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DTLK > SEC Filings for DTLK > Form 10-Q on 9-Nov-2012All Recent SEC Filings

Show all filings for DATALINK CORP

Form 10-Q for DATALINK CORP


9-Nov-2012

Quarterly Report


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

NOTE REGARDING FORWARD-LOOKING STATEMENTS

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

OVERVIEW

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

Our solutions can include hardware products, such as servers, disk arrays, tape systems, networking and interconnection components and software products. Our data center strategy is supported through multiple trends in the market and involves supporting the market and our customers with a single vendor to provide their data center infrastructure needs. As of September 30, 2012, we have 30 locations, including both leased facilities and home offices, throughout the United States. We historically have derived our greatest percentage of net sales from customers located in the central part of the United States.

We sell support service contracts to most of our customers. In about half of the support service contracts that we sell, our customers purchase support services through us, resulting in customers receiving the benefit of integrated system wide support. We have a qualified, independent support desk that takes calls from customers, diagnoses the issues they are facing and either solves the problem or coordinates with our and/or vendor technical staff to meet the customer's needs. Our support service agreements with our customers include an underlying agreement with the product manufacturer. The manufacturer provides on-site support assistance if


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necessary. The other half of the support service contracts that we sell to our customers are direct with the product manufacturers. For all support service contracts we sell, we defer revenues and direct costs resulting from these contracts, and amortize these revenues and expenses into operations, over the term of the contracts, which are generally twelve months.

The data center infrastructure solutions and services market is rapidly evolving and highly competitive. Our competition includes other independent storage, server and networking system integrators, high end value-added resellers, distributors, consultants and the internal sales force of our suppliers. Our ability to hire and retain qualified outside sales representatives and engineers with enterprise-class information storage, server and networking experience is critical to effectively 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 center infrastructure solutions before customers deploy them, the size of customer orders, the complexity of our customers' network environments, necessary system configuration to deploy our solutions and new product introductions by suppliers. Current economic conditions and competition also affect our customers' decisions and timing to place orders with us and the size of those orders. As a result, our net sales may fluctuate from quarter to quarter.

RESULTS OF OPERATIONS



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



                                      Three Months Ended      Nine Months Ended
                                        September 30,           September 30,
                                      2012         2011        2012        2011
Net sales                               100.0 %      100.0 %    100.0 %     100.0 %
Cost of sales                            77.1         76.4       76.9        76.0
Gross profit                             22.9         23.6       23.1        24.0
Operating expenses:
Sales and marketing                       9.6          9.7       10.1        10.3
General and administrative                4.0          4.2        3.9         4.3
Engineering                               5.5          4.3        4.9         4.6
Other income                                -         (0.6 )        -        (0.2 )
Integration and transaction costs         0.1          0.2          -           -
Amortization of intangibles               0.6          0.4        0.6         0.4
Total operating expenses                 19.8         18.2       19.5        19.4
Earnings from operations                  3.1 %        5.4 %      3.6 %       4.6 %

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

                                           Three Months Ended         Nine Months Ended
                                             September 30,              September 30,
                                           2012          2011         2012         2011
                                                          (in thousands)
Product sales                           $    64,052    $  55,671    $ 221,586    $ 167,811
Service sales                                40,722       34,469      122,318       97,504

Product gross profit                    $    14,257    $  12,708    $  49,402    $  39,655
Service gross profit                          9,755        8,532       29,969       24,019

Product gross profit as a percentage
of product sales                               22.3 %       22.8 %       22.3 %       23.6 %
Service gross profit as a percentage
of service sales                               24.0 %       24.8 %       24.5 %       24.6 %

Our product sales continue to reflect a diversification in the mix of our offerings. For the three and nine months ended September 30, 2012, product sales represented 61.1% and 64.4%, respectively, of our total sales compared to 61.8% and 63.2%, respectively, for the comparable periods in 2011. The increase in our product sales reflects the impact of our acquisition of Midwave Corporation in October 2011 ("Midwave acquisition") and the increase in product offerings due to our transition to servicing the complete data center. In addition to storage, our server and network sales have increased as part of our strategy to deliver data center hardware, software and services. Going forward, we expect our customers will continue to closely scrutinize their expenditures and what impact,


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if any, current economic conditions may have on the growth and profitability of their business. We cannot assure that changes in customer spending or economic conditions will positively impact our future product sales.

