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 September 30, 1998 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 330284454 (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) (619) 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 XX No The number of shares of Registrant's Common Stock outstanding as of September 30, 1998: 17,685,722 Page 1 DAOU SYSTEMS, INC. Index to Form 10-Q PART I. FINANCIAL INFORMATION Item 1. Condensed Consolidated Financial Statements Page Condensed Consolidated Balance Sheets (unaudited) at September 30, 1998 and December 31, 1997 3 Condensed Consolidated Statements of Operations (unaudited) for the Three Months and Nine Months Ended September 30, 1998 and 1997 4 Condensed Consolidated Statements of Cash Flows (unaudited) for the Nine Months Ended September 30, 1998 and 1997 5 Notes to Condensed Consolidated Financial Statements 6-9 Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 10-12 PART II. OTHER INFORMATION 13 Item 1. Legal Proceedings 13 Item 2. Changes in Securities and Use of Proceeds 13 Item 6. Exhibits and Reports on Form 8-K 13-14 SIGNATURES 15 Page 2 PART I. FINANCIAL INFORMATION Item 1. Condensed Consolidated Financial Statements DAOU SYSTEMS, INC. CONDENSED CONSOLIDATED BALANCE SHEETS (IN THOUSANDS, EXCEPT FOR PER SHARE DATA) (unaudited) ASSETS SEPTEMBER 30, DECEMBER 31, 1998 1997 ------------ ------------ Current assets Cash and cash equivalents $ 2,140 $ 7,981 Short-term investments 2,821 10,307 Accounts receivable, net 30,536 15,744 Contract work in progress 12,342 13,291 Other current assets 2,198 2,089 -------- -------- Total current assets 50,037 49,412 Equipment, furniture and fixtures, net 4,848 3,859 Other assets 741 839 -------- -------- $ 55,626 $ 54,110 -------- -------- -------- -------- LIABILITIES AND STOCKHOLDERS' EQUITY Current liabilities Accounts payable and other accrued liabilities $ 6,529 $ 5,727 Accrued salaries and wages 4,201 2,675 Current portion of lines of credit and long-term debt 4,708 1,437 -------- -------- Total current liabilities 15,438 9,839 Long-term liabilities 3,310 2,434 Commitments and contingencies Stockholders' equity Preferred stock, $.001 par value Authorized shares - 5,000 Issued and outstanding - none - - Common stock, $.001 par value Authorized shares - 50,000 Issued and outstanding - 17,686 and 16,945 at September 30, 1998 and December 31, 1997, respectively 18 17 Additional paid-in capital 37,407 36,040 Deferred compensation (713) (907) Unrealized gain on short-term investments 4 146 Retained earnings 162 6,541 -------- -------- Total stockholders' equity 36,878 41,837 -------- -------- $ 55,626 $ 54,110 -------- -------- -------- -------- See accompanying notes. Page 3 DAOU SYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS (IN THOUSANDS, EXCEPT FOR PER SHARE DATA) (UNAUDITED) PERIODS ENDED SEPTEMBER 30, THREE MONTHS NINE MONTHS 1998 1997 1998 1997 -------- -------- -------- -------- Revenues $ 27,351 $ 18,540 $ 79,379 $ 46,485 Cost of revenues 22,905 12,316 56,340 30,961 -------- -------- -------- -------- Gross profit 4,446 6,224 23,039 15,524 Operating expenses: Sales and marketing 3,536 1,725 9,338 5,572 General and administrative 5,606 2,569 12,279 7,507 Merger and related costs - 684 2,825 684 -------- -------- -------- -------- Total operating expenses 9,142 4,978 24,442 13,763 -------- -------- -------- -------- Income(loss)from operations (4,696) 1,246 (1,403) 1,761 Other income (expense), net (177) 249 (50) 621 -------- -------- -------- -------- Income (loss) before income taxes (4,873) 1,495 (1,453) 2,382 Provision (benefit)for income taxes (1,785) 705 1,325 799 -------- -------- -------- -------- Net income(loss) $ (3,088) $ 790 $ (2,778) $ 1,583 -------- -------- -------- -------- -------- -------- -------- -------- Net income(loss) per share: Basic $ (.17) $ .05 $ (.16) $ .10 -------- -------- -------- -------- -------- -------- -------- -------- Diluted $ (.17) $ .04 $ (.16) $ .09 -------- -------- -------- -------- -------- -------- -------- -------- Shares used in calculation of net income (loss) per share: Basic 17,681 16,878 17,640 16,062 -------- -------- -------- -------- -------- -------- -------- -------- Diluted 17,681 17,933 17,640 16,956 -------- -------- -------- -------- -------- -------- -------- -------- See accompanying notes. Page 4 DAOU SYSTEMS, INC. CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS (IN THOUSANDS) (UNAUDITED) NINE MONTHS ENDED SEPTEMBER 30, 1998 1997 -------- -------- Operating activities: Net income (loss) $(2,778) $1,583 Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: Depreciation and amortization 1,217 800 Changes in operating assets and liabilities (10,723) (1,257) ------- ------- Net cash (used in) provided by operating activities (12,284) 1,126 Investing activities: Additions to equipment, furniture and fixtures (2,012) (2,361) Proceeds from (purchases of) short-term investments 7,344 (9,974) Changes in other assets 93 (1,499) ------- ------- Net cash provided by (used in) investing activities 5,425 (13,834) Financing activities: Sale of common stock, net 1,368 25,338 Proceeds from lines of credit and long-term debt, net 3,251 1,994 Distributions to stockholders of acquired companies (3,601) (1,646) ------- ------- Net cash provided by financing activities 1,018 25,686 ------- ------- Net (decrease) increase in cash and cash equivalents (5,841) 12,978 Cash and cash equivalents at beginning of period 7,981 3,123 ------- ------- Cash and cash equivalents at end of period $ 2,140 $16,101 ------- ------- ------- ------- See accompanying notes. Page 5 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 September 30, 1998 and for the three and nine-month periods ended September 30, 1998 and 1997 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 September 30, 1998 and the results of operations for the three and nine-month periods ended September 30, 1998 and 1997. The results of operations for the three and nine months ended September 30, 1998 are not necessarily indicative of the results to be expected for the year ending December 31, 1998. For more information, these financial statements should be read in conjunction with the Company's Form 10-KSB,as amended, and the audited supplemental consolidated financial statements included in the Company's Current Report on Form 8-K filed with the Securities and Exchange Commission ("SEC") on May 19, 1998. 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. Acquisitions During March 1998, the Company acquired Synexus Incorporated ("Synexus"), a privately-held company specializing in the planning, design and implementation of enterprise networks in healthcare environments, and Sentient Systems, Inc. ("Sentient"), a privately-held company that provides integration and support services primarily to healthcare organizations. The shareholders of Synexus and Sentient received a total of 161,235 and 1,397,550 shares, respectively, of the Company's common stock in exchange for all of the outstanding stock of each of these companies. The acquisitions have been accounted for under the pooling-of-interests method of accounting, and accordingly, the historical financial statements of periods prior to the consummation of the combinations have been restated as though the companies had been combined for all periods presented. During June 1998, the Company acquired (i) Technology Management, Inc.("TMI"), a privately-held company that provides information technology consulting services primarily to the healthcare industry, (ii) International Health Care Systems, Inc. ("IHCS"), a privately-held company with a common shareholder of TMI that provides information technology consulting services primarily to the healthcare industry on behalf of TMI, (iii) Resources in Healthcare Innovations, Inc. ("RHI"), a privately-held information technology services firm that provides contract management services for healthcare information systems to hospitals and managed care organizations, and (iv) Healthcare Transition Resources, Inc. ("HTR"), Ultitech Resources Group, Inc. ("URG"), Innovative Systems Solutions, Inc. ("ISS") and Grand Isle Consulting, Inc. ("GIC"), each a privately-held company with common shareholders of RHI that implements software applications from third parties and provides support services to healthcare enterprises. Shareholders of TMI, IHCS, RHI, HTR, URG, ISS and GIC received a total of 1,078,963, 224,668, 1,839,381, 275,662, 282,551, 308,583 and 223,645 shares, respectively, of the Company's common stock in exchange for all of the outstanding stock of each of these companies. The acquisitions have been accounted for under the pooling-of-interests method of accounting, and accordingly, the historical financial statements of periods prior to the consummation of the combinations have been restated as though the companies had been combined for all periods presented. Page 6 Separate results for each of DAOU, Sentient, Synexus, TMI (including IHCS), and RHI (including HTR, URG, ISS and GIC) for the three and nine months ended September 30, 1998 and 1997 were as follows: (In thousands) DAOU SENTIENT SYNEXUS TMI RHI COMBINED ---------------------------------------------------------------------------------- Three months ended September 30, 1998: Total revenues $14,436 $3,509 $508 $3,039 $5,859 $27,351 Net income (loss) (4,213) 289 64 429 343 (3,088) Three months ended September 30, 1997: Total revenues 11,305 2,493 390 1,866 2,486 18,540 Net income (loss) (38) 142 100 532 54 790 Nine months ended September 30, 1998: Total revenues 45,257 9,873 1,601 8,787 13,861 79,379 Net income (loss) (5,376) 301 174 832 1,291 (2,778) Nine months ended September 30, 1997: Total revenues 27,191 7,280 1,204 4,225 6,585 46,485 Net income 255 315 228 445 340 1,583 In connection with these acquisitions, the Company recorded direct merger and related costs (before income taxes) during March 1998 and June 1998 totaling $1.8 million and $1.0 million, respectively. These costs include transaction costs of approximately $720,000, estimated costs to combine and integrate operations of approximately $570,000, and other merger related costs of approximately $1.5 million. 