<PAGE>
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
WASHINGTON, DC 20549
FORM 8-K
CURRENT REPORT
PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
Date of Report (Date of earliest event reported): June 25, 1998
DAOU SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
DELAWARE
(State or other jurisdiction of incorporation)
0-22073 330284454
(Commission File Number) (IRS Employer Identification No.)
5120 Shoreham Place, San Diego, California 92122
(Address of principal executive offices, including zip code)
(619) 452-2221
(Registrant's telephone number, including area code)
<PAGE>
ITEM 5. OTHER EVENTS.
REPORTING OF CERTAIN FINANCIAL AND OTHER INFORMATION FOR REGISTRATION AND
OTHER PURPOSES
DAOU Systems, Inc., a Delaware corporation (the "Company"), is
filing herewith audited supplemental consolidated financial statements,
selected consolidated financial data (supplemental), and Management's
Discussion and Analysis of Financial Condition and Results of Operations
(supplemental), which reflect the Company's acquisition of Synexus
Incorporated, a Pennsylvania corporation, Sentient Systems, Inc., a Maryland
corporation, Technology Management, Inc., an Indiana corporation,
International Health Care Systems, Inc., a Florida corporation, Resources in
Healthcare Innovations, Inc., an Indiana corporation, Healthcare Transition
Resources, Inc., an Indiana Corporation, Innovative Systems Solutions, Inc.,
an Indiana corporation, Grande Isle Consulting, Inc., an Indiana corporation,
and Ultitech Resources Group, Inc., an Indiana corporation. Each of these
acquisitions was accounted for as a pooling of interests. Upon release of
financial information covering the periods in which these transactions were
consummated, these supplemental consolidated financial statements will become
the historical financial statements of the Company.
2
<PAGE>
INDEX TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<S> <C>
DAOU SYSTEMS, INC.
Report of Ernst & Young LLP, Independent Auditors..................................... 4
Report of Deloitte & Touche LLP, Independent Auditors................................. 5
Report of PricewaterhouseCoopers LLP, Independent Accountants......................... 6
Supplemental Consolidated Balance Sheets at December 31, 1997 and 1996................ 7
Supplemental Consolidated Statements of Income for the years ended
December 31, 1997, 1996 and 1995.................................................... 8
Supplemental Consolidated Statements of Stockholders' Equity for the
years ended December 31, 1997, 1996 and 1995........................................ 9
Supplemental Consolidated Statements of Cash Flows for the years ended
December 31, 1997, 1996 and 1995................................................... 10
Notes to Supplemental Consolidated Financial Statements............................... 11
</TABLE>
3
<PAGE>
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders
DAOU Systems, Inc.
We have audited the accompanying supplemental consolidated balance sheets of
DAOU Systems, Inc. (formed as a result of the consolidation of DAOU Systems,
Inc., Sentient Systems, Inc., Synexus Incorporated, Technology Management,
Inc. and Affiliate and Resources in Healthcare Innovations, Inc. and
Affiliates) as of December 31, 1997 and 1996 and the related supplemental
consolidated statements of income, stockholders' equity, and cash flows for
each of the three years in the period ended December 31, 1997. The
supplemental consolidated financial statements give retroactive effect to the
mergers of DAOU Systems, Inc., Synexus Incorporated and Sentient Systems,
Inc., in March 1998 and Technology Management, Inc. and Affiliate and
Resources in Healthcare Innovations, Inc. and Affiliates in June 1998, which
have been accounted for using the pooling-of-interests method as described in
the notes to the supplemental consolidated financial statements. These
supplemental consolidated financial statements are the responsibility of the
Company's management. Our responsibility is to express an opinion on these
supplemental consolidated financial statements based on our audits. We did
not audit the financial statements of Sentient Systems, Inc. which statements
reflect total assets constituting 6% for 1997 and 12% for 1996 of the related
consolidated supplemental financial statement totals, and which reflect net
income constituting 28%, 22% and 6% of the related supplemental consolidated
financial statement totals for the years ended December 31, 1997, 1996 and
1995, respectively. These statements were audited by other auditors whose
reports have been furnished to us, and our opinion, insofar as it relates to
data included for Sentient Systems, Inc., is based solely on the reports of
other auditors.
We conducted our audits in accordance with generally accepted auditing
standards. 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 and the reports
of the other auditors provide a reasonable basis for our opinion.
In our opinion, based on our audits and the reports of other auditors, the
supplemental consolidated financial statements referred to above present
fairly, in all material respects, the consolidated financial position of DAOU
Systems, Inc. at December 31, 1997 and 1996 and the results of its operations
and its cash flows for each of the three years in the period ended December
31, 1997, after giving retroactive effect to the mergers of DAOU Systems,
Inc., Synexus Incorporated, Sentient Systems, Inc., Technology Management,
Inc. and Affiliate and Resources in Healthcare Innovations, Inc. and
Affiliates, as described in the notes to the supplemental consolidated
financial statements, in conformity with generally accepted accounting
principles.
ERNST & YOUNG LLP
San Diego, California
August 4, 1998
4
<PAGE>
INDEPENDENT AUDITORS' REPORT
To the Board of Directors of
Sentient Systems, Inc.
Kensington, Maryland
We have audited the accompanying balance sheets of Sentient Systems, Inc. (the
Company) as of December 31, 1997 and 1996, and the related statements of
operations, changes in stockholders' equity, and cash flows for the years ended
December 31, 1997 and 1996 (not presented separately herein). These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audits.
We conducted our audits in accordance with generally accepted auditing
standards. 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, such financial statements present fairly, in all material
respects, the financial position of the Company as of December 31, 1997 and
1996, and the results of its operations and its cash flows for the years
ended December 31, 1997 and 1996, in conformity with generally accepted
accounting principles.
/s/ Deloitte & Touche LLP
McLean, Virginia
February 13, 1998
5
<PAGE>
REPORT OF INDEPENDENT ACCOUNTANTS
Board of Directors
Sentient Systems, Inc.
We have audited the accompanying balance sheet of Sentient Systems, Inc. (the
Company) as of November 30, 1995 and the related statements of operations,
changes in stockholders' equity, and cash flows for the year then ended. These
financial statements are the responsibility of the Company's management. Our
responsibility is to express an opinion on these financial statements based on
our audit.
We conducted our audit in accordance with generally accepted auditing standards.
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 audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in
all material respects, the financial position of Sentient Systems, Inc. as of
November 30, 1995, and the results of its operations and its cash flows for the
year then ended in conformity with generally accepted accounting principles.
/s/ PricewaterhouseCoopers L.L.P.
McLean, Virginia
March 8, 1996
6
<PAGE>
DAOU Systems, Inc.
Supplemental Consolidated Balance Sheets
(IN THOUSANDS, EXCEPT FOR PER SHARE DATA)
<TABLE>
<CAPTION>
DECEMBER 31,
1997 1996
------------------------------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 7,981 $ 3,123
Short-term investments, available-for-sale 10,307 839
Accounts receivable, net of allowance of $312 and $310 in
1997 and 1996, respectively 15,744 10,444
Contract work in progress 13,291 4,122
Deferred income taxes 320 176
Other current assets 1,769 682
------------------------------------
Total current assets 49,412 19,386
Due from officers/stockholders 371 228
Equipment, furniture and fixtures, net 3,859 1,761
Deferred income taxes 3 23
Other assets 465 274
------------------------------------
$ 54,110 $ 21,672
====================================
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Trade accounts payable $ 1,661 $ 869
Accrued salaries and wages 2,675 2,256
Other accrued liabilities 2,995 1,328
Accrued dividends payable 487 -
Income taxes payable 5 106
Deferred revenue 369 1,110
Current portion of long-term debt and line of credit 1,437 268
Current portion of severence payable 210 -
------------------------------------
Total current liabilities 9,839 5,937
Deferred rent 55 92
Long-term debt 49 32
Deferred income taxes 390 -
Long-term portion of severence payable 823 -
Deferred compensation to officers 1,117 1,117
Commitments and contingencies
Redeemable preferred stock - 8,190
Stockholders' equity:
Preferred stock, $.001 par value:
Authorized shares - 5,000
Issued and outstanding shares - none -
Common stock, $.001 par value:
Authorized shares - 50,000
Issued and outstanding shares - 16,945 in 1997 and 12,796 in 1996 17 13
Additional paid-in capital 36,040 1,584
Deferred compensation (907) (1,166)
Unrealized gain on short-term investments 146 101
Accretion of redeemable preferred stock - (572)
Retained earnings 6,541 6,344
------------------------------------
Total stockholders' equity 41,837 6,304
------------------------------------
$ 54,110 $ 21,672
====================================
</TABLE>
See accompanying notes.
