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 988 billion gigabytes, by 2010. As of March 31, 2009, we have 18 locations throughout the United States. We historically have derived our greatest percentage of net sales from customers located in the central part of the United States.

We sell support service contracts to most of our customers. When customers purchase support services through us, customers receive the benefit of integrated system wide support. We have a qualified, independent support desk that takes calls from customers, diagnoses the issues they are facing and either solves the problem or coordinates with Datalink and/or vendor technical staff to meet the 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.

The enterprise-class information storage market is rapidly evolving and highly competitive. Our competition includes other independent storage system integrators, high end value added resellers, distributors, consultants and the internal sales force of our suppliers. Our ability to hire and retain qualified outside sales representatives and engineers with enterprise-class information storage experience is critical to effectively competing in the marketplace and achieving our growth strategies.

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

We view the current data storage market as providing significant opportunity for growth. Currently, 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:

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

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

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

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

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

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

To pursue these strategies, we are:

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

†          Focusing on corporate expense reductions.

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

†          Meeting with potential acquisition candidates.

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

† The worldwide economic downturn adversely affects our customers' buying patterns.

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

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

RESULTS OF OPERATIONS

We ended the first quarter of 2009 with a backlog of $29 million, which represents firm orders we expect to recognize as revenue in future periods. This compares to a backlog of $33 million as of December 31, 2008. In the current environment, we are seeing the negative impact of the worldwide economic downturn affect many of our customers, resulting in greater scrutiny given to storage spending projects and providing us with less visibility into their purchasing plans. We have also had some customers decide to significantly delay the implementation of projects for which they have already purchased and paid for the product. We cannot predict what impact these economic uncertainties will have on our profitability going forward.

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

                                   Three Months Ended
                                        March 31,
                                    2009         2008
Net sales                            100.0 %      100.0 %
Cost of sales                         73.5         72.7
Gross profit                          26.5         27.3
Operating expenses:
Sales and marketing                   13.8         12.2
General and administrative             7.3          6.6
Engineering                            7.1          6.6
Amortization of intangibles            0.4          0.4
Total operating expenses              28.6         25.8
Earnings (loss) from operations       (2.1 )%       1.5 %

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

                                                          Three Months Ended
                                                              March 31,
                                                           2009         2008
                                                            (in thousands)
Product sales                                           $    19,252   $ 28,526
Service sales                                                20,616     19,199

Product gross profit                                    $     4,852   $  7,459
Service gross profit                                          5,721      5,547

Product gross profit as a percentage of product sales          25.2 %     26.1 %
Service gross profit as a percentage of service sales          27.7 %     28.9 %

Net Sales. Our total net sales decreased by $7.9 million for the three months ended March 31, 2009, or 16.4%, from $47.7 million for the comparable quarter in 2008. Our product sales decreased $9.3 million, or 32.5%, to $19.3 million for the three months ended March 31, 2009, from $28.5 million for the comparable quarter in 2008. Our service sales increased $1.4 million, or 7.3%, to $20.6 million for the three months ended March 31, 2009 from $19.2 million for the comparable quarter in 2008.

The decline in our product revenues for the first quarter of 2009, as compared to the same period in 2008 reflects the continuing negative impact of the economic slowdown that many of our customers are experiencing. We expect our product revenues will continue to reflect our customers' closer scrutiny of expenditures as they focus more attention on the actual or anticipated impact that current economic conditions may have on the growth and profitability of their business. Our bookings activity for the first quarter of 2009 was very slow during January and February and then increased the last two weeks of March and into April.

Our service sales increase for the first quarter of 2009 as compared to the same period in 2008 was due primarily to an increase in customer support contracts of $1.2 million. In addition, our installation and configuration service sales increased $196,000 between the same periods. We continue to benefit from sales of customer support contracts related to 2008 product sales, which are recognized over the contract term. With the decrease in product revenues in late 2008 and into 2009, we cannot assure that our future service sales will not similarly decline.

We had no single customer account for 10% or greater of our revenues for either of the three months ended March 31, 2009 or 2008.

Gross Profit. Our total gross profit as a percentage of net sales decreased to 26.5% for the quarter ended March 31, 2009, as compared to 27.2% for the comparable quarter in 2008. Product gross profit as a percentage of product sales decreased to 25.2% in the first quarter of 2009 from 26.1% for the comparable quarter in 2008. Service gross profit as a percentage of service sales decreased to 27.7% for the first quarter of 2009 from 28.8% for the comparable quarter in 2008.

