<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): March 31, 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 acquisitions of Synexus Incorporated, a Pennsylvania
corporation, on March 31, 1998, and Sentient Systems, Inc., a Maryland
corporation, on March 31, 1998. 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
financial statements will become the historical financial statements of the
Company.
2
<PAGE>
INDEX TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS
<TABLE>
<CAPTION>
DAOU SYSTEMS, INC. Page
<S> <C>
Report of Ernst & Young LLP, Independent Auditors . . . . . . . . . . . . . 4
Report of Deloitte & Touche LLP, Independent Auditors . . . . . . . . . . . 5
Report of Coopers & Lybrand 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. and Synexus Incorporated) 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., Sentient Systems, Inc.
and Synexus Incorporated in March 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 7% for 1997 and 15% for 1996 of the related supplemental
consolidated financial statement totals, and which reflect net income
constituting approximately 77%, 42% and 7% 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
the 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 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 Sentient Systems, Inc. and
Synexus Incorporated, as described in the notes to the supplemental consolidated
financial statements, in conformity with generally accepted accounting
principles.
/s/ ERNST & YOUNG LLP
San Diego, California
February 13, 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, and the one month ended December 31, 1995. 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, and the one month ended December 31, 1995, 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/ Coopers & Lybrand L.L.P.
McLean, Virginia
March 8, 1996
6
<PAGE>
DAOU Systems, Inc.
Supplemental Consolidated Balance Sheets
(IN THOUSANDS, EXCEPT FOR PAR VALUE DATA)
<TABLE>
<CAPTION>
DECEMBER 31,
1997 1996
---------------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $5,699 $2,520
Short-term investments, available-for-sale 9,949 698
Accounts receivable, net of allowance of $202 and
$210 in 1997 and 1996, respectively 12,411 7,901
Contract work in progress 12,412 3,783
Deferred income taxes 320 176
Other current assets 1,713 678
---------------------
Total current assets 42,504 15,756
Due from officers/stockholders 371 228
Equipment, furniture and fixtures, net 3,501 1,548
Deferred income taxes 3 23
Other assets 457 266
---------------------
$46,836 $17,821
---------------------
---------------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Trade accounts payable $1,032 $ 814
Accrued salaries and wages 1,757 1,319
Other accrued liabilities 2,852 1,324
Income taxes payable 5 106
Deferred revenue 369 1,110
Current portion of long-term debt 87 268
---------------------
Total current liabilities 6,102 4,941
Deferred rent 55 92
Long-term debt 49 32
Deferred income taxes 390 -
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 - 13,318 in 1997
and 9,073 in 1996 13 9
Additional paid-in capital 35,828 1,368
Deferred compensation (907) (1,166)
Unrealized gain on short-term investments 143 118
Accretion of redeemable preferred stock - (572)
Retained earnings 5,163 4,809
---------------------
Total stockholders' equity 40,240 4,566
---------------------
$46,836 $17,821
---------------------
---------------------
</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 $53,139 $39,795 $29,005
Cost of revenues 35,572 26,867 17,304
---------------------------------
Gross profit 17,567 12,928 11,701
Operating expenses:
Sales and marketing 6,837 3,487 2,357
General and administrative 9,117 7,811 7,307
Merger and related expenses 718 - -
---------------------------------
16,672 11,298 9,664
---------------------------------
Income from operations 895 1,630 2,037
Interest income, net 841 268 103
---------------------------------
Income before income taxes 1,736 1,898 2,140
Provision for income taxes 834 149 889
---------------------------------
Net income $ 902 $ 1,749 $ 1,251
---------------------------------
---------------------------------
Net income per common share:
Basic $0.07 $0.16 $0.13
---------------------------------
---------------------------------
Diluted $0.07 $0.16 $0.13
---------------------------------
---------------------------------
Shares used in computing net income per
common share:
Basic 12,665 10,646 9,301
---------------------------------
---------------------------------
Diluted 13,491 10,848 9,301
---------------------------------
---------------------------------
</TABLE>
See accompanying notes.
8
<PAGE>
DAOU Systems, Inc.
