-----BEGIN PRIVACY-ENHANCED MESSAGE----- Proc-Type: 2001,MIC-CLEAR Originator-Name: webmaster@www.sec.gov Originator-Key-Asymmetric: MFgwCgYEVQgBAQICAf8DSgAwRwJAW2sNKK9AVtBzYZmr6aGjlWyK3XmZv3dTINen TWSM7vrzLADbmYQaionwg5sDW3P6oaM5D3tdezXMm7z1T+B+twIDAQAB MIC-Info: RSA-MD5,RSA, QsNMHwpRWpbHyVqoM5FjmzY3UmdWb9sS6b0VenmlhjIMvCgVNXFylJ3L4OmeiTnu nr6estbfglH+oA5qjRmLKw== 0001047469-98-042177.txt : 19981125 0001047469-98-042177.hdr.sgml : 19981125 ACCESSION NUMBER: 0001047469-98-042177 CONFORMED SUBMISSION TYPE: 8-K PUBLIC DOCUMENT COUNT: 7 CONFORMED PERIOD OF REPORT: 19980625 ITEM INFORMATION: ITEM INFORMATION: ITEM INFORMATION: FILED AS OF DATE: 19981124 FILER: COMPANY DATA: COMPANY CONFORMED NAME: DAOU SYSTEMS INC CENTRAL INDEX KEY: 0001003989 STANDARD INDUSTRIAL CLASSIFICATION: RETAIL-RETAIL STORES, NEC [5990] IRS NUMBER: 330284454 STATE OF INCORPORATION: DE FISCAL YEAR END: 1231 FILING VALUES: FORM TYPE: 8-K SEC ACT: SEC FILE NUMBER: 000-22073 FILM NUMBER: 98758697 BUSINESS ADDRESS: STREET 1: 5120 SHOREHAM PL CITY: SAN DIEGO STATE: CA ZIP: 92122 BUSINESS PHONE: 6194522221 MAIL ADDRESS: STREET 1: 5120 SHOREHAM PL CITY: SAN DIEGO STATE: CA ZIP: 92122 8-K 1 8-K UNITED STATES SECURITIES AND EXCHANGE COMMISSION WASHINGTON, DC 20549 FORM 8-K CURRENT REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 Date of Report (Date of earliest event reported): June 25, 1998 DAOU SYSTEMS, INC. (Exact name of registrant as specified in its charter) DELAWARE (State or other jurisdiction of incorporation) 0-22073 330284454 (Commission File Number) (IRS Employer Identification No.) 5120 Shoreham Place, San Diego, California 92122 (Address of principal executive offices, including zip code) (619) 452-2221 (Registrant's telephone number, including area code) ITEM 5. OTHER EVENTS. REPORTING OF CERTAIN FINANCIAL AND OTHER INFORMATION FOR REGISTRATION AND OTHER PURPOSES DAOU Systems, Inc., a Delaware corporation (the "Company"), is filing herewith audited supplemental consolidated financial statements, selected consolidated financial data (supplemental), and Management's Discussion and Analysis of Financial Condition and Results of Operations (supplemental), which reflect the Company's acquisition of Synexus Incorporated, a Pennsylvania corporation, Sentient Systems, Inc., a Maryland corporation, Technology Management, Inc., an Indiana corporation, International Health Care Systems, Inc., a Florida corporation, Resources in Healthcare Innovations, Inc., an Indiana corporation, Healthcare Transition Resources, Inc., an Indiana Corporation, Innovative Systems Solutions, Inc., an Indiana corporation, Grande Isle Consulting, Inc., an Indiana corporation, and Ultitech Resources Group, Inc., an Indiana corporation. Each of these acquisitions was accounted for as a pooling of interests. Upon release of financial information covering the periods in which these transactions were consummated, these supplemental consolidated financial statements will become the historical financial statements of the Company. 2 INDEX TO SUPPLEMENTAL CONSOLIDATED FINANCIAL STATEMENTS DAOU SYSTEMS, INC. Report of Ernst & Young LLP, Independent Auditors..................................... 4 Report of Deloitte & Touche LLP, Independent Auditors................................. 5 Report of PricewaterhouseCoopers LLP, Independent Accountants......................... 6 Supplemental Consolidated Balance Sheets at December 31, 1997 and 1996................ 7 Supplemental Consolidated Statements of Income for the years ended December 31, 1997, 1996 and 1995.................................................... 8 Supplemental Consolidated Statements of Stockholders' Equity for the years ended December 31, 1997, 1996 and 1995........................................ 9 Supplemental Consolidated Statements of Cash Flows for the years ended December 31, 1997, 1996 and 1995................................................... 10 Notes to Supplemental Consolidated Financial Statements............................... 11
3 REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS The Board of Directors and Stockholders DAOU Systems, Inc. We have audited the accompanying supplemental consolidated balance sheets of DAOU Systems, Inc. (formed as a result of the consolidation of DAOU Systems, Inc., Sentient Systems, Inc., Synexus Incorporated, Technology Management, Inc. and Affiliate and Resources in Healthcare Innovations, Inc. and Affiliates) as of December 31, 1997 and 1996 and the related supplemental consolidated statements of income, stockholders' equity, and cash flows for each of the three years in the period ended December 31, 1997. The supplemental consolidated financial statements give retroactive effect to the mergers of DAOU Systems, Inc., Synexus Incorporated and Sentient Systems, Inc., in March 1998 and Technology Management, Inc. and Affiliate and Resources in Healthcare Innovations, Inc. and Affiliates in June 1998, which have been accounted for using the pooling-of-interests method as described in the notes to the supplemental consolidated financial statements. These supplemental consolidated financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these supplemental consolidated financial statements based on our audits. We did not audit the financial statements of Sentient Systems, Inc. which statements reflect total assets constituting 6% for 1997 and 12% for 1996 of the related consolidated supplemental financial statement totals, and which reflect net income constituting 28%, 22% and 6% of the related supplemental consolidated financial statement totals for the years ended December 31, 1997, 1996 and 1995, respectively. These statements were audited by other auditors whose reports have been furnished to us, and our opinion, insofar as it relates to data included for Sentient Systems, Inc., is based solely on the reports of other auditors. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits and the reports of the other auditors provide a reasonable basis for our opinion. In our opinion, based on our audits and the reports of other auditors, the supplemental consolidated financial statements referred to above present fairly, in all material respects, the consolidated financial position of DAOU Systems, Inc. at December 31, 1997 and 1996 and the results of its operations and its cash flows for each of the three years in the period ended December 31, 1997, after giving retroactive effect to the mergers of DAOU Systems, Inc., Synexus Incorporated, Sentient Systems, Inc., Technology Management, Inc. and Affiliate and Resources in Healthcare Innovations, Inc. and Affiliates, as described in the notes to the supplemental consolidated financial statements, in conformity with generally accepted accounting principles. ERNST & YOUNG LLP San Diego, California August 4, 1998 4 INDEPENDENT AUDITORS' REPORT To the Board of Directors of Sentient Systems, Inc. Kensington, Maryland We have audited the accompanying balance sheets of Sentient Systems, Inc. (the Company) as of December 31, 1997 and 1996, and the related statements of operations, changes in stockholders' equity, and cash flows for the years ended December 31, 1997 and 1996 (not presented separately herein). These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audits. We conducted our audits in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion. In our opinion, such financial statements present fairly, in all material respects, the financial position of the Company as of December 31, 1997 and 1996, and the results of its operations and its cash flows for the years ended December 31, 1997 and 1996, in conformity with generally accepted accounting principles. /s/ Deloitte & Touche LLP McLean, Virginia February 13, 1998 5 REPORT OF INDEPENDENT ACCOUNTANTS Board of Directors Sentient Systems, Inc. We have audited the accompanying balance sheet of Sentient Systems, Inc. (the Company) as of November 30, 1995 and the related statements of operations, changes in stockholders' equity, and cash flows for the year then ended. These financial statements are the responsibility of the Company's management. Our responsibility is to express an opinion on these financial statements based on our audit. We conducted our audit in accordance with generally accepted auditing standards. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis. evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion. In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Sentient Systems, Inc. as of November 30, 1995, and the results of its operations and its cash flows for the year then ended in conformity with generally accepted accounting principles. /s/ PricewaterhouseCoopers L.L.P. McLean, Virginia March 8, 1996 6 DAOU Systems, Inc. Supplemental Consolidated Balance Sheets (IN THOUSANDS, EXCEPT FOR PER SHARE DATA)
