**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

**FORM 10-Q**

 

**ý****                                      ****QUARTERLY REPORT PURSUANT TOSECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934**

 

# **For thequarterly period ended June 30, 2005**

#  

**OR**

 

**o****                               ****TRANSITIONREPORT 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 asspecified in its charter)

 
| **Delaware**                              | ** ** | **33-0284454**                        |
|-------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of          |       | (I.R.S. Employer  Identification No.) |
| incorporation or organization)            |       |                                  |
|                                      |       |                                  |
| **412 Creamery Way, Suite 300**           | ** ** | ** **                            |
| **Exton, Pennsylvania**                   | ** ** | **19341**                             |
| (Address of principal executive  offices) |       | (Zip Code)                            |

 

**(610) 594-2700**

(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 theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter 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 ý   No o

 

Indicate by check mark whether the registrantis an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).  Yes o   No ý

 

The number of shares of Registrant’s CommonStock, par value $.001 per share, outstanding as of July 30, 2005: 21,815,378

 

 

----

 

**Daou Systems, Inc.**

 

### Index to Form 10-Q

###  

| PART I.   | FINANCIAL INFORMATION                                                                                     |   |
|-----------|-----------------------------------------------------------------------------------------------------------|--------|
|      |                                                                                                      |   |
| Item 1.   | Condensed Financial Statements                                                                            |   |
|      |                                                                                                      |   |
|      | Condensed  Balance Sheets at June 30, 2005 (unaudited) and December 31, 2004 (restated)                   |   |
|      |                                                                                                      |   |
|      | Condensed Statements of Operations (unaudited) for the Three and Six  Months Ended June 30, 2005 and 2004 |   |
|      |                                                                                                      |   |
|      | Condensed Statements of Cash Flows (unaudited) for the Three and Six  Months Ended June 30, 2005 and 2004 |   |
|      |                                                                                                      |   |
|      | Notes to Condensed Financial Statements (unaudited)                                                       |   |
|      |                                                                                                      |   |
| Item 2.   | Management’s Discussion and Analysis of Financial Condition and  Results of Operations               |   |
|      |                                                                                                      |   |
| Item 3.   | Quantitative and Qualitative Disclosure about Market Risk                                                 |   |
|      |                                                                                                      |   |
| Item 4.   | Controls and Procedures                                                                                   |   |
|      |                                                                                                      |   |
| PART  II. | OTHER  INFORMATION                                                                                        |   |
|      |                                                                                                      |   |
| Item  1.  | Legal  Proceedings                                                                                        |   |
|      |                                                                                                      |   |
| Item 2.   | Unregistered Sales of Equities Securities and Use of Proceeds                                             |   |
|      |                                                                                                      |   |
| Item 3.   | Defaults Upon Senior Securities                                                                           |   |
|      |                                                                                                      |   |
| Item 4.   | Submission of Matters to a Vote of Security Holders                                                       |   |
|      |                                                                                                      |   |
| Item  5.  | Other  Information                                                                                        |   |
|      |                                                                                                      |   |
| Item 6.   | Exhibits                                                                                                  |   |
|      |                                                                                                      |   |
|      | SIGNATURES                                                                                                |   |

 

1

----

 

**PART I.   FINANCIAL INFORMATION**

 

ITEM 1.   CONDENSED FINANCIAL STATEMENTS

 

**Daou Systems, Inc.**

**Condensed Balance Sheets**

**(In thousands, except for per share data)**

 
| ** **                                                                                                                                                                                                                                           | ** ** | **June 30,**    | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------|------------|------------------|------------|
| ** **                                                                                                                                                                                                                                           | ** ** | **2005**        | ** ** | **2004**         | ** ** |
| ** **                                                                                                                                                                                                                                           | ** ** | **(unaudited)** | ** ** | ** **       | ** ** |
| **Assets**                                                                                                                                                                                                                                           |       |            |       |             |       |
| Current assets:                                                                                                                                                                                                                                      |       |            |       |             |       |
| Cash and cash equivalents                                                                                                                                                                                                                            |       | $               | 4,297      |             | $          | 5,932 |   |
| Investments, available-for-sale                                                                                                                                                                                                                      |       | 5,172           |       | 5,137            |       |
| Accounts receivable, net of allowance for  doubtful accounts of $337 and $367 at June 30, 2005 and December 31, 2004,  respectively                                                                                                                  |       | 6,793           |       | 5,218            |       |
| Contract work in progress                                                                                                                                                                                                                            |       | 494             |       | 190              |       |
| Other current assets                                                                                                                                                                                                                                 |       | 514             |       | 571              |       |
| Total current assets                                                                                                                                                                                                                                 |       | 17,270          |       | 17,048           |       |
|                                                                                                                                                                                                                                                 |       |            |       |             |       |
| Equipment, furniture and fixtures, net                                                                                                                                                                                                               |       | 782             |       | 885              |       |
| Other assets                                                                                                                                                                                                                                         |       | 579             |       | 747              |       |
| **Total Assets**                                                                                                                                                                                                                                     |       | $               | 18,631     |             | $          | 18,680 |   |
|                                                                                                                                                                                                                                                 |       |            |       |             |       |
| **Liabilities and Stockholders’ Deficit**                                                                                                                                                                                                       |       |            |       |             |       |
| Current liabilities:                                                                                                                                                                                                                                 |       |            |       |             |       |
| Accounts payable and other accrued  liabilities                                                                                                                                                                                                      |       | $               | 1,462      |             | $          | 1,708 |   |
| Accrued salaries and benefits                                                                                                                                                                                                                        |       | 1,478           |       | 1,814            |       |
| Deferred revenue                                                                                                                                                                                                                                     |       | 523             |       | 489              |       |
| Total current liabilities                                                                                                                                                                                                                            |       | 3,463           |       | 4,011            |       |
|                                                                                                                                                                                                                                                 |       |            |       |             |       |
| Long-term liabilities                                                                                                                                                                                                                                |       | 364             |       | 394              |       |
|                                                                                                                                                                                                                                                 |       |            |       |             |       |
| Commitments and contingencies                                                                                                                                                                                                                        |       | —          |       | —           |       |
|                                                                                                                                                                                                                                                 |       |            |       |             |       |
| Redeemable preferred stock, $.001 par  value. Authorized 3,520 shares; issued and outstanding 2,182 shares with a  liquidation preference of $18,718 and $17,827, respectively, at June 30, 2005  and December 31, 2004, including accrued dividends |       | 18,718          |       | 17,827           |       |
|                                                                                                                                                                                                                                                 |       |            |       |             |       |
| Stockholders’ deficit:                                                                                                                                                                                                                          |       |            |       |             |       |
|                                                                                                                                                                                                                                                 |       |            |       |             |       |
| Common stock, $.001 par value. Authorized  50,000 shares; issued and outstanding 21,815 shares at June 30, 2005 and  December 31, 2004 and 1,292 shares held in treasury                                                                             |       | 22              |       | 22               |       |
| Additional paid-in capital                                                                                                                                                                                                                           |       | 39,721          |       | 39,721           |       |
| Notes receivable from stockholders                                                                                                                                                                                                                   |       | (1,160          | )          | (1,160           | )          |
| Accumulated other comprehensive loss                                                                                                                                                                                                                 |       | (62             | )          | (3               | )          |
| Accumulated deficit                                                                                                                                                                                                                                  |       | (42,435         | )          | (42,132          | )          |
| Total stockholders’ deficit                                                                                                                                                                                                                     |       | (3,914          | )          | (3,552           | )          |
| **Total Liabilities and Stockholders’ Deficit**                                                                                                                                                                                                 |       | $               | 18,631     |             | $          | 18,680 |   |

 

*See accompanying notes to the condensedfinancial statements.*

 

