**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**Form 10-Q**

 

**(Mark One)**

 

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

 

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

 

## **OR**

 

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

** **

**For the transition period from                     to                    **

 

**Commission File Number: 0-25457**

 

**NEON Systems, Inc.**

(Exact name of Registrant as specified in itscharter)

 

| **Delaware**                                                     | ** ** | **76-0345839**                      |
|------------------------------------------------------------------|------------|-------------------------------------|
| (State or other jurisdiction of                                  |       | (I.R.S.Employer Identification No.) |
| incorporation or organization)                                   |       |                                |
| ** **                                                       | ** ** | ** **                          |
| **14100  Southwest Freeway, Suite 500,**

**Sugar  Land, Texas** |       | **77478**                           |
| (Address of principal executive offices)                         |       | (zip code)                          |

 

**(281) 491-4200**

(Registrant’s telephone number, including areacode)

 

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

 

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

 

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

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

(Title of Class)

 

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

 

The number of shares of theregistrant’s common stock outstanding as of July 31, 2005, was 9,558,198.

 

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

Yes  o No ý

 

 

----

 

NEON SYSTEMS, INC.

 

FORM 10-Q

 

FOR THE QUARTER ENDED JUNE 30, 2005

 

INDEX

 
| PART I.    | FINANCIAL INFORMATION                                                                       |   |
|------------|---------------------------------------------------------------------------------------------|--------|
|       |                                                                                        |   |
| Item 1.    | Financial Statements                                                                        |   |
|       |                                                                                        |   |
|       | Consolidated Balance Sheets at June 30, 2005 and March  31, 2005                            |   |
|       |                                                                                        |   |
|       | Consolidated Statements of Operations for the Three  Months Ended June 30, 2005 and 2004    |   |
|       |                                                                                        |   |
|       | Consolidated Statements of Cash Flows for the Three  Months Ended June 30, 2005 and 2004    |   |
|       |                                                                                        |   |
|       | Condensed Notes to Consolidated Financial Statements                                        |   |
|       |                                                                                        |   |
| Item 2.    | Management’s Discussion and  Analysis of Financial Condition and Results of Operations |   |
|       |                                                                                        |   |
| Item 3.    | Quantitative and Qualitative  Disclosures About Market Risk                                 |   |
|       |                                                                                        |   |
| Item 4.    | Controls and Procedures                                                                     |   |
|       |                                                                                        |   |
| PART II.   | OTHER INFORMATION                                                                           |   |
|       |                                                                                        |   |
| Item 1.    | Legal Proceedings                                                                           |   |
|       |                                                                                        |   |
| Item 2.    | Unregistered Sales of Equity Securities  and Use of Proceeds                                |   |
|       |                                                                                        |   |
| Item 3.    | Defaults Upon Senior Securities                                                             |   |
|       |                                                                                        |   |
| Item 4.    | Submission of Matters to a  Vote of Security Holders                                        |   |
|       |                                                                                        |   |
| Item 5.    | Other Information                                                                           |   |
|       |                                                                                        |   |
| SIGNATURES |                                                                                        |

 

2

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PART I - FINANCIAL INFORMATION

 

ITEM 1. FINANCIAL STATEMENTS

 

NEON SYSTEMS, INC. ANDSUBSIDIARIESCONSOLIDATED BALANCE SHEETS(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)

 
| ** **                                                                                                                                                            | ** ** | **JUNE 30, 2005** | ** ** | **MARCH 31, 2005** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-------------------|------------|--------------------|------------|
| ** **                                                                                                                                                            | ** ** | **(UNAUDITED)**   | ** ** | ** **         | ** ** |
| ASSETS                                                                                                                                                                |       |              |       |               |       |
|                                                                                                                                                                  |       |              |       |               |       |
| CURRENT ASSETS:                                                                                                                                                       |       |              |       |               |       |
| Cash and cash equivalents                                                                                                                                             |       | $                 | 17,317     |               | $          | 13,317 |   |
| Accounts receivable, net                                                                                                                                              |       | 1,840             |       | 5,056              |       |
| Notes receivable, net (Note 8)                                                                                                                                        |       | —            |       | 4,260              |       |
| Prepaid and other current  assets                                                                                                                                     |       | 1,107             |       | 1,112              |       |
| Total current assets                                                                                                                                                  |       | 20,264            |       | 23,745             |       |
|                                                                                                                                                                  |       |              |       |               |       |
| Property and equipment, net                                                                                                                                           |       | 688               |       | 725                |       |
| Acquired intangibles, net                                                                                                                                             |       | 7,917             |       | 8,386              |       |
| Goodwill                                                                                                                                                              |       | 9,594             |       | 9,594              |       |
| Other assets                                                                                                                                                          |       | 527               |       | 550                |       |
| Total assets                                                                                                                                                          |       | $                 | 38,990     |               | $          | 43,000 |   |
|                                                                                                                                                                  |       |              |       |               |       |
| LIABILITIES & STOCKHOLDERS’  EQUITY                                                                                                                          |       |              |       |               |       |
|                                                                                                                                                                  |       |              |       |               |       |
| CURRENT LIABILITIES:                                                                                                                                                  |       |              |       |               |       |
| Accounts payable and accrued  liabilities                                                                                                                             |       | $                 | 1,561      |               | $          | 3,359 |   |
| Deferred revenue                                                                                                                                                      |       | 6,816             |       | 7,485              |       |
| Total current liabilities                                                                                                                                             |       | 8,377             |       | 10,844             |       |
|                                                                                                                                                                  |       |              |       |               |       |
| Non-current Liabilities:                                                                                                                                              |       |              |       |               |       |
| Accrued liabilities                                                                                                                                                   |       | 629               |       | 678                |       |
| Deferred revenue                                                                                                                                                      |       | 3,495             |       | 4,138              |       |
| Deferred income taxes                                                                                                                                                 |       | 488               |       | 493                |       |
| Total liabilities                                                                                                                                                     |       | 12,989            |       | 16,153             |       |
|                                                                                                                                                                  |       |              |       |               |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                            |       |              |       |               |       |
| Preferred stock, $.01 par  value. Authorized 10,000,000 shares; no shares issued and outstanding                                                                      |       | —            |       | —             |       |
| Common stock, $.01 par value.  Authorized 30,000,000 shares; 9,558,198 and 9,499,544 shares issued and  outstanding at June 30, 2005 and March 31, 2005, respectively |       | 105               |       | 104                |       |
| Additional paid-in capital                                                                                                                                            |       | 54,829            |       | 54,708             |       |
| Treasury Stock, 913,400 shares  at cost                                                                                                                               |       | (2,649            | )          | (2,649             | )          |
| Accumulated other  comprehensive loss                                                                                                                                 |       | (385              | )          | (418               | )          |
| Accumulated deficit                                                                                                                                                   |       | (25,899           | )          | (24,898            | )          |
| Total stockholders’ equity                                                                                                                                       |       | 26,001            |       | 26,847             |       |
| Commitments and contingencies  (Note 6)                                                                                                                               |       |              |       |               |       |
|                                                                                                                                                                  |       |              |       |               |       |
| Total liabilities and  stockholders’ equity                                                                                                                      |       | $                 | 38,990     |               | $          | 43,000 |   |

 

SEE ACCOMPANYING CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

3

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NEON SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

(UNAUDITED)

 
| ** **                                 | ** ** | **THREE MONTHS ENDED JUNE 30,** | ** ** |
|--------------------------------------------|------------|---------------------------------|------------|
| ** **                                 | ** ** | **2005**                        | ** ** | **2004** | ** ** |
| Revenues:                                  |       |                            |       |   |   |
| License                                    |       | $                               | 986        |   | $ | 1,103 |   |
| Maintenance                                |       | 3,020                           |       | 2,420 |   |
| Service                                    |       | 286                             |       | 48 |   |
| Total revenues                             |       | 4,292                           |       | 3,571 |   |
|                                       |       |                            |       |   |   |
| Cost of revenues:                          |       |                            |       |   |   |
| Cost of license                            |       | 476                             |       | 32 |   |
| Cost of maintenance                        |       | 311                             |       | 364 |   |
| Cost of service                            |       | 106                             |       | — |   |
| Total cost of revenues                     |       | 893                             |       | 396 |   |
|                                       |       |                            |       |   |   |
| Gross profit                               |       | 3,399                           |       | 3,175 |   |
|                                       |       |                            |       |   |   |
| Operating expenses:                        |       |                            |       |   |   |
| Sales and marketing                        |       | 2,167                           |       | 1,555 |   |
| Research and development                   |       | 1,359                           |       | 983 |   |
| General and administrative                 |       | 1,094                           |       | 930 |   |
| Total operating expenses                   |       | 4,620                           |       | 3,468 |   |
|                                       |       |                            |       |   |   |
| Operating loss                             |       | (1,221                          | )          | (293 | ) |
|                                       |       |                            |       |   |   |
| Gain on sale of notes  receivable          |       | 86                              |       | 1,215 |   |
| Interest and other income, net             |       | 147                             |       | 45 |   |
|                                       |       |                            |       |   |   |
| Income (loss) before income  taxes         |       | (988                            | )          | 967 |   |
| Income taxes                               |       | 13                              |       | — |   |
| Net income (loss)                          |       | $                               | (1,001     | ) | $ | 967 |   |
|                                       |       |                            |       |   |   |
| Earnings per common share —  basic:   |       |                            |       |   |   |
| Net income (loss)                          |       | $                               | (0.11      | ) | $ | 0.11 |   |
|                                       |       |                            |       |   |   |
| Earnings per common share —  diluted: |       |                            |       |   |   |
| Net income (loss)                          |       | $                               | (0.11      | ) | $ | 0.10 |   |
|                                       |       |                            |       |   |   |
| Weighted average shares  outstanding:      |       |                            |       |   |   |
| Basic                                      |       | 9,510                           |       | 8,915 |   |
| Diluted                                    |       | 9,510                           |       | 9,379 |   |