7
<PAGE>
DAOU Systems, Inc.
Supplemental Consolidated Statements of Income
(IN THOUSANDS, EXCEPT FOR PER SHARE DATA)
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
1997 1996 1995
------------------------------------------------------
<S> <C> <C> <C>
Revenues $69,055 $50,947 $36,448
Cost of revenues 45,553 33,730 22,583
------------------------------------------------------
Gross profit 23,502 17,217 13,865
Operating expenses:
Sales and marketing 7,780 4,166 2,928
General and administrative 12,425 9,945 8,930
Merger and related expenses 718 - -
------------------------------------------------------
20,923 14,111 11,858
------------------------------------------------------
Income from operations 2,579 3,106 2,007
Interest income, net 873 369 193
------------------------------------------------------
Income before income taxes 3,452 3,475 2,200
Provision for income taxes 947 149 889
------------------------------------------------------
Net income 2,505 3,326 1,311
Accretion of redeemable preferred stock - 485 87
------------------------------------------------------
Net income attributable to common stock $ 2,505 $ 2,841 $ 1,224
======================================================
Net income per share:
Basic $ 0.15 $ 0.23 $ 0.10
======================================================
Diluted $ 0.15 $ 0.23 $ 0.10
======================================================
Shares used in computing net income per
share:
Basic 16,231 12,580 12,260
======================================================
Diluted 17,246 14,385 12,548
======================================================
</TABLE>
See accompanying notes.
8
<PAGE>
DAOU Systems, Inc.
Supplemental Consolidated Statements of Stockholders' Equity
(IN THOUSANDS)
<TABLE>
<CAPTION>
COMMON STOCK ADDITIONAL
-------------------------------- PAID-IN DEFERRED
SHARES AMOUNT CAPITAL COMPENSATION
-------------------------------------------------------------
<S> <C> <C> <C> <C>
Balance at December 31, 1994 12,251 $12 $ 169 $ -
Accretion of redeemable preferred stock - - - -
Issuance of common stock in exchange for
services 70 - 23 -
Unrealized gain on short-term investments - - - -
Net income - - - -
-------------------------------------------------------------
Balance at December 31, 1995 12,321 12 192 -
Deferred compensation - - 1,243 (1,243)
Amortization of deferred compensation - - - 77
Issuance of common stock in exchange for
services 35 - 30 -
Shares issued in connection with formation of
S Corporation 225 - 25 -
Issuance of common stock for cash 252 1 100 -
Repurchase and retirement of common stock (37) - (6) -
Accretion of redeemable preferred stock - - - -
Distribution to Sentient stockholders (Note 2) - - - -
Unrealized gain on short-term investments - - - -
Adjustment for change in Sentient Systems,
Inc.'s year end - - - -
Net income - - - -
-------------------------------------------------------------
Balance at December 31, 1996 12,796 13 1,584 (1,166)
Issuance of common stock upon initial public
offering, net 2,000 2 15,782 -
Conversion of redeemable preferred stock upon
initial public offering 1,603 2 7,616 -
Issuance of common stock upon secondary public
offering, net 500 - 9,320 -
Issuance of common stock upon exercise of stock
options 142 - 639 -
Tax effect from exercise of noncompensatory
stock options - - 1,103 -
Amortization of deferred compensation - - - 259
Shares issued in connection with formation of -
S Corporation 584 1 (1)
Distribution to Integrex stockholders (Note 2) - - - -
Distribution to On-Line stockholders (Note 2) - - - -
Distribution to Sentient stockholders (Note 2) - - - -
Distribution to TMI stockholders (Note 2) - - - -
Repurchase of founders stock (680) (1) (3) -
Unrealized gain on short-term investments - - - -
Net income - - - -
-------------------------------------------------------------
Balance at December 31, 1997 16,945 $17 $36,040 $ (907)
=============================================================
<CAPTION>
ACCRETION OF
UNREALIZED GAIN REDEEMABLE TOTAL
ON SHORT-TERM PREFERRED RETAINED STOCKHOLDERS'
INVESTMENTS STOCK EARNINGS EQUITY
-------------------------------------------------------------------
<S> <C> <C> <C> <C>
Balance at December 31, 1994 $ - $ - $ 1,976 $ 2,157
Accretion of redeemable preferred stock - (87) - (87)
Issuance of common stock in exchange for
services - - - 23
Unrealized gain on short-term investments 95 - - 95
Net income - - 1,311 1,311
-------------------------------------------------------------------
Balance at December 31, 1995 95 (87) 3,287 3,499
Deferred compensation - - - -
Amortization of deferred compensation - - - 77
Issuance of common stock in exchange for
services - - - 30
Shares issued in connection with formation of
S Corporation - - - 25
Issuance of common stock for cash - - - 101
Repurchase and retirement of common stock - - (34) (40)
Accretion of redeemable preferred stock - (485) - (485)
Distribution to Sentient stockholders (Note 2) - - (146) (146)
Unrealized gain on short-term investments 13 - - 13
Adjustment for change in Sentient Systems,
Inc.'s year end (7) - (89) (96)
Net income - - 3,326 3,326
-------------------------------------------------------------------
Balance at December 31, 1996 101 (572) 6,344 6,304
Issuance of common stock upon initial public
offering, net - - - 15,784
Conversion of redeemable preferred stock upon
initial public offering - 572 - 8,190
Issuance of common stock upon secondary public
offering, net - - - 9,320
Issuance of common stock upon exercise of stock
options - - - 639
Tax effect from exercise of noncompensatory
stock options - - - 1,103
Amortization of deferred compensation - - - 259
Shares issued in connection with formation of
S Corporation - - - -
Distribution to Integrex stockholders (Note 2) - - (94) (94)
Distribution to On-Line stockholders (Note 2) - - (63) (63)
Distribution to Sentient stockholders (Note 2) - - (391) (391)
Distribution to TMI stockholders (Note 2) - - (644) (644)
Repurchase of founders stock - - (1,116) (1,120)
Unrealized gain on short-term investments 45 - - 45
Net income - - 2,505 2,505
-------------------------------------------------------------------
Balance at December 31, 1997 $ 146 $ - $ 6,541 $41,837
===================================================================
</TABLE>
See accompanying notes.
9
<PAGE>
DAOU Systems, Inc.
Supplemental Consolidated Statements of Cash Flows
(IN THOUSANDS)
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
1997 1996 1995
------------------------------------------------------
<S> <C> <C> <C>
OPERATING ACTIVITIES
Net income $ 2,505 $ 3,326 $ 1,311
Adjustments to reconcile net income to net
cash used in operating activities:
Depreciation and amortization 1,324 613 510
Provision for uncollectible accounts 70 108 100
Common stock issued in exchange for services - 30 23
Deferred income taxes 266 20 (288)
Changes in operating assets and liabilities:
Accounts receivable (5,370) (949) (6,906)
Contract work in progress (9,169) (3,263) 189
Other current assets (1,087) (520) (78)
Trade accounts payable 792 (539) 493
Accrued salaries and wages 419 (195) 1,295
Deferred revenue (741) 574 (393)
Other accrued liabilities 1,667 (582) 1,230
Income taxes payable (101) (842) 751
Deferred rent (37) 66 (18)
Severence payable 1,033 - -
------------------------------------------------------
Net cash used in operating activities (8,429) (2,153) (1,781)
INVESTING ACTIVITIES
Purchase of equipment, furniture and fixtures (3,163) (1,247) (675)
Proceeds from sale of assets - - 300
Increase in other assets (186) (96) (5)
Purchases of short-term investments (9,462) (130) (4,178)
Maturities of short-term investments 39 3,879 176
Advances to officers/stockholders (143) (17) (306)
Proceeds from repayment of due from officers - - 209
------------------------------------------------------
Net cash (used in) provided by investing activities (12,915) 2,389 (4,479)
FINANCING ACTIVITIES
Net advances under the line of credit 145 20 165
Proceeds from long-term debt 1,101 96 -
Repayment of long-term debt (60) (87) (50)
Distributions to stockholders of acquired companies (706) (146) -
Proceeds from issuance of common stock and redeemable
preferred stock 26,842 126 7,618
Repurchase of founders stock (1,120) (40) -
------------------------------------------------------
Net cash provided by (used in) financing activities 26,202 (31) 7,733
------------------------------------------------------
Increase in cash and cash equivalents 4,858 205 1,473
Cash and cash equivalents at beginning of year 3,123 2,918 1,445
------------------------------------------------------
Cash and cash equivalents at end of year $ 7,981 $ 3,123 $ 2,918
======================================================
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid during the year for:
Income taxes $ 115 $ 982 $ 429
------------------------------------------------------
Interest $ 113 $ 46 $ 13
------------------------------------------------------
SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND
FINANCING ACTIVITIES:
Accrued dividends payable to TMI, Inc. stockholders $ 487 $ - $ -
======================================================
Conversion of redeemable preferred stock and accreted
dividends to common stock $ 7,618 $ - $ -
======================================================
</TABLE>
See accompanying notes.