2

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**Daou Systems, Inc.**

**Condensed Statements of Operations**

**(In thousands, except for per share data)**

*(unaudited)*

 
| ** **                                           | ** ** | **Three months ended** | ** ** | **Six months ended** | ** ** |
|------------------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                           | ** ** | **June 30,**           | ** ** | **June 30,**         | ** ** |
| ** **                                           | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue before reimbursements (net revenue)          |       | $                      | 7,436      |                 | $          | 6,643 |   | $ | 13,709 |   | $ | 15,481 |   |
| Out-of-pocket reimbursements                         |       | 577                    |       | 595                  |       | 764 |   | 1,304 |   |
| **Total revenue**                                    |       | 8,013                  |       | 7,238                |       | 14,473 |   | 16,785 |   |
|                                                 |       |                   |       |                 |       |   |   |   |   |
| Cost of revenue before reimbursable  expenses        |       | 5,205                  |       | 4,888                |       | 9,811 |   | 12,010 |   |
| Out-of-pocket reimbursable expenses                  |       | 577                    |       | 595                  |       | 764 |   | 1,304 |   |
| **Total cost of revenue**                            |       | 5,782                  |       | 5,483                |       | 10,575 |   | 13,314 |   |
| Gross profit                                         |       | 2,231                  |       | 1,755                |       | 3,898 |   | 3,471 |   |
|                                                 |       |                   |       |                 |       |   |   |   |   |
| Operating expenses:                                  |       |                   |       |                 |       |   |   |   |   |
| Sales and marketing                                  |       | 449                    |       | 810                  |       | 1,063 |   | 1,967 |   |
| General and administrative                           |       | 1,190                  |       | 1,944                |       | 2,516 |   | 3,457 |   |
|                                                 |       |                   |       |                 |       |   |   |   |   |
|                                                 |       | 1,639                  |       | 2,754                |       | 3,579 |   | 5,424 |   |
| Income (loss) from operations                        |       | 592                    |       | (999                 | )          | 319 |   | (1,953 | ) |
| Other income, net                                    |       | 129                    |       | 45                   |       | 269 |   | 88 |   |
|                                                 |       |                   |       |                 |       |   |   |   |   |
| Net income (loss)                                    |       | 721                    |       | (954                 | )          | 588 |   | (1,865 | ) |
| Accrued dividends on preferred stock                 |       | (448                   | )          | (369                 | )          | (891 | ) | (733 | ) |
| Net income (loss) available to common  stockholders  |       | $                      | 273        |                 | $          | (1,323 | ) | $ | (303 | ) | $ | (2,598 | ) |
| Earnings (loss) per share:                           |       |                   |       |                 |       |   |   |   |   |
| Basic                                                |       | $                      | 0.01       |                 | $          | (0.06 | ) | $ | (0.01 | ) | $ | (0.12 | ) |
| Diluted                                              |       | $                      | 0.01       |                 | $          | (0.06 | ) | $ | (0.01 | ) | $ | (0.12 | ) |
|                                                 |       |                   |       |                 |       |   |   |   |   |
| Shares used in computing earnings (loss)  per share: |       |                   |       |                 |       |   |   |   |   |
|                                                 |       |                   |       |                 |       |   |   |   |   |
| Basic                                                |       | 21,815                 |       | 21,675               |       | 21,815 |   | 21,506 |   |
| Diluted                                              |       | 25,850                 |       | 21,675               |       | 21,815 |   | 21,506 |   |

 

*See accompanying notes to the condensedfinancial statements.*

 

3

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**Daou Systems, Inc.**

**Condensed Statements of Cash Flows**

**(In thousands)**

*(**unaudited**)*

 
| ** **                                                                            | ** ** | **Six Months Ended June 30,** | ** ** |
|---------------------------------------------------------------------------------------|------------|-------------------------------|------------|
| ** **                                                                            | ** ** | **2005**                      | ** ** | **2004** | ** ** |
|                                                                                  |       |                          |       |   |   |
| **Operating activities**                                                              |       |                          |       |   |   |
| Net income (loss)                                                                     |       | $                             | 588        |   | $ | (1,865 | ) |
| Adjustments to reconcile net income (loss)  to net cash used in operating activities: |       |                          |       |   |   |
| Depreciation and amortization                                                         |       | 252                           |       | 310 |   |
| Amortization of deferred compensation                                                 |       | —                        |       | 40 |   |
| Provision for uncollectible accounts                                                  |       | 45                            |       | 26 |   |
| Non cash compensation charge                                                          |       | —                        |       | — |   |
| Changes in operating assets and  liabilities:                                         |       |                          |       |   |   |
| Accounts receivable                                                                   |       | (1,620                        | )          | 1,971 |   |
| Contract work in process                                                              |       | (304                          | )          | 1,306 |   |
| Other current assets                                                                  |       | 57                            |       | (112 | ) |
| Accounts payable and accrued liabilities                                              |       | (246                          | )          | (576 | ) |
| Accrued salaries and benefits                                                         |       | (336                          | )          | (1,844 | ) |
| Deferred revenue                                                                      |       | 34                            |       | (1,206 | ) |
| Other                                                                                 |       | 148                           |       | 29 |   |
| Net cash used in operating activities                                                 |       | (1,382                        | )          | (1,921 | ) |
|                                                                                  |       |                          |       |   |   |
| **Investing activities**                                                              |       |                          |       |   |   |
| Purchases of equipment, furniture and  fixtures, net                                  |       | (149                          | )          | (258 | ) |
| Purchases of available-for-sale investments                                           |       | (94                           | )          | — |   |
| Changes in other assets                                                               |       | (10                           | )          | 27 |   |
| Net cash used in investing activities                                                 |       | (253                          | )          | (231 | ) |
|                                                                                  |       |                          |       |   |   |
| **Financing activities**                                                              |       |                          |       |   |   |
| Proceeds from issuance of common stock                                                |       | —                        |       | 33 |   |
| Net cash provided by financing activities                                             |       | —                        |       | 33 |   |
|                                                                                  |       |                          |       |   |   |
| Decrease in cash and cash equivalents                                                 |       | (1,635                        | )          | (2,119 | ) |
| Cash and cash equivalents at beginning of  period                                     |       | 5,932                         |       | 13,045 |   |
| Cash and cash equivalents at end of period                                            |       | $                             | 4,297      |   | $ | 10,926 |   |

 

*See accompanying notes to the condensedfinancial statements.*

 

4

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**Daou Systems, Inc.**

**Notes to Condensed Financial Statements**

**(unaudited)**

 

1. Basis of Presentation

 

Theunaudited condensed financial statements of Daou Systems, Inc. (“Daou” or the “Company”)at June 30, 2005 and for the three and six-month periods ended June 30, 2005and 2004 have been prepared in accordance with generally accepted accountingprinciples (“GAAP”) for interim financial information. Accordingly, they do notinclude all information and footnotes required by GAAP for a complete set offinancial statements.  These financialstatements reflect all adjustments, consisting of normal recurring adjustments,which in the opinion of management are necessary to present fairly thefinancial position of the Company at June 30, 2005 and the results ofoperations for the three and six-month periods ended June 30, 2005 and2004.  The results of operations for thethree and six months ended June 30, 2005 are not necessarily indicative of theresults to be expected for the year ending December 31, 2005.  The Company has experienced significantquarterly fluctuations in operating results and it expects that these fluctuationswill continue.  The balance sheet atDecember 31, 2004 has been derived from the audited financial statements atthat date, as amended (see below), but does not include all of the informationand footnotes required by generally accepted accounting principles for completefinancial statements.  Certain balancesin prior periods have been reclassified to conform with the current year’spresentation.

 

**The Company’s public filings with the SEC from 1999 through2004 reference an outstanding series of preferred stock referred to as “SeriesA Preferred Stock.”  This series ofpreferred stock was authorized and designated pursuant to a Certificate ofDesignations filed with the Delaware Secretary of State on July 23, 1999 (theCertificate of Designations was filed as Exhibit 4.1 to the Company’s Form 8-Kfiled with the SEC on July 29, 1999).  Atthat time, the Company sold shares of this new Series A Preferred Stock tocertain investors.  However, the Companyrecently discovered that a previously outstanding series of preferred stock,also referred to as “Series A Preferred Stock,” which was outstanding prior tothe Company’s initial public offering of its common stock in February 1997 andwhich was converted to common stock in the initial public offering, was nevereliminated from the Company’s Certificate of Incorporation.  Because the earlier Series A Preferred Stockwas never eliminated from the Company’s Certificate of Incorporation, the newseries of preferred stock issued in July 1999 should have been designated asSeries A-1 Preferred Stock, not Series A Preferred Stock.  This error was corrected by a Certificate ofCorrection filed with the Delaware Secretary of State on June 14, 2005.**

** **

Thefinancial statements and related disclosures have been prepared with thepresumption that users of the interim financial information have read or haveaccess to the audited financial statements for the preceding fiscal year.  Accordingly, these financial statementsshould be read in conjunction with the audited financial statements and therelated notes thereto contained in the Company’s amended Annual Report on Form10-K/A Amendment No. 2 filed with the Securities and Exchange Commission (“SEC”)on August 12, 2005.

 

2. Recent Pronouncements

 

On December 16, 2004, the FinancialAccounting Standards Board (FASB) issued Statement 123 (revised 2004), “ShareBased Payment” (FAS 123R). FAS 123R supersedes APB 25, “Accounting for StockIssued to Employees,” and is effective for the Company on January 1, 2006.   FAS 123R requires that the fair value ofequity based awards be recognized in the financial statements for new awardsand previously granted awards that are not yet fully vested on the adoptiondate. The Company is currently evaluating the impact of adopting FAS 123R butdoes not expect a material impact.

 

3. Use of Estimates

 

The preparation of financial statements inconformity with accounting principles requires management to make estimates andassumptions about the future that affect the amounts reported in the financialstatements and disclosures made in the accompanying notes of the financialstatements.   The actual results coulddiffer from those estimates.

 

5

----

 

4. Earnings (Loss) Per Share

 

The following table details the computationof basic and diluted earnings per share:

 

*(In thousands, except per shareinformation)*

* *
| ** **                                                                                             | ** ** | **Three Months Ended June 30,** | ** ** | **Six Months Ended June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------|------------|---------------------------------|------------|-------------------------------|------------|
| ** **                                                                                             | ** ** | **2005**                        | ** ** | **2004**                      | ** ** | **2005** | ** ** | **2004** | ** ** |
| Numerator:                                                                                             |       |                            |       |                          |       |   |   |   |   |
| Net income (loss)                                                                                      |       | $                               | 721        |                          | $          | (954 | ) | $ | 588 |   | $ | (1,865 | ) |
| Preferred stock dividends                                                                              |       | 448                             |       | 369                           |       | 891 |   | 733 |   |
| Numerator for basic and diluted  loss per share – income (loss) available to common stockholders  |       | $                               | 273        |                          | $          | (1,323 | ) | $ | (303 | ) | $ | (2,598 | ) |
|                                                                                                   |       |                            |       |                          |       |   |   |   |   |
| Denominator:                                                                                           |       |                            |       |                          |       |   |   |   |   |
| Weighted-average common shares  outstanding                                                            |       | 21,815                          |       | 21,744                        |       | 21,815 |   | 21,680 |   |
| Weighted-average unvested  common shares subject to repurchase agreements                              |       | —                          |       | (69                           | )          | — |   | (174 | ) |
| Denominator for basic loss per  share                                                                  |       | 21,815                          |       | 21,675                        |       | 21,815 |   | 21,506 |   |
|                                                                                                   |       |                            |       |                          |       |   |   |   |   |
| Effect of dilutive securities:                                                                         |       |                            |       |                          |       |   |   |   |   |
| Unvested common shares subject  to repurchase agreements                                               |       | —                          |       | —                        |       | — |   | — |   |
| Employee stock options                                                                                 |       | 659                             |       | —                        |       | — |   | — |   |
| Warrants                                                                                               |       | 3,376                           |       | —                        |       | — |   | — |   |
| Dilutive potential common  shares                                                                      |       | —                          |       | —                        |       | — |   | — |   |
| Denominator for diluted loss  per share – adjusted weighted-average common shares and equivalents |       | 25,850                          |       | 21,675                        |       | 21,815 |   | 21,506 |   |
|                                                                                                   |       |                            |       |                          |       |   |   |   |   |
| Basic income (loss) per share                                                                          |       | $                               | 0.01       |                          | $          | (0.06 | ) | $ | (0.01 | ) | $ | (0.12 | ) |
| Diluted income (loss per) share                                                                        |       | $                               | 0.01       |                          | $          | (0.06 | ) | $ | (0.01 | ) | $ | (0.12 | ) |

 

Options to purchase anadditional 1,734,609 shares of common stock were outstanding during the three monthperiod ended June 30, 2005 but were not included in the computation of dilutedearnings per share because the options’ exercise prices were greater than theaverage market price of the common shares and, therefore, the effect would beanti-dilutive. In addition, the Series A-1 Convertible Preferred Stock andaccrued dividends were excluded from diluted earnings per share for the three-and six-month periods ended June 30, 2005 as the assumed conversion would beanti-dilutive.

 

6

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5. Stock-Based Compensation

 

The Company has stock-based employee compensation plans. The Companyapplies the recognition and measurement principles of APB Opinion No. 25, “Accountingfor Stock Issued to Employees,” and related interpretations in accounting forthose plans. Pro forma information regarding net income and earnings per shareis required by SFAS No. 123, “Accounting for Stock-Based Compensation,” and hasbeen determined as if the Company had accounted for its stock plans under thefair value method of SFAS No. 123.  Forpurposes of the pro forma disclosures, the estimated fair value of the optionsis amortized to expense over the options’ vesting periods. The following tableillustrates the effect on net income (loss) available to common shareholdersand earnings (loss) per share if the Company had applied the fair valuerecognition provisions of SFAS No. 123:

 

| ** **                                                                                                         | ** ** | **Three Months Ended  June 30,** | ** ** | **Six Months Ended  June 30,** | ** ** |
|--------------------------------------------------------------------------------------------------------------------|------------|----------------------------------|------------|--------------------------------|------------|
| ** **                                                                                                         | ** ** | **2005**                         | ** ** | **2004**                       | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                                                                                         | ** ** | ** **                       | ** ** | ** **                     | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net income (loss) available to common  shareholders before stock-based employee compensation                       |       | $                                | 273        |                           | $          | (1,323 | ) | $ | (303 | ) | $ | (2,598 | ) |
| Deduct total stock-based employee  compensation determined under the fair value method for all awards, net of  tax |       | (46                              | )          | (50                            | )          | (92 | ) | (110 | ) |
| Pro forma net income (loss) available to  common shareholders                                                      |       | $                                | 227        |                           | $          | (1,373 | ) | $ | (395 | ) | $ | (2,708 | ) |
|                                                                                                               |       |                             |       |                           |       |   |   |   |   |
| Earnings (loss) per share:                                                                                         |       |                             |       |                           |       |   |   |   |   |
| Basic – as reported                                                                                           |       | $                                | 0.01       |                           | $          | (0.06 | ) | $ | (0.01 | ) | $ | (0.12 | ) |
| Diluted – as reported                                                                                         |       | $                                | 0.01       |                           | $          | (0.06 | ) | $ | (0.01 | ) | $ | (0.12 | ) |
|                                                                                                               |       |                             |       |                           |       |   |   |   |   |
| Basic – pro forma                                                                                             |       | $                                | 0.01       |                           | $          | (0.06 | ) | $ | (0.02 | ) | $ | (0.13 | ) |
| Diluted – pro forma                                                                                           |       | $                                | 0.01       |                           | $          | (0.06 | ) | $ | (0.02 | ) | $ | (0.13 | ) |

 

The fair value of options granted wasestimated at the date of grant using the Black-Scholes option pricing modelwith the following weighted-average assumptions for option grants during thefirst half of 2004: risk-free interest rate of 3%; dividend yield of 0%;volatility factors of the expected market price of the Company’s common stockof 82%; and a weighted-average expected life of the options of five years. Nooptions were granted during the first half of 2005.

 

6. Restructuring Plan

 

The Company recorded restructuring charges for years prior to 2003 inaccordance with SEC SAB  No. 100, Restructuring And Impairment Charges,and EITF No. 94-3, Liability Recognition For Certain Employee TerminationBenefits And Other Costs To Exit An Activity (Including Certain Cost IncurredIn A Restructuring). Effective January 1, 2003, the Company follows theprovisions of SFAS 146, “Accounting for Costs Associated with Exit or DisposalActivities.”

 

As of June 30, 2005, the Company’s remaining restructuring liabilitywas $33,000 related to the closure of certain facilities. The final leaseobligations relating to the closure of these facilities will be settled in thethird quarter of fiscal 2005.

