10-Q 1 d10q.txt FORM 10-Q--DAOU SYSTEMS INC UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X] QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the quarterly period ended June 30, 2002 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) 412 Creamery Way, Suite 300 Exton, Pennsylvania 19341 (Address of principal executive offices) (Zip Code) (610) 594-2700 (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 August 10, 2002: 21,623,466 Daou Systems, Inc. Index to Form 10-Q
Page ---- PART I. FINANCIAL INFORMATION Item 1. Condensed Financial Statements 2 Condensed Balance Sheets at June 30, 2002 (unaudited) and December 31, 2001 2 Condensed Statements of Operations (unaudited) for the Three Months and Six Months Ended June 30, 2002 and 2001 3 Condensed Statements of Cash Flows (unaudited) for the Six Months Ended June 30, 2002 and 2001 4 Notes to Condensed Financial Statements (unaudited) 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 15 PART II. OTHER INFORMATION Item 1. Legal Proceedings 16 Item 2. Changes in Securities and Use of Proceeds 16 Item 3. Defaults Upon Senior Securities 16 Item 4. Submission of Matters to a Vote of Security Holders 17 Item 5. Other Information 17 Item 6. Exhibits and Reports on Form 8-K 17 SIGNATURES 18
1 PART I. FINANCIAL INFORMATION Item 1. Condensed Financial Statements Daou Systems, Inc. Condensed Balance Sheets (In thousands, except per share data)
June 30, December 31, 2002 2001 (unaudited) -------------------------- Assets Current assets: Cash and cash equivalents $ 11,936 $ 14,868 Restricted cash -- 147 Short-term investments, available-for-sale 61 59 Accounts receivable, net of allowance for doubtful accounts of $667 and $715 at June 30, 2002 and December 31, 2001, respectively 8,749 7,572 Contract work in progress 162 310 Other current assets 997 328 -------------------------- Total current assets 21,905 23,284 Equipment, furniture and fixtures, net 1,091 970 Other assets 145 130 -------------------------- Total Assets $ 23,141 $ 24,384 ========================== Liabilities and Stockholders' Equity Current liabilities: Trade accounts payable and other accrued liabilities $ 2,495 $ 2,933 Accrued salaries and benefits 3,757 3,254 Deferred revenue 362 585 Current portion of severance payable 95 193 -------------------------- Total current liabilities 6,709 6,965 Long-term liabilities 40 51 Commitments and contingencies Stockholders' equity: Convertible preferred stock, $.001 par value. Authorized 3,520 shares; issued and outstanding 2,182 shares at June 30, 2002 and December 31, 2001, with a liquidation preference of $14,399 and $13,912 at June 30, 2002 and December 31, 2001 2 2 Common stock, $.001 par value. Authorized 50,000 shares; issued and outstanding 21,623 shares at June 30, 2002 and 21,556 shares at December 31, 2001 23 22 Additional paid-in capital 54,523 53,989 Notes receivable from stockholders (1,281) (1,281) Deferred compensation (207) (261) Accumulated other comprehensive loss (70) (72) Accumulated deficit (36,598) (35,031) -------------------------- Total stockholders' equity 16,392 17,368 -------------------------- Total Liabilities and Stockholders' Equity $ 23,141 $ 24,384 ==========================
See accompanying notes to the condensed financial statements. 2 Daou Systems, Inc. Condensed Statements of Operations (In thousands, except per share data) (unaudited)
Three Months Ended June 30, Six Months Ended June 30, 2002 2001 2002 2001 --------------------------- ------------------------- Revenues before reimbursements (net revenues) $ 9,734 $10,121 $18,838 $22,881 Out-of-pocket reimbursements 829 822 1,605 1,760 --------------------------- ------------------------- Total revenues 10,563 10,943 20,443 24,641 Cost of revenues before reimbursable expenses 7,336 8,431 13,865 18,763 Out-of-pocket reimbursable expenses 829 822 1,605 1,760 --------------------------- ------------------------- Total cost of revenues 8,165 9,253 15,470 20,523 --------------------------- ------------------------- Gross profit 2,398 1,690 4,973 4,118 Operating expenses: Sales and marketing 1,293 724 2,427 1,652 General and administrative 1,767 1,957 3,737 3,962 --------------------------- ------------------------- 3,060 2,681 6,164 5,614 --------------------------- ------------------------- Loss from operations (662) (991) (1,191) (1,496) Other income, net 49 125 111 203 --------------------------- ------------------------- Net loss (613) (866) (1,080) (1,293) Accrued dividends on preferred stock (245) (196) (487) (391) --------------------------- ------------------------- Net loss available to common stockholders $ (858) $(1,062) $(1,567) $(1,684) =========================== ========================= Basic and diluted net loss per share $ (0.05) $ (0.06) $ (0.08) $ (0.10) =========================== ========================= Shares used in computing basic and diluted net loss per share 18,864 17,198 18,682 17,512 =========================== =========================
See accompanying notes to the condensed financial statements. 3 Daou Systems, Inc. Condensed Statements of Cash Flows (In thousands) (unaudited)