10
<PAGE>
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
ORGANIZATION AND BASIS OF PRESENTATION
DAOU Systems, Inc. ("DAOU" or the "Company") designs, implements, supports
and manages advanced computer network systems for hospitals, integrated
healthcare delivery systems and other healthcare provider organizations,
located throughout the United States.
The Company's design services include an assessment of the customer's
existing computer network system and the preparation of voice, video and data
network specifications, technical design documentation and diagrams. DAOU's
implementation services include the purchase, delivery and installation of
enterprise-wide computer network systems. The Company's support and
management services are typically provided under multi-year contracts and
include remote and on-site network management services, as well as
information systems outsourcing. DAOU typically provides its services under a
fixed-price contract and over a fixed period of time.
In March 1998, the Company acquired all of the issued and outstanding shares
of Synexus Incorporated ("Synexus") and Sentient Systems, Inc. ("Sentient")
through the Company's wholly-owned subsidiaries DAOU-Synexus, Inc. and
DAOU-Sentient, Inc. In June 1998, the Company acquired all of the issued and
outstanding shares of Technology Management, Inc. and Affiliate and Resources
in Healthcare Innovations, Inc. and Affiliates, through the Company's
wholly-owned subsidiaries DAOU-TMI, Inc. and DAOU-RHI, Inc. The above
acquisitions were accounted for using the pooling-of-interests method of
accounting and, accordingly, the supplemental consolidated financial
statements reflect the combined financial position and operating results for
the Company, Synexus, Sentient, Technology Management, Inc. and Affiliate, and
Resources in Healthcare Innovations and Affiliates for all periods presented
giving retroactive effect to the pooling transactions. All significant
intercompany accounts have been eliminated. These supplemental consolidated
financial statements will become the historical consolidated financial
statements of DAOU upon the issuance of financial statements for a period
that includes the date of the mergers.
REVENUE RECOGNITION
Contract revenue for the development and implementation of network solutions
is recognized using the percentage-of-completion method with progress to
completion measured by labor costs incurred to date compared to total
estimated labor costs. Provisions for estimated losses on contracts, if any,
are made during the period when the loss becomes probable and can be
reasonably estimated. Revenues recognized in excess of amounts billed and
project costs are classified as contract work in progress. Revenue from
technical support and network management services is recognized as the
services are performed. Payments received in advance of services performed
are recorded as deferred revenue and amortized as the services are performed.
CONCENTRATION OF CREDIT RISK AND MAJOR CUSTOMER
Substantially all of the Company's accounts receivable are from hospitals and
other healthcare providers. Generally, the Company obtains a significant
deposit from its customers upon signing a contract and collateral is not
required. The Company provides for losses from uncollectible accounts and
such losses have historically not exceeded management's expectations. During
1995, one customer accounted for 22% of the Company's revenues. No other
customer accounted for more than 10% of the Company's revenues in any period
presented.
11
<PAGE>
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
CASH, CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS
Cash and cash equivalents consist of cash and highly liquid investments with
maturities of three months or less when purchased. The Company has
established guidelines relative to diversification and maturities that are
periodically reviewed and modified to take advantage of trends in yields and
interest rates. The Company historically has not experienced any losses on
its cash equivalents or short-term investments.
The Company classifies its short-term investments as "Available-for-Sale" and
records such assets at the estimated fair value on the balance sheet with
unrealized gains and losses excluded from earnings and reported as a separate
component of stockholders' equity until realized. The basis for computing
realized gains or losses is by specific identification.
EQUIPMENT, FURNITURE AND FIXTURES
Equipment, furniture and fixtures are carried at cost. Depreciation is
computed using the straight-line method over the estimated useful lives of
the assets, ranging from three to seven years. Leasehold improvements are
amortized over the lesser of the estimated useful lives of the assets or the
remaining lease term.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions
about the future that affect the amounts reported in the financial statements
and disclosures made in the accompanying notes of the financial statements.
The actual results could differ from those estimates.
NET INCOME PER SHARE
In February 1997, the Financial Accounting Standards Board issued Statement
of Financial Accounting Standards ("SFAS") No. 128, EARNINGS PER SHARE, which
supersedes Accounting Principles Board ("APB") Opinion No. 15. SFAS No. 128
replaces the presentation of primary earnings per share (EPS) with "Basic
EPS" which includes no dilution and is based on weighted-average common
shares outstanding for the period. Companies with complex capital structures,
including DAOU, will also be required to present "Diluted EPS" that reflects
the potential dilution of securities such as stock options and warrants. SFAS
No. 128 is effective for financial statements issued for periods ending after
December 15, 1997. On February 3, 1998, the SEC issued Staff Accounting
Bulletin (SAB) No. 98 which revised the previous instructions for determining
the dilutive effects in earnings per share computations of common stock and
common stock equivalents issued at prices below the IPO price prior to the
effectiveness of the IPO.
12
<PAGE>
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
The following table sets forth the computation of the shares used in the
basic and diluted net income per share calculation (IN THOUSANDS):
<TABLE>
<CAPTION>
DECEMBER 31,
1997 1996 1995
------------------------------------------------------
<S> <C> <C> <C>
Shares used in Basic net income per share -
weighted average common shares
outstanding 16,231 12,580 12,260
------------------------------------------------------
Effect of conversion of preferred stock from date
of issuance 189 1,603 288
Net effect of dilutive common share equivalents
based on treasury stock method 826 202 -
------------------------------------------------------
Shares used in Diluted net income per share 17,246 14,385 12,548
======================================================
</TABLE>
STOCK-BASED COMPENSATION
Effective January 1, 1996, the Company adopted SFAS No. 123, ACCOUNTING FOR
STOCK-BASED COMPENSATION. SFAS No. 123 allows companies to either account for
stock-based compensation under the new provisions of SFAS No. 123 or under
the provisions of APB Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO
EMPLOYEES ("APB 25"), but requires pro forma disclosure in the footnotes to
the financial statements as if the measurement provisions of SFAS No. 123 had
been adopted. The Company has continued accounting for its stock-based
compensation in accordance with the provisions of APB 25.
NEW ACCOUNTING STANDARDS
In June 1997, the Financial Accounting Standards Board issued SFAS No. 130,
REPORTING COMPREHENSIVE INCOME and SFAS No. 131, SEGMENT INFORMATION. Both of
these standards are effective for fiscal years beginning after December 15,
1997. SFAS No. 130 requires that all components of comprehensive income,
including net income, be reported in the financial statements in the period
in which they are recognized. Comprehensive income is defined as the change
in equity during a period from transactions and other events and
circumstances from non-owner sources. Net income and other comprehensive
income, including foreign currency translation adjustments and unrealized
gains and losses on investments, shall be reported, net of their related tax
effect, to arrive at comprehensive income. The Company does not believe that
comprehensive income or loss will be materially different than net income or
loss. SFAS No. 131 amends the requirements for public enterprises to report
financial and descriptive information about its reportable operating
segments. Operating segments, as defined in SFAS No. 131, are components of
an enterprise for which separate financial information is available and is
evaluated regularly by the Company in deciding how to allocate resources and
in assessing performance. The financial information is required to be
reported on the basis that is used internally for evaluating the segment
performance. The Company believes it operates in one business and operating
segment and does not believe the adoption of these standards will have a
material impact on the Company's financial statements.
13
<PAGE>
2. ACQUISITIONS
During June 1998, the Company acquired (i) Technology Management, Inc.
("TMI"), a privately-held company that provides information technology
consulting services primarily to the healthcare industry, (ii) International
Health Care Systems, Inc.("IHCS"), a privately-held company with a common
shareholder with TMI that provides information technology consulting services
primarily to the healthcare industry on behalf of TMI, (iii) Resources in
Healthcare Innovations, Inc. ("RHI"), a privately-held information technology
services firm that provides contract management services for healthcare
information systems to hospitals and managed care organizations, and (iv)
Healthcare Transition Resources, Inc. ("HTR"), Ultitech Resources Group, Inc.
