NEON SYSTEMS INC - 10-Q Quarterly Report

UNITED STATES
SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-Q

(Mark One)

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

For the Quarterly Period Ended December 31, 2003

OR

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

For the transition period from to

Commission File Number: 0-25457

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

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

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

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

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

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

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

	Common Stock, par value $0.01 per share
	(Title of Class)

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

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes oNo ý

The number of shares of the registrant’s common stock outstanding as of January 31, 2004, was 8,902,097.

NEON SYSTEMS, INC.

FORM 10-Q

FOR THE QUARTER ENDED DECEMBER 31, 2003

INDEX

PART I FINANCIAL INFORMATION

Item 1.	Financial Statements

	Consolidated Balance Sheets at December 31, 2003 and March 31, 2003

	Consolidated Statements of Operations for the Three and Nine Months Ended
	December 31, 2003 and 2002.

	Consolidated Statements of Cash Flows for the Nine Months Ended December 31, 2003 and 2002

	Condensed Notes to Consolidated Financial Statements

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

Item 3.	Quantitative and Qualitative Disclosures About Market Risk

Item 4.	Controls and Procedures

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings

Item 2.	Changes in Securities and Use of Proceeds

Item 3.	Defaults Upon Senior Securities

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

Item 5.	Other Information – Risk Factors that May Affect Future Results

Item 6.	Exhibits and Reports on Form 8-K


SIGNATURES

PART I - FINANCIAL INFORMATION

ITEM 1. FINANCIAL STATEMENTS

NEON SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(IN THOUSANDS, EXCEPT SHARE AMOUNTS)

	DECEMBER 31, 2003			MARCH 31, 2003
	(UNAUDITED)
ASSETS

CURRENT ASSETS:
Cash and cash equivalents	$	20,213		$	19,791
Accounts receivable, net	3,305			3,443
Taxes receivable	—			1,311
Other current assets	519			655
Total current assets	24,037			25,200

Property and equipment, net	518			839
Notes receivable, net (related party, Note 7)	7,760			7,760
Other assets	100			515
Total assets	$	32,415		$	34,314

LIABILITIES & STOCKHOLDERS’ EQUITY

CURRENT LIABILITIES:
Accounts payable	$	304		$	424
Accrued expenses	1,397			2,116
Deferred revenue	5,269			6,086
Total current liabilities	6,970			8,626

Accrued restructuring expenses – long term (Note 6)	1,030			1,297
Total liabilities	8,000			9,923

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; 8,885,097 and 8,764,427 shares issued and outstanding at December 31, 2003 and March 31, 2003, respectively	98			97
Additional paid-in capital	51,677			51,585
Treasury stock, 913,400 shares at cost	(2,649		)	(2,649		)
Accumulative other comprehensive loss	(426		)	(473		)
Accumulated deficit	(24,285		)	(24,169		)
Total stockholders’ equity	24,415			24,391
Commitments and contingencies (Note 5)
Total liabilities and stockholders’ equity	$	32,415		$	34,314

SEE ACCOMPANYING CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.

NEON SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(IN THOUSANDS, EXCEPT PER SHARE AMOUNTS)

(UNAUDITED)

	THREE MONTHS ENDED DECEMBER 31,						NINE MONTHS ENDED DECEMBER 31,
	2003			2002			2003			2002
Revenues:
License	$	1,157		$	2,233		$	3,855		$	5,582
Maintenance	2,489			2,363			7,519			7,113
Total revenues	3,646			4,596			11,374			12,695

Cost of revenues:
Cost of licenses	1			5			84			270
Cost of maintenance	342			475			1,077			1,521
Total cost of revenues	343			480			1,161			1,791

Gross profit	3,303			4,116			10,213			10,904

Operating expenses:
Sales and marketing	1,471			2,912			4,483			8,691
Research and development	1,097			985			3,391			3,226
General and administrative	934			1,325			2,582			3,910
Restructuring costs	179			—			212			133
Loss on disposal	—			—			—			687
Total operating expenses	3,681			5,222			10,668			16,647

Operating loss	(378		)	(1,106		)	(455		)	(5,743		)

Interest and other income, net	60			79			231			332
Equity loss in affiliate	—			(1,004		)	—			(3,187		)
Valuation allowance of note receivable	—			105			—			(378		)
Loss from continuing operations before income taxes and cumulative effect of change in accounting principle	(318		)	(1,926		)	(224		)	(8,976		)

Provision for income taxes	—			—			—			—
Loss from continuing operations before cumulative effect of change in accounting principle	(318		)	(1,926		)	(224		)	(8,976		)
Loss from discontinued operations	—			(476		)	(244		)	(3,267		)
Gain on disposal of discontinued operations	10			—			352			—
Loss before cumulative effect of change in accounting principle	(308		)	(2,402		)	(116		)	(12,243		)
Cumulative effect of change in accounting principle	—			—			—			(1,043		)
Net loss	$	(308	)	$	(2,402	)	$	(116	)	$	(13,286	)

Loss per common share —Basic:
Loss from continuing operations before cumulative effect of change in accounting principle	$	(0.03	)	$	(0.23	)	$	(0.02	)	$	(1.03	)
Loss from discontinued operations	—			(0.05		)	(0.03		)	(0.38		)
Gain on disposal of discontinued operations	—			—			0.04			—
Loss before cumulative effect of change in accounting principle	(0.03		)	(0.28		)	(0.01		)	(1.41		)
Cumulative effect of change in accounting principle	—			—			—			(0.12		)
Net loss	$	(0.03	)	$	(0.28	)	$	(0.01	)	$	(1.53	)

