You should read the following discussion in conjunction with our financial statements and the related notes included in Item 8. The following information includes forward-looking statements, the realization of which may be affected by certain important factors discussed under "Risk Factors."

OVERVIEW

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 more than six times its current quantity, or 988 billion gigabytes, by 2010. As of December 31, 2008, we have 19 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 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. 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.

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, 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 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:

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º Investing in customer-facing teams to acquire top tier sales and technical talent which we believe will increase our market share in key locations.

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º Deepening our presence in existing enterprise accounts and penetrating new enterprise accounts.

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º Targeting high growth market segments and deploying new technologies which focus on cost savings technologies for our customers.

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º Reducing our cost structure and realigning resources to improve efficiencies.

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º Expanding our customer support capabilities and tools-based professional services offerings that we believe will provide more value to our customers.

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º Exploring potential acquisitions that we believe can strengthen our resources and capabilities in key geographic locations.

To pursue these strategies, we are:

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º Improving our training, tools and recruiting efforts for sales and technical teams to increase productivity.

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º Focusing on corporate expense reductions.

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º Driving high levels of efficiency by streamlining our supply chain and expanding our professional services tools.

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º Meeting with potential acquisition candidates.

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

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º The worldwide economic downturn may adversely affect our customers' buying patterns.

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

In January 2007, we entered into an agreement and plan of merger with Midrange Computer Systems Inc. (MCSI), a storage consulting, solutions and service provider based in Chicago, Illinois. We believe the acquisition has strengthened our presence in existing regional markets and expanded our reach into a number of key new regional markets. We paid a purchase price of approximately $14.3 million for MCSI, consisting of $5.0 million cash and 1,163,384 shares of our common stock. Our results of operations for 2007 reflect the addition of MCSI for eleven months.

Results of Operations

We ended 2008 with a record backlog of $33.0 million, which represents firm orders expected to be recognized as revenue in the next 90 days. However, 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.

Our sales for 2008 increased $17.8 million or 10.0% to $195.6 million for 2008 as compared to 2007. Our gross margin increased $7.4 million or 16.2% to $52.7 million for 2008 as compared to 2007. Our earnings from operations increased $3.9 million from $1.2 million in 2007 to $5.1 million in 2008. The following table shows, for the periods indicated, certain selected financial data expressed as a percentage of net sales.

                                                Years Ended December 31,
                                               2008         2007      2006
             Net sales                           100.0 %     100.0 %   100.0 %
             Cost of sales                        73.1        74.5      73.9

             Gross profit                         26.9        25.5      26.1

             Operating expenses:
               Sales and marketing                11.9        12.4      10.9
               General and administrative          6.1         6.6       7.2
               Engineering                         5.9         5.2       4.2
               Integration costs                     -         0.2         -
               Amortization of intangibles         0.4         0.4         -

             Total operating expenses             24.3        24.8      22.3

             Operating earnings                    2.6 %       0.7 %     3.8 %

Comparison of Years Ended December 31, 2008, 2007 and 2006

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

                                                 Years Ended December 31,
                                               2008        2007        2006
         Product sales                       $ 113,493   $ 111,201   $ 102,400
         Service sales                          82,104      66,571      43,583
         Product gross profit                $  28,513   $  26,832   $  25,035
         Service gross profit                   24,138      18,460      13,062
         Product gross profit as a                25.1 %      24.1 %      24.4 %
         percentage of product sales
         Service gross profit as a                29.4 %      27.7 %      30.0 %
         percentage of service sales

Net Sales. Our product sales increased 2.1% in 2008 from 2007 to $113.5 million, and increased 8.6% in 2007 from 2006 to $111.2 million. Our service sales, which includes customer support, consulting and installation services, increased 23.3% in 2008 from 2007 to $82.1 million, and increased 52.7% in 2007 from 2006 to $66.6 million.

