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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
/X/ ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
FOR THE FISCAL YEAR ENDED DECEMBER 31, 1998
/ / 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.: 0-22073
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)
Registrant's telephone number, including area code: (619) 452-2221
Securities registered pursuant to Section 12(b) of the Act:
NONE
Securities registered pursuant to Section 12(g) of the Act:
COMMON STOCK, $0.001 PAR VALUE PER SHARE
(Title of Class)
Indicate by check mark whether Registrant (1) has filed all reports
required to be filed by Section 13 or 15(d) of the Securities Exchange Act of
1934 during the preceding 12 months (or for such shorter periods that the
Registrant was required to file such reports), and (2) has been subject to
such filing requirements for the past 90 days. YES X NO
Indicate by check mark if disclosure of delinquent filers pursuant
to Item 405 of Regulation S-K is not contained herein, and will not be
contained, to the best of Registrant's knowledge, in definitive proxy or
information statements incorporated by reference in Part III of this Form
10-K or any amendment to this Form 10-K. / /
The aggregate market value of the voting stock held by non-affiliates
of the Registrant as of March 23, 1999 was $77,842,812.
As of March 23, 1999, the number of issued and outstanding shares of
the Registrant's Common Stock was 17,689,728.
DOCUMENTS INCORPORATED BY REFERENCE
Registrant's definitive Proxy Statement which will be filed with the
Securities and Exchange Commission on or before April 30, 1998 in connection
with Registrant's annual meeting of stockholders to be held on May 19, 1999
is incorporated by reference into Part III of this Report.
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PART I
ITEM 1: BUSINESS.
This Report contains forward-looking statements within the meaning
of Section 27A of the Securities Act of 1933, as amended. Prospective
investors are cautioned that such statements are only predictions and that
actual event or results may differ materially. Forward-looking statements
usually contain the word "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
below and in the Company's other SEC filings. In evaluating such statements,
prospective investors should specifically consider various factors identified
in this Report, including the matters set forth below under the caption "Risk
Factors," which could cause actual results to differ materially from those
indicated by such forward-looking statements.
GENERAL
DAOU Systems, Inc. ("DAOU" or the "Company") provides integrated
information technology ("IT") solutions and services to the U.S. healthcare
industry. DAOU's capabilities range from up-front strategic consulting to IT
system design, implementation and long-term tactical support. DAOU's
information technology offerings include Application Implementation,
Communications Infrastructure, Management Consulting, and Integration
Services.
The Company was incorporated in California on July 16, 1987 under
the name DAOU Systems, Inc., and reincorporated in Delaware on November 15,
1996. Unless the context otherwise requires, as used in this Report the
"Company" and "DAOU" refer to the Company, its predecessor entity and its
wholly-owned subsidiaries, DAOU-Integrex, Inc., a Delaware corporation
("DAOU-Integrex"), DAOU On-Line, Inc., a Delaware corporation ("DAOU
On-Line"), DAOU-Sentient, Inc., a Delaware corporation ("DAOU-Sentient"),
DAOU-Synexus, Inc., a Delaware corporation ("DAOU-Synexus"), DAOU-TMI, Inc.,
a Delaware corporation ("DAOU-TMI"), and DAOU-RHI, Inc., a Delaware
corporation ("DAOU-RHI"). The Company's principal executive offices are
located at 5120 Shoreham Place, San Diego, California 92122; its telephone
and facsimile numbers are (619) 452-2221 and (619) 452-1338; its e-mail
address is [email protected]; and its URL is http://www.daou.com.
APPLICATION IMPLEMENTATION
DAOU's Application Implementation Group (formerly Resources in
Healthcare Innovations, Inc.) has supplied staffing resources to hospitals
and other healthcare organizations over the past five years. DAOU's vendor
certified consultants are capable of installing nearly 90% of the most common
healthcare applications. These consultants work nationally to install
cost-effective and timely applications. The engagement period for these
services generally averages six months, but varies depending on the size and
complexity of the project.
DAOU's Application Implementation Group provides expertise in the
following areas: service in interim IS management, application
implementation, project management, application programming, system
programming, decision support, Y2K support and interface support. The
Applications Group also supports the following service lines: (i) CORE
Healthcare Information Systems ("HIS"); (ii) general accounting;
(iii) decision support and (iv) interface support.
COMMUNICATIONS INFRASTRUCTURE
DAOU's Communications Infrastructure Group focuses on the
information superstructure in healthcare enterprises, including networking,
Intranet and Internet, desktop, and voice, video and data solutions. The
group can support healthcare organizations in all stages of infrastructure
upgrades and implementations, from the requisition and purchase of hardware
to on-site help desk staffing and desktop management.
NETWORK IMPLEMENTATION. In the area of network design, implementation
and management, DAOU's certified network staff analyzes, designs and installs
all networks, from the most intricate wide area network ("WAN") to a local
solution using today's newest technologies, as well as to manage the operation
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center for networks. The Company's network implementation services involve
the purchase, testing, delivery and installation of enterprise-wide computer
network systems. Networks installed by the Company provide a variety of
features and services, including switch/bridge/router configuration,
PC-to-host emulation, legacy network integration, gateway installation,
universal workstation design and installation, remote-site connectivity
solutions, dial-up remote access solutions, document management, imaging
installations, video conferencing, telecommunications and telemedicine
installations. For each implementation project, the Company assigns a project
management team typically consisting of a project manager, a senior engineer
and other technical personnel, as well as subcontractors and third-party
vendors if required. The project team creates an installation schedule,
ensures compliance with established milestones, provides on-site coordination
of the activities of DAOU's personnel, subcontractors and third-party
vendors, tests network performance, including stress and data traffic
diagnostics, and provides regular progress reports to the project manager.
The Company installs a computer network by first conducting a
detailed review of the network design to determine the connectivity and
product requirements. DAOU typically purchases the various network components
which have been specified. After delivery to its facilities, the Company
connects these components prior to installation at the customer's site and
then conducts various tests of the computer network system, simulating the
customer's actual computing environment in accordance with the customer's
software specifications. The Company also tests the network's configuration,
connectivity and compatibility and analyzes the load and data throughput
capacity of the network. This testing process reduces downtime risk and helps
ensure that the network installation will occur with minimal disruption to
the customer's ongoing business operations. The engagement period for these
services generally ranges from three to six months, although certain projects
have required up to 13 months for completion, and varies depending on the
size and complexity of the implementation project.
MANAGEMENT SERVICES. As computer network systems become more
complex, provider organizations are experiencing difficulties in hiring,
training and retaining information technology professionals who can maintain
the performance and functionality of their computer network systems.
Accordingly, healthcare provider organizations have begun to outsource
certain maintenance and management functions of their information systems
departments. DAOU provides support and management services that are designed
to maintain the effective performance of a customer's computer network
system, as well as I/S function outsourcing services, such as desktop
outsourcing, that are designed to manage a customer's information services
functions. The Company generally provides these services in multi-year
engagements on a fixed-price basis.
NETWORK SUPPORT. The Company provides a 24-hour technical support
hotline available seven days a week, as well as other network support
resources such as on-site seminars, on-line support and continuous network
monitoring in order to monitor remotely the performance of computer network
systems on an ongoing basis and detect and report network problems. DAOU also
informs its customers of new technological advances and network solutions
that may help increase the utility and functionality of their computer
network systems. The initial engagement period for the Company's existing
support services typically is for one year, subject to annual renewal.
ENTERPRISE NETWORK MANAGEMENT. The Company provides a range of
enterprise network management services to manage and support a customer's
computer network system. The Company uses its technical expertise and
staffing experience to package, price and deliver combinations of these
services at collective rates which are frequently lower than if provided
in-house by the customer. The engagement period for these services typically
ranges from one to five years. The Company's enterprise network management
services include combinations of the following services, which are selected
by the customer to meet its specific needs:
- - DAOU EMPLOYEES ON-SITE. DAOU works with a customer to assess the
appropriate staffing needs to maintain and support its computer network
system. The Company places its employees on-site on a full-time basis
to provide network support services and ongoing training of the
customer's internal staff.
- - CONTINUOUS NETWORK PLANNING. DAOU's design personnel evaluate a
customer's computer network system and provide recommendations for new
network capabilities and capacity on an ongoing basis consistent with
the evolving needs and strategy of the customer. In addition, DAOU
evaluates hardware and software options, interprets research and
development results, updates existing network designs and researches
specific products and technologies of interest to customers. The
Company provides these services subject to predetermined schedules.
- - "BURST MODE" IMPLEMENTATION. DAOU provides additional technical
personnel during periods of peak network requirements to accommodate
and assist in network upgrade implementation or to accommodate the
anticipated or unanticipated need for additional technical staff.
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- - NETWORK SUPPORT. Depending on the specific needs of each customer, the
Company also provides network support services as part of its
combination of enterprise network management services.
I/S FUNCTION OUTSOURCING. The Company provides I/S function
outsourcing services for healthcare provider organizations that elect to
outsource all or a portion of their information systems functions. I/S
function outsourcing services involve long-term engagements whereby the
Company may staff portions of its customers' information systems department
and is responsible for the management and support of those functions. DAOU
provides its I/S function outsourcing services in accordance with
pre-determined, detailed schedules and plans established with the customer.
INTERNET AND INTRANET. In the rapidly evolving area of the Internet
and Intranet, DAOU engineers provide solutions and support ranging from
initial assessment to web site design, development and hosting, full-scale
transaction processing, and training. In addition, DAOU provides
cost-effective solutions to the security risks that are associated with the
Internet, electronic medical records and e-mail.
VOICE, VIDEO, AND DATA SOLUTIONS. For voice applications, DAOU helps
customers interface their local and long-range pagers, wireless phones,
high-tech call centers, PBX and integrated messaging systems. DAOU video
consultants assist customers in the area of telemedicine with the selection,
negotiation and implementation of cost-effective video solutions ranging from
tele-based solutions to digital video and image processing.
MANAGEMENT CONSULTING
DAOU's Management Consulting Group is focused on helping healthcare
management meet their business and IT objectives as well as anticipate and
plan for their future IT needs. Formerly Technology Management Inc., DAOU's
Management Consulting Group has been in business for 15 years and has served
approximately 500 clients. The group's senior consultants, with an average of
20 years of management consulting experience, offer clients the benefit of
overall project management vision as well as application and technical skills
appropriate for specific assignments. DAOU works with its consulting clients
in a goal-directed, strategic partnership to achieve results in a timely and
cost-effective manner.
Among its specific capabilities, DAOU's Management Consulting Group
develops business plans and solves problems for healthcare IT managers,
installs and integrates applications, engineers, installs and integrates
infrastructure, and manages IT systems.
In the area of general management consulting, DAOU's Management
Consulting Group provides counsel on business process improvement, business
strategy and critical management problem solving. IT management consulting
includes strategic and tactical planning, assessment and problem solving and
organizational staffing. Health system Chief Information Officer ("CIO")
support includes strategic planning, mentoring programs, interim and project
management, as well as focused services such as right sourcing and Joint
Commission on Healthcare Organizations audit support. DAOU also provides
management consulting services that address the specific planning,
procurement and implementation needs of managed care systems, hospital
systems and physician practice management systems. The group also provides
strategic consulting in the areas of decision support and data warehousing,
including physician profiling, loss ratio analysis and profitability
improvement, managed secondary organizations development and management,
including planning, implementation and procurement of systems, and healthcare
systems information, including user satisfaction surveys, vendor information
and budget/cost analysis. The engagement period for these services typically
averages six months, but varies depending on the size and complexity of the
project.
INTEGRATION SERVICES
DAOU's Integration Services Group (formerly Sentient Systems, Inc.),
a leading healthcare systems integrator with over 17 years consulting
experience, analyzes, customizes, integrates and supports information systems
that meet a customer's business objectives and reduce the cost and improve
the quality of care. The engagement period for these services generally
ranges from nine to twelve months, but varies depending on the size and
complexity of the project.
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The group's consultants are experienced in healthcare information
systems (financial, clinical and management) for hospitals, HMOs, insurers,
clinics and physician offices, HSII, Lawson and Sunquest. DAOU Integration
adds value to its technical offerings by entering into partner relationships
with both its vendors and end-user clients. The substantial collective
experience of this partnership effort distinguishes DAOU's capabilities from
anything that its clients could achieve through internal staffing.
The Group offers expertise in three specific healthcare application
areas:
- Government health care systems, including the Department of
Defense, Health Affairs, Department of Veterans Affairs and
Indian Health Services;
- Hospital, clinical and physician offices clinical/financial
application systems for laboratory, pharmacy, radiology,
nursing, medical records, DRG, materials management, patient
accounting, medical billing, HIS and physician offices; and
- Managed care support including conversion and development
projects for health plans, insurance companies and managed
care organizations migrating to new enterprise applications.
During 1998, this group achieved a number of significant
accomplishments. In the government area, the group achieved a breakthrough
into the Department of Defense Health Affairs arena, providing Informix DBA,
application/system integration, and application development services. In the
clinical area, the Group established relationships with major clinical
information system vendors. For the managed healthcare area, the group
completed several successful conversion projects for clients migrating to new
enterprise applications.
DAOU ADVISORY BOARD
In 1994, the Company established its Advisory Board (the "Advisory
Board"), a non-governing body is comprised of up to 15 chief information
officers ("CIOs") of various healthcare provider organizations. The Advisory
Board meets as a group annually and the members confer separately with the
Company periodically to provide advice on issues and trends in the healthcare
industry and emerging technologies, as well as to provide strategic direction
and feedback regarding the Company's present and future services. Members of
the Advisory Board are reimbursed for travel, lodging and meal expenses
incurred in connection with attendance at the Advisory Board's sessions. Ward
Keever, the CIO of the University of Pennsylvania serves as the Chairman of
the Advisory Board.
RECRUITING AND TRAINING OF TECHNICAL EMPLOYEES
The Company dedicates significant time and resources to recruit,
train and retain qualified technical personnel. The technical staff of the
Company consists of consultants, engineers and technicians providing
consulting, application, integration and communications infrastructure
services. The Company hires many of its communication's infrastructure
technical staff as entry-level network systems technicians and provides these
individuals with the necessary training and experience to become network
engineers who are responsible for network configuration, testing, burn-in
analysis, installation and documentation. Further training and experience are
provided to enable these engineers to become senior network engineers who are
responsible for project and resource management. The Company's technical
staff undergoes extensive training and maintains certifications from leading
network technology vendors such as Cisco Systems, Inc., Bay Networks, Inc.,
Microsoft Corporation and 3Com Corporation, SMS, McKesson HBOC and
application vendors. In addition, the Company is a member of leading
technological forums and organizations, including the ATM Forum, the CHIM
Telecommunications Committee, the HL7 Committee and the BICSI Organization.
The Company believes that its future success will depend in large
part on its ability to hire, train and retain qualified technical personnel
who together have expertise in a wide array of network and computer systems
and a broad understanding of the healthcare provider organizations that the
Company serves. Competition for qualified technical personnel is intense and
is expected to increase. Consequently, there can be no assurance that the
Company will be successful in attracting and retaining such personnel. Any
inability of the Company to hire, train and retain a sufficient number of
qualified technical personnel could impair the Company's ability to
adequately manage and complete its existing projects or to obtain new
projects, which, in turn, could have a material adverse effect on the
Company's business, financial condition and results of
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operations. See "--Risk Factors--Need to Attract and Retain Key Employees and
Qualified Technical Personnel."
Each technical employee is required to enter into a confidentiality
agreement with the Company designed to protect the Company's trade secrets
and other confidential information during and subsequent to employment with
the Company. Any significant loss of employees to a competitor could have a
material adverse effect on the Company's business, financial condition and
results of operations
SALES AND MARKETING
The Company's sales and support operations are divided into four
regional organizations located in the west, central, mid-atlantic and east
regions of the United States. A vice president heads each regional
organization and oversees the management of existing customers by the account
managers and the development of new customers by the account executives. In
particular, account managers are responsible for maintaining customer
satisfaction and developing new business opportunities, as customer needs for
computer network services evolve or increase.