DECEMBER 31, 1997 1996 ------------------------------------ ASSETS Current assets: Cash and cash equivalents $ 7,981 $ 3,123 Short-term investments, available-for-sale 10,307 839 Accounts receivable, net of allowance of $312 and $310 in 1997 and 1996, respectively 15,744 10,444 Contract work in progress 13,291 4,122 Deferred income taxes 320 176 Other current assets 1,769 682 ------------------------------------ Total current assets 49,412 19,386 Due from officers/stockholders 371 228 Equipment, furniture and fixtures, net 3,859 1,761 Deferred income taxes 3 23 Other assets 465 274 ------------------------------------ $ 54,110 $ 21,672 ==================================== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Trade accounts payable $ 1,661 $ 869 Accrued salaries and wages 2,675 2,256 Other accrued liabilities 2,995 1,328 Accrued dividends payable 487 - Income taxes payable 5 106 Deferred revenue 369 1,110 Current portion of long-term debt and line of credit 1,437 268 Current portion of severence payable 210 - ------------------------------------ Total current liabilities 9,839 5,937 Deferred rent 55 92 Long-term debt 49 32 Deferred income taxes 390 - Long-term portion of severence payable 823 - Deferred compensation to officers 1,117 1,117 Commitments and contingencies Redeemable preferred stock - 8,190 Stockholders' equity: Preferred stock, $.001 par value: Authorized shares - 5,000 Issued and outstanding shares - none - Common stock, $.001 par value: Authorized shares - 50,000 Issued and outstanding shares - 16,945 in 1997 and 12,796 in 1996 17 13 Additional paid-in capital 36,040 1,584 Deferred compensation (907) (1,166) Unrealized gain on short-term investments 146 101 Accretion of redeemable preferred stock - (572) Retained earnings 6,541 6,344 ------------------------------------ Total stockholders' equity 41,837 6,304 ------------------------------------ $ 54,110 $ 21,672 ====================================
See accompanying notes. 7 DAOU Systems, Inc. Supplemental Consolidated Statements of Income (IN THOUSANDS, EXCEPT FOR PER SHARE DATA)
YEARS ENDED DECEMBER 31, 1997 1996 1995 ------------------------------------------------------ Revenues $69,055 $50,947 $36,448 Cost of revenues 45,553 33,730 22,583 ------------------------------------------------------ Gross profit 23,502 17,217 13,865 Operating expenses: Sales and marketing 7,780 4,166 2,928 General and administrative 12,425 9,945 8,930 Merger and related expenses 718 - - ------------------------------------------------------ 20,923 14,111 11,858 ------------------------------------------------------ Income from operations 2,579 3,106 2,007 Interest income, net 873 369 193 ------------------------------------------------------ Income before income taxes 3,452 3,475 2,200 Provision for income taxes 947 149 889 ------------------------------------------------------ Net income 2,505 3,326 1,311 Accretion of redeemable preferred stock - 485 87 ------------------------------------------------------ Net income attributable to common stock $ 2,505 $ 2,841 $ 1,224 ====================================================== Net income per share: Basic $ 0.15 $ 0.23 $ 0.10 ====================================================== Diluted $ 0.15 $ 0.23 $ 0.10 ====================================================== Shares used in computing net income per share: Basic 16,231 12,580 12,260 ====================================================== Diluted 17,246 14,385 12,548 ======================================================
See accompanying notes. 8 DAOU Systems, Inc. Supplemental Consolidated Statements of Stockholders' Equity (IN THOUSANDS)
COMMON STOCK ADDITIONAL -------------------------------- PAID-IN DEFERRED SHARES AMOUNT CAPITAL COMPENSATION ------------------------------------------------------------- Balance at December 31, 1994 12,251 $12 $ 169 $ - Accretion of redeemable preferred stock - - - - Issuance of common stock in exchange for services 70 - 23 - Unrealized gain on short-term investments - - - - Net income - - - - ------------------------------------------------------------- Balance at December 31, 1995 12,321 12 192 - Deferred compensation - - 1,243 (1,243) Amortization of deferred compensation - - - 77 Issuance of common stock in exchange for services 35 - 30 - Shares issued in connection with formation of S Corporation 225 - 25 - Issuance of common stock for cash 252 1 100 - Repurchase and retirement of common stock (37) - (6) - Accretion of redeemable preferred stock - - - - Distribution to Sentient stockholders (Note 2) - - - - Unrealized gain on short-term investments - - - - Adjustment for change in Sentient Systems, Inc.'s year end - - - - Net income - - - - ------------------------------------------------------------- Balance at December 31, 1996 12,796 13 1,584 (1,166) Issuance of common stock upon initial public offering, net 2,000 2 15,782 - Conversion of redeemable preferred stock upon initial public offering 1,603 2 7,616 - Issuance of common stock upon secondary public offering, net 500 - 9,320 - Issuance of common stock upon exercise of stock options 142 - 639 - Tax effect from exercise of noncompensatory stock options - - 1,103 - Amortization of deferred compensation - - - 259 Shares issued in connection with formation of - S Corporation 584 1 (1) Distribution to Integrex stockholders (Note 2) - - - - Distribution to On-Line stockholders (Note 2) - - - - Distribution to Sentient stockholders (Note 2) - - - - Distribution to TMI stockholders (Note 2) - - - - Repurchase of founders stock (680) (1) (3) - Unrealized gain on short-term investments - - - - Net income - - - - ------------------------------------------------------------- Balance at December 31, 1997 16,945 $17 $36,040 $ (907) ============================================================= ACCRETION OF UNREALIZED GAIN REDEEMABLE TOTAL ON SHORT-TERM PREFERRED RETAINED STOCKHOLDERS' INVESTMENTS STOCK EARNINGS EQUITY ------------------------------------------------------------------- Balance at December 31, 1994 $ - $ - $ 1,976 $ 2,157 Accretion of redeemable preferred stock - (87) - (87) Issuance of common stock in exchange for services - - - 23 Unrealized gain on short-term investments 95 - - 95 Net income - - 1,311 1,311 ------------------------------------------------------------------- Balance at December 31, 1995 95 (87) 3,287 3,499 Deferred compensation - - - - Amortization of deferred compensation - - - 77 Issuance of common stock in exchange for services - - - 30 Shares issued in connection with formation of S Corporation - - - 25 Issuance of common stock for cash - - - 101 Repurchase and retirement of common stock - - (34) (40) Accretion of redeemable preferred stock - (485) - (485) Distribution to Sentient stockholders (Note 2) - - (146) (146) Unrealized gain on short-term investments 13 - - 13 Adjustment for change in Sentient Systems, Inc.'s year end (7) - (89) (96) Net income - - 3,326 3,326 ------------------------------------------------------------------- Balance at December 31, 1996 101 (572) 6,344 6,304 Issuance of common stock upon initial public offering, net - - - 15,784 Conversion of redeemable preferred stock upon initial public offering - 572 - 8,190 Issuance of common stock upon secondary public offering, net - - - 9,320 Issuance of common stock upon exercise of stock options - - - 639 Tax effect from exercise of noncompensatory stock options - - - 1,103 Amortization of deferred compensation - - - 259 Shares issued in connection with formation of S Corporation - - - - Distribution to Integrex stockholders (Note 2) - - (94) (94) Distribution to On-Line stockholders (Note 2) - - (63) (63) Distribution to Sentient stockholders (Note 2) - - (391) (391) Distribution to TMI stockholders (Note 2) - - (644) (644) Repurchase of founders stock - - (1,116) (1,120) Unrealized gain on short-term investments 45 - - 45 Net income - - 2,505 2,505 ------------------------------------------------------------------- Balance at December 31, 1997 $ 146 $ - $ 6,541 $41,837 ===================================================================
See accompanying notes. 9 DAOU Systems, Inc. Supplemental Consolidated Statements of Cash Flows (IN THOUSANDS)
YEARS ENDED DECEMBER 31, 1997 1996 1995 ------------------------------------------------------ OPERATING ACTIVITIES Net income $ 2,505 $ 3,326 $ 1,311 Adjustments to reconcile net income to net cash used in operating activities: Depreciation and amortization 1,324 613 510 Provision for uncollectible accounts 70 108 100 Common stock issued in exchange for services - 30 23 Deferred income taxes 266 20 (288) Changes in operating assets and liabilities: Accounts receivable (5,370) (949) (6,906) Contract work in progress (9,169) (3,263) 189 Other current assets (1,087) (520) (78) Trade accounts payable 792 (539) 493 Accrued salaries and wages 419 (195) 1,295 Deferred revenue (741) 574 (393) Other accrued liabilities 1,667 (582) 1,230 Income taxes payable (101) (842) 751 Deferred rent (37) 66 (18) Severence payable 1,033 - - ------------------------------------------------------ Net cash used in operating activities (8,429) (2,153) (1,781) INVESTING ACTIVITIES Purchase of equipment, furniture and fixtures (3,163) (1,247) (675) Proceeds from sale of assets - - 300 Increase in other assets (186) (96) (5) Purchases of short-term investments (9,462) (130) (4,178) Maturities of short-term investments 39 3,879 176 Advances to officers/stockholders (143) (17) (306) Proceeds from repayment of due from officers - - 209 ------------------------------------------------------ Net cash (used in) provided by investing activities (12,915) 2,389 (4,479) FINANCING ACTIVITIES Net advances under the line of credit 145 20 165 Proceeds from long-term debt 1,101 96 - Repayment of long-term debt (60) (87) (50) Distributions to stockholders of acquired companies (706) (146) - Proceeds from issuance of common stock and redeemable preferred stock 26,842 126 7,618 Repurchase of founders stock (1,120) (40) - ------------------------------------------------------ Net cash provided by (used in) financing activities 26,202 (31) 7,733 ------------------------------------------------------ Increase in cash and cash equivalents 4,858 205 1,473 Cash and cash equivalents at beginning of year 3,123 2,918 1,445 ------------------------------------------------------ Cash and cash equivalents at end of year $ 7,981 $ 3,123 $ 2,918 ====================================================== SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION: Cash paid during the year for: Income taxes $ 115 $ 982 $ 429 ------------------------------------------------------ Interest $ 113 $ 46 $ 13 ------------------------------------------------------ SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING ACTIVITIES: Accrued dividends payable to TMI, Inc. stockholders $ 487 $ - $ - ====================================================== Conversion of redeemable preferred stock and accreted dividends to common stock $ 7,618 $ - $ - ======================================================
