UNITED STATES SECURITIES AND EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q /X/ QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2000 OR / / TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934 For the transition period from ______________ to _______________, Commission File No.: 000-22073 DAOU SYSTEMS, INC. (Exact name of registrant as specified in its charter) Delaware 33-0284454 (State or other jurisdiction of (I.R.S. Employer Identification No.) incorporation or organization) 5120 Shoreham Place San Diego, California 92122 (Address of principal executive offices) (Zip Code) (858) 452-2221 (Registrant's telephone number, including area code) Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days: Yes X No --- --- The number of shares of Registrant's Common Stock, par value $.001 per share, outstanding as of August 11, 2000: 17,712,768 DAOU SYSTEMS, INC. Index to Form 10-Q PART I. FINANCIAL INFORMATION Page ---------- Item 1. Condensed Consolidated Financial Statements Condensed Consolidated Balance Sheets at June 30, 2000 (unaudited) and December 31, 1999 2 Condensed Consolidated Statements of Operations (unaudited) for the Three Months and Six Months Ended June 30, 2000 and 1999 3 Condensed Consolidated Statements of Cash Flows (unaudited) for the Six Months Ended June 30, 2000 and 1999 4 Notes to Condensed Consolidated Financial Statements 5 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 10 Item 3. Quantitative and Qualitative Disclosure about Market Risk 14 PART II. OTHER INFORMATION Item 1. Legal Proceedings 15 Item 4. Submission of Matters to a Vote of Security Holders 15 Item 6. Exhibits and Reports on Form 8-K 16 SIGNATURES 17 PART I. FINANCIAL INFORMATION Item 1. Condensed Consolidated Financial Statements DAOU Systems, Inc. Condensed Consolidated Balance Sheets (IN THOUSANDS, EXCEPT FOR PER SHARE DATA) JUNE 30, DECEMBER 31, 2000 1999 (UNAUDITED) ------------------------------------ ASSETS Current assets: Cash and cash equivalents $ 12,822 $ 15,480 Short-term investments, available-for-sale 64 68 Accounts receivable, net of allowance for doubtful accounts of $1,771 and $1,868 at June 30, 2000 and December 31, 1999, respectively 14,692 21,912 Contract work in progress 1,456 2,816 Income tax receivable - 378 Other current assets 1,692 670 ------------------------------------ Total current assets 30,726 41,324 Due from officers/stockholders 96 98 Equipment, furniture and fixtures, net 4,032 4,319 Other assets 171 319 ------------------------------------ TOTAL ASSETS $ 35,025 $ 46,060 ==================================== LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities: Trade accounts payable and other accrued liabilities $ 2,287 $ 4,698 Accrued salaries and benefits 3,505 4,248 Current portion of severance payable 210 210 ------------------------------------ Total current liabilities 6,002 9,156 Long-term liabilities 471 548 Commitments and contingencies Redeemable convertible preferred stock, $.001 par value. Authorized 3,520 shares; issued and outstanding 2,182 shares at June 30, 2000 and December 31, 1999 11,751 11,382 Stockholders' equity: Common stock, $.001 par value. Authorized shares 50,000 shares; issued and outstanding 17,713 shares at June 30, 2000 and 17,712 shares at December 31, 1999 18 18 Additional paid-in capital 37,396 37,395 Deferred compensation (117) (192) Accumulated other comprehensive income (47) (43) Retained deficit (20,449) (12,204) ------------------------------------ Total stockholders' equity 16,801 24,974 ------------------------------------ TOTAL LIABILITIES AND STOCKHOLDERS' EQUITY $ 35,025 $ 46,060 ==================================== SEE ACCOMPANYING NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS. 2 DAOU Systems, Inc. Condensed Consolidated Statements of Operations (IN THOUSANDS, EXCEPT FOR PER SHARE DATA) (UNAUDITED) THREE MONTHS ENDED JUNE 30, SIX MONTHS ENDED JUNE 30, 2000 1999 2000 1999 ------------------ ----------------- ---------------- ----------------- Revenues $ 16,127 $ 27,051 $ 33,702 $ 54,373 Cost of revenues 13,045 19,117 29,001 40,936 ------------------ ----------------- ---------------- ----------------- Gross profit 3,082 7,934 4,701 13,437 Operating expenses: Sales and marketing 1,651 2,414 3,441 5,319 General and administrative 4,178 5,325 8,642 10,661 Restructuring charges 827 - 827 - ------------------ ----------------- ---------------- ----------------- 6,656 7,739 12,910 15,980 ------------------ ----------------- ---------------- ----------------- Income (loss) from operations (3,574) 195 (8,209) (2,543) Interest income (expense), net 164 (95) 333 (181) ------------------ ----------------- ---------------- ----------------- Income (loss) before income taxes (3,410) 100 (7,876) (2,724) Provision (benefit) for income taxes - 40 - (1,116) ------------------ ----------------- ---------------- ----------------- Net income (loss) (3,410) 60 (7,876) (1,608) Accrued dividends on preferred stock (185) - (369) - ------------------ ----------------- ---------------- ----------------- Net income (loss) available to common stockholders $ (3,595) $ 60 $ (8,245) $ (1,608) ================== ================= ================ ================= Net income (loss) per common share: Basic $ (0.20) $ 0.00 $ (0.47) $ (0.09) ================== ================= ================ ================= Diluted $ (0.20) $ 0.00 $ (0.47) $ (0.09) ================== ================= ================ ================= Shares used in computing net income (loss) per share: Basic 17,713 17,691 17,712 17,691 ================== ================= ================ ================= Diluted 17,713 17,918 17,712 17,691 ================== ================= ================ ================= SEE ACCOMPANYING NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL statements. 3 DAOU Systems, Inc. Condensed Consolidated Statements of Cash Flows (IN THOUSANDS) (UNAUDITED) SIX MONTHS ENDED JUNE 30, 2000 1999 ----------------- ------------------ OPERATING ACTIVITIES Net loss $ (7,876) $ (1,608) Adjustments to reconcile net loss to net cash provided by (used in) operating activities: Depreciation and amortization 1,156 734 Provision for uncollectible accounts 197 90 Deferred income taxes - (1,560) Changes in operating assets and liabilities: Accounts receivable 7,023 2,890 Contract work in process 1,360 3,666 Other current assets (644) 184 Accounts payable and accrued liabilities (2,411) (2,092) Accrued salaries and benefits (743) 1,594 Other accounts 103 234 ----------------- ------------------ Net cash provided by (used in) operating activities (1,835) 4,132 INVESTING ACTIVITIES: Purchases of equipment, furniture and fixtures (869) (699) Maturities of short-term investments - 52 Changes in other assets 150 10 ----------------- ------------------ Net cash used in investing activities (719) (637) FINANCING ACTIVITIES: Repayments of long-term debt and line of credit (105) (901) Proceeds from inssuance of common stock 1 11 ----------------- ------------------ Net cash used in financing activities (104) (890) ----------------- ------------------ Increase (decrease) in cash and cash equivalents (2,658) 2,605 Cash and cash equivalents at beginning of period 15,480 6,756 ----------------- ------------------ Cash and cash equivalents at end of period $ 12,822 $ 9,361 ================= ================== SEE ACCOMPANYING NOTES TO THE CONDENSED CONSOLIDATED FINANCIAL STATEMENTS. 4 DAOU SYSTEMS, INC. NOTES TO CONDENSED CONSOLIDATED FINANCIAL STATEMENTS 1. Basis of Presentation The unaudited condensed consolidated financial statements of DAOU Systems, Inc. ("DAOU" or the "Company") at June 30, 2000 and for the three and six month periods ended June 30, 2000 and 1999 have been prepared in accordance with generally accepted accounting principles ("GAAP") for interim financial information. Accordingly, they do not include all information and footnotes required by GAAP for a complete set of financial statements. These financial statements reflect all adjustments, consisting of normal recurring adjustments, which in the opinion of management are necessary to fairly present the financial position of the Company at June 30, 2000 and the results of operations for the three and six month periods ended June 30, 2000 and 1999. The results of operations for the three and six months ended June 30, 2000 are not necessarily indicative of the results to be expected for the year ending December 31, 2000. The Company has experienced significant quarterly fluctuations in operating results and it expects that these fluctuations in revenues, expenses and net income or losses will continue. The financial statements and related disclosures have been prepared with the presumption that users of the interim financial information have read or have access to the audited financial statements for the preceding fiscal year. Accordingly, these financials should be read in conjunction with the audited financial statements and the related notes thereto contained in the Company's Annual Report on Form 10-K filed with the Securities and Exchange Commission ("SEC") on March 30, 2000 and in the Company's Proxy Statement Schedule 14A Information filed with the SEC on May 1, 2000. 2. 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. 3. Lines of Credit On June 29, 1999, the Company secured a replacement $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 June 30, 2000. 4. Related Party Transactions The Company provides implementation services to a company in which the Chairman of the Board is an investor. At June, 30, 2000, the Company has approximately $30,000 in accounts receivable outstanding related to these implementation services. 