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, 1999
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 X No
The number of shares of Registrant's Common Stock outstanding as of July 20,
1999:
17,691,149
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, 1999 (unaudited) and
December 31, 1998 3
Condensed Consolidated Statements of Operations (unaudited) for the Three
Months and Six Months Ended June 30, 1999 and 1998 4
Condensed Consolidated Statements of Cash Flows (unaudited) for the Three
Months and Six Months Ended June 30, 1999 and 1998 5
Notes to Condensed Consolidated Financial Statements 6-7
Item 2. Management's Discussion and Analysis of Financial Condition and Results of Operations 8-13
Item 3. Quantitative and Qualitative Disclosure about Market Risk 13
PART II. OTHER INFORMATION 14
Item 1. Legal Proceedings 14
Item 4. Submission of Matters to a Vote of Security Holders
Item 6. Exhibits and Reports on Form 8-K 14
SIGNATURES 15
-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)
JUNE 30, DECEMBER 31,
1999 1998
(UNAUDITED)
-----------------------------
ASSETS
Current assets:
Cash and cash equivalents $ 9,361 $ 6,756
Short-term investments, available-for-sale 1,194 1,024
Accounts receivable, net of allowance for doubtful accounts of $858
and $956 at June 30, 1999 and December 31, 1998, respectively 21,602 24,582
Contract work-in-progress 8,606 12,272
Deferred income taxes 5,077 3,362
Other current assets 1,122 1,306
-----------------------------
Total current assets 46,962 49,302
Equipment, furniture and fixtures, net 4,699 4,735
Other assets 468 480
-----------------------------
$ 52,129 $ 54,517
-----------------------------
-----------------------------
LIABILITIES AND STOCKHOLDERS' EQUITY
Current liabilities:
Trade accounts payable and other accrued liabilities $ 6,185 $ 8,277
Accrued salaries and benefits 5,501 3,907
Current portion of long-term liabilities and line of credit 4,579 5,453
-----------------------------
Total current liabilities 16,265 17,637
Long-term liabilities 724 684
Deferred income taxes 1,576 1,421
Commitments and contingencies
Stockholders' equity:
Preferred stock, $.001 par value:
Authorized shares - 5,000
Issued and outstanding shares - none - -
Common stock, $.001 par value:
Authorized shares - 50,000
Issued and outstanding shares - 17,691 at June 30, 1999 and
17,689 at December 31, 1998 18 18
Additional paid-in capital 38,430 38,419
Deferred compensation (816) (980)
Accumulated other comprehensive income 458 236
Retained deficit (4,526) (2,918)
-----------------------------
Total stockholders' equity 33,564 34,775
-----------------------------
$ 52,129 $ 54,517
-----------------------------
-----------------------------
SEE ACCOMPANYING NOTES.
-3-
DAOU Systems, Inc.
Condensed Consolidated Statement of Operations
(IN THOUSANDS, EXCEPT FOR PER SHARE DATA)
(UNAUDITED)
PERIODS ENDED JUNE 30,
THREE MONTHS SIX MONTHS
1999 1998 1999 1998
------------------- ------------------ ------------------------------------
Revenues $27,051 $28,043 $54,373 $52,028
Cost of revenues 19,117 18,947 40,936 33,435
------------------- ------------------ ------------------------------------
Gross profit 7,934 9,096 13,437 18,593
Operating expenses:
Sales and marketing 2,414 3,069 5,319 5,802
General and administrative 5,325 3,545 10,661 6,673
Merger and related expenses - 1,029 - 2,825
------------------- ------------------ ------------------------------------
7,739 7,643 15,980 15,300
------------------- ------------------ ------------------------------------
Income (loss) from operations 195 1,453 (2,543) 3,293
Interest income (expense), net (95) 59 (181) 201
------------------- ------------------ ------------------------------------
Income (loss) before income taxes 100 1,512 (2,724) 3,494
Provision (benefit) for income taxes 40 2,200 (1,116) 3,114
------------------- ------------------ ------------------------------------
Net income (loss) $60 $(688) $(1,608) $380
------------------- ------------------ ------------------------------------
------------------- ------------------ ------------------------------------
Net income (loss) per common share:
Basic $0.00 $(0.04) $(0.09) $0.02
------------------- ------------------ ------------------------------------
------------------- ------------------ ------------------------------------
Diluted $0.00 $(0.04) $(0.09) $0.02
------------------- ------------------ ------------------------------------
------------------- ------------------ ------------------------------------
Shares used in computing net income
(loss) per common share:
Basic 17,691 17,645 17,691 17,620
------------------- ------------------ ------------------------------------
------------------- ------------------ ------------------------------------
Diluted 17,918 17,645 17,691 18,513
------------------- ------------------ ------------------------------------
------------------- ------------------ ------------------------------------
SEE ACCOMPANYING NOTES.
