10-Q 1 d10q.txt FORM 10-Q 9/30/2001 SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q (Mark One) /X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. For the quarterly period ended September 30, 2001 OR / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934. For the transition period from ______________ to ___________ Commission File No.: 000-22073 DAOU SYSTEMS, INC. (Exact Name of Registrant as Specified in Its Charter) Delaware 33-0284454 (State or Other Jurisdiction of (I.R.S. Employer Identification No.) Incorporation or Organization) 5120 Shoreham Place San Diego, California 92122 (Address of Principal Executive Offices) (Zip Code) (858) 452-2221 (Registrant's Telephone Number, Including Area Code) Indicate by check mark whether the registrant: (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days Yes X No --- --- The number of shares of registrant's Common Stock, par value $.001 per share, outstanding as of November 8, 2001: 21,293,164 DAOU SYSTEMS, INC. Index to Form 10-Q
PART I. FINANCIAL INFORMATION Page ---------- Item 1. Condensed Financial Statements 2 Condensed Balance Sheets at September 30, 2001 (unaudited) and December 31, 2000 2 Condensed Statements of Operations (unaudited) for the Three Months and Nine Months Ended September 30, 2001 and 2000 3 Condensed Statements of Cash Flows (unaudited) for the Nine Months Ended September 30, 2001 and 2000 4 Notes to Condensed Financial Statements 5 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 10 Item 3. Quantitative and Qualitative Disclosure about Market Risk 14 PART II. OTHER INFORMATION Item 1. Legal Proceedings 15 Item 2. Changes In Securities and Use of Proceeds 15 Item 6. Exhibits and Reports on Form 8-K 15 SIGNATURES 16
-------------------------------------------------------------------------------- 1 PART I. FINANCIAL INFORMATION Item 1. Condensed Financial Statements DAOU Systems, Inc. Condensed Balance Sheets (In thousands, except for per share data)
September 30, December 31, 2001 2000 ------------------------------------ (unaudited) Assets Current assets: Cash and cash equivalents $ 13,787 $ 10,504 Short-term investments, available-for-sale 77 82 Accounts receivable, net of allowance for doubtful accounts of $808 and $1,138 at September 30, 2001 and December 31, 2000, respectively 7,725 11,900 Contract work in progress 429 1,060 Other current assets 500 558 -------- -------- Total current assets 22,518 24,104 Equipment, furniture and fixtures, net 1,354 2,565 Other assets 69 163 -------- -------- Total Assets $ 23,941 $ 26,832 ======== ======== Liabilities and Stockholders' Equity Current liabilities: Trade accounts payable and other accrued liabilities $ 1,764 $ 3,286 Accrued salaries and benefits 2,925 2,273 Deferred revenue 672 397 Current portion of severance payable 210 210 -------- -------- Total current liabilities 5,571 6,166 Long-term liabilities 156 306 Commitments and contingencies Stockholders' equity: Convertible preferred stock, $.001 par value. Authorized 3,520 shares; issued and outstanding 2,182 shares at September 30, 2001 and December 31, 2000 2 2 Common stock, $.001 par value. Authorized shares 50,000 shares; issued and outstanding 21,293 shares at September 30, 2001 and 17,831 shares at December 31, 2000 23 18 Additional paid-in capital 53,399 51,614 Notes receivable from stockholders (1,282) -- Accumulated other comprehensive income (54) (49) Accumulated deficit (33,874) (31,225) -------- -------- Total stockholders' equity 18,214 20,360 -------- -------- Total Liabilities and Stockholders' Equity $ 23,941 $ 26,832 ======== ========
See accompanying notes to the condensed financial statements. -------------------------------------------------------------------------------- 2 DAOU Systems, Inc. Condensed Statements of Operations (In thousands, except for per share data) (unaudited)
Three Months Ended September 30, Nine Months Ended September 30, 2001 2000 2001 2000 -------- -------- -------- -------- Revenues $ 9,129 $ 15,341 $ 32,010 $ 49,043 Cost of revenues 7,051 13,259 23,665 42,260 -------- -------- -------- -------- Gross profit 2,078 2,082 8,345 6,783 Operating expenses: Sales and marketing 725 1,390 2,375 4,831 General and administrative 2,235 4,791 8,348 13,433 Restructuring charges - - - 827 -------- -------- -------- -------- 2,960 6,181 10,723 19,091 -------- -------- -------- -------- Loss from operations (882) (4,099) (2,378) (12,308) Other income, net 162 184 426 517 -------- -------- -------- -------- Loss before income taxes (720) (3,915) (1,952) (11,791) Provision for income taxes 19 - 80 - -------- -------- -------- -------- Net loss (739) (3,915) (2,032) (11,791) Accrued dividends on preferred stock (226) (189) (618) (558) -------- -------- -------- -------- Net loss available to common stockholders $ (965) $ (4,104) $ (2,650) $(12,349) ======== ======== ======== ======== Basic and diluted net loss available to common stockholders per common share $ (0.06) $ (0.23) $ (0.15) $ (0.70) ======== ======== ======== ======== Shares used in computing basic and diluted net loss available to common stockholders per common share 17,372 17,713 17,465 17,712 ======== ======== ======== ========
