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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

Form 10-K

(Mark One)

For the Fiscal Year Ended March 31, 2003

OR

For the transition period from                         to                    

Commission File Number: 0-25457

NEON Systems, Inc.

(Exact name of Registrant as specified in its charter)

(281) 491-4200

(Registrant’s telephone number, including area code)

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

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

Common Stock, par value $0.01 per share

(Title of Class)

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

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

Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not contained herein, and will not be contained, to the best of Registrant’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K.  x

The aggregate market value of the voting stock held by non-affiliates of Registrant as of September 30, 2002 was $13,815,328, based on the last sale price of $3.09 for Registrant’s Common Stock on the Nasdaq National Market on September 30, 2002.

As of May 31, 2003, 8,821,385 shares of the Registrant’s Common Stock were outstanding.

DOCUMENTS INCORPORATED BY REFERENCE:

Selected portions of the Proxy Statement for the Annual Meeting of Stockholders to be held on September 22, 2003 to be filed with the Securities and Exchange Commission not later than 120 days after the end of Registrant’s fiscal year ended March 31, 2003 are incorporated by reference into Part III of this Form 10-K.

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NEON SYSTEMS, INC.

FORM 10-K

FOR FISCAL YEAR ENDED MARCH 31, 2003

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PART I

The statements contained in this Annual Report on Form 10-K that are not purely historical are forward-looking statements within the meaning of Section 27A of the Securities Act of 1993 and Section 21E of the Securities Exchange Act of 1934, including statements regarding our expectations, intentions, strategies, and expected operating results and financial condition. Forward-looking statements also include statements regarding events, conditions, and financial trends that may affect our future plans of operations, business strategy, results of operations, and financial position. All forward-looking statements included in this document are based on information available to us on the date hereof, and we assume no obligation to update any such forward-looking statements. Investors are cautioned that any forward-looking statements are not guarantees of future performance and are subject to risks and uncertainties and that actual results may differ materially from those included within the forward-looking statements as a result of various factors. These forward-looking statements are made in reliance upon the safe harbor provision of The Private Securities Litigation Reform Act of 1995. Factors that could cause or contribute to such differences include, but are not limited to, those described in Management’s Discussion and Analysis of Financial Condition and Results of Operations, in the section below titled “Risk Factors,” and elsewhere in this Annual Report on Form 10-K.

Item 1.    Business

OVERVIEW

NEON Systems, Inc. (“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 is an enterprise software company that develops, markets, and supports computer software products that allow Global 2000 Companies with IBM mainframes to integrate legacy data and applications with distributed or Internet applications. The IBM mainframe is a critical processing platform for major corporations due to the high performance, availability, scalability, and security inherent in the platform. For more than thirty years, there has been ongoing investment in mission critical data and applications that reside on the IBM mainframe platform and it remains today a primary repository for corporate data and applications for large organizations. NEON’s Shadow technology simplifies access to mainframe data and applications and we believe it is emerging as the industry’s choice when integrating application platform suites with IBM zSeries mainframes running IBM’s OS/390 or z/OS operating systems. NEON’s Shadow technology allows our customers to more effectively utilize their investment in IBM mainframe-based database and application systems to implement new applications that leverage legacy data and application assets.

In mid 2001, NEON refocused its product development, sales, and support personnel in three key solution areas based on the following products. These product lines included the “Shadow” branded product line providing access and integration of IBM mainframe data and applications from standard application client environments, the Enterprise Subsystem Management (“ESM”) product line providing enhanced availability, recoverability, and control for the IBM IMS database management system allowing more rapid deployment of CICS applications in the IBM CICSPlex environment, and the “iWave” branded product line integrating disparate helpdesk, network management, database management, and systems management applications across mainframe and distributed systems environments.

During the fiscal year just ended, NEON refocused its operations on its core technology, the Shadow products. In the fiscal years 2003, 2002, and 2001, the Shadow products accounted for 88%, 79% and 75%, respectively, of NEON’s revenues. In the 2003, 2002, and 2001 fiscal years, the ESM products accounted for 5%, 13% and 18%, respectively, of NEON’s revenues in such years. The iWave products have never accounted for more than 8% of NEON’s revenues in any of such years. As a result, during the fiscal year ended March 31, 2003, NEON terminated its distribution agreement with respect to the ESM product line, downsized its iWave product line and related personnel, and concentrated its resources toward enhancing and improving the Shadow product line. In addition, subsequent to the end of the fiscal year, NEON sold its iWave product line. See Note 13 to NEON’s consolidated financial statements.

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Shadow Branded Products—Simplified Access to the Mainframe

Shadow Technology

Shadow enterprise-class mainframe adapter technology reduces integration complexity and simplifies access to the mainframe. Shadow technology is an inherently more robust solution than competing integration technology, utilizing a mainframe software component to enable secure interoperability at the highest level of performance and scalability, while also providing rich monitoring and diagnostics. Shadow’s unified architecture delivers significant operational efficiencies and cost benefits over point integration products, while also providing the flexibility of infrastructure or single adapter implementations.

