Datalink 10-K 2006
Documents found in this filing:
Washington, D.C. 20549
FOR THE FISCAL YEAR ENDED DECEMBER 31, 2005
For The Transition Period From To
Commission file number: 00029758
(Exact name of registrant as specified in its charter)
8170 UPLAND CIRCLE
(Address of Principal Executive Offices)
(Registrants Telephone Number, Including Area Code)
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 if the registrant is a well known seasoned issuer as defined in Rule 405 of the Securities Act. Yes o No x
Indicate by check mark if the registrant is not required to file reports pursuant to Section 13 or Section 15(d) of the Act. Yes o No x
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days. Yes x No 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. x
Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer or a non-accelerated filer.
Indicate by check mark whether the registrant is a shell company (as defined by Rule 12b-2 of the Exchange Act). Yes o No x
Aggregate market value of the voting and non-voting common equity held by non-affiliates of the registrant at June 30, 2005: $19,133,116.
At March 10, 2006, the number of shares outstanding of each of the registrants classes of common stock was 10,487,237.
DOCUMENTS INCORPORATED BY REFERENCE
Portions of the Registrants Proxy Statement for its Annual Meeting of Stockholders to be held in 2006 (the 2005 Proxy Statement), to be filed with the Securities and Exchange Commission, are incorporated by reference to Part III of this Form 10-K.
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.
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:
· Data AvailabilityDatalink architectures are designed to protect against planned and unplanned downtime and provide fast access to information. Solutions span fault tolerant storage and clustering.
· Data RecoveryData recovery solutions enable companies to recover data, applications and entire computing environments following data loss or a disaster. Solutions include local and remote backup, snapshot and replication.
· Storage ManagementDatalink storage management architectures maximize utilization of storage technologies and the resources that manage them. Solutions span storage consolidation, storage area network (SAN) management, virtualization, storage resource management (SRM) and data lifecycle management and storage security.
· Support and MaintenanceAfter designing and installing data storage solutions for its customers, Datalink provides expertise through 24 hours-a-day telephone problem solving support and when necessary on site maintenance.
We offer a comprehensive suite of services spanning analysis, design, implementation and support. Our highly skilled technical services and product management teams test and compare data storage technologies available from the leading manufacturers and software developers. Once a product is
approved for our solution sets, our technical services team then has the flexibility to choose from the best of these storage technologies to solve our customers growing data storage needs. In addition, our support staff 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.
International Data Corporation (IDC) projects data growth at an annual compound rate of approximately 8-10% 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 2005 estimated at $36 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 virtualization, storage resource management and data 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:
· Enhanced data protection.
· Storage security.
· Continued migration to networked storage infrastructures using
storage device utilization levels, improved quality of service, reduced administration costs and increased operational efficiency.
· Evolution to modular storage systems.
· Retention and retrieval of data to address Email, regulatory,
compliance and litigation support issues.
· Adoption of robust storage management software solutions.
· Acceptance and growing need for storage services.
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. Advanced functionalities, such as disk-based backup and recovery, storage security, and virtualization, further increase the level of complexity. 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 disk-based backup and recovery solutions require the integration of highly specialized products made by a variety of manufacturers. A typical enhanced data recovery
architecture, for instance, can utilize components such as software, tape libraries, and disk systems, each from a different manufacturer. High-end data storage manufacturers generally focus on only a portion of the overall enhanced data recovery 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 manufacturers. Our customers value our independence and rely on us to choose the best available hardware and software and tailor it to their individual needs.
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 using industry best practices.
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 manufacturers 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 our SupportLink program is one of very few customer service plans 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 times 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 high, we believe it can be enhanced. 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 several 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 the acquisition of select regional competitors.
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 are reflected by our significant repeat business. Spanning a broad array of industries, our customers include CBS SportsLine.com, Cingular Wireless, Harris Corporation, Fidelity National Financial, GMAC-RFC, St. Jude Medical, Inc., Tyson Foods, Inc., Valero Energy Corporation and World Savings.
