<PAGE>

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

                                    FORM 10-Q

(Mark One)

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

                For the Quarterly Period Ended September 30, 2002

                                       OR

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

                   For the transition period from          to

                         Commission File Number: 0-25457

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

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

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

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

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

     The number of shares of the registrant's common stock outstanding as of
November 11, 2002, was 8,718,427.

<PAGE>

                               NEON SYSTEMS, INC.

                                    FORM 10-Q

                    FOR THE QUARTER ENDED SEPTEMBER 30, 2002

                                      INDEX

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

Item 1.   Financial Statements

          Consolidated Balance Sheets at September 30, 2002 and March 31, 2002                                        3

          Consolidated Statements of Operations for the Three and Six Months Ended September 30, 2002 and 2001        4

          Consolidated Statements of Cash Flows for the Six Months Ended September 30, 2002 and 2001                  5

          Condensed Notes to Consolidated Financial Statements                                                        6

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

Item 3.   Quantitative and Qualitative Disclosures About Market Risk                                                  25

Item 4.   Controls and Procedures                                                                                     26

PART II. OTHER INFORMATION

Item 1.   Legal Proceedings                                                                                           26

Item 2.   Changes in Securities and Use of Proceeds                                                                   26

Item 3.   Defaults Upon Senior Securities                                                                             27

Item 4.   Submission of Matters to a Vote of Security Holders                                                         27

Item 5.   Other Information                                                                                           27

Item 6.   Exhibits                                                                                                    30

SIGNATURES                                                                                                            31
</TABLE>

                                       2

<PAGE>

PART I - FINANCIAL INFORMATION

   ITEM 1. FINANCIAL STATEMENTS

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

<TABLE>
<CAPTION>
                                                                   SEPTEMBER 30, 2002        MARCH 31, 2002
                                                                   ------------------        --------------
                                                                       (UNAUDITED)
        <S>                                                        <C>                       <C>
                           ASSETS

        CURRENT ASSETS:
          Cash and cash equivalents                                  $    23,035              $     34,506
          Accounts receivable, net                                         3,296                     4,650
          Taxes receivable                                                 1,069                     1,054
          Deferred income taxes                                              608                       608
          Prepaid royalty (related party, Note 7)                             --                     2,128
          Other current assets                                               765                     1,005
                                                                     -----------               -----------
              Total current assets                                        28,773                    43,951
                                                                     -----------               -----------

        Property and equipment, net                                        2,061                     2,171
        Notes receivable, net (related parties, Note 7)                    7,761                     3,702
        Intangible assets, net                                               650                     3,713
        Other assets                                                          53                        63
                                                                     -----------               -----------
              Total assets                                           $    39,298               $    53,600
                                                                     ===========               ===========

              LIABILITIES & STOCKHOLDERS' EQUITY

        CURRENT LIABILITIES:
           Accounts payable                                          $       421               $       297
           Accrued expenses                                                1,212                     2,204
           Deferred revenue                                                5,306                     8,174
                                                                     -----------               -----------
              Total current liabilities                                    6,939                    10,675
                                                                     -----------               -----------

        STOCKHOLDERS' EQUITY:
        Preferred stock, $.01 par value. Authorized
          10,000,000 shares; no shares issued and outstanding                 --                        --
        Common stock, $.01 par value. Authorized
          30,000,000 shares; 8,711,677 and 8,674,953 shares
          issued and outstanding at September 30, 2002 and
          March 31, 2002, respectively                                        96                        96
        Additional paid-in capital                                        51,574                    51,233
        Treasury Stock, 913,400 shares at cost                            (2,649)                   (2,649)
        Accumulative other comprehensive income (loss)                      (524)                     (475)
        Unearned portion of deferred compensation                             --                       (26)
        Accumulated deficit                                              (16,138)                   (5,254)
                                                                     -----------               -----------
              Total stockholders' equity                                  32,359                    42,925
        Commitments and contingencies (Note 5)
                                                                     -----------               -----------
              Total liabilities and stockholders' equity             $    39,298               $    53,600
                                                                     ===========               ===========
</TABLE>

     SEE ACCOMPANYING CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.

                                       3

<PAGE>



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

<TABLE>
<CAPTION>


                                              THREE MONTHS ENDED SEPTEMBER 30,            SIX MONTHS ENDED SEPTEMBER 30,
                                              --------------------------------            ------------------------------
                                                  2002                  2001                 2002                 2001
                                          ----------------------------------------------------------------------------------
<S>                                               <C>                   <C>                   <C>                 <C>
Revenues:
   License                                      $ 1,276              $  2,475              $  3,521             $  6,374
   Maintenance                                    2,518                 2,377                 5,395                4,675
                                                -------              --------              --------             --------
     Total revenues                               3,794                 4,852                 8,916               11,049

Cost of revenues:
   Cost of licenses                                 448                   616                   997                1,115
   Cost of maintenance                              479                   469                 1,046                1,045
                                                -------              --------              --------             --------
     Total cost of revenues                         927                 1,085                 2,043                2,160
                                                -------              --------              --------             --------

Gross profit                                      2,867                 3,767                 6,873                8,889
                                                -------              --------              --------             --------

Operating expenses:
   Sales and marketing                            3,259                 3,206                 6,500                7,315
   Research and development                       1,529                 1,466                 3,108                3,249
   General and administrative                     1,346                   959                 2,585                2,890
   Asset write-down charges                          --                   887                    --                  887
   Impairment of intangibles                      1,288                    --                 1,288                   --
   Amortization of goodwill                          --                   120                    --                  239
   Restructuring costs                              271                   908                   133                  908
   Loss on disposal                                 687                    --                   687                   --
                                                -------              --------              --------             --------
    Total operating expenses                      8,380                 7,546                14,301               15,488
                                                -------              --------              --------             --------

Operating loss                                   (5,513)               (3,779)               (7,428)              (6,599)

Interest and other income, net                      111                   334                   253                  744
Gain from settlement of litigation                   --                 9,260                    --                9,260
Equity loss in affiliate                           (939)                   --                (2,184)                  --
Valuation allowance on note receivable               91                    --                  (482)                  --
                                                -------              --------              --------             --------
   Income (loss) before income
     taxes and cumulative effect of change
     in accounting principle                     (6,250)                5,815                (9,841)               3,405
                                                -------              --------              --------             --------
Benefit (provision) for income taxes                 --                   143                    --                  143
                                                -------              --------              --------             --------
Income (loss) before cumulative
   effect of change in accounting principle      (6,250)                5,958                (9,841)               3,548
Cumulative effect of change in
   accounting principle                              --                    --                (1,043)                  --
                                                -------              --------              --------             --------
   Net income (loss)                            $(6,250)             $  5,958              $(10,884)            $  3,548
                                                =======              ========              ========             ========

Earnings (loss) per share - Basic:
Income (loss) before cumulative
   effect of change in accounting principle     $ (0.72)             $   0.62              $  (1.13)            $   0.37
Cumulative effect of change in
   accounting principle                              --                    --                 (0.12)                  --
                                                -------              --------              --------             --------
    Net income (loss)                           $ (0.72)             $   0.62              $  (1.25)            $   0.37
                                                =======              ========              ========             ========

Earnings (loss) per share - Diluted:
Income (loss) before cumulative
   effect of change in accounting principle     $ (0.72)             $   0.59              $  (1.13)            $   0.35
Cumulative effect of change in
   accounting principle                              --                    --                 (0.12)                  --
                                                -------              --------              --------             --------
    Net income (loss)                           $ (0.72)             $   0.59              $  (1.25)            $   0.35
                                                =======              ========              ========             ========
Shares used in computing earnings:
   per share
   Basic                                          8,703                 9,562                 8,693                9,544
                                                =======              ========              ========             ========
   Diluted                                        8,703                10,116                 8,693               10,113
                                                =======              ========              ========             ========

</TABLE>


     SEE ACCOMPANYING CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.