 

SEEACCOMPANYING CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

4

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NEON SYSTEMS, INC. ANDSUBSIDIARIESCONSOLIDATED STATEMENTSOF CASH FLOWS(IN THOUSANDS)

(UNAUDITED)

 
| ** **                                                                                 | ** ** | **THREE MONTHS ENDED JUNE 30,** | ** ** |
|--------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                 | ** ** | **2005**                        | ** ** | **2004** | ** ** |
| CASH FLOWS FROM OPERATING  ACTIVITIES:                                                     |       |                            |       |   |   |
| Net income (loss)                                                                          |       | $                               | (1,001     | ) | $ | 967 |   |
| Adjustments to reconcile net  loss to net cash provided by (used in) operating activities: |       |                            |       |   |   |
| Depreciation                                                                               |       | 99                              |       | 131 |   |
| Amortization of acquired  intangibles                                                      |       | 469                             |       | — |   |
| Gain on sale of notes  receivable                                                          |       | (86                             | )          | (1,215 | ) |
| Gain on sale of assets                                                                     |       | (41                             | )          | — |   |
| Deferred tax expense                                                                       |       | 13                              |       | — |   |
| Increase (decrease) in cash  resulting from changes in:                                    |       |                            |       |   |   |
| Accounts receivable                                                                        |       | 3,166                           |       | 3,641 |   |
| Prepaid and other assets                                                                   |       | (5                              | )          | (66 | ) |
| Accounts payable and accrued  liabilities                                                  |       | (1,762                          | )          | (1,391 | ) |
| Deferred revenue and other                                                                 |       | (1,172                          | )          | (593 | ) |
|                                                                                       |       |                            |       |   |   |
| Net cash provided by (used in)  operating activities                                       |       | (320                            | )          | 1,474 |   |
|                                                                                       |       |                            |       |   |   |
| CASH FLOWS FROM INVESTING  ACTIVITIES:                                                     |       |                            |       |   |   |
| Purchases of furniture and  equipment                                                      |       | (61                             | )          | (169 | ) |
| Purchase of technology                                                                     |       | —                          |       | (264 | ) |
| Acquisitions, net of cash  acquired                                                        |       | —                          |       | (172 | ) |
| Proceeds from sale of notes  receivable, net                                               |       | 4,346                           |       | 4,715 |   |
| Other investment costs                                                                     |       | (41                             | )          | — |   |
|                                                                                       |       |                            |       |   |   |
| Net cash provided by investing  activities                                                 |       | 4,244                           |       | 4,110 |   |
|                                                                                       |       |                            |       |   |   |
| CASH FLOWS FROM FINANCING  ACTIVITIES:                                                     |       |                            |       |   |   |
| Proceeds from exercises of  stock options                                                  |       | 122                             |       | 7 |   |
| Net cash provided by financing  activities                                                 |       | 122                             |       | 7 |   |
|                                                                                       |       |                            |       |   |   |
| Net increase in cash and cash  equivalents                                                 |       | 4,046                           |       | 5,591 |   |
| Effect of exchange rates on  cash                                                          |       | (46                             | )          | (16 | ) |
| Cash and cash equivalents at  beginning of period                                          |       | 13,317                          |       | 20,899 |   |
|                                                                                       |       |                            |       |   |   |
| Cash and cash equivalents at  end of period                                                |       | $                               | 17,317     |   | $ | 26,474 |   |

 

SEE ACCOMPANYING CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

5

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NEON SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(UNAUDITED)

 

NOTE 1—BASIS OF PRESENTATION

 

The accompanying unauditedconsolidated financial statements for NEON Systems, Inc. and its subsidiaries(collectively, “NEON”) have been prepared in accordance with U.S. generallyaccepted accounting principles for interim financial reporting and inaccordance with Regulation S-X of the Securities and Exchange Commission.Accordingly, they do not include all of the information and footnotes requiredby U.S. generally accepted accounting principles for complete financialstatements. In the opinion of management, the unaudited consolidated financialstatements contained in this report reflect all adjustments, consisting of onlynormal recurring adjustments, considered necessary for a fair presentation ofthe financial position and the results of operations for the interim periodspresented. Operating results for interim periods are not necessarily indicativeof results for the full year. These unaudited consolidated financialstatements, footnote disclosures and other information should be read inconjunction with the financial statements and the notes thereto included inNEON’s audited consolidated financial statements for the fiscal year endedMarch 31, 2005, which are included in NEON’s Form 10-K for the fiscal yearended March 31, 2005.  Certain priorperiod amounts have been reclassified to conform to current periodpresentation.

 

NOTE 2—PER SHARE INFORMATION

 

##### ***Significant Accounting Policy***

 

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

 

Earnings per share:

(*In thousands, except per share date)*

 
| ** **                                          | ** ** | **THREE MONTHS ENDED JUNE 30,** | ** ** |
|-----------------------------------------------------|------------|---------------------------------|------------|
| ** **                                          | ** ** | **2005**                        | ** ** | **2004** | ** ** |
| ** **                                          | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Net income (loss) available for common shareholders |       | $                               | (1,001     | ) | $ | 967 |   |
|                                                |       |                            |       |   |   |
| Weighted average outstanding shares of common stock |       | 9,510                           |       | 8,915 |   |
| Dilutive effect of employee stock options           |       | —                          |       | 464 |   |
| Common stock and common stock equivalents           |       | 9,510                           |       | 9,379 |   |
|                                                |       |                            |       |   |   |
| Earnings per share:                                 |       |                            |       |   |   |
| Basic                                               |       | $                               | (0.11      | ) | $ | 0.11 |   |
| Diluted                                             |       | $                               | (0.11      | ) | $ | 0.10 |   |

 

At June 30, 2005 and 2004, therewere options outstanding to purchase 2.9 million shares and 2.8 million shares,respectively, of common stock with a weighted-average exercise price of $5.39and $6.00, respectively. For the three months ended June 30, 2005 and 2004, 2.9million and 1.4 million, respectively, were excluded from the calculation ofdiluted earnings per share because the effect was anti-dilutive.  Also excluded from the computation ofdiluted earnings per share for the three months ended June 30, 2005 was awarrant to acquire up to 1.1 million shares of NEON common stock at a price of$4.80 per share.  This warrant was issued in conjunction with the acquisitionof ClientSoft, Inc. (ClientSoft).

 

6

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

 

NEON applies the intrinsicvalue-based method of accounting prescribed by Accounting Principles Board (“APB”)Opinion No. 25, *Accounting For Stock IssuedTo Employees*, and related interpretations.  As such, compensation expense has beenrecorded on the date of grant only if the estimated value of the underlyingstock exceeded the exercise price.  SFASNo. 123, *Accounting For Stock-BasedCompensation*, established accounting and disclosure requirementsusing a fair value-based method of accounting for stock-based employeecompensation plans.  Alternatively, SFASNo. 123 allows entities to continue to apply the provisions of APB Opinion No.25 and provide pro forma net income and pro forma earnings per sharedisclosures for employee stock option grants made in 1996 and future years asif the fair-value-based method defined in SFAS No. 123 had been applied.  NEON has elected to continue to apply theprovisions of APB Opinion No. 25 and provide the pro forma disclosureprovisions of SFAS No. 123, as amended by SFAS No. 148, *Accounting for Stock-Based Compensation—Transitionand Disclosure—an amendment of FASB Statement No. 123*.  The following table illustrates the effect onnet income if the fair-value-based method had been applied to all outstandingand unvested awards in each period (in thousands, except per share data):

 
| ** **                                                                                                       | ** ** | **THREE MONTHS ENDED JUNE 30,** | ** ** |
|------------------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|
| ** **                                                                                                       | ** ** | **2005**                        | ** ** | **2004** | ** ** |
| ** **                                                                                                       | ** ** | ** **                      | ** ** | ** ** | ** ** |
| Net income (loss) as reported                                                                                    |       | $                               | (1,001     | ) | $ | 967 |   |
| Deduct total stock-based  employee compensation expense determined under fair-value-based method for  all awards |       | (331                            | )          | (385 | ) |
| Pro forma net income (loss)                                                                                      |       | $                               | (1,332     | ) | $ | 582 |   |
|                                                                                                             |       |                            |       |   |   |
| Basic earnings (loss) per share:                                                                                 |       |                            |       |   |   |
| As reported                                                                                                      |       | $                               | (0.11      | ) | $ | 0.11 |   |
| Pro forma                                                                                                        |       | $                               | (0.14      | ) | $ | 0.07 |   |
|                                                                                                             |       |                            |       |   |   |
| Diluted earnings (loss) per  share:                                                                              |       |                            |       |   |   |
| As reported                                                                                                      |       | $                               | (0.11      | ) | $ | 0.10 |   |
| Pro forma                                                                                                        |       | $                               | (0.14      | ) | $ | 0.06 |   |