5. 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 5 stock options and warrants. In 2000 and for the six months ended June 30, 1999, 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 details the computation of basic and diluted net loss per share: (In thousands, except per share information) (unaudited) Three Months Ended Six Months Ended June 30, June 30, 2000 1999 2000 1999 ------------------------- ----------------------------- Numerator: Net income (loss) available to common stockholders $(3,595) $60 $ (8,245) $ (1,608) Denominator: Denominator for basic net loss per share - weighted average common shares outstanding 17,713 17,691 17,712 17,691 Effect of dilutive securities: Warrants - 15 - - Common stock options - 212 - - ------------------------- ----------------------------- - 227 - - ------------------------- ----------------------------- Denominator for diluted net loss per share -adjusted weighted average common shares outstanding 17,713 17,918 17, 712 17,691 ======================== ============================= Basic net loss per share (0.20) 0.00 (0.47) (0.09) ======================== ============================= Diluted net loss per share (0.20) 0.00 (0.47) (0.09) ======================== ============================= 6. Comprehensive Loss Comprehensive income (loss) for the three months ended June 30, 2000 and 1999 totaled $(3,598,000) and $137,000, respectively. Comprehensive loss for the six months ended June 30, 2000 and 1999 totaled $(8,249,000) and $(1,477,000), respectively. The difference from reported net loss arises from the unrealized gains and losses on short-term investments. 7. Series A Preferred Stock 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 June 30, 2000, the Company has accrued but undeclared preferred stock dividends of $677,000, payable in shares of Series A Preferred Stock. 8. Restructuring Charges In connection with the Restructuring Plan, the Company has undertaken various actions to reduce the cost structure of the Company. As a result, the Company recorded restructuring charges in the period ending June 30, 2000, totaling approximately $827,000. Such charges were determined in accordance with Staff Accounting Bulletin No. 6 100, RESTRUCTURING AND IMPAIRMENT CHARGES, and Emerging Issues Task Force No. 94-3, LIABILITY RECOGNITION FOR CERTAIN EMPLOYEE TERMINATION BENEFITS AND OTHER COSTS TO EXIT AN ACTIVITY (INCLUDING CERTAIN COSTS INCURRED IN A RESTRUCTURING). These charges include severance costs related to a reduction in work force and the closure and combination of certain facilities. The following table summarizes the restructuring and other related charges recorded in the period ended June 30, 2000, of which $107,000 are included in accrued liabilities at June 30, 2000. Severance costs for involuntary employee terminations $ 752,000 Costs related to closure and combination of facilities 75,000 ------------------- $ 827,000 =================== 9. Disclosure of Segment Information For the three months and six months ended June 30, 2000 and 1999, the Company has the following five reportable segments: information technology (IT) consulting and managed care implementation, communications infrastructure, applications implementation, integration services, and outsourcing. Beginning in early 2000, the Company formed a new segment, Enosus. The IT consulting and managed care implementation group focuses on providing senior consultants to assist healthcare management to plan and meet their business and IT objectives. The communications infrastructure group installs, implements and maintains IT infrastructure for healthcare organizations. The applications implementation group provides IT consulting resources to hospitals and other healthcare organizations. The integration services group concentrates on integration of existing healthcare systems (financial, clinical and management) to reduce overall costs and improve the quality of care. The outsourcing group 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. Enosus provides Internet professional services and solutions to organizations executing an eBusiness strategy. 