The modest increase in our product sales in 2008 as compared to 2007 is primarily from the successful integration of MCSI and increased storage spending in the marketplace. In addition, our product revenues 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. The increase in our product sales in 2007 as compared to 2006 is primarily due to the acquisition of MCSI in January 2007. Product sales growth decreased from 25.5% in 2006 to 8.6% in 2007 and 2.1% in 2008 continuing to reflect what we believe to be a slow down in IT and storage spending with some of our larger customers, as they have become more cautious about the economy and their individual growth prospects. This has created longer sales cycles with a number of large project delays. We believe that this spending slow down among our customers will continue in 2009.

The increase in our service revenues for 2008 over 2007 and 2007 over 2006 reflects an increase in our customer support contract revenues and installation and configuration service revenues. For 2008, customer support contract revenues increased $14.7 million or 26.1% over 2007 and installation and configuration service revenues increased $1.1 million or 15.8%. For 2007 customer support contract revenues increased $21.4 million or 61.7% over 2006 and installation and configuration service revenues increased $1.3 million or 82.3%. For 2008, the slow down in the growth of our customer support and installation and configuration services is due to both the acquisition of MCSI in 2007 and the slow down in the growth of our product revenues. We expect to see flat to declining customer support and installation and configuration services in 2009 as spending on product declines due to current economic conditions. The majority of our increase in customer support contract revenues in 2007 was due to the acquisition of MCSI.

We derived approximately 13.9% of our sales from our customer, AT&T Inc., during 2006. We do not expect that this customer will account for a substantial portion of our future sales. We had no customers that comprised more than 10% of our sales in 2008 or 2007.

Gross Profit. Our total gross profit as a percentage of net sales was 26.9% in 2008 increasing from 25.5% in 2007 and 26.1% in 2006.

Product gross profit as a percentage of product sales increased to 25.1% in 2008 as compared to 2007 and decreased to 24.1% in 2007 as compared to 24.4% in 2006. 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 as a percentage of product sales increased for 2008 over 2007 due to the continuing efforts by our sales force to sell higher margin storage solutions. This included the increased percentage of our product sales coming from disk sales which have historically experienced higher margins. With the current economic downturn, we expect a decline in the number and profitability of disk sales. Our product gross profit as a percentage of product sales decreased for 2007 over 2006 due to the additional MCSI revenues which historically had lower product margins. Our efforts to successfully integrate the MCSI sales force, by leveraging product and service offerings across our vendors, has gradually improved the gross margins realized by the MCSI sales force. We have various programs in place with our vendors that provide economic incentives for achieving various sales performance targets. Achieving these targets contributed favorably to our product gross profit by $1.5 million, $2.0 million and $1.5 million in 2008, 2007 and 2006, respectively. These vendor incentive programs constantly change and we negotiate them separately with each vendor. While we expect the incentive programs to continue, the vendors could modify or discontinue them, particularly in light of current economic conditions, which would unfavorably impact our product gross profit margins. We estimate that our product gross margins will be approximately 24% to 25% going forward.

Service gross profit as a percentage of service sales was 29.4% in 2008 as compared to 27.7% in 2007 and 30.0% in 2006. In 2008, we had $509,000 less in MCSI acquisition purchase accounting adjustments that required us to reduce revenues and corresponding margins to reflect the fair value of acquired maintenance contracts. Accordingly, for 2008, our gross profit percentage of service sales returned to our historical range of between 29% and 30%. The percentage decrease in 2007 as compared to 2006 is primarily due to a $664,000 reduction in revenues and corresponding margins for the MCSI acquisition to reflect the fair value of maintenance contracts we acquired.