 

NOTE 3—INCOME TAXES

 

As of March 31, 2005, NEON has anet operating loss carry-forward for income tax purposes of $23.6 million thatis available to offset future taxable income, if any. The estimated netoperating loss carry-forward consists of $19.8 million in the United States,$1.4 million in the United Kingdom, $600,000 in Canada and $1.7 million inGermany. The net operating loss carry-forwards in the United Kingdom andGermany carry forward indefinitely. The net operating loss carry-forwards forthe United States and Canada begin expiring in 2020 and 2008, respectively.  Additionally, NEON has a United States losscarryforward of $4.8 million available to offset future capital gains.

 

In assessing the realizabilityof net deferred tax assets in each taxation jurisdiction, management considerswhether it is more likely than not that some portion or all of the deferred taxassets will not be realized.  Thisassessment may result in recording a valuation allowance.  Due to the Company’s history of operatinglosses, as of June 30, 2005 and 2004, management determined that it was notmore likely than not that the Company would be able to realize the benefits ofits net deferred tax assets in the United States, the United Kingdom andGermany. Therefore, management has recorded a valuation allowance to fullyreserve the net deferred tax assets in these countries.

 

As of June 30, 2005, NEON hasdeferred tax assets and liabilities related primarily to net operating losscarryforwards in Canada, as well as deductible goodwill and non-deductible acquiredintangibles resulting from the acquisitions of businesses in the U.S. andCanada.  The deferred tax expense of $13,000for the three months ended June 30, 2005 relates primarily to changes in thesebalances.  At June 30, 2004 NEON had no suchdeferred tax balances.

 

7

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NOTE 4—SEGMENT REPORTING

 

NEON considers its businessactivities to be in a single segment. NEON did not have any customers, individually or in aggregate thataccounted for 10% or more of consolidated revenue during the three-monthperiods ended June 30, 2005 and June 30, 2004.

 

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

 
| ** **               | ** ** | **THREE MONTHS ENDED JUNE 30,** | ** ** |
|--------------------------|------------|---------------------------------|------------|
| ** **               | ** ** | **2005**                        | ** ** | **2004** | ** ** |
| Revenues:                |       |                            |       |   |   |
| North America            |       | $                               | 3,511      |   | $ | 2,551 |   |
| United Kingdom           |       | 767                             |       | 928 |   |
| Other                    |       | 14                              |       | 92 |   |
|                     |       | $                               | 4,292      |   | $ | 3,571 |   |
|                     |       |                            |       |   |   |
| Operating income (loss): |       |                            |       |   |   |
| North America            |       | $                               | (1,373     | ) | $ | (574 | ) |
| United Kingdom           |       | 138                             |       | 313 |   |
| Other                    |       | 14                              |       | (32 | ) |
|                     |       | $                               | (1,221     | ) | $ | (293 | ) |
|                     |       |                            |       |   |   |
|                     |       | **JUNE 30, 2005**               | ** ** | **MARCH 31, 2005** |   |
| Identifiable Assets:     |       |                            |       |   |   |
| North America            |       | $                               | 18,405     |   | $ | 18,916 |   |
| United Kingdom           |       | 321                             |       | 339 |   |
|                     |       | $                               | 18,726     |   | $ | 19,255 |   |

 

NOTE 5—COMPREHENSIVE INCOME

 

The components ofcomprehensive income (loss) are as follows (in thousands):

 
| ** **                               | ** ** | **THREE MONTHS ENDED JUNE 30,** | ** ** |
|------------------------------------------|------------|---------------------------------|------------|
| ** **                               | ** ** | **2005**                        | ** ** | **2004** | ** ** |
| Net income (loss)                        |       | $                               | (1,001     | ) | $ | 967 |   |
|                                     |       |                            |       |   |   |
| Other comprehensive income:              |       |                            |       |   |   |
| Foreign currency translation  adjustment |       | 33                              |       | (2 | ) |
| Comprehensive income                     |       | $                               | (968       | ) | $ | 965 |   |

 

NOTE 6—LITIGATION

 

On January 29, 2003, NEON received notification thatit had been sued in Fort Bend County, Texas for alleged tortious interferencewith contract, tortious interference with prospective business relations andunfair competition in a lawsuit styled Phoenix Network Technologies (Europe)Limited vs. NEON Systems, Inc. and Computer Associates International Inc., 400th District Court, Ft. BendCounty, Richmond, Texas, Cause Number 03-CV-127800. On October 27, 2003, thecourt granted NEON’s motion to dismiss the case.  Phoenix Network Technologies has appealedthis decision, and NEON will continue to defend this action.  Oral arguments were heard on PNTE’s appeal onMay 31, 2005.  Aside from these actions,NEON is not involved in any material current claim or legal action other thanthose arising in the ordinary course of business.

 

8

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NOTE 7—RESTRUCTURINGCHARGES

 

During fiscal 2005, NEON recorded employee severancecharges related to streamlining the organization after the acquisitions of InnerAccessTechnologies Inc. (InnerAccess) and ClientSoft.

 

During periods prior to fiscal 2004, NEON recordedcosts associated with vacated facility leases and employee severance related tocorporate reorganization. NEON was not able to sublease a portion of thevacated facilities for the duration of the lease commitments, and therefore, accruedcosts related to the unused portion of the future lease commitments. Securingnew subleases of additional portions of these facilities or renegotiation ofexisting leases in the future may result in reversal of this accrual.

 

The followingtable provides a roll-forward of the restructuring accrual account for thethree months ended June 30, 2005 and 2004 (in thousands):

 
| ** **             | ** ** | **Vacated   Facilities** | ** ** | **Severance   and Other** | ** ** | **Total** | ** ** |
|------------------------|------------|--------------------------|------------|---------------------------|------------|-----------|------------|
|                   |       |                     |       |                      |       |      |       |
| Balance March 31, 2005 |       | 782                      |       | 230                       |       | 1,012     |       |
| Amounts paid           |       | (38                      | )          | (179                      | )          | (217      | )          |
| Other adjustments      |       | (10                      | )          | —                    |       | (10       | )          |
| Balance June 30, 2005  |       | $                        | 734        |                      | 51         |      | $          | 785 |   |
|                   |       |                     |       |                      |       |      |       |
| Balance March 31, 2004 |       | $                        | 1,516      |                      | $          | 38        |       | $ | 1,554 |   |
| Charges (reversals)    |       | (114                     | )          | —                    |       | (114      | )          |
| Amounts paid           |       | (127                     | )          | (38                       | )          | (165      | )          |
| Other adjustments      |       | (12                      | )          | —                    |       | (12       | )          |
| Balance June 30, 2004  |       | $                        | 1,263      |                      | $          | —-   |       | $ | 1,263 |   |

 

Of the $785,000 balance at June 30, 2005, $734,000consists of future cash payments for vacated facilities that will be paid through2010. The remaining $51,000 consists of severance cost to be paid during fiscal2006.  Of the total liability, $207,000and $578,000 are reflected in current and non-current accrued liabilities,respectively.  NEON does not expect to incur significantfuture costs in addition to those previously accrued, related to theserestructuring activities.

 

Other adjustments to thebalance for the three months ended June 30, 2005 and 2004 relate primarily tothe effects of accretion of the present value of accrued lease obligations aswell as currency translation on foreign balances.

 

NOTE 8—RELATED PARTY TRANSACTIONS

 

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

 

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

 

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

 

In connection with the closing of the Termination andCustomer Support Agreement in August 2002, NESI issued two

 

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promissory notesto NEON in the aggregate principal amount of $6.6 million, each secured by allof the intellectual property of NESI (“NESI IP”). On the closing of thetransaction in August 2002, NEON recorded the notes receivable from NESI at theestimated fair value, which was calculated at $4.3 million.

 

On April 15, 2005, NEON sold the notes issued to NESIto John J. Moores.  Mr. Moores paid NEON$4.4 million on April 15, 2005 and issued a personal promissory note in theamount of $2.2 million to NEON.  Suchpromissory note will bear interest of 4.0% per annum and will be payable at arate of $250,000 per quarter.   NEONrecorded a gain on sale of $86,000 for the three months ended June 30, 2005,based on net proceeds of the cash payment in excess of the recorded value ofthe notes.  Due to uncertainty associatedwith the related party nature of the unsecured promissory note, NEON willrecognize gain on sale attributable to the promissory note as cash proceeds arereceived.

