Datalink 10-Q 2008
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
x Quarterly report pursuant to Section 13 or 15(d) of
For the quarterly period ended: March 31, 2008
o Transition report pursuant to Section 13 or 15(d) of
For the transition period from to
Commission file number: 00029758
(Exact name of registrant as specified in its charter)
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 whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company. See definitions of large accelerated filer, accelerated filer, and smaller reporting company in Rule 12b-2 of the Exchange Act. (Check one):
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):
Yes o No x
As of May 5, 2008, 12,471,395 shares of the registrants common stock, $.001 par value, were outstanding.
The Private Securities Litigation Reform Act of 1995 provides a safe harbor for certain forward-looking statements. This report on Form 10-Q contains forward-looking statements, including our internal projections of anticipated 2008 results, which reflect our views regarding future events and financial performance. These forward-looking statements are subject to certain risks and uncertainties, including those identified below, which could cause actual results to differ materially from historical results or those anticipated. The words aim, believe, expect, anticipate, intend, estimate and other expressions which indicate future events and trends identify forward-looking statements. Actual future results and trends may differ materially from historical results or those anticipated depending upon a variety of factors, including, but not limited to: the level of continuing demand for storage, including the effects of economic conditions; 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 key technical and sales 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. Further, our revenues for any particular quarter are not necessarily reflected by our backlog of contracted orders, which also may fluctuate unpredictably.
PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
(In thousands, except share data)
The accompanying notes are an integral part of these financial statements.
Statements of Operations
(In thousands, except per share data)
The accompanying notes are an integral part of these financial statements.
Statements of Cash Flows
(In thousands, except share data)
The accompanying notes are an integral part of these financial statements.
Notes To Financial Statements
(In thousands, except share and per share data)
1. Basis of Presentation
We have prepared the interim financial statements included in this Form 10-Q without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). We have condensed or omitted certain information and footnote disclosures, normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States, pursuant to such rules and regulations. These financial statements should be read in conjunction with the financial statements and related notes thereto included in our 2007 Annual Report on Form 10-K.
The financial statements presented herein as of March 31, 2008, and for the three ended March 31, 2008 and 2007, reflect, in the opinion of management, all adjustments (which consist only of normal, recurring adjustments) necessary for a fair presentation of the financial position and the results of operations and cash flows for the periods presented. The results of operations for any interim period are not necessarily indicative of results for the full year.
Management is required to make certain estimates and assumptions which affect the amounts of assets, liabilities, revenues and expenses we have reported, and our disclosure of contingent assets and liabilities at the date of the financial statements. The results of the interim periods are not necessarily indicative of the results for the full year. Accordingly, these condensed financial statements should be read in conjunction with the audited financial statements and the related notes included in our 2007 Annual Report on Form 10-K. Actual results could differ materially from these estimates and assumptions.
2. Net Earnings (Loss) per Share
We compute basic net earnings (loss) per share using the weighted average number of shares outstanding. Diluted net earnings (loss) per share includes the effect of common stock equivalents, if any, for each period. Diluted per share amounts assume the conversion, exercise or issuance of all potential common stock instruments unless their effect is anti-dilutive. The following table computes basic and diluted net earnings (loss) per share:
For the three months ended March 31, 2008 and 2007 242,333 and 375,000 shares of non-vested common stock and options to purchase 724,080 and 1,241,658 shares of common stock were excluded from the computation of diluted earnings per share as their effect would have been anti-dilutive.
3. Stock Based Compensation
Stock Compensation Plans:
We account for stock based compensation in accordance with SFAS No. 123 (Revised 2004), Share-Based Payments, (SFAS 123R), which requires the measurement and recognition of compensation costs at fair value for all share-based payments, including stock options and non-vested stock.
In March and April 2007, respectively, we awarded 120,000 and 86,000 shares of non-vested stock to executive officers and managers. Partial vesting of these restricted stock awards was based upon the achievement of our predetermined earnings from operations objective for 2007 as approved by our board of directors (the 2007 Objective). We did not meet the 2007 Objective. Based on the award grant conditions, one-third of the awards expired on February 6, 2008, the date we publicly announced our 2007 financial results.