Shadow Products and Packaging

Shadow Direct—Shadow branded products are packaged to meet the needs of two distinct buyers of access and integration software for the IBM mainframe. Shadow Direct is a mainframe centric product that is targeting the organization that has a mainframe centric view of information technology. Shadow Direct is positioned as the best of breed “IT infrastructure” for all access and integration of mainframe data and transactions and is well suited for direct sales into the traditional mainframe software buyer community.

Shadow Connect—Shadow Connect is a connector packaging of Shadow and targets organizations who view mainframes as one of the many platforms that must be integrated with non-mainframe platforms. These buyers do not have a mainframe-centric view of information technology. Shadow Connect is NEON’s primary offering through its OEM/Reseller indirect channel.

Shadow Web Server—Shadow Web Server is an HTTP browser interface which provides direct HTTP access to mainframe data, applications and programs from Web browsers without the need for an intermediate server or data replication.

Shadow Console—Shadow Console extends the industry-leading diagnostic and management capabilities of Shadow technology to a modern, Windows^™ based, graphical user interface, offering both application developers and production operations personnel a consolidated, end-to-end view of the middleware component from the initial API adapter call in the application platform suite to the backend data or transaction source on the mainframe.

NEON’s Markets

NEON’s Shadow technology addresses market opportunities found in large organizations around the world. The Shadow products support business-critical applications of large companies that use mainframes independently or in conjunction with new systems deployments, especially deployments of application platforms from large and rising vendors, such as IBM’s Websphere Integration Servers and BEA’s WebLogic Integration Servers. NEON’s Shadow products help customers continue to leverage and increase the value of their mainframe and enterprise computing systems, allowing them to create, manage, and maintain high-value applications dependent on the IBM mainframe platform. For financial information attributable to each of NEON’s geographic sales areas, see Note 9 to NEON’s consolidated financial statements.

Industry Background

A critical aspect of all large business operations is the ability to effectively utilize information technology. Organizations are dependent on a variety of applications, information systems, and technology infrastructures, which are used to run the day-to-day operations of the business. Over time, organizations have made huge

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investments in these various applications, information systems, and technology infrastructures that have become known as legacy systems. Ever changing business demands along with the constant introduction of new technology create new challenges for these organizations, as they must implement new solutions in harmony with these legacy systems.

Many organizational initiatives, such as managing information flow across a supply chain, gaining a deeper understanding of customer buying habits or characteristics, or engaging in more targeted marketing, selling, and production depend on the effective delivery of information where it is needed and when it is needed. Organizations today must rapidly integrate existing applications and take advantage of the Internet to deliver new capabilities to suppliers, customers, employees, and trading networks to stay competitive. The demand for flexible integration of legacy systems comes at the same time as there are increasing demands to improve availability of critical legacy database management systems and manage an increasingly complex information technology infrastructure.

The following critical elements of information technology infrastructure are key considerations for organizations meeting the ongoing challenges of successful business operations in an age of ever increasing technology choices:

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NEON Product Advantages

The integration of disparate IT systems is one of the major imperatives for businesses and government in dealing with rapidly changing global issues and competition. Integration is increasingly complex, with packaged applications and application platforms suites now leveraging mainframe resources for modern service oriented development architectures. Integration adapters are part of the foundation required for reducing integration complexity. With NEON’s Shadow adapter technology, it is possible to simplify access to mainframe data, applications and programs, delivering it in a familiar format useable by developers and their development tools in both Java and .NET environments.

NEON’s Shadow products provide organizations with the following benefits in deploying new applications and extending existing applications:

The NEON Strategy

NEON’s goal is to emerge as the “best-of-breed” technology leader in the enterprise-class mainframe adapter market and to continue to grow as a leading provider of software solutions in markets for or related to the IBM mainframe platform. The following are key elements of the NEON strategy:

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Sales Strategy

NEON sells its products through a direct sales channel and indirect channels.

Direct Sales Channel.    NEON utilizes a direct sales model that minimizes the number of remote sales offices and customer site visits and focuses on effective use of the telephone and Internet communications for product demonstrations and sales. The direct sales force for North America is based in Sugar Land, Texas and generates a substantial majority of NEON’s revenues. In January 1997, NEON established its first international direct sales office in Windsor, England. In August 1997, NEON established another international direct sales office in Frankfurt, Germany and in May 2000, NEON established a sales presence in Sydney, Australia.

Indirect Sales Channel.    NEON utilizes indirect sales channels, emphasizing International Distributorship, OEM/Reseller Relationships and Marketing/Referral Relationships with key partners.

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NEON’s marketing activities support revenue generation and sales enablement for the direct sales channel and the indirect sales channel, as well as enhancing NEON’s corporate reputation. Marketing activities include integrated marketing communications, public relations, industry analyst relations, investor relations, trade shows/events, and web-based seminars and advertising.

