Datalink 10-K 2005
Documents found in this filing:
SECURITIES AND EXCHANGE COMMISSION
Washington, D. C. 20549
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2004
For The Transition Period From To
Commission file number: 00029758
(Exact name of registrant as specified in its charter)
Securities registered pursuant to Section 12(b) of the Act: None.
Securities registered pursuant to Section 12(g) of the Act: Common Stock, $0.001 par value.
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes ý No o
Indicate by check mark if disclosure of delinquent filers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is not contained herein, and will not be contained, to the best of registrants knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-K or any amendment to this Form 10-K. ý
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Act). Yes o No ý
Aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant at June 30, 2004: $20,069,214.
At March 14, 2005, the number of shares outstanding of each of the registrants classes of common stock was 10,295,113.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrants Proxy Statement for its Annual Meeting of Stockholders to be held in 2005 (the 2004 Proxy Statement), to be filed with the Securities and Exchange Commission, are incorporated by reference to Part III of this Form 10-K.
NOTE REGARDING FORWARD-LOOKING STATEMENTS
This Annual Report contains forward-looking statements. We have based these forward looking statements on our current expectations and projections about future events, including, among other things: the level of continuing demand for storage, including the impact of economic conditions on technology spending; competition and pricing pressures and timing of our installations that may adversely affect our revenues and profits; fixed employment costs that may impact profitability if we suffer revenue shortfalls; revenue recognition policies that may unpredictably defer reporting of our revenues; our ability to hire and retain sales representatives and key technical and other personnel; our dependence on key suppliers; our ability to adapt to rapid technological change; risks associated with possible future acquisitions; fluctuations in our quarterly operating results; future changes in applicable accounting rules; and volatility in our stock price. You may find these statements throughout this Annual Report and specifically in the sections entitled Risk Factors, Managements Discussion and Analysis of Financial Condition and Results of Operations and Business. Our actual results may differ materially from those anticipated in these forward-looking statements as a result of various factors, including all the risks discussed in Risk Factors and elsewhere in this Annual Report.
We use the terms aim, believe, expect, plan, intend, estimate and anticipate and similar expressions to identify forward-looking statements. These statements reflect our current views with respect to future events and are based on assumptions subject to risks and uncertainties. We do not intend to update or revise any forward-looking statements whether as a result of new information, future events or otherwise.
Item 1. Business.
We are a leading independent information storage architect with operations throughout the United States. We work with customers to analyze, design, implement, and support information storage infrastructures that store, protect, and provide continuous access to information. Our areas of expertise include:
Our highly skilled technical services and product management staff tests and compares data storage technologies available from the leading manufacturers and software developers. Once a product is approved for our solution sets, our technical staff then has the flexibility to choose from the best of these storage technologies to solve our customers growing data storage needs. In addition, we maintain a sales and support staff that ensures the continued success of our data storage solutions for each customer. We believe these value-added services and our adherence to the highest quality standards have resulted in superior levels of customer satisfaction.
The Data Storage Industry
International Data Corporation (IDC) projects data growth at a compound rate of approximately 50% through 2007. With this ongoing growth in creation and storage of data and the increasing strategic importance of having the data available, we expect the data storage markets in which we compete to continue to expand. Data storage is currently a large market, with spending in 2004 estimated at $34 billion and expected to exceed $40 billion by 2007. Information technology (IT) departments are faced with a daunting challenge of rapidly expanding amounts of data to manage coupled with increasing demands for availability of this data for day-to-day business and to meet regulatory requirements. We expect these issues will continue to generate interest in new data storage solutions that allow users to be more productive and to meet the needs of their organizations.
At the same time, IT headcount is estimated to remain relatively flat over the next several years, making it necessary for organizations to dramatically improve storage management productivity to avoid being inundated by growing data storage capacities. To address this growing gap, we expect that organizations will consolidate their storage infrastructures and augment them with enhanced software capabilities such as storage area network management, virtualization, storage resource management and information lifecycle management.
IDC predicts that disk-based data protection, modular disk and SAN/NAS convergence, storage management software, and storage services will grow rapidly over the next several years. IDC estimates that, together, these areas will grow through 2007 at more than double the storage industry standard rate of growth of 6-8 percent. Organizations recognize the importance and value of data as a strategic and competitive asset. Employees, customers and suppliers demand uninterrupted access to mission-critical data 24 hours a day, 7 days a week. As a result, the ability to efficiently store, manage, protect and provide access to this data is fast becoming one of the most important aspects of business-critical decision-making, increasing the need for high-performance, scalable and highly available solutions.
In light of the importance of data to businesses, we believe that organizations will dedicate an increasing percentage of their information technology budgets to data storage. We believe that capital investment priorities will include:
Increased need for high throughput performance, greater frequency of backups, quick restoration of data and stringent data availability requirements are key factors that we expect to drive the migration to disk-based data protection solutions. Disk is no longer being used as only a target device for replication and mirroring, but also is being incorporated into traditional backup systems.
iSCSI is a protocol that transfers block-level data over IP networks. Similarly iSCSI takes SCSI commands and encapsulates them into a TCP/IP packet for delivery over the Internet. The significance of this is in IPs ability to span unlimited distances as compared to the distance limitations found in traditional SCSI and fibre channel interconnects. Companies gain the storage advantages of networked storage (including consolidation, easier management and shared pools of storage) but at a fraction of its cost due to IP SANs use of existing Ethernet infrastructures. In addition, the IT staff can leverage its existing Ethernet training and knowledge base rather than separately learning the fibre channel protocols. IP storage is still in an early adoption phase. However, we believe it has a vital role in storage infrastructures. We expect enterprises to utilize IP SANs to consolidate stranded servers, globally separated SANs, or smaller office locations.
Continued migration to networked storage infrastructures.
We expect that through a variety of storage networking technologies, organizations will attain shared (consolidated) storage capabilities. Consolidated storage benefits include increased flexibility in implementing and managing storage, increased storage device utilization levels, improved quality of service, reduced administration costs and increased operational efficiency.
ILM is a process and methodology of handling the flow of data from its creation to its deletion. With ILM, the IT department establishes a written policy for classification and data movement. The storage system automatically moves data from one type of storage device to another based on the policy metrics and rules. This results in a more automated environment ensuring efficient and cost-effective data management.
We expect that many organizations will implement modular storage systems as compared to large, monolithic storage systems. Smaller versions of their high-end, full-featured counterparts, modular disk systems enable organizations to cost-effectively implement storage, while enjoying the performance and functionality of large, enterprise systems.
Long-term data retention has become the norm with recent industry regulations such as the Sarbanes-Oxley Act, HIPAA (Health Insurance Portability and Accountability Act) and SEC section 17a-4 (electronic communication preservation) mandating the retention of documents for many years. The consequences can be great if a company does not have the proper retention of documents for compliance, including stiff monetary penalties.
A number of storage management software innovations have recently entered the market. Storage management software enhancements can be divided into four segments: storage area network management, virtualization, storage resource management and automated resource management. We anticipate that advances in each of these areas will enable improved storage availability, manageability and performance.
We expect three factors to drive IT organizations to increasingly outsource storage-related services (consulting, implementation and support). They include the growing strategic importance of data storage, growing complexity of networked storage environments and increasing scope of spending on storage.
The Datalink Opportunity
The increased need for data storage and the development of sophisticated, enterprise-class information data storage systems have created a demand for independent data storage solution providers, such as Datalink. Both potential customers and data storage device manufacturers are looking to independent storage solutions providers such as Datalink primarily for the following reasons:
Pressures on Customers. We believe organizations will increasingly look outside their in-house technical staff to independent information storage architects, such as Datalink, for specialized expertise. Networked storage architecture design is complex. Although organization-wide data storage solutions, such as SANs, are designed to ease data management functions, these systems are difficult to understand and implement because they integrate diverse operating systems, hardware and software. In addition, there continues to be a steady influx of new products and technologies introduced to the market. In-house information technology departments prefer to focus their efforts on mission-critical applications. Accordingly, they often turn to outside storage experts that are able to research, design, implement and support networked storage solutions.
Pressures on Manufacturers. We believe manufacturers increasingly rely on channel partners such as us for two principal reasons:
Sophisticated data storage solutions require the integration of highly specialized products made by a variety of manufacturers. A typical SAN, for instance, can utilize components such as routers, switches, host bus adaptors, storage and backup devices and storage management software, each from a different manufacturer. High-end data storage manufacturers generally focus on only a portion of the overall SAN system, leaving companies like us to integrate comprehensive networked data storage solutions from the best available products and technologies.
Gross profit margins have been under severe pressure for many storage companies. Because of the high cost of maintaining a national sales and marketing organization, and especially in light of economic conditions over the past several years, high-end data storage manufacturers increasingly are focusing their resources on their research and development functions. This strategy requires them to leverage their sales and marketing functions by partnering with companies such as Datalink.
We believe we are uniquely positioned to capitalize on this significant opportunity for the following reasons:
Expertise. We have been implementing sophisticated data storage solutions for over fifteen years. This experience has given us significant expertise in understanding and applying data storage technologies and has allowed us to earn and retain the trust and confidence of our customers and suppliers. We invest in and train resources to differentiate our company, adapt to the ever-changing needs of our customers and capitalize on opportunities.