Six Months Ended June 30, 2002 2001 ------- ------- Operating activities Net loss $(1,080) $(1,293) Adjustments to reconcile net loss to net cash (used in) provided by operating activities: Depreciation and amortization 438 709 Amortization of deferred compensation 54 - Provision for uncollectible accounts 91 399 (Gain) loss on retirement of fixed assets (10) 352 Changes in operating assets and liabilities: Restricted cash 147 -- Accounts receivable (1,268) 3,238 Contract work in process 148 710 Other current assets (669) (53) Accounts payable and accrued liabilities (438) (1,709) Accrued salaries and benefits 503 921 Other (332) 285 ------- ------- Net cash (used in) provided by operating activities (2,416) 3,559 Investing activities Purchases of equipment, furniture and fixtures, net (549) (135) Changes in other assets (15) 56 ------- ------- Net cash used in investing activities (564) (79) Financing activities Proceeds from issuance of common stock 48 55 Purchase of treasury stock -- (198) ------- ------- Net cash provided by (used in) financing activities 48 (143) (Decrease) increase in cash and cash equivalents (2,932) 3,337 Cash and cash equivalents at beginning of period 14,868 10,504 ------- ------- Cash and cash equivalents at end of period $11,936 $13,841 ======= ======= Supplemental Disclosure of Non-cash Activities: Common stock issued for services $ -- $ 25 ======= ======= Common stock issued for settlement $ -- $ 3 ======= ======= Common stock issuable for notes receivable from stockholder $ -- $ 1,204 ======= ======= Accrued preferred stock dividends $ 487 $ 391 ======= =======
See accompanying notes to the condensed financial statements. 4 Daou Systems, Inc. Notes to Condensed Financial Statements (unaudited) 1. Basis of Presentation The unaudited condensed financial statements of Daou Systems, Inc. ("Daou" or the "Company") at June 30, 2002 and for the three- and six-month periods ended June 30, 2002 and 2001 have been prepared in accordance with generally accepted accounting principles ("GAAP") for interim financial information. Accordingly, they do not include all information and footnotes required by GAAP for a complete set of financial statements. These financial statements reflect all adjustments, consisting of normal recurring adjustments, which in the opinion of management are necessary to fairly present the financial position of the Company at June 30, 2002 and the results of operations for the three-and six-month periods ended June 30, 2002 and 2001. The results of operations for the three and six months ended June 30, 2002 are not necessarily indicative of the results to be expected for the year ending December 31, 2002. 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 balance sheet at December 31, 2001 has been derived from the audited financial statements at that date but does not include all of the information and footnotes required by generally accepted accounting principles for complete financial statements. 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 financial statements 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 April 1, 2002. In late 2001, the Company further defined the mission and focus of each of its business units and has assigned profit responsibilities to each business unit leader. Effective January 1, 2002, certain overhead expenses directly attributable to the business units and formerly recorded as general and administrative expenses are now recorded as cost of revenues before reimbursable expenses. The prior period amounts have been reclassified to conform to their current period presentation. 2. New Accounting Standard On January 1, 2002, the Company adopted the provisions of the Emerging Issues Task Force ("EITF") Topic D-103, Income Statement Characterization of Reimbursements for "Out-of-Pocket" Expenses Incurred. In accordance with the provisions of EITF Topic D-103, the Company adjusted revenues and cost of revenues for all periods reported to include out-of-pocket expenses. The Company has reclassified its prior period financial statements in accordance with this accounting pronouncement. Adoption of the provisions of EITF Topic D-103 had no impact on reported net loss, net loss available to common stockholders or net loss per share for the periods presented. 3. 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. 5 Daou Systems, Inc. Notes to Condensed Financial Statements - continued (unaudited) 4. 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 six months ended June 30, 2002 and 2001, diluted loss per share is unchanged from basic loss per share because the effects of the assumed conversion of Series A Preferred Stock, stock options and warrants would be anti-dilutive. The following table details the computation of basic and diluted net loss per share: (In thousands, except per share information) Three Months Ended Six Months Ended June 30, June 30, 2002 2001 2002 2001 ------------------ ----------------- Numerator: Net loss available to common $ (858) $(1,062) $(1,567) $(1,684) Denominator: Weighted average common shares outstanding 21,559 17,198 21,557 17,512 Weighted average unvested common shares subject to repurchase agreements (2,695) -- (2,875) -- ------------------ ----------------- Denominator for basic and diluted calculation 18,864 17,198 18,682 17,512 ================== ================= Basic and diluted net loss per share $ (0.05) $ (0.06) $ (0.08) $ (0.10) ================== ================== 5. 