Customers

NEON’s customer base spans major industries, including energy, manufacturing, financial services, government, and retail. NEON provides its products to customers under non-exclusive, non-transferable licenses. Under NEON’s current standard license agreement, licensed software may be used solely for the customer’s internal operations, and NEON does not sell or transfer title to its products to its customers. During fiscal 2003, NEON did not have any customers that individually accounted for 10% or more of total revenue. NEON had one customer that represented 10% of consolidated revenue in fiscal 2002 and one customer that represented 16% of consolidated revenue in fiscal 2001.

Customer Support

Customer support personnel provide pre-sale, installation, and post-sale technical support by toll-free telephone, E-mail, and facsimile, and through NEON’s Internet site and bulletin boards. Customer support is available on a 24x7 basis. In addition, customer service representatives contact each customer within six months after installation to assess customer satisfaction and obtain feedback. As a result of the “out-of-the-box” functionality of its products, NEON does not require a large customer support organization. At March 31, 2003, NEON had 8 customer support employees.

Product Development

NEON’s research and development efforts are focused on continuing to deliver new capabilities that allow our customers to extend their usage of our products, developing support for new releases of software on which our products are dependent, and providing maintenance for resolution of problems which may be encountered when using our software. All such development effort is funded by NEON. NEON incorporates the recommendations of existing and potential customers when developing its products and believes that continued dialogue with customers is an important element in developing enhancements to existing products and in the development of new products.

NEON has in the past dedicated and expects in the future to dedicate a significant amount of resources to developing new and enhanced products. NEON continues to follow a plan of continuous product improvement and enhancement. At any point in time a number of product development initiatives will be underway. We believe these development efforts will increase Shadow’s technical leadership in the integration market.

Competition

NEON competes in markets that are intensely competitive and characterized by rapidly changing technology and evolving standards. NEON has experienced, and expects to continue to experience, increased competition from current and potential competitors, many of whom have greater name recognition, a larger installed customer base, and significantly greater financial, technical, marketing, and other resources than NEON.

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NEON’s Shadow Direct infrastructure products compete principally with products from established vendors such as IBM, Jacada, and WRQ. NEON’s Shadow Connect adapter products compete principally with products from established vendors such as Attachmate, Attunity, and iWay. Other competitive factors include:

NEON’s competitors may be able to respond more quickly to new or emerging technologies and changes in customer requirements or devote greater resources to the development, promotion, and sale of their products than NEON. Increased competition could result in price reductions, fewer customer orders, reduced gross margins, longer sales cycles, and loss of market share, any of which could materially adversely affect NEON’s business, operating results, and financial condition.

Proprietary Rights

NEON relies primarily on a combination of copyright, trademark, and trade secret laws, confidentiality procedures, and contractual provisions to protect its proprietary rights. NEON licenses its products pursuant to software license agreements, which include acknowledgments and agreements by the licensee that are intended to establish and protect NEON’s proprietary rights and confidential information. NEON believes, however, that these measures afford only limited protection. Despite NEON’s efforts to protect its proprietary rights, unauthorized parties may attempt to copy aspects of NEON’s products or to obtain and use information that NEON regards as proprietary. Policing unauthorized use of NEON’s products is difficult and NEON is unable to determine the extent to which piracy of its software products exists. In addition, the laws of some foreign countries do not protect NEON’s proprietary rights as fully as do the laws of the United States. There can be no assurance that NEON’s means of protecting its proprietary rights will be adequate or that competition will not independently develop similar or superior technology.

NEON is not aware that it is infringing any proprietary rights of third parties. There can be no assurance, however, that third parties will not claim infringement by NEON of their intellectual property rights. NEON expects that software product developers will increasingly be subject to infringement claims as the number of products and competitors in NEON’s industry segment grows and the functionality of products in different industry segments overlaps. Any such claims, with or without merit, could be time-consuming to defend, result in costly litigation, divert management’s attention and resources, cause product shipment delays, or require NEON to enter into royalty or licensing agreements. Such royalty or licensing agreements, if required, may not be available on terms acceptable to NEON, if at all. In the event of a successful claim of product infringement against NEON and failure or inability of NEON to either license the infringed or similar technology or develop alternative technology on a timely basis, NEON’s business, operating results and financial condition could be materially adversely affected.

Human Resources

As of March 31, 2003, NEON and its subsidiaries employed 74 persons, including 29 in sales, marketing and field operations, 31 in research and development and 14 in finance and administration. None of NEON’s employees are represented by a labor union. NEON has experienced no work stoppages and believes its relationship with its employees is good. Competition for qualified personnel in NEON’s industry is intense.

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RISK FACTORS

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

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

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

See Management’s Discussions and Analysis of Financial Condition and Results of Operations—Related Party Transactions and Note 4 to NEON’s consolidated financial statements.

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

Uncertainty Regarding Our Management After Changes May Adversely Affect Our Business

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

Loss of Key Software Developers Could Adversely Affect Our Business

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

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

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.

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:

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.