Loss per common share —Diluted:
Loss from continuing operations before cumulative effect of change in accounting principle	$	(0.03	)	$	(0.23	)	$	(0.02	)	$	(1.03	)
Loss from discontinued operations	—			(0.05		)	(0.03		)	(0.38		)
Gain on disposal of discontinued operations	—			—			0.04			—
Loss before cumulative effect of change in accounting principle	(0.03		)	(0.28		)	(0.01		)	(1.41		)
Cumulative effect of change in accounting principle	—			—			—			(0.12		)
Net loss	$	(0.03	)	$	(0.28	)	$	(0.01	)	$	(1.53	)

Weighted average shares outstanding:
Basic	8,876			8,734			8,839			8,707
Diluted	8,876			8,734			8,839			8,707

SEE ACCOMPANYING CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NEON SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF CASH FLOWS

(IN THOUSANDS)

(UNAUDITED)

	NINE MONTHS ENDED DECEMBER 31,
	2003			2002
CASH FLOWS FROM OPERATING ACTIVITIES:
Net loss	$	(116	)	$	(13,286	)
Adjustments to reconcile net loss to net cash used in operating activities:
Depreciation and amortization	238			258
Loss from discontinued operations	244			3,267
Gain on disposal of discontinued operations	(352		)	—
Cumulative effect of change in accounting principle	—			1,043
Non-cash compensation expense	—			349
Equity loss in affiliate	—			3,187
Valuation allowance of accounts receivable	—			169
Valuation allowance of note receivable	—			378
Loss on Disposal	—			687
Impairment of fixed assets	50			—
Increase (decrease) in cash resulting from changes in operating assets and liabilities:
Accounts receivable	(37		)	431
Tax receivable	1,311			—
Other current assets	369			556
Prepaid royalty (related party, Note 7)	—			(1,756		)
Other assets	54			17
Accrued expenses	(1,353		)	(1,180		)
Accounts payable	(137		)	(69		)
Deferred revenue	(686		)	(2,084		)
Net cash used in operating activities	(415		)	(8,033		)

CASH FLOWS FROM INVESTING ACTIVITIES:
Advances to Scalable Software (related party, Note 7)	—			(3,362		)
Advances to NESI (related party, Note 7)	—			(2,200		)
Purchases of furniture and equipment	(57		)	(319		)
Proceeds from sale of business	538			—

Net cash provided by (used in) investing activities	481			(5,881		)

CASH FLOWS FROM FINANCING ACTIVITIES:
Proceeds from exercises of stock options	94			29
Net cash provided by financing activities	94			29

Net cash flows from discontinued operations	9			(353		)

Net increase (decrease) in cash and cash equivalents	169			(14,238		)
Effect of exchange rate changes on cash	253			(8		)
Cash and cash equivalents at beginning of period	19,791			34,506

Cash and cash equivalents at end of period	$	20,213		$	20,260

Supplemental disclosure of cash flow information:

Cash received during the period for income tax refund	$	1,420		$	—
Cash paid during the period for interest	$	—		$	—

SEE ACCOMPANYING CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS.

NEON SYSTEMS, INC. AND SUBSIDIARIES

CONDENSED NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

NOTE 1—BASIS OF PRESENTATION

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

NOTE 2—PER SHARE INFORMATION

In calculating earnings per share information, NEON follows the provisions of Statement of Financial Accounting Standards (“SFAS”) No. 128, Earnings Per Share. Basic income (loss) per share is computed by dividing net income (loss) applicable to common stockholders by the weighted average number of shares of common stock outstanding during the period. Diluted net income (loss) per share is computed by dividing net income (loss) applicable to common stockholders by the weighted average number of shares of common stock outstanding, adjusted to reflect common stock equivalents, such as convertible preferred stock, stock options and warrants to purchase common stock, to the extent they are dilutive, less the number of shares that could have been repurchased with the exercise proceeds using the treasury stock method. The Company reported net loss for the quarter ended December 31, 2003. Therefore, no potential common stock equivalents have been included in the computation of any diluted per share amounts, in accordance with SFAS No. 128.

Earnings per share:

(In thousands, except per share date)	THREE MONTHS ENDED DECEMBER 31,						NINE MONTHS ENDED DECEMBER 31,
	2003			2002			2003			2002
Net loss available for common shareholders	$	(308	)	$	(2,402	)	$	(116	)	$	(13,286	)

Weighted average outstanding shares of common stock	8,876			8,734			8,839			8,707
Dilutive effect of employee stock options	—			—			—			—
Common stock and common stock equivalents	8,876			8,734			8,839			8,707

Loss per share:
Basic	$	(0.03		$	(0.28	)	$	(0.01	)	$	(1.53	)
Diluted	$	(0.03	)	$	(0.28	)	$	(0.01	)	$	(1.53	)

At December 31, 2003, there were options outstanding to purchase 2.7 million shares of common stock with a weighted-average exercise price of $6.29. All outstanding options were excluded from the calculation of diluted loss per share for the three and nine months ended December 31, 2003 and 2002, as they were anti-dilutive.

Employee Stock-Based Compensation

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

	THREE MONTHS ENDED DECEMBER 31,						NINE MONTHS ENDED DECEMBER 31,
	2003			2002			2003			2002

Net loss as reported	$	(308	)	$	(2,402	)	$	(116	)	$	(13,286	)
Add stock-based employee compensation expense included in reported net loss	—			—			—			349
Deduct total stock-based employee compensation expense determined under fair-value-based method for all rewards	263			649			905			1,924
Pro forma net loss	$	(571	)	$	(3,051	)	$	(1,021	)	$	(14,861	)

Basic loss per share:
As reported	$	(0.03	)	$	(0.28	)	$	(0.01	)	$	(1.53	)
Pro forma	$	(0.06	)	$	(0.35	)	$	(0.12	)	$	(1.71	)

Diluted loss per share:
As reported	$	(0.03	)	$	(0.28	)	$	(0.01	)	$	(1.53	)
Pro forma	$	(0.06	)	$	(0.35	)	$	(0.12	)	$	(1.71	)

NOTE 3—INCOME TAXES

NEON has recorded no income tax benefit related to the current year net loss as the net operating loss carry-forwards have been fully reserved. At March 31, 2003, NEON had a net operating loss carry-forward for income tax purposes of approximately $17.3 million that is available to offset future taxable income. The net operating loss carry-forwards in the United Kingdom, Germany and Australia carry forward indefinitely. The net operating loss carry-forward for the United States begins expiring in the tax year 2020. Given the recent tax losses experienced by NEON, there can be no assurance that the operations will generate taxable income in the future to utilize these losses. As of March 31, 2003 and December 31, 2003, the valuation allowance fully offsets the Company’s net deferred tax assets.