Supplemental Consolidated Statements of Stockholders' Equity
(IN THOUSANDS)
<TABLE>
<CAPTION>
UNREALIZED
COMMON STOCK ADDITIONAL GAIN ON
------------------ PAID-IN DEFERRED SHORT-TERM
SHARES AMOUNT CAPITAL COMPENSATION INVESTMENTS
-------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Balance at December 31, 1994 9,004 $ 9 $ 78 $ -- $--
Accretion of redeemable preferred stock -- -- -- --
Issuance of common stock in exchange for services 70 -- 23 --
Unrealized gain on short-term investments -- -- -- -- 81
Net income -- -- -- --
---------------------------------------------------------
Balance at December 31, 1995 9,074 9 101 -- 81
Deferred compensation -- -- 1,243 (1,243)
Amortization of deferred compensation -- -- -- 77
Issuance of common stock in exchange for services 35 -- 30 --
Repurchase and retirement of stock (36) -- (6) -- --
Accretion of redeemable preferred stock -- -- -- --
Distribution to Sentient stockholders (NOTE 2) -- -- -- -- --
Unrealized gain on short-term investments -- -- -- -- 44
Adjustment for change in Sentient Systems, Inc.'s year end -- -- -- -- (7)
Net income -- -- -- --
---------------------------------------------------------
Balance at December 31, 1996 9,073 9 1,368 (1,166) 118
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 --
Distribution to Integrex stockholders (NOTE 2) -- -- -- -- --
Distribution to On-Line stockholders (NOTE 2) -- -- -- -- --
Distribution to Sentient stockholders (NOTE 2) -- -- -- -- --
Unrealized gain on short-term investments -- -- -- -- 25
Net income -- -- -- -- --
---------------------------------------------------------
Balance at December 31, 1997 13,318 $ 13 $ 35,828 $ (907) $ 143
---------------------------------------------------------
---------------------------------------------------------
<CAPTION>
ACCRETION OF
REDEEMABLE TOTAL
PREFERRED RETAINED STOCKHOLDERS'
STOCK EARNINGS EQUITY
-------------------------------------
<S> <C> <C> <C>
Balance at December 31, 1994 $ -- $ 2,078 $ 2,165
Accretion of redeemable preferred stock (87) -- (87)
Issuance of common stock in exchange for services -- -- 23
Unrealized gain on short-term investments -- -- 81
Net income -- 1,251 1,251
-------------------------------------
Balance at December 31, 1995 (87) 3,329 3,433
Deferred compensation -- -- --
Amortization of deferred compensation -- -- 77
Issuance of common stock in exchange for services -- -- 30
Repurchase and retirement of stock -- (34) (40)
Accretion of redeemable preferred stock (485) -- (485)
Distribution to Sentient stockholders (NOTE 2) -- (146) (146)
Unrealized gain on short-term investments -- -- 44
Adjustment for change in Sentient Systems, Inc.'s year end -- (89) (96)
Net income -- 1,749 1,749
-------------------------------------
Balance at December 31, 1996 (572) 4,809 4,566
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
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)
Unrealized gain on short-term investments -- -- 25
Net income -- 902 902
-------------------------------------
Balance at December 31, 1997 $ -- $ 5,163 $ 40,240
-------------------------------------
-------------------------------------
</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 $ 902 $ 1,749 $ 1,251
Adjustments to reconcile net income to net cash used in
operating activities:
Depreciation and amortization 1,236 546 451
Provision for uncollectible accounts 60 108 -
Common stock issued in exchange for services - 30 23
Deferred income taxes 269 21 (288)
Changes in operating assets and liabilities:
Accounts receivable (4,571) 138 (6,317)
Contract work in progress (8,629) (3,229) 195
Other current assets (1,045) (566) (77)
Trade accounts payable 218 (496) 485
Accrued salaries and wages 644 (216) 886
Deferred revenue (730) 574 (393)
Other accrued liabilities 1,315 (582) 1,226
Income taxes payable (101) (842) 751
Deferred rent (37) 68 (19)
--------------------------------------
Net cash used in operating activities (10,469) (2,697) (1,826)
INVESTING ACTIVITIES
Purchase of equipment, furniture and fixtures (2,930) (1,120) (562)
Proceeds from sale of assets - - 300
Increase in other asset (183) (96) (5)
Purchase of short-term investments (9,226) (130) (4,178)
Maturities of short-term investments - 3,864 168
Advances to officers/stockholders (143) (17) (306)
Proceeds from repayment of due from officers - - 209
--------------------------------------
Net cash provided by (used in) investing activities (12,482) 2,501 (4,374)
FINANCING ACTIVITIES
Advances (repayments) under the line of credit (205) 20 165
Proceeds from long-term debt 96 96 -
Repayment of long-term debt (60) (87) (50)
Distributions to stockholders of acquired companies (548) (146) -
Proceeds from issuance of common stock and redeemable
preferred stock 26,847 - 7,618
Repurchase of stock - (40) -
--------------------------------------
Net cash provided by (used in) financing activities 26,130 (157) 7,733
--------------------------------------
Increase (decrease) in cash and cash equivalents 3,179 (353) 1,533
Cash and cash equivalents at beginning of year 2,520 2,873 1,340
--------------------------------------
Cash and cash equivalents at end of year $ 5,699 $ 2,520 $ 2,873
--------------------------------------
--------------------------------------
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid during the year for:
Income taxes $ 113 $ 979 $ 425
--------------------------------------
--------------------------------------
Interest $ 31 $ 33 $ 11
--------------------------------------
--------------------------------------
</TABLE>
See accompanying notes.
