Datalink (DTLK)

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FORM 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

(Mark One)

For the quarterly period ended:  June 30, 2012

or

For the transition period from                 to                

Commission file number: 00029758

(Exact name of registrant as specified in its charter)

10050 Crosstown Circle, Suite 500

EDEN PRAIRIE, MINNESOTA 55344

(Address of Principal Executive Offices)

(952) 944-3462

(Registrant’s Telephone Number, Including Area Code)

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 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  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 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 August 8, 2012, 18,064,234 shares of the registrant’s common stock, $.001 par value, were outstanding.

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DATALINK CORPORATION

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PART I. FINANCIAL INFORMATION

Item 1.   Financial Statements

Datalink Corporation

Balance Sheets

(In thousands, except share data)

The accompanying notes are an integral part of these financial statements.

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Datalink Corporation

Statements of Operations

(In thousands, except per share data)

(Unaudited)

The accompanying notes are an integral part of these financial statements.

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Datalink Corporation

Statements of Cash Flows

(In thousands)

(Unaudited)

The accompanying notes are an integral part of these financial statements.

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Datalink Corporation

Notes To Financial Statements

(Unaudited)

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.  You should read these financial statements in conjunction with the financial statements and related notes thereto included in our 2011 Annual Report on Form 10-K.

The financial statements presented herein as of June 30, 2012, and for the three months and six months ended June 30, 2012 and 2011, 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. Management makes estimates and assumptions affecting the amounts of assets, liabilities, revenues and expenses we report, 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.  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 data center solutions and services including the effects of current economic and credit conditions and the ability of organizations to outsource data center infrastructure-related services to service providers such as us; the migration of organizations to virtualized server environments, including using a private cloud computing infrastructure; the extent to which customers deploy disk-based backup recovery solutions; the realization of the expected trends identified for advanced network infrastructures; continuing receipt of vendor incentives; reliance by manufacturers on their data service partners to integrate their specialized products;  continued preferred status with certain principal suppliers; competition and pricing pressures and timing of our installations that may adversely affect our revenues and profits; the length of our sales cycle; 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;  continued productivity of our sales personnel; our dependence on key suppliers; our ability to adapt to rapid technological change; risks associated with integrating our acquisition of Midwave Corporation, as well as future acquisitions; fluctuations in our quarterly operating results; future changes in applicable accounting rules; future changes in effective tax rates; 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. We cannot assure that we can grow or maintain our revenue and backlog from current levels. Accordingly, you should read these condensed financial statements in conjunction with the audited financial statements and the related notes included in our 2011 Annual Report on Form 10-K.  Actual results could differ materially from these estimates and assumptions.

In May 2011, the FASB issued an update to ASC 820 Fair Value Measurement (“ASC 820”): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and International Financial Reporting Standards (“IFRS”).  The update requires an entity with fair value measurement disclosures to provide a consistent definition of fair value and ensure that the fair value measurement and disclosure requirements are similar between U.S. GAAP and IFRS. The guidance changes certain fair value measurement principles and enhances the disclosure requirements, particularly for level 3 fair value measurements.  The update to ASC 820 was effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Adoption of this update did not have a material impact on our financial statements.

In June 2011, the FASB issued an update to ASC 220 Fair Comprehensive Income (“ASC 820”): Presentation of Comprehensive Income.  The update eliminates the option to present components of other comprehensive income in the statement of stockholders’ equity. Instead, the new guidance now requires an entity to present all non-owner changes in stockholders’ equity either as a single continuous statement of comprehensive income or as two separate but consecutive statements. The update to ASC 220 is effective for fiscal years, and interim periods within those years beginning, after December 15, 2011. Adoption of this update did not have an impact on our financial statements.

In September 2011, the FASB issued an update to ASC 350 Intangibles — Goodwill and Other (“ASC 350”): Testing Goodwill for Impairment. The update allows an entity to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test. Under these amendments, an entity would not be required to calculate the fair value of a reporting unit unless the entity determines, based on a qualitative assessment, that it is more likely than not that its fair value is less than its carrying amount. The amendments include a number of events and circumstances for an entity to consider in conducting the qualitative assessment. The update to ASC 350 is effective for fiscal years, and interim periods within those years beginning, after December 15, 2011. Adoption of this update did not have a material impact on our financial statements.