The Company seeks to establish long-term relationships with its
customers by providing high levels of service and by becoming an integral
part of their computer network systems operations. The Company focuses its
sales and marketing efforts on the CIOs and other technology decision-makers
of integrated delivery networks ("IDNs"), hospitals and other healthcare
provider organizations. The Company relies upon its reputation in the
marketplace, the personal contacts and networking of its professionals and
the various programs of its marketing department to develop new business
opportunities. The Company also receives sales leads directly from
consultants, value added resellers ("VARs"), and product and service vendors.
The principal objectives of the Company's marketing department are
to increase the Company's market presence, provide strategic direction and
generate sales leads. All components of the marketing program are centered
around the corporate positioning of the DAOU Systems, Inc., "The Life Saver
People", the single source for healthcare information technology solutions.
As a supplement to the direct selling efforts of the Company, the marketing
department has developed various programs that include advertising campaigns,
trade show participation, direct mail campaigns, public relations programs,
marketing research and communications and the development of sales
presentation materials. The Company's marketing efforts are enhanced by
speaking engagements and the publication of technical articles and reports
directed to the healthcare information technology industry. The Company's
marketing department is also responsible for the continued development of the
Company's presence on the Internet as a new marketing channel.
The Company has entered into marketing agreements with LAN Vision
Systems, Inc., IDX Systems Corporation and Health Systems Technologies, which
companies market the Company's services to their respective customer bases.
The Company also has entered into a marketing alliance with VHA, Inc.
("VHA"), whereby, as one of VHA's preferred information system integration
vendors, the Company offers computer network design, implementation and
support services to VHA members. The Company intends to pursue additional
marketing agreements, joint ventures and alliances as part of its marketing
plan.
COMPETITION
The healthcare network services industry is comprised of a large
number of participants and is subject to rapid change and intense
competition. The Company's competitors include (i) system integrators, (ii)
VARs, (iii) consulting companies, (iv) local and regional network services
firms, (v) telecommunications providers and network equipment vendors and
(vi) computer systems and healthcare software vendors. Many of the Company's
competitors have significantly greater financial, technical and marketing
resources and greater name recognition than does the Company. The Company's
competitors include healthcare information technology companies such as
McKesson HBOC and Shared Medical Systems Corporation; hardware firms such as
Cisco Systems, Inc., FORE Systems Inc., 3Com Corporation and International
Business Machines Corporation; networking/telecommunications firms such as
GTE Corporation, AT&T Corporation and Sprint Corporation; and consulting
firms such as First Consulting Group, Inc., and Superior Consulting Holdings
Corporation. In addition to these major companies, the Company also competes
with smaller regional network systems firms, which have a niche in selected
geographical areas of the country. In addition, the Company has faced, and
expects to continue to face, additional competition from new entrants into
its markets. Other healthcare information technology companies not presently
offering or emphasizing network systems services and large network services
companies not currently focusing on healthcare may enter the Company's
markets. Increased competition could result in price reductions, fewer
customer projects, under-utilization of employees, reduced operating margins
and loss of market share, any of which could materially and adversely affect
the Company's business, financial condition and
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results of operations. There can be no assurance that the Company will be
able to compete successfully against current and future competitors. The
failure of the Company to compete successfully would have a material adverse
effect on the Company's business, financial condition and results of
operations. In addition, most of the Company's customers have internal
network support and service capabilities and could choose to satisfy their
needs through internal resources rather than through outside service
providers. As a result, the decision by the Company's customers or potential
customers to perform network services internally could have a material
adverse effect on the Company's business, financial condition and results of
operations. See "--Risk Factors--Competition."
The Company believes that the principal competitive factors in the
markets in which it competes include: reputation, healthcare industry
expertise, network performance and reliability, timely delivery of services,
quality of service, responsiveness to customers, product knowledge and
technological expertise, marketing, customer relationships and price. The
Company believes that it is competitive with respect to the above mentioned
factors.
CUSTOMERS
The Company has derived, and believes that it will continue to
derive, a significant portion of its revenues from a relatively limited
number of large customer contracts. For the year ended December 31, 1998, the
Company's five largest customers accounted for approximately 19% of total
revenues, with no single customer accounting for 10% or more of total
revenues. For the years ended December 31, 1997 and 1996, the Company's five
largest customers accounted for approximately 22% and 27% of total revenues,
respectively, with no single customer accounting for 10% or more of total
revenues. See "--Risk Factors--Customer Concentration."
EMPLOYEES
As of December 31, 1998, the Company employed 812 persons. Of these
employees, 653 were involved in providing computer network services, 61 in
sales and marketing and 98 in general administration, finance and clerical.
The Company's employees are not represented by a labor union and the
Company's management believes that its relationship with its employees is
good.
RISK FACTORS
An investment in DAOU'S Common Stock involves a high degree of risk.
In addition to the other information in this report, the following risk
factors should be considered carefully in evaluating the Company and its
business. This Report contains forward-looking statements within the meaning
of Section 27A of the Securities Act of 1933, 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 word "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
below and in the Company's other SEC filings. These risks and uncertainties
could cause the Company's actual results to differ materially from those
projected in the forward-looking statements.
MANAGEMENT OF GROWTH. The Company recently has experienced a period of rapid
growth, which has placed significant and increasing demands on the Company's
management and operational, technical, financial and other resources. For the
year ended December 31, 1998, the Company's revenues increased 53% to $104.8
million from $68.7 million for the year ended December 31, 1997. For the year
ended December 31, 1997, the Company's revenues increased 36% to $68.7
million from $50.3 million for the year ended December 31, 1996. For the year
ended December 31, 1996, the Company's revenues increased 38% to $50.3 million
from $36.4 million for the year ended December 31, 1995. In addition, since
January 1, 1995, DAOU's workforce increased from 198 to more than 800 full-time
employees as of December 31, 1998. Further increases in staffing levels are
expected during 1999. This growth has resulted in new and increased
responsibilities for management personnel and has placed significant demands on
the Company's management and operating and financial systems. DAOU will be
required to continue to develop and improve its operational, financial and other
internal systems to accommodate the increased number of transactions and
customers and the increased size of the Company's operations, workforce and
facilities. These responsibilities and demands are compounded by the fact that
a substantial portion of the Company's current revenue derives from businesses
that have been acquired by the Company since mid-1997. There can be no
assurance, however, that the Company's management or systems will
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be adequate to support the Company's existing or future operations. Any
failure to develop and improve the Company's systems or to hire and retain
appropriate personnel to manage its operations could have a material adverse
effect on the Company's business, financial condition and results of
operations. In addition, any future unexpected shortfall in revenues without
a corresponding and timely reduction in staffing and other expenses (or
redeployment of employees to other customer projects), or any staffing
increase that is unaccompanied by a corresponding increase in revenues, could
have a material adverse effect on DAOU's business, financial condition and
results of operations. See "Item 7: Management's Discussion and Analysis of
Financial Condition and Results of Operations."
NEED TO ATTRACT AND RETAIN KEY EMPLOYEES AND QUALIFIED TECHNICAL PERSONNEL.
The Company's success and execution of its business strategy will depend in
large part on the continued services of its key management and technical
personnel. The loss of the services of one or more of the Company's key
employees or the inability to hire additional key personnel as needed could
have a material adverse effect on the Company's business, financial condition
and results of operations. The future of the Company's labor-intensive
business will depend in large part on its ability to hire, train and retain
qualified technical personnel who together have expertise in a wide array of
network and computer systems and a broad understanding of the hospitals,
integrated healthcare delivery networks and other healthcare provider
organizations that the Company serves. Competition for qualified technical
personnel is intense and is expected to increase. In particular, competition
is intense for the limited number of qualified management personnel and
senior network engineers. There can be no assurance that the Company will be
successful in attracting and retaining such personnel. Any inability of the
Company to hire, train and retain a sufficient number of qualified technical
personnel could impair the Company's ability to adequately manage and
complete its existing projects or to obtain new projects, which, in turn,
could have a material adverse effect on the Company's business, financial
condition and results of operations. See "Item 7: Management's Discussion and
Analysis of Financial Condition and Results of Operations" and "--Recruiting
and Training of Technical Employees."
RISKS ASSOCIATED WITH ACQUISITIONS. During 1997, the Company acquired
Integrex Systems Corporation, a Delaware corporation ("Integrex"), and
On-Line Networking, Inc., a New Jersey corporation ("On-Line"). During 1998,
the Company acquired Synexus Incorporated, a Pennsylvania corporation
("Synexus"), Sentient Systems, Inc., a Maryland corporation ("Sentient"),
Technology Management Inc., an Indiana corporation ("TMI"), International
Health Care Systems, Inc., a Florida corporation ("IHCS"), Resources in
Healthcare Innovations, Inc., an Indiana corporation, ("RHI"), Healthcare
Transition Resources, Inc., an Indiana corporation ("HTR"), Ultitech
Resources Group, Inc., an Indiana corporation ("URG"), Innovative Systems
Solutions, Inc., an Indiana corporation ("ISS"), and Grand Isle Consulting,
Inc., an Indiana corporation ("GIC"). As part of its business strategy, the
Company may pursue additional acquisitions of complementary businesses as it
seeks to compete in the rapidly changing industry of healthcare information
technology. Acquisitions involve numerous risks, including (i) difficulties
in the assimilation of the operations and personnel of the acquired business,
(ii) the integration of management information and accounting systems of the
acquired business, (iii) the diversion of management's attention from other
business concerns, (iv) risks of entering markets in which the Company has no
direct prior experience, and (v) the potential loss of key employees of the
acquired business. The Company's management continue to devote substantial
time and attention to the integration of the recently acquired businesses,
any newly acquired businesses, as well as to any material operational or
financial problems arising from these acquisitions. There can be no assurance
that operational or financial problems will not occur as a result of any
acquisition. Failure to effectively integrate acquired businesses could have
a material adverse effect on the Company's business, financial condition and
results of operations.
Future acquisitions by the Company may result in potentially
dilutive issuances of equity securities, the incurrence of additional debt
and amortization expenses related to goodwill and other intangible assets
which could adversely affect the Company's business, financial condition and
results of operations. There can be no assurance that the Company will
consummate any acquisition in the future or, if consummated, that any such
acquisition will ultimately be beneficial to the Company.
CONTRACT CANCELLATION RIGHTS; ABSENCE OF LONG-TERM CONTRACTS. The Company
believes that the number and size of its existing projects are not reliable
indicators or measures of future revenues. Although the Company enters into
agreements with certain of its customers which contemplate multi-year
contract terms, certain of the Company's customers are able to reduce or
cancel their use of the Company's services before the end of the contract
term. For example, Candler Health System, Savannah Georgia ("Candler"),
previously a large I/S outsourcing customer of the Company, terminated its
contract with the Company effective November 30, 1997, which termination was
influenced by Candler's consolidation with another healthcare enterprise. As
another example, the Information Management Agreement between the Company and
Saint Mary's Health Network may
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be terminated without cause within 90 days of receipt of written notification
by either party. In addition, the Company has in the past provided, and is
likely in the future to provide, services to customers without long-term
contracts. When a customer defers, modifies or cancels a project, the Company
must be able to rapidly redeploy technical and other personnel to other
projects in order to minimize the under-utilization of employees and the
resulting adverse impact on operating results. Furthermore, the Company's
operating expenses are relatively fixed and cannot be reduced on short notice
to compensate for unanticipated variations in the number or size of projects
in progress. As a result, any termination, significant reduction or
modification of DAOU's business relationships with any of its significant
customers or with a number of smaller customers could have a material adverse
effect on the Company's business, financial condition and results of
operations. See "Item 7: Management's Discussion and Analysis of Financial
Condition and Results of Operations".
VARIABILITY OF QUARTERLY OPERATING RESULTS. A substantial majority of the
Company's operating expenses, particularly personnel and related costs,
depreciation and rent, are relatively fixed in advance of any particular
quarter. However, variations in the Company's revenues and operating results
may occur from time to time, as a result of various factors, including: (i)
the reduction in size, delay in commencement, interruption or termination of
one or more significant projects or contracts; (ii) the commencement or
completion during a quarter of one or more significant projects; (iii) the
failure to estimate accurately the resources required to complete new or
ongoing projects, including increased labor costs due to delays in project
delivery schedules; (iv) the failure to secure new contracts at the budgeted
rate; (v) the relatively longer sales cycle in obtaining new customers and
larger contracts; (vi) the timing and extent of employee training or the loss
of key employees; (vii) competition; (viii) the development and introduction
of new services; (ix) variations in the product or professional services
content of the Company's projects; (x) the effect of acquisitions, including
additional administrative staffing and other increased infrastructure
requirements to integrate the newly acquired companies; (xi) the effect of
negative publicity; and (xii) general economic conditions which may affect
the buying decisions of the Company's current and prospective customers. In
addition, the Company plans to continue to expand its operations by hiring
additional technical personnel and other employees, and adding new offices,
systems and other infrastructure. The resulting increase in operating
expenses, including personnel costs and related recruiting expenses, may be
incurred prior to any increase in revenues. Consequently, the Company's
business, financial condition and results of operations would be materially
and adversely affected if revenues do not increase to support such expenses.
A variation in the timing of the commencement or completion of customer
projects or contracts, particularly at or near the end of any quarter, may
cause significant variations in operating results from quarter to quarter and
could result in losses for a particular quarter. In addition, an
unanticipated delay or termination of a major project or contract (or series
of smaller projects or contracts) could require the Company to maintain or
terminate under-utilized employees, which could, in either case, result in
higher than expected expenses during a quarter. The Company believes that
quarterly revenues and operating results are likely to vary significantly in
the future and that period-to-period comparisons of its revenues and
operating results are not necessarily meaningful and should not be relied on
as indications of future performance. Furthermore, these variations in
revenues and operating results could cause significant variations in the
price of the Company's Common Stock. See "Item 7: Management's Discussion and
Analysis of Financial Condition and Results of Operations."
CUSTOMER CONCENTRATION. The Company has derived, and believes that it will
continue to derive, a significant portion of its revenues from a relatively
limited number of large customer contracts. For the year ended December 31,
1998, the Company's five largest customers accounted for approximately 19% of
total revenues, with no single customer accounting for 10% or more of total
revenues. For the years ended December 31, 1997 and 1996, the Company's five
largest customers accounted for approximately 22% and 27% of total revenues,
respectively, with no single customer accounting for 10% or more of total
revenues. The volume of work performed for specific customers is likely to
vary from year to year, and a major customer in one year may not constitute
the same level of revenues in any subsequent year. The loss of any large
customer could have a material adverse effect on the Company's business,
financial condition and results of operations. See "--Risk Factors--Contract
Cancellation Rights; Absence of Long-Term Contracts," "--Risk
Factors--Consolidation and Uncertainty in the Healthcare Industry" and "Item
7: Management's Discussion and Analysis of Financial Condition and Results of
Operations."
PROJECT RISKS. The Company's computer network systems are designed to provide
access to and accurate delivery of a wide range of information within a
provider organization, including information used by clinicians in the
diagnosis and treatment of patients. Many of the Company's projects are
critical to the operation of its customers' businesses. Therefore, the
Company may expose itself to potentially adverse risks in the event that the
Company's services do not meet the desired expectations of its customers. For
example, the failure to perform services that meet a customer's expectations
may result in the Company not being paid for services rendered and may damage
the Company's reputation and adversely affect its ability to attract new
business. In addition, any failure by the Company's computer network systems
to provide accurate, reliable and timely information could result in claims
against the Company. For example, where the unavailability of such
9
<PAGE>
information to a provider of healthcare services is alleged to have resulted
in any physical or emotional injury to a patient, such provider may become
subject to a medical malpractice, product liability or other claims. The
Company then could become subject to a claim relating to its installation or
management of a computer network system. The Company is also subject to
claims by its customers for actions of the Company's employees which may have
caused damages to customers' businesses or otherwise. Although the Company
maintains errors and/or omissions insurance, there can be no assurance that
such insurance coverage would adequately cover any claims asserted against
the Company and any such claim could have a material adverse effect on the
Company's business, financial condition and results of operations. In
addition, there can be no assurance that the Company will not be subject to
claims that will result in liability in excess of its insurance coverage or
that appropriate insurance will continue to be available to the Company in
the future at commercially reasonable rates.