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. IT Consulting and Managed Care Communications Application Integration Implementation Infrastructure Implementation Services Outsourcing Enosus Total -------------- --------------- --------------- ------------ ------------ ---------- ----------- THREE MONTHS ENDED JUNE 30, 2000 - ---------------------------------------- Total revenues $ 1,709 $ 2,493 $ 3,763 $ 2,502 $ 5,323 $ 337 $ 16,127 Cost of services 1,482 2,311 2,511 1,709 4,573 459 13,045 -------- -------- -------- -------- -------- -------- -------- Gross profit 227 182 1,252 793 750 (122) 3,082 Gross profit percent 13% 7% 33% 32% 14% -36% 19% Sales and marketing 1,651 General and administrative 4,178 Restructuring charges 827 ----------- Loss from operations $ (3,574) =========== 7 IT Consulting and Managed Care Communications Application Integration Implementation Infrastructure Implementation Services Outsourcing Enosus Total -------------- --------------- --------------- ------------ ------------ ---------- ----------- THREE MONTHS ENDED JUNE 30, 1999 Total revenues $ 3,052 $ 4,638 $ 9,060 $ 3,437 $ 6,864 $ -- 27,051 Cost of services 1,699 4,365 4,647 2,162 6,244 -- 19,117 ------------------------------------------------------------------------------------ Gross profit 1,353 273 4,413 1,275 620 -- 7,934 Gross profit percent 44% 6% 49% 37% 9% -- 29% Sales and marketing 2,414 General and administrative 5,325 Restructuring charges -- -------- Income from operations $ 195 ======== SIX MONTHS ENDED JUNE 30, 2000 Total revenues $ 3,126 $ 6,441 $ 8,144 $ 5,014 $ 10,594 $ 383 $ 33,702 Cost of services 2,822 5,764 6,849 3,885 9,062 619 29,001 ------------------------------------------------------------------------------------ Gross profit 304 677 1,295 1,129 1,532 (236) 4,701 Gross profit percent 10% 11% 16% 23% 14% -62% 14% Sales and marketing 3,441 General and administrative 8,642 Restructuring charges 827 -------- Loss from operations $ (8,209) ======== SIX MONTHS ENDED JUNE 30, 1999 Total revenues $ 5,394 $ 13,088 $ 16,410 $ 6,858 $ 12,623 $ -- $ 54,373 Cost of services 3,195 15,062 8,700 4,340 9,639 -- 40,936 ------------------------------------------------------------------------------------ Gross profit 2,199 (1,974) 7,710 2,518 2,984 -- 13,437 Gross profit percent 41% -15% 47% 37% 24% -- 25% Sales and marketing 5,319 General and administrative 10,661 Restructuring charges ------- Loss from operations $ (2,543) ======== 10. Contingencies On August 24, 1998, August 31, 1998, September 14, 1998 and September 23, 1998, separate complaints were filed against the Company and certain of its officers and directors in the United States District Court for the Southern District of California. A group of shareholders has been appointed the lead plaintiffs and they filed an amended consolidated complaint on February 24, 1999. The new complaint realleges the same theory of liability previously asserted, namely the alleged improper use of the percentage-of-completion accounting method for revenue recognition. These complaints were brought on behalf of a purported class of investors in the Company's Common Stock and do not allege specific damage amounts. In addition, on October 7, 1998 and October 15, 1998, separate complaints were filed in the Superior Court of San Diego, California. These additional complaints mirror the allegations set forth in the federal complaints and assert common law fraud and the violation of certain California statutes. By stipulation of the parties, the state court litigation has been stayed pending the resolution of a motion to dismiss, which was filed on February 22, 2000 in the federal litigation. That motion has been fully briefed and 8 awaits the Court's ruling which will occur at the November 20, 2000 hearing on the matter. The Company believes that the allegations set forth in all of the foregoing complaints are without merit and intends to defend against these allegations vigorously. No assurance as to the outcome of this matter can be given, however, and an unfavorable resolution of this matter could have a material adverse effect on the Company's business, results of operations and financial condition. 9 ITEM 2. MANAGEMENT'S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS This Quarterly Report on Form 10-Q contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended. Prospective investors are cautioned that such statements are only predictions and that actual events or results may differ materially. Forward-looking statements usually contain the words "estimate," "anticipate," "believe," "expect" or similar expressions. All forward-looking statements are inherently uncertain as they are based on various expectations and assumptions concerning future events and are subject to numerous known and unknown risks and uncertainties. The forward-looking statements included herein are based on current expectations and entail various risks and uncertainties as those set forth herein and in the Company's other SEC filings, including those more fully set forth in the "Risk Factors," "Management's Discussion and Analysis of Financial Condition and Results of Operations" and other sections of the Company's Form 10-K for the year ended December 31, 1999 on file with the SEC, and in the Company's Proxy Statement Schedule 14A Information filed with the SEC on May 1, 2000. These risks and uncertainties could cause the Company's actual results to differ materially from those projected in the forward-looking statements. The Company disclaims any obligation to update or publicly announce revisions to any such statements to reflect future events or developments. MERGER DISCUSSIONS On August 10, 2000, DAOU announced that it is seeking strategic alternatives designed to maximize shareholder value and that it is currently holding discussions with Perot Systems Corporation, a Delaware Corporation, regarding the possible sale of the Company. Although no definitive agreement has been signed and a price has not been agreed to, the price currently being discussed would not be at a substantial premium over the current market price. There can be no assurance that an agreement regarding the sale of the Company will be reached as a result of the current discussions at such a price or at any price, or that an agreement will be reached with any other company at all. OVERVIEW DAOU provides integrated information technology (IT) solutions and services to the U.S. healthcare and Internet professional services industries. The Company's capabilities range from strategic planning (using IT to support key business goals), to the design and integration of IT components (voice, video and data networks, application implementation, Internet infrastructure, data warehouses), to the management and delivery of operational services (IT department, desktop management, ASP services, network management), and to Internet solutions and professional services supporting organizations executing an eBusiness strategy. The Company's service offerings are segmented into the following business units: - - IT CONSULTING AND MANAGED CARE IMPLEMENTATION (IT Consulting) - develops business and IT strategic plans and solves execution challenges for managed care and healthcare delivery organizations, installs and integrates managed care applications, and manages IT systems. - - COMMUNICATIONS INFRASTRUCTURE - focuses on the IT infrastructure in healthcare enterprises, primarily IDNs, hospitals, academic medical centers and medical groups, provides networking, desktop, and voice, video and data solutions. - - 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. 10 - - INTEGRATION SERVICES - focuses on integration of the customers information systems 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. - - ENOSUS - provides Internet professional services and solutions to 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's gross margin with respect to fixed-fee based service contracts varies significantly depending on the percentage of third-party products versus professional services provided by the Company. Payments received in advance of services performed are recorded as deferred revenues. Certain contract payment terms may result in customer billing occurring at a pace slower than revenue recognition. The resulting revenues recognized in excess of amounts billed and project costs are included in contract work in progress on the Company's balance sheet. In 1999, the Company began to focus on providing its professional services 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. RESULTS OF OPERATIONS The following table sets forth, for the periods indicated, certain statement of operations data as a percentage of net revenues. Three Months Ended Six Months Ended June 30, June 30, ------------------------------ ---------------------------- 2000 1999 2000 1999 --------------- ------------- ------------- -------------- Revenues 100% 100% 100% 100% Cost of revenues 81 71 86 75 --------------- ------------- ------------- -------------- Gross profit 19 29 14 25 Selling, general and administrative expenses 36 29 36 30 Restructuring charges 5 - 2 - --------------- ------------- ------------- -------------- Income (loss) from operations (22) - (24) (5) Interest income (expense), net 1 - 1 - --------------- ------------- ------------- -------------- Income (loss) before income taxes (21) - (23) (5) Provision (benefit) for income taxes - - - (2) --------------- ------------- ------------- -------------- Net income (loss) (21) - (23) (3) =============== ============= ============= ============== THREE MONTHS ENDED JUNE 30, 2000 AND 1999 The Company's revenues decreased 40% or $11.0 million to $16.1 million for the three months ended June 30, 2000 from $27.1 million for the three months ended June 30, 1999, primarily due to continued weakness in the Company's core health care information technology (IT) business, that management attributes 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. Services to DAOU's five largest customers accounted for 33% or $5.3 million of total revenues for the three months ended June 30, 2000. 