10
<PAGE>
DAOU Systems, Inc.
Notes To Supplemental Consolidated Financial Statements
December 31, 1997
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
ORGANIZATION
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.
As described more fully in Note 2, in March 1998, the Company acquired all of
the issued and outstanding shares of Sentient Systems, Inc. ("Sentient") and
Synexus Incorporated ("Synexus"), through the Company's wholly-owned
subsidiaries DAOU-Sentient, Inc. and DAOU-Synexus, Inc. The acquisitions
were accounted for as pooling of interests and, accordingly, the supplemental
consolidated financial statements reflect the combined financial position and
operating results for the Company, Sentient and Synexus for all periods
presented giving retroactive effect to the pooling transactions. These
supplemental consolidated financial statements will become the historical
consolidated financial statements of DAOU upon the issuance of financial
statements for the period that includes the date of the merger. The
financial statements included for Sentient for 1997, 1996 and 1995 are for
the years ended December 31, 1997 and 1996 and the year ended November 30,
1995, respectively. During 1996, Sentient changed its fiscal year end from
November 30 to December 31. The month of December 1995 relating to
Sentient's operating activity, during which Sentient had net revenues of
approximately $724,000 and a net loss of approximately $89,000, is included
in the accompanying supplemental consolidated financial statements as an
adjustment to retained earnings.
As described more fully in Note 2, on July 9, 1997 and September 25, 1997, the
Company acquired all of the issued and outstanding shares of Integrex Systems
Corporation ("Integrex") and On-Line Networking, Inc. ("On-Line"), respectively,
through the Company's wholly-owned subsidiaries DAOU-Integrex, Inc. and
DAOU On-Line, Inc. These acquisitions were accounted for using the
pooling-of-interests
11
<PAGE>
DAOU Systems, Inc.
Notes to Supplemental Consolidated Financial Statements (continued)
December 31, 1997
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
method of accounting and, accordingly, the consolidated financial statements
reflect the combined financial position and operating results for the Company,
DAOU-Integrex and DAOU On-Line for all periods presented. All significant
intercompany accounts have been eliminated.
REVENUE RECOGNITION
Contract revenue for the development and implementation of network solutions is
recognized on 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 over the period 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
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.
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 applies Statement of Financial Accounting Standards (SFAS) No. 115,
ACCOUNTING FOR CERTAIN INVESTMENTS IN DEBT AND EQUITY SECURITIES, to value its
investments. Under the Statement, the Company classifies its short-term
investments as "Available-for-Sale" and records such assets at estimated fair
12
<PAGE>
DAOU Systems, Inc.
Notes to Supplemental Consolidated Financial Statements (continued)
December 31, 1997
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
value in the balance sheet with unrealized gains and losses excluded from
earnings and reported in 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,
generally three years. Leasehold improvements are amortized over the estimated
useful lives of the assets or the remaining lease term, whichever is less.
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 SFAS No. 128,
EARNINGS PER SHARE, which supersedes 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.
13
<PAGE>
DAOU Systems, Inc.