NOTE 4—SEGMENT REPORTING

NEON considers its business activities to be in a single segment. NEON did not have any customers, individually or in aggregate that accounted for 10% or more of consolidated revenue during the nine-month periods ending December 31, 2003 and December 31, 2002.

The table below summarizes revenues by geographic region.

	THREE MONTHS ENDED DECEMBER 31,						NINE MONTHS ENDED DECEMBER 31,
	2003			2002			2003			2002
Revenues:
United States	$	2,367		$	2,669		$	7,605		$	8,954
United Kingdom	1,162			1,705			3,377			3,167
Other	117			222			392			574
	$	3,646		$	4,596		$	11,374		$	12,695

Operating income (loss):
United States	$	(868	)	$	(1,779	)	$	(2,016	)	$	(6,571	)
United Kingdom	598			807			1,669			1,078
Other	(108		)	(134		)	(108		)	(250		)
	$	(378	)	$	(1,106	)	$	(455	)	$	(5,743	)

	DECEMBER 31, 2003		MARCH 31, 2003

Identifiable Assets:
United States	$	28,418	$	30,842
United Kingdom	3,433		2,703
Other	564		769
	$	32,415	$	34,314

NOTE 5—COMMITMENTS AND CONTINGENCIES

On January 29, 2003, NEON received notification that it had been sued in Fort Bend County, Texas for alleged tortious interference with contract, tortious interference with prospective business relations and unfair competition in a lawsuit styled Phoenix Network Technologies (Europe) Limited vs. NEON Systems, Inc. and Computer Associates International Inc., 400^th District Court, Ft. Bend County, Richmond, Texas, Cause Number 03-CV-127800. On October 27, 2003, the court granted NEON’s motion to dismiss the case. Phoenix Network Technologies has appealed this decision, and NEON will continue to defend this action. Aside from this action, NEON is not involved in any current claim or legal action other than those arising in the ordinary course of business.

NOTE 6—RESTRUCTURING CHARGES

During the three months ended December 31, 2003, NEON incurred restructuring charges of $179,000. The charges consist of severance and other costs related to the elimination of direct sales operations in two foreign locations. During the nine months ended December 31, 2003, NEON incurred additional charges resulting from the revision of facility cost estimates. During the year ended March 31, 2003, NEON incurred restructuring charges of $3.0 million. The charges primarily relate to future losses due to the abandonment of leased facilities associated with a corporate reorganization as well as severance and non-cash stock compensation costs related to the termination of the distribution agreement with NEON Enterprise Software, Inc. The Company has not been able to sublease a large portion of the abandoned facilities and therefore, has accrued costs related to this portion of the future lease commitments. If the Company is able to sublease additional portions of the facilities in the future, it may result in reversal of this accrual. During fiscal 2002, NEON also recorded losses from lease commitments due to the abandonment of certain leased facilities. All such costs have been reported as restructuring costs in the Consolidated Statements of Operations.

The following table provides a roll forward of the restructuring accrual balance for the nine months ended December 31, 2003 (in thousands):

		Balance at March 31, 2003		Amounts Charged to Expense		Net Amounts Paid		Other			Balance at December 31, 2003
2002 Restructuring Accrual	Facility closure	$	62	$	17	$	18	$	—		$	61

2003 Restructuring Accrual	Employee severance	149		—		149		—
	Facility closure	1,957		16		459		68			1,582

2004 Restructuring Accrual	Employee severance	—		132		24		3			111
	Facility closure	—		47		—		(5		)	42

	Totals	$	2,168	$	212	$	650	$	66		$	1,796

Of the $1.8 million balance at December 31, 2003, $1.6 million consists of future cash payments for abandoned facilities that will be paid through 2006. The remaining $153,000 consists primarily of severance cost to be paid through March 2004, as well as other office closure costs. The current portion of this liability, $766,000, is included in accrued expenses. NEON does not expect to incur significant future costs in addition to those previously accrued, related to these restructuring activities.

Other adjustments to the balance for the nine months ended December 31, 2003 relate primarily to the effect of currency translation on foreign balances.

NOTE 7 —RELATED PARTY TRANSACTIONS

Certain former members of NEON’s Board of Directors and certain former executive officers of NEON were shareholders and/or directors in other companies with which NEON currently has investments. Transactions between NEON and these other companies are described below. The directors and officers involved in such transactions are no longer officers and directors of NEON. On March 6, 2003, Louis R. Woodhill resigned as a director and Chief Executive Officer of NEON. In June 2003, Jim Woodhill resigned as a director of NEON. At NEON’s annual meeting of stockholders on September 22, 2003, Mr. Moores, Mr. Noell, and Mr. Schaeffer did not stand for re-election and are no longer directors of NEON.