("URG"), Innovative Systems Solutions, Inc. ("ISS") and Grand Isle
Consulting, Inc. ("GIC"), each a privately held company with common
shareholders of RHI that implements software applications from third parties
and provides support services to healthcare enterprises. Shareholders of TMI,
IHCS, RHI, HTR, URG, ISS and GIC received 1,078,963, 224,668, 1,839,381,
275,662, 282,551, 308,583 and 223,645 shares, respectively, of the Company's
common stock in exchange for the outstanding stock of each of these
companies. The above acquisitions have been accounted for using the
pooling-of-interests method of accounting, and accordingly, the historical
financial statements of periods prior to the consummation of the combinations
have been restated as though the companies had been combined for all periods
presented. Estimated merger costs, net of tax effects, related to these
acquisitions were $2,882,000, and were recorded during June 1998.
During March 1998, the Company acquired Synexus, a privately-held company
specializing in the planning, design and implementation of enterprise
networks in healthcare environments, and Sentient, a privately-held company
which provides integration and support services primarily to health-care
organizations. Shareholders of Synexus and Sentient received 161,235 and
1,397,550 shares, respectively, of the Company's common stock in exchange for
all of the outstanding stock of each of these companies. The acquisitions
have been accounted for using the pooling-of-interests method of accounting,
and accordingly, the historical financial statements of periods prior to the
consummation of the combinations have been restated as though the companies
had been combined for all periods presented. Estimated merger costs, net of
tax effects, related to these acquisitions were $1,722,000, and were recorded
during March 1998.
On September 25, 1997, the Company acquired through its wholly-owned
subsidiary DAOU On-Line, Inc. all of the issued and outstanding shares of
On-Line Networking, Inc. ("On-Line") in exchange for 150,000 shares of the
Company's common stock. On-Line is a provider of communication infrastructure
services primarily within the healthcare information technology market.
On July 9, 1997, the Company acquired through its wholly-owned subsidiary
DAOU-Integrex, Inc. all of the issued and outstanding shares of Integrex
Systems Corporation ("Integrex") in exchange for 700,000 shares of the
Company's common stock. Integrex provides advanced network design,
integration and consulting support services primarily to healthcare
organizations and also to educational and governmental institutions, all of
which are primarily located in the state of Virginia. Integrex specializes in
voice and video networks and also designs integrated cable plants capable of
supporting voice, video and high-speed data transmission.
Both the Integrex and On-Line acquisitions were accounted for using the
pooling-of-interests method of accounting and, accordingly, the historical
financial statements for all periods prior to the consummation of the
combinations have been restated as though the companies had been combined for
all periods presented.
14
<PAGE>
2. ACQUISITIONS (CONTINUED)
Total revenues and net income (loss) of DAOU, Integrex, On-Line, Synexus,
Sentient, TMI (including IHCS) and RHI (including HTR, URG, ISS and GIC) for
the three years ended December 31, 1997 were (in thousands):
<TABLE>
<CAPTION>
DAOU INTEGREX ON-LINE SYNEXUS SENTIENT TMI RHI COMBINED
--------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C> <C> <C>
Year ended December 31, 1997
Total revenues $30,606 $5,426 $5,668 $1,578 $9,861 $6,371 $9,545 $69,055
Net income (loss) (820) 951 (44) 121 694 1,576 27 2,505
Year ended December 31, 1996
Total revenues 19,311 4,456 4,616 1,680 9,732 5,374 5,778 50,947
Net income 83 478 361 97 730 1,061 516 3,326
Year ended December 31, 1995
Total revenues 14,330 2,548 2,985 985 8,157 4,327 3,116 36,448
Net income (loss) 1,240 179 (301) 50 83 (30) 90 1,311
</TABLE>
3. SHORT-TERM INVESTMENTS, AVAILABLE-FOR-SALE
Short-term investments, available-for-sale, consist of the following (IN
THOUSANDS):
<TABLE>
<CAPTION>
GROSS
AMORTIZED GROSS UNREALIZED ESTIMATED
COST UNREALIZED GAINS LOSSES FAIR VALUE
-----------------------------------------------------------------------
<S> <C> <C> <C> <C>
DECEMBER 31, 1997
Equity securities $ 707 $154 $ (2) $ 859
Government and corporate debt securities 9,454 - (6) 9,448
-----------------------------------------------------------------------
$ 10,161 $154 $ (8) $ 10,307
=======================================================================
DECEMBER 31, 1996
Equity securities $ 629 $124 $ (5) $ 748
Government and corporate debt securities 109 (18) 91
-----------------------------------------------------------------------
$ 738 $124 $ (23) $ 839
=======================================================================
</TABLE>
Short-term investments by contractual maturity are as follows at December 31,
1997:
<TABLE>
<S> <C>
Due in one year or less $10,105
Due after one year through two years 30
Greater than two years 172
---------------
$10,307
===============
</TABLE>
15
<PAGE>
4. SELECTED BALANCE SHEET DETAILS
Equipment, furniture and fixtures consist of the following (IN THOUSANDS):
<TABLE>
<CAPTION>
DECEMBER 31,
1997 1996
-------------------------------------
<S> <C> <C>
Equipment and furniture $ 6,630 $ 3,646
Leasehold improvements 171 147
-------------------------------------
6,801 3,793
Less accumulated depreciation and amortization (2,942) (2,032)
-------------------------------------
$ 3,859 $ 1,761
=====================================
</TABLE>
Other accrued liabilities consist of the following (IN THOUSANDS):
<TABLE>
<CAPTION>
DECEMBER 31,
1997 1996
-------------------------------------
<S> <C> <C>
Accrued contract costs $2,390 $ 626
Other accrued liabilities 605 702
-------------------------------------
$2,995 $ 1,328
=====================================
</TABLE>
5. LINES OF CREDIT
In August 1997, On-Line amended its previous $300,000 line of credit with a
bank by increasing it to $500,000. The agreement provides for the payment of
interest at the bank's variable base rate, as defined (9.00% at December 31,
1997) plus 1%, callable on demand, and expired on March 31, 1998. The line is
secured by accounts receivable, inventories and equipment, and is personally
guaranteed by the three former stockholders of On-Line. At December 31, 1997,
there were no amounts outstanding under the line of credit.
The RHI line of credit is for $700,000 and expires on May 1, 1999. Under the
terms of the agreement, advances bear interest at the bank's prime rate plus
.25% (8.75% at December 31, 1997). There are no compensating balance
requirements and borrowings under the line of credit are limited to 65% of
qualifying receivables. At December 31, 1997, $350,000 was outstanding under
the line of credit.
Interest expense for the above lines of credit for years ended December 31,
1997, 1996 and 1995 was $43,100, $16,400 and $2,400, respectively.
6. LONG-TERM DEBT
Long-term debt at December 31, 1997 consists of secured notes payable of
On-Line to a financing company, a secured note payable of RHI to a bank and a
secured five-year term loan of Synexus.
As of December 31, 1997, the On-Line notes require aggregate monthly payments
of $2,634, including interest with rates ranging from 9.25% to 10.75%. The
notes mature from May 1998 to August 2001 and are secured by vehicles.
The RHI note payable is a $1,000,000 note payable to a bank which has a
maturity date of September 1, 1998 and an interest rate of 8.5%. As of
December 31, 1997, no principal payments had been made.
16
<PAGE>
6. LONG-TERM DEBT (CONTINUED)
The Synexus five-year term loan is for capital asset acquisitions with
maximum borrowing available of $360,000, bears interest at the Wall Street
Journal prime rate plus 1.25% (9.75% as of December 31, 1997), and is payable
in monthly installments of $6,000 principal plus accrued interest. This note
is collateralized by the general assets of Synexus and is guaranteed by
certain of the Company's stockholders. At December 31, 1997, $168,000 remains
available for future borrowings.
Interest expense for the above long-term debt for the years ended December
31, 1997, 1996 and 1995 was $19,600, $3,600 and $5,600, respectively.
7. COMMITMENTS
LEASE COMMITMENTS
The Company leases its facilities and certain equipment under operating lease
agreements. The facility leases provide for abatement of rent during certain
periods and escalating rent payments during the lease term. Rent expense for
1997, 1996 and 1995 totaled $1,187,000, $1,122,000 and $726,000, respectively.
Annual future minimum lease payments under noncancellable operating leases
with initial terms of one year or more at December 31, 1997, consist of the
following (IN THOUSANDS):
<TABLE>
<S> <C>
1998 $1,257
1999 872
2000 719
2001 693
2002 704
------------------
$4,245
==================
</TABLE>
SEVERANCE PAYABLE
In connection with the retirement of one of the RHI original founders, RHI
entered into a severance agreement whereby RHI will repay the retiring
founder a total of $1,050,000 in severance payments, payable in sixty
consecutive monthly installments of $17,500 beginning on December 20, 1997.