11 Cost of revenues decreased 32% or $6.1 million to $13.0 million for the three months ended June 30, 2000 from $19.1 million for the three months ended June 30, 1999, primarily as a result of a workforce reduction and employee related expenses in the second quarter driven by the reduced demand for professional services. Gross margin percentage decreased to 19% for the three months ended June 30, 2000 from 29% for the three months ended June 30, 1999. Sales and marketing expenses decreased 32% or $0.7 million to $1.7 million for the three months ended June 30, 2000 from $2.4 million for the three months ended June 30, 1999, primarily due to the continued consolidation of sales and marketing efforts into the corporate office and a reduction of sales expenditures. Sales and marketing expenses represented approximately 10% and 9% of total revenues for the three months ended June 30, 2000 and 1999, respectively. General and administrative expenses decreased 22% or $1.1 million to $4.2 million for the three months ended June 30, 2000 from $5.3 million for the three months ended June 30, 1999, primarily as a result of synergies related to the integration of acquired companies and a workforce reduction and employee related expenses. General and administrative expenses represented approximately 26% and 20% of total revenues for the three months ended June 30, 2000 and 1999, respectively. In connection with the Restructuring Plan, the Company has undertaken various actions to improve the cost structure of the Company. As a result, the Company recorded restructuring charges in the three months ended June 30, 2000 totaling $827,000. These charges result primarily from severance costs related to a workforce reduction and the costs related to the closure and combination of certain facilities. Other income (expense), net, was $164,000 and $(95,000) for the three months ended June 30, 2000 and 1999, respectively. Other income is primarily interest income on cash and cash equivalents, and short-term investments. Other 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 higher average cash reserves available for investment and reduced interest expense after the payoff of outstanding debt in 1999. Income taxes provided in 2000 are based on the Company's estimated effective tax rate. During 1999, the Company was estimating that it would receive tax benefit for its losses. In the fourth quarter, the tax benefit previously recorded was reversed due to the total loss in 1999. SIX MONTHS ENDED JUNE 30, 2000 AND 1999 The Company's revenues decreased 38% or $20.7 million to $33.7 million for the six months ended June 30, 2000 from $54.4 million for the six months ended June 30, 1999, primarily due to continued weakness in the Company's core health care information technology (IT) business, that management attributes 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. Services to DAOU's five largest customers accounted for 28% or $9.4 million of total revenues for the six months ended June 30, 2000. Cost of revenues decreased 29% or $11.9 million to $29.0 million for the six months ended June 30, 2000 from $40.9 million for the six months ended June 30, 1999, primarily as a result of a workforce reduction and employee related expenses in the second quarter driven by the reduced demand for professional services. Gross margin percentage decreased to 14% for the six months ended June 30, 2000 from 25% for the six months ended June 30, 1999. Sales and marketing expenses decreased 35% or $1.9 million to $3.4 million for the six months ended June 30, 2000 from $5.3 million for the six months ended June 30, 1999, primarily due to the continued consolidation of sales and marketing efforts into the corporate office and a reduction of sales expenditures. Sales and marketing expenses represented approximately 10% total revenues for the six months ended June 30, 2000 and 1999. 12 General and administrative expenses decreased 19% or $2.1 million to $8.6 million for the six months ended June 30, 2000 from $10.7 million for the six months ended June 30, 1999, primarily as a result of synergies related to the integration of acquired companies and a workforce reduction and employee related expenses. General and administrative expenses represented approximately 26% and 20% of total revenues for the six months ended June 30, 2000 and 1999, respectively. In connection with the Restructuring Plan, the Company has undertaken various actions to improve the cost structure of the Company. As a result, the Company recorded restructuring charges in the three months ended June 30, 2000 totaling $827,000. These charges result primarily from severance costs related to a workforce reduction and the costs related to the closure and combination of certain facilities. Other income (expense), net, was $333,000 and $(181,000) for the six months ended June 30, 2000 and 1999, respectively. Other income is primarily interest income on cash and cash equivalents, and short-term investments. Other 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 higher average cash reserves available for investment and reduced interest expense after the payoff of outstanding debt in 1999. Income taxes provided in 2000 are based on the Company's estimated effective tax rate. During 1999, the Company was estimating that it would receive tax benefit for its losses. In the fourth quarter, the tax benefit previously recorded was reversed due to the total loss in 1999. LIQUIDITY AND CAPITAL RESOURCES On June 30, 2000, the Company had working capital of $24.7 million, a decrease of $7.5 million from $32.2 million on December 31, 1999. For the six months ended June 30, 2000, cash used in operating activities was $1.8 million compared to cash used in operating activities of $4.1 million for the six months ended June 30, 1999. This change resulted primarily from the loss from operations and decreases in accounts payable and accrued liabilities offset by decreases in accounts receivable and contract work in progress. Net cash used in investing activities was $719,000 in the current period, compared to net cash used in investing activities of $637,000 in the comparable prior period. This change resulted primarily from slightly increased equipment purchases for the six months ended June 30, 2000. Net cash used in financing activities was $104,000 for the six months ended June 30, 2000, compared to net cash used in financing activities of $890,000 in the comparable prior period. This change resulted primarily from repayments of debt and lines of credit during the six months ended June 30, 1999. 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 amounts are outstanding under this revolving line of credit and there are no outstanding letters of credit as of August 11, 2000. This credit facility contains change of control provisions that will be triggered by a merger involving the Company, such as the one being discussed with Perot Systems Corporation. If the creditor fails to consent to this transaction, or any similar transaction, any amounts outstanding under this facility at that time would have to be repaid and this facility could be terminated. Although the Company does not have any reason to believe that such creditor would withhold consent, there can be no assurance that such consent will be obtained. In addition, if such facility is terminated, there can be no assurance that the Company will be able to obtain another facility on similar terms or at all. Although the Company has an accumulated deficit as of June 30, 2000, the Company believes that its existing cash and short term investments together with anticipated cash from operating activities will be sufficient to meet its capital requirements, including the start-up costs for Enosus, for the foreseeable future. The Company may draw down its credit facility, sell additional equity or debt securities or obtain additional credit facilities. The sale of additional equity securities or issuance of equity securities in future acquisitions would result in dilution to the 13 Company's stockholders and the incurrence of additional debt could result in additional interest expense. In July 1999, the Company issued 2,181,818 shares of Series A Preferred Stock. The Series A Preferred Stock accrues dividends at a six percent annual rate. Such rate will increase one percent each year after the second anniversary of the issue date of the Series A Preferred Stock. The dividend is payable in shares of Series A Preferred Stock except in the case of redemption or liquidation. The holders of the Series A Preferred Stock have the right to cause the Company to redeem their stock for an aggregate amount equal to $12 million, plus accrued dividends, which were $677,000 as of June 30, 2000, upon the occurrence of certain events that are outside the Company's control. If the Company is forced to redeem the Series A Preferred Stock, then the Company may be forced to sell additional equity or debt securities, or draw down its credit facility. The Company may not be able to raise additional capital on terms favorable to the Company, if at all. BUSINESS RISKS In addition to the factors addressed in the preceding sections, certain dynamics of the Company's markets and operations create fluctuations in the Company's quarterly results. Uncertainty and cost containment in healthcare and competitive conditions present various other risks to operating results which are more fully described in the Company's Form 10-K filed with the SEC and other SEC filings. ITEM 3. QUANTITATIVE AND QUALITATIVE DISCLOSURES ABOUT MARKET RISK The Company is exposed to changes in interest rates, primarily from its variable-rate long-term debt arrangements and, to a lessor extent, its investments in certain available-for-sale marketable securities. Under its current policies, the Company does not use interest rate derivatives instruments to manage this exposure to interest rate changes. The Company does not have the option to convert its variable-rate long-term debt arrangement to fixed-rate debt arrangements for a nominal transaction fee. At August 11, 2000, the Company had no outstanding balance on its variable-rate debt. A hypothetical 1% adverse move in the interest rates along the entire interest rate yield curve would not materially effect the fair value of the Company's financial instruments that are exposed to changes in interest rates. 