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 at the lower of 85% of the fair market value at the beginning of the measurement period or 85% of the fair market value at the end of the measurement period. On June 30, 2002, the Company issued 54,237 shares of common stock at $0.8415 per share. At June 30, 2002, 1,009,719 shares remained available for issuance under the ESPP. 6. Restructuring Plan In connection with the Company's decision to close and combine certain facilities, the Company recorded restructuring charges totaling $1.3 million during the fourth quarter of 2001. These charges include severance costs related to a reduction in workforce of approximately 28 employees and the costs estimated to be incurred in connection with the closure of certain facilities. Such charges were determined in accordance with SEC SAB No. 100, Restructuring And Impairment Charge, and EITF No. 94-3, Liability Recognition For Certain Employee Termination Benefits And Other Costs To Exit An Activity (Including Certain Cost Incurred In A Restructuring). In 2000, the Company recorded restructuring charges totaling approximately $2.1 million in connection with the various actions to reduce the cost structure of the Company. These charges, which were recorded in accordance with SEC SAB No. 100 and EITF No. 94-3, included severance costs related to a reduction in workforce of approximately 50 employees and the closure of certain facilities. The Company anticipates that the above restructuring plans will be completed by December 31, 2003. 6 Daou Systems, Inc. Notes to Condensed Financial Statements - continued (unaudited) 6. Restructuring Plan (continued) The following table summarizes the restructuring and other related charges paid in 2002 and remaining charges in accrued liabilities as of June 30, 2002.
Restructuring Charges --------------------------------------------- Accrued as of Paid in Six Accrued as of December 31, Months Ended June 30, 2001 June 30, 2002 2002 --------------------------------------------- Severance costs for involuntary employee terminations $ 151,000 $151,000 $ -- Costs related to closure and combination of facilities 1,161,000 844,000 317,000 --------------------------------------------- $1,312,000 $995,000 $317,000 =============================================
7. Disclosure of Segment Information For internal control and marketing/sales synergy purposes, the Company continues to group its business units within two divisions - Technology Services Division ("TSD") and Application Services Division ("ASD"). Externally, with respect to marketing/sales and related customer service, the Company's interaction with customers will take place at the business unit level. TSD consists of the following three business units: (i) Infrastructure Services Group ("ISG"), which designs and deploys HIT infrastructure components essential to delivering and securing access to applications across the enterprise; (ii) Sentient ("Sentient"), which builds and supports M/MUMPS-based systems typically used by government healthcare organizations; and (iii) Daou Technology Center (the "DTC", formerly "RTC"), which provides Help Desk services to mitigate risk via systems support of the desktop, network, server and security environments. ASD is comprised of the following two business units: (i) Technology Management ("TMI"), which provides strategic consulting services to payors and providers, including those related to the Health Insurance Portability & Accountability Act of 1996 ("HIPAA") and provides application planning, implementation and support of payor-based HIT applications to insurance companies and managed care organizations; and (ii) Resources in Healthcare Innovation ("RHI"), which provides temporary staffing resources to hospitals, IDNs and third-party vendors focused on the implementation and support of provider-based HIT applications. The Company manages segment reporting at a gross margin level. Selling, general and administrative expenses, and 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. 7 Daou Systems, Inc. Notes to Condensed Financial Statements - continued (unaudited) 7. Disclosure of Segment Information (continued) (in thousands) Application Technology Services Services Division Division Total --------------------------------- Three months ended June 30, 2002 -------------------------------- Revenues before reimbursements (net revenues) $4,993 $4,741 $9,734 Cost of revenues before reimbursable expenses 3,670 3,666 7,336 --------------------------------- Gross profit 1,323 1,075 2,398 Gross profit percent 26% 23% 25% Sales and marketing 1,293 General and administrative 1,767 ------ Loss from operations $ (662) ====== Three months ended June 30, 2001 -------------------------------- Revenues before reimbursements (net revenues) $4,345 $5,776 $10,121 Cost of revenues before reimbursable expenses 3,810 4,621 8,431 ---------------------------------- Gross profit 535 1,155 1,690 Gross profit percent 12% 20% 17% Sales and marketing 724 General and administrative 1,957 ------- Loss from operations $ (991) ======= Application Technology Services Services Division Division Total ---------------------------------- Six months ended June 30, 2002 -------------------------------- Revenues before reimbursements (net revenues) $9,392 $ 9,446 $18,838 Cost of revenues before reimbursable expenses 6,767 7,098 13,865 ---------------------------------- Gross profit 2,625 2,348 4,973 Gross profit percent 28% 25% 26% Sales and marketing 2,427 General and administrative 3,737 ------- Loss from operations $(1,191) ======= Six months ended June 30, 2001 -------------------------------- Revenues before reimbursements (net revenues) $8,950 $13,931 $22,881 Cost of revenues before reimbursable expenses 7,193 11,570 18,763 ---------------------------------- Gross profit 1,757 2,361 4,118 Gross profit percent 20% 17% 18% Sales and marketing 1,652 General and administrative 3,962 ------- Loss from operations $(1,496) ======= 8 Daou Systems, Inc. Notes to Condensed Financial Statements - continued (unaudited) 8. 