 

*Scalable Software, Inc.*

 

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

 

In June 2002, NEON obtained a two-year option toacquire Scalable Software as outlined in the Agreement and Plan of Merger datedJune 26, 2002. In connection with this Option, NEON provided $6.0 million inbridge financing to Scalable Software during fiscal 2002 and 2003, in additionto $3.5 million previously loaned to Scalable Software that was secured bypersonal guarantees from John J. Moores, Louis R. Woodhill and Jim Woodhill.The aggregate financing had a 36-month term and did not bear interest duringthe term of the two-year option to acquire Scalable Software, which expiredJune 26, 2004.

 

OnJune 9, 2004, NEON entered into a Note Purchase Agreement with JMI Services,Inc., the largest shareholder of Scalable Software, to sell the $3.5 millionguaranteed note and the $6.0 million secured note issued by Scalable Softwareto NEON for a cash purchase price of $4.8 million.  During the threemonths ended June 30, 2004, NEON recognized a gain of $1.2 million as a resultof net cash proceeds in excess of the recorded book value of the notes. JMIServices is an affiliate of John J. Moores, NEON’s largest shareholder. The proposed sale of the Scalable Software notes was reviewed and approved bythe Special Committee of the Board of Directors, consisting of “independent”and disinterested directors, and finally by the full Board of Directors, nomember of which was an interested or related party of either JMI Services, Inc.or Scalable Software.  The Board requested and received a fairness opinionfrom Avail Consulting, Inc., a Houston, Texas based independent valuation andfinancial consultant, stating that the transaction was fair to the stockholdersof NEON from a financial standpoint and recommending that the Board accept thepurchase offer made by JMI Services, Inc.  Based on such fairness opinion,consideration of possible decline in the value of the underlying security forthe secured note and the potential expense of collection efforts when the notesmatured in June 2005, the Board approved the sale of the NESI Notes to JMIServices, Inc. Closing of the transaction occurred on June 17, 2004.

 

NOTE 9—GOODWILL AND ACQUIRED INTANGIBLE ASSETS

 

**Goodwill:**

 

In accordance with SFASNo. 141, *Business Combinations*,purchase price in excess of the fair values of acquired tangible and identifiableintangible net assets has been classified as goodwill.  The acquiredgoodwill, although not subject to recurring amortization, will be assessed forimpairment on an annual basis, or sooner if factors indicate such isnecessary.  Goodwill acquired in the InnerAccess and ClientSofttransactions was $2.1 million and $7.5 million, respectively.  The $7.5million of goodwill related to the ClientSoft acquisition is expected to bedeductible for tax purposes.  NEON reports one operating segment, and thatoperating segment has been identified as the reporting unit for the purpose ofassessing future impairment of the acquired goodwill.

 

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**IntangibleAssets:**

 

The components ofidentifiable intangible assets acquired in the InnerAccess and ClientSofttransactions are as follows (in thousands):

 
| ** **                                   | ** ** | **As of June 30, 2005**    | ** ** |
|----------------------------------------------|------------|----------------------------|------------|
| ** **                                   | ** ** | **Gross Carrying  Amount** | ** ** | **Accumulated  Amortization** | ** ** | **Net   Carrying Value** | ** ** |
| InnerAccess:                                 |       |                       |       |   |   |   |   |
| Core technology                              |       | $                          | 2,600      |   | $ | 502 |   | $ | 2,098 |   |
| Maintenance contracts/customer relationships |       | 660                        |       | 127 |   | 533 |   |
| Total                                        |       | $                          | 3,260      |   | $ | 629 |   | $ | 2,631 |   |
| ClientSoft:                                  |       |                       |       |   |   |   |   |
| Core technology                              |       | $                          | 4,500      |   | $ | 488 |   | $ | 4,012 |   |
| Maintenance contracts/customer relationships |       | 1,100                      |       | 119 |   | 981 |   |
| Total                                        |       | $                          | 5,600      |   | $ | 607 |   | $ | 4,993 |   |
|                                         |       |                       |       |   |   |   |   |
| Total intangibles                            |       | $                          | 8,860      |   | $ | 1,236 |   | $ | 7,624 |   |

 

These identifiableintangible assets are amortized using the straight-line method over anestimated five-year life. No significant residual value is estimated for theintangible assets.

 

In addition to thoseintangible assets acquired by business combination, NEON acquired certainsoftware code at a cost of $426,000 in April 2004.  The asset, net ofaccumulated amortization of $133,000 and $27,000 as of June 30, 2005 and 2004,respectively, is classified as acquired intangibles in the accompanyingunaudited consolidated balance sheet, and has been assigned a useful life offour years.

 

Total amortizationexpense for the three months ended June 30, 2005 and 2004 was $469,000 and $27,000,respectively, and is presented as Cost of license in the accompanying unauditedconsolidated statements of operations.

 

The estimated annualamortization expense for the complete current fiscal year and fiscal yearsfollowing is as follows (in thousands):

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

 

 

NOTE 10—IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS

 

In December 2004, theFinancial Accounting Standards Board (FASB) issued SFAS No. 123, as revised, *Share-based Payment*(SFAS 123(R)).  The implementationof SFAS 123(R) is effective for SEC filings for the first interim period of thefirst fiscal year beginning after June 15, 2005.  SFAS 123(R) requiresthat compensation cost for all share-based employee payments be recognized inthe statement of operations based on grant date fair values of the awards,adjusted to reflect actual forfeitures and the outcome of certain otherconditions. The fair value is generally not re-measured, except in limitedcircumstances, or if the award is subsequently modified.  The statementwill require NEON to estimate the fair value of stock-based awards andrecognize expense in the statement of operations as the related services areprovided. This will change current practice as, upon adoption, NEON must ceaseusing the intrinsic value method of accounting, currently permitted by APB 25that resulted in no expense for most of the Company’s stock option awards.

 

NEON will adopt theprovisions of the statement as of April 1, 2006.  The standard willrequire NEON to recognize compensation expense in future periods as stockoptions granted prior to adoption of the standard continue to vest over time.

 

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Adoption of the standard will likely have a materialimpact on the results of operations.  However, the impact of adoption willdepend on levels of share-based payments granted in the future.  TheCompany currently uses the Black-Scholes option pricing model to value itsawards.  Selection of a different valuation model could result in adifferent fair value measure than that determined by the previously usedpricing model.

 

In May 2005, the FASB issuedSFAS No. 154, *Accounting Changes and Error Corrections—areplacement of APB Opinion No. 20 and FASB Statement No. 3.*  This Statement changes the accounting andreporting requirements for a change in accounting principle, requiringretrospective application to prior period financial statements of changes inaccounting principle as if that principle had always been used, unless it isimpracticable to determine either the period-specific effects or the cumulativeeffect of the change.  This Statementapplies to all voluntary changes in accounting principle and redefines “restatement”as the revising of previously issued financial statements to reflect thecorrection of an error.

 

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

 

The followingdiscussion and analysis should be read in conjunction with NEON’s consolidatedfinancial statements and the related notes thereto included in this report onForm 10-K. The discussion and analysis contains forward-looking statementswithin the meaning of Section 27A of the Securities Act of 1933 and Section 21Eof the Securities Exchange Act of 1934. These statements are based on our current expectations and entailvarious risks and uncertainties such as ourplans, objectives, expectations and intentions. Our actual results could differ materially from those projectedin the forward-looking statements as a result of various factors, includingthose set forth in our Form 10-K for the fiscal year ended March 31, 2005 filedwith the Securities Exchange Commission on June 29, 2005.  In somecases, 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 comparableterms.

 

**Overview**

 

NEON Systems, Inc.(“NEON”) is a leading provider of enterprise-class mainframe integrationsoftware.  NEON develops, markets andsupports a unified mainframe integration platform for modern Service-OrientedArchitectures and emerging Event-Driven Architectures. NEON’s Shadow technologyprovides flexible, industry standard interfaces to enable highly secure and scalablemainframe integration, thereby enabling organizations to reduce their totalcosts of ownership and risk associated with mainframe integration.

