation
clarifies the requirements for a guarantor's accounting for and disclosures of
certain guarantees issued and outstanding. This Interpretation also incorporates
without reconsideration the guidance in FASB Interpretation No. 34 "Disclosure
of Indirect Guarantees of Indebtedness of Others", which is being superseded.
Interpretation No. 45 will be effective for the fiscal year beginning April 1,
2003. NEON does not anticipate that the adoption of FASB Interpretation No. 45
will have a material impact on NEON's consolidated financial statements.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

     The majority of NEON's foreign currency transactions are denominated in the
British pound sterling, which is the functional currency of NEON Systems (UK)
Ltd. As sales contracts are denominated and settled in the functional currency,
risks associated with currency fluctuations are minimized to foreign currency
translation adjustments. NEON does not currently hedge against foreign currency
translation risks and believes that foreign currency exchange risk is not
significant to its operations.

     NEON adheres to a conservative investment policy, whereby its principal
concern is the preservation of liquid funds while maximizing its yield on such
assets. Cash and cash equivalents approximated $20.3 million at December 31,
2002, and were

                                       25

<PAGE>

invested in different types of short-term low-risk securities. NEON believes
that a near-term change in interest rates would not materially affect its
financial position, results of operations or net cash flows for fiscal year
2003.

ITEM 4. CONTROLS AND PROCEDURES

     Within the 90-day period prior to the filing of this report, an evaluation
was carried out under the supervision and with the participation of NEON's
management, including the Chief Executive Officer ("CEO") and Chief Financial
Officer ("CFO"), of the effectiveness of our disclosure controls and procedures.
Based on that evaluation, the CEO and CFO have concluded that NEON's disclosure
controls and procedures were adequately effective to ensure that information
required to be disclosed by NEON in reports it files or submits under the
Securities Exchange Act of 1934 is recorded, processed, summarized and reported
within the time periods specified in the Securities and Exchange Commission
rules and forms.

     Subsequent to the date of their evaluation, there were no significant
changes in NEON's internal controls or in other factors that could significantly
affect these controls, including any corrective actions with regard to
significant deficiencies and material weaknesses.

PART II - OTHER INFORMATION

ITEM 1. LEGAL PROCEEDINGS

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

ITEM 2. SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS - Not applicable.

ITEM 5. OTHER INFORMATION -

FACTORS THAT MAY AFFECT FUTURE RESULTS

RISK FACTORS

     This report on Form 10-Q, including Management's Discussion and Analysis of
Financial Condition and Results of Operations, contains forward-looking
statements and other prospective information relating to future events. These
forward-looking statements and other information are subject to certain risks
and uncertainties that could cause results to differ materially from historical
results or anticipated results, including the following:

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

     Members of our Board of Directors and certain of our executive officers are
shareholders, directors and/or officers in other companies, some of which are
identified and discussed in Management's Discussions and Analysis of Financial
Condition and Results of Operations section on "Related Party Transactions" and
Note 7 to NEON's Condensed Notes to Consolidated Financial Statements herein.
These companies include Peregrine/Bridge Transfer Corporation (now known as NEON
Enterprise Software, Inc.), Scalable Software, Inc. and Sheer Genius Software,
Inc. Such relationships may give rise to conflicts of interest resulting from
the balancing of such officer/director's duties to NEON's stockholders and their
corresponding duties to the stockholders of any company in which they also hold
positions as directors (or officers), especially in the context of business
negotiations between NEON and such other company. In any event where an officer
or director has a conflict of interest, the Board of Directors has reviewed such
conflict and fully discussed the interests of the directors and/or officers
involved. Notwithstanding such procedures, NEON may face the threat of
shareholder claims based solely on the mere appearance of conflicts of interest
in any related party business transaction. In addition, since Mr. Woodhill is
still the Chief Executive Officer and President of Scalable Software, the
failure of NEON to exercise its option to acquire Scalable Software may result
in additional uncertainty with respect to his continued management of NEON,
which uncertainty could materially adversely affect our business, operating
results and financial condition.