Independence. Unlike many of our competitors, we are independent of any manufacturer or particular technology. Our customers are increasingly using open systems computing architectures, which can combine products from multiple suppliers. Our customers value our independence and rely on us to choose the best available hardware and software and tailor it to their individual needs.
The Datalink Solution
We combine our technical expertise, the best products from leading manufacturers and comprehensive services to meet each customers specific needs. Our services include:
At the beginning of an engagement, we place considerable emphasis on formulating a needs analysis based on each customers business initiatives, operating environment and current and anticipated data storage requirements. While our focus is on each customers unique situation, we bring to each engagement our extensive product knowledge and the experience we have gained from providing data storage solutions for over fifteen years to customers in numerous industries.
Datalinks AssessLink assessment services provide customers with objective guidance on developing data storage strategies that optimize their resources, leverage their existing environments and facilitate cost-effective growth for the future. AssessLink services provide an independent viewpoint to align people, processes and technologies with business objectives. These services help organizations maximize current investments, outline recommendations for future purchases and provide assurance that storage infrastructures are efficient, reliable and scalable.
Once we have completed our initial analysis, we begin the design phase of the project. Our professional services teams work together to design a system that meets the customers data storage needs and budget. Our independence permits us to choose from a wide range of technologies in order to fuse together the appropriate hardware, software and services for each project.
Datalinks DesignLink services utilize a customers developed detailed business requirements to design the data storage solution. The engagement begins with a definition of the projects objectives, scope and key milestones. The Datalink team then prepares an outline of the schedule and deliverables. Following a thorough analysis, the team prepares a comprehensive blueprint of the storage solution, including a detailed design schematic, key implementation milestones and recommendations for handling potential configuration issues to ensure a smooth transition to the new storage environment.
Once we design and test a system, we formulate a detailed project implementation plan with our customers to meet their financial and operating objectives and minimize disruption to their operations. We oversee the timely delivery of hardware and software products to the customers location. We then coordinate the installation with our technical services team, or personnel from the equipment manufacturer, and complete the installation at the customers site.
We provide our customers advanced technical support from a team of customer support and field engineers. Our extensive experience in data storage systems enables our staff to deliver expert configuration and usage assistance, technical advice and prompt incident detection and resolution. The support desk staff also acts as our primary interface with suppliers technical support organizations.
Datalinks SupportLink support services offer additional flexible levels of service to help organizations maximize the return on their storage technology investments. We believe that SupportLink is one of very few customer service programs that provide support across multiple storage product lines and manufacturers.
We offer maintenance and repair service options under our service program. We offer a variety of on-site service options, including four hour guaranteed response time service seven days per week, 24 hours per day. Our technical staff first assists customers in identifying the source of system problems and in determining whether there is defective hardware or software. We contract with a number of our suppliers and other independent service organizations to provide any required on-site maintenance and repair services.
We provide our analysis, design and support services to customers through either a stand-alone services engagement or as a part of an overall project that includes a storage solution and services.
Our strategy is to improve our position as a leading, independent information storage architect and to develop a customer-focused high performance company with sustainable profitable growth. To achieve these objectives, we intend to build upon our record of successfully addressing the evolving enterprise-class information storage management needs of our customers. Key elements of our strategy include:
Increase Sales Team Productivity
Although we believe that Datalinks sales productivity is amongst the highest in the industry, we believe we can increase it further. We plan to accelerate the learning and productivity curve of our newer sales professionals and enhance the skills of seasoned executives through implementation of techniques and best practices learned from our top producers.
Scale Existing Locations
We intend to focus on our existing geographic locations to increase market share, leverage fixed expenses and provide higher quality service levels. Datalink will drive this growth by hiring experienced, quality account executives and storage engineers to gain sales productivity and field engineering utilization.
Expand Customer Support Revenues
We have significantly increased our customer support capabilities and performance over the last two years and will continue to make this a focus. Our customers appreciate our quality support initiatives, which, we believe will continue to be a key differentiator and growth driver for Datalink.
Enhance Our Professional Services Business
There is significant opportunity to sell more of our storage services expertise to customers. By improving our assessment, storage audit and implementation service methodologies and sales tools, we plan to enhance our solution selling capabilities and continue to drive gross margins to higher levels.
Pursue Regional Acquisitions
We believe there is an opportunity to strengthen our resources and presence in key geographies through acquisition of select regional competitors.
Suppliers and Products
As an independent information storage architect, we do not manufacture data storage products. Instead, we continually evaluate and test new and emerging technologies from leading manufacturers to ensure that our solutions incorporate state-of-the-art, high performance, cost-effective technologies. This enables us to maintain our technological leadership, identify new and innovative products and applications and objectively help our customers align their data storage solutions with their business needs.
We have strong, established relationships with the major enterprise-class information storage hardware and software suppliers. Our expertise in open system environments includes UNIX, Microsoft Windows, Linux and Novell NetWare and in-depth knowledge of all major hardware platforms manufactured by industry leaders, including Hewlett-Packard Company, International Business Machines Corp. and Sun Microsystems, Inc. This expertise has earned us preferred status with many of our principal suppliers. Preferred status often enables us to participate in our suppliers new product development, evaluation, introduction and marketing programs. These collaborations enable us to identify and market innovative new hardware and software products and exchange critical information in order to maximize customer satisfaction.
Some of our major suppliers and the products they provide are listed:
Our customers trust us with their most demanding data storage projects. Customer engagements range from specialized professional assessment and design services, to complex organization-wide SAN implementations. We serve customers throughout the United States in a diverse group of data intensive industries. Our broad industry experience enables us to understand application and business issues specific to each customer and to design and implement appropriate networked storage solutions. We enjoy strong relationships with our customers, which is reflected by our significant repeat business. Spanning a broad array of industries, our customers include Motorola, Inc., The Chicago Board of Trade, Tyson Foods, Inc., Harris Corporation, Cingular Wireless, St. Jude Medical, Inc., Washington University in St. Louis and United Defense Industries, Inc.
Sales and Marketing
We market and sell our products and services throughout the United States primarily through a direct sales force. In addition to our Minneapolis headquarters, we have 14 field sales offices in order to efficiently serve our customers needs.
Our field account executives and account associates work closely with our professional services team in evaluating the enterprise-class information storage needs of existing and prospective customers and in designing high quality, cost effective solutions. To ensure quality service, we assign each customer a specific field account executive and account associate. We believe that the average longevity of service of our sales force is a key factor to earning and retaining the trust and confidence of our customers. We believe this differentiates us from many other storage solution providers.
In addition to the efforts of our field account executives and inside account associates, we engage in a variety of other marketing activities designed to attract new business and retain customer loyalty. We regularly execute integrated, demand creation campaigns, gain exposure through online and print trade publications, hold webcasts and informational seminars and publish a quarterly newsletter.
Quality Management System
We have a long history of being committed to a strategic quality effort. In the early 1990s, we adopted the ISO 9001 quality management system to better identify and meet the needs of our customers, achieve a competitive market advantage and improve overall company performance. We obtained an ISO 9001 certificate of registration in 1996 with successful re-registration in 1999. In 2003, we successfully upgraded our ISO registration to the new 9001:2000 standards with successful re-registration in December 2004. Today, our quality system focuses on achieving business results through high levels of customer satisfaction, employee satisfaction, continual improvement and operational excellence.
Datalink competes in the mid and large enterprise-class information storage solutions market. Our primary competition is from other storage system suppliers. These include storage resellers and VARs, such as MTI Technology Corporation, Forsythe Technology, Inc., SAN Holdings, Inc., Stack Computer Services and Adexis (the storage division of Cranel, Inc.) each of whom sells storage solutions with different technologies. Additionally, we frequently compete against the direct sales forces of storage OEMs. Besides Datalinks current technology partners, these OEM competitors include International Business Machines Corp., Hewlett-Packard Company, Sun Microsystems, Inc. and Dell Computer Corporation.
As of December 31, 2004, we had a total of 147 full-time employees. We have no employment agreements with any of our employees. None of our employees are unionized or subject to a collective bargaining agreement. We have experienced no work stoppages and believe that our employee relations are good.
We configure products to customer specifications and generally ship them shortly after we receive our customers order. Customers may change their orders with little or no penalty. We do not recognize revenue on hardware or software products until we have completed the functionally essential portions of the installation or related configuration services in connection with the sale.
Customer constraints and the availability of engineering resources can have a significant impact on when we can complete an installation and configuration service. These factors prevent us from relying on backlog as a predictor of our future sales levels.
Item 2. Properties.
Our corporate headquarters including our principal technical operations and our integration, assembly and support service operations is located in a 104,000 square foot office and warehouse facility in Chanhassen, Minnesota. On December 15, 2004, we agreed to sublease approximately 55,000 of the 104,000 square feet we currently occupy as our corporate headquarters. Our other 14 locations which house sales and technical staff are small- to medium-sized offices located throughout the United States.
Item 3. Legal Proceedings.
We are not currently involved in any material legal proceedings. We also had no material legal proceedings that terminated during the fourth quarter of 2004.
Item 4. Submission of Matters to a Vote of Security Holders.
We submitted no matters during the fourth quarter of 2004 to a vote of security holders, through the solicitation of proxies or otherwise.
Item 5. Market for Registrants Common Equity, Related Stockholder Matters and Issuer Purchases of Equity Securities.