See accompanying notes. 10 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES ORGANIZATION AND BASIS OF PRESENTATION DAOU Systems, Inc. ("DAOU" or the "Company") designs, implements, supports and manages advanced computer network systems for hospitals, integrated healthcare delivery systems and other healthcare provider organizations, located throughout the United States. The Company's design services include an assessment of the customer's existing computer network system and the preparation of voice, video and data network specifications, technical design documentation and diagrams. DAOU's implementation services include the purchase, delivery and installation of enterprise-wide computer network systems. The Company's support and management services are typically provided under multi-year contracts and include remote and on-site network management services, as well as information systems outsourcing. DAOU typically provides its services under a fixed-price contract and over a fixed period of time. In March 1998, the Company acquired all of the issued and outstanding shares of Synexus Incorporated ("Synexus") and Sentient Systems, Inc. ("Sentient") through the Company's wholly-owned subsidiaries DAOU-Synexus, Inc. and DAOU-Sentient, Inc. In June 1998, the Company acquired all of the issued and outstanding shares of Technology Management, Inc. and Affiliate and Resources in Healthcare Innovations, Inc. and Affiliates, through the Company's wholly-owned subsidiaries DAOU-TMI, Inc. and DAOU-RHI, Inc. The above acquisitions were accounted for using the pooling-of-interests method of accounting and, accordingly, the supplemental consolidated financial statements reflect the combined financial position and operating results for the Company, Synexus, Sentient, Technology Management, Inc. and Affiliate, and Resources in Healthcare Innovations and Affiliates for all periods presented giving retroactive effect to the pooling transactions. All significant intercompany accounts have been eliminated. These supplemental consolidated financial statements will become the historical consolidated financial statements of DAOU upon the issuance of financial statements for a period that includes the date of the mergers. REVENUE RECOGNITION Contract revenue for the development and implementation of network solutions is recognized using the percentage-of-completion method with progress to completion measured by labor costs incurred to date compared to total estimated labor costs. Provisions for estimated losses on contracts, if any, are made during the period when the loss becomes probable and can be reasonably estimated. Revenues recognized in excess of amounts billed and project costs are classified as contract work in progress. Revenue from technical support and network management services is recognized as the services are performed. Payments received in advance of services performed are recorded as deferred revenue and amortized as the services are performed. CONCENTRATION OF CREDIT RISK AND MAJOR CUSTOMER Substantially all of the Company's accounts receivable are from hospitals and other healthcare providers. Generally, the Company obtains a significant deposit from its customers upon signing a contract and collateral is not required. The Company provides for losses from uncollectible accounts and such losses have historically not exceeded management's expectations. During 1995, one customer accounted for 22% of the Company's revenues. No other customer accounted for more than 10% of the Company's revenues in any period presented. 11 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) CASH, CASH EQUIVALENTS AND SHORT-TERM INVESTMENTS Cash and cash equivalents consist of cash and highly liquid investments with maturities of three months or less when purchased. The Company has established guidelines relative to diversification and maturities that are periodically reviewed and modified to take advantage of trends in yields and interest rates. The Company historically has not experienced any losses on its cash equivalents or short-term investments. The Company classifies its short-term investments as "Available-for-Sale" and records such assets at the estimated fair value on the balance sheet with unrealized gains and losses excluded from earnings and reported as a separate component of stockholders' equity until realized. The basis for computing realized gains or losses is by specific identification. EQUIPMENT, FURNITURE AND FIXTURES Equipment, furniture and fixtures are carried at cost. Depreciation is computed using the straight-line method over the estimated useful lives of the assets, ranging from three to seven years. Leasehold improvements are amortized over the lesser of the estimated useful lives of the assets or the remaining lease term. USE OF ESTIMATES The preparation of financial statements in conformity with generally accepted accounting principles requires management to make estimates and assumptions about the future that affect the amounts reported in the financial statements and disclosures made in the accompanying notes of the financial statements. The actual results could differ from those estimates. NET INCOME PER SHARE In February 1997, the Financial Accounting Standards Board issued Statement of Financial Accounting Standards ("SFAS") No. 128, EARNINGS PER SHARE, which supersedes Accounting Principles Board ("APB") Opinion No. 15. SFAS No. 128 replaces the presentation of primary earnings per share (EPS) with "Basic EPS" which includes no dilution and is based on weighted-average common shares outstanding for the period. Companies with complex capital structures, including DAOU, will also be required to present "Diluted EPS" that reflects the potential dilution of securities such as stock options and warrants. SFAS No. 128 is effective for financial statements issued for periods ending after December 15, 1997. On February 3, 1998, the SEC issued Staff Accounting Bulletin (SAB) No. 98 which revised the previous instructions for determining the dilutive effects in earnings per share computations of common stock and common stock equivalents issued at prices below the IPO price prior to the effectiveness of the IPO. 12 1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES (CONTINUED) The following table sets forth the computation of the shares used in the basic and diluted net income per share calculation (IN THOUSANDS):
DECEMBER 31, 1997 1996 1995 ------------------------------------------------------ Shares used in Basic net income per share - weighted average common shares outstanding 16,231 12,580 12,260 ------------------------------------------------------ Effect of conversion of preferred stock from date of issuance 189 1,603 288 Net effect of dilutive common share equivalents based on treasury stock method 826 202 - ------------------------------------------------------ Shares used in Diluted net income per share 17,246 14,385 12,548 ======================================================
STOCK-BASED COMPENSATION Effective January 1, 1996, the Company adopted SFAS No. 123, ACCOUNTING FOR STOCK-BASED COMPENSATION. SFAS No. 123 allows companies to either account for stock-based compensation under the new provisions of SFAS No. 123 or under the provisions of APB Opinion No. 25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES ("APB 25"), but requires pro forma disclosure in the footnotes to the financial statements as if the measurement provisions of SFAS No. 123 had been adopted. The Company has continued accounting for its stock-based compensation in accordance with the provisions of APB 25. NEW ACCOUNTING STANDARDS In June 1997, the Financial Accounting Standards Board issued SFAS No. 130, REPORTING COMPREHENSIVE INCOME and SFAS No. 131, SEGMENT INFORMATION. Both of these standards are effective for fiscal years beginning after December 15, 1997. SFAS No. 130 requires that all components of comprehensive income, including net income, be reported in the financial statements in the period in which they are recognized. Comprehensive income is defined as the change in equity during a period from transactions and other events and circumstances from non-owner sources. Net income and other comprehensive income, including foreign currency translation adjustments and unrealized gains and losses on investments, shall be reported, net of their related tax effect, to arrive at comprehensive income. The Company does not believe that comprehensive income or loss will be materially different than net income or loss. SFAS No. 131 amends the requirements for public enterprises to report financial and descriptive information about its reportable operating segments. Operating segments, as defined in SFAS No. 131, are components of an enterprise for which separate financial information is available and is evaluated regularly by the Company in deciding how to allocate resources and in assessing performance. The financial information is required to be reported on the basis that is used internally for evaluating the segment performance. The Company believes it operates in one business and operating segment and does not believe the adoption of these standards will have a material impact on the Company's financial statements. 