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, of which $386,000 was recorded in net revenues in the second quarter of 2001 and $257,000 was recorded in the third quarter of 2001. 9. 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 former 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 a second amended consolidated class action 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. Claims are pleaded under both the Securities Act of 1933, as amended, (relating to the Company's initial public offering) and section 10b of the 1934 Securities Exchange Act. The complaint was brought on behalf of a purported class of investors who purchased the Company's Common Stock between February 13, 1997 and October 28, 1998, but it does 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. As with their Federal court counterparts, they do not allege specific damage amounts. On April 1, 1999, a consolidated amended class action was filed on behalf of the same plaintiffs and the new state complaint alleges the same factual basis as is asserted in the Federal litigation. By stipulation of the parties, the state court litigation has been stayed pending the resolution of a motion to dismiss that was filed on February 22, 2000 in the federal litigation. That motion was granted on March 27, 2002, but the Court extended to plaintiffs the opportunity to file a Third Amended Complaint. The plaintiffs filed their Third Amended Complaint on May 16, 2002, to which the Company responded with another Motion to Dismiss. The motion was filed on June 24, 2002 and challenged the legal sufficiency of the allegations. The plaintiffs have until August 14, 2002 to oppose the motion with the Company's reply to the opposition due August 30, 2002. The hearing on the Motion to Dismiss is calendared for September 9, 2002. 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. On February 27, 2002, a complaint was filed against certain of the Company's former officers and directors, as well as Daou On-Line, Inc., in the Superior Court of New Jersey located in Bergen County. A First Amended Complaint was filed on March 1, 2002 adding the Company and its former Chief Financial Officer as parties-defendant. The gravamen of the First Amended Complaint is two-fold. First, it alleges Daou's financial statements were misleading and fraudulently induced the plaintiff to merge his company with Daou. Second, the First Amended Complaint alleges breach of an idemnification and severance agreement obligating the Company to defend the plaintiff in a lawsuit filed by Traci Melia, a former employee. Neither the Complaint nor the First Amended Complaint allege specific damage amounts. On April 24, 2002 the Company filed a Motion to Dismiss the First Amended Complaint. The Court conducted a hearing on June 7, 2002 and granted the Company's motion. On July 23, 2002, the plaintiff filed a Notice of Appeal. A hearing date for the appeal has not yet been set. The Company is party to various claims and legal actions arising in the normal course of business. Although the ultimate outcome of the matters is not presently determinable, management believes that the resolution of all such pending matters, net of amounts accrued, will not have a material adverse affect on the Company's business, results of operations or financial condition; however, there can be no assurance that the ultimate resolution of these matters will not have a material impact on the Company's results of operations, cash flows or financial position. 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 for the year ended December 31, 2001 on file with the SEC, and in the Company's Proxy Statement Schedule 14A Information filed with the SEC on April 30, 2002. 