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UNITED STATES
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
FORM 10-K
[X]ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
ACT OF 1934
For the fiscal year ended December 31, 2000
[_]TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES
EXCHANGE ACT OF 1934
For the transition period from to
Commission File No.: 0-22073
DAOU SYSTEMS, INC.
(Exact name of registrant as specified in its charter)
Delaware 33-0284454
(State or other jurisdiction of (IRS Employer Identification No.)
incorporation or organization)
5120 Shoreham Place, San Diego, California 92122
(Address of principal executive offices) (Zip Code)
Registrant's telephone number, including area code: (858) 452-2221
Securities registered pursuant to Section 12(b) of the Act:
None
Securities registered pursuant to Section 12(g) of the Act:
Common Stock, $0.001 par value per share
(Title of Class)
Indicate by check mark whether 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 [_]
Indicate by check mark if disclosure of delinquent filers pursuant to Item
405 of Regulation S-K is not contained herein, and will not be contained, to
the best of Registrant's knowledge, in definitive proxy or information
statements incorporated by reference in Part III of this Form 10-K or any
amendment to this Form 10-K. [_]
The aggregate market value of the voting stock held by non-affiliates of
the Registrant as of March 23, 2001 was $4,502,919.
As of March 23, 2001, the number of issued and outstanding shares of the
Registrant's Common Stock was 17,830,634.
Portions of the registrant's Proxy Statement for its 2001 Annual Meeting of
Stockholders are incorporated herein by reference into Part III of this Form
10-K. If the Proxy Statement is not filed with the Securities and Exchange
Commission in definitive form prior to April 30, 2001, the registrant intends
to amend this report to include information omitted from Part III hereof.
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PART I
Item 1: Business.
This report contains forward-looking statements within the meaning of
Section 27A of the Securities Act of 1933, as amended, and Section 21E of the
Securities Exchange Act of 1934, as amended. All forward-looking statements
are inherently uncertain as they are based on current expectations and
assumptions concerning future events or future performance of the Company.
Readers are cautioned not to place undue reliance on these forward-looking
statements, which are only predictions and speak only as of the date hereof.
Forward-looking statements usually contain the words "estimate," "anticipate,"
"believe," "expect" or similar expressions, and are subject to numerous known
and unknown risks and uncertainties. In evaluating such statements,
prospective investors should carefully review various risks and uncertainties
identified in this report, including the matters set forth under the captions
"Risk Factors" and in the Company's other SEC filings. These risks and
uncertainties could cause the Company's actual results to differ materially
from those indicated in the forward-looking statements. The Company undertakes
no obligation to update or publicly announce revisions to any forward-looking
statements to reflect future events or developments.
General
DAOU Systems, Inc. ("DAOU" or the "Company") performs applications
consulting and implementation, traditional network services, remote help desk
and related technology support services and integrates legacy systems with
emerging technologies, such as wireless and other portable computing solutions
for the U.S. healthcare industry. DAOU's IT offerings include data and voice
networking, applications consulting and implementation, as well as operational
and Internet solutions. DAOU has approximately 340 employees, and has provided
services to more than 1,300 health care organizations, including many of the
nation's top 100 integrated delivery systems and middle market payor
organizations.
DAOU is principally focused on providing IT services and solutions to
healthcare organizations, such as managed care and insurance companies,
integrated delivery networks (IDN's), hospitals, medical groups, academic
medical centers and government organizations. DAOU's key competitive advantage
is its extensive knowledge and experience in the healthcare industry. Through
extensive research and its 15 member chief information officer (CIO) Advisory
Board, DAOU has the opportunity to fine-tune its strategic plans with
influential healthcare executives. DAOU is a trusted advisor to leading
organizations in the payor/insurer segment of the market (health maintenance
organizations (HMO), health insurers, blues plans, independent practice
associations, preferred provider organizations (PPO), physician/hospital
organizations); in the provider arena (integrated delivery networks,
hospitals, physician groups, ancillaries); as well as in the
administrative/vendor segment (third-party administrators, medical services
organizations, service vendors, software vendors, hardware vendors). DAOU's
operating philosophy is to meet or exceed the customer's objectives and to
pursue excellence in every area in which its professional staff works. DAOU
sells no proprietary hardware, and other than its Enosis Integration Engine
product, develops no major software applications.
The Company was incorporated in California on July 16, 1987 under the name
DAOU Systems, Inc., and reincorporated in Delaware on November 15, 1996.
Unless the context otherwise requires, as used in this report the "Company"
and "DAOU" refer to the Company, its predecessor entity and, until December
31, 2000, its wholly-owned subsidiaries, DAOU-Sentient, Inc., a Delaware
corporation ("DAOU-Sentient"), DAOU-Synexus, Inc., a Delaware corporation
("DAOU-Synexus"), DAOU-TMI, Inc., a Delaware corporation ("DAOU-TMI"), DAOU-
RHI, Inc., a Delaware corporation ("DAOU-RHI") and Enosus, Inc., a Delaware
corporation ("Enosus"). On December 31, 2000, the Company merged all of its
subsidiaries with and into the Company. The Company's principal executive
offices are located at 5120 Shoreham Place, San Diego, California 92122; its
telephone and facsimile numbers are (858) 452-2221 and (858) 452-1338; its e-
mail address is info@daou.com; and its URL is http://www.daou.com.
1
Reorganization
On February 6, 2001, DAOU Systems, Inc. announced that it had consolidated
the operations of its five former subsidiaries into two divisions. DAOU has
been a leading provider of IT solutions to the healthcare industry since 1987,
helping over 1,300 healthcare enterprises and vendors, including many of the
nation's top 100 integrated delivery systems and middle market payor
organizations, identify and solve technology, process, and resource
challenges. Pioneers in the assessment, design and implementation of network
solutions for healthcare, the Company believes the new structure will better
serve its clients in the areas of strategic consulting, applications,
infrastructure and operations.
The principal elements of the reorganization were the formation of an
Application Services division and a Technology Services division. Application
Services combines the Company's IT Consulting and Managed Care Implementation
and Application Implementation groups. The Technology Services division is the
combination of the Company's Communication Infrastructure, Application
Development and Integration Services, Outsourcing, and Internet and Electronic
Commerce (formerly known as Enosus) groups. The Company believes the
consolidation was necessary due to changing market forces in the healthcare
industry. The Company also believes that two operating divisions will allow
DAOU to focus on its core competencies and more profitable lines of service.
The Application Services division provides clients with strategic
consulting (eHealth, mHealth, HIPAA, and application selection), software
implementation, project management, and support services, including staff
augmentation. Additionally, this division assists clients by recruiting
strategic skill sets for their critical long term needs. The Technology
Services division provides clients with solutions in key areas, including
network infrastructure (servers, data and voice networks, and security),
application and web development and integration projects, help desk solutions
(remote or on-site) and network management.
In addition to the two divisions, a Strategic Services Office was created
to identify and develop capabilities and services responsive to emerging
technologies and applications, such as wireless and other portable computing
solutions.
Application Services Division
DAOU's Application Services division provides strategic consulting,
application (software) implementation, project management and support
activities.
IT Consulting and Managed Care Implementation Services
The IT consulting and managed care implementation services help healthcare
management meet their business and IT objectives and anticipate and plan their
future IT needs. Senior consultants offer clients the benefit of overall
project management vision as well as application and technical skills
appropriate for specific assignments. The division works with its clients in a
goal-directed, strategic partnership to achieve results in a timely and cost-
effective manner.
Among its specific capabilities, the division installs and integrates
applications, manages IT systems, and develops business plans and solves
problems for healthcare IT managers. More than two-thirds of DAOU's consulting
revenue derives from the implementation of managed care systems such as
Erisco's(R) Facets(R), McKessonHBOC's AMISYS(R), QCSI's QMACS(R), and HSD's
DIAMOND(R) systems.
In the area of general management consulting, the IT Consulting group
provides counsel on business process improvement, business strategy and
critical management problem solving, planning, and procurement of managed care
systems, hospital systems and physician practice management systems.
The engagement period for these services typically averages six months, but
varies depending on the size and complexity of the project. Implementation
projects can last one to two years.
2
Application Implementation Services
Application implementation services include supplying temporary, vendor-
certified consultants to hospitals and other healthcare organizations. The
primary focus is assisting customers with the installation of third-party
software applications such as McKessonHBOC-STAR(R), SMS INVISION(R) and most
other commonly used healthcare software applications.
The application implementation group provides expertise in application
implementation, project management, interim IT management, application
programming, system programming, decision support and interface support. The
group also supports the following service lines:
. healthcare information systems;
. clinical systems;
. financial systems;
. decision support systems; and
. interface support.
The engagement period for these services generally averages three to six
months, but varies depending on the size and complexity of the project. The
group's services are provided to customers on a time and expense basis.
Technology Services Division
The Technology Services division provides clients with solutions in key
areas, including network infrastructure, application and web development and
integration projects, help desk solutions and network management.
Communications Infrastructure
Communications infrastructure services focus on IT infrastructure solutions
for healthcare enterprises, including IDN's, hospitals and large academic
medical centers. Services include the design and implementation of
sophisticated computer networks, desktop support, and voice, video and data
solutions. 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 networks.
The engagement period for design and implementation services generally
ranges from three to nine months, although certain projects have required a
year or more for completion, and varies depending on the size and complexity
of the implementation project. Services are generally performed on a time and
expense basis and billed semi-monthly or monthly. Certain projects, generally
those with significant hardware content, are performed on a fixed-fee basis,
with revenue recognized on a percentage of completion basis as services are
performed.
DAOU's voice and data solutions services provide leading-edge voice and
data solutions to IDN's, hospitals, academic medical centers, educational
institutions, architects and government organizations. Voice solutions include
baseline assessment and detailed designs of current telecommunications
hardware, software, carrier and support services. The group's consultants
examine cable infrastructure, PBX systems, call centers, key systems, voice
processing systems and local and long distance service. The group prepares an
enterprise-wide plan to determine cost-effective wireless systems, integrated
call centers and interactive voice-response programs. For voice applications,
DAOU helps customers interface their local and long-range pagers, wireless
phones, high-tech call centers, PBX and integrated messaging systems.
The engagement period for voice consulting services generally ranges from
three to six months, but varies depending on the size and complexity of the
project. The group's services are primarily provided to customers
3
on a time and expense basis, with billing occurring semi-monthly or monthly.
Certain architectural and educational projects are bid on a fixed-fee basis
and billed monthly.
In 2000, the Company offered desktop computing services to healthcare
providers, primarily IDN's, to optimize, understand and manage the cost of
desktop computing. These services enabled customers to appropriately balance
their end-user service levels with costs. Consultants also assisted healthcare
organizations in the preparation of and transition to co-source or outsource
strategies for help desk, call center and IT department/facilities functions.
Communication infrastructure consultants also provided support for integration
of desktop and network solutions, asset management services from procurement
through disposal, cost of desktop computing analysis, break/fix problem
resolutions, help desk analysis, virus repair processes, on-going software
management audit, quality controls and end-user satisfaction measurement. The
group's asset management services included asset inventory and management, PC
configuration and rollout, development of hardware/software standards and
technology refresh. In 2001, the Company has limited its focus in this area.
The engagement period for these services generally averages three months,
but varies depending on the size and complexity of the project. The group's
services are normally provided to customers on a time and expense basis, with
billing occurring semi-monthly or monthly. Certain projects are bid on a price
per node basis and billed monthly.
Application Development and Integration Services
DAOU's application development and integration services provide custom
integration, data warehousing and programming solutions that allow healthcare
organizations to share and access data housed across multiple platforms and
environments. By developing interfaces, implementing existing interfaces, Web-
enabling a system or migrating data to more compatible systems, the
integration services group provides healthcare organizations with low-cost
methods of sharing data between legacy systems, on-line transaction processing
systems and off-the-shelf applications, regardless of technology platform or
location. The engagement period for these services generally ranges from nine
to twelve months, but varies depending on the size and complexity of the
project.
The group's consultants are experienced in healthcare information systems
(financial, clinical and management) for hospitals, HMOs, insurers, clinics
and physician offices. This group offers expertise in three specific
healthcare application areas:
. MUMPS-based government healthcare systems, including the Department of
Defense, Health Affairs, the Department of Veterans Affairs and the
Department of Indian Health Services;
. Clinical/financial application systems for laboratory, pharmacy,
radiology, nursing, medical records, diagnosis-related groups, materials
management, patient accounting, medical billing, healthcare information
systems and physician practice management for hospitals, clinical and
physician's offices; and
. Managed care support including conversion and development projects for
health plans, insurance companies and managed care organizations
migrating to new enterprise applications.
Outsourcing
DAOU's outsourcing services provide remote help desk and related technology
support services, support and management services that are designed to
maintain the effective performance of a customer's computer network system, as
well as IT function outsourcing services that are designed to manage a
customer's information services functions. As healthcare IT systems become
more complex, organizations are experiencing difficulties in hiring, training
and retaining information technology professionals who can maintain the
performance and functionality of their advanced systems. Accordingly,
healthcare organizations have begun to outsource certain functions of their
information systems departments. The Company generally provides these services
in multi-year engagements on a fixed-price basis.
4
The Company provides a 24-hour technical support hotline available seven
days a week, as well as other network support resources such as on-site
seminars, on-line support and continuous network monitoring in order to
monitor remotely the performance of computer network systems on an ongoing
basis and detect and report network problems. DAOU also informs its customers
of new technological advances and network solutions that may help increase the
utility and functionality of their computer network systems. The initial
engagement period for the Company's existing support services typically is for
one year, subject to annual renewal.
The Company provides a range of technical management services to manage and
support its customer's computer network systems. The Company uses its
technical expertise and staffing experience to package, price and deliver
combinations of technical management services at collective rates that are
frequently lower than if provided in-house by the customer. The engagement
period for these services typically ranges from one to five years. The Company
offers the following technical management services, including combinations of
these services, selected by the customer to meet its specific needs:
. Remote Help Desk. DAOU provides technical information system support via
its remote, Support Center Practices certified, call center using
integrated telephone, web and e-mail. DAOU's customized service to
healthcare related customers utilizes best-practices, service level
agreements, and service level guarantees.
. DAOU Employees On-site. DAOU works with the customer to assess the
appropriate staffing needs to maintain and support its computer network
system. The Company places its employees on-site on a full-time basis to
provide network support services and ongoing training of the customer's
internal staff.
. Continuous Network Planning. DAOU's design personnel evaluate the
customer's computer network system and provide recommendations for new
network capabilities and capacity on an ongoing basis consistent with
the evolving needs and strategy of the customer. In addition, DAOU
evaluates hardware and software options, interprets research and
development results, updates existing network designs and researches
specific products and technologies of interest to customers. The Company
provides these services subject to predetermined schedules.
. Burst Mode Implementation. DAOU provides additional technical personnel
during periods of peak network requirements to accommodate and assist in
network upgrade implementation or to accommodate the anticipated or
unanticipated need for additional technical staff.
. Technical Support. Depending on the specific needs of each customer, the
Company also provides network support services as part of its
combination of enterprise network management services.
The Company provides IT function outsourcing services for healthcare
provider organizations that elect to outsource all or a portion of their
information systems functions. IT function outsourcing services involve long-
term engagements where the Company may staff portions of a customers
information systems department and is responsible for the management and
support of those functions. DAOU provides its IT function outsourcing services
in accordance with pre-determined, detailed schedules and plans established
with the customer. The Company typically provides help desk and these services
in multi-year engagements on a fixed-price fee per node or fee per call basis.
Internet and Electronic Commerce
The Internet and electronic commerce services provide consulting services
to healthcare organizations for Internet, web development and electronic
commerce (eCommerce) services. These services were delivered under the name
Enosus for the year 2000 and included customers outside of the healthcare
industry. Enosus marketed these services to healthcare companies and other
small to medium businesses seeking to outsource some or all of their Internet
and eCommerce requirements. Enosus developed its own sales team that focused
on providing services to eHealth companies and supporting venture capital
firms efforts to accelerate the IT capabilities of their start-ups. In
addition, Enosus utilized the Company's existing service offerings to provide
data and voice
5
services to its customers. On February 6, 2001, the Company announced as part
of its reorganization, the consolidation of Enosus into its Technology
Services division, focused exclusively on the healthcare industry.