2.             Net Earnings per Share

We compute basic net earnings per share using the weighted average number of shares outstanding.  Diluted net earnings per share include the effect of common stock equivalents, if any, for each period.  Diluted net earnings per share amounts assume the conversion,

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exercise or issuance of all potential common stock instruments unless their effect is anti-dilutive.  The following table computes basic and diluted net earnings per share:

We excluded the following restricted stock grants that have not yet vested 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

Common Stock Offering

On March 14, 2011, we completed a public offering of 4,266,500 shares of common stock with a price to the public of $5.75 per share. We issued and sold 3,306,500 shares in the offering and the selling shareholder sold 960,000 shares in the offering. We received proceeds from the common stock sold by us, net of offering costs, of approximately $17.5 million.  We did not receive any proceeds from the shares sold by the selling shareholder.

Restricted Stock:

Total stock-based compensation expense related to restricted stock was $579,000 and $370,000 for the three months ended June 30, 2012 and 2011, respectively.  Total stock-based compensation expense related to restricted stock was $1.0 million and $667,000 for the six months ended June 30, 2012 and 2011, respectively.  Unrecognized stock-based compensation expense related to restricted stock was $3.9 million at June 30, 2012 which we will amortize ratably through January 2016.

The following table summarizes our restricted stock activity for the six months ended June 30, 2012:

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Stock Options:

Total stock-based compensation expense related to stock options was $60,000 and $65,000 for the three months ended June 30, 2012 and 2011, respectively.  Total stock-based compensation expense related to stock options was $121,000 and $134,000 for the six months ended June 30, 2012 and 2011, respectively.  Unrecognized stock-based compensation expense related to stock options was $255,000 at June 30, 2012 which we will amortize ratably through July 2013.

The following table represents stock option activity for the six months ended June 30, 2012:

Other:

During the three months ended June 30, 2012 and 2011, we recognized expense of $86,000 and $64,000 related to the issuance of 9,000 and 9,216 shares of fully vested common stock, respectively, to members of our Board of Directors.  During the six months ended June 30, 2012 and 2011, we recognized expense of $172,000 and $124,000, respectively, related to the issuance of 18,000 and 18,607 shares, respectively, 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 June 30, 2012 and 2011, our effective tax rate was 40.5% and 38.4%, respectively.  For the first six months of 2012 and 2011, our effective tax rate was 40.3% and 39.8%, respectively.  The higher tax rate for the three and six months ended June 30, 2012 as compared to the same periods in 2011 resulted primarily from the impact of a slight increase in our statutory tax rate, from 34% in 2011 to 35% in 2012, and the ratio of permanent differences to net earnings. Our permanent differences increased at a higher rate than our earnings for the three and six months ended June 30, 2012 than in the comparable 2011 periods, which resulted in a higher effective tax rate in 2012.  We expect our annual effective tax rate for 2012 to be 40.5%.

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 we may deduct these temporary differences.  For the three and six months ended June 30, 2012, we recorded income tax expense of $2.2 million and $3.6 million, respectively, with an effective tax rate of 40% for both periods.

We assess our uncertain tax positions for tax years that are still open for examination.  As of June 30, 2012 and 2011, 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 operations under general and administrative expenses. As of June 30, 2012 and 2011, we had no accrued interest or penalties related to uncertain tax positions. The tax years 2008-2011 remain open to examination by both the Federal government and by other major income taxing jurisdictions to which we are subject.

Our ability to utilize a portion of our net operating loss carryforwards to offset future taxable income is subject to certain limitations under Section 382 of the Internal Revenue Code due to changes in our equity ownership.  We do not believe that an ownership change under Section 382 has occurred, and therefore, no such limitations exist.

5.             Goodwill and Valuation of Long-Lived Assets

We 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.  We perform an impairment test for finite-lived assets, such as intangible

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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.  Circumstances that could represent triggering events and therefore require an interim impairment test of goodwill or evaluation of our finite-life intangible assets or other long lived assets include the following:  loss of key personnel, unanticipated competition, higher or earlier than expected customer attrition, deterioration of operating performance, significant adverse industry conditions, economic or regulatory changes or a significant decline in market capitalization.

We have only one operating and reporting unit that earns revenues, incurs expenses and makes available discrete financial information for review by our chief operations decision maker.  Accordingly, we complete our goodwill impairment testing on this single reporting unit.

