DATALINK CORP - 10-Q Quarterly Report

FORM 10-Q

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

(Mark One)

ý Quarterly report pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934

For the quarterly period ended: March 31, 2005

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

DATALINK CORPORATION

(Exact name of registrant as specified in its charter)

MINNESOTA		41-0856543
(State or other jurisdiction of Incorporation)		(IRS Employer Identification Number)

8170 UPLAND CIRCLE CHANHASSEN, MINNESOTA 55317-8589
(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 ý No o

Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act):

Yes o No ý

As of May 6, 2005, 10,309,205 shares of the registrant’s common stock, $.001 par value, were outstanding.

PART I. FINANCIAL INFORMATION

Item 1. Financial Statements

Datalink Corporation

Balance Sheets

(In thousands)

	March 31, 2005			December 31, 2004
	(Unaudited)
Assets
Current assets
Cash and cash equivalents	$	11,791		$	12,663
Accounts receivable, net	11,410			11,485
Inventories	1,776			627
Deferred customer support contract costs	12,437			10,770
Inventories shipped but not installed	2,738			2,343
Other current assets	376			284
Total current assets	40,528			38,172
Property and equipment, net	2,598			3,134
Goodwill	5,500			5,500
Intangibles, net	159			225
Other assets	434			38
Total assets	$	49,219		$	47,069

Liabilities and Stockholders’ Equity
Current liabilities
Accounts payable	$	12,915		$	11,031
Accrued commissions	1,136			1,227
Accrued income tax	92			109
Accrued sales and use tax	438			510
Accrued expenses, other	952			1,276
Sublease reserve current	787			—
Deferred revenue from customer support contracts	16,669			14,012
Total current liabilities	32,989			28,165
Deferred rent	355			392
Sublease reserve non-current	2,025			—
Total liabilities	35,369			28,557

Commitments and contingencies

Stockholders’ equity
Common stock, $.001 par value, 50,000,000 shares authorized, 10,295,113 and 10,282,545 shares issued and outstanding as of March 31, 2005 and December 31, 2004, respectively	10			10
Additional paid in capital	26,646			26,624
Deferred compensation	(290		)	(307		)
Accumulated deficit	(12,516		)	(7,815		)
Total stockholders’ equity	13,850			18,512
Total liabilities and stockholders’ equity	$	49,219		$	47,069

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

Datalink Corporation
Statements of Operations
(In thousands, except per share data)
(Unaudited)

	Three Months Ended March 31,
	2005			2004
Net sales:
Products	$	13,655		$	13,229
Services	7,586			6,975
	21,241			20,204
Cost of sales:
Cost of products	10,368			10,442
Cost of services	5,114			4,754
Total cost of sales	15,482			15,196
Gross profit	5,759			5,008
Operating expenses:
Sales and marketing	3,293			3,069
General and administrative	2,546			2,866
Engineering	1,128			868
Charge for sublease reserve	3,502			—
Amortization of intangibles	65			65
	10,534			6,868
Loss from operations	(4,775		)	(1,860		)
Interest income, net	74			20
Loss before income taxes	(4,701		)	(1,840		)
Income tax benefit	—			—
Net loss	$	(4,701	)	$	(1,840	)

Net loss per common share:
Basic and diluted	$	(0.46	)	$	(0.18	)
Weighted average common shares outstanding:
Basic and diluted	10,293			10,253

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

Datalink Corporation
Statements of Cash Flows
(In thousands)
(Unaudited)

	Three Months Ended March 31,
	2005			2004
Cash flows from operating activities:
Net loss	$	(4,701	)	$	(1,840	)
Adjustments to reconcile net loss to net cash used in operating activities:
Provision for bad debts	6			9
Depreciation	362			509
Amortization of intangibles	66			65
Deferred rent	(37		)	(61		)
Loss on disposal of assets	—			15
Charge for sublease reserve	3,239			—
Stock compensation expense	17			—
Changes in operating assets and liabilities:
Accounts receivable	69			(3,929		)
Inventories	(1,544		)	(2,687		)
Deferred customer support contract costs	(1,667		)	(2,994		)
Other current assets	(92		)	(38		)
Other assets	(396		)	—
Accounts payable	1,884			3,444
Accrued expenses	(487		)	465
Income taxes	(17		)	244
Deferred revenue from customer support contracts	2,657			4,062
Net cash used in operating activities	(641		)	(2,736		)