 

7

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7. Contingencies

 

On August 24, 1998, August 31, 1998, September 14, 1998 and September23, 1998, four separate complaints were filed against the Company and certainof its officers and directors in the United States District Court for theSouthern District of California.  A groupof shareholders has been appointed the lead plaintiff in this federallitigation, and they filed a second amended consolidated class action complainton January 21, 2000.  This new complaintrealleges that the Company improperly used the “percentage-of-completion”accounting method for revenue recognition. Claims are pleaded under both the 1933 Securities Act (relating to theCompany’s initial public offering) and section 10(b) of the 1934 Securities ExchangeAct.  The complaint was brought on behalfof a purported class of investors who purchased the Company’s Common Stockbetween February 13, 1997 and October 28, 1998, but it does not allege specificdamage amounts.

 

A Motion to Dismiss the second amended consolidated class actioncomplaint was filed on February 22, 2000. On March 27, 2002, the Court granted the Motion but extended toplaintiffs the opportunity to file a Third Amended Complaint.  The plaintiffs filed their third amendedconsolidated class action complaint on May 16, 2002, to which the Companyresponded with another Motion to Dismiss. The Motion was filed on June 24, 2002 and challenged the legalsufficiency of the allegations.  OnOctober 15, 2002, the Court granted that Motion, this time with prejudice.

 

Plaintiffs timely noticed an appeal and filed their Appellants’ Briefwith the Ninth Circuit Court of Appeals on April 9, 2003.  On July 2, 2003, the Company filed itsRespondents’ Brief and Cross-Appeal.  TheCross-Appeal challenges the trial court’s failure to assess whether thecomplaint complied with applicable pleadings standards.  The matter was argued before the court onFebruary 12, 2004.  On February 2, 2005,the court reversed the dismissal and remanded the case back to the districtcourt. Because it reversed the dismissal, it did not decide the Company’scross-appeal.  On February 23, 2005, theCompany appealed the reversal by way of petition for rehearing to the samepanel of the Ninth Circuit Court of Appeals that decided the appeal.  The panel issued its decision on June 21,2005 denying the petition for rehearing. As a result, the Company filed another petition for rehearing on July 5.2005, this one directed to Ninth Circuit en banc.  No hearing date has been set and the plaintiffshave yet to oppose.  If the Court doesnot grant relief, the Company intends to appeal to the Supreme Court by way ofwrit of certiorari.

 

On October 7, 1998 and October 15, 1998, two separate complaints werefiled in the Superior Court of San Diego County, California.  These state court complaints mirror theallegations set forth in the federal complaints.  They also assert claims for common law fraudand the violation of certain California statutes.  As with their federal counterparts, they donot allege specific damage amounts.  OnApril 1, 1999, a Consolidated Amended Class Action was filed on behalf of thesame state court plaintiffs, and this new complaint alleges the same factualbasis as is asserted in the federal litigation. The state litigation pleads claims for fraud and violations of certainCalifornia Corporation Code provisions. By stipulation of the parties and order of the court, this state courtlitigation was stayed pending the outcome of the motion to dismiss the federallawsuits, as well as the resulting Appeal and Cross-Appeal.

 

The Company believes that the allegations setforth in the federal and state complaints are without merit, and the Companyintends to defend against these lawsuits vigorously.  The Company is occasionally party to othervarious claims and legal actions arising in the normal course of business.Although the ultimate outcome of the matters is not presently determinable,management believes that the resolution of all such matters, net of amountsaccrued, will not have a material adverse affect on the Company’s business,results of operations or financial condition; however, there can be noassurance that the ultimate resolution of these matters will not have amaterial impact on the Company’s results of operations in any period.

 

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8. Subsequent Event

 

On August 11, 2005, the Company announced that it had reached a definitive agreement for the acquisition of all the preferred and common stock of Daou by Proxicom, Inc., a portfolio company of Gores Technology Group, LLC.  The transaction has an aggregate value of approximately $21.6 million, less applicable transaction related expenses. Subject to certain potential pre-closing balance sheet adjustments, each outstanding share of Daou common stock will receive cash equal to approximately $0.305 per share.  The holders of Daou’s Series A-1 Preferred Stock will receive an aggregate of $12.2 million in cash.  The consummation of the transaction is subject to the approval of Daou’s stockholders and other customary conditions. Either party may terminate the agreement in the event that the common stock per share consideration is less than $0.27.  The transaction is expected to close during the fourth quarter of 2005.

 

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**ITEM 2.**                 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIALCONDITION AND RESULTS OF OPERATIONS

** **

This discussion containsforward-looking statements within the meaning of Section 27A of the SecuritiesAct of 1933, as amended, and Section 21E of the Securities Exchange Act of1934. All forward-looking statements are inherently uncertain as they are basedon current expectations and assumptions concerning future events or futureperformance of Daou Systems, Inc. You should not place undue reliance on theseforward-looking statements, which are only predictions and speak only as of thedate hereof. Forward-looking statements usually contain the word “estimate,” “anticipate,”“hope”, “believe,” “think”, “expect,” “intend”, “plan” or similar expressions,and are subject to numerous known and unknown risks and uncertainties. Theforward-looking statements included herein are based on current expectationsand certain assumptions and entail various risks and uncertainties, includingrisks and uncertainties relating to: the Company’s ability to sell its servicesto existing and new customers; the long sales cycle in obtaining new customersand larger contracts; the timing and extent of employee training or theloss of key employees; industry spending patterns and marketconditions; the reduction in size, delay in commencement or loss or terminationof one or more significant projects; increased competition and the resultingpricing pressure; the Company’s ability to continually offer services andproducts that meet its customers’ demands, as new technologies or industrystandards could render its services obsolete or unmarketable; the ability ofthe company to successfully execute strategies for realizing shareholder value;the effects of healthcare industry consolidation and changes in the healthcareregulatory environment on existing customer contracts; and the continuedeffect of our high costs associated with certain dividend rights of ourpreferred shareholders. In evaluating such statements, you should carefullyreview various risks and uncertainties identified in this report, including ourFinancial Statements and the related notes and in our other SEC filings, including those more fully set forthin the “Risk Factors,” “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” and other sections of the amended Form10-K/A Amendment No. 2 for the year ended December 31, 2004 which was filedwith the SEC concurrent with the filing of this Form 10-Q. These risksand uncertainties could cause our actual results to differ materially fromthose indicated in the forward-looking statements. We do not undertake anyobligation to update or publicly announce revisions to any forward-lookingstatements to reflect future events or developments.

 

**Overview of the Company**

 

Daou performsapplications consulting and implementation, wireless and traditional networkservices, enterprise application integration, software engineering and databasemigration and conversions. Our broad-based technical expertise has led us tokey offerings in the integration of legacy systems with emerging technologies,such as web-portals and wireless and other portable computing solutions for theU.S. healthcare industry. Our IT services include data and voice networking,applications consulting and implementation, as well as operational and Internetsolutions. We organize our business by markets, with specific focus areas in 1)payers of health care services in the commercial markets, including healthplans, insurance companies, managed care organizations, and third partyadministrators; 2) providers of clinical services such as community and urbanhospitals and hospital systems;, and 3) government healthcare organizationsincluding Veterans Health Administration, Department of Defense Military HealthService, and the Department of Health and Human Services.

 

**Overview of the healthcare ITindustry and material trends impacting the Company’s results of operations**

 

The healthcare IT market has fared comparatively well in recent months,notwithstanding the industry’s reputation for being slow to adopt newinformation technologies. The industry’s general hesitation to adopt newtechnologies is the result of reimbursement pressures, demands of consolidation,and constant pressure to reduce administrative expenditures while improving thequality of care. Executive members participating in a recent HealthcareInformation and Management Systems Society (HIMSS) survey said they are stillnot receiving enough financial support from their organizations to implementIT. The survey indicates that more healthcare organizations will outsource ITfunctions over the next two years. Even so, the Company believes that ITstaffing needs and budgets will continue to rise, although at slower rates thanin past years. Also on the increase will be the functionality of Web sites forconsumers. In the next two years, more Web sites will enable access to medicalrecords and health assessment applications, HIMSS survey respondents predicted.