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

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

NEON currently holds a consolidated promissory note payable to NEON in the aggregate principal amount of $3.6 million, bearing no interest to its due date of March 31, 2005. This consolidated promissory note is secured by all of the intellectual property of NESI (“NESI IP”). NEON also currently holds a $3.0 million dollar convertible promissory note payable to NEON bearing no interest to its due date of March 31, 2005, which is also secured by the NESI IP. The $3.0 million convertible note is convertible by NEON, in its discretion, into equity in NESI at an agreed pre-cash valuation of $30.0 million dollars. Such conversion right will expire on the due date of the $3.0 million convertible note. On the Closing of the transaction in August 2002, NEON recorded the notes receivable from NESI at their estimated net present value, which was calculated at $4.3 million in aggregate value. As a result of the Termination Agreement, NEON recorded a loss on disposal of $687,000. NEON also evaluates the NESI IP on a quarterly basis to determine the note’s net realizable value. Accordingly, NEON will adjust the carrying value of the note if the net realizable value is determined to be below the carrying value. NEON management had an

external valuation of the NESI IP performed as of March 31, 2003 and determined that no further impairment of the note was required. No changes have occurred since that date that NEON believes should require adjustment of the carrying value.

Scalable Software, Inc.

Scalable Software, Inc., a Houston-based provider of software solutions for IT portfolio management, is a company founded by Louis R. Woodhill, who served as NEON’s Chief Executive Officer until March 2003. Several former members of NEON’s Board of Directors, including Louis R. Woodhill, John J. Moores, Peter Schaeffer, Charles E. Noell III and Jim Woodhill, had or have a financial interest in Scalable Software.

In June 2002, NEON obtained a two-year option to acquire Scalable Software as outlined in the Agreement and Plan of Merger dated June 26, 2002. In connection with this Option, NEON agreed to provide bridge financing of up to $5.5 million (subsequently increased to $6.0 million in October 2002), in addition to $3.5 million previously loaned to Scalable Software that was secured by personal guarantees from John J. Moores, Louis R. Woodhill and Jim Woodhill. The aggregate financing has a 36-month term and does not bear interest during the term of the two-year option to acquire Scalable Software, which option expires June 26, 2004. After the expiration of the option, the loan will bear interest at the prime rate plus two percentage points to its due date of June 26, 2005 and thereafter on any unpaid principal and interest amount outstanding. 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 $6.0 million loan is secured by all of the intellectual property rights of Scalable Software. As of January 2003, Scalable had exhausted its credit facility with NEON. Scalable has asked for and received waivers of NEON’s right of first refusal with respect to additional venture capital bridge financing and has closed a private placement of Convertible Preferred Stock.

During the period in which NEON was advancing funds to Scalable Software, NEON accounted for its investment in Scalable Software using the modified equity method of accounting. Under this method of accounting, NEON recognized 100% of Scalable Software’s losses to the extent of advances made in excess of the guaranteed amount. At December 31, 2003, NEON had made total advances of $9.5 million to Scalable Software (including $6.0 million of unguaranteed advances) and recognized cumulative losses of $5.6 million, of which $3.5 million were recorded during fiscal 2003. No losses have been recognized in fiscal year 2004 since NEON has no further obligation to advance funds to Scalable Software. Due to the uncertainties regarding NEON’s ultimate ability to recover any unguaranteed advances to Scalable Software, NEON has determined that it should not record the carrying value of its net advance to Scalable Software above the guaranteed amount of $3.5 million.

NOTE 8 – IMPAIRMENT OF INTANGIBLES

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

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

The pro-forma effects of the adoption of SFAS No. 142 on net loss per share for NEON for the nine months ended December 31, 2002 is as follows (in thousands, except per share data):

	NINE MONTHS ENDED DECEMBER 31, 2002

Net loss as reported	$	(13,286	)
Add back: Cumulative effect of change in accounting Principle	1,043
Adjusted net loss	$	(12,243	)

Loss per share—Basic and diluted:
Loss per share, as reported	$	(1.53	)
Add back: Cumulative effect of change in accounting Principle	$	0.12

Pro forma loss per share	$	(1.41	)

There has been no effect of adoption recognized in subsequent periods.

NOTE 9 – IMPACT OF RECENTLY ISSUED ACCOUNTING STANDARDS

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

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

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

prominent disclosure about the effects on reported net income of an entity’s accounting policy decisions with respect to stock-based employee compensation. SFAS No. 148 also amends APB Opinion No. 28, Interim Financial Reporting, to require disclosure about those effects in interim financial information. NEON adopted the disclosure requirements of SFAS No. 148 and these disclosures are included in the notes to NEON’s consolidated financial statements.

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

In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of ARB No. 51. This Interpretation addresses the consolidation by business enterprises of variable interest entities as defined in the Interpretation. The Interpretation, as revised in December 2003 for partial deferral, applies immediately to variable interests in variable interest entities created after January 31, 2003, for periods ending after December 15, 2003 to special purpose entities obtained before February 1, 2003 and for periods ending after March 15, 2003 to variable interests in other variable interest entities obtained before February 1, 2003. Management is continuing to evaluate the impact that application of this Interpretation may have on NEON’s consolidated financial statements.

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

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

In December 2003 the SEC issued Staff Accounting Bulletin No. 104 (SAB 104), Revenue Recognition. The bulletin clarifies certain issues addressed in SAB 101 and EITF Issue No. 00-21, Accounting for Revenue Arrangements with Multiple Deliverables. The adoption of SAB 104 did not have a material effect on NEON’s financial statements.

NOTE 10 – DISCONTINUED OPERATIONS

On June 20, 2003, NEON entered into an Asset Purchase Agreement with a third party software vendor to sell its iWave product line assets. As a result of the transaction, NEON recorded a gain on the sale of $352,000, net of closing expenses, during the nine months ended December 31, 2003. Total revenues attributed to the iWave product line for the three and nine months ended December 31, 2002 were $290,000 and $1.1 million, respectively. Total revenue for the three months ended June 30, 2003 was $194,000. Operating losses associated with the iWave product line were classified as discontinued operations and represented $348,000 and $3.1 million for the three and nine months ended December 31, 2002, respectively. Operating loss for the three months ended June 30, 2003 was $244,000.