Notes to Supplemental Consolidated Financial Statements (continued)
December 31, 1997
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
The following table sets forth the computation of basic and dilutive earnings
per share (IN THOUSANDS, EXCEPT PER SHARE AMOUNTS):
<TABLE>
<CAPTION>
DECEMBER 31,
1997 1996 1995
-------------------------------------
<S> <C> <C> <C>
Net income $902 $1,749 $1,251
-------------------------------------
-------------------------------------
Denominator:
Average common shares outstanding 12,476 9,043 9,013
Effect of assumed conversion of preferred
stock from date of issuance 189 1,603 288
-------------------------------------
Denominator for Basic earnings per share 12,665 10,646 9,301
-------------------------------------
Net effect of dilutive common share
equivalents based on treasury stock method 826 202 -
-------------------------------------
Denominator for Diluted earnings per share 13,491 10,848 9,301
-------------------------------------
-------------------------------------
Net income per share - Basic $0.07 $0.16 $0.13
-------------------------------------
-------------------------------------
Net income per share - Diluted $0.07 $0.16 $0.13
-------------------------------------
-------------------------------------
</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 Accounting Principles 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.
14
<PAGE>
DAOU Systems, Inc.
Notes to Supplemental Consolidated Financial Statements (continued)
December 31, 1997
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
NEW ACCOUNTING STANDARDS
In June 1997, the Financial Accounting Standards Board issued Statement of
Financial Accounting Standards No. 130 ("SFAS No. 130"), REPORTING
COMPREHENSIVE INCOME and Statement of Financial Accounting Standards No. 131,
SEGMENT INFORMATION ("SFAS No. 131"). 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.
2. ACQUISITIONS
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 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. Merger costs, net of tax effects,
related to these acquisitions are estimated at $1,722,000, which will be
recorded during March 1998.
15
<PAGE>
DAOU Systems, Inc.
Notes to Supplemental Consolidated Financial Statements (continued)
December 31, 1997
2. ACQUISITIONS (CONTINUED)
On July 9, 1997, the Company acquired all of the issued and outstanding shares
of 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.
On September 25, 1997, the Company acquired all of the issued and outstanding
shares of 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.
Both the Integrex and On-Line acquisitions were accounted for as
pooling-of-interests 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.
Total revenues and net income (loss) of DAOU, Integrex, On-Line, Synexus, and
Sentient for the three years ended December 31, 1997 were (in thousands):
<TABLE>
<CAPTION>
DAOU INTEGREX ON-LINE SYNEXUS SENTIENT COMBINED
-------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Year ended December 31, 1997
Total revenues $30,606 $5,426 $5,668 $1,578 $9,861 $53,139
Net income (loss) (820) 951 (44) 121 694 902
Year ended December 31, 1996
Total revenues 19,311 4,456 4,616 1,680 9,732 39,795
Net income 83 478 361 97 730 1,749
Year ended December 31, 1995
Total revenues 14,330 2,548 2,985 985 8,157 29,005
Net income (loss) 1,240 179 (301) 50 83 1,251
</TABLE>
Merger costs, net of tax effects, related to the Integrex and On-Line
acquisitions were $1,068,000 (net of tax charge of $350,000).
16
<PAGE>
DAOU Systems, Inc.
Notes to Supplemental Consolidated Financial Statements (continued)
December 31, 1997
3. SHORT-TERM INVESTMENTS, AVAILABLE-FOR-SALE
Short-term investments, available-for-sale, consist of the following (IN
THOUSANDS):
<TABLE>
<CAPTION>
AMORTIZED UNREALIZED TOTAL FAIR
COST GAINS VALUE
---------------------------------------
<S> <C> <C> <C>
DECEMBER 31, 1997
Equity securities $ 660 $143 $ 803
Corporate debt securities 9,146 - 9,146
---------------------------------------
$9,806 $143 $9,949
---------------------------------------
---------------------------------------
DECEMBER 31, 1996
Equity securities $ 580 $118 $ 698
---------------------------------------
---------------------------------------
</TABLE>
At December 31, 1997, short-term investments totaling approximately $9,006,000
mature within one year, with approximately $800,000 maturing in 1999.
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 $5,887 $3,136
Leasehold improvements 171 147
---------------------
6,058 3,283
Less accumulated depreciation and amortization (2,557) (1,735)
---------------------
$3,501 $1,548
---------------------
---------------------
</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 462 698
---------------------
$2,852 $1,324
---------------------
---------------------
</TABLE>
17
<PAGE>
DAOU Systems, Inc.
Notes to Supplemental Consolidated Financial Statements (continued)
December 31, 1997
5. LINE 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, due in full 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. Interest expense for the years
ended December 31, 1997 and 1996 was $18,285 and $3,252, respectively.
6. LONG-TERM DEBT
Long-term debt at December 31, 1997 consists of secured notes payable of On-Line
to a financing company and 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. Interest
expense for the years ended December 31, 1997, 1996 and 1995 was $5,290, $3,691
and $5,684, respectively.