LONG SALES AND PROJECT DELIVERY CYCLES. The Company's sales process is often
subject to delays associated with the lengthy approval process that typically
accompanies significant capital expenditures by a customer. During this
process, the Company expends substantial time, effort and resources marketing
its services, preparing contract proposals and negotiating contracts. Any
failure by the Company to procure a signed contract after expending
significant time, effort and resources could have a material adverse effect
on the Company's business, financial condition and results of operations. The
delivery of computer network services generally requires a significant
commitment of resources by the Company and by the customer. The length of
time required to complete a project may depend on many factors outside the
control of the Company, including the state of the customer's existing
information systems, budgetary constraints and the customer's ability to
commit the personnel and other resources necessary to complete elements of
the project for which the customer is responsible. In certain instances,
projects have been prolonged substantially as a result of delays attributable
to customers. Consequently, the failure of the Company to deliver its
services on a timely and cost-efficient basis could have a material adverse
effect on its business, financial condition and results of operations. See
"--Sales and Marketing" and "Item 7: Management's Discussion and Analysis of
Financial Condition and Results of Operations."
COMPETITION. The healthcare network services industry is comprised of a large
number of participants and is subject to rapid change and intense
competition. DAOU's competitors include: (i) system integrators, (ii) VARs,
(iii) consulting companies, (iv) local and regional network services firms,
(v) telecommunications providers and network equipment vendors and (vi)
computer systems and healthcare software vendors. Many of the Company's
competitors have significantly greater financial, technical and marketing
resources and greater name recognition than does the Company. The Company's
competitors include healthcare information technology companies such as
McKesson HBOC and Shared Medical Systems Corporation; hardware firms such as
Cisco Systems, Inc., FORE Systems Inc., 3Com Corporation and International
Business Machines Corporation; networking/telecommunications firms such as
GTE Corporation, AT&T Corporation and Sprint Corporation; and consulting
firms such as First Consulting Group, Inc., and Superior Consulting Holdings
Corporation. In addition to these major companies, the Company also competes
with smaller regional network systems firms, which have a niche in selected
geographical areas of the country. In addition, the Company has faced, and
expects to continue to face, additional competition from new entrants into
its markets. Other healthcare information technology companies not presently
offering or emphasizing network systems services and large network services
companies not currently focusing on healthcare may enter the Company's
markets. Increased competition could result in price reductions, fewer
customer projects, under-utilization of employees, reduced operating margins
and loss of market share, any of which could materially and adversely affect
the Company's business, financial condition and results of operations. There
can be no assurance that the Company will be able to compete successfully
against current and future competitors. The failure of the Company to compete
successfully would have a material adverse effect on its business, financial
condition and results of operations. In addition, most of the Company's
customers have internal network support and service capabilities and could
choose to satisfy their needs through internal resources rather than through
outside service providers. As a result, the decision by the Company's
customers or potential customers to perform network services internally could
have a material adverse effect on its business, financial condition and
results of operations. See "--Competition."
FIXED-PRICE, FIXED-TIME FRAME CONTRACTS. The Company offers a significant
number of its computer network systems services on a fixed-price, fixed-time
frame basis, rather than on a time-and-expense basis. Consequently, the
Company bears the risk of cost over-runs in connection with these projects.
The Company's failure to estimate accurately the resources and time required
for a project or its failure to complete its contractual obligations within
the committed fixed-time frame committed could have a material adverse effect
on the Company's business, financial condition and results of operations. See
"Item 7: Management's Discussion and Analysis of Financial Condition and
Results of Operations."
CONSOLIDATION AND UNCERTAINTY IN THE HEALTHCARE INDUSTRY. Substantially all
of the Company's revenues are derived from customers involved in the
healthcare industry. As a result, the Company's business, financial
10
<PAGE>
condition and results of operations are influenced by conditions affecting
this industry. Many healthcare provider organizations are consolidating to
create larger organizations with greater regional market power and are
forming affiliations for purchasing products and services. This consolidation
could reduce the Company's target market and result in the termination of
certain engagements of the Company. In particular, this consolidation has
resulted, and is likely to continue to result, in the acquisition of certain
of the Company's customers, and such customers may scale back or terminate
their relationship with the Company following their acquisition. Moreover,
these consolidating and affiliating enterprises also could have greater
bargaining power, which could lead, to reductions in the amounts paid to DAOU
for its services. The reduction in the size of the Company's target market or
the failure of the Company to maintain adequate price levels could have a
material adverse effect on its business, financial condition and results of
operations. The healthcare industry is also subject to changing political,
economic and regulatory influences that may affect the procurement practices
and operations of participants in the healthcare industry. The Company cannot
predict with any certainty what impact, if any, these developments could have
on its business, financial condition and results of operations.
RAPID TECHNOLOGICAL CHANGE. The Company has derived, and expects to continue
to derive, substantially all of its revenues from projects based on complex
computer networks. The markets for computer network products and services are
continuing to develop and are subject to rapid change. The Company's success
will depend in part on its ability to offer services that keep pace with
continuing changes in technology, evolving industry standards and changing
customer preferences and to hire, train and retain technical personnel who
can fulfill the increasingly complex needs of its customers. There can be no
assurance that the Company will be successful in addressing these
developments in a timely manner. Any delay or failure by the Company to
address these developments could have a material adverse effect on the
Company's business, financial condition and results of operations. In
addition, there can be no assurance that products, systems or technologies
developed by third parties will not render certain of the Company's services
noncompetitive or obsolete.
DEPENDENCE ON THIRD-PARTY HARDWARE AND SOFTWARE VENDORS. The network systems
solutions delivered by the Company utilize the products of third-party
hardware and software vendors. A significant portion of the Company's
implementation service revenues are derived from the purchase and resale of
these products. Although the Company has distribution agreements with certain
product vendors, there can be no assurance that these agreements will be
renewed. Any significant adverse change in any of these relationships could
have a material adverse effect on the Company's business, financial condition
and results of operations.
POTENTIAL "YEAR 2000" PROBLEMS. It is possible that the Company's currently
installed computer systems, software products or other business systems, 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 with 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 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. See "Item 7: Management's
Discussion and Analysis of Financial Condition and Results of Operations."
FUTURE ADDITIONAL CAPITAL REQUIREMENTS. Since its inception, the Company has
financed its operations through cash provided by operations, the sale of
equity and through debt. If the Company is unable to generate sufficient
revenues to fund its operations in the future, the Company may be required to
raise additional funds to meet its capital and operating requirements through
public or private financing, including equity financing. Any additional
equity financing may be dilutive to stockholders, and debt financing, if
available, will require payment of interest and may involve restrictive
covenants that could impose limitations on the operating flexibility of the
Company. Adequate funds for the Company's operations may not be available
when needed and, if available, may not be on terms attractive to the Company.
The failure to obtain funding on a timely basis could have a material adverse
effect on DAOU's business, financial condition and results of operations. See
"Item 7: Management's Discussion and Analysis of Financial Condition and
Results of Operations-Liquidity and Capital Resources."
11
<PAGE>
CONTROL BY EXISTING STOCKHOLDERS AND MANAGEMENT. As of December 31, 1998, the
Company's executive officers, directors and their respective family members
and affiliates beneficially own approximately 27% of the outstanding shares of
Common Stock. As a result, these stockholders are able to exercise significant
influence over all matters requiring stockholder approval, including the
election of directors and approval of significant corporate transactions. Such
concentration of ownership may also have the effect of delaying or preventing a
change in control of the Company.
POSSIBLE VOLATILITY OF STOCK PRICE. The market price of the Company's Common
Stock has been, and is likely to continue to be, volatile. Factors such as
announcements of new customer contracts or services by the Company or its
competitors, changes in pricing policies by the Company or its competitors,
quarterly fluctuations in the Company's operating results, announcements
relating to strategic relationships or acquisitions, changes in earnings
estimates by analysts, government regulatory actions, general conditions in the
market for computer network services, overall market conditions and other
factors may have a significant impact on the market price of the Common Stock.
In addition, in recent years the stock market in general, and the shares of
technology companies in particular, have experienced extreme price fluctuations.
This volatility has had a substantial effect on the market prices of securities
issued by many companies for reasons unrelated to the operating performance of
the specific companies. These broad market fluctuations may adversely affect the
market price of the Company's Common Stock. See "--Risk Factors --Variability of
Quarterly Operating Results."
SHARES ELIGIBLE FOR FUTURE SALE. Sales of substantial amounts of Common Stock in
the public market could adversely affect prevailing market prices for the Common
Stock. Of the 17,688,624 shares outstanding as of December 31, 1998, 15,450,977
shares of Common Stock are freely tradeable without restriction in the public
market, unless such shares are held by "affiliates" of the Company (as such term
is defined in Rule 144 ("Rule 144") promulgated under the Securities Act of
1933, as amended (the "Securities Act")), or are otherwise subject to certain
sale volume limitations and other restrictions under Rule 144. The remaining
2,237,647 shares are "restricted securities" as such term is defined in Rule
144.
In addition, the Company has registered on Form S-8 Registration
Statement an aggregate of 4,000,000 shares of Common Stock reserved for issuance
under the DAOU Systems, Inc. 1996 Stock Option Plan (as amended, the "1996 Stock
Option Plan"). As of such date, an additional 112,240 shares of Common Stock
were subject to other outstanding stock options.
POTENTIAL ANTI-TAKEOVER EFFECTS OF DELAWARE LAW AND CERTAIN CHARTER PROVISIONS.
Certain provisions of Delaware law applicable to the Company could delay or make
more difficult a merger tender offer or proxy contest involving the Company. For
example, Section 203 of the Delaware General Corporation Law prohibits a
Delaware corporation from engaging in any business combination with any
interested stockholder for a period of three years from the date the person
became an interested stockholder unless certain conditions are met. In addition,
the Board of Directors of the Company (the "Board") may issue shares of
Preferred Stock without stockholder approval on such terms as the Board may
determine. The rights of the holders of Common Stock will be subject to, and may
be adversely affected by, the rights of the holders of any Preferred Stock that
may be issued in the future. In addition, the Company's Certificate of
Incorporation and Bylaws: (i) provide for a classified board of directors, (ii)
eliminate the right of stockholders to act by written consent without a meeting,
(iii) require advanced stockholder notice to nominate directors and raise
matters at the annual stockholders meeting, (iv) eliminate cumulative voting in
the election of directors and (v) allow for the removal of directors only for
cause and with a two-thirds vote of the Company's outstanding shares. All of the
foregoing could have the effect of delaying, deferring or preventing a change in
control of the Company and could limit the price that certain investors might be
willing to pay in the future for shares of the Company's Common Stock.
ABSENCE OF DIVIDENDS. The Company has never declared nor paid cash dividends on
its capital stock. The Company currently intends to retain any earnings for
funding growth and, therefore, does not intend to pay any cash dividends in the
foreseeable future.
ITEM 2: DESCRIPTION OF PROPERTIES.
The Company leases the following office space for its principal administrative,
operating, support and training facilities:
<TABLE>
<CAPTION>
Approximate
Location Square Footage Expiration Principal Use
- ------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
San Diego, CA 38,000 February 2005 Corporate office facility
</TABLE>
12
<PAGE>
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Kensington, MD 30,000 February 2001 Operating and support facilities
Alexandria, VA 21,000 November 2003 Operating and support facilities
Indianapolis, IN 5,100 April 2000 Operating and support facilities
Mountainside, NJ 4,000 November 2003 Operating and support facilities
Saddlebrook, NJ 2,400 May 1999 Operating and support facilities
Glen Ellyn, IL 1,600 July 2000 Operating and support facilities
</TABLE>
In addition, the Company has leased executive offices in several locations in
the United States to provide regional sales and support activities to its
customers. The Company continually evaluates the adequacy of its existing
facilities and believes that its current and planned facilities will be adequate
for the next twelve months.
ITEM 3: LEGAL PROCEEDINGS.
Gary Colvin, an ex-employee of the Company, filed a lawsuit on February
25, 1997 against the Company and certain of its officers and directors in the
U.S. District Court of the Southern District of California (Colvin v. DAOU
Systems, et al.). The complaint alleged various causes of action, including
wrongful termination, civil rights violations, breach of contract, fraud and
violations of wage & hour laws. On February 9, 1998, the parties stipulated to
the dismissal of the ex-employee's remaining Federal claim under the Fair Labor
Standards Act. As a result, on March 4, 1998, the lawsuit was dismissed without
prejudice after the court declined to exercise supplemental jurisdiction over
the remaining state law claims. On March 31, 1998, the plaintiff re-filed in
state court (Colvin v. DAOU Systems, Inc., et., al.). On March 19, 1999, the
Company received a verdict in its favor on all causes of action. The time period
within which to file an appeal has not yet expired and it is unknown whether Mr.
Colvin will proceed with an appellate effort.
On September 18, 1997, seven present and/or former employees of the
Company filed a lawsuit in the Superior Court of the State of California for the
County of San Diego, titled Smyth, et al. v. DAOU Systems, Inc. (Case No.
714187), purporting to represent a class of all present and former DAOU
employees classified as exempt from overtime pay requirements within the
preceding three years. The plaintiffs claim that they and other exempt employees
were not actually exempt under Federal and California law from overtime pay and
are entitled to pay for unpaid overtime and penalties in an unstated amount. The
plaintiffs also claim that, in response to their filing complaints with the
Labor Board for the State of California, they were subjected to retaliatory
discrimination by the Company. The lawsuit currently is in the preliminary
stages of discovery. As of the date of this Report, the potential amount of
exposure to the Company from this lawsuit, in the event of an unfavorable
outcome, cannot be estimated. The Company believes that the lawsuit is without
merit and intends to defend the lawsuit vigorously.
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. A group of shareholders has been appointed the lead
plaintiffs and they filed an amended consolidated complaint on February 24,
1999. The new complaint realleges the same theory of liability previously
asserted, namely 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 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. By stipulation of the parties, the state court litigation
has been stayed pending the resolution of a motion to dismiss that will be filed
on April 22, 1999 in the federal litigation. 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 4: SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS.
None.
PART II
ITEM 5: MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS.
The Company's shares of Common Stock have traded on the Nasdaq National
Market System under the symbol DAOU since February 12, 1997. The prices set
forth below represent quotes between dealers and do not
13
<PAGE>
include commissions, mark-ups or mark-downs, and may not necessarily
represent actual transactions.
Common Stock
<TABLE>
<CAPTION>
HIGH LOW
----------- -----------
<S> <C> <C>
1998
1st Quarter $31.000 $16.250
2nd Quarter 23.656 15.063
3rd Quarter 23.438 5.750
4th Quarter 7.000 3.438
1997
1st Quarter (from February 12, 1997) $9.750 $6.000
2nd Quarter 19.250 5.625
3rd Quarter 25.375 15.250
4th Quarter 34.250 24.250
</TABLE>
On March 23, 1999, the closing bid and ask prices of the Company's
Common Stock were $5.906 and $6.000, respectively. As of March 23, 1999, there
were approximately 106 holders of record of common stock.
DIVIDEND POLICY
DAOU has never declared nor paid cash dividends on its capital stock.
The Company currently intends to retain any earnings for future growth and,
therefore, does not intend to pay any cash dividends in the foreseeable future.
RECENT SALES OF UNREGISTERED SECURITIES
Between January 1, 1998 and December 31, 1998, the Company issued and
sold (without payment of any selling commission to any person) the following
unregistered securities:
1. On March 27, 1998, DAOU acquired all the outstanding stock of
Synexus, pursuant to a merger of DAOU-Synexus and Synexus.
Under the terms of the related merger agreement, all of the
outstanding stock of Synexus was exchanged for 161,235 shares
of the Company's Common Stock. At the time of the transaction,
the shares of the Company's Common Stock issued to the former
Synexus stockholders were not registered under the Securities
Act because the transaction involved a non-public offering
exempt from registration under Section 4(2) of the Securities
Act and Regulation D promulgated thereunder.