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 13 field sales offices in order to efficiently serve our customers needs.
Our field account executives and account associates work closely with our technical 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, and their close collaboration with our technical services team, 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, inside account associates, and technical services team 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.
Datalink primarily competes with 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. In addition, we compete with channel partners of storage OEMs. These include MTI Technology Corporation, Forsythe Technology, Inc., SAN Holdings, and Sirius.
As of December 31, 2005, we had a total of 147 full-time employees. We have no employment agreements with any of our employees, except for our Chief Financial Officer. 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.
We have available a website on the Internet. Our address is www.datalink.com. We make available at our website our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q, Current Reports on Form 8-K, and amendments to those reports filed or furnished pursuant to Section 13(a) or 15(d) of the Exchange Act as soon as reasonably practicable after we electronically file such material with, or furnish it to, the SEC.
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:
Although we achieved positive net income in the fourth quarter of 2004 and for the second, third and fourth quarters of 2005, we have incurred net losses all other quarters since the fourth quarter of 2001. 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.
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 mid to large enterprise market and numerous value added resellers, distributors and consultants. We also compete in the storage systems market with general purpose computer platform 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 reseller 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 likely 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.
In 2005, we had no customers that accounted for at least 10% of our revenues. However, our top five customers collectively accounted for 27% of our 2005 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 quarter to quarter and year to year. Unpredictable revenue and profit fluctuations may make our stock price more volatile and lead to a decline in our stock price.
We increasingly sell complex enterprise-class information storage solutions, which include installation and configuration services. 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 can 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.
Several of our key vendors have offered incentive programs to us over the past several years based on our achievement of particular sales levels of their products. These programs contributed to our profitability in 2004 and 2005. We cannot assure that these programs will continue. If they do not, we may be unable to achieve profitability in the future.
Our future operating results depend upon our ability to attract, retain and motivate qualified engineers and sales people with enterprise-class information storage solutions experience. If we fail to recruit and retain additional engineering and sales 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.
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. Except as to our new Chief Financial Officer, we generally 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 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.
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.
Beginning with our year-end audit for 2007, Section 404 of the Sarbanes-Oxley Act of 2002 will require us 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 2007. If we are not compliant, we may incur additional costs to become compliant, we could lose our Nasdaq Stock Market listing and our stock price could be unfavorably impacted.
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.
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:
· actual or anticipated fluctuations in our operating results, including those resulting from changes in accounting rules;
· announcements of technical innovations;
· new products or services offered by us, our suppliers or our competitors;
· changes in estimates by securities analysts of our future financial performance;
· our compliance with SEC and Nasdaq rules and regulations, including the Sarbanes-Oxley Act of 2002; and
· general market conditions, including the effects of economic conditions over the past several years and war and terrorism threats.
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.
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.
In March 2006, one of our directors, Gregory T. Barnum, accepted employment with us as our new Chief Financial Officer. At that time, Mr. Barnum resigned from our Board of Directors. This action left us with six directors, only three of whom we have determined are independent under the rules of the Nasdaq Stock Market. Nasdaq requires that we have a majority of directors who are independent. In accordance with Nasdaq rules, we have until our next scheduled annual meeting (in May 2006) to correct this deficiency. Until we do so, Nasdaq will identify us as a non-compliant company, which could adversely affect our stock price. We cannot assure that we will timely identify and elect a new independent director or obtain the resignation of a non-independent director to otherwise comply with the Nasdaq rules. If we fail to timely comply, Nasdaq could remove our stock from trading, which could adversely affect our stock price.