At December 31, 1997, the Company had an outstanding payable of $1,032,500.
The aggregate minimum future payments under the severance agreements as of
December 31, 1997 are $210,000, $210,000, $210,000, $210,000 and $192,500 for
the years ending December 31, 1998, 1999, 2000, 2001 and 2002, respectively.
17
<PAGE>
8. REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY
REDEEMABLE PREFERRED STOCK
During 1995, 1,603,430 shares of redeemable preferred stock were issued at
$4.99 per share for proceeds of $7,618,000 net of issuance costs. Holders of
the redeemable preferred stock were entitled to receive cumulative dividends
at the rate of $0.03 per share per annum, when and if declared by the Board
of Directors and prior to any dividends on the common stock.
The redeemable preferred stock had a liquidation preference of $4.99 per
share plus any declared but unpaid dividends and was convertible at the
option of the holder into one share of common stock, subject to certain
antidilution adjustments. The shares of preferred stock were automatically
converted into shares of common stock in connection with the initial public
offering of the Company's common stock which closed in February 1997. The
increase in the redemption value of the redeemable preferred stock was
$87,000 in 1995 and $485,000 in 1996.
STOCK OPTION PLANS
During 1996, the Company adopted the 1996 Stock Option Plan (the "Plan"),
under which 947,025 shares of the Company's common stock were initially
reserved for issuance upon exercise of options granted by the Company. During
November 1996, the Board of Directors increased the number of shares reserved
for issuance under the plan to 1,367,925. In October 1997, the Board of
Directors, subject to stockholder approval, approved an additional 3,000,000
shares to be reserved under the Plan. The Plan provides for the grant of both
incentive and nonstatutory stock options to officers, directors, employees
and consultants of the Company. Options granted by the Company generally vest
over a three to five-year period and are exercisable for a period of ten
years from the date of the grant.
The Company recorded $1,243,000 of deferred compensation for options granted
during the year ended December 31, 1996, representing the difference between
the option exercise price and the deemed fair value for financial statement
presentation purposes. The Company is amortizing the deferred compensation
ratably over the vesting period of the options.
18
<PAGE>
8. REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY (CONTINUED)
A summary of the Company's stock option activity under the Plan and
related information for the years ended December 31 follows:
<TABLE>
<CAPTION>
1997 1996
-------------------------------- ------------------------------
WEIGHTED- WEIGHTED-
AVERAGE AVERAGE
EXERCISE PRICE EXERCISE PRICE
OPTIONS OPTIONS
-------------------------------- ------------------------------
<S> <C> <C> <C> <C>
Outstanding -beginning of year 801,113 $5.16 - $ -
Granted 793,339 9.61 822,158 5.16
Exercised (144,487) 4.44 - -
Forfeited (228,470) 5.86 (21,045) 4.28
-------------------------------- ------------------------------
1,221,495 $8.13 801,113 $5.16
================================ ==============================
Exercisable at end of year 52,101 $6.57 - -
================================ ==============================
Weighted-average fair value of
options granted during the year $4.30 $2.81
================ =================
</TABLE>
In November 1996, the Company granted 140,300 non-qualified stock options at
an exercise price of $4.28 per share outside of the Plan. These options vest
ratably over a five-year period.
The following table summarizes information about stock options outstanding
under the Plan at December 31, 1997:
<TABLE>
<CAPTION>
OUTSTANDING EXERCISABLE
------------------------------------------------- ------------------------------
WEIGHTED
AVERAGE
REMAINING
RANGE OF NUMBER CONTRACTUAL WEIGHTED-AVERAGE NUMBER WEIGHTED-AVERAGE
EXERCISE PRICE OUTSTANDING LIFE EXERCISE PRICE EXERCISABLE EXERCISE PRICE
- -------------------------------------------------------------------------- ------------------------------
<S> <C> <C> <C> <C> <C>
$4.28 to $4.35 401,988 8.3 $4.28 33,454 $4.28
$4.35 to $ 6.53 386,475 9.2 6.03 - -
$8.70 to $10.88 194,532 9.1 10.22 18,647 10.69
$10.88 to $13.05 6,000 9.5 12.75 - -
$15.23 to $17.40 232,500 9.5 16.43 - -
------------------------------------------------- ------------------------------
1,221,495 8.9 $8.13 52,101 $6.57
================================================= ==============================
</TABLE>
At December 31, 1997, 196,588 options were vested and options for 1,943
common shares were available for future grant.
Adjusted pro forma information regarding net income and earnings per share is
required by SFAS No. 123, and has been determined as if the Company had
accounted for its employee stock options under the fair value method of that
statement. The fair value for these options was estimated at the date of
grant using the Black-Scholes option pricing model with the following
weighted-average assumptions for 1997 and 1996: risk-free interest rate of
6%; dividend yield of 0%; volatility factors of the expected market price of
the Company's common stock of 75% and 0%, respectively; and a
weighted-average expected life of the option of seven years.
19
<PAGE>
8. REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY (CONTINUED)
The Black-Scholes option valuation model was developed for use in estimating
the fair value of traded options which have no vesting restrictions and are
fully transferable. In addition, option valuation models require the input of
highly subjective assumptions including the expected stock price volatility.
Because the Company's employee stock options have characteristics
significantly different from those of traded options, and because changes in
the subjective input assumptions can materially affect the fair value
estimate, in management's opinion, the existing models do no necessarily
provide a reliable single measure of the fair value of its employee stock
options. For purposes of adjusted pro forma disclosures, the estimated fair
value of the options is amortized to expense over the vesting period of the
options. The Company's adjusted pro forma information is as follows (IN
THOUSANDS, EXCEPT FOR PER SHARE INFORMATION):
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
1997 1996
---------------------------
<S> <C> <C>
Adjusted pro forma net income $2,256 $2,364
===========================
Adjusted pro forma net income per share:
Basic $ 0.14 $ 0.19
===========================
Diluted $ 0.13 $ 0.16
===========================
</TABLE>
The results above are not likely to be representative of the effects of
applying SFAS No. 123 on reported net income or loss for future years as
these amounts reflect the expense for only one or two years vesting.
In August 1997, TMI issued rights to employees to buy up to 178,604 shares of
DAOU stock on an as converted basis. Each right could be exercised to
purchase one share of DAOU's Common Stock at an exercise price of $5.05.
Effective January 1, 1998, DAOU issued 100,312 shares of Common Stock to
employees under the terms of stock rights outstanding. The remaining 78,292
shares in the stock rights plan expire on December 31, 1998 under the terms
of the original issuance.
WARRANTS
In connection with the issuance of the redeemable preferred stock, the
Company issued two warrants to purchase an aggregate of 133,285 shares of
common stock at an exercise price of $4.99 per share. The warrants are
exercisable immediately and expire on October 26, 2000.
COMMON STOCK RESERVED
At December 31, 1997, a total of 1,497,023 shares of the Company's common
stock have been reserved for the exercise of stock options and warrants.
20
<PAGE>
9. INCOME TAXES
The provision for income taxes consists of the following (IN THOUSANDS):
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
1997 1996 1995
-----------------------------------------
<S> <C> <C> <C>
Current:
Federal $581 $ 66 $907
State 97 62 270
-----------------------------------------
678 128 1,177
Deferred:
Federal 238 33 (246)
State 31 (12) (42)
-----------------------------------------
269 21 (288)
-----------------------------------------
$947 $149 $889
=========================================
</TABLE>
Deferred income taxes are provided for temporary differences in recognizing
certain income and expense items for financial and tax reporting purposes.
Significant components of the Company's deferred tax assets and liabilities
consist of the following (IN THOUSANDS):
<TABLE>
<CAPTION>
DECEMBER 31,
1997 1996
-----------------------------
<S> <C> <C>
Deferred tax liabilities:
Accounting method change for tax purposes $423 $ -
Depreciation and amortization 120 3
-----------------------------
543 3
Deferred tax assets:
Reserves and allowances 423 198
Net operating losses 50 -
Other 3 4
-----------------------------
476 202
-----------------------------
Net deferred tax (asset) liability $ 67 $(199)
=============================
</TABLE>
At December 31, 1997, the Company has state net operating losses of $842,000.
This net operating loss will expire in 2002.