2. On March 30, 1998, DAOU acquired all the outstanding stock of
Sentient, pursuant to a merger of DAOU-Sentient and Sentient.
Under the terms of the related merger agreement, all of the
outstanding stock of Sentient was exchanged for 1,397,550
shares of the Company's Common Stock. At the time of the
transaction, the shares of the Company's Common Stock issued
to the former Sentient stockholders were not registered under
the Securities Act because the transaction involved a
non-public offering exempt from registration under Section
4(2) of the Securities Act and Regulation D promulgated
thereunder.
3. On June 16, 1998, DAOU acquired all the outstanding stock of
TMI and affiliate IHCS (collectively "TMI"), pursuant to a
merger of DAOU-TMI and TMI. Under the terms of the related
merger agreement, all of the outstanding stock of TMI was
exchanged for 1,303,631 shares of the Company's Common Stock.
At the time of the transaction, the shares of the Company's
Common Stock issued to the former TMI stockholders were not
registered under the Securities Act because the transaction
involved a non-public offering exempt from registration under
Section 4(2) of the Securities Act and Regulation D
promulgated thereunder.
4. On June 26, 1998, DAOU acquired all the outstanding stock of
RHI and affiliates HTR, URG, ISS and GIC (collectively "RHI"),
pursuant to a merger of DAOU-RHI and RHI. Under the terms of
the related merger agreement, all of the outstanding stock of
RHI was exchanged for 2,929,822 shares of the Company's Common
Stock. At the time of the transaction, the shares of the
Company's Common Stock issued to the former RHI stockholders
were not registered under the Securities Act because the
transaction involved a non-public offering exempt from
registration
14
<PAGE>
under Section 4(2) of the Securities Act and
Regulation D promulgated thereunder.
USE OF PROCEEDS FROM INITIAL PUBLIC OFFERING. On February 12, 1997, the
Securities and Exchange Commission declared effective the Company's Registration
Statement on Form SB-2 File No. 333-18155 (the "Registration Statement")
relating to the initial public offering (the "Offering") of the Company's Common
Stock. The managing underwriters for the offering were Alex. Brown & Sons
Incorporated, Cowen & Company and Hambrecht & Quist LLC. The Registration
Statement registered an aggregate of 2,000,000 shares of Common Stock offered by
the Company. The Offering commenced on February 13, 1997 and the 2,000,000
shares of Common Stock covered by the Registration Statement were sold at $9.00
per share, resulting in aggregate offering proceeds to the Company of
$18,000,000.
The expenses incurred by the Company in connection with the Offering
were approximately $2,216,000, of which $1,260,000 constituted underwriting
discounts and commissions and $956,000 constituted other expenses including
registration and filing fees, printing, accounting and legal expenses. No direct
or indirect payments were made to any directors, officers, owners of ten percent
or more of any class of the Company's equity securities or other affiliates of
the Company other than for reimbursement of expenses incurred on the road show.
Net offering proceeds to the Company after deducting these expenses were
approximately $15,784,000.
The following sets forth certain information regarding the Company's
application of the net proceeds from the Offering through December 31, 1998:
<TABLE>
<S> <C>
Construction of Plant, Building and Facilities $ 27,000
Purchase and Installation of Machinery and Equipment $ 2,560,000
Purchase of Real Estate $ --
Acquisition of Other Business $ --
Repayment of Indebtedness $ 193,000
Working Capital $ 3,858,000
Marketable Securities $ 9,146,000
--------------
$15,784,000
--------------
</TABLE>
15
<PAGE>
ITEM 6: SELECTED CONSOLIDATED FINANCIAL DATA.
The following table presents selected 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" in Item 7 of this Report and the consolidated
financial statements and the related notes thereto included elsewhere herein.
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
1994 1995 1996 1997 1998
---------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Revenues $ 24,336 $ 36,448 $ 50,327 $ 68,656 $ 104,784
Cost of revenues 15,178 22,583 33,110 45,154 78,021
---------------------------------------------------------------------------
Gross profit 9,158 13,865 17,217 23,502 26,763
Operating expenses:
Sales and marketing 2,501 2,928 4,166 7,780 12,203
General and administrative 5,300 8,930 9,945 12,425 18,456
Merger and related expenses - - - 718 2,825
---------------------------------------------------------------------------
Total operating expenses 7,801 11,858 14,111 20,923 33,484
---------------------------------------------------------------------------
Income (loss) from operations 1,357 2,007 3,106 2,579 (6,721)
Interest income (expense), net 627 193 369 873 163
---------------------------------------------------------------------------
Income (loss) before income taxes 1,984 2,200 3,475 3,452 (6,558)
Provision (benefit) for income taxes 439 889 149 947 (802)
---------------------------------------------------------------------------
Net income (loss) $ 1,545 $ 1,311 $ 3,326 $ 2,505 $ (5,756)
---------------------------------------------------------------------------
---------------------------------------------------------------------------
Net income (loss) per common share:
Basic $ 0.13 $ 0.11 $ 0.26 $ 0.15 $ (0.33)
---------------------------------------------------------------------------
---------------------------------------------------------------------------
Diluted $ 0.13 $ 0.10 $ 0.23 $ 0.15 $ (0.33)
---------------------------------------------------------------------------
---------------------------------------------------------------------------
Shares used in computing net
income (loss) per common share:
Basic 12,251 12,260 12,580 16,231 17,657
---------------------------------------------------------------------------
---------------------------------------------------------------------------
Diluted 12,251 12,548 14,385 17,246 17,657
---------------------------------------------------------------------------
---------------------------------------------------------------------------
Cash equivalents and short-term
investments $ 1,847 $ 7,493 $ 3,962 $ 18,288 $ 7,780
Total assets 7,010 19,735 21,672 54,105 54,517
Long-term debt, less current portion 64 45 32 49 26
Redeemable preferred stock - 7,705 8,190 - -
Total stockholders' equity 2,009 3,498 6,304 41,837 34,775
</TABLE>
16
<PAGE>
ITEM 7: MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND
RESULTS OF OPERATIONS.
The following discussion of the Financial Condition and Results of
Operations contains forward-looking statements within the meaning of Section
27A of the Securities Act of 1933, 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
word "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 previously and in the
Company's other SEC filings. In evaluating such statements, prospective
investors should specifically consider various factors identified in this
Report, including the matters set forth previously under the caption "Risk
Factors," which could cause actual results to differ materially from those
indicated by such forward-looking statements.
OVERVIEW
The Company provides integrated information technology solutions and
services to the U.S. healthcare industry. DAOU's capabilities range from
up-front strategic consulting to IT system design, implementation and long-term
tactical support. DAOU's information technology offerings include Application
Implementation, Communications Infrastructure, Management Consulting and
Integration Services. The Company's Application Implementation Group supplies
staffing resources to hospitals and other healthcare organizations. DAOU's
vendor certified consultants are capable of installing nearly 90% of the most
common healthcare applications. The Company's Communications Infrastructure
Group focuses on the information superstructure in healthcare enterprises,
including networking, Intranet and Internet, desktop, and voice, video and data
solutions. Management Consulting develops business plans and solves problems for
healthcare IT managers, installs and integrates applications, engineers,
installs and integrates infrastructure, and manages IT systems. DAOU's
Integration Services Group analyzes, implements and supports information systems
that meet a customer's business objectives and reduce the cost and improve the
quality of care. 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.
During June 1998, the Company acquired through its wholly-owned
subsidiaries DAOU-TMI, Inc. and DAOU-RHI, Inc. (i) Technology Management, Inc.
("TMI"), a privately-held company that provides information technology
consulting services primarily to the healthcare industry, (ii) International
Health Care Systems, Inc.("IHCS"), a privately-held company with a common
shareholder with TMI that provides information technology consulting services
primarily to the healthcare industry on behalf of TMI, (iii) Resources in
Healthcare Innovations, Inc. ("RHI"), a privately-held information technology
services firm that provides contract management services for healthcare
information systems to hospitals and managed care organizations, and (iv)
Healthcare Transition Resources, Inc. ("HTR"), Ultitech Resources Group, Inc.
("URG"), Innovative Systems Solutions, Inc. ("ISS") and Grand Isle Consulting,
Inc. ("GIC"), each a privately held company with common shareholders of RHI that
implement software applications from third parties and provides support services
to healthcare enterprises. Shareholders of TMI, IHCS, RHI, HTR, URG, ISS and GIC
received 1,078,963, 224,668, 1,839,381, 275,662, 282,551, 308,583 and 223,645
shares, respectively, of the Company's Common Stock in exchange for all of the
outstanding stock of each of these companies. The above acquisitions have been
accounted for using the pooling-of-interests method of accounting. 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 March 1998, the Company acquired through its wholly-owned
subsidiaries DAOU-Synexus, Inc. and DAOU- Sentient, Inc.: 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 which provides integration
and support services primarily to healthcare organizations. Shareholders of
Synexus and Sentient received 161,235 and 1,397,550 shares, respectively, of the
Company's Common Stock in exchange for all of the outstanding stock of each of
these companies. The above acquisitions have been accounted for using the
pooling-of-interests method of accounting, and accordingly, the historical
financial statements of periods prior to the consummation of the combinations
have been restated as though the companies had been combined for all periods
presented.
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
17
<PAGE>
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
activities.
The Company's Consolidated Financial Statements and Notes thereto
reflect the combined financial position and operating results for the Company,
DAOU-Integrex, DAOU On-Line, DAOU-Synexus, DAOU-Sentient, DAOU-TMI and DAOU-RHI
for all periods presented in this Report.
Historically, the majority of the Company's revenues have been derived
from network implementation services, which are generally provided on a
fixed-fee basis and professional services consulting and management contracts,
which are provided on a "time and expense" basis. Revenues on fixed-fee
contracts 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'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. Professional services consulting and
management services are generally provided on a "time and expense" basis for
which revenues are recognized as the services are performed. The time to
complete implementation projects generally ranges from three to six months,
although certain projects have required up to 13 months for completion. The
Company also provides support and management service revenues, which are
recognized ratably over the period that these services are provided. 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.
RESULTS OF OPERATIONS
YEARS ENDED DECEMBER 31, 1998 AND 1997
The Company's revenues were $104.8 million and $68.7 million for the
years ended December 31, 1998 and 1997, respectively, representing an increase
of $36.1 million or approximately 53%. Revenues increased primarily due to the
increased number of professional services consulting contracts, which accounted
for $15.6 million, increases in professional services management contracts which
accounted for $7.3 million and an increase in large network implementation
contracts of $6.3 million. Services to DAOU's five largest customers accounted
for $20.3 million of total revenues in 1998, representing 19% of total revenues.
Cost of revenues for the years ended December 31, 1998 and 1997 were
$78.0 million and $45.2 million, respectively, representing an increase of $32.8
million or approximately 73%. Gross margin for the years ended December 31, 1998
and 1997, was approximately 26% and 34%, respectively. This decrease in gross
margin during 1998 was 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 concerning questions about the
Company's accounting practices. The Company's margins also were 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 $12.2 million and $7.8 million for
the years ended December 31, 1998 and 1997, respectively, representing an
increase of approximately 57%. 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 approximately 12% and 11% of total revenues for the years ended
December 31, 1998 and 1997, respectively. Although the Company believes
18
<PAGE>
that 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 $18.5 million (excluding
one-time direct merger costs of $2.8 million) and $12.4 million for the years
ended December 31, 1998 and 1997, respectively, representing an increase of
approximately 49%. 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, increases in the provision for
uncollectible accounts 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 approximately 18%
of total revenues for the years ended December 31, 1998 and 1997. 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 continued
integration of acquired companies.
Net interest income was $163,000 and $873,000 for the years ended
December 31, 1998 and 1997, 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 lines of credit.
The decrease in net interest income was primarily due to overall lower average
cash reserves available for investment during 1998 as compared to 1997.
YEARS ENDED DECEMBER 31, 1997 AND 1996
The Company's revenues were $68.7 million and $50.3 million for the
years ended December 31, 1997 and 1996, respectively, representing an increase
of $18.3 million or approximately 36%. Revenues increased primarily due to the
increased number of professional services consulting contracts, which accounted
for $9.0 million, increases in professional services management contracts which
accounted for $4.5 million and an increase in large network implementation
contracts of $4.8 million. Services to DAOU's five largest customers accounted
for $15.4 million of total revenues in 1997, representing 22% of total revenues.
Cost of revenues was $45.2 million and $33.1 million for the years
ended December 31, 1997 and 1996, respectively, representing an increase of
$12.0 million or approximately 36%. Gross margin was 34% for the years ended
December 31, 1997 and 1996. The margin remained consistent with the prior year
due primarily to a higher percentage of product content within implementation
services as compared to 1996 and increased revenues from low-margin desktop
node fee contracts.
Sales and marketing expenses were $7.8 million and $4.2 million for the
years ended December 31, 1997 and 1996, respectively, representing an increase
of approximately 87%. This increase was primarily due to the 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 11% and 8% of revenues for the years ended December 31, 1997 and
1996, respectively.
General and administrative expenses were $12.4 million (excluding
one-time direct merger costs of $718,000) and $9.9 million for the years ended
December 31, 1997 and 1996, respectively, representing an increase of
approximately 25%. The primary factors contributing to this increase were costs
associated with the 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 18% and 20% of revenues
for the years ended December 31, 1997 and 1996, respectively.
Net interest income was $873,000 and $369,000 for the years ended
December 31, 1997 and 1996, 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 financing of insurance premiums,
but was not significant during either period. This increase was due primarily to
overall higher average cash reserves available for investment during 1997 as
compared to 1996. The Company's initial public offering of Common Stock in
February 1997 raised $15.8 million, net of issuance costs, and the Company's
secondary public offering in August 1997 raised $9.3 million, net of issuance
costs.
INCOME TAXES
In 1998, 1997 and 1996, the effective tax rates were approximately
(12)%, 27% and 4%, respectively, and were different from the expected
combined federal statutory rate of 35% primarily due to the fact that
19
<PAGE>
Integrex, On-Line, Sentient, Synexus, TMI and RHI were S-corporations prior
to the merger with DAOU and the conversion from the cash method to the
accrual method of accounting for tax purposes. Consequently, taxes on the
pre-acquisition income of Integrex, On-Line, Sentient, Synexus, TMI and RHI
were the direct responsibility of its stockholders. During 1998 and 1997, the
benefit of Integrex, On-Line's, Sentient's, Synexus, TMI's and RHI's lower
tax rates were partially offset by additional taxes on the conversion of
S-corporation to C-corporation.
LIQUIDITY AND CAPITAL RESOURCES
On December 31, 1998, the Company had working capital of $31.7 million,
a decrease of $7.9 million from $39.6 million on December 31, 1997. For the year
ended December 31, 1998, cash used in operating activities was $9.0 million
which resulted primarily from the loss from operations and an increase in the
Company's investment in accounts receivable due to the growth in revenues.
Net cash provided by investing activities was $7.5 million in the
current period, compared to net cash used in investing activities of $12.9
million in the comparable prior period. This change was primarily the result of
the generation of $9.4 million in cash as a result of maturing marketable
securities, which were not reinvested.
Net cash provided by financing activities decreased to $328,000 for
the year ended December 31, 1998, compared to $26.2 million in the comparable
prior period. This change was primarily the result of the Company's initial
and secondary public offerings of Common Stock in 1997, which raised $15.8
million, net of issuance costs and $9.3 million, net of issuance costs,
respectively. Additionally, during 1998 distributions to stockholders and
repayments of debt and lines of credit of acquired companies accounted for an
additional $6.8 million of the change.
During June 1998, the Company secured two borrowing facilities, a
$2.0 million revolving line of credit, under which none is available for
future borrowings at December 31, 1998, and an additional $8,000,000 line of
credit, under which $6.0 million is available for future borrowings at
December 31, 1998. Advances under both lines bear interest at the bank's
prime rate plus 0.25% (8.0% at December 31, 1998) per annum. These lines of
credit expire July 31, 1999, are secured by substantially all of the assets
of the Company and contain customary covenants and restrictions. As of
December 31, 1998, the Company was not in compliance with one of the
covenants and has been informed by the bank that the Company cannot avail
itself to the unused lines of credit. Management is actively negotiating for
a replacement line of credit, believes that a replacement line will be
obtained before expiration of the existing lines of credit and that the
Company has sufficient liquidity to fund operations until this new line is in
place. At February 28, 1999, the Company had cash equivalents of
approximately $7.5 million (Unaudited), accounts receivable of approximately
$22.5 million (Unaudited) and has provided positive cash flows from operating
activities of approximately $700,000 for the two months ended February 28,
1999 (Unaudited).