Our common stock has been quoted on the Nasdaq National Market under the symbol DTLK since August 6, 1999, the day of our initial public offering. The table below sets forth, for the calendar quarters indicated, the high and low per share closing sale prices of our common stock as reported by the Nasdaq National Market.
On March 24, 2005, the closing price per share of our common stock was $2.91. We urge potential investors to obtain current market quotations before making any decision to invest in our common stock. On March 4, 2005, there were approximately 80 holders of common stock, including record holders and stockholders whose shares are held by a bank, broker or other nominee. However, we estimate that our shares are held through a small number of record holders by over 1,500 beneficial owners.
Except for distributions paid to our pre-initial public offering corporation stockholders related to S corporation earnings generated prior to August 6, 1999, we have paid no dividends on our common stock. We intend to retain future earnings for use in our business, and we do not anticipate paying any cash dividends on our common stock in the foreseeable future.
We did not purchase any of our securities during 2004. You can find additional information about our equity compensation plans in Part III, Item 12 of the Annual Report on Form 10-K.
Item 6. Selected Financial Data.
You should read the information below with our Managements Discussion and Analysis of Financial Condition and Results of Operations and our financial statements. The data as of December 31, 2004 and 2003, and for the years ended December 31, 2004, 2003 and 2002, was derived from our financial statements that are included in this Annual Report. The data as of December 31, 2002, 2001 and 2000, and for the years ended December 31, 2001 and 2000, was derived from our financial statements that are not included in this Annual Report.
(1) We recorded restructuring expense as a result of cost reduction initiatives in the fourth quarter of 2003. These initiatives included severance expenses for headcount reductions, office closure expenses and a charge for impairment of our customer base intangible asset.
(2) With the adoption of SFAS No. 142 on January 1, 2002, we ceased amortizing $5.5 million of goodwill.
(3) Reflects legal, accounting and other costs associated with our initial and a subsequent public offering, which we expensed when we postponed both offerings due to market conditions. We successfully completed our initial public offering on August 6, 1999. We did not complete our second public offering.
(4) Our 1999 income tax expense resulted from the taxable income we generated between August 6, 1999 (when we terminated our S corporation status) and December 31, 1999, and the tax effect of our merger with DCSI. Our 2002 income tax benefit was offset by $1.6 million of expense for a valuation allowance for deferred tax assets. The ultimate realization of deferred tax assets depends upon the generation of future taxable income during the periods in which those temporary differences become deductible. Based upon the level of taxable losses in 2004, 2003 and 2002 and the near-term uncertainty of taxable income, management cannot reasonably predict when or if we will realize these deductible differences.
(5) Reflects a $3.0 million promissory note, less payments made, issued to one of our former stockholders in connection with our redemption, effective February 28, 1999, of 1,096 shares of common stock.
Item 7. Managements Discussion and Analysis of Financial Condition and Results of Operation.
You should read the following discussion in conjunction with our financial statements and the related notes included in Item 8. The following information includes forward-looking statements, the realization of which may be affected by certain important factors discussed under Risk Factors.
We are an independent architect of enterprise-class information storage infrastructures. We derive our revenues principally from designing, installing and supporting data storage systems. Our solutions can include hardware products, such as disk arrays, tape systems and interconnection components and storage management software products. The market for data storage products and services is large, estimated at $34 billion in 2004. We have 15 locations throughout the United States with the highest concentration of revenues in the central states.
We sell support service contracts to most of our customers. When customers purchase support services through us, customers receive the benefit of integrated system wide support. We have a qualified, independent support desk that takes calls from customers, diagnoses the issues they are facing and either solves the problem or coordinates with Datalink and/or vendor technical staff to meet the customers needs. Our support service agreements with our customers include an underlying agreement with the product vendor. The vendor provides on-site support assistance if necessary. We defer revenues and direct costs resulting from these contracts, and amortize these revenues and expenses into operations, over the term of the contracts, which are generally twelve months.
The enterprise-class information storage market is rapidly evolving and highly competitive. Our competition includes other independent storage system suppliers, high end market resellers, distributors, consultants and our suppliers through other independent data storage solution providers, original equipment manufacturers and their own internal sales forces. Our ability to
hire and retain qualified outside sales representatives and engineers with enterprise-class information storage experience is critical to effectively competing in the marketplace and achieving our growth strategies.
In the past, we have experienced fluctuations in the timing of orders from our customers, and we expect to continue to experience these fluctuations in the future. These fluctuations have resulted from, among other things, the time required to design, test and evaluate our data storage solutions before customers deploy them, the size of customer orders, the complexity of our customers network environments, necessary system configuration to deploy our solutions and new product introductions by suppliers. Completion of our installation and configuration services may also delay recognition of revenues. Economic conditions and competition also affect our customers decisions to place orders with us. As a result, our net sales may fluctuate from quarter to quarter.
We view the current data storage market as having significant opportunity for Datalinks growth. Currently, Datalinks market share is a small part of the overall market. However, the providers of the data storage industrys products and technologies are increasing their utilization of indirect sales approaches to broaden their reach and optimize their margins. Increasingly, they are turning to companies such as Datalink to sell their products. While these trends provide opportunity for Datalink, we must improve our business model to generate sustainable, profitable growth. Our model requires highly skilled sales and technical staff which results in substantial fixed costs for the Company. We believe the best way to improve our company and create long-term shareholder value it to focus on building capabilities that are scaleable and a cost structure that we can better leverage. Our current strategies are focused on:
Increasing productivity of our sales and technical teams in our existing locations.
Growing our customer support revenue and market share. We believe that our customer support services offerings are becoming increasingly attractive to companies looking for system-wide integrated support.
Increasing our professional services revenues. We believe there is an opportunity to sell more of our data storage services such as implementation services, storage environment assessments and on-site managed data storage services.
Exploring potential regional acquisitions that we perceive can strengthen our resources and presence in key geographic locations.
To pursue these strategies, our actions include:
Improving our training, tools and recruiting for sales teams to increase productivity.
Hiring additional customer support staff and enhancing communications and technology.
Developing more effective delivery of professional service solutions.
All of these plans have various challenges and risks associated with them, including that:
We may not increase our productivity and may lose, or not successfully recruit and retain key sales, technical or other personnel.
Competition is intense and may adversely impact our profit margin. Customers have many options for data storage products and services.
We may not identify suitable acquisition candidates.
Results of Operations
The following table shows, for the periods indicated, certain selected financial data expressed as a percentage of net sales.
Comparison of Years Ended December 31, 2004, 2003 and 2002
The following table shows, for the periods indicated, revenue and gross profit information for our product and service sales.
Net Sales. Our product sales increased 3.1% in 2004 from 2003 to $63.2 million, and increased 4.9% in 2003 from 2002 to $61.4 million. Our service sales, which include customer support and installation services, remained relatively flat between 2004 and 2003 at $30.0 million as compared to $29.8 million, and increased 6.4% in 2003 from 2002 to $29.8 million.
The increase in our product sales from 2003 to 2004 reflects a greater number of customers funding large projects, particularly for enhanced data recovery technology purchases. Since 2002, we have increased the productivity of our sales executives. The following table shows the change in our average number of account executives and the increase in our net sales per average number of account executives.
The decline in the number of account executives reflects our closure of selected offices and turnover primarily in late calendar 2003. Based on our current hiring plans we expect the average number of account executives to increase modestly in 2005.
The increase in our product sales from 2002 to 2003 reflects an improvement in technology spending particularly with our large existing customers.
The slight increase in our service revenues between 2003 and 2004 reflects a $1.9 million increase in consulting service revenues, offset by a $1.1 million decrease in installation and configuration service revenues and a $360,000 decrease in customer support contract revenues. In 2003, we completed a particularly large storage solution installation and configuration project and also were unable to renew a large customer support contract. The increase in our service revenues between 2002 and 2003 reflects an increase in installation and configuration revenues of $1.4 million primarily due to a single large installation and configuration project completed in 2003.
We derived approximately 3%, 10% and 5% of our sales from our customer, Gateway, Inc., during 2004, 2003 and 2002, respectively. We cannot be assured that this customer will account for a substantial portion of our future sales. We had no other customers that comprised more than 10% of our sales in 2002 through 2004.
Gross Profit. Our total gross profit as a percentage of net sales decreased to 25.2% in 2004 from 25.7% in 2003, which was an increase from 25.1% in 2002.
Product gross profit as a percentage of product sales increased to 23.2% in 2004 as compared to 22.6% in 2003. This percentage improvement reflects the increase in enhanced data recover technology solution purchases made by our customers for which we achieved a higher gross profit. We have various programs in place with our vendors that provide economic incentives for achieving various sales performance targets. Achieving these targets contributed favorably to our 2004 product gross profit. These vendor incentive programs constantly change and we negotiate them separately with each vendor. While we expect the incentive programs to continue, the vendors could modify or discontinue them, which would unfavorably impact our gross profit margins.
Product gross profit as a percentage of net product sales decreased to 22.6% in 2003 as compared to 23.4% in 2002. Due to economic conditions during 2002 and 2003, our customers sought storage solutions to meet minimum needs rather than implementing comprehensive infrastructure changes. Solutions that meet a minimum need generally carry lower product margins than comprehensive infrastructure changes. In addition, our product gross profit percentage suffered due to the high level of pricing competition in the marketplace. Charges for excess and obsolete inventory in 2004, 2003 and 2002 of $185,000, $349,000 and $188,000, respectively, adversely affected our product gross profit.