See accompanying notes to the condensed financial statements. -------------------------------------------------------------------------------- 3 DAOU Systems, Inc. Condensed Statements of Cash Flows (In thousands) (unaudited)
Nine Months Ended September 30, 2001 2000 ------- --------- Operating Activities Net loss $(2,032) $(11,791) Adjustments to reconcile net loss to net cash provided by (used in) operating activities: Depreciation and amortization 1,038 1,898 Stock based compensation 35 - Provision for uncollectible accounts 447 197 Loss on retirement of fixed assets 350 - Changes in operating assets and liabilities: Accounts receivable 3,728 8,324 Contract work in process 631 2,493 Other current assets 58 (713) Accounts payable and accrued liabilities (1,522) (2,468) Accrued salaries and benefits 652 (729) Deferred revenue 275 - Other long term liabilities (150) (5) ------- -------- Net cash provided by (used in) operating activities 3,510 (2,794) Investing Activities: Purchases of equipment, furniture and fixtures, net (177) (893) Purchases of short-term investments - (20) Changes in other assets 94 262 ------- -------- Net cash used in investing activities (83) (651) Financing Activities: Repayments of long-term debt and line of credit - - Proceeds from issuance of common stock 54 1 Purchase of treasury stock (198) - ------- -------- Net cash (used in) provided by financing activities (144) 1 ------- -------- Increase (decrease) in cash and cash equivalents 3,283 (3,444) Cash and cash equivalents at beginning of period 10,504 15,480 ------- -------- Cash and cash equivalents at end of period $13,787 12,036 ======= ======== Supplemental Disclosure of Non-cash Activities: Common stock issued for services $ 25 $ - ======= ======== Unrealized (gain) loss on investments $ 5 $ (13) ======= ======== Common stock and options issued for settlement $ 10 $ - ======= ======== Common stock issuable for notes receivable from stockholder $ 1,204 $ - ======= ======== Accrued preferred stock dividends $ 618 $ 558 ======= ========
See accompanying notes to the condensed financial statements. -------------------------------------------------------------------------------- 4 DAOU SYSTEMS, INC. NOTES TO CONDENSED FINANCIAL STATEMENTS 1. Basis of Presentation The unaudited condensed financial statements of DAOU Systems, Inc. ("DAOU" or the "Company") at September 30, 2001 and for the three and nine-month periods ended September 30, 2001 and 2000 have been prepared in accordance with accounting principles generally accepted in the United States for interim financial information. Accordingly, they do not include all information and footnotes required by accounting principles generally accepted in the United States for a complete set of financial statements. These financial statements reflect all adjustments, consisting of normal recurring adjustments, which in the opinion of management are necessary to fairly present the financial position of the Company at September 30, 2001 and the results of operations for the three and nine-month periods ended September 30, 2001 and 2000. The results of operations for the three and nine-months ended September 30, 2001 are not necessarily indicative of the results to be expected for the year ending December 31, 2001. The Company has experienced significant quarterly fluctuations in operating results and it expects that these fluctuations in revenues, expenses and net income or losses will continue. The financial statements and related disclosures have been prepared with the presumption that users of the interim financial information have read or have access to the audited financial statements for the preceding fiscal year. Accordingly, these financials should be read in conjunction with the audited financial statements and the related notes thereto contained in the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission ("SEC") on March 30, 2001. The Company has two operating divisions: Application Services and Technology Services. The Application Services division provides clients with strategic consulting, software implementation, project management, and support services, including staff augmentation. The Technology Services division provides clients with solutions in key areas, including network infrastructure (servers, data and voice networks, and security), web development and integration projects, help desk solutions (remote or on-site) and network management. Certain of the 2000 amounts have been reclassified to conform to the current presentation. 