<PAGE>
UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-Q
/X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the quarterly period ended September 30, 1998
OR
/ / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from ______________ to ___________,
Commission File No.: 000-22073
DAOU SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
Delaware 330284454
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
5120 Shoreham Place
San Diego, California 92122
(Address of principal executive offices) (Zip Code)
(619) 452-2221
(Registrant's telephone number, including area code)
Indicate by check mark whether the 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 the
registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days:
Yes XX No
The number of shares of Registrant's Common Stock outstanding as of September
30, 1998:
17,685,722
Page 1
<PAGE>
DAOU SYSTEMS, INC.
Index to Form 10-Q
<TABLE>
<CAPTION>
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements Page
<S> <C>
Condensed Consolidated Balance Sheets (unaudited)
at September 30, 1998 and December 31, 1997 3
Condensed Consolidated Statements of Operations (unaudited) for the
Three Months and Nine Months Ended September 30, 1998 and 1997 4
Condensed Consolidated Statements of Cash Flows (unaudited) for the
Nine Months Ended September 30, 1998 and 1997 5
Notes to Condensed Consolidated Financial Statements 6-9
Item 2. Management's Discussion and Analysis of
Financial Condition and Results of Operations 10-12
PART II. OTHER INFORMATION 13
Item 1. Legal Proceedings 13
Item 2. Changes in Securities and Use of Proceeds 13
Item 6. Exhibits and Reports on Form 8-K 13-14
SIGNATURES 15
</TABLE>
Page 2
<PAGE>
PART I. FINANCIAL INFORMATION
Item 1. Condensed Consolidated Financial Statements
DAOU SYSTEMS, INC.
CONDENSED CONSOLIDATED BALANCE SHEETS
(IN THOUSANDS, EXCEPT FOR PER SHARE DATA)
(unaudited)
ASSETS
<TABLE>
<CAPTION>
SEPTEMBER 30, DECEMBER 31,
1998 1997
------------ ------------
<S> <C> <C>
Current assets
Cash and cash equivalents $ 2,140 $ 7,981
Short-term investments 2,821 10,307
Accounts receivable, net 30,536 15,744
Contract work in progress 12,342 13,291
Other current assets 2,198 2,089
-------- --------
Total current assets 50,037 49,412
Equipment, furniture and fixtures, net 4,848 3,859
Other assets 741 839
-------- --------
$ 55,626 $ 54,110
-------- --------
-------- --------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities
Accounts payable and other accrued liabilities $ 6,529 $ 5,727
Accrued salaries and wages 4,201 2,675
Current portion of lines of credit and
long-term debt 4,708 1,437
-------- --------
Total current liabilities 15,438 9,839
Long-term liabilities 3,310 2,434
Commitments and contingencies
Stockholders' equity
Preferred stock, $.001 par value
Authorized shares - 5,000
Issued and outstanding - none - -
Common stock, $.001 par value
Authorized shares - 50,000
Issued and outstanding - 17,686 and 16,945
at September 30, 1998 and December 31,
1997, respectively 18 17
Additional paid-in capital 37,407 36,040
Deferred compensation (713) (907)
Unrealized gain on short-term investments 4 146
Retained earnings 162 6,541
-------- --------
Total stockholders' equity 36,878 41,837
-------- --------
$ 55,626 $ 54,110
-------- --------
-------- --------
</TABLE>
See accompanying notes.