14 PART II OTHER INFORMATION Item 1. Legal Proceedings On August 24, 1998, August 31, 1998, September 14, 1998 and September 23, 1998, separate complaints were filed against the Company and certain of its officers and directors in the United States District Court for the Southern District of California. A group of shareholders has been appointed the lead plaintiffs and they filed an amended consolidated complaint on February 24, 1999. The new complaint realleges the same theory of liability previously asserted, namely the alleged improper use of the percentage-of-completion accounting method for revenue recognition. These complaints were brought on behalf of a purported class of investors in the Company's Common Stock and do not allege specific damage amounts. In addition, on October 7, 1998 and October 15, 1998, separate complaints were filed in the Superior Court of San Diego, California. These additional complaints mirror the allegations set forth in the federal complaints and assert common law fraud and the violation of certain California statutes. By stipulation of the parties, the state court litigation has been stayed pending the resolution of a motion to dismiss, which was filed on February 22, 2000 in the federal litigation. That motion has been fully briefed and awaits the Court's ruling which will occur at the November 20, 2000 hearing on the matter. The Company believes that the allegations set forth in all of the foregoing complaints are without merit and intends to defend against these allegations vigorously. No assurance as to the outcome of this matter can be given, however, and an unfavorable resolution of this matter could have a material adverse effect on the Company's business, results of operations and financial condition. Item 4. Submission of Matters to a Vote of Security Holders The Company's 2000 Annual Meeting of Stockholders was held on May 31, 2000. The following matters were voted on by the stockholders. 1. Election of two Class II Directors John H. Morange and Kevin Fickenscher were reelected to the Board of Directors for terms extending through the 2003 Annual Meeting of Stockholders. The vote was 15.9 million in favor of Mr. Morange and 0.5 million votes withheld, and 15.9 million in favor of Mr. Fickenscher and 0.5 million votes withheld. 2. Amend the 1996 Stock Option Plan The stockholders adopted an amendment to the Company's 1996 Stock Option Plan increasing the aggregate number of shares of common stock which may be affected under the plan from 4,000,000 to 5,000,000. The vote was 5.8 million in favor of the amendment, with 3.7 million votes against and 21,000 withheld. 3. Adopt the 2000 Employee Stock Purchase Plan The stockholders adopted the 2000 Employee Stock Purchase Plan. An aggregate of 1,500,000 shares of common stock may be purchased by eligible employees through payroll deductions. The vote was 8.8 million in favor, with 0.7 million votes against and 14,000 withheld. 4. Ratification of Independent Auditors The stockholders ratified the selection of Ernst & Young LLP as the Company's independent auditors for the fiscal year ending December 31, 2000. Ernst & Young LLP has audited the Company's financial statements annually since March 1995. The vote was 16.1 million in favor, with 0.3 million votes against and 5,000 withheld. 15 Item 6. Exhibits and Reports on Form 8-K (a) Exhibits Exhibit No. Description -------------- ---------------- 27.1 Financial Data Schedule (b) Current Reports on Form 8-K. The Registrant did not file any Current Reports on Form 8-K with the Commission during the quarter ended June 30, 2000. 16 SIGNATURES Pursuant to the requirements of the Securities Exchange Act of 1934, this registrant has duly caused this report to be signed on its behalf by the undersigned thereto duly authorized. Date: August 11, 2000 DAOU SYSTEMS, INC. By: /s/ Larry D. Grandia -------------------------------------- Larry D. Grandia President and Chief Executive Officer, Duly authorized officer By: /s/ Donald R. Myll -------------------------------------- Donald R. Myll Executive Vice President, Chief Financial Officer, and Secretary, Principal financial and accounting officer. 17