 

NEON initiallydeveloped its mainframe integration adapters under the Shadow brand to provideODBC access to IBM mainframe data and databases. NEON has continually expandedits mainframe integration product suite, but prior to fiscal 2003, the companyalso marketed and sold products outside of the mainframe integration market. Infiscal 2003, NEON began restructuring the company to concentrate on its coremainframe integration business, which has historically accounted for themajority of its revenues. In August 2002, NEON terminated the distributionagreement for its Enterprise Subsystem Management (“ESM”) products, owned byNEON Enterprise Software, Inc. (formerly Peregrine/Bridge Transfer Corporation,hereafter “NESI”). In January 2003, NEON discontinued its financingobligation to Scalable Software, a provider of IT portfolio managementsoftware, which NEON received the option to acquire in June 2002. Finally, in June 2003, NEON sold its iWave division. *See**Management’sDiscussion and Analysis—Related Party Transactions.*

 

In September 2004,NEON brought to market an event-based mainframe integration solutions, nowknown as Shadow z/Events, which introduced Event-Driven Architectures tomainframe integration customers.  In July2004, NEON acquired InnerAccess, gaining a mainframe web services product andsubstantial experience in supporting Computer Associates’ CA-IDMS databaseaccess to the mainframe.  After theintegration of InnerAccess and release of NEON’s Shadow z/Services product,NEON acquired substantially all of the assets of ClientSoft, in December of2004.  ClientSoft’s ServiceBuldertechnology was then-recognized by major industry analysts as the leadingtechnology for standards based mainframe web services.  In addition, the acquisition of ClientSoftallowed increased .NET support to NEON’s product and services offering.  *See  Acquisition Activity.*

 

As a result of theabove acquisitions, combined with its internal development efforts, NEON nowoffers customers a unified mainframe integration platform that supports a broadrange of requirements for modern Service-Oriented Architectures and emerging Event-DrivenArchitectures.

 

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NEON was formed asan Illinois corporation in 1991 and reincorporated in Delaware in 1993.

 

*Business Environment*

 

NEON derives revenue from software licenses, maintenanceand professional services. License fees, which are graduated and based uponvarious industry standard measures of product usage such as mainframe potentialprocessing capacity, CPUs, and users, are generally due upon license grant andrequire a one-year maintenance period. The sales process typically takesbetween six and nine months. After the initial year of required maintenance,NEON provides optional ongoing maintenance services, which include technicalsupport and product enhancements, for an annual fee. Any factors adverselyaffecting the pricing of, demand for, or market acceptance of, our products,such as competition or technological change, could materially adversely affectour business, operating results and financial condition.

 

In mid-2000, we believe that the mainframe software marketbegan to weaken as the global economies entered a recessionary period. Prior to 2000, many of NEON’s customers were experiencing consistent growth oftheir mainframe systems and, as a result, they purchased additional softwarecapacity in anticipation of continued growth at rates consistent with history.Additionally, during this time frame, the competitive landscape for NEON’sproduct also began to intensify.

 

During fiscal 2003, NEON began restructuring the company toconcentrate on its core mainframe integration business, which has historicallyaccounted for the majority of its revenues.  NEON divested its non-coreproducts and reduced the size of its sales, marketing and administrativeorganizations. During this period NEON also began to develop new mainframeintegration products, such as Shadow z/Events, as well as identify otheradjacent market products, technologies and companies, which were complementaryto NEON’s existing product portfolio.

 

NEON’s strategy was to expand its product offerings throughinternal product development and acquisitions. NEON sought to create a unifiedplatform for mainframe integration, which could meet all of the requirements ofmodern Service-Oriented Architectures and Event Driven Architectures.  Infurtherance of this goal, NEON acquired InnerAccess in July 2004, adding anascent web services product to its product portfolio.  NEON released itsShadow z/Services product in September 2004, which is based on InnerAccess’technology.  In December 2004, NEON continued its market consolidation byacquiring substantially all of the assets of ClientSoft, a developer ofmainframe integration and web services. ClientSoft was considered a technologyleader by certain industry analysts in the mainframe web services market. NEON continues to evaluate additional product and company acquisitions tofurther support its strategy.

 

Notwithstanding the expansion of NEON’s product offeringsand positioning with industry analysts, many of NEON’s customers remaincautious about their capital spending. Although general economic conditionshave improved, NEON is still uncertain as to future spending patterns of itscustomers and the market conditions of the mainframe integration market. NEONbelieves that period-to-period comparisons of our revenue and operating resultsshould not be relied upon as indications of our future performance. Further,NEON does not believe that its historical growth rates in prior years arenecessarily representative of its future growth potential.

 

**Acquisition Activity**

 

*Summary*

 

During fiscal 2005, NEON acquired one company andsubstantially all of the assets of another company, in an effort to expand itsproduct portfolio. The following table summarizes the assigned values for eachacquisition.

 

| ** **             | ** ** | **Acquired Net Assets   (in thousands)** | ** ** |
|------------------------|------------|------------------------------------------|------------|
| **Acquired    Entity** | ** ** | **Cash and  Tangible Assets**            | ** ** | **Amortizable  Tangible Assets** | ** ** | **Goodwill** | ** ** | **Less:   Liabilities** | ** ** | **Total   Net Assets** | ** ** |
| InnerAccess            |       | $                                        | 826        |   | $ | 3,260 |   | $ | 2,067 |   | $ | 1,677 |   | $ | 4,476 |   |
| ClientSoft             |       | 89                                       |       | 5,600 |   | 7,528 |   | 569 |   | 12,648 |   |
|                   |       | $                                        | 915        |   | $ | 8,860 |   | $ | 9,595 |   | $ | 2,246 |   | $ | 17,124 |   |

 

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The amortizable intangibles relate primarily to acquiredsoftware technology, as well as maintenance contracts and customerrelationships.  All amounts are beingamortized over five years on a straight-line basis.  Goodwill will be tested annually forimpairment in accordance with United States GAAP.

 

*InnerAccessTechnologies, Inc.*

 

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

 

*ClientSoft, Inc.*

 

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

 

*****RelatedParty Transactions*****

 

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

 

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

 

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

 

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

 

On April 15, 2005, NEON sold the notes issued to NESIto John J. Moores.  Mr. Moores paid NEON$4.4 million on April 15, 2005 and issued a personal promissory note in theamount of $2.2 million to NEON.  Suchpromissory note will bear interest of 4.0% per annum and will be payable at arate of $250,000 per quarter.   NEONrecorded a gain on sale of $86,000 for the three months ended June 30, 2005,based on net proceeds of the cash payment in excess of the recorded value ofthe notes. Due to uncertainty associated with the related party nature of theunsecured promissory note, NEON will recognize gain on sale attributable to thepromissory note as cash proceeds are received.

 

*Scalable Software, Inc.*

 

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

 

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In June 2002, NEON obtained a two-year option toacquire Scalable Software as outlined in the Agreement and Plan of Merger datedJune 26, 2002. In connection with this Option, NEON provided $6.0 million inbridge financing to Scalable Software during fiscal 2002 and 2003, in additionto $3.5 million previously loaned to Scalable Software that was secured bypersonal guarantees from John J. Moores, Louis R. Woodhill and Jim Woodhill.The aggregate financing had a 36-month term and did not bear interest during theterm of the two-year option to acquire Scalable Software, which expired June26, 2004.

 

OnJune 9, 2004, NEON entered into a Note Purchase Agreement with JMI Services,Inc., the largest shareholder of Scalable Software, to sell the $3.5 millionguaranteed note and the $6.0 million secured note issued by Scalable Softwareto NEON for a cash purchase price of $4.8 million.  During the threemonths ended June 30, 2004 NEON recognized a gain of $1.2 million as a resultof net cash proceeds in excess of the recorded book value of the notes. JMIServices is an affiliate of John J. Moores, NEON’s largest shareholder. The proposed sale of the Scalable Software notes was reviewed and approved bythe Special Committee of the Board of Directors, consisting of “independent”and disinterested directors, and finally by the full Board of Directors, nomember of which was an interested or related party of either JMI Services, Inc.or Scalable Software.  The Board requested and received a fairness opinionfrom Avail Consulting, Inc., a Houston, Texas based independent valuation andfinancial consultant, stating that the transaction was fair to the stockholdersof NEON from a financial standpoint and recommending that the Board accept thepurchase offer made by JMI Services, Inc.  Based on such fairness opinion,consideration of possible decline in the value of the underlying security forthe secured note and the potential expense of collection efforts when the notesmatured in June 2005, the Board approved the sale of the NESI Notes to JMIServices, Inc. Closing of the transaction occurred on June 17, 2004.