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Rapid Technological Change Could Render Our Products Obsolete

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

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

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

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

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

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

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

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

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

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Item 2.    Properties

NEON’s principal administrative, product development, marketing and sales facility comprises approximately 51,700 square feet and is located in Sugar Land, Texas. The lease for this facility will expire on March 31, 2005. In addition, NEON leases offices in London, England and Frankfurt, Germany. In March 2003, NEON abandoned approximately 20,000 square feet of its leased facility space, including an entire floor in each of its Sugar Land office and its London, England office. See Note 6 to NEON’s consolidated financial statements. Management believes that its current facilities are adequate to meet its needs through the next 12 months and that, if required, suitable additional space will be available on commercially reasonable terms to accommodate expansion of NEON’s operations.

Item 3.    Legal Proceedings

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. NEON is in the process of defending 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.

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

On February 4, 2003, NEON convened its Annual Meeting of Stockholders for the fiscal year ended March 31, 2002. As of the record date of December 11, 2002, there were approximately 8.7 million shares issued and outstanding. At the Annual Meeting, which was held at NEON’s headquarters in Sugar Land, Texas on February 4, the following matters were submitted to the stockholders for a vote and were approved by the vote reflected below each such proposal:

We currently have eight directors holding office. The directors are divided into three classes with staggered terms:

Class I Directors, Charles E. Noell, III, whose terms will expire at the next annual meeting to be held on September 22, 2003. Our other two Class I Directors, Louis R. Woodhill and James R. Woodhill, resigned as directors in March 2003 and June 2003, respectively. These positions on the Board of Directors have not been filled as of the date of this filing.

Class II Directors, Richard Holcomb, George H. Ellis and Norris van den Berg, whose terms will expire at the annual meeting to be held in the third calendar quarter of 2004.

Class III Directors, John J. Moores, David F. Cary, Loretta Cross, and Peter Schaeffer, whose terms expire at the annual meeting to be held in the third calendar quarter of 2005.

At the annual meeting of stockholders held on February 4, 2003, the following three directors were elected as Class III Directors for terms expiring at the annual meeting to be held in 2005: John J. Moores, David F. Cary, Loretta Cross and Peter Schaeffer.

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The voting results were as follows:

(In thousands)

The Audit Committee of the Board of Directors selected KPMG LLP as the Company’s independent public accountants for the fiscal year ending March 31, 2003. KPMG LLP has audited the Company’s financial statements since its initial public offering in fiscal 1999.

At the Annual Meeting of Stockholders on February 4, 2003, the stockholders ratified the Board’s selection of KPMG as NEON’s independent auditors, casting approximately 8.2 million votes in favor of the ratification (94.25%) and 24,000 votes against ratification (0.28%), with 5,000 abstentions (0.06%).

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PART II

Item 5.    Market for Registrant’s Common Equity and Related Stockholder Matters

Market Information

NEON’s Common Stock traded on the Nasdaq Stock Market under the symbol “NESY” from its initial public offering until June 2, 2002. On June 3, 2002, NEON changed the ticker symbol for its shares of common stock trading on the Nasdaq Stock Market from “NESY” to “NEON”. NEON completed its initial public offering in March 1999 and sold 3.0 million shares of its common stock at a price of $15.00 per share. The following table sets forth, for the fiscal periods indicated, the ranges of high and low last reported sale prices for the Common Stock.

During the fiscal year ended March 31, 2003, NEON issued no unregistered shares of its Common Stock.

Holders

On June 25, 2003, the last reported sale price of the common stock on the Nasdaq Stock Market was $3.179 per share. At June 25, 2003, there were 193 registered holders of record of NEON’s common stock (although NEON believes that the number of beneficial owners of its common stock is substantially greater) and approximately 8.8 million shares outstanding.

Dividends

NEON has never declared any cash dividends on its common stock. NEON does not anticipate paying any cash dividends on its common stock in the foreseeable future and intends to retain its earnings, if any, to finance the expansion of its business and for general corporate purposes. Any payment of future dividends will be at the discretion of the Board of Directors and will depend upon, among other things, NEON’s earnings, financial condition, capital requirements, level of indebtedness, contractual restrictions and other factors that NEON’s Board of Directors deems relevant.

Securities Authorized for Issuance Under Equity Compensation Plans

See Item 12. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters.

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Item 6.    Selected Consolidated Financial Data

SELECTED CONSOLIDATED FINANCIAL DATA

(In thousands, except per share data)

The selected consolidated financial data below should be read in conjunction with Item 7, Management’s Discussion and Analysis of Financial Condition and Results of Operations, and Item 8, Consolidated Financial Statements and Supplementary Data, included elsewhere herein.