There are three categories of services for Internet and eCommerce:
. innovation services to assist healthcare organizations in finding
innovative solutions to their eBusiness needs;
. engineering services that will utilize project managers, programmers,
database administrators, network designers, Internet-call centers and
telecommunications specialists to implement the solutions devised by
innovation services; and
. operations services to assist customers in maintaining these solutions
over the long term by providing hosting, system monitoring, security,
technical support and maintenance services.
DAOU Advisory Board
In 1994, the Company established its Advisory Board (the "Advisory Board"),
a non-governing body currently comprised of 15 CIOs of various healthcare
provider organizations. The Advisory Board meets bi-annually and the members
confer separately with the Company periodically to provide advice on issues
and trends in the healthcare industry and emerging technologies, as well as to
provide strategic direction and feedback regarding the Company's current and
future services. Members of the Advisory Board are reimbursed for travel,
lodging and meal expenses incurred in connection with attendance at the
Advisory Board's sessions. Peter Strombom, Chief Information Officer of
Meriter Health Systems, currently serves as the Chairman of the Advisory
Board.
Recruiting and Training of Technical Employees
The Company dedicates significant time and resources to recruit, train and
retain qualified technical personnel, including consultants, engineers and
technicians providing IT Consulting, managed care implementation, application
implementation, integration, communications infrastructure, outsourcing and
Internet services. In 2000, the Company maintained an internal recruiting team
to attract technical personnel.
The Company's technical staff undergoes extensive training and maintains
certifications from leading IT technology vendors such as Cisco Systems,
Erisco, Everdream, Fore, HSD, Novell, Lotus, Microsoft, Network Engines,
Oracle, Premier, Sybase, STC, Sunquest, 3Com, McKessonHBOC, SMS, and other
leading application vendors. In addition, the Company is a member of leading
technological forums and organizations, including the Healthcare Research and
Development Institute (HRDI), the ATM Forum, the Center for Healthcare
Information Management (CHIM) Telecommunications Committee, the HL7 Committee
and the BICSI Organization.
The Company believes that its future success will depend in large part on
its ability to hire, train and retain qualified technical personnel who
together have expertise in a wide array of sophisticated IT solutions and a
broad understanding of the healthcare provider organizations that the Company
serves. Competition for qualified technical personnel is intense and is
expected to increase. Consequently, there can be no assurance that the Company
will be successful in attracting and retaining such personnel. Any inability
of the Company to hire, train and retain a sufficient number of qualified
technical personnel could impair the Company's ability to adequately manage
and complete its existing projects or to obtain new projects, which, in turn,
could have a material adverse effect on the Company's business, financial
condition and results of operations. See "--Risk Factors--The Company may not
manage successfully its business operations if it fails to hire, train and
retain qualified computer network engineers, software application consultants,
integration programmers and key management employees."
Each technical employee is required to enter into a confidentiality and
proprietary information agreement with the Company designed to protect the
Company's trade secrets and other confidential information during
6
and subsequent to employment with the Company. Any significant loss of
employees to a competitor could have a material adverse effect on the
Company's business, financial condition and results of operations.
Sales and Marketing
Effective February 6, 2001, the Company announced a reorganization of its
national sales force to create separate sales teams for each of its newly
created divisions: Application Services and Technology Services. In 2000, the
Company's communications infrastructure, application implementation,
outsourcing and eHealth sales were generated primarily from corporate-managed
regional sales organizations located in the west, central, northeast and
southeast regions of the United States. A vice president managed each regional
organization and oversaw the development of new customers and the management
of existing customers by local business development directors. The corporate-
managed sales team generally sold to providers, such as IDNs, hospitals,
academic medical centers and large clinics. Each of the Company's business
units maintained smaller, dedicated business development teams dedicated to
pursuing opportunities within specific healthcare IT technology market
segments.
DAOU's IT Consulting sales team marketed its services primarily to payor
organizations (managed care and insurance companies) and has also created and
resourced a HIPAA practice comprised of multidisciplinary talent from all of
DAOU's business divisions. DAOU's set of security-focused products and
services, enhanced through a recent resale agreement with respect to Celotek
Corporation's CellCase encryption devices, positions the Company to help
customers respond to HIPAA's requirements and to support secure eBusiness-
based initiatives in the healthcare arena. The Company's integration
subsidiary sales team marketed its services to clinical and governmental
organizations. Enosus, the Company's eCommerce and Internet solutions
provider, now known as Internet and Electronic Commerce group, maintained a
dedicated sales team to market its Internet professional services and
solutions to organizations executing an eBusiness strategy and dot.com
companies.
The Company seeks to establish long-term relationships with its customers
by providing high levels of service and by becoming an integral part of their
IT operations. The Company focuses its sales and marketing efforts on the CIOs
and other technology decision-makers of IDNs, hospitals, managed care and
insurance companies and other healthcare provider organizations. The Company
relies upon its reputation in the marketplace, the personal contacts and
networking of its professionals and the various programs of its marketing
department to develop new business opportunities. The Company also receives
sales leads directly from consultants, value added resellers, and product and
service vendors.
The principal objectives of the Company's marketing department are to
increase the Company's market presence, provide strategic direction and
generate sales leads. Based primarily on valuable feedback from customers,
HRDI, the Advisory Board, and other trusted advisors, DAOU's marketing program
is centered around the corporate positioning of DAOU as a leading provider of
integrated information technolgy solutions and services to the U.S. healthcare
industry. As a supplement to the direct selling efforts of the Company, the
marketing department has developed various programs that include advertising
campaigns, tradeshow participation, direct mail campaigns, public relations
programs, marketing research and communications and the development of sales
presentation materials. Public speaking engagements and the publication of
technical articles and reports directed to the healthcare information
technology industry enhance the Company's marketing efforts. The Company
continues to develop its presence on the Internet as a new marketing channel.
The Company has entered into a marketing agreement with McKessonHBOC, which
markets the Company's services to their customer base. The Company also has
entered into a marketing alliance with SeeBeyond, whereby, as one of
SeeBeyond's preferred information system integration vendors, the Company
offers computer network design, implementation and support services to
SeeBeyond's customers. The Company intends to pursue additional marketing
agreements, joint ventures and alliances as part of its marketing plan. In
addition, the Internet and Electronic Commerce group entered into a strategic
relationship with Viador Inc., a leader in the Enterprise Information Portal
(EIP) market, to provide healthcare and non-healthcare customers with secure,
web-based access to enterprise-wide information.
7
Competition
The healthcare IT services industry is comprised of a large number of
participants and is subject to rapid change and intense competition. The
Company's competitors include:
. consulting companies;
. information technology vendors;
. value added resellers;
. system integrators;
. local and regional network services firms; and
. telecommunications providers and network equipment vendors.
Many of the Company's competitors have significantly greater financial,
technical and marketing resources and greater name recognition than does the
Company. The Company's competitors include consulting firms such as First
Consulting Group, Inc. and Superior Consultant Holdings Corporation;
healthcare information technology companies such as McKessonHBOC and Shared
Medical Systems Corporation; hardware firms such as Cisco Systems, Inc.,
Marconi Communications, 3Com Corporation and Integrated Systems Solution
Corporation, a division of International Business Machines Corporation; and
networking/telecommunications firms such as GTE Corporation, AT&T Corporation
and Sprint Corporation. Each DAOU business segment may compete against a
different group of companies. For example, the integration services group of
the Technology Services division competes against the information technology
companies and consulting firms, but has little competition with hardware or
networking telecommunication firms. The Internet offering of the Technology
Services division competes against consulting firms and pure Internet services
firms such as iXL, Sapient, Appnet, etc. In addition to these major companies,
the Company also competes with smaller regional IT systems firms, which have a
niche in selected geographical areas of the country.
The Company has faced, and expects to continue to face, additional
competition from new entrants into its markets. Other healthcare information
technology companies not presently offering or emphasizing application and
network systems services and large network services companies not currently
focusing on healthcare may enter the Company's markets. Increased competition
could result in price reductions, fewer customer projects, under-utilization
of employees, reduced operating margins and loss of market share, any of which
could materially and adversely affect the Company's business, financial
condition and results of operations. There can be no assurance that the
Company will be able to compete successfully against current and future
competitors. The failure of the Company to compete successfully would have a
material adverse effect on the Company's business, financial condition and
results of operations. In addition, most of the Company's customers have
internal IT support and service capabilities and could choose to satisfy their
needs through internal resources rather than through outside service
providers. As a result, the decision by the Company's customers or potential
customers to perform IT services internally could have a material adverse
effect on the Company's business, financial condition and results of
operations. See "--Risk Factors--Intense competition in its industry from
competitors with greater financial, technical and marketing resources could
prevent the Company from increasing revenues and achieving or sustaining
profitability."
The Company believes that the principal competitive factors in the markets
in which it competes include reputation, healthcare industry expertise, system
performance and reliability, timely delivery of services, quality of service,
responsiveness to customers, product knowledge and technological expertise,
marketing, customer relationships and price. The Company believes that it is
competitive with respect to the above mentioned factors.
8
Customers
The Company has provided services to over 1,300 U.S. healthcare
organizations, including many of the top IDNs and middle market payor
organizations. The Company provides services to managed care and insurance
companies, IDNs, hospitals, academic medical centers, government organizations
and medical groups. In 2000, Enosus pursued selective business to business
(B2B) opportunities outside of the healthcare industry with companies
executing eBusiness strategies and dot.com companies.
The Company has derived, and believes that it will continue to derive, a
significant portion of its revenues from a relatively limited number of large
customer contracts. For the years ended December 31, 2000 and 1999, the
Company's five largest customers accounted for approximately 33% and 26% of
total revenues, respectively, with Saint Mary's Health Network (SMHN)
accounting for approximately 16% and 10% of total revenues, respectively. For
the year ended December 31, 1998, the Company's five largest customers
accounted for approximately 19% of total revenues, with no single customer
accounting for 10% or more of total revenues. On February 27, 2001, SMHN, the
Company's largest client, notified the Company of its intent to terminate the
outsourcing agreement. The Company is currently negotiating the termination
and transition agreement in which the Company will transition all of its on-
site employees to SMHN effective March 31, 2001. The settlement includes a
transition fee from SMHN to cover transition costs.
In 2000, the Company's top five revenue generating customers were from the
following business segments:
1. Outsourcing;
2. Outsourcing;
3. Application Development and Integration Services;
4. Outsourcing; and
5. Outsourcing.
Employees
As of December 31, 2000, the Company employed 406 technology and support
professionals. Of these employees, 32 were involved in IT Consulting and
managed care implementations, 34 in communications infrastructure, 66 in
application implementation, 58 in integration services, 117 in outsourcing, 17
in Internet and electronic commerce (formerly Enosus) and 82 in sales and
marketing, finance, human resources, recruiting and administrative. The
Company employs full-time recruiters dedicated to the hiring of its technical
and support professionals. The Company also has an internal referral bonus
program throughout the organization to encourage employees to refer or
recommend qualified professionals for employment with the Company. Referring
employees are rewarded with a bonus for each candidate hired by the Company.
The Company's employees are not represented by a labor union and the Company's
management believes that its relationship with its employees is good.
In 2001, the Company reduced its workforce in connection with its
restructuring plan. As of March 23, 2001, the Company employed 343 technology
and support professionals. Of these employees, 37 were involved in
IT consulting and managed care implementations, 25 in communications
infrastructure, 55 in application implementation, 50 in integration services,
116 in outsourcing, 5 in Internet and electronic commerce (formerly Enosus)
and 55 in sales and marketing, finance, human resources, recruiting and
administrative.
Risk Factors
An investment in DAOU's Common Stock involves a high degree of risk. In
addition to the other information in this report, the following risk factors
should be considered carefully in evaluating the Company and its business.
This report contains forward-looking statements within the meaning of Section
27A of the Securities Act of 1933, as amended. Prospective investors are
cautioned that such statements are only predictions
9
and that actual event or results may differ materially. Forward-looking
statements usually contain the word "estimate," "anticipate," "believe,"
"expect" or similar expressions. All forward-looking statements are inherently
uncertain as they are based on various expectations and assumptions concerning
future events and are subject to numerous known and unknown risks and
uncertainties. The forward-looking statements included herein are based on
current expectations and entail various risks and uncertainties as those sets
forth below and in the Company's other SEC filings. These risks and
uncertainties could cause the Company's actual results to differ materially
from those projected in the forward-looking statements.
The Company may not successfully manage its business operations if it fails to
hire, train and retain qualified software application consultants, computer
network engineers, integration programmers and key management employees.
DAOU's business strategy depends in large part on the services of its key
management and technical personnel such as software application consultants,
computer network engineers and programmers. These personnel are in short
supply, and the competition for their services is intense. This shortage is
especially acute for software application consultants, senior network
engineers and programmers who have experience in and understand the payor
organizations, hospitals, integrated healthcare delivery networks and other
healthcare provider organizations that the Company serves, and for the
programmers, database administrators, network engineers and system analysts
with internet and electronic commerce experience that the Company intends to
recruit for its Internet and wireless offerings. DAOU's business also requires
that its employees learn and implement the latest technical applications and
innovations for its customers. In addition, the Company has experienced
significant turnover among its technical personnel due in part to the
significant time and travel demands, increased competition for their services
and recent reorganization. The Company continues to face significant
challenges and risks relating to its acquisitions consumated during 1997 and
1998, including the standardization of diverse employee compensation and
benefit programs, training and policies and procedures. Any inability to hire,
train and retain a sufficient number of qualified applications consultants,
computer network engineers, programmers, database administrators (DBA's),
eBusiness specialists, network engineers, and system analysts with internet
and electronic commerce experience, could impair its ability to adequately
manage and complete its existing projects or to obtain new customers and
projects. DAOU's failure to retain key personnel or to attract additional
qualified employees could materially and adversely affect its ability to
deliver services to its customers in a timely and effective manner, if at all.
During 2000, the Company has experienced turnover in its senior management.
In October 2000, after the resignation of Donald Myll, the Company appointed
Neil Cassidy to serve as its Chief Financial Officer. In addition, in November
2000, after the resignation of Larry Grandia, the Company appointed James
Roberto to serve as its Chief Executive Officer. Mr. Grandia, however, remains
a member of the Board of Directors of the Company. This transition of
management personnel may adversely affect the Company's operating performance,
given the diversion of management's attention from operational to recruitment
activities and the time required for new senior personnel to assimilate and
manage effectively its business operations.
The Company depends on a small number of large customers to provide a
significant portion of its revenues.
The Company receives a significant portion of its revenues from a
relatively limited number of large customer contracts, and expects this
pattern to continue in the future. As a percentage of total revenues, its five
largest customers accounted for approximately 33% for the year ended December
31, 2000, 26% for the year ended December 31, 1999, and 19% for the year ended
December 31, 1998.
The loss of any large customer could materially and adversely affect its
revenues and financial condition. On February 27, 2001, the Company's largest
client, Saint Mary's Health Network ("SMHN"), notified the Company of its
intent to terminate its outsourcing agreement with the Company as of March 31,
2001. The client accounted for approximately 16% of revenues for the year
ended December 31, 2000.
10
The Company's customers can terminate, without penalty, some of their fixed-
price and outsourcing contracts.
Although the Company enters into multi-year contracts with many of its
customers, certain of its fixed-price and outsourcing customers can reduce or
cancel their use of its services before the end of the contract term. In
addition, the Company has provided and expects to continue providing services
to customers without long-term contracts. When a customer defers, modifies or
cancels a project, the Company must rapidly redeploy its technical and other
personnel to other projects to minimize the under-utilization of employees and
the resulting adverse impact on its operating results. Furthermore, its
operating expenses are relatively fixed and cannot be reduced on short notice
to compensate for unanticipated variations in the number or size of projects
in progress. As a result, any termination, significant reduction or
modification of its business relationships with any significant customers or
with a number of smaller customers could materially and adversely affect its
operating results.
On February 27, 2001, the Company's largest client, SMHN notified the
Company of its intent to terminate the outsourcing agreement with the Company
as of March 31, 2001. The client accounted for approximately 16% of revenues
for the year ended December 31, 2000.
The Company may experience disruptions in its business operations and
increased expenses if it does not effectively integrate its business segments.