                                       4


<PAGE>

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

<TABLE>
<CAPTION>
                                                                          SIX MONTHS ENDED SEPTEMBER 30,
                                                                          2002                      2001
                                                                     --------------             -------------
<S>                                                                  <C>                        <C>
CASH FLOWS FROM OPERATING ACTIVITIES:
 Net income (loss)                                                   $   (10,884)               $     3,548

 Adjustments to reconcile net loss to net cash used
  in operating activities:
  Depreciation and amortization                                            1,076                      1,313
  Cumulative effect of change in accounting principle                      1,043                         --
  Non-cash compensation expense                                              349                        176
  Deferred tax benefit                                                        --                       (143)
  Asset write-down charges                                                    --                        887
  Impairment of intangibles                                                1,288                         --
  Equity loss in affiliate                                                 2,184                         --
  Valuation allowance on note receivable                                     482                         --
  Loss on disposal                                                           687                         --
  Increase (decrease) in cash resulting from
   changes in operating assets and liabilities:
   Accounts receivable                                                     1,591                      2,230
   Tax receivable                                                             --                      1,330
   Other current assets                                                      327                       (824)
   Prepaid royalty (related party, Note 7)                                (1,756)                        --
   Other assets                                                               12                         --
   Accrued expenses                                                       (1,065)                    (1,490)
   Accounts payable                                                          117                     (1,127)
   Other non-current assets                                                   --                         26
   Deferred revenue                                                       (2,020)                    (1,340)
                                                                     -----------                -----------
Net cash used in operating activities                                     (6,569)                     4,586
                                                                     -----------                -----------

CASH FLOWS FROM INVESTING ACTIVITIES:
 Maturity of marketable securities                                            --                        820
 Advances to Scalable Software (related party, Note 7)                    (2,465)                    (2,000)
 Advances to PBTC (related party, Note 7)                                 (2,200)                        --
 Advances to Enterworks                                                       --                     (2,000)
 Purchases of furniture and equipment                                       (236)                      (494)
                                                                     -----------                -----------
Net cash used in investing activities                                     (4,901)                    (3,674)
                                                                     -----------                -----------

CASH FLOWS FROM FINANCING ACTIVITIES:
 Proceeds from exercises of stock options                                     19                         95
                                                                     -----------                -----------
Net cash used in financing activities                                         19                         95
                                                                     -----------                -----------

Net increase (decrease) in cash and cash equivalents                     (11,451)                     1,007
Effect of exchange rate changes on cash                                      (20)                        53
Cash and cash equivalents at beginning of period                          34,506                     42,774
                                                                     -----------                -----------

Cash and cash equivalents at end of period                           $    23,035                $    43,834
                                                                     ===========                ===========

Supplemental disclosure of cash flow information:

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

     SEE ACCOMPANYING CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.

                                       5

<PAGE>

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

NOTE 1--BASIS OF PRESENTATION

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

NOTE 2--PER SHARE INFORMATION

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

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

<TABLE>
<CAPTION>
                                         THREE MONTHS ENDED SEPTEMBER 30,          SIX MONTHS ENDED SEPTEMBER 30,
                                         --------------------------------          ------------------------------
                                               2002            2001                 2002                  2001
                                        ---------------------------------------------------------------------------
<S>                                     <C>                 <C>                  <C>                   <C>
Net income (loss)                          $    (6,250)     $     5,958          $   (10,884)          $    3,548
                                           ===========      ===========          ===========           ==========

Weighted average number of common
 shares outstanding during the period:
Basic                                            8,703            9,562                8,693                9,544
Dilutive stock options                              --              554                   --                  569
                                           -----------      -----------          -----------           ----------
Diluted                                          8,703           10,116                8,693               10,113
                                           ===========      ===========          ===========           ==========

Income (loss) per common share:
  Basic                                    $     (0.72)     $      0.62          $     (1.25)          $     0.37
                                           ===========      ===========          ===========           ==========
  Diluted                                  $     (0.72)     $      0.59          $     (1.25)          $     0.35
                                           ===========      ===========          ===========           ==========
</TABLE>

     In the period April 1, 2002 through September 30, 2002 options to purchase
39,574 shares of common stock at exercise prices between $0.20 to $1.80 per
share were exercised. At September 30, 2002, there were options outstanding to
purchase 3,145,192 shares of common stock with a weighted-average exercise price
of $7.79, These options were excluded from the calculation of diluted loss per
share for the three and six months ended September 30, 2002, as they were
anti-dilutive.

NOTE 3--INCOME TAXES

     As of March 31, 2002 NEON had a net operating loss carry-forward for income
tax purposes of approximately $5.4 million that is available to offset future
taxable income, if any. The net operating loss carry-forwards in the United
Kingdom, Germany and Australia carry forward indefinitely. The net operating
loss carry-forward for the United States begins expiring in the tax year 2020.
Given the recent tax losses experienced by NEON, there can be no assurance that
the operations will generate taxable income in the future to utilize these
losses, therefore, as of September 30, 2002, NEON has recorded a full valuation
allowance for the deferred tax assets related to the future benefits, if any,
for these loss carryforwards. Management currently believes that it is more
likely than not that the Company will have sufficient future taxable income to
allow it to realize the net deferred tax asset recorded as of September 30,
2002.

                                       6

<PAGE>

NOTE 4--SEGMENT REPORTING

     NEON considers its business activities to be in a single segment. During
the three-month and six-month periods ended September 30, 2002, NEON did not
have any customers that individually accounted for more than 10% of total
revenue. During the three-month period ended September 30, 2001, NEON had one
customer that individually accounted for 22% of total revenues. During the
six-month period ended September 30, 2001, NEON had one customer that accounted
for 20% of total revenue.

     The table below summarizes revenues by geographic region.

<TABLE>
<CAPTION>
                                  THREE MONTHS ENDED SEPTEMBER 30,          SIX MONTHS ENDED SEPTEMBER 30,
                                  --------------------------------          ------------------------------
                                   2002                   2001                 2002               2001
        <S>                       <C>                  <C>                  <C>                <C>
        Revenues:
          United States           $    2,967           $    4,217           $    6,820         $    9,758
          United Kingdom                 706                  509                1,662                961
          Other                          121                  126                  434                330
                                  ----------           ----------           ----------         ----------
                                  $    3,794           $    4,852           $    8,916         $   11,049
                                  ==========           ==========           ==========         ==========

        Operating Loss:
          United States           $   (5,385)          $   (3,721)          $   (7,650)        $   (5,783)
          United Kingdom                 (11)                   2                  257               (590)
          Other                         (117)                 (60)                 (35)              (226)
                                  ----------           ----------           ----------         ----------
                                  $   (5,513)          $   (3,779)          $   (7,428)        $   (6,599)
                                  ==========           ==========           ==========         ==========

        Identifiable Assets:
          United States           $   41,366           $   61,001
          United Kingdom                (569)               1,724
          Other                       (1,499)                 499
                                  ----------           ----------
                                  $   39,298           $   63,224
                                  ==========           ==========
</TABLE>

NOTE 5--CONTINGENCIES

     NEON is involved in various claims and legal actions arising in the
ordinary course of business. In the opinion of management, the ultimate
dispositions of any of these matters will not have a material adverse effect on
NEON's consolidated financial position, results of operations or liquidity.