*** ***

*****CriticalAccounting Policies*****

 

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

 

***RevenueRecognition Policies***

 

Statement of Position(SOP) 97-2, *Software Revenue Recognition*, was issuedin October 1997 by the American Institute of Certified Public Accountants(AICPA) and was amended by Statement of Position 98-4 and Statement of Position98-9. NEON adopted SOP 97-2 effective July 1, 1997, SOP 98-4 effectiveMarch 31, 1998 and SOP 98-9 effective April 1, 1999. NEON believesits current revenue recognition policies and practices are consistent with SOP97-2, SOP 98-4 and SOP 98-9. Revenues from software license sales are recognizedwhen all of the following conditions are met: a non-cancelable licenseagreement has been obtained, the product has been delivered; there are nomaterial uncertainties regarding customer acceptance; collection of thereceivable is probable; no other significant vendor obligations exist; andvendor-specific objective evidence exists to allocate the total fee to eachelement of the arrangement. Vendor-specific objective evidence is based on theprice generally charged when an element is sold separately. All elements ofeach order are valued at the time of revenue recognition. NEON will deferlicense revenue for all delivered elements associated with a sales arrangement,if vendor-specific objective evidence cannot be established for eachundelivered element. License sales generally include software maintenanceagreements for the first year following the date of sale. In such cases,revenues are allocated between license and maintenance revenues based on theresidual method provided by SOP 98-9. Deferred revenue is generally based onvendor-specific objective evidence of the fair value of maintenance with theremaining portion of the total arrangement value allocated to licenserevenues.  If vendor-specific objective evidence cannot be established fordeferred revenue, then the value of the sales arrangement is amortized ratablyon a straight-line basis over the contract term. Revenues from first-yearmaintenance agreements and separately priced software maintenance agreementsfor subsequent years are deferred and recognized ratably on a straight-linebasis over the maintenance period. NEON also markets and sells its productsthrough independent distributors and resellers. License and maintenancerevenues from these transactions are recognized as above, when sold to theultimate end user and all of the above conditions are met. NEON also providesconsulting services, which are recognized as the services are performed.Consulting services primarily consist of implementation services related to ourproducts. NEON’s consulting services do not include the customization of itsunderlying software code.

 

***CapitalizedSoftware Costs***

*** ***

NEON follows Statement of Financial AccountingStandards (SFAS) No. 86, *Accounting forthe Costs of Computer Software to be Sold, Leased or Otherwise Marketed*.Research and development expenditures have been charged to operating expensesas incurred. No such costs have been capitalized to date, as the impact on the financial statements wouldbe

 

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insignificantbecause the time between a product meeting the definition of technologicalfeasibility and readiness for market is very short.

 

***Allowancefor Doubtful Accounts Receivable***

*** ***

##### **As a part of its normal accounting procedures, NEONevaluates outstanding accounts receivable to estimate whether they will becollected. This is a subjective process that involves making judgments aboutour customers’ ability and willingness to pay these accounts. An allowance fordoubtful accounts is recorded as an offset to accounts receivable in order topresent a net balance that NEON believes will be collected. In estimating theappropriate balance for this allowance, NEON considers specific accountsreceivable as well as historical write-off experience to determine its allowancefor doubtful accounts.  Additions to theallowance for doubtful accounts are charged to operating expenses, anddeductions from the allowance are recorded when specific accounts receivableare written off as uncollectible or when actual experience differs frommanagement’s original estimate. If NEON’s estimate of uncollectible accountsshould prove to be inaccurate at some future date, the results of operationsfor the period could be materially affected by any necessary correction to theallowance for doubtful accounts.**

 

***Goodwill and Acquired IntangibleAssets***

** **

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

 

The determination of the value of amortizableintangible assets acquired involves certain judgments and estimates that aresubject to change over time based on internal and external factors.  These judgments can include, but are notlimited to the cash flows that an asset is expected to generate in the futureand the appropriate cost of capital of similar investments.  The value of an amortizable intangible assetis amortized to expense in the statement of operations on a straight-line basisover the estimated useful life.  Theestimated useful life is determined by management considering, among otherthings, expected use, any applicable legal provisions, expected technologicaldevelopment, expected demand and other company-specific, economic or otherexternal factors.

 

***DeferredIncome Taxes***

*** ***

NEON records deferred income tax assets andliabilities on its balance sheet related to events that impact its financialstatements and tax returns in different periods, analyzed by taxationjurisdiction. In order to compute these deferred tax balances, NEON firstanalyzes the differences between the book basis and tax basis of its assets andliabilities (referred to as “temporary differences”). These temporarydifferences are then multiplied by current tax rates to arrive at the balancesfor the deferred income tax assets and liabilities. NEON must assess whetherdeferred income tax asset amounts will be realized in the future. Thisassessment requires management to make certain estimates about tax planningstrategies, the expected future timing of the reversal of temporary differencesand future taxable income.  A valuationallowance is then provided for deferred asset amounts that are estimated bymanagement as not being more likely than not to be realized.

 

The change in NEON’s net deferred income tax balances duringa period results in a deferred income tax provision or benefit in its statementof operations. If NEON’s expectations about the future tax consequences of pastevents should prove to be inaccurate or management should change theseestimates, the balances of NEON’s deferred income tax assets and liabilitiescould require significant adjustments in future periods. Such adjustments couldcause a material effect on NEON’s results of

 

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operations for the period of the adjustment.

 

 

RESULTS OF OPERATIONS

 

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

 
| ** **                        | ** ** | **THREE MONTHS ENDED JUNE 30,** | ** ** |
|-----------------------------------|------------|---------------------------------|------------|
| ** **                        | ** ** | **2005**                        | ** ** | **2004** | ** ** |
| Revenues:                         |       |                            |       |   |   |
| License                           |       | 23                              | %          | 31 | % |
| Maintenance                       |       | 70                              |       | 68 |   |
| Service                           |       | 7                               |       | 1 |   |
| Total revenues                    |       | 100                             |       | 100 |   |
|                              |       |                            |       |   |   |
| Cost of revenues:                 |       |                            |       |   |   |
| Cost of license                   |       | 11                              |       | 1 |   |
| Cost of maintenance               |       | 7                               |       | 10 |   |
| Cost of service                   |       | 3                               |       | — |   |
| Total cost of revenues            |       | 21                              |       | 11 |   |
|                              |       |                            |       |   |   |
| Gross profit                      |       | 79                              |       | 89 |   |
|                              |       |                            |       |   |   |
| Operating expenses:               |       |                            |       |   |   |
| Sales and marketing               |       | 51                              |       | 44 |   |
| Research and development          |       | 32                              |       | 27 |   |
| General and administrative        |       | 25                              |       | 26 |   |
| Total operating expenses          |       | 108                             |       | 97 |   |
|                              |       |                            |       |   |   |
| Operating loss                    |       | (28                             | )          | (8 | ) |
|                              |       |                            |       |   |   |
| Gain on sale of notes  receivable |       | 2                               |       | 34 |   |
| Interest and other income, net    |       | 3                               |       | 1 |   |
|                              |       |                            |       |   |   |
| Loss before income taxes          |       | (23                             | )          | 27 |   |
| Income taxes                      |       | —                          |       | — |   |
| Net loss                          |       | (23                             | )          | 27 |   |

 

 

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

 

REVENUES

 

License revenues for the threemonths ended June 30, 2005 were $986,000, a decrease of $117,000 from $1.1million for the three months ended June 30, 2004. The decline in licenserevenue was primarily due to a decline in sales in the European region.

 

Maintenance revenues for thethree months ended June 30, 2005 were $3.0 million, an increase of $600,000 from$2.4 million for the three months ended June 30, 2004. The increase primarilyresulted from the acquisitions of ClientSoft and InnerAccess during fiscal 2005.

 

Service revenues for the threemonths ended June 30, 2005 and 2004 were $286,000 and $48,000, respectively, asa result of new professional services offerings associated with the acquisitionof ClientSoft.  No such services wereperformed in the comparable prior year period.

 

17

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COST OF REVENUES

 

Cost of license revenues primarilyrepresents amortization of acquired intangible assets. For the three monthsended June 30, 2005 and 2004 cost of license revenues were $476,000 and$32,000, respectively. The increase in cost of license revenues was due to the acquisitionsof ClientSoft and InnerAccess in July 2004 and December 2004, respectively.

 

Cost of maintenance revenuesincludes personnel and other customer support costs. Cost of maintenancerevenues for the three months ended June 30, 2005 were $311,000, or 10% ofmaintenance revenues, as compared to $364,000, or 15% of maintenance revenues,for the three months ended June 30, 2004.  The decrease in cost of maintenance wasprimarily due to the consolidation of the technical support staff.

 

Cost of service revenueprimarily represents personnel costs associated with providing professionalservices to customers.  Cost of servicefor the three months ended June 30, 2005 was $106,000, or 37% of servicerevenues. NEON did not recognize cost of service revenue for the quarter endedJune 30, 2004. The increase in cost of service revenue was due to the growth inthe number of professional service hours delivered during the period.

 

OPERATING EXPENSES

 

Sales and marketing expenses include personnel costs, sales commissions,travel and promotional expenses. Sales and marketing expenses for the threemonths ended June 30, 2005 were $2.2 million, an increase of $612,000 from $1.6million for the three months ended June 30, 2004. The increase was primarilydue to expansion of NEON’s direct sales force as a result of the ClientSoft acquisition.

 

Research and development expenses primarily include personnel costsassociated with NEON’s product development staff. Research and developmentexpenses for the three months ended June 30, 2005 were $1.4 million, an increaseof $376,000 from $983,000 for the three months ended June 30, 2004.  The increase in research and development isprimarily due to the expansion of the research and development staff as aresult of the ClientSoft and InnerAccess acquisitions.