Total stock-based compensation expense related to non-vested stock was $153,000 and $128,000 for the three months ended March 31, 2008 and 2007, respectively.
The following table summarizes our non-vested stock activity for the three months ended March 31, 2008:
The following table represents stock option activity for the three months ended March 31, 2008:
We use the Black-Scholes option pricing model to estimate the fair value of stock options. The weighted-average fair value per option at the date of grant was $2.52 for 2008. We estimated the fair value for the stock option grant using the following weighted average assumptions:
The risk-free rate is based on a treasury instrument whose term is consistent with the expected life of our stock options. Expected volatility is based on the historical volatility of our share price for the period prior to the option grant equivalent to the expected holding period of the options. The expected holding period and dividend yield are based on historical experience. Total stock-based compensation expense related to stock options was $44,000 and $0 for the three months ended March 31, 2008 and 2007, respectively. Unrecognized stock-based compensation expense related to stock options was $750,000 at March 31, 2008 and will be amortized ratably over the period ending January 2011.
During the three months ended March 31, 2008 and 2007 we recognized expense of $23,000 and $48,000 related to the issuance of 5,883 and 9,813 shares of fully vested common stock to members of our Board of Directors.
4. Income Taxes
As part of the process of preparing financial statements, we are required to estimate income taxes, both state and federal. This process involves management estimating the actual current tax exposure together with assessing temporary differences resulting from different treatment for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which we include within the balance sheet. Management must then assess the likelihood that we will utilize deferred tax assets to offset future taxable income during the periods in which these temporary differences are deductible. For the three months ended March 31, 2008, we recorded income tax expense of $353,000, with an effective tax rate of 41%. In future periods of taxable earnings, we expect to report an income tax provision using an effective tax rate of approximately 41%.
Effective January 1, 2007, we adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48). FIN 48 clarifies the accounting for uncertainty in income taxes recognized in a companys financial statements in accordance with FASB Statement No. 109, Accounting for Income Taxes. FIN 48 requires a company to determine whether it is more likely than not that a tax position will be sustained upon examination based upon the technical merits of the position. If the more-likely-than-not threshold is met, a company must measure the tax position to determine the amount to recognize in the financial statements.
At the adoption date of January 1, 2007 and at March 31, 2008 and 2007, we had no unrecognized tax benefits which would affect our effective tax rate if recognized.
We classify interest and penalties arising from the underpayment of income taxes in the statement of income under general and administrative expenses. As of March 31, 2008 and 2007, we had no accrued interest or penalties related to uncertain tax positions. The tax years 2004-2007 remain open to examination by both the Federal government and by other major income taxing jurisdictions to which we are subject.
On January 31, 2007, we entered into an agreement and plan of merger with Midrange Computer Systems Inc. (MCSI), a storage consulting, solutions and service provider based in Chicago, Illinois. We believe the acquisition has strengthened our presence in existing regional markets and expanded our reach into a number of key new regional markets. We paid a purchase price of approximately $14.3 million for MCSI, consisting of $5.0 million cash and 1,163,384 shares of our common stock.
In connection with this acquisition, we allocated the total purchase consideration to the net assets and liabilities acquired, including identifiable intangible assets, based on their respective fair values at the acquisition date, resulting in goodwill of approximately $12.2 million which is non-deductible for income tax purposes. The following table summarizes the allocation of the purchase price to the fair value of the assets and liabilities acquired:
The finite lived intangibles which consisted of customer relationships and backlog have estimated lives of six years and two months, respectively and we are amortizing them using the straight line method.
The pro forma unaudited results of operation for the three months ended March 31, 2007, assuming consummation of the purchase of the assets from MCSI as of January 1, 2007, are as follows:
Integration expenses, including the salaries, benefits, retention bonuses and severances of MCSI employees, some of whom assisted with the initial integration but were ultimately not retained by us, were $442,000 for 2007.