                                       26

<PAGE>

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

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

     Our future operating results may vary significantly from quarter to quarter
due to a variety of factors, many of which are outside our control. In addition,
the amount of revenues associated with sales of our software can vary
significantly. Therefore, it is likely that in one or more future quarters our
results may fall below the expectations of securities analysts and investors.
Further, we believe that period-to-period comparisons of our operating results
are not necessarily a meaningful indication of future performance. If our
quarterly results do not meet investors' expectations, the trading price of our
common stock will likely decline.

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

     Historically, our revenues have tended to be strongest in the third and
fourth quarters of our fiscal year and to decrease slightly in our first fiscal
quarter. The expectations of investors who rely on our third or fourth quarter
results in a given year may be adversely impacted if this seasonal trend
continues. We believe that our seasonality is due in part to the calendar year
budgeting cycles of many of our customers, our employee recognition policies
which tend to reward our sales personnel for achieving fiscal year-end rather
than quarterly revenue quotas, and the timing of our hiring of sales force
personnel. In future periods, we expect that this seasonal trend will continue
to cause first fiscal quarter license revenues to decrease from the level
achieved in the preceding quarter. Also, the majority of sales close in the last
few days of every quarter, which may result in significant fluctuations of
revenues that the company cannot predict.

Because A Significant Percentage Of Our Revenues Are Derived From Our Shadow
Product Line, Decreased Demand For These Products Could Adversely Affect Our
Business

     The Shadow product line represented 88%, 75%, and 86% of our revenues in
fiscal 2000, 2001 and 2002, respectively. We anticipate that these products will
account for a substantial amount of our revenues for the foreseeable future.
Consequently, our future success will depend on continued market acceptance of
the Shadow product line and enhancements to these products. Competition,
technological change or other factors could reduce demand for, or market
acceptance of, these products and could have a material adverse effect on our
business, operating results and financial condition.

The Availability Of Significant Amounts Of Our Common Stock For Sale Could
Adversely Affect Its Market Price

     If our stockholders sell substantial amounts of our common stock in the
public market, the market price of our common stock could fall. A substantial
number of sales, or the perception that such sales might occur, also might make
it more difficult for us to sell equity or equity-related securities in the
future at a time and price that we deem appropriate. We granted registration
rights to two of our stockholders, Peter Schaeffer and JMI Equity Fund, L.P.
Those rights enabled these stockholders to require that we register, at NEON's
expense, resales of their shares of common stock. Mr. Schaeffer and the
individuals and entities to which JMI Equity Fund, L.P. has distributed its
shares of our common stock beneficially own, in the aggregate, approximately 4.3
million shares, or approximately 50%, of our common stock. If they sell a large
portion of their shares on the open market and at one time, our market price per
share may decline.

Reduced Customer Reliance Upon Mainframe Computers Could Adversely Affect Our
Business

     We are dependent upon the continued use and acceptance of mainframe
computers in a computing environment increasingly based on distributed
platforms, including client/server and Internet-based computing networks.
Decreased use of the mainframe or reduced demand for Web-based and client/server
applications accessing mainframe data and transactions could have a material
adverse effect on our business, operating results and financial condition. We
derive our revenues primarily from our Shadow products. Our continued success
depends on a number of factors, including:

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

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<PAGE>

     Lack of growth in business demands for access to the data, applications and
     transactions residing on mainframe computers from Web-based and
     client/server applications could have a material adverse effect on our
     business operating results and financial condition.

..    We May Lose Market Share And Be Required To Reduce Prices As A Result Of
     Competition From Our Existing Competitors, Other Vendors And Information
     Systems Departments Of Customers

     We compete in markets that are intensely competitive and feature rapidly
     changing technology and evolving standards. Our competitors may be able to
     respond more quickly than we can to new or emerging technologies and
     changes in customer requirements. Competitive pressures could reduce our
     market share or require us to reduce the price of our products, either of
     which could have a material adverse effect on our business, operating
     results and financial condition.

..    Rapid Technological Change Could Render Our Products Obsolete

     Our markets are characterized by rapid technological change, frequent new
     product introductions and enhancements, uncertain product life cycles,
     changes in customer requirements and evolving industry standards. The
     introduction of new products embodying new technologies and the emergence
     of new industry standards could render our existing products obsolete which
     would have a material adverse effect on our business, operating results and
     financial condition. Our future success will depend upon our ability to
     continue to develop and introduce a variety of new products and product
     enhancements to address the increasingly sophisticated needs of our
     customers. We may experience delays in releasing new products and product
     enhancements in the future. Material delays in introducing new products or
     product enhancements may cause customers to forego purchases of our
     products and purchase those of our competitors.