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 Developments In late March of 2002, the Company began moving its corporate headquarters from San Diego, California to Exton, Pennsylvania and completed the move by mid-April of 2002. In connection with this move, the Company recorded a one-time charge of approximately $1.3 million in the fourth quarter of 2001 related to the buyout of its office lease in San Diego, as well as certain expenses related to the reduction of staff and consolidation of marketing and administrative staff in Exton, Pennsylvania. Overview Daou Systems, Inc. provides expert consulting and management services to healthcare organizations in the design, deployment and support of IT infrastructure and application systems. The firm offers a range of comprehensive services, from strategic consulting, to IT application design and implementation, to long-term, outsourced operational management. Daou has provided services to more than 1,500 healthcare organizations, including leading private and public hospitals, managed care organizations on both the payor and provider sides of the market, as well as integrated healthcare delivery networks (IDNs) and government healthcare. Daou Systems, Inc. is a publicly traded company listed on the OTC Bulletin Board under the stock symbol DAOU. Daou currently has approximately 235 employees. The Company's service offerings are segmented into the following operating divisions and service lines: Application Services Division ("ASD") - provides strategic IT consulting and planning services, including HIPAA consulting and remediation, managed care system implementation, post-implementation support, transition management and interim staffing. . TMI - performs strategic IT consulting, HIPAA consulting and remediation, managed care system implementation and post-implementation support to help healthcare management meet their business and IT objectives and anticipate and plan their future IT needs. . RHI - supplies hospitals and other healthcare organizations with temporary, certified consultants who are capable of installing and servicing the most common healthcare software applications. 10 Technology Services Division ("TSD") - provides services focused on two vital components of a healthcare organization's infrastructure: the information technology itself and the resources who manage it. TSD provides solutions in key areas, including deployment of the network infrastructure, helping clients extend the value of legacy systems and enabling them to work with emerging technologies, web development and integration projects, and long-term management of complex information technologies, including help desk solutions and network management. . ISG - focuses on IT infrastructure solutions for healthcare enterprises, including IDNs, hospitals and large academic medical centers. ISG services include the design and delivery of network infrastructure and the underlying components essential to delivering information and securing access to applications across the healthcare enterprise. The group supports healthcare organizations in all stages of infrastructure design and implementations, from the requisition and purchase of hardware to the installation and support of turn-key data networks. . Sentient - Sentient capabilities include building and supporting the M/MUMPS-based systems typically used by government-run healthcare organizations and focuses on integration of the customers information systems within government healthcare with existing or new infrastructure that allow healthcare organizations to share and access data housed across multiple platforms and environments. . DTC - performs a full range of IT functional outsourcing services including co-source or outsource of call centers, help desks, desktop support, server management, network management and voice management. The Company generates substantially all of its revenues from professional services, primarily on a "time and expense" project basis, under which revenues are recognized as the services are performed. Billings for these services occur on a semi-monthly or monthly basis as specified by the contract with a particular customer. The Company's billing rates are commensurate with the healthcare-domain IT expertise, know-how and skills of its consultants. The Company's time and expense projects generally range from three to six months, although certain projects have been for periods in excess of a year. The Company also provides support, management and help desk services, under multi-year engagements, which revenues are recognized ratably over the period that these services are provided. Fees for these outsourcing services are typically determined on a price per call or a price per node 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 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. The Company bills its customers for out-of-pocket expenses, primarily travel and related expenses incurred with respect to services provided to customers, and has adopted the provisions of the Emerging Issues Task Force ("EITF") Topic D-103, Income Statement Characterization of Reimbursements for "Out-of-Pocket" Expenses Incurred. 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. 11 Cost of revenues primarily consist of all expenses that are directly attributable to the business units and include the salaries, bonuses and related benefits of client-serving professionals as well as non-billable managers and support staff, subcontractor expenses, recruiting and training costs and office space costs. The Company's consultant-related costs are relatively fixed and therefore fluctuations in the Company's gross margin may occur due to changes in project margins and utilization rates of its professional staff. Sales and marketing expenses primarily consist of the salaries, benefits, travel and other costs of the Company's sales and marketing teams, as well as marketing initiatives and business development expenses. General and administrative expenses primarily consist of the costs attributable to the support of the Company's client-serving professionals, such as: investments in information systems, salaries, expenses and office space costs for executive management, financial accounting and human resources personnel, legal and other professional services. 