##### Table of Contents

---



UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



---



FORM 10-Q



(Mark One)

|x |  | QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
|- |  | -------------------------------------------------------

| |  | SECURITIES EXCHANGE ACT OF 1934
| |  | -------------------------------



| |  | For the Quarterly Period Ended June 30, 2003
| |  | --------------------------------------------



OR



| ̈ |  | TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
|- |  | --------------------------------------------------------

| |  | SECURITIES EXCHANGE ACT OF 1934
| |  | -------------------------------



| |  | For the transition period from
 to
| |  | ----------------------------------



Commission File Number: 0-25457



---



NEON Systems, Inc.

(Exact name of Registrant as specified in its charter)



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



|14100 Southwest Freeway, Suite 500, Sugar Land, Texas |  | 77478     
|----------------------------------------------------- |  | ----------
|(Address of principal executive offices)              |  | (zip code)



(281) 491-4200

(Registrants telephone number, including area code)



---



Securities registered pursuant to Section 12(b) of the Act:



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



Securities
registered pursuant to Section 12(g) of the Act:



Common
Stock, par value $0.01 per share

(Title of Class)



---



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



The number of shares of the registrants common stock outstanding as of August 13, 2003, was 8,832,170.



Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange
Act).  Yes ̈No  x



---



---

##### Table of Contents

NEON SYSTEMS, INC.



FORM 10-Q



FOR THE QUARTER ENDED JUNE 30, 2003



INDEX



|                             |  |                                                                                         |  | PAGE
|---------------------------- |  | --------------------------------------------------------------------------------------- |  | ----
|                             | 
|PART I FINANCIAL INFORMATION |  |                                                                                        
|                             |  |                                                                                        
|Item 1.                      |  | Financial Statements                                                                    |  |     
|                             |  |                                                                                        
|                             |  | Consolidated Balance Sheets at June 30, 2003 and March 31, 2003                         |  | 3   
|                             |  |                                                                                        
|                             |  | Consolidated Statements of Operations for the Three Months Ended June 30, 2003 and 2002 |  | 4   
|                             |  |                                                                                        
|                             |  | Consolidated Statements of Cash Flows for the Three Months Ended June 30, 2003 and 2002 |  | 6   
|                             |  |                                                                                        
|                             |  | Condensed Notes to Consolidated Financial Statements                                    |  | 7   
|                             |  |                                                                                        
|Item 2.                      |  | Managements Discussion and Analysis of Financial Condition and Results of Operations   |  | 16  
|                             |  |                                                                                        
|Item 3.                      |  | Quantitative and Qualitative Disclosures About Market Risk                              |  | 26  
|                             |  |                                                                                        
|Item 4.                      |  | Controls and Procedures                                                                 |  | 26  
|                             | 
|PART II. OTHER INFORMATION   |  |                                                                                        
|                             |  |                                                                                        
|Item 1.                      |  | Legal Proceedings                                                                       |  | 26  
|                             |  |                                                                                        
|Item 2.                      |  | Defaults Upon Senior Securities                                                         |  | 26  
|                             |  |                                                                                        
|Item 3.                      |  | Submission of Matters to a Vote of Security Holders                                     |  | 26  
|                             |  |                                                                                        
|Item 4.                      |  | Other Information                                                                       |  | 27  
|                             |  |                                                                                        
|Item 5.                      |  | Exhibits and Reports on Form 8-K                                                        |  | 30  
|                             | 
|SIGNATURES                   |  | 31                                                                                     



2



---

##### Table of Contents

PART IFINANCIAL INFORMATION



|ITEM 1. |  | FINANCIAL STATEMENTS
|------- |  | --------------------



NEON SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS, EXCEPT SHARE AMOUNTS)



|                                                                                                                                                                    |  | JUNE 30, 2003 |         |   | MARCH 31, 2003 |  
|------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------- | ------- | - | -------------- | -
|                                                                                                                                                                    |  | (UNAUDITED)   |         |   |                |  
|ASSETS                                                                                                                                                              |  |               |         |   |                |  
|CURRENT ASSETS:                                                                                                                                                     |  |               |         |   |                |  
|Cash and cash equivalents                                                                                                                                           |  | $             | 19,365  |   |                | $
|Accounts receivable, net                                                                                                                                            |  |               | 3,106   |   |                |  
|Taxes receivable                                                                                                                                                    |  |               | 1,311   |   |                |  
|Other current assets                                                                                                                                                |  |               | 600     |   |                |  
|                                                                                                                                                                    |  |               |         |   |                |  
|Total current assets                                                                                                                                                |  |               | 24,382  |   |                |  
|                                                                                                                                                                    |  |               |         |   |                |  
|Property and equipment, net                                                                                                                                         |  |               | 753     |   |                |  
|Note receivable, net (related party, Note 7)                                                                                                                        |  |               | 7,760   |   |                |  
|Other assets                                                                                                                                                        |  |               | 44      |   |                |  
|                                                                                                                                                                    |  |               |         |   |                |  
|Total assets                                                                                                                                                        |  | $             | 32,939  |   |                | $
|                                                                                                                                                                    |  |               |         |   |                |  
|LIABILITIES & STOCKHOLDERS EQUITY                                                                                                                                  |  |               |         |   |                |  
|CURRENT LIABILITIES:                                                                                                                                                |  |               |         |   |                |  
|Accounts payable                                                                                                                                                    |  | $             | 395     |   |                | $
|Accrued expenses                                                                                                                                                    |  |               | 1,971   |   |                |  
|Deferred revenue                                                                                                                                                    |  |               | 4,873   |   |                |  
|                                                                                                                                                                    |  |               |         |   |                |  
|Total current liabilities                                                                                                                                           |  |               | 7,239   |   |                |  
|                                                                                                                                                                    |  |               |         |   |                |  
|Accrued restructuring expenseslong term (Note 6)                                                                                                                   |  |               | 1,159   |   |                |  
|                                                                                                                                                                    |  |               |         |   |                |  
|Total liabilities                                                                                                                                                   |  |               | 8,398   |   |                |  
|                                                                                                                                                                    |  |               |         |   |                |  
|STOCKHOLDERS EQUITY:                                                                                                                                               |  |               |         |   |                |  
|Preferred stock, $.01 par value. Authorized 10,000,000 shares; no shares issued and outstanding                                                                     |  |               |        |   |                |  
|Common stock, $.01 par value. Authorized 30,000,000 shares; 8,825,945 and 8,764,427 shares issued and outstanding at June 30, 2003
and March 31, 2003, respectively |  |               | 97      |   |                |  
|Additional paid-in capital                                                                                                                                          |  |               | 51,609  |   |                |  
|Treasury Stock, 913,400 shares at cost                                                                                                                              |  |               | (2,649  | ) |                |  
|Accumulative other comprehensive loss                                                                                                                               |  |               | (502    | ) |                |  
|Accumulated deficit                                                                                                                                                 |  |               | (24,014 | ) |                |  
|                                                                                                                                                                    |  |               |         |   |                |  
|Total stockholders equity                                                                                                                                          |  |               | 24,541  |   |                |  
|                                                                                                                                                                    |  |               |         |   |                |  
|Commitments and contingencies (Note 5)                                                                                                                              |  |               |         |   |                |  
|Total liabilities and stockholders equity                                                                                                                          |  | $             | 32,939  |   |                | $
|                                                                                                                                                                    |  |               |         |   |                |  



SEE ACCOMPANYING
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.



3



---

##### Table of Contents

NEON SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

(UNAUDITED)



|                                                                                                                     |  | THREE MONTHS ENDED JUNE 30, |      
|-------------------------------------------------------------------------------------------------------------------- |  | --------------------------- | -----
|                                                                                                                     |  | 2003                        |      
|Revenues:                                                                                                            |  |                             |      
|License                                                                                                              |  | $                           | 1,560
|Maintenance                                                                                                          |  |                             | 2,580
|                                                                                                                     |  |                             |      
|Total revenues                                                                                                       |  |                             | 4,140
|Cost of revenues:                                                                                                    |  |                             |      
|Cost of licenses                                                                                                     |  |                             | 83   
|Cost of maintenance                                                                                                  |  |                             | 374  
|                                                                                                                     |  |                             |      
|Total cost of revenues                                                                                               |  |                             | 457  
|                                                                                                                     |  |                             |      
|Gross profit                                                                                                         |  |                             | 3,683
|                                                                                                                     |  |                             |      
|Operating expenses:                                                                                                  |  |                             |      
|Sales and marketing                                                                                                  |  |                             | 1,816
|Research and development                                                                                             |  |                             | 1,031
|General and administrative                                                                                           |  |                             | 780  
|Restructuring costs                                                                                                  |  |                             |     
|                                                                                                                     |  |                             |      
|Total operating expenses                                                                                             |  |                             | 3,627
|                                                                                                                     |  |                             |      
|Operating income (loss)                                                                                              |  |                             | 56   
|                                                                                                                     |  |                             |      
|Interest and other income, net                                                                                       |  |                             | 53   
|Equity loss in affiliate                                                                                             |  |                             |     
|Valuation allowance of note receivable                                                                               |  |                             |     
|                                                                                                                     |  |                             |      
|Income (loss) from continuing operations before income taxes and cumulative effect of change in accounting
principle |  |                             | 109  
|                                                                                                                     |  |                             |      
|Provision for income taxes                                                                                           |  |                             |     
|                                                                                                                     |  |                             |      
|Income (loss) from continuing operations before cumulative effect of change in accounting principle                  |  |                             | 109  
|                                                                                                                     |  |                             |      
|Loss from discontinued operations                                                                                    |  |                             | (244 
|Gain on disposal of discontinued operations                                                                          |  |                             | 290  
|                                                                                                                     |  |                             |      
|Income (loss) before cumulative effect of change in accounting principle                                             |  |                             | 155  
|Cumulative effect of change in accounting principle                                                                  |  |                             |     
|                                                                                                                     |  |                             |      
|Net income (loss)                                                                                                    |  | $                           | 155  
|                                                                                                                     |  |                             |      
|Earnings (loss) per common shareBasic:                                                                              |  |                             |      
|Income (loss) from continuing operations before cumulative effect of change in accounting principle                  |  | $                           | 0.01 
|                                                                                                                     |  |                             |      
|Loss from discontinued operations                                                                                    |  |                             | (0.02
|Gain on disposal of discontinued operations                                                                          |  |                             | 0.03 
|                                                                                                                     |  |                             |      
|Income (loss) before cumulative effect of change in accounting principle                                             |  |                             | 0.02 
|Cumulative effect of change in accounting principle                                                                  |  |                             |     
|                                                                                                                     |  |                             |      
|Net income (loss)                                                                                                    |  | $                           | 0.02 
|                                                                                                                     |  |                             |      
|Earnings (loss) per common shareDiluted:                                                                            |  |                             |      
|Income (loss) from continuing operations before cumulative effect of change in accounting principle                  |  | $                           | 0.01 
|                                                                                                                     |  |                             |      
|Loss from discontinued operations                                                                                    |  |                             | (0.02
|Gain on disposal of discontinued operations                                                                          |  |                             | 0.03 
|                                                                                                                     |  |                             |      