In the first quarter of 2006, we will adopt SFAS 123(R), which will require us to measure and recognize compensation expense for all stock-based compensation based on estimated fair values. As a result, our operating results for 2006 and future years will contain a charge for stock-based compensation related to restricted stock and stock options granted to employees and employee stock purchases. This charge is in addition to any stock-based compensation we have recognized in the past. SFAS 123(R) requires the use of an option pricing model to determine the fair value of share-based payment awards. Our stock price, as well as assumptions regarding a number of highly complex and subjective variables, will affect our determination of fair value. We cannot assure that the valuation models we apply will accurately measure the fair value of our stock-based compensation. Our stock price may be adversely affected by the existence, amount or unpredictability of our future stock-based compensation expense.
We occupy 49,000 square feet of an office and warehouse facility in Chanhassen, Minnesota as our corporate headquarters, including our principal technical operations and our integration, assembly and support service operations. Our other 13 locations which house sales and technical staff are small-to-medium-sized offices throughout the United States.
We are not currently involved in any material legal proceedings. We also had no material legal proceedings that terminated during the fourth quarter of 2005.
We submitted no matters during the fourth quarter of 2005 to a vote of security holders, through the solicitation of proxies or otherwise.
Our common is quoted on the Nasdaq National Market under the symbol DTLK. 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, 2006, the closing price per share of our common stock was $4.01. We urge potential investors to obtain current market quotations before making any decision to invest in our common stock. On March 3, 2006, there were approximately 89 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 1,536 beneficial owners.
Except for distributions paid to our pre-initial public offering corporation stockholders related to S corporation earnings generated prior to our initial public offering in 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 2005. You can find additional information about our equity compensation plans in Part III, Item 12 of this Annual Report on Form 10-K.
You should read the information below with our Managements Discussion and Analysis of Financial Condition and Results of Operations and our financial statements. We derived the data as of December 31, 2005 and 2004, and for the years ended December 31, 2005, 2004 and 2003, from our financial statements that are included in this Annual Report. We derived the data as of December 31, 2003, 2002 and 2001, and for the years ended December 31, 2002 and 2001, from our financial statements not included in this Annual Report.
(1) We recorded a charge for sublease reserve of $3.5 million related to the sublease of approximately 55,000 of the 104,000 square feet we formerly occupied as part of our corporate headquarters in Chanhassen, Minnesota and the sale of a lot we owned next to our headquarters.
(2) 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.
(3) With the adoption of SFAS No. 142 on January 1, 2002, we ceased amortizing $5.5 million of goodwill.
(4) 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 2005, 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.
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. IDC estimates that external disk storage revenue grew more than 12% year over year and networked storage (SAN and NAS) grew nearly 70% year over year. We have 14 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 manufacturer. The manufacturer 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 integrators, high end value added resellers, distributors, consultants and the internal sales force of our suppliers. 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 providing significant opportunity for 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 us. We believe the best way to improve our company and create long-term shareholder value is to focus on building scaleable capabilities and a leverageable cost structure. 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 data storage management and architecture services.
· Exploring potential regional acquisitions that we believe can strengthen our resources and capabilities in key geographic locations.
To pursue these strategies, we are:
· Improving our training, tools and recruiting efforts for sales and engineering teams to increase productivity.
· Hiring additional customer support staff and enhancing the customer support staffs communications and call management capabilities.
· Developing more effective delivery capabilities for professional services and 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.
The following table shows, for the periods indicated, certain selected financial data expressed as a percentage of net sales.
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 29.0% in 2005 from 2004 to $81.6 million, and increased 3.1% in 2004 from 2003 to $63.2 million. Our service sales, which include customer support, consulting and installation services, increased 18.2% in 2005 from 2004 to $35.5 million, and remained relatively flat between 2004 and 2003 at $30.0 million as compared to $29.8 million.
The increase in our product sales in 2005 as compared to 2004 reflects a greater number of customers funding large projects, particularly for enhanced data recovery technology solutions. We had an increase in customers representing more than $500,000 in annual revenues from 29 in 2004 to 43 in 2005. Since 2003, we have continued to increase 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 increase in the average number of account executives from 2004 to 2005 reflects our hiring of experienced, quality account executives in key geographic locations. The decline in the number of account executives from 2003 to 2004 reflects our closure of selected offices and turnover primarily in late calendar 2003.