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 4 under “Risk Factors that May Affect Future Results.” In some cases, you can identify forward-looking statements by terminology such as “may,” “will,” “should,” “expects,” “plans,” “anticipates,” “believes,” “estimates,” “predicts,” “potential,” “continue,” or the negative of these terms or other comparable terms.

OVERVIEW

NEON develops, markets and supports software products for the IBM mainframe platform. NEON was incorporated in May 1993 and is a successor by merger to NEON Systems, Inc., an Illinois corporation, which was incorporated in June 1991. NEON’s Shadow products provide access and integration of IBM mainframe data and applications from standard application client environments, including the Internet, application platforms, and client/server systems. NEON’s product mix in the past three fiscal years has consisted of NEON’s Shadow branded products, its iWave products, and the Enterprise Subsystem Management (“ESM”) products. The ESM products are owned by NEON Enterprise Software, Inc. (formerly Peregrine/Bridge Transfer Corporation, hereafter “NESI”) and were distributed by NEON. Over the last two fiscal years, NEON’s Shadow products accounted for the majority of its sales mix, representing 88% and 79% of NEON’s sales for fiscal 2003 and 2002, respectively. During fiscal year 2003, NEON phased out its ESM and iWave product lines. In August 2002, NEON terminated its distribution agreement with NESI, effectively exiting the ESM market. See Management’s Discussion and Analysis—Related Party Transactions and Note 7 to NEON’s consolidated financial statements. On June 20, 2003, NEON entered into an Asset Purchase Agreement with a third party software vendor to sell the iWave product line assets. See Note 10 to NEON’s consolidated financial statements.

NEON derives revenue from software licenses and maintenance services. License fees, which are based upon the number and capacity of servers as well as the number of client users, are generally due upon license grant and include a one-year maintenance period. The sales process typically takes between six and 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. In fiscal 2003 and 2002, maintenance revenues represented 58% and 44% of total revenues, respectively. Maintenance revenues are expected to continue to increase as a percentage of total revenues in the future. During fiscal 2003, NEON did not have any customers that individually accounted for 10% or more of total revenue. In fiscal 2002 NEON had one customer that accounted for 10% of total revenue.

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

NEON conducts its business in the United Kingdom and Germany through two wholly owned consolidated subsidiaries, and revenues from these subsidiaries are denominated in local currencies. In connection with these foreign operations, NEON is exposed to foreign currency fluctuations for its net working capital positions. During the three months ended December 31, 2003, NEON restructured German operations, further reducing its exposure to currency fluctuations. At December 31, 2003, NEON had an operating lease for office facilities denominated in British pound sterling. There were no other material commitments to 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 generally

denominated in U.S. dollars. Revenues recognized from sales to customers outside North America, primarily in Europe, represented approximately 28% and 14% in fiscal 2003 and 2002, 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

Certain former members of NEON’s Board of Directors and certain former executive officers of NEON were shareholders and/or directors in other companies with which NEON had investments or currently transacts business. Transactions between NEON and these other companies are described below. The directors and officers involved in such transactions are no longer officers and directors of NEON. On March 6, 2003, Louis R. Woodhill resigned as a director and Chief Executive Officer of NEON. In June 2003, Jim Woodhill resigned as a director of NEON. At NEON’s annual meeting of stockholders on September 22, 2003, Mr. Moores, Mr. Noell, and Mr. Schaeffer did not stand for re-election and are no longer directors of NEON.

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

In January 1996, NEON entered into a Termination and Customer Support Agreement on August 14, 2002, which terminated a distribution agreement with Peregrine/Bridge Transfer Corporation, a database software company whose sole stockholder is an affiliate of John J. Moores, NEON’s former Chairman of the Board of Directors. PBTC subsequently changed its name to NEON Enterprise Software, Inc. (“NESI”).

Scalable Software, Inc.

In June 2002, NEON obtained a two-year option to acquire Scalable Software as outlined in the Agreement and Plan of Merger dated June 26, 2002. In connection with this Option, NEON agreed to provide bridge financing of up to $5.5 million (subsequently increased to $6.0 million in October 2002), in addition to $3.5 million previously loaned to Scalable Software that was secured by personal guarantees from John J. Moores, Louis R. Woodhill and Jim Woodhill. The aggregate financing has a 36-month term and does not bear interest during the term of the two-year option to acquire Scalable Software, which expires June 26, 2004. After the expiration of the option, the loan will bear interest at the prime rate plus two percentage points to its due date of June 26, 2005 and thereafter on any unpaid principal and interest amounts outstanding. 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 $6.0 million loan is secured by all of the intellectual property rights of Scalable Software. As of January 2003,

Scalable had exhausted its credit facility with NEON. Scalable has asked for and received waivers of NEON’s right of first refusal with respect to additional venture capital bridge financing and NEON believes that Scalable has closed a private placement of Convertible Preferred Stock.

of Scalable Software’s losses to the extent of advances made in excess of the guaranteed amount. At December 31, 2003, NEON had made total advances of $9.5 million to Scalable Software (including $6.0 million of unguaranteed advances) and recognized cumulative losses of $5.6 million, of which $3.5 million were recorded during fiscal 2003. No losses have been recognized in fiscal year 2004 since NEON has no further obligation to advance funds to Scalable Software. Due to the uncertainties regarding NEON’s ultimate ability to recover any unguaranteed advances to Scalable Software, NEON has determined that it should not record the carrying value of its net advance to Scalable Software above the guaranteed amount of $3.5 million.

Critical Accounting Policies

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

Revenue Recognition Policies

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

Capitalized Software Costs

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

Allowance for Doubtful Accounts Receivable

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

15 some future date, the results of operations for the period could be materially affected by any necessary correction to the allowance for doubtful accounts.

Deferred Income Taxes

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

The change in NEON’s net deferred income tax balances during a period results in a deferred income tax provision or benefit in its statement of operations. If NEON’s expectations about the future tax consequences of past events should prove to

be inaccurate, the balances of its deferred income tax assets and liabilities could require significant adjustments in future periods. Such adjustments could cause a material effect on NEON’s results of operations for the period of the adjustment.

Accounting for Advances to Scalable Software

RESULTS OF OPERATIONS

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

	THREE MONTHS ENDED DECEMBER 31,				NINE MONTHS ENDED DECEMBER 31,
	2003		2002		2003		2002
Revenues:
License	32	%	49	%	34	%	44	%
Maintenance	68		51		66		56
Total revenues	100		100		100		100

Cost of revenues:
Cost of licenses	—		—		—		2
Cost of maintenance	9		10		10		12
Total cost of revenues	9		10		10		14

Gross profit	91		90		90		86

Operating expenses:
Sales and marketing	40		63		39		69
Research and development	30		22		30		25
General and administrative	26		29		23		31
Restructuring costs	5		—		2		1
Loss on disposal	—		—		—		5
Total operating expenses	101		114		94		131

Operating loss	(10	)	(24	)	(4	)	(45	)

Interest and other income, net	2		2		2		2
Equity loss in affiliate	—		(22	)	—		(25	)
Valuation allowance of note receivable	—		2		—		(3	)

Loss from continuing operations before income taxes and cumulative effect of change in accounting principle	(8	)	(42	)	(2	)	(71	)
Provision for income taxes	—		—		—		—

Loss from continuing operations before cumulative effect of change in accounting principle	(8	)	(42	)	(2	)	(71	)
Loss on discontinued operations	—		(10	)	(2	)	(26	)
Gain on disposal of discontinued operations	—		—		3		—
Loss before cumulative effect of change in accounting principle	(8	)	(52	)	(1	)	(97	)
Cumulative effect of change in accounting principle	—		—		—		(8	)
Net loss	(8	)%	(52	)%	(1	)%	(105	)%

THREE MONTHS ENDED DECEMBER 31, 2003 COMPARED TO THREE MONTHS ENDED DECEMBER 31, 2002

REVENUES

License revenues for the three months ended December 31, 2003 were $1.2 million, a decrease of $1.0 from $2.2 million for the three months ended December 31, 2002. The reduction in license revenue was primarily due to a lower volume of large dollar value license transactions during the period.

Maintenance revenues for the three months ended December 31, 2003 were $2.5 million, an increase of $126,000 from $2.4 million for the three months ended December 31, 2002. The increase in maintenance revenue was due to cumulative growth of NEON’s installed customer base combined with increases in maintenance renewal fees.

COST OF REVENUES

Cost of license revenues primarily consists of royalty payments to third parties. NEON did not incur significant cost of license revenues during the three months ended December 31, 2003 and 2002, respectively.

Cost of maintenance revenues includes personnel and other customer support costs. Cost of maintenance revenues for the three months ended December 31, 2003 were $342,000, or 14% of maintenance revenues, as compared to $475,000, or 20% of

maintenance revenues, for the three months ended December 31, 2002. The reduction in cost of maintenance revenue as a percentage of maintenance revenue was due to the cumulative growth in NEON’s installed customer base and increases in maintenance renewal fees combined with consolidation of the technical support staff.

OPERATING EXPENSES

Sales and marketing expenses include personnel costs, sales commissions and travel expenses of sales, presales support and marketing personnel, along with other promotional expenses. Sales and marketing expenses for the three months ended December 31, 2003 were $1.5 million, a decrease of $1.4 million from $2.9 million for the three months ended December 31, 2002. The reduction was primarily due to lower personnel and promotional costs as a result of a reorganization of the NEON sales department.

Research and development expenses primarily include personnel costs associated with NEON’s product development staff. Research and development expenses for the three months ended December 31, 2003 and 2002 remained consistent at $1.1 million and $1.0 million, respectively.

General and administrative expenses include personnel and other costs associated with NEON’s executive, financial, legal and administrative functions. General and administrative expenses for the three months ended December 31, 2003 were $934,000, a decrease of $391,000 from $1.3 million for the three months ended December 31, 2002. The decrease was primarily related to a reduction in administrative personnel.

During the three months ended December 31, 2003, NEON incurred restructuring charges of $179,000 related to the elimination of direct sales operations in two foreign locations. NEON plans to replace these with distributor relationships. No such charges were incurred during the three months ended December 31, 2002.

Interest and other income for the three months ended December 31, 2003 was $60,000 as compared to $79,000 for the three months ended December 31, 2002. The decrease is due primarily to a decline in short-term interest rates.

One June 20, 2003, NEON entered into an Asset Purchase Agreement with a third party software vendor to sell its iWave product line assets. Total revenues attributed to the iWave product line for the three months ended December 31, 2002 were $290,000. Operating losses associated with the iWave product line were classified as discontinued operations and represented $476,000 for the three months ended December 31, 2002.

NEON accounts for its investment in Scalable Software using the modified equity method of accounting. Under this method, NEON recognizes 100% of Scalable Software’s income or loss to the extent of advances made in excess of the guaranteed amount. For the three months ended December 31, 2002 NEON recorded equity in loss of $1.0 million. NEON also recorded a valuation allowance against the Scalable note receivable to write-down the outstanding balance of the note to the guaranteed amount. NEON is no longer advancing funds to Scalable, therefore equity income or loss was not recognized for the three months ended December 31, 2003. The note receivable from Scalable Software is recorded at the amount guaranteed by certain individuals. See “Related Party Transactions” and Note 7 to NEON’s consolidated financial statements.