Service gross profit as a percentage of service sales decreased to 29.5% in 2004 as compared to 32.2% in 2003 and increased as compared to 28.6% in 2002. The percentage decrease in 2004 as compared to 2003, and the percentage increase for 2003 over 2002, is primarily due a single large installation and configuration project in 2003 on which we achieved a higher than normal gross profit percentage. For 2004, we also failed to renew a couple of large customer support contracts.
Sales and Marketing. Sales and marketing expenses include wages and commissions paid to sales and marketing personnel, travel costs and advertising, promotion and hiring expenses. Sales and marketing expenses totaled $12.4 million, or 13.3% of net sales for 2004 compared to $11.0 million, or 12.1% of net sales for 2003 and $11.5 million, or 13.3% of net sales for 2002. The increase in sales and marketing expense in absolute dollars is a result of higher commission expense of $1.7 million due to a change in compensation plans and higher sales volume in 2004 as compared to 2003. The decrease in sales and marketing expense in absolute dollars in 2003 as compared to 2002 is a result of lower bad debt expense of $141,000 and a reduction in our sales management workforce and expenses of $153,000. The increase in sales and marketing expense as a percentage of net sales from 2004 as compared to 2003 resulted from the increase in commission expenses due to compensation plan changes. The decrease in sales and marketing expense as a percentage of net sales from 2003 as compared to 2002 resulted primarily from higher revenues combined with reduced expenses in 2003. As we continue to selectively hire additional outside sales representatives, our sales and marketing expenses may increase without a commensurate increase in sales.
General and Administrative. General and administrative expenses include wages for administrative personnel, professional fees, depreciation, communication expenses and rent and related facility expenses. General and administrative expenses decreased to $10.4 million, or 11.1% of net sales for 2004 compared to $11.0 million, or 12.0% of net sales for 2003 and $10.4 million, or 12.0% in 2002. The decrease in general and administrative expenses in absolute dollars is due to lower depreciation expense of $225,000 on our customer relationship management system and reduced facilities expenses of $412,000 related to our office closures and subleases. When comparing 2003 to 2002, the increase in general and administrative expenses in absolute dollars reflects higher property taxes for our Chanhassen facility of $205,000, higher training expenses to maintain vendor certifications of $99,000 and the settlement of a sales and use tax audit of $127,000. Our general and administrative expenses were lower as a percentage of net sales in 2004 as compared to 2003 due to the reduced spending coupled with an increase in sales. Our general and administrative expenses were flat as a percentage of net sales in 2003 as compared to 2002.
Engineering. Engineering expenses include employee wages and travel, hiring and training expenses for our professional engineers and technicians. We allocate engineering costs associated with installation and configuration services and with consulting services to our cost of service sales. Engineering expenses decreased to $3.8 million, or 4.0% of net sales in 2004 compared to $4.2 million, or 4.6% of net sales in 2003 and $5.0 million, or 5.7% of net sales in 2002. The decrease in engineering expenses in absolute dollars from 2004 as compared to 2003 is due to an $862,000 compensation savings associated with a reduction in the number of engineers and engineering managers, offset by an increase in outside consulting expenses of $155,000 and a $71,000 increase in travel and entertainment expenses.
The decrease in engineering expenses in absolute dollars from 2003 as compared to 2002 reflects an increase in installation and configuration and consulting service revenues of $388,000 in 2003 over 2002. Accordingly, we had a corresponding decline in the proportion of our engineering costs allocated to engineering expenses and an increase in our allocation to cost of service sales. In 2003, we also had $149,000 less of engineering travel and entertainment on installation and configuration projects than in 2002
The decrease in engineering expenses as a percentage of sales for 2004 as compared to 2003 is the result of higher revenues and lower expenses in 2004. The decrease in engineering expenses as a percentage of sales for 2003 as compared to 2002 is the result of higher revenues and lower expenses in 2003.
Overall Cost Reduction Initiatives. Because of the difficult economic climate for technology spending that we faced over the past several years, and with our recent operating losses, we have actively sought to reduce costs across our business. In October 2003, we announced several cost reduction initiatives and management changes. These changes resulted in a fourth quarter 2003 charge of $2.1 million. As part of these cost reduction initiatives, we reduced our staff by 16%. Employee severance charges were $568,000. We also announced the closure of four offices. Office closing costs for lease terminations
were $584,000. The office closures included closing an office and terminating personnel from our OpenSystems.com, Inc. acquisition in November 2000, resulting in an impairment of our customer base intangible asset. The resulting impairment charge of the asset was $926,000.
On December 15, 2004, we agreed to sublease approximately 55,000 of the 104,000 square feet we currently occupy as our corporate headquarters in Chanhassen, Minnesota. The initial sublease term is co-terminal with our lease and is for 85 months starting on April 1, 2005 and ending April 27, 2012. The sublessee will pay us rent ranging from approximately $55,000 per month at the beginning of the term to approximately $60,000 per month by the end of the term. We also negotiated with our landlord to sell the 2.5 acre lot adjoining our facility for $200,000. In the first quarter of 2005, we expect to incur a one-time, non-cash charge of approximately $3.5 million related to the sublease and lot sale. We expect cost savings of approximately $950,000 per year as a result of the sublease agreement.
Intangible Amortization. Amortization of intangible assets decreased to $261,000 in 2004 compared to $724,000 in 2003 and $1.1 million in 2002. The amortization relates primarily to our acquisition of the data storage and services business of OpenSystems.com, Inc. in November 2000. We adopted Statement of Financial Accounting Standards (SFAS) 142, Goodwill and Intangible Assets, on January 1, 2002. This Statement required that we no longer amortize goodwill and intangible assets with indefinite lives, but instead test for impairment annually or whenever impairment is indicated. For 2004, we determined that our goodwill was not impaired. However, in the fourth quarter of 2003, we recorded an impairment charge on our OpenSystems.com customer base intangible asset in connection with our cost reduction initiatives.
During 2003, we amortized the remaining $76,000 balance of the customer base intangible asset we acquired in our July 1998 acquisition of Direct Connect Systems, Inc. In 2002, we amortized the remaining $163,000 balance of the trademark and name intangible asset we acquired in that acquisition. This is because we do not operate under the Direct Connect Systems name and realization of future uses became uncertain in the fourth quarter of 2002. For more information, see Note 2 of the Notes to our Financial Statements.
Operating Loss. We incurred operating losses of $3.2 million in 2004 compared to $5.5 million in 2003 and $6.2 million in 2002. Since the restructuring in October 2003, our financial results have steadily improved during 2004. In the fourth quarter of 2004 we generated net income of $445,000. However, we expect to post a net loss in the first quarter ending March 31, 2005. This relates to the $3.5 million sublease charge described above, together with normal, increased first quarter recurring costs for payroll taxes, public reporting compliance and benefit accruals. We also will incur expenses related to Sarbanes-Oxley compliance requirements which will contribute to the expected first-quarter operating loss. We expect these compliance and other costs to decline in 2005 after the first quarter.
The reduction in our operating losses of $2.3 million for 2004 as compared to 2003 is a result of $2.1 million of restructuring charges included in the 2003 operating loss and the favorable impact of our cost reduction efforts in our 2004 operating results. The decrease in our operating losses of $700,000 for 2003 as compared to 2002 is due to a 5.4% improvement in sales and a reduction in amortization expense, offset by $2.1 million of restructuring charges included in the 2003 operating loss.
Income Taxes. We had no income tax benefit or expense in 2004. We provided for an income tax benefit of $276,000 in 2003 and $618,000 in 2002. The income tax benefit generated for 2003 represents a higher than expected federal income tax refund from our 2002 tax return. Included in the income tax provision for 2002 is a non-cash charge of $1.6 million related to the recording of a valuation reserve for the deferred tax asset. The ultimate realization of deferred tax assets is dependent upon carry back to prior periods and upon the generation of future taxable income during the periods in which those temporary differences become deductible. Based upon the level of taxable losses in 2004, 2003 and 2002 and the near-term uncertainty of taxable income, management cannot reasonably predict when or if these deductible differences will be realized. In addition, we do not have the ability to realize future income tax benefits on future losses.
Quarterly Results and Seasonality
The following table sets forth our unaudited quarterly financial data for each quarter of 2004 and 2003. In our opinion, this unaudited information has been prepared on the same basis as the audited information and includes all adjustments (including all normal recurring adjustments) necessary to present fairly the information set forth below. The operating results for any quarter are not necessarily indicative of results for any future period.
We have experienced, and expect to continue to experience, quarterly variations in our net sales as a result of a number of factors, including the length of the sales cycle with customers for large storage system evaluations and purchases, delays in storage system installations or configurations, new product introductions by suppliers and their market acceptance, delays in product shipments or other quality control difficulties, trends in the enterprise-class information storage industry in general or the geographic and industry specific markets in which we are currently active, or may be in the future. In addition, economic conditions and competition also affect our customers decisions to place order with us. Further, our success in integrating any acquired business or in opening any new field offices could impact our net sales.