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Item 7.    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-K. 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 in the section above titled “Risk Factors.” 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 primary product group, the 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 ESM products owned by NEON Enterprise Software, Inc. (formerly Peregrine/Bridge Transfer Corporation, hereafter “NESI”) and distributed by NEON. Over the last three fiscal years, NEON’s Shadow products accounted for the majority of its sales mix, representing 88%, 79%, and 75% of NEON’s sales for fiscal 2003, 2002, and 2001, respectively. During fiscal year 2003, NEON phased out its ESM product line and iWave product line. In August 2002, NEON terminated its distribution agreement with NESI, effectively exiting the ESM market See Management’s Discussion and Analysis—Related Party Transactions and Note 4 to NEON’s consolidated financial statements. On October 31, 2002, NEON reduced the scope of its iWave operations and hired an investment advisor to assist NEON in divesting its iWave product line. On June 20, 2003, NEON entered into an Asset Purchase Agreement with a subsidiary of Skywire Ventures, L.L.C., a Dallas-based software vendor, to sell the iWave product line assets. See Note 13 to NEON’s consolidated financial statements.

NEON derives revenue from software licenses and maintenance services. License fees, which are based upon the number and capacity of servers as well as the number of client users, are generally due upon license grant and include a one-year maintenance period. The sales process typically takes approximately nine months. After the initial year of license, NEON provides ongoing maintenance services, which include technical support and product enhancements, for an annual fee. Any factors adversely affecting the pricing of, demand for, or market acceptance of, our products, such as competition or technological change, could materially adversely affect our business, operating results and financial condition. In fiscal 2003, 2002, and 2001, maintenance revenues represented 58%, 44%, and 33% of total revenues, respectively. Maintenance revenues are expected to continue to increase as a percentage of total revenues in the future. During fiscal 2003, NEON did not have any customers that individually accounted for 10% or more of total revenue. In fiscal 2002 NEON had one customer

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that accounted for 10% of total revenue. In fiscal 2001, NEON had one customer that represented 16% of total revenue.

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

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

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

Related Party Transactions

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

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

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

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payments have historically been recorded by NEON as a prepaid expense and offset by 50% of NEON’s sales of NESI products. The amended distribution agreement also provided that NESI would reimburse NEON for the amount of any unearned royalty advances when the agreement terminated in 2004.

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

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

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

Pursuant to the Termination and Customer Support Agreement and an assignment executed in connection with the closing of the Termination and Customer Support Agreement and effective as of August 1, 2002, NESI was assigned all of NEON’s rights and obligations under any customer license and maintenance agreements related to the NESI software products previously marketed by NEON, including customer support obligations. In

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addition, the terms of the Termination and Customer Support Agreement provide that NESI offered employment to certain sales and support personnel of NEON that were assigned to market the ESM software products. The Termination and Customer Support Agreement also contemplated the resignation of Wayne E. Webb Jr. as Senior Vice President and General Counsel of NEON effective as of August 1, 2002 to focus on his role as President and CEO of NESI.

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

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

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

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

NEON interlocks with NEON Enterprise Software, Inc. John J. Moores, Charles E. Noell, III and Norris van den Berg, directors of NEON, also serve as directors of NESI. Wayne E. Webb, Jr., former Senior Vice President and General Counsel of NEON, served as the Vice President and General Counsel of NESI 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 NESI. Through their interests in Skunkware, Inc., each of Messrs. Noell, van den Berg and Webb beneficially own approximately 1% of NESI. 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, who served as NEON’s Chief Executive Officer until March 2003. Several current and former members of NEON’s Board of Directors, including Louis R. Woodhill, John J.

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Moores, Peter Schaeffer, Charles E. Noell III and Jim Woodhill, have a financial interest in Scalable Software. The percentage beneficial ownership of the current and former NEON directors and executive officers that have a financial interest in Scalable Software as of March 31, 2003 is set forth below:

On July 17, 2001, NEON announced that it had entered into a letter of intent to acquire Scalable Software, Inc. At that time, Louis R. Woodhill, then-Chief Executive Officer of NEON, was 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 October 17, 2001, Mr. Woodhill was asked to serve as the President and Chief Executive Officer of NEON. On November 13, 2001, the promissory note was amended to increase the maximum lending limit to $3.5 million with an original maturity date of March 31, 2002, with such increased amount also being guaranteed by Messrs. Moores, Woodhill and Woodhill. On December 21, 2001, Louis R. Woodhill and his brother Jim Woodhill, were asked to join the Board of Directors of NEON.

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

NEON obtained a two-year option to acquire Scalable Software as outlined in the Agreement and Plan of Merger dated June 26, 2002. In connection with this Option, NEON agreed to provide bridge financing of up to $5.5 million, in addition to the $3.5 million previously loaned to Scalable Software that is secured by personal guarantees from John J. Moores, Louis R. Woodhill and Jim Woodhill. The aggregate financing had a 36-month term and does not bear interest during the term of the two-year option to acquire Scalable Software. After the expiration of the option, the loan will bear interest at the prime rate plus two percentage points. In addition to the personal guarantees of John J. Moores, Louis R. Woodhill and Jim Woodhill for the initial $3.5 million loaned to Scalable Software, the $5.5 million loan will be secured by all of the intellectual property rights of Scalable Software. NEON may exercise the option to acquire Scalable Software at any time during the two-year term, subject to provisions that require NEON to exercise its option within a 30-day window under certain circumstances or forfeit the option. If NEON exercises the option and acquires Scalable Software, each of the approximately 19.4 million outstanding shares of common stock of Scalable Software will be converted into approximately 0.135 of a share of NEON common stock and outstanding options and warrants to purchase approximately 3.0 million shares of common stock of Scalable Software will become options and warrants to purchase common stock of NEON on the same conversion basis. If Scalable Software incurs more indebtedness for borrowed money or issues more equity, the exchange ratio will be adjusted accordingly. Prior to NEON exercising the option to acquire Scalable Software, a Special Committee would be appointed to review the negotiated terms of the proposed acquisition and NEON would seek to obtain a fairness opinion regarding the transaction from a financial advisory firm. The acquisition of Scalable Software will also require approval of the stockholders of NEON and the NEON Board of Directors.

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

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

Sheer Genius Software, Inc.

On January 3, 2002, NEON entered into a services agreement with Sheer Genius Software, Inc. of Austin, Texas, a company owned by Jim Woodhill. Jim Woodhill was a member of NEON’s Board of Directors at such time. Also, JMI Services, Inc., a private company owned by John J. Moores, NEON’s Chairman, is a creditor of Sheer Genius. Under the first project description negotiated for such services agreement, Sheer Genius provided development services to NEON on a budgeted time and materials basis and delivered fixed deliverables consisting primarily of developed source code. The term of the initial project description was six months and the aggregate fees were $480,000. This agreement was extended by the Board for an additional three months with additional aggregate fees of $300,000. On October 16, 2002, the Board determined that the Services Agreement with Sheer Genius should be extended on a month-to-month basis. On May 20, 2003, NEON terminated the Agreement with Sheer Genius and will continue such development efforts internally. All fees under the arrangement were expensed as incurred and included in research and development. While NEON was Sheer Genius’ sole source of income, it was free to solicit other customers. Under the services agreement, all intellectual property created by Sheer Genius in the course of performing the services is owned by NEON. Sheer Genius received a license back of such intellectual property for limited use in the development by Sheer Genius of software that does not compete with software distributed by NEON. The Board of Directors reviewed the

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terms of the services agreement and project description and approved such agreements following disclosure of the interest of its officers and directors associated with Sheer Genius. For the year ended March 31, 2003, NEON paid $900,000 to Sheer Genius Software for services fees. As of the date of termination of the Services agreement with Sheer Genius, NEON had paid services fees in aggregate amount of $1.3 million.

Critical Accounting Policies

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

Revenue Recognition Policies

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

Capitalized Software Costs

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

Allowance for Doubtful Accounts Receivable

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

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Deferred Income Taxes

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

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

Accounting for Advances to Scalable Software

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

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Results of Operations

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

Fiscal Years Ended March 31, 2003, 2002 and 2001

Revenues

License revenues were $7.9 million, $12.0 million, and $17.8 million in fiscal 2003, 2002 and 2001, respectively, representing period-to-period declines of 34% and 33% for fiscal 2003 and 2002, respectively. The decrease in license revenues in fiscal 2003 from fiscal 2002 of $4.1 million was due to NEON’s termination of the NESI distribution agreement in August 2002, effectively exiting the ESM market, and NEON’s phasing out of the iWave product line during the year, combined with the expiration of a two-year software distribution agreement with BMC Software in September 2001. License revenue decreased $5.8 million in fiscal

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2002 from fiscal 2001 and was due to an overall weakness in the mainframe software market as well as a reduction in revenue associated with the BMC distribution agreement. For fiscal 2002 and 2001, respectively, license revenues included $2.2 million and $4.4 million of revenue under the BMC Software distribution agreement entered in connection with NEON’s settlement of a lawsuit originally filed by BMC Software.

Maintenance revenues were $10.7 million, $9.4 million, and $8.8 million, in fiscal 2003, 2002 and 2001, respectively, representing period-to-period increases of 14% and 7% for the fiscal 2003 and 2002 periods. These increases resulted from growth of NEON’s cumulative installed customer base combined with annual increases in maintenance renewal fees.

Cost of Revenues

Cost of license revenues primarily consists of amortization charges associated with acquired product technology and royalty payments to third parties. Cost of license revenues was $1.2 million, $3.0 million, and $2.5 million, in fiscal 2003, 2002 and 2001, respectively, representing 15%, 25%, and 14% of total license revenues in the respective periods. The fiscal 2003 reduction in cost of license revenues was primarily due to lower product royalty payments associated with the termination of the NESI distribution agreement in August 2002. See Related Party Transactions and Note 4 to NEON’s consolidated financial statements. The increase in fiscal 2002 was due to greater royalty payments to NESI as a result of increased sales of the ESM products. Cost of licenses increased as a percentage of license revenue during fiscal 2002 as NEON’s ESM products accounted for a greater percentage of the sales mix in fiscal 2002 than in fiscal 2001.