Page 3
<PAGE>
DAOU SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS
(IN THOUSANDS, EXCEPT FOR PER SHARE DATA)
(UNAUDITED)
<TABLE>
<CAPTION>
PERIODS ENDED SEPTEMBER 30,
THREE MONTHS NINE MONTHS
1998 1997 1998 1997
-------- -------- -------- --------
<S> <C> <C> <C> <C>
Revenues $ 27,351 $ 18,540 $ 79,379 $ 46,485
Cost of revenues 22,905 12,316 56,340 30,961
-------- -------- -------- --------
Gross profit 4,446 6,224 23,039 15,524
Operating expenses:
Sales and marketing 3,536 1,725 9,338 5,572
General and administrative 5,606 2,569 12,279 7,507
Merger and related costs - 684 2,825 684
-------- -------- -------- --------
Total operating expenses 9,142 4,978 24,442 13,763
-------- -------- -------- --------
Income(loss)from operations (4,696) 1,246 (1,403) 1,761
Other income (expense), net (177) 249 (50) 621
-------- -------- -------- --------
Income (loss) before income taxes (4,873) 1,495 (1,453) 2,382
Provision (benefit)for income taxes (1,785) 705 1,325 799
-------- -------- -------- --------
Net income(loss) $ (3,088) $ 790 $ (2,778) $ 1,583
-------- -------- -------- --------
-------- -------- -------- --------
Net income(loss) per share:
Basic $ (.17) $ .05 $ (.16) $ .10
-------- -------- -------- --------
-------- -------- -------- --------
Diluted $ (.17) $ .04 $ (.16) $ .09
-------- -------- -------- --------
-------- -------- -------- --------
Shares used in calculation of
net income (loss) per share:
Basic 17,681 16,878 17,640 16,062
-------- -------- -------- --------
-------- -------- -------- --------
Diluted 17,681 17,933 17,640 16,956
-------- -------- -------- --------
-------- -------- -------- --------
</TABLE>
See accompanying notes.
Page 4
<PAGE>
DAOU SYSTEMS, INC.
CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS
(IN THOUSANDS)
(UNAUDITED)
<TABLE>
<CAPTION>
NINE MONTHS ENDED SEPTEMBER 30,
1998 1997
-------- --------
<S> <C> <C>
Operating activities:
Net income (loss) $(2,778) $1,583
Adjustments to reconcile net income (loss) to net
cash provided by (used in) operating activities:
Depreciation and amortization 1,217 800
Changes in operating assets and liabilities (10,723) (1,257)
------- -------
Net cash (used in) provided by operating
activities (12,284) 1,126
Investing activities:
Additions to equipment, furniture
and fixtures (2,012) (2,361)
Proceeds from (purchases of) short-term
investments 7,344 (9,974)
Changes in other assets 93 (1,499)
------- -------
Net cash provided by (used in)
investing activities 5,425 (13,834)
Financing activities:
Sale of common stock, net 1,368 25,338
Proceeds from lines of credit and long-term debt,
net 3,251 1,994
Distributions to stockholders of acquired companies (3,601) (1,646)
------- -------
Net cash provided by financing activities 1,018 25,686
------- -------
Net (decrease) increase in cash and cash equivalents (5,841) 12,978
Cash and cash equivalents at
beginning of period 7,981 3,123
------- -------
Cash and cash equivalents at
end of period $ 2,140 $16,101
------- -------
------- -------
</TABLE>
See accompanying notes.
Page 5
<PAGE>
DAOU SYSTEMS, INC.
NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
1. Basis of Presentation
The unaudited condensed consolidated financial statements of DAOU Systems,
Inc. ("DAOU" or the "Company") at September 30, 1998 and for the three and
nine-month periods ended September 30, 1998 and 1997 have been prepared in
accordance with generally accepted accounting principles ("GAAP") for interim
financial information. Accordingly, they do not include all information and
footnotes required by GAAP for a complete set of financial statements. These
financial statements reflect all adjustments, consisting of normal recurring
adjustments, which in the opinion of management are necessary to fairly
present the financial position of the Company at September 30, 1998 and the
results of operations for the three and nine-month periods ended September
30, 1998 and 1997. The results of operations for the three and nine months
ended September 30, 1998 are not necessarily indicative of the results to be
expected for the year ending December 31, 1998. For more information, these
financial statements should be read in conjunction with the Company's Form
10-KSB,as amended, and the audited supplemental consolidated financial
statements included in the Company's Current Report on Form 8-K filed with
the Securities and Exchange Commission ("SEC") on May 19, 1998.
2. 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.