Cash flows from investing activities:
Purchase of property and equipment	(253		)	(96		)
Net cash used in investing activities	(253		)	(96		)

Cash flows from financing activities:
Proceeds from issuance of common stock	22			59
Net cash provided by financing activities	22			59

Decrease in cash and cash equivalents	(872		)	(2,773		)
Cash and cash equivalents, beginning of period	12,663			12,565
Cash and cash equivalents, end of period	$	11,791		$	9,792

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

Datalink Corporation
Notes To Financial Statements
(In thousands, except share and per share data)
(Unaudited)

1. Basis of Presentation

The interim financial statements included in this Form 10-Q have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Certain information and footnote disclosures, normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States, have been condensed or omitted, pursuant to such rules and regulations. These financial statements should be read in conjunction with the financial statements and related notes thereto included in the Company’s 2004 Annual Report on Form 10-K.

The financial statements presented herein as of March 31, 2005, and for the three months ended March 31, 2005 and 2004, 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.

2. Inventories

Inventories, including inventories shipped but not installed, principally consist of data storage products and components, that are valued at the lower of cost or market with cost determined on a first-in, first-out (FIFO) method.

3. Net Loss Per Share

Basic net loss per share is computed using the weighted average number of shares outstanding. Diluted net loss per share includes the effect of potential common stock equivalents, if any, for each period. The number of additional shares is calculated by assuming that outstanding stock options were exercised and that the proceeds from such exercise were used to acquire shares of common stock at the average market price during the reporting period. Due to the net loss for the three months ended March 31, 2005 and 2004, common stock equivalents of 76,000 and 143,000, respectively, would have been anti-dilutive to losses and as a result were excluded from the calculation of diluted loss per share.

4. Stock Options

Pro forma loss and loss per share have been determined as if the Company had used the fair value method of accounting for its stock option grants and employee stock purchase plan share elections consistent with the method of SFAS No. 123. Under this method, compensation expense is recognized over the applicable vesting periods and is based on the shares under option and their related fair values on the grant date.

	Three Months Ended March 31,
	2005		2004
	(In thousands)
Net loss:
As reported	$(4,701	)	$(1,840	)
Non cash compensation expense	$(96	)	$(235	)
Stock compensation cost on stock based awards granted below fair market value	$—		$15
Pro forma	$(4,797	)	$(2,060	)

Basic and diluted loss per share:
As reported	$(0.46	)	$(0.18	)
Non cash compensation expense	$(0.01	)	$(0.02	)
Stock compensation cost on stock based awards granted below fair market value	$0.00		$0.00
Pro forma	$(0.47	)	$(0.20	)

5. Goodwill and Intangible Assets

The balance of goodwill at March 31, 2005, and December 31, 2004, was $5.5 million.

Information regarding the Company’s other intangible asset that continues to be amortized is as follows:

	As of March 31, 2005
	(In thousands)
	Carrying Amount		Accumulated Amortization		Net

Customer lists	$	3,374	$	3,215	$	159

Amortization expense for the three months ended March 31, 2005, was $65,000. Estimated amortization expense for the remainder of fiscal 2005 is $159,000.

6. Income Taxes

As part of the process of preparing financial statements, the Company is 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 are included within the balance sheet. Management must then assess the likelihood that deferred tax assets will be utilized to offset future taxable income during the periods in which these temporary differences are deductible. As a result of the Company’s cumulative losses and the full utilization of the Company’s loss carry back potential, the Company concluded during the fourth quarter of fiscal 2002 to record a full valuation allowance against the Company’s net deferred tax assets. The valuation allowance at March 31, 2005 was $4.7 million. In addition, the Company expects to provide a full valuation allowance on any future tax benefits until the Company can sustain a level of profitability that demonstrates its ability to realize these assets.