 

General and administrativeexpenses include personnel and other costs associated with NEON’s executive, financial,legal and administrative functions. General and administrative expenses for thethree months ended June 30, 2005 were $1.1 million, an increase of $164,000 from$930,000 for the three months ended June 30, 2004. In the three months endedJune 30, 2004, general and administrative expenses included a $186,000reduction of previously accrued future lease obligations for vacated facilitiesas a result of the renegotiation and sublease of two of NEON’s corporate officeleases.  Excluding this reduction,general and administrative expenses were relatively consistent in both periods

 

Interest and other income forthe three months ended June 30, 2005 and 2004 was $147,000 and $45,000,respectively.   The increase was primarilydue to higher average short-term interest rates during the first quarter offiscal 2006.

 

In April, 2005, NEON sold the notes issued to NESI toJohn J. Moores.  Mr. Moores paid NEON$4.4 million and issued a personal promissory note in the amount of $2.2million to NEON.  Such promissory notewill bear interest of 4.0% per annum and will be payable at a rate of $250,000per quarter.   NEON recorded a gain onsale of $86,000 for the three months ended June 30, 2005 for net proceeds ofthe cash payment in excess of the recorded value of the notes.  NEON recognized the unsecured installmentpromissory note at its estimated net realizable value and expects that futureproceeds from the note will be recorded as gain on sale when received. SeeRelated Party Transactions.

 

In June 2004, NEONsold its notes receivable from Scalable Software for $4.7 million, net ofdirect costs, and recognized a gain on the sale of $1.2 million.  SeeRelated Party Transactions.

 

During the three months ended June 30, 2005, NEON recognized $13,000 indeferred tax expense resulting from changes in deferred tax assets andliabilities related primarily to acquired goodwill and intangible assets.  No provision for income taxes was recordedfor the three months ended June 30, 2004, as the taxable income was offset bynet operating loss carry-forwards that NEON had previously reserved.

 

As of March 31, 2005, NEON has anet operating loss carry-forward for income tax purposes of approximately $23.6

 

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millionthat is available to offset future taxable income, if any. The net operatingloss carry-forward consists of approximately $19.8 million in the UnitedStates, $1.4 million in the United Kingdom, $600,000 in Canada and $1.7 millionin Germany. The net operating loss carry-forwards in the United Kingdom andGermany carry forward indefinitely. The net operating loss carry-forwards forthe United States and Canada begin expiring in 2020 and 2008,respectively.  Additionally, NEON has a UnitedStates loss carryforward of $4.8 million available to offset future capitalgains.  NEON has recorded a fullvaluation allowance against the loss carryforwards in the United States, UnitedKingdom and Germany.  The deferred taxassets resulting from loss carryforwards in Canada are offset by deferred taxliabilities at June 30, 2005.

 

 

LIQUIDITY AND CAPITAL RESOURCES

 

NEON’s cash and cash equivalentsat June 30, 2005 were $17.3 million, an increase of $4.0 million from $13.3million at March 31, 2005. This increase was due primarily to the sale of thenotes receivable from NESI.

 

Net cash used in operatingactivities was $320,000 for the three months ended June 30, 2005, versus $1.5million provided by operating activities in the three months ended June 30, 2004.  Net cash used in operating activities for thethree months ended June 30, 2005 resulted primarily from the net loss incurredduring the period, which was offset by non-cash depreciation and amortizationcharges of $568,000.  Net cash used inoperating activities for the three months ended June 30, 2005 also included a$3.2 million reduction in Accounts Receivable due to the collection of certainlarge trade receivables, which was offset by a reduction of $1.8 million inaccounts payable and accrued expenses as well as a $1.2 million decline indeferred revenue. The net cash provided by operating activities during thethree months ended June 30, 2004, resulted primarily from collection ofreceivables, less reduction of certain accrued liabilities.

 

During the three months endedJune 30, 2005, net cash provided by investing activities was $4.2 million, whichwas primarily attributable to the proceeds from the sale of the NESI notesreceivable.  Net cash provided byinvesting activities during the three months ended June 30, 2004 was $4.1million and was primarily due to the sale of the notes receivable from ScalableSoftware.

 

NEON’s net cash provided byfinancing activities was $122,000 and $7,000 for the three months ended June30, 2005 and 2004, respectively. The net cash provided by financing activitiesin both periods represents proceeds from the exercise of employee stockoptions.

 

NEON’s futureliquidity and capital requirements will depend upon numerous factors, includingthe costs associated with potential future business and product acquisitions,the sales of multi-year maintenance and support contracts to customers, thecosts of the expansion of product development, sales and marketing efforts andthe success of these efforts, the extent to which our existing and new productsgain market acceptance, the level and timing of license revenue and otherfactors. NEON believes that its current balance of cash and cash equivalentswill be sufficient to meet its working capital, funding commitments andanticipated capital expenditure requirements for at least the next 12 months.NEON may require additional funds to support its working capital requirementsor for other purposes and may seek to raise additional funds through public orprivate equity financing or from other sources. There can be no assurance thatadditional financing will be available at all, or if available, that suchfinancing will be obtainable on terms acceptable to NEON, or that anyadditional financing will not be dilutive.

 

**New Accounting Pronouncements**

 

In December 2004, theFinancial Accounting Standards Board (FASB) issued SFAS No. 123, as revised, *Share-based Payment* (SFAS 123(R)).  The implementationof SFAS 123(R) is effective for SEC filings for the first interim period of thefirst fiscal year beginning after June 15, 2005.  SFAS 123(R) requiresthat compensation cost for all share-based employee payments be recognized inthe statement of operations based on grant date fair values of the awards,adjusted to reflect actual forfeitures and the outcome of certain otherconditions. The fair value is generally not re-measured, except in limitedcircumstances, or if the award is subsequently modified.  The statementwill require NEON to estimate the fair value of stock-based awards andrecognize expense in the statement of operations as the related services areprovided. This will change current practice as, upon adoption, NEON must ceaseusing the intrinsic value method of accounting, currently permitted by APB 25that resulted in no expense for most of the Company’s stock option awards.

 

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NEON will adopt theprovisions of the statement as of April 1, 2006.  The standard willrequire NEON to recognize compensation expense in future periods as stockoptions granted prior to adoption of the standard continue to vest over time.Adoption of the standard will likely have a material impact on the results ofoperations.  However, the impact of adoption will depend on levels ofshare-based payments granted in the future.  The Company currently usesthe Black-Scholes option pricing model to value its awards.  Selection ofa different valuation model could result in a different fair value measure thanthat determined by the previously used pricing model.

 

In May 2005, the FASBissued SFAS No. 154, *Accounting Changes andError Corrections—a replacement of APB Opinion No. 20 and FASB Statement No. 3.*  This Statement changes the accounting andreporting requirements for a change in accounting principle, requiringretrospective application to prior period financial statements of changes inaccounting principle as if that principle had always been used, unless it isimpracticable to determine either the period-specific effects or the cumulativeeffect of the change.  This statementapplies to all voluntary changes in accounting principle and redefines “restatement”as the revising of previously issued financial statements to reflect thecorrection of an error.

 

**Tabular Disclosure of ContractualObligations**

 

The following table presents NEON’s contractual cash obligations for thefull fiscal year periods beginning April 1, 2005:

 
| ** **                                                                    | ** ** | **Payments Due by Period  As of March 31, 2005** | ** ** |
|-------------------------------------------------------------------------------|------------|--------------------------------------------------|------------|
| ** **                                                                    | ** ** | **Total**                                        | ** ** | **Fiscal** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                    | ** ** | ** Due**                                    | ** ** | ** 2006** | ** ** | **1-3 Years** | ** ** | **4-5 Years** | ** ** | **> 5 Years** | ** ** |
|                                                                          |       |                                             |       |   |   |   |   |   |   |   |   |
| Long-Term debt obligations                                                    |       | $                                                | 19         |   | $ | 19 |   | $ | — |   | $ | — |   | $ | — |   |
| Operating lease obligations (1)                                               |       | 4,706                                            |       | 1,124 |   | 1,989 |   | 1,593 |   | — |   |
| Purchase obligations                                                          |       | —                                           |       | — |   | — |   | — |   | — |   |
| Other long-term liabilities reflected on the balance  sheet under US GAAP (2) |       | 184                                              |       | 88 |   | 96 |   | — |   | — |   |
|                                                                          |       |                                             |       |   |   |   |   |   |   |   |   |
| Total                                                                         |       | $                                                | 4,909      |   | $ | 1,231 |   | $ | 2,085 |   | $ | 1,593 |   | $ | — |   |

 

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(1)          Leases of office space and equipment

(2)          Contractual payments under software licenses for internal developmentuse

 

**Factors That May Affect Future Operating Results**

 

This report on Form10-Q, including Management’s Discussion and Analysis of Financial Condition andResults of Operations, contains forward-looking statements and otherprospective information relating to future events. These forward-lookingstatements and other information are subject to certain risks and uncertaintiesthat could cause results to differ materially from historical results oranticipated results, including the following:

 

***Our Stock Price May Fluctuate And Be Impacted By A Number OfInternal And External Factors***

 

•                  *Our stock price has fluctuated and is subject to wideswings in price based on a number of factors, including our quarterly operatingresults, which may vary significantly from quarter to quarter.*

 

Our futureoperating results may vary significantly from quarter to quarter due to avariety of factors, many of which are outside our control. Therefore, it islikely that in one or more future quarters our results may fall below theexpectations of securities analysts and investors. We operate with virtually noorder backlog because our products are shipped and revenues are recognizedshortly after orders are received. In addition, the amount of revenuesassociated with sales of our software can vary significantly. In variousquarters in the past, we have derived a significant portion of our softwarelicense revenues from a small number of relatively large sales. An inability toclose one or more large sales that we had targeted to close in a particularperiod could materially adversely affect our operating results for that period.Moreover, we typically realize a majority of our

 

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software license revenuesin the last month of a quarter. As a result, minor delays in the timing ofcustomer orders can shift a sale from its contemplated quarter of completion toa subsequent quarter and cause significant variability in our operating resultsfor any particular period. Accordingly, we believe that period-to-periodcomparisons of our operating results are not necessarily a meaningfulindication of future performance. Although we generally do not give guidance asto future operating results, if our quarterly results do not meet investors’expectations, the trading price of our common stock will likely decline.