3. Acquisitions
During March 1998, the Company acquired Synexus Incorporated ("Synexus"), a
privately-held company specializing in the planning, design and
implementation of enterprise networks in healthcare environments, and
Sentient Systems, Inc. ("Sentient"), a privately-held company that provides
integration and support services primarily to healthcare organizations. The
shareholders of Synexus and Sentient received a total of 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 under 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.
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 of 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 a total of 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 all of the outstanding stock of each
of these companies. The acquisitions have been accounted for under 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.
Page 6
<PAGE>
Separate results for each of DAOU, Sentient, Synexus, TMI (including IHCS),
and RHI (including HTR, URG, ISS and GIC) for the three and nine months ended
September 30, 1998 and 1997 were as follows:
(In thousands)
<TABLE>
<CAPTION>
DAOU SENTIENT SYNEXUS TMI RHI COMBINED
----------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Three months ended September 30, 1998:
Total revenues $14,436 $3,509 $508 $3,039 $5,859 $27,351
Net income (loss) (4,213) 289 64 429 343 (3,088)
Three months ended September 30,
1997:
Total revenues 11,305 2,493 390 1,866 2,486 18,540
Net income (loss) (38) 142 100 532 54 790
Nine months ended September 30,
1998:
Total revenues 45,257 9,873 1,601 8,787 13,861 79,379
Net income (loss) (5,376) 301 174 832 1,291 (2,778)
Nine months ended September 30,
1997:
Total revenues 27,191 7,280 1,204 4,225 6,585 46,485
Net income 255 315 228 445 340 1,583
</TABLE>
In connection with these acquisitions, the Company recorded direct merger and
related costs (before income taxes) during March 1998 and June 1998 totaling
$1.8 million and $1.0 million, respectively. These costs include transaction
costs of approximately $720,000, estimated costs to combine and integrate
operations of approximately $570,000, and other merger related costs of
approximately $1.5 million.
4. Lines of Credit
During September 1998, the Company secured two borrowing facilities, a $2.0
million revolving line of credit, under which none is available for future
borrowings at September 30, 1998, and an additional $8,000,000 line of
credit, under which $6.0 million is available for future borrowings at
September 30, 1998. Advances under both the revolving line of credit and
line of credit bear interest at the bank's prime rate (8.25% at September 30,
1998) plus 0.25% per annum. Through September 30, 1998, borrowings under the
revolving line of credit, which expires July 31, 1999, total approximately
$2.0 million, while borrowings under the line of credit, which expires July
31, 1999, total approximately $2.0 million. These lines of credit are secured
by substantially all of the assets of the Company and contain customary
covenants and restrictions. As of September 30, 1998, the Company was not in
compliance with certain of these covenants and restrictions, however, the
Company has obtained a waiver from the financial institutions for the
violation.
In addition, through its acquisition of RHI (and related companies), the Company
has an additional $700,000 line of credit with a bank, under which outstanding
borrowings totaled $670,000 at September 30, 1998. The $700,000 line of credit
bears interest at prime plus 0.25%, is due on May 1, 1999 and is secured by
all of the assets of RHI.
Page 7
<PAGE>
5. Net Income (Loss) Per Share Information
The following table details the computation of basic and diluted net income
(loss) per share:
(In thousands, except per share information)
<TABLE>
<CAPTION>
THREE MONTHS ENDED NINE MONTHS ENDED
SEPTEMBER 30, SEPTEMBER 30,
1998 1997 1998 1997
------------------------------------------------------------------
<S> <C> <C> <C> <C>
Numerator:
Net income (loss) $ (3,088) $ 790 $ (2,778) $ 1,583
Denominator:
Denominator for basic net income (loss) per share -
weighted average common shares outstanding 17,681 16,878 17,640 16,062
Effect of dilutive securities:
Warrants - 105 - 74
Common stock options - 950 - 642
Convertible preferred stock - - - 178
------------------------------------------------------------------
- 1,055 - 894
------------------------------------------------------------------
Denominator for diluted net income (loss) per
share - adjusted weighted average common shares
outstanding and assumed conversion of preferred stock 17,681 17,933 17,640 16,956
------------------------------------------------------------------
------------------------------------------------------------------
Basic net income (loss) per share $ (.17) $ .05 $ (.16) $ .10
------------------------------------------------------------------
------------------------------------------------------------------
Diluted net income (loss) per share $ (.17) $ .04 $ (.16) $ .09
------------------------------------------------------------------
------------------------------------------------------------------
</TABLE>
Recent interpretations by the SEC of Financial Accounting Standard No. 128,
"Earnings per Share", have changed the treatment of convertible preferred
stock previously included in the computation of basic net income (loss) per
share. For periods prior to its initial public offering ("IPO"), the Company
previously included preferred stock which converted into common stock upon
completion of the IPO as outstanding from the date of original issuance ("as
if converted method") in the computation of basic net income (loss) per share.