Sales and Marketing. Sales and marketing expenses include wages and commissions paid to sales and marketing personnel, travel costs and advertising, promotion and hiring expenses. Sales and marketing expenses totaled $23.4 million, or 11.9% of net sales for 2008 as compared to $22.1 million, or 12.4% of net sales for 2007 and $16.0 million, or 10.9% of net sales for 2006. The increase in sales and marketing expense in absolute dollars for 2008 over 2007 is primarily a result of higher commission expense of $1.3 million which is due to our increase in revenues for the year. The increase in sales and marketing expense in absolute dollars for 2007 over 2006 is primarily a result of higher commission expense of $1.6 million and compensation expense of $3.7 million. The increase in commission expense is due to our increase in revenues for the year. The increase in compensation expense is due to our acquisition of MCSI which increased our sales and marketing headcount by approximately 45%. The decrease in sales and marketing expense as a percentage of net sales from 2008 to 2006 reflects better leverage of our fixed costs as revenues increased in 2008. The increase in sales and marketing expense as a percentage of net sales from 2007 to 2006 reflects primarily the increase in sales and marketing headcount as a result of our MCSI acquisition, and investments in sales management. As we continue to selectively hire additional outside sales representatives, our sales and marketing expenses may increase without a commensurate increase in sales. We are carefully monitoring our travel and other sales and marketing expenses in light of current economic conditions.

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 increased to $11.9 million, or 6.1% of net sales for 2008 compared to $11.7 million, or 6.6% of net sales for 2007 and $10.4 million, or 7.2% in 2006. The modest increase in general and administrative expense in absolute dollars for 2008 as compared to 2007 is primarily due to an increase in variable compensation expense of $300,000 related to exceeding 2008 performance objectives. The increase in general and administrative expenses in absolute dollars for 2007 as compared to 2006 is primarily due to an increase in facility expenses of $496,000 with the acquisition of MCSI in January 2007, an increase in audit fees and outside consulting fees for Sarbanes-Oxley compliance of $213,000, an increase in compensation expense of $200,000 and an

increase in depreciation expense of $120,000. Our general and administrative expenses were lower as a percentage of net sales for 2008 as compared to 2007, and 2007 as compared to 2006, primarily due to more controlled spending coupled with an increase in revenues.

Engineering. Engineering expenses include employee wages and travel, hiring and training expenses for our field and customer support engineers and technicians. We allocate engineering costs associated with installation and configuration services and with consulting services to our cost of service sales. Therefore, if we incur a slowdown in product sales during 2009 because of current economic conditions, we will have higher engineering expenses. Engineering expenses increased to $11.6 million, or 5.9% of net sales in 2008 compared to $9.2 million, or 5.2% of net sales in 2007 and $6.1 million, or 4.2% of net sales in 2006. The increase in engineering expenses in absolute dollars for 2008 over 2007 is due primarily to an increase in compensation expense of $1.6 million for additional regional and customer support resources and an increase in variable compensation expense of $751,000 related to exceeding 2008 performance objectives. The increase in engineering expenses in absolute dollars for 2007 over 2006 is due primarily to an increase in compensation expense of $3.6 million related to our MCSI acquisition. The MCSI acquisition increased our engineering headcount approximately 26%. The increase in engineering expenses as a percentage of sales for 2008 as compared to 2007 and 2007 as compared to 2006 is primarily the result of investments in regional engineering support, regional management and customer support resources.

Integration Costs. We had integration expenses of $442,000 in 2007 related to the January 31, 2007 acquisition of MCSI. Integration expenses include salaries and benefits of MCSI employees who assisted with the initial integration but whom we ultimately did not retain, together with retention bonuses and severance payments.

Intangible Amortization. We had expenses related to the amortization of finite-lived intangible assets of $711,000, $727,000 and $0 in 2008, 2007 and 2006, respectively. Amortization of intangible assets decreased to $711,000 in 2008 from $727,000 in 2007 due to the amortization of backlog which was completed in 2007. Amortization of intangible assets increased to $727,000 in 2007 from $0 in 2006. The increase in finite-lived intangible assets and subsequent amortization is due to our acquisition of MCSI on January 31, 2007. The finite lived intangibles we acquired, consisting of customer relationships and backlog, have estimated lives of six years and two months, respectively, and we are amortizing them using the straight line method. For 2008, 2007 and 2006, we determined that our goodwill was not impaired.

In accordance with SFAS No. 142, Goodwill and Other Intangible Assets (SFAS 142), we are required to assess the carrying amount of our finite life intangibles and goodwill for potential impairment annually or more frequently if events or a change in circumstances indicate that impairment may have occurred.