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.
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 $1,096,000, $1,032,000 and $631,000, respectively.
18
<PAGE>
DAOU Systems, Inc.
Notes to Supplemental Consolidated Financial Statements (continued)
December 31, 1997
7. COMMITMENTS (CONTINUED)
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 $1,176
1999 788
2000 691
2001 693
2002 704
---------
$4,052
---------
---------
</TABLE>
LITIGATION
In early 1997, a customer filed a complaint against the Company for breach of
contract alleging damages of $1.1 million, and subsequently increased the claim
to approximately $3 million (SEE NOTE 12).
8. MAJOR CUSTOMERS
Sales to individual customers exceeding 10% or more of revenues in the years
ended December 31 were as follows: during 1996 one customer accounted for 10% of
revenues and during 1995, one customer accounted for 28% of revenues.
9. 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.
19
<PAGE>
DAOU Systems, Inc.
Notes to Supplemental Consolidated Financial Statements (continued)
December 31, 1997
9. REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY (CONTINUED)
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 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 $485,000 and $87,000 in 1996 and 1995, respectively.
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.
20
<PAGE>
DAOU Systems, Inc.
Notes to Supplemental Consolidated Financial Statements (continued)
December 31, 1997
9. 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>
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 WEIGHTED- WEIGHTED-
RANGE OF NUMBER CONTRACTUAL AVERAGE NUMBER 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>
21
<PAGE>
DAOU Systems, Inc.
Notes to Supplemental Consolidated Financial Statements (continued)
December 31, 1997
9. REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY (CONTINUED)
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 0% and 75%; and a weighted-average expected life of the option of seven
years.
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 $ 675 $ 787
------------------------
------------------------
Adjusted pro forma net income per share:
Basic $0.05 $0.07
------------------------
------------------------
Diluted $0.05 $0.07
------------------------
------------------------
</TABLE>
22
<PAGE>
DAOU Systems, Inc.
Notes to Supplemental Consolidated Financial Statements (continued)
December 31, 1997
9. REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY (CONTINUED)
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.
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.
10. 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 $468 $ 66 $907
State 97 62 270
------------------------------------
565 128 1,177
Deferred:
Federal 238 33 (246)
State 31 (12) (42)
------------------------------------
269 21 (288)
------------------------------------
$834 $149 $889
------------------------------------
------------------------------------
</TABLE>
23
<PAGE>
DAOU Systems, Inc.
Notes to Supplemental Consolidated Financial Statements (continued)
December 31, 1997
10. INCOME TAXES (CONTINUED)
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 -
---------------------
473 198
---------------------
Net deferred tax (asset) liability $70 $(195)
---------------------
---------------------
</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 (32.3) (31.0) .8
Nondeductible expenses 18.7 1.8 1.4
Adjustment on conversion of S
corporation to C corporation 30.6 - -
State taxes, net of federal benefit 4.0 2.1 7.1
Other (8.0) - (2.7)
---------------------------------------
48.0% 7.9% 41.6%
---------------------------------------
---------------------------------------
</TABLE>
24
<PAGE>
DAOU Systems, Inc.
Notes to Supplemental Consolidated Financial Statements (continued)
December 31, 1997
11. 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. 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
25
<PAGE>
DAOU Systems, Inc.
Notes to Supplemental Consolidated Financial Statements (continued)
December 31, 1997
11. BENEFIT PLANS (CONTINUED)
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.
12. SUBSEQUENT EVENT (UNAUDITED)
In May 1998, the breach of contract claim discussed in Note 7 was settled for an
amount less than the original $1.1 million claim amount, with both parties
agreeing to undertake certain continuing obligations.
26
<PAGE>
ITEM 6.
MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF
OPERATIONS - SUPPLEMENTAL
THIS REPORT CONTAINS CERTAIN STATEMENTS OF A FORWARD-LOOKING NATURE
RELATING TO FUTURE EVENTS OR THE FUTURE PERFORMANCE OF THE COMPANY. PROSPECTIVE
INVESTORS ARE CAUTIONED THAT SUCH STATEMENTS ARE ONLY PREDICTIONS AND THAT
ACTUAL EVENTS OR RESULTS MAY DIFFER MATERIALLY. IN EVALUATING SUCH STATEMENTS,
PROSPECTIVE INVESTORS SHOULD SPECIFICALLY CONSIDER VARIOUS FACTORS IDENTIFIED IN
THIS REPORT, INCLUDING THE MATTERS SET FORTH ABOVE UNDER THE CAPTION "RISK
FACTORS," WHICH COULD CAUSE ACTUAL RESULTS TO DIFFER MATERIALLY FROM THOSE
INDICATED BY SUCH FORWARD-LOOKING STATEMENTS.