DAOU's acquisitions during the last few years have placed significant
demands on its management, operational, technical, financial and other systems
and resources. These acquisitions have:
. increased its working capital funding requirements;
. caused it to expand its efforts to recruit qualified personnel;
. forced it to expand its operational capacity; and
. resulted in new and increased responsibilities for management personnel.
During 1997 and 1998, the Company acquired 11 companies through pooling-of-
interests mergers. The Company continues to face significant challenges and
risks relating to these acquisitions, including the standardization of diverse
employee compensation and benefits programs, human resource policies and
procedures, management information and accounting systems and the training and
retention of employees who work at various Company and customer sites
throughout the United States. To more effectively manage its various business
divisions, the Company implemented a new enterprise resource planning software
application that is designed to coordinate accounting, utilization management,
purchasing and other management functions.
The Company must continue to analyze and determine which processes and
functions require standardization across the Company, such as common billing,
collection and contract procedures, and which functions are better managed
independently by the operating divisions. The Company cannot assure you that
it will address successfully the continued demands caused by the integration
of its acquisitions.
Intense competition in its industry from competitors with greater financial,
technical and marketing resources could prevent the Company from increasing
revenues and achieving or sustaining profitability.
The industry for healthcare information technology services has a large
number of participants and is subject to rapid change and intense competition.
In addition, many of its competitors have significantly greater financial,
technical and marketing resources and greater name recognition than the
Company. The Company currently competes against:
. consulting firms such as First Consulting Group, Inc. and Superior
Consulting Holdings Corporation and the consulting divisions of the
major accounting firms;
. healthcare information technology companies such as McKessonHBOC and
Shared Medical Systems Corporation;
11
. system integrators such as Science Applications International
Corporation, Electronic Data Systems Corporation and Perot Systems
Corporation;
. telecommunications providers and network equipment vendors; and
. eCommerce consulting firms such as IXC, Scient, Viant and Razorfish.
The Company also competes with smaller regional IT services firms in
selected geographical areas of the country. In addition, the Company has
faced, and expects to continue to face, additional competition from new
entrants into its markets, such as other healthcare information technology
companies not presently offering or emphasizing applications and network
systems services and large network services companies not currently focusing
on healthcare. Increased competition could result in price reductions, fewer
customer projects, under-utilization of employees, reduced operating margins
and loss of market share, any of which could materially and adversely affect
its business, financial condition and results of operations. The Company
cannot assure you that it will compete successfully against current and future
competitors.
The Internet and eCommerce services industry is new, rapidly evolving and
intensely competitive, and DAOU expects this competition to intensify in the
future. Barriers to entry are minimal, and competitors may develop and offer
similar services in the future. Although the Company believes that there may
be opportunities for several providers of services similar to its emerging
Internet service offerings, a single provider may dominate the market. The
Company's business, financial condition and operating results, could be
severely harmed if its emerging Internet service offerings do not compete
successfully against current or future competitors. Most of DAOU's current and
potential competitors have longer operating histories, larger customer bases
and greater brand recognition in business and Internet markets and
significantly greater financial, marketing, technical and other resources.
DAOU's Internet competitors may be able to devote significantly greater
resources to marketing and promotional campaigns, may adopt more aggressive
pricing polices or may try to attract users by offering products or services
for free or below their cost, and may devote substantially more resources to
develop new services.
Many factors have caused and will continue to cause the Company's financial
results to fluctuate.
The Company has experienced significant quarterly fluctuations in its
operating results mainly due to: shift in demand for the Company's services;
difficulties in successfully integrating its acquired companies; the
commencement and completion of large fixed fee contracts; and the closure and
wind down of operating units. Variations in its revenues and operating results
may continue from time to time, due to various factors, including:
. the failure to achieve a successful sales program and to secure and
deliver new customer contracts at the budgeted rate;
. industry spending patterns and market conditions that may affect
adversely the buying decisions of the Company's current and prospective
customers, such as the uncertain level of spending on information
technology before, during and after HIPAA compliance, the continued
consolidation among healthcare provider entities and the projected
reduction in reimbursements available to healthcare providers;
. the relatively longer sales cycle in obtaining new customers and larger
contracts;
. the timing and extent of employee training or the loss of key employees;
. competition;
. the effect of negative publicity relating to the Company's possible
delisting from the Nasdaq National Market System;
. government regulations;
. the reduction in size, delay in commencement, interruption or
termination of one or more significant projects;
12
. the loss or termination of preferred partnership relationships with
software vendors or hospital groups;
. the failure to estimate accurately the resources required to complete
new or ongoing projects, including increased labor costs due to delays
in project delivery schedules;
. the commencement or completion during a quarter of one or more
significant projects;
. variations in the product or professional service content of the
Company's projects;
. the development and introduction of new services;
. the continued effect of acquisitions, including additional
administrative staffing and other increased infrastructure requirements
to integrate the acquired companies; and
. the effect of negative publicity relating to the Company's litigation
and operations.
Although the Company's revenues fluctuate from quarter to quarter, the
substantial majority of its operating expenses, particularly personnel and
related costs, depreciation and rent, are relatively fixed. The Company expect
these costs to increase in the future as it intends to grow its business and
correspondingly expand its resources, such as additional applications
consultants, programmers, database administrators, network engineers and
system analysts and other employees and new offices, systems and other
infrastructure. Accordingly, a variation in the timing of the commencement or
completion of customer projects or contracts, particularly at or near the end
of any quarter, may cause significant variations in operating results from
quarter to quarter and could result in losses for a particular quarter. In
addition, an unanticipated delay or termination of a major project or
contract, or a series of smaller projects or contracts, could require it to
maintain or terminate under-utilized employees, which could result in higher
than expected expenses during a quarter.
Through its emerging technology service offerings, the Company will enter into
an entirely new business segment and will encounter numerous risks associated
with this new industry; the Company's prior operating history may not be a
meaningful guide to evaluating the future performance of its emerging
technology service lines.
In February 2000, the Company began to offer Internet and eCommerce
services to its traditional healthcare customers and to other non-healthcare
related entities under the name Enosus. However, the Company decided not to
continue the Enosus' business model outside of the healthcare industry. The
Company may not be able to successfully provide emerging technology services.
This risk is heightened because the Company is operating in the new and
rapidly evolving Internet and eCommerce services market. The Company's
historical results of operations do not reflect its new service offerings, and
could be materially and adversely affected if the Company fails to implement
successfully its emerging technology service offerings business plan.
DAOU's emerging technology service offerings initially will depend on
agreements with outside service providers to perform certain Internet and
eCommerce services that it intends to offer to its customers.
Although DAOU intends to offer end-to-end Internet and eCommerce services
to its customers, the Company does not believe that it initially will have all
of the necessary employees in place to perform each of these services.
Accordingly, DAOU will need to enter into agreements with outside service
providers to fulfill certain Internet and eCommerce services until it can
recruit these necessary employees. If these outside service providers fail to
provide DAOU's customers with quality service, then DAOU may lose the affected
customers. In addition, if DAOU loses one or more of these service providers,
even for a short period of time, then DAOU may not provide its customers
certain Internet and eCommerce services that it is contractually obligated to
provide.
13
The success of DAOU's emerging technology service lines will depend on the
increased acceptance and use of the Internet as a medium of commerce.
The ability of DAOU to grow its revenues will depend on the increasing use
of the Internet as a medium of commerce. If the Internet fails to grow at
anticipated rates, then DAOU's emerging technology service lines will be
materially and adversely affected. Rapid growth in the use of the Internet is
a recent phenomenon, and, as a result, acceptance and use of the Internet may
not develop at projected rates. If the Internet is not broadly adopted as
quickly as the Company anticipates, then its ability to increase revenues will
be materially and adversely affected. A number of factors could prevent the
acceptance and growth of electronic commerce, including:
. electronic commerce is at an early stage and buyers may be unwilling to
shift their traditional means of obtaining business services;
. increased government regulations or taxation may adversely affect the
viability of electronic commerce;
. insufficient availability of telecommunications services or changes in
telecommunication services may result in slower response times; and
. adverse publicity and consumer concern about the reliability, cost, ease
of access, quality of service, capacity, performance and security of
electronic commerce transactions could discourage its acceptance and
growth.
The Company must continually offer services and products that meet its
customers' demands, as new technologies or industry standards could render its
services obsolete or unmarketable.
The Company receives a significant portion of its revenues from projects
based on complex healthcare applications and computer networks. The markets
for software applications and computer network products and services are
continuing to develop and are characterized by rapid change, including
emerging Internet based solutions. The Company cannot make assurances that
products, systems or technologies developed by third parties will not render
one or more of its services noncompetitive or obsolete. DAOU's success will
depend on its ability to offer services and products that keep pace with
continuing changes in technology, evolving industry standards and the changing
preferences of its healthcare customers. The Company cannot assure that it
will successfully address these developments.
Future sales of the Company's common stock in the public market could
adversely affect the price of its common stock and its ability to raise
additional equity capital.
The sale of substantial amounts of its common stock in the public market,
the prospect of these sales or the sale or issuance of convertible securities
or warrants could affect adversely the market price of the Company's common
stock. Of the 17,830,634 shares outstanding as of March 23, 2000, 14,195,083
shares of common stock are freely tradable without restriction in the public
market, unless the shares are held by "affiliates" of the Company as defined
in Rule 144 under the Securities Act of 1933, or are otherwise required to
comply with specific sale volume limitations and other restrictions under Rule
144. The remaining 3,635,551 shares are "restricted securities" as defined in
Rule 144. In September 1999, the Company registered 2,750,000 shares of common
stock that will be freely tradable upon conversion of the 2,181,818
outstanding shares of series A convertible preferred stock. In addition, the
Company has registered an aggregate of 5,000,000 shares of common stock under
the DAOU Systems, Inc. 1996 Stock Option Plan. An additional 750,000 shares of
common stock were subject to options issued outside of the Company's 1996
Stock Option Plan. In December 2000, the Company also registered an aggregate
of 1,500,000 shares of common stock under the Daou Systems, Inc. Employee
Stock Purchase Plan. The Company has also issued warrants exercisable for
3,540,000 shares of common stock exercisable at $.001 per share. The Company
has the obligation to register for sale the shares of common stock deliverable
upon exercise of the warrants.
14
The Company may be sued if its integration, Internet, computer network systems
or software application implementations fail to provide accurate, reliable and
timely information to healthcare providers.
DAOU's integration services, computer network systems and software
application implementations are designed to provide access to and accurate
delivery of a wide range of information within a healthcare organization,
including information used by clinicians in the diagnosis and treatment of
patients. If a computer network system or software application that the
Company installed or maintains fails to provide accurate, reliable and timely
information to a patient's healthcare provider, and, as a result, that patient
is injured, then either the patient or the healthcare provider might bring a
claim against the Company based on its installation or management of the
computer network system. In addition, the Company may be sued if a patient is
injured because of a service that the Company have performed or failed to
perform for the healthcare provider organization. Although the Company
maintains errors and/or omissions insurance, this insurance coverage may not
adequately cover any claims asserted against the Company. In addition,
appropriate insurance may not continue to be available to the Company in the
future at commercially reasonable rates.
Fixed-price and fixed-time frame contracts may adversely affect its
profitability if the Company does not accurately estimate the resources and
time required to complete these contracts.
The Company offers a portion of its computer network system and consulting
services on a fixed-price, fixed-time frame basis. Consequently, the Company
bears the risk of cost over-runs in connection with these projects. DAOU's
failure to estimate accurately the resources and time required for a project
or its failure to complete its contractual obligations within the committed
fixed-time frame could reduce its profit or cause a loss. In addition, the
amount of time that it takes to complete a project often depends on factors
outside of its control, including the customer's existing information
technology systems or the customer's lack of resources to devote to the
project. The Company might not achieve the profitability and staff utilization
that it expects under its fixed-price and fixed-time contracts, and may even
incur losses on these contracts in the future.
The Company's long sales and project delivery cycles expose it to potential
losses.
DAOU's sales process for network and outsourcing projects is often subject
to delays associated with the lengthy approval process that typically
accompanies significant capital expenditures by its customers. During this
process, the Company expends substantial time, effort and resources marketing
its services, preparing contract proposals and negotiating contracts. Any
failure to obtain a signed contract and receive payment for its services after
expending significant time, effort and resources could materially and
adversely affect its revenues and financial condition.
The Company's officers and directors have the power to influence the election
of directors and the passage of stockholder proposals because they
collectively hold a substantial number of shares of its common stock.
As of March 23, 2000, the Company's executive officers, directors and
affiliated persons beneficially owned approximately 37% of the outstanding
shares of common stock. As a result, these stockholders can exercise
significant influence over all matters requiring stockholder approval,
including the election of directors and approval of significant corporate
transactions. This concentration of ownership also may delay or prevent a
change in control of the Company.
The consolidation and changing regulatory environment of the healthcare
industry may reduce the size of its target customer market and result in the
termination of customer contracts.
The Company receives substantially all of its revenues from customers
involved in the healthcare industry. Consequently, its business is vulnerable
to changing conditions affecting this industry. Many healthcare provider
organizations are combining through affiliation and consolidation to create
larger organizations with greater regional market power and are forming
affiliations for purchasing products and services. This consolidation could
reduce its target market and result in the termination of customer contracts.
In particular, some of its customers
15
have scaled back or terminated their relationship with the Company following
their acquisition, and this trend may continue in the future. Moreover,
consolidated enterprises or affiliated enterprises may try to use their
greater bargaining power to negotiate reductions in the amounts paid to the
Company for its services. Any reduction in the size of its target market or
failure to maintain adequate price levels could materially and adversely
affect its revenues and financial condition. In addition new regulations
governing the standardization and security for healthcare information under
the recently enacted Health Insurance Portability and Accountability Act of
1996 (HIPAA) could significantly impact the amount, timing and types of
services requested by customers.
The healthcare industry also is subject to changing political, economic and
regulatory influences that may affect the procurement practices and operations
of participants in the healthcare industry. For example, recent federal
legislation may reduce the reimbursements available for hospitals. Reduced
reimbursements may negatively impact the spending patterns and demand for its
information technology services. The Company cannot predict with any certainty
what impact these developments could have on its business.
Many factors related to the Company's business operations and industry could
impact its future stock price, causing wide fluctuations in value and
significant volatility.
Based upon the historical performance of its common stock, the Company
anticipates that the future price of its common stock may be subject to wide
fluctuations because of announcements of:
. loss of its outsourcing contract with SMHN;
. quarterly fluctuations in its operating results
. negative publicity relating to its possible delisting from the Nasdaq
National Market System;
. changes in earnings estimates by analysts;
. negative publicity relating to its litigation and operations;
. strategic relationships or acquisitions;
. new customer contracts or services by the Company or its competitors;
. general conditions in the market for healthcare IT applications and
computer network services;
. healthcare industry and general market conditions, including HIPAA
developments; and
. changes in its pricing policies or those of its competitors.
In addition, in recent years, the stock market in general and the shares of
technology companies in particular have experienced extreme price
fluctuations. Fluctuations in the price of the Company's shares of common
stock may be disproportionate or unrelated to its operating performance and
may affect adversely the market price of its common stock.
The Company's common stock may be delisted from the Nasdaq National Market
which could adversely affect the price of its common stock and its ability to
raise additional equity capital.
The Common Stock is currently listed for trading on the Nasdaq Stock
Market's National Market. For continued listing, a company, among other
things, must meet certain minimum requirements with respect to net tangible
assets, market value of its securities held by non-affiliates, and minimum bid
prices per share. The Common Stock, has been trading below the minimum bid
price required for continued listing, and the Company cannot be sure that the
bid price will rise above the required minimum bid price. The Company received
notice that its Common Stock would be delisted from the Nasdaq National Market
and as a result its Common Stock may be delisted from the Nasdaq National
Market. Trading, if any, in the Common Stock would thereafter be
16
conducted in the over-the-counter market in the so-called "pink sheets" or the
NASD's "Electronic Bulletin Board". The Electronic Bulletin Board is a less
liquid market than the Nasdaq National Market. As a consequence of such
delisting, an investor would likely find it more difficult to dispose of, or
to obtain quotations as to, the price of the Common Stock. If the Company's
Common Stock is delisted, the Company may find it more difficult to raise
equity financing on terms favorable to the Company, if at all. Delisting of
the Common Stock may result in lower prices for the Common Stock than would
otherwise prevail.