The increase in our service revenues for 2005 over 2004 reflects an increase in all categories of our service revenue. Customer support contract revenues increased $2.2 million or 9%, consulting service revenues increased $1.1 million or 81% and installation and configuration service revenues increased $2.2 million or 64%. With the growth in our product revenues, we continue to successfully sell our installation and configuration services. 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, but did not renew a large customer support contract.
We derived approximately 10% of our sales from our customer, Gateway, Inc., during 2003. We had no other customers that comprised more than 10% of our sales in 2003, 2004 or 2005.
Gross Profit. Our total gross profit as a percentage of net sales increased to 26.2% in 2005 from 25.2% in 2004, which was a decrease from 25.7% in 2003.
Product gross profit as a percentage of product sales increased to 23.8% in 2005 as compared to 23.2% in 2004 and as compared to 22.6% in 2003. The percentage improvement in both 2005 and 2004 reflects the increase in enhanced data recovery 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 2005 and 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 product gross profit margins.
Service gross profit as a percentage of service sales increased to 31.5% in 2005 as compared to 29.5% in 2004 and decreased as compared to 32.2% in 2003. The percentage increase in 2005 as compared to 2004 reflects an improvement in our gross profit percentage for customer support contract renewals. The percentage decrease in 2004 as compared to 2003 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 few 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 $15.1 million, or 12.8% of net sales for 2005 as compared to $12.4 million, or 13.3% of net
sales for 2004 and $11.0 million, or 12.1% of net sales for 2003. The increase in sales and marketing expense in absolute dollars is primarily a result of higher commission and bonus expenses of $1.7 million due to the higher sales volume in 2005 as compared to 2004. The increase in sales and marketing expense in absolute dollars for 2004 as compared to 2003 is also a result of higher commission expense of $1.7 million due to a change in compensation plans and higher sales volume. The decrease in sales and marketing expense as a percentage of net sales from 2005 to 2004 reflects better leverage of our fixed costs as revenues increased in 2005. 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. 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 $9.9 million, or 8.5% of net sales for 2005 compared to $10.4 million, or 11.1% of net sales for 2004 and $11.0 million, or 12.0% in 2003. The decrease in general and administrative expenses in absolute dollars for 2005 as compared to 2004 is due to a decrease of $507,000 in depreciation expense primarily for our customer relationship management system and reduced facilities expenses of $950,000 related to the sublease of our Chanhassen facility. This decrease was partially offset by an increase in variable compensation for executives and managers of $701,000 and an increase in accounting, legal and consulting fees of $187,000 for fees related to SEC and Sarbanes-Oxley compliance activity. The decrease in general and administrative expenses in absolute dollars in 2004 compared to 2003 is due to lower depreciation expense primarily for our customer relationship management system of $225,000 and reduced facilities expenses of $412,000 related to our office closures and subleases. Our general and administrative expenses were lower as a percentage of net sales for 2005 as compared to 2004 and for 2004 as compared to 2003, due to the reduced spending coupled with an increase in sales.
Engineering. Engineering expenses include employee wages and travel, hiring and training expenses for our field and customer support 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 increased to $5.1 million, or 4.4% of net sales in 2005 compared to $3.8 million, or 4.0% of net sales in 2004 and $4.2 million, or 4.6% of net sales in 2003. The increase in engineering expenses in absolute dollars for 2005 as compared to 2004 is due primarily to an increase in compensation expense of $1.0 million related to a 12% increase in headcount coupled with higher health insurance expenses and variable compensation expenses. The decrease in engineering expenses in absolute dollars for 2004 as compared to 2003 is due to $862,000 of 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 increase in engineering expenses as a percentage of sales for 2005 as compared to 2004 is the result of higher engineering expenses despite the growth in revenues. We added personnel resources for our customer support desk staff. 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.