-4-
DAOU Systems, Inc.
Condensed Consolidated Statements of Cash Flows
(IN THOUSANDS)
(UNAUDITED)
SIX MONTHS ENDED JUNE 30,
1999 1998
-----------------------------------------
OPERATING ACTIVITIES
Net income (loss) $(1,608) $380
Adjustments to reconcile net income (loss) to net
cash used in operating activities:
Depreciation and amortization 734 899
Changes in operating assets and liabilities 5,006 (7,365)
-----------------------------------------
Net cash provided by (used in) operating activities 4,132 (6,086)
INVESTING ACTIVITIES
Purchases of equipment, furniture and fixtures (699) (1,539)
(Purchases) maturities of short-term investments 52 7,166
Changes in other assets 10 (173)
-----------------------------------------
Net cash (used in) provided by investing activities (637) 5,454
FINANCING ACTIVITIES
Proceeds (repayments) of long-term liabilities (901) 869
Proceeds from issuance of common stock 11 1,183
Distributions to stockholders - (3,598)
-----------------------------------------
Net cash (used in) provided by financing activities (890) (1,546)
-----------------------------------------
Increase (decrease) in cash and cash equivalents 2,605 (2,178)
Cash and cash equivalents at beginning of period 6,756 7,973
-----------------------------------------
Cash and cash equivalents at end of period $9,361 $5,795
-----------------------------------------
-----------------------------------------
SEE ACCOMPANYING NOTES.
-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 June 30, 1999 and for the three and
six-month periods ended June 30, 1999 and 1998 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, 1999 and the
results of operations for the three and six-month periods ended June 30, 1999
and 1998. The results of operations for the three and six-months ended June
30, 1999 are not necessarily indicative of the results to be expected for the
year ending December 31, 1999. 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 31, 1999 and in the Company's Annual Report on Form 10-K/A
filed with the SEC on April 30, 1999.
2. Use of Estimates
The preparation of financial statements in conformity with GAAP 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
During June 1999, the Company secured an $8.0 million revolving line of credit,
which 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. As of June 30, 1999, $4.6 million remained outstanding
under this revolving line of credit. Two previous lines of credit expired July
31, 1999. No amounts were outstanding under these previous lines of credit as of
June 30, 1999.
4. Related Party Transactions
The Company has an agreement with an officer of the Company that guarantees a
cash bonus (approximately $664,000 at June 30, 1999) in 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.
5. Net Income (loss) Per Share
The following table details the computation of basic and diluted net income
(loss) per share:
(In thousands, except per share information)
(unaudited)
-6-
Three Months Ended Six Months Ended
June 30, June 30,
1999 1998 1999 1998
------------- ------------ --- ------------- -------------
Numerator:
Net income (loss)
$ 60 $(688) $(1,608) $ 380
Denominator:
Denominator for basic net income (loss) per share-
Weighted average common shares outstanding 17,691 17,645 17,691 17,620
Effect of dilutive securities:
Warrants 15 - - 102
Common stock options 213 - - 791
------------- ------------ --- ------------- -------------
228 - - 893
------------- ------------ --- ------------- -------------
Denominator for diluted net income (loss) per share -
adjusted weighted average common shares
outstanding and assumed conversion of preferred
stock 17,918 17,645 17,691 18,513
------------- ------------ --- ------------- -------------
------------- ------------ --- ------------- -------------
Basic net income (loss) per share $0.00 $(0.04) $ (0.09) $ 0.02
------------- ------------ --- ------------- -------------
------------- ------------ --- ------------- -------------
Diluted net income (loss) per share
$0.00 $(0.04) $ (0.09) $ 0.02
------------- ------------ --- ------------- -------------
------------- ------------ --- ------------- -------------
6. Comprehensive Income (loss)
Comprehensive income (loss) for the three months ended June 30, 1999 and 1998
totaled $137,000 and $(708,000), respectively. Comprehensive income (loss) for
the six months ended June 30, 1999 and 1998 totaled $(1,477,000) and $466,000,
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 six-months ended June 30, 1999
and 1998 was 40% and 41%, respectively. At June 30, 1999, net deferred tax
assets were approximately $3.5 million. Because the Company incurred an
operating loss for 1998 and through the first quarter for 1999, management will
continue to evaluate the realization of the net deferred tax assets. If
realization becomes doubtful a valuation allowance will be provided.