To conform with recent interpretations, the effect of assuming the conversion
of these securities prior to their actual conversion in the basic net income
(loss) per share calculation has been excluded.
6. New Accounting Standards
In June 1997, the Financial Accounting Standards Board issued Statement
No. 130, "Reporting Comprehensive Income," and Statement No. 131,
"Disclosures About Segments of an Enterprise and Related Information," both
of which are effective for fiscal periods beginning after December 15, 1997.
The adoption of Statements No. 130 and 131 did not have a material effect on
the Company's financial statements.
Page 8
<PAGE>
Comprehensive income (loss) for the three months ended September 30, 1998 and
1997 totaled $(3,316,000) and $900,000, respectively. Comprehensive income
(loss) for the nine months ended September 30, 1998 and 1997 totaled
$(2,920,000) and $1,750,000, respectively. The difference from reported net
income (loss) arises from the unrealized gains and losses on short-term
investments.
7. Income Tax Expense
The effective income tax rate for the three and nine months ended September
30, 1998 was (37%) and 91%, respectively, due to the non-deductibility of
certain merger and related costs and adjustments made to convert the former S
corporation status of certain acquired businesses to the C corporation status
of the Company.
Page 9
<PAGE>
ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS
This Quarterly Report on Form 10-Q 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
information systems function outsourcing. The Company typically provides
these services under multi-year contracts.
During March 1998, the Company acquired all of the issued and outstanding
shares of Synexus, a privately-held company, that specializes in the
planning, design and implementation of enterprise networks in healthcare
environments, and Sentient, a privately-held company that provides
integration and support services primarily to healthcare organizations. The
shareholders of Synexus and Sentient received a total of 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 under 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.
During June 1998, the Company acquired (i) TMI, a privately-held company that
provides information technology consulting services primarily to the healthcare
industry, (ii) 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) 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) HTR, URG, ISS and GIC, each a privately-held company with common
shareholders with 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 a total of 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 all of the outstanding stock of each of
these companies. The acquisitions have been accounted for under 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.
Results of Operations
The Company's revenues were $27.4 million and $18.5 million for the quarters
ended September 30, 1998 and 1997, respectively, representing an increase of
48%. This increase was due primarily to the increased number of professional
services consulting contracts, which accounted for $5.2 million of the
increase for the three months ended September 30, 1998. Increases in
professional services management contracts ($2.4 million) and large network
implementation contracts ($1.2 million) accounted for the remainder of the
increase. Services to five customers accounted for $5.4 million of total
revenues in this quarter, representing 20% of total revenues. For the nine
months ended September 30, 1998 and 1997, respectively, revenues were $79.4
million and $46.5 million, representing an increase of 71%. This increase was
primarily the result of increased revenues from professional services
consulting contracts ($15.0 million), large network implementation contracts
($12.2 million) and increased revenues in professional services management
contracts ($5.7 million).
Page 10
<PAGE>
Cost of revenues was $22.9 million and $12.3 million for the quarters ended
September 30, 1998 and 1997, respectively, representing an increase of 86%.