Our service sales increased for the three and nine months ended September 30, 2012, as compared to the same periods in 2011. With the impact of the Midwave acquisition and growth in our product sales, we continue to successfully sell our installation and configuration services and customer support contracts. Without continued sustainable growth in our product sales going forward, we expect our customer support contracts sales may suffer and we cannot assure that our future customer support contract sales will not decline.

We had no single customer account for 10% or greater of our sales for the three and nine months ended September 30, 2012 or 2011.

Gross Profit. Our total gross profit as a percentage of net sales decreased to 22.9% for the quarter ended September 30, 2012, as compared to 23.6% for the comparable quarter in 2011. Our total gross profit as a percentage of net sales decreased to 23.1% for the nine months ended September 30, 2012, as compared to 24.0% for the comparable period in 2011. Product gross profit as a percentage of product sales decreased to 22.3% in the third quarter of 2012 from 22.8% for the comparable quarter in 2011. Product gross profit as a percentage of product sales decreased to 22.3% for the nine months ended September 30, 2012 from 23.6% for the same period in 2011. Service gross profit as a percentage of service sales decreased to 24.0% for the third quarter of 2012 from 24.8% for the comparable quarter in 2011. Service gross profit as a percentage of service sales decreased slightly to 24.5% for the nine months ended September 30, 2012 from 24.6% for the same period in 2011.

Our product gross profit as a percentage of product sales is impacted by the mix and type of projects we complete for our customers. Product gross profit as a percentage of product sales for the three and nine months ended September 30, 2012 decreased 0.5% and 1.3%, respectively, as compared to the same periods in 2011. We have experienced a decrease in our product gross profit percentage as we saw an increase in our networking and server business, which historically has carried lower gross margins. The product gross margin percentages we achieved in the third quarter 2012 fall within the range of product gross margin percentages we expect as our strategy continues to mature. Our product gross profit is also impacted by various vendor incentive programs that provide economic incentives for achieving various sales performance targets. Vendor incentives were $1.6 million and $1.4 million, respectively, for the three month periods ended September 30, 2012 and 2011. Vendor incentives were $5.3 million and $4.1 million, respectively, for the nine month periods ended September 30, 2012 and 2011. As a percentage of product cost of goods sold, vendor incentives were 3.2% for the both three months ended September 30, 2012 and 2011, and 3.1% and 3.2% for the nine months ended September 30, 2012 and 2011, respectively. Several of our vendors have tightened eligibility for their programs in the current economic climate and may further change or terminate their programs at any time. Accordingly, we cannot assure that we will achieve and receive similar vendor incentives in the future. Taking into consideration our acquisition of Strategic Technologies, Inc. ("StraTech"), we expect that as we continue implementing our strategy to sell comprehensive data center solutions with servers and networking products that our product gross margins for the remainder of 2012 will be between 21% and 23%.

Service gross profit as a percentage of service sales for the three and nine months ended September 30, 2012 decreased 0.8% and 0.1%, respectively, as compared to the same periods in 2011. This decrease is primarily due to a reduction in the gross margin percentage for our customer support contracts due to an increase in the sales of products on which we are not able to sell first call support and Datalink professional services, which carry lower gross margins. Taking into consideration our acquisition of StraTech, we expect that service gross margins will be within the 23% to 25% range for the remainder of fiscal year 2012.

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 $10.1 million, or 9.6% of net sales for the quarter ended September 30, 2012, compared to $8.8 million, or 9.7% of net sales for the third quarter in 2011. Sales and marketing expenses totaled $34.8 million, or 10.1% of net sales for the nine months ended September 30, 2012, compared to $27.3 million, or 10.3% of net sales for the same period in 2011.

Sales and marketing expenses increased $1.3 million and $7.5 million for the three and nine month periods ended September 30, 2012, respectively, as compared to the same periods in 2011. The increase in sales and marketing expenses for the three months ended September 30, 2012 is primarily due to an increase in variable compensation expense for the period, including commissions and bonuses of $808,000, commensurate with the increase in revenues for the period, and an increase in salary expense of $400,000 due in part to an increase in headcount as a result of the Midwave acquisition in October 2011. The increase in sales and marketing expenses for the nine months ended September 30, 2012 is primarily due to an increase in variable compensation expense, including commission and bonuses of $4.6 million, commensurate with the increase in revenues for the period, and an increase in salary expense of $1.3 million due in part to an increase in headcount as a result of the Midwave acquisition in October 2011.