The assessment to determine if a potential impairment of goodwill exists involves comparing our market capitalization to the carrying value of our net assets. 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 fiscal 2008 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 $2.34 during the fourth quarter of fiscal 2008, remained below $3.00 per share for an extended period of time during the fourth quarter of 2008 and closed at $3.20 on December 31, 2008. 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 December 31, 2008 our market capitalization was approximately $41.4 million as compared to our stockholders' equity at December 31, 2008 of $42.5 million.

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 long-lived assets on an annual basis or whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable. Impairment is recognized based on the difference between the fair value of the asset and its carrying value, and fair value is generally measured based on discounted cash flow analyses. For 2008, 2007 and 2006, we determined that our long-lived assets were not impaired.

Operating Earnings. We realized operating earnings of $5.1 million in 2008, $1.2 million in 2007 and $5.6 million in 2006. The increase in our operating earnings in 2008 as compared to 2007 is a result of higher revenues and gross margins partially offset by higher operating expenses. The decrease in our operating earnings in 2007 as compared to 2006 is due to our lower gross margin and increased operating expenses in 2007 primarily as a result of our acquisition of MCSI.

Income Taxes. We had income tax expense of $2.2 million in 2008 which resulted in our estimated effective tax rate of 40%. We had income tax expense of $864,000 in 2007 which resulted in our estimated effective tax rate of 42%. We had an income tax benefit of $2.2 million in 2006. Prior to fiscal 2006, we recorded a full valuation allowance against our deferred tax assets due to the uncertainty of the realization and timing of the benefits from those deferred tax assets as we had not achieved a sufficient level of sustained profitability. During 2006, we utilized approximately $4.8 million of our net operating loss carryforwards. Furthermore, we concluded that we had attained a sufficient level of sustained profitability to reverse the remaining $2.8 million valuation allowance. We utilized approximately $1.9 million and $4.8 million of our federal net operating loss carryforwards in 2007 and 2006, respectively. As of December 31, 2007, we fully utilized our federal net operating loss carryforwards. As of December 31, 2008 we have state net operating loss carryforwards of approximately $843,000, which are available to offset future state taxable income. If not used, these state net operating loss carryforwards will expire between 2013 and 2024. For 2008, 2007 and 2006, respectively, we recorded approximately $2,000, $104,000 and $392,000 to equity for tax benefits associated with the exercise of stock options. In future periods of taxable earnings, we expect to report an income tax provision using an effective tax rate of approximately 40%.

Quarterly Results and Seasonality

    The following table sets forth our unaudited quarterly financial data for
each quarter of 2008 and 2007. We have prepared this unaudited information on
the same basis as the audited information. In our opinion, we have made all
adjustments (including all normal recurring adjustments) necessary to present
fairly the information set forth below. The operating results for any quarter
are not necessarily indicative of results for any future period.

                                                        Quarters Ended
                                       2008                                        2007
                     Mar. 31    Jun. 30    Sep. 30    Dec. 31    Mar. 31    Jun. 30    Sep. 30    Dec. 31
                                                        (in thousands)
Net sales            $ 47,725   $ 49,707   $ 49,980   $ 48,185   $ 40,911   $ 40,338   $ 45,848   $ 50,675
Gross profit           13,006     13,332     13,757     12,556      9,874     10,147     11,857     13,414
Operating earnings        660      1,524      1,709      1,187     (1,450 )     (763 )    1,125      2,243
(loss)
Net earnings              505        979      1,068        843       (719 )     (346 )      844      1,420
(loss)

We have experienced, and expect to continue to experience, quarterly variations in our net sales as a result of a number of factors, including the length of the sales cycle with customers for large storage system evaluations and purchases, delays in storage system installations or configurations, new product introductions by suppliers and their market acceptance, delays in product shipments or other quality control difficulties, trends in the enterprise-class information storage industry in general or the geographic and industry specific markets in which we are currently active, or may be in the future. In addition, current economic conditions and competition also affect our customers' decisions to place or delay orders with us, and the size and scale of their orders. Further, our success in integrating any acquired business or in opening any new field offices could impact our operating results.