Gross margin was 16% and 34% for the quarters ended September 30, 1998 and
1997, respectively. Cost of revenues for the nine-month period ended
September 30, 1998 and 1997 were $56.3 million and $31.0 million,
respectively, which is an increase of 82%. Gross margin for the nine months
ended September 30, 1998 and 1997, was 29% and 33%, respectively. The
decrease in gross margins for the three and nine month periods ended
September 30, 1998 were primarily due to the following: i) an increase in the
product content of the Company's large network implementation contracts, ii)
increased labor costs as a result of delays in project delivery schedules due
to both external and internal customer delays and the associated loss of
revenues to cover the fixed labor costs, iii) an unforeseen requirement on
one fixed price contract to use an alternate labor union at a higher than
projected cost and iv) increased labor costs as a result of a shortfall in
planned revenue which the Company believes was caused by delays in
contract signings due to the negative publicity and shareholder lawsuits
surrounding the Company's accounting practices. The Company's margins were
also affected by a decision to provide additional services on certain fixed
price contracts at no additional cost to certain customers to increase the
probability of closing large long-term professional services management
contracts.
Sales and marketing expenses were $3.5 million and $1.7 million for the
quarters ended September 30, 1998 and 1997, respectively, representing an
increase of 105%. This increase was primarily due to continued development of
a regional sales structure, an increase in sales personnel and related
expenses due to increased sales volume and activity. Sales and marketing
expenses were 13% and 9% of revenues for the quarters ended September 30,
1998 and 1997, respectively. For the nine-month periods ended September 30,
1998 and 1997, sales and marketing expenses were $9.3 million and $5.6
million, respectively, representing 12% of revenues in those periods.
Although the Company believes it can achieve a decrease in these expenses as a
percentage of revenue, the Company also 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 $5.6 million and $2.6 million for
the quarters ended September 30, 1998 and 1997, respectively, representing an
increase of 118%. The primary factors contributing to this increase were
costs associated with additional administrative staffing and other increased
infrastructure requirements to support growth and integration of acquired
companies, increased recruiting costs and increased legal and accounting fees
associated with the negative publicity and shareholder lawsuits surrounding
the Company's accounting practices. General and administrative expenses were
20% and 14% of revenues for the quarters ended September 30, 1998 and 1997,
respectively. General and administrative expenses for the nine-month periods
ended September 30, 1998 and 1997 were $12.3 million and $7.5 million, or 15%
and 16% of revenues, respectively. The Company expects some increase in
general and administrative expenses in dollar terms to support the
anticipated growth in the Company's business and the anticipated integration
of subsidiaries.
Direct merger and related costs totaled $2.8 million during the nine months
ended September 30, 1998, which include costs recorded during the first and
second quarters of 1998 in connection with the acquisitions of Sentient,
Synexus, TMI, IHCS, RHI, HTR, URG, ISS and GIC. The $2.8 million total costs
include transaction fees of approximately $720,000, estimated costs to
combine and integrate operations of approximately $570,000 and other
acquisition related costs of approximately $1.5 million.
Other income (expense), net, was ($177,000) and $249,000 for the quarters
ended September 30, 1998 and 1997, respectively. For the nine-month period
ended September 30, 1998 and 1997, respectively, other income, net, was
($50,000) and $621,000. Other income is primarily interest income on cash and
cash equivalents, and short-term investments. Interest expense consists of
interest associated with the Company's business lines of credit. The
decrease in other income (expense), net, was primarily due to overall lower
average cash reserves available for investment for the three and nine-month
periods ended September 30, 1998 as compared to the same period in 1997.
The effective income tax rate for the three and nine months ended September
30, 1998 was (37%) and 91%, respectively, due to the non-deductibility of
certain merger and related costs and adjustments made relative to the former
S corporation status of certain acquired businesses.
Page 11
<PAGE>
Liquidity and Capital Resources
At September 30, 1998, the Company had working capital of $34.6 million,
which is slightly down from the $39.6 million on December 31, 1997. The
Company has a $2.0 million revolving line of credit, under which none is
available for future borrowings at September 30, 1998. In addition, the
Company has secured an additional $8,000,000 line of credit, of which $6.0
million is available for future borrowings at September 30, 1998. Advances
under both the revolving line of credit and line of credit bear interest at
the bank's reference rate (8.25% at September 30, 1998) plus 0.25% per annum.