NOTE 6--RESTRUCTURING CHARGES

     During the year ended March 31, 2002, NEON recorded restructuring charges
of $908,000, which related to reductions in force and the abandonment of leased
facilities as a result of a corporate reorganization. These restructuring
expenses included severance costs of $570,000 and losses from lease commitments
of $338,000. As of March 31, 2002, NEON has paid all severance related
restructuring costs. In May 2002, NEON subleased its previously abandoned leased
facilities, and as a result, NEON reduced its previously recorded restructuring
charges by $138,000. As of September 30, 2002, cumulative cash paid for leasing
expenses totaled $125,000 and NEON included the remaining net lease liability of
$75,000 in accrued liabilities.

     During the three months ended September 30, 2002, NEON incurred additional
restructuring charges of $271,000, related to the termination of its
distribution agreement with Peregrine/Bridge Transfer Corporation. These
restructuring expenses included severance costs of $50,000 and non cash
compensation expense related to stock option extensions. As of September 30,
2002, NEON paid $5,000 severance related restructuring costs and included the
remaining $45,000 in accrued liabilities.

NOTE 7 --RELATED PARTY TRANSACTIONS

     Members of NEON's Board of Directors and certain executive officers of NEON
are shareholders and/or directors in other companies with which NEON has
business relationships. Transactions between NEON and these other companies are
described below.

Peregrine/Bridge Transfer Corporation

     In January 1996, NEON entered into a distribution agreement with
Peregrine/Bridge Transfer Corporation ("PBTC"), a database software company
whose sole stockholder is an affiliate of John J. Moores, NEON's Chairman of the
Board of Directors. The distribution agreement had an initial term through
January 1, 1998 and could be automatically renewed for successive one-year
terms. The agreement also provided that NEON pay royalties to PBTC for the
license of products and for maintenance and support and upgrade services equal
to 50% of the revenues received by NEON for NEON's distribution of

                                       7

<PAGE>

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

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

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

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

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

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

     Pursuant to the Termination and Customer Support Agreement and an
assignment executed in connection with the closing of the Termination and
Customer Support Agreement and effective as of August 1, 2002, PBTC was assigned
all of NEON's rights and obligations under any customer license and maintenance
agreements related to the PBTC software products previously marketed by NEON,
including customer support obligations. In addition, the terms of the
Termination and Customer Support Agreement provide that PBTC offered employment
to certain sales and support personnel of NEON that

                                       8

<PAGE>

were assigned to market the PBTC software products. The Termination and Customer
Support Agreement also contemplated the resignation of Wayne E. Webb Jr. as
Senior Vice President and General Counsel of NEON effective as of August 1, 2002
to focus on his role as President and CEO of PBTC.

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

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

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

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

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

Scalable Software, Inc.

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

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

                                       9

<PAGE>

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

     Due to the interests in Scalable Software of several members of NEON's
Board of Directors, the Board of Directors concluded that it would be
appropriate to create a Special Committee comprised solely of independent
directors who had no interest in Scalable Software to review the terms of the
proposed acquisition. After thorough consideration and discussion by the Special
Committee and its advisors, the Special Committee proposed that the payment of
the consideration for the proposed acquisition be structured as an earn out, in
which the NEON stock to be used as consideration would be placed in escrow
subject to release to the Scalable Software shareholders upon Scalable
Software's attainment of specified revenue and profitability goals. This
proposal was unacceptable to Scalable Software's management and its Board of
Directors and was rejected. The status of the proposed acquisition was then
discussed at a special meeting of NEON's Board of Directors in December 2001.
After thorough consideration and discussion and upon endorsement by the Special
Committee, NEON's Board of Directors approved modifications to the proposed
terms and conditions for the acquisition such that the transaction would be
structured as an option to acquire Scalable Software as discussed below. In
addition, NEON also announced on December 21, 2001, that Louis R. Woodhill, its
President and Chief Executive Officer, and Jim Woodhill had been appointed to
the Board of Directors of NEON. As of September 30, 2002, there has been no
change to the status of the directors and officers of NEON who are listed as
shareholders, directors or officers of Scalable Software above.

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

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

     As noted above, certain member's of NEON's board of directors and executive
officers also serve as directors and executive officers of Scalable Software and
claim beneficial ownership of approximately 81% of Scalable's common stock. In
addition, NEON has an option to acquire all of the outstanding shares of
Scalable Software and is currently providing Scalable's primary financing for
its operations. Therefore, NEON recognizes 100% of Scalable Software's losses to
the extent of advances made in excess of the guaranteed amount. At September 30,
2002, NEON had made total advances of $8.3 million to Scalable Software
(including $4.8 million of unguaranteed advances) and recognized cumulative
losses of $4.3 million. In addition, due to the uncertainties regarding NEON's
ultimate ability to recover any unguaranteed advances to Scalable Software, NEON
will not record the carrying value of its net advance to Scalable Software above
the guaranteed amount. Accordingly, for the six months ended September 30, 2002,
NEON recorded a valuation allowance of $482,000 against the Scalable note
receivable, reducing the carrying value of the note receivable to the $3.5
million guaranteed amount.


                                       10

<PAGE>

     Sheer Genius Software, Inc.

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

NOTE 8 - IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS

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

     Under the transition provisions of SFAS No. 142, NEON tested the goodwill
balances associated with the September 1999 acquisition of Beyond Software, Inc.
("BSI") for impairment by comparing the fair value of BSI to its carrying value.
Fair value was determined after considering changes in operational strategies
and plans, as well as assumptions regarding the potential future cash flows from
the acquired assets. As a result, NEON determined that the carrying value of the
goodwill related to the BSI acquisition had been impaired by $1.0 million, which
is shown as a cumulative effect of a change in accounting principle as of
April 1, 2002. This impairment charge resulted in a net carrying value of
$150,000 at September 30, 2002.