Cost of maintenance revenues includes personnel and other customer support costs. Cost of maintenance was $2.0 million, $2.1 million, and $2.4 million in fiscal 2003, 2002 and 2001, respectively, representing 19%, 22%, and 27% of total maintenance revenues in the respective periods. The decrease in cost of maintenance revenue as a percentage of maintenance revenue was due to the cumulative growth in NEON’s customer base and annual increases in maintenance fees.

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 were $12.4 million, $13.4 million, and $15.6 million in fiscal 2003, 2002 and 2001, respectively, representing 67%, 62% and 59% of total revenue in the respective periods. The reduction in sales and marketing expenses in fiscal 2003 from fiscal 2002 was primarily due to lower personnel costs associated with headcount reductions during fiscal 2003, combined with lower promotional marketing costs, as NEON reduced the scope of its iWave product operations and exited the ESM market. The decline in sales and marketing in fiscal 2002 from fiscal 2001 was primarily due to decreases in travel costs and marketing activities such as trade shows and advertisements as well as decreased commissions related to lower sales.

Research and development expenses primarily include personnel costs associated with NEON’s product development staff. Research and development expenses were $5.6 million, $6.0 million, and $8.3 million in fiscal 2003, 2002 and 2001, respectively, representing 30%, 28% and 31% of total revenues in each of the respective periods. The decreases in fiscal 2003 and 2002 were primarily attributed to the reduction in scope of NEON’s iWave product operations, which resulted in the closure of its North Carolina development facility in June 2001. During fiscal 2003, this reduction was partially offset by contract development fees paid to Sheer Genius Software, Inc. See “Related Party Transactions.”

General and administrative expenses include personnel and other costs associated with NEON’s executive, financial, legal and administrative functions. General and administrative expenses were $6.3 million, $5.1 million, and $4.5 million (excluding $4.5 million from nonrecurring charges during fiscal 2001) in fiscal 2003, 2002 and 2001, respectively, representing 34%, 24%, and 17% of total revenues of the respective periods. The increase in general and administrative expenses from fiscal 2002 to fiscal 2003 is primarily due to a $959,000

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nonrecurring charge related to excess depreciation expense incurred as a result of a change in the estimated lives of certain fixed assets. The nonrecurring charges in fiscal 2001 consisted of $3.8 million for charges related to the departure of certain executives, a $400,000 charge for the cost of strategic consulting projects and a $250,000 realized foreign currency loss. The dollar increase from fiscal 2001 to fiscal 2002, excluding nonrecurring charges, is primarily from increases in office occupancy costs, related office expansion expenses and increases in personnel costs.

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

During fiscal 2003, NEON performed impairment tests on its intangible assets related to the intellectual property acquired from Sterling Software in October 2000 (“iWave IP”) and the goodwill related to the September 1999 acquisition of Beyond Software, Inc. (“BSI”). As a result, NEON recorded impairment charges of $1.4 million during the year. The impairment charges primarily relate to the reduction in carrying value of its iWave IP, as NEON adjusted the estimated future cash flows attributable to the assets due to lower than expected operating performance and changes in the future operating strategies related to this product. See Note 1 to NEON’s consolidated financial statements.

During fiscal 2003, NEON recorded a $687,000 loss associated with the termination of the NESI distribution agreement. See Note 4 to NEON’s consolidated financial statements.

NEON recorded non-cash charges of $887,000 during fiscal 2002 related to the write-down of pre-paid royalties and other assets.

Effective fiscal 2003, 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. Amortization expense of $478,000 related to the acquisition of BSI was recognized in each of fiscal 2002 and 2001.

Interest and other income, net was $431,000 million, $1.2 million, and $2.5 million for the fiscal years ended March 31, 2003, 2002, and 2001, respectively. The reduction in interest income was due to lower available cash balances combined with a decline in interest rates.

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. NEON recorded an equity loss of $3.5 million and $2.1 million in fiscal 2003 and 2002, respectively. In fiscal 2003, NEON recorded a valuation allowance of $378,000 against the Scalable note receivable to write-down the outstanding balance of the note to the guaranteed amount. See Note 4 to NEON’s consolidated financial statements.

During the fiscal year ending 2002, 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. See note 5 to NEON’s consolidated financial statements.

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During fiscal 2003, NEON recorded a net $194,000 provision for income taxes due to establishing a reserve for the deferred tax asset. There was no benefit (provision) for income taxes in fiscal 2002, due to the recording of a valuation allowance against all tax benefits arising from NEON’s operating losses. NEON recorded a tax benefit for fiscal 2001 using the effective income tax rate of 21%. As of March 31, 2003, NEON had a net operating loss carry-forward for income tax purposes of approximately $21.7 million that is available to offset future taxable income, if any. The net operating loss carry-forwards in the United Kingdom, Germany and Australia carry forward indefinitely. The net operating loss carry-forward for the United States begins expiring in the tax year 2020.