The reconciliation of income tax computed at the federal statutory rate to the
total provision for income taxes is as follows:
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
1997 1996 1995
-------------------------------------------------
<S> <C> <C> <C>
Tax at federal statutory rate 35.0% 35.0% 35.0%
S corporation income not subject to
corporate income taxes (33.7) (32.8) (.2)
Nondeductible expenses 9.4 1.0 1.3
Adjustment on conversion of S
corporation to C corporation 15.4 - -
State taxes, net of federal benefit 2.1 1.1 6.9
Other (.8) - (2.6)
-------------------------------------------------
27.4% 4.3% 40.4%
=================================================
</TABLE>
21
<PAGE>
10. BENEFIT PLANS
The Company sponsors the DAOU Systems, Inc. 401(k) Salary Savings Plan which
covers employees who meet certain age and service requirements. Employees may
contribute a portion of their earnings each plan year subject to certain
Internal Revenue Service limitations. The Company made elective contributions
to the Plan of $13,000, $16,000 and $50,000 for the years ended December 31,
1997, 1996 and 1995, respectively.
In October 1994, Integrex adopted a retirement benefit plan effective January
1, 1995. The plan is intended to qualify under Internal Revenue Code Section
401(a) and provides for employee salary deferrals under Internal Revenue Code
Section 401(k), company matching payments, and company profit sharing
payments. Integrex made profit sharing payments of $44,572, $97,605 and
$60,000 for the years ended December 31, 1997, 1996 and 1995, respectively.
In December 1995, On-Line adopted a defined contribution profit sharing plan
covering substantially all employees who have completed one year of service
and are twenty-one years of age and older. Profit sharing contributions are
made at the discretion of On-Line's management. Contributions vest 20% after
two years and an additional 20% for each year thereafter. Profit sharing
expense was $67,500, $77,124 and $68,498 for the years ended December 31,
1997, 1996 and 1995, respectively. Effective January 1, 1998, On-Line's
employees became eligible to participate in the Company's 401(k) plan, and
the existing profit sharing plan of On-Line was terminated.
Sentient formerly had an employee stock purchase plan available to certain
employees of Sentient. During 1994, the Board of Directors discontinued
issuance of new shares under the plan. During 1996, Sentient purchased and
retired all 36,329 shares held by employees at approximately $1.09 per share.
Concurrently with the repurchase of the shares, each employee holding stock
was issued an equivalent number of nontransferable "share units". These share
units entitle the holder, upon termination of employment or other liquidating
event, to a payment equal to the increase in the book value per share of
Sentient between the most recent audited financial statements at the
liquidating event date and the most recent audited financial statements prior
to the issuance of the share units, multiplied by the number of share units
held. As of December 31, 1997 and 1996, 30,445 and 35,991 share units,
respectively, were outstanding. In the event of an initial public offering of
its common stock or a change in control, the holders are entitled to receive
the difference between the fair market value of the share units based on the
consideration involved and the book value per share per the most recent
audited financial statements. The Company recorded $7,139 and $13,642 of
expense associated with these share units in 1997 and 1996, respectively.
Sentient has a 401(k) savings plan available to employees who have completed
at least 1,000 hours of service. Matching contributions to the plan are at
the Company's discretion. The Company made matching contributions to the plan
for 1997, 1996 and 1995 of approximately $84,000, $62,000 and $51,000,
respectively. The Company pays all administrative costs associated with the
plan, which were $3,981, $2,410 and $1,380 in 1997, 1996 and 1995,
respectively.
TMI maintains a defined contribution profit sharing plan for all eligible
employees. Contributions are discretionary and are made solely by the
Company. Actual contributions are based on a formula applied to each
participants' annual compensation. Contribution expense for the plan was
approximately $89,000, $74,000 and $72,000 for the years ended December 31,
1997, 1996 and 1995, respectively.
RHI has a 401(k) savings plan available to employees who have completed 6
months of eligible service and are 21 years of age or older. Employees can
voluntarily contribute up to 10% of their gross salaries, subject to IRS
limitations. Matching contributions to the plan are at the Company's
discretion. The Company made matching contributions to the plan of $100,000,
$50,000 and $31,000 for the years ended December 31, 1997, 1996 and 1995,
respectively.
22
<PAGE>
11. SUBSEQUENT EVENT (unaudited)
In August and September 1998, four separate complaints were filed against the
Company and certain of its officers and directors in the United States
District Court for the Southern District of California. These complaints
assert violations of the federal securities law based on the alleged improper
use of the percentage-of-completion method for revenue recognition. These
complaints were brought on behalf of a purported class of investors in the
Company's common stock and do not allege specific damage amounts. In
addition, in October 1998, two separate complaints were filed in the Superior
Court of San Diego, California. These additional complaints mirror the
allegations set forth in the federal complaints and assert common law fraud
and the violation of certain California statutes. The Company believes that
the allegations are without merit and intends to defend against these
allegations vigorously. No assurance as to the outcome of this matter can be
given, however, an unfavorable resolution of this matter could have a
material adverse effect on the Company's business, results of operations and
financial condition.
23
<PAGE>
ITEM 6.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS - SUPPLEMENTAL
This Report on Form 8-K contains forward-looking statements within
the meaning of Section 27A of the Securities Act of 1933, as amended, and
Section 21E of the Securities Exchange Act of 1934, as amended. Prospective
investors are cautioned that such statements are only predictions and that
actual events or results may differ materially. Forward-looking statements
usually contain the words "estimate," "anticipate," "believe", "expect" or
similar expressions. All forward-looking statements are inherently uncertain
as they are based on various expectations and assumptions concerning future
events and are subject to numerous known and unknown risks and uncertainties.
The forward-looking statements included herein are based on current
expectations and entail various risks and uncertainties as those set forth
herein and the Company's other SEC filings, including those more fully set
forth in the "Risk Factors," "Management's Discussion and Analysis of
Financial Condition and Results of Operations" and other sections of the
Company's Form 10-KSB, as amended, for the most recently completed fiscal
year on file with the SEC. These risks and uncertainties could cause the
Company's actual results to differ materially from those projected in the
forward-looking statements. The Company disclaims any obligation to update or
publicly announce revisions to any such statements to reflect future events
or developments.
OVERVIEW
The Company designs, implements, supports and manages advanced computer
network systems primarily for hospitals, integrated delivery networks (IDNs")
and other provider organizations. The Company's design services include an
assessment of the customer's existing computer network system, the
preparation of voice, video and data network specifications, technical design
documentation and diagrams. DAOU's implementation services include the
purchase, delivery and installation of enterprise-wide computer network
systems. Implementation service revenues consist of third-party hardware and
software products, as well as the Company's professional services. The
Company's gross margin with respect to implementation services varies
significantly depending on the percentage of such services consisting of
products (with respect to which the Company obtains a lower margin) versus
professional services. Also, the Company often hires employees in anticipation
of commencement of a project and if delays in contract signing occur the
Company's gross margin could vary due to the associated loss of revenues to
cover fixed labor costs. The Company's support and management services
include remote and on-site network management, as well as I/S function
outsourcing. The Company typically provides these services under multi-year
contracts.
In June 1998, the Company acquired Technology Management, Inc. and
Affiliate ("TMI") and Resources in Healthcare Innovations, Inc. and
Affiliates ("RHI"). In March 1998, the Company acquired Sentient Systems,
Inc. ("Sentient") and Synexus Incorporated ("Synexus"). The acquisitions were
accounted for using the pooling-of-interests method of accounting and,
accordingly, the supplemental consolidated financial statements reflect the
combined financial position and operating results for the Company, Sentient,
Synexus, TMI and RHI for all periods presented giving retroactive effect to
the pooling transactions. These supplemental consolidated financial
statements will become the historical consolidated financial statements of
the Company upon the issuance of financial statements for the period that
includes the date of the merger. During March 1998 and June 1998, the Company
recorded merger related costs totaling $1,722,000 and $2,882,000,
respectively, net of related tax effects, incurred in connection with these
acquisitions.
In July 1997, the Company acquired through a pooling-of-interests merger
all of the issued and outstanding shares of Integrex in exchange for 700,000
shares of Common Stock. DAOU-Integrex provides advanced network
design,integration and consulting support services primarily to healthcare
organizations, as well as to educational and governmental institutions.
DAOU-Integrex specializes in the design and integration of voice and video
networks and designs integrated cable plants capable of supporting voice,
video and high-speed data transmission. In addition, in September 1997, the
Company similarly acquired On-Line in exchange for 150,000 shares of Common
Stock. DAOU On-Line services local area computer and voice network systems,
provides other telecommunications infrastructure applications and sells
network services related to those
24
<PAGE>
activities. The Company recorded merger related costs of approximately
$1,068,000 (net of tax charge of $350,000). The Company's Supplemental
Consolidated Financial Statements and Notes thereto reflect the combined
financial position and operating results for the Company, Integrex, On-Line
Synexus, Sentient, TMI, and RHI for all periods presented in this Report.