No provision for income tax was recorded for the three months ended December 31, 2003 or 2002, as NEON incurred pretax losses. At March 31, 2003, NEON has a net operating loss carry-forward for income tax purposes of approximately $17.3 million that is available to offset future taxable income, if any. The net operating loss carry-forwards in the United Kingdom, Germany and Australia carry forward indefinitely. The net operating loss carry-forward for the United States begins expiring in the tax year 2020. Given the recent tax losses experienced by NEON, there can be no assurance that the operations will generate taxable income in the future to utilize these losses, therefore, as of December 31, 2003, NEON has recorded a full valuation allowance for the deferred tax assets related to the future benefits, if any, for these loss carryforwards.

NINE MONTHS ENDED DECEMBER 31, 2003 COMPARED TO NINE MONTHS ENDED DECEMBER 31, 2002

REVENUES

License revenues for the nine months ended December 31, 2003 were $3.9 million, a decrease of $1.7 million from

$5.6 million for the nine months ended December 31, 2002. The reduction in license revenue was due to the termination of the distribution agreement for ESM products, which accounted for $575,000 in license revenue during the nine months ended December 31, 2002, as well as a lower volume of large dollar value license transactions during the period.

Maintenance revenues for the nine months ended December 31, 2003 were $7.5 million, an increase of $406,000 from $7.1 million for the nine months ended December 31, 2002. ESM products accounted for $323,000 in maintenance revenue during the nine months ended December 31, 2003. The increase in maintenance revenue was due to cumulative growth of NEON’s installed customer base combined with increases in maintenance renewal fees.

COST OF REVENUES

Cost of license revenues primarily consists of royalty payments to third parties. Cost of license revenues for the nine months ended December 31, 2003 were $84,000, or 2% of license revenues, as compared to $270,000, or 5% of license revenues, for the nine months ended December 31, 2002. The decrease in the cost of license revenues as a percentage of license revenue was due to the termination of product royalty payments to NESI, see “Related Party Transactions”.

Cost of maintenance revenues includes personnel and other customer support costs. Cost of maintenance revenues for the nine months ended December 31, 2003 were $1.1 million, or 14% of maintenance revenues, as compared to $1.5 million, or 21% of maintenance revenues, for the nine months ended December 31, 2002. The reduction in cost of maintenance revenue as a percentage of maintenance revenue was due to the cumulative growth in NEON’s installed customer base and increases in maintenance renewal fees combined with consolidation of the technical support staff.

OPERATING EXPENSES

Sales and marketing expenses include personnel costs, sales commissions and travel expenses of sales, presales support and marketing personnel, along with other promotional expenses. Sales and marketing expenses for the nine months ended December 31, 2003 were $4.5 million, a decrease of $4.2 million from $8.7 million for the nine months ended December 31, 2002. The reduction was primarily due to lower personnel and promotional costs, which resulted from the termination of the distribution agreement for ESM products and the reorganization of the Shadow sales department.

Research and development expenses primarily include personnel costs associated with NEON’s product development staff. Research and development expenses for the nine months ended December 31, 2003 and 2002 were relatively consistent, accounting for $3.4 million and $3.2 million, respectively.

General and administrative expenses include personnel and other costs associated with NEON’s executive, financial, legal and administrative functions. General and administrative expenses for the nine months ended December 31, 2003 were $2.6 million, a decrease of $1.3 million from $3.9 million for the nine months ended December 31, 2002. The decrease was primarily related to a reduction in administrative personnel.

During the nine months ended December 31, 2003, NEON incurred $212,000 of restructuring charges. These charges primarily relate to employee severance costs associated with the elimination of direct sales operations in two foreign locations. NEON plans to replace these with distributorship relationships NEON incurred restructuring charges of $133,000 during the nine months ended December 31, 2002. This represents $271,000 related to the termination of NEON’s distribution agreement with NESI. 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.

As a result of terminating prior agreements with NESI on August 14, 2002, NEON recorded a loss on disposal of $687,000 during the nine months ended December 31, 2002.

Interest and other income for the nine months ended December 31, 2003 was $231,000 as compared to $332,000 for the nine months ended December 31, 2002. For the nine months ended December 31, 2003, interest and other income includes interest received on an income tax receivable collected during the period. This income was offset by lower interest income as a result of a reduction in NEON’s average cash balances combined with a decline in short-term interest rates.

On June 20, 2003, NEON entered into an Asset Purchase Agreement with a third party software vendor to sell its iWave product line assets. As a result of the transaction, NEON recorded a gain on the sale of $352,000, net of closing expenses during the nine months ended December 31, 2003. Total revenues attributed to the iWave product line for the nine months ended December 31, 2003 and 2002 were $194,000 and $1.1 million, respectively. Operating losses associated with the iWave product line were classified as discontinued operations and represented $244,000 and $3.3 million for the nine months ended December 31, 2003 and 2002, respectively.

During the nine months ended December 31, 2002, NEON performed impairment tests on its intangible assets related to the iWave intellectual property. As a result, NEON recorded impairment charges of $1.3 million during the period. Such impairment charges are included in the loss from discontinued operations.

NEON accounts for its investment in Scalable Software using the modified equity method of accounting. Under this method, NEON recognized 100% of Scalable Software’s income or loss to the extent of advances made in excess of the guaranteed amount. For the nine months ended December 31, 2002 NEON recorded equity in loss of $3.2 million. NEON also recorded a valuation allowance of $378,000 for the nine months ended December 31, 2002 against the Scalable note receivable to write-down the outstanding balance of the note to the guaranteed amount. NEON is no longer advancing funds to Scalable, therefore an equity loss was not recognized for the nine months ended December 31, 2003. The note receivable from Scalable

Software is recorded at the amount guaranteed by certain individuals. See “Related Party Transactions” and Note 7 to NEON’s financial statements.