13 2. ACQUISITIONS During June 1998, the Company acquired (i) Technology Management, Inc. ("TMI"), a privately-held company that provides information technology consulting services primarily to the healthcare industry, (ii) International Health Care Systems, Inc.("IHCS"), a privately-held company with a common shareholder with TMI that provides information technology consulting services primarily to the healthcare industry on behalf of TMI, (iii) Resources in Healthcare Innovations, Inc. ("RHI"), a privately-held information technology services firm that provides contract management services for healthcare information systems to hospitals and managed care organizations, and (iv) Healthcare Transition Resources, Inc. ("HTR"), Ultitech Resources Group, Inc. ("URG"), Innovative Systems Solutions, Inc. ("ISS") and Grand Isle Consulting, Inc. ("GIC"), each a privately held company with common shareholders of RHI that implements software applications from third parties and provides support services to healthcare enterprises. Shareholders of TMI, IHCS, RHI, HTR, URG, ISS and GIC received 1,078,963, 224,668, 1,839,381, 275,662, 282,551, 308,583 and 223,645 shares, respectively, of the Company's common stock in exchange for the outstanding stock of each of these companies. The above acquisitions have been accounted for using the pooling-of-interests method of accounting, and accordingly, the historical financial statements of periods prior to the consummation of the combinations have been restated as though the companies had been combined for all periods presented. Estimated merger costs, net of tax effects, related to these acquisitions were $2,882,000, and were recorded during June 1998. During March 1998, the Company acquired Synexus, a privately-held company specializing in the planning, design and implementation of enterprise networks in healthcare environments, and Sentient, a privately-held company which provides integration and support services primarily to health-care organizations. Shareholders of Synexus and Sentient received 161,235 and 1,397,550 shares, respectively, of the Company's common stock in exchange for all of the outstanding stock of each of these companies. The acquisitions have been accounted for using the pooling-of-interests method of accounting, and accordingly, the historical financial statements of periods prior to the consummation of the combinations have been restated as though the companies had been combined for all periods presented. Estimated merger costs, net of tax effects, related to these acquisitions were $1,722,000, and were recorded during March 1998. On September 25, 1997, the Company acquired through its wholly-owned subsidiary DAOU On-Line, Inc. all of the issued and outstanding shares of On-Line Networking, Inc. ("On-Line") in exchange for 150,000 shares of the Company's common stock. On-Line is a provider of communication infrastructure services primarily within the healthcare information technology market. On July 9, 1997, the Company acquired through its wholly-owned subsidiary DAOU-Integrex, Inc. all of the issued and outstanding shares of Integrex Systems Corporation ("Integrex") in exchange for 700,000 shares of the Company's common stock. Integrex provides advanced network design, integration and consulting support services primarily to healthcare organizations and also to educational and governmental institutions, all of which are primarily located in the state of Virginia. Integrex specializes in voice and video networks and also designs integrated cable plants capable of supporting voice, video and high-speed data transmission. Both the Integrex and On-Line acquisitions were accounted for using the pooling-of-interests method of accounting and, accordingly, the historical financial statements for all periods prior to the consummation of the combinations have been restated as though the companies had been combined for all periods presented. 14 2. ACQUISITIONS (CONTINUED) Total revenues and net income (loss) of DAOU, Integrex, On-Line, Synexus, Sentient, TMI (including IHCS) and RHI (including HTR, URG, ISS and GIC) for the three years ended December 31, 1997 were (in thousands):
DAOU INTEGREX ON-LINE SYNEXUS SENTIENT TMI RHI COMBINED -------------------------------------------------------------------------------------------------- Year ended December 31, 1997 Total revenues $30,606 $5,426 $5,668 $1,578 $9,861 $6,371 $9,545 $69,055 Net income (loss) (820) 951 (44) 121 694 1,576 27 2,505 Year ended December 31, 1996 Total revenues 19,311 4,456 4,616 1,680 9,732 5,374 5,778 50,947 Net income 83 478 361 97 730 1,061 516 3,326 Year ended December 31, 1995 Total revenues 14,330 2,548 2,985 985 8,157 4,327 3,116 36,448 Net income (loss) 1,240 179 (301) 50 83 (30) 90 1,311
3. SHORT-TERM INVESTMENTS, AVAILABLE-FOR-SALE Short-term investments, available-for-sale, consist of the following (IN THOUSANDS):
GROSS AMORTIZED GROSS UNREALIZED ESTIMATED COST UNREALIZED GAINS LOSSES FAIR VALUE ----------------------------------------------------------------------- DECEMBER 31, 1997 Equity securities $ 707 $154 $ (2) $ 859 Government and corporate debt securities 9,454 - (6) 9,448 ----------------------------------------------------------------------- $ 10,161 $154 $ (8) $ 10,307 ======================================================================= DECEMBER 31, 1996 Equity securities $ 629 $124 $ (5) $ 748 Government and corporate debt securities 109 (18) 91 ----------------------------------------------------------------------- $ 738 $124 $ (23) $ 839 =======================================================================
Short-term investments by contractual maturity are as follows at December 31, 1997: Due in one year or less $10,105 Due after one year through two years 30 Greater than two years 172 --------------- $10,307 ===============
15 4. SELECTED BALANCE SHEET DETAILS Equipment, furniture and fixtures consist of the following (IN THOUSANDS):
DECEMBER 31, 1997 1996 ------------------------------------- Equipment and furniture $ 6,630 $ 3,646 Leasehold improvements 171 147 ------------------------------------- 6,801 3,793 Less accumulated depreciation and amortization (2,942) (2,032) ------------------------------------- $ 3,859 $ 1,761 =====================================
Other accrued liabilities consist of the following (IN THOUSANDS):
DECEMBER 31, 1997 1996 ------------------------------------- Accrued contract costs $2,390 $ 626 Other accrued liabilities 605 702 ------------------------------------- $2,995 $ 1,328 =====================================
5. LINES OF CREDIT In August 1997, On-Line amended its previous $300,000 line of credit with a bank by increasing it to $500,000. The agreement provides for the payment of interest at the bank's variable base rate, as defined (9.00% at December 31, 1997) plus 1%, callable on demand, and expired on March 31, 1998. The line is secured by accounts receivable, inventories and equipment, and is personally guaranteed by the three former stockholders of On-Line. At December 31, 1997, there were no amounts outstanding under the line of credit. The RHI line of credit is for $700,000 and expires on May 1, 1999. Under the terms of the agreement, advances bear interest at the bank's prime rate plus .25% (8.75% at December 31, 1997). There are no compensating balance requirements and borrowings under the line of credit are limited to 65% of qualifying receivables. At December 31, 1997, $350,000 was outstanding under the line of credit. Interest expense for the above lines of credit for years ended December 31, 1997, 1996 and 1995 was $43,100, $16,400 and $2,400, respectively. 6. LONG-TERM DEBT Long-term debt at December 31, 1997 consists of secured notes payable of On-Line to a financing company, a secured note payable of RHI to a bank and a secured five-year term loan of Synexus. As of December 31, 1997, the On-Line notes require aggregate monthly payments of $2,634, including interest with rates ranging from 9.25% to 10.75%. The notes mature from May 1998 to August 2001 and are secured by vehicles. The RHI note payable is a $1,000,000 note payable to a bank which has a maturity date of September 1, 1998 and an interest rate of 8.5%. As of December 31, 1997, no principal payments had been made. 16 6. LONG-TERM DEBT (CONTINUED) The Synexus five-year term loan is for capital asset acquisitions with maximum borrowing available of $360,000, bears interest at the Wall Street Journal prime rate plus 1.25% (9.75% as of December 31, 1997), and is payable in monthly installments of $6,000 principal plus accrued interest. This note is collateralized by the general assets of Synexus and is guaranteed by certain of the Company's stockholders. At December 31, 1997, $168,000 remains available for future borrowings. Interest expense for the above long-term debt for the years ended December 31, 1997, 1996 and 1995 was $19,600, $3,600 and $5,600, respectively. 7. COMMITMENTS LEASE COMMITMENTS The Company leases its facilities and certain equipment under operating lease agreements. The facility leases provide for abatement of rent during certain periods and escalating rent payments during the lease term. Rent expense for 1997, 1996 and 1995 totaled $1,187,000, $1,122,000 and $726,000, respectively. Annual future minimum lease payments under noncancellable operating leases with initial terms of one year or more at December 31, 1997, consist of the following (IN THOUSANDS): 1998 $1,257 1999 872 2000 719 2001 693 2002 704 ------------------ $4,245 ==================