Candler Health Systems ("Candler"), a large I/S outsourcing customer of
the Company, terminated its contract with the Company effective November 30,
1997. In addition to revenue from specified services under the Candler
contract, the Company recognized revenue of approximately $100,000, $200,000
and $300,000 during the second, third and fourth quarters of 1997,
respectively, as a result of the termination fee payable by Candler under the
contract.
Historically, the majority of the Company's revenues have been derived
from network design and implementation services which are generally provided
on a fixed-fee basis. These revenues are recognized using the
percentage-of-completion method with progress to completion measured by labor
costs incurred to date compared to total estimated labor costs. The Company
may also provide services on a "time and expense" basis for which revenues
are also recognized as the services are performed. A design project typically
lasts from three to five months. The time to complete implementation projects
generally ranges from three to six months, although certain projects have
required up to 13 months for completion.
Support and management service revenues are recognized ratably over the
period that these services are provided. The Company anticipates that
revenues from support and management services will increase as a percent of
total revenues in the future. Payments received in advance of services
performed are recorded as deferred revenues. Certain contract payment terms
may result in customer billing occurring at a pace slower than revenue
recognition. The resulting revenues recognized in excess of amounts billed
and project costs are included in contract work in progress on the Company's
balance sheet.
SELECTED SUPPLEMENTAL CONSOLIDATED FINANCIAL DATA.
The following table presents selected supplemental consolidated
financial data of the Company. The information set forth below is not
necessarily indicative of the results of future operations and should be read
in conjunction with the other sections of this Item 6 and the supplemental
consolidated financial statements and the related notes thereto included
elsewhere herein.
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
------------------------------------------------------------------
1993 1994 1995 1996 1997
------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Revenues $17,190 $24,336 $36,448 $50,947 $69,055
Cost of revenues 9,501 15,178 22,583 33,730 45,553
------------------------------------------------------------------
Gross profit 7,689 9,158 13,865 17,217 23,502
25
<PAGE>
Operating expenses:
Sales and marketing 2,165 2,501 2,928 4,166 7,780
General and administrative 4,670 5,300 8,930 9,945 12,425
Merger and related costs - - - - 718
------------------------------------------------------------------
Total operating expenses 6,835 7,801 11,858 14,111 20,923
------------------------------------------------------------------
Income from operations 854 1,357 2,007 3,106 2,579
Interest income (expense),
net (23) 627 193 369 873
------------------------------------------------------------------
Income before income taxes 831 1,984 2,200 3,475 3,452
Provision for income taxes 101 439 889 149 947
------------------------------------------------------------------
Net income 730 1,545 1,311 3,326 2,505
Accretion of preferred stock - - 87 485 -
------------------------------------------------------------------
Net income attributable to
common stock $ 730 $1,545 $1,224 $ 2,841 $ 2,505
------------------------------------------------------------------
Net income per common
share: (1)
Basic $0.06 $0.13 $0.10 $0.23 $0.15
------------------------------------------------------------------
Diluted $0.06 $0.13 $0.10 $0.23 $0.15
------------------------------------------------------------------
Shares used in computing
net income per common
share:
Basic 11,876 12,251 12,260 12,580 16,231
------------------------------------------------------------------
Diluted 11,876 12,251 12,548 14,385 17,246
------------------------------------------------------------------
Cash, cash equivalents and
short-term investments $1,038 $1,847 $7,493 $3,962 $18,288
Total assets 4,722 7,010 19,735 21,672 54,110
Long term debt, less current 155 64 45 32 49
Redeemable preferred stock - - 7,705 8,190 -
Total stockholders equity 1,107 2,009 3,498 6,304 41,837
</TABLE>
(1) See Note 1 of Notes to Supplemental Consolidated Financial Statements for
information concerning the calculation of net income per share.
RESULTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 1997 AND 1996
The Company's revenues were $69.1 million and $50.9 million for the
years ended December 31, 1997 and 1996, respectively, representing an
increase of approximately 36%. Revenues increased primarily due to the I/S
outsourcing services which the Company began providing during April of 1996.
Cost of revenues for the years ended December 31, 1997 and 1996 were
$45.6 million and $33.7 million, respectively, representing an increase of
approximately 35%. Gross margin for the years ended December 31, 1997 and
1996, remained relatively constant at approximately 34%.
Sales and marketing expenses were $7.8 million and $4.2 million for the
years ended December 31, 1997 and 1996, respectively, representing an
increase of approximately 87%. This increase was primarily due to the further
implementation of a regional sales structure, an increase in sales personnel
and the expansion of the Company's marketing programs. Sales and marketing
expenses were approximately 11% and 8% of total revenues for the years ended
December 31, 1997 and 1996, respectively. The Company expects that sales and
marketing expenses will continue to increase in dollar terms to support the
anticipated growth in the Company's business.
General and administrative expenses were $12.4 million (excluding
26
<PAGE>
one-time merger costs of $718,000) and $9.9 million for the years ended
December 31, 1997 and 1996, respectively, representing an increase of
approximately 25%. The primary factors contributing to this increase were
costs associated with the implementation of the Company's management
information system, the addition of senior management and other
infrastructure requirements. General and administrative expenses were
approximately 18% and 20% of total revenues for the years ended December 31,
1997 and 1996, respectively. The Company expects general and administrative
expenses to continue to increase in dollar terms to support the anticipated
growth in the Company's business.
Net interest income was $873,000 and $369,000 for the years ended
December 31, 1997 and 1996, respectively. Interest income consisted of
interest on cash and cash equivalents and short-term investments. Interest
expense consisted of interest associated with the Company's business line of
credit and term financing of insurance premiums but was not significant
during either period.
YEARS ENDED DECEMBER 31, 1996 AND 1995
The Company's revenues were $50.9 million and $36.4 million for the
years ended December 31, 1996 and 1995, respectively, representing an
increase of approximately 40%. Revenues increased primarily due to the
introduction of the Company's I/S outsourcing services under the Candler
contract in April 1996. Services to Catholic Medical Center of Brooklyn
accounted for approximately $4.1 million of total revenues in 1996,
representing approximately 8% of total revenues.
Cost of revenues was $33.7 million and $22.6 million for the years ended
December 31, 1996 and 1995, respectively, representing an increase of
approximately 49%. Gross margin was 34% and 38% for the years ended December
31, 1996 and 1995, respectively. This decrease in gross margin was primarily
due to the increased content of professional services in certain
implementation projects during 1995, as well as the lower gross margin
related to the Company's I/S outsourcing services initiated in 1996.
Sales and marketing expenses were $4.2 million and $2.9 million for the
years ended December 31, 1996 and 1995, respectively, representing an
increase of approximately 42%. This increase was primarily due to the
establishment of a regional sales structure, an increase in sales and
marketing personnel and the expansion of the Company's marketing programs.
Sales and marketing expenses were approximately 8% of revenues for the
years ended December 31, 1996 and 1995.
General and administrative expenses were $9.9 million and $8.9 million
for the years ended December 31, 1996 and 1995, respectively, representing an
increase of approximately 11%. The primary factors contributing to this
increase were costs associated with the Company's larger corporate facility,
implementation of a management information system and the addition of senior
management during 1996. General and administrative expenses were
approximately 20% and 25% of revenues for the years ended December 31, 1996
and 1995, respectively.
Net interest income was $369,000 and $193,000 for the years ended
December 31, 1996 and 1995, respectively. Interest income consists of
interest on short-term investments, cash and cash equivalents and notes
receivable from officers and stockholders. Interest expense consists of
interest associated with the Company's business line of credit and term
27
<PAGE>
financing of insurance premiums, but was not significant during either period.
INCOME TAXES
In 1997, 1996 and 1995, the effective tax rates were approximately 27%,
4% and 40%, respectively, and were different than the expected combined
federal statutory rate of 35% primarily due to the fact that Integrex,
Sentient, Synexus, TMI and RHI were S-corporations prior to their respective
mergers with DAOU. Consequently, taxes on the income of these entities were
the direct responsibility of its stockholders. In 1996, the benefit of
Integrex's lower tax rate was partially offset by the amortization expense
related to compensatory stock options granted by the Company during 1996 and
additional taxes on the conversion of S-corporation to C-corporation.