OVERVIEW
The Company designs, implements, supports and manages advanced computer
network systems primarily for hospitals, 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. 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 March 1998, the Company acquired Sentient Systems, Inc. (Sentient) and
Synexus Incorporated (Synexus). The acquisitions were accounted for as a
pooling of interests and, accordingly, the supplemental consolidated financial
statements reflect the combined financial position and operating results for the
Company, Sentient and Synexus 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. The financial statements included for Sentient for
1997, 1996 and 1995 are for the year ended December 31, 1997, the thirteen
months ended December 31, 1996 and the year ended November 30, 1995. During
March 1998, the Company will record merger related costs totaling $1,722,000,
net of related tax effects, expected to be 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
27
<PAGE>
activities. The Company's Consolidated Financial Statements and Notes thereto
reflect the combined financial position and operating results for the Company,
Integrex and On-Line for all periods presented in this Report. The Company
recorded merger related costs of approximately $1,068,000 (net of tax charge of
$350,000).
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 a
total 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 "Management's Discussion and Analysis of Financial
Condition and Results of Operations - Supplemental" in Item 6 of this Report 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 $13,418 $19,572 $29,005 $39,795 $53,139
Cost of revenues 7,664 12,213 17,304 26,867 35,572
------------------------------------------------------------------
Gross profit 5,754 7,359 11,701 12,928 17,567
Operating expenses:
Sales and marketing 1,871 2,216 2,357 3,487 6,837
General and administrative 3,325 4,240 7,307 7,811 9,117
Merger and related costs - - - - 718
------------------------------------------------------------------
Total operating expenses 5,196 6,456 9,664 11,298 16,672
------------------------------------------------------------------
28
<PAGE>
Income from operations 558 903 2,037 1,630 895
Interest income (expense),net (67) 583 103 268 841
------------------------------------------------------------------
Income before income taxes 491 1,486 2,140 1,898 1,736
Provision for income taxes 101 439 889 149 834
------------------------------------------------------------------
Net income 390 1,047 1,251 1,749 902
Accretion of preferred stock - - 87 485 -
------------------------------------------------------------------
Net income attributable to
common stock $ 390 $1,047 $1,164 $ 1,264 $ 902
------------------------------------------------------------------
Net income per common share: (1)
Basic $0.05 $0.12 $0.13 $0.16 $0.07
------------------------------------------------------------------
Diluted $0.05 $0.12 $0.13 $0.16 $0.07
------------------------------------------------------------------
Shares used in computing net income
per common share:
Basic 8,629 9,004 9,301 10,646 12,665
------------------------------------------------------------------
Diluted 8,629 9,004 9,301 10,848 13,491
------------------------------------------------------------------
Cash, cash equivalents and short
term investments $ 751 $1,560 $7,261 $3,218 $15,648
Total assets 4,329 5,350 17,579 17,821 46,836
Long term debt, less current 155 64 45 32 49
Redeemable preferred stock - - 7,705 8,190 -
Total stockholders equity 702 2,018 3,432 4,566 40,240
</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 $53.1 million and $39.8 million for the years
ended December 31, 1997 and 1996, respectively, representing an increase of
approximately 34%. Revenues increased primarily due to the I/S outsourcing
services which the Company began providing during the second quarter of 1996.
Cost of revenues for the years ended December 31, 1997 and 1996 were $35.6
million and $26.9 million, respectively, representing an increase of
approximately 32%. Gross margin for the years ended December 31, 1997 and 1996,
remained relatively constant at approximately 33% and 32%, respectively.
Sales and marketing expenses were $6.8 million and $3.5 million for the
years ended December 31, 1997 and 1996, respectively, representing an increase
of approximately 96%. 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 13% and 9% 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 $9.1 million (excluding
29
<PAGE>
one-time merger costs of $718,000) and $7.8 million for the years ended December
31, 1997 and 1996, respectively, representing an increase of approximately 17%.
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 17% 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 $841,000 and $268,000 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, term financing
of insurance premiums, and auto loans from Ford Motor Credit Corporation, but
was not significant during either period.