                                       11

<PAGE>

     The pro forma effects of the adoption of SFAS 142 on net income (loss) and
income (loss) per share for NEON for the three and six months ended September
30, 2002 and 2001 is as follows:

<TABLE>
<CAPTION>

                                         THREE MONTHS             THREE MONTHS             SIX MONTHS           SIX MONTHS
                                            ENDED                     ENDED                  ENDED                 ENDED
                                      SEPTEMBER 30, 2002         SEPTEMBER 30, 2001    SEPTEMBER 30, 2002   SEPTEMBER 30, 2001
                                      ----------------------------------------------------------------------------------------
<S>                                       <C>                       <C>                    <C>                  <C>
Net income (loss) as reported             $  (6,250)                $   5,958              $  (10,884)          $   3,548
Add back: Cumulative effect of
 change in accounting principle                --                        --                     1,043                --
Add back: Amortization of goodwill             --                         120                    --                   239
                                          ---------                 ---------              ----------           ---------
    Adjusted net income (loss)            $  (6,250)                $   6,078              $   (9,841)          $   3,787
                                          =========                 =========              ==========           =========
Income (loss) per share - Basic:
 Income (loss) per share, as              $   (0.72)                $     .62              $    (1.25)          $     .37
  reported
 Add back: Cumulative effect of
  change in accounting principle               --                        --                      0.12                --
 Add back: Amortization of goodwill            --                         .01                    --                   .03
                                          ---------                 ---------              ----------           ---------
 Pro forma income (loss) per share        $   (0.72)                $     .63              $    (1.13)          $     .40
                                          =========                 =========              ==========           =========
Income (loss) per share - Diluted:
 Income (loss) per share as reported      $   (0.72)                $    0.59              $    (1.25)          $    0.35
 Add back: Cumulative effect of
  change in accounting principle               --                        --                      0.12                --
 Add back: Amortization of goodwill            --                         .01                    --                   .02
                                          ---------                 ---------              ----------           ---------
 Pro forma income (loss) per share        $   (0.72)                $     .60              $    (1.13)          $     .37
                                          =========                 =========              ==========           =========
</TABLE>

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

     In April 2002, the FASB issued SFAS No. 145 "Rescission of FASB Statements
No. 4, 44, and 64, Amendment of FASB Statement No. 13, and Technical
Corrections." SFAS No. 145 rescinds FASB Statement No. 4, "Reporting Gains and
Losses from Extinguishment of Debt," and an amendment of that Statement, FASB
Statement No. 64, "Extinguishments of Debt Made to Satisfy Sinking-Fund
Requirements." SFAS No. 145 also rescinds FASB Statement No. 44, "Accounting for
Intangible Assets of Motor Carriers" and amends FASB Statement No. 13,
"Accounting for Leases." SFAS No. 145 also amends other existing authoritative
pronouncements to make various technical corrections, clarify meanings, or
describe their applicability under changed conditions. SFAS No. 145 will be
effective for fiscal year beginning at May 15, 2002. NEON does not anticipate
that the adoption of SFAS No. 145 will have a material impact of NEON's
consolidated financial statements.

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

NOTE 9 - IMPAIRMENT OF INTANGIBLES

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

     In addition, under SFAS No. 142, NEON determined that fair value of
goodwill related to the BSI acquisition was approximately $150,000. The carrying
value of goodwill related to the BSI acquisition at June 30, 2002 was $1.2
million, and as a result, NEON recorded an impairment charge of $1.0 million
upon the adoption of SFAS No. 142 as of April 1, 2002. See Note 8 to NEON's
financial statements.

                                       12

<PAGE>

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

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

OVERVIEW

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

     NEON derives revenue from software licenses and maintenance services.
License fees, which are based upon the number and capacity of servers as well as
the number of client users, are generally due upon license grant and include a
one-year maintenance period. The sales process typically takes approximately
nine months. After the initial year of license, NEON provides ongoing
maintenance services, which include technical support and product enhancements,
for an annual fee. Any factors adversely affecting the pricing of, demand for,
or market acceptance of, our products, such as competition or technological
change, could materially adversely affect our business, operating results and
financial condition. During the three-month period ended September 30, 2002,
NEON did not have any customers that individually accounted more than 10% of
total revenue. During the three-month period ended September 30, 2001 NEON had
one customer that accounted for 22% of total revenue.

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

     NEON conducts business in the United Kingdom and Germany through two wholly
owned consolidated subsidiaries and revenues from these subsidiaries are
denominated in local currencies. In connection with these foreign operations,
NEON is exposed to foreign currency fluctuations for its net working capital
positions. NEON has no material commitments that would

                                       13

<PAGE>

be satisfied in currencies other than U.S. dollars. In other international
markets, NEON conducts substantially all of its business through independent
third-party distributors. Revenues derived from third-party distributors are
denominated in U.S. dollars. Revenues recognized from sales to customers outside
North America, primarily in Europe, represented approximately 24% and 12% for
the six months ended September 30, 2002 and 2001, respectively. Foreign currency
fluctuations have not had a significant impact on NEON's revenues or operating
results. Management does not currently have an active foreign exchange hedging
program; however, NEON may implement a program to mitigate foreign currency
transaction risk in the future.

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

Related Party Transactions

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

Peregrine/Bridge Transfer Corporation

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

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

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

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


                                       14

<PAGE>

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

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

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

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

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

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

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

                                       15

<PAGE>

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

Scalable Software, Inc.

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

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

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

     Due to the interests in Scalable Software of several members of NEON's
Board of Directors, the Board of Directors concluded that it would be
appropriate to create a Special Committee comprised solely of independent
directors who had no interest in Scalable Software to review the terms of the
proposed acquisition. After thorough consideration and discussion by the Special
Committee and its advisors, the Special Committee proposed that the payment of
the consideration for the proposed acquisition be structured as an earn out, in
which the NEON stock to be used as consideration would be placed in escrow
subject to release to the Scalable Software shareholders upon Scalable
Software's attainment of specified revenue and profitability goals. This
proposal was unacceptable to Scalable Software's management and its Board of
Directors and was rejected. The status of the proposed acquisition was then
discussed at a special meeting of NEON's Board of Directors in December 2001.
After thorough consideration and discussion and upon endorsement by the Special
Committee, NEON's Board of Directors approved modifications to the proposed
terms and conditions for the acquisition such that the transaction would be
structured as an option to acquire Scalable Software as discussed below. In
addition, NEON also announced on December 21, 2001, that Louis R. Woodhill, its
President and Chief Executive Officer, and Jim Woodhill had been appointed to
the Board of Directors of NEON. As of September 30, 2002, there has been no
change to the status of the directors and officers of NEON who are listed as
shareholders, directors or officers of Scalable Software above.

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

                                       16

<PAGE>

the initial $3.5 million loaned to Scalable Software, the $5.5 million loan will
be secured by all of the intellectual property rights of Scalable Software. NEON
may exercise the option to acquire Scalable Software at any time during the
two-year term, subject to provisions that require NEON to exercise its option
within a 30-day window under certain circumstances or forfeit the option. If
NEON exercises the option and acquires Scalable Software, each of the
approximately 19,400,000 outstanding shares of common stock of Scalable Software
will be converted into approximately 0.135 of a share of NEON common stock and
outstanding options and warrants to purchase approximately 3,000,000 shares of
common stock of Scalable Software will become options and warrants to purchase
common stock of NEON on the same conversion basis. If Scalable Software incurs
more indebtedness for borrowed money or issues more equity, the exchange ratio
will be adjusted accordingly. Prior to NEON exercising the option to acquire
Scalable Software, a Special Committee would be appointed to review the
negotiated terms of the proposed acquisition and NEON would seek to obtain a
fairness opinion regarding the transaction from a financial advisory firm. The
acquisition of Scalable Software will also require approval of the stockholders
of NEON and the NEON Board of Directors.