SEVERANCE PAYABLE In connection with the retirement of one of the RHI original founders, RHI entered into a severance agreement whereby RHI will repay the retiring founder a total of $1,050,000 in severance payments, payable in sixty consecutive monthly installments of $17,500 beginning on December 20, 1997. At December 31, 1997, the Company had an outstanding payable of $1,032,500. The aggregate minimum future payments under the severance agreements as of December 31, 1997 are $210,000, $210,000, $210,000, $210,000 and $192,500 for the years ending December 31, 1998, 1999, 2000, 2001 and 2002, respectively. 17 8. REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY REDEEMABLE PREFERRED STOCK During 1995, 1,603,430 shares of redeemable preferred stock were issued at $4.99 per share for proceeds of $7,618,000 net of issuance costs. Holders of the redeemable preferred stock were entitled to receive cumulative dividends at the rate of $0.03 per share per annum, when and if declared by the Board of Directors and prior to any dividends on the common stock. The redeemable preferred stock had a liquidation preference of $4.99 per share plus any declared but unpaid dividends and was convertible at the option of the holder into one share of common stock, subject to certain antidilution adjustments. The shares of preferred stock were automatically converted into shares of common stock in connection with the initial public offering of the Company's common stock which closed in February 1997. The increase in the redemption value of the redeemable preferred stock was $87,000 in 1995 and $485,000 in 1996. STOCK OPTION PLANS During 1996, the Company adopted the 1996 Stock Option Plan (the "Plan"), under which 947,025 shares of the Company's common stock were initially reserved for issuance upon exercise of options granted by the Company. During November 1996, the Board of Directors increased the number of shares reserved for issuance under the plan to 1,367,925. In October 1997, the Board of Directors, subject to stockholder approval, approved an additional 3,000,000 shares to be reserved under the Plan. The Plan provides for the grant of both incentive and nonstatutory stock options to officers, directors, employees and consultants of the Company. Options granted by the Company generally vest over a three to five-year period and are exercisable for a period of ten years from the date of the grant. The Company recorded $1,243,000 of deferred compensation for options granted during the year ended December 31, 1996, representing the difference between the option exercise price and the deemed fair value for financial statement presentation purposes. The Company is amortizing the deferred compensation ratably over the vesting period of the options. 18 8. REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY (CONTINUED) A summary of the Company's stock option activity under the Plan and related information for the years ended December 31 follows:
1997 1996 -------------------------------- ------------------------------ WEIGHTED- WEIGHTED- AVERAGE AVERAGE EXERCISE PRICE EXERCISE PRICE OPTIONS OPTIONS -------------------------------- ------------------------------ Outstanding -beginning of year 801,113 $5.16 - $ - Granted 793,339 9.61 822,158 5.16 Exercised (144,487) 4.44 - - Forfeited (228,470) 5.86 (21,045) 4.28 -------------------------------- ------------------------------ 1,221,495 $8.13 801,113 $5.16 ================================ ============================== Exercisable at end of year 52,101 $6.57 - - ================================ ============================== Weighted-average fair value of options granted during the year $4.30 $2.81 ================ =================
In November 1996, the Company granted 140,300 non-qualified stock options at an exercise price of $4.28 per share outside of the Plan. These options vest ratably over a five-year period. The following table summarizes information about stock options outstanding under the Plan at December 31, 1997:
OUTSTANDING EXERCISABLE ------------------------------------------------- ------------------------------ WEIGHTED AVERAGE REMAINING RANGE OF NUMBER CONTRACTUAL WEIGHTED-AVERAGE NUMBER WEIGHTED-AVERAGE EXERCISE PRICE OUTSTANDING LIFE EXERCISE PRICE EXERCISABLE EXERCISE PRICE - -------------------------------------------------------------------------- ------------------------------ $4.28 to $4.35 401,988 8.3 $4.28 33,454 $4.28 $4.35 to $ 6.53 386,475 9.2 6.03 - - $8.70 to $10.88 194,532 9.1 10.22 18,647 10.69 $10.88 to $13.05 6,000 9.5 12.75 - - $15.23 to $17.40 232,500 9.5 16.43 - - ------------------------------------------------- ------------------------------ 1,221,495 8.9 $8.13 52,101 $6.57 ================================================= ==============================
At December 31, 1997, 196,588 options were vested and options for 1,943 common shares were available for future grant. Adjusted pro forma information regarding net income and earnings per share is required by SFAS No. 123, and has been determined as if the Company had accounted for its employee stock options under the fair value method of that statement. The fair value for these options was estimated at the date of grant using the Black-Scholes option pricing model with the following weighted-average assumptions for 1997 and 1996: risk-free interest rate of 6%; dividend yield of 0%; volatility factors of the expected market price of the Company's common stock of 75% and 0%, respectively; and a weighted-average expected life of the option of seven years. 19 8. REDEEMABLE PREFERRED STOCK AND STOCKHOLDERS' EQUITY (CONTINUED) The Black-Scholes option valuation model was developed for use in estimating the fair value of traded options which have no vesting restrictions and are fully transferable. In addition, option valuation models require the input of highly subjective assumptions including the expected stock price volatility. Because the Company's employee stock options have characteristics significantly different from those of traded options, and because changes in the subjective input assumptions can materially affect the fair value estimate, in management's opinion, the existing models do no necessarily provide a reliable single measure of the fair value of its employee stock options. For purposes of adjusted pro forma disclosures, the estimated fair value of the options is amortized to expense over the vesting period of the options. The Company's adjusted pro forma information is as follows (IN THOUSANDS, EXCEPT FOR PER SHARE INFORMATION):
YEARS ENDED DECEMBER 31, 1997 1996 --------------------------- Adjusted pro forma net income $2,256 $2,364 =========================== Adjusted pro forma net income per share: Basic $ 0.14 $ 0.19 =========================== Diluted $ 0.13 $ 0.16 ===========================
The results above are not likely to be representative of the effects of applying SFAS No. 123 on reported net income or loss for future years as these amounts reflect the expense for only one or two years vesting. In August 1997, TMI issued rights to employees to buy up to 178,604 shares of DAOU stock on an as converted basis. Each right could be exercised to purchase one share of DAOU's Common Stock at an exercise price of $5.05. Effective January 1, 1998, DAOU issued 100,312 shares of Common Stock to employees under the terms of stock rights outstanding. The remaining 78,292 shares in the stock rights plan expire on December 31, 1998 under the terms of the original issuance. WARRANTS In connection with the issuance of the redeemable preferred stock, the Company issued two warrants to purchase an aggregate of 133,285 shares of common stock at an exercise price of $4.99 per share. The warrants are exercisable immediately and expire on October 26, 2000. COMMON STOCK RESERVED At December 31, 1997, a total of 1,497,023 shares of the Company's common stock have been reserved for the exercise of stock options and warrants. 20 9. INCOME TAXES The provision for income taxes consists of the following (IN THOUSANDS):
YEARS ENDED DECEMBER 31, 1997 1996 1995 ----------------------------------------- Current: Federal $581 $ 66 $907 State 97 62 270 ----------------------------------------- 678 128 1,177 Deferred: Federal 238 33 (246) State 31 (12) (42) ----------------------------------------- 269 21 (288) ----------------------------------------- $947 $149 $889 =========================================