Although the Company has an accumulated deficit and has used cash in
its operating activities over the past three years, the Company believes that
its available funds together with anticipated cash from operating activities in
future years will be sufficient to meet its capital requirements for the
foreseeable future. The Company may sell additional equity or debt securities or
obtain additional credit facilities. The sale of additional equity securities or
issuance of equity securities in future acquisitions could result in additional
dilution to the Company's stockholders and the incurrence of additional debt
could result in additional interest expense.
YEAR 2000
The Company is preparing for the impact of the arrival of the Year 2000
on its business, as well as on the businesses of its customers and suppliers.
The "Year 2000 Issue" is a term used to describe the problems created by systems
that are unable to accurately interpret dates after December 31, 1999. These
problems are derived predominantly from the fact that many software programs
have historically categorized the "year" in a two-digit format. The Year 2000
Issue creates potential risks for the Company, including potential problems in
the Company's Information Technology and non-IT systems that the Company uses in
its business operations. The Company may also be exposed to risks from third
parties with whom the Company interacts who fail to adequately address their own
Year 2000 Issues.
While the Company's Year 2000 efforts have been underway for several years, the
Company centralized its focus on addressing the Year 2000 Issue in 1998 by
forming a Year 2000 cross-functional project team. The Audit Committee of the
Board of Directors is advised periodically on the status of the Company's Year
2000 compliance program.
20
<PAGE>
The Company has undertaken various initiatives intended to ensure that
its computer equipment and software will function properly with respect to dates
in the year 2000 and thereafter. For this purpose, the term "computer equipment
and software" includes systems that are commonly thought of as information
technology ("IT") systems, including accounting, data processing, and
telephone/PBX systems, scanning equipment, and other miscellaneous systems, as
well as systems that are not commonly thought of as IT systems, such as alarm
systems, sprinkler systems, fax machines, or other miscellaneous systems. Both
IT and non-IT systems may contain imbedded technology, which complicates the
Company's Year 2000 identification, assessment, remediation, and testing
efforts. Based upon its identification and assessment efforts to date, the
Company believes that certain of the computer equipment and software that it
currently uses will require replacement or modification. In addition, in the
ordinary course of replacing computer equipment and software, the Company
attempts to obtain replacements that it believes are Year 2000 compliant.
Utilizing both internal and external resources to identify and assess needed
Year 2000 remediation, the Company currently anticipates that its Year 2000
identification, assessment, remediation, and testing efforts, which began in
1996, will be completed by September 30, 1999, and that such efforts will be
completed prior to any currently anticipated impact on its computer equipment
and software. The Company estimates that as of December 31, 1998, it had
completed approximately 60% of the initiatives that it believes will be
necessary to fully address potential Year 2000 issues relating to its computer
equipment and software. The projects comprising the remaining 40% of the
initiatives are in process and expected to be completed on or about September
30, 1999.
The Company intends to mail letters to its significant vendors and
service providers and has verbally communicated with many strategic customers
and vendors to determine the extent to which interfaces with such entities are
vulnerable to Year 2000 issues and whether the products and services purchased
from or by such entities are Year 2000 compliant. As of December 31, 1998, the
Company has assembled Year 2000 compliance statements from 100% of its vendors.
The Company believes that the cost of its Year 2000 identification,
assessment, remediation, and testing efforts, as well as currently anticipated
costs to be incurred by the Company with respect to Year 2000 issues of third
parties, will not exceed $200,000, which expenditures will be funded from
operating cash flows. As of December 31, 1998, the Company had incurred costs of
approximately $50,000 related to its Year 2000 identification, assessment,
remediation, and testing efforts. Other non-Year 2000 IT efforts have not been
materially delayed or impacted by Year 2000 initiatives.
There can be no assurance that the Company will be completely
successful in its efforts to address Year 2000 Issues. If some of the Company's
products are not Year 2000 compliant, the Company could suffer lost sales or
other negative consequences, including, but not limited to, diversion of
resources, damage to the Company's reputation, increased service and warranty
costs and litigation, any of which could materially adversely affect the
Company's business operations or financial results.
The Company also is dependent on third parties such as its customers,
suppliers and service providers. If these or other third parties fail to
adequately address Year 2000 issues, the Company could experience a negative
impact on its business operations or financial results.
Although the Company has not yet developed a comprehensive contingency
plan to address situations that may result if the Company or any of the third
parties upon which the Company is dependent is unable to achieve Year 2000
readiness, the Company's Year 2000 compliance program is ongoing and its
ultimate scope, as well as the consideration of contingency plans, will continue
to be evaluated as new information becomes available.
The costs of the Company's Year 2000 identification, assessment,
remediation, and testing efforts and the dates on which the Company believes
it will complete such efforts are based upon management's best estimates,
which were derived using numerous assumptions regarding future events,
including the continued availability of certain resources, third-party
remediation plans, and other factors. There can be no assurance that these
estimates will prove to be accurate and actual results could differ
materially from those currently anticipated. Specific factors that could
cause such material differences include, but are not limited to, the
availability and cost of personnel trained in Year 2000 issues, the ability
to identify, assess, remediate, and test all relevant computer codes and
imbedded technology, and similar uncertainties. In addition, variability of
definitions of "compliance with Year 2000" and the myriad of different
products and services, and combinations thereof, sold by the Company may lead
to claims whose impact on the Company is not currently estimable. No
assurance can be given that the aggregate cost of defending and resolving
such claims, if any, will not materially adversely affect the Company's
business, financial condition and results of operations. Although some of the
Company's agreements with manufacturers and others from whom it purchases
products for resale contain provisions requiring such parties to indemnify
the Company under some circumstances, there can be no
21
<PAGE>
assurance that such indemnification arrangements will cover all of the
Company's liabilities and costs related to claims by third parties related to
the Year 2000 issue.
ITEM 7A. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISKS
The Company does not have any significant financial instruments. The
Company's bank lines of credit are affected by the general level of U.S.
interest rates. Due to the short duration of the Company's investment
portfolio, an immediate 100 basis point increase in interest rates would have
no material impact on the Company's financial condition or results of
operations.
ITEM 8: FINANCIAL STATEMENTS.
INDEX TO CONSOLIDATED FINANCIAL STATEMENTS
DAOU SYSTEMS, INC.
<TABLE>
<S> <C>
Report of Ernst & Young LLP, Independent Auditors 23
Report of Deloitte & Touche LLP, Independent Auditors 24
Consolidated Balance Sheets at December 31, 1998 and 1997 25
Consolidated Statements of Operations for the years ended
December 31, 1998, 1997 and 1996 26
Consolidated Statements of Stockholders' Equity for the
years ended December 31, 1998, 1997 and 1996 27
Consolidated Statements of Cash Flows for the years ended
December 31, 1998, 1997 and 1996 29
Notes to Consolidated Financial Statements 30
</TABLE>
22
<PAGE>
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders,
DAOU Systems, Inc.
We have audited the consolidated balance sheets of DAOU Systems, Inc. as of
December 31, 1998 and 1997 and the related consolidated statements of
operations, stockholders' equity, and cash flows for each of the three years
in the period ended December 31, 1998. Our audits also include the financial
statement schedule listed in the index of item 14(a). These consolidated
financial statements and schedule are the responsibility of the Company's
management. Our responsibility is to express an opinion on these consolidated
financial statements based on our audits. We did not audit the balance sheet
of Sentient Systems, Inc. as of December 31, 1997 or the related statements
of operations, stockholders' equity and cash flows for the years ended
December 31, 1997 and 1996, which statements reflect total assets of 6% as of
December 31, 1997 of the related consolidated financial statement totals and
which reflect net income constituting 28% and 22% of the related consolidated
financial statement totals for the years ended December 31, 1997 and 1996.
These statements were audited by other auditors whose report has been
furnished to us, and our opinion, insofar as it relates to Sentient Systems,
Inc., is based solely on the report of other auditors.
We conducted our audits in accordance with generally accepted auditing
standards. Those standards require that we plan and perform the audit to obtain
reasonable assurance about whether the financial statements are free of material
misstatement. An audit includes examining, on a test basis, evidence supporting
the amounts and disclosures in the financial statements. An audit also includes
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement presentation.
We believe that our audits and the report of the other auditors provide a
reasonable basis for our opinion.
In our opinion, based on our audits and the report of other auditors, the
consolidated financial statements referred to above present fairly, in all
material respects, the consolidated financial position of DAOU Systems, Inc. at
December 31, 1998 and 1997 and the results of its operations and its cash flows
for each of the three years in the period ended December 31, 1998 in conformity
with generally accepted accounting principles. Also, in our opinion the
related financial statement schedule, when considered in relation to the
basic financial statements taken as a whole, present fairly in all material
respects the information set forth therein.
ERNST & YOUNG LLP
San Diego, California
February 12, 1999
23
<PAGE>
INDEPENDENT AUDITORS' REPORT
To the Board of Directors of Sentient Systems, Inc.
Kensington, Maryland
We have audited the accompanying balance sheet of Sentient Systems, Inc. (the
Company) as of December 31, 1997 and the related statements of operations,
changes in stockholders' equity, and cash flows for the years ended December
31, 1997 and 1996. 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 the
results of its operations and its cash flows for the years ended December 31,
1997 and 1996, in conformity with generally accepted accounting principles.
/s/ Deloitte & Touche LLP
McLean, Virginia
February 13, 1998
24
<PAGE>
DAOU Systems, Inc.
Consolidated Balance Sheets
(IN THOUSANDS, EXCEPT FOR PER SHARE DATA)
<TABLE>
<CAPTION>
DECEMBER 31,
1998 1997
--------------------------
<S> <C> <C>
ASSETS
Current assets:
Cash and cash equivalents $ 6,756 $ 7,981
Short-term investments, available-for-sale 1,024 10,307
Accounts receivable, net of allowance for doubtful
accounts of $956 and $312 in 1998 and 1997, respectively 24,582 15,744
Contract work in progress 12,272 13,291
Income tax receivable 234 421
Deferred income taxes 3,362 323
Other current assets 1,072 1,343
--------------------------
Total current assets 49,302 49,410
Due from officers/stockholders 171 371
Equipment, furniture and fixtures, net 4,735 3,859
Other assets 309 465
--------------------------
$ 54,517 $ 54,105
--------------------------
--------------------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Trade accounts payable $ 3,514 $ 1,661
Accrued salaries and benefits 3,907 2,675
Other accrued liabilities 4,402 3,482
Deferred revenue 361 369
Current portion of deferred compensation to officers 559 -
Current portion of severance payable 210 210
Current portion of long-term debt and line of credit 4,684 1,437
--------------------------
Total current liabilities 17,637 9,834
Deferred rent 45 55
Long-term debt 26 49
Severance payable 613 823
Deferred compensation to officers - 1,117
Deferred income taxes 1,421 390
Commitments and contingencies
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 - 17,689 in 1998 and 16,945 in 1997 18 17
Additional paid-in capital 38,419 36,040
Deferred compensation (980) (907)
Accumulated other comprehensive income 236 146
Retained earnings (deficit) (2,918) 6,541
--------------------------
Total stockholders' equity 34,775 41,837
--------------------------
$ 54,517 $ 54,105
--------------------------
--------------------------
</TABLE>
SEE ACCOMPANYING NOTES.
25
<PAGE>
DAOU Systems, Inc.
Consolidated Statements of Operations
(IN THOUSANDS, EXCEPT FOR PER SHARE DATA)
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
1998 1997 1996
---------------------------------------------
<S> <C> <C> <C>
Revenues $ 104,784 $ 68,656 $ 50,327
Cost of revenues 78,021 45,154 33,110
---------------------------------------------
Gross profit 26,763 23,502 17,217
Operating expenses:
Sales and marketing 12,203 7,780 4,166
General and administrative 18,456 12,425 9,945
Merger and related expenses 2,825 718 -
---------------------------------------------
33,484 20,923 14,111
---------------------------------------------
Income (loss) from operations (6,721) 2,579 3,106
Interest income, net 163 873 369
---------------------------------------------
Income (loss) before income taxes (6,558) 3,452 3,475
Provision (benefit) for income taxes (802) 947 149
---------------------------------------------
Net income (loss) $ (5,756) $ 2,505 $ 3,326
---------------------------------------------
---------------------------------------------
Net income (loss) per common share:
Basic $ (0.33) $ 0.15 $ 0.26
---------------------------------------------
---------------------------------------------
Diluted $ (0.33) $ 0.15 $ 0.23
---------------------------------------------
---------------------------------------------
Shares used in computing net income (loss) per common share:
Basic 17,657 16,231 12,580
---------------------------------------------
---------------------------------------------
Diluted 17,657 17,246 14,385
---------------------------------------------
---------------------------------------------
</TABLE>
SEE ACCOMPANYING NOTES.