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

     As noted above, certain member's of NEON's board of directors and executive
officers also serve as directors and executive officers of Scalable Software and
claim beneficial ownership of approximately 81% of Scalable's common stock. In
addition, NEON has an option to acquire all of the outstanding shares of
Scalable Software and is currently providing Scalable's primary financing for
its operations. Therefore, NEON recognizes 100% of Scalable Software's losses to
the extent of advances made in excess of the guaranteed amount. At September 30,
2002, NEON had made total advances of $8.3 million to Scalable Software
(including $4.8 million of unguaranteed advances) and recognized cumulative
losses of $4.3 million. In addition, due to the uncertainties regarding NEON's
ultimate ability to recover any unguaranteed advances to Scalable Software, NEON
will not record the carrying value of its net advance to Scalable Software above
the guaranteed amount. Accordingly, for the six months ended September 30, 2002,
NEON recorded a valuation allowance of $482,000 against the Scalable note
receivable, reducing the carrying value of the net revenue to the $3.5 million
guaranteed amount

Sheer Genius Software, Inc.

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

                                       17

<PAGE>

Critical Accounting Policies

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

Revenue Recognition Policies

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

Capitalized Software Costs

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

Allowance for Doubtful Accounts Receivable

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

Deferred Income Taxes

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

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

                                       18

<PAGE>

Accounting for Advances to Scalable Software

     As discussed more fully in "Related Party Transactions" above, certain
members of NEON's board of directors and executive officers also serve as
directors and executive officers of Scalable Software and claim beneficial
ownership of approximately 81% of Scalable's common stock. In addition, NEON has
an option to acquire all of the outstanding shares of Scalable Software and is
currently providing Scalable's primary financing for its operations. Therefore,
NEON determined that it has effective control of Scalable Software and began
accounting for its investment in Scalable Software using the modified equity
method of accounting. Under this method of accounting, NEON recognizes 100% of
Scalable Software's losses to the extent of its advances made to Scalable
Software in excess of the amounts guaranteed by Messrs. Moores, Woodhill and
Woodhill.

RESULTS OF OPERATIONS

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

<TABLE>
<CAPTION>

                                                      THREE MONTHS ENDED SEPTEMBER 30,        SIX MONTHS ENDED SEPTEMBER 30,
                                                      --------------------------------        ------------------------------
                                                            2002           2001                    2002            2001
                                                            ----           ----                    ----            ----
<S>                                                     <C>            <C>                     <C>             <C>
     Revenues:
        License                                               34%            51 %                     39%            58%
        Maintenance                                           66             49                       61             42
                                                            ----            ---                     ----           ----
           Total revenues                                    100            100                      100            100
     Cost of revenues:
        Cost of licenses                                      12             13                       11             10
        Cost of maintenance                                   12             10                       12              9
                                                            ----            ---                     ----           ----
           Total cost of revenues                             24             23                       23             19
                                                            ----            ---                     ----           ----
     Gross profit                                             76             77                       77             81
     Operating expenses:
        Sales and marketing                                   86             66                       73             66
        Research and development                              40             30                       35             29
        General and administrative                            36             20                       29             26
        Asset write-down charges                                             18                       --              8
        Impairment of intangibles                             34                                      14
        Amortization of acquisition
           related costs                                      --              2                       --              2
        Restructuring costs                                    7             19                        1              8
        Loss on disposals                                     18             --                        8             --
                                                            ----            ---                     ----           ----
           Total operating expenses                          221            155                      160            139
                                                            ----            ---                     ----           ----
     Operating income (loss)                                (145)           (78)                     (83)           (58)
     Interest and other, net                                   3              7                        2              6
     Gain from settlement of lawsuit                          --            191                       --             83
     Equity Loss in Affiliate                                (25)            --                      (24)            --
     Valuation allowance on note
      receivable                                               2             --                       (5)            --
                                                            ----            ---                     ----           ----
     Income (loss) before income taxes
       and cumulative effect of change
       in accounting principle                              (165)           120                     (110)            31
     Benefit for income taxes                                 --              3                       --              1
                                                            ----            ---                     ----           ----
     Income (loss) before cumulative
       effect of change in accounting
       principle                                            (165)           123                     (110)            32
     Cumulative effect of change in
        accounting principle                                  --             --                      (12)            --
                                                            ----            ---                     ----           ----
     Net income (loss)                                      (165)%          123 %                   (122)            32%
                                                            ====            ===                     ====           ====

</TABLE>


THREE MONTHS ENDED SEPTEMBER 30, 2002 COMPARED TO THREE MONTHS ENDED SEPTEMBER
30, 2001

REVENUES

     License revenues for the three months ended September 30, 2002 were $1.3
million, a decrease of $1.2 million from $2.5 million for the three months ended
September 30, 2001. The reduction in license revenue was primarily due to the
expiration of a two-year software distribution agreement with BMC Software
entered into in October 1999, in connection with NEON's settlement of a lawsuit
originally filed by BMC Software. NEON recognized $1.1 million in license
revenue for the three-month period ended September 30, 2001 under the agreement.

     Maintenance revenues for the three months ended September 30, 2002 were
$2.5 million, an increase of $141,000 from $2.4 million for the three months
ended September 30, 2001. The increase primarily resulted from the growth of
NEON's cumulative installed customer base.

                                       19

<PAGE>

COST OF REVENUES

     Cost of license revenues primarily consist of amortization charges
associated with acquired product technology, royalty payments to third parties,
as well as other direct product costs such as product manuals and distribution
and media costs associated with NEON's software products. Cost of license
revenues for the three months ended September 30, 2002 were $448,000, or 35% of
license revenues, as compared to $616,000, or 25% of license revenues, for the
three months ended September 30, 2001. The increase in cost of license revenues
as a percentage of license revenue was primarily due to lower license revenue as
amortization charges for purchased product technology were consistent between
both periods. Excluding amortization charges cost of license revenues as a
percentage of revenues decreased due to lower product royalty payments
associated with the termination of the PBTC distribution agreement in August
2002 (see Related Party Transaction).

     Cost of maintenance revenues includes personnel and other customer support
costs. Cost of maintenance revenues for the three months ended September 30,
2002 and 2001 remained consistent, representing $479,000, or 19% of maintenance
revenues for the three months ended September 30, 2002, as compared to $469,000,
or 20% of maintenance revenues, for the three months ended September 30, 2001.

OPERATING EXPENSES

     Sales and marketing expenses include personnel costs, sales commissions and
travel expenses of sales, presales support and marketing personnel, along with
trade show participation and other promotional expenses. Sales and marketing
expenses for the three months ended September 30, 2002 and 2001 were consistent,
representing $3.3 million and $3.2 million, respectively. Sales and marketing
expenses may increase as NEON continues to expand its sales channel and global
footprint.

     Research and development expenses primarily include personnel costs
associated with NEON's product development staff. Research and development
expenses for the three months ended September 30, 2002 and 2001 were consistent,
representing $1.5 million and $1.5 million, respectively. Research and
development may increase as NEON continues to expand its existing product lines
and develop new products.

     General and administrative expenses include personnel and other costs
associated with NEON's executive, financial, legal and administrative functions.
General and administrative expenses for the three months ended September 30,
2002 were $1.3 million, an increase of $387,000 from $959,000 for the three
months ended September 30, 2001. The increase was primarily related to greater
compensation costs associated with the transition of new executive management,
including severance, recruiting and relocation costs.

     NEON recorded non-cash charges of $887,000 during the three months ended
September 30, 2001 related to the write-down of pre-paid royalties and other
assets.