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% in 2003. 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.
In December 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 for 85 months starting in April 2005 and ending in April 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 incurred a one-time, non-cash charge of $3.5 million related to the sublease and lot sale. We obtained cost savings of approximately $950,000 in 2005 as a result of the sublease agreement and expect to achieve comparable savings in future years during the sublease term.
Intangible Amortization. Amortization of intangible assets decreased to $224,000 in 2005 from $261,000 in 2004 and $724,000 in 2003. The amortization relates primarily to our acquisition of the data storage and services business of OpenSystems.com, Inc. in November 2000. We test for impairment of goodwill and intangibles annually or whenever impairment is indicated. For 2005 and 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. We fully amortized the remaining customer base intangible asset in 2005. 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.
Operating Loss. We incurred operating losses of $3.2 million in 2005 and 2004 and $5.5 million in 2003. Since the restructuring in October 2003, our financial results have steadily improved. Excluding the sublease charge of $3.5 million in the first quarter of 2005, we generated operating income of $284,000 in 2005. In the fourth quarter of 2005, we generated net income of $1.0 million. However, we expect to post a slight net loss to a slight profit for the first quarter ending March 31, 2006. This relates to an expected decrease in sales, typically our slowest quarter, and an expected increase in operating expenses in the first quarter of 2006 primarily due to normal recurring costs more heavily weighted to the early part of the year. The higher costs relate to payroll taxes, public reporting and benefit accruals.
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 2004.
Income Taxes. We had no income tax benefit or expense in 2005 or 2004. We provided for an income tax benefit of $276,000 in 2003. The income tax benefit generated for 2003 represents a higher than expected federal income tax refund from our 2002 tax return. The ultimate realization of deferred tax assets, which are currently fully reserved, 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 2005, 2004 and 2003 and the near-term uncertainty of taxable income, we cannot reasonably predict when or if we will realize these deductible differences. In addition, we do not have the ability to realize future income tax benefits on future losses.
The following table sets forth our unaudited quarterly financial data for each quarter of 2005 and 2004. We have prepared this unaudited information on the same basis as the audited information. In our opinion, we have made 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 orders with us. Further, our success in integrating any acquired business or in opening any new field offices could impact our net sales.
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 $9.4 million at December 31, 2005 as compared to $10.0 million at December 31, 2004. Our current ratio was 1.2:1 at December 31, 2005 as compared to 1.4:1 at December 31, 2004. At December 31, 2005, our cash and cash equivalents balance was $13.4 million.
Cash provided by operating activities for 2005 was $1.7 million as compared to $396,000 in 2004 and $3.2 million in 2003. Significant items which impacted our operating cash flows in 2005 were:
· A $7.2 million increase in accounts receivable reflecting increasing sales activity over the prior year.
· An $8.6 million increase in accounts payable reflecting the increase in business with our vendors for our increasing sales activity.
· A net increase of $2.5 million related to the sublease of part of our Chanhassen facility. This includes the $3.5 million non-cash charge related to the sublease and lot sale offset by $1.0 million of amortization for the year.
· A $2.9 million increase in inventories shipped but not installed for our backlog of orders at the beginning of 2006.
· A net $1.6 million increase in deferred customer support contracts. While we amortize the revenues from these contracts over the life of the contract, the customer typically pays for the contracts at the beginning of the contract period which favorably impacts our cash flows.
The cash provided in 2004 resulted from:
· A $3.0 million increase in accounts receivable, reflecting increasing sales activity offset by an increase in accured expenses for employee bonus incentives.
· A $2.2 million increase in accounts payable due to higher sales activity.
· A net increase in $1.0 million in deferred customer support contracts.
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 partially offset by a $3.5 million reduction in accounts payable.