2. Use of Estimates The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions about the future that affect the amounts reported in the financial statements and disclosures made in the accompanying notes of the financial statements. The actual results could differ from those estimates. 3. Net Loss Per Share Net loss per share is computed in accordance with FASB Statement No. 128, EARNINGS PER SHARE. Basic net loss per share is computed using the weighted average number of common shares outstanding during each period. Diluted net loss per share includes the dilutive effect of common shares potentially issuable upon the exercise of stock options and warrants. For the three and nine months ended September 30, 2001 and 2000, 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. -------------------------------------------------------------------------------- 5 The following table details the computation of basic and diluted net loss per share: (In thousands, except per share information) (unaudited)
Three Months Ended Nine Months Ended September 30, September 30, 2001 2000 2001 2000 -------- -------- ------- --------- Numerator: Net loss available to common stockholders $ (965) $ (4,104) $(2,650) $(12,349) Denominator: Weighted average common shares outstanding 21,293 17,713 19,249 17,712 Weighted average unvested common shares subject to repurchase agreements (3,921) - (1,784) - ------- -------- ------- -------- Denominator for diluted basic and diluted calculation 17,372 17,713 17,465 17,712 ======= ======== ======= ======== Basic and diluted net loss per share $ (0.06) $ (0.23) $ (0.15) $ (0.70) ======= ======== ======= ========
4. Comprehensive Loss Comprehensive loss for the three months ended September 30, 2001 and 2000 totaled $(965,000) and $(4,104,000), respectively. Comprehensive loss for the nine months ended September 30, 2001 and 2000 totaled $(2,650,000) and $(12,349,000), respectively. The difference from reported net loss arises from the unrealized gains and losses on short-term investments. 5. Stockholders Equity Treasury Stock On April 25, 2001, the Company re-purchased 992,111 shares of the Company's common stock from the former Chairman of the Board of the Company at a price equal to $.20 per share for a total purchase price of $198,000. The Company holds these shares in treasury as of September 30, 2001. Employee Stock Purchase Plan Under the Company's Employee Stock Purchase Plan ("ESPP"), employees are allowed to purchase the Company's common stock at six-month intervals. Employees pay the lower of 85% of the fair market value of the common stock at the beginning of the measurement period or 85% of the fair market value of the common stock at the end of the measurement period. On June 30, 2001, the Company recorded the issuance of 205,714 shares of common stock under the ESPP with proceeds of $55,000. On September 30, 2001, 1,176,061 shares remained reserved for issuance under the ESPP. 6. Related Party Transactions On July 24, 2001, the Company agreed to sell 150,000 shares of restricted common stock at the July 24, 2001 closing price of $.52 per share to Mr. Dan Malcolm of the Company in exchange for a full-recourse note receivable that accrues interest at a rate of 6.75% due on July 23, 2006. On June 1, 2001, the Company agreed to sell 1,500,000, 150,000 and 2,500,000 shares of restricted common stock at the June 1, 2001 closing price of $.29 per share to Messers. James T. Roberto, Neil R. Cassidy and Vincent K. Roach, respectively, of the Company in exchange for full-recourse notes receivable that accrue interest at a rate of 6.75% and which are due on May 31, 2006. As part of the agreement, 1,710,000 options to purchase common stock previously granted to these executive officers were cancelled. 7. Series A Preferred Stock Holders of the Series A Preferred Stock are entitled to receive cumulative dividends payable in the form of shares of -------------------------------------------------------------------------------- 6 Series A Preferred Stock. The dividends accrued at a rate of six percent per annum for the first two years. On July 26, 2001, the dividend rate increased to seven percent per annum. The dividend rate increases by one percent each successive year after the second anniversary. As of September 30, 2001, the Company has accrued but undeclared preferred stock dividends of $1,675,215, which are payable in shares of Series A Preferred Stock. 8. Restructuring Plan The Company recorded restructuring charges in 2000, totaling $2,133,000 in connection with its restructuring plans. Such charges were determined in accordance with Staff Accounting Bulletin No. 100, RESTRUCTURING AND IMPAIRMENT CHARGES, and Emerging Issues Task Force No. 94-3, LIABILITY RECOGNITION FOR CERTAIN EMPLOYEE TERMINATION BENEFITS AND OTHER COSTS TO EXIT AN ACTIVITY (INCLUDING CERTAIN COSTS INCURRED IN A RESTRUCTURING). The following table summarizes the restructuring and other related charges paid in 2001 and remaining charges in accrued liabilities as of September 30, 2001.