Through September 30, 1998, borrowings under the revolving line of credit,
which expires July 31, 1999, are approximately $2.0 million, while borrowings
under the line of credit, which expires July 31, 1999, total approximately
$2.0 million. These lines of credit are secured by substantially all of the
assets of the Company and contain customary covenants and restrictions. As of
September 30, 1998, the Company was not in compliance with certain of these
covenants and restrictions, however, the Company has obtained a waiver from
the financial institutions for the violation. For the nine months ended
September 30, 1998, cash used in operating activities was $12.3 million which
resulted primarily from an increase in the Company's accounts receivable due
to timing of billings.
The Company believes that its present sources of liquidity will be sufficient
to finance operations for the foreseeable future and such sources of
liquidity may be used to fund additional acquisitions of complimentary
businesses, although the Company does not have any specific proposals,
arrangements or understandings with respect to any future acquisitions. The
Company may sell additional equity or debt securities or obtain additional
credit facilities. The sale of additional equity securities or issuance of
same in future acquisitions could result in additional dilution to the
Company's stockholders and the incurrence of debt could result in additional
interest expense.
Business Risks
In addition to the factors addressed in the preceding sections, certain
dynamics of the Company's markets and operations create fluctuations in the
Company's quarterly results. Uncertainty and cost containment in healthcare
and competitive conditions present certain other risks to operating results
which are more fully described in the Company's Form 10-KSB filed with the
Securities and Exchange Commission (SEC) and other SEC filings. Except for
the historical information presented herein, the matters discussed in this
document are forward-looking statements that involve numerous risks and
uncertainties. The Company's actual results could differ materially from
those projected in such forward-looking statements and will depend upon a
number of factors, including those discussed in this document and in prior
SEC filings, press releases and other public filings of the Company.
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.
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.
Page 12
<PAGE>
PART II OTHER INFORMATION
1. Legal Proceedings
On August 24, 1998, August 31, 1998, September 14, 1998 and September 23,
1998, 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 laws based on the alleged improper use of the
percentage-of-completion accounting 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, on October 7, 1998 and October 15, 1998, separate complaints were
filed in the 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 set forth in all of the foregoing
complaints are without merit and intends to defend against these allegations
vigorously. No assurance as to the outcome of this matter can be given,
however, and an unfavorable resolution of this matter could have a material
adverse effect on the Company's business, results of operations and financial
condition.
Item 2. Changes in Securities and Use of Proceeds.
Effective July 24, 1998, the Company issued 1,839,381, 275,662, 282,551,
308,583 and 223,645 shares of Common Stock, respectively, to the former
shareholders of RHI, HTR,URG,ISS and GIC, in exchange for all of the
outstanding capital stock of each of these companies. These share issuance's
were exempt from registration under the Securities Act of 1933, as amended,
pursuant to Section 4(2) thereof.
See Note 3 of Notes to the Condensed Consolidated Financial Statements in
Part I Item 1 of this report for further information concerning these share
issuance's.
Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
<TABLE>
<CAPTION>
Exhibit No. Description
- ----------- -----------
<S> <C>
27.1 Financial Data Schedule
27.2 Financial Data Schedule
(1997 Restated)
</TABLE>
a) On September 8, 1998, a Form 8-K was filed which included audited
financial statements of TMI and affiliate as of December 31, 1997 and
1996 and for the two years then ended and audited financial statements
of RHI and affiliates as of December 31, 1997 and for the year then
ended. Also included was the unaudited pro forma combined condensed
balance sheet at June 30, 1998 and December 31, 1997 and unaudited pro
forma combined condensed statements of operations for the six months
ended June 30, 1998 and the years ended December 31, 1997 and 1996 which
give effect to the acquisition of TMI, IHCS, RHI, HTR, ISS, GIC and URG as
of December 31, 1997 for the combined condensed pro forma balance sheet
and January 1, 1996 for the combined condensed pro forma statements of
operations.