..    We May Be Unable To Enforce Or Defend Our Ownership And Use Of Proprietary
     Technology

     Our success depends to a significant degree upon our proprietary
     technology. We rely on a combination of trademark, trade secret and
     copyright law, and contractual restrictions and passwords to protect our
     proprietary technology. However, these measures provide only limited
     protection, and we may not be able to detect unauthorized use or take
     appropriate steps to enforce our intellectual property rights, particularly
     in foreign countries where the laws may not protect our proprietary rights
     as fully as in the United States. Companies in the software industry have
     experienced substantial litigation regarding intellectual property. Any
     litigation to enforce our intellectual property rights would be expensive
     and time-consuming, would divert management resources and may not be
     adequate to protect our business.

     We could be subject to claims that we have infringed the intellectual
     property rights of others. In addition, we may be required to indemnify our
     distribution partners and end-users for similar claims made against them.
     Any claims against us could require us to spend significant time and money
     in litigation, pay damages, develop new intellectual property or acquire
     licenses to intellectual property that is the subject of the infringement
     claims. These licenses, if required, may not be available on acceptable
     terms. As a result, intellectual property claims against us could have a
     material adverse effect on our business, operating results and financial
     condition.

..    Loss Of Code-Sharing Or Distributor Rights Could Divert Our Resources From
     New Product Development

     We have code-sharing arrangements with third parties under which we have
     obtained and used some source code in the development of some of our
     software products. If any of these agreements are terminated, we could be
     required to discontinue our use of the acquired code, and we would have to
     spend time and software development resources to replace that code. Any
     diversion of these resources could delay our development of new products or
     product enhancements.

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

     Our software products and the software products that we sell for others are
     complex and may contain undetected errors. These undetected errors could
     result in adverse publicity, loss of revenues, delay in market acceptance
     or claims against us by customers, all of which could have a material
     adverse effect on our business, operating results and financial condition.
     Despite testing, we cannot be certain that errors will not be found in our
     products. Liability

                                       28

<PAGE>

     claims could require us to spend significant time and money in litigation
     or to pay significant damages. As a result, any such claims, whether or not
     successful, could have a material adverse effect on our reputation and
     business, operating results and financial condition.

Our Officers And Directors Control NEON, And These Officers And Directors Could
Control Matters Submitted To Our Stockholders

    At present, our executive officers and directors and entities affiliated
with them beneficially own approximately 54.0% of our outstanding common stock.
As a result, these stockholders, if they act together, could control most
matters submitted to our stockholders for a vote, including the election of
directors.

Provisions Of Our Charter And Bylaws And Delaware Law Could Deter Takeover
Attempts

    Provisions of our Certificate of Incorporation and Bylaws as well as
Delaware law could make it more difficult for a third party to acquire us, even
if doing so would be beneficial to our stockholders. We are subject to the
provisions of Delaware law, which restrict certain business combinations with
interested stockholders, which may have the effect of inhibiting a
non-negotiated merger or other business combinations.

ITEM 6.   EXHIBITS AND REPORTS ON FORM 8-K

          (a)  EXHIBITS

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

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

               99.3 Certification of Louis R. Woodhill, Chief Executive Officer
                    of NEON Systems, Inc. pursuant to Section 302 of the
                    Sarbanes-Oxley Act of 2002.

               99.4 Certification of Brian D. Helman, Chief Financial Officer of
                    NEON Systems, Inc. pursuant to Section 302 of the
                    Sarbanes-Oxley Act of 2002.

          (b)  REPORTS ON FORM 8-K

               During the quarter ended December 31, 2002, NEON filed a Current
               Report on Form 8-K dated December 5, 2002. Items 5 and 7 were
               reported and no financial statements were filed.

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<PAGE>

                                   SIGNATURES

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

                                                NEON SYSTEMS, INC.

Date:  February 12, 2003                        /s/ Brian D. Helman
                                                --------------------------
                                                Chief Financial Officer
                                                (Principal financial officer)