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 $4.2 million,


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or 4.0% of net sales for the quarter ended September 30, 2012, compared to $3.8 million, or 4.2% of net sales for the third quarter in 2011. General and administrative expenses were $13.6 million, or 3.9% of net sales for the nine months ended September 30, 2012, compared to $11.3 million, or 4.3% of net sales for the same period in 2011. Our general and administrative expenses have decreased as a percentage of net sales for both the three and nine month periods ended September 30, 2012 as compared to the same periods in 2011.

General and administrative expenses increased $426,000 and $2.3 million for the three and nine months ended September 30, 2012, respectively, as compared to the same periods in 2011. The increase in general and administrative expenses for the three months ended September 30, 2012 as compared to the same period in 2011 was primarily due to an increase of $224,000 in salary expense for headcount additions to support our business growth and an increase of $172,000 in outside consulting expenses. The increase in general and administrative expenses for the nine months ended September 30, 2012 as compared to the same period in 2011 was primarily due to a combination of an increase in salary expense of $574,000 due to headcount additions and an increase in depreciation expense of $485,000 resulting from increased capital expenditures to support the growth of the business, and an increase outside consulting expenses of $406,000.

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 $5.8 million, or 5.5% of net sales for the quarter ended September 30, 2012, compared to $3.9 million, or 4.3% of net sales for the third quarter in 2011. Engineering expenses were $16.7 million, or 4.9% of net sales for the nine months ended September 30, 2012, compared to $12.1 million, or 4.6% of net sales for the same period in 2011.

Engineering expenses increased $1.9 million and $4.6 million for the three and nine months ended September 30, 2012, respectively, as compared to the same periods in 2011. The increase in engineering expenses for the three months ended September 30, 2012 is primarily due to an increase in salaries and benefits of $2.4 million associated with the increase in engineering headcount from our Midwave acquisition. This was partially offset by an increase of $534,000 in cost allocations to our cost of service sales, commensurate with the increase in our professional services sales. The increase in engineering expenses for the nine months ended September 30, 2012 is primarily due to an increase in salaries and benefits of $7.4 million associated with the increase in engineering headcount from our Midwave acquisition. This was partially offset by an increase of $4.2 million in cost allocations to our cost of service sales, commensurate with the increase in our professional services sales.

Other Income. We had no other income for the three and nine months ended September 30, 2012. Other income was $574,000 for the three and nine months ended September 30, 2011. Our 2009 Cross acquisition included a services agreement, which we also refer to as a reverse earn-out agreement, which required Cross to purchase at least $1.8 million of networking products and services from us over three years. Cross agreed to pay any shortfall between customer purchases and the guaranteed annual purchase amount. We believed that we would meet the revenue targets and accordingly, we determined that the reverse earn-out had no fair value at the date of this business combination or in any subsequent periods prior to the settlement date. At September 30, 2010 the first year of the three year reverse earn-out agreement came to an end and there was a shortfall between customer purchases and the guaranteed annual purchase of $503,000. At September 30, 2011 the second year of the three year reverse earn-out agreement came to an end and there was a shortfall between customer purchases and the guaranteed annual purchase of $574,000. Per the services agreement any shortfall between customer purchases and the guaranteed annual purchase amount would be payable by Cross at that time. Since we had assumed that the revenue targets would be met and the reverse earn-out had no fair value, the shortfall amount of $503,000 represented a change in fair value of the acquisition date reverse earn-out and, in accordance with ASC 805-30-35 was classified as other income within operation expenses on our statement of operations.

Integration and Transaction Costs. Integration and transactions costs were $103,000 for the quarter ended September 30, 2012, compared to $125,000 for the third quarter in 2011. Integration and transaction costs were $123,000 for the nine months ended September 30, 2012, compared to $125,000 for the same period in 2011. Integration costs for 2012 are related to legal fees associated with our acquisition of StraTech. Integration costs for 2011 are related to legal fees associated with our October 2011 acquisition of Midwave Corporation.

Amortization of Intangibles. We had $619,000 of intangible asset amortization expenses for the three months ended September 30, 2012 as compared to intangible amortization expenses of $382,000 for the same three months in 2011. We had $1.9 million of intangible asset amortization expenses for the nine months ended September 30, 2012 as compared to intangible amortization of expenses of $1.1 million for the same nine months in 2011. The increase in amortization of intangibles expenses in 2012 as compared to 2011 is primarily due to the Midwave acquisition. The finite-lived intangibles we acquired in our acquisition of Midwave consisted of covenants not to compete, order backlog and customer relationships having estimated lives of 3 years, 3 months and 5 years, respectively.