Our product gross profit as a percentage of product sales is impacted by the mix and type of projects we complete for our customers. Our product gross profit is also impacted by various vendor incentive programs that provide economic incentives for achieving various sales performance targets. We had lower product purchases during the first quarter of 2009 as compared to the same period in 2008 and this qualified us for fewer vendor incentives. Vendor incentives were $592,000 and $837,000, respectively, for the three month periods ended March 31, 2009 and 2008. With the current economic downturn, we may continue to see a decline in the number and profitability of disk sales. Our vendors may also change or terminate these programs at any time, and, accordingly, we cannot assure that we will achieve and receive similar vendor incentives in the future. We estimate that our product gross margins in the foreseeable future will be approximately 24% to 25%.

Our service gross profit as a percentage of service sales for the three months ended March 31, 2009 decreased 0.9% as compared to the same period in 2008. Our vendors provided a larger portion of our installation and configuration services for the 2009 quarter, which typically results in lower gross margins.

Sales and Marketing. Sales and marketing expenses include wages and commission paid to sales and marketing personnel, travel costs and advertising, promotion and hiring expenses. Sales and marketing expenses totaled $5.5 million, or 13.7% of net sales for the quarter ended March 31, 2009, compared to $5.8 million, or 12.2% of net sales for the first quarter in 2008.

Sales and marketing expenses decreased $336,000 for the three month periods ended March 31, 2009, as compared to the same period in 2008. With our decline in overall revenue, we had a decrease in variable compensation for commissions.

General and Administrative. General and administrative expenses include wages for administrative personnel, professional fees, depreciation, communication expenses and rent and related facility expenses. General and administrative expenses were $2.9 million, or 7.3% of net sales for the quarter ended March 31, 2009, compared to $3.2 million, or 6.6% of net sales for the first quarter in 2008.

General and administrative expenses decreased $243,000 for the three months ended March 31, 2009, as compared to the same period in 2008. We attribute this primarily to the cancellation of our annual sales meeting resulting in savings of $205,000 and a decrease in training expenses of $55,000.

Engineering. Engineering expenses include employee wages, bonuses and travel, hiring and training expenses for our field and customer support engineers and technicians. Engineering expenses were $2.8 million, or 7.1% of net sales for the quarter ended March 31, 2009, compared to $3.2 million, or 6.6% of net sales for the first quarter in 2008.

Engineering expenses decreased $338,000 for the three months ended March 31, 2009 as compared to the same period in 2008. This is primarily due to a decrease in variable compensation for bonuses of $114,000 and outside consulting expenses of $226,000.

Amortization of Intangibles. We had $178,000 of intangible asset amortization expenses for each of the three month periods ended March 31, 2009 and 2008. The identifiable intangible asset and subsequent amortization is due to our acquisition of MCSI on January 31, 2007.

Earnings (Loss) from Operations. We had a loss from operations of $856,000 for the three months ended March 31, 2009 and earnings from operations of $660,000 for the three months ended March 31, 2008. The 2009 loss from operations is a result of a decrease in our revenues and margins due to the current economic downturn. The 2008 earnings from operations is a result of higher revenues and margins with a limited increase in operating expenses.

Income Taxes. We had income tax benefit of $221,000 for the three months ended March 31, 2009 and income tax expense of $353,000 for the three months ended March 31, 2008. Our estimated effective tax rate for the first quarter of 2009 is 27%. Our estimated effective tax rate for 2008 was 41%. In future periods of taxable earnings, we expect to report an income tax provision using an effective tax rate of approximately 44%.

LIQUIDITY AND CAPITAL RESOURCES

Net cash provided by operating activities was $1.5 million for the three months ended March 31, 2009 as compared to $1.4 million for the three months ended March 31, 2008. Significant items which impacted our operating cash flows as of March 31, 2009 were:

† A net loss of $596,000.

† A net increase in cash of approximately $2.0 million for accounts receivable and accounts payable. This was primarily due to the collection of customer support contracts. While we amortize the revenues from these contracts over the life of the contract, the customer typically pays for the contracts at the beginning of the contract period which favorably impacts our cash flows.

Net cash used in investing activities was $5,000 for the three months ended March 31, 2009. We used this cash for minimal computer equipment purchases. Net cash provided by investing activities was $2.4 million for the three months ended March 31, 2008. This cash was primarily provided by the sale of a short-term investment. We are planning for $200,000 of capital expenditures for the remainder of 2009 related primarily to computer and communication system upgrades or other management information system enhancements.

Net cash used in financing activities was $63,000 for the three months ended March 31, 2009, from tax withholding payments reimbursed by restricted stock and a tax adjustment for stock based compensation. Net cash used in financing activities was $21,000 for the three months ended March 31, 2008, from tax withholding payments reimbursed by restricted stock.

We have elected not to pursue a credit facility at this time. With our current cash position, we believe we have the liquidity to meet our operating needs for the foreseeable future. We have no outstanding debt, and if the need should arise to borrow funds, we believe that we could obtain a secured facility.