8. Subsequent Event
On July 27, 1999, DAOU completed a $12 million private placement financing
involving the sale of 2,181,818 shares of Series A Preferred Stock (the
"Shares") to certain investors at the purchase price of $5.50 per share. Each
Share is convertible into one share of DAOU Common Stock, subject to certain
anti-dilution adjustments. Holders of the Shares will be entitled to receive
dividends, on a cumulative basis, at the annual rate of six percent, payable in
shares of Series A Preferred Stock. The Shares are redeemable at DAOU's option
on or after July 27, 2003, and at the option of the holders under specified
terms and conditions. In addition, the Shares are subject to mandatory
conversion in the event that the price per share of DAOU's Common Stock reaches
certain specified price ranges.
-7-
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, and Section 21E of the
Securities Exchange Act of 1934. 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, 1998 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 provides integrated information technology solutions and services to
the U.S. healthcare industry. DAOU's capabilities range from up-front strategic
consulting to information technology ("IT") system design, implementation and
long-term tactical support. DAOU's IT offerings include application
implementation, communications infrastructure, management consulting and
integration services. The Company's application implementation group supplies
staffing resources to hospitals and other healthcare organizations. DAOU's
vendor certified consultants are capable of installing nearly 90% of the most
common healthcare applications. The Company's communications infrastructure
group focuses on the information superstructure in healthcare enterprises,
including networking, Intranet and Internet, desktop, and voice, video and data
solutions. Management consulting develops business plans and solves problems for
healthcare IT managers, installs and integrates applications, engineers,
installs and integrates infrastructure, and manages IT systems. DAOU's
integration services group analyzes, implements and supports information systems
that meet a customer's business objectives and are designed to reduce the cost
and improve the quality of care. The Company's gross margin with respect to
implementation services varies significantly depending on the percentage of
these 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 signings occur, then the Company's gross margins could vary due to the
associated loss of revenue to cover the fixed labor costs.
Results of Operations
The Company's revenues were $27.1 million and $28.0 million for the three months
ended June 30, 1999 and 1998, respectively, representing a decrease of 4%.
Revenues decreased primarily from the closure of the Company's cabling division,
DAOU On-Line, Inc., resulting in fewer cabling contracts, and from decreases in
implementation contracts. The Company's revenues were $54.4 million and $52.0
million for the six months ended June 30, 1999 and 1998, respectively,
representing an increase of 5%. Services to DAOU's five largest customers
accounted for $7.8 million and $14.0 million of total revenues for the three and
six-months ended June 30, 1999, respectively, representing 29% and 26% of total
revenues, respectively.
Cost of revenues was $19.1 million and $18.9 million for the three months ended
June 30, 1999 and 1998, respectively, representing an increase of 1%. Gross
margin was 29% and 32% for the three months ended June 30, 1999 and 1998,
respectively. Cost of revenues was $40.9 million and $33.4 million for the six
months ended June 30, 1999 and 1998, respectively, representing an increase of
22%. Gross margin was 25% and 36% for the six months ended June 30, 1999 and
1998, respectively. This decrease in gross margin during the three and
six-months ended June 30, 1999 was primarily due to: (i) an increase in the
product content of the Company's large network implementation contracts; and
(ii) decreases in networking labor utilization rates due to decreases in network
sales within the communications infrastructure group.
-8-
Sales and marketing expenses were $2.4 million and $3.1 million for the three
months ended June 30, 1999 and 1998, respectively, representing a decrease of
21%. Sales and marketing expenses were $5.3 million and $5.8 million for the six
months ended June 30, 1999 and 1998, respectively, representing a decrease of
8%. This decrease resulted primarily from the centralization of the Company's
sales and marketing functions. Sales and marketing expenses were approximately
9% and 11% of total revenues for the three months ended June 30, 1999 and 1998,
respectively, while sales and marketing expenses were approximately 10% and 11%
of total revenues for the six months ended June 30, 1999 and 1998, respectively.
Although the Company believes that it can achieve a decrease in these expenses
as a percentage of revenue, the Company also believes that sales and marketing
expenses may increase in absolute dollars to support the anticipated growth in
the Company's business.
General and administrative expenses were $5.3 million and $3.5 million for the
three months ended June 30, 1999 and 1998, respectively, representing an
increase of 50%. General and administrative expenses were $10.7 million and $6.7
million for the six months ended June 30, 1999 and 1998, respectively,
representing an increase of 60%. The primary factors contributing to this
increase in general and administrative expenses were costs associated with
additional administrative staffing and other increased infrastructure
requirements to support the growth and integration of acquired companies,
increased legal fees resulting primarily from the stockholder litigation, and
increased recruiting costs. General and administrative expenses were
approximately 20% and 13% of total revenues for the three months ended June 30,
1999 and 1998, respectively, and approximately 20% and 13% of total revenues for
the six months ended June 30, 1999 and 1998, respectively.
Other income (expense), net was $(95,000) and $59,000 for the three months ended
June 30, 1999 and 1998, respectively. For the six months ended June 30, 1999 and
1998, income (expense), net was $(181,000) and $201,000, respectively. Other
income is primarily interest income on cash and cash equivalents, and short-term
investments. Interest expense consists primarily of interest associated with the
Company's business lines of credit. The decrease in net other income (expense),
net was primarily due to lower average cash reserves available for investment
during the three and six month periods ended June 30, 1999 as compared to 1998.
The effective income tax rate for the three and six-months ended June 30, 1999
and 1998 was 40% and 41%, respectively. At June 30, 1999, net deferred tax
assets were approximately $3.5 million. Because the Company incurred an
operating loss for 1998 and for the first quarter of 1999, management will
continue to evaluate the realization of the net deferred tax assets. If
realization becomes doubtful, then a valuation allowance will be provided.
Liquidity and Capital Resources
On June 30, 1999, the Company had working capital of $30.7 million, a decrease
of $1.0 million from $31.7 million on December 31, 1998. For the six months
ended June 30, 1999, cash provided by operating activities was $4.1 million
compared to cash used in operating activities of $6.1 million for the six months
ended June 30, 1998. This change resulted primarily from decreases in trade
accounts receivable and contract work in progress for the six months ended June
30, 1999 as compared to 1998.
Net cash used in investing activities was $637,000 in the six months ended June
30, 1999, compared to net cash provided by investing activities of $5.5 million
in the comparable prior period. This change resulted primarily from $7.2 million
in 1998 of maturing marketable securities that were not reinvested.
Net cash used in financing activities was $890,000 for the six months ended June
30,1999, compared to net cash used in financing activities of $1.5 million in
the comparable prior period.
During June 1999, the Company secured an $8.0 million revolving line of credit,
which 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 accounts receivable. As of June 30, 1999, $4.6 million remained
outstanding under this revolving line of credit.
-9-
On July 27, 1999, DAOU completed a $12 million private placement financing
involving the sale of 2,181,818 shares of Series A Preferred Stock (the
"Shares") to certain investors at the purchase price of $5.50 per share. Each
Share is convertible into one share of DAOU Common Stock, subject to certain
anti-dilution adjustments. Holders of the Shares will be entitled to receive
dividends, on a cumulative basis, at the annual rate of six percent, payable in
shares of Series A Preferred Stock. The Shares are redeemable at DAOU's option
on or after July 27, 2003, and at the option of the holders under specified
terms and conditions. In addition, the Shares are subject to mandatory
conversion in the event that the price per share of DAOU's Common Stock reaches
certain specified price ranges.
Although the Company has an accumulated deficit and has used cash in its
operating activities over the past three years, the Company believes that its
available funds together with anticipated cash from operating activities will be
sufficient to meet its capital requirements for the foreseeable future. The
Company may sell additional equity or debt securities or obtain additional
credit facilities. The sale of additional equity securities or issuance of
equity securities in future acquisitions would result in dilution to the
Company's stockholders and the incurrence of additional debt could result in
additional interest expense.
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.
YEAR 2000
THIS STATEMENT IS INTENDED AS A YEAR 2000 READINESS DISCLOSURE.