26
<PAGE>
DAOU SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
(IN THOUSANDS)
<TABLE>
<CAPTION>
ACCUMULATED ACCRETION OF
COMMON STOCK ADDITIONAL OTHER REDEEMABLE
----------------- PAID-IN DEFERRED COMPREHENSIVE PREFERRED
SHARES AMOUNT CAPITAL COMPENSATION INCOME STOCK
------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1995 12,321 $12 $ 192 $ - $ 95 $ (87)
Deferred compensation - - 1,243 (1,243) - -
Amortization of deferred compensation - - - 77 - -
Issuance of common stock in exchange for
services 35 - 30 - - -
Shares issued in connection with formation of
S corporation 225 - 25 - - -
Issuance of common stock for cash 252 1 100 - - -
Repurchase and retirement of stock (37) - (6) - - -
Accretion of redeemable preferred stock - - - - - (485)
Distribution to Sentient stockholders (NOTE 2) - - - - - -
Adjustment for change in Sentient Systems,
Inc.'s year end - - - - (7) -
Comprehensive Income:
Unrealized gain on short-term investments - - - - 13 -
Net income - - - - - -
Comprehensive income
-----------------------------------------------------------------------
Balance at December 31, 1996 12,796 13 1,584 (1,166) 101 (572)
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 - - 572
Issuance of common stock upon secondary public
offering, net 500 - 9,320 - - -
Issuance of common stock upon exercise of
stock options 142 - 639 - - -
Tax benefit from exercise of noncompensatory
stock options - - 1,103 - - -
Amortization of deferred compensation - - - 259 - -
Shares issued in connection with formation of
S corporation 584 1 (1) - - -
Repurchase of founders stock (680) (1) (3) - - -
Distribution to Integrex stockholders (NOTE 2) - - - - - -
Distribution to On-Line stockholders (NOTE 2) - - - - - -
Distribution to Sentient stockholders (NOTE 2) - - - - - -
Distribution to TMI stockholders (NOTE 2) - - - - - -
Comprehensive Income:
Unrealized gain on short-term investments - - - - 45 -
Net income - - - - - -
Comprehensive income
-----------------------------------------------------------------------
Balance at December 31, 1997 16,945 $17 $36,040 $ (907) $146 $ -
<CAPTION>
RETAINED
EARNINGS TOTAL STOCKHOLDERS'
(DEFICIT) EQUITY
-------------------------------
<S> <C> <C>
Balance at December 31, 1995 $ 3,287 $ 3,499
Deferred compensation - -
Amortization of deferred compensation - 77
Issuance of common stock in exchange for
services - 30
Shares issued in connection with formation of
S corporation - 25
Issuance of common stock for cash - 101
Repurchase and retirement of stock (34) (40)
Accretion of redeemable preferred stock - (485)
Distribution to Sentient stockholders (NOTE 2) (146) (146)
Adjustment for change in Sentient Systems,
Inc.'s year end (89) (96)
Comprehensive Income:
Unrealized gain on short-term investments - 13
Net income 3,326 3,326
-------
Comprehensive income 3,339
-------
-------------------------
Balance at December 31, 1996 6,344 6,304
Issuance of common stock upon initial public
offering, net - 15,784
Conversion of redeemable preferred stock upon
initial public offering - 8,190
Issuance of common stock upon secondary public
offering, net - 9,320
Issuance of common stock upon exercise of
stock options - 639
Tax benefit from exercise of noncompensatory
stock options - 1,103
Amortization of deferred compensation - 259
Shares issued in connection with formation of
S corporation - -
Repurchase of founders stock (1,116) (1,120)
Distribution to Integrex stockholders (NOTE 2) (94) (94)
Distribution to On-Line stockholders (NOTE 2) (63) (63)
Distribution to Sentient stockholders (NOTE 2) (391) (391)
Distribution to TMI stockholders (NOTE 2) (644) (644)
Comprehensive Income:
Unrealized gain on short-term investments - 45
Net income 2,505 2,505
-------
Comprehensive income 2,550
-------
----------------------
Balance at December 31, 1997 $ 6,541 $41,837
</TABLE>
27
<PAGE>
DAOU SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY (CONTINUED)
(IN THOUSANDS)
<TABLE>
<CAPTION>
ACCUMULATED ACCRETION OF
COMMON STOCK ADDITIONAL OTHER REDEEMABLE
----------------- PAID-IN DEFERRED COMPREHENSIVE PREFERRED
SHARES AMOUNT CAPITAL COMPENSATION INCOME STOCK
------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Balance at December 31, 1997 16,945 $17 $36,040 $ (907) $146 $ -
Shares issued in connection with formation of
S corporations 506 1 506 - - -
Deferred compensation - - 385 (385) - -
Tax benefit from exercise of noncompensatory
stock options - - 630 - - -
Amortization of deferred compensation - - - 312 - -
Distribution to Sentient stockholders (NOTE 2) - - - - - -
Distribution to TMI stockholders (NOTE 2) - - - - - -
Distribution to RHI stockholders (NOTE 2) - - - - - -
Issuance of common stock upon exercise of stock
options 236 - 844 - - -
Issuance of common stock upon exercise of
warrants 2 - 14 - - -
Comprehensive loss:
Unrealized gain on short-term investments - - - - 90 -
Net loss - - - - - -
Comprehensive loss
------------------------------------------------------------------------
Balance at December 31, 1998 17,689 $18 $38,419 $ (980) $236 $ -
------------------------------------------------------------------------
------------------------------------------------------------------------
<CAPTION>
RETAINED
EARNINGS TOTAL STOCKHOLDERS'
(DEFICIT) EQUITY
-------------------------------
<S> <C> <C>
Balance at December 31, 1997 $6,541 $41,837
Shares issued in connection with formation of
S corporations - 507
Deferred compensation - -
Tax benefit from exercise of noncompensatory
stock options - 630
Amortization of deferred compensation - 312
Distribution to Sentient stockholders (NOTE 2) (252) (252)
Distribution to TMI stockholders (NOTE 2) (2,945) (2,945)
Distribution to RHI stockholders (NOTE 2) (506) (506)
Issuance of common stock upon exercise of stock
options - 844
Issuance of common stock upon exercise of
warrants - 14
Comprehensive loss:
Unrealized gain on short-term investments - 90
Net loss (5,756) (5,756)
--------------
Comprehensive loss (5,666)
--------------
-------------------------------
Balance at December 31, 1998 $(2,918) $34,775
-------------------------------
-------------------------------
</TABLE>
SEE ACCOMPANYING NOTES.
28
<PAGE>
DAOU Systems, Inc.
Consolidated Statements of Cash Flows
(IN THOUSANDS)
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
1998 1997 1996
-------------------------------------------
<S> <C> <C> <C>
OPERATING ACTIVITIES
Net income (loss) $(5,756) $2,505 $3,326
Adjustments to reconcile net income (loss) to net
cash used in operating activities:
Depreciation and amortization 1,715 1,324 613
Provision for uncollectible accounts 644 70 108
Common stock issued in exchange for services - - 30
Deferred income taxes (1,378) 266 20
Changes in operating assets and liabilities:
Accounts receivable (9,482) (5,370) (949)
Contract work in progress 1,019 (9,169) (3,263)
Other current assets 458 (1,087) (520)
Accounts payable and accrued liabilities 2,773 2,358 (1,963)
Accrued salaries and benefits 1,232 419 (195)
Deferred revenue (8) (741) 574
Severance payable (210) 1,033 -
Deferred rent (10) (37) 66
-------------------------------------------
Net cash used in operating activities (9,003) (8,429) (2,153)
INVESTING ACTIVITIES
Purchase of equipment, furniture and fixtures (2,279) (3,163) (1,247)
Decrease (increase) in other assets 156 (186) (96)
Purchases of short-term investments (8) (9,462) (130)
Maturities of short-term investments 9,381 39 3,879
Payments from (advances to) officers/stockholders 200 (143) (17)
-------------------------------------------
Net cash provided by (used in) investing activities 7,450 (12,915) 2,389
FINANCING ACTIVITIES
Proceeds from long-term debt, line of credit and
deferred compensation to officers 5,795 1,246 116
Repayments of long-term debt, line of credit and
deferred compensation to officers (3,129) (60) (87)
Distributions to stockholders of acquired companies (3,703) (706) (146)
Proceeds from issuance of common stock and redeemable
preferred stock 1,365 26,842 126
Repurchase of founders stock - (1,120) (40)
-------------------------------------------
Net cash provided by (used in) financing activities 328 26,202 (31)
-------------------------------------------
Increase (decrease) in cash and cash equivalents (1,225) 4,858 205
Cash and cash equivalents at beginning of year 7,981 3,123 2,918
-------------------------------------------
Cash and cash equivalents at end of year $ 6,756 $ 7,981 $ 3,123
-------------------------------------------
-------------------------------------------
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION:
Cash paid during the year for:
Income taxes $ 144 $ 115 $ 982
-------------------------------------------
-------------------------------------------
Interest $ 290 $ 113 $ 46
-------------------------------------------
-------------------------------------------
SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND
FINANCING ACTIVITIES:
Accrued dividends payable to TMI, Inc. stockholders $ - $ 487 $ -
-------------------------------------------
-------------------------------------------
Tax benefit from exercise of noncompensatory options $ 630 $ - $ -
-------------------------------------------
-------------------------------------------
Conversion of redeemable preferred stock and
accreted dividends to common stock $ - $ 7,618 $ -
-------------------------------------------
-------------------------------------------
</TABLE>
SEE ACCOMPANYING NOTES.
- -------------------------------------------------------------------------------
29
<PAGE>
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
ORGANIZATION AND BASIS OF PRESENTATION
DAOU Systems, Inc. ("DAOU" or the "Company") provides integrated information
technology ("IT") solutions and services to the U.S. healthcare industry. DAOU's
capabilities range from up-front strategic consulting to IT system design,
implementation and long-term tactical support. DAOU's information technology
offerings include Application Implementation, Communications Infrastructure,
Management Consulting and Integration Services. The Company's Application
Implementations Group supplies staffing resources to hospitals and other
healthcare organizations. DAOU's vendor certified consultants are capable of
installing nearly 90% of the most common healthcare applications. The Company's
Communications Infrastructure group focuses on the information superstructure in
healthcare enterprises, including networking, Intranet and Internet, desktop,
and voice, video and data solutions. Management Consulting develops business
plans and solves problems for healthcare IT managers, installs and integrates
applications, engineers, installs and integrates infrastructure, and manages IT
systems. DAOU's Integration Services Group analyzes, implements and supports
information systems that meet a customer's business objectives and reduce the
cost and improve the quality of care.
In March 1998, the Company acquired all of the issued and outstanding shares of
Synexus Incorporated ("Synexus") and Sentient Systems, Inc. ("Sentient") through
the Company's wholly-owned subsidiaries DAOU-Synexus, Inc. and DAOU-Sentient,
Inc. In June 1998, the Company acquired all of the issued and outstanding shares
of Technology Management, Inc. and Affiliate and Resources in Healthcare
Innovations, Inc. and Affiliates, through the Company's wholly-owned
subsidiaries DAOU-TMI, Inc. and DAOU-RHI, Inc. The above acquisitions were
accounted for using the pooling-of-interests method of accounting and,
accordingly, the consolidated financial statements reflect the combined
financial position and operating results for the Company, Synexus, Sentient,
Technology Management, Inc. and Affiliate, and Resources in Healthcare
Innovations and Affiliates for all periods presented giving retroactive effect
to the pooling transactions. All significant intercompany accounts have been
eliminated.
REVENUE RECOGNITION
Contract revenue for the development and implementation of network solutions
under fixed-fee contracts is recognized using the percentage-of-completion
method with progress to completion measured by labor costs incurred to date
compared to total estimated labor costs. Provisions for estimated losses on
contracts, if any, are made during the period when the loss becomes probable and
can be reasonably estimated. Revenues recognized in excess of amounts billed and
project costs are classified as contract work in progress. Revenue from
technical support and network management services is recognized as the services
are performed. Payments received in advance of services performed are recorded
as deferred revenue and amortized as the services are performed.
CONCENTRATION OF CREDIT RISK AND MAJOR CUSTOMER
Substantially all of the Company's accounts receivable are from hospitals and
other healthcare providers. Generally, the Company obtains a significant deposit
from its customers upon signing a contract and collateral is not required. The
Company provides for losses from uncollectible accounts and such losses have
historically not exceeded management's expectations. No customer accounted for
more than 10% of the Company's revenues in any period presented.
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 material losses on its cash
equivalents or short-term investments.
The Company classifies its short-term investments as "Available-for-Sale" and
records such assets at the estimated fair value on the balance sheet with
unrealized gains and losses excluded from earnings and reported as a separate
component of stockholders' equity until realized. The basis for computing
realized gains or losses is by specific identification.
- -------------------------------------------------------------------------------
30
<PAGE>
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
EQUIPMENT, FURNITURE AND FIXTURES
Equipment, furniture and fixtures are carried at cost. Depreciation is computed
using the straight-line method over the estimated useful lives of the assets,
ranging from three to seven years. Leasehold improvements are amortized over the
lesser of the estimated useful lives of the assets or the remaining lease term.
USE OF ESTIMATES
The preparation of financial statements in conformity with generally accepted
accounting principles requires management to make estimates and assumptions
about the future that affect the amounts reported in the financial statements
and disclosures made in the accompanying notes of the financial statements. The
actual results could differ from those estimates.
NET INCOME (LOSS) PER SHARE
Net income (loss) per share are computed in accordance with FASB Statement No.
128, EARNINGS PER SHARE. Basic net income (loss) per share are computed using
the weighted average number of common shares outstanding during each period.
Diluted net income (loss) per share includes the dilutive effect of common
shares potentially issuable upon the exercise of stock options and warrants. In
1998, diluted loss per share is unchanged from basic loss per share because the
effects of the assumed conversion of stock options and warrants would be
anti-dilutive.
The following table sets forth the computation of the shares used in the basic
and diluted net income (loss) per share calculation (IN THOUSANDS):
<TABLE>
<CAPTION>
DECEMBER 31,
1998 1997 1996
-----------------------------------------------
<S> <C> <C> <C>
Shares used in Basic net income (loss) per share -
weighted average common shares outstanding 17,657 16,231 12,580
-----------------------------------------------
-----------------------------------------------
Effect of conversion of preferred stock from date
of issuance - 189 1,603
Net effect of dilutive common share equivalents
based on treasury stock method - 826 202
-----------------------------------------------
Shares used in Diluted net income (loss) per share 17,657 17,246 14,385
-----------------------------------------------
-----------------------------------------------
</TABLE>
STOCK-BASED COMPENSATION
The Company has elected to follow Accounting Principles Board Opinion No. 25,
ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES ("APB 25"), and related interpretations
in accounting for its employee and director stock options because the
alternative fair value accounting provided for under SFAS No. 123, ACCOUNTING
FOR STOCK-BASED COMPENSTATION ("SFAS 123"), requires the use of option valuation
models that were not developed for use in valuing employee and director stock
options. Under SFAS 123, compensation cost is determined using the fair value of
stock-based compensation determined as of the grant date, and is recognized over
the periods in which the related services are rendered. If companies elect to
continue using the current implicit value accounting method specified in APB 25
to account for stock-based compensation, they must disclose in the notes to the
financial statements the pro forma effect of using the fair value method for its
stock-based compensation.
- -------------------------------------------------------------------------------
31
<PAGE>
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED)
NEW ACCOUNTING STANDARDS
Effective January 1, 1998, the Company adopted SFAS No. 130, REPORTING
COMPREHENSIVE INCOME and SFAS No. 131, SEGMENT INFORMATION. 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, is reported, net of
their related tax effect, to arrive at comprehensive income. 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, which is healthcare IT services.
2. ACQUISITIONS
During June 1998, the Company acquired through its wholly-owned subsidiaries
DAOU-TMI, Inc. and DAOU-RHI, Inc. (i) Technology Management, Inc. ("TMI"), a
privately-held company that provides information technology consulting services
primarily to the healthcare industry, (ii) International Health Care Systems,
Inc. ("IHCS"), a privately-held company with a common shareholder with TMI that
provides information technology consulting services primarily to the healthcare
industry on behalf of TMI, (iii) Resources in Healthcare Innovations, Inc.
("RHI"), a privately-held information technology services firm that provides
contract management services for healthcare information systems to hospitals and
managed care organizations, and (iv) Healthcare Transition Resources, Inc.
("HTR"), (v) Ultitech Resources Group, Inc. ("URG"), (vi) Innovative Systems
Solutions, Inc. ("ISS") and (viii) Grand Isle Consulting, Inc. ("GIC"), each a
privately held company with common shareholders of RHI that implements software
applications from third parties and provides support services to healthcare
enterprises. Shareholders of TMI, IHCS, RHI, HTR, URG, ISS and GIC received
1,078,963, 224,668, 1,839,381, 275,662, 282,551, 308,583 and 223,645 shares,
respectively, of the Company's common stock in exchange for all of the
outstanding stock of each of these companies. The above acquisitions have been
accounted for using the pooling-of-interests method of accounting, and
accordingly, the historical financial statements of periods prior to the
consummation of the combinations have been restated as though the companies had
been combined for all periods presented.
During March 1998, the Company acquired through its wholly-owned subsidiaries
DAOU-Synexus, Inc. and DAOU- Sentient, Inc.; 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 which provides integration and support
services primarily to healthcare organizations. Shareholders of Synexus and
Sentient received 161,235 and 1,397,550 shares, respectively, of the Company's
common stock in exchange for all of the outstanding stock of each of these
companies. The acquisitions have been accounted for using the
pooling-of-interests method of accounting, and accordingly, the historical
financial statements of periods prior to the consummation of the combinations
have been restated as though the companies had been combined for all periods
presented.
On September 25, 1997, the Company acquired through its wholly-owned subsidiary
DAOU On-Line, Inc. all of the issued and outstanding shares of On-Line
Networking, Inc. ("On-Line") in exchange for 150,000 shares of the Company's
common stock. On-Line is a provider of communication infrastructure services
primarily within the healthcare information technology market.
On July 9, 1997, the Company acquired through its wholly-owned subsidiary
DAOU-Integrex, Inc. all of the issued and outstanding shares of Integrex Systems
Corporation ("Integrex") in exchange for 700,000 shares of the Company's common
stock. Integrex provides advanced network design, integration and consulting
support services primarily to healthcare organizations and also to educational
and governmental institutions, all of which are primarily located in the state
of Virginia. Integrex specializes in voice and video networks and also designs
integrated cable plants capable of supporting voice, video and high-speed data
transmission.
- -------------------------------------------------------------------------------
32
<PAGE>
2. ACQUISITIONS (CONTINUED)
Both the Integrex and On-Line acquisitions were accounted for using the
pooling-of-interests method of accounting and, accordingly, the historical
financial statements for all periods prior to the consummation of the
combinations have been restated as though the companies had been combined for
all periods presented.