Our contractual cash obligations consist of future minimum lease payments due under non-cancelable operating leases. These obligations are as of March 31, 2009, for the remainder of 2009 and each of the full years thereafter as follows:

                            (in thousands)
                 Lease         Sublease       Net Lease
              Obligations     Agreements     Obligations
2009         $       1,507   $       (576 ) $         931
2010                 1,674           (752 )           922
2011                 1,596           (719 )           877
2012                   592           (239 )           353
Thereafter               -              -               -
             $       5,369   $     (2,286 ) $       3,083

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

The preparation of financial statements requires us to make estimates and assumptions that affect reported earnings. We evaluate these estimates and assumptions on an on-going basis based on historical experience and on other factors that we believe are reasonable. Estimates and assumptions include, but are not limited to, the areas of customer receivables, establishment of vendor specific objective evidence of fair value for customer contracts with multiple elements, inventories, income taxes, self-insurance reserves and commitments and contingencies.

Our significant accounting policies and estimates are summarized in our annual financial statements. Some of our accounting policies require management to exercise significant judgment in selecting the appropriate assumptions for calculating financial estimates. Such judgments are subject to an inherent degree of uncertainty. These judgments are based on our historical experience, known trends in our industry, terms of existing contracts and other information from outside sources, as appropriate. We believe these estimates and assumptions are reasonable based on the facts and circumstances as of March 31, 2009. However, actual results may differ from these estimates under different assumptions and circumstances.

We believe that the following represent the areas where we use more critical estimates and assumptions in the preparation of our financial statements:

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

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

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

Product Sales With Service. If we sell a bundled arrangement, then we defer recognizing any revenues on it until we finish our installation and/or configuration work. We account for the hardware, software and service elements of our bundled arrangements by applying the provisions of Statement of Position (SOP) 97-2, Software Revenue Recognition, as amended by SOP 98-4 and SOP 98-9.

Pursuant to the provisions of SOP 97-2, we apply contract accounting to our bundled arrangements. In accordance with SOP 81-1, "Accounting for Performance of Construction Type and Certain Production Type Contracts," we apply the completed contract method. Factors we have considered in applying the completed contract method accounting include (i) the relatively short duration of our contracts, (ii) the difficulty of estimating our revenues on a percentage-of-completion method and (iii) our use of acceptance provisions on larger bundled arrangements.

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

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

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

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

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

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

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

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

†          We are responsible for the installation and configuration services

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

Valuation of Goodwill. We test goodwill for impairment annually or more frequently if changes in circumstance or the occurrence of events suggests an impairment exists. Testing for goodwill impairment is a two step process. The first step screens for potential impairment and if there is an indication of possible impairment we must complete the second step to measure the amount of impairment loss, if any. The first step of the goodwill impairment test, used to identify potential impairment, compares the fair value of our market capitalization with the carrying value of our net assets. If our total market capitalization is at or below the carrying value of our net assets, we perform the second step of the goodwill impairment test to measure the amount of impairment loss we record, if any. With the worldwide decline in stock prices, the potential for this is increased. We consider goodwill impairment test estimates critical due to the amount of goodwill recorded on our balance sheet and the judgment required in determining fair value amounts.

Valuation of Long-Lived Assets, Including Finite-Lived Intangibles. We evaluate long-lived assets and intangible assets with finite lives for impairment, as well as the related amortization periods, to determine whether adjustments to these amounts or useful lives are required based on current events and circumstances. We base the evaluation on our projection of the undiscounted future operating cash flows of the underlying assets. The downturn in the U.S. economy makes it increasingly difficult for us to accurately predict our future cash flows. To the extent our projections indicate that future undiscounted cash flows are not sufficient to recover the carrying amounts of related assets, we record a charge to reduce the carrying amount to its estimated fair value. The test for impairment requires us to make several estimates about fair value, most of which are based on projected future cash flows. We consider the estimates associated with the asset impairment tests critical due to the judgments required in determining fair value amounts, including projected future cash flows. Changes in these estimates may result in the recognition of an impairment loss.

Stock-Based Compensation. We adopted the provisions of FASB No. 123R, Share Based Payment on January 1, 2006. SFAS 123(R) requires us to measure and recognize in our statements of operations the expense associated with all share-based payment awards made to employees and directors based on estimated fair values. SFAS 123(R) requires the use of an option pricing model to determine the fair value of share-based payment awards. Our stock price, as well as assumptions regarding a number of highly complex and subjective variables, will affect our determination of fair value. We base recognition of compensation expense for our

performance-based, non-vested shares on management's estimate of the probable outcome of the performance condition. Management reassesses the probability of meeting these performance conditions on a quarterly basis. Changes in management's estimate of meeting these performance conditions may result in significant fluctuations in compensation expense from period to period.