Restructuring Charges ------------------------------------------------------ Accrued as of Paid in Nine Accrued as of December 31, Months Ended September 30, 2000 September 30, 2001 2001 ---------------- ------------------- ----------------- Severance costs for involuntary employee terminations $ 388,000 $ 388,000 $ - Costs related to closure and combination of facilities 918,000 553,000 365,000 ---------------- ------------------- ----------------- $ 1,306,000 $ 941,000 $ 365,000 ================ =================== =================
9. Disclosure of Segment Information For the three and nine months ended September 30, 2001, the Company has the following two reportable segments: Application Services division and Technology Services division. Application Services - provides clients with strategic consulting, software implementation, project management, and support services, including staff augmentation. Technology Services - provides clients with solutions in key areas, including network infrastructure, application development and integration projects, help desk solutions and network management. The Company manages segment reporting at a gross margin level. Certain selling, general and administrative expenses, and fixed assets are managed at the corporate level separately from the segments and therefore are not separately allocated to the segments. The Company's segments are managed on an integrated basis in order to serve clients by assembling multi-disciplinary teams, which provide comprehensive services across its principal services. Segment disclosures for the three and nine months ended September 30, 2000 were restated to correspond to the 2001 reportable segment disclosures for comparative purposes.
Technology Application Services Services Total ----------------- ------------------ ----------------- Three months ended September 30, 2001 ------------------------------------- Total revenues $ 5,064 $ 4,065 $ 9,129 Cost of services 3,657 3,394 7,051 ----------------- ------------------ ----------------- Gross profit 1,407 671 2,078 Gross profit percent 28% 17% 23% Sales and marketing 725 General and administrative 2,235 Restructuring charges - ----------------- Loss from operations $ (882) =================
7 Three months ended September 30, 2000 ------------------------------------- Total revenues $ 9,628 $ 5,713 $ 15,341 Cost of services 8,469 4,790 13,259 ----------------- ------------------ ----------------- Gross profit 1,159 923 2,082 Gross profit percent 12% 16% 14% Sales and marketing 1,390 General and administrative 4,791 Restructuring charges - ----------------- Loss from operations $ (4,099) ================= Technology Application Services Services Total Nine months ended September 30, 2001 ------------------------------------ Total revenues $ 18,994 $ 13,016 $ 32,010 Cost of services 13,860 9,805 23,665 ----------------- ------------------ ----------------- Gross profit 5,134 3,211 8,345 Gross profit percent 27% 25% 26% Sales and marketing 2,375 General and administrative 8,348 Restructuring charges - ----------------- Loss from operations $ (2,378) ================= Nine months ended September 30, 2000 ------------------------------------ Total revenues $ 32,032 $ 17,011 $ 49,043 Cost of services 27,772 14,488 42,260 ----------------- ------------------ ----------------- Gross profit 4,260 2,523 6,783 Gross profit percent 13% 15% 14% Sales and marketing 4,831 General and administrative 13,433 Restructuring charges 827 ----------------- Loss from operations $ (12,308) =================
10. Termination of Outsourcing Agreement The Company provided on-site outsourcing services to a customer under a five-year outsourcing agreement which began January 1, 1999. On March 30, 2001, the Company entered into a termination agreement in which the outsourcing agreement terminated as of March 31, 2001. Under the termination agreement, all of the Company's on-site employees transferred to the customer effective April 1, 2001 and the customer paid the Company a transition fee of $643,000. For the three months ended September 30, 2001 the Company recorded the remaining $257,000 of the transition fee as revenue. 11. 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. They filed an amended consolidated complaint on February 24, 1999 and a second amended consolidated complaint on January 21, 2000. 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 8 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, which was filed on February 22, 2000 in the federal litigation. That motion was heard on February 20, 2001 and the court took the matter under submission. 