Total revenues and net income (loss) of DAOU (includes DAOU-Integrex and
DAOU-On-Line), Synexus, Sentient, TMI (including IHCS) and RHI (including HTR,
URG, ISS and GIC) for the three years ended December 31, 1998 were (IN
THOUSANDS):
<TABLE>
<CAPTION>
DAOU SYNEXUS SENTIENT TMI RHI COMBINED
---------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
YEAR ENDED DECEMBER 31, 1998
Total revenues $ 57,676 $ 2,438 $ 12,897 $ 11,161 $ 20,612 $ 104,784
Net income (loss) $ (11,394) $ 502 $ 409 $ 2,383 $ 2,344 $ (5,756)
YEAR ENDED DECEMBER 31, 1997
Total revenues $ 41,700 $ 1,578 $ 9,462 $ 6,371 $ 9,545 $ 68,656
Net income $ 87 $ 121 $ 694 $ 1,576 $ 27 $ 2,505
YEAR ENDED DECEMBER 31, 1996
Total revenues $ 28,383 $ 1,680 $ 9,112 $ 5,374 $ 5,778 $ 50,327
Net income $ 922 $ 97 $ 730 $ 1,061 $ 516 $ 3,326
</TABLE>
3. SHORT-TERM INVESTMENTS, AVAILABLE-FOR-SALE
Short-term investments, available-for-sale, consist of the following (IN
THOUSANDS):
<TABLE>
<CAPTION>
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED ESTIMATED FAIR
COST GAINS LOSSES VALUE
---------------------------------------------------------------------
<S> <C> <C> <C> <C>
DECEMBER 31, 1998
Mutual Funds $ 788 $ 286 $ (50) $ 1,024
---------------------------------------------------------------------
---------------------------------------------------------------------
</TABLE>
<TABLE>
<CAPTION>
GROSS GROSS
AMORTIZED UNREALIZED UNREALIZED ESTIMATED FAIR
COST GAINS LOSSES VALUE
---------------------------------------------------------------------
<S> <C> <C> <C> <C>
DECEMBER 31, 1997
Equity securities $ 707 $ 154 $ (2) $ 859
Government and corporate
debt securities 9,454 - (6) 9,448
---------------------------------------------------------------------
$ 10,161 $ 154 $ (8) $ 10,307
---------------------------------------------------------------------
---------------------------------------------------------------------
</TABLE>
- -------------------------------------------------------------------------------
33
<PAGE>
4. SELECTED BALANCE SHEET DETAILS
Contract work in progress consist of the following (IN THOUSANDS):
<TABLE>
<CAPTION>
DECEMBER 31,
1998 1997
---------------------
<S> <C> <C>
Unbilled accounts receivable $10,296 $11,713
Other 1,976 1,578
---------------------
$12,272 $13,291
---------------------
---------------------
</TABLE>
Equipment, furniture and fixtures consist of the following (IN THOUSANDS):
<TABLE>
<CAPTION>
DECEMBER 31,
1998 1997
---------------------
<S> <C> <C>
Equipment and furniture $ 8,836 $ 6,630
Leasehold improvements 244 171
---------------------
9,080 6,801
Less accumulated depreciation and amortization (4,345) (2,942)
---------------------
$ 4,735 $ 3,859
---------------------
---------------------
</TABLE>
Other accrued liabilities consist of the following (IN THOUSANDS):
<TABLE>
<CAPTION>
DECEMBER 31,
1998 1997
---------------------
<S> <C> <C>
Accrued contract costs $ 2,936 $ 2,390
Other accrued liabilities 1,466 1,092
---------------------
$ 4,402 $ 3,482
---------------------
---------------------
</TABLE>
5. LINES OF CREDIT
The Company has a line of credit for $700,000, which expires on May 1, 1999.
Under the terms of the agreement, advances bear interest at the bank's prime
rate plus 0.25% (8.00% at December 31, 1998) per annum. There are no
compensating balance requirements and borrowings under the line of credit are
limited to 65% of qualifying receivables. At December 31, 1998, $670,000 was
outstanding under the line of credit.
During June 1998, the Company secured two borrowing facilities, a $2.0
million revolving line of credit, under which none is available for future
borrowings at December 31, 1998, and an additional $8,000,000 line of credit,
under which $6.0 million is available for future borrowings at December 31,
1998. Advances under both lines bear interest at the bank's prime rate plus
0.25% (8.0% at December 31, 1998) per annum. These lines of credit expire
July 31, 1999, are secured by substantially all of the assets of the Company
and contain customary covenants and restrictions. As of December 31, 1998,
the Company was not in compliance with one of the covenants and has been
informed by the bank that the Company cannot avail itself to the unused lines
of credit. Management is actively negotiating for a replacement line of
credit, believes that a replacement line will be obtained before expiration
of the existing line of credit and that the Company has sufficient liquidity
to fund operations until this new line is in place.
Interest expense for the above lines of credit for years ended December 31,
1998, 1997 and 1996 was approximately $216,000, $43,000 and $16,000,
respectively.
- -------------------------------------------------------------------------------
34
<PAGE>
6. 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
1998, 1997 and 1996 totaled approximately $1,665,000, $1,187,000 and $1,122,000,
respectively.
Annual future minimum lease payments under noncancellable operating leases with
initial terms of one year or more at December 31, 1998, consist of the following
(IN THOUSANDS):
<TABLE>
<S> <C>
1999 $ 1,910
2000 1,815
2001 1,323
2002 1,222
2003 1,256
Thereafter 1,666
-------
$ 9,192
-------
-------
</TABLE>
SEVERANCE PAYABLE
In connection with the retirement of one of the RHI original founders, RHI
entered into a severance agreement whereby RHI will repay the retiring founder a
total of $1,050,000 in severance payments, payable in sixty consecutive monthly
installments of $17,500 beginning on December 20, 1997. At December 31, 1998,
the Company had an outstanding payable of $822,500. The aggregate minimum future
payments under the severance agreements as of December 31, 1998 are $210,000,
$210,000, $210,000 and $192,500 for the years ending December 31, 1999, 2000,
2001 and 2002, respectively.
RELATED PARTY TRANSACTIONS
In June 1997, TMI entered into an agreement to pay interest on the deferred
compensation to certain stockholders of TMI. The interest rate is based upon the
30 year Treasury Bond rate plus 1%, adjusted annually. At December 31, 1998, the
Company had an outstanding payable of $558,500, which is repayable on or before
June 16, 1999. Interest expense was approximately $76,000, $44,000 and zero for
the years ended December 31, 1998, 1997 and 1996, respectively.
The Company also has an agreement with an officer that guarantees a cash bonus
(approximately $550,000 at December 31, 1998) in the amount of any difference
between (i) the net value at November 11, 1999 of the options granted to the
officer during 1996 and (ii) $1,550,000.
7. REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY
STOCK OFFERINGS
In February 1997, the Company completed an initial public offering of its common
stock. The offering raised net proceeds to the Company of approximately $15.8
million. In August 1997, the Company completed a secondary offering of common
stock in which the Company raised net proceeds of approximately $9.3 million.
REDEEMABLE PREFERRED STOCK
During 1995, 1,603,430 shares of redeemable preferred stock were issued at $4.99
per share for proceeds of $7,618,000, net of issuance costs. Holders of the
redeemable preferred stock were entitled to receive cumulative dividends at the
rate of $0.03 per share per annum, when and if declared by the Board of
Directors and prior to any dividends on the common stock. The redeemable
preferred stock had a liquidation preference of $4.99 per share plus any
declared but unpaid dividends and was convertible at the option of the holder
into one share of common stock, subject to certain antidilution adjustments. The
shares of preferred stock were automatically converted into shares of common
stock in connection with the initial public offering of the Company's common
stock, which closed in February 1997. The increase in the redemption value of
the redeemable preferred stock was $87,000 in 1995 and $485,000 in 1996.
- -------------------------------------------------------------------------------
35
<PAGE>
7. REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY (CONTINUED)
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 adopted and the shareholders approved an amendment to the
Plan, which increased the number of shares reserved for issuance under the plan
to 1,367,925. In May 1998, the Board of Directors adopted and the shareholders
approved an amendment to the Plan, which increased the number of shares reserved
for issuance under the Plan to 4,000,000 shares. 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. From January through May 1998, the Company recorded
$385,000 of deferred compensation related to options granted with exercise
prices below the fair market value on the date of the increase in the number of
shares reserved for issuance under the Plan was approved by the shareholders.
The Company is amortizing the deferred compensation ratably over the vesting
period of the options.
A summary of the Company's stock option activity and related information, which
includes 140,300 non-qualified stock options at an exercise price of $4.28 in
November 1996 that were granted outside of the Plan, for the years ended
December 31 follows:
<TABLE>
<CAPTION>
1998 1997 1996
------------------------------------------------------------------------------------------
WEIGHTED- WEIGHTED- WEIGHTED-
AVERAGE AVERAGE AVERAGE
EXERCISE EXERCISE EXERCISE
OPTIONS PRICE OPTIONS PRICE OPTIONS PRICE
------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C> <C>
Outstanding - beginning of
year 1,540,399 $ 7.49 941,413 $5.05 - $ -
Granted 2,699,045 13.22 971,943 9.61 962,458 5.03
Exercised (235,637) 6.16 (144,487) 4.44 - -
Forfeited (777,013) 16.29 (228,470) 5.86 (21,045) 4.28
------------------------------------------------------------------------------------------
Outstanding - end of year 3,226,794 $10.44 1,540,399 $7.49 941,413 $5.05
------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------
Exercisable at end of year 266,526 $13.35 230,705 $6.57 - $ -
------------------------------------------------------------------------------------------
------------------------------------------------------------------------------------------
Weighted-average fair value
of options granted during
the year $ 6.79 $4.30 $2.81
------- ------ ------
------- ------ ------
</TABLE>
- -------------------------------------------------------------------------------
36
<PAGE>
7. REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY (CONTINUED)
The following table summarizes information about stock options outstanding at
December 31, 1998:
<TABLE>
<CAPTION>
OUTSTANDING EXERCISABLE
----------------------------------------------------------------------------------------
WEIGHTED- WEIGHTED-
AVERAGE WEIGHTED- AVERAGE
RANGE OF EXERCISE NUMBER REMAINING AVERAGE NUMBER EXERCISE
PRICES OUTSTANDING CONTRACTUAL LIFE EXERCISE PRICE EXERCISABLE PRICE
- --------------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
$ 2.75 - $5.50 1,614,055 9.1 $ 4.87 81,516 $ 4.87
$ 5.50 - $8.25 277,803 8.1 $ 6.01 35,593 $ 6.01
$ 8.25 - $11.00 123,436 8.1 $10.28 32,916 $10.28
$11.00 - $13.75 384,000 9.4 $13.62 600 $12.75
$13.75 - $16.50 154,000 9.2 $16.11 600 $15.25
$16.50 - $19.25 145,500 8.5 $16.87 28,300 $16.82
$19.25 - $22.00 123,000 9.1 $21.75 - $ -
$22.00 - $24.75 72,000 9.0 $24.25 14,400 $24.25
$24.75 - $27.50 333,000 8.8 $25.00 72,601 $25.00
----------------------------------------------------------------------------------------
3,226,794 9.0 $10.44 266,526 $13.35
----------------------------------------------------------------------------------------
----------------------------------------------------------------------------------------
</TABLE>
At December 31, 1998, options for 633,694 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 1998, 1997 and 1996: risk-free interest rate of 5.06%, 6% and
6%, respectively; dividend yield of 0% for all years; volatility factors of the
expected market price of the Company's common stock of 75%, 75% and 0%,
respectively; and a weighted-average expected life of the options of five, seven
and seven years, respectively.
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,
1998 1997 1996
----------------------------------
<S> <C> <C> <C>
Adjusted pro forma net income (loss) $(16,380) $(1,129) $1,985
----------------------------------
----------------------------------
Adjusted pro forma net income (loss) per share:
Basic $ (0.93) $ (0.07) $ 0.16
----------------------------------
----------------------------------
Diluted $ (0.93) $ (0.07) $ 0.14
----------------------------------
----------------------------------
</TABLE>
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. As of December 31, 1998, warrants to
purchase an aggregate of 130,393 shares of common stock remain outstanding.
- -------------------------------------------------------------------------------
37
<PAGE>
7. REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY (CONTINUED)
COMMON STOCK RESERVED
Shares reserved for future issuance:
<TABLE>
<CAPTION>
<S> <C>
Stock options 3,860,488
Warrants 130,393
---------
Total 3,990,881
---------
---------
</TABLE>
Of the shares available for future issuance under the Plan, 3,226,794 are
outstanding grants and 633,694 remain available for future grant.
8. INCOME TAXES
The provision for income taxes consists of the following (IN THOUSANDS):
<TABLE>
<CAPTION>
YEARS ENDED DECEMBER 31,
- -----------------------------------------------------
1998 1997 1996
- -----------------------------------------------------
<S> <C> <C> <C>
Current:
Federal $ - $ 581 $ 66
State 576 97 62
------------------------------------
576 678 128
Deferred:
Federal (1,205) 238 33
State (173) 31 (12)
------------------------------------
(1,378) 269 21
------------------------------------
$ (802) $ 947 $ 149
------------------------------------
------------------------------------
</TABLE>
Deferred income taxes are provided for temporary differences in recognizing
certain income and expense items for financial and tax reporting purposes.
Significant components of the Company's deferred tax assets and liabilities
consist of the following (IN THOUSANDS):
<TABLE>
<CAPTION>
1998 1997
- -------------------------------------------------------------------------------
<S> <C> <C>
Deferred tax liabilities:
Accounting method change for tax purposes $2,005 $423
Depreciation and amortization 126 120
--------------------------------
2,131 543
Deferred tax assets:
Reserves and allowances 1,792 423
Net operating losses 2,280 50
Other - 3
--------------------------------
4,072 476
--------------------------------
Net deferred tax (asset) liability $(1,941) $ 67
--------------------------------
--------------------------------
</TABLE>
Approximately $630,000 of the net operating losses included in the above
deferred assets relates to tax benefits of stock option deductions, which
have been allocated directly to additional paid-in capital.
At December 31, 1998, the Company has federal and state net operating loss
carryforwards of approximately $5,455,000 and $6,499,000, respectively. The
federal and state loss carryforwards will begin to expire in 2013 and 2003,
respectively, unless previously utilized.
Under sections 382 and 383 of the Internal Revenue Code, the annual use of
the Company's net operating loss carryforwards may be limited in the event of
a cumulative change in ownership of more that 50%. However, the Company does
not believe such a limitation will have a material impact on the ultimate
utilization of these carryforwards.
- -------------------------------------------------------------------------------
38
<PAGE>
8. INCOME TAXES (CONTINUED)
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,
---------------------------------------
1998 1997 1996
- -----------------------------------------------------------------------------------------------------------
<S> <C> <C> <C>
Tax at federal statutory rate (35.0)% 35.0% 35.0%
S corporation income not subject to corporate income taxes (18.1) (33.7) (32.8)
Nondeductible expenses 10.6 9.4 1.0
Adjustment on conversion of S corporation to C corporation 27.6 15.4 -
State taxes, net of federal benefit 1.9 2.1 1.1
Other 1.0 (.8) -
---------------------------------------
(12.0)% 27.4% 4.3%
---------------------------------------
---------------------------------------
</TABLE>
9. 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 $98,000, $13,000 and $16,000 for the years ended December 31,
1998, 1997 and 1996, 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 and $97,605 for
the years ended December 31, 1997 and 1996, respectively. Effective January
1, 1998, Integrex employees became eligible to participate in the Company's
401(k) plan, and the existing profit sharing plan of Integrex was terminated.
In December 1995, On-Line adopted a defined contribution profit sharing plan
covering substantially all employees who have completed one year of service
and are twenty-one years of age and older. Profit sharing contributions are
made at the discretion of On-Line's management. Contributions vest 20% after
two years and an additional 20% for each year thereafter. Profit sharing
expense was $67,500 and $77,124 for the years ended December 31, 1997 and
1996, respectively. Effective January 1, 1998, On-Line's employees became
eligible to participate in the Company's 401(k) plan, and the existing profit
sharing plan of On-Line was terminated.
Sentient formerly had an employee stock purchase plan available to certain
employees of Sentient. During 1994, the Board of Directors discontinued
issuance of new shares under the plan. During 1996, Sentient purchased and
retired all 36,329 shares held by employees at approximately $1.09 per share.
Concurrently with the repurchase of the shares, each employee holding stock
was issued an equivalent number of nontransferable "share units". These share
units entitle the holder, upon termination of employment or other liquidating
event, to a payment equal to the increase in the book value per share of
Sentient between the most recent audited financial statements at the
liquidating event date and the most recent audited financial statements prior
to the issuance of the share units, multiplied by the number of share units
held. As of December 31, 1997 and 1996, 30,445 and 35,991 share units,
respectively, were outstanding. In the event of an initial public offering of
its common stock or a change in control, the holders are entitled to receive
the difference between the fair market value of the share units based on the
consideration involved and the book value per share per the most recent
audited financial statements. As a result of the acquisition, the share units
were retired and a cash payment was made to the holders of the share units
based upon the stock appreciation as valued at the time of acquisition. 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 1998, 1997 and 1996 of approximately $114,000, $84,000 and $62,000,
respectively.
TMI maintains a defined contribution profit sharing plan for all eligible
employees. Contributions are discretionary and are made solely by the
Company. Actual contributions are based on a formula applied to each
participant's annual compensation. Contribution expense for the plan was
approximately $112,000, $89,000 and $74,000 for the years ended December 31,
1998, 1997 and 1996, respectively.
- -------------------------------------------------------------------------------
39
<PAGE>
9. BENEFIT PLANS (CONTINUED)
RHI has a 401(k) savings plan available to employees who have completed 6
months of eligible service and are 21 years of age or older. Employees can
voluntarily contribute up to 10% of their gross salaries, subject to IRS
limitations. Matching contributions to the plan are at the Company's
discretion. The Company made matching contributions to the plan of $147,000,
$100,000 and $50,000 for the years ended December 31, 1998, 1997 and 1996,
respectively.
10. CONTINGENCIES
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. A group of shareholders has been
appointed the lead plaintiffs and they filed an amended consolidated
complaint on February 24, 1999. The new complaint realleges the same theory
of liability previously asserted, namely 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 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. By
stipulation of the parties, the state court litigation has been stayed
pending the resolution of a motion to dismiss that will be filed on April 22,
1999 in the federal litigation. 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.
- -------------------------------------------------------------------------------
40
<PAGE>
ITEM 9: CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND
FINANCIAL DISCLOSURE.
None.
PART III
ITEM 10: DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS;
COMPLIANCE WITH SECTION 16(a) OF THE EXCHANGE ACT.
The information required by this item is included under the captions
entitled "Election of Directors" and "Information Concerning Directors and
Executive Officers" in the Company's Proxy Statement and is incorporated
herein by reference.
ITEM 11: EXECUTIVE COMPENSATION.
The information required by this item is included under the caption
entitled "Executive Compensation" in the Company's Proxy Statement and is
incorporated herein by reference.
ITEM 12: SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT
The information required by this item is included under the caption
entitled "Security Ownership of Certain Beneficial Owners and Management" in
the Company's Proxy Statement and is incorporated herein by reference.
ITEM 13: CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS
The information required by this item is included under the caption
entitled "Certain Relationships and Related Transactions" in the Company's
Proxy Statement and is incorporated herein by reference.
PART IV
ITEM 14: EXHIBITS, FINANCIAL STATEMENT SCHEDULES, AND REPORTS ON FORM 8-K
(a) The following are filed as part of this Report.
(1) CURRENT REPORTS ON FORM 8-K. The Registrant filed the following
Current Reports on Form 8-K with the Commission during the fourth quarter of
the year ended December 31, 1998:
(2) Current Report on Form 8-K, filed on November 24, 1998, which
included audited supplemental consolidated financial statements, selected
supplemental consolidated financial data and Management's Discussion and
- -------------------------------------------------------------------------------
41
<PAGE>
Analysis of Financial Condition and Results of Operations (supplemental)
which reflects the Company's acquisitions of Technology Management, Inc.,
Resources in Healthcare Innovations, Inc., Sentient Systems, Inc., and
Synexus Incorporated on June 16, 1998, June 26, 1998, March 30, 1998 and
March 27, 1998, respectively. Each of the acquisitions was accounted for as
pooling-of-interests.
(3) Financial Statement Schedule: Schedule II - Valuation and
Qualifying Accounts for the three years ended December 31, 1998.
SCHEDULE II - VALUATION AND QUALIFYING ACCOUNTS
<TABLE>
<CAPTION>
- ------------------------------------------------------------------------------------------------------------
COL. A COL. B COL. C COL. D COL. E
- ------------------------------------------------------------------------------------------------------------
Additions
----------------------------------------------------------
Charged to
Balance at Charged to Other
Description Beginning Costs Accounts-- Balance at
of Period and Expenses Describe Write-offs End of Period
- ------------------------------------------------------------------------------------------------------------
<S> <C> <C> <C> <C> <C>
Year Ended December 31, 1998:
Allowance for doubtful accounts $312 $644 $ - $ - $956
Year Ended December 31, 1997:
Allowance for doubtful accounts $310 $ 70 $ - $ 68 $312
Year Ended December 31, 1996:
Allowance for doubtful accounts $202 $108 $ - $ - $310
</TABLE>
(b) EXHIBITS.
<TABLE>
<CAPTION>
EXHIBIT
NUMBER EXHIBIT
-------- -------
<S> <C>
2.1(1) -- Agreement and Plan of Merger, dated January 9, 1997, by and
between the Registrant and DAOU Systems, Inc., a California corporation.
2.2(2) -- Agreement and Plan of Merger, dated as of July 8, 1997, by and among
the Registrant, DAOU-Integrex, Inc., a Delaware corporation and
wholly-owned subsidiary of the Registrant, Integrex Systems Corporation,
a Delaware corporation, and the stockholders of Integrex Systems
Corporation.
2.3+(3) -- Agreement and Plan of Merger, dated as of September 25, 1997, by
and among the Registrant, DAOU On-Line, On-Line and the stockholders
of On-Line.
2.4+(5) -- Agreement and Plan of Merger, dated as of March 27, 1998, by
and among the Registrant, DAOU Synexus, Synexus and the stockholders
of Synexus.
2.5+(5) -- Agreement and Plan of Merger, dated as of March 30, 1998,
by and among the Registrant, DAOU Sentient, Sentient and the
stockholders of Sentient.
2.6+(6) -- Agreement and Plan of Merger, dated as of June 16, 1998, by and
among the Registrant, DAOU TMI, TMI and the stockholders of TMI.
2.6+(6) -- Agreement and Plan of Merger, dated as of June 16, 1998, by and
among the Registrant, DAOU TMI, IHCS and the stockholders of IHCS.
2.7+(7) -- Agreement and Plan of Merger, dated as of June 26, 1998, by
and among the Registrant, DAOU RHI, RHI, HTR, URG, ISS, and
GIC and the shareholders of RHI, HTR, URG, ISS and GIC.
3.1(1) -- Amended and Restated Certificate of Incorporation of the
Registrant.
3.2(1) -- Bylaws of the Registrant.
4.1 -- Reference is made to Exhibits 3.1 and 3.2.
4.2(1) -- Specimen stock certificate.
4.3(1) -- Investors' Rights Agreement, dated October 26, 1995, between
the Registrant and the parties named therein.
4.4(1) -- Series A Preferred Stock Purchase Warrant No.1, dated
October 26, 1995, between the Registrant and Needham &
Company, Inc.
4.5(1) -- Series A Preferred Stock Purchase Warrant No. 2, dated
October 26, 1995, between the Registrant and Needham Capital
S.B.I.C., L.P.
10.1(1) -- Form of Indemnification Agreement.
10.2(1)(4) -- DAOU Systems, Inc. 1996 Stock Option Plan, as amended.
10.3(1)(4) -- Form of Incentive Stock Option Agreement under the 1996
Stock Option Plan.
- -------------------------------------------------------------------------------
42
<PAGE>
10.4(1)(4) -- Form of Nonstatutory Stock Option Agreement under the 1996
Stock Option Plan.
10.5(1)(4) -- Employment Agreement, effective as of November 11, 1996,
between Robert C. McNeill and the Registrant.
10.6(1) -- Sublease Agreement, dated March 1, 1996, between the
Registrant and Adobe Systems Incorporated.
10.7+(1) -- Information Management Agreement, dated April 1, 1996,
between the Registrant and Candler Health System.
10.8+(1) -- Principle Agreement, dated June 18, 1996, between the
Registrant and Catholic Medical Center of Brooklyn & Queens,
Inc.
10.9+(1) -- Principal Agreement, dated June 29, 1995, between the
Registrant and Mercy Health Services.
10.10+(1) -- Master Agreement, dated June 4, 1996, between the
Registrant and Atlantic Health System.
10.11(1) -- Form of Master Services Agreement.
10.12*(8) -- Information Management Agreement, dated as of January 1, 1999,
between Saint Mary's Health Network and the Registrant
21 -- Subsidiaries of the Registrant.
23.1 -- Consent of Ernst & Young LLP, independent auditors.
23.2 -- Consent of Deloitte & Touche LLP, independent auditors.
24 -- Power of Attorney (included on the signature page to this
Report).
27 -- Financial Data Schedule.
</TABLE>
+ Confidential treatment has been granted with respect to certain portions of
this exhibit.
* Confidential treatment has been requested with respect to certain portions
of this exhibit.
(1) Incorporated by reference to the similarly described exhibits filed in
connection with the Registrant's Registration Statement on Form SB-2, File
No. 333-18155, declared effective by the Commission on February 12, 1997.
(2) Incorporated by reference to the exhibit filed in connection with the
Registrant's Current Report on Form 8-K filed with the Commission on July
18, 1997.
(3) Incorporated by reference to the exhibit filed in connection with the
Registrant's Current Report on Form 8-K with the Commission filed on
October 29, 1997.
(4) Identifies a management contract or compensatory plan or arrangement of the
Registrant.
(5) Incorporated by reference to the exhibit filed in connection with the
Registrant's Current Report on Form 8-K with the Commission filed on April
14, 1998.
(6) Incorporated by reference to the exhibit filed in connection with the
Registrant's Current Report on Form 8-K with the Commission filed on July
10, 1998.
(7) Incorporated by reference to the exhibit filed in connection with the
Registrant's Current Report on Form 8-K with the Commission filed on August
7, 1998.
(8) Incorporated by reference to the exhibit filed in connection with the
Registrant's Current Report on Form 8-K with the Commission filed on
January 15, 1999.
- -------------------------------------------------------------------------------
43
<PAGE>
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) 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.
Date: March 31, 1999
DAOU SYSTEMS, INC.
By: /s/ Georges J. Daou Georges J. Daou Chief Executive Officer and
Chairman of the Board
POWER OF ATTORNEY
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature
appears below constitutes and appoints Daniel J. Daou, Georges J. Daou and
Fred C. McGee, jointly and severally, as his or her attorney-in-fact, each
with the power of substitution, for him or her in any and all capacities, to
sign any amendments to this Report and to file the same, with exhibits
thereto and other documents in connection therewith, with the Commission,
hereby ratifying and confirming all that each of said attorneys-in-fact, or
his substitute or substitutes, may do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934,
this Report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
<TABLE>
<CAPTION>
SIGNATURE TITLE DATE
- --------------------------------------------------------------------------------------------------------------
<S> <C> <C>
/s/ Georges J. Daou Chief Executive Officer and Chairman of the Board March 31,
- ------------------------------ (Principal Executive Officer) 1999
Georges J. Daou
/s/ Larry Grandia President and Director March 31,
- ------------------------------ 1999
Larry Grandia
/s/ Daniel J. Daou Vice-Chairman of the Board March 31,
- ------------------------------ 1999
Daniel J. Daou
/s/ Fred C. McGee Executive Vice President, Chief Financial Officer and March 31,
- ------------------------------ Secretary (Principal Financial and Accounting Officer) 1999
Fred C. McGee
/s/ Richard B. Jaffe Director March 31,
- ------------------------------ 1999
Richard B. Jaffe
/s/ David W. Jahns Director March 31,
- ------------------------------ 1999
David W. Jahns
/s/ Kevin M. Fickenscher, M.D. Director March 31,
- ------------------------------ 1999
Kevin M. Fickenscher, M.D.
/s/ John H. Moragne Director March 31,
- ------------------------------ 1999
John H. Moragne
</TABLE>
- -------------------------------------------------------------------------------
44
<PAGE>
Exhibit 21
SUBSIDIARIES OF THE REGISTRANT
DAOU-Integrex, Inc., a Delaware Corporation
DAOU On-Line, Inc., a Delaware Corporation
DAOU Sentient, Inc., a Delaware Corporation
DAOU Synexus, Inc., a Delaware Corporation
DAOU TMI, Inc., a Delaware Corporation
DAOU RHI, Inc., a Delaware Corporation
- -------------------------------------------------------------------------------
45
<PAGE>
CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
We consent to the incorporation by reference in the Registration Statements on
Forms S-3 No's 333-47777, 333-52791 and 333-68197 and Form S-8 No
333-59795 of Daou Systems, Inc., of our report dated February 12, 1999, with
respect to the consolidated financial statements and schedule of Daou Systems,
Inc. included in the Annual Report on Form 10-K for the year ended December 31,
1998.
ERNST & YOUNG LLP
San Diego, California
March 31, 1999
<PAGE>
EXHIBIT 23.2
INDEPENDENT AUDITORS' CONSENT
We consent to the incorporation by reference in Registration Statements No.
333-47777, No. 333-52791 and No. 333-68197 on Form S-3 and No. 333-59795 on
Form S-8 of DAOU Systems, Inc. of our report dated February 13, 1998 on the
financial statements of Sentient Systems, Inc., appearing in the Annual
Report on Form 10-K of DAOU Systems, Inc. for the year ended December 31,
1998.
DELOITTE & TOUCHE LLP
McLean, Virginia
March 31, 1999
<TABLE> <S> <C>
<PAGE>
<ARTICLE> 5
<LEGEND>
THIS SCHEDULE CONTAINS SUMMARY FINANCIAL INFORMATION EXTRACTED FROM THE
REGISTRANT'S FINANCIAL STATEMENTS AS OF DECEMBER 31, 1998 AND IS QUALIFIED IN
ITS ENTIRETY BY REFERENCE TO SUCH FINANCIAL STATEMENTS.
</LEGEND>
<MULTIPLIER> 1,000
<S> <C>
<PERIOD-TYPE> YEAR
<FISCAL-YEAR-END> DEC-31-1998
<PERIOD-START> JAN-01-1998
<PERIOD-END> DEC-31-1998
<CASH> 6,756
<SECURITIES> 1,024
<RECEIVABLES> 25,538
<ALLOWANCES> 956
<INVENTORY> 12,272
<CURRENT-ASSETS> 49,302
<PP&E> 9,080
<DEPRECIATION> 4,345
<TOTAL-ASSETS> 54,517
<CURRENT-LIABILITIES> 17,637
<BONDS> 0
0
0
<COMMON> 18
<OTHER-SE> 34,757
<TOTAL-LIABILITY-AND-EQUITY> 34,775
<SALES> 104,784
<TOTAL-REVENUES> 104,784
<CGS> 78,021
<TOTAL-COSTS> 78,021
<OTHER-EXPENSES> 33,484
<LOSS-PROVISION> 644
<INTEREST-EXPENSE> 234
<INCOME-PRETAX> (6,558)
<INCOME-TAX> (802)
<INCOME-CONTINUING> (6,721)
<DISCONTINUED> 0
<EXTRAORDINARY> 0
<CHANGES> 0
<NET-INCOME> (5,756)
<EPS-PRIMARY> (0.33)
<EPS-DILUTED> (0.33)
</TABLE>
