Datalink 10-Q 2009
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
x Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
For the quarterly period ended: March 31, 2009
o Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934
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 Noo
Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files). Yes o 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 definition of large accelerated filer, accelerated filer and small 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 11, 2009, 12,921,709 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 2009 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 impact of the worldwide adverse 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 current and possible future acquisitions; fluctuations in our quarterly operating results; future changes in applicable accounting rules; and volatility in our stock price, particularly in light of the substantial decline in worldwide stock markets. 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
The accompanying notes are an integral part of these financial statements.
Notes To Financial Statements
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 2008 Annual Report on Form 10-K.
The financial statements presented herein as of March 31, 2009, and for the three months ended March 31, 2009 and 2008, 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 2008 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 include 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:
We excluded the following non-vested common stock and options to purchase shares of common stock 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.
Total stock-based compensation expense related to non-vested stock was $147,000 and $153,000 for the three months ended March 31, 2009 and 2008, respectively.
The following table summarizes our non-vested stock activity for the three months ended March 31, 2009:
The following table represents stock option activity for the three months ended March 31, 2009:
Total stock-based compensation expense related to stock options was $65,000 and $44,000 for the three months ended March 31, 2009 and 2008, respectively. Unrecognized stock-based compensation expense related to stock options was $471,000 at March 31, 2009 which we will amortize ratably through January 2011.
During the three months ended March 31, 2009 and 2008, we recognized expense of $37,000 and $23,000 related to the issuance of 12,922 and 5,883 shares of fully vested common stock to members of our Board of Directors.
4. Income Taxes
We base the provision for income taxes upon estimated annual effective tax rates in the tax jurisdictions in which we operate. For the three months ended March 31, 2009 and 2008, the effective tax rate was 27.0% and 41.1%, respectively. The lower tax rate for the
first quarter of 2009 compared to the first quarter of 2008 resulted primarily from a loss in Q1 2009 as opposed to income in Q1 2008 and from an increase in stock-based compensation expense as a result of a shortfall recognized in excess of the APIC pool for incentive stock options and vested restricted stock under SFAS 123(R). In accordance, with APB No. 28 and FIN 18, the impact of the shortfall was recorded as a discrete item and recognized in the current period. At March 31, 2009, excluding the impact of discrete items, our estimated annual effective tax rate for 2009 is 44.0% compared to our annual effective tax rate for 2008 of 39.7%.
As part of the process of preparing financial statements, we estimate federal and state income taxes. Management estimates 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 our 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, 2009, we recorded income tax benefit of $221,000 with an effective tax rate of 27%. In future periods of taxable earnings, we expect to report an income tax provision using an effective tax rate of approximately 44%.
On January 1, 2007, we adopted the provisions of FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes (FIN 48). At the adoption date of January 1, 2007 and at March 31, 2009 and 2008, 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, 2009 and 2008, we had no accrued interest or penalties related to uncertain tax positions. The tax years 2005-2008 remain open to examination by both the Federal government and by other major income taxing jurisdictions to which we are subject.
In accordance with SFAS No. 142, Goodwill and Other Intangible Assets (SFAS 142), we are required to assess the carrying amount of our goodwill for potential impairment annually or more frequently if events or a change in circumstances indicate that impairment may have occurred.
Testing for goodwill impairment is a two step process. The first step screens for potential impairment and if there is an indication of possible impairment we must complete the second step to measure the amount of impairment loss, if any. The first step of the goodwill impairment test, used to identify potential impairment, compares the fair value of our market capitalization with the carrying value of our net assets. If our total market capitalization is at or below the carrying value of our net assets, we perform the second step of the goodwill impairment test to measure the amount of impairment loss we record, if any. We consider 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.
Historically, our market capitalization has been well above the carrying value of our net assets and there has been no indication of potential impairment. However, during the fourth quarter of 2008 and the first quarter of 2009, the price of our common stock was significantly impacted by the volatility in the U.S. equity markets. The price of our common stock reached a low of $2.50 during the first quarter of 2009, remained below $3.00 per share for an extended period of time during the first quarter of 2009 and closed at $2.89 on March 31, 2009. These lows in the price of our common stock have coincided with the stock markets 52 week lows recorded as the financial crisis has intensified. As of March 31, 2009, our market capitalization was approximately $37.3 million as compared to our stockholders equity at March 31, 2009 of $42.1 million.
We believe that the fair value of our company exceeds our market capitalization because our fair value should include a control premium. A control premium is the amount that a buyer is willing to pay over the current market price of a company as indicated by the traded price per share (i.e. market capitalization), in order to acquire a controlling interest. The premium is justified by the expected synergies, such as the expected increase in cash flow resulting from cost savings and revenue enhancements. We believe a control premium of 20 to 40 percent is appropriate for our company. Applying a control premium of 20 to 40 percent results in a revised market capitalization at March 31, 2009 of between $44.8 million and $52.2 million, which is in excess of our stockholders equity at that date of $42.1 million and indicates there was not then an impairment of our goodwill. However, we can provide no assurance that these continuing conditions will not trigger goodwill impairment testing in the future or whether we may record an impairment charge. We will continue to monitor and evaluate the carrying value of our goodwill to determine whether interim asset impairment testing is warranted.
6. Valuation of Long-Lived Assets
In accordance with SFAS No. 144, Accounting for the Impairment or Disposal of Long-Lived Assets (SFAS 144), we are required to perform an impairment test for finite-lived assets and other long-lived assets, such as fixed assets, whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. As March 31, 2009 and 2008, respectively, we determined that no triggering events had occurred during the quarter and our long-lived assets were not impaired.
7. Recently Issued Accounting Standards
Effective January 1, 2009, we adopted SFAS 157 for nonfinancial assets and nonfinancial liabilities. 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 for nonfinancial assets and liabilities 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 for disclosure to enable evaluation of the nature and financial effects of the business combination. The adoption of SFAS 141(R), effective January 1, 2009, did not have any impact on our financial statements.
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 in a subsidiary. SFAS 160 also changes the accounting 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 adopted this standard as of January 1, 2009 and it did not have any impact on our financial statements.
In April 2008, the FASB issued Staff Position FSP FAS 142-3, Determination of the Useful Life of Intangible Assets (FSP FAS 142-3). The FSP amends the factors considered in developing renewal or extension assumptions for determining the useful life of a recognized intangible asset under SFAS No. 142, Goodwill and Other Intangible Assets. The FSPs intent is to improve the consistency between the useful life of a recognized intangible asset under SFAS No. 142 and the period of expected cash flows used to measure the fair value of the asset under other accounting principles generally accepted in the U.S. Companies must adopt the FSP for fiscal years and interim periods beginning after December 15, 2008. Early adoption is prohibited. Companies must apply the guidance for determining the useful life of a recognized intangible asset prospectively to intangible assets acquired after the effective date. Companies must also apply certain disclosure requirements prospectively to all intangible assets recognized as of, and subsequent to, the effective date. The adoption of FAS 142-3, effective January 1, 2009, did not have any impact on our financial statements.
Item 2. Managements Discussion and Analysis of Financial Condition and Results of Operations
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, 2009, we have 18 locations throughout the United States. We historically have derived our greatest percentage of net sales from customers located in the central part of the United 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. Current economic conditions and competition also affect our customers decisions and timing to place orders with us and the size of those orders. 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:
· Investing in customer-facing teams to attract top tier sales and technical talent which we believe will increase our market share in key locations.
· Deepening our presence in existing enterprise accounts and penetrating new enterprise accounts.
· Targeting high growth market segments and deploying new technologies which focus on cost savings technologies for our customers.
· Reducing our cost structure and realigning resources to improve efficiencies.
· Expanding our customer support capabilities and tools-based professional services offerings that we believe will provide more value to our customers.
· 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 technical teams to increase productivity.
· Focusing on corporate expense reductions.
· Driving high levels of efficiency by streamlining our supply chain and expanding our professional services tools.
· Meeting with potential acquisition candidates.
All of these plans have various challenges and risks associated with them, including that:
· The worldwide economic downturn adversely affects our customers buying patterns.
· 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
We ended the first quarter of 2009 with a backlog of $29 million, which represents firm orders we expect to recognize as revenue in future periods. This compares to a backlog of $33 million as of December 31, 2008. In the current environment, we are seeing the negative impact of the worldwide economic downturn affect many of our customers, resulting in greater scrutiny given to storage spending projects and providing us with less visibility into their purchasing plans. We have also had some customers decide to significantly delay the implementation of projects for which they have already purchased and paid for the product. We cannot predict what impact these economic uncertainties will have on our profitability going forward.
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 decreased by $7.9 million for the three months ended March 31, 2009, or 16.4%, from $47.7 million for the comparable quarter in 2008. Our product sales decreased $9.3 million, or 32.5%, to $19.3 million for the three months ended March 31, 2009, from $28.5 million for the comparable quarter in 2008. Our service sales increased $1.4 million, or 7.3%, to $20.6 million for the three months ended March 31, 2009 from $19.2 million for the comparable quarter in 2008.
The decline in our product revenues for the first quarter of 2009, as compared to the same period in 2008 reflects the continuing negative impact of the economic slowdown that many of our customers are experiencing. We expect our product revenues will continue to reflect our customers closer scrutiny of expenditures as they focus more attention on the actual or anticipated impact that current economic conditions may have on the growth and profitability of their business. Our bookings activity for the first quarter of 2009 was very slow during January and February and then increased the last two weeks of March and into April.
Our service sales increase for the first quarter of 2009 as compared to the same period in 2008 was due primarily to an increase in customer support contracts of $1.2 million. In addition, our installation and configuration service sales increased $196,000 between the same periods. We continue to benefit from sales of customer support contracts related to 2008 product sales, which are recognized over the contract term. With the decrease in product revenues in late 2008 and into 2009, we cannot assure that our future service sales will not similarly decline.
We had no single customer account for 10% or greater of our revenues for either of the three months ended March 31, 2009 or 2008.
Gross Profit. Our total gross profit as a percentage of net sales decreased to 26.5% for the quarter ended March 31, 2009, as compared to 27.2% for the comparable quarter in 2008. Product gross profit as a percentage of product sales decreased to 25.2% in the first quarter of 2009 from 26.1% for the comparable quarter in 2008. Service gross profit as a percentage of service sales decreased to 27.7% for the first quarter of 2009 from 28.8% for the comparable quarter in 2008.
Our product gross profit as a percentage of product sales is impacted by the mix and type of projects we complete for our customers. Our product gross profit is also impacted by various vendor incentive programs that provide economic incentives for achieving various sales performance targets. We had lower product purchases during the first quarter of 2009 as compared to the same period in 2008 and this qualified us for fewer vendor incentives. Vendor incentives were $592,000 and $837,000, respectively, for the three month periods ended March 31, 2009 and 2008. With the current economic downturn, we may continue to see a decline in the number and profitability of disk sales. Our vendors may also change or terminate these programs at any time, and, accordingly, we cannot assure that we will achieve and receive similar vendor incentives in the future. We estimate that our product gross margins in the foreseeable future will be approximately 24% to 25%.
Our service gross profit as a percentage of service sales for the three months ended March 31, 2009 decreased 0.9% as compared to the same period in 2008. Our vendors provided a larger portion of our installation and configuration services for the 2009 quarter, which typically results in lower gross margins.
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 $5.5 million, or 13.7% of net sales for the quarter ended March 31, 2009, compared to $5.8 million, or 12.2% of net sales for the first quarter in 2008.
Sales and marketing expenses decreased $336,000 for the three month periods ended March 31, 2009, as compared to the same period in 2008. With our decline in overall revenue, we had a decrease in variable compensation for commissions.
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 $2.9 million, or 7.3% of net sales for the quarter ended March 31, 2009, compared to $3.2 million, or 6.6% of net sales for the first quarter in 2008.
General and administrative expenses decreased $243,000 for the three months ended March 31, 2009, as compared to the same period in 2008. We attribute this primarily to the cancellation of our annual sales meeting resulting in savings of $205,000 and a decrease in training expenses of $55,000.
Engineering. Engineering expenses include employee wages, bonuses and travel, hiring and training expenses for our field and customer support engineers and technicians. Engineering expenses were $2.8 million, or 7.1% of net sales for the quarter ended March 31, 2009, compared to $3.2 million, or 6.6% of net sales for the first quarter in 2008.
Engineering expenses decreased $338,000 for the three months ended March 31, 2009 as compared to the same period in 2008. This is primarily due to a decrease in variable compensation for bonuses of $114,000 and outside consulting expenses of $226,000.
Amortization of Intangibles. We had $178,000 of intangible asset amortization expenses for each of the three month periods ended March 31, 2009 and 2008. The identifiable intangible asset and subsequent amortization is due to our acquisition of MCSI on January 31, 2007.
Earnings (Loss) from Operations. We had a loss from operations of $856,000 for the three months ended March 31, 2009 and earnings from operations of $660,000 for the three months ended March 31, 2008. The 2009 loss from operations is a result of a decrease in our revenues and margins due to the current economic downturn. The 2008 earnings from operations is a result of higher revenues and margins with a limited increase in operating expenses.
Income Taxes. We had income tax benefit of $221,000 for the three months ended March 31, 2009 and income tax expense of $353,000 for the three months ended March 31, 2008. Our estimated effective tax rate for the first quarter of 2009 is 27%. Our estimated effective tax rate for 2008 was 41%. In future periods of taxable earnings, we expect to report an income tax provision using an effective tax rate of approximately 44%.
LIQUIDITY AND CAPITAL RESOURCES
Net cash provided by operating activities was $1.5 million for the three months ended March 31, 2009 as compared to $1.4 million for the three months ended March 31, 2008. Significant items which impacted our operating cash flows as of March 31, 2009 were:
· A net loss of $596,000.
· A net increase in cash of approximately $2.0 million for accounts receivable and accounts payable. This was primarily due to the collection of 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.
Net cash used in investing activities was $5,000 for the three months ended March 31, 2009. We used this cash for minimal computer equipment purchases. 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 $200,000 of capital expenditures for the remainder of 2009 related primarily to computer and communication system upgrades or other management information system enhancements.
Net cash used in financing activities was $63,000 for the three months ended March 31, 2009, from tax withholding payments reimbursed by restricted stock and a tax adjustment for stock based compensation. 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.
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, 2009, for the remainder of 2009 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, 2009. 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 Valuation. 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. Testing for goodwill impairment is a two step process. The first step screens for potential impairment and if there is an indication of possible impairment we must complete the second step to measure the amount of impairment loss, if any. The first step of the goodwill impairment test, used to identify potential impairment, compares the fair value of our market capitalization with the carrying value of our net assets. If our total market capitalization is at or below the carrying value of our net assets, we perform the second step of the goodwill impairment test to measure the amount of impairment loss we record, if any. With the worldwide decline in stock prices, the potential for this is increased. We consider 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. The downturn in the U.S. economy makes it increasingly difficult for us to accurately predict our future cash flows. To the extent our 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.
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. However, due to the nature of our short-term investments, we have concluded they have no material market risk.
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, 2009, we had $27.6 million of cash and money market accounts and $1.5 million of short term investments consisting primarily of certificates of deposit. 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. Disclosure 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 operation 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 Commission (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 2009.
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, 2008.
Dependence on Significant Customers. We had no single customer account for 10% or greater of our revenues for the three months ended March 31, 2009 and 2008, respectively.
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 product. 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. Initially 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.