     During the three months ended September 30, 2002, NEON performed impairment
tests on its intangible assets related to the intellectual property acquired
from Sterling Software in October 2000. In September 2002, NEON adjusted the
estimated future cash flows attributable to these assets due to lower than
expected operating performance and changes in the future operating strategies
related to this product. As a result, NEON determined that the carrying value of
the intangibles was impaired. NEON recorded impairment charges of $1.3 million
during the three months ended September 30, 2002, related to intellectual
property acquired from Sterling Software. See Note 9 to NEON's financial
statements.

     NEON incurred restructuring charges of $271,000 during the three months
ended September 30, 2002 related to termination of its distribution agreement
with PBTC. The charges primarily represented non-cash stock compensation costs
resulting from the extension of stock options for severed employees. During the
three month period ended September 30, 2001, NEON

                                       20

<PAGE>

recorded a restructuring charge of $908,000. These charges related to reductions
in the Company's cost structure and corporate reorganization, including
reductions in force resulting in severance charges of $570,000 and losses from
lease commitments of $338,000 due to the abandonment of certain leased
facilities.

     Interest and other income for the three months ended September 30, 2002 was
$111,000 as compared to $334,000 for the three months ended September 30, 2001.
The reduction in interest income was due to lower available cash balances
combined with a decline in interest rates.

     In the quarter ending September 30, 2001, NEON resolved its trademark
litigation with New Era of Networks, and as a result NEON received a cash
payment of approximately $9.3 million, net of attorney fees.

     As previously discussed, NEON accounts for its investment in Scalable
Software using the modified equity method of accounting. Under this method, NEON
recognizes 100% of Scalable Software's income or loss to the extent of advances
made in excess of the guaranteed amount. For the three months ended September
30, 2002 NEON recorded an equity loss of $939,000. NEON records the note
receivable from Scalable at the guaranteed amount. During the three months ended
September 30, 2002, NEON reduced the valuation against the note by $91,000 to
increase the carrying value of the note to the guaranteed amount of $3.5
million. See "Related Party Transactions" and Note 7 to NEON's financial
statements.

     No provision for income taxes was recorded for the three months ended
September 30, 2002 as NEON had pre-tax losses of $6.3 million. A tax benefit of
$143,000 was recorded for the three months ending September 2001. As of March
31, 2002 NEON had a net operating loss carry-forward for income tax purposes of
approximately $5.4 million that is available to offset future taxable income, if
any. The net operating loss carry-forwards in the United Kingdom, Germany and
Australia carry forward indefinitely. The net operating loss carry-forward for
the United States begins expiring in the tax year 2020. Given the recent tax
losses experienced by NEON, there can be no assurance that the operations will
generate taxable income in the future to utilize these losses, therefore, as of
September 30, 2002, NEON has recorded a full valuation allowance for the
deferred tax assets related to the future benefits, if any, for these loss
carryforwards. Management currently believes that it is more likely than not
that the Company will have sufficient future taxable income to allow it to
realize the net deferred tax asset recorded as of September 30, 2002.

SIX MONTHS ENDED SEPTEMBER 30, 2002 COMPARED TO SIX MONTHS ENDED SEPTEMBER 30,
2001

REVENUES

     License revenues for the six months ended September 30, 2002 were $3.5
million, a decrease of $2.9 million from $6.4 million for the six months ended
September 30, 2001. The reduction in license revenue was primarily due to the
expiration of a two-year software distribution agreement with BMC Software
entered into in October 1999, in connection with NEON's settlement of a lawsuit
originally filed by BMC Software. NEON recognized $2.2 million in license
revenue for the six-month period ended September 30, 2001 under the agreement.
The overall weakness in the mainframe software market also contributed to the
decline in license revenues.

     Maintenance revenues for the six months ended September 30, 2002 were $5.4
million, an increase of $720,000 from $4.7 million for the six months ended
September 30, 2001. The increase primarily resulted from the growth of NEON's
cumulative installed customer base.

COST OF REVENUES

     Cost of license revenues primarily consists of amortization charges
associated with acquired product technology, royalty payments to third parties,
as well as other direct product costs such as product manuals and distribution
and media costs associated with NEON's software products. Cost of license
revenues for the six months ended September 30, 2002 were $997,000, or 28% of
license revenues, as compared to $1.1 million, or 17% of license revenues, for
the six months ended September 30, 2001. The increase in cost of license
revenues as a percentage of license revenue was primarily due to lower license
revenue as amortization charges for purchased product technology were consistent
between both periods. Excluding amortization charges, cost of license revenues
as a percentage of revenues decreased due to lower product royalty payments
associated with the termination of the PBTC distribution agreement in August
2002, see "Related Party Transaction".

     Cost of maintenance revenues includes personnel and other customer support
costs. Cost of maintenance revenues for the six months ended September 30, 2002
were $1.0 million, or 19% of maintenance revenues, as compared to $1.0 million,
or 22% of maintenance revenues, for the six months ended September 30, 2001. The
decrease in cost of maintenance revenue as a

                                       21

<PAGE>

percentage of maintenance revenue was due to the cumulative growth in NEON's
customer base and annual increases in maintenance fees.

OPERATING EXPENSES

     Sales and marketing expenses include personnel costs, sales commissions and
travel expenses of sales, presales support and marketing personnel, along with
trade show participation and other promotional expenses. Sales and marketing
expenses for the six months ended September 30, 2002 were $6.5 million, a
decrease of $816,000 from $7.3 million for the six months ended September 30,
2001. The reduction was primarily due to lower personnel costs associated with a
headcount reduction during the six months ended September 30, 2001, combined
with lower promotional marketing costs, as NEON reduced the scope of its iWave
product operations and refocused its marketing efforts to emphasize its Shadow
product line. Sales and marketing expenses may increase as NEON continues to
expand its sales channel and global footprint.

     Research and development expenses primarily include personnel costs
associated with NEON's product development staff. Research and development
expenses for the six months ended September 30, 2002 were $3.1 million, a
decrease of $141,000 from $3.2 million for the six months ended September 30,
2001. The decrease was primarily attributed to the reduction in scope of NEON's
iWave product operations, which resulted in the closure of its North Carolina
facility in June 2001. This reduction was partially offset by contract
development fees paid to Sheer Genius Software, Inc., see "Related Party
Transactions." Research and development may increase as NEON continues to expand
its existing product lines and develop new products.

    General and administrative expenses include personnel and other costs
associated with NEON's executive, financial, legal and administrative functions.
General and administrative expenses for the six months ended September 30, 2002
were $2.6 million, a decrease of $304,000 from $2.9 million for the six months
ended September 30, 2001. Excluding severance costs of $1.1 million related to
the departure of certain executives during the three months ended June 30, 2001,
general and administrative expenses increased by $795,000. The increase was
primarily related to greater compensation costs associated with the transition
of new executive management, including severance, recruiting and relocation
costs, as well as the reclassification of certain IT infrastructure expenses.

     NEON recorded non-cash charges of $887,000 during the six months ended
September 30, 2001 related to the write-down of pre-paid royalties and other
assets.

     During the six months ended September 30, 2002, NEON performed impairment
tests on its intangible assets related to the intellectual property acquired
from Sterling Software in October 2000. In September 2002, NEON adjusted the
estimated future cash flows attributable to these assets due to lower than
expected operating performance and changes in the future operating strategies
related to this product. As a result, NEON determined that the carrying value of
the intangibles was impaired. NEON recorded impairment charges of $1.3 million
during the six months ended September 30, 2002, related to intellectual property
acquired from Sterling Software. See Note 9 to NEON's financial statements.