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. 9 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Prospective investors are cautioned that such statements are only predictions and that actual events or results may differ materially. Forward-looking statements usually contain the words "estimate," "anticipate," "believe," "expect" or similar expressions. All forward-looking statements are inherently uncertain as they are based on various expectations and assumptions concerning future events and are subject to numerous known and unknown risks and uncertainties. The forward-looking statements included herein are based on current expectations and entail various risks and uncertainties as those set forth herein and in the Company's other SEC filings, including those more fully set forth in the "Risk Factors," "Management's Discussion and Analysis of Financial Condition and Results of Operations" and other sections of the Company's Forms 10-K and 10-K/A-1 for the year ended December 31, 2000 on file with the SEC, and in the Company's Proxy Statement Schedule 14A Information filed with the SEC on May 14, 2001. These risks and uncertainties could cause the Company's actual results to differ materially from those projected in the forward-looking statements. The Company disclaims any obligation to update or publicly announce revisions to any such statements to reflect future events or developments. Recent Events On June 1, 2001, the Company agreed to sell 1,500,000, 150,000 and 2,500,000 shares of restricted common stock at the June 1, 2001 closing price of $.29 per share to Messers. James T. Roberto, Neil R. Cassidy and Vincent K. Roach, respectively, of the Company in exchange for full-recourse notes receivable that accrue interest at a rate of 6.75% and which are due on May 31, 2006. As part of the agreement, 1,710,000 options to purchase common stock previously granted to these executive officers were cancelled. The Company provided on-site outsourcing services to a customer under a five-year outsourcing agreement which began January 1, 1999. On March 30, 2001, the Company entered into a termination agreement in which the outsourcing agreement terminated as of March 31, 2001. Under the termination agreement, all of the Company's on-site employees transferred to the customer effective April 1, 2001 and the customer paid the Company a transition fee of $643,000. For the three months ended September 30, 2001 the Company recorded the remaining $257,000 of the transition fee as revenue. On April 24, 2001, the Company received notice from The Nasdaq Stock Market that the Company's common stock would be traded and quoted on the OTC Bulletin Board ("OTC"), under the symbol DAOU, effective immediately. The Company's common stock previously had been quoted on The Nasdaq National Market, but the Company was no longer in compliance with the $1 minimum bid price requirement for continued listing. Overview DAOU is one of the top 50 healthcare information technology (IT) companies in the United States. DAOU's services include applications consulting and implementation, traditional network services, remote help desk and related technology support services, and integrates legacy systems with emerging technologies, such as wireless and other portable computing solutions for the U.S. healthcare industry. The Company's service offerings are segmented into two divisions: Application Services and Technology Services. Application Services - provides clients with strategic consulting, software implementation, project management and support services, including staff augmentation. Technology Services - provides clients with solutions in key areas, including network infrastructure, application development and integration projects, help desk solutions and network management. The Company provides its professional services primarily on a "time and expense" basis, under which revenues are generally recognized as services are performed. Billings for these services occur on a semi-monthly or monthly basis. The Company also provides support and management services, for which revenues are recognized ratably 10 over the period that these services are provided. 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 fixed-fee contracts varies significantly depending on the percentage of such services consisting of third-party products (with respect to which the Company obtains a lower margin) versus professional services provided by the Company. 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 The following table sets forth, for the periods indicated, certain statement of operations data as a percentage of net revenues.