INTRODUCTION
The year 2000 issue creates risks for all companies, particularly those
heavily dependent on or producing information technology products such as the
Company. The "year 2000 issue" is a term used to describe the problems
created by systems that are unable to accurately interpret dates after
December 31, 1999. These problems are derived predominantly from the fact
that software programs, computer equipment and embedded technology
historically have categorized the "year" in a two-digit format.
Management believes that the year 2000 issue creates potential risks that
relate to, among other things, the Company's:
- - Internally-used information technology ("IT") and non-IT systems;
- - Third-party products and sales, service and maintenance agreements; and
- - Software products of its own design.
STATE OF READINESS
The company has centralized its focus on the year 2000 issue through a
cross-functional project team whose task is to identify, assess, test and
remediate, as applicable, the Company's internal use systems, its sales,
service and maintenance agreements and the software products of its own
design. Although the Company's efforts to address year 2000 issues do not
fall precisely into sequential phases, these efforts generally involve an
assessment and testing phase, a deployment or remediation phase and a
contingency planning phase. The Audit Committee of the Board of Directors is
advised periodically on the status of the Company's Year 2000 compliance
program.
INTERNAL USE SYSTEMS. Year 2000 issues relating to the Company's
internally-used IT and non-IT systems, including computer equipment, software
and devices with embedded technology (collectively, "Internal Use Systems"),
could result in the Company's failure or inability to process transactions,
send invoices, conduct communications or engage in similar business
activities, any of which could affect materially and adversely the Company's
business, results of operations and financial condition.
Based upon its assessment and testing efforts through June 30, 1999, the
Company believes that its internal local and wide area network systems are
year 2000 compliant, but that certain PC hardware and software relating to
its Internal Use systems will require replacement or modification through,
for example, ROM-BIOS upgrades to certain hardware components and year 2000
compliant software upgrades. These remaining products are anticipated to be
reviewed and upgraded by September 30, 1999. The Company is also evaluating
contingency plans for its Internal Use Systems with an anticipated completion
date of September 30, 1999. In the ordinary course of replacing computer
equipment and software, the Company also attempts to obtain replacements that
it believes are year 2000 compliant. As of June 30, 1999, the Company had
assembled year 2000 compliance statements from its major vendors and
suppliers. Even where assurances are received from third parties, however,
risks remain that the failure of the Company's Internal Use Systems could
affect materially and adversely the Company's business, results of operations
and financial condition.
The Company estimates that, as of June 30, 1999, it had completed
approximately 93% of the initiatives that it believes will be necessary to
fully address potential year 2000 issues relating to its Internal Use
Systems. The Company currently anticipates that its year 2000
identification, assessment, testing and remediation efforts with respect to
its Internal Use Systems will be completed by September 30, 1999.
Notwithstanding the above assessment, both IT and non-IT systems may contain
embedded technology that could delay the Company's year 2000 identification,
assessment, testing and remediation efforts with respect to its Internal Use
Systems.
THIRD-PARTY PRODUCTS AND SALES, SERVICE AND MAINTENANCE AGREEMENTS.
Third-party products ("Third-Party Products") that are re-sold, installed
and/or maintained by the Company in connection with sales, service and
maintenance agreements with its customers may fail to operate properly or as
expected because of year 2000 issues. These system failures could disrupt
customer operations through a temporary inability to, among other things,
diagnose and treat patients, operate medical communications systems, access
medical information and databases, process transactions, send invoices or
engage in similar medical and business activities.
The Company has completed compiling vendor, manufacturer and service provider
statements and assurances regarding the year 2000 issue from major suppliers
of Third-Party Products. The Company is in the process of notifying key
customers regarding these statements and assurances as they pertain to
Third-Party Products that the Company has sold or installed, or currently
maintains in accordance with its contractual obligations.
If vendors, manufacturers and service providers of Third-Party Products do
not remediate successfully Third-Party Products by the year 2000 or
adequately indemnify or provide pass-through warranties for products re-sold,
installed and maintained by the Company, then the Company may face claims and
increased obligations under its sales, services and maintenance agreements
that could affect materially and adversely its business, results of
operations and financial condition.