4. Lines of Credit During September 1998, the Company secured two borrowing facilities, a $2.0 million revolving line of credit, under which none is available for future borrowings at September 30, 1998, and an additional $8,000,000 line of credit, under which $6.0 million is available for future borrowings at September 30, 1998. Advances under both the revolving line of credit and line of credit bear interest at the bank's prime rate (8.25% at September 30, 1998) plus 0.25% per annum. Through September 30, 1998, borrowings under the revolving line of credit, which expires July 31, 1999, total approximately $2.0 million, while borrowings under the line of credit, which expires July 31, 1999, total approximately $2.0 million. These lines of credit are secured by substantially all of the assets of the Company and contain customary covenants and restrictions. As of September 30, 1998, the Company was not in compliance with certain of these covenants and restrictions, however, the Company has obtained a waiver from the financial institutions for the violation. In addition, through its acquisition of RHI (and related companies), the Company has an additional $700,000 line of credit with a bank, under which outstanding borrowings totaled $670,000 at September 30, 1998. The $700,000 line of credit bears interest at prime plus 0.25%, is due on May 1, 1999 and is secured by all of the assets of RHI. Page 7 5. Net Income (Loss) Per Share Information The following table details the computation of basic and diluted net income (loss) per share: (In thousands, except per share information) THREE MONTHS ENDED NINE MONTHS ENDED SEPTEMBER 30, SEPTEMBER 30, 1998 1997 1998 1997 ------------------------------------------------------------------ Numerator: Net income (loss) $ (3,088) $ 790 $ (2,778) $ 1,583 Denominator: Denominator for basic net income (loss) per share - weighted average common shares outstanding 17,681 16,878 17,640 16,062 Effect of dilutive securities: Warrants - 105 - 74 Common stock options - 950 - 642 Convertible preferred stock - - - 178 ------------------------------------------------------------------ - 1,055 - 894 ------------------------------------------------------------------ Denominator for diluted net income (loss) per share - adjusted weighted average common shares outstanding and assumed conversion of preferred stock 17,681 17,933 17,640 16,956 ------------------------------------------------------------------ ------------------------------------------------------------------ Basic net income (loss) per share $ (.17) $ .05 $ (.16) $ .10 ------------------------------------------------------------------ ------------------------------------------------------------------ Diluted net income (loss) per share $ (.17) $ .04 $ (.16) $ .09 ------------------------------------------------------------------ ------------------------------------------------------------------ Recent interpretations by the SEC of Financial Accounting Standard No. 128, "Earnings per Share", have changed the treatment of convertible preferred stock previously included in the computation of basic net income (loss) per share. For periods prior to its initial public offering ("IPO"), the Company previously included preferred stock which converted into common stock upon completion of the IPO as outstanding from the date of original issuance ("as if converted method") in the computation of basic net income (loss) per share. To conform with recent interpretations, the effect of assuming the conversion of these securities prior to their actual conversion in the basic net income (loss) per share calculation has been excluded. 6. New Accounting Standards In June 1997, the Financial Accounting Standards Board issued Statement No. 130, "Reporting Comprehensive Income," and Statement No. 131, "Disclosures About Segments of an Enterprise and Related Information," both of which are effective for fiscal periods beginning after December 15, 1997. The adoption of Statements No. 130 and 131 did not have a material effect on the Company's financial statements. Page 8 Comprehensive income (loss) for the three months ended September 30, 1998 and 1997 totaled $(3,316,000) and $900,000, respectively. Comprehensive income (loss) for the nine months ended September 30, 1998 and 1997 totaled $(2,920,000) and $1,750,000, respectively. The difference from reported net income (loss) arises from the unrealized gains and losses on short-term investments. 