No provision for income taxes was recorded for the nine months ended December 31, 2003 or 2002 as NEON incurred pretax losses. At March 31, 2003, NEON has a net operating loss carry-forward for income tax purposes of approximately $17.3 million that is available to offset future taxable income, if any. The net operating loss carry-forwards in the United Kingdom, Germany and Australia carry forward indefinitely. The net operating loss carry-forward for the United States begins expiring in the tax year 2020. Given the recent tax losses experienced by NEON, there can be no assurance that the operations will generate taxable income in the future to utilize these losses, therefore, as of December 31, 2003, NEON has recorded a full valuation allowance for the deferred tax assets related to the future benefits, if any, for these loss carryforwards.

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

LIQUIDITY AND CAPITAL RESOURCES

NEON’s cash and cash equivalents at December 31, 2003 were $20.2 million, an increase of $422,000 from $19.8 million at March 31, 2003.

Net cash used in operating activities was $415,000 and $8.0 million for the nine months ended December 31, 2003 and 2002, respectively. The net cash used in operating activities in both periods was primarily due to NEON’s net operating loss.

During the nine months ended December 31, 2003, net cash provided by investing activities was $481,000, primarily as a result from the proceeds from the sale of the iWave product line. Net cash used in investing activities during the nine months ended December 31, 2002 was $5.9 million, primarily due to advances to Scalable Software and NESI (see “Related Party Transactions”).

NEON’s net cash provided by financing activities was $94,000 and $29,000 for the nine months ended December 31, 2003 and 2002, 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 and timing of expansion of product development efforts and the success of these development efforts, the costs and timing of expansion of

sales and marketing activities, the extent to which our existing and new products gain market acceptance, market developments, the costs involved in maintaining and enforcing intellectual property rights, the level and timing of license revenue, and other factors. NEON believes that its current balance of cash and cash equivalents will be sufficient to meet its working capital, and anticipated capital expenditure requirements for at least the next 12 months. Thereafter, NEON may require additional funds to support its working capital requirements or for other purposes and may seek to raise additional funds through public or private equity financing or from other sources. There can be no assurance that additional financing will

be available at all, or if available, that such financing will be obtainable on terms acceptable to NEON, or that any additional financing will not be dilutive.

New Accounting Pronouncements

of each period to reflect the passage of time and changes in the estimated future cash flows underlying the obligation. NEON adopted SFAS No. 143 on April 1, 2003. The adoption of SFAS No. 143 did not have a material effect on the NEON’s consolidated financial statements.

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

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

In January 2003, the FASB issued Interpretation No. 46, Consolidation of Variable Interest Entities, an interpretation of ARB No. 51. This Interpretation addresses the consolidation by business enterprises of variable interest entities as defined in the Interpretation. The Interpretation as revised in December 2003 for partial deferral, applies immediately to variable interests in variable interest entities created after January 31, 2003, to special purpose entities obtained before February 1, 2003 and for periods ending after March 15, 2003 to variable interests in other variable interest entities obtained before February 1, 2003.

Management is continuing to evaluate the impact that application of this Interpretation may have on NEON’s consolidated financial statements.

ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK

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

The majority of NEON’s foreign currency transactions are denominated in the British pound sterling, which is the functional currency of NEON Systems (UK) Ltd. As these 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.

Cash equivalents approximated $15.0 million at December 31, 2003, and were invested in various types of high-grade commercial paper and money securities. NEON believes that a near-term change in interest rates would not materially affect its financial position, results of operations or net cash flows for fiscal year 2004.

ITEM 4. CONTROLS AND PROCEDURES

As of the end of the period covered by this Quarterly Report on Form 10-Q, NEON carried out an evaluation, under the supervision and with the participation of NEON’s management, including the Principal Executive Officer and Chief Financial Officer, of the effectiveness of the design and operation of NEON’s disclosure controls and procedures (as defined in Rule 13a-15(e) of the Securities Exchange Act of 1934). Based upon that evaluation, the Principal Executive Officer and Chief Financial Officer concluded that NEON’s disclosure controls and procedures are effective in ensuring that material information is accumulated and communicated to management, and made known to the Principal Executive Officer and Chief Financial Officer, on a timely basis to allow disclosure as required in this Quarterly Report on Form 10-Q. There have been no significant changes in NEON’s internal controls or in other factors that could significantly affect internal controls subsequent to the date NEON carried out its evaluation.

PART II - OTHER INFORMATION

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

ITEM 2. CHANGES IN SECURITIES AND USE OF PROCEEDS - None

ITEM 3. DEFAULTS UPON SENIOR SECURITIES - None.

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS – None

ITEM 5. OTHER INFORMATION – RISK FACTORS THAT MAY AFFECT FUTURE RESULTS

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

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

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

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

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

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

Reduced Customer Reliance Upon Mainframe Computers Could Adversely Affect Our Business

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

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

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

• Continued market acceptance of the Shadow products and enhancements to these products.

Loss of Key Software Developers Could Adversely Affect Our Business

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

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

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

Rapid Technological Change Could Render Our Products Obsolete

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

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

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

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.

ITEM 6. EXHIBITS AND REPORTS ON FORM 8-K

(a) EXHIBITS

Exhibit Number		Description

31.1		Certification of Mark J. Cresswell, principal executive officer of NEON Systems, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

31.2		Certification of Brian D. Helman, principal financial and accounting officer of NEON Systems, Inc. pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.

32.1		Certification of Mark J. Cresswell, principal executive officer of NEON Systems, Inc. pursuant to 18 U.S.C. SECTION 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

32.2		Certification of Brian D. Helman, principal financial and accounting officer of NEON Systems, Inc. pursuant to 18 U.S.C. SECTION 1350, as adopted pursuant to Section 906 of the Sarbanes-Oxley Act of 2002.

(b) REPORTS ON FORM 8-K

None

SIGNATURES

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

		NEON SYSTEMS, INC.

Date:	February 17, 2004	/s/ Brian D. Helman
		Chief Financial Officer
		(principal financial and accounting officer)


Date:	February 17, 2004	/s/ Mark J. Cresswell
		President and Chief Operating Officer
		(principal executive officer)