Deferred income taxes are provided for temporary differences in recognizing certain income and expense items for financial and tax reporting purposes. Significant components of the Company's deferred tax assets and liabilities consist of the following (IN THOUSANDS):
DECEMBER 31, 1997 1996 ----------------------------- Deferred tax liabilities: Accounting method change for tax purposes $423 $ - Depreciation and amortization 120 3 ----------------------------- 543 3 Deferred tax assets: Reserves and allowances 423 198 Net operating losses 50 - Other 3 4 ----------------------------- 476 202 ----------------------------- Net deferred tax (asset) liability $ 67 $(199) =============================
At December 31, 1997, the Company has state net operating losses of $842,000. This net operating loss will expire in 2002. The reconciliation of income tax computed at the federal statutory rate to the total provision for income taxes is as follows:
YEARS ENDED DECEMBER 31, 1997 1996 1995 ------------------------------------------------- Tax at federal statutory rate 35.0% 35.0% 35.0% S corporation income not subject to corporate income taxes (33.7) (32.8) (.2) Nondeductible expenses 9.4 1.0 1.3 Adjustment on conversion of S corporation to C corporation 15.4 - - State taxes, net of federal benefit 2.1 1.1 6.9 Other (.8) - (2.6) ------------------------------------------------- 27.4% 4.3% 40.4% =================================================
21 10. BENEFIT PLANS The Company sponsors the DAOU Systems, Inc. 401(k) Salary Savings Plan which covers employees who meet certain age and service requirements. Employees may contribute a portion of their earnings each plan year subject to certain Internal Revenue Service limitations. The Company made elective contributions to the Plan of $13,000, $16,000 and $50,000 for the years ended December 31, 1997, 1996 and 1995, respectively. In October 1994, Integrex adopted a retirement benefit plan effective January 1, 1995. The plan is intended to qualify under Internal Revenue Code Section 401(a) and provides for employee salary deferrals under Internal Revenue Code Section 401(k), company matching payments, and company profit sharing payments. Integrex made profit sharing payments of $44,572, $97,605 and $60,000 for the years ended December 31, 1997, 1996 and 1995, respectively. In December 1995, On-Line adopted a defined contribution profit sharing plan covering substantially all employees who have completed one year of service and are twenty-one years of age and older. Profit sharing contributions are made at the discretion of On-Line's management. Contributions vest 20% after two years and an additional 20% for each year thereafter. Profit sharing expense was $67,500, $77,124 and $68,498 for the years ended December 31, 1997, 1996 and 1995, respectively. Effective January 1, 1998, On-Line's employees became eligible to participate in the Company's 401(k) plan, and the existing profit sharing plan of On-Line was terminated. Sentient formerly had an employee stock purchase plan available to certain employees of Sentient. During 1994, the Board of Directors discontinued issuance of new shares under the plan. During 1996, Sentient purchased and retired all 36,329 shares held by employees at approximately $1.09 per share. Concurrently with the repurchase of the shares, each employee holding stock was issued an equivalent number of nontransferable "share units". These share units entitle the holder, upon termination of employment or other liquidating event, to a payment equal to the increase in the book value per share of Sentient between the most recent audited financial statements at the liquidating event date and the most recent audited financial statements prior to the issuance of the share units, multiplied by the number of share units held. As of December 31, 1997 and 1996, 30,445 and 35,991 share units, respectively, were outstanding. In the event of an initial public offering of its common stock or a change in control, the holders are entitled to receive the difference between the fair market value of the share units based on the consideration involved and the book value per share per the most recent audited financial statements. The Company recorded $7,139 and $13,642 of expense associated with these share units in 1997 and 1996, respectively. Sentient has a 401(k) savings plan available to employees who have completed at least 1,000 hours of service. Matching contributions to the plan are at the Company's discretion. The Company made matching contributions to the plan for 1997, 1996 and 1995 of approximately $84,000, $62,000 and $51,000, respectively. The Company pays all administrative costs associated with the plan, which were $3,981, $2,410 and $1,380 in 1997, 1996 and 1995, respectively. TMI maintains a defined contribution profit sharing plan for all eligible employees. Contributions are discretionary and are made solely by the Company. Actual contributions are based on a formula applied to each participants' annual compensation. Contribution expense for the plan was approximately $89,000, $74,000 and $72,000 for the years ended December 31, 1997, 1996 and 1995, respectively. RHI has a 401(k) savings plan available to employees who have completed 6 months of eligible service and are 21 years of age or older. Employees can voluntarily contribute up to 10% of their gross salaries, subject to IRS limitations. Matching contributions to the plan are at the Company's discretion. The Company made matching contributions to the plan of $100,000, $50,000 and $31,000 for the years ended December 31, 1997, 1996 and 1995, respectively. 22 11. SUBSEQUENT EVENT (unaudited) In August and September 1998, four separate complaints were filed against the Company and certain of its officers and directors in the United States District Court for the Southern District of California. These complaints assert violations of the federal securities law based on the alleged improper use of the percentage-of-completion 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, in October 1998, two 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. The Company believes that the allegations are without merit and intends to defend against these allegations vigorously. No assurance as to the outcome of this matter can be given, however, an unfavorable resolution of this matter could have a material adverse effect on the Company's business, results of operations and financial condition. 23 ITEM 6. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS - SUPPLEMENTAL This Report on Form 8-K contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Prospective investors are cautioned that such statements are only predictions and that actual events or results may differ materially. Forward-looking statements usually contain the words "estimate," "anticipate," "believe", "expect" or similar expressions. All forward-looking statements are inherently uncertain as they are based on various expectations and assumptions concerning future events and are subject to numerous known and unknown risks and uncertainties. The forward-looking statements included herein are based on current expectations and entail various risks and uncertainties as those set forth herein and the Company's other SEC filings, including those more fully set forth in the "Risk Factors," "Management's Discussion and Analysis of Financial Condition and Results of Operations" and other sections of the Company's Form 10-KSB, as amended, for the most recently completed fiscal year on file with the SEC. These risks and uncertainties could cause the Company's actual results to differ materially from those projected in the forward-looking statements. The Company disclaims any obligation to update or publicly announce revisions to any such statements to reflect future events or developments. OVERVIEW The Company designs, implements, supports and manages advanced computer network systems primarily for hospitals, integrated delivery networks (IDNs") and other provider organizations. The Company's design services include an assessment of the customer's existing computer network system, the preparation of voice, video and data network specifications, technical design documentation and diagrams. DAOU's implementation services include the purchase, delivery and installation of enterprise-wide computer network systems. Implementation service revenues consist of third-party hardware and software products, as well as the Company's professional services. The Company's gross margin with respect to implementation services varies significantly depending on the percentage of such services consisting of products (with respect to which the Company obtains a lower margin) versus professional services. Also, the Company often hires employees in anticipation of commencement of a project and if delays in contract signing occur the Company's gross margin could vary due to the associated loss of revenues to cover fixed labor costs. The Company's support and management services include remote and on-site network management, as well as I/S function outsourcing. The Company typically provides these services under multi-year contracts. In June 1998, the Company acquired Technology Management, Inc. and Affiliate ("TMI") and Resources in Healthcare Innovations, Inc. and Affiliates ("RHI"). In March 1998, the Company acquired Sentient Systems, Inc. ("Sentient") and Synexus Incorporated ("Synexus"). The acquisitions were accounted for using the pooling-of-interests method of accounting and, accordingly, the supplemental