In conducting the annual impairment test of our goodwill, qualitative factors are first examined to determine whether the existence of events, or circumstances, indicate that it is more likely than not that the fair value of a reporting unit is less than it carrying amount.  If it is determined that it is more likely than not that the fair value of the reporting unit is less than its carrying amount, a two step impairment test is applied.  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.

Goodwill was $32.4 million as of June 30, 2012 and December 31, 2011.  We conducted our annual goodwill impairment test as of December 31, 2011, our last measurement date.  Based on this analysis, we determined that there was no impairment to goodwill.  We will continue to monitor conditions and changes that could indicate impairment of our recorded goodwill.

At each of June 30, 2012 and December 31, 2011, we determined that no triggering events had occurred during the quarter and our finite-lived assets and long-lived assets were not impaired.

Identified intangible assets are summarized as follows:

Amortization expense for identified intangible assets is summarized below:

Based on the identified intangible assets recorded at June 30, 2012, future amortization expense for the next five years is as follows:

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6.             Short Term Investments

The following table summarizes our short term investments (in thousands):

As of June 30, 2012 and December 31, 2011, we had no unrealized holding gains/losses on investments.

Our $596,000 of short term investments are comprised of fully insured certificates of deposits with maturities within thirty days and interest rates ranging from 0.45% to 0.55%.

7.             Fair Value Measurements

Fair value is the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  In determining fair value for assets and liabilities required or permitted to be recorded at fair value, we consider the principal or most advantageous market in which it would transact and the assumptions that market participants would use when pricing the asset or liability.  We apply fair value measurements for both financial and nonfinancial assets and liabilities.  We have no nonfinancial assets or liabilities that require measurement at fair value on a recurring basis as of June 30, 2012.

The fair value of our financial instruments, including cash and cash equivalents, accounts receivable, accounts payable and accrued liabilities, approximate cost because of their short maturities.

We use the three-level fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair values.  The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements).  The three levels of the fair value hierarchy are described below:

·                  Level 1 — Unadjusted quoted prices available in active markets for the identical assets or liabilities at the measurement date.

·                  Level 2 — Significant other observable inputs available at the measurement date, other than quoted prices included in Level 1, either directly or indirectly.

·                  Level 3 — Significant unobservable inputs that we cannot corroborate by observable market data and thus reflect the use of significant management judgment.  We generally determine these values using pricing models based on assumptions our management believes other market participants would make.

The fair value hierarchy requires the use of observable market data when available.  In instances in which the inputs used to measure fair value fall into different levels of the fair value hierarchy, we determine the fair value measurement based on the lowest level input that is significant to the fair value measurement in its entirety.  Our assessment of the significance of a particular item to the fair value measurement in its entirety requires judgment, including the consideration of inputs specific to the asset or liability.  The following table sets forth, by level within the fair value hierarchy, the accounting of our financial assets and/or liabilities at fair value on a recurring basis as of June 30, 2012 according to the valuation techniques we used to determine their fair value(s).

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8.             Line of Credit

We have available for use a line of credit not to exceed $10.0 million with Wells Fargo Bank, N.A. which expires on July 31, 2012. As of June 30, 2012, we had no borrowings outstanding on the line of credit. The credit line bears interest at 2.0% above the bank’s three month LIBOR rate and requires us to meet certain financial covenants.  At June 30, 2012, we were in compliance with the covenants.

On July 31, 2012, we entered into the Third Amendment to Credit Agreement, which amended the existing line of credit agreement with Wells Fargo Bank, N.A (“Amended Agreement”). The Amended Agreement continues to provide a revolving line of credit facility with a maximum borrowing amount of $10.0 million that now matures on July 31, 2014. In connection with the extension of the maturity date, we executed an Amended and Restated Revolving Line of Credit Note. The credit line continues to bear interest at 2.0% above the bank’s three month LIBOR rate.

The other terms, conditions, and financial covenants in the Amended Agreement are substantially the same as those defined in the original line of credit agreement. In the event of noncompliance with the financial covenants and other defined events of default, the lender is entitled to certain remedies, including acceleration of the repayment of amounts outstanding on the line of credit facility.

9.                                       Lease Receivables

In June 2012, we entered into a sales-type lease agreement with a single customer resulting from the sale of certain products. Our lease receivable is recorded at cost within the accounts receivable, net balance on our balance sheet and is due in monthly installments over an initial term of two years. Cash received and applied against this receivable balance is recorded within changes in operating assets and liabilities in the net cash provided by operating activities section of the statement of cash flows.  Finance income is derived over the term of the sales-type lease arrangement as the unearned income on financed sales-type leases is earned. Unearned income is amortized over the life of the lease using the interest method.  The contractual amounts due under sales-type leases at June 30, 2012 were as follows (in thousands):

Lease receivables are individually evaluated for impairment. In the event we determine that a lease receivable may not be paid, we include in our allowance an amount for the outstanding balance related to the lease receivable. As of June 30, 2012, there were no amounts past due related to lease receivables.

10.                                 12-Month Earnings Statement

Pursuant to section 11(A) of the Securities Act of 1933 and Rule 158 promulgated thereunder, the following is an unaudited quarterly and 12-month earnings statement covering the period from July 1, 2011 through June 30, 2012.

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Item 2.    Management’s Discussion and Analysis of Financial Condition and Results of Operations

The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for certain forward-looking statements. This Quarterly Report on Form 10-Q contains forward-looking statements regarding us, our business prospects and our results of operations that are subject to certain risks and uncertainties posed by many factors and events that could cause our actual business, prospects and results of operations to differ materially from those that may be anticipated by such forward-looking statements.  The words “aim,” “believe,” “expect,” “anticipate,” “intend,” “estimate,” “project,” “should,” 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 data center solutions and services including the effects of current economic and credit conditions and the ability of organizations to outsource data center infrastructure-related services to service providers such as us; the migration of organizations to virtualized server environments, including using a private cloud computing infrastructure; the extent to which customers deploy disk-based backup recovery solutions; the realization of the expected trends identified for advanced network infrastructures; continuing receipt of vendor incentives; reliance by manufacturers on their data service partners to integrate their specialized products;  continued preferred status with certain principal suppliers; competition and pricing pressures and timing of our installations that may adversely affect our revenues and profits; the length of our sales cycle; 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;  continued productivity of our sales personnel; our dependence on key suppliers; our ability to adapt to rapid technological change; risks associated with integrating our acquisition of Midwave Corporation, as well as future acquisitions; fluctuations in our quarterly operating results; future changes in applicable accounting rules; future changes in effective tax rates; 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. We cannot assure that we can grow or maintain our revenue and backlog from current levels.  Additional risks, uncertainties and other factors are included in the “Risk Factors” section on our Annual Report on Form 10-K for the year ended December 31, 2011.  We undertake no obligation to revise any forward-looking statements in order to reflect events or circumstances that may subsequently arise. Any forward-looking statement made by us in this report is based on information currently available to us and speaks only on the date on which it is made.  Readers are urged to carefully review and consider the various disclosures made by us in this report and in our other reports filed with the Securities and Exchange Commission that advises interested parties of the risks and factors that may affect our business.

We provide solutions and services that make data centers more efficient, manageable and responsive to changing business needs.  Focused on mid- and large-size companies, we assess, design, deploy and support infrastructures such as servers, storage and networks. We also resell hardware and software from the industry’s leading original equipment manufacturers (“OEMs”) as part of our customer offerings. Our portfolio of solutions and services spans four practices: consolidation and virtualization, data storage protection, advanced network infrastructures and business continuity and disaster recovery solutions.  We offer a full suite of practice-specific consulting, analysis, design, implementation, management and support services.

Our solutions can include hardware products, such as servers, disk arrays, tape systems, networking and interconnection components and software products.  Our data center strategy is supported through multiple trends in the market and involves supporting the market and our customers with a single vendor to provide their data center infrastructure needs.  As of June 30, 2012, we have 30 locations, including both leased facilities and home offices, 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.  In about half of the support service contracts that we sell, our customers purchase support services through us, resulting in customers receiving 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 our and/or vendor technical staff to meet the customer’s 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. The other half of the support service contracts that we sell to our customers are direct with the product manufacturers. For all support service contracts we sell, 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.

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The data center infrastructure solutions and services market is rapidly evolving and highly competitive.  Our competition includes other independent storage, server and networking 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, server and networking experience is critical to effectively compete in the marketplace and achieve 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 center infrastructure 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.  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.

RESULTS OF OPERATIONS

The following table shows, for the periods indicated, certain selected financial data expressed as a percentage of net sales.