Under the transition provision of SFAS No. 142, NEON tested the goodwill balances associated with the September 1999 acquisition of 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.

Liquidity and Capital Resources

NEON’s cash and cash equivalent balance was $19.8 million and $34.5 million at March 31, 2003 and 2002, respectively. The decrease is due primarily to operating losses, loan advances to Scalable Software, and advanced royalty payments and other advances to NESI. See “Related Party Transactions” and Note 4 to NEON’s consolidated financial statements.

Net cash used in operating activities was $8.7 million in fiscal 2003 and was primarily due to NEON’s operating losses. Net cash provided by operating activities in fiscal 2002 and 2001 was $2.0 million and $3.3 million, respectively. The funds provided in fiscal 2002 resulted primarily from the proceeds of the settlement of its lawsuit against New Era of Networks offset by operational losses. The funds provided in fiscal 2001 resulted primarily from operating income.

Net cash used in investing activities was $6.2 million and, $7.7 million in fiscal 2003 and 2002, respectively. The funds used in fiscal 2003 resulted primarily from the loan advances made to Scalable Software and NESI. The funds used in fiscal 2002 resulted primarily from the loan advances made to Scalable Software. See “Related Party Transactions” and Note 4 to NEON’s consolidated financial statements. Net cash provided by investing activities in fiscal 2001 resulted primarily from maturities of short-term and long-term marketable securities partially offset by purchases of property and equipment and the $1 million payment to complete the acquisition of the iWave IP. As of March 31, 2003, NEON had no material commitment for capital expenditures or any further commitments to advance funds to Scalable Software or NESI.

NEON’s net cash provided by financing activities was $30,000 and $241,000 in fiscal 2003 and 2001, respectively, primarily related to exercises of employee stock options. Net cash used in fiscal 2002 was $2.5 million and primarily resulted from the repurchase of common stock by NEON in December of 2001. See Note 8 to NEON’s consolidated financial statements.

NEON believes that its current balances 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 such 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.

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The following table summarizes our contractual cash obligations as of March 31, 2003 (in thousands):

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. 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. Amortization expense related to goodwill was $478,000 for the years ended March 31, 2002 and 2001.

Under the transition provision of SFAS No. 142, NEON tested the goodwill balances associated with the September 1999 acquisition of 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.

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

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 January 1, 2003. The adoption of SFAS No. 143 is not expected to have a material effect on the NEON’s consolidated financial statements.

NEON adopted SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets, effective April 1, 2002. SFAS No. 144 supersedes SFAS 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 classifications 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 on 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 on NEON’s consolidated financial statements.

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

In December 2002, the FASB issued SFAS No. 148, Accounting for Stock-Based Compensation-Transition and Disclosure, and 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 those 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. Interpretation No. 45 will be effective for the fiscal year beginning April 1, 2003. NEON does not anticipate that the adoption of FASB Interpretation No. 45 will have a material impact on NEON’s consolidated financial statements.

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

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

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

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Item 7a.    Quantitative and Qualitative Disclosures about Market Risk

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

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

NEON adheres to a conservative investment policy, whereby its principal concern is the preservation of liquid funds while maximizing its yield on such assets. Cash and cash equivalents approximated $19.8 million at March 31, 2003, and were invested in different types of short-term low-risk 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 2003.

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

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Item 8.    Consolidated Financial Statements and Supplementary Data

NEON SYSTEMS, INC. AND SUBSIDIARIES

INDEX TO CONSOLIDATED FINANCIAL STATEMENTS

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INDEPENDENT AUDITORS’ REPORT

The Board of Directors and Stockholders

NEON Systems, Inc.:

We have audited the accompanying consolidated balance sheets of NEON Systems, Inc. and subsidiaries as of March 31, 2003 and 2002, and the related consolidated statements of operations, stockholders’ equity and comprehensive loss, and cash flows for each of the years in the three-year period ended March 31, 2003. These consolidated financial statements are the responsibility of the Company’s management. Our responsibility is to express an opinion on these consolidated financial statements based on our audits.

We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the consolidated financial statements referred to above present fairly, in all material respects, the financial position of NEON Systems, Inc. and subsidiaries as of March 31, 2003 and 2002, and the results of their operations and their cash flows for each of the years in the three-year period ended March 31, 2003, in conformity with accounting principles generally accepted in the United States of America.

As discussed in Note 1 to the consolidated financial statements, the Company adopted the provisions of Statement of Financial Accounting Standards No. 142, Goodwill and Other Intangible Assets, on April 1, 2002.

KPMG LLP

Houston, Texas

May 2, 2003

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NEON SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED BALANCE SHEETS

(In thousands, except share amounts)

See Accompanying Notes to Consolidated Financial Statements.

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NEON SYSTEMS, INC. AND SUBSIDIARIES

CONSOLIDATED STATEMENTS OF OPERATIONS

(In thousands, except per share data)