LIQUIDITY AND CAPITAL RESOURCES
On December 31, 1997, the Company had working capital of $39.6 million,
an increase of $26.2 million from $13.4 million on December 31, 1996. This
increase was due primarily to the Company's initial public offering of Common
Stock in February 1997 which raised $15.8 million, net of issuance costs, and
the Company's secondary public offering in August 1997 which raised $9.3
million, net of issuance costs. For the year ended December 31, 1997, cash
used in operating activities was $8.4 million which resulted primarily from
an increase in the Company's investment in contract work in process and
accounts receivable due to growth in revenues.
The Company believes that its available funds will be sufficient to meet
its capital requirements for the foreseeable future. The Company may sell
additional equity or debt securities or obtain additional credit facilities.
The sale of additional equity securities or issuance of equity securities in
future acquisitions could result in additional dilution to the Company's
stockholders, and the incurrence of additional debt could result in
additional interest expense.
YEAR 2000
The Company provides information, communications technology and
services to its customers and must therefore address two critical areas of
Year 2000 readiness: i) internal readiness; and, ii) external system
readiness. The Company is currently conducting a detailed assessment of its
internal Year 2000 status and developing an aggressive action plan to address
all required upgrades in computer systems, applications, equipment and
facilities. This assessment and plan includes an ongoing review of the
Company and its Subsidiaries information systems and the integration of these
systems into the existing Year 2000 ready systems. The current plan calls for
complete internal readiness by April 1999. Financial impact for internal
compliance should be minimal. The Company's current internal equipment and
applications are substantially compliant and the costs to integrate the
subsidiary applications were planned for as part of the recent mergers.
The Company is initiating communications with its critical external
relationships including customers and suppliers to determine the extent to
which the Company may be vulnerable to such parties' failure to resolve their
own Year 2000 issues. Where practicable, the Company will assess and attempt
to mitigate its risks with respect to the failure of these entities to be
Year 2000 ready. The effect if any, on the Company's results of operations
from the failure of such parties to be Year 2000 ready, is not reasonably
estimable.
28
<PAGE>
The costs of the project and the date on which the Company plans to
complete the Year 2000 modifications are based on management's best
estimates, which were derived utilizing numerous assumptions of future events
including the continued availability of certain resources, third party
modification plans and other factors. However, there can be no guarantee that
these estimates will be achieved and actual results could differ materially
from those plans. Specific factors that might cause such material differences
include, but are not limited to, availability and cost of personnel trained
in this area and the ability to locate and correct all relevant computer
systems.
29
<PAGE>
ITEM 7. FINANCIAL STATEMENTS AND EXHIBITS
(c) Exhibits.
The following exhibits are filed herewith or incorporated by reference
as part of this report:
<TABLE>
<CAPTION>
Exhibit
No. Document Description
- ------------ -----------------------------------------------------------------
<S> <C>
23.1 Consent of Ernst & Young LLP, Independent Auditors
23.2 Consent of Deloitte & Touche LLP, Independent Auditors
23.3 Consent of PricewaterhouseCoopers LLP, Independent Accountants
27.1 Financial Data Schedule for the period ended December 31, 1997 (Restated)
27.2 Financial Data Schedule for the period ended December 31, 1996 (Restated)
27.3 Financial Data Schedule for the period ended December 31, 1995 (Restated)
</TABLE>
30
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities and Exchange Act of 1934,
the registrant has duly caused this report to be signed on its behalf by the
undersigned hereunto duly authorized.
Date: November 20, 1998 DAOU SYSTEMS, INC.
By: /s/ FRED C. MCGEE
----------------------------------------
Fred C. McGee, Chief Financial Officer
31
<PAGE>
EXHIBIT INDEX
<TABLE>
<CAPTION>
Exhibit
No. Document Description
- -------------- ---------------------------------------------------------------
<S> <C>
23.1 Consent of Ernst & Young LLP, Independent Auditors
23.2 Consent of Deloitte & Touche LLP, Independent Auditors
23.3 Consent of PricewaterhouseCoopers LLP, Independent Accountants
27.1 Financial Data Schedule for the period ended December 31, 1997 (Restated)
27.2 Financial Data Schedule for the period ended December 31, 1996 (Restated)
27.3 Financial Data Schedule for the period ended December 31, 1995 (Restated)
</TABLE>
32
<PAGE>
Exhibit 23.1
CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
We consent to the incorporation by reference in the Registration Statement
Form S-8 (No. 333-29745, No. 333-40393 and No. 333-59795) pertaining to the
1996 Stock Option Plan of DAOU Systems, Inc. of our report dated August 4, 1998
with respect to the supplemental consolidated financial statements of
DAOU Systems, Inc. included in its Current Report on Form 8-K dated
November 20, 1998 filed with the Securities and Exchange Commission.
/s/ ERNST & YOUNG LLP
San Diego, California
November 19, 1998
<PAGE>
Exhibit 23.2
INDEPENDENT AUDITORS' CONSENT
We consent to the incorporation by reference in Registration Statements No.
333-40393, No. 333-29745 and No. 333-59795 of DAOU Systems, Inc. on Form S-8
of our report dated February 13, 1998 (relating to the financial statements
of Sentient Systems, Inc. not presented separately herein) appearing in this
Form 8-K of DAOU Systems, Inc.
/s/DELOITTE & TOUCHE LLP
McLean, Virginia
November 20, 1998
<PAGE>
Exhibit 23.3
CONSENT OF INDEPENDENT ACCOUNTANTS
We consent to the incorporation by reference in the registration statements
on Form S-8 of DAOU Systems, Inc. (File Nos. 333-40393, 333-29745 and
333-59795) of our report, dated March 8, 1996, on our audit of the finacial
statements of Sentient Systems, Inc. as of November 30, 1995 and for the year
then ended, which report is included in this current report on Form 8-K for
DAOU Systems, Inc.
/s/ PricewaterhouseCoopers LLP
McLean, Virginia
November 19, 1998
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> DEC-31-1997
<CASH> 7,981
<SECURITIES> 10,307
<RECEIVABLES> 16,056
<ALLOWANCES> 312
<INVENTORY> 13,291
<CURRENT-ASSETS> 49,412
<PP&E> 6,801
<DEPRECIATION> 2,942
<TOTAL-ASSETS> 54,110
<CURRENT-LIABILITIES> 9,839
<BONDS> 0
0
0
<COMMON> 17
<OTHER-SE> 41,820
<TOTAL-LIABILITY-AND-EQUITY> 54,110
<SALES> 69,055
<TOTAL-REVENUES> 69,055
<CGS> 45,553
<TOTAL-COSTS> 45,553
<OTHER-EXPENSES> 20,923
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 3,452
<INCOME-TAX> 947
<INCOME-CONTINUING> 2,505
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 2,505
<EPS-PRIMARY> 0.15
<EPS-DILUTED> 0.15
</TABLE>
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1996
<PERIOD-START> JAN-01-1996
<PERIOD-END> DEC-31-1996
<CASH> 3,123
<SECURITIES> 839
<RECEIVABLES> 10,754
<ALLOWANCES> 310
<INVENTORY> 4,122
<CURRENT-ASSETS> 19,386
<PP&E> 3,793
<DEPRECIATION> 2,032
<TOTAL-ASSETS> 21,672
<CURRENT-LIABILITIES> 5,937
<BONDS> 0
8,190
0
<COMMON> 13
<OTHER-SE> 6,291
<TOTAL-LIABILITY-AND-EQUITY> 21,672
<SALES> 50,947
<TOTAL-REVENUES> 50,947
<CGS> 33,730
<TOTAL-COSTS> 33,730
<OTHER-EXPENSES> 14,111
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 3,475
<INCOME-TAX> 149
<INCOME-CONTINUING> 3,326
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 3,326
<EPS-PRIMARY> 0.23
<EPS-DILUTED> 0.23
</TABLE>
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1995
<PERIOD-START> JAN-01-1995
<PERIOD-END> DEC-31-1995
<CASH> 0
<SECURITIES> 0
<RECEIVABLES> 0
<ALLOWANCES> 0
<INVENTORY> 0
<CURRENT-ASSETS> 0
<PP&E> 0
<DEPRECIATION> 0
<TOTAL-ASSETS> 0
<CURRENT-LIABILITIES> 0
<BONDS> 0
0
0
<COMMON> 0
<OTHER-SE> 0
<TOTAL-LIABILITY-AND-EQUITY> 0
<SALES> 36,448
<TOTAL-REVENUES> 36,448
<CGS> 22,583
<TOTAL-COSTS> 22,583
<OTHER-EXPENSES> 11,858
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 2,200
<INCOME-TAX> 889
<INCOME-CONTINUING> 1,311
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 1,311
<EPS-PRIMARY> 0.10
<EPS-DILUTED> 0.10
</TABLE>