     NEON incurred restructuring charges of $133,000 during the six months ended
September 30, 2002. This represents $271,000 related to the termination of
NEON's distribution agreement with PBTC. The charges primarily represented
non-cash stock compensation costs resulting from the extension of stock options
for severed employees. This amount was offset by a $138,000 reduction to an
outstanding restructuring accrual for abandoned facilities, as those facilities
were subleased during the period. During the six month period ended September
30, 2001, NEON recorded a restructuring charge of $908,000. These charges
related to reductions in the Company's cost structure and corporate
reorganization, including reductions in force

                                       22

<PAGE>

resulting in severance charges of $570,000 and losses from lease commitments of
$338,000 due to the abandonment of certain leased facilities.

     Interest and other income for the six months ended September 30, 2002 was
$253,000 as compared to $744,000 for the six months ended September 30, 2001.
The reduction in interest income was due to lower available cash balances
combined with a decline in interest rates.

     During the six months ending September 30, 2001, NEON resolved its
trademark litigation with New Era of Networks, and as a result NEON received a
cash payment of approximately $9.3 million, net of attorney fees.

     As previously discussed, NEON accounts for its investment in Scalable
Software using the modified equity method of accounting. Under this method, NEON
recognizes 100% of Scalable Software's income or loss to the extent of advances
made in excess of the guaranteed amount. For the six months ended September 30,
2002 NEON recorded an equity loss of $2.2 million. NEON also recorded a
valuation allowance of $482,000 during the six months ended September 30, 2002
against the Scalable note receivable to write-down the outstanding balance of
the note to the guaranteed amount. See "Related Party Transactions" and Note 7
to NEON's financial statements.

     No provision for income taxes was recorded for the six months ended
September 30, 2002 as NEON had pre-tax losses of $9.8 million. A tax benefit of
$143,000, or 4.2% of pre-tax income was recorded for the six months ending
September 2001. As of March 31, 2002 NEON had a net operating loss carry-forward
for income tax purposes of approximately $5.4 million that is available to
offset future taxable income, if any. The net operating loss carry-forwards in
the United Kingdom, Germany and Australia carry forward indefinitely. The net
operating loss carry-forward for the United States begins expiring in the tax
year 2020. Given the recent tax losses experienced by NEON, there can be no
assurance that the operations will generate taxable income in the future to
utilize these losses, therefore, as of September 30, 2002, NEON has recorded a
full valuation allowance for the deferred tax assets related to the future
benefits, if any, for these loss carryforwards. Management currently believes
that it is more likely than not that the Company will have sufficient future
taxable income to allow it to realize the net deferred tax asset recorded as of
September 30, 2002.

     Under the transition provisions of SFAS No. 142, NEON tested the goodwill
balances associated with the September 1999 acquisition of Beyond Software, Inc.
("BSI") for impairment by comparing the fair value of BSI to its carrying value.
Fair value was determined after considering changes in operational strategies
and plans, as well as assumptions regarding the potential future cash flows from
the acquired assets. As a result, NEON determined that the carrying value of the
goodwill related to the BSI acquisition had been impaired by $1.0 million, which
is shown as a cumulative effect of a change in accounting principle as of
April 1, 2002. This impairment charge resulted in a net carrying value of
$150,000 at September 30, 2002.

LIQUIDITY AND CAPITAL RESOURCES

     NEON's cash and cash equivalents at September 30, 2002 were $23.0 million,
a decline of $11.5 million from $34.5 million at March 31, 2002. This decrease
was due primarily to a net operating loss of $7.4 million for the six months
ended September 30, 2002, and advances on a note receivable and prepaid
royalties to PBTC and advances to Scalable Software, Inc. of $4.2 million and
$2.5 million, respectively (see Related Party Transactions).

     Net cash used in operating activities for the six months ended September
30, 2002 was $6.6 million and was primarily due to NEON's net operating losses.
For the six months ended September 30, 2001 net cash provided by operating
activities was $4.6 million and resulted from NEON's $9.3 million trademark
settlement, net of attorney fees, with New Era of Networks, offset by a $6.6
million in operating losses.

     Net cash used in investing activities was $4.9 million and $3.7 million for
the six months ended September 30, 2002 and 2001, respectively. For the six
months ended September 30, 2002, net cash used in investing activities
represents advances on a note receivable to Scalable Software of $2.5 million,
an advance on a note receivable to PBTC of $2.2 million and purchases of
property and equipment of $236,000. The principal investing uses in the six
months ended September 30, 2001 were an advance on a note receivable to Scalable
Software of $2.0 million, an advance on a note receivable to Enterworks
Software, Inc. of $2.0 million, and $494,000 in purchases of property and
equipment partially offset by the maturity of $820,000 in marketable securities.
As of September 30, 2002, NEON had no material commitment for capital
expenditures. As of September 30, 2002, Scalable had additional funding
available of $735,000 increased by an additional $500,000 resulting in a total
of $1.2 million for future funding commitments.

     NEON's net cash provided by financing activities was $19,000 and $95,000
for the six months ended September 30, 2002 and 2001, respectively. The net cash
provided by financing activities in both periods represents proceeds from the
exercise of employee stock options.

     NEON's future liquidity and capital requirements will depend upon numerous
factors, including the costs, timing and scale of NEON's product development
efforts and the success of such efforts, the costs, timing and sales of NEON's
sales and marketing activities, the extent to which its existing and new
products gain market acceptance, market developments, the costs involved in
maintaining and enforcing intellectual property rights, the level and timing of
license revenue, and other factors.

                                       23

<PAGE>

NEON believes that its current balance of cash and cash equivalents will be
sufficient to meet its working capital, funding commitments and anticipated
capital expenditure requirements for at least the next 12 months. Thereafter,
NEON may require additional funds to support its working capital requirements or
for other purposes and may seek to raise additional funds through public or
private equity financing or from other sources. There can be no assurance that
additional financing will be available at all, or if available, that such
financing will be obtainable on terms acceptable to NEON, or that any additional
financing will not be dilutive.

                                       24

<PAGE>

New Accounting Pronouncements

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

     Under the transition provisions of SFAS No. 142, NEON tested the goodwill
balances associated with the September 1999 acquisition of Beyond Software, Inc.
("BSI") for impairment by comparing the fair value of BSI to its carrying value.
Fair value was determined after considering changes in operational strategies
and plans, as well as assumptions regarding the potential future cash flows from
the acquired assets. As a result, NEON determined that the carrying value of the
goodwill related to the BSI acquisition had been impaired by $1.0 million, which
is shown as a cumulative effect of a change in accounting principle as of April
1, 2002. This impairment charge resulted in a net carrying value of $150,000 at
September 30, 2002.

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

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

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

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

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

     NEON adheres to a conservative investment policy, whereby its principal
concern is the preservation of liquid funds while maximizing its yield on such
assets. Cash and cash equivalents approximated $23.0 million at September 30,
2002, and were invested in different types of commercial paper and money
securities. NEON believes that a near-term change in interest rates

                                       25

<PAGE>

would not materially affect its financial position, results of operations or net
cash flows for fiscal year 2003.