YEARS ENDED DECEMBER 31, 1996 AND 1995
The Company's revenues were $39.8 million and $29.0 million for the years
ended December 31, 1996 and 1995, respectively, representing an increase of
approximately 37%. Revenues increased primarily due to the introduction of the
Company's I/S outsourcing services under the Candler contract in April 1996.
Services to CMC accounted for approximately $4.1 million of total revenues in
1996, representing approximately 10% of total revenues, respectively.
Cost of revenues was $26.9 million and $17.3 million for the years ended
December 31, 1996 and 1995, respectively, representing an increase of
approximately 55%. Gross margin was 32% and 40% 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 $3.5 million and $2.4 million for the
years ended December 31, 1996 and 1995, respectively, representing an increase
of approximately 48%. 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 9% and 8% of revenues for the years ended December 31, 1996 and
1995, respectively.
General and administrative expenses were $7.8 million and $7.3 million for
the years ended December 31, 1996 and 1995, respectively, representing an
increase of approximately 7%. 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 $268,000 and $103,000 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
30
<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
48%, 8% and 42%, respectively, and were different than the expected combined
federal statutory rate of 35% primarily due to the fact that Integrex, Sentient
and Synexus were S-corporations prior to the merger 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 $36.4 million, an
increase of $25.6 million from $10.8 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 $10.5 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.
POTENTIAL "YEAR 2000" PROBLEMS
POTENTIAL "YEAR 2000" PROBLEMS. It is possible that the Company's
currently installed computer systems, software products or other
businesssystems, or those of its suppliers or customers, will not always accept
input of, store, manipulate or output dates in the years 1999, 2000 or
thereafter without error or interruption. DAOU has conducted a review of its
business systems, including its computer systems, to attempt to identify ways in
which its systems could be affected by problems in correctly processing date
information. Based on this review, the Company does not expect the Year 2000
issue to have a material adverse effect on its operations. In addition, the
Company is requesting assurances from all software vendors from which it has
purchased or from which it may purchase software that the software sold to the
Company will correctly process all date information at all times and the Company
is querying its customers and suppliers as to their progress in identifying and
addressing problems that their computer systems will face in correctly
processing date information as the year 2000 approaches and is reached.
However, there can be no assurance that DAOU will identify all date-handling
problems in its business systems or those of its customers and suppliers in
advance of their occurrence or that DAOU will be able to successfully remedy
problems that are discovered. The expenses of the Company 's efforts to
identify and
31
<PAGE>
address such problems, or the expenses or liabilities to which the
Company may become subject as a result of such problems, could have a material
adverse effect on the Company's business, results of operations and financial
condition.
32
<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 Coopers & Lybrand LLP, Independent Accountants
27.1 Financial Data Schedule for the period ended December 31, 1997
27.2 Financial Data Schedule for the period ended December 31, 1996
27.3 Financial Data Schedule for the period ended December 31, 1995
</TABLE>
33
<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: May 18, 1998 DAOU SYSTEMS, INC.
By: /s/ FRED C. MCGEE
----------------------------------------
Fred C. McGee, Chief Financial Officer
<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 Coopers & Lybrand LLP, Independent Accountants
27.1 Financial Data Schedule for the period ended December 31, 1997
27.2 Financial Data Schedule for the period ended December 31, 1996
27.3 Financial Data Schedule for the period ended December 31, 1995
</TABLE>
<PAGE>
CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
We consent to the incorporation by reference in the Registration Statement Form
S-8 (No. 333-29745 and No. 333-40393) pertaining to the 1996 Stock Option Plan
of DAOU Systems, Inc. of our report dated February 13, 1998 with respect to the
supplemental consolidated financial statements of DAOU Systems, Inc. included
in its Current Report on Form 8-K dated May 18, 1998 filed with the Securities
and Exchange Commission.
/s/ ERNST & YOUNG LLP
San Diego, California
May 15, 1998
<PAGE>
Exhibit 23.2
INDEPENDENT AUDITORS' CONSENT
We consent to the incorporation by reference in Registration Statements
No. 333-40393 and No. 333-29745 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.
DELOITTE & TOUCHE LLP
McLean, Virginia
May 15, 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 and 333-29745) of our
report, dated March 8, 1996, on our audit of the financial 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/ Coopers & Lybrand L.L.P.
McLean, Virginia
May 18, 1998
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