 

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

 

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

 

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

 

We are dependentupon the continued use and acceptance of mainframe computers in a computingenvironment increasingly based on distributed platforms, includingclient/server and Internet-based computing networks. Decreased use of themainframe or in the growth of demand for Web-based and client/serverapplications accessing mainframe data and transactions could have a materialadverse effect on our business, operating results and financial condition. Wenow derive our revenues solely from our Shadow products. Our continued successdepends on a number of factors, including:

 

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

 

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

 

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

 

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

 

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

 

***We May Lose Market Share And Be Required To Reduce Prices AsA Result Of Competition From Our Existing Competitors, Other Vendors AndInformation Systems Departments Of Customers***

 

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

 

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

 

Our markets arecharacterized by rapid technological change, frequent new product introductionsand enhancements, uncertain product life cycles, changes in customerrequirements and evolving industry standards. The introduction of new productsembodying new technologies and the emergence of new industry standards couldrender our existing products obsolete which would have a material adverseeffect on our business, operating results and financial condition. Our futuresuccess will depend upon our ability to continue to develop and introduce avariety of new products and product enhancements to address the increasingly sophisticatedneeds of our customers. We may experience delays in releasing new products andproduct enhancements in the future. Material delays in introducing new productsor product enhancements may cause customers to forego purchases of our productsand purchase those of our competitors.

 

***We May Be Unable To Enforce Or Defend Our Ownership And UseOf Proprietary Technology***

 

Our successdepends to a significant degree upon our proprietary technology. We rely on acombination of trademark, trade secret and copyright law, and contractualrestrictions and passwords to protect our proprietary technology. However,these

 

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measures provide onlylimited protection, and we may not be able to detect unauthorized use or takeappropriate steps to enforce our intellectual property rights, particularly inforeign countries where the laws may not protect our proprietary rights asfully as in the United States. Companies in the software industry haveexperienced substantial litigation regarding intellectual property. Anylitigation to enforce our intellectual property rights would be expensive andtime-consuming, would divert management resources and may not be adequate toprotect our business. We could be subject to claims that we have infringed theintellectual property rights of others. In addition, we may be required toindemnify our distribution partners and end-users for similar claims madeagainst them. Any claims against us could require us to spend significant timeand money in litigation, pay damages, develop new intellectual property oracquire licenses to intellectual property that is the subject of theinfringement claims. These licenses, if required, may not be available onacceptable terms. As a result, intellectual property claims against us couldhave a material adverse effect on our business, operating results and financialcondition.

 

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

 

Our softwareproducts and the software products that we sell for others are complex and maycontain undetected errors. These undetected errors could result in adversepublicity, loss of revenues, delay in market acceptance or claims against us bycustomers, all of which could have a material adverse effect on our business,operating results and financial condition. Despite testing, we cannot becertain that errors will not be found in our products. Liability claims couldrequire us to spend significant time and money in litigation or to paysignificant damages. As a result, any such claims, whether or not successful,could have a material adverse effect on our reputation and business, operatingresults and financial condition.

 

ITEM 3.                       QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK

 

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

 

The majority of NEON’s foreign currency transactionsare denominated in the British pounds sterling, the functional currency of NEONSystems (UK) Ltd. As the British pound sterling transactions are denominatedand settled in the functional currency, risks associated with currencyfluctuations are minimized to foreign currency translation adjustments. Duringfiscal 2005, 29% of NEON’s sales were denominated in other currencies.  NEON does not currently hedge against theseforeign currency transaction risks and believes that foreign currency exchangerisk is not significant to its operations, as the related accounts receivableare generally collected within a short time-frame.  As a result of the acquisition of InnerAccessTechnologies, Inc. in July 2004, NEON is exposed to operating expensesdenominated in the Canadian dollar that are funded in U.S. dollars from U.S.operations.  Sales transactions relatedto the technology acquired from InnerAccess are generally denominated in U.S.dollars.

 

NEON adheres to a conservativeinvestment policy, whereby its principal concern is the preservation of liquidfunds while maximizing its yield on such assets. Cash and cash equivalentsapproximated $17.3 million at June 30, 2005, and were invested in differenttypes of investment-grade commercial paper and money securities.  NEON believes that a near-term change ininterest rates would not materially affect its financial position, results ofoperations or net cash flows for fiscal year 2006.

 

ITEM 4.   CONTROLS AND PROCEDURES

 

As of the end of theperiod covered by this Quarterly Report on Form 10-Q, NEON carried out an evaluation,under the supervision and with the participation of NEON’s management,including the Chief Executive Officer and Chief Financial Officer, of theeffectiveness of the design and operation of NEON’s disclosure controls andprocedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of1934).  Based upon that evaluation, the Chief Executive Officer and ChiefFinancial Officer concluded that NEON’s disclosure controls and procedures areeffective in ensuring that material information is accumulated and communicatedto management, and made known to the Chief Executive Officer and ChiefFinancial Officer, on a timely basis to allow disclosure as required in thisQuarterly Report on Form 10-Q.  There has been no change in our internal controlover financial reporting during the three months ended June 30, 2005 that hasmaterially affected, or is reasonably likely to materially affect, our internalcontrol over financial reporting.

 

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PARTII - OTHER INFORMATION

 

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

 

ITEM 2.                       UNREGISTERED SALES OF SECURITIESAND USE OF PROCEEDS – Not applicable

 

ITEM 3.                       DEFAULTS UPON SENIOR SECURITIES -Not applicable.

 

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

 

ITEM 5.        OTHER INFORMATION – On May 26, 2005, the CompensationCommittee approved an Amendment of the Executive Officer Employment Agreementand increased the severance amount on termination of the CEO and GeneralCounsel's agreements from six months to twelve months compensation. In additiona constructive termination provision was added. Attached as Exhibit 10.1 is theform of such amendment. Appendix 1 to such amendment sets forth the severanceamounts applicable to each of the executive officers.

 

 

ITEM6.        EXHIBITS

 

EXHIBITS

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                |
|---------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                |       |                                                                                                                                                                                                           |
| 10.1                |       | Form of Amendment No. 1 to the Executive Officer Employment Agreement  between NEON Systems, Inc. and each executive officer of NEON Systems, Inc.  dated August 11, 2005.                                     |
|                |       |                                                                                                                                                                                                           |
| 31.1                |       | Certification of Mark J. Cresswell, principal executive officer of NEON  Systems, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.                                                              |
|                |       |                                                                                                                                                                                                           |
| 31.2                |       | Certification of Brian D. Helman, principal financial and accounting  officer of NEON Systems, Inc. pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002.                                                |
|                |       |                                                                                                                                                                                                           |
| 32.1                |       | Certification of Mark J. Cresswell, principal executive officer of NEON  Systems, Inc. pursuant to 18 U.S.C. SECTION 1350, as adopted pursuant to  Section 906 of the Sarbanes-Oxley Act of 2002.              |
|                |       |                                                                                                                                                                                                           |
| 32.2                |       | Certification of Brian D. Helman, principal financial and accounting  officer of NEON Systems, Inc. pursuant to 18 U.S.C. SECTION 1350, as adopted  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. |

 

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SIGNATURES

 

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

 
|                  |   | NEON SYSTEMS, INC.                           |
|-----------------------|--------|----------------------------------------------|
|                  |   |                                         |
| Date: August 15, 2005 |   | /s/ Brian D. Helman                          |   |
|                  |   | Brian D. Helman                              |   |
|                  |   | Chief Financial Officer                      |
|                  |   | (principal financial and accounting officer) |
|                  |   |                                         |
|                  |   |                                         |
| Date: August 15, 2005 |   | /s/ Mark Cresswell                           |   |
|                  |   | Mark Cresswell                               |   |
|                  |   | President and Chief Executive Officer        |
|                  |   | (principal executive officer)                |

 

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