7. Income Tax Expense The effective income tax rate for the three and nine months ended September 30, 1998 was (37%) and 91%, respectively, due to the non-deductibility of certain merger and related costs and adjustments made to convert the former S corporation status of certain acquired businesses to the C corporation status of the Company. Page 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 the Company's other SEC filings, including those more fully set forth in the "Risk Factors," "Management's Discussion and Analysis of Financial Condition and Results of Operations" and other sections of the Company's Form 10-KSB, as amended, for the most recently completed fiscal year on file with the SEC. These risks and uncertainties could cause the Company's actual results to differ materially from those projected in the forward-looking statements. The Company disclaims any obligation to update or publicly announce revisions to any such statements to reflect future events or developments. Overview The Company designs, implements, supports and manages advanced computer network systems primarily for hospitals, integrated delivery networks ("IDNs") and other provider organizations. The Company's design services include an assessment of the customer's existing computer network system, the preparation of voice, video and data network specifications, technical design documentation and diagrams. DAOU's implementation services include the purchase, delivery and installation of enterprise-wide computer network systems. Implementation service revenues consist of third-party hardware and software products, as well as the Company's professional services. The Company's gross margin with respect to implementation services varies significantly depending on the percentage of such services consisting of products (with respect to which the Company obtains a lower margin) versus professional services. Also, the Company often hires employees in anticipation of commencement of a project and if delays in contract signing occur the Company's gross margin could vary due to the associated loss of revenues to cover fixed labor costs. The Company's support and management services include remote and on-site network management, as well as information systems function outsourcing. The Company typically provides these services under multi-year contracts. During March 1998, the Company acquired all of the issued and outstanding shares of Synexus, a privately-held company, that specializes in the planning, design and implementation of enterprise networks in healthcare environments, and Sentient, a privately-held company that provides integration and support services primarily to healthcare organizations. The shareholders of Synexus and Sentient received a total of 161,235 and 1,397,550 shares, respectively, of the Company's common stock in exchange for all of the outstanding stock of each of these companies. The acquisitions have been accounted for under the pooling-of-interests method of accounting, and accordingly, the historical financial statements of periods prior to the consummation of the combinations have been restated as though the companies had been combined for all periods presented. During June 1998, the Company acquired (i) TMI, a privately-held company that provides information technology consulting services primarily to the healthcare industry, (ii) IHCS, a privately-held company with a common shareholder with TMI that provides information technology consulting services primarily to the healthcare industry on behalf of TMI, (iii) RHI, a privately-held information technology services firm that provides contract management services for healthcare information systems to hospitals and managed care organizations, and (iv) HTR, URG, ISS and GIC, each a privately-held company with common shareholders with RHI that implements software applications from third parties and provides support services to healthcare enterprises. Shareholders of TMI, IHCS, RHI, HTR, URG, ISS and GIC received a total of 1,078,963, 224,668, 1,839,381, 275,662, 282,551, 308,583 and 223,645 shares, respectively, of the Company's common stock in exchange for all of the outstanding stock of each of these companies. The acquisitions have been accounted for under the pooling-of-interests method of accounting, and accordingly, the historical financial statements of periods prior to the consummation of the combinations have been restated as though the companies had been combined for all periods presented. Results of Operations The Company's revenues were $27.4 million and $18.5 million for the quarters ended September 30, 1998 and 1997, respectively, representing an increase of 48%. This increase was due primarily to the increased number of professional services consulting contracts, which accounted for $5.2 million