7. Borrowing Arrangements

The Company has elected not to pursue a credit facility at this time. With the Company’s current cash position, it believes it has the liquidity to meet its operating needs for the foreseeable future. The Company has no outstanding debt, and if the need should arise to borrow funds, the Company believes that it could obtain a secured facility.

8. Recently Issued Accounting Standards

In December 2004, the FASB issued SFAS No. 123R, Share-Based Payment. This statement revises SFAS No. 123, Accounting for Stock-Based Compensation, and requires companies to expense the value of employee stock options and similar awards using the fair value method. The effective date of this standard is for annual periods beginning after June 30, 2005. Although management has not fully analyzed the effect this new statement will have on the Company's consolidated financial statements in the future, the pro forma net income effect of using the fair value method for the past three fiscal years as well as further information on this new statement is presented in Note 2 to the Company's consolidated financial statements on Form 10-K.

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

OVERVIEW

The following information should be read 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 other Company 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, estimated at $34 billion in 2004. We have 15 locations throughout the United States with the highest concentration of revenues in the central states.

We sell support service contracts to most of our customers. When customers purchase support services through us, customers receive the benefit of integrated system wide support. We have a qualified, independent support desk that takes calls from customers, diagnoses the issues they are facing and either solves the problem or coordinates with Datalink and/or vendor technical staff to meet the customer’s needs. Our support service agreements with our customers include an underlying agreement with the product vendor. The vendor provides on-site support assistance if necessary. We defer revenues and direct costs resulting from these contracts, and amortize these revenues and expenses into operations, over the term of the contracts, which are generally twelve months.

The enterprise-class information storage market is rapidly evolving and highly competitive. Our competition includes other independent storage system suppliers, high end market resellers, distributors, consultants and our suppliers through other independent data storage solution providers, original equipment manufacturers and their own internal sales forces. Our ability to hire and retain qualified outside sales representatives and engineers with enterprise-class information storage experience is critical to effectively competing in the marketplace and achieving our growth strategies.

In the past, we have experienced fluctuations in the timing of orders from our customers, and we expect to continue to experience these fluctuations in the future. These fluctuations have resulted from, among other things, the time required to design, test and evaluate our data storage solutions before customers deploy them, the size of customer orders, the complexity of our customers’ network environments, necessary system configuration to deploy our solutions and new product introductions by suppliers. Completion of our installation and configuration services may also delay recognition of revenues. Economic conditions and competition also affect our customers’ decisions to place orders with us. As a result, our net sales may fluctuate from quarter to quarter.

We view the current data storage market as having significant opportunity for Datalink’s growth. Currently, Datalink’s market share is a small part of the overall market. However, the providers of the data storage industry’s products and technologies are increasing their utilization of indirect sales approaches to broaden their reach and optimize their margins. Increasingly, they are turning to companies such as Datalink to sell their products. While these trends provide opportunity for Datalink, we must improve our business model to generate sustainable, profitable growth. Our model requires highly skilled sales and technical staff which results in substantial fixed costs for the Company. We believe the best way to improve our company and create long-term shareholder value it to focus on building capabilities that are scaleable and a cost structure that we can leverage. Our current strategies are focused on:

• Increasing productivity of our sales and technical teams in our existing locations.

• Growing our customer support revenue and market share. We believe that our customer support services offerings are becoming increasingly attractive to companies looking for system-wide integrated support.

• Increasing our professional services revenues. We believe there is an opportunity to sell more of our data storage services such as implementation services, storage environment assessments and on-site managed data storage services.

• Exploring potential regional acquisitions that we perceive can strengthen our resources and presence in key geographic locations.

To pursue these strategies, our actions include:

• Improving our training, tools and recruiting for sales teams to increase productivity.

• Hiring additional customer support staff and enhancing communications and technology.

• Developing more effective delivery of professional service solutions.

All of these plans have various challenges and risks associated with them, including that:

• We may not increase our productivity and may lose, or not successfully recruit and retain key sales, technical or other personnel.

• Competition is intense and may adversely impact our profit margin. Customers have many options for data storage products and services.

• We may not identify suitable acquisition candidates.

RESULTS OF OPERATIONS

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

	Quarter Ended March 31,
	2005		2004
Net sales	100.0	%	100.0	%
Cost of sales	72.9		75.2
Gross profit	27.1		24.8
Operating expenses:
Sales and marketing	15.5		15.2
General and administrative	12.0		14.2
Engineering	5.3		4.3
Charge for sublease reserve	16.5		—
Amortization of intangibles	0.3		0.3
Total operating expenses	49.6		34.0
Operating loss	(22.5	)%	(9.2	)%

The following table shows, for the periods indicated, revenue and gross profit information for our product and service sales.

	Quarter Ended March 31,
	2005			2004
Product sales	$	13,655		$	13,229
Service sales	7,586			6,975

Product gross profit	$	3,287		$	2,787
Service gross profit	2,472			2,221

Product gross profit as a percentage of product sales	24.1		%	21.1		%
Service gross profit as a percentage of service sales	32.6		%	31.8		%

Net Sales. Our total net sales increased by $1.0 million for the three months ended March 31, 2005, or 5.1%, from $20.2 million for the comparable quarter in 2004. Our product sales increased $426,000, or 3.2%, to $13.7 million for the three months ended March 31, 2005, from $13.2 million for the comparable quarter in 2004. Our service sales increased $611,000, or 8.8%, to $7.6 million for the three months ended March 31, 2005 from $7.0 million for the comparable quarter in 2004.

Product sales can be impacted by a variety of factors including the timing of completion of projects and the number and productivity of our sales executives. While our product sales increased 5.1% over the same period a year ago, product sales declined 23.6% sequentially from our fourth quarter ended December 31, 2004. The increase in sales over the prior year is partially a reflection of a 10% increase in the number of sales executives over the prior year. In the past we have experienced seasonality in the first quarter which in part explains the decline from our fourth quarter. Based on customer sales orders received to date, we expect our product sales for the second quarter ending June 30, 2005 to exceed our product sales from the comparable quarter of the prior year.

Our service sales increase for the three month period ended March 31, 2005 was primarily due to an increase in on-site support services $500,000 and implementation services $106,000. Our customers are increasingly relying on our storage expertise for their storage projects and infrastructure support.

We derived 14% of our revenues during the current quarter from Cingular Wireless.

Gross Profit. Our total gross profit as a percentage of net sales increased to 27.1% for the quarter ended March 31, 2005, as compared to 24.8% for the comparable quarter in 2004. Product gross profit as a percentage of product sales increased to 24.1% in the first quarter of 2005 from 21.1% for the comparable quarter in 2004. Service gross profit as a percentage of service sales increased to 32.6% in the first quarter of 2005 from 31.8% for the comparable quarter in 2004.

Our product gross profit as a percentage of product sales is impacted by the mix and type of projects we complete for our customers. In the first quarter of 2005 as compared to the first quarter of 2004, we delivered more value-add storage solutions to our customers which typically generate a higher gross profit.

Our service gross profit as a percentage of service sales for the three month period ended March 31, 2005 as compared to the same period in 2004 improved slightly as value-add storage solutions yield higher gross profits for both product and service sales.

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 $3.3 million, or 15.5% of net sales for the quarter ended March 31, 2005 compared to $3.1 million, or 15.2% of net sales for the first quarter in 2004. Sales and marketing expenses in absolute dollars increased $224,000 for the three month period ended March 31, 2005, as compared to the three month period ended March 31, 2004.

The increase of $224,000 for the three month period ended March 31, 2005, as compared to March 31, 2004 was due to higher commission and payroll tax expenses of $112,000 due to higher revenue and gross profit for the period and an increase in meeting expenses of $61,000 for various field sales employees held in the first quarter of 2005.

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 $2.5 million, or 12.0% of net sales for the quarter ended March 31, 2005, compared to $2.9 million, or 14.2% of net sales for the first quarter in

2004. General and administrative expenses in absolute dollars decreased $320,000 for the three month period ended March 31, 2005, as compared to the three month period ended March 31, 2004.

The decrease of $320,000 for the three month period ended March 31, 2005, as compared to the same period in 2004 was due to a decrease in rent and other facilities expenses of $353,000. We subleased 55,000 of the 104,000 square feet we occupy at our corporate headquarters in Chanhassen, Minnesota. In addition, depreciation for our customer relationship management system decreased by $134,000. These decreases were partially offset by $113,000 for Sarbanes-Oxley compliance consulting expenses and $70,000 for higher outside audit and accounting expenses.

Engineering. Engineering expenses include employee wages and travel, hiring and training expenses for our professional engineers and technicians. Engineering expenses were $1.1 million or 5.3% of net sales for the quarter ended March 31, 2005 compared to $868,000, or 4.3% of net sales for the first quarter in 2004. Engineering expenses in absolute dollars increased $260,000 for the three month period ended March 31, 2005, as compared to the three month period ended March 31, 2004.

The increase in engineering expenses of $260,000 for the three month period ended March 31, 2005, as compared to March 31, 2004 reflects an increase in salaries and benefits due to the addition of technical staff primarily directed to enhance our growing customer support and on-site technical staffing businesses.

Charge for Sublease Reserve. On December 15, 2004, we agreed to sublease approximately 55,000 of the 104,000 square feet we currently occupy as our corporate headquarters in Chanhassen, Minnesota. The initial sublease is co-terminal with our lease and is for 85 months starting on April 1, 2005 and ending April 27, 2012. The sublessee will pay us rent ranging from approximately $55,000 per month at the beginning of the term to approximately $60,000 per month by the end of the term. We also negotiated with our landlord to sell the 2.5 acre lot adjoining our facility for $200,000. In January 2005, we discontinued use of the sublease area and we incurred a one-time, non-cash charge of $3.5 million related to the sublease and lot sale. We expect cost savings of approximately $950,000 per year as a result of the sublease agreement.

Intangible Amortization. Amortization of intangible assets was $65,000 or 0.3% of net sales for the quarter ended March 31, 2005, as compared to $65,000 or 0.3% of net sales for the first quarter in 2004. We expect to amortize the remaining balance of the customer base intangible will be amortized by November 2005.

Operating Loss. We incurred an operating loss of $4.7 million for the three months ended March 31, 2005 as compared to an operating loss of $1.8 million for the three months ended March 31, 2004. Excluding the $3.5 million sublease charge, our operating loss for the three months ended March 31, 2005 was $1.2 million. The $641,000 reduction in operating loss (excluding our sublease charge) is a result of modest revenue increase coupled with a 230 basis point improvement in gross margins for the three month period ended March 31, 2005, as compared to March 31, 2004.

Income Taxes. We had no income tax benefit or expense for the three months ended March 31, 2005, and March 31, 2004 as the net operating loss carryforwards are offset by increases in the valuation reserve for deferred income taxes. The ultimate realization of deferred tax assets is dependent upon carry back to prior periods and upon the generation of future taxable income during the periods in which those temporary differences become deductible. Based upon the level of taxable losses in 2004, 2003 and 2002 and the near-term uncertainty of taxable income, management cannot reasonably predict when or if these deductible differences will be realized. In addition, we do not have the ability to realize future income tax benefits on future losses. We expect to provide a full valuation allowance on any future tax benefits until we can sustain a level of profitability that demonstrates to us that recoverability of such tax assets is more likely than not.

LIQUIDITY AND CAPITAL RESOURCES

Net cash used in operating activities was $641,000 for the three months ended March 31, 2005 as compared to $2.7 million for the three months ended March 31, 2004. Significant items which impacted our operating cash flows as March 31, 2005 were:

• Our operating loss for the quarter of $4.7 million included a $3.5 million one-time non-cash charge related to the sublease and lot sale for a portion of our corporate headquarters in Chanhassen, Minnesota.