Provisions of Delaware law and the Company's certificate of incorporation and
bylaws may deter, prevent, or delay takeover attempts and a change of control
of the Company.
A number of provisions of Delaware law and the Company's certificate of
incorporation and bylaws could delay, defer or prevent a change in control of
the Company and could limit the price that some investors might be willing to
pay in the future for shares of its common stock. These provisions:
. prohibit the Company from engaging in any business combination with any
interested stockholder for a period of three years from the date the
person became an interested stockholder unless specific conditions are
met;
. permit its board of directors to issue shares of preferred stock without
stockholder approval on the terms as its board may determine;
. provide for a classified board of directors;
. eliminate the right of its stockholders to act by written consent
without a meeting;
. require advanced stockholder notice to nominate directors and raise
matters at the annual stockholders meeting;
. eliminate cumulative voting in the election of directors; and
. allow for the removal of directors only for cause and with a two-thirds
vote of its outstanding shares.
Item 2: Description of Properties.
The Company leases the following office space for its principal
administrative, operating, support and training facilities:
Approximate
Location Square Footage Expiration Principal Use
- -------- -------------- ---------- -------------
San Diego, CA........... 38,000 September 2005 Corporate office facility(1)
Kensington, MD.......... 30,000 February 2001 Operating and support facilities
Alexandria, VA.......... 21,000 May 2005 Operating and support facilities(1)
Alexandria, VA.......... 4,000 June 2005 Operating and support facilities(1)
Indianapolis, IN........ 6,000 April 2001 Operating and support facilities
Mountainside, NJ........ 4,000 November 2003 Operating and support facilities(1)
Exton, PA............... 4,000 January 2003 Operating and support facilities
- --------
(1) Portions of the property have been subleased.
In addition, the Company has leased executive offices in several locations
in the United States to provide regional sales and support activities to its
customers. The Company continually evaluates the adequacy of its existing
facilities and believes that its current and planned facilities will be
adequate for the next twelve months.
Item 3: Legal Proceedings.
On August 24, 1998, August 31, 1998, September 14, 1998 and September 23,
1998, separate complaints were filed against the Company and certain of its
officers and directors in the United States District Court for the Southern
District of California. A group of shareholders has been appointed the lead
plaintiffs and they filed a
17
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 Securities Exchange Act of 1934, as amended. 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. 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 heard on February 20, 2001 and the court took the
matter under submission. The Company believes that the allegations set forth
in all of the foregoing complaints are without merit and intends to defend
against these allegations vigorously. No assurance as to the outcome of this
matter can be given, however, and an unfavorable resolution of this matter
could have a material adverse effect on the Company's business, results of
operations or financial condition.
The Company is party to various claims and legal actions arising in the
normal course of business. Although the ultimate outcome of these 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 in any period.
Item 4: Submission of Matters to a Vote of Security Holders.
No matters were submitted to a vote of stockholders during the fourth
quarter of 2000.
18
PART II
Item 5: Market for Registrants Common Equity and Related Stockholder Matters.
The Company's shares of Common Stock have traded on the Nasdaq National
Market System under the symbol "DAOU" since February 12, 1997. The following
table sets forth the high and low closing bid information for the Common
Stock. Bid quotations reflect interdealer prices without retail mark-up or
mark-down and may not necessarily represent actual transactions.
Common Stock
-------------
High Low
------ ------
2000
1st Quarter................................................ $5.250 $3.000
2nd Quarter................................................ 3.313 1.500
3rd Quarter................................................ 2.750 0.875
4th Quarter................................................ 0.875 0.344
1999
1st Quarter................................................ $9.063 $5.125
2nd Quarter................................................ 6.500 4.563
3rd Quarter................................................ 5.750 4.063
4th Quarter................................................ 5.500 2.750
On March 23, 2001, the closing bid and ask prices of the Company's Common
Stock were $0.281 and $0.313, respectively. As of March 23, 2001, there were
114 holders of record of common stock.
Dividend Policy
DAOU has never declared nor paid cash dividends on its Common Stock. The
Company currently intends to retain any earnings for future growth and,
therefore, does not intend to pay any cash dividends in the foreseeable
future.
Holders of the Series A Preferred Stock are entitled to receive cumulative
dividends at the rate of six percent per annum, payable in the form of shares
of Series A Preferred Stock. Such dividend rate shall increase an additional
one-percent per annum for each successive year after the second anniversary of
the purchase date. As of December 31, 2000, the Company has accrued but
undeclared preferred stock dividends of $1,057,000 payable in shares of Series
A Preferred Stock.
On November 9, 2000, as a consequence of the resignation of Larry Grandia
as the Chief Executive Officer of the Company, holders of the Series A
Preferred Stock had the right to cause the Company to redeem their Series A
Preferred Stock for approximately $12.9 million. The holders of the Series A
Preferred Stock and the Company entered into an agreement whereby the holders
of the Series A Preferred Stock have 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. The total
consideration of this transaction was valued at approximately $4.1 million and
for financial reporting purposes was recorded as a one-time dividend in the
fourth quarter of 2000. The $2.0 million cash payment was treated for
financial reporting purposes as a one-time dividend in the fourth quarter of
2000.
Recent Sales of Unregistered Securities
On July 26, 1999, the Company issued an aggregate of 2,181,818 shares of
its Series A Preferred Stock to Galen Partners III, L.P., Galen Partners
International III, L.P., and Galen Employee Fund III, L.P., for aggregate
proceeds of $12,000,000. The Series A Preferred Stock is convertible at the
option of the holder into Common Stock at a conversion price of $5.50 per
share (subject to adjustment), and automatically converts at the adjusted
19
conversion price if the closing price of the Common Stock equals or exceeds
$11.00 per share (after adjustments for any stock split, dividend, combination
or other recapitalization) for 20 consecutive trading days after July 26,
2000. The holders of the Series A Preferred Stock had the right to cause the
Company to redeem their shares upon the occurrence of (i) the resignation of
Larry Grandia as Chief Executive Officer of the Company, (ii) the failure of
the Company to hire a replacement for Larry Grandia as Chief Executive Officer
within 180 days of his termination as Chief Executive Officer, or (iii) the
failure of Georges Daou or Daniel Daou to vote their shares of Common Stock in
favor of a merger transaction or a liquidation of the Company if the majority
of the Company's board of directors has approved such merger transaction or
liquidation. On November 9, 2000, as a consequence of the resignation of Larry
Grandia as Chief Executive Officer of the Company, holders of the Series A
Preferred Stock had the right to cause the Company to redeem their Series A
Preferred Stock for approximately $12.9 million. The holders of the Series A
Preferred Stock and the Company entered into an agreement whereby the holders
of the Series A Preferred Stock have 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. The
Company has an obligation to register the shares of common stock deliverable
upon exercise of the warrants. The total consideration of this transaction was
valued at approximately $4.1 million and for financial reporting purposes was
recorded as a one-time dividend in the fourth quarter of 2000. 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.
The holders of the Series A Preferred Stock are entitled to receive
cumulative dividends at an initial annual rate of 6%. This annual rate will
increase by 1% per year after July 26, 2001, up to a maximum annual rate of
12%. The dividends on the Series A Preferred Stock, which accrue and are
payable semi-annually, are payable in additional shares of Series A Preferred
Stock valued at $5.50 per share.
The shares of Series A Preferred stock were sold in a private placement to
accredited investors pursuant to Regulation D under the Securities Act of
1933, as amended (the "Securities Act").
The Company registered 2,750,000 shares of Common Stock for resale upon the
conversion of the shares of Series A Preferred Stock. The related Registration
Statement on Form S-3 (file no. 33-87103) was declared effective by the SEC on
October 25, 1999.
The net proceeds were used to retire the Company's line of credit that
expired in July 1999 and approximately $5,300,000 of the Company's long term
debt. The balance of the net proceeds will be used for general corporate and
working capital purposes.
20
Item 6: Selected Consolidated Financial Data.
The following table presents selected consolidated financial data of the
Company. The information set forth below is not necessarily indicative of the
results of future operations and should be read in conjunction with the other
sections of "Management's Discussion and Analysis of Financial Condition and
Results of Operations" in Item 7 of this report and the consolidated financial
statements and the related notes thereto included elsewhere herein. (in
thousands, except per share data):
Years ended December 31,
--------------------------------------------
1996 1997 1998 1999 2000
------- ------- -------- -------- --------
Revenues........................ $50,327 $68,656 $104,784 $103,400 $ 63,748
Cost of revenues................ 33,110 45,154 78,021 75,927 52,781
------- ------- -------- -------- --------
Gross profit................ 17,217 23,502 26,763 27,473 10,967
Operating expenses:
Sales and marketing........... 4,166 7,780 12,203 10,398 5,744
General and administrative.... 9,945 12,425 18,456 25,071 17,973
Restructuring charges......... -- -- -- -- 2,133
Merger related expenses....... -- 718 2,825 -- --
------- ------- -------- -------- --------
Total operating expenses.... 14,111 20,923 33,484 35,469 25,850
------- ------- -------- -------- --------
Income (loss) from operations... 3,106 2,579 (6,721) (7,996) (14,883)
Interest income, net............ 369 873 163 779 699
------- ------- -------- -------- --------
Income (loss) before income
taxes.......................... 3,475 3,452 (6,558) (7,217) (14,184)
Provision (benefit) for income
taxes.......................... 149 947 (802) 1,761 --
------- ------- -------- -------- --------
Net income (loss)............... 3,326 2,505 (5,756) (8,978) (14,184)
Dividends on preferred stock.... -- -- -- (308) (4,837)
------- ------- -------- -------- --------
Net income (loss) available to
common stockholders............ $ 3,326 $ 2,505 $ (5,756) $ (9,286) $(19,021)
======= ======= ======== ======== ========
Net income (loss) available to
common stockholders per common
share:
Basic......................... $ 0.26 $ 0.15 $ (0.33) $ (0.52) $ (1.07)
======= ======= ======== ======== ========
Diluted....................... $ 0.23 $ 0.15 $ (0.33) $ (0.52) $ (1.07)
======= ======= ======== ======== ========
Shares used in computing net
income (loss) available to
common stockholders per common
share:
Basic......................... 12,580 16,231 17,657 17,697 17,712
======= ======= ======== ======== ========
Diluted....................... 14,385 17,246 17,657 17,697 17,712
======= ======= ======== ======== ========
Cash equivalents and short-term
investments.................... $ 3,962 $18,288 $ 7,780 $ 15,548 $ 10,586
Total assets.................... 21,672 54,105 54,517 46,060 26,437
Long-term debt, less current
portion........................ 32 49 26 -- --
Redeemable convertible preferred
stock.......................... 8,190 -- -- 11,382 --
Total stockholders' equity...... 6,304 41,837 34,775 24,974 20,360
21
Item 7: Management's Discussion and Analysis of Financial Condition and
Results of Operations.
The following discussion of the Financial Condition and Results of
Operations contains forward-looking statements within the meaning of Section
27A of the Securities Act of 1933, as amended. Prospective investors are
cautioned that such statements are only predictions and that actual events or
results may differ materially. Forward-looking statements usually contain the
word "estimate," "anticipate," "believe", "expect" or similar expressions. All
forward-looking statements are inherently uncertain as they are based on
various expectations and assumptions concerning future events and are subject
to numerous known and unknown risks and uncertainties. The forward-looking
statements included herein are based on current expectations and entail
various risks and uncertainties as those set forth previously and in the
Company's other SEC filings. In evaluating such statements, prospective
investors should specifically consider various factors identified in this
report, including the matters set forth previously under the caption "Risk
Factors," which could cause actual results to differ materially from those
indicated by such forward-looking statements.
Recent Developments
On November 13, 2000, the Company received notification from the NASDAQ
Stock Market that the Company's common stock had failed to maintain a minimum
bid price of $1.00 over the prior 30 consecutive trading days as required for
continued listing on the NASDAQ. The Company had an oral hearing on March 28,
2001 to demonstrate its ability to regain compliance. The Nasdaq Stock Market
has requested more information from the Company before making a final
determination on the proposed delisting. There can be no assurance Nasdaq will
grant the Company's request for continued listing. In the event of delisting
by Nasdaq, the Company's common stock may be eligible for quotation on another
marketplace such as the OTC Bulletin Board.
On February 27, 2001, the Company's largest client, SMHN notified the
Company of its intent to terminate the outsourcing agreement with the Company.
The client accounted for approximately 16% of revenues for the year ended
December 31, 2000. The Company is currently negotiating the termination and
transition agreement in which the Company will transition all of its on-site
employees to SMHN effective March 23, 2001. The settlement includes a
transition fee from SMHN to cover transition costs.
On February 6, 2001, DAOU Systems, Inc. announced that it had consolidated
its five former subsidiaries into two divisions: Application Services and
Technology Services. The Company believes the new structure will better serve
its clients in the areas of strategic consulting, applications, infrastructure
and operations.
Overview
DAOU Systems, Inc. provides applications consulting and implementation,
traditional network services, remote help desk and related technology support
services, and integrates legacy systems with emerging technologies, such as
wireless and other portable computing solutions for the U.S. healthcare
industry. On February 6, 2001, DAOU Systems, Inc. announced that it had
consolidated the operations of its five former subsidiaries into two operating
divisions: Application Services and Technology Services. The Application
Services division combines the Company's IT Consulting and Managed Care
Implementation and Application Implementation groups. The Technology Services
division is the combination of the Company's Communication Infrastructure,
Integration Services, Outsourcing, and Internet and Electronic Commerce
(formerly known as Enosus) groups. Prior to the consolidation in 2001, the
Company operated each of the divisions as a separate segment. The Company
believes the consolidation was necessary due to changing market forces in the
healthcare industry. The Company also believes that two operating divisions
will allow DAOU to focus on its core competencies and more profitable lines of
service.
The Application Services division provides clients with strategic
consulting (eHealth, mHealth, HIPAA, and application selection), software
implementation, project management, and support services, including staff
22
augmentation. Additionally, this division assists clients by recruiting
strategic skill sets for their critical long term needs. The Technology
Services division provides clients with solutions in key areas, including
network infrastructure (servers, data and voice networks, and security), web
development and integration projects, help desk solutions (remote or on-site)
and network management. In addition to the two divisions, a Strategic Services
Office was created to identify and develop capabilities and services
responsive to emerging technologies and applications, such as wireless and
other portable computing solutions.
The Company's service offerings are segmented into the following operating
divisions and service lines:
Application Services
. IT consulting and managed care implementation--installs and integrates
managed care applications, and manages IT systems, and develops business
plans and solves problems for managed care organizations.
. Application implementation--supplies hospitals and other healthcare
organizations with temporary, certified consultants who are capable of
installing and servicing approximately 90% of the most common healthcare
software applications.
Technology Services
. Communications infrastructure--focuses on the IT infrastructure in
healthcare enterprises, primarily IDNs, hospitals, academic medical
centers and medical groups, provides networking, voice, video and data
solutions and desktop services.
. Application Development and Integration services--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.
. Outsourcing--performs a full range of IT outsourcing services including
co-source or outsource of call centers, help desks, desktop support,
server management, network management, voice management and complete IT
department outsourcing.
. Internet and electronic commerce--provides Internet professional
services and solutions to healthcare organizations executing an
eBusiness strategy.
The Company's service offerings represent aggregated end-to-end healthcare
IT solutions. Depending on the specific needs of its customers, the Company's
relationships may begin anywhere along the IT solution process, growing within
one of the groups or developing cohesively across the complete end-to-end IT
solution process from conceptualization to operation.
The Company provides its professional services primarily on a "time and
expense" basis, under which revenues are recognized as the services are
performed. Billings for these services occur on a semi-monthly or monthly
basis. The Company also provides support and management service revenues,
which are recognized ratably over the period that these services are provided.
Prior to 1999, the majority of the Company's contract services were generally
provided on a fixed-fee 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.
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.
23
The communications infrastructure, application implementation, integration
services and Enosus groups' projects generally range from three to six months,
although certain projects have been for periods in excess of a year. The IT
Consulting group engagements typically average six months but may vary
depending on the size and complexity of the project. The outsourcing group
generally provides services in multi-year engagements on a fixed-price basis.
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.
Results of Operations
The following table sets forth, for the years indicated, certain statement
of operations data as a percentage of net revenues.
Years Ended
December 31,
------------------
2000 1999 1998
---- ---- ----
Revenues................................................ 100% 100% 100%
Cost of revenues........................................ 83 73 74
--- --- ---
Gross profit.......................................... 17 27 26
Operating expenses...................................... 37 34 32
Restructuring charges................................... 3 -- --
--- --- ---
Loss from operations.................................. (23) (7) (6)
Interest income (expense), net.......................... 1 1 0
--- --- ---
Loss before income taxes................................ (22) (6) (6)
Provision (benefit) for income taxes.................... -- 2 (1)
--- --- ---
Net loss.............................................. (22)% (8)% (5)%
=== === ===
Years Ended December 31, 2000 and 1999
The Company's revenues decreased 38% or $39.7 million to $63.7 million for
the year ended December 31, 2000 from $103.4 million for the year ended
December 31, 1999, due to a decrease in revenue primarily in the applications
implementation segment and from continued weakness in the Company's core
health care information technology (IT) business. Management attributes such
weakness to reduced demand for such services as compared to fiscal year 1999
in which customers dedicated more resources to information technology matters
in light of Year 2000 issues. Revenues from third-party material sales
decreased to $4.7 million in 2000 from $18.5 million in 1999. In addition,
1999 revenues included approximately $2.8 million from its former cabling
division, DAOU On-Line, Inc. and an outsourcing contract that the Company
terminated in early 1999.
Services to the Company's five largest customers accounted for $21.0
million of revenues for the year ended December 31, 2000, representing 33% of
total revenues. One of the top five customers, which accounted for $10.1
million in revenues for the year ended December 31, 2000, representing 16% of
total revenues, has given notice of its intent to terminate its outsourcing
contract as of March 31, 2001.
Cost of revenues decreased 30% or $23.1 million to $52.8 million for the
year ended December 31, 2000, from $75.9 million for the year ended December
31, 1999, primarily due to reduced material and employee costs as a result of
the decrease in revenues. The Company decreased its workforce significantly
during 2000 in the Application Implementation, Communications Infrastructure
and Outsourcing divisions.
Gross margin decreased to 17% for the year ended December 31, 2000 as
compared to 27% for the year ended December 31, 1999 as a result of the
significant reduction in revenues, which caused significantly lower labor
utilization rates throughout all of the Company's divisions. The Company also
experienced slightly
24
increased employee costs and expenses related to staff reductions while
billing rates remained fairly stable. Also, in February 2000, the Company
formed its Enosus subsidiary division to provide Internet and eCommerce
services. Start up investments in Enosus further reduced gross margin.
Sales and marketing expenses decreased 45% or $4.7 million to $5.7 million
for the year ended December 31, 2000 as compared to $10.4 million for the year
ended December 31, 1999, primarily due to a reduction in sales staff and
related expenditures as a result of consolidation and integration of the sales
and marketing functions of acquired companies. Also, in the second quarter of
2000 the Company reorganized and reduced its sales force. Sales and marketing
expenses were 9% and 10% of total revenues for the years ended December 31,
2000 and 1999, respectively.
General and administrative expenses decreased 28% or $7.1 million to $18.0
million for the year ended December 31, 2000 as compared to $25.1 million for
the year ended December 31, 1999, primarily due to efficiencies realized with
the consolidation and integration of certain general and administrative
functions of the divisions. During 2000, the Company completed the
implementation of its ERP system and has been able to centralize certain
functions into the corporate office and reduce overhead costs as a result.
Additionally, in 1999 the Company had increased costs related to staffing and
infrastructure requirements at the beginning of 1999 to support growth and
integration of acquired companies, executive management severance, the closure
of DAOU-On Line, increased legal fees resulting from the stockholder
litigation, and increased bad debt expenses. General and administrative
expenses were 28% and 24% of total revenues for the years ended December 31,
2000 and 1999, respectively. The increase was primarily due to certain fixed
administrative expenses that remained in place in 2000 while revenues were
declining.
The Company recorded restructuring charges for the year ended December 31,
2000 totaling $2.1 million, primarily due to severance costs related to a
workforce reduction and the costs related to the closure and combination of
certain facilities. The Company implemented the restructuring plan in order to
improve its overhead cost structure and to refocus operations into areas in
which the Company believes it has a core competency. The Company believes the
restructuring was necessary due to the significant decline in revenue and
gross margin in 2000 as compared to 1999. The restructuring charges recorded
in 2000, includes the estimated costs of workforce reductions of $1.1 million
and the closure of certain facilities in periods subsequent to December 31,
2000 of $1.0 million. The Company believes these estimates reflect the
anticipated costs to complete the restructuring plan. However, the loss of the
Company's SMHN outsourcing agreement and other unanticipated events may result
in additional restructuring expenses in the future.
Other income (expense), net, decreased 10% or $80,000 to $699,000 for the
year ended December 31, 2000 as compared to $779,000 for the year ended
December 31, 1999,. This other income is comprised primarily of interest
income on cash and cash equivalents, and investments. Interest expense
consists primarily of interest associated with the Company's business lines of
credit. The slight decrease in other income (expense), net, was primarily due
to a $546,000 gain from the sale of investments recorded in 1999 offset by
increased interest income due to higher average cash reserves available for
investment and reduced interest expense due to the payoff of outstanding debt
in 1999.
Due to the Company's current operating loss and the loss carryforwards, no
provision for taxes was recorded in 2000. The effective income tax rate for
the year ended December 31, 1999 was 56%. Although the Company had a pre-tax
loss for 1999, the Company recorded a provision for taxes to reserve the
Company's net deferred tax assets, resulting from previously recorded tax
benefits, when the realization of the tax benefits became uncertain.
25
Years Ended December 31, 1999 and 1998
The Company's revenues decreased 1% or $1.4 million to $103.4 million for
the fiscal year ended December 31, 1999 as compared to $104.8 million for the
year ended December 31, 1998, primarily from the closure of the Company's
cabling division and reduced demand for the infrastructure group's services
due to delays in the customer's decisions regarding investment in IT
infrastructure pending Y2k remediation efforts. This decrease in
communications infrastructure group revenue was partially offset by increased
revenue in the outsourcing group due to the SMHN outsourcing contract and
increased demand for application implementation services during the first and
second quarters driven by Y2k remediation demand. Services to DAOU's five
largest customers accounted for $26.4 million of revenues for the year ended
December 31, 1999, representing 26% of total revenues. One of the top five
customers, accounted for $10.8 million in revenues for the year ended December
31, 1999, representing 10% of total revenues.
Cost of revenues decreased 3% or $2.1 million to $75.9 million for the
fiscal year ended December 31, 1999 as compared to $78.0 million for the year
ended December 31, 1998, primarily the result of a decrease in revenues from
the communications infrastructure group resulting from the closure of the
Company's cabling division.
Gross margin increased to 27% for the fiscal year ended December 31, 1999
as compared to 26% for the year ended December 31, 1998, primarily due to
improved gross margins associated with the increased use of time and expense
contracts and the completion or expiration of the fixed-fee contracts which
historically had lower profit margins. The improved margins were partially
offset by lower labor utilization rates within the communications
infrastructure and integration services groups.
Sales and marketing expenses decreased 15% or $1.8 million to $10.4 million
for the fiscal year ended December 31, 1999 as compared to $12.2 million for
the year ended December 31, 1998, primarily due to a reduction in sales staff
and related expenditures as a result of consolidation and integration of the
sales and marketing functions of acquired companies to the corporate level.
Sales and marketing expenses were 10% and 12% of total revenues for the years
ended December 31, 1999 and 1998, respectively.
General and administrative expenses increased 36% or $6.6 million to $25.1
million for the fiscal year ended December 31, 1999 as compared to $18.5
million for the year ended December 31, 1998, primarily due to costs
associated with additional administrative staffing and infrastructure
requirements at the beginning of 1999 to support growth and integration of
acquired companies, executive management severance, the closure of DAOU-On
Line, increased legal fees resulting from the stockholder litigation, and
increased bad debt expenses. As a percentage of total revenues, general and
administrative expenses were 24% and 18% of total revenues for the years ended
December 31, 1999 and 1998, respectively.
Other income (expense), net, increased to $779,000 for the fiscal year
ended December 31, 1999 as compared to $163,000 for the year ended December
31, 1998. This other income is comprised primarily of interest income on cash
and cash equivalents, and investments. Interest expense consists primarily of
interest associated with the Company's business lines of credit. The increase
in net other income (expense), net was primarily due to a $546,000 gain from
the sale of investments, higher average cash reserves available for investment
and reduced interest expense after the payoff of outstanding debt during the
year ended December 31, 1999 as compared to 1998.
The effective income tax rate for the year ended December 31, 1999 was 56%.
Although the Company had a pre-tax loss, a provision for taxes was required to
reserve the Company's net deferred tax assets. The effective income tax
benefit rate for the year ended December 31, 1998 was (12)% due to the non-
deductibility of certain merger related costs and adjustments made to convert
the former S corporation status of certain acquired businesses to the C
corporation status of the Company.
26
Income Taxes
In 2000, 1999 and 1998, the effective tax rates were 0%, 56% and (12)%,
respectively. In 2000, the effective rate was different from the expected
federal statutory rate of 35% due to the Company's current operating loss and
the loss carryforwards, no provision for taxes was recorded. In 1999 the
effective rate was different from the expected federal statutory rate due to a
provision for taxes to reserve the Company's net deferred tax assets
attributable to income tax benefits received in prior years. In 1998, the
effective rate was different from the expected federal statutory rate due to
the fact that Integrex, On-Line, Sentient, Synexus, TMI and RHI were
S-corporations prior to the merger with DAOU and the conversion from the cash
method to the accrual method of accounting for tax purposes. Consequently,
taxes on the pre-acquisition income of Integrex, On-Line, Sentient, Synexus,
TMI and RHI were the direct responsibility of its stockholders. During 1998,
the benefit of Integrex, On-Line's, Sentient's, Synexus, TMI's and RHI's lower
tax rates were partially offset by additional taxes on the conversion of S-
corporation to C-corporation.
Liquidity and Capital Resources
On December 31, 2000, the Company had working capital of $17.9 million, a
decrease of $14.3 million from $32.2 million on December 31, 1999. The
decrease is primarily from a decrease in the accounts receivable balance as a
result of lower revenues and increased collection efforts.
Cash used in operating activities was $2.4 million, for the year ended
December 31, 2000, compared to cash provided by operating activities of $3.3
million for the year ended December 31, 1999. The decrease in cash from
operations resulted primarily from the Company's net loss, decreases in trade
accounts payable and other accrued liabilities, and in accrued salaries and
benefits offset by decreases in trade accounts receivable as compared to 1999.
Net cash used in investing activities was $673,000 for the year ended
December 31, 2000, compared to $164,000 in the comparable prior period. The
increase in cash used by investing activities was primarily due to the
maturing of investments of $1.2 million that were not reinvested in 1999,
offset by decreased purchases of equipment, furniture and fixtures.
Net cash used in financing activities was $1.9 million for the year ended
December 31, 2000, compared to cash provided by of $5.6 million in the
comparable prior period. This decrease was primarily the result of the net
proceeds from the issuance of Series A Preferred Stock in 1999, which raised
$11.1 million, after expenses, partially offset by the repayments of debt and
lines of credit of $5.2 million in 1999 offset by the $2.0 million cash
portion of the one-time dividend paid to the holders of the Series A Preferred
Stock in 2000.
On June 29, 1999, the Company secured an $8.0 million revolving line of
credit that expires on June 29, 2001. The line of credit bears interest at
prime plus 1% per annum, is secured by substantially all of the assets of the
Company and contains customary covenants and restrictions. There are no
compensating balance requirements and borrowings under the line of credit are
limited to 80% of qualifying receivables. No amount remained outstanding under
this revolving line of credit as of December 31, 2000.
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.
Although the Company has an accumulated deficit as of December 31, 2000,
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
27
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. The Company may not be able to raise
additional capital on terms favorable to the Company, if at all. See "Risk
Factors--Future sales of the Company's common stock in the public market could
adversely affect the price of its common stock and its ability to raise
additional equity capital."
Item 7A. Quantitative and Qualitative Disclosures about Market Risks
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.
28
Item 8: Financial Statements.
Index to Consolidated Financial Statements
DAOU SYSTEMS, INC.
Report of Ernst & Young LLP, Independent Auditors......................... F-1
Consolidated Balance Sheets at December 31, 2000 and 1999................. F-2
Consolidated Statements of Operations for the years ended December 31,
2000, 1999 and 1998...................................................... F-3
Consolidated Statements of Stockholders' Equity for the years ended
December 31, 2000, 1999 and 1998......................................... F-4
Consolidated Statements of Cash Flows for the years ended December 31,
2000, 1999 and 1998...................................................... F-5
Notes to Consolidated Financial Statements................................ F-7
REPORT OF ERNST & YOUNG LLP, INDEPENDENT AUDITORS
The Board of Directors and Stockholders
DAOU Systems, Inc.
We have audited the consolidated balance sheets of DAOU Systems, Inc. as of
December 31, 2000 and 1999 and the related consolidated statements of
operations, stockholders' equity, and cash flows for each of the three years
in the period ended December 31, 2000. Our audits also included financial
statement Schedule II listed in Item 14(a). These financial statements and
schedule 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 auditing standards generally
accepted in the United States. 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, the financial statements referred to above present fairly,
in all material respects, the consolidated financial position of DAOU Systems,
Inc. at December 31, 2000 and 1999 and the consolidated results of its
operations and its cash flows for each of the three years in the period ended
December 31, 2000 in conformity with accounting principles generally accepted
in the United States. Also, in our opinion, the related financial statement
schedule, when considered in relation to the basic financial statements taken
as a whole, presents fairly in all material respects the information set forth
therein.
/s/ Ernst & Young LLP
San Diego, California
February 15, 2000
F-1
DAOU SYSTEMS, INC.
CONSOLIDATED BALANCE SHEETS
(In thousands)
December 31,
------------------
2000 1999
-------- --------
ASSETS
------
Current assets:
Cash and cash equivalents................................ $ 10,504 $ 15,480
Investments, available-for-sale.......................... 82 68
Accounts receivable, net of allowance for doubtful
accounts of $1,138 and $1,868 in 2000 and 1999,
respectively............................................ 11,900 21,912
Contract work in progress................................ 665 2,816
Income tax receivable.................................... -- 378
Other current assets..................................... 558 670
-------- --------
Total current assets................................... 23,709 41,324
Due from officers/stockholders............................. -- 98
Equipment, furniture and fixtures, net..................... 2,565 4,319
Other assets............................................... 163 319
-------- --------
$ 26,437 $ 46,060
======== ========
LIABILITIES AND STOCKHOLDERS' EQUITY
------------------------------------
Current liabilities:
Trade accounts payable................................... $ 342 $ 849
Accrued salaries and benefits............................ 2,273 4,248
Other accrued liabilities................................ 2,944 3,220
Income taxes payable..................................... -- 450
Deferred revenue......................................... 2 179
Current portion of severance payable..................... 210 210
-------- --------
Total current liabilities.............................. 5,771 9,156
Deferred rent.............................................. 113 145
Severance payable.......................................... 193 403
Commitments and contingencies
Redeemable convertible preferred stock, $.001 par value.
Authorized 3,520 shares; issued and outstanding 2,182
shares at December 31, 1999, with a liquidation preference
of $12,308 at December 31, 1999, including accrued
dividends................................................. -- 11,382
Stockholders' equity:
Convertible preferred stock, $.001 par value. Authorized
3,520 shares; issued and outstanding 2,182 shares at
December 31, 2000, with a liquidation preference of
$13,057 at December 31, 2000, including accrued
dividends............................................... 2 --
Common stock, $.001 par value. Authorized 50,000 shares;
issued and outstanding 17,831 and 17,712 at December 31,
2000 and 1999, respectively............................. 18 18
Additional paid-in capital............................... 51,614 37,395
Deferred compensation.................................... -- (192)
Accumulated other comprehensive income................... (49) (43)
Retained deficit......................................... (31,225) (12,204)
-------- --------
Total stockholders' equity............................. 20,360 24,974
-------- --------
$ 26,437 $ 46,060
======== ========
See accompanying notes to consolidated financial statements.
F-2
DAOU SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF OPERATIONS
(In thousands, except for per share data)
Years Ended December 31,
----------------------------
2000 1999 1998
-------- -------- --------
Revenues........................................ $ 63,748 $103,400 $104,784
Cost of revenues................................ 52,781 75,927 78,021
-------- -------- --------
Gross profit.................................... 10,967 27,473 26,763
Operating expenses:
Sales and marketing........................... 5,744 10,398 12,203
General and administrative.................... 17,973 25,071 18,456
Restructuring charges......................... 2,133 -- --
Merger related expenses....................... -- -- 2,825
-------- -------- --------
25,850 35,469 33,484
-------- -------- --------
Loss from operations............................ (14,883) (7,996) (6,721)
Interest income, net............................ 699 779 163
-------- -------- --------
Loss before income taxes........................ (14,184) (7,217) (6,558)
Provision (benefit) for income taxes............ -- 1,761 (802)
-------- -------- --------
Net loss.................................... (14,184) (8,978) (5,756)
Accrued dividends on preferred stock............ (4,837) (308) --
-------- -------- --------
Net loss available to common stockholders... $(19,021) $ (9,286) $ (5,756)
======== ======== ========
Basic and diluted net loss available to common
stockholders per common share.................. $ (1.07) $ (0.52) $ (0.33)
======== ======== ========
Shares used in computing basic and diluted net
loss available to common stockholders per
common share................................... 17,712 17,697 17,657
======== ======== ========
See accompanying notes to consolidated financial statements.
F-3
DAOU SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF STOCKHOLDERS' EQUITY
For the Years Ended December 31, 2000, 1999 and 1998
(In thousands)
Convertible
Preferred Accumulated
Stock Common Stock Additional other Retained Total
------------- ------------- paid-in Deferred comprehensive earnings stockholders'
Shares Amount Shares Amount capital compensation income (deficit) equity
------ ------ ------ ------ ---------- ------------ ------------- --------- -------------
Balance at December 31,
1997.................... -- $ -- 16,945 $17 $36,040 $(907) $146 $ 6,541 $ 41,837
Shares issued in
connection with
formation of S
corporations............ -- -- 506 1 506 -- -- -- 507
Deferred compensation... -- -- -- -- 385 (385) -- -- --
Tax benefit from
exercise of
noncompensatory stock
options................. -- -- -- -- 630 -- -- -- 630
Amortization of deferred
compensation............ -- -- -- -- -- 312 -- -- 312
Distribution to Sentient
stockholders (Note 3)... -- -- -- -- -- -- -- (252) (252)
Distribution to TMI
stockholders (Note 3)... -- -- -- -- -- -- -- (2,945) (2,945)
Distribution to RHI
stockholders (Note 3)... -- -- -- -- -- -- -- (506) (506)
Issuance of common stock
upon exercise of stock
options................. -- -- 236 -- 844 -- -- -- 844
Issuance of common stock
upon exercise of
warrants................ -- -- 2 -- 14 -- -- -- 14
Comprehensive loss:
Unrealized gain on
short-term
investments............ -- -- -- -- -- -- 90 -- 90
Net loss............... -- -- -- -- -- -- -- (5,756) (5,756)
--------
Comprehensive loss...... (5,666)
----- ---- ------ --- ------- ----- ---- -------- --------
Balance at December 31,
1998.................... -- -- 17,689 18 38,419 (980) 236 (2,918) 34,775
----- ---- ------ --- ------- ----- ---- -------- --------
Issuance of common stock
upon exercise of stock
options................. -- -- 23 -- 95 -- -- -- 95
Amortization of deferred
compensation............ -- -- -- -- -- 299 -- -- 299
Reversal of deferred
compensation for
separated employees..... -- -- -- -- (489) 489 -- -- --
Accrued dividends on
preferred stock......... -- -- -- -- -- -- -- (308) (308)
Reversal of tax benefit
from exercise of
noncompensatory stock
options................. -- -- -- -- (630) -- -- -- (630)
Comprehensive loss:
Net realized gain on
investments............ -- -- -- -- -- -- (279) -- (279)
Net loss............... -- -- -- -- -- -- -- (8,978) (8,978)
--------
Comprehensive loss...... (9,257)
----- ---- ------ --- ------- ----- ---- -------- --------
Balance at December 31,
1999.................... -- -- 17,712 18 37,395 (192) (43) (12,204) 24,974
===== ==== ====== === ======= ===== ==== ======== ========
Issuance of common stock
upon exercise of stock
options................. -- -- 1 -- 1 -- -- -- 1
Issuance of common stock
under employee stock
purchase plan........... -- -- 118 -- 54 -- -- -- 54
Amortization of deferred
compensation............ -- -- -- -- -- 139 -- -- 139
Reversal of deferred
compensation for
separated employees..... -- -- -- -- (53) 53 -- -- --
Removal of redemption
feature on preferred
stock................... 2,182 2 -- -- 11,380 -- -- (2,000) 9,382
Warrants issued to
preferred stockholders.. -- -- -- -- 2,088 -- -- (2,088) --
Accrued dividends on
preferred stock......... -- -- -- -- 749 -- -- (749) --
Comprehensive loss:
Unrealized loss on
investments............ -- -- -- -- -- -- (6) -- (6)
Net loss............... -- -- -- -- -- -- -- (14,184) (14,184)
--------
Comprehensive loss...... (14,190)
----- ---- ------ --- ------- ----- ---- -------- --------
Balance at December 31,
2000.................... 2,182 $ 2 17,831 $18 $51,614 $ -- $(49) $(31,225) $ 20,360
===== ==== ====== === ======= ===== ==== ======== ========
See accompanying notes to consolidated financial statements.
F-4
DAOU SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
Years Ended December 31,
--------------------------
2000 1999 1998
-------- ------- -------
Operating activities
Net loss........................................... $(14,184) $(8,978) $(5,756)
Adjustments to reconcile net income (loss) to net
cash used in operating activities:
Depreciation and amortization.................... 2,388 2,077 1,715
Amortization of deferred compensation............ 139 299 312
Provision for uncollectible accounts............. 402 1,643 644
Deferred income taxes............................ -- 1,311 (1,378)
Gain on sale of investment....................... -- (546) --
Loss on retirement of fixed assets............... 273 88 --
Changes in operating assets and liabilities:
Accounts receivable............................ 9,610 1,027 (9,482)
Contract work in progress...................... 2,151 9,456 1,019
Other current assets and income taxes
receivable.................................... 490 258 458
Accounts payable, accrued liabilities and
income taxes payable.......................... (1,233) (3,397) 2,773
Accrued salaries and benefits.................. (1,975) 341 1,232
Deferred revenue............................... (177) (182) (8)
Severance payable.............................. (210) (210) (210)
Deferred rent.................................. (32) 100 (10)
-------- ------- -------
Net cash (used in) provided by operating
activities.................................. (2,358) 3,287 (8,691)
Investing activities
Purchase of equipment, furniture and fixtures...... (907) (1,450) (2,279)
Decrease (increase) in other assets................ 156 (10) 156
Purchases of investments........................... (20) -- (8)
Proceeds from sale and maturities of investments... -- 1,223 9,381
Payments from (advances to) officers/stockholders.. 98 73 200
-------- ------- -------
Net cash (used in) provided by investing
activities.................................. (673) (164) 7,450
Financing Activities
Proceeds from long-term debt and line of credit.... -- 358 5,483
Repayments of long-term debt and line of credit.... -- (5,926) (3,129)
Distributions to stockholders of acquired
companies......................................... -- -- (3,703)
Proceeds from issuance of common stock............. 55 95 1,365
Proceeds of redeemable convertible preferred
stock............................................. -- 11,074 --
Payment and issuance costs to remove redemption
feature of preferred stock........................ (2,000) -- --
-------- ------- -------
Net cash (used in) provided by financing
activities.................................. (1,945) 5,601 16
-------- ------- -------
(Decrease) increase in cash and cash equivalents... (4,976) 8,724 (1,225)
Cash and cash equivalents at beginning of year..... 15,480 6,756 7,981
-------- ------- -------
Cash and cash equivalents at end of year..... $ 10,504 $15,480 $ 6,756
======== ======= =======
Cash paid during the year for:
Income taxes..................................... $ -- $ 213 $ 144
======== ======= =======
Interest......................................... $ 11 $ 262 $ 290
======== ======= =======
F-5
DAOU SYSTEMS, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS
(In thousands)
Years Ended
December 31,
---------------------
2000 1999 1998
------- ----- -----
Supplemental disclosure of noncash investing and
financing activities:
Deferred tax benefit from exercise of noncompensatory
options............................................... $ -- $(630) $ 630
======= ===== =====
Accrued preferred stock dividends to redeemable
preferred stockholders................................ $ 749 $ 308 $ --
======= ===== =====
Issuance of warrants to remove redemption feature of
preferred stock....................................... $(2,088) $ -- $ --
======= ===== =====
Unrealized (loss) gain on investments.................. $ (6) $ 7 $ (42)
======= ===== =====
See accompanying notes to consolidated financial statements.
F-6
DAOU SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
1. ORGANIZATION AND SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES
Organization and Basis of Presentation
DAOU Systems, Inc. ("DAOU" or the "Company") a Delaware company, was
incorporated in July 1987. DAOU provides applications consulting and
implementation, traditional network services, remote help desk and related
technology support services, and integrates legacy systems with emerging
technologies, such as wireless and other portable computing solutions for the
U.S. healthcare industry. On February 6, 2001, DAOU Systems, Inc. announced
that it had consolidated its five subsidiary operating companies into two
operating divisions: Application Services and Technology Services. The
Application Services division combines the Company's IT Consulting and Managed
Care Implementation and Application Implementation groups. The Technology
Services division is the combination of the Company's Communication
Infrastructure, Integration Services, Outsourcing, and Internet and Electronic
Commerce (formerly known as Enosus).
In the year 2000, The Company's segments included, IT consulting and
managed care implementation services (IT Consulting), communications
infrastructure group, application implementation, integration services,
outsourcing and Internet services through Enosus. The IT consulting and
managed care implementation services group is focused on helping managed care
organizations meet their business and IT objectives. The Company's
communications infrastructure group focuses on the information superstructure
in healthcare enterprises, including networking, Intranet and Internet,
desktop, voice, video and data solutions. The Company's application
implementation group supplies IT staffing resources to hospitals and other
healthcare organizations. Integration services provide custom integration
solutions that allow organizations to share and access data housed across
multiple platforms and environments. The outsourcing group performs a full
range of IT outsourcing services, including co-source or outsourcing of call
centers, help desks, desktop support, server, network, voice management, and
complete IT outsourcing. Enosus provides Internet consulting services and
solutions to organizations executing an eBusiness strategy. The consolidated
financial statements reflect the combined financial position and operating
results for the Company. All intercompany accounts have been eliminated.
On December 31, 2000, the Company merged all of its subsidiaries into the
parent company, Daou Systems, Inc.
Revenue Recognition
The Company recognizes revenue in accordance with Staff Accounting Bulletin
("SAB") No. 101, REVENUE RECOGNITION IN FINANCIAL STATEMENTS. SAB 101 requires
that the following criteria are met in determining whether revenue has been
earned:
. Persuasive evidence of an arrangement,
. Services have been delivered,
. Price is fixed and determinable, and
. Collectibility is reasonably assured.
The Company has the following types of revenue recognition: 1) services
performed on a hourly basis, 2) services performed on a fixed fee basis and 3)
sales of material and maintenance contracts. In general, the Company enters
into contracts with customers to provide services at a specified fee or rate
per hour. Revenue from professional services is recognized primarily on a
hourly basis. Revenue from technical support and network management services
is recognized as the services are performed. Contract revenue for the
development and implementation of network solutions under fixed-fee contracts
is recognized using the percentage-of-
F-7
DAOU SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
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.
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 Customers
Substantially all of the Company's accounts receivable are from managed
care organizations, hospitals and other healthcare providers. Generally, the
Company obtains a significant deposit from its customers upon signing a fixed
fee contract and collateral is not required. The Company provides for losses
from uncollectible accounts and such losses have historically not exceeded
management's expectations. Services to DAOU's five largest customers accounted
for approximately $21.0 million of revenues for the year ended December 31,
2000, representing approximately 33% of total revenues. One of the top five
customers accounted for $10.1 million and $10.8 million of revenues for the
years ended December 31, 2000 and 1999, respectively, representing
approximately 16% and 10% of total revenues, respectively. This customer has
notified the Company of its intent to terminate the outsourcing agreement. The
Company is currently negotiating an extended transition period.
Cash, Cash Equivalents and Investments
Cash and cash equivalents consist of cash and highly liquid investments
with maturities of three months or less when purchased. The Company has
established guidelines relative to diversification and maturities that are
periodically reviewed and modified to take advantage of trends in yields and
interest rates. The Company historically has not experienced any material
losses on its cash equivalents or short-term investments.
The Company classifies its 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 comprehensive income 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.
Software development costs, consisting of internally developed software and
web site development costs, are accounted for using Statement of Position
("SOP") 98-1, ACCOUNTING FOR THE COSTS OF COMPUTER SOFTWARE DEVELOPED OR
OBTAINED FOR INTERNAL USE. In accordance with SOP 98-1, internal and external
costs incurred to develop internal use computer software during the
application development stage are capitalized. Application development stage
costs generally include software configuration, coding, installation to
hardware, and testing. Capitalized internal-use software development costs are
included in property and equipment and are amortized on a straight-line basis
over the estimated useful lives of the related software applications of up to
three years.
Advertising Expense
Advertising expenditures are charged to expense as incurred. The Company
expensed $145,000, $64,000 and $61,000 for the years ended December 31, 2000,
1999 and 1998, respectively.
F-8
DAOU SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
New Accounting Standards
In June 1998, the Financial Accounting Standards Board ("FASB") issued
Statement of Financial Accounting Standards No. 133 ("FAS 133"), ACCOUNTING
FOR DERIVATIVE INSTRUMENTS AND HEDGING ACTIVITIES. In May 1999, the FASB
delayed the effective date of FAS 133 by one year. The Company will be
required to adopt FAS 133 for fiscal year 2001. This statement establishes a
new model for accounting for derivatives and hedging activities. Under FAS
133, certain derivatives must be recognized as assets and liabilities and
measured at fair value. The Company is not currently engaged in derivative or
hedging activities.
In December 1999, the Securities and Exchange Commission ("SEC") issued
Staff Accounting Bulletin ("SAB") No. 101 , REVENUE RECOGNITION IN FINANCIAL
STATEMENTS. In June 2000, the SEC staff amended SAB 101 to provide registrants
with additional time to implement SAB 101. The Company adopted SAB 101 in the
fourth quarter of fiscal 2000. The adoption of SAB 101 did not have a material
effect on its consolidated financial position or results of operations.
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 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. In 2000, 1999 and
1998 diluted loss per share is unchanged from basic loss per share because the
effects of the assumed conversion of stock options and warrants would be
antidilutive.
The following table sets forth the computation of the shares used in the
basic and diluted net loss per share and calculation thereof (in thousands,
except per share information):
2000 1999 1998
-------- ------- -------
Numerator:
Net loss available to common shareholders.... $(19,021) $(9,286) $(5,756)
Denominator:
Shares used in basic net loss per share--
weighted average common shares outstanding.. 17,712 17,697 17,657
Net effect of dilutive common share
equivalents based on treasury stock method.. -- -- --
-------- ------- -------
Denominator for diluted net loss per share--
adjusted weighted average common shares
outstanding................................. 17,712 17,697 17,657
======== ======= =======
Basic loss per share....................... $ (1.07) $ (.52) $ (.33)
======== ======= =======
Diluted loss per share..................... $ (1.07) $ (.52) $ (.33)
======== ======= =======
F-9
Stock-Based Compensation
The Company has elected to follow Accounting Principles Board Opinion No.
25, ACCOUNTING FOR STOCK ISSUED TO EMPLOYEES ("APB 25"), and related
interpretations in accounting for its employee and director stock options
because the alternative fair value accounting provided for under SFAS No. 123,
ACCOUNTING FOR STOCK-BASED COMPENSATION ("SFAS 123"), requires the use of
option valuation models that were not developed for use in valuing employee
and director stock options. Under SFAS 123, compensation cost is determined
using the fair value of stock-based compensation determined as of the grant
date, and is recognized over the periods in which the related services are
rendered. If companies elect to continue using the current implicit value
accounting method specified in APB 25 to account for stock-based compensation,
they must disclose in the notes to the financial statements the pro forma
effect of using the fair value method for its stock-based compensation.
Compensation charges for options granted to non-employees have been
determined in accordance with SFAS No. 123 and EITF 96-18 as the fair value of
the consideration received or the fair value of equity instruments issued,
whichever is more reliably measured. Charges for options granted to non-
employees are periodically remeasured as the underlying options vest.
In March 2000, the Financial Accounting Standards Board ("FASB"), released
FASB Interpretation No. 44 ("FIN 44"), ACCOUNTING FOR CERTAIN TRANSACTIONS
INVOLVING STOCK COMPENSATION AND INTERPRETATION OF APB OPINION NO. 25. FIN 44
provides clarification of APB Opinion 25 for certain issues such as the
determination of who is an employee, the criteria for determining whether a
plan qualifies as a non-compensatory plan, the accounting consequence of
various modifications to the terms of a previously fixed stock option or
award, and the accounting for an exchange of stock compensation awards in a
business combination. The Company believes that its practices are in
conformity with this guidance, and therefore, FIN 44 had no impact on its
financial statements.
2. RESTRUCTURING CHARGES AND FOURTH QUARTER ADJUSTMENTS
In connections with the Restructuring Plan, the Company has undertaken
various actions to reduce the cost structure of the Company. As a result, the
Company has recorded restructuring charges in the second and the fourth
quarters of 2000 totaling approximately $2.1 million. Such charges were
determined in accordance with SEC SAB No. 100, RESTRUCTURING AND IMPAIRMENT
CHARGES, and Emerging Issues Task Force No. 94-3, LIABILITY RECOGNITION FOR
CERTAIN EMPLOYEE TERMINATION BENEFITS AND OTHER COSTS TO EXIT AN ACTIVITY
(INCLUDING CERTAIN COST INCURRED IN A RESTRUCTURING). These charges include
severance costs related to a reduction in workforce of approximately 50
employees and the closure of certain facilities.
The following table summarizes the restructuring and other related charges
recorded in 2000, of which $1,306,000 are included in accrued liabilities at
December 31, 2000.
Severance costs for involuntary employee terminations.......... $1,140,000
Costs related to closure and combination of facilities......... 993,000
----------
$2,133,000
==========
During the fourth quarter of 1999 the Company recorded reserves and related
charges totaling $4 million directly related to its previously closed down On-
Line business and also based on a critical review of its receivables. During
1999, in addition to the closedown of On-Line, the Company reduced headcount,
experienced turnover in key positions and restructured its organization.
During 1999, the Company's net loss resulted in the Company being in a
cumulative loss position over the previous three years. In accordance with
generally accepted accounting principles, the realization of the Company's net
deferred tax assets is not assured beyond a reasonable doubt. Accordingly,
during 1999 a revaluation allowance of $3.5 million was also recorded to fully
reserve cumulative deferred tax assets recorded.
F-10
DAOU SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
3. INVESTMENTS, AVAILABLE-FOR-SALE
Short-term investments, available-for-sale, consist of the following (in
thousands):
Gross Gross
Amortized Unrealized Unrealized Estimated Fair
Cost Gains Losses Value
--------- ---------- ---------- --------------
DECEMBER 31, 2000
Government debt
securities............... $131 $ -- $(49) $ 82
==== ===== ==== ======
DECEMBER 31, 1999
Government debt
securities............... $111 $ -- $(43) $ 68
==== ===== ==== ======
DECEMBER 31, 1998
Mutual Funds.............. $788 $ 286 $(50) $1,024
==== ===== ==== ======
The government debt securities mature in 2008.
4. SELECTED BALANCE SHEET DETAILS
Contract work in progress consists of the following (in thousands):
December
31,
-----------
2000 1999
---- ------
Unbilled accounts receivable.................................. $354 $2,474
Other......................................................... 311 342
---- ------
$665 $2,816
==== ======
Equipment, furniture and fixtures consist of the following (in thousands):
December 31,
----------------
2000 1999
------- -------
Equipment and furniture.................................. $ 6,108 $ 9,575
Leasehold improvements................................... 578 664
------- -------
6,686 10,239
Less accumulated depreciation and amortization........... (4,121) (5,920)
------- -------
$ 2,565 $ 4,319
======= =======
Other accrued liabilities consist of the following (in thousands):
December 31,
-------------
2000 1999
------ ------
Accrued contract costs...................................... $ 778 $ 740
Other accrued liabilities................................... 2,166 2,480
------ ------
$2,944 $3,220
====== ======
F-11
DAOU SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
5. LINES OF CREDIT
On June 29, 1999, the Company secured an $8.0 million revolving line of
credit, which expires June 29, 2001. The line of credit bears interest at
prime plus 1% per annum and is secured by substantially all of the assets of
the Company and contains customary covenants and restrictions. There are no
compensating balance requirements and borrowings under the line of credit are
limited to 80% of qualifying receivables. No amounts were outstanding under
this revolving line of credit as of December 31, 2000 and 1999. Interest
expense for the years ended December 31, 2000, 1999 and 1998 was approximately
$0, $253,000 and $216,000, respectively.
6. COMMITMENTS
Lease Commitments
The Company leases its facilities and certain equipment under operating
lease agreements. The facility leases provide for abatement of rent during
certain periods and escalating rent payments during the lease term. Rent
expense for 2000, 1999 and 1998 totaled $2,144,000, $2,213,000 and $1,665,000,
respectively.
Annual future minimum lease payments under noncancelable operating leases
with initial terms of one year or more at December 31, 2000, consist of the
following (in thousands):
2001.............................................................. $2,248
2002.............................................................. 2,149
2003.............................................................. 2,074
2004.............................................................. 1,524
2005.............................................................. 853
Thereafter........................................................ --
------
$8,848
======
Severance Payable
In connection with the retirement of a founder of one of the Company's
acquired businesses, the founder received a severance agreement whereby the
retiring founder will receive 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, 2000 and 1999, the Company had an
outstanding payable of $402,500 and $612,500, respectively. The aggregate
minimum future payments under the severance agreements as of December 31, 2000
are $210,000 and $192,500 for the years ending December 31, 2001 and 2002,
respectively.
Related Party Transactions
The Company had an agreement with a former officer that guaranteed a cash
bonus for the amount of any difference between (i) the net value at November
11, 1999 of the options granted to the officer during 1996 and (ii)
$1,550,000. The Company paid the officer, who is no longer an employee,
$827,000 in November of 1999.
In 2000 and 1999 the Company provided implementation services to a company
in which the Chairman of the Board is an investor. Revenues, costs, and gross
profit related to these contracts were not material in 2000. In 1999,
revenues, costs and gross profit totaled $1,567,000, $1,377,000 and $190,000,
respectively. The company has $0 and $840,000 in accounts receivable
outstanding at December 31, 2000 and 1999, respectively, related to the
implementation services provided.
F-12
DAOU SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
7. STOCKHOLDERS' EQUITY
Redeemable Convertible Preferred Stock
On July 26, 1999, 2,181,818 shares of Series A Preferred Stock were issued
at $5.50 per share to a related party. Holders of the Series A Preferred Stock
are entitled to receive cumulative dividends at the rate of six percent per
annum, payable in the form of shares of Series A Preferred Stock. Such
dividend rate shall increase an additional one-percent per annum for each
successive year after the second anniversary of the purchase date. At December
31, 2000, the Company had accumulated but unpaid dividends of $1,057,000. The
Series A Preferred Stock has a liquidation preference of $5.50 per share plus
any accrued (whether or not declared) but unpaid dividends and is convertible,
at the option of the holder, into 2,181,818 shares of common stock, subject to
certain antidilution adjustments. The Series A Preferred Stock is redeemable
at the option of the Company four years after the date of issuance.
The Series A Preferred Stock is subject to mandatory conversion in the
event the Company's common stock price reaches certain predetermined price
targets. The offering resulted in net proceeds of approximately $11.1 million
after expenses incurred by the Company in connection with the Offering of
approximately $926,000 (which include commissions and other expenses including
registration and filing fees, printing, accounting and legal expenses).
On November 9, 2000, as a consequence of the resignation of Larry Grandia,
holders of the Series A Preferred Stock had the right to cause the Company to
redeem their Series A Preferred Stock for approximately $12.9 million. The
holders of the Series A Preferred Stock and the Company entered into an
agreement whereby the holders of the Series A Preferred Stock have 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. The total consideration of this transaction was valued at
approximately $4.1 million and for financial reporting purposes was recorded
as a one-time dividend in the fourth quarter of 2000. 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.
The Company registered 2,750,000 shares of Common Stock for issuance upon
conversion of 2,181,818 shares of Series A Preferred Stock on the Registration
Statement on Form S-3 (File No. 33-87103), as declared effective by the
Commission on October 25, 1999.
Employee Stock Purchase Plan
In May 2000, the Company adopted the Daou Systems, Inc. Employee Stock
Purchase Plan ("ESPP"), under which 1,500,000 shares of the Company's common
stock are reserved for issuance. Under the ESPP, eligible employees are
allowed to purchase 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 December 31, 2000,
the Company recorded the issuance of 118,266 shares of common stock under the
ESPP at $0.45 per share.
Stock Option Plans
During 1996, the Company adopted the 1996 Stock Option Plan (the "Plan"),
under which 5,000,000, as amended, shares of the Company's common stock are
reserved for issuance upon exercise of options granted by the Company. 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.
F-13
DAOU SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The following summary of the Company's stock option activity and related
information includes 140,300 non-qualified stock options at an exercise price
of $4.28 per share, 550,000 stock options at an exercise price ranging from
$4.31 to $5.50 per share, and 750,000 stock options at an exercise price of
$0.50 granted outside the plan in 1996, 1999 and 2000, respectively:
2000 1999 1998
--------------------- -------------------- --------------------
Weighted- Weighted- Weighted-
Average Average Average
Exercise Exercise Exercise
Options Price Options Price Options Price
---------- --------- --------- --------- --------- ---------
Outstanding--beginning
of year................ 3,366,186 $7.94 3,226,794 $10.44 1,540,399 $ 7.49
Granted............... 2,083,700 1.21 1,091,500 4.94 2,699,045 13.22
Exercised............. (400) 3.25 (22,240) 4.28 (235,637) 6.16
Forfeited............. (1,608,373) 7.21 (929,868) 13.21 (777,013) 16.29
---------- ----- --------- ------ --------- ------
Outstanding--end of
year............... 3,841,113 $4.59 3,366,186 $ 7.94 3,226,794 $10.44
========== ===== ========= ====== ========= ======
Exercisable at end of
year................... 1,148,033 $8.70 985,534 $ 8.58 266,526 $13.35
========== ===== ========= ====== ========= ======
Weighted-average fair
value of options
granted during the
year................... $0.50 $ 3.30 $ 6.79
===== ====== ======
The following table summarizes information about stock options outstanding
at December 31, 2000:
Outstanding Exercisable
--------------------------------- ---------------------
Weighted-
Average Weighted- Weighted-
Remaining Average Average
Number Contractual Exercise Number Exercise
Range of Exercise Prices Outstanding Life Price Exercisable Price
- ------------------------ ----------- ----------- --------- ----------- ---------
$ 0.00-$ 2.74.......... 1,727,700 9.9 $ 0.56 -- $ 0.00
$ 2.75-$ 5.49.......... 1,407,747 7.1 $ 4.72 674,710 $ 4.69
$ 5.50-$ 8.24.......... 156,442 4.0 $ 6.02 115,639 $ 6.01
$ 8.25-$10.99.......... 72,602 5.9 $10.16 58,344 $10.12
$11.00-$13.74.......... 260,200 6.5 $13.61 133,333 $13.61
$13.75-$16.49.......... 24,400 5.5 $16.02 13,600 $16.01
$16.50-$19.24.......... 26,600 1.7 $16.95 23,800 $16.99
$19.25-$21.99.......... 50,155 5.1 $21.75 28,540 $21.75
$22.00-$24.74.......... 24,400 2.3 $24.25 21,200 $24.25
$24.75-$27.50.......... 90,867 4.9 $25.01 78,867 $25.00
--------- --- ------ --------- ------
3,841,113 8.0 $ 4.59 1,148,033 $ 8.70
========= === ====== ========= ======
At December 31, 2000, options for 1,306,875 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 2000, 1999 and 1998: risk-
F-14
DAOU SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
free interest rate of 6% for all years; dividend yield of 0% for all years;
volatility factors of the expected market price of the Company's common stock
of 138% for all years; and a weighted-average expected life of the options of
five years for all years.
The Black-Scholes option valuation model was developed for use in
estimating the fair value of traded options, which have no vesting
restrictions and are fully transferable. In addition, option valuation models
require the input of highly subjective assumptions including the expected
stock price volatility. Because the Company's employee stock options have
characteristics significantly different from those of traded options, and
because changes in the subjective input assumptions can materially affect the
fair value estimate, in management's opinion, the existing models do not
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,
----------------------------
2000 1999 1998
-------- -------- --------
Adjusted pro forma net income (loss)....... $(18,476) $(19,294) $(16,380)
======== ======== ========
Adjusted pro forma net income (loss) per
share:
Basic.................................... $ (1.04) $ (1.09) $ (0.93)
======== ======== ========
Diluted.................................. $ (1.04) $ (1.09) $ (0.93)
======== ======== ========
Common Stock Reserved
At December 31, 2000, the Company had the following shares reserved for
future issuance:
Redeemable convertible preferred stock.......................... 2,750,000
Warrants........................................................ 3,540,000
Stock option plan............................................... 5,144,696
Employee stock purchase plan.................................... 1,381,734
----------
Total......................................................... 12,816,430
==========
8.INCOME TAXES
The provision for income taxes consists of the following (in thousands):
Years Ended
December 31,
-------------------
Current:
Federal............................................. $ -- $ -- $ --
State............................................... -- 450 576
---- ------ -------
-- 450 576
Deferred:
Federal............................................. -- 1,119 (1,205)
State............................................... -- 192 (173)
---- ------ -------
-- 1,311 (1,378)
---- ------ -------
$ -- $1,761 $ (802)
==== ====== =======
Deferred income taxes are provided for temporary differences in recognizing
certain income and expense items for financial and tax reporting purposes.
F-15
DAOU SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Significant components of the Company's deferred tax assets and liabilities
are shown below (in thousands):
2000 1999
------- -------
Deferred tax liabilities:
Accounting method change for tax purposes.............. $ 575 $ 1,322
Depreciation and amortization.......................... -- 229
------- -------
575 1,551
Deferred tax assets:
Reserves and allowances................................ 1,451 945
Depreciation........................................... 270 --
Net operating losses................................... 6,091 3,594
------- -------
7,812 4,539
Net deferred tax asset before valuation allowance........ 7,237 (2,988)
------- -------
Valuation allowance for deferred tax assets.............. (7,237) 2,988
------- -------
Net deferred tax asset................................... $ -- $ --
======= =======
At December 31, 2000, the Company has federal and state net operating loss
carryforwards of approximately $16.1 million and $7.6 million, respectively.
The federal and state loss carryforwards will begin to expire in 2019 and
2002, respectively, unless previously utilized.
Under sections 382 and 383 of the Internal Revenue Code, the annual use of
the Company's net operating loss carryforwards may be limited in the event of
a cumulative change in ownership of more that 50%. However, the Company does
not believe such a limitation will have a material impact on the ultimate
utilization of these carryforwards.
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,
---------------------
2000 1999 1998
----- ----- -----
Tax at federal statutory rate.................... (35.0)% (35.0)% (35.0)%
S corporation income not subject to corporate
income taxes.................................... -- -- (18.1)
Nondeductible expenses........................... 0.4 -- 10.6
Adjustment on conversion of S corporation to C
corporation..................................... -- -- 27.6
State taxes, net of federal benefit.............. (2.6) 9.3 1.9
Valuation allowance.............................. 30.0 81.9 --
Other............................................ 7.2 -- 1.0
----- ----- -----
0.0 % 56.2 % (12.0)%
===== ===== =====
9.BENEFIT PLANS
Effective November 1, 1999, the Company initiated a new DAOU Systems, Inc.