The Company currently is assessing its Year 2000 related obligations under
its sales, service and maintenance agreements. To date, the Company has
identified one major sales, service and maintenance agrement under which it
has agreed to repair, modify and replace certain Third-Party Products that
are not year 2000 compliant. Accordingly, the Company's year 2000 liability
under this agreement depends on the year 2000 compliance of Third-Party
Products that are re-sold, installed and/or maintained under the agreement
and the Company's ability to seek adequate indemnification and/or warranty
coverage from the vendors, manufactures and service providers of Third-Party
Products. As of June 30, 1999, the Company has received confirmation from
vendors that more than 95% of the Third-Party Products covered by this
agreement are year 2000 compliant. The customer has advised the Company that
the remaining portion of these Third-Party Products will be replaced for year
2000 compliance prior to the end of this year. Because this process is still
incomplete and because the third-party vendor assurances may be inaccurate,
the Company cannot assure that it will not incur significant expenses under
this agrement that could impact materially and adversely the Company's
business, results of operations and financial condition.
In addition, based on its review to date, the Company has determined that
approximately 15% of its master contracts have no specific liability
limitations including those with regard to Year 2000 issues. The absence of
such limitations could expose the Company to increased claims and obligations
for Year 2000 compliance. Additional liability could result from certain
agreements that were entered into by the Company's subsidiaries. The Company
currently anticipates that its year 2000 identification assessment, testing
and remediation efforts with respect to Third-Party Products and key sales,
service and maintenance agreements will be completed by September 30, 1999.
COMPANY SOFTWARE PRODUCTS. The Company also distributes certain software
products through its subsidiary, DAOU-Sentient, Inc. The Company has
completed its assessment and testing of these products and believes that they
are year 2000 compliant.
COSTS
As of June 30, 1999, the Company had incurred costs of approximately $115,000
related to its year 2000 identification, assessment, testing and remediation,
of which $37,000 was incurred for Internal Use Systems and $80,000 was
incurred for its assessing liability and status of the year 2000 compliance
of Third-Party Products.
The Company currently estimates that the cost of its year 2000 identification,
assessment, remediation, and testing efforts will not exceed $200,000, of
which the Company expects to incur additional costs of $65,000 for year 2000
issues relating to Internal Use Systems and additional costs of $20,000 for
the identification, assessment, and notification to customers of year 2000
issues relating to Third-Party Products that are re-sold, installed or
maintained in accordance with the Company's contractual obligations. These
expenditures will be funded from operating cash flows. Other non-year 2000 IT
efforts have not been materially delayed or impacted by year 2000 initiatives.
The costs of the Company's year 2000 identification, assessment, remediation,
and testing efforts and the dates on which the Company believes it will
complete such efforts are based upon management's best estimates, which are
derived using numerous assumptions regarding future events. There can be no
assurance that these estimates will prove to be accurate and actual results
could differ materially from those currently anticipated. Specific factors
that could cause material differences include, among others, increased
obligations and liability under the Company's contractual obligations, the
availability and cost of personnel trained in year 2000 issues and the
ability to identify, assess and remediate Internal Use Systems and Third
Party Products as appropriate. In addition, if year 2000 issues cause
customers and prospects to defer current projects or prospective purchase
decisions, then the Company's financial, business and operational goals may
be delayed or may not be realized at all, causing the Company's business,
results of operations and financial condition to be affected materially and
adversely.
RISKS
If certain Internal Use Systems and Third-Party Products are not year 2000
compliant, then the Company could experience a negative impact on its
business, results of operations and financial condition relating to factors
that include, among others:
- - diversion of resources by the Company to address and/or remediate year
2000 issues;
- - damage to the Company's reputation;
- - litigation;
- - service delays to the Company's customers arising from the failure of
vendors, manufacturers and service providers to adequately address year 2000
issues;
- - increased warranty and other claims by the Company's customers and/or
increased product and system repair, replacement, service and maintenance
obligations under its existing and future sales, service and maintenance
agreements; and
- - decreased revenues if current and prospective customers devote a
substantial portion of their information systems spending to evaluation and
remediation of Year 2000 issues that could divert money away from
expenditures relating to the Company's services.
The Company currently cannot accurately assess or estimate the possible
impact of the foregoing risks and liability because:
- - there is no uniform definition of "compliance with Year 2000;"
- - the legal standards for year 2000 liability presently are uncertain;
- - the Company's year 2000 obligations will depend on, among other things,
the varying contractual terms contained in its sales, service and
maintenance agreements with respect to the particular customer and the nature
of such customer's year 2000 issue; and
- - there can be no assurance that indemnification or pass-through
arrangements relating to the Company's sales, service and maintenance
agreements will cover all of the Company's liabilities and costs incurred in
year 2000 related claims.