6. Recently Issued Accounting Standards
Effective January 1, 2008 we adopted SFAS No. 157, Fair Value Measurements (SFAS 157), which provides guidance on how to measure assets and liabilities that use fair value. SFAS 157 applies whenever another U.S. GAAP standard requires (or permits) measurement of assets or liabilities at fair value, but does not expand the use of fair value to any new circumstances. We also adopted FASB Staff Position (FSP) No. FAS 157-2, Effective Date of FASB Statement No. 157, which allows us to partially defer the adoption of SFAS 157 This FSP defers the effective date of SFAS 157 for nonfinancial assets and nonfinancial liabilities, except those that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), to fiscal years beginning after November 15, 2008, and interim periods within those fiscal years. Nonfinancial assets and nonfinancial liabilities include all assets and liabilities other than those meeting the definition of a financial asset or financial liability as defined in paragraph 6 of Statement No. 159, The Fair Value Option for Financial Assets and Financial Liabilities. The adoption of SFAS No. 157 and FSP No. 157-2 had no impact on our financial statements.
In December 2007, the FASB issued SFAS No. 141R, Business Combinations (SFAS 141R) which establishes principles and requirements for how the acquirer of a business recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, and any noncontrolling interest in the acquiree. The statement also provides guidance for recognizing and measuring the goodwill acquired in the business combination and determines what information to disclose to enable users of the financial statement to evaluate the nature and financial effects of the business combination. SFAS 141R is effective for financial statements issued for fiscal years beginning after December 15, 2008. Accordingly, until January 1, 2009, we will record and disclose any business combinations we engage in by following existing GAAP. We are evaluating the impact of SFAS No. 141R, but do not currently expect it to have a significant impact on our financial statements when effective. However, the nature and magnitude of the specific future effects will depend upon the nature, terms and size of any acquisitions we consummate after the effective date.
In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial Statements, an amendment of ARB No. 51 (SFAS 160). SFAS 160 introduces significant changes in the accounting and reporting for business acquisitions and noncontrolling interest (NCI) in a subsidiary. SFAS 160 also changes the accounting for and reporting for the deconsolidation of a subsidiary. Companies are required to adopt the new standard for fiscal years beginning after January 1, 2009. We are evaluating the impact of this standard and currently do not expect it to have a significant impact on our financial statements.
In March 2008, the FASB issued SFAS No. 161, Disclosures about Derivative Instruments and Hedging Activities an amendment of FASB Statement No. 133 (SFAS 161), which changes the disclosure requirements for derivative instruments and hedging activities. SFAS 161 requires an entity to provide enhanced disclosures about (a) how and why the entity uses derivative instruments, (b) how the entity accounts for derivative instruments and related hedged items are accounted for under Statement 133 and its related interpretations, and (c) how derivative instruments and related hedged items affect the entitys financial position, financial performance, and cash flows. Companies are required to adopt SFAS 161 for fiscal years beginning after November 15, 2008. We are currently evaluating the impact of this standard and currently do not expect it to have a significant impact on our financial statements.
Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
You should read the following information in conjunction with the unaudited financial statements and the notes thereto included in Item 1 of this Quarterly Report and with the Forward-Looking Statements section in this filing and in our other filings with the U.S. Securities and Exchange Commission.
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 digital information will occupy 988 billion gigabytes, by 2010. As of March 31, 2008, we have 21 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 continue to 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, technical and customer support teams in our existing locations.
· Deepening our presence in existing enterprise accounts and penetrating new enterprise accounts.
· Targeting high growth market segments and deploying new technologies.
· 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 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.
· Meeting regularly with potential acquisition candidates.
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.
RESULTS OF OPERATIONS
On January 30, 2007 we entered into an agreement and plan of merger with Midrange Computer Systems Inc. (MCSI), a storage consulting solutions and services provider. Our results of operations for the three months ended March 31, 2007 reflect the addition of MCSI for two months.
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 total net sales increased by $6.8 million, or 16.7%, to $47.7 million for the three months ended March 31, 2008, from $40.9 million for the comparable quarter in 2007. Our product sales increased $960,000, or 3.5%, to $28.5 million for the three months ended March 31, 2008 from $27.6 million for the comparable quarter in 2007. Our service sales increased $5.9 million, or 43.9%, to $19.2 million for the three months ended March 31, 2008 from $13.3 million for the comparable quarter in 2007.
We had a modest increase in our product sales for the three month period ended March 31, 2008, as compared to the same period in 2007. Our product revenues continue to reflect our customers closer scrutiny of expenditures as they focus more attention on the impact or potential impact that macro economic conditions will have on the growth and profitability of their business. This resulted in a lull in bookings activity during the first half of the quarter. We saw a pick up in orders beginning in late February that continued throughout March, and we ended the quarter with a backlog of over $30 million.
Our service sales increase for the three month period ended March 31, 2008 as compared to the same periods in 2007 was due to an increase in customer support contracts of $5.2 million. With the growth in our product revenues, we continue to successfully sell our installation and configuration services and customer support contracts.
We had no single customer account for greater than 10% of our revenues for the three months ended March 31, 2008. We derived 12% of our revenues for the three months ended March 31, 2007, from AT&T Inc.
Gross Profit. Our total gross profit as a percentage of net sales increased to 27.3% for the quarter ended March 31, 2008, as compared to 24.1% for the comparable quarter in 2007. Product gross profit as a percentage of product sales increased to 26.1% in the first quarter of 2008 from 22.8% for the comparable quarter in 2007. Service gross profit as a percentage of service sales increased to 28.9% for the first quarter of 2008 from 27.0% for the comparable quarter in 2007.
Our product gross profit as a percentage of product sales is impacted by the mix and type of projects we complete for our customers. For the three months ended March 31, 2008 as compared to the same period in 2007, our product gross profit as a percentage of product sales increased as we have successfully integrated the MCSI sales force, leveraging product and service offerings across our vendors, and we continue to sell higher margin products and services. Our product gross profits are also impacted by various vendor incentive programs that provide economic incentives for achieving various sales performance targets. Achieving these targets contributed favorably to our product gross profit by $837,000 and $211,000, respectively, for the three month periods ended March 31, 2008 and 2007.
Our service gross profit as a percentage of service sales for the three month period ended March 31, 2008 as compared to the same periods in 2007 increased 1.9%. The percentage increase in 2008 over 2007 was impacted by an $180,000 reduction in revenues and corresponding margins, for the three months ended March 31, 2007. This is compared to a $50,000 reduction in revenues and corresponding margins for the three months ended March 31, 2008 for the MCSI acquisition to reflect the fair value of maintenance contracts we acquired.
Sales and Marketing. Sales and marketing expenses include wages and commission paid to sales and marketing personnel, travel costs and advertising, promotion and hiring expenses. Sales and marketing expenses totaled $5.8 million, or 12.2% of net sales for the quarter ended March 31, 2008, compared to $5.3 million, or 12.9% of net sales for the first quarter in 2007.
Sales and marketing expenses increased $557,000 for the three month period ended March 31, 2008, as compared to the same period in 2007. The increase in expenses is primarily due to an increase in variable compensation for commissions and bonuses related to our first quarter 2008 performance.
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 were $3.2 million, or 6.6% of net sales for the quarter ended March 31, 2008, compared to $3.1 million, or 7.7% of net sales for the first quarter in 2007.
General and administrative expenses increased $37,000 for the three months ended March 31, 2008, as compared to the same period in 2007. We attribute the flat level of spending to our continued focus on leveraging our corporate resources.
Engineering. Engineering expenses include employee wages and travel, hiring and training expenses for our field and customer support engineers and technicians. Engineering expenses were $3.2 million or 6.6% of net sales for the quarter ended March 31, 2008, compared to $2.3 million, or 5.6% of net sales for the first quarter in 2007.
Engineering expenses increased $886,000 for the three month period ended March 31, 2008 as compared to the same period in 2007. The increase in expenses is primarily due to an increase in salaries, benefits and bonuses of $659,000 and an increase in outside consulting fees of $298,000 to support some of our staff augmentation professional services projects.
Integration Costs. Integration expenses include salaries and benefits of MCSI employees who assisted with the initial integration but whom we ultimately did not retain, together with retention bonuses and severances. We had no integration expenses for the three months ended March 31, 2008. Integration expenses for the three months ended March 31, 2007, were $442,000 related to the January 31, 2007 acquisition of MCSI.
Amortization of Intangibles. We had intangible asset amortization expense for the three month period ended March 31, 2008 and 2007 of $178,000 and $194,000, respectively. The identifiable intangible asset and subsequent amortization is due to our acquisition of MCSI on January 31, 2007.
Operating Earnings (Loss). We had operating earnings of $660,000 for the three months ended March 31, 2008 and a loss from operations of $1.4 million for the three months ended March 31, 2007. The increase in operating earnings for the three month period ended March 31, 2008 as compared to the same period in 2007 is a result of higher revenues and margins with a limited increase in operating expenses.
Income Taxes. We had income tax expense of $353,000 for the three month period ended March 31, 2008, as a result of our estimated effective tax rate of 41%. We had an income tax benefit of $477,000 for the three month period ended March 31, 2007, as a result of
our estimated tax rate of 40%. In future periods of taxable earnings, we expect to continue reporting an income tax provision using an effective tax rate of approximately 41%.
LIQUIDITY AND CAPITAL RESOURCES
Net cash provided by operating activities was $1.4 million for the three months ended March 31, 2008 as compared to net cash provided by operating activities of $2.8 million for the three months ended March 31, 2007. Significant items which impacted our operating cash flows as of March 31, 2008 were:
· Net earnings of $505,000.
· A $622,000 net increase in deferred customer support contracts. While we amortize the revenues from these contracts over the life of the contract, the customer almost always pays for the contracts at the beginning of the contract period which favorably impacts our cash flows.
· A net increase in cash of approximately $1.4 million for accounts receivable, inventory and accounts payable. This was primarily due to a decrease in inventories related to a higher balance of inventories in transit at December 31, 2007.
· A decrease in cash of $1.7 million related to a decrease in variable compensation and sales and use tax accruals since December 31, 2007.
Net cash provided by investing activities was $2.4 million for the three months ended March 31, 2008. This cash was primarily provided by the sale of a short-term investment. We are planning for $500,000 of capital expenditures for the remainder of 2008 related primarily to computer and communication system upgrades or other management information system enhancements.
Net cash used in financing activities was $21,000 for the three months ended March 31, 2008, from tax withholding payments reimbursed by restricted stock. Net cash provided by financing activities was $7,000 for the three months ended March 31, 2007, from the exercise of stock options offset by tax withholding payments reimbursed by restricted stock.
We have elected not to pursue a credit facility at this time. With our current cash position, we believe we have the liquidity to meet our operating needs for the foreseeable future. We have no outstanding debt, and if the need should arise to borrow funds, we believe that we could obtain a secured facility.
Our contractual cash obligations consist of future minimum lease payments due under non-cancelable operating leases. These obligations are as of March 31, 2008, for the remainder of 2008 and each of the full years thereafter as follows:
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of financial statements requires us to make estimates and assumptions that affect reported earnings. We evaluate these estimates and assumptions on an on-going basis based on historical experience and on other factors that we believe are reasonable. Estimates and assumptions include, but are not limited to, the areas of customer receivables, establishment of vendor specific objective evidence of fair value for customer contracts with multiple elements, inventories, income taxes, self-insurance reserves and commitments and contingencies.
Our significant accounting policies and estimates are summarized in our annual financial statements. Some of our accounting policies require management to exercise significant judgment in selecting the appropriate assumptions for calculating financial estimates. Such judgments are subject to an inherent degree of uncertainty. These judgments are based on our historical experience, known trends in our industry, terms of existing contracts and other information from outside sources, as appropriate. We believe these estimates and assumptions are reasonable based on the facts and circumstances as of March 31, 2008. However, actual results may differ from these estimates under different assumptions and circumstances.
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.
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. 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 is 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.
Valuation of Long-Lived Assets, Including Finite-Lived Intangibles. We evaluate long-lived assets and intangible assets with finite lives for impairment, as well as the related amortization periods, to determine whether adjustments to these amounts or useful lives are required based on current events and circumstances. We base the evaluation on our projection of the undiscounted future operating cash flows of the underlying assets. To the extent such projections indicate that future undiscounted cash flows are not sufficient to recover the carrying amounts of related assets, we record a charge to reduce the carrying amount to its estimated fair value. The test for impairment requires us to make several estimates about fair value, most of which are based on projected future cash flows. We consider the estimates associated with the asset impairment tests critical due to the judgments required in determining fair value amounts, including projected future cash flows. Changes in these estimates may result in the recognition of an impairment loss.
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 consider projected future taxable income and ongoing tax planning strategies in assessing the need for a valuation allowance.
Stock-Based Compensation. We adopted the provisions of FASB No. 123R, Share Based Payment on January 1, 2006. SFAS 123(R) requires us to measure and recognize in our statements of operations the expense associated with all share-based payment awards made to employees and directors based on estimated fair values. 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 base recognition of compensation expense for our performance-based, non-vested shares on managements estimate of the probable outcome of the performance condition. Management reassesses the probability of meeting these performance conditions on a quarterly basis. Changes in managements estimate of meeting these performance conditions may result in significant fluctuations in compensation expense from period to period.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
All of our operations are based in the U.S. and all of our transactions are denominated in U.S. dollars. Our interest income is sensitive to changes in the general level of U.S. interest rates. 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 March 31, 2008 we had $26.4 million of cash and money market accounts. A decrease in market rates of interest on these accounts would have no material effect on the value of our assets or the related interest income. We have no short or long-term debt.
Foreign currency exchange rate risk. We market and sell all of our products in the United States. Therefore, we are not currently exposed to any direct foreign currency exchange rate risk.
Equity price risk. We do not own any equity investments. Therefore, we are not currently exposed to any direct equity price risk.
Item 4. Controls and Procedures.
Evaluation of disclosure controls and procedures. Under the supervision and with the participation of our Chief Executive Officer and our Chief Financial Officer, we conducted an evaluation of the effectiveness of the design and option of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities and Exchange Act of 1934 (the Exchange Act)), as of the end of the period covered by this Quarterly Report on Form 10-Q (the Evaluation Date).
The purpose of this evaluation is to determine if, as of the Evaluation Date, our disclosure controls and procedures were operating effectively such that the information relating to Datalink Corporation, required to be disclosed in our Securities and Exchange Commissions (SEC) reports (i) was recorded, processed, summarized and reported within the time periods specified in SEC rules
and forms, and (ii) was accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.
Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of the Evaluation Date, our disclosure controls and procedures were operating effectively.
Changes in internal control over financial reporting. There was no change in our internal control over financial reporting during our most recently competed fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
PART II. OTHER INFORMATION
Item 1. Legal Proceedings.
As of the date of this filing, we are not involved in any material legal proceedings. We also were not involved in any material legal proceedings that were terminated during the first quarter of 2008.
Item 1A. Risk Factors.
Except as provided below, there has not been a material change to the risk factors as set forth in our annual report on Form 10-K for the fiscal year ended December 31, 2007.
Dependence on Significant Customers. We had no single customer account for greater than 10% of our revenues for the three months ended March 31, 2008. We derived 12% of our revenues for the three months ended March 31, 2007 from AT&T Inc. We cannot provide assurance that this customer will account for a substantial portion of our future sales.
Our profitability depends in part on vendor incentive programs. Several of our key vendors regularly provide us with economic incentives for achieving various sales performance targets on their products. The vendors may terminate or change these programs at any time. We cannot assure that these vendor incentive programs will continue to provide us with rebates at current levels, or at all. To the extent that we do not qualify for vendor incentives, or they are cut back, our profitability may suffer.
Effect of Credit Market Tightening on Data Storage Spending. In response to credit risks in the subprime mortgage marketplace, lenders recently have generally made credit less available, and more expensive, for corporate borrowers, including our customers. A reduction in the availability or an increase in the price of borrowed funds could adversely affect our customers decisions or timing to purchase our data storage products and services.
Item 2. Changes in Securities and Use of Proceeds.
Item 3. Defaults Upon Senior Securities.
Item 4. Submission of Matters to a vote of Security Holders.
Item 5. Other Information
Item 6. Exhibits
31.1 Certifications by the President and Chief Executive Officer and Vice President Finance and Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certifications by the President and Chief Executive Officer and Vice President Finance and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (This Exhibit is furnished pursuant to SEC rules, but is deemed not filed.)
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.