consolidated financial statements reflect the combined financial position and operating results for the Company, Sentient, Synexus, TMI and RHI for all periods presented giving retroactive effect to the pooling transactions. These supplemental consolidated financial statements will become the historical consolidated financial statements of the Company upon the issuance of financial statements for the period that includes the date of the merger. During March 1998 and June 1998, the Company recorded merger related costs totaling $1,722,000 and $2,882,000, respectively, net of related tax effects, incurred in connection with these acquisitions. In July 1997, the Company acquired through a pooling-of-interests merger all of the issued and outstanding shares of Integrex in exchange for 700,000 shares of Common Stock. DAOU-Integrex provides advanced network design,integration and consulting support services primarily to healthcare organizations, as well as to educational and governmental institutions. DAOU-Integrex specializes in the design and integration of voice and video networks and designs integrated cable plants capable of supporting voice, video and high-speed data transmission. In addition, in September 1997, the Company similarly acquired On-Line in exchange for 150,000 shares of Common Stock. DAOU On-Line services local area computer and voice network systems, provides other telecommunications infrastructure applications and sells network services related to those 24 activities. The Company recorded merger related costs of approximately $1,068,000 (net of tax charge of $350,000). The Company's Supplemental Consolidated Financial Statements and Notes thereto reflect the combined financial position and operating results for the Company, Integrex, On-Line Synexus, Sentient, TMI, and RHI for all periods presented in this Report. Candler Health Systems ("Candler"), a large I/S outsourcing customer of the Company, terminated its contract with the Company effective November 30, 1997. In addition to revenue from specified services under the Candler contract, the Company recognized revenue of approximately $100,000, $200,000 and $300,000 during the second, third and fourth quarters of 1997, respectively, as a result of the termination fee payable by Candler under the contract. Historically, the majority of the Company's revenues have been derived from network design and implementation services which are generally provided on a fixed-fee basis. These revenues are recognized using the percentage-of-completion method with progress to completion measured by labor costs incurred to date compared to total estimated labor costs. The Company may also provide services on a "time and expense" basis for which revenues are also recognized as the services are performed. A design project typically lasts from three to five months. The time to complete implementation projects generally ranges from three to six months, although certain projects have required up to 13 months for completion. Support and management service revenues are recognized ratably over the period that these services are provided. The Company anticipates that revenues from support and management services will increase as a percent of total revenues in the future. Payments received in advance of services performed are recorded as deferred revenues. Certain contract payment terms may result in customer billing occurring at a pace slower than revenue recognition. The resulting revenues recognized in excess of amounts billed and project costs are included in contract work in progress on the Company's balance sheet. SELECTED SUPPLEMENTAL CONSOLIDATED FINANCIAL DATA. The following table presents selected supplemental consolidated financial data of the Company. The information set forth below is not necessarily indicative of the results of future operations and should be read in conjunction with the other sections of this Item 6 and the supplemental consolidated financial statements and the related notes thereto included elsewhere herein.
YEARS ENDED DECEMBER 31, ------------------------------------------------------------------ 1993 1994 1995 1996 1997 ------------------------------------------------------------------ Revenues $17,190 $24,336 $36,448 $50,947 $69,055 Cost of revenues 9,501 15,178 22,583 33,730 45,553 ------------------------------------------------------------------ Gross profit 7,689 9,158 13,865 17,217 23,502 25 Operating expenses: Sales and marketing 2,165 2,501 2,928 4,166 7,780 General and administrative 4,670 5,300 8,930 9,945 12,425 Merger and related costs - - - - 718 ------------------------------------------------------------------ Total operating expenses 6,835 7,801 11,858 14,111 20,923 ------------------------------------------------------------------ Income from operations 854 1,357 2,007 3,106 2,579 Interest income (expense), net (23) 627 193 369 873 ------------------------------------------------------------------ Income before income taxes 831 1,984 2,200 3,475 3,452 Provision for income taxes 101 439 889 149 947 ------------------------------------------------------------------ Net income 730 1,545 1,311 3,326 2,505 Accretion of preferred stock - - 87 485 - ------------------------------------------------------------------ Net income attributable to common stock $ 730 $1,545 $1,224 $ 2,841 $ 2,505 ------------------------------------------------------------------ Net income per common share: (1) Basic $0.06 $0.13 $0.10 $0.23 $0.15 ------------------------------------------------------------------ Diluted $0.06 $0.13 $0.10 $0.23 $0.15 ------------------------------------------------------------------ Shares used in computing net income per common share: Basic 11,876 12,251 12,260 12,580 16,231 ------------------------------------------------------------------ Diluted 11,876 12,251 12,548 14,385 17,246 ------------------------------------------------------------------ Cash, cash equivalents and short-term investments $1,038 $1,847 $7,493 $3,962 $18,288 Total assets 4,722 7,010 19,735 21,672 54,110 Long term debt, less current 155 64 45 32 49 Redeemable preferred stock - - 7,705 8,190 - Total stockholders equity 1,107 2,009 3,498 6,304 41,837
(1) See Note 1 of Notes to Supplemental Consolidated Financial Statements for information concerning the calculation of net income per share. RESULTS OF OPERATIONS YEARS ENDED DECEMBER 31, 1997 AND 1996 The Company's revenues were $69.1 million and $50.9 million for the years ended December 31, 1997 and 1996, respectively, representing an increase of approximately 36%. Revenues increased primarily due to the I/S outsourcing services which the Company began providing during April of 1996. Cost of revenues for the years ended December 31, 1997 and 1996 were $45.6 million and $33.7 million, respectively, representing an increase of approximately 35%. Gross margin for the years ended December 31, 1997 and 1996, remained relatively constant at approximately 34%. Sales and marketing expenses were $7.8 million and $4.2 million for the years ended December 31, 1997 and 1996, respectively, representing an increase of approximately 87%. This increase was primarily due to the further implementation of a regional sales structure, an increase in sales personnel and the expansion of the Company's marketing programs. Sales and marketing expenses were approximately 11% and 8% of total revenues for the years ended December 31, 1997 and 1996, respectively. The Company expects that sales and marketing expenses will continue to increase in dollar terms to support the anticipated growth in the Company's business. General and administrative expenses were $12.4 million (excluding 26 one-time merger costs of $718,000) and $9.9 million for the years ended December 31, 1997 and 1996, respectively, representing an increase of approximately 25%. The primary factors contributing to this increase were costs associated with the implementation of the Company's management information system, the addition of senior management and other infrastructure requirements. General and administrative expenses were approximately 18% and 20% of total revenues for the years ended December 31, 1997 and 1996, respectively. The Company expects general and administrative expenses to continue to increase in dollar terms to support the anticipated growth in the Company's business. Net interest income was $873,000 and $369,000 for the years ended December 31, 1997 and 1996, respectively. Interest income consisted of interest on cash and cash equivalents and short-term investments. Interest expense consisted of interest associated with the Company's business line of credit and term financing of insurance premiums but was not significant during either period. YEARS ENDED DECEMBER 31, 1996 AND 1995 The Company's revenues were $50.9 million and $36.4 million for the years ended December 31, 1996 and 1995, respectively, representing an increase of approximately 40%. Revenues increased primarily due to the introduction of the Company's I/S outsourcing services under the Candler contract in April 1996. Services to Catholic Medical Center of Brooklyn accounted for approximately $4.1 million of total revenues in 1996, representing approximately 8% of total revenues. Cost of revenues was $33.7 million and $22.6 million for the years ended December 31, 1996 and 1995, respectively, representing an increase of approximately 49%. Gross margin was 34% and 38% for the years ended