Three Months Ended Nine Months Ended September 30, September 30, ---------------------------------- --------------------------------- 2001 2000 2001 2000 --------------- ------------------ ----------------- --------------- Revenues 100% 100% 100% 100% Cost of revenues 77 86 74 86 --------------- ------------------ ----------------- --------------- Gross profit 23 14 26 14 Selling, general and administrative expenses 33 41 33 37 Restructuring charges - - - 2 --------------- ------------------ ----------------- --------------- Loss from operations (10) (27) (7) (25) Other income, net 2 1 1 1 --------------- ------------------ ----------------- --------------- Loss before income taxes (8) (26) (6) (24) Provision for income taxes - - - - --------------- ------------------ ----------------- --------------- Net Loss (8) (26) (6) (24) =============== ================== ================= ===============
Three Months Ended September 30, 2001 and 2000 The Company's revenues decreased 40% or $6.2 million to $9.1 million for the three months ended September 30, 2001 from $15.3 million for the three months ended September 30, 2000, primarily due to the termination of a large outsourcing contract. The Company also experienced a significant decrease in revenue from a decline in the applications implementation services in the provider segment and the termination of another large unprofitable outsourcing contract in the Technology Services division in the third quarter of 2000. In addition, the Company eliminated certain underperforming service lines in the Technology Services division. The Company provided on-site outsourcing services to a customer under a five-year outsourcing agreement which began January 1, 1999. On March 30, 2001, the Company entered into a termination agreement in which the outsourcing agreement terminated as of March 31, 2001. Under the termination agreement, all of the Company's on-site employees transferred to the customer effective April 1, 2001 and the customer paid the Company a transition fee of $643,000. Revenues related to this contract were $257,000 and $2.5 million for the three months ended September 30, 2001 and 2000, respectively. Services to DAOU's five largest customers accounted for 35% or $3.2 million of total revenues for the three months ended September 30, 2001. Cost of revenues decreased 47% or $6.2 million to $7.1 million for the three months ended September 30, 2001 from $13.3 million for the three months ended September 30, 2000, primarily as a result of reductions in personnel and material costs in line with the decrease in revenues, the termination of the Company's largest outsourcing contract in the first quarter of 2001 and the termination of unprofitable contracts in 2000. The Company further 11 reduced the number of employees during the first quarter of 2001 in connection with its restructuring plan. Total employees as of September 30, 2001 were 243 compared to 492 as of September 30, 2000. Gross profit as a percentage of revenues increased to 23% for the three months ended September 30, 2001 compared to 14% for the three months ended September 30, 2000, primarily due to an increase in billable utilization and the termination of certain unprofitable service lines. Sales and marketing expenses decreased 48% or $665,000 to $725,000 for the three months ended September 30, 2001 from $1.4 million for the three months ended September 30, 2000, primarily due to a restructuring of the Company's national sales force and a reduction in marketing expenses related to the Company's merger of its Enosus operating subsidiary with the Technology Services division in January 2001. Sales and marketing expenses represented approximately 8% and 9% of total revenues for the three months ended September 30, 2001 and 2000, respectively. General and administrative expenses decreased 53% or $2.6 million to $2.2 million for the three months ended September 30, 2001 from $4.8 million for the three months ended September 30, 2000, primarily due to a reduction in corporate and subsidiary personnel and related overhead expenses. The Company reduced the on-going general and administrative costs from the same period in 2000, primarily as a result of synergies related to the integration of acquired companies, the closure of certain administrative offices, a reduction in administrative staff and other cost control measures. General and administrative expenses represented approximately 24% and 31% of total revenues for the three months ended September 30, 2001 and 2000, respectively. Other income, net, was $162,000 and $184,000 for the three months ended September 30, 2001 and 2000, respectively. Other income is primarily interest income on cash and cash equivalents and short-term investments. Provision for income taxes was $19,000 for the three months ended September 30, 2001 due to various states income taxes. The provision for income taxes is based on the Company's effective tax rate. Due to the Company's operating loss and the loss carry forwards, no provision for taxes was recorded for the three months ended September 30, 2000. The Company has fully reserved for the net deferred tax assets resulting from previously recorded tax benefits. Nine Months Ended September 30, 2001 and 2000 The Company's revenues decreased 35% or $17.0 million to $32.0 million for the nine months ended September 30, 2001 from $49.0 million for the nine months ended September 30, 2000, primarily due to a decrease in revenue from the application implementation services in the provider segment and the termination of a large outsourcing contract. In addition, the Company terminated two large unprofitable outsourcing contracts in the Technology Services division in the second and third quarters of 2000 and eliminated certain