 

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The three sectors of the health care market we serve (payers, providersand government) remain under financial pressure to continue to reduce ITrelated costs while meeting the clinical and administrative demands drivingquality of care, reimbursement, and data security. As a result, our revenuefrom professional services remained flat in the quarter.  However, revenue increased from the sale of materialsand equipment to support infrastructure projects, and the completion of a webportal project, resulting in an improvement in overall revenue in the secondquarter 2005 as compared to the first quarter 2005, increasing 19% from $6.3million to $7.4 million.

 

**Key indicators of our financial condition and operating performance**

 

Utilization of our professional staff, which is the ratio of totalbillable hours to available hours in a given period, and our ability to managefixed price contracts, are among our top challenges. We employed 100 billableprofessionals on June 30, 2005. The salaries and benefits of this staff, aswell as the direct costs associated with billable sub-contractors, arerecognized in our cost of revenue before reimbursable expenses. Mostnon-billable employee salaries and benefits are recognized as a component ofeither selling or general and administrative expenses.

 

Quarterly net revenues increased by 12% in the second quarter 2005 ascompared to the second quarter 2004, up $793,000 to $7.4 million from $6.6million.  However, this increase was theresult of two mobile health implementation projects that began in the secondquarter of 2005, the completion of a data center consolidation project in ourpayer business unit and the improvement in professional services revenue fromseveral large projects in our government business unit.

 

Selling, general and administrative (SG&A) overhead expenses of$1.6 million in the second quarter 2005 were $1.1 million lower than the secondquarter 2004 as a result of reduced: sales and administrative staff, travel andrelated expenses, and general overhead expenses. We have reduced our generaland administrative expenses by managing those costs that are mostlycontrollable such as staffing, facilities, IT and operating systems in order tomore closely align these costs with net revenue.  We are not currently undergoing furtherreductions in general and administrative expenses, except as taken in theordinary course of business.

 

**Characteristics of our revenue and expenses**

 

We generate substantially all of our revenue from professionalservices, primarily on a “time and expense” project basis, under which revenueis recognized as the services are performed. Billings for these services occuron a semi-monthly or monthly basis as specified by the contract with aparticular customer. Our billing rates are commensurate with thehealthcare-domain IT expertise, know-how and skills of our people. Our time andexpense projects generally range from three to six months, although certainprojects have been for periods in excess of a year. Our network system andpayer application system implementation engagements typically average sixmonths, but may vary depending on the size and complexity of the project.

 

We continue to provide some of our professional services on a fixed-feebasis. Revenue on fixed-fee contracts is recognized relative to the level ofservice performed based upon the amount of labor cost incurred on the projectversus the total labor costs to complete the project. Our gross margin withrespect to fixed fee contracts varies significantly depending on the percentageof such services consisting of the resale of third-party products (with respectto which we obtain a lower margin) versus professional services.

 

We bill our customers for out-of-pocket expenses, primarily travel andrelated expenses incurred with respect to services provided to customers, andhave adopted the provisions of the Emerging Issues Task Force (“EITF”) TopicD-103, Income Statement Characterization of Reimbursements for “Out-of-Pocket”Expenses Incurred, issued in November 2001. EITF Topic D-103 states that reimbursements received for out of pocketexpenses should be characterized as revenue on the income statement.  The application of EITF Topic D-103 does nothave an impact on current or previously reported net income (loss) or netincome (loss) per share.  We willcontinue to use net revenue (revenue before reimbursements) and cost of revenuebefore reimbursable expenses to compute percentage and margin calculations, aswell as for purposes of comparing the results of operations for the three andsix months ended June 30, 2005 to the three and six months ended June 30, 2004.

 

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Payments received in advance of services performed are recorded asdeferred revenue. Certain contract payment terms may result in customer billingoccurring at a pace slower than revenue recognition. The resulting revenuerecognized in excess of amounts billed and project cost is included in contractwork in progress on our balance sheet.

 

Cost of revenue primarily consists of all expenses that are directlyattributable to our service lines and include the salaries, bonuses and relatedbenefits of our consultants as well as non-billable managers and support staff,subcontractor expenses, training costs and unit-specific office space costs.Our consultant-related costs are relatively fixed; therefore, fluctuations inour gross margin may occur due to changes in project margins and utilization ratesof our professional staff. We often continue to employ non-engaged employees inanticipation of commencement of a project. We invest in training these keybillable employees not engaged in contract work in order to improve our abilityto diversify our service offerings to include business process improvementconsulting, wireless and mobile computing, and other related IT consultingservices. If delays in contract signing occur or projects do not materialize,our gross margin could vary due to the associated loss of revenue to coverfixed labor costs.

 

Sales and marketing expenses primarily consist of the salaries,benefits, travel and other costs of our sales and marketing teams, as well asmarketing initiatives and business development expenses. In the second quarter2005, while we have reduced our overall direct sales expenses, we continue tomake investments in our sales development and marketing plans in the providermarket as we develop our web portal, integration and mobile health solutionscapabilities.

 

General and administrative expenses primarily consist of the costsattributable to the support of our consultants, such as: investments ininformation systems, salaries, expenses and office space costs for executivemanagement, financial accounting, purchasing, administrative and humanresources personnel, recruiting fees, legal and other professional services.

 

## **Results ofOperations**

## ** **

The following table setsforth, for the periods indicated, certain statement of operations data as apercentage of net revenues.

 
| ** **                                    | ** ** | **Three Months Ended** | ** ** | **Six Months Ended** | ** ** |
|-----------------------------------------------|------------|------------------------|------------|----------------------|------------|
| ** **                                    | ** ** | **June 30,**           | ** ** | **June 30,**         | ** ** |
| ** **                                    | ** ** | **2005**               | ** ** | **2004**             | ** ** | **2005** | ** ** | **2004** | ** ** |
| Revenue before reimbursements (net revenue)   |       | 100                    | %          | 100                  | %          | 100 | % | 100 | % |
| Cost of revenue before reimbursable  expenses |       | 70                     |       | 74                   |       | 72 |   | 78 |   |
| Gross profit                                  |       | 30                     |       | 26                   |       | 28 |   | 22 |   |
| Operating expenses                            |       | 22                     |       | 41                   |       | 26 |   | 35 |   |
| Income (loss) from operations                 |       | 8                      |       | (15                  | )          | 2 |   | (13 | ) |
| Other income, net                             |       | 2                      |       | 1                    |       | 2 |   | 1 |   |
| Net income (loss)                             |       | 10                     | %          | (14                  | )%         | 4 | % | (12 | )% |

 

**Three Months Ended June 30, 2005 and 2004**

 

Our net revenue increased 12% or $793,000 to$7.4 million for the three months ended June 30, 2005 from $6.6 million for thethree months ended June 30, 2004.  We experienced an improvement of $862,000 in revenue primarily as aresult of the sale of materials and equipment to support IT infrastructure and webportal implementation projects.  Professionalservices in our government business unit increased by $627,000 but was largelyoffset by a combined decrease in professional services revenue of $597,000 in our payer and provider business units as well asthe closure of our support center in 2004.

 

Services toour five largest customers accounted for $2.8 million of net revenue for thethree months ended June  30, 2005,

 

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representing38% of total net revenue, with no one customer accounting for more than 10% oftotal net revenue. This compares to net revenue from the five largest customersfor the three months ended June 30, 2004 totaling $2.0 million of net revenuerepresenting 31% of total net revenue; with no one customer accounting for morethan 10% of total net revenue.

 

Cost ofrevenue before reimbursable expenses increased 7% or $317,000 to $5.2 millionfor the three months ended June 30, 2005 from $4.9 million for the three monthsended June 30, 2004.  This increase wasattributable primarily to an increase of $574,000 in materials and equipmentrelated to IT infrastructure projects initiated in the second quarter 2005 andan increase of $113,000 and $109,000 of billable professional staff andsub-contractors in our government business, and partially offset by a decreaseof $444,000 in billable sub-contractor expense in our payer business unit.

 

Gross marginwas 30% in the second quarter of 2005, compared to 26% in the second quarter of2004.  We experienced higher margins onprofessional services as a result of improved utilization of our billableconsultants in all of our business units.

 

Second quarter 2005 operatingresults reflected a reduced level of marketing and business developmentexpenses as we continue to lower our costs as a result of lower revenue. Forthe three months ended June 30, 2005, sales and marketing expenses decreased by$361,000, or 44.6%, to $449,000 from $810,000 for the three months ended June30, 2004.