Cash used in investing activities was $1.1 million in 2005, $415,000 in 2004 and $1.1 million in 2003. In 2005, we used this cash to complete the facility build-out related to our Chanhassen sublease, purchase computer equipment and provide further enhancements to our web-enabled reporting tools. 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.
Cash provided in financing activities in 2005, 2004 and 2003 was $148,000, $117,000 and $111,000, respectively, all of which we received from stock sold under our employee stock purchase plan and from the exercise of options. We discontinued our employee stock purchase plan in December 2005.
Our bank revolving credit facility expired in June 2004. We have not renewed it or pursued a new facility. 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 4 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 annual base rental payments of approximately $1.3 million. In December 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 in April 2005 and ending in 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 6 of the Notes to our Financial Statements.
As of December 31, 2005, our contractual cash obligations consisting of future minimum lease payments due under non-cancelable operating leases are as follows:
In December 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 in April 2005 and ending in April 2012. The sublessee pays 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 incurred the following charges in the first quarter of 2005 associated with our sublease and related activities:
We also incurred cash expenditures, for leasehold improvements and transaction fees, associated with our sublease and the related activities, net of the proceeds from our lot sale, at $822,000. We capitalized these cash outlays and are amortizing them over the lease term.
We believe that our current cash balance and funds generated from operations will 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 during 2006 primarily related to enhancements to our management information systems.
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 we have met our 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. We account 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.
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 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. 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.
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 have made a full valuation allowance against our net deferred tax assets. The valuation allowance at December 31, 2005 was $4.8 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.
In December 2004, the Financial Accounting Standards Board published FASB Statement No. 123 (revised 2004), Share-Based Payment (SFAS 123(R)). In March 2005, the U.S. Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 relating to the adoption of SFAS 123(R). SFAS 123(R), which will begin to apply in our first quarter of 2006, 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 at the grant date. The cost of employee services received in exchange for an award of liability instruments is measured initially at fair value and re-measured subsequently at each reporting date through the settlement date. SFAS 123(R) 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.
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.
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, 2005, we had $13.4 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 and services 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.
Report of Independent Registered Public Accounting Firm
To the Board of Directors
We have audited the accompanying balance sheets of Datalink Corporation as of December 31, 2005 and 2004 and the related statements of operations, changes in stockholders equity and cash flows for each of the years in the two year period then ending. 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 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 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, 2005 and 2004, and the results of its operations and its cash flows for each of the years in the two year period then ending, in conformity with accounting principles generally accepted in the United States of America.
/s/ McGLADREY & PULLEN, LLP
January 26, 2006
Report of Independent Registered Public Accounting Firm
The Board of Directors and Stockholders
We have audited the accompanying statements of operations, stockholders equity and cash flows of Datalink Corporation for the year ended December 31, 2003. 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 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 audit provides a reasonable basis for our opinion.
In our opinion, the financial statements referred to above present fairly, in all material respects, the results of operations and cash flows of Datalink Corporation for the year ended December 31, 2003 in conformity with accounting principles generally accepted in the United States of America.
/s/ KPMG LLP
February 6, 2004
The accompanying notes are an integral part of these financial statements.
The accompanying notes are an integral part of these financial statements.
The accompanying notes are an integral part of these financial statements.
The accompanying notes are an integral part of these financial statements.
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.
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 $72,000 and $70,000 at December 31, 2005 and 2004, respectively.
Concentration of Credit Risk:
During 2003, net sales from our customer, Gateway, Inc., 10% of total net sales. The Company had no other customers that comprised more than 10% of its sales in 2003, 2004 or 2005. The balance of accounts receivable for this customer as a percentage of total accounts receivable as of December 31, 2005 and 2004, respectively is 0% and 0%.
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. 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. The Company has also capitalized other software develop costs for enhancements to our business reporting software tool. Amortization of software costs were $543,000 in 2005, $729,000 in 2004, and $815,000 in 2003.
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 $100,000 and $71,000 at December 31, 2005 and 2004, 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, 2005 and 2004, and determined that no impairment existed.
Identifiable intangible assets were 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 was 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 $3.42, $2.47 and $3.35 for 2005, 2004 and 2003 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 2005, the Companys employees elected to purchase 49,032 shares under the Employee Stock Purchase Plan (ESPP). Using the Black-Scholes pricing model, the weighted average fair value was $1.08 per share for each election. During the 2004 and 2003 ESPP offering, employees elected to purchase 35,246 and 23,883 shares respectively. Using the Black-Scholes pricing model, the weighted average fair value was $0.42 per share for each election in 2004 and $0.40 per share for each election in 2003.
In December 2004, the Financial Accounting Standards Board published FASB Statement No. 123 (revised 2004), Share-Based Payment (FAS 123(R)). In March 2005, the U.S. Securities and Exchange Commission issued Staff Accounting Bulletin No. 107 relating to the adoption of SFAS 123(R). SFAS 123(R), which will begin to apply in the Companys first quarter of 2006, 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 requires the employee to provide services for the award. SFAS 123(R) is effective for the Company as of January 1, 2006. The Company is evaluating the adoption criteria outlined in SFAS 123(R). However, the pro forma effect on net income using the fair value method for the past three years is presented in the table above. The pro forma information may not be indicative of the actual effect on net income when SFAS 123(R) is adopted as such effect is dependent upon many factors, including the number of stock options granted in the future as well as their related terms.
On December 19, 2005, the Companys Board of Directors took action to accelerate vesting of all outstanding employee stock options. As of that date, the Company had a total of 1,768,037 employee options outstanding, of which 1,442,912 were vested and 325,125 were unvested. The Board accelerated the vesting schedule of the 325,125 unvested employee options, of which 197,125 (the underwater options) had exercise prices in excess of $3.40 per share and 128,000 (the in the money options) had exercise prices less than the current market price on the accelerated vesting date. The Company did not accelerate the vesting of options granted to Board members.
Summary information related to these options, as outstanding on December 19, 2005, is shown below:
The Board took the action to accelerate the vesting of the options in order to eliminate approximately $244,000 in compensation expense that the Company would otherwise have incurred over two years beginning in 2006, upon the adoption of FAS 123(R). Under FAS 123(R), the Company would have recognized the expense associated with these options grants as the options vested. The Company also recorded compensation expense of $2,300 during 2005, related to the 128,000 unvested in the money options, because of the likelihood that certain employees may terminate employment with the Company prior to when the options would have vested under the original vesting schedule.
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 its 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, the Company recognizes the product revenues upon shipment.
Product Sales With Service. If the Company sells a bundled arrangement, then the Company defers recognizing any revenues on it until the Company finishes its installation and/or configuration work. The Company accounts for the hardware, software and service elements of its 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 applies contract accounting to its bundled arrangements. In accordance with SOP 81-1, Accounting for Performance of Construction Type and Certain Production Type Contracts, the Company applies 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.
Service Sales. In addition to installation and configuration services that are part of the Companys 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 the Company or has been invoiced but for which the Company 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 the Company has with its hardware and software vendors.
When the Company sells a service contract as part of a bundled arrangement, it 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 the Company 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 2005, 2004 and 2003, potential common shares of 172,028, 80,756 and 105,931, 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, 2005 and 2004, 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.
Information regarding the Companys other intangible assets that continue to be amortized are as follows:
Amortization expense for the years ended December 31, 2005, 2004 and 2003 was $225,000, $261,000 and $724,000, respectively. The intangible assets as of December 31, 2005 are fully amortized.
The Companys bank revolving credit facility expired on June 30, 2004. The Company has elected not to pursue a new facility at this time. With the Companys 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.
The benefit from income taxes in 2003 consisted primarily of current federal income taxes.
The reconciliation of the U.S. federal statutory tax rate to the Companys effective income tax rate is as follows:
Significant components of the Companys deferred tax assets and liabilities are as follows: