**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**Form10-Q**

 

**(Mark One)**

 
| **ý****QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE****SECURITIES EXCHANGE ACT OF 1934**                                                                                                      |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|                                                                                                                                                                                                          |
| **For the Quarterly Period Ended December 31, 2004**                                                                                                                                                          |
| ** **                                                                                                                                                                                                    |
| **OR**                                                                                                                                                                                                        |
| ** **                                                                                                                                                                                                    |
| **o****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 itscharter)

 
| **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 areacode)

 

Indicate by check mark whether Registrant (1) has filedall reports required to be filed by Section 13 or 15(d) of the SecuritiesExchange Act of 1934 during the preceding 12 months (or for such shorter periodthat Registrant was required to file such reports), and (2) has been subject tosuch filing requirements for the past 90 days. Yes ý  No  o

 

Indicateby check mark whether the registrant is an accelerated filer (as defined inRule 12b-2 of the Exchange Act).

Yes  oNo ý

 

Thenumber of shares of the registrant’s common stock outstanding as of January 31,2005, was 9,371,539.

 

 

----

 

NEON SYSTEMS, INC.

 

FORM 10-Q

 

FOR THE QUARTER ENDED DECEMBER 31, 2004

 

INDEX

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

 

2

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**PART I -FINANCIAL INFORMATION**

 

**ITEM 1. FINANCIAL STATEMENTS**

 

NEON SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATEDBALANCE SHEETS

(IN THOUSANDS, EXCEPT SHARE AND PER SHARE AMOUNTS)

 
| ** **                                                                                                                                                                 | ** ** | **DECEMBER 31, 2004** | ** ** | **MARCH 31, 2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|--------------------|------------|
| ** **                                                                                                                                                                 | ** ** | **(UNAUDITED)**       | ** ** | ** **         | ** ** |
| ASSETS                                                                                                                                                                     |       |                  |       |               |       |
|                                                                                                                                                                       |       |                  |       |               |       |
| CURRENT ASSETS:                                                                                                                                                            |       |                  |       |               |       |
| Cash and cash equivalents                                                                                                                                                  |       | $                     | 13,259     |               | $          | 20,899 |   |
| Accounts receivable, net                                                                                                                                                   |       | 3,709                 |       | 6,150              |       |
| Other current assets                                                                                                                                                       |       | 980                   |       | 1,232              |       |
| Total current assets                                                                                                                                                       |       | 17,948                |       | 28,281             |       |
|                                                                                                                                                                       |       |                  |       |               |       |
| Property and equipment, net                                                                                                                                                |       | 700                   |       | 475                |       |
| Note receivable, net (Note 7)                                                                                                                                              |       | 4,260                 |       | 7,760              |       |
| Acquired intangibles, net (Note 10)                                                                                                                                        |       | 8,856                 |       | —             |       |
| Goodwill                                                                                                                                                                   |       | 8,785                 |       | —             |       |
| Other assets                                                                                                                                                               |       | 301                   |       | 341                |       |
| Total assets                                                                                                                                                               |       | $                     | 40,850     |               | $          | 36,857 |   |
|                                                                                                                                                                       |       |                  |       |               |       |
| LIABILITIES & STOCKHOLDERS’ EQUITY                                                                                                                                |       |                  |       |               |       |
|                                                                                                                                                                       |       |                  |       |               |       |
| CURRENT LIABILITIES:                                                                                                                                                       |       |                  |       |               |       |
| Accounts payable                                                                                                                                                           |       | $                     | 384        |               | $          | 298 |   |
| Accrued expenses and other                                                                                                                                                 |       | 1,455                 |       | 2,733              |       |
| Deferred revenue                                                                                                                                                           |       | 6,796                 |       | 7,540              |       |
| Total current liabilities                                                                                                                                                  |       | 8,635                 |       | 10,571             |       |
|                                                                                                                                                                       |       |                  |       |               |       |
| Deferred revenue – long term                                                                                                                                          |       | 3,676                 |       | 931                |       |
| Accrued expenses – long term (Note 6)                                                                                                                                 |       | 798                   |       | 898                |       |
| Total liabilities                                                                                                                                                          |       | 13,109                |       | 12,400             |       |
|                                                                                                                                                                       |       |                  |       |               |       |
| STOCKHOLDERS’ EQUITY:                                                                                                                                                 |       |                  |       |               |       |
| Preferred stock, $.01 par value. Authorized  10,000,000 shares; no shares issued and outstanding                                                                           |       | —                |       | —             |       |
| Common stock, $.01 par value. Authorized  30,000,000 shares; 9,371,058 and 8,914,547 shares  issued and outstanding at December 31, 2004 and  March 31, 2004, respectively |       | 103                   |       | 98                 |       |
| Additional paid-in capital                                                                                                                                                 |       | 54,668                |       | 51,696             |       |
| Treasury stock, 913,400 shares at cost                                                                                                                                     |       | (2,649                | )          | (2,649             | )          |
| Accumulated other comprehensive loss                                                                                                                                       |       | (398                  | )          | (421               | )          |
| Accumulated deficit                                                                                                                                                        |       | (23,983               | )          | (24,267            | )          |
| Total stockholders’ equity                                                                                                                                            |       | 27,741                |       | 24,457             |       |
| Commitments and contingencies (Note 5)                                                                                                                                     |       |                  |       |               |       |
|                                                                                                                                                                       |       |                  |       |               |       |
| Total liabilities and stockholders’ equity                                                                                                                            |       | $                     | 40,850     |               | $          | 36,857 |   |

 

SEE ACCOMPANYING CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

3

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NEON SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

(UNAUDITED)

 
| ** **                                                   | ** ** | **THREE MONTHS ENDED DECEMBER 31,** | ** ** | **NINE MONTHS ENDED DECEMBER 31,** | ** ** |
|--------------------------------------------------------------|------------|-------------------------------------|------------|------------------------------------|------------|
| ** **                                                   | ** ** | **2004**                            | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues:                                                    |       |                                |       |                               |       |   |   |   |   |
| License                                                      |       | $                                   | 2,072      |                               | $          | 1,157 |   | $ | 4,360 |   | $ | 3,855 |   |
| Maintenance and services                                     |       | 2,630                               |       | 2,489                              |       | 7,668 |   | 7,519 |   |
| Total revenues                                               |       | 4,702                               |       | 3,646                              |       | 12,028 |   | 11,374 |   |
|                                                         |       |                                |       |                               |       |   |   |   |   |
| Cost of revenues:                                            |       |                                |       |                               |       |   |   |   |   |
| Cost of licenses                                             |       | 246                                 |       | 1                                  |       | 441 |   | 84 |   |
| Cost of maintenance and services                             |       | 445                                 |       | 342                                |       | 1,182 |   | 1,077 |   |
| Total cost of revenues                                       |       | 691                                 |       | 343                                |       | 1,623 |   | 1,161 |   |
|                                                         |       |                                |       |                               |       |   |   |   |   |
| Gross profit                                                 |       | 4,011                               |       | 3,303                              |       | 10,405 |   | 10,213 |   |
|                                                         |       |                                |       |                               |       |   |   |   |   |
| Operating expenses:                                          |       |                                |       |                               |       |   |   |   |   |
| Sales and marketing                                          |       | 2,191                               |       | 1,471                              |       | 5,432 |   | 4,483 |   |
| Research and development                                     |       | 1,279                               |       | 1,097                              |       | 3,557 |   | 3,391 |   |
| General and administrative                                   |       | 738                                 |       | 1,113                              |       | 2,541 |   | 2,794 |   |
| Total operating expenses                                     |       | 4,208                               |       | 3,681                              |       | 11,530 |   | 10,668 |   |
|                                                         |       |                                |       |                               |       |   |   |   |   |
| Operating loss                                               |       | (197                                | )          | (378                               | )          | (1,125 | ) | (455 | ) |
|                                                         |       |                                |       |                               |       |   |   |   |   |
| Gain on sale of notes receivable (Note 7)                    |       | —                              |       | —                             |       | 1,215 |   | — |   |
| Interest and other income, net                               |       | 80                                  |       | 60                                 |       | 194 |   | 231 |   |
| Income (loss) from continuing operations before income taxes |       | (117                                | )          | (318                               | )          | 284 |   | (224 | ) |
|                                                         |       |                                |       |                               |       |   |   |   |   |
| Provision for income taxes                                   |       | —                              |       | —                             |       | — |   | — |   |
| Income (loss) from continuing operations                     |       | (117                                | )          | (318                               | )          | 284 |   | (224 | ) |
| Income from discontinued operations, net                     |       | —                              |       | 10                                 |       | — |   | 108 |   |
| Net income (loss)                                            |       | $                                   | (117       | )                                  | $          | (308 | ) | $ | 284 |   | $ | (116 | ) |
|                                                         |       |                                |       |                               |       |   |   |   |   |
| Earnings (loss) per common share —Basic:                |       |                                |       |                               |       |   |   |   |   |
| Income (loss) from continuing operations                     |       | $                                   | (0.01      | )                                  | $          | (0.03 | ) | $ | 0.03 |   | $ | (0.02 | ) |
| Income from discontinued operations, net                     |       | —                              |       | —                             |       | — |   | 0.01 |   |
| Net income (loss)                                            |       | $                                   | (0.01      | )                                  | $          | (0.03 | ) | $ | 0.03 |   | $ | (0.01 | ) |
|                                                         |       |                                |       |                               |       |   |   |   |   |
| Earnings (loss) per common share —Diluted:              |       |                                |       |                               |       |   |   |   |   |
| Income (loss) from continuing operations                     |       | $                                   | (0.01      | )                                  | $          | (0.03 | ) | $ | 0.03 |   | $ | (0.02 | ) |
| Income from discontinued operations, net                     |       | —                              |       | —                             |       | — |   | 0.01 |   |
| Net income (loss)                                            |       | $                                   | (0.01      | )                                  | $          | (0.03 | ) | $ | 0.03 |   | $ | (0.01 | ) |
|                                                         |       |                                |       |                               |       |   |   |   |   |
| Weighted average shares outstanding:                         |       |                                |       |                               |       |   |   |   |   |
| Basic                                                        |       | 9,350                               |       | 8,876                              |       | 9,179 |   | 8,839 |   |
| Diluted                                                      |       | 9,350                               |       | 8,876                              |       | 9,332 |   | 8,839 |   |

 

SEE ACCOMPANYING CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

4

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NEON SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(IN THOUSANDS)

(UNAUDITED)

 
| ** **                                                                               | ** ** | **NINE MONTHS ENDED DECEMBER 31,** | ** ** |
|------------------------------------------------------------------------------------------|------------|------------------------------------|------------|
| ** **                                                                               | ** ** | **2004**                           | ** ** | **2003** | ** ** |
| CASH FLOWS FROM OPERATING ACTIVITIES:                                                    |       |                               |       |   |   |
| Net income (loss)                                                                        |       | $                                  | 284        |   | $ | (116 | ) |
| Adjustments to reconcile net income (loss) to net cash  used in operating activities:    |       |                               |       |   |   |
| Depreciation                                                                             |       | 287                                |       | 238 |   |
| Amortization of acquired intangibles                                                     |       | 430                                |       | — |   |
| Gain on sale of notes receivable (Note 7)                                                |       | (1,215                             | )          | — |   |
| Income from discontinued operations, net                                                 |       | —                             |       | (108 | ) |
| Impairment of fixed assets                                                               |       | —                             |       | 50 |   |
| Increase (decrease) in cash resulting from changes  in operating assets and liabilities: |       |                               |       |   |   |
| Accounts receivable                                                                      |       | 2,754                              |       | (37 | ) |
| Tax receivable                                                                           |       | —                             |       | 1,311 |   |
| Other assets                                                                             |       | 336                                |       | 423 |   |
| Accounts payable and accrued expenses                                                    |       | (2,111                             | )          | (1,490 | ) |
| Deferred revenue                                                                         |       | 1,070                              |       | (686 | ) |
|                                                                                     |       |                               |       |   |   |
| Net cash provided by (used in) operating activities                                      |       | 1,835                              |       | (415 | ) |
|                                                                                     |       |                               |       |   |   |
| CASH FLOWS FROM INVESTING ACTIVITIES:                                                    |       |                               |       |   |   |
| Purchases of fixed assets                                                                |       | (307                               | )          | (57 | ) |
| Purchase of technology                                                                   |       | (264                               | )          | — |   |
| Acquisitions, net of cash acquired                                                       |       | (13,701                            | )          | — |   |
| Proceeds from sales of notes receivable, net                                             |       | 4,715                              |       | — |   |
| Proceeds from sale of business                                                           |       | —                             |       | 538 |   |
|                                                                                     |       |                               |       |   |   |
| Net cash provided by (used in) investing activities                                      |       | (9,557                             | )          | 481 |   |
|                                                                                     |       |                               |       |   |   |
| CASH FLOWS FROM FINANCING ACTIVITIES:                                                    |       |                               |       |   |   |
| Proceeds from exercises of stock options                                                 |       | 56                                 |       | 94 |   |
| Payments on capital lease                                                                |       | (11                                | )          | — |   |
|                                                                                     |       |                               |       |   |   |
| Net cash provided by financing activities                                                |       | 45                                 |       | 94 |   |
|                                                                                     |       |                               |       |   |   |
| Net cash flows from discontinued operations                                              |       | —                             |       | 9 |   |
|                                                                                     |       |                               |       |   |   |
| Net increase (decrease) in cash and cash equivalents                                     |       | (7,677                             | )          | 169 |   |
| Effect of exchange rate changes on cash                                                  |       | 37                                 |       | 253 |   |
| Cash and cash equivalents at beginning of period                                         |       | 20,899                             |       | 19,791 |   |
|                                                                                     |       |                               |       |   |   |
| Cash and cash equivalents at end of period                                               |       | $                                  | 13,259     |   | $ | 20,213 |   |
|                                                                                     |       |                               |       |   |   |
| Supplemental disclosure of cash flow information:                                        |       |                               |       |   |   |
|                                                                                     |       |                               |       |   |   |
| Cash (paid) received during the period for income taxes                                  |       | $                                  | (40        | ) | $ | 1,420 |   |
| Cash paid during the period for interest                                                 |       | $                                  | —     |   | $ | — |   |

 

SEE ACCOMPANYING CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

5

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NEON SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

 

NOTE 1—BASIS OF PRESENTATION

 

Theaccompanying unaudited consolidated financial statements for NEON Systems, Inc.and its subsidiaries (collectively, “NEON”) have been prepared in accordancewith accounting principles generally accepted in the United States of Americafor interim financial reporting and in accordance with Regulation S-X of theSecurities and Exchange Commission. Accordingly, they do not include all of theinformation and footnotes required by accounting principles generally acceptedin the United States of America for complete financial statements. In theopinion of management, the unaudited consolidated financial statements containedin this report reflect all adjustments, consisting of only normal recurringadjustments, considered necessary for a fair presentation of the financialposition and the results of operations for the interim periods presented.Operating results for interim periods are not necessarily indicative of resultsfor the full year. These unaudited consolidated financial statements, footnotedisclosures and other information should be read in conjunction with thefinancial statements and the notes thereto included in NEON’s auditedconsolidated financial statements for the fiscal year ended March 31, 2004,which are included in NEON’s Form 10-K for the fiscal year ended March 31,2004.  Certain prior period amounts havebeen reclassified to conform to current period presentation.

 

NOTE2—PER SHARE INFORMATION

 

Incalculating earnings per share information, NEON follows the provisions ofStatement of Financial Accounting Standards (“SFAS”) No. 128, *Earnings Per Share*. Basic earnings per share is computed bydividing net income applicable to common stockholders by the weighted averagenumber of shares of common stock outstanding during the period.  Diluted earnings per share is computed bydividing net income applicable to common stockholders by the weighted averagenumber of shares of common stock outstanding, adjusted to reflect common stockequivalents, such as convertible preferred stock, stock options and warrants topurchase common stock, to the extent they are dilutive, less the number ofshares that could have been repurchased with the exercise proceeds using thetreasury stock method.

 

Earningsper share:

(*In thousands, except per share data)*

 
| ** **                                           | ** ** | **THREE MONTHS ENDED  DECEMBER 31,** | ** ** | **NINE MONTHS ENDED  DECEMBER 31,** | ** ** |
|------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                           | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                           | ** ** | ** **                           | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income  (loss) available for common shareholders |       | $                                    | (117       | )                                   | $          | (308 | ) | $ | 284 |   | $ | (116 | ) |
|                                                 |       |                                 |       |                                |       |   |   |   |   |
| Weighted average  outstanding shares of common stock |       | 9,350                                |       | 8,876                               |       | 9,179 |   | 8,839 |   |
| Dilutive effect  of employee stock options           |       | —                               |       | —                              |       | 153 |   | — |   |
| Common stock and  common stock equivalents           |       | 9,350                                |       | 8,876                               |       | 9,332 |   | 8,839 |   |
|                                                 |       |                                 |       |                                |       |   |   |   |   |
| Earnings (loss)  per share:                          |       |                                 |       |                                |       |   |   |   |   |
| Basic                                                |       | $                                    | (0.01      | )                                   | $          | (0.03 | ) | $ | 0.03 |   | $ | (0.01 | ) |
| Diluted                                              |       | $                                    | (0.01      | )                                   | $          | (0.03 | ) | $ | 0.03 |   | $ | (0.01 | ) |

 

At December 31, 2004, there were options outstanding to purchase 3.1million shares of common stock with a weighted-average exercise price of $5.74.For the three and nine months ended December 31, 2004, 3.1 million and 2.7million options, respectively, were excluded from the computation of dilutedearnings per share.  All outstandingoptions were excluded from the calculation for the three and nine months endedDecember 31, 2003, as they were anti-dilutive.

 

6

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

##### ** **

NEON applies the intrinsic value-based method of accounting prescribed byAccounting Principles Board (“APB”) Opinion No. 25, *Accounting For Stock Issued To Employees*, and relatedinterpretations.  As such, compensationexpense has been recorded on the date of grant only if the estimated value ofthe underlying stock exceeded the exercise price.  SFAS No. 123, *Accounting For Stock-Based Compensation*, establishedaccounting and disclosure requirements using a fair value-based method ofaccounting for stock-based employee compensation plans.  SFAS No. 123 allows entities to continue toapply the provisions of APB Opinion No. 25 and provide pro forma net income andpro forma earnings per share disclosures for stock option grants made in 1996and future years as if the fair value-based method defined in SFAS No. 123 hadbeen applied.  NEON has elected tocontinue to apply the provisions of APB Opinion No. 25 and provide the proforma disclosure provisions of SFAS No. 123. The following table illustrates the effect on net income if the fairvalue-based method had been applied to all outstanding and unvested awards ineach period (in thousands, except per share data):

 
| ** **                                                                                                        | ** ** | **THREE MONTHS ENDED  DECEMBER 31,** | ** ** | **NINE MONTHS ENDED  DECEMBER 31,** | ** ** |
|-------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------|------------|-------------------------------------|------------|
| ** **                                                                                                        | ** ** | **2004**                             | ** ** | **2003**                            | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                                                                                        | ** ** | ** **                           | ** ** | ** **                          | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income (loss) as reported                                                                                     |       | $                                    | (117       | )                                   | $          | (308 | ) | $ | 284 |   | $ | (116 | ) |
| Deduct total stock-based employee compensation expense  determined under fair-value-based method for all  rewards |       | 438                                  |       | 263                                 |       | 1,232 |   | 905 |   |
| Pro forma net loss                                                                                                |       | $                                    | (555       | )                                   | $          | (571 | ) | $ | (948 | ) | $ | (1,021 | ) |
|                                                                                                              |       |                                 |       |                                |       |   |   |   |   |
| Basic earnings (loss) per share:                                                                                  |       |                                 |       |                                |       |   |   |   |   |
| As reported                                                                                                       |       | $                                    | (0.01      | )                                   | $          | (0.03 | ) | $ | 0.03 |   | $ | (0.01 | ) |
| Pro forma                                                                                                         |       | $                                    | (0.06      | )                                   | $          | (0.06 | ) | $ | (0.10 | ) | $ | (0.12 | ) |
|                                                                                                              |       |                                 |       |                                |       |   |   |   |   |
| Diluted earnings (loss) per share:                                                                                |       |                                 |       |                                |       |   |   |   |   |
| As reported                                                                                                       |       | $                                    | (0.01      | )                                   | $          | (0.03 | ) | $ | 0.03 |   | $ | (0.01 | ) |
| Pro forma                                                                                                         |       | $                                    | (0.06      | )                                   | $          | (0.06 | ) | $ | (0.10 | ) | $ | (0.12 | ) |

 

NOTE3—INCOME TAXES

 

NEON has recorded no income tax provision as the current year taxableincome is offset by net operating loss carry-forwards that NEON had previouslyreserved.  At March 31, 2004, NEON had anet operating loss carry-forward for income tax purposes of approximately $20million that is available to offset future taxable income. The net operatingloss carry-forwards for the United Kingdom, Germany and Australia carry forwardindefinitely.  The net operating losscarry-forward for the United States begins expiring in the tax year 2020.  There can be no assurance that the operationswill generate sufficient taxable income in the future to utilize theselosses.  As of December 31, 2004 andMarch 31, 2004, the valuation allowance fully offset the Company’s net deferredtax assets.

 

7

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NOTE4—SEGMENT REPORTING

 

NEON did not have any customers that accounted for 10% or more ofconsolidated revenue during the three or nine months ended December 31, 2004 or2003.

 

The table below summarizes revenues by geographic region.

 
| ** **               | ** ** | **THREE MONTHS ENDED DECEMBER 31,** | ** ** | **NINE MONTHS ENDED DECEMBER 31,** | ** ** |
|--------------------------|------------|-------------------------------------|------------|------------------------------------|------------|
| ** **               | ** ** | **2004**                            | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues:                |       |                                |       |                               |       |   |   |   |   |
| North America            |       | $                                   | 3,540      |                               | $          | 2,367 |   | $ | 8,954 |   | $ | 7,605 |   |
| United Kingdom           |       | 1,081                               |       | 1,162                              |       | 2,806 |   | 3,377 |   |
| Other                    |       | 81                                  |       | 117                                |       | 268 |   | 392 |   |
|                     |       | $                                   | 4,702      |                               | $          | 3,646 |   | $ | 12,028 |   | $ | 11,374 |   |
|                     |       |                                |       |                               |       |   |   |   |   |
| Operating income (loss): |       |                                |       |                               |       |   |   |   |   |
| North America            |       | $                                   | (865       | )                                  | $          | (868 | ) | $ | (2,492 | ) | $ | (2,016 | ) |
| United Kingdom           |       | 613                                 |       | 598                                |       | 1,288 |   | 1,669 |   |
| Other                    |       | 55                                  |       | (108                               | )          | 79 |   | (108 | ) |
|                     |       | $                                   | (197       | )                                  | $          | (378 | ) | $ | (1,125 | ) | $ | (455 | ) |

 
| ** **         | ** ** | **DECEMBER 31, 2004** | ** ** | **MARCH 31, 2004** | ** ** |
|--------------------|------------|-----------------------|------------|--------------------|------------|
|               |       |                  |       |               |       |
| Long-lived Assets: |       |                  |       |               |       |
| North America      |       | $                     | 18,558     |               | $          | 705 |   |
| United Kingdom     |       | 84                    |       | 111                |       |
| Other              |       | —                |       | —             |       |
|               |       | $                     | 18,642     |               | $          | 816 |   |

 

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 interferencewith prospective business relations and unfair competition in a lawsuit styledPhoenix Network Technologies (Europe) Limited vs. NEON Systems, Inc. andComputer Associates International Inc., 400th District Court, Ft. BendCounty, Richmond, Texas, Cause Number 03-CV-127800. On October 27, 2003, thecourt granted NEON’s motion to dismiss the case.  Phoenix Network Technologies has appealedthis decision, and NEON is continuing to defend this action.  Aside from this action, NEON is not involvedin any current material claim or legal action other than those arising in theordinary course of business.

 

NOTE 6—RESTRUCTURINGCHARGES

 

During priorperiods, NEON recorded various restructuring charges related to future lossesfrom leases of vacated facilities associated with corporatereorganization.  If, in the future, thesefacilities are subleased for additional periods or leases are renegotiated, NEONwill adjust the accrued liability.

 

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The followingtable provides a roll-forward of the restructuring accrual account for the ninemonths ended December 31, 2004 (in thousands):

 
| ** **                  | ** ** | ** **         | ** ** | **Balance at********March 31,  2004** | ** ** | **Decrease  to Expense** | ** ** | **Net  Amounts  Paid** | ** ** | **Other** | ** ** | **Balance at  December 31,  2004** | ** ** |
|-----------------------------|------------|--------------------|------------|-------------------------------------------------|------------|-------------------------------|------------|------------------------|------------|-----------|------------|-----------------------------------------|------------|
|                        |       |               |       |                                            |       |                          |       |                   |       |      |       |                                    |       |
| 2002  Restructuring Accrual |       | Facility closure   |       | $                                               | 54         |                          | $          | —                 |       | $         | (18        | )                                       | $          | — |   | $ | 36 |   |
|                        |       |               |       |                                            |       |                          |       |                   |       |      |       |                                    |       |
| 2003  Restructuring Accrual |       | Facility closure   |       | 1,462                                           |       | (425                          | )          | (344                   | )          | 122       |       | 815                                     |       |
|                        |       |               |       |                                            |       |                          |       |                   |       |      |       |                                    |       |
| 2004  Restructuring Accrual |       | Employee severance |       | 35                                              |       | —                        |       | (35                    | )          | —    |       | —                                  |       |
|                        |       | Facility closure   |       | 3                                               |       | —                        |       | (3                     | )          | —    |       | —                                  |       |
|                        |       |               |       |                                            |       |                          |       |                   |       |      |       |                                    |       |
|                        |       | Totals             |       | $                                               | 1,554      |                          | $          | (425                   | )          | $         | (400       | )                                       | $          | 122 |   | $ | 851 |   |

 

The $851,000balance at December 31, 2004 consists of future cash payments for vacatedfacilities that will be paid through 2006. The current and long-term portionsof this liability included in accrued expenses are $99,000 and $752,000,respectively.

 

During the ninemonths ended December 31, 2004, NEON renegotiated a lease and finalized a newsublease agreement associated with previously vacated properties.  These transactions resulted in a decrease inthe accrued liability of $425,000, of which $229,000 related to the threemonths ended December 31, 2004.  Theseamounts are reported in general and administrative expenses in the accompanyingunaudited consolidated statements of operations.

 

Other adjustmentsrelate primarily to the effect of currency translation on foreign balances.

 

NOTE7—RELATED PARTY TRANSACTIONS

 

Certain formermembers of NEON’s Board of Directors and certain former executive officers ofNEON were shareholders and/or directors in other companies with which NEON hasinvestments.  Transactions between NEONand these other companies are described below. The directors and officersinvolved in such transactions are no longer officers and directors of NEON.

 

*NEONEnterprise Software, Inc. (formerly Peregrine/Bridge Transfer Corporation)*

 

NEON entered intoa Termination and Customer Support Agreement on August 14, 2002, whichterminated a distribution agreement with Peregrine/Bridge Transfer Corporation(PBTC), a database software company whose sole stockholder is an affiliate ofJohn J. Moores, NEON’s former Chairman of the Board of Directors. PBTCsubsequently changed its name to NEON Enterprise Software, Inc. (“NESI”).

 

NEON currentlyholds a consolidated promissory note receivable from NESI in the aggregateprincipal amount of $3.6 million, bearing no interest to its due date of March31, 2005. This consolidated promissory note is secured by all of theintellectual property of NESI (“NESI IP”). NEON also currently holds a $3.0million convertible promissory note receivable from NESI bearing no interest toits due date of March 31, 2005, which is also secured by the NESI IP. The $3.0million convertible note is convertible by NEON, in its discretion, into equityin NESI at an agreed pre-cash valuation of NESI equity of $30.0 million.   Such conversion right will expire on the duedate of the $3.0 million convertible note. On the closing of the transaction inAugust 2002, NEON recorded the notes receivable from NESI at their estimatednet present value, which was calculated at $4.3 million in aggregate value.NEON will adjust the carrying value of the note if the net realizable value isdetermined to be below the carrying value. NEON had an external valuation ofthe NESI IP performed as of March 31, 2004 and determined that no furtherimpairment of the notes was required.  NEONalso evaluates the NESI IP on a quarterly basis to determine the notes’

 

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net realizable value.NEON is not aware of any changes that have occurred that would result in anadjustment to the carrying value.

 

*ScalableSoftware, Inc.*

 

On June 9, 2004,NEON entered into a Note Purchase Agreement with JMI Services, Inc., thelargest shareholder of Scalable, to sell the $3.5 million guaranteed note andthe $6.0 million secured note issued by Scalable to NEON for cash purchaseprice of $4.8 million.  A gain of $1.2million resulted from the cash proceeds in excess of the recorded combined bookvalue of the notes and direct selling expenses. JMI Services is an affiliate ofJohn J. Moores, NEON’s largest shareholder. The proposed sale of the Scalable notes was reviewed and approved by theSpecial Committee of the Board of Directors consisting of “independent” anddisinterested directors, and finally approved by NEON’s Board of Directors, nomember of which was an interested or related party of either JMI Services, Inc.or Scalable.  The Board requested andreceived a fairness opinion from Avail Consulting, Inc., a Houston, Texas basedindependent valuation and financial consultant, stating that the transactionwas fair to the stockholders of NEON from a financial standpoint andrecommending that the Board accept the purchase offer made by JMI Services,Inc.  Closing of the transaction occurredon June 17, 2004.

 

NOTE 8 – DISCONTINUEDOPERATIONS

 

On June 20, 2003,NEON entered into an Asset Purchase Agreement with a third party softwarevendor to sell it iWave product line assets. As a result of the transaction, NEON recorded a gain of $343,000 on thesale, net of closing expenses, during the nine months ended December 31, 2003.Total revenues for the nine months ended December 31, 2003 were $194,000.  Operating losses associated with the iWaveproduct line were classified as discontinued operations.  Operating loss for the nine months endedDecember 31, 2003 was $244,000.

 

NOTE 9 – BUSINESSCOMBINATIONS

 

*InnerAccessTechnologies, Inc.*

 

On July 14, 2004,NEON acquired 100% interest in InnerAccess Technologies, Inc. (InnerAccess), acompany incorporated under the laws of the province of Quebec, Canada.  InnerAccess developed, marketed and licensedweb services technology and provided services related to the integration ofmainframe data sources with modern distributed computing systems.  NEON paid the InnerAccess shareholders atotal of $2.4 million in cash and issued 407,000 shares of NEON restrictedcommon stock to the amalgamated entity, of which 407,000 have been transferredto the shareholders of InnerAccess in consideration for the acquisition.  All issuances and transfers of NEON commonstock were exempt from SEC regulation registration requirements underRegulation S.  These shares are includedin the weighted average shares outstanding for the respective periods. Theresults of operations of the acquired entity are included in the consolidatedresults of operations of NEON from the date of acquisition through the end ofthe period.

 

In addition, NEONassumed certain special warrants of InnerAccess, which, on a converted basis,represent the right to acquire an additional 19,894 shares of NEON common stockat a cash exercise price equal to $9.50 per share.  In connection with the issuance of the sharesof NEON common stock, NEON also agreed to enter into a registration rightsagreement with each former InnerAccess shareholder in the form attached asExhibit 4.1 to our Form 8-K filed with the SEC on July 29, 2004.  Such registration rights agreement grants toeach such former InnerAccess shareholder a piggyback registration right on anyregistration by NEON of NEON shares of common stock occurring during the oneyear period following the closing of the acquisition of InnerAccess by NEON.

 

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PurchasePrice:

 

NEON paid anestimated total purchase price of approximately $4.5 million for 100% ofthe outstanding common stock of InnerAccess. The assessed fair value of theNEON restricted common stock issued, $1.5 million, was based on theaverage market price of NEON common stock for the period beginning two tradingdays before and ending two trading days after July 14, 2004, the announcementdate of the acquisition. The estimated value of the total purchase price forthe acquisition is as follows (in thousands):

 
| Cash                                          |   | $     | 2,400  |   |
|-----------------------------------------------|--------|-------|--------|--------|
| Fair value of  NEON common stock to be issued |   | 1,466 |   |
| Estimated direct  acquisition costs           |   | 611   |   |
| Total estimated  purchase price               |   | $     | 4,477  |   |

 

The ultimate value of thepurchase price is dependent on the actual direct acquisition costs.

 

CondensedBalance Sheet:

 

Under the purchase methodof accounting, the total estimated purchase price has been allocated to thetangible and intangible assets acquired and liabilities assumed on the basis oftheir respective estimated fair values on the date of acquisition. Thevaluation of the identifiable intangible assets acquired reflects management’sestimates based on, among other factors, a valuation of the intangible assetsprepared by an independent third party. Based on the estimated purchase price and the preliminary valuations,the preliminary estimated purchase price allocation, subject to completion offinal analysis, is as follows (in thousands): 

 
| Cash                                          |   | $      | 259    |   |
|-----------------------------------------------|--------|--------|--------|--------|
| Tangible assets                               |   | 567    |   |
| Amortizable  intangible assets:               |   |   |   |
| Core technology                               |   | 2,600  |   |
| Maintenance  contracts/customer relationships |   | 660    |   |
| Goodwill                                      |   | 1,308  |   |
| Total assets  acquired                        |   | 5,394  |   |
| Liabilities  assumed                          |   | 917    |   |
| Net assets  acquired                          |   | $      | 4,477  |   |

 

Approximately$3.3 million has been allocated to amortizable intangible assetsconsisting of existing technology, maintenance contracts and customerrelationships. An estimated $1.3 million has been allocated to goodwill.Goodwill represents the excess of the purchase price over the fair value of thenet tangible and amortizable intangible assets acquired.

 

*ClientSoft, Inc.*

 

OnDecember 13, 2004, NEON acquired substantially all of the assets, andassumed certain liabilities, of ClientSoft, Inc. (“ClientSoft”) for a cashpurchase price of $10.5 million and the issuance to ClientSoft of awarrant to acquire up to 1,125,000 shares of NEON common stock (the “Warrant”).  ClientSoft developed, marketed and licensedweb services technology and provided services related to the integration ofmainframe data sources with modern distributed computing systems. The assetsacquired by NEON included intellectual property, contracts and equipment andother tangible personal property. The liabilities assumed by NEON related tofuture customer support.

 

The transactioncontemplated was evidenced by an Asset Purchase Agreement among NEON,ClientSoft, a Delaware corporation and U.S. Bank, National Association, asescrow agent (the “Asset Purchase Agreement”). Approximately $2.3 million

 

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of the cash and theWarrant were placed in escrow at closing. The Warrant is exercisable in wholeor in part at any time prior to or on June 13, 2008. The exercise priceper share of the Warrant is $4.80, which is the closing price per share of NEONcommon stock on the NASDAQ Stock Market on December 13, 2004, multipliedby 1.33.  In connection with the assetpurchase, NEON added approximately 25 former ClientSoft employees.  NEON now has approximately 100 employeesworldwide. In connection with the issuance of the Warrant, NEON entered into aregistration rights agreement with ClientSoft. The registration rightsagreement obligates NEON to file, as soon as practicable following the Company’sfiling of its annual report on Form 10-K for the fiscal year endedMarch 31, 2005, a shelf registration on Form S-3 to register theshares of Common Stock underlying the Warrant for resale by the holder(s) ofthe Warrant.  The results of the acquiredoperations are included in the consolidated results of operations from theperiod from the date of acquisition through December 31, 2004.

 

PurchasePrice:

 

NEON paid anestimated preliminary total purchase price of approximately $12.6 million forthe net assets acquired from ClientSoft. The preliminary estimated value of theNEON warrant issued of $1.5 million was determined by an independent thirdparty using the Black-Scholes option pricing model.  The estimated preliminary total purchaseprice for the acquisition is as follows (in thousands):

 
| Cash                                |   | $      | 10,500 |   |
|-------------------------------------|--------|--------|--------|--------|
| Fair value of  NEON warrant issued  |   | 1,455  |   |
| Estimated direct  acquisition costs |   | 601    |   |
|                                |   |   |   |
| Total estimated  purchase price     |   | $      | 12,556 |   |

 

The final purchase priceis dependent on the actual final direct acquisition costs and valuation of thewarrant.

 

CondensedBalance Sheet:

 

Under the purchase methodof accounting, the total estimated purchase price has been allocated to thetangible and intangible assets acquired and liabilities assumed on the basis oftheir respective estimated fair values on the date of acquisition. Thevaluation of the identifiable intangible assets acquired reflects management’sestimates based on, among other factors, a valuation of the intangible assetsprepared by an independent third party. Based on the estimated purchase price and the preliminary valuations,the preliminary purchase price allocation, subject to change pending completionof final analysis, is as follows (in thousands): 

 
| Tangible assets                               |   | 113    |   |
|-----------------------------------------------|--------|--------|--------|
| Amortizable  intangible assets:               |   |   |   |
| Core technology                               |   | 4,500  |   |
| Maintenance  contracts/customer relationships |   | 1,100  |   |
| Goodwill                                      |   | 7,477  |   |
| Total assets  acquired                        |   | 13,190 |   |
| Liabilities  assumed                          |   | 634    |   |
| Net assets  acquired                          |   | $      | 12,556 |   |
|                                               |        |        |        |  |

 

Approximately $5.6million has been allocated to amortizable intangible assets consisting ofexisting technology, maintenance contracts and customer relationships. Apreliminary estimate of $7.5 million has been allocated to goodwill. Goodwillrepresents the excess of the purchase price over the fair value of the nettangible and amortizable intangible assets acquired.

 

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** **

**Pro FormaInformation:**

 

The following proforma information presents the consolidated operating results of NEON as if theacquisitions of InnerAccess and ClientSoft had occurred at the beginning of thefiscal period presented:

 
| ** **                            | ** ** | **Three Months Ended,** | ** ** | **Nine Months Ended,** | ** ** |
|---------------------------------------|------------|-------------------------|------------|------------------------|------------|
| **Results of Operations:**            | ** ** | **12/31/04**            | ** ** | **12/31/03**           | ** ** | **12/31/04** | ** ** | **12/31/03** | ** ** |
|                                  |       |                    |       |                   |       |   |   |   |   |
| Total revenues                        |       | $                       | 5,394      |                   | $          | 5,118 |   | $ | 15,607 |   | $ | 16,508 |   |
|                                  |       |                    |       |                   |       |   |   |   |   |
| Net loss                              |       | (677                    | )          | (1,000                 | )          | (1,253 | ) | (1,889 | ) |
|                                  |       |                    |       |                   |       |   |   |   |   |
| Earning per  share:                   |       |                    |       |                   |       |   |   |   |   |
| Basic                                 |       | $                       | (0.07      | )                      | $          | (0.11 | ) | $ | (0.13 | ) | $ | (0.20 | ) |
| Diluted                               |       | $                       | (0.07      | )                      | $          | (0.11 | ) | $ | (0.13 | ) | $ | (0.20 | ) |
|                                  |       |                    |       |                   |       |   |   |   |   |
| Weighted-average  shares outstanding: |       |                    |       |                   |       |   |   |   |   |
| Basic                                 |       | 9,350                   |       | 9,283                  |       | 9,333 |   | 9,246 |   |
| Diluted                               |       | 9,350                   |       | 9,283                  |       | 9,333 |   | 9,246 |   |

 

NOTE 10 – GOODWILL AND INTANGIBLE ASSETS

 

**Goodwill:**

 

In accordance with Statement of Financial AccountingStandards No. 141, *Business Combinations*(FAS 141), purchase price in excess of the fair values of acquired tangible andamortizable intangible net assets has been classified as goodwill.  The value of recorded goodwill is subject tofinalization of the preliminary purchase price and allocations.  The acquired goodwill, although not subjectto regular amortization, will be assessed for impairment on an annual basis, orsooner if factors indicate such is necessary. Estimated goodwill acquired in the InnerAccess and ClientSoft transactionswas $1.3 million and $7.5 million, respectively.  NEON reports one operating segment, and thatoperating segment has been identified as the reporting unit for the purpose ofassessing future impairment of the acquired goodwill.  No impairments of the InnerAccess orClientSoft goodwill have occurred to date.

 

**Intangible Assets:**

 

The components of identifiable intangible assetsacquired in the InnerAccess and ClientSoft transactions are as follows (inthousands):

 
| ** **                                    | ** ** | **As of December 31, 2004** | ** ** |
|-----------------------------------------------|------------|-----------------------------|------------|
| ** **                                    | ** ** | **Gross Carrying  Amount**  | ** ** | **Accumulated  Amortization** | ** ** | **Net  Carrying Value** | ** ** |
| InnerAccess:                                  |       |                        |       |   |   |   |   |
| Core technology                               |       | $                           | 2,600      |   | $ | 242 |   | $ | 2,358 |   |
| Maintenance  contracts/customer relationships |       | 660                         |       | 61 |   | 599 |   |
| Total                                         |       | $                           | 3,260      |   | $ | 303 |   | $ | 2,957 |   |
| ClientSoft:                                   |       |                        |       |   |   |   |   |
| Core technology                               |       | $                           | 4,500      |   | $ | 38 |   | $ | 4,462 |   |
| Maintenance  contracts/customer relationships |       | 1,100                       |       | 9 |   | 1,091 |   |
| Total                                         |       | $                           | 5,600      |   | $ | 47 |   | $ | 5,553 |   |
|                                          |       |                        |       |   |   |   |   |
| Total  intangibles                            |       | $                           | 8,860      |   | $ | 350 |   | $ | 8,510 |   |

 

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

 

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In addition tothose intangible assets acquired by business combination, NEON acquired certainsoftware code at a cost of $426,000 in April 2004.  The asset, net of accumulated amortization,is classified as acquired intangibles in the accompanying unauditedconsolidated balance sheet, and has been assigned a useful life of fouryears.  Amortization expense, calculatedon a straight-line basis, is presented as cost of license in the accompanyingunaudited consolidated statements of operations and represented $27,000 and $80,000for the three and nine months ended December 31, 2004, respectively.

 

Amortizationexpense for the three and nine months ended December 31, 2004 was $236,000 and$430,000, respectively, and is presented as cost of licenses in theaccompanying unaudited consolidated statements of operations.

 

NOTE 11 – SIGNIFICANTREVENUE DEFERRAL

 

In March 2004,NEON entered into a four-year enterprise license and maintenance agreement withone of its largest customers.  Thecontract provides service through March 31, 2008 and has an aggregate value of$2,900,000.  All software productslicensed by the customer were delivered by October 1, 2004.  Since vendor specific objective evidencecould not be determined for the maintenance portion of the contract, NEON willamortize the contract value on a straight-line basis over the remaining term ofthe agreement, beginning on October 1, 2004, in accordance with NEON’s revenuerecognition policy.  See CriticalAccounting Policies – *Revenue RecognitionPolicies*.

 

NOTE 12 – IMPACT OFRECENTLY ISSUED ACCOUNTING STANDARDS

 

In December 2004the Financial Accounting Standards Board (FASB) issued Statement of FinancialAccounting Standard No. 123, as revised*, Share-based Payment*(FAS 123(R)).  The provisions of the newstandard are effective for all interim or annual periods beginning after June15, 2005.  FAS 123(R) requires thatcompensation cost for all share-based employee payments be recognized in thestatement of operations based on grant date fair values of the awards, adjustedto reflect actual forfeitures and the outcome of certain other conditions. Thefair value is generally not re-measured, except in limited circumstances, or ifthe award is subsequently modified.  Thestatement will require NEON to estimate the fair value of stock-based awardsand recognize expense in the statement of operations as the related servicesare provided.  This will change currentpractice as, upon adoption, NEON must cease using the “intrinsic value” methodof accounting, currently permitted by APB 25, that resulted in no expense formost of the Company’s stock option awards.

 

NEON will adoptthe provisions of the statement as of the beginning of its fiscal quarterending September 30, 2005 and for future periods.  The standard will require NEON to recognizecompensation expense in future periods as stock options granted prior toadoption of the standard continue to vest over time.  Adoption of the standard will likely have amaterial impact on the results of operations. However, the impact of adoption will depend on levels of share-basedpayments granted in the future. Additionally, NEON is still evaluating the most appropriate method ofvaluing its share-based employee payments. The Company currently uses the Black-Scholes option pricing model tovalue its awards, as disclosed in accordance with FAS 123 in the notes to theconsolidated financial statements. Selection of a different valuation model could result in a differentfair value measure than that determined by the previously used pricing model.

 

**ITEM 2****.****                             MANAGEMENT’S DISCUSSION ANDANALYSIS OF FINANCIAL CONDITION AND RESULTS OFOPERATIONS**

 

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

 

OVERVIEW

 

NEON Systems, Inc.(“NEON”) is a leading provider of enterprise-class mainframe integrationsoftware.  NEON develops, markets andsupports a unified mainframe integration platform that supports a broad rangeof requirements for modern Service-Oriented Architectures and emergingEvent-Driven Architectures. NEON’s Shadow technology provides flexible, industry

 

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standardinterfaces to enable highly secure and scalable mainframe integration,allowing organizations to reducetotal cost of ownership and risk associated with mainframe integration, whilestreamlining the number of incumbent technologies needed for such integration.

 

In July 2004, NEONclosed its acquisition of InnerAccess Technologies, Inc., a Quebec corporationwhich develops mainframe integration software products with particularspecialization in web services for mainframe integration and integration ofIDMS databases.

 

In December 2004,NEON acquired substantially all of the assets and the business of ClientSoft,Inc. (“ClientSoft”) and assumed certain of the liabilities of ClientSoft.  ClientSoft developed mainframe integrationsoftware products with particular specialization in web services for mainframeintegration with a further specialization for integrating mainframe data andtransaction systems with Microsoft .NET Server.

 

##### ***Business Environment***

##### ** **

NEON derivesrevenue from software licenses and maintenance services. License fees, whichare graduated and based upon various industry standard measures of productusage such as mainframe potential processing capacity, CPUs, and users, aregenerally due upon license grant and require a one-year maintenance period. Thesales process typically takes between six and nine months. After the initialyear of required maintenance, NEON provides optional ongoing maintenanceservices, which include technical support and product enhancements, for anannual fee. Any factors adversely affecting the pricing of, demand for, ormarket acceptance of, our products, such as competition or technologicalchange, could materially adversely affect our business, operating results andfinancial condition.

 

In mid-2000, webelieve that the mainframe software market began to weaken as the globaleconomies entered a recessionary period. Prior to 2000, many of NEON’s customers were experiencing consistentgrowth of their mainframe systems and, as a result, they purchased additionalsoftware capacity in anticipation of continued growth at rates consistent withhistory. Additionally, during this time frame, the competitive landscape forNEON’s product also began to intensify.

 

During fiscal2003, NEON began restructuring the company to concentrate on its core mainframeintegration business, which has historically accounted for the majority of itsrevenues.  NEON divested its non-coreproducts and reduced the size of its sales, marketing and administrativeorganizations. During this period NEON also began to develop new mainframeintegration products, as well as identify other adjacent market products,technologies and companies, which were complementary to NEON’s existing productportfolio.

 

During fiscal2004, NEON saw an opportunity for market consolidation and set out on astrategy to acquire products and companies in order to expand its productofferings. NEON sought to create a unified platform for mainframe integration,which could meet all of the requirements of modern Service-OrientedArchitectures and Event Driven Architectures. In furtherance of this goal, NEON acquired InnerAccess Technologies,Inc., (“InnerAccess”) in July 2004, adding a nascent web services product toits product portfolio.  NEON released itsShadow z/Services product in September 2004, which is based on InnerAccess’technology.  In December 2004, NEONcontinued its market consolidation by acquiring substantially all of the assetsof ClientSoft, Inc. (“ClientSoft”), a developer of mainframe integration andweb services. ClientSoft was considered a technology leader by certain industryanalysts in the mainframe web services market. NEON would consider additional product and company acquisitions tofurther support its strategy.

 

Notwithstanding theimprovements made in NEON’s product offering and positioning with industryanalysts, many of NEON’s customers remain cautious about their capitalspending. Although general economic conditions have improved, NEON is stilluncertain as to future spending patterns of its customers. NEON believes thatperiod-to-period comparisons of our revenue and operating results should not berelied upon as indications of our future performance. Further, NEON does notbelieve that its historical growth rates in prior years are necessarilyrepresentative of its future growth potential.

 

*****Related PartyTransactions*****

 

Certain former members ofNEON’s Board of Directors and certain former executive officers of NEON wereshareholders and/or directors in other companies with which NEON hasinvestments.  Transactions between NEONand these other companies are described below. The directors and officersinvolved in such transactions are no longer officers and directors of NEON.

 

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

 

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

 

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

 

*Scalable Software, Inc.*

 

On June 9, 2004, NEON entered into a Note PurchaseAgreement with JMI Services, Inc., the largest shareholder of Scalable, to sellthe $3.5 million guaranteed note and the $6.0 million secured note issued byScalable to NEON for cash purchase price of $4.8 million.  A gain of $1.2 million resulted from the cashproceeds in excess of the recorded combined book value of the notes and directselling expenses. JMI Services is an affiliate of John J. Moores, NEON’slargest shareholder.  The proposed saleof the Scalable notes was reviewed and approved by the Special Committee of theBoard of Directors, consisting of “independent” and disinterested directors,and finally by the full Board of Directors, no member of which was aninterested or related party of either JMI Services, Inc. or Scalable.  The Board requested and received a fairnessopinion from Avail Consulting, Inc., a Houston, Texas based independentvaluation and financial consultant, stating that the transaction was fair tothe stockholders of NEON from a financial standpoint and recommending that theBoard accept the purchase offer made by JMI Services, Inc.  Closing of the transaction occurred on June17, 2004.

 

*****Critical Accounting Policies*****

*** ***

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

 

***Revenue Recognition Policies***

*** ***

Statement of Position 97-2, *Software Revenue Recognition* (SOP 97-2), was issued inOctober 1997 by the American Institute of Certified Public Accountants (AICPA)and was amended by Statement of Position 98-4 (SOP 98-4) and Statement ofPosition 98-9 (SOP 98-9). NEON adopted SOP 97-2 effective July 1, 1997, SOP98-4 effective March 31, 1998 and SOP 98-9 effective April 1, 1999. NEONbelieves its current revenue recognition policies and practices are consistentwith SOP 97-2, SOP 98-4 and SOP 98-9. Revenues from software license sales arerecognized when all of the following conditions are met: a non-cancelablelicense agreement has been obtained, the product has been delivered; there areno material uncertainties regarding customer acceptance; collection of thereceivable is probable; no other significant vendor obligations exist; andvendor-specific objective evidence exists to allocate the total fee to eachelement of the arrangement. Vendor-specific objective evidence is based on theprice generally charged when an element is sold separately. All elements ofeach order are valued at the time of revenue recognition. NEON will deferlicense revenue for all delivered elements associated with a sales arrangement,if vendor-specific objective evidence cannot be established for eachundelivered element. License revenues generally include software maintenanceagreements for the first year following the date of sale. In such cases,revenues are allocated between license and maintenance revenues based on theresidual method provided by SOP 98-9. Deferred revenue is generally based onvendor-specific objective evidence of the fair value of maintenance with theremaining portion of the total arrangement value allocated to licenserevenues.  If vendor-specific objectiveevidence cannot be established for deferred revenue, then the value of thesales arrangement is amortized ratably on a straight-line basis over thecontract term. Revenues from first-year maintenance agreements and separately

 

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priced software maintenance agreements for subsequent years aredeferred and recognized ratably on a straight-line basis over the maintenanceperiod. NEON also markets and sells its products through independentdistributors and resellers. License and maintenance revenues from thesetransactions are recognized as above, when sold to the ultimate end user andall of the above conditions are met.

 

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CapitalizedSoftware Costs

 

NEON follows SFAS No. 86, *Accounting for the Costs of Computer Software to be Sold, Leased orOtherwise Marketed*. Research and development expenditures have beencharged to operating expenses as incurred. No such costs have been capitalizedto date, as the impact on the financialstatements would be insignificant because the time between a product meetingthe definition of technological feasibility and readiness for market is veryshort.

 

***Allowance for Doubtful Accounts Receivable***

 

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

 

***Goodwill and Acquired Intangible Assets***

 

In accordance with Statement of Financial AccountingStandards No. 141, *Business Combinations*(FAS141), the cost of an acquired entity is allocated to assets acquired andliabilities assumed with any excess of the fair values of tangible andamortizable intangible net assets acquired recognized as goodwill. Value isassigned to amortizable intangible assets based on estimated fair values, ifthose assets arise from contractual or legal obligations or are otherwise separablefrom goodwill.  In accordance withStatement of Financial Accounting Standards No.142,  *Goodwill and OtherIntangible Assets*(FAS 142), each acquired goodwill and identifiableintangible asset must be assigned to a reporting unit of NEON for the purposeof assessing the possibility of impairment. Assessments are performed on an annual basis or more often if events orchanges in circumstances indicate that the carrying value may not berecoverable.  The impairment of goodwillrequires that judgments and estimates be made by management, including thoseregarding the value of the reporting unit. Impairment testing is performed using a two-step process.  The first step requires assessing whether apotential impairment has occurred by comparing the fair value of the assignedreporting unit with its carrying amount, including goodwill.  The second step requires measuring anypotential impairment identified by allocating the assessed fair value to theassets and liabilities of the reporting unit, excluding goodwill.  Any excess fair value is compared to therecorded value of goodwill to measure the impairment.

 

The determinationof the value of amortizable intangible assets acquired involves certainjudgments and estimates that are subject to change over time based on internaland external factors.  These judgmentscan include, but are not limited to the cash flows that an asset is expected togenerate in the future and the appropriate weighted average cost of capital ofsimilar investments.  The value of an amortizableintangible asset is amortized to expense in the statement of operations on astraight-line basis over the estimated useful life.  The estimated useful life is determined bymanagement considering, among other things, expected use, any applicable legalprovisions, expected technological development, expected demand and othercompany-specific, economic or other external factors.

 

***Deferred Income Taxes***

*** ***

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

 

The change in NEON’s net deferred income tax balancesduring a period results in a deferred income tax provision or benefit in itsstatement of operations. If NEON’s expectations about the future taxconsequences of past events should prove to be inaccurate, the balances of itsdeferred income tax assets and liabilities could require significantadjustments in future periods. Such adjustments could cause a material effecton NEON’s results of operations for the period of the adjustment.

 

RESULTS OF OPERATIONS

 

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

 

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| ** **                                                    | ** ** | **THREE MONTHS ENDED DECEMBER 31,** | ** ** | **NINE MONTHS ENDED DECEMBER 31,** | ** ** |
|---------------------------------------------------------------|------------|-------------------------------------|------------|------------------------------------|------------|
| ** **                                                    | ** ** | **2004**                            | ** ** | **2003**                           | ** ** | **2004** | ** ** | **2003** | ** ** |
| Revenues:                                                     |       |                                |       |                               |       |   |   |   |   |
| License                                                       |       | 44.1                                | %          | 31.7                               | %          | 36.2 | % | 33.9 | % |
| Maintenance and services                                      |       | 55.9                                |       | 68.3                               |       | 63.8 |   | 66.1 |   |
| Total revenues                                                |       | 100.0                               |       | 100.0                              |       | 100.0 |   | 100.0 |   |
|                                                          |       |                                |       |                               |       |   |   |   |   |
| Cost of revenues:                                             |       |                                |       |                               |       |   |   |   |   |
| Cost of licenses                                              |       | 5.2                                 |       | —                             |       | 3.7 |   | 0.7 |   |
| Cost of maintenance and  services                             |       | 9.5                                 |       | 9.4                                |       | 9.8 |   | 9.5 |   |
| Total cost of revenues                                        |       | 14.7                                |       | 9.4                                |       | 13.5 |   | 10.2 |   |
|                                                          |       |                                |       |                               |       |   |   |   |   |
| Gross profit                                                  |       | 85.3                                |       | 90.6                               |       | 86.5 |   | 89.8 |   |
|                                                          |       |                                |       |                               |       |   |   |   |   |
| Operating expenses:                                           |       |                                |       |                               |       |   |   |   |   |
| Sales and marketing                                           |       | 46.6                                |       | 40.3                               |       | 45.1 |   | 39.4 |   |
| Research and development                                      |       | 27.2                                |       | 30.1                               |       | 29.6 |   | 29.8 |   |
| General and administrative                                    |       | 15.7                                |       | 30.5                               |       | 21.1 |   | 24.6 |   |
| Total operating expenses                                      |       | 89.5                                |       | 100.9                              |       | 95.8 |   | 93.8 |   |
|                                                          |       |                                |       |                               |       |   |   |   |   |
| Operating loss                                                |       | (4.2                                | )          | (10.4                              | )          | (9.3 | ) | (4.0 | ) |
| Gain on sale of notes  receivable (Note 7)                    |       | —                              |       | —                             |       | 10.1 |   | — |   |
| Interest and other income, net                                |       | 1.7                                 |       | 1.6                                |       | 1.6 |   | 2.0 |   |
|                                                          |       |                                |       |                               |       |   |   |   |   |
| Income (loss) from continuing  operations before income taxes |       | (2.5                                | )          | (8.8                               | )          | 2.4 |   | (2.0 | ) |
| Provision for income taxes                                    |       | —                              |       | —                             |       | — |   | — |   |
|                                                          |       |                                |       |                               |       |   |   |   |   |
| Loss from continuing  operations                              |       | (2.5                                | )          | (8.8                               | )          | 2.4 |   | (2.0 | ) |
| Income from discontinued  operations, net                     |       | —                              |       | 0.3                                |       | — |   | 0.9 |   |
| Net income (loss)                                             |       | (2.5                                | )%         | (8.5                               | )%         | 2.4 | % | (1.1 | )% |

 

THREE MONTHS ENDED DECEMBER 31, 2004 COMPARED TOTHREE MONTHS ENDED DECEMBER 31, 2003

 

REVENUES

 

License revenues for the threemonths ended December 31, 2004 were $2.1 million, an increase of $915,000 from$1.2 million for the three months ended December 31, 2003. The increase was dueto improved sales productivity in North America and the introduction of newproducts along with the acquisitions of InnerAccess and ClientSoft, whichcombined, accounted for 18% of license revenue.

 

Maintenance and service revenuesfor the three months ended December 31, 2004 were $2.6 million, an increase of$141,000 from $2.5 million for the three months ended December 31, 2003.  The increase was attributable to theacquisitions of InnerAccess and ClientSoft as well as greater servicesrevenues. These increases were offset by a reduction in maintenance revenuefrom NEON’s historical installed customer base primarily associated withmaintenance cancellations.

 

COST OF REVENUES

 

Cost of license revenues for thethree months ended December 31, 2004 were $246,000, or 12% of license revenues,and primarily represented amortization of acquired product technologyassociated with the InnerAccess and ClientSoft acquisitions during fiscal 2005.

 

Cost of maintenance and servicerevenues includes personnel and other customer support costs. Cost ofmaintenance and service revenues for the three months ended December 31, 2004was $445,000 or 17% of maintenance and service revenues, as compared to$342,000, or 14% of maintenance and service revenues, for the three monthsended December 31, 2003. Cost of maintenance and service revenue as apercentage of maintenance and service revenue increased primarily as a resultof the InnerAccess and ClientSoft acquisitions.

 

OPERATING EXPENSES

 

Sales and marketing expensesinclude personnel costs, sales commissions, travel and promotional expenses.Sales and marketing expenses for the three months ended December 31, 2004 were$2.2 million, or 47% of total revenue, compared to $1.5

 

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million, or 40% of total revenue, for the threemonths ended December 31, 2003. The increase in sales and marketing as apercentage of total revenue was primarily associated with growth in the directsales force as well as increased marketing and promotional activities.

 

Research and developmentexpenses primarily include personnel costs associated with NEON’s productdevelopment activities. Research and development expenses for the three monthsended December 31, 2004 were $1.3 million, an increase of $182,000 from $1.1million for the three months ended December 31, 2003.  The increase in research and development isprimarily due to the acquisitions of InnerAccess and ClientSoft.

 

General and administrativeexpenses include personnel and other costs associated with NEON’s executive,financial, legal and administrative functions. General and administrativeexpenses for the three months ended December 31, 2004 were $738,000, versus$1.1 million for the three months ended December 31, 2003. The decrease of $375,000in general and administrative expenses during the period was primarily due to a$229,000 reduction in previously accrued future lease obligations related toabandoned facilities, as a result of the renegotiation of NEON’s United Kingdomoffice lease. Additionally, during the three months ended December 31, 2003,general and administrative expenses included $179,000 in restructuring chargesrelated to the elimination of direct sales operations in two foreign locations.

 

Interest and other income forthe three months ended December 31, 2004 was $80,000, as compared to $60,000for the three months ended December 31, 2003. The increase was primarily due tohigher interest rates on invested cash and cash equivalents.

 

As of March 31, 2004, NEON had anet operating loss carry-forward for income tax purposes of approximately $20million that is available to offset future taxable income, if any. The netoperating loss carry-forwards in the United Kingdom, Germany and Australiacarry forward indefinitely.  The netoperating loss carry-forward for the United States begins expiring in the taxyear 2020.  There can be no assurancethat the operations will generate taxable income in the future to utilize theselosses.  Therefore, as of September 30,2004 and March 31, 2004, NEON has recorded a full valuation allowance for the netdeferred tax assets related to the future benefits, if any, for these losscarryforwards.

 

NINE MONTHS ENDED DECEMBER 31, 2004 COMPARED TONINE MONTHS ENDED DECEMBER 31, 2003

 

REVENUES

 

License revenues for the ninemonths ended December 31, 2004 were $4.4 million, an increase of $505,000 from$3.9 million for the nine months ended December 31, 2003. The increase wasprimarily due to the acquisitions of InnerAccess and ClientSoft. Furthermore,greater license revenue in North America was offset by a reduction in theUnited Kingdom.

 

In March 2003, NEON entered intoa four-year enterprise license and maintenance agreement with one of itslargest customers. The contract provides service through March 31, 2008 and hadan aggregate value of $2,900,000. All software products licensed by thecustomer were delivered by October 1, 2004. Since vendor-specific objective evidence could not be determined for themaintenance portion of the contract, NEON began amortizing the contract valueon a straight-line basis over the remaining term of the agreement, beginning onOctober 1, 2004, in accordance with NEON’s revenue recognition policy.  See Critical Accounting Policies – *Revenue Recognition Policies*.  In the nine-month period ended December 31,2004, NEON recognized license revenue of $207,000 from such transaction.

 

Maintenance and service revenuesfor the nine months ended December 31, 2004 were $7.7 million, an increase of$149,000 from $7.5 million for the nine months ended December 31, 2003.  The increase was attributable to theacquisitions of InnerAccess and ClientSoft as well as greater servicesrevenues. These increases were partially offset by a reduction in maintenancerevenue from NEON’s historical installed customer base primarily associatedwith maintenance cancellations.

 

COST OF REVENUES

 

Cost of license revenuesprimarily consists of amortization of purchased technology and royalty paymentsto third parties. Cost of license revenues for the nine months ended December31, 2004 were $441,000, or 10% of license revenues, as compared to $84,000, or2% of license revenues, for the nine months ended December 31, 2003. Theincrease in cost of license revenues was due to amortization of acquiredtechnology primarily associated with the InnerAccess and ClientSoftacquisitions during fiscal 2005.

 

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Cost of maintenance revenuesincludes personnel and other customer support costs. Cost of maintenancerevenues for the nine months ended December 31, 2004 were $1.2 million, or 15%of maintenance revenues, as compared to $1.1 million, or 14% of maintenancerevenues, for the nine months ended December 31, 2003. Cost of maintenancerevenue as a percentage of maintenance revenue remained fairly consistent inboth periods.

 

OPERATING EXPENSES

 

Sales and marketing expensesinclude personnel costs, sales commissions, travel and promotional expenses.Sales and marketing expenses for the nine months ended December 31, 2004 were$5.4 million, or 45% of total revenue, compared to $4.5 million, or 39% of totalrevenue, for the nine months ended December 31, 2003. The increase in sales andmarketing as a percentage of total revenue was primarily associated with growthin the direct sales force as well as increased marketing and promotionalactivities.

 

Research and developmentexpenses primarily include personnel costs associated with NEON’s productdevelopment activities. Research and development expenses for the nine monthsended December 31, 2004 were $3.6 million, compared to $3.4 for the nine monthsended December 31, 2003.  Research anddevelopment expenses increased during the period primarily due to theacquisitions of InnerAccess and ClientSoft, although these expenses were offsetby reductions in other personnel costs.

 

General and administrativeexpenses include personnel and other costs associated with NEON’s executive,financial, legal and administrative functions. General and administrativeexpenses for the nine months ended December 31, 2004 were $2.5 million, areduction of $253,000 from $2.8 million for the nine months ended December 31,2003. The decrease was primarily related to a reduction of $425,000 inpreviously accrued future lease obligations for vacated facilities as a resultof the renegotiation of two of NEON’s corporate office leases. This reductionwas partially offset by the greater personnel costs associated with theacquisitions of InnerAccess and ClientSoft.

 

During the nine months endedDecember 31, 2004, NEON recognized a gain on sale of the notes receivable fromScalable Software (see Related Party Transactions).  The gain of $1.2 million resulted from cashproceeds, net of direct costs, of $4.7 million, which was in excess of therecorded net book value of $3.5 million.

 

Interest and other income forthe nine months ended December 31, 2004 was $194,000 as compared to $231,000for the nine months ended December 31, 2003. Interest and other income in theprior period included interest received on an income tax receivable collectedduring that quarter.

 

On June 20, 2003, NEON closed the sales of its iWaveproduct line assets to an unrelated third party.  As a result of the transaction, NEON recordeda gain on the sale of $352,000, net of closing expenses during the nine monthsended December 31, 2003. Total revenues attributed to the iWave product linefor the nine months ended December 31, 2003 were $194,000.  Operating losses associated with the iWaveproduct line were classified as discontinued operations and represented$244,000 for the nine months ended December 31, 2003.

 

No provision for income taxeswas recorded for the nine months ended December 31, 2004 or 2003, as thecurrent year taxable income is offset by net operating loss carry-forwards thatNEON had previously reserved.  At March 31,2004, NEON has a net operating loss carry-forward for income tax purposes ofapproximately $20 million that is available to offset future taxable income, ifany. The net operating loss carry-forwards in the United Kingdom, Germany andAustralia carry forward indefinitely. The net operating loss carry-forward for the United States beginsexpiring in the tax year 2020.  Given therecent tax losses experienced by NEON, there can be no assurance that theoperations will generate taxable income in the future to utilize these lossestherefore, as of December 31, 2004, NEON has recorded a full valuationallowance for the net deferred tax assets related to the future benefits, ifany, for these loss carry forwards.

 

LIQUIDITY AND CAPITAL RESOURCES

 

NEON’s cash and cash equivalentsat December 31, 2004 were $13.3 million, a decrease of $7.6 million from $20.9million at March 31, 2004. This decrease was due primarily to the use of fundsfor the acquisitions of InnerAccess and ClientSoft, partially offset by thesale of notes receivable from Scalable Software (See Related PartyTransactions) and the generation of $1.8 million in operating cash flow duringthe period.

 

Net cash provided by operatingactivities was $1.8 million for the nine months ended December 31, 2004, versus$415,000

 

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used in operations during the nine months endedDecember 31, 2003.  Net cash provided byoperating activities for the nine months ended December 31, 2004 resultedprimarily from an increase in deferred revenue as well as collections ofaccounts receivable in excess of payments on liabilities.  The net cash used in operating activitiesduring the nine months ended December 31, 2003, resulted primarily from anoperating loss for the period.

 

During the nine months endedDecember 31, 2004, net cash used in investing activities was $9.6 million. Cashpaid for the InnerAccess and ClientSoft acquisitions was $13.7 million, whichwas offset by the receipt of $4.7 million from the sale of notes receivablefrom Scalable Software.  Net cashprovided by investing activities during the nine months ended December 31, 2003was $481,000, primarily due to the sale of the iWave product line.

 

NEON’s net cash provided byfinancing activities was $45,000 and $94,000 for the nine months ended December31, 2004 and 2003, respectively. The net cash provided by financing activitiesin both periods consisted of proceeds from the exercise of employee stockoptions.

 

NEON’s future liquidity andcapital requirements will depend upon numerous factors, including the costsassociated with potential future business and product acquisitions, the costsand timing of expansion of product development efforts and the success of thesedevelopment 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 enforcingintellectual property rights, the level and timing of license revenue, andother factors. NEON believes that its current balance of cash and cashequivalents will be sufficient to meet its working capital, funding commitmentsand anticipated capital expenditure requirements for at least the next 12months. NEON holds two notes from NEON Enterprise Software, Inc. in theaggregate amount of $6.6 million, currently recorded at a net value of $4.3million, that will mature on March 31, 2004. There is no assurance of collection of such notes when they mature andany collection efforts may result in costs of collection as costs to assertNEON’s security interest.  NEON mayrequire additional funds to support its working capital requirements or forother purposes and may seek to raise additional funds through public or privateequity financing or from other sources. There can be no assurance thatadditional financing will be available at all, or if available, that suchfinancing will be obtainable on terms acceptable to NEON, or that anyadditional financing will not be dilutive.

 

**New Accounting Pronouncements**

 

In December 2004 the Financial Accounting StandardsBoard (FASB) issued Statement of Financial Accounting Standard No. 123, asrevised*, Share-based Payment* (FAS 123(R)).  The provisions of the new standard areeffective for all interim or annual periods beginning after June 15, 2005.  FAS 123(R) requires that compensation cost forall share-based employee payments be recognized in the statement of operationsbased on grant date fair values of the awards, adjusted to reflect actualforfeitures and the outcome of certain other conditions. The fair value isgenerally not re-measured, except in limited circumstances, or if the award issubsequently modified.  The statementwill require NEON to estimate the fair value of stock-based awards andrecognize expense in the statement of operations as the related services areprovided.  This will change currentpractice as, upon adoption, NEON must cease using the “intrinsic value” methodof accounting, currently permitted by APB 25, that resulted in no expense formost of the Company’s stock option awards.

 

NEON will adopt the provisions of the statement as ofthe beginning of its fiscal quarter ending September 30, 2005 and for futureperiods.  The standard will require NEONto recognize compensation expense in future periods as stock options grantedprior to adoption of the standard continue to vest over time.  Adoption of the standard will likely have amaterial impact on the results of operations. However, the impact of adoption will depend on levels of share-basedpayments granted in the future. Additionally, NEON is still evaluating the most appropriate method ofvaluing its share-based employee payments. The Company currently uses the Black-Scholes option pricing model tovalue its awards, as disclosed in accordance with FAS 123 in the notes to theconsolidated financial statements. Selection of a different valuation model could result in a differentfair value measure than that determined by the previously used pricing model.

 

**ITEM 3****.****                             QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

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

 

The majority of NEON’s foreigncurrency transactions are denominated in the British pounds sterling, which isthe functional currency of NEON Systems (UK) Ltd. As these sales contracts aredenominated and settled in the functional currency, risks

 

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associated with currency fluctuations areminimized to foreign currency translation adjustments. NEON does not currentlyhedge against foreign currency translation risks and believes that foreigncurrency exchange risk is not significant to its operations.  As a result of NEON’s acquisition ofInnerAccess Technologies, Inc. in July 2004, additional risks associated withcurrency fluctuation between the Canadian dollar and the US dollar may occur. Suchexposure is primarily limited to operating cash balances held in Canadiandollars for the ongoing operating expenses of Canadian operations.  Sales transactions related to the technologyacquired from InnerAccess are generally denominated in US dollars.

 

NEON adheres to a conservativeinvestment policy, whereby its principal concern is the preservation of liquidfunds while maximizing its yield on such assets. Cash and cash equivalentsapproximated $13.3 million at December 31, 2004 and were invested in varioustypes of investment grade short-term commercial paper and money securities.  NEON believes that a near-term change ininterest rates would not materially affect its financial position, results ofoperations or net cash flows for fiscal year 2005.

 

**ITEM 4****.          CONTROLSAND PROCEDURES**

 

As of the end of the periodcovered by this Quarterly Report on Form 10-Q, NEON carried out an evaluation,under the supervision and with the participation of NEON’s management,including the Chief Executive Officer and Chief Financial Officer, of theeffectiveness of the design and operation of NEON’s disclosure controls andprocedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of1934).  Based upon that evaluation, theChief Executive Officer and Chief Financial Officer concluded that NEON’sdisclosure controls and procedures are effective in ensuring that materialinformation is accumulated and communicated to management, and made known tothe Chief Executive Officer and Chief Financial Officer, on a timely basis toallow disclosure as required in this Quarterly Report on Form 10-Q.  There has been no change in our internalcontrol over financial reporting during the three months ended December 31,2004 that has materially affected, or is reasonably likely to materiallyaffect, our internal control over financial reporting.

 

PART II - OTHER INFORMATION

 

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

 

ITEM 2.                             UNREGISTERED SALES OF EQUITYSECURITIES AND USE OF PROCEEDS

 

On July 14, 2004, NEON acquired 100% interest inInnerAccess Technologies, Inc. (InnerAccess), a company incorporated under thelaws of the province of Quebec, Canada. InnerAccess developed, marketed and licensed web services technology andprovides services related to the integration of mainframe data sources withmodern distributed computing systems. NEON paid the InnerAccess Shareholders a total of $2.4 million dollarsin cash and issued 407,000 shares of NEON restricted common stock to theamalgamated entity, transferring them to the shareholders of InnerAccess inconsideration for the acquisition.  Allissuances and transfers of NEON common stock were exempt from SEC registrationrequirements under Regulation S.  Theseshares are included in the weighted average shares outstanding for therespective periods.

 

In addition, NEON has assumed certain special warrantsof InnerAccess, which, on a converted basis, represent the right to acquire anadditional 19,894 shares of NEON common stock at a cash exercise price equal to$9.50 per share.  In connection with theissuance of the shares of NEON common stock, NEON has also agreed to enter intoa registration rights agreement with each former InnerAccess Shareholder in theform attached as Exhibit 4.1 to our Form 8-K filed with the SEC on July 29,2004.  Such Registration Rights Agreementgrants to each such former InnerAccess Shareholder a right to piggyback on anypublic offering of NEON shares of common stock during the one year periodfollowing the closing of the acquisition of InnerAccess by NEON.  The warrants and the common stock underlyingthe warrants were issued pursuant to a private placement exemption underRegulation D.

 

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OnDecember 13, 2004, NEON acquired substantially all of the assets and thebusiness of ClientSoft, Inc. (“ClientSoft”) and assumed certain of theliabilities of ClientSoft for a cash purchase price of $10.5 million andthe issuance to ClientSoft of a warrant to acquire up to 1,125,000 shares ofNEON common stock (the “Warrant”). ClientSoft developed, marketed and licensed web services technology andprovided services related to the integration of mainframe data sources withmodern distributed computing systems. The assets acquired by NEON includedintellectual property, contracts and equipment and other tangible personalproperty. The liabilities assumed by NEON related to future customer support.

 

The transaction contemplated was evidenced by an AssetPurchase Agreement among NEON, ClientSoft, a Delaware corporation and U.S.Bank, National Association, as escrow agent (the “Asset Purchase Agreement”).Approximately $2.3 million of the cash and the Warrant were placed inescrow at closing. The Warrant is exercisable in whole or in part at any timeprior to or on June 13, 2008. The exercise price per share of the Warrantis $4.80, which is the closing price per share of NEON common stock on theNASDAQ Stock Market on December 13, 2004, multiplied by 1.33.  In connection with the issuance of theWarrant, NEON entered into a registration rights agreement with ClientSoft. Theregistration rights agreement obligates NEON to file, as soon as practicablefollowing the Company’s filing of its annual report on Form 10-K for thefiscal year ended March 31, 2005, a shelf registration on Form S-3 toregister the shares of Common Stock underlying the Warrant for resale by theholder(s) of the Warrant.  The results ofthe acquired operations are included in the consolidated results of operationsfrom the period from the date of acquisition through December 31, 2004.

 

ITEM 3.                             DEFAULTS UPON SENIOR SECURITIES -Not applicable.

 

ITEM 4.                             SUBMISSION OF MATTERS TO A VOTE OF SECURITYHOLDERS  – None

 

ITEM 5.                             OTHER INFORMATION – On November 3, 2004.  The Compensation Committee of NEON’s Board ofDirectors approved a merit raise for Chris Garner, NEON’s Senior Vice Presidentof Research & Development, from an annual salary of $160,000 to an annualsalary of $180,000, in recognition of his efforts in the integration of theInnerAccess development team and the additional management responsibilitiesassociated with managing a distributed development team.  In connection with such merit raise, the NEONCompensation Committee also granted to Mr. Garner an incentive stock optionunder NEON’s 2002 Stock Plan to purchase 15,949 shares of NEON common stock atan exercise price of $3.21, the closing price of the NEON common stock onNovember 3, 2004.  No formal amendment ofMr. Garner’s Employment Agreement was executed.

 

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ITEM 6.                             EXHIBITS AND REPORTS ON FORM 8-K

 

(a)          EXHIBITS

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

 

(b)         REPORTSON FORM 8-K

 

Form 8-K filed with theSecurities and Exchange Commission on December 16, 2004 regarding theacquisition of ClientSoft, Inc.

 

Form 8-K filed with theSecurities and Exchange Commission on November 15, 2004 regarding the earningspress release.

 

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SIGNATURES

 

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

 
|   | NEON SYSTEMS, INC. |
|--------|--------------------|
|   |               |
| Date:  | February 14, 2005  |   | /s/ Brian D. Helman |   |
|   |               | Chief Financial Officer  (principal financial and accounting officer) |
|   |               |   |
|   |               |   |
| Date:  | February 14, 2005  |   | /s/ Mark J. Cresswell |   |
|   |               | President and Chief Executive Officer  (principal executive officer) |

 

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