 

General and administrative expenses decreased 39%, or approximately$754,000, to $1.2 million for the three months ended June 30, 2005 from $1.9million for the three months ended June 30, 2004, partially due to the reducednumber of administrative staff, and reduced general overhead costs. We continueto manage those costs that are mostly controllable such as staffing, facilitiesand operational overhead.

 

**Six Months Ended June 30, 2005 and 2004**

 

Our net revenue decreased 11% or $1.8 million to $13.7 million for thesix months ended June 30, 2005 from $15.5 million for the six months ended June30, 2004.  The decrease was primarily dueto the discontinuation of our support center management services and the completionof a large network upgrade project in the first quarter of 2004, and a declinein professional services revenue from our provider and payer business units,offset by an increase in revenue from our government and integration businessunit.

 

Services to our five largest customers accounted for $5.0 million ofnet revenue for the six months ended June 30, 2005, representing 37% of totalnet revenue, This compares to net revenue from the five largest customers forthe six months ended June 30, 2004 totaling $5.4 million, or 35% of total net revenuewith one customer accounting for 11% of total net revenue. 

 

Cost of revenue before reimbursable expenses decreased 18%, or $2.2million, to $9.8 million on revenue of $13.7 million for the six months endedJune 30, 2005, from $12.0 million on revenue of $15.5 million for the sixmonths ended June 30, 2004. The decrease in cost of revenue was attributable tothe reduction in our billable workforce and utilization of third partysub-contractors in our provider and payer business units. 

 

Gross margin increased to 28% for the six months ended June 30, 2005compared to 22% for the six months ended June 30, 2004. We experienced highermargins on professional services related to our payer and government andintegration business units, offset by lower margins in our provider servicesbusiness. Higher margins were attributable to an improvement in the utilizationof our professional staff and sub-contractors. 

 

Operating results reflected a reduced level of marketing and businessdevelopment expenses as we continued to lower our controllable costs as aresult of declining revenue. During the first six months of 2005, sales andmarketing expenses decreased $904,000 to $1.1 million for the six months endedJune 30, 2005 from $2.0 million for the six months ended June 30, 2004. 

 

General and administrative expenses decreased 27%, or $941,000, to $2.5million for the six months ended June 30, 2005 from $3.5 million for the sixmonths ended June 30, 2004, partially due to the reduced number ofadministrative staff, and reduced general overhead costs. We continue to managethose costs that are mostly controllable such as staffing, facilities andoperational overhead.

 

**Income Taxes**

 

We have a history of losses, which, for income tax purposes, generatedsizeable federal and state tax net operating loss (“NOL”) carryforwards, atDecember 31, 2004, of approximately $32.0 million and approximately $10.9million, respectively. The federal loss carryforwards will expire beginning2018 through 2024, and the state loss carryforwards expire from 2004 through2024, unless previously utilized. Pursuant to generally accepted accountingprinciples, we previously recorded a valuation allowance against the deferredtax asset associated with these NOL carryforwards as it is more likely than notthat we will not be able to utilize the NOL carryforwards to offset futuretaxes. Due to the size of the NOL carryforwards in relation to our history ofunprofitable operations, we have not recognized any of this net deferred taxasset. It is possible that we could be profitable in the future at levels whichwould cause us to conclude that it is more likely than not that we will be ableto realize all or a portion of the NOL carryforwards. Upon reaching such aconclusion, we would record the estimated net realizable value of the deferredtax asset at that time and would then begin to provide for income taxes at arate equal to our combined federal and state effective rates, which we believewould approximate 40%. Subsequent revisions to the estimated net realizablevalue of the deferred tax asset could cause our provision for income taxes tovary significantly from period to period.

 

Under Section 382 of the Internal Revenue Code, the annual use of ourNOL carryforwards may be limited in the event of a cumulative change inownership of more that 50%.

 

**Liquidity and Capital Resources**

 

At June 30, 2005, we had working capital of approximately $13.8million.

 

For the six months ended June 30, 2005, net cash used by operatingactivities of $1.4 million was attributable to initiating an IT infrastructureservice contract in the first and second quarters of 2005, resulting in anincrease in accounts receivable and contract work in process, and the decreasein accrued salaries and benefits as a result of the payment of variouscompensation commitments accrued in 2004. This compares to net cash used byoperating

 

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activities of $1.9 million for the six months ended June 30, 2004 whichwas primarily the result of net operating losses experienced in that period.

 

Net cash used in investing activities was $253,000 for the six monthsended June 30, 2005, compared to net cash used in investing activities of$231,000 in the comparable prior period. The use of these funds in both periods was primarily due to the purchaseof fixed assets and, in fiscal 2005, the purchase of available-for-saleinvestments.

 

There were no financing activities in the first half of fiscal2005.  Net cash provided by financingactivities for the six months ended June 30, 2004 was $33,000 which wasattributable to proceeds from the issuance of common stock.

 

**The Company’s public filings with the SEC from 1999 through2004 reference an outstanding series of preferred stock referred to as “SeriesA Preferred Stock.”  This series ofpreferred stock was authorized and designated pursuant to a Certificate ofDesignations filed with the Delaware Secretary of State on July 23, 1999 (theCertificate of Designations was filed as Exhibit 4.1 to the Company’s Form 8-Kfiled with the SEC on July 29, 1999).  Atthat time, the Company sold shares of this new Series A Preferred Stock tocertain investors.  However, the Companyrecently discovered that a previously outstanding series of preferred stock,also referred to as “Series A Preferred Stock,” which was outstanding prior tothe Company’s initial public offering of its common stock in February 1997 andwhich was converted to common stock in the initial public offering, was nevereliminated from the Company’s Certificate of Incorporation.  Because the earlier Series A Preferred Stockwas never eliminated from the Company’s Certificate of Incorporation, the newseries of preferred stock issued in July 1999 should have been designated asSeries A-1 Preferred Stock, not Series A Preferred Stock.  This error was corrected by a Certificate ofCorrection filed with the Delaware Secretary of State on June 14, 2005.**

** **

In July 1999, the Company issued 2,181,818shares of Series A-1 Convertible Preferred Stock to Galen Partners and theiraffiliates for an aggregate amount of $12 million or $5.50 per share. Holderswere initially entitled to receive cumulative dividends at the rate of sixpercent per annum, generally payable in the form of shares of Series A-1Preferred Stock until July 26, 2001. The dividend rate increased to 7% on July26, 2001, to 8% on July 26, 2002, to 9% on July 26, 2003, to 10% on July 26,2004, and will continue to increase an additional 1% on July 26 of each year upto a maximum of 12%. No cash dividends may be paid on the common stock unlessfull dividends on the Series A-1 Preferred Stock for the then current dividendperiod have been either paid or declared with a sum sufficient for the paymentset apart.

 

The holders of the Series A-1 ConvertiblePreferred Stock vote on an as converted to common stock basis with the holdersof common stock. The Series A-1 Preferred stockholders also have a liquidationpreference of $5.50 per Series A-1 share, plus any accrued but unpaiddividends. At the option of the holders, shares of the Series A-1 PreferredStock can be converted into shares of common stock at any time, subject tocertain antidilution adjustments. The Company is required to make a bestefforts attempt to secure one Board of Director seat for a representative ofthe holders of Series A-1 Preferred Stock. The holders of Series A-1 PreferredStock also obtained certain redemption rights as part of the original financingtransaction in July 1999. They have since permanently waived those rights asdescribed below.

 

On November 9, 2000, as a consequence ofthe resignation of Larry Grandia, the Company’s former President and ChiefExecutive Officer, holders of the Series A-1 Preferred Stock had the right tocause the redemption of their Series A-1 Preferred Stock for approximately$12.9 million. The Company entered into an agreement with the holders of theSeries A-1 Preferred Stock under which the holders of the Series A-1 PreferredStock permanently waived their redemption rights in return for $2.0 million incash and warrants to purchase 3,540,000 shares of the Company’s common stockexercisable at $0.01 per share. The warrants expire on November 9, 2005, andthe common stock for which the warrants may be exercised is subject to demandregistration rights. The total consideration for this transaction was valued atapproximately $4.1 million and for financial reporting purposes was recorded asa one-time dividend in the fourth quarter of 2000.

 

As of June 30, 2005, the Company hadaccrued but undeclared preferred stock dividends of approximately $6.7 million(payable in kind by the issuance of approximately 1.2 million shares of SeriesA-1 Preferred Stock), thereby

 

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entitling the holders of the Series A-1Preferred Stock to a total liquidation preference of approximately $18.7million.

 

As a result of the routine review of theCompany’s Form 10-K for the year ended December 31, 2004 by the staff of theSEC, the Company examined the classification on its balance sheet of its SeriesA-1 Preferred Stock.  The Company hadclassified this amount as a component of stockholders’ equity in its financialstatements for the years ended December 31, 2004, 2003 and 2002 filed in its2004 Form 10-K/A with the SEC.

 

Based on the staff’s comment, the Companyreviewed the terms of the Series A-1 Preferred Stock and noted that in theevent of an unsolicited tender offer that results in the Company’s stockholdersimmediately prior to such transaction not holding at least 50% of the votingsecurities of the surviving entity, the holders of the Series A-1 PreferredStock would be entitled to receive for each share of such stock an amount pershare at least equal to Five Dollars and Fifty Cents ($5.50) plus any accruedbut unpaid dividends.  Because such atransaction could result in a cash liquidation of the Series A-1 PreferredStock that is outside the control of the Company, management, in consultationwith the Company’s independent registered public accounting firm, concluded onJuly 13, 2005 that the Series A-1 Preferred Stock should be classified as acomponent of mezzanine equity and not a component of permanent equity on theCompany’s balance sheet and that the Company should restate its previouslyissued financial statements.  On July 18,2005, the Audit Committee of the Company’s Board of Directors, in consultationwith management and the Company’s independent registered public accountingfirm, confirmed management’s conclusion that a restatement of the previouslyissued financial statements was required. The restatement is an adjustment of the Company’s balance sheet and willhave no impact on the Company’s historical or future statements of operationsor cash flows.

 

Although wehave an accumulated deficit as of June 30, 2005, we believe that our availablefunds are sufficient to meet our current operating needs. However, there can beno assurances that our available cash and investments will be adequate tosustain cash requirements in the future. We have no bank debt or outstandinglines of credit.  We may sell additionalequity or debt securities or obtain credit facilities. The sale of equitysecurities could result in dilution to our stockholders and the incurrence ofdebt could result in interest expense. However, there can be no assurance thatwe will be able to sell additional equity or debt securities, or be able toobtain financing on acceptable terms, if at all. Our management and Board ofDirectors continue to explore alternatives to address the Preferred Stock tomaximize common shareholder value. In connection with such opportunities, wemay decide to incur debt or sell additional equity securities. There can be noassurances that we will be successful in modifying our capital structure.

 

**Critical Accounting Policies**

 

Our discussion and analysis of our financial condition and results ofoperations are based upon our financial statements, which have been prepared inaccordance with accounting principles generally accepted in the United States.The preparation of these financial statements requires management to makeestimates and judgments that affect the reported amounts of assets,liabilities, revenue and expenses, and related disclosures. On an on-goingbasis, we evaluate these estimates, including those related to revenuerecognition, long-lived assets, accrued liabilities, stock-based compensation,and income taxes. Estimates are based on historical experience, informationreceived from third parties and on various other assumptions that are believedto be reasonable under the circumstances, the results of which form the basisfor making judgments about the carrying values of assets and liabilities thatare not readily apparent from other sources. Actual results may differ fromthese estimates under different assumptions or conditions.

 

We believe the following critical accounting policies affect thesignificant judgments and estimates used in the preparation of our financialstatements.

 

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*Revenue Recognition*

 

Daou recognizes all of its revenue inaccordance with Staff Accounting Bulletin (“SAB”) No. 104, Revenue Recognition,and complies with SAB 104 requirements that the following criteria be met indetermining whether revenue has been earned:

 

• persuasive evidence of an arrangement,

 

• services have been delivered,

 

• price is fixed and determinable, and

 

• collectibility is reasonably assured.

 

We record revenue from the following typesof transactions: i) services performed on an hourly basis, ii) servicesperformed on a fixed fee basis and iii) sales of material and maintenancecontracts. In general, Daou enters into contracts with customers to provideservices at a specified fee or rate per hour. Revenue from professionalservices contracts is recognized on an hourly basis as work is performed.Contract revenue for the development and implementation of network solutionsunder fixed-fee contracts is recognized under a proportionate performancemethod by determining the level of service performed based upon the amount oflabor incurred on the project versus the total labor costs to perform theproject as this is the most readily reliable measure of output (i.e. the amountof the installation complete as of any date) for an installation project.  Our policy for recording a provision for aloss on a fixed fee contract would be made during the period when the lossbecomes probable and can be reasonably estimated.  There were no contract losses recognized ineither fiscal 2005 or fiscal 2004. Revenue from technical support, network management and help deskservices is recognized on a pro-rata basis over the performance period.  Revenue from the sale of material or goods isrecognized upon transfer of title as long as the four elements of revenuerecognition discussed above are met.

 

During the six months ended June 30, 2005and 2004, we were engaged in only one (1) outsourcing contract and that was inthe first quarter of 2004. All contracts had expired by the end of the firstquarter 2004. Daou hired client employees at the inception of one of the fiveoutsourcing contracts that was initiated on January 23, 1998. Daou’s revenuerecognition policy on outsourcing contracts is to recognize revenue ratablyover the period that these services are provided. One of these contractsprovided contingency payments (risk/reward) based on meeting service levelcriteria each month.  Daou’s policy onrecognizing revenue for these contingency payments was to record the revenue inthe period which the contingency was resolved. The contingency revenue was lessthan 1% of the total revenue earned on this contract.

 

*Bad Debt*

 

We are required to estimate the collectibility of our trade accountsreceivable. We perform this analysis on a specific customer identificationbasis. A considerable amount of judgment is required in assessing the ultimaterealization of these receivables, including the credit worthiness of eachcustomer and the age of the customer balances. We estimate the amount toreserve for a specific customer by taking into account the age of thereceivables and the payment history of the customer. Significant changes inrequired reserves have been recorded in recent periods and may occur in thefuture due to the current market environment and changes in client payment history.

 

*Litigation*

 

We are currently involved in legal proceedings regarding shareholderlitigation and other general legal proceedings. As discussed in Note 7 of ourfinancial statements, we believe that the lawsuits are without merit and we intendto defend against them vigorously. Although the ultimate outcome of thesematters is not presently determinable, management believes that the resolutionof all such pending matters, net of amounts accrued, will not have a materialadverse effect on our financial position. It is possible, however, that futureresults of operations for any particular quarterly or annual period could bematerially affected by changes in our assumptions, or the effectiveness of ourstrategies, related to these proceedings.

 

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ITEM 3.                       QUANTITATIVE AND QUALITATIVEDISCLOSURES ABOUT MARKET RISK

 

Daou investsexcess cash primarily in U.S. government securities and marketable debtsecurities of financial institutions and corporations with strong creditratings. These instruments have maturities of three months or less whenacquired. We do not utilize derivative financial instruments, derivativecommodity instruments or other market risk sensitive instruments, positions ortransactions in any material fashion. Accordingly, we believe that, while theinstruments held are subject to changes in the financial standing of the issuerof such securities, we are not subject to any material risks arising fromchanges in interest rates, foreign currency exchanges rates, commodity prices,equity prices or other market changes that affect market risk sensitiveinstruments.

 

ITEM 4.                       CONTROLS AND PROCEDURES

 

The Company evaluates, under the supervision and with the participationof the Company’s management including the Company’s Chief Executive Officer(Principal Executive Officer) and Chief Financial Officer (Principal FinancialOfficer), the effectiveness of the design and operation of the Company’sdisclosure controls and procedures pursuant to Exchange Act Rule 13a-15.  Based on that evaluation, the Company’s ChiefExecutive Officer and Chief Financial Officer concluded that the Company’sdisclosure controls and procedures are effective, as of June 30, 2005, inalerting them in a timely manner to material information relating to theCompany required to be included in the Company’s periodic SEC filings. Therewere no significant changes in the Company’s disclosure controls or internalcontrols over financial reporting during the first quarter of 2005.

 

During July 2005, a routine review by theSEC staff of our original Form 10-K for the year ended December 31, 2004resulted in management evaluating the Company’s accounting for the Series A-1Preferred Stock that was issued in July 1999. Based on guidance from several technical pronouncements andconsultations with the Company’s independent registered public accounting firm,the Company concluded on July 13, 2005 that the Series A-1 Preferred Stockshould be classified as a component of mezzanine equity and not a component ofpermanent equity on the Company’s balance sheet and that the Company shouldrestate its previously issued financial statements.  On July 18, 2005, the Audit Committee of theCompany’s Board of Directors, in consultation with management and the Company’sindependent registered public accounting firm, confirmed management’sconclusion that a restatement of the previously issued financial statements wasrequired.  The restatement primarilyincludes a reclassification of Preferred Stock between permanent equity andmezzanine equity on the balance sheet and will have no impact on the Company’shistorical or future income statements or cash flows.  Additionally, the Company had previouslydisclosed the material terms of its preferred stock in its SEC filings.  As such, the Company believes that theconclusion to reclassify the preferred stock does not reflect a weakness in theCompany’s disclosure controls and procedures pursuant to Exchange Act Rules13a-15(a) and 15d-15(e).  The Companywill continue to monitor its internal controls and, if further improvements orenhancements are identified, the Company will take the necessary steps toimplement such improvements or enhancements.

 

Disclosure controls and procedures are designed to ensure informationrequired to be disclosed in reports filed with the Securities Exchange Act of1934 (Exchange Act) is recorded, processed, summarized and reported within thetime periods specified in the SEC’s rules and forms.  Disclosure controls are also designed with theobjective of ensuring that such information is accumulated and communicated tothe Company’s management, including the Chief Executive Officer and the ChiefFinancial Officer, as appropriate, to allow timely decisions regarding requireddisclosure.  Disclosure controls includeinternal controls that are designed to provide reasonable assurance thattransactions are safeguarded against unauthorized or improper use and thattransactions are properly recorded and reported.

 

Any control system, no matter how well conceived and operated, canprovide only reasonable, not absolute, assurance that the objectives of thecontrol system are met.  The design ofthe control system inherently has limitations, and the benefits of controlsmust be weighed against their costs. Additionally, controls can be circumvented by the individual acts ofsome persons, by collusion of two or more people, or by management override ofthe control.  Therefore, no evaluation ofa cost-effective system of controls can provide absolute assurance that allcontrol issues and instances of fraud, if any, will be detected.

 

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**PART II OTHER INFORMATION**

 

ITEM1.   LEGAL PROCEEDINGS

 

On August 24, 1998, August 31, 1998, September 14, 1998 and September23, 1998, four separate complaints were filed against the Company and certainof its officers and directors in the United States District Court for theSouthern District of California.  A groupof shareholders has been appointed the lead plaintiff in this federallitigation, and they filed a second amended consolidated class action complainton January 21, 2000.  This new complaintrealleges that the Company improperly used the “percentage-of-completion”accounting method for revenue recognition. Claims are pleaded under both the 1933 Securities Exchange Act (relatingto the Company’s initial public offering) and section 10(b) of the 1934Securities Exchange Act.  The complaintwas brought on behalf of a purported class of investors who purchased the Company’sCommon Stock between February 13, 1997 and October 28, 1998, but it does notallege specific damage amounts.

 

A Motion to Dismiss the second amended consolidated class actioncomplaint was filed on February 22, 2000. On March 27, 2002, the Court granted the Motion but extended toplaintiffs the opportunity to file a Third Amended Complaint.  The plaintiffs filed their third amendedconsolidated class action complaint on May 16, 2002, to which the Company respondedwith another Motion to Dismiss.  TheMotion was filed on June 24, 2002 and challenged the legal sufficiency of theallegations.  On October 15, 2002, theCourt granted that Motion, this time with prejudice.

 

Plaintiffs timely noticed an appeal and filed their Appellants’ Briefwith the Ninth Circuit Court of Appeals on April 9, 2003.  On July 2, 2003, the Company filed itsRespondents’ Brief and Cross-Appeal.  TheCross-Appeal challenges the trial court’s failure to assess whether thecomplaint complied with applicable pleadings standards.  The matter was argued before the court onFebruary 12, 2004.  On February 2, 2005,the court reversed the dismissal and remanded the case back to the districtcourt. Because it reversed the dismissal, it did not decide the Company’scross-appeal.  On February 23, 2005, theCompany appealed the reversal by way of petition for rehearing to the samepanel of the Ninth Circuit Court of Appeals that decided the appeal.  The panel issued its decision on June 21,2005 denying the petition for rehearing. As a result, the Company filed another petition for rehearing on July 5.2005, this one directed to Ninth Circuit en banc.  No hearing date has been set and theplaintiffs have yet to oppose.  If theCourt does not grant relief, the Company intends to appeal to the Supreme Courtby way of writ of certiorari.

 

On October 7, 1998 and October 15, 1998, two separate complaints werefiled in the Superior Court of San Diego County, California.  These state court complaints mirror theallegations set forth in the federal complaints.  They also assert claims for common law fraudand the violation of certain California statutes.  As with their federal counterparts, they donot allege specific damage amounts.  OnApril 1, 1999, a Consolidated Amended Class Action was filed on behalf of thesame state court plaintiffs, and this new complaint alleges the same factualbasis as is asserted in the federal litigation. The state litigation pleads claims for fraud and violations of certainCalifornia Corporation Code provisions. By stipulation of the parties and order of the court, this state courtlitigation was stayed pending the outcome of the motion to dismiss the federallawsuits, as well as the resulting Appeal and Cross-Appeal.

 

The Company believes thatthe allegations set forth in the federal and state complaints are withoutmerit, and the Company intends to defend against these lawsuitsvigorously.  The Company is occasionallyparty to other various claims and legal actions arising in the normal course ofbusiness. Although the ultimate outcome of the matters is not presentlydeterminable, management believes that the resolution of such matters, net ofamounts accrued, will not have a material adverse affect on the Company’sbusiness, results of operations or financial condition; however, there can beno assurance that the ultimate resolution of these matters will not have amaterial impact on the Company’s results of operations in any period.

 

ITEM 2. UNREGISTERED SALES OF EQUITYSECURITIES AND USE OF PROCEEDS

 

None.

 

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ITEM 3. DEFAULTS UPON SENIOR SECURITIES

 

None.

 

ITEM 4. SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS

 

None.

 

ITEM 5.  OTHER INFORMATION

 

None.

 

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ITEM 6.  EXHIBITS

 
| **Exhibit  No.** | ** ** | **Description**                                                                                                                                                                                                                           |
|------------------|------------|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|             |       |                                                                                                                                                                                                                                      |
| 31.1             |       | Certification of  Vincent K. Roach required by Rule 13a-14(a) or Rule 15d-14(a) under the  Securities Exchange Act of 1934, as amended                                                                                                    |
| 31.2             |       | Certification of John  A. Roberts required by Rule 13a-14(a) or Rule 15d-14(a) under the Securities  Exchange Act of 1934, as amended                                                                                                     |
| 32.1             |       | Certification of  Vincent K. Roach required by Rule 13a-14(b) or Rule 15a-14(b) under the Securities  Exchange Act of 1934, as amended, and 18 U.S.C. Section 1350, as adopted pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002 |
| 32.2             |       | Certification of John  A. Roberts required by Rule 13a-14(b) or Rule 15a-14(b) under the Securities  Exchange Act of 1934, as amended, and 18 U.S.C. Section 1350, as adopted pursuant  to Section 906 of the Sarbanes-Oxley Act of 2002  |

 

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SIGNATURES

 

Pursuant to the requirements of theSecurities Exchange Act of 1934, this registrant has duly caused this report tobe signed on its behalf by the undersigned thereunto duly authorized.

 

Date:       August 12, 2005

 
|   | Daou Systems, Inc. |
|--------|--------------------|
|   |               |   |
|   |               |   |
|   | By:                | /s/ Vincent K. Roach |   |
|   |               | Vincent K. Roach |
|   |               | Chief Executive Officer and President |
|   |               |   |
|   |               |   |
|   | By:                | /s/ John A. Roberts |   |
|   |               | John A. Roberts |
|   |               | Chief Financial Officer and |
|   |               | Secretary (principal financial |
|   |               | and accounting officer) |

 

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