underperforming service lines. The Company provided on-site outsourcing services to a customer under a five-year outsourcing agreement which began January 1, 1999. On March 30, 2001, the Company entered into a termination agreement in which the outsourcing agreement terminated as of March 31, 2001. Under the termination agreement, all of the Company's on-site employees transferred to the customer effective April 1, 2001 and the customer paid the Company a transition fee of $643,000. The Company recorded the transition fee as revenue over the second and third quarters of 2001. Revenues related to this contract were $2.9 million and $7.4 million for the nine months ended September 30, 2001 and 2000, respectively. Services to DAOU's five largest customers accounted for 33% or $10.8 million of total revenues for the nine months ended September 30, 2001. Cost of revenues decreased 44% or $18.6 million to $23.7 million for the nine months ended September 30, 2001 from $42.3 million for the nine months ended September 30, 2000, primarily as a result of reductions in personnel and material costs in line with the decrease in revenues, the termination of the Company's largest outsourcing contract in the first quarter of 2001, and the termination of unprofitable contracts in 2000. The Company further reduced the number of employees in the first quarter of 2001 in connection with its restructuring plan. Total employees as of September 30, 2001 were 243 compared to 492 as of September 30, 2000. Gross profit as a percentage of revenues increased to 26% for the nine months ended September 30, 2001 compared to 14% for the nine months ended September 30, 2000, primarily due to an increase in billable utilization and the termination of 12 certain unprofitable service lines. Sales and marketing expenses decreased 50% or $2.4 million to $2.4 million for the nine months ended September 30, 2001 from $4.8 million for the nine months ended September 30, 2000, primarily due to a restructuring of the Company's national sales force and a reduction in marketing expenses related to the Company's merger of its Enosus operating subsidiary with the Technology Services division in January 2001. Sales and marketing expenses represented approximately 7% and 10% of total revenues for the nine months ended September 30, 2001 and 2000, respectively. General and administrative expenses decreased 38% or $5.1 million to $8.3 million for the nine months ended September 30, 2001 from $13.4 million for the nine months ended September 30, 2000, primarily due to a reduction in corporate and subsidiary personnel and related overhead expenses. The Company reduced the on-going general and administrative costs from the same period in 2000, primarily as a result of synergies related to the integration of acquired companies, the closure of certain administrative offices, a reduction in administrative staff and other cost saving measures. General and administrative expenses represented approximately 26% and 27% of total revenues for the nine months ended September 30, 2001 and 2000, respectively. Other income, net, was $426,000 and $517,000 for the nine months ended September 30, 2001 and 2000, respectively. Other income is primarily interest income on cash and cash equivalents and short-term investments. Provision for income taxes was $80,000 for the nine months ended September 30, 2001 due to various states' income taxes. The provision for income taxes is based on the Company's effective tax rate. Due to the Company's operating loss and the loss carryforwards, no provision for taxes was recorded for the nine months ended September 30, 2000. The Company has fully reserved for the net deferred tax assets resulting from previously recorded tax benefits. Liquidity and Capital Resources On September 30, 2001, the Company had working capital of $16.9 million, a decrease of $1.0 million from $17.9 million on December 31, 2000. For the nine months ended September 30, 2001, cash provided by operating activities was $3.5 million compared to cash used in operating activities of $2.8 million for the nine months ended September 30, 2000. The increase resulted primarily from reduced operating expenses and increased gross margin. In addition, the Company has experienced further declines in the accounts receivable and contract work in progress balances which also contributed to the positive cash flow from operating activities. Net cash used in investing activities was $83,000 for the nine months ended September 30, 2001, compared to net cash used in investing activities of $651,000 in the comparable prior period, primarily due to fewer equipment purchases. On July 26, 1999, the Company issued 2,181,818 shares of Series A Preferred Stock. Holders of the Series A Preferred Stock are entitled to receive cumulative dividends payable in the form of shares of Series A Preferred Stock. The dividends accrued at a rate of six percent per annum for the first two years. On July 26, 2001, the dividend rate increased to seven percent per annum. The dividend rate increases by one percent each successive year after the second anniversary. As of September 30, 2001, the Company has accrued but undeclared preferred stock dividends of $1,675,000, which are payable in shares of Series A Preferred Stock. On June 29, 2001, the Company's $8.0 million revolving line of credit expired. No amounts were outstanding under this revolving line of credit as of June 29, 2001. Although the Company has an accumulated deficit as of September 30, 2001, the Company believes that its existing cash and short-term investments together with anticipated cash from operating activities will be sufficient to meet its capital requirements for the next twelve months. 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 would result in dilution to the Company's stockholders and the incurrence of additional debt could result in additional interest expense. However, there can be no assurance that the Company will be able to sell additional equity or debt securities or be able to obtain additional financing on terms acceptable to it, if at all. 13 Business Risks In addition to the factors addressed in the preceding sections, certain dynamics of the Company's markets and operations create fluctuations in the Company's quarterly results. Uncertainty and cost containment in healthcare and competitive conditions present various other risks to operating results which are more fully described in the Company's Form 10-K filed with the SEC and other SEC filings. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company is exposed to changes in interest rates, primarily if it should enter into variable-rate long-term debt arrangements and, to a lessor extent, its investments in certain available-for-sale marketable securities. Under its current policies, the Company does not use interest rate derivative instruments to manage this exposure to interest rate changes. On June 29, 2001, the Company's $8.0 million revolving line of credit expired. No amounts were outstanding under this revolving line of credit as of June 29, 2001. A hypothetical 1% adverse move in the interest rates along the entire interest rate yield curve would not materially effect the fair value of the Company's financial instruments that are exposed to changes in interest rates. 14 PART II OTHER INFORMATION Item 1. Legal Proceedings On August 24, 1998, August 31, 1998, September 14, 1998 and September 23, 1998, separate complaints were filed against the Company and certain of its officers and directors in the United States District Court for the Southern District of California. A group of shareholders has been appointed the lead plaintiffs. They filed an amended consolidated complaint on February 24, 1999 and a second amended consolidated complaint on January 21, 2000. 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, which was filed on February 22, 2000 in the federal litigation. That motion was heard on February 20, 2001 and the court took the matter under submission. The Company believes that the allegations set forth in all of the foregoing complaints are without merit and intends to defend against these allegations vigorously. No assurance as to the outcome of this matter can be given, however, and an unfavorable resolution of this matter could have a material adverse effect on the Company's business, results of operations and financial condition. Item 2. Changes In Securities and Use of Proceeds On July 24, 2001, the Company agreed to sell 150,000 shares of restricted common stock at the July 24, 2001 closing price of $.52 per share to Mr. Dan Malcolm of the Company in exchange for a full-recourse note receivable that accrues interest at a rate of 6.75% due on July 23, 2006. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits Exhibit No. Description 4.1 Restricted Stock Purchase Agreement, dated June 1, 2001, by and between the Company and Neil R. Cassidy 4.2 Registration Rights Agreement, dated June 1, 2001, by and between the Company and Neil R. Cassidy 4.3 Restricted Stock Purchase Agreement, dated June 1, 2001, by and between the Company and James T. Roberto 4.4 Registration Rights Agreement, dated June 1, 2001, by and between the Company and James T. Roberto 10.1 Amendment to Employment Agreement, dated June 1, 2001, by and between the Company and Neil R. Cassidy 10.2 Secured Promissory Note, dated June 1, 2001, by and between the Company and Neil R. Cassidy 10.3 Stock Pledge Agreement, dated June 1, 2001, by and between the Company and Neil R. Cassidy 10.4 Amendment to Employment Agreement, dated June 1, 2001, by and between the Company and James T. Roberto 10.5 Secured Promissory Note, dated June 1, 2001, by and between the Company and James T. Roberto 10.6 Stock Pledge Agreement, dated June 1, 2001, by and between the Company and James T. Roberto ---------- (b) Current Reports on Form 8-K. The Registrant did not file any Current Reports on Form 8-K with the SEC during the quarter ended September 30, 2001. 15 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, this registrant has duly caused this report to be signed on its behalf by the undersigned thereto duly authorized. Date: November 8, 2001 DAOU SYSTEMS, INC. By: /s/ James T. Roberto ---------------------------------- James T. Roberto President and Chief Executive Officer, duly authorized officer By: /s/ Neil R. Cassidy ---------------------------------- Neil R. Cassidy Executive Vice President, Chief Financial Officer, and Secretary, principal financial and accounting officer 16 Exhibit Index 4.1 Restricted Stock Purchase Agreement, dated June 1, 2001, by and between the Company and Neil R. Cassidy 4.2 Registration Rights Agreement, dated June 1, 2001, by and between the Company and Neil R. Cassidy 4.3 Restricted Stock Purchase Agreement, dated June 1, 2001, by and between the Company and James T. Roberto 4.4 Registration Rights Agreement, dated June 1, 2001, by and between the Company and James T. Roberto 10.1 Amendment to Employment Agreement, dated June 1, 2001, by and between the Company and Neil R. Cassidy 10.2 Secured Promissory Note, dated June 1, 2001, by and between the Company and Neil R. Cassidy 10.3 Stock Pledge Agreement, dated June 1, 2001, by and between the Company and Neil R. Cassidy 10.4 Amendment to Employment Agreement, dated June 1, 2001, by and between the Company and James T. Roberto 10.5 Secured Promissory Note, dated June 1, 2001, by and between the Company and James T. Roberto 10.6 Stock Pledge Agreement, dated June 1, 2001, by and between the Company and James T. Roberto 17