401(k) Salary Savings Plan (New 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. This new Plan replaces the former DAOU Systems, Inc. 401(k)
Salary Savings Plan. The Company has various other defined contribution plans
under which employees also participated. Contributions under these plans are
made at the sole discretion of the Company and were $832,000, $428,000 and
$471,000 for 2000, 1999 and 1998, respectively.
F-16
DAOU SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
10. CONTINGENCIES
On August 24, 1998, August 31, 1998, September 14, 1998 and September 23,
1998, separate complaints were filed against the Company and certain of its
officers and directors in the United States District Court for the Southern
District of California. A group of shareholders has been appointed the lead
plaintiffs and they filed 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. 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 heard on February 20, 2001 and the court
took the matter under submission. The Company believes that the allegations
set forth in all of the foregoing complaints are without merit and intends to
defend against these allegations vigorously. No assurance as to the outcome of
this matter can be given, however, and an unfavorable resolution of this
matter could have a material adverse effect on the Company's business, results
of operations or financial condition.
The Company is party to various claims and legal actions arising in the
normal course of business. Although the ultimate outcome of these 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 in any period.
11. DISCLOSURE OF SEGMENT INFORMATION
DAOU Systems, Inc. provides applications consulting and implementation,
traditional network services, remote help desk and related technology support
services, and integrates legacy systems with emerging technologies, such as
wireless and other portable computing solutions for the U.S. healthcare
industry. On February 6, 2001, DAOU Systems, Inc. announced that it had
consolidated its five subsidiary operating companies into two operating
divisions: Application Services and Technology Services. The Application
Services division combines the Company's IT Consulting and Managed Care
Implementation and Application Implementation groups. The Technology Services
division is the combination of the Company's Communication Infrastructure,
Integration Services, Outsourcing, and Internet and Electronic Commerce
(formerly known as Enosus formed in February 2000). Prior to the consolidation
in 2001, the Company operated each of the divisions as a separate segment.
The Application Services division provides clients with strategic
consulting (eHealth, mHealth, HIPAA, and application selection), software
implementation, project management, and support services, including staff
augmentation. Additionally, this division assists clients by recruiting
strategic skill sets for their critical long term needs. The Technology
Services division provides clients with solutions in key areas, including
network infrastructure (servers, data and voice networks, and security), web
development and integration projects, help desk solutions (remote or on-site)
and network management.
F-17
DAOU SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
The Company's service offerings are segmented into the following operating
divisions and service lines:
Application Services
. IT consulting and managed care implementation--installs and integrates
managed care applications, and manages IT systems, and develops business
plans and solves problems for managed care organizations.
. Application implementation--supplies hospitals and other healthcare
organizations with temporary, certified consultants who are capable of
installing and servicing approximately 90% of the most common healthcare
software applications.
Technology Services
. Communications infrastructure--focuses on the IT infrastructure in
healthcare enterprises, primarily IDNs, hospitals, academic medical
centers and medical groups, provides networking, voice, video and data
solutions and desktop services.
. Integration services--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.
. Outsourcing--performs a full range of IT outsourcing services including
co-source or outsource of call centers, help desks, desktop support,
server management, network management, voice management and complete IT
department outsourcing.
. Internet and electronic commerce--provides Internet professional
services and solutions to healthcare organizations executing an
eBusiness strategy.
The accounting policies used to develop segment information correspond to
those described in the summary of significant accounting policies. The Company
manages segment reporting at a gross margin level. Selling, general and
administrative expenses, and fixed assets are managed at the corporate level
separately from the segments and, therefore, are not separately allocated to
the segments. The Company's segments are managed on an integrated basis in
order to serve clients by assembling multi-disciplinary teams, which provide
comprehensive services across its principal services.
F-18
DAOU SYSTEMS, INC.
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS--(Continued)
Application Services Division Technology Service Division
----------------------------- -------------------------------------------------
IT Consulting Application Internet
and Managed Development and
Care Application and Communication Electronic
Implementation Implementation Integration Infrastructure Outsourcing Commerce Total
-------------- -------------- ----------- -------------- ----------- ---------- --------
2000
Total revenues.......... $ 8,318 $13,851 $10,074 $10,397 $20,438 $ 670 $ 63,748
Cost of services........ 6,446 11,189 6,999 9,382 17,377 1,388 52,781
------- ------- ------- ------- ------- ----- --------
Gross profit........... $ 1,872 $ 2,662 $ 3,075 $ 1,015 $ 3,061 $(718) 10,967
======= ======= ======= ======= ======= =====
Gross profit percent.... 23% 19% 31% 10 % 15% (107)%
Sales and marketing..... 5,744
General and
administrative......... 17,973
Restructuring charges... 2,133
--------
Loss from operations.... $(14,883)
--------
1999
Total revenues.......... $11,353 $30,938 $14,166 $23,493 $23,450 $ -- $103,400
Cost of services........ 6,713 17,135 8,831 24,854 18,394 -- 75,927
------- ------- ------- ------- ------- ----- --------
Gross profit........... $ 4,640 $13,803 $ 5,335 $(1,361) $ 5,056 $ -- 27,473
======= ======= ======= ======= ======= ===== ========
Gross profit percent.... 41% 45% 38% (6)% 22% 0 %
Sales and marketing..... 10,398
General and
administrative......... 25,071
--------
Loss from operations.... $ (7,996)
--------
1998
Total revenues.......... $11,161 $20,612 $12,897 $44,248 $15,866 $ -- $104,784
Cost of services........ 6,880 11,500 7,328 39,415 12,898 -- 78,021
------- ------- ------- ------- ------- ----- --------
Gross profit........... $ 4,281 $ 9,112 $ 5,569 $ 4,833 $ 2,968 $ -- 26,763
======= ======= ======= ======= ======= =====
Gross profit percent.... 38% 44% 43% 11 % 19% 0 %
Sales and marketing..... 12,203
General and
administrative......... 18,456
Merger related
expenses............... 2,825
--------
Income from operations.. $ (6,721)
========
12. QUARTERLY FINANCIAL DATA (Unaudited)
Quarter Ended
----------------------------------------------
March 31, June 30, September 30, December 31,
--------- -------- ------------- ------------
2000
Net revenue.................... $17,575 $16,127 $15,341 $14,705
Gross margin................... 1,619 3,082 2,082 4,184
Net loss available to common
stockholders.................. (4,650) (3,595) (4,104) (6,672)
Basic and diluted net loss
available to common
stockholders per common
share....................... $ (0.26) $ (0.20) $ (0.23) $ (0.38)
1999
Net revenue.................... $27,323 $27,051 $25,382 $23,644
Gross margin................... 5,503 7,934 7,681 6,355
Net income (loss) available to
common stockholders........... (1,668) 60 625 (8,303)
Basic and diluted net income
(loss) available to common
stock-holders per common
share....................... $ (0.09) $ 0.00 $ 0.04 $ (0.47)
F-19
SCHEDULE II--VALUATION AND QUALIFYING ACCOUNTS
Col. A Col. B Col. C Col. D Col. E
------ ---------- --------------------- ---------- ----------
Additions
---------------------
Charged to
Balance at Charged to Other Balance at
Beginning Costs and Accounts-- End of
Description of Period Expenses Describe Write-offs Period
----------- ---------- ---------- ---------- ---------- ----------
Year Ended December 31,
2000:
Allowance for doubtful
accounts............. $1,868 $ 402 $ -- $1,132 $1,138
Year Ended December 31,
1999:
Allowance for doubtful
accounts............. $ 956 $1,643 $ -- $ 731 $1,868
Year Ended December 31,
1998:
Allowance for doubtful
accounts............. $ 312 $ 644 $ -- $ -- $ 956
29
Item 9: Changes in and Disagreements With Accountants on Accounting and
Financial Disclosure.
None.
Part III
Item 10: Directors, Executive Officers, Promoters and Control Persons;
Compliance with Section 16(a) of the Exchange Act.
The information required by this item will be included under the captions
entitled "Elections of Directors" and "Information Concerning Directors and
Executive Officers" in the Company's Proxy Statement and is incorporated
herein by reference.
Item 11: Executive Compensation.
The information required by this item will be included under the caption
entitled "Executive Compensation" in the Company's Proxy Statement and is
incorporated herein by reference.
Item 12: Security Ownership of Certain Beneficial Owners and Management
The information required by this item will be included under the caption
entitled "Security Ownership of Certain Beneficial Owners and Management" in
the Company's Proxy Statement and is incorporated herein by reference.
Item 13: Certain Relationships and Related Transactions
The information required by this item will be included under the caption
entitled "Certain Relationships and Related Transactions " in the Company's
Proxy Statement and is incorporated herein by reference.
30
PART IV
Item 14: Exhibits, Financial Statement Schedules, and reports on Form 8-K
(a) The following are filed as part of this Report.
(1) Consolidated balance sheets of the Registrant as of December 31,
2000 and 1999 and the related consolidated statements of
operations, stockholders' equity, and cash flows for each of the
three years in the period ended December 31, 2000.
(2) Schedule II--Valuation and Qualifying Accounts.
(b) Reports on Form 8-K.
(1) Current reports on Form 8-K, filed on October 2, 2000, reporting
press release of new Chief Financial Officer and retention of
strategic consulting firm.
(c) Exhibits.
Exhibit
Number Description
------- -----------
2.1 Agreement and Plan of Merger by and between the Registrant and each
of its former subsidiaries, dated December 31, 2000
3.1(1) Amended and Restated Certificate of Incorporation of the
Registrant.
3.2(1) Bylaws of the Registrant.
4.1 Reference is made to Exhibits 3.1 and 3.2.
4.2(1) Specimen stock certificate.
4.3(4) Certificate of Designations of the Registrant, as filed with the
Secretary of State of the State of Delaware on July 23, 1999.
4.4(4) Registration Rights Agreement, dated as of July 26, 1999, by and
between the Registrant, Galen Partners III, L.P., a Delaware
limited partnership ("Galen III"), Galen Partners
International III, L.P., a Delaware limited partnership ("Galen
International"), and Galen Employee Fund III, L.P., a Delaware
limited partnership ("Galen Employee Fund").
4.5(5) Registration Rights Agreement, dated as of November 9, 2000, by and
between the Registrant, Galen Partners III, L.P., a Delaware
limited partnership ("Galen III"), Galen Partners International
III, L.P., a Delaware limited partnership ("Galen International"),
and Galen Employee Fund III, L.P., a Delaware limited partnership
("Galen Employee Fund").
4.7(5) Form of Warrant
10.1(1) Form of Indemnification Agreement.
10.2(#)(1) DAOU Systems, Inc. 1996 Stock Option Plan, as amended.
10.3(#)(1) Form of Incentive Stock Option Agreement under the 1996 Stock
Option Plan.
10.4(#)(1) Form of Nonstatutory Stock Option Agreement under the 1996 Stock
Option Plan.
10.6(1) Sublease Agreement, dated as of March 1, 1996, by and between the
Registrant and Adobe Systems Incorporated.
10.7(+)(1) Information Management Agreement, dated as of April 1, 1996, by and
between the Registrant and Candler Health System.
10.8(+)(1) Principal Agreement, dated as of June 18, 1996, by and between the
Registrant and Catholic Medical Center of Brooklyn & Queens, Inc.
10.9(+)(1) Principal Agreement, dated as of June 29, 1995, by and between the
Registrant and Mercy Health Services.
31
Exhibit
Number Description
------- -----------
10.10(+)(1) Master Agreement, dated as of June 4, 1996, by and between the
Registrant and Atlantic Health System.
10.11(1) Form of Master Services Agreement.
10.12(*)(2) Information Management Agreement, dated as of January 1, 1999, by
and between the Registrant and Saint Mary's Health Network.
10.15(3) Loan and Security Agreement, dated as of June 29, 1999, by and
among the Registrant, DAOU-Sentient, Inc., DAOU-RHI, Inc., DAOU-
TMI, Inc., DAOU-Synexus, Inc. and HCFP Funding, Inc.
10.16(3) Revolving Credit Note, dated as of June 29, 1999, issued to HCFP
Funding, Inc. by the Registrant, DAOU-Sentient, Inc., DAOU-RHI,
Inc., DAOU-TMI, Inc. and DAOU-Synexus, Inc.
10.17(4) Voting Agreement, dated as of July 26, 1999, by and among the
Registrant, Daniel J. Daou, Georges J. Daou, Galen III, Galen
International and Galen Employee Fund.
10.18(4) Series A Preferred Stock Purchase Agreement, dated as of July 26,
1999, by and among the Registrant, Galen III, Galen International
and Galen Employee Fund.
10.19(5) Investment Agreement, dated November 9, 2000, by and among the
Registrant, Galen III, Galen International and Galen Employee
Fund.
10.20(5) Separation and General Release, dated November 11, 2000 by and
between the Registrant and Larry D. Grandia.
10.21(6) Daou Systems, Inc., Employee Stock Purchase Plan.
10.22 Employment Agreement dated November 9, 2000, by and between the
Registrant and James T. Roberto.
23.1 Consent of Ernst & Young LLP, independent auditors.
24 Power of Attorney (included on the signature page to this report).
- --------
(+) Confidential treatment has been granted with respect to certain portions
of this exhibit.
(*) Confidential treatment has been requested with respect to certain portions
of this exhibit.
(#) Identifies a management contract or compensatory plan or arrangement of
the Registrant.
(1) Incorporated by reference to the similarly described exhibit included with
the Registrant's Registration Statement on Form SB-2, File No. 333-18155,
declared effective by the Commission on February 12, 1997.
(2) Incorporated by reference to the similarly described exhibit included with
the Registrant's Current Report on Form 8-K, filed with the Commission on
January 15, 1999.
(3) Incorporated by reference to the similarly described exhibit included with
the Registrant's Quarterly Report on Form 10-Q for the quarter ended June
30, 1999, filed with the Commission on August 16, 1999.
(4) Incorporated by reference to the similarly described exhibit included with
the Registrant's Current Report on Form 8-K, filed with the Commission on
July 29, 1999.
(5) Incorporated by reference to the similarly described exhibit included with
the Registrant's Quarterly Report on Form 10-Q for the quarter ended
September 30, 2000, filed with the Commission on November 15, 2000.
(6) Incorporated by reference to the similarly described exhibit included with
the Registrant's Registration Statement on Form S-8, File No. 333-52704.
32
SIGNATURES
Pursuant to the requirements of Section 13 or 15(d) of the Securities
Exchange Act of 1934, the Registrant has duly caused this report to be signed
on its behalf by the undersigned, thereunto duly authorized.
Date: March 28, 2001
DAOU SYSTEMS, INC.
/s/ James T. Roberto
By: _________________________________
James T. Roberto
Chief Executive Officer
POWER OF ATTORNEY
KNOW ALL MEN BY THESE PRESENTS, that each person whose signature appears
below constitutes and appoints James T. Roberto and Neil R. Cassidy, jointly
and severally, as his or her attorney-in-fact, each with the power of
substitution, for him or her in any and all capacities, to sign any amendments
to this report and to file the same, with exhibits thereto and other documents
in connection therewith, with the Commission, hereby ratifying and confirming
all that each of said attorneys-in-fact, or his substitute or substitutes, may
do or cause to be done by virtue hereof.
Pursuant to the requirements of the Securities Exchange Act of 1934, this
report has been signed below by the following persons on behalf of the
Registrant and in the capacities and on the dates indicated.
Signature Title Date
--------- ----- ----
/s/ Georges J. Daou Chairman of the Board March 28, 2001
____________________________________
Georges J. Daou
/s/ James T. Roberto President and Chief March 28, 2001
____________________________________ Executive Officer and
James T. Roberto Director
(Principal Executive
Officer)
/s/ Neil R. Cassidy Executive Vice President, March 28, 2001
____________________________________ Chief Financial Officer and
Neil R. Cassidy Secretary (Principal
Financial and Accounting
Officer)
/s/ David W. Jahns Director March 28, 2001
____________________________________
David W. Jahns
/s/ Kevin M. Fickenscher, M.D. Director March 28, 2001
____________________________________
Kevin M. Fickenscher, M.D.
/s/ Larry D. Grandia Director March 28, 2001
____________________________________
Larry D. Grandia
33