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 Six Months Ended June 30, June 30, 2002 2001 2002 2001 -------------------------------------- Revenues before reimbursements (net revenues) 100% 100% 100% 100% Cost of revenues before reimbursable expenses 75 84 74 82 ---- ---- ---- ---- Gross profit 25 16 26 18 Operating expenses: 31 26 33 25 ---- ---- ---- ---- Loss from operations (6) (10) (7) (7) Other income, net -- 1 1 1 ---- ---- ---- ---- Net loss (6)% (9)% (6)% (6)% ==== ==== ==== ==== Three Months Ended June 30, 2002 and 2001 The Company's net revenues decreased 4% or $400,000 to $9.7 million for the three months ended June 30, 2002 from $10.1 million for the three months ended June 30, 2001. The decrease is primarily due to the Company's previously announced decision to exit certain lines of business that were not profitable, and termination of certain large outsourcing contracts in 2001, partially offset by higher revenues from the Company's applications services offerings in the payor market. Services to the Company's five largest customers accounted for $3.4 million of net revenues for the three months ended June 30, 2002, representing 35% of total net revenues, with one customer in each of the DTC and the Sentient business units each accounting for 9% of total net revenues. This compares to net revenues from the five largest customers for the three months ended June 30, 2001 totaling $3.1 million, or 30% of total net revenues. 12 Cost of revenues before reimbursable expenses decreased 13%, or $1.1 million, to $7.3 million for the three months ended June 30, 2002 from $8.4 million for the three months ended June 30, 2001. This decrease is attributable primarily to the above-referenced efforts to eliminate under-performing lines of businesses and a reduction of costs and more effective management of the Company's workforce, offset by higher costs in the Company's managed care applications business associated with the higher revenue attainment in that business. At June 30, 2002, the Company had approximately 235 employees, compared with approximately 247 employees at June 30, 2001. Gross margin increased to 25% for the three months ended June 30, 2002 compared to 16% for the three months ended June 30, 2001. This increase is primarily attributable to the above-referenced reduction of cost and elimination of under-performing lines of business, resulting in higher utilization rates primarily in the Company's managed care applications business and government healthcare integration services business, and increased project realization rates. Second quarter 2002 operating results reflect a higher level of sales and marketing expenses in support of the Company's goal of reemerging in the healthcare IT market and increasing future revenues. During the second quarter 2002, sales and marketing expenses increased 86%, or $600,000, to $1.3 million from $700,000 for the three months ended June 30, 2001. Daou expects the increase in spending in sales and marketing to continue for the remainder of 2002 as it re-establishes market presence following a period of relative inactivity as the Company focused internally to restructure and gain operating efficiencies. General and administrative expenses decreased 10%, or $200,000, to $1.8 million for the three months ended June 30, 2002 from $2.0 million for the three months ended June 30, 2001. The decrease year over year is primarily the result of a decrease in legal expenses, as well as a decrease in depreciation, rent and personnel costs as a result of the Company's relocation of its corporate offices, offset by certain one-time, non-recurring expenses related to the relocation. Other income, net, declined to $49,000 for the three months ended June 30, 2002 from $125,000 for the three months ended June 30, 2001, due to lower cash levels and lower interest rates. Other income is primarily interest income on cash and cash equivalents and short-term investments. Six Months Ended June 30, 2002 and 2001 The Company's net revenues decreased 17% or $4 million to $18.9 million for the six months ended June 30, 2002 from $22.9 million for the six months ended June 30, 2001. The decrease is primarily due to the previously announced termination of certain large outsourcing contracts, its decision to exit certain lines of business that were not profitable, and a reduction in revenues from temporary staffing services, partially offset by higher revenues from the Company's applications services offerings in the payor market. On March 30, 2001 the Company entered into an agreement to terminate an outsourcing contract for its largest customer effective March 31, 2001. Net revenues related to this contract were $2.7 million for the six months ended June 30, 2001. Services to the Company's five largest customers accounted for $6.4 million of net revenues for the six months ended June 30, 2002, representing 34% of total net revenues, with one customer in each of the DTC and the Sentient business units each accounting for 9% of total net revenues. This compares to net revenues from the five largest customers for the six months ended June 30, 2001 totaling $7.9 million, or 35% of total net revenues. Cost of revenues before reimbursable expenses decreased 26%, or $4.9 million, to $13.9 million for the six months ended June 30, 2002 from $18.8 million for the six months ended June 30, 2001. This decrease is attributable primarily to the above-referenced efforts to eliminate under-performing lines of businesses and a reduction of costs and more effective management of the Company's workforce, offset by higher costs in the Company's managed care applications business associated with the higher revenue attainment in that business. At June 30, 2002, the Company had approximately 235 employees, compared with approximately 247 employees at June 30, 2001. 13 Gross margin increased to 26% for the six months ended June 30, 2002 compared to 18% for the six months ended June 30, 2001. This increase is primarily attributable to the above-referenced reduction of cost and elimination of under-performing lines of business, resulting in higher utilization rates primarily in the Company's managed care applications, infrastructure services and government healthcare integration businesses, and increased project realization rates. Operating results for the first six months of 2002 reflect a higher level of sales and marketing expenses in support of the Company's goal of reemerging in the healthcare IT market and increasing future revenues. Sales and marketing expenses increased 50%, or $800,000, to $2.4 million for the six months ended June 30, 2002 from $1.6 million for the six months ended June 30, 2001. Daou expects the increase in spending in sales and marketing to continue for the remainder of 2002 as it re-establishes market presence following a period of relative inactivity as the Company focused internally to restructure and gain operating efficiencies. General and administrative expenses decreased 7%, or $300,000, to $3.7 million for the six months ended June 30, 2002 from $4.0 million for the six months ended June 30, 2001. The decrease year over year is primarily the result of a decrease in legal expenses, as well as a decrease in depreciation, rent and personnel costs as a result of the Company's relocation of its corporate offices, offset by certain one-time, non-recurring expenses related to the relocation and other employment related matters. Other income, net, declined to $111,000 for the six months ended June 30, 2002 from $203,000 for the six months ended June 30, 2001, due to lower cash levels and lower interest rates. Other income is primarily interest income on cash and cash equivalents and short-term investments. Liquidity and Capital Resources On June 30, 2002, the Company had cash, cash equivalents and short term investments available for sale of $12 million, a decrease of $2.9 million from $14.9 million on December 31, 2001. For the six months ended June 30, 2002, cash used in operating activities was $2.4 million compared to cash provided by operating activities of $3.6 million for the six months ended June 30, 2001. The use of cash during the six months ended June 30, 2002 is primarily due to an increase in accounts receivable and other current assets, and includes approximately $1 million of previously recorded restructuring liabilities paid primarily related to the Company's relocation of its corporate headquarters from San Diego, California to Exton, Pennsylvania. Days Sales Outstanding were 84 for the quarter ended June 30, 2002 compared with 83 in the first quarter of 2002 and 89 in the fourth quarter of 2001. Net cash used in investing activities was $564,000 for the six months ended June 30, 2002, compared to net cash used in investing activities of $79,000 for the six months ended June 30, 2001, primarily due to increased purchases of equipment related to the Company's relocation of its corporate headquarters from San Diego, California to Exton, Pennsylvania as well as investments in equipment used in the Company's help desk service line. Cash provided by financing activities was $48,000 for the six months ended June 30, 2002 and was related to proceeds from the issuance of the Company's common stock. On July 27, 1999 the Company issued 2,181,818 shares of Series A Preferred Stock. The Series A Preferred Stock agreement contained a redemption feature which was outside of the control of the Company. On November 9, 2000, the holders of the Series A Preferred Stock permanently waived their redemption rights in return for $2.0 million in cash and warrants to purchase 3,540,000 shares of the Company's common stock exercisable at $0.01 per share. Even though the holders of the Series A Preferred Stock have waived their redemption rights, the Company still has its right to redeem the Series A Preferred Stock anytime after the fourth anniversary of the purchase date for the issue price and accrued dividends per share. 14 Although the Company has an accumulated deficit as of June 30, 2002, the Company believes that its available funds together with anticipated cash from operating activities 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 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 acceptable terms, if at all. 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 invests excess cash primarily in U.S. government securities and marketable debt securities of financial institutions and corporations with strong credit ratings. These instruments have maturities of three months or less when acquired. The Company does not utilize derivative financial instruments, derivative commodity instruments or other market risk sensitive instruments, positions or transactions in any material fashion. Accordingly, the Company believes that, while the instruments held are subject to changes in the financial standing of the issuer of such securities, the Company is not subject to any material risks arising from changes in interest rates, foreign currency exchanges rates, commodity prices, equity prices or other market changes that affect market risk sensitive instruments. 15 PART II OTHER INFORMATION Item 1. Legal Proceedings DAOU SYSTEMS SECURITIES LITIGATION 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 former 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 a second amended consolidated class action 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. Claims are pleaded under both the Securities Act of 1933, as amended, (relating to the Company's initial public offering) and section 10b of the 1934 Securities Exchange Act. The complaint was brought on behalf of a purported class of investors who purchased the Company's Common Stock between February 13, 1997 and October 28, 1998, but it does 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. As with their Federal court counterparts, they do not allege specific damage amounts. On April 1, 1999, a consolidated amended class action was filed on behalf of the same plaintiffs and the new state complaint alleges the same factual basis as is asserted in the Federal litigation. By stipulation of the parties, the state court litigation has been stayed pending the resolution of a motion to dismiss that was filed on February 22, 2000 in the federal litigation. That motion was granted on March 27, 2002, but the Court extended to plaintiffs the opportunity to file a Third Amended Complaint. The plaintiffs filed their Third Amended Complaint on May 16, 2002, to which the Company responded with another Motion to Dismiss. The motion was filed on June 24, 2002 and challenged the legal sufficiency of the allegations. The plaintiffs have until August 14, 2002 to oppose the motion with the Company's reply to the opposition due August 30, 2002. The hearing on the Motion to Dismiss is calendared for September 9, 2002. 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. DICKSON V DAOU SYSTEMS, INC. ET AL On February 27, 2002, a complaint was filed against certain of the Company's former officers and directors, as well as Daou On-Line, Inc., in the Superior Court of New Jersey located in Bergen County. A First Amended Complaint was filed on March 1, 2002 adding the Company and its former Chief Financial Officer as parties-defendant. The gravamen of the First Amended Complaint is two-fold. First, it alleges Daou's financial statements were misleading and fraudulently induced the plaintiff to merge his company with Daou. Second, the First Amended Complaint alleges breach of an idemnification and severance agreement obligating the Company to defend the plaintiff in a lawsuit filed by Traci Melia, a former employee. Neither the Complaint nor the First Amended Complaint allege specific damage amounts. On April 24, 2002 the Company filed a Motion to Dismiss the First Amended Complaint. The Court conducted a hearing on June 7, 2002 and granted the Company's motion. On July 23, 2002, the plaintiff filed a Notice of Appeal. A hearing date for the appeal has not yet been set. Item 2. Changes in Securities and Use of Proceeds None. Item 3. Defaults Upon Senior Securities None. 16 Item 4. Submission of Matters to a Vote of Security Holders The Company's 2002 Annual Meeting of Stockholders was held on June 11, 2002. The following matters were voted on the by stockholders: 1. Election of two Class III Directors Vincent K. Roach and David W. Jahns were elected to the Board of Directors for terms expiring at the 2005 Annual Meeting of Stockholders and until their successors are duly qualified and elected. The vote was 14.3 million in favor of Mr. Roach and 29,000 votes withheld, and 14.3 million in favor of Mr. Jahns and 24,000 votes withheld. 2. Ratification of Independent Auditors The stockholders ratified the selection of Ernst & Young LLP as the Company's independent auditors for the fiscal year ending December 31, 2002. Ernst & Young LLP has audited the Company's financial statements annually since March 1995. The vote was 14.3 million in favor, with 37,000 votes against and 1,000 withheld. Item 5. Other Information None. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits Exhibit No. Description ----------- ----------- 99.1 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 99.2 Certification Pursuant to 18 U.S.C. Section 1350, as Adopted Pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 (b) Current Reports on Form 8-K. The Registrant did not file any Current Reports on Form 8-K with the Commission during the quarter ended June 30, 2002. 17 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: August 14, 2002 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 18