Page 13
<PAGE>
b) On August 31, 1998, a Form 8-K was filed to report the announcement of the
filing of a purported class action lawsuit against the Company and certain
of its directors and officers.
c) On August 7, 1998, a Form 8-K was filed to report that the Company acquired
RHI, HTR, URG, ISS and GIC through the issuance of 1,839,381, 275,662,
282,551, 308,583 and 223,645 shares of the Company's common stock in
exchange for all of the outstanding shares of RHI, HTR, URG, ISS and GIC.
The merger was effective on July 24, 1998 and will be accounted for as a
pooling-of-interests.
d) On August 5, 1998, a Form 8-K was filed to report the unaudited revenue and
net income of the Company for the month ended July 31, 1998.
e) On July 10, 1998, a Form 8-K was filed to report that the Company acquired
TMI and IHCS through the issuance of 1,078,963 and 224,668 shares of the
Company's common stock in exchange for all of the outstanding shares of TMI
and IHCS. The merger was effective on June 25, 1998 and will be accounted
for as a pooling-of-interests.
f) On July 6, 1998, a Form 8-K was filed to report that the Company had
entered into a merger agreement to exchange shares of the Company's common
stock in exchange for all of the outstanding shares of RHI and affiliates.
Page 14
<PAGE>
SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the
registrant has duly caused this report to be signed on its behalf by the
undersigned thereunto duly authorized.
DAOU SYSTEMS, INC.
Date: November 14, 1998 By: /s/ Daniel J. Daou
Daniel J. Daou
President
Date: November 14, 1998 By: /s/ Fred C. McGee
Fred C. McGee
Chief Financial Officer
Page 15
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
REGISTRANT'S FINANCIAL STATEMENTS AS OF AND FOR THE QUARTERS ENDED SEPTEMBER 30,
1998 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> SEP-30-1998
<CASH> 2,140
<SECURITIES> 2,821
<RECEIVABLES> 31,355
<ALLOWANCES> 819
<INVENTORY> 12,342
<CURRENT-ASSETS> 50,037
<PP&E> 8,813
<DEPRECIATION> 3,965
<TOTAL-ASSETS> 55,626
<CURRENT-LIABILITIES> 15,438
<BONDS> 0
0
0
<COMMON> 18
<OTHER-SE> 36,860
<TOTAL-LIABILITY-AND-EQUITY> 55,626
<SALES> 79,379
<TOTAL-REVENUES> 79,379
<CGS> 56,340
<TOTAL-COSTS> 80,782
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 50
<INCOME-PRETAX> (1,453)
<INCOME-TAX> 1,325
<INCOME-CONTINUING> (2,778)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (2,778)
<EPS-PRIMARY> (0.16)
<EPS-DILUTED> (0.16)
</TABLE>
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
REGISTRANT'S FINANCIAL STATEMENTS AS OF AND FOR THE QUARTER ENDED SEPTEMBER 30,
1997 AND IS QUALIFIED IN ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<RESTATED>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> 9-MOS
<FISCAL-YEAR-END> DEC-31-1997
<PERIOD-START> JAN-01-1997
<PERIOD-END> SEP-30-1997
<CASH> 7,981
<SECURITIES> 10,307
<RECEIVABLES> 16,042
<ALLOWANCES> 298
<INVENTORY> 13,291
<CURRENT-ASSETS> 49,412
<PP&E> 6,497
<DEPRECIATION> 2,638
<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> 0
<TOTAL-REVENUES> 46,485
<CGS> 30,961
<TOTAL-COSTS> 44,724
<OTHER-EXPENSES> 0
<LOSS-PROVISION> 0
<INTEREST-EXPENSE> 0
<INCOME-PRETAX> 2,382
<INCOME-TAX> 621
<INCOME-CONTINUING> 2,382
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> 1,583
<EPS-PRIMARY> .10
<EPS-DILUTED> .09
</TABLE>