of the increase for the three months ended September 30, 1998. Increases in professional services management contracts ($2.4 million) and large network implementation contracts ($1.2 million) accounted for the remainder of the increase. Services to five customers accounted for $5.4 million of total revenues in this quarter, representing 20% of total revenues. For the nine months ended September 30, 1998 and 1997, respectively, revenues were $79.4 million and $46.5 million, representing an increase of 71%. This increase was primarily the result of increased revenues from professional services consulting contracts ($15.0 million), large network implementation contracts ($12.2 million) and increased revenues in professional services management contracts ($5.7 million). Page 10 Cost of revenues was $22.9 million and $12.3 million for the quarters ended September 30, 1998 and 1997, respectively, representing an increase of 86%. Gross margin was 16% and 34% for the quarters ended September 30, 1998 and 1997, respectively. Cost of revenues for the nine-month period ended September 30, 1998 and 1997 were $56.3 million and $31.0 million, respectively, which is an increase of 82%. Gross margin for the nine months ended September 30, 1998 and 1997, was 29% and 33%, respectively. The decrease in gross margins for the three and nine month periods ended September 30, 1998 were primarily due to the following: i) an increase in the product content of the Company's large network implementation contracts, ii) increased labor costs as a result of delays in project delivery schedules due to both external and internal customer delays and the associated loss of revenues to cover the fixed labor costs, iii) an unforeseen requirement on one fixed price contract to use an alternate labor union at a higher than projected cost and iv) increased labor costs as a result of a shortfall in planned revenue which the Company believes was caused by delays in contract signings due to the negative publicity and shareholder lawsuits surrounding the Company's accounting practices. The Company's margins were also affected by a decision to provide additional services on certain fixed price contracts at no additional cost to certain customers to increase the probability of closing large long-term professional services management contracts. Sales and marketing expenses were $3.5 million and $1.7 million for the quarters ended September 30, 1998 and 1997, respectively, representing an increase of 105%. This increase was primarily due to continued development of a regional sales structure, an increase in sales personnel and related expenses due to increased sales volume and activity. Sales and marketing expenses were 13% and 9% of revenues for the quarters ended September 30, 1998 and 1997, respectively. For the nine-month periods ended September 30, 1998 and 1997, sales and marketing expenses were $9.3 million and $5.6 million, respectively, representing 12% of revenues in those periods. Although the Company believes it can achieve a decrease in these expenses as a percentage of revenue, the Company also expects that sales and marketing expenses will continue to increase in dollar terms to support the anticipated growth in the Company's business. General and administrative expenses were $5.6 million and $2.6 million for the quarters ended September 30, 1998 and 1997, respectively, representing an increase of 118%. The primary factors contributing to this increase were costs associated with additional administrative staffing and other increased infrastructure requirements to support growth and integration of acquired companies, increased recruiting costs and increased legal and accounting fees associated with the negative publicity and shareholder lawsuits surrounding the Company's accounting practices. General and administrative expenses were 20% and 14% of revenues for the quarters ended September 30, 1998 and 1997, respectively. General and administrative expenses for the nine-month periods ended September 30, 1998 and 1997 were $12.3 million and $7.5 million, or 15% and 16% of revenues, respectively. The Company expects some increase in general and administrative expenses in dollar terms to support the anticipated growth in the Company's business and the anticipated integration of subsidiaries. Direct merger and related costs totaled $2.8 million during the nine months ended September 30, 1998, which include costs recorded during the first and second quarters of 1998 in connection with the acquisitions of Sentient, Synexus, TMI, IHCS, RHI, HTR, URG, ISS and GIC. The $2.8 million total costs include transaction fees of approximately $720,000, estimated costs to combine and integrate operations of approximately $570,000 and other acquisition related costs of approximately $1.5 million. Other income (expense), net, was ($177,000) and $249,000 for