• A $1.0 million increase for a 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 use of approximately $600,000 in working capital primarily related to inventory increases related to customer orders.

Net cash used in investing activities was $253,000 for the three months ended March 31, 2005. We used this cash primarily for upgraded computer equipment and leasehold improvements related to our sublease agreement. We are planning for $500,000 of capital expenditures for the remainder of 2005 related primarily to enhancements to our management information systems.

Net cash provided by financing activities was $22,000 for the three months ended March 31, 2005, from stock sold under our employee stock purchase plan. Net cash provided by financing activities was $59,000 for the three months ended March 31, 2004.

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, 2005, for the remainder of 2005 and each of the full years thereafter as follows:

	(in thousands)
	Lease Obligations		Sublease Income			Net Lease Obligations
2005	$	1,502	$	(877	)	$	625
2006	1,900		(1,147		)	753
2007	1,575		(1,130		)	445
2008	1,310		(1,053		)	257
2009	1,306		(1,053		)	253
Thereafter	3,056		(2,457		)	599
	$	10,649	$	(7,717	)	$	2,932

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of financial statements requires us to make estimates and assumptions that affect reported earnings. We evaluate these estimates and assumptions on an on-going basis based on historical experience and on other factors that we believe are reasonable. Estimates and assumptions include, but are not limited to, the areas of customer receivables, inventories, investments, income taxes, self-insurance reserves and commitments and contingencies. We believe that the following represent the areas where we use more critical estimates and assumptions in the preparation of our financial statements:

Revenue Recognition. We realize revenue from the design, installation and support of data storage solutions, which may include hardware, software and services. We recognize revenue when it has met its obligations for installation or other services and collectability is reasonably assured.

Product Sales. We sell software and hardware products on both a “free-standing” basis without any services and as data storage solutions bundled with our installation and configuration services (“bundled arrangements”).

Product Sales Without Service. If we sell a software or hardware product and do not provide any installation or configuration services with it, we recognize the product revenues upon shipment.

Product Sales With Service. If we sell a bundled arrangement, then we defer recognizing any revenues on it until we finish our installation and/or configuration work. 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.

For 2002, we originally applied the provisions of Staff Accounting Bulletin No. 101 to account for our bundled arrangements. In 2003, we changed the accounting guidance we apply based on our determination that the software component of our sales was more than incidental to our products or services as a whole. However, the change did not affect the revenue amounts or the timing of our revenue recognition on bundled arrangements for 2002. This is because, under SAB No. 101, we also recognized revenue on our bundled arrangements only after we completed our installation and configuration services.

Service Sales. In addition to installation and configuration services that are part of our bundled arrangements described above, our service sales include customer support contracts and consulting services. On our balance sheet, deferred revenue relates to service sales for which our customer has paid us or has been invoiced but for which we have not yet performed the applicable services.

Customer Support Contracts. We sell service contracts to most of our customers. These contracts are support service agreements. We have an internal support desk that provides integrated customer support services, including configuration and usage assistance, technical advice and prompt incident detection and resolution. Our technical staff first assists a customer in identifying the source of system problems and in determining whether there is defective hardware or software. If our customer requires on-site maintenance or repair services, we arrange for a service call pursuant to underlying third-party support service agreements we have with our hardware and software vendors.

When we sell a service contract as part of a bundled arrangement, we use vendor specific objective evidence to allocate revenue to the service contract element. In all cases, we defer revenues and direct costs resulting from our service contracts and amortize them into operations over the term of the contracts, which are generally twelve months. We are contractually obligated to provide or arrange to provide these underlying support services to our customers in the unlikely event that the hardware or software vendor, or its designee, fails to perform according to the terms of its contact.

Consulting Services. Some of our customers engage us to analyze their existing storage architectures and offer our recommendations. Other customers engage us to assist them on-site with extended data storage projects, to support their data storage environments and to help with long-term data storage design challenges. For these types of consulting services that do not include the sale of hardware or software products, we recognize revenues as we perform these services.