ITEM 4.  CONTROLS AND PROCEDURES

     Within the 90-day period prior to the filing of this report, an evaluation
was carried out under the supervision and with the participation of NEON's
management, including the Chief Executive Officer ("CEO") and Chief Financial
Officer ("CFO"), of the effectiveness of our disclosure controls and procedures.
Based on that evaluation, the CEO and CFO have concluded that NEON's disclosure
controls and procedures were adequately effective to ensure that information
required to be disclosed by NEON in reports it files or submits under the
Securities Exchange Act of 1934 is recorded, processed, summarized and reported
within the time periods specified in the Securities and Exchange Commission
rules and forms. Subsequent to the date of their evaluation, there were no
significant changes in NEON's internal controls or in other factors that could
significantly affect the disclosure controls, including any corrective actions
with regard to significant deficiencies and material weaknesses.

PART II - OTHER INFORMATION

ITEM 1.   LEGAL PROCEEDINGS

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

ITEM 2.   CHANGES IN SECURITIES AND USE OF PROCEEDS

     In March 1999, NEON completed the initial public offering of its common
stock (the "IPO"). In the IPO, NEON issued and sold 3,041,000 shares for an
aggregate price to the public of $45,615,000, and a sole selling stockholder
sold 64,000 shares of common stock for an aggregate offering price of $960,000.
The IPO was a firm commitment underwriting, and the managing underwriters of the
IPO were Donaldson, Lufkin & Jenrette Securities Corporation, Hambrecht & Quist
LLC and the CIBC Oppenheimer Corp. The underwriting discount incurred by NEON
relating to the IPO was $3,193,050. Net offering proceeds received by NEON from
the IPO were approximately $41.2 million. Approximately $1.0 million of the
proceeds received by NEON from the IPO were used to repay existing indebtedness
and $1.9 million was used in connection with the September 1999 acquisition of
the assets of Beyond Software Inc. An additional $4.5 million was paid to
Computer Associates, Inc. through December 2000 to pay certain software product
royalties and to purchase certain software products and intellectual property
rights. Additionally, $2.0 million was loaned to Enterworks Software, Inc. as
bridge financing in June 2001. In connection with NEON's entering into a Letter
of Intent on July 17, 2001, to acquire Scalable Software, Inc., Scalable
executed a promissory note that permits them to borrow up to $3,000,000 from
NEON. On November 13, 2001, the promissory note was amended to increase the
maximum lending limit to $3,500,000. NEON has obtained a two-year option to
acquire Scalable Software as outlined in the Agreement and Plan of Merger dated
June 26, 2002. This term sheet reflected a revision by NEON and Scalable
Software of NEON's previously announced plan to acquire Scalable Software. In
connection with the option to acquire Scalable Software, NEON agreed to
provide bridge financing of up to $5.5 million, in addition to the $3.5 million
previously loaned to Scalable Software that is secured by personal guarantees
from John Moores, Louis R. Woodhill and James Woodhill. On October 16, 2002, the
bridge financing lending limited was increased by $500,000 to $6.0 million. The
aggregate financing has a 36-month term and will not bear interest during the
term of the two-year option to acquire Scalable Software. After the expiration
of the option, the loan will bear interest at the prime rate plus two percentage
points. In addition to the personal guarantees of John J. Moores, Louis R.
Woodhill and James R. Woodhill for the initial $3.5 million loaned to Scalable
Software, the aggregate loan amount will be secured by all of the intellectual
property rights of Scalable Software. As of September 30, 2002, $8.3 million of
the bridge financing had been drawn upon by Scalable Software, and is reflected
as a note receivable. On January 2, 2002, NEON announced that it had purchased
913,400 shares of its outstanding common stock in a transaction arising from an
unsolicited offer. The transaction occurred December 21, 2001 at a purchase
price of $2.90 per share for a total aggregate purchase price of $2,648,860. The
shares purchased amounted to approximately 9.5% of NEON's then outstanding
9,577,533 shares of common stock, which after the purchase totaled 8,664,133
shares. NEON has used the remainder of its IPO proceeds as working capital.

                                       26

<PAGE>

ITEM 3.  DEFAULTS UPON SENIOR SECURITIES - Not applicable.

ITEM 4.  SUBMISSION OF MATTERS TO VOTE OF SECURITY HOLDERS - Not applicable.

ITEM 5.  OTHER INFORMATION -

FACTORS THAT MAY AFFECT FUTURE RESULTS

RISK FACTORS

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

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

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

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

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

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

                                       27

<PAGE>

future performance. If our quarterly results do not meet investors'
expectations, the trading price of our common stock will likely decline.

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

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

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

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

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

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

Reduced Customer Reliance Upon Mainframe Computers Could Adversely Affect Our
Business

     We are dependent upon the continued use and acceptance of mainframe
computers in a computing environment increasingly based on distributed
platforms, including client/server and Internet-based computing networks.
Decreased use of the mainframe or reduced demand for Web-based and client/server
applications accessing mainframe data and transactions could have a material
adverse effect on our business, operating results and financial condition. We
derive our revenues primarily from our Shadow products, and, to a lesser extent,
from our Enterprise Subsystem Management products that backup, recover,
reorganize and manage IMS databases, and our helpdesk integration software
products that allow customers to integrate helpdesk systems either with other
helpdesk systems, network system management products or asset management
products. Our continued success depends on a number of factors, including:

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

          Lack of growth in business demands for access to the data,
          applications and transactions residing on mainframe computers from
          Web-based and client/server applications and to integrate helpdesk
          systems, and/or to integrate helpdesk systems with network system
          management or asset management software products could have a material
          adverse effect on our business operating results and financial
          condition.

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

          We compete in markets that are intensely competitive and feature
          rapidly changing technology and evolving standards. Our competitors
          may be able to respond more quickly than we can to new or emerging
          technologies and

                                       28

<PAGE>

          changes in customer requirements. Competitive pressures could reduce
          our market share or require us to reduce the price of our products,
          either of which could have a material adverse effect on our business,
          operating results and financial condition.

     .    Rapid Technological Change Could Render Our Products Obsolete

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

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

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

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

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

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

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

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

                                       29

<PAGE>

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

     At present, our executive officers and directors and entities affiliated
with them beneficially own approximately 53.8% of our outstanding common stock.
As a result, these stockholders, if they act together, could control most
matters submitted to our stockholders for a vote, including the election of
directors.

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

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

ITEM 6.  EXHIBITS

         (a)  EXHIBITS

              6.1   Employment Agreement dated May 29, 2002 between NEON
                    Systems, Inc. and Brian D. Helman
              99.1  Certification of Louis R. Woodhill, Chief Executive Officer
                    of NEON Systems, Inc. pursuant to 18 U. S. C. SECION 1350,
                    as adopted pursuant to Section 906 of the Sarbanes-Oxley Act
                    of 2002.
              99.2  Certification of Brian D. Helman, Chief Financial Officer of
                    NEON Systems, Inc. pursuant to 18 U. S. C. SECTION 1350, as
                    adopted pursuant to Section 906 of the Sarbanes-Oxley Act of
                    2002.

                                       30

<PAGE>

                                   SIGNATURES

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

                                            NEON SYSTEMS, INC.

Date: November 12, 2002                     /s/ Brian D. Helman
                                            ------------------------------------
                                            Chief Financial Officer
                                            (Principal financial officer)

                                       31