the quarters ended September 30, 1998 and 1997, respectively. For the nine-month period ended September 30, 1998 and 1997, respectively, other income, net, was ($50,000) and $621,000. Other income is primarily interest income on cash and cash equivalents, and short-term investments. Interest expense consists of interest associated with the Company's business lines of credit. The decrease in other income (expense), net, was primarily due to overall lower average cash reserves available for investment for the three and nine-month periods ended September 30, 1998 as compared to the same period in 1997. The effective income tax rate for the three and nine months ended September 30, 1998 was (37%) and 91%, respectively, due to the non-deductibility of certain merger and related costs and adjustments made relative to the former S corporation status of certain acquired businesses. Page 11 Liquidity and Capital Resources At September 30, 1998, the Company had working capital of $34.6 million, which is slightly down from the $39.6 million on December 31, 1997. The Company has a $2.0 million revolving line of credit, under which none is available for future borrowings at September 30, 1998. In addition, the Company has secured an additional $8,000,000 line of credit, of which $6.0 million is available for future borrowings at September 30, 1998. Advances under both the revolving line of credit and line of credit bear interest at the bank's reference rate (8.25% at September 30, 1998) plus 0.25% per annum. Through September 30, 1998, borrowings under the revolving line of credit, which expires July 31, 1999, are approximately $2.0 million, while borrowings under the line of credit, which expires July 31, 1999, total approximately $2.0 million. These lines of credit are secured by substantially all of the assets of the Company and contain customary covenants and restrictions. As of September 30, 1998, the Company was not in compliance with certain of these covenants and restrictions, however, the Company has obtained a waiver from the financial institutions for the violation. For the nine months ended September 30, 1998, cash used in operating activities was $12.3 million which resulted primarily from an increase in the Company's accounts receivable due to timing of billings. The Company believes that its present sources of liquidity will be sufficient to finance operations for the foreseeable future and such sources of liquidity may be used to fund additional acquisitions of complimentary businesses, although the Company does not have any specific proposals, arrangements or understandings with respect to any future acquisitions. The Company may sell additional equity or debt securities or obtain additional credit facilities. The sale of additional equity securities or issuance of same in future acquisitions could result in additional dilution to the Company's stockholders and the incurrence of debt could result in additional interest expense. 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 certain other risks to operating results which are more fully described in the Company's Form 10-KSB filed with the Securities and Exchange Commission (SEC) and other SEC filings. Except for the historical information presented herein, the matters discussed in this document are forward-looking statements that involve numerous risks and uncertainties. The Company's actual results could differ materially from those projected in such forward-looking statements and will depend upon a number of factors, including those discussed in this document and in prior SEC filings, press releases and other public filings of the Company. Year 2000 The Company provides information, communications technology and services to its customers and must therefore address two critical areas of Year 2000 readiness: i) internal readiness; and, ii) external system readiness. The Company is currently conducting a detailed assessment of its internal Year 2000 status and developing an aggressive action plan to address all required upgrades in computer systems, applications, equipment and facilities. This assessment and plan includes an ongoing review of the Company and its Subsidiaries information systems and the integration of these systems into the existing Year 2000 ready systems. The current plan calls for complete internal readiness by April 1999. Financial impact for internal compliance should be minimal. The Company's current internal equipment and applications are substantially compliant and the costs to integrate the subsidiary applications were planned for as part of the recent mergers. The Company is initiating communications with its critical external relationships including customers and suppliers to determine the extent to which the Company may be vulnerable to such parties' failure to resolve their own Year 2000 issues. Where practicable, the