Gross Reporting of Revenues. We report our revenues from the sale of hardware and software products on a gross, rather than a net, basis. In reporting our revenues on a gross basis, we considered that:

• We are the primary obligor to our customers. We are responsible for fulfillment, including the acceptability of the products and services to our customers.

• We have the risk of loss for inventory and credit.

• We establish the prices for our products and services with our customers.

• We are responsible for the installation and configuration services ordered by our customers.

Commission Expense. We utilize a direct internal sales force to generate virtually all of our revenues. We pay our sales people a combination of base salary and commissions. We pay commissions based on the amount of gross profit generated from the products and services sold. We match commissions to the appropriate transactions and recognize commission expense at the time we recognize the related revenues and gross profit.

Inventory. We periodically review, estimate and adjust our reserves for obsolete or unmarketable inventory equal to the difference between the inventory cost and the estimated market value based upon assumptions about future demand and market conditions. Results could be materially different if demand for our products decreased because of economic or competitive conditions, or the length of our industry downturn, or if products become obsolete because of technical advancements in the industry.

Valuation of Goodwill and Other Intangible Assets. We test goodwill for impairment annually or more frequently if changes in circumstance or the occurrence of events suggests an impairment exists. The test for impairment requires us to make several estimates about fair value, most of which are based on total market capitalization as compared to the carrying value of our net assets. If our total market capitalization is at or below the carrying value of our net assets, it may prompt us to engage a third party valuation firm to perform a valuation of us to further assess whether our goodwill or other intangibles are impaired pursuant to SFAS 142. We consider our goodwill impairment test estimates critical due to the amount of goodwill recorded on our balance sheet and the judgment required in determining fair value amounts.

Other intangible assets consist of customer lists. We amortize customer lists using the straight-line method over an estimated useful life of five years. We review these intangible assets for impairment as changes in circumstance or the occurrence of events suggests the remaining value is not recoverable.

Income Taxes. We utilize the asset and liability method of accounting for income taxes. We recognize deferred tax liabilities or assets for the expected future tax consequences of temporary differences between the book and tax bases of assets and liabilities. We regularly assess the likelihood that our deferred tax assets will be recovered from future taxable income. We record a valuation allowance to reduce our deferred tax assets to the amounts we believe to be realizable. We consider projected future taxable income and ongoing tax planning strategies in assessing the amount of the valuation allowance. If we determine it is more likely than not that we will not realize all or part of our deferred tax assets, we will adjust our earnings for the increase in the deferred tax valuation allowance in the period we make this determination.

As a result of our cumulative losses and the full utilization of our loss carry back potential, we concluded during the fourth quarter of fiscal 2002 to record a full valuation allowance against our net deferred tax assets. The valuation allowance at March 31, 2005 was $6.3 million. In addition, we expect to provide a full valuation allowance on any future tax benefits until we can sustain a level of profitability that demonstrates our ability to realize these assets.

RECENTLY ISSUED ACCOUNTING STANDARDS

In December 2004, the FASB issued SFAS No. 123R, Share-Based Payment. This statement revises SFAS No. 123, Accounting for Stock-Based Compensation, and requires companies to expense the value of employee stock options and similar awards using the fair value method. The effective date of this standard is for annual periods beginning after June 30, 2005. Although management has not fully analyzed the effect this new statement will have on our consolidated financial statements in the future, the pro forma net income effect of using the fair value method for the past three fiscal years as well as further information on this new statement is presented in Note 2 to our consolidated financial statements on Form 10-K.

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 that these are exposed to 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, 2005, we had $11.8 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. Disclosure Controls and Procedures.

As of the end of the period covered by this report, we conducted an evaluation, under the supervision and with the participation of the principal executive officer and the principal financial officer, 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”)). Based on this evaluation, the principal executive officer and the principal financial officer concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. 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.

Dated: May 13, 2005	Datalink Corporation


	By:	/s/ Daniel J. Kinsella
	Daniel J. Kinsella, Vice President Finance and
	Chief Financial Officer