4



---

##### Table of Contents

|Income (loss) before cumulative effect of change in accounting principle |  |   | 0.02  |  |   | (0.41 | )
|------------------------------------------------------------------------ |  | - | ----- |  | - | ----- | -
|Cumulative effect of change in accounting principle                      |  |   |      |  |   | (0.12 | )
|                                                                         |  |   |       |  |   |       |  
|Net income (loss)                                                        |  | $ | 0.02  |  | $ | (0.53 | )
|                                                                         |  |   |       |  |   |       |  
|Weighted average shares outstanding:                                     |  |   |       |  |   |       |  
|Basic                                                                    |  |   | 8,801 |  |   | 8,682 |  
|                                                                         |  |   |       |  |   |       |  
|Diluted                                                                  |  |   | 9,058 |  |   | 8,682 |  
|                                                                         |  |   |       |  |   |       |  



SEE ACCOMPANYING
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



5



---

##### Table of Contents

NEON SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(IN THOUSANDS)

(UNAUDITED)



|                                                                                        |  | THREE MONTHS ENDED JUNE 30, |       
|--------------------------------------------------------------------------------------- |  | --------------------------- | ------
|                                                                                        |  | 2003                        |       
|CASH FLOWS FROM OPERATING ACTIVITIES:                                                   |  |                             |       
|Net income (loss)                                                                       |  | $                           | 155   
|Adjustments to reconcile net income (loss) to net cash used in operating activities:    |  |                             |       
|Depreciation and amortization                                                           |  |                             | 116   
|Loss from discontinued operations                                                       |  |                             | 244   
|Gain on disposal of discontinued operations                                             |  |                             | (290  
|Cumulative effect of change in accounting principle                                     |  |                             |      
|Non-cash compensation expense                                                           |  |                             |      
|Equity loss in affiliate                                                                |  |                             |      
|Valuation allowance of note receivable                                                  |  |                             |       
|Increase (decrease) in cash resulting from changes in operating assets and liabilities: |  |                             |       
|Accounts receivable                                                                     |  |                             | 195   
|Other current assets                                                                    |  |                             | 290   
|Prepaid royalty (related party, Note 7)                                                 |  |                             |      
|Other assets                                                                            |  |                             | 10    
|Accrued expenses                                                                        |  |                             | (390  
|Accounts payable                                                                        |  |                             | (60   
|Deferred revenue                                                                        |  |                             | (1,034
|                                                                                        |  |                             |       
|Net cash used in operating activities                                                   |  |                             | (764  
|                                                                                        |  |                             |       
|CASH FLOWS FROM INVESTING ACTIVITIES:                                                   |  |                             |       
|Advances to Scalable Software (related party, Note 7)                                   |  |                             |      
|Purchases of furniture and equipment                                                    |  |                             | (31   
|Proceeds from sale of business                                                          |  |                             | 335   
|                                                                                        |  |                             |       
|Net cash provided by (used in) investing activities                                     |  |                             | 304   
|                                                                                        |  |                             |       
|CASH FLOWS FROM FINANCING ACTIVITIES:                                                   |  |                             |       
|Proceeds from exercises of stock options                                                |  |                             | 24    
|                                                                                        |  |                             |       
|Net cash provided by financing activities                                               |  |                             | 24    
|                                                                                        |  |                             |       
|Net cash flows from discontinued operations                                             |  |                             | 9     
|                                                                                        |  |                             |       
|Net decrease in cash and cash equivalents                                               |  |                             | (427  
|Effect of exchange rate changes on cash                                                 |  |                             | 1     
|Cash and cash equivalents at beginning of period                                        |  |                             | 19,791
|                                                                                        |  |                             |       
|Cash and cash equivalents at end of period                                              |  | $                           | 19,365
|                                                                                        |  |                             |       
|Supplemental disclosure of cash flow information:                                       |  |                             |       
|Cash paid during the period for income taxes                                            |  | $                           |      
|                                                                                        |  |                             |       
|Cash paid during the period for interest                                                |  | $                           |      
|                                                                                        |  |                             |       



SEE ACCOMPANYING
CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.



6



---

##### Table of Contents

NEON SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS



NOTE 1BASIS OF PRESENTATION



The accompanying unaudited consolidated financial statements for NEON Systems, Inc. and its subsidiaries (collectively, NEON) have been
prepared in accordance with accounting principles generally accepted in the United States of America for interim financial reporting and in accordance with Regulation S-X of the Securities and Exchange Commission. Accordingly, they do not include
all of the information and footnotes required by accounting principles generally accepted in the United States of America for complete financial statements. In the opinion of management, the unaudited consolidated financial statements contained in
this report reflect all adjustments, consisting of only normal recurring adjustments, considered necessary for a fair presentation of the financial position and the results of operations for the interim periods presented. Operating results for
interim periods are not necessarily indicative of results for the full year. These unaudited consolidated financial statements, footnote disclosures and other information should be read in conjunction with the financial statements and the notes
thereto included in NEONs audited financial statements for the fiscal year ended March 31, 2003 which are included in NEONs Form 10-K for the fiscal year ended March 31, 2003.



NOTE 2PER SHARE INFORMATION



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



Earnings per share:



(In thousands, except per share date)



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



At June 30, 2003,
there were options outstanding to purchase 2.8 million shares of common stock with a weighted-average exercise price of $8.96. For the three months ended June 30, 2003, 1.8 million were excluded from the calculation of diluted earnings per share
because the effect was anti-dilutive. All outstanding options were excluded from the calculation of diluted loss per share for the three months ended June 30, 2002, as they were anti-dilutive.



7



---

##### Table of Contents

NEON SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)





Employee Stock-Based Compensation



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



|                                                                                                                |  | THREE MONTHS ENDED JUNE 30, |      
|--------------------------------------------------------------------------------------------------------------- |  | --------------------------- | -----
|                                                                                                                |  | 2003                        |      
|Net income (loss) as reported                                                                                   |  | $                           | 155  
|Add stock-based employee compensation expense included in reported net income (loss)                            |  |                             |     
|Deduct total stock-based employee compensation expense determined under fair-value-based method for all rewards |  |                             | 410  
|                                                                                                                |  |                             |      
|Pro forma net income (loss)                                                                                     |  | $                           | (255 
|                                                                                                                |  |                             |      
|Basic earnings (loss) per share:                                                                                |  |                             |      
|As reported                                                                                                     |  | $                           | 0.02 
|                                                                                                                |  |                             |      
|Pro forma                                                                                                       |  | $                           | (0.03
|                                                                                                                |  |                             |      
|Diluted earnings (loss) per share:                                                                              |  |                             |      
|As reported                                                                                                     |  | $                           | 0.02 
|                                                                                                                |  |                             |      
|Pro forma                                                                                                       |  | $                           | (0.03
|                                                                                                                |  |                             |      



NOTE
3INCOME TAXES



NEON has recorded no income tax provision
as the current year taxable income is offset by net operating loss carry-forwards that NEON had previously reserved. At March 31, 2003, NEON has a net operating loss carry-forward for income tax purposes of approximately $21.7 million that is
available to offset future taxable income. The net operating loss carry-forwards in the United Kingdom, Germany and Australia carry forward indefinitely. The net operating loss carry-forward for the United States begins expiring in the tax year
2020. Given the recent tax losses experienced by NEON, there can be no assurance that the operations will generate taxable income in the future to utilize these losses. As of March 31, 2003, the valuation allowance fully offsets the Companys
net deferred tax assets.



NOTE 4SEGMENT
REPORTING



NEON considers its business activities to be in a
single segment. NEON did not have any customers, individually or in aggregate that accounted for 10% or more of consolidated revenue during the three-month period ending June 30, 2003 and June 30, 2002.



8



---

##### Table of Contents

NEON SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



The table below summarizes revenues by geographic region.



|                     |  | THREE MONTHS ENDED JUNE 30, |       
|-------------------- |  | --------------------------- | ------
|                     |  | 2003                        |       
|Revenues:            |  |                             |       
|North America        |  | $                           | 2,670 
|United Kingdom       |  |                             | 1,296 
|Other                |  |                             | 174   
|                     |  |                             |       
|                     |  | $                           | 4,140 
|                     |  |                             |       
|Operating loss:      |  |                             |       
|United States        |  | $                           | (624  
|United Kingdom       |  |                             | 629   
|Other                |  |                             | 51    
|                     |  |                             |       
|                     |  | $                           | 56    
|                     |  |                             |       
|                     |  |                             |       
|                     |  | JUNE 30, 2003               |       
|Identifiable Assets: |  |                             |       
|United States        |  | $                           | 28,918
|United Kingdom       |  |                             | 3,311 
|Other                |  |                             | 710   
|                     |  |                             |       
|                     |  | $                           | 32,939
|                     |  |                             |       



NOTE
5COMMITMENTS AND CONTINGENCIES



On January 29, 2003,
NEON received notification that it had been sued in Fort Bend County, Texas for alleged tortious interference with contract, tortious interference with prospective business relations and unfair competition in a lawsuit styled Phoenix Network
Technologies (Europe) Limited vs. NEON Systems, Inc. and Computer Associates International Inc., 400thDistrict
Court, Ft. Bend County, Richmond, Texas, Cause Number 03-CV-127800. NEON is in the process of defending such action. Aside from this action, NEON is not involved in any current claim as legal action other than those arising in the ordinary course of
business.



NOTE 6RESTRUCTURING CHARGES



During the year ended March 31, 2003, NEON incurred
restructuring charges of $3.0 million. The charges primarily relate to future losses due to the abandonment of leased facilities associated with a corporate reorganization as well as severance and non-cash stock compensation costs related with the
termination of the distribution agreement with NEON Enterprise Software, Inc. The Company has not been able to sublease the abandoned facilities and therefore, has accrued the full amount of the future lease commitments. If the Company is able to
sublease these facilities in the future, it may result in a reversal of this accrual. During fiscal 2002, NEON recorded a restructuring charge of $908,000. These charges also related to reductions in the Companys cost structure, including
reductions in force resulting in severance charges of $570,000 and losses from lease commitments of $338,000 due to the abandonment of certain leased facilities.



9



---

##### Table of Contents

NEON SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)





The following table
provides a roll forward of the restructuring accrual account for the three months ended June 30, 2003 (in thousands):



|                           |  |                    |  | Balance at March 31,2003 |       | AmountsChargedto Expense |   | AmountsPaid |  |   | Balance atJune 30,2003
|-------------------------- |  | ------------------ |  | ------------------------ | ----- | ------------------------ | - | ----------- |  | - | ----------------------
|2002 Restructuring Accrual |  | Facility closure   |  | $                        | 62    |                          | $ |            |  | $ | (11                   
|2003 Restructuring Accrual |  | Employee severance |  |                          | 149   |                          |   |            |  |   | (117                  
|                           |  | Facility closure   |  |                          | 1,957 |                          |   |            |  |   | (176                  
|                           |  |                    |  |                          |       |                          |   |             |  |   |                       
|                           |  | Totals             |  | $                        | 2,168 |                          | $ |            |  | $ | (304                  
|                           |  |                    |  |                          |       |                          |   |             |  |   |                       



The $1.9 million
balance at June 30, 2003 consists primarily of future cash payments for abandoned facilities that will be paid through 2006. The current portion of this liability, $705,000, is included in accrued expenses.



NOTE 7RELATED PARTY TRANSACTIONS



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



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



In January 1996, NEON entered into a distribution agreement with
Peregrine/Bridge Transfer Corporation, a database software company whose sole stockholder is an affiliate of John J. Moores, NEONs Chairman of the Board of Directors. PBTC subsequently changed its name to NEON Enterprise Software, Inc.
(NESI). The distribution agreement had an initial term through January 1, 1998 and could be automatically renewed for successive one-year terms. The agreement also provided that NEON pay royalties to NESI for the license of products and
for maintenance and support and upgrade services equal to 50% of the revenues received by NEON for NEONs distribution of NESIs only products, its Enterprise Subsystem Management products (referred to elsewhere as the ESM products). NEON
also entered into a services agreement with NESI pursuant to which NESI reimbursed NEON for NESIs share of the general and administrative expenses supplied to it by NEON. Such amounts have historically been presented as a reduction of general
and administrative expenses in the accompanying consolidated financial statements. NEON revised the services agreement with NESI in October 2001, as a result of which NESIs monthly payment to NEON declined from $30,000 per month to $5,000 per
month and NEONs services were reduced. In December 1998, NEON amended its distribution agreement with NESI and NESI granted NEON an exclusive, worldwide license to market and sublicense NESIs ESM products in exchange for NEONs
agreement to extend the term of the agreement through March 31, 2004 and pay NESI a minimum advance royalty of $250,000 per quarter during fiscal year 2000, $500,000 per quarter during fiscal year 2001, $750,000 per quarter during fiscal year 2002,
$1.0 million per quarter during fiscal year 2003, and $1.3 million per quarter during fiscal year 2004, for an aggregate payment of $15 million. Such advance royalty payments have historically been recorded by NEON as a prepaid expense and offset by
50% of NEONs sales of ESM products. The amended distribution agreement also provided that NESI would reimburse NEON for the amount of any unearned royalty advances when the agreement terminated in 2004.



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



10



---

##### Table of Contents

NEON SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



negative net worth. As a result, NEONs Board had concerns regarding NESIs ability to repay any balance of
unearned advances at the termination of the agreement in 2004.



On July 2, 2002, the independent directors of NEON authorized the officers of NEON to review the distributor relationship with NESI and to negotiate a termination of the distribution agreement. On July 24, 2002, the independent directors of
NEON approved a letter of intent with proposed terms for a termination of the distribution agreement, which letter of intent was executed by NESI and NEON on such date. Pursuant to the provisions of the letter of intent and after the review and
approval of the independent directors of NEON and the ratification by the full Board of Directors on August 12, 2002, NEON and NESI entered into a Termination and Customer Support Agreement dated August 14, 2002 pursuant to which the distribution
agreement, the services agreement, and all other agreements between NEON and NESI were terminated effective as of August 1, 2002.



Upon the closing of the Termination and Customer Support Agreement on August 14, 2002, NESIs right to receive from NEON, and NEONs
corresponding obligation to pay to NESI, the advance royalty payments described in the distribution agreement terminated. Additionally, NEONs option to purchase NESI and right of first refusal under the distribution agreement also terminated.
The Termination and Customer Support Agreement provides that, in consideration of NESIs consent to terminate its existing agreements with NEON, NEON paid NESI a final cash advance of $2.2 million, which amount has been consolidated with
$884,000 of the outstanding unearned royalty advance under the distribution agreement as of July 31, 2002 and the $500,000 payment with respect to the transfer of rights described below and represented by the consolidated promissory note payable to
NEON in the aggregate principal amount of $3.6 million, bearing no interest to its due date of March 31, 2005. This consolidated promissory note is secured by all of the intellectual property of NESI (NESI IP). The Termination and
Customer Support Agreement also provided that the remaining outstanding unearned royalty advance of $3.0 million as of July 31, 2002 was converted into a $3.0 million dollar convertible promissory note payable to NEON bearing no interest to its due
date of March 31, 2005, which is also secured by the NESI IP. The $3.0 million convertible note is convertible by NEON, in its discretion, into equity in NESI at an agreed pre-cash valuation of $30.0 million dollars. Such conversion right will
expire on the due date of the $3.0 million convertible note. Upon closing, NEON recorded the notes receivable from NESI at their estimated net present value, which was calculated at $4.3 million in aggregate. As a result of the termination
agreement, NEON recorded a loss on disposal of $687,000. NEON also evaluates the NESI IP on a quarterly basis to determine the notes net realizable value, as it is secured by the NESI IP. Accordingly, NEON will adjust the carrying value of the
note if the net realizable value is determined to be below the carrying value. After March 31, 2003, NEON management had an external valuation of the NESI IP performed and determined that no further impairment of the note was required.



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



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



In further consideration of NESI entering into the Termination and Customer Support Agreement, NEON agreed to provide NESI with administrative, accounting
and legal services pursuant to the terms of a new services agreement. Such services will be provided by NEON at no cost to NESI, other than reimbursement of reasonable business expenses, for the twelve-month period beginning August 1, 2002. After
the initial twelve-month period of the services agreement, NESI may elect to receive



11



---

##### Table of Contents

NEON SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



the services, at its option, for up to an additional twelve months for a fee of $10,000 per month. At the end of such
additional term, or in the event NESI does not elect to continue receiving the services described above for the additional term, at the end of the initial term, NEON shall have no further obligations under the services agreement.



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



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



Scalable Software, Inc.



Scalable Software,
Inc., a Houston-based provider of software solutions for IT portfolio management, is a company founded by Louis R. Woodhill, who served as NEONs Chief Executive Officer until March 2003. Several current and former members of NEONs Board
of Directors, including Louis R. Woodhill, John J. Moores, Peter Schaeffer, Charles E. Noell III and Jim Woodhill, have a financial interest in Scalable Software. The percentage beneficial ownership of the current and former NEON directors and
executive officers that have a financial interest in Scalable Software as of March 31, 2003 is set forth below:



|Name                                  |  | Ownership Percentage |  
|------------------------------------- |  | -------------------- | -
|Jim Woodhill                          |  | 24                   | %
|John J. Moores (and affiliates)       |  | 24                   | %
|Louis R. Woodhill (former NEON CEO)   |  | 17                   | %
|Charles E. Noell III (and affiliates) |  | 15                   | %
|Peter Schaeffer                       |  | 2                    | %
|                                      |  |                      |  
|Total                                 |  | 82                   | %
|                                      |  |                      |  



On July 17, 2001, NEON
announced that it had entered into a letter of intent to acquire Scalable Software, Inc. At that time, Louis R. Woodhill was a director, and the President and Chief Executive Officer of Scalable Software. In connection with the letter of intent,
NEON and Scalable Software entered into a Promissory Note dated July 17, 2001, which provided bridge financing to Scalable in a maximum amount of $3.0 million with a maturity date of December 31, 2001, secured by the personal guarantees of John J.
Moores, Louis R. Woodhill and Jim Woodhill. On October 17, 2001, Mr. Woodhill was asked to serve as the President and Chief Executive Officer of NEON. On November 13, 2001, the promissory note was amended to increase the maximum lending limit to
$3.5 million with an original maturity date of March 31, 2002, with such increased amount also being guaranteed by Messrs. Moores, Woodhill and Woodhill. On December 21, 2001, Mr. Woodhill and his twin brother Jim Woodhill, were asked to join the
Board of Directors of NEON.



Due to the interests in Scalable
Software of several members of NEONs Board of Directors, the Board of Directors concluded that it would be appropriate to create a Special Committee comprised solely of independent directors who had no interest in Scalable Software to review
the terms of the proposed acquisition. After thorough consideration and discussion and upon endorsement by the Special Committee, NEONs Board of Directors approved modifications to the proposed terms and conditions for the acquisition such
that the transaction would be structured as an option to acquire Scalable Software as discussed below.



NEON obtained a two-year option to acquire Scalable Software as outlined in the Agreement and Plan of Merger dated June 26, 2002. In connection with this
Option, NEON agreed to provide bridge financing of up to $5.5 million, in addition to the $3.5 million previously loaned to Scalable Software that is secured by personal guarantees from John J. Moores, Louis R. Woodhill and Jim Woodhill. The
aggregate financing had a 36-month term and does not bear interest during the term of the



12



---

##### Table of Contents

NEON SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



two-year option to acquire Scalable Software. After the expiration of the option, the loan will bear interest at the
prime rate plus two percentage points. In addition to the personal guarantees of John J. Moores, Louis R. Woodhill and Jim Woodhill for the initial $3.5 million loaned to Scalable Software, the $5.5 million loan will be secured by all of the
intellectual property rights of Scalable Software. NEON may exercise the option to acquire Scalable Software at any time during the two-year term, subject to provisions that require NEON to exercise its option within a 30-day window under certain
circumstances or forfeit the option. If NEON exercises the option and acquires Scalable Software, each of the approximately 19.4 million outstanding shares of common stock of Scalable Software will be converted into approximately 0.135 of a share of
NEON common stock and outstanding options and warrants to purchase approximately 3.0 million shares of common stock of Scalable Software will become options and warrants to purchase common stock of NEON on the same conversion basis. If Scalable
Software incurs more indebtedness for borrowed money or issues more equity, the exchange ratio will be adjusted accordingly. Prior to NEON exercising the option to acquire Scalable Software, a Special Committee would be appointed to review the
negotiated terms of the proposed acquisition and NEON would seek to obtain a fairness opinion regarding the transaction from a financial advisory firm. The acquisition of Scalable Software will also require approval of the stockholders of NEON and
the NEON Board of Directors.



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



As noted above, certain current and former members of NEONs board of directors and executive officers also serve as directors and executive officers of Scalable Software and claim beneficial ownership of approximately 82% of
Scalables common stock. In addition, NEON has an option to acquire all of the outstanding shares of Scalable Software and is Scalables primary creditor. Therefore, NEON determined that it had effective control of Scalable Software while
it was advancing funds to Scalable and accounted for its investment in Scalable Software using the modified equity method of accounting. Under this method of accounting, NEON recognized 100% of Scalable Softwares losses to the extent of
advances made in excess of the guaranteed amount. At March 31, 2003, NEON had made total advances of $9.5 million to Scalable Software (including $6.0 million of unguaranteed advances) and recognized cumulative losses of $5.6 million, of which $3.5
million were recorded during fiscal 2003. Due to the uncertainties regarding NEONs ultimate ability to recover any unguaranteed advances to Scalable Software, NEON has determined that it should not record the carrying value of its net advance
to Scalable Software above the guaranteed amount. Accordingly, for fiscal 2003, NEON recorded a valuation allowance of $378,000 against the Scalable note receivable, reducing the carrying value of the note receivable to the $3.5 million guaranteed
amount.



Sheer Genius Software, Inc.



On January 3, 2002, NEON entered into a services
agreement with Sheer Genius Software, Inc. of Austin, Texas, a company owned by Jim Woodhill. Jim Woodhill was a member of NEONs Board of Directors at such time. Mr. Woodhill resigned as a director in June 2003. Also, JMI Services, Inc., a
private company owned by John J. Moores, NEONs Chairman, is a creditor of Sheer Genius. Under the first project description negotiated for such services agreement, Sheer Genius provided development services to NEON on a budgeted time and
materials basis and delivered fixed deliverables



13



---

##### Table of Contents

NEON SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



consisting primarily of developed source code. The term of the initial project description was six months and the
aggregate fees were $480,000. This agreement was extended by the Board for an additional three months with additional aggregate fees of $300,000. On October 16, 2002, the Board determined that the Services Agreement with Sheer Genius should be
extended on a month-to-month basis. On May 20, 2003, NEON terminated the Agreement with Sheer Genius and will continue such development efforts internally. All fees under the arrangement were expensed as incurred and included in research and
development. While NEON was Sheer Genius sole source of income, it was free to solicit other customers. Under the services agreement, all intellectual property created by Sheer Genius in the course of performing the services is owned by NEON.
Sheer Genius received a license back of such intellectual property for limited use in the development by Sheer Genius of software that does not compete with software distributed by NEON. The Board of Directors reviewed the terms of the services
agreement and project description and approved such agreements following disclosure of the interest of its officers and directors associated with Sheer Genius. For the year ended March 31, 2003, NEON paid $900,000 to Sheer Genius Software for
services fees. As of the date of termination of the Services agreement with Sheer Genius, NEON had paid services fees in aggregate of $1.3 million.



NOTE 8IMPAIRMENT OF INTANGIBLES



NEON adopted SFAS No. 141, Business Combinations, and SFAS No. 142, Goodwill and Other Intangible Assets, effective April 1, 2002. SFAS No.
141 requires that the purchase method of accounting be used for all business combinations initiated or completed after June 30, 2001, and specifies criteria for the recognition and reporting of intangible assets apart from goodwill. Under SFAS No.
142, NEON no longer amortizes goodwill and intangible assets with indefinite useful lives, but instead will test those assets for impairment at least annually. SFAS No. 142 also requires that intangible assets with definite useful lives be amortized
over such lives to their estimated residual values. As of the date of adoption of SFAS Nos. 141 and 142, the Companys unamortized goodwill in the amount of $1.2 million, was subject to transition provisions of SFAS Nos. 141 and 142.



Under the transition provision of SFAS No. 142, NEON tested
the goodwill balances associated with the September 1999 acquisition of Beyond Software, Inc. (BSI) for impairment by comparing the fair value of BSI to its carrying value. Fair value was determined after considering changes in
operational strategies and plans, as well as assumptions regarding the potential future cash flows from the acquired assets. As a result, NEON determined that the carrying value of the goodwill related to the BSI acquisition had been impaired by
$1.0 million, which is shown as a cumulative effect of a change in accounting principle as of April 1, 2002. This impairment charge resulted in a net carrying value of $150,000, which was subsequently written off to impairment charges as of March
31, 2003.



The pro-forma effects of the adoption of SFAS No.
142 on net loss and loss per share for NEON for the three months ended June 30, 2002 is as follows (in thousands, except per share data):



|                                                              |  | THREE MONTHS ENDED JUNE 30, 2002 |       
|------------------------------------------------------------- |  | -------------------------------- | ------
|Net loss as reported                                          |  | $                                | (4,634
|Add back: Cumulative effect of change in accounting principle |  |                                  | 1,043 
|                                                              |  |                                  |       
|Adjusted net loss                                             |  | $                                | (3,591
|                                                              |  |                                  |       
|Loss per shareBasic and diluted                              |  |                                  |       
|Loss per share, as reported                                   |  | $                                | (0.53 
|Add back: Cumulative effect of change in accounting principle |  |                                  | 0.12  
|                                                              |  |                                  |       
|Pro forma loss per share                                      |  | $                                | (0.41 
|                                                              |  |                                  |       



14



---

##### Table of Contents

NOTE 9IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS



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



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



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



In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure, an amendment of FASB Statement
No. 123. SFAS No. 148 amends FASB Statement No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for an entity that voluntarily changes to the fair value based method of accounting for stock-based
employee compensation. It also amends the disclosure provisions of that Statement to require prominent disclosure about the effects on reported net income of an entitys accounting policy decisions with respect to stock-based employee
compensation. SFAS No. 148 also amends APB Opinion No. 28, Interim Financial Reporting, to require disclosure about those effects in interim financial information. NEON adopted the disclosure requirements of SFAS No. 148 and these disclosures
are included in the notes to NEONs consolidated financial statements.



In November 2002, the FASB issued Interpretation No. 45, Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, an interpretation of
FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No. 34. This interpretation clarifies the requirements for a guarantors accounting for and disclosures of certain guarantees issued and outstanding. This Interpretation
also incorporates without reconsideration the guidance in FASB Interpretation No. 34, Disclosure of Indirect Guarantees of Indebtedness of Others, which is being superseded. The adoption of SFAS No. 145 on April 1, 2003 did not have a
material impact on NEONs consolidated financial statements.



In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of ARB No. 51. This Interpretation addresses the consolidation by business enterprises of variable interest
entities as defined in the Interpretation. The Interpretation applies immediately to variable interests in variable interest entities created after January 31, 2003, and to variable interests in variable interest entities obtained after January 31,
2003. The application of this Interpretation is not expected to have a material effect on NEONs consolidated financial statements.



In April 2003, the FASB issued Statement of Financial Accounting Standard No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging
Activities. This statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging
activities under SFAS Statement No. 133, Accounting for Derivative Instruments and Hedging



15



---

##### Table of Contents

NEON SYSTEMS, INC. AND SUBSIDIARIES



CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS(Continued)



Activities. This Statement is effective for contracts entered into or modified after June 30, 2003. NEON does
not believe that the adoption of this Statement will have a material effect on the results of operations or financial position of the Company.



On May 15, 2003, the Financial Accounting Standards Board issued Statement No. 150, Accounting for Certain Financial Instruments with Characteristics
of Both Liabilities and Equity.The Statement requires issuers to classify as liabilities (or assets in some circumstance) three classes of freestanding financial instruments that embody obligations for the issuer. NEON will adopt the provisions
of the Statement on July 1, 2003. The adoption of SFAS No. 150 is not expected to have a material effect on NEONs financial statements.



NOTE 10DISCONTINUED OPERATIONS



On June 20, 2003, NEON entered into an Asset Purchase Agreement with a subsidiary of Skywire Ventures, L.L.C., a Dallas-based software vendor, to sell its
iWave product line assets. As a result of the transaction, NEON recorded a gain on the sale of $290,000, net of closing expenses during the three months ended June 30, 2003. Total revenues attributed to the iWave product line for the three months
ended June 30, 2003 and 2002 were $194,000 and $424,000, respectively. Operating losses associated with the iWave product line were classified as discontinued operations and represented $244,000 and $525,000 for the three months ended June 30, 2003
and 2002, respectively.



|ITEM 2. |  | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|------- |  | -------------------------------------------------------------------------------------



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



OVERVIEW



NEON develops, markets and supports software products for the IBM mainframe
platform. NEON was incorporated in May 1993 and is a successor by merger to NEON Systems, Inc., an Illinois corporation, which was incorporated in June 1991. NEONs Shadow products provide access and integration of IBM mainframe data and
applications from standard application client environments, including the Internet application platforms, and client/server systems. NEONs product mix in the past three fiscal years has consisted of NEONs Shadow branded products, its
iWave products, and the Enterprise Subsystem Management (ESM) products owned by NEON Enterprise Software, Inc. (formerly Peregrine/Bridge Transfer Corporation, hereafter NESI) and distributed by NEON. Over the last three
fiscal years, NEONs Shadow products accounted for the majority of its sales mix, representing 88%, 79%, and 75% of NEONs sales for fiscal 2003, 2002, and 2001, respectively. During fiscal year 2003, NEON phased out its ESM product line
and iWave product line. In August 2002, NEON terminated its distribution agreement with NESI, effectively exiting the ESM market SeeManagements Discussion and AnalysisRelated Party Transactions and Note 7 to NEONs
consolidated financial statements. On October 31, 2002, NEON reduced the scope of its iWave operations and hired an investment advisor to assist NEON in divesting its iWave product line. On June 20, 2003, NEON entered into an Asset Purchase
Agreement with a subsidiary of Skywire Ventures, L.L.C., a Dallas-based software vendor, to sell the iWave product line assets. See Note 10 to NEONs consolidated financial statements.



NEON derives revenue from software licenses and maintenance services. License
fees, which are based upon the number and capacity of servers as well as the number of client users, are generally due upon license grant and include a one-year maintenance period. The sales process typically takes approximately nine months. After
the initial year of license, NEON provides ongoing maintenance services, which include technical support and product enhancements, for an annual fee. Any



16



---

##### Table of Contents

factors adversely affecting the pricing of, demand for, or market acceptance of, our products, such as competition or
technological change, could materially adversely affect our business, operating results and financial condition. In fiscal 2003, 2002, and 2001, maintenance revenues represented 58%, 44%, and 33% of total revenues, respectively. Maintenance revenues
are expected to continue to increase as a percentage of total revenues in the future. During fiscal 2003, NEON did not have any customers that individually accounted for 10% or more of total revenue. In fiscal 2002 NEON had one customer that
accounted for 10% of total revenue. In fiscal 2001, NEON had one customer that represented 16% of total revenue.



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



NEON conducts its business in the United
Kingdom and Germany through two wholly owned consolidated subsidiaries and revenues from these subsidiaries are denominated in local currencies. In connection with these foreign operations, NEON is exposed to foreign currency fluctuations for its
net working capital positions. At that date, NEON had no material commitments that would be satisfied in currencies other than U.S. dollars. In other international markets, NEON conducts substantially all of its business through independent
third-party distributors. Revenues derived from third-party distributors are denominated in U.S. dollars. Revenues recognized from sales to customers outside North America, primarily in Europe, represented approximately 28%, 14% and 16% in fiscal
2003, 2002, and 2001, respectively. Foreign currency fluctuations have not had a significant impact on NEONs revenues or operating results. Management does not currently have an active foreign exchange hedging program; however, NEON may
implement a program to mitigate foreign currency transaction risk in the future.



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



Related Party Transactions



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



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



In January 1996, NEON entered into a distribution agreement with
Peregrine/Bridge Transfer Corporation, a database software company whose sole stockholder is an affiliate of John J. Moores, NEONs Chairman of the Board of Directors. PBTC subsequently changed its name to NEON Enterprise Software, Inc.
(NESI). The distribution agreement had an initial term through January 1, 1998 and could be automatically renewed for successive one-year terms. The agreement also provided that NEON pay royalties to NESI for the license of products and
for maintenance and support and upgrade services equal to 50% of the revenues received by NEON for NEONs distribution of NESIs only products, its Enterprise Subsystem Management products (referred to elsewhere as the ESM products). NEON
also entered into a services agreement with NESI pursuant to which NESI reimbursed NEON for NESIs share of the general and administrative expenses supplied to it by NEON. Such amounts have historically been presented as a reduction of general
and administrative expenses in the accompanying consolidated financial statements. NEON revised the services agreement with NESI in October 2001, as a result of which NESIs monthly payment to NEON declined from $30,000 per month to $5,000 per
month and NEONs services were reduced. In December 1998, NEON amended its distribution agreement with NESI and NESI granted NEON an exclusive, worldwide license to market and sublicense NESIs ESM products in exchange for NEONs
agreement to extend the term of the agreement through March 31, 2004 and pay NESI a minimum advance royalty of $250,000 per quarter during fiscal year 2000, $500,000 per quarter during fiscal year 2001, $750,000 per quarter during fiscal year 2002,
$1.0 million per quarter during fiscal year 2003, and $1.3 million per quarter during fiscal year 2004, for an aggregate payment of $15 million. Such advance royalty payments have historically been recorded by NEON as a prepaid expense and offset by
50% of NEONs sales



17



---

##### Table of Contents

of ESM products. The amended distribution agreement also provided that NESI would reimburse NEON for the amount of any
unearned royalty advances when the agreement terminated in 2004.



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



On July 2, 2002, the independent directors of NEON authorized the officers of NEON to review the distributor relationship with NESI and to negotiate a termination of the distribution agreement. On July 24, 2002, the independent directors of
NEON approved a letter of intent with proposed terms for a termination of the distribution agreement, which letter of intent was executed by NESI and NEON on such date. Pursuant to the provisions of the letter of intent and after the review and
approval of the independent directors of NEON and the ratification by the full Board of Directors on August 12, 2002, NEON and NESI entered into a Termination and Customer Support Agreement dated August 14, 2002 pursuant to which the distribution
agreement, the services agreement, and all other agreements between NEON and NESI were terminated effective as of August 1, 2002.



Upon the closing of the Termination and Customer Support Agreement on August 14, 2002, NESIs right to receive from NEON, and NEONs
corresponding obligation to pay to NESI, the advance royalty payments described in the distribution agreement terminated. Additionally, NEONs option to purchase NESI and right of first refusal under the distribution agreement also terminated.
The Termination and Customer Support Agreement provides that, in consideration of NESIs consent to terminate its existing agreements with NEON, NEON paid NESI a final cash advance of $2.2 million, which amount has been consolidated with
$884,000 of the outstanding unearned royalty advance under the distribution agreement as of July 31, 2002 and the $500,000 payment with respect to the transfer of rights described below and represented by the consolidated promissory note payable to
NEON in the aggregate principal amount of $3.6 million, bearing no interest to its due date of March 31, 2005. This consolidated promissory note is secured by all of the intellectual property of NESI (NESI IP). The Termination and
Customer Support Agreement also provided that the remaining outstanding unearned royalty advance of $3.0 million as of July 31, 2002 was converted into a $3.0 million dollar convertible promissory note payable to NEON bearing no interest to its due
date of March 31, 2005, which is also secured by the NESI IP. The $3.0 million convertible note is convertible by NEON, in its discretion, into equity in NESI at an agreed pre-cash valuation of $30.0 million dollars. Such conversion right will
expire on the due date of the $3.0 million convertible note. Upon closing, NEON recorded the notes receivable from NESI at their estimated net present value, which was calculated at $4.3 million in aggregate. As a result of the termination
agreement, NEON recorded a loss on disposal of $687,000. NEON also evaluates the NESI IP on a quarterly basis to determine the notes net realizable value, as it is secured by the NESI IP. Accordingly, NEON will adjust the carrying value of the
note if the net realizable value is determined to be below the carrying value. After March 31, 2003, NEON management had an external valuation of the NESI IP performed and determined that no further impairment of the note was required.



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



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



18



---

##### Table of Contents

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



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



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



Scalable Software, Inc.



Scalable Software,
Inc., a Houston-based provider of software solutions for IT portfolio management, is a company founded by Louis R. Woodhill, who served as NEONs Chief Executive Officer until March 2003. Several current and former members of NEONs Board
of Directors, including Louis R. Woodhill, John J. Moores, Peter Schaeffer, Charles E. Noell III and Jim Woodhill, have a financial interest in Scalable Software. The percentage beneficial ownership of the current and former NEON directors and
executive officers that have a financial interest in Scalable Software as of March 31, 2003 is set forth below:



|Name                                  |  | Ownership Percentage |  
|------------------------------------- |  | -------------------- | -
|Jim Woodhill                          |  | 24                   | %
|John J. Moores (and affiliates)       |  | 24                   | %
|Louis R. Woodhill (former NEON CEO)   |  | 17                   | %
|Charles E. Noell III (and affiliates) |  | 15                   | %
|Peter Schaeffer                       |  | 2                    | %
|                                      |  |                      |  
|Total                                 |  | 82                   | %
|                                      |  |                      |  



On July 17, 2001, NEON
announced that it had entered into a letter of intent to acquire Scalable Software, Inc. At that time, Louis R. Woodhill was a director, and the President and Chief Executive Officer of Scalable Software. In connection with the letter of intent,
NEON and Scalable Software entered into a Promissory Note dated July 17, 2001, which provided bridge financing to Scalable in a maximum amount of $3.0 million with a maturity date of December 31, 2001, secured by the personal guarantees of John J.
Moores, Louis R. Woodhill and Jim Woodhill. On October 17, 2001, Mr. Woodhill was asked to serve as the President and Chief Executive Officer of NEON and served in such capacity until his resignation in March 2003. On November 13, 2001, the
promissory note was amended to increase the maximum lending limit to $3.5 million with an original maturity date of March 31, 2002, with such increased amount also being guaranteed by Messrs. Moores, Woodhill and Woodhill. On December 21, 2001, Mr.
Woodhill and his twin brother Jim Woodhill, were asked to join the Board of Directors of NEON and served in such capacity until their resignation in March 2003.



Due to the interests in Scalable Software of several members of NEONs Board of Directors, the Board of Directors concluded that it would be
appropriate to create a Special Committee comprised solely of independent directors who had no interest in Scalable Software to review the terms of the proposed acquisition. After thorough consideration and discussion and upon endorsement by the
Special Committee, NEONs Board of Directors approved modifications to the proposed terms and conditions for the acquisition such that the transaction would be structured as an option to acquire Scalable Software as discussed below.



NEON obtained a two-year option to acquire Scalable Software as outlined
in the Agreement and Plan of Merger dated June 26, 2002. In connection with this Option, NEON agreed to provide bridge financing of up to $5.5 million, in addition to the $3.5 million previously loaned to Scalable Software that is secured by
personal guarantees from John J. Moores, Louis R. Woodhill and Jim Woodhill. The aggregate financing had a 36-month term and does not bear interest during the term of the



19



---

##### Table of Contents

two-year option to acquire Scalable Software. After the expiration of the option, the loan will bear interest at the
prime rate plus two percentage points. In addition to the personal guarantees of John J. Moores, Louis R. Woodhill and Jim Woodhill for the initial $3.5 million loaned to Scalable Software, the $5.5 million loan will be secured by all of the
intellectual property rights of Scalable Software. NEON may exercise the option to acquire Scalable Software at any time during the two-year term, subject to provisions that require NEON to exercise its option within a 30-day window under certain
circumstances or forfeit the option. If NEON exercises the option and acquires Scalable Software, each of the approximately 19.4 million outstanding shares of common stock of Scalable Software will be converted into approximately 0.135 of a share of
NEON common stock and outstanding options and warrants to purchase approximately 3.0 million shares of common stock of Scalable Software will become options and warrants to purchase common stock of NEON on the same conversion basis. If Scalable
Software incurs more indebtedness for borrowed money or issues more equity, the exchange ratio will be adjusted accordingly. Prior to NEON exercising the option to acquire Scalable Software, a Special Committee would be appointed to review the
negotiated terms of the proposed acquisition and NEON would seek to obtain a fairness opinion regarding the transaction from a financial advisory firm. The acquisition of Scalable Software will also require approval of the stockholders of NEON and
the NEON Board of Directors.



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



As noted above, certain current and former members of NEONs board of directors and executive officers also serve as directors and executive officers of Scalable Software and claim beneficial ownership of approximately 82% of
Scalables common stock. In addition, NEON has an option to acquire all of the outstanding shares of Scalable Software and is Scalables primary creditor. Therefore, NEON determined that it had effective control of Scalable Software while
it was advancing funds to Scalable and accounted for its investment in Scalable Software using the modified equity method of accounting. Under this method of accounting, NEON recognized 100% of Scalable Softwares losses to the extent of
advances made in excess of the guaranteed amount. At March 31, 2003, NEON had made total advances of $9.5 million to Scalable Software (including $6.0 million of unguaranteed advances) and recognized cumulative losses of $5.6 million, of which $3.5
million were recorded during fiscal 2003. Due to the uncertainties regarding NEONs ultimate ability to recover any unguaranteed advances to Scalable Software, NEON has determined that it should not record the carrying value of its net advance
to Scalable Software above the guaranteed amount. Accordingly, for fiscal 2003, NEON recorded a valuation allowance of $378,000 against the Scalable note receivable, reducing the carrying value of the note receivable to the $3.5 million guaranteed
amount.



Sheer Genius Software, Inc.



On January 3, 2002, NEON entered into a services
agreement with Sheer Genius Software, Inc. of Austin, Texas, a company owned by Jim Woodhill. Jim Woodhill was a member of NEONs Board of Directors at such time. Also, JMI Services, Inc., a private company owned by John J. Moores, NEONs
Chairman, is a creditor of Sheer Genius. Under the first project description negotiated for such services agreement, Sheer Genius provided development services to NEON on a budgeted time and materials basis and delivered fixed deliverables
consisting primarily of developed source code. The term of the initial project description was six months and the aggregate fees were $480,000. This agreement was extended by the Board for an additional three months with additional aggregate fees of
$300,000. On October 16, 2002, the Board determined that the Services Agreement with Sheer Genius should be extended on a month-to-month basis. On May 20, 2003, NEON terminated the Agreement with Sheer Genius and will continue such development
efforts internally. All fees under the arrangement were expensed as incurred and included in research and development. While NEON was Sheer Genius sole source of income, it was free to solicit other customers. Under the services agreement, all
intellectual property created by Sheer Genius in the course of



20



---

##### Table of Contents

performing the services is owned by NEON. Sheer Genius received a license back of such intellectual property for limited
use in the development by Sheer Genius of software that does not compete with software distributed by NEON. The Board of Directors reviewed the terms of the services agreement and project description and approved such agreements following disclosure
of the interest of its officers and directors associated with Sheer Genius. For the year ended March 31, 2003, NEON paid $900,000 to Sheer Genius Software for services fees. As of the date of termination of the Services agreement with Sheer Genius,
NEON had paid services fees in aggregate of $1.3 million.



Critical Accounting Policies



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



Revenue Recognition Policies



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



Capitalized Software Costs



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



Allowance for Doubtful Accounts Receivable



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



21



---

##### Table of Contents

Deferred Income Taxes



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



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



Accounting for Advances to Scalable Software



As discussed more fully in Related Party Transactions above, certain members of NEONs board of directors and executive officers also
serve as directors and executive officers of Scalable Software and claim beneficial ownership of approximately 82% of Scalables common stock. In addition, NEON has an option to acquire all of the outstanding shares of Scalable Software and
during fiscal year 2003 provided Scalables primary financing for its operations. Therefore, NEON determined that it has effective control of Scalable Software and began accounting for its investment in Scalable Software using the modified
equity method of accounting. Under this method of accounting, NEON recognizes 100% of Scalable Softwares losses to the extent of its advances made to Scalable Software in excess of the amounts guaranteed by Messrs. Moores, Woodhill and
Woodhill.



RESULTS OF OPERATIONS



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



|                           |  | THREE MONTHS ENDED JUNE 30, |  
|-------------------------- |  | --------------------------- | -
|                           |  | 2003                        |  
|Revenues:                  |  |                             |  
|License                    |  | 38                          | %
|Maintenance                |  | 62                          |  
|                           |  |                             |  
|Total revenues             |  | 100                         |  
|Cost of revenues:          |  |                             |  
|Cost of licenses           |  | 2                           |  
|Cost of maintenance        |  | 9                           |  
|                           |  |                             |  
|Total cost of revenues     |  | 11                          |  
|                           |  |                             |  
|Gross profit               |  | 89                          |  
|Operating expenses:        |  |                             |  
|Sales and marketing        |  | 44                          |  
|Research and development   |  | 25                          |  
|General and administrative |  | 18                          |  
|Restructuring costs        |  |                            |  
|                           |  |                             |  
|Total operating expenses   |  | 87                          |  
|                           |  |                             |  



22



---

##### Table of Contents

|Operating income (loss)                                                  |  | 2  |   |  | (30 | ) 
|------------------------------------------------------------------------ |  | -- | - |  | --- | --
|Interest and other income, net                                           |  | 1  |   |  | 3   |   
|Equity loss in affiliate                                                 |  |   |   |  | (27 | ) 
|Valuation allowance of note receivable                                   |  |   |   |  | (12 | ) 
|                                                                         |  |    |   |  |     |   
|Income (loss) from continuing operations before income taxes and         |  |    |   |  |     |   
|cumulative effect of change in accounting principle                      |  | 3  |   |  | (66 | ) 
|Provision for income taxes                                               |  |   |   |  |    |   
|                                                                         |  |    |   |  |     |   
|Income (loss) from continuing operations before cumulative effect of     |  |    |   |  |     |   
|change in accounting principle                                           |  | 3  |   |  | (66 | ) 
|                                                                         |  |    |   |  |     |   
|Loss on discontinued operations                                          |  | (6 | ) |  | (11 | ) 
|Gain on disposal of discontinued operations                              |  | 7  |   |  |    |   
|                                                                         |  |    |   |  |     |   
|Income (loss) before cumulative effect of change in accounting principle |  | 4  |   |  | (77 | ) 
|                                                                         |  |    |   |  |     |   
|Cumulative effect of change in accounting principle                      |  |   |   |  | (22 | ) 
|                                                                         |  |    |   |  |     |   
|Net income (loss)                                                        |  | 4  | % |  | (99 | )%
|                                                                         |  |    |   |  |     |   



THREE
MONTHS ENDED JUNE 30, 2003 COMPARED TO THREE MONTHS ENDED JUNE 30, 2002



REVENUES



License revenues for
the three months ended June 30, 2003 were $1.6 million, a decrease of $630,000 from $2.2 million for the three months ended June 30, 2002. The reduction in license revenue was due to the elimination of NEONs ESM product line, in addition to
the overall weakness in the mainframe software market. ESM products accounted for $339,000 in license revenue during the three months ended June 30, 2002.



Maintenance revenues for the three months ended June 30, 2003 were $2.6 million, an increase of $72,000 from $2.5 million for the three months ended June
30, 2002. The increase primarily resulted from increases in maintenance renewal fees reflected as a percentage of current license fees, as well as growth of NEONs accumulated installed customer base.



COST OF REVENUES



Cost of license revenues primarily consists of royalty payments to third
parties, as well as other direct product costs such as product manuals and distribution and media costs associated with NEONs software products. Cost of license revenues for the three months ended June 30, 2003 were $83,000, or 5.3% of license
revenues, as compared to $183,000, or 8.4% of license revenues, for the three months ended June 30, 2002. The decrease in the cost of license revenues as a percentage of license revenue was due to the termination of product royalty payments to NESI,
see Related Party Transactions.



Cost of
maintenance revenues includes personnel and other customer support costs. Cost of maintenance revenues for the three months ended June 30, 2003 were $374,000, or 14.5% of maintenance revenues, as compared to $567,000, or 22.6% of maintenance
revenues, for the three months ended June 30, 2002. The reduction in cost of maintenance revenue as a percentage of maintenance revenue was due to the cumulative growth in NEONs customer base and annual increases in maintenance fees combined
with consolidation of the technical support staff.



OPERATING EXPENSES



Sales and marketing expenses
include personnel costs, sales commissions and travel expenses of sales, presales support and marketing personnel, along with trade show participation and other promotional expenses. Sales and marketing expenses for the three months ended June 30,
2003 were $1.8 million, a decrease of $1.4 million from $3.2 million for the three months ended June 30, 2002. The reduction was primarily due to lower personnel costs associated with a headcount reduction during fiscal year 2003, combined with
lower promotional marketing costs due to the elimination of the EMS product line and refocused its marketing efforts to emphasize its Shadow product line.



Research and development expenses primarily include personnel costs associated with NEONs product development staff. Research and development
expenses for the three months ended June 30, 2003 and 2002 were consistent, representing $1.0



23



---

##### Table of Contents

million in both periods. Research and development may increase as NEON continues to expand its existing product lines and
develop new products.



General and administrative expenses
include personnel and other costs associated with NEONs executive, financial, legal and administrative functions. General and administrative expenses for the three months ended June 30, 2003 were $780,000 million, a decrease of $459,000 from
$1.2 million for the three months ended June 30, 2002. The decrease was primarily related to a reduction in administrative personnel.



Interest and other income for the three months ended June 30, 2003 was $53,000 as compared to $142,000 for the three months ended June 30, 2002. The
reduction in interest income was primarily due to lower available cash balances combined with a decline in interest rates.



On June 20, 2003, NEON entered into an Asset Purchase Agreement with a subsidiary of Skywire Ventures, L.L.C., a Dallas-based software vendor, to sell its
iWave product line assets. As a result of the transaction, NEON recorded a gain on the sale of $290,000, net of closing expenses during the three months ended June 30, 2003. Total revenues attributed to the iWave product line for the three months
ended June 30, 2003 and 2002 were $194,000 and $424,000, respectively. Operating losses associated with the iWave product line were classified as discontinued operations and represented $244,000 and $525,000 for the three months ended June 30, 2003
and 2002, respectively.



NEON accounts for its investment in
Scalable Software using the modified equity method of accounting. Under this method, NEON recognizes 100% of Scalable Softwares income or loss to the extent of advances made in excess of the guaranteed amount. For the three months ended June
30, 2002 NEON recorded an equity in loss of $1.2 million. NEON also recorded a valuation allowance of $573,000 for the three months ended June 30, 2002 against the Scalable note receivable to write-down the outstanding balance of the note to the
guaranteed amount. NEON is no longer advancing funds to Scalable, therefore an equity loss was not recognized for the three months ended June 30, 2003. The note receivable from Scalable Software is recorded at the amount guaranteed by certain
individuals. See Related Party Transactions and Note 7 to NEONs financial statements.



No provision for income taxes was recorded for the three months ended June 30, 2003 as the current year taxable income is offset by net operating loss
carry-forwards that NEON had previously reserved. No provision for income tax was recorded for the three months ended June 30, 2002, as NEON had a pre-tax loss for the period of $3.1 million. At March 31, 2003, NEON has a net operating loss
carry-forward for income tax purposes of approximately $21.7 million that is available to offset future taxable income, if any. The net operating loss carry-forwards in the United Kingdom, Germany and Australia carry forward indefinitely. The net
operating loss carry-forward for the United States begins expiring in the tax year 2020. Given the recent tax losses experienced by NEON, there can be no assurance that the operations will generate taxable income in the future to utilize these
losses, therefore, as of June 30, 2003, NEON has recorded a full valuation allowance for the deferred tax assets related to the future benefits, if any, for these loss carryforwards.



LIQUIDITY AND CAPITAL RESOURCES



NEONs cash and cash equivalents at June 30, 2003 were $19.4 million, a decline of $426,000 from $19.8 million at March
31, 2003. This decrease was due primarily to cash used in normal operating activities.



Net cash used in operating activities was $764,000 and $2.3 million for the three months ended June 30, 2003 and 2002, respectively. The net cash used in operating activities for the three months ended June 30, 2003
resulted primarily from a reduction in deferred revenue. The net cash used in operating activities for the three months ended June 30, 2002, resulted primarily from NEONs net operating loss.



During the three months ended June 30, 2003, net cash provided by investing
activities was $304,000, primarily as a result from the proceeds from the sale of the iWave product line. Net cash used in investing activities during the three months ended June 30, 2002 was $1.8 million, primarily due to advances to Scalable
Software (see Related Party Transactions).



NEONs net cash provided by financing activities was $24,000 and $3,000 for the three months ended June 30, 2003 and 2002, respectively. The net cash provided by financing activities in both periods represents proceeds from the
exercise of employee stock options.



24



---

##### Table of Contents

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



New Accounting Pronouncements



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



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



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



In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based
Compensation-Transition and Disclosure, an amendment of FASB Statement No. 123. SFAS No. 148 amends FASB Statement No. 123, Accounting for Stock-Based Compensation, to provide alternative methods of transition for an entity that
voluntarily changes to the fair value based method of accounting for stock-based employee compensation. It also amends the disclosure provisions of that Statement to require prominent disclosure about the effects on reported net income of an
entitys accounting policy decisions with respect to stock-based employee compensation. SFAS No. 148 also amends APB Opinion No. 28, Interim Financial Reporting, to require disclosure about those effects in interim financial information.
NEON adopted the disclosure requirements of SFAS No. 148 and these disclosures are included in the notes to NEONs consolidated financial statements.



In November 2002, the FASB issued Interpretation No. 45, Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect
Guarantees of Indebtedness of Others, an interpretation of FASB Statements No. 5, 57, and 107 and rescission of FASB Interpretation No. 34. This interpretation clarifies the requirements for a guarantors accounting for and disclosures of
certain guarantees issued and outstanding. This Interpretation also incorporates without reconsideration the guidance in FASB Interpretation No. 34, Disclosure of Indirect Guarantees of Indebtedness of Others, which is being superseded. The
adoption of SFAS No. 145 on April 1, 2003 did not have a material impact on NEONs consolidated financial statements.



In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of ARB No. 51. This
Interpretation addresses the consolidation by business enterprises of variable interest entities as defined in the Interpretation. The Interpretation applies immediately to variable interests in variable interest entities created after January 31,



25



---

##### Table of Contents

2003, and to variable interests in variable interest entities obtained after January 31, 2003. The application of this
Interpretation is not expected to have a material effect on NEONs consolidated financial statements.



In April 2003, the FASB issued Statement of Financial Accounting Standard No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging
Activities. This statement amends and clarifies financial accounting and reporting for derivative instruments, including certain derivative instruments embedded in other contracts (collectively referred to as derivatives) and for hedging
activities under SFAS Statement No. 133, Accounting for Derivative Instruments and Hedging Activities. This Statement is effective for contracts entered into or modified after June 30, 2003. NEON does not believe that the adoption of this
Statement will have a material effect on the results of operations or financial position of the Company.



On May 15, 2003, the Financial Accounting Standards Board issued Statement No. 150, Accounting for Certain Financial Instruments with Characteristics
of Both Liabilities and Equity.The Statement requires issuers to classify as liabilities (or assets in some circumstance) three classes of freestanding financial instruments that embody obligations for the issuer. NEON will adopt the provisions
of the Statement on July 1, 2003. The adoption of SFAS No. 150 is not expected to have a material effect on NEONs financial statements.



|ITEM 3. |  | QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK
|------- |  | ----------------------------------------------------------



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



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



NEON adheres to a conservative investment policy, whereby its principal
concern is the preservation of liquid funds while maximizing its yield on such assets. Cash and cash equivalents approximated $19.4 million at June 30, 2003, and were invested in different types of commercial paper and money securities. NEON
believes that a near-term change in interest rates would not materially affect its financial position, results of operations or net cash flows for fiscal year 2004.



|ITEM 4. |  | CONTROLS AND PROCEDURES
|------- |  | -----------------------



As of the end of the period 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 principal executive officer and principal financial officer, of the effectiveness of the design and operation of NEONs disclosure controls and procedures (as defined in Rule 13a-15(e) of
the Securities Exchange Act of 1934). Based upon that evaluation, the principal executive officer and principal financial officer concluded that NEONs disclosure controls and procedures are effective in ensuring that material information is
accumulated and communicated to management, and made known to the principal executive officer and principal financial officer, on a timely basis to allow disclosure as required in this Quarterly Report on Form 10-Q. There have been no significant
changes in NEONs internal controls or in other factors which could significantly affect internal controls subsequent to the date NEON carried out its evaluation.



PART IIOTHER INFORMATION



|ITEM 1. |  | LEGAL PROCEEDINGSPlease see the discussion in Part I, Note 5 of the Condensed Notes to Consolidated Financial Statements, which is incorporated by reference in
this Part II, Item 1.
|------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|ITEM 2. |  | DEFAULTS UPON SENIOR SECURITIESNot applicable.
|------- |  | -----------------------------------------------



|ITEM 3. |  | SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERSNot applicable.
|------- |  | -----------------------------------------------------------------



26



---

##### Table of Contents

|ITEM 4. |  | OTHER INFORMATION
|------- |  | ------------------



RISK FACTORS THAT MAY AFFECT FUTURE RESULTS



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



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



Members of our Board of Directors and our current and former Executive Officers are shareholders, directors and/or officers in other companies, some of which are identified and discussed under Managements Discussion and Analysis
of Financial Condition and Results of OperationsRelated Party Transactions in the section on Related Party Transactions herein, including the following:



| |  |  | NEON Enterprise Software, Inc. (formerly Peregrine/Bridge Transfer Corporation)
| | - |  | -------------------------------------------------------------------------------



| |  |  | Scalable Software, Inc.
| | - |  | -----------------------



| |  |  | Sheer Genius Software, Inc.
| | - |  | ---------------------------



See Managements Discussions and Analysis of Financial Condition and Results of OperationsRelated Party Transactions and Note 7 to NEONs consolidated financial statements.



Such relationships may give rise to conflicts of interest resulting from the
balancing of such officer/directors duties to NEONs stockholders and their corresponding duties to the stockholders of any company in which they also hold positions as directors (or officers), especially in the context of business
negotiations between NEON and such other company. In any event where an officer or director has a conflict of interest, the Board of Directors has appointed a Special Committee to review such conflict. Notwithstanding such procedures, NEON may face
the threat of shareholder claims based solely on the mere appearance of conflicts of interest in any related party business transaction.



Uncertainty Regarding Our Management After Changes May Adversely Affect Our Business



On March 7, 2003, NEON announced in a press release that we had undergone a corporate-wide reorganization of our business to
focus on our core Shadow product line. In connection with this reorganization and in response to the changing economic outlook, NEON undertook a reduction in force of approximately 26% of its overall employee base and announced that Louis R.
Woodhill had resigned from his positions as President, Chief Executive Officer, and as a member of the Board of Directors of NEON. Mr. Woodhill had served in such capacities since October 17, 2001. The NEON Board of Directors appointed Mark
Cresswell, our Senior Vice President and General Manager of the Shadow product line, to serve as President and Chief Operating Officer of the Company. Mr. Cresswell joins Brian D. Helman, NEONs Chief Financial Officer since July 2002, as
NEONs key executive officers. Such reduction-in-force and changes in management may have caused or could cause uncertainty about NEONs future direction and results.



Loss of Key Software Developers Could Adversely Affect Our Business



Our success is dependent 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 a negative impact on our business because of their unique skills, years of industry experience and the difficulty of promptly finding qualified
replacement personnel. We do not intend to maintain key-man life insurance policies covering any of our employees. Significant competition exists for employees with the skills required to develop the software products and perform the
maintenance services that we offer, and we may not be able to continue to retain sufficient numbers of highly skilled employees.



27



---

##### Table of Contents

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



| |  |  | Our stock price has fluctuated and is subject to wide swings in price based on a number of factors, including our quarterly operating results, which may vary significantly from
quarter to quarter.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Our future operating
results may vary significantly from quarter to quarter due to a variety of factors, many of which are outside our control. Therefore, it is likely that in one or more future quarters our results may fall below the expectations of securities analysts
and investors. We operate with virtually no order backlog because our products are shipped and revenues are recognized shortly after orders are received. In addition, the amount of revenues associated with sales of our software can vary
significantly. In various quarters in the past, we have derived a significant portion of our software license revenues from a small number of relatively large sales. An inability to close one or more large sales that we had targeted to close in a
particular period could materially adversely affect our operating results for that period. Moreover, we typically realize a majority of our software license revenues in the last month of a quarter. As a result, minor delays in the timing of customer
orders can shift a sale from its contemplated quarter of completion to a subsequent quarter and cause significant variability in our operating results for any particular period. Accordingly, we believe that period-to-period comparisons of our
operating results are not necessarily a meaningful indication of future performance. Although we generally do not give guidance as to 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 Common Stock For Sale Could Adversely Affect Its Market Price
| | - |  | ------------------------------------------------------------------------------------------------------------



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



Reduced Customer Reliance Upon
Mainframe Computers Could Adversely Affect Our Business



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



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



| |  |  | Growth in business demands for access to the data, applications and transactions residing on mainframe computers from Web-based and client/server applications; and
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Continued market acceptance of the Shadow products and enhancements to these products.
| | - |  | --------------------------------------------------------------------------------------



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



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



28



---

##### Table of Contents

Rapid Technological Change Could Render Our Products Obsolete



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



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



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



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



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



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



At present, our executive officers and directors and entities affiliated with them beneficially own more than 50% of our
outstanding common stock. As a result, these stockholders, if they act together, could control most matters submitted to our stockholders for a vote, including the election of directors.



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



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



29



---

##### Table of Contents

|ITEM 5. |  | EXHIBITS AND REPORTS ON FORM 8-K
|------- |  | --------------------------------



| | (a) |  | EXHIBITS
| | --- |  | --------







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



| | (b) |  | REPORTS ON FORM 8-K
| | --- |  | -------------------



None



30



---

##### Table of Contents

SIGNATURES



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



|      |  | NEON SYSTEMS, INC.
|----- |  | ------------------
|      |  |                   
|Date: |  | August 13, 2003   
|      |  |                   



|      |  |                
|----- |  | ---------------
|Date: |  | August 13, 2003
|      |  |                



31