Daou-btful Numbers
Daou Systems' accounting raises earnings, balance-sheet questions
Barron's
By Barry Henderson
August 17, 1998
Market Action
Georges and Daniel Daou were playing cards on the balcony of their Beirut
home on May 23, 1973, when their house-and their lives-were shattered by a
Palestinian rocket attack. The boys, then 12 and 8, along with their sister
Michelle, sustained serious injuries. Georges was in a coma for a month. A
piece of shrapnel severed a nerve on the right side of Daniel's face, which
has been paralyzed ever since.
The experience was a crucible of sorts for both brothers. "It was pretty
traumatic," says Daniel, now president of Daou Systems (pronounced like the
Dow in Dow Jones). "It forces you to have a different perspective. I think
it's made us willing to fight very hard [for success] because you don't
know how long you're going to be here." Georges, Daou's chief executive,
said in an interview published last year that this early brush with death
helped him develop what he calls acharne, a French word that describes the
intensity and fierceness of an unleashed tiger.
Whatever you call it, this aggressiveness has propelled the brothers a long
way. Founded in 1987, Daou Systems has become an "information-technologies
solutions" company that does everything from consulting to network design
to reselling hardware and software to hospitals. After going public at $9 a
share in February 1997, the stock traded as high as 34 3/8.
But during the past six months, it's been a different story. As we were
going to press last week, Daou disclosed a major difference between what it
told analysts about expenses for the second quarter and what showed up on
the company's 10Q filing.
The company had said it had $2.34 million in general and administrative
expenses and $2.23 million in expenses related to the acquisition of two
consulting companies. But the 10Q showed general and administrative costs
of $3.54 million and merger-related costs of $1.02 million. The problem:
Merger expenses are nonrecurring, and therefore less troublesome to the
market, while the higher general and administrative costs are ongoing. In
response, the stock traded as low as 8 7/8, and closed at 12 3/4, down 5
3/4 on the day.
The company claims there was no discrepancy. "In the conference call the
number I used [$2.23 million] included both direct merger costs, like
paying for lawyers and bankers and accountants, and indirect costs like
consolidating offices," says chief financial officer Fred McGee. "The
number for merger-related costs in the 10Q only includes those direct
costs," he says. The indirect costs, he continues, have been put into the
general and administrative bracket, and that's why they're up. Therefore,
general and administrative expenses won't stay so high as the company
digests the acquisitions.
Even before this incident, critics have contended that Daou's
aggressiveness has carried over into its accounting, which has hurt
management's credibility. They point to Daou's use of a methodology that
allows it to recognize revenues before actually billing its customers.
Called the Work In Progress account, it works like this: When Daou gets a
contract -- particularly a network contract that requires hardware or
software -- it begins work on the job and then bills its customers in
installments. But it actually recognizes revenues before it bills its
customers. How is this possible? The Work In Progress rule allows the
company to recognize sales based on estimates of how much of a contract it
has completed-not how much the company has billed to the customer.
Daniel Daou says the company has little choice but to use WIP based on its
business model. "We get the hardware and the software from our suppliers
and then we assemble it and 'burn in' the system in one of our labs before
we send it to a customer," he says. As a consequence, this hardware and
software cost bulks up the WIP account. "I see the WIP account as a
positive because it shows that we have a backlog of business," he says.
Perhaps. But what concerns some analysts is how that account can be used to
affect earnings. "You can always change your percentage completion assumed
to suit your needs," says Jack T. Ciesielski, a Baltimore-based accounting
expert who advises institutional investors.
Daou's WIP at the end of 1997 totaled $12.4 million, or 30% of $41.7
million in revenues. A year earlier, WIP totaled $3.8 million, or just 13%
of revenues of $28.4 million. If Daou had recorded revenues at the time of
billing instead of using the WIP account, the revenue and earnings picture
would have been dramatically different, according to one critical analyst.
For 1997, he says, revenues would have been reduced by $8.6 million (the
difference between the $12.4 million in unbilled receivables in 1997 and
the $3.8 million in 1996). That, he continues, would have left the company
with revenues of $33.1 million in 1997, instead of $41.7 million as
reported by the company. Daou then would have lost 46 cents per share, in
contrast to a penny per share profit reported by the company, according to
this analysis.
A related problem has been the growth in the company's accounts receivable.
In the first quarter, accounts receivable rose 35% to $16.5 million, while
WIP rose 62.1% from $12.4 million to $20.1 million. As a result, days of
sales outstanding -- a common benchmark used to measure the growth in
receivables relative to revenues calculated by dividing the accounts
receivable by average daily sales -- totaled 82.4. In the fourth quarter of
1997, Daou's receivables stood at $11.1 million on sales of $14.5 million
for the quarter, resulting in 69 days sales outstanding.
The company says it turned the corner on its balance-sheet problems this
quarter, although the picture is muddied by the acquisition. The numbers
aren't broken out this way, but Daou told analysts that on a stand-alone
basis, the WIP account actually declined to just under $20 million. Days'
sales outstanding for Daou alone are down to 64, which is under the
company's "mid 70s" target, according to Fred McGee, the chief financial
officer.
Some of the company's critics aren't buying it. If the WIP account were
treated as accounts receivable, the days' sales outstanding would look far
worse. If you calculated on that basis in the first quarter, says one
analyst, you'd "still get two quarters of total days' sales outstanding
(182.7 days) in total receivables on the balance sheet. That speaks louder
to me than anything management says." (As a rule of thumb, anything over 90
days starts to make analysts nervous.)
Even with the balance-sheet improvement in the June quarter, WIP accounts
and accounts receivable combined totaled 136 days. This investor favors a
system where Daou passes the hardware along directly to the customer and
doesn't recognize revenues until the customer is actually billed. The
company says that would be impractical.
Even a couple of Wall Street analysts, who are usually loath to say
anything negative for fear of losing investment banking business for their
firms, have raised caution flags about Daou. Bradley G. Whitt, an analyst
at Morgan Keegan & Co., wrote March 17 that "... the quarter may be
progressing slower than expected," based on his conversations with
management. That day the stock plunged to 16 from 24 3/8 on the news.
Besides accounting matters, the Daou brothers also are fighting a lawsuit
brought by ex-employees in California state court, who claim they're owed
for unpaid overtime, which the company denies. Among the allegations,
Anthony Smyth, a former Daou engineer who is a plaintiff in the
class-action suit, claims the company misrepresented his credentials to
prospective customers.
While Daou dismisses Smyth's allegations as sour grapes, others may see
them as an indication of an excess of corporate acharne.
Daniel Daou maintains his company has never crossed that line of
misrepresenting its employee's credentials to dress up its corporate resume
to win business. "Look, we fight really hard for our contracts and we're
constantly thinking about what we have to do, whether it's reducing the
price or offering more service" to get the business, he says. But he'll
stop short to keep Daou from taking on unprofitable jobs. "To quote Mother
Teresa, I thank God twice for the prayers that go unanswered." |