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Earnings from Operations. We had earnings from operations of $3.3 million compared to earnings from operations of $4.9 million for the three months ended September 30, 2012 and 2011, respectively. We had earnings from operations of $12.3 million compared to earnings from operations of $12.2 million for the nine months ended September 30, 2012 and 2011, respectively. The earnings from operations for the three and nine months ended September 30, 2012 is a result of the financial leverage we achieved by keeping operating expenses relatively flat and realizing substantial growth in our revenues and gross margins.

Income Taxes. We had income tax expense of $1.3 million and income tax expense of $2.1 million for the three months ended September 30, 2012 and 2011, respectively. We had income tax expense of $5.0 million for the nine months ended September 30, 2012 and 2011, respectively. Our estimated effective tax rate for the three and nine months ended September 30, 2012 was 41.2% and 40.5%, respectively. For the balance of 2012, we expect to report an income tax provision using an effective tax rate of approximately 40.5%.

LIQUIDITY AND CAPITAL RESOURCES



                                            Nine Months Ended September 30,
                                              2012                  2011
Total cash provided by (used in):
Operating activities                    $          10,059     $           8,188
Investing activities                                   (7 )              (4,937 )
Financing activities                                  157                18,581
Increase in cash and cash equivalents   $          10,209     $          21,832

Net cash provided by operating activities was $10.1 million and $8.2 million for the nine months ended September 30, 2012 and 2011, respectively. Net cash provided by operating activities for the nine months ended September 30, 2012 was due primarily to net earnings of $7.3 million and non-cash add backs including depreciation of $1.2 million and amortization of intangibles of $1.9 million. Net cash provided by operating activities for the nine months ended September 30, 2011 was due primarily to net earnings of $7.2 million and non-cash add backs including depreciation of $716,000 and amortization of intangibles of $1.1 million.

Net cash used in investing activities was $7,000 and $4.9 million for the nine months ended September 30, 2012 and 2011, respectively. The primary use of cash for the first nine months of 2012 was for the purchase of $3.5 million of property and equipment partially offset by the sale of $3.5 million in short term investments. The primary use of cash for the first nine months of 2011 was for the purchase of $10.0 million in short term investments partially offset by the sale of $5.7 million in short term investments. For the remainder of 2012, we are planning for capital expenditures of up to $300,000 related to enhancements to our management information systems and upgraded computer equipment.

Net cash provided by financing activities was $157,000 for the nine months ended September 30, 2012, due mainly to stock-based compensation transactions during the period. Net cash provided by financing activities was $18.6 million for the nine months ended September 30, 2011 which is primarily from proceeds from our public stock offering. On March 14, 2011, we completed a public offering of 4,266,500 shares of common stock with a price to the public of $5.75 per share. We issued and sold 3,306,500 shares in the offering and the selling shareholder sold 960,000 shares in the offering. We did not receive any proceeds from the shares sold by the selling shareholder, therefore, such amounts are not reflected in the net cash provided by financing activities for the nine months ended September 30, 2011.

On March 31, 2011, we entered into a Credit Agreement with Wells Fargo Bank, NA. The Credit Agreement provides for a line of credit not to exceed $10.0 million for general working capital purposes. The line of credit is secured by substantially all of our personal property and expired on July 31, 2012. Borrowings under the line of credit are limited to three times the aggregate of our EBITDA (as defined in the Credit Agreement) for the trailing two fiscal quarters. The Credit Agreement also requires that we have working capital of not less than $15.0 million at each fiscal quarter-end, and certain levels of net income after taxes.

On July 31, 2012, we entered into the Third Amendment to Credit Agreement, which amended our existing line of credit agreement with Wells Fargo Bank, N.A. and continues to provide a revolving line of credit facility with a maximum borrowing amount of $10.0 million that now matures on July 31, 2014. In connection with the extension of the maturity date, we executed an Amended and Restated Revolving Line of Credit Note. The credit line continues to bear interest at 2.0% above the bank's three month LIBOR rate. As of September 30, 2012, we had no borrowings outstanding on the line of credit and could borrow the full $10.0 million available.

On October 2, 2012, we entered into the Fourth Amendment to Credit Agreement ("Amended Agreement"), which amended our existing line of credit agreement with . . .

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