December 31, 1996 and 1995, respectively. This decrease in gross margin was primarily due to the increased content of professional services in certain implementation projects during 1995, as well as the lower gross margin related to the Company's I/S outsourcing services initiated in 1996. Sales and marketing expenses were $4.2 million and $2.9 million for the years ended December 31, 1996 and 1995, respectively, representing an increase of approximately 42%. This increase was primarily due to the establishment of a regional sales structure, an increase in sales and marketing personnel and the expansion of the Company's marketing programs. Sales and marketing expenses were approximately 8% of revenues for the years ended December 31, 1996 and 1995. General and administrative expenses were $9.9 million and $8.9 million for the years ended December 31, 1996 and 1995, respectively, representing an increase of approximately 11%. The primary factors contributing to this increase were costs associated with the Company's larger corporate facility, implementation of a management information system and the addition of senior management during 1996. General and administrative expenses were approximately 20% and 25% of revenues for the years ended December 31, 1996 and 1995, respectively. Net interest income was $369,000 and $193,000 for the years ended December 31, 1996 and 1995, respectively. Interest income consists of interest on short-term investments, cash and cash equivalents and notes receivable from officers and stockholders. Interest expense consists of interest associated with the Company's business line of credit and term 27 financing of insurance premiums, but was not significant during either period. INCOME TAXES In 1997, 1996 and 1995, the effective tax rates were approximately 27%, 4% and 40%, respectively, and were different than the expected combined federal statutory rate of 35% primarily due to the fact that Integrex, Sentient, Synexus, TMI and RHI were S-corporations prior to their respective mergers with DAOU. Consequently, taxes on the income of these entities were the direct responsibility of its stockholders. In 1996, the benefit of Integrex's lower tax rate was partially offset by the amortization expense related to compensatory stock options granted by the Company during 1996 and additional taxes on the conversion of S-corporation to C-corporation. LIQUIDITY AND CAPITAL RESOURCES On December 31, 1997, the Company had working capital of $39.6 million, an increase of $26.2 million from $13.4 million on December 31, 1996. This increase was due primarily to the Company's initial public offering of Common Stock in February 1997 which raised $15.8 million, net of issuance costs, and the Company's secondary public offering in August 1997 which raised $9.3 million, net of issuance costs. For the year ended December 31, 1997, cash used in operating activities was $8.4 million which resulted primarily from an increase in the Company's investment in contract work in process and accounts receivable due to growth in revenues. The Company believes that its available funds will be sufficient to meet its capital requirements for the foreseeable future. The Company may sell additional equity or debt securities or obtain additional credit facilities. The sale of additional equity securities or issuance of equity securities in future acquisitions could result in additional dilution to the Company's stockholders, and the incurrence of additional debt could result in additional interest expense. YEAR 2000 The Company provides information, communications technology and services to its customers and must therefore address two critical areas of Year 2000 readiness: i) internal readiness; and, ii) external system readiness. The Company is currently conducting a detailed assessment of its internal Year 2000 status and developing an aggressive action plan to address all required upgrades in computer systems, applications, equipment and facilities. This assessment and plan includes an ongoing review of the Company and its Subsidiaries information systems and the integration of these systems into the existing Year 2000 ready systems. The current plan calls for complete internal readiness by April 1999. Financial impact for internal compliance should be minimal. The Company's current internal equipment and applications are substantially compliant and the costs to integrate the subsidiary applications were planned for as part of the recent mergers. The Company is initiating communications with its critical external relationships including customers and suppliers to determine the extent to which the Company may be vulnerable to such parties' failure to resolve their own Year 2000 issues. Where practicable, the Company will assess and attempt to mitigate its risks with respect to the failure of these entities to be Year 2000 ready. The effect if any, on the Company's results of operations from the failure of such parties to be Year 2000 ready, is not reasonably estimable. 28 The costs of the project and the date on which the Company plans to complete the Year 2000 modifications are based on management's best estimates, which were derived utilizing numerous assumptions of future events including the continued availability of certain resources, third party modification plans and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ materially from those plans. Specific factors that might cause such material differences include, but are not limited to, availability and cost of personnel trained in this area and the ability to locate and correct all relevant computer systems. 29 ITEM 7. FINANCIAL STATEMENTS AND EXHIBITS (c) Exhibits. The following exhibits are filed herewith or incorporated by reference as part of this report:
Exhibit No. Document Description - ------------ ----------------------------------------------------------------- 23.1 Consent of Ernst & Young LLP, Independent Auditors 23.2 Consent of Deloitte & Touche LLP, Independent Auditors 23.3 Consent of PricewaterhouseCoopers LLP, Independent Accountants 27.1 Financial Data Schedule for the period ended December 31, 1997 (Restated) 27.2 Financial Data Schedule for the period ended December 31, 1996 (Restated) 27.3 Financial Data Schedule for the period ended December 31, 1995 (Restated)
30 SIGNATURES Pursuant to the requirements of the Securities and Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned hereunto duly authorized. Date: November 20, 1998 DAOU SYSTEMS, INC. By: /s/ FRED C. MCGEE ---------------------------------------- Fred C. McGee, Chief Financial Officer 31 EXHIBIT INDEX
Exhibit No. Document Description - -------------- --------------------------------------------------------------- 23.1 Consent of Ernst & Young LLP, Independent Auditors 23.2 Consent of Deloitte & Touche LLP, Independent Auditors 23.3 Consent of PricewaterhouseCoopers LLP, Independent Accountants 27.1 Financial Data Schedule for the period ended December 31, 1997 (Restated) 27.2 Financial Data Schedule for the period ended December 31, 1996 (Restated) 27.3 Financial Data Schedule for the period ended December 31, 1995 (Restated)
32 EX-23.1 2 EXHIBIT 23.1 Exhibit 23.1 CONSENT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS We consent to the incorporation by reference in the Registration Statement Form S-8 (No. 333-29745, No. 333-40393 and No. 333-59795) pertaining to the 1996 Stock Option Plan of DAOU Systems, Inc. of our report dated August 4, 1998 with respect to the supplemental consolidated financial statements of DAOU Systems, Inc. included in its Current Report on Form 8-K dated November 20, 1998 filed with the Securities and Exchange Commission. /s/ ERNST & YOUNG LLP San Diego, California November 19, 1998 EX-23.2 3 EXHIBIT 23.2 Exhibit 23.2 INDEPENDENT AUDITORS' CONSENT We consent to the incorporation by reference in Registration Statements No. 333-40393, No. 333-29745 and No. 333-59795 of DAOU Systems, Inc. on Form S-8 of our report dated February 13, 1998 (relating to the financial statements of Sentient Systems, Inc. not presented separately herein) appearing in this Form 8-K of DAOU Systems, Inc. /s/DELOITTE & TOUCHE LLP McLean, Virginia November 20, 1998 EX-23.3 4 EXHIBIT 23.3 Exhibit 23.3 CONSENT OF INDEPENDENT ACCOUNTANTS We consent to the incorporation by reference in the registration statements on Form S-8 of DAOU Systems, Inc. (File Nos. 333-40393, 333-29745 and 333-59795) of our report, dated March 8, 1996, on our audit of the finacial statements of Sentient Systems, Inc. as of November 30, 1995 and for the year then ended, which report is included in this current report on Form 8-K for DAOU Systems, Inc. /s/ PricewaterhouseCoopers LLP McLean, Virginia November 19, 1998 EX-27.1 5 EX-27-1
5 1,000 YEAR DEC-31-1997 JAN-01-1997 DEC-31-1997 7,981 10,307 16,056 312 13,291 49,412 6,801 2,942 54,110 9,839 0 0 0 17 41,820 54,110 69,055 69,055 45,553 45,553 20,923 0 0 3,452 947 2,505 0 0 0 2,505 0.15 0.15
EX-27.2 6 EX-27-2
5 1,000 YEAR DEC-31-1996 JAN-01-1996 DEC-31-1996 3,123 839 10,754 310 4,122 19,386 3,793 2,032 21,672 5,937 0 8,190 0 13 6,291 21,672 50,947 50,947 33,730 33,730 14,111 0 0 3,475 149 3,326 0 0 0 3,326 0.23 0.23
EX-27.3 7 EX-27-3
5 1,000 YEAR DEC-31-1995 JAN-01-1995 DEC-31-1995 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 36,448 36,448 22,583 22,583 11,858 0 0 2,200 889 1,311 0 0 0 1,311 0.10 0.10
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