Liquidity and Capital Resources
We have financed our operations and capital requirements through cash flows generated from operations and the proceeds from our offerings of our common stock. Our working capital was $10.0 million at December 31, 2004 as compared to $11.5 million at December 31, 2003. Our current ratio was 1.4:1 at December 31, 2004 as compared to 1.5:1 at December 31, 2003. At December 31, 2004, our cash and cash equivalents balance was $12.7 million.
Cash provided by operating activities for 2004 was $396,000 as compared to $3.2 million in 2003 and $984,000 in 2002. Significant items which impacted our operating cash flows in 2004 were:
A $3.0 million increase in accounts receivable reflecting increasing sales activity versus the prior year.
A $2.2 million increase in accrued expenses and accounts payable due primarily to increased employee bonus incentive accruals.
A net $1.0 million increase in deferred customer support contracts. While we amortize the revenues from these contracts over the life of the contract, the customer almost always pays for the contracts at the beginning of the contract period which favorably impacts our cash flows.
The cash provided in 2003 resulted primarily from a reduction in our net operating assets. This included a $2.0 million income tax refund, a $1.9 million reduction in inventory shipped but not installed with fewer projects left to be installed at year end, a $441,000 reduction in field evaluation inventory and a $3.9 million reduction in accounts receivable due to an improvement in our days sales outstanding. These reductions were offset by a $3.5 million reduction in accounts payable. The cash provided in 2002 resulted primarily from a reduction in our net operating assets from timing of certain payments and receipts and a reduction in the overall level of working capital.
Cash used in investing activities was $415,000 in 2004 and $1.1 million during each of 2003 and 2002. In 2004, we used this cash to purchase computer equipment, complete a data warehouse project and provide further enhancements to our business reporting software tool. In 2003, we used this cash to complete our own storage and data recovery project, purchase computer equipment and provide further enhancements to our customer relationship management information systems and our business reporting software tool. In 2002, we used this cash primarily to implement our customer relationship management information system.
Cash provided by financing activities during 2004, 2003 and 2002 was $117,000, $111,000 and $4.7 million, respectively. In 2004 and 2003, we received $117,000 and $111,000, respectively, from stock sold under our employee stock purchase plan and from the exercise of stock options. In 2002, we received $5.3 million from a direct private offering of newly issued common stock to institutional investors and $186,000 from stock sold under our employee stock purchase plan. This cash was partially offset by the final scheduled payment of $704,000 on a note due to a former stockholder.
The revolving credit facility we have had with a bank since June 2003, expired in June 2004. We have elected not to pursue a new facility at this time. We have no outstanding debt, and if the need should arise to borrow funds, we believe that we could obtain a secured facility. For more information, see Note 5 of the Notes to our Financial Statements.
We have an 11-year non-cancelable operating lease for our corporate headquarters in Chanhassen, Minnesota which expires in 2012. The lease requires base rental payments of approximately $1.0 million in the first year and $1.3 million for each subsequent year. On December 15, 2004, we agreed to sublease approximately 55,000 of the 104,000 square feet we then occupied. The initial term of the sublease is co-terminal with our lease and is for 85 months starting on April 2005 and ending
on April 2012. The sublease requires rent payments ranging from $55,000 per month at the beginning of the term to approximately $60,000 per month by the end of the term. For more information, see Note 7 of the Notes to our Financial Statements.
Contractual Obligations and Commitments
As of December 31, 2004, our contractual cash obligations consisting of future minimum lease payments due under non-cancelable operating leases are as follows:
On December 15, 2004, we agreed to sublease approximately 55,000 of the 104,000 square feet we then occupied as our corporate headquarters in Chanhassen, Minnesota. The initial sublease term is co-terminal with our lease and is 85 months starting on April 1, 2005 and ending April 27, 2012. The sublessee will pay us rent ranging from approximately $55,000 per month at the beginning of the term to approximately $60,000 per month by the end of the term. The rent includes the costs of common area management, common systems repairs, real estate taxes and standard utilities. We also negotiated with our landlord to sell the 2.5 acre lot adjoining our facility for $200,000, which we originally acquired in 2001 for $384,000. We expect to incur the following charges in the first quarter of 2005 associated with our sublease and related activities:
We also estimate our cash expenditures associated with our sublease and the related activities, net of the anticipated proceeds from our proposed lot sale, at $674,000. We will capitalize these cash outlays and amortize them over the lease term.
We believe that funds generated from operations will be sufficient to finance our current operations and planned capital expenditures for at least the next twelve months. We believe if the need should arise to borrow funds, we could obtain a secured facility. We are planning for $500,000 to $1.0 million of capital expenditures through 2005 primarily related to enhancements to our management information systems.
Critical Accounting Policies and Estimates
The preparation of financial statements requires us to make estimates and assumptions that affect reported earnings. We evaluate these estimates and assumptions on an on-going basis based on historical experience and on other factors that we believe are reasonable. Estimates and assumptions include, but are not limited to, the areas of customer receivables, inventories, investments, income taxes, self-insurance reserves and commitments and contingencies. We believe that the following represent the areas where we use more critical estimates and assumptions in the preparation of our financial statements:
Revenue Recognition. We realize revenue from the design, installation and support of data storage solutions, which may include hardware, software and services. We recognize revenue when it has met its obligations for installation or other services and collectability is reasonably assured.
Product Sales. We sell software and hardware products on both a free-standing basis without any services and as data storage solutions bundled with our installation and configuration services (bundled arrangements).
Product Sales Without Service. If we sell a software or hardware product and do not provide any installation or configuration services with it, we recognize the product revenues upon shipment.
Product Sales With Service. If we sell a bundled arrangement, then we defer recognizing any revenues on it until we finish our installation and/or configuration work. For the three years ended December 31, 2004, we have accounted for the hardware, software and service elements of our bundled arrangements by applying the provisions of Statement of Position (SOP) 97-2, Software Revenue Recognition, as amended by SOP 98-4 and SOP 98-9.
Pursuant to the provisions of SOP 97-2, we apply contract accounting to our bundled arrangements. In accordance with SOP 81-1, Accounting for Performance of Construction Type and Certain Production Type Contracts, we apply the completed contract method. Factors we have considered in applying the completed contract method accounting include (i) the relatively short duration of our contracts, (ii) the difficulty of estimating our revenues on a percentage-of-completion method and (iii) our use of acceptance provisions on larger bundled arrangements.
For 2002, we originally applied the provisions of Staff Accounting Bulletin No. 101 to account for our bundled arrangements. In 2003, we changed the accounting guidance we apply based on our determination that the software component of our sales was more than incidental to our products or services as a whole. However, the change did not affect the revenue amounts or the timing of our revenue recognition on bundled arrangements for 2002. This is because, under SAB No. 101, we also recognized revenue on our bundled arrangements only after we completed our installation and configuration services.
Service Sales. In addition to installation and configuration services that are part of our bundled arrangements described above, our service sales include customer support contracts and consulting services. On our balance sheet, deferred revenue relates to service sales for which our customer has paid us or has been invoiced but for which we have not yet performed the applicable services.
Customer Support Contracts. We sell service contracts to most of our customers. These contracts are support service agreements. We have an internal support desk that provides integrated customer support services, including configuration and usage assistance, technical advice and prompt incident detection and resolution. Our technical staff first assists a customer in identifying the source of system problems and in determining whether there is defective hardware or software. If our customer requires on-site maintenance or repair services, we arrange for a service call pursuant to underlying third-party support service agreements we have with our hardware and software vendors.
When we sell a service contract as part of a bundled arrangement, we use vendor specific objective evidence to allocate revenue to the service contract element. In all cases, we defer revenues and direct costs resulting from our service contracts and amortize them into operations over the term of the contracts, which are generally twelve months. We are contractually obligated to provide or arrange to provide these underlying support services to our customers in the unlikely event that the hardware or software vendor, or its designee, fails to perform according to the terms of its contact.
Consulting Services. Some of our customers engage us to analyze their existing storage architectures and offer our recommendations. Other customers engage us to assist them on-site with extended data storage projects, to support their data storage environments and to help with long-term data storage design challenges. For these types of consulting services that do not include the sale of hardware or software products, we recognize revenues as we perform these services.
Gross Reporting of Revenues. We report our revenues from the sale of hardware and software products on a gross, rather than a net, basis. In reporting our revenues on a gross basis, we considered that:
We are the primary obligor to our customers. We are responsible for fulfillment, including the acceptability of the products and services to our customers.
We have the risk of loss for inventory and credit.
We establish the prices for our products and services with our customers.
We are responsible for the installation and configuration services ordered by our customers.
Commission Expense. We utilize a direct internal sales force to generate virtually all of our revenues. We pay our sales people a combination of base salary and commissions. We pay commissions based on the amount of gross profit generated from the products and services sold. We match commissions to the appropriate transactions and recognize commission expense at the time we recognize the related revenues and gross profit.
Inventory. We periodically review, estimate and adjust our reserves for obsolete or unmarketable inventory equal to the difference between the inventory cost and the estimated market value based upon assumptions about future demand and market
conditions. Results could be materially different if demand for our products decreased because of economic or competitive conditions, length of industry downturn, or if products become obsolete because of technical advancements in the industry.
Valuation of Goodwill and Other Intangible Assets. On January 1, 2002, we adopted Statement of Financial Accounting Standards (SFAS) 142, Goodwill and Other Intangible Assets, and reclassified $652,000 of assembled workforce to goodwill. As a result, we have ceased to amortize approximately $5.5 million of goodwill. We test goodwill for impairment annually or more frequently if changes in circumstance or the occurrence of events suggests an impairment exists. The test for impairment requires us to make several estimates about fair value, most of which are based on total market capitalization as compared to the carrying value of our net assets. If our total market capitalization is at or below the carrying value of our net assets, it may prompt us to engage a third party valuation firm to perform a valuation of us to further assess whether our goodwill or other intangibles are impaired pursuant to SFAS 142. We consider our goodwill impairment test estimates critical due to the amount of goodwill recorded on our balance sheet and the judgment required in determining fair value amounts.
Other intangible assets consist of customer lists. We amortize customer lists using the straight-line method over an estimated useful life of five years. We review these intangible assets for impairment as changes in circumstance or the occurrence of events suggests the remaining value is not recoverable.
Income Taxes. We utilize the asset and liability method of accounting for income taxes. We recognize deferred tax liabilities or assets for the expected future tax consequences of temporary differences between the book and tax bases of assets and liabilities. We regularly assess the likelihood that we will recover our deferred tax assets from future taxable income We record a valuation allowance to reduce our deferred tax assets to the amounts we believe are more likely than not to be realizable. We consider projected future taxable income and ongoing tax planning strategies in assessing the amount of the valuation allowance. If we determine it is more likely than not that we will not realize all or part of our deferred tax assets, we will adjust our earnings for the deferred tax in the period we make this determination.
As a result of our cumulative losses over the past two years and the full utilization of our loss carry back potential, we concluded during the fourth quarter of fiscal 2002 to make a full valuation allowance against our net deferred tax assets. The valuation allowance at December 31, 2004 was $4.7 million. In addition, we expect to provide a full valuation allowance on any future tax benefits until we can sustain a level of profitability that demonstrates our ability to realize these assets.
Recent Accounting Pronouncements
In December 2004, the Financial Accounting Standards Board published FASB Statement No. 123 (revised 2004), Share-Based Payment. This statement, which will begin to apply in our third quarter of 2005, requires us to recognize the compensation cost relating to share-based payment transactions, including grants of employee stock options, in our financial statements. We are to measure this cost based on the fair value of the equity or liability instruments issued. The statement covers a wide range of share-based compensation arrangements, including stock options, restricted share plans, performance-based awards, share appreciation rights and employee share purchase plans. The statement will require us to measure the cost of employee services received in exchange for stock options based on the grant-date fair value of the award. We then will recognize the cost over the period we require the employee to provide services for the award.
The new statement allows two methods for transitioning our expensing of share-based transactions. We are studying the new statement and have not yet determined which transition method we will apply. Under the modified prospective transition method, we would use the fair value-based accounting method for all employee awards granted, modified or settled after the effective date. As of the effective date, we would base the compensation cost for the non-vested portion of awards outstanding as of that date on the grant-date fair value of those awards as calculated under our current accounting methods. As a result, we would not re-measure the grant-date fair value estimate for the unvested portion of awards granted prior to the effective date. As part of this transition method, we would also decide whether to apply the new statement to only our third quarter of 2005 and subsequent periods, or to all of 2005. Under the modified retrospective method of transition, we would need to revise our previously issued financial statements to recognize employee compensation cost for all prior periods we present in our financial statements.
We do not believe that inflation has had a material effect on our results of operations in recent years. We cannot assure you that inflation will not adversely affect our business in the future.
As indicated in this Annual Report under the caption Note Regarding Forward-Looking Statements, certain information contained in this Annual Report consists of forward-looking statements. Important factors that could cause actual results to differ materially from the forward-looking statements made in this Annual Report include the following:
We have incurred substantial net losses and may not achieve profitability.
Except for the fourth quarter of 2004, we have incurred net losses each quarter since the fourth quarter of 2001. We also expect to incur a net loss in the first quarter of 2005. We cannot assure that we will return to profitability in the foreseeable future, or at all. Our continued losses may adversely affect our stock price.
Competition could prevent us from increasing or sustaining our revenues or profitability.
The enterprise-class information storage market is rapidly evolving and highly competitive. As technologies change rapidly, we expect that competition will increase in the future. We compete with independent storage system suppliers to the high-end market and numerous resellers, distributors and consultants. We also compete in the storage systems market with general purpose computer suppliers. Many of our current and potential competitors have significantly greater financial, technical, marketing, purchasing and other resources than we do. As a result, they may respond more quickly to new or emerging technologies and changes in customer requirements, devote greater resources to the development, promotion and sale of products and deliver competitive products at lower end-user prices.
Some of our current and potential competitors include our suppliers. We are not the exclusive supplier of any data storage product we offer. Instead, our suppliers market their products through other independent data storage solution providers, original equipment manufacturers and, often, through their own internal sales forces. We believe direct competition from our suppliers is likely to increase if, as expected, the data storage industry continues to consolidate. This consolidation would probably result in fewer suppliers with greater resources to devote to internal sales and marketing efforts. In addition, our suppliers have established and will probably continue to establish cooperative relationships with other suppliers and other data storage solution providers. These cooperative relationships are often intended to enable our suppliers to offer comprehensive storage solutions, which compete with those we offer. If our relationships with our suppliers become adversarial, it will be more difficult for us to stay ahead of industry developments and provide our customers with the type of service they expect from us.
In addition, most of our customers already employ in-house technical staffs. To the extent a customers in-house technical staff develops sophisticated storage systems expertise, the customer may be less likely to seek our services. Further, we compete with storage service providers who manage, store and backup their customers data at off-site, networked data storage locations.
We derive a significant percentage of our revenues from a small number of customers.
In 2004, we had no customers that accounted for at least 10% of our revenues. However, our top six customers collectively accounted for 27% of our 2004 revenues. Because we intend to continue to seek out large projects, we expect that a significant percentage of our revenues will continue to come from a small number of customers, although the composition of our key customers is likely to change from year to year. If we fail to obtain a growing number of large projects each year, our revenues and profitability will likely be adversely affected. In addition, our reliance on large projects makes it more likely that our revenues and profits will fluctuate unpredictably from year to year. Unpredictable revenue and profit fluctuations may make our stock price more volatile and lead to a decline in our stock price.
Our revenue recognition policies unpredictably defer reporting of our revenues.
We increasingly sell complex enterprise-class information storage solutions. We do not recognize revenues from our sale of hardware and software products to our customers until we complete our required installation or configuration of these products. Installation and configuration of these solutions requires significant coordination with our customers and vendors. Therefore, even if we have shipped all products to our customers, we may be unable to control the timing of product installation and configuration. These delays prevent us from recognizing revenue on products we ship and may adversely affect our quarterly reported revenues. As a result, our stock price may decline.
We rely on only a few key suppliers and would suffer materially if we could not obtain their products.
We rely on our close relationships with our suppliers to provide access to products and new technology necessary to design and implement leading-edge enterprise-class information storage solutions for our customers. We do not have long-term supply contracts with any of our suppliers. In many instances, we rely upon only two or three suppliers for each of our key products. Our
reliance on these suppliers leaves us vulnerable to an inadequate supply of required products, price increases, late deliveries and poor product quality. Disruption or termination of the supply of products from our suppliers for any reason would likely prevent or delay our shipments to our customers. Our customers expect reliable and prompt service from us. If we cannot obtain necessary components, or the components we obtain are unreliable or unexpectedly expensive, we will not meet our customers expectations. If we cannot meet our customers expectations, our business will suffer considerably.
Our business depends on our ability to hire and retain technical personnel.
Our future operating results depend upon our ability to attract, retain and motivate qualified engineers with enterprise-class information storage solutions experience. If we fail to recruit and retain additional engineering personnel, or if continued losses require us in the future to terminate employment of some of these personnel, we will experience greater difficulty realizing our growth strategy, which could negatively affect our business, financial condition and stock price.
We generally do not have employment agreements with our key employees.
Our future operating results depend in significant part upon the continued contributions of our executive officers, managers, salespeople, engineers and other technical personnel, many who have substantial experience in our industry and would be difficult to replace. In general, we do not have employment, non-competition or nondisclosure agreements with our officers or employees, including our executive officers. Accordingly, our employees may voluntarily leave us at any time and work for our competitors. Our growth strategy depends in part on our ability to retain our current employees and hire new employees. Any failure to retain our key employees will make it much more difficult for us to maintain our operations and attain our growth objectives and could therefore be expected to adversely affect our operating results, financial condition and stock price.
Our long sales cycle may cause fluctuating operating results, which may adversely affect our stock price.
Our sales cycle is typically long and unpredictable, making it difficult to plan our business. Economic conditions over the past several years have increased this uncertainty. Our long sales cycle requires us to invest resources in potential projects that may not occur. In addition, our long and unpredictable sales cycle may cause us to experience significant fluctuations in our future annual and quarterly operating results. It can also result in delayed revenues, difficulty in matching revenues with expenses and increased expenditures. Our business, operating results or financial condition and stock price may suffer as a result of any of these factors.
If the data storage industry fails to develop compelling new storage technologies, our business may suffer.