Company will assess and attempt to mitigate its risks with respect to the failure of these entities to be Year 2000 ready. The effect if any, on the Company's results of operations from the failure of such parties to be Year 2000 ready, is not reasonably estimable. The costs of the project and the date on which the Company plans to complete the Year 2000 modifications are based on management's best estimates, which were derived utilizing numerous assumptions of future events including the continued availability of certain resources, third party modification plans and other factors. However, there can be no guarantee that these estimates will be achieved and actual results could differ materially from those plans. Specific factors that might cause such material differences include, but are not limited to, availability and cost of personnel trained in this area and the ability to locate and correct all relevant computer systems. Page 12 PART II OTHER INFORMATION 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. These complaints assert violations of the federal securities laws based on 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 the Superior Court of San Diego, California. These additional complaints mirror the allegations set forth in the federal complaints and assert common law fraud and the violation of certain California statutes. The Company believes that the allegations set forth in all of the foregoing complaints are without merit and intends to defend against these allegations vigorously. No assurance as to the outcome of this matter can be given, however, and an unfavorable resolution of this matter could have a material adverse effect on the Company's business, results of operations and financial condition. Item 2. Changes in Securities and Use of Proceeds. Effective July 24, 1998, the Company issued 1,839,381, 275,662, 282,551, 308,583 and 223,645 shares of Common Stock, respectively, to the former shareholders of RHI, HTR,URG,ISS and GIC, in exchange for all of the outstanding capital stock of each of these companies. These share issuance's were exempt from registration under the Securities Act of 1933, as amended, pursuant to Section 4(2) thereof. See Note 3 of Notes to the Condensed Consolidated Financial Statements in Part I Item 1 of this report for further information concerning these share issuance's. Item 6. Exhibits and Reports on Form 8-K (a) Exhibits Exhibit No. Description - ----------- ----------- 27.1 Financial Data Schedule 27.2 Financial Data Schedule (1997 Restated) a) On September 8, 1998, a Form 8-K was filed which included audited financial statements of TMI and affiliate as of December 31, 1997 and 1996 and for the two years then ended and audited financial statements of RHI and affiliates as of December 31, 1997 and for the year then ended. Also included was the unaudited pro forma combined condensed balance sheet at June 30, 1998 and December 31, 1997 and unaudited pro forma combined condensed statements of operations for the six months ended June 30, 1998 and the years ended December 31, 1997 and 1996 which give effect to the acquisition of TMI, IHCS, RHI, HTR, ISS, GIC and URG as of December 31, 1997 for the combined condensed pro forma balance sheet and January 1, 1996 for the combined condensed pro forma statements of operations. Page 13 b) On August 31, 1998, a Form 8-K was filed to report the announcement of the filing of a purported class action lawsuit against the Company and certain of its directors and officers. c) On August 7, 1998, a Form 8-K was filed to report that the Company acquired RHI, HTR, URG, ISS and GIC through the issuance of 1,839,381, 275,662, 282,551, 308,583 and 223,645 shares of the Company's common stock in exchange for all of the outstanding shares of RHI, HTR, URG, ISS and GIC. The merger was effective on July 24, 1998 and will be accounted for as a pooling-of-interests. d) On August 5, 1998, a Form 8-K was filed to report the unaudited revenue and net income of the Company for the month ended July 31, 1998. e) On July 10, 1998, a Form 8-K was filed to report that the Company acquired TMI and IHCS through the issuance of 1,078,963 and 224,668 shares of the Company's common stock in exchange for all of the outstanding shares of TMI and IHCS. The merger was effective on June 25, 1998 and will be accounted for as a pooling-of-interests. f) On July 6, 1998, a Form 8-K was filed to report that the Company had entered into a merger agreement to exchange shares of the Company's common stock in exchange for all of the outstanding shares of RHI and affiliates. Page 14 SIGNATURES Pursuant to the requirements 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. DAOU SYSTEMS, INC. Date: November 14, 1998 By: /s/ Daniel J. Daou Daniel J. Daou President Date: November 14, 1998 By: /s/ Fred C. McGee Fred C. McGee Chief Financial Officer Page 15