Consequently, the Company cannot provide assurances that the aggregate cost
of defending and resolving the foregoing issues and claims will not affect
materially and adversely the Company's business, results of operations and
financial condition.
CONTINGENCY PLANS
The Company has not yet developed a comprehensive contigency plan to address
situations that may result if the Company or any of the third parties on
which the Company depends is unable to achieve year 2000 readiness. However,
the Company currently expects to complete its contingency planning by
September 30, 1999. This contingency planning will encompass "worst case"
scenarios that assume the failure of significant communications and computing
infrastructures of the Company, its customers and suppliers, together with
failures of governmental infrastructures affecting transportation. The
Company subsequently may identify other factors that could affect materially
and adversely the Company's business, results of operations and financial
condition. Notwithstanding the Company's formation of a comprehensive
contingency plan, it is unlikely that any contingency planning will
adequately address all potential scenarios related to the year 2000 issue.
The foregoing statements are based on management's best estimates at the
present time, which were derived using numerous assumptions of future events
and conditions, including the continued availability of certain resources,
third party modification plans, third party assurances of year 2000
compliance and other factors. There can be no assurance that these
assumptions will be accurate and that the estimates will be achieved, and
actual results could differ materially from those anticipated. Specific
factors that could cause such material differences include, but are not
limited to: the availability and costs of personnel trained in year 2000
remediation; the accuracy of third party assurances; and the success of the
Company's customers and suppliers in addressing the year 2000 issue. The
Company's evaluation and assessment is ongoing and it expects that new or
different information may become available as its assessment and evaluation
continues. Consequently, there is no guarantee that the Company's efforts to
mitigate potential liability will be successful.
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 lesser 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 have the
option to convert its variable-rate long-term debt arrangements to fixed-rate
debt arrangements for a nominal transaction fee. At June 30, 1999, the Company
had variable-rate debt totaling $4.6 million. A hypothetical 1% adverse move in
interest rates along the entire interest rate yield curve would not materially
affect the fair value of the Company's financial instruments that are exposed to
changes in interest rates.
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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 theories 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 the federal court
action, which was filed on April 12, 1999. 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 held its annual meeting of stockholders on June 22, 1999. At such
meeting the following actions were voted upon:
WITHHELD/ BROKER/
ITEM AFFIRMATIVE NEGATIVE ABSTENTIONS NON-VOTE
- ---------------------------------------------- ------------------ --------------- ------------------ -----------------
ELECTION OF BOARD MEMBERS
Class III Directors (term expiring at
annual meeting of stockholders in 2002)
David W. Jahns 13,604,333 - 106,824 -
Larry D. Grandia 13,695,028 - 16,129 -
OTHER MATTERS
Ratification of Ernst & Young LLP as independent auditors for fiscal year
1999.
13,603,570 38,271 69,316 -
NAMES OF EACH OTHER DIRECTOR WHOSE TERM OF OFFICE AS A DIRECTOR CONTINUED AFTER
THE MEETING:
Georges J. Daou
Daniel J. Daou
Richard B. Jaffe
John H. Moragne
Kevin M. Fickenscher
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Item 6. Exhibits and Reports on Form 8-K
(a) Exhibits
10.1 Employment Agreement, dated as of June 15, 1999, between
Larry D. Grandia and the Registrant.
10.2 Loan and Security Agreement, dated as of June 29, 1999, by and
among HCFP Funding, Inc. and Registrant, DAOU-Sentient, Inc.,
DAOU-RHI, Inc., DAOU-TMI, Inc. and DAOU-Synexus, Inc.
10.3 Revolving Credit Note, dated June 29, 1999, issued to HCFP
Funding, Inc. by Registrant, DAOU-Sentient, Inc., DAOU-RHI,
Inc., DAOU-TMI, Inc. and DAOU-Synexus, Inc.
27 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,
1999.
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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: August 16, 1999 By: /s/ Larry D. Grandia
-------------------------------
Larry D. Grandia
Chief Executive Officer and Director
By: /s/ Fred C. McGee
-------------------------------
Fred C. McGee
Executive Vice President, Chief
Financial Officer and Secretary
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