Rapid and complex technological change, frequent new product introductions and evolving industry standards increase demand for our services. Because of this, our future success depends in part on the data storage industrys ability to continue to develop leading-edge storage technology solutions. Our customers utilize our services in part because they know that newer technologies offer them significant benefits over the older technologies they are using. If the data storage industry ceases to develop compelling new storage solutions, or if a single data storage standard becomes widely accepted and implemented, it will be more difficult to sell new data storage systems to our customers.
Accounting for equity compensation future accounting changes may adversely impact our expected financial results.
Under current accounting rules, we do not record charges to our financial statements in connection with the grant at fair market value of employee stock options. However, these accounting rules will change during 2005. Our new option-related expenses may unpredictably affect our reported results, which may adversely affect our stock price.
Beginning with the calendar year end December 31, 2006, we will be required by Section 404 of the Sarbanes-Oxley Act of 2002 to formally assess and attest that our internal controls are sufficient to provide accurate reporting of financial results. We will engage our independent accountants to perform an audit of our assessment and issue an opinion on the sufficiency of our internal controls. We are in the beginning phases of our assessment. Although we expect to incur significant costs to achieve compliance, we do not know if we will be fully compliant with the regulations by the end of 2006. If we are not compliant, we may incur additional costs to become compliant and our stock price could be unfavorably impacted.
Control by our existing stockholders could discourage the potential acquisition of our business.
Currently, our executive officers and directors beneficially own approximately 38% of our outstanding common stock. Acting together, these insiders may be able to elect our entire Board of Directors and control the outcome of all other matters requiring stockholder approval. This voting concentration may also have the effect of delaying or preventing a change in our management or control or otherwise discourage potential acquirers from attempting to gain control of us. If potential acquirers are deterred, you may lose an opportunity to profit from a possible acquisition premium in our stock price.
Our stock price is volatile.
The market price of our common stock has fluctuated significantly since our initial public offering, and may continue to be volatile. We cannot assure you that our stock price will increase, or even that it will not decline significantly from the price you pay. Our stock price may be adversely affected by many factors, including:
Our governing documents and Minnesota law may discourage the potential acquisitions of our business.
Our Board of Directors may issue additional shares of capital stock and establish their rights, preferences and classes, in some cases without stockholder approval. In addition, we are subject to anti-takeover provisions of Minnesota law. These provisions may deter or discourage takeover attempts and other changes in control of us not approved by our Board of Directors. If potential acquirers are deterred, you may lose an opportunity to profit from a possible acquisition premium in our stock price.
Future goodwill impairment may unpredictably affect our financial results.
Effective January 1, 2002, we no longer amortize goodwill. Instead, we perform impairment analyses of our goodwill at least annually or when we believe there is an impairment. Future events could cause us to conclude that impairment indicators exist and that goodwill associated with our acquired businesses is impaired. Any resulting impairment loss could have a material adverse impact on our financial condition and results of operations.
Item 7A. Quantitative and Qualitative Disclosures about Market Risk
Our interest income is sensitive to changes in the general level of U.S. interest rates, particularly since the majority of our investments are in short-term instruments. Due to the nature of our short-term investments, we do not believe that we have any material market risk exposure. Therefore, no quantitative tabular disclosures are required.
The following discusses our exposure to market risk related to changes in interest rates, foreign exchange rates and equity prices.
Interest rate risk. As of December 31, 2004, we had $12.7 million of cash and money market accounts. A decrease in market rates of interest would have no material effect on the value of these assets or the related interest income due to the nature of money market accounts. We have no short or long-term debt.
Foreign currency exchange rate risk. We market and sell all of our products in the United States. Therefore, we are not currently exposed to any direct foreign currency exchange rate risk.
Equity price risk. We do not own any equity investments. Therefore, we are not currently exposed to any direct equity price risk.
Item 8. Financial Statements and Supplementary Data.
Report of Independent Registered Public Accounting Firm
To the Board of Directors
We have audited the accompanying balance sheet of Datalink Corporation as of December 31, 2004 and the related statements of income, changes in stockholders equity and cash flows for the year then ended. These financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements based on our audit.
We conducted our audit in accordance with the standards of the Public Company Accounting Oversight Board (United States). Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and the significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Datalink Corporation as of December 31, 2004, and the results of its operations and its cash flows for the year then ended, in conformity with accounting principles generally accepted in the United States of America.
February 4, 2005
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
We have audited the accompanying balance sheets of Datalink Corporation as of December 31, 2003 and the related statements of operations, stockholders equity and cash flows for each of the years in the two-year period then ended. These financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on these financial statements based on our audits.
We conducted our audits in accordance with auditing standards generally accepted in the United States of America. Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements. An audit also includes assessing the accounting principles used and significant estimates made by management, as well as evaluating the overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the financial position of Datalink Corporation as of December 31, 2003 and the results of its operations and its cash flows for each of the years in the two-year period then ended in conformity with accounting principles generally accepted in the United States of America.
(In thousands, except share data)
The accompanying notes are an integral part of these financial statements.
STATEMENTS OF OPERATIONS
(In thousands, except per share data)
The accompanying notes are an integral part of these financial statements.
STATEMENTS OF STOCKHOLDERS EQUITY
(In thousands, except per share data)
The accompanying notes are an integral part of these financial statements.
STATEMENTS OF CASH FLOWS
The accompanying notes are an integral part of these financial statements.
NOTES TO FINANCIAL STATEMENTS
1. Description of Business:
Datalink Corporation (the Company) is an independent architect of enterprise-class information storage infrastructures. The Company derives its revenues principally from designing, installing and supporting data storage systems. The Companys solutions can include hardware products, such as disk arrays, tape systems and interconnection components, and storage management software products. The Company is frequently engaged to provide assistance in the installation of solutions and to provide support services subsequent to the installation. Occasionally, the Company is engaged for consulting services.
2. Summary of Significant Accounting Policies:
Cash and Cash Equivalents:
Cash equivalents consist principally of money market funds with original maturities of three months or less, are readily convertible to cash and are stated at cost, which approximates fair value. The Company maintains its cash in bank deposit and money market accounts which, at times, may exceed federally insured limits. The Company has not experienced any losses in such accounts.
Accounts Receivable, net:
Trade receivables are carried at original invoice amount less an estimate made for doubtful receivables based on a review of all outstanding amounts on a monthly basis. Management determines the allowance for doubtful accounts by regularly evaluating individual customer receivables and considering a customers financial condition and credit history and current economic conditions. Trade receivables are written off when deemed uncollectible. Recoveries of trade receivables previously written off are recorded when received.
Accounts receivable are recorded net of the reserve for doubtful accounts of $70,000 and $98,000 at December 31, 2004 and 2003, respectively.
Concentration of Credit Risk:
During 2004, 2003 and 2002, net sales to one customer totaled 3%, 10% and 5% of total net sales, respectively. The balance of accounts receivable for this customer as a percentage of total accounts receivable as of December 31, 2004 and 2003, respectively is 0% and 3%.
Software Development Costs:
In compliance with the American Institute of Certified Public Accountants (AICPA) Statement of Position 98-1, Accounting for Computer Software Developed for or Obtained for Internal Use, the company capitalized certain costs associated with software developed or obtained for internal use.
During 2000, the Company began the implementation of a new customer relationship management (CRM) application suite which was completed in 2003. The Company capitalized costs of the implementation of $234,000 in 2003 and $1.3 million in 2002. The system is complete and no further costs are expected. Amounts are being amortized over a period of 3 years from the date they are available for use. Amortization of software costs were $729,000 in 2004, $815,000 in 2003, and $536,000 in 2002.
Inventories, including inventories shipped but not installed, principally consist of data storage products and components, that are valued at the lower of cost or market with cost determined on a first-in, first-out (FIFO) method. Inventories have been reduced by obsolete and slow moving reserves of $71,000 and $211,000 at December 31, 2004 and 2003, respectively.
Property and Equipment:
Property and equipment, including purchased software, are stated at cost. Depreciation and amortization are provided by charges to operations using the straight-line method over the estimated useful lives of the assets (ranging from 2 to 10 years).
Leasehold improvements are amortized on a straight-line basis over the shorter of their estimated useful lives or the underlying lease term. The costs and related accumulated depreciation and amortization on asset disposals are removed from the accounts and any gain or loss is included in operations. Major renewals and betterments are capitalized, while maintenance and repairs are charged to current operations when incurred.
In accordance with Financial Accounting Standards Board (FASB) Statement No. 142, goodwill is tested for impairment annually, and additionally if an event occurs or circumstances change that would indicate the carrying amount may be impaired. Impairment testing for goodwill is done at a reporting-unit level. An impairment loss would generally be recognized when the carrying amount of the reporting units net assets exceeds the estimated fair value of the reporting unit. The Company completed its impairment assessments for December 31, 2004 and 2003, and determined that no impairment existed.
Identifiable intangible assets are amortized on a straight-line basis over their estimated useful lives of 3 to 7 years. In October 2003, the Company announced several cost reduction actions. These actions included the closing an office and terminating personnel acquired by the Company from OpenSystems.com in November 2000, resulting in an impairment of the Companys customer base intangible asset. The Company estimated the impact that closure of this office and termination of its personnel would have on the OpenSystems.com customer accounts and the related expected cash flows, considering the likelihood of retaining the customers without an office presence. The Company then compared the undiscounted cash flows with the net book value of the intangible asset which indicated the asset was impaired. To determine the impairment charge of $926,000, the Company calculated the discounted cash flows and compared them to the net book value of the intangible and determined the resulting impairment charge of the asset. The remaining balance of the intangible at December 31, 2004 of $224,000 will be fully amortized in 2005.
Valuation of Long-Lived Assets:
The Company periodically (at least annually) analyzes its long-lived assets, including identifiable intangible assets with discrete lives, for potential impairment, assessing the appropriateness of lives and recoverability of unamortized balances through measurement of undiscounted operating cash flows on a basis consistent with generally accepted accounting principles.
As permitted by Statement of Financial Accounting Standards (SFAS) No. 123, the Company has elected to continue following the guidance of Accounting Principles Board (APB) Opinion No. 25 for measurement and recognition of stock-based transactions with employees. No compensation cost has been recognized for stock options granted to employees under the plans where the exercise price of the options granted was equal to the fair value of the common stock at the date of grant.
Pro forma net loss and loss per share have been determined as if the Company had used the fair value method of accounting for its stock option grants and employee stock purchase plan share elections consistent with the method of SFAS No. 123. Under this method, compensation expense is recognized over the applicable vesting periods and is based on the shares under option and their related fair values on the grant date.
The weighted-average fair values per option at the date of grant were $2.47, $3.35 and $4.35 for 2004, 2003 and 2002 respectively. The fair value for the stock option grants was estimated using the Black-Scholes option pricing model with the following weighted average assumptions:
During 2004, the Companys employees elected to purchase 35,246 shares under the Employee Stock Purchase Plan (ESPP). Using the Black-Scholes pricing model, the weighted average fair value was $0.42 per share for each election. During the 2003 and 2002 ESPP offering, employees elected to purchase 23,883 and 59,504 shares respectively. Using the Black-Scholes pricing model, the weighted average fair value was $0.40 per share for each election in 2003 and $0.54 per share for each election in 2002.
In December 2004, the Financial Accounting Standards Board published FASB Statement No. 123 (revised 2004), Share-Based Payment. This statement, which will begin to apply in the Companys third quarter of 2005, requires the Company to recognize the compensation cost relating to share-based payment transactions, including grants of employee stock options, in its financial statements. The Company will measure this cost based on the fair value of the equity or liability instruments issued. The statement covers a wide range of share-based compensation arrangements, including stock options, restricted share plans, performance-based awards, share appreciation rights and employee share purchase plans. The statement will require the Company to measure the cost of employee services received in exchange for stock options based on the grant-date fair value of the award. The Company then will recognize the cost over the period it required the employee to provide services for the award.
The new statement allows two methods for transitioning the Companys expensing of share-based transactions. The Company is studying the new statement and has not yet determined which transition method it will apply. Under the modified prospective transition method, the Company would use the fair value-based accounting method for all employee awards granted, modified or settled after the effective date. As of the effective date, the Company would base the compensation cost for the non-vested portion of awards outstanding as of that date on the grant-date fair value of those awards as calculated under its current accounting methods. As a result, the Company would not re-measure the grant-date fair value estimate for the unvested portion of awards granted prior to the effective date. As part of this transition method, the Company would also decide whether to apply the new statement to only its third quarter of 2005 and subsequent periods, or to all of 2005. Under the modified retrospective method of transition, the Company would need to revise its previously issued financial statements to recognize employee compensation cost for all prior periods it presents in its financial statements.
The Company calculates income taxes in accordance with the provisions of SFAS No. 109, Accounting for Income Taxes, which requires the use of the asset and liability method of accounting for income taxes. Under the liability method, deferred income taxes are recorded to reflect the tax consequences in future years of temporary differences between the tax bases of assets and liabilities and their financial reporting amounts using enacted tax rates for the years in which these items are expected to affect taxable income. The Company establishes valuation allowances when necessary to reduce deferred tax assets to the amount the Company expects are more likely than not to realize. Income tax (benefit) expense is the tax payable (receivable) for the period and the change during the period in deferred tax assets and liabilities.
Use of Estimates:
The preparation of financial statements in conformity with accounting principles generally accepted in the United States requires management to make estimates and assumptions that affect the reported amounts of assets and liabilities and disclosure of contingent assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Significant items subject to estimates and assumptions include the valuation for deferred tax assets, reserve for doubtful accounts, reserve for obsolete and slow moving (excess) inventory and valuation of long-lived assets. Actual results could differ from those estimates.
Revenue Recognition. The Company realizes revenue from the design, installation and support of data storage solutions, which may include hardware, software and services. The Company recognizes revenue when it has met its obligations for installation or other services and collectability is reasonably assured.
Product Sales. The Company sells software and hardware products on both a free-standing basis without any services and as data storage solutions bundled with our installation and configuration services (bundled arrangements).
Product Sales Without Service. If the Company sells a software or hardware product and does not provide any installation or configuration services with it, it recognizes the product revenues upon shipment
Product Sales With Service. If the Company sells a bundled arrangement, then it defers recognizing any revenues on it until the Company finishes the installation and/or configuration work. For the three years ended December 31, 2004, the Company has accounted for the hardware, software and service elements of our bundled arrangements by applying the provisions of Statement of Position (SOP) 97-2, Software Revenue Recognition, as amended by SOP 98-4 and SOP 98-9.
Pursuant to the provisions of SOP 97-2, the Company applied contract accounting to our bundled arrangements. In accordance with SOP 81-1, Accounting for Performance of Construction Type and Certain Production Type Contracts, the Company applied the completed contract method. Factors the Company has considered in applying the completed contract method accounting include (i) the relatively short duration of its contracts, (ii) the difficulty of estimating its revenues on a percentage-of-completion method and (iii) its use of acceptance provisions on larger bundled arrangements.
For 2002, the Company originally applied the provisions of Staff Accounting Bulletin No. 101 to account for its bundled arrangements. In 2003, the Company changed the accounting guidance it applied based on its determination that the software component of its sales was more than incidental to its products or services as a whole. However, the change did not affect the revenue amounts or the timing of the Companys revenue recognition on bundled arrangements for 2002. This is because, under SAB No. 101, the Company also recognized revenue on its bundled arrangements only after it completed its installation and configuration services.
Service Sales. In addition to installation and configuration services that are part of our bundled arrangements described above, the Companys service sales include customer support contracts and consulting services. On the Companys balance sheet, deferred revenue relates to service sales for which the Companys customer has paid them or has been invoiced but for which it has not yet performed the applicable services.
Customer Support Contracts. The Company sells service contracts to most of its customers. These contracts are support service agreements. The Company has an internal support desk that provides integrated customer support services, including configuration and usage assistance, technical advice and prompt incident detection and resolution. The Companys technical staff first assists a customer in identifying the source of system problems and in determining whether there is defective hardware or software. If the Companys customer requires on-site maintenance or repair services, the Company arranges for a service call pursuant to underlying third-party support service agreements it has with its hardware and software vendors.
When the Company sells a service contract as part of a bundled arrangement, the Company uses vendor specific objective evidence to allocate revenue to the service contract element. In all cases, the Company defers revenues and direct costs resulting from its service contracts and amortizes them into operations over the term of the contracts, which are generally twelve months. The Company is contractually obligated to provide or arrange to provide these underlying support services to its customers in the unlikely event that the hardware or software vendor, or its designee, fails to perform according to the terms of its contact.
Consulting Services. Some of the Companys customers engage them to analyze their existing storage architectures and offer its recommendations. Other customers engage the Company to assist them on-site with extended data storage projects, to support their data storage environments and to help with long-term data storage design challenges. For these types of consulting services that do not include the sale of hardware or software products, the Company recognizes revenues as it performs these services.
Net Income (Loss) Per Share:
Basic net income (loss) per share is computed using the weighted average number of shares outstanding. Diluted net income per share includes the effect of common stock equivalents, if any, for each period. The number of additional shares is calculated by assuming that outstanding stock options were exercised and that the proceeds from such exercise were used to acquire shares of common stock at the average market price during the reporting period. Due to the net loss in 2004, 2003 and 2002, potential common shares of 80,756, 105,931 and 62,536, respectively, would have been anti-dilutive to losses and as a result were excluded from the calculation of diluted loss per share.
Comprehensive Income (Loss):
The Companys comprehensive income (loss) is equal to its net loss for all periods presented.
Fair Value of Financial Instruments. At December 31, 2004 and 2003, the carrying values of current financial instruments such as cash and cash equivalents, accounts receivable, accounts payable, other current assets, accrued liabilities and other current liabilities, approximated their market values, based on the short-term maturities of these instruments.
3. Intangibles, net:
Information regarding the Companys other intangible assets that continue to be amortized are as follows:
Amortization expense for the years ended December 31, 2004, 2003 and 2002 was $261,000, $724,000 and $1.1 million, respectively. The intangible assets as of December 31, 2004 of $224,000 will become fully amortized in 2005.
4. Borrowing Arrangements:
The revolving credit facility the Company has had with a bank since June 30, 2003, expired on June 30, 2004. The Company has elected not to pursue a new facility at this time. With the Company's current cash position, it believes it has the liquidity to meet its operating needs for the foreseeable future. The Company has no outstanding debt, and if the need should arise to borrow funds, the Company believes that it could obtain a secured facility.
5. Income Taxes:
The benefit from income taxes consisted of the following: