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DTLK > SEC Filings for DTLK > Form 10-K on 15-Mar-2013All Recent SEC Filings

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Form 10-K for DATALINK CORP


15-Mar-2013

Annual Report


Item 7. Management's Discussion and Analysis of Financial Condition and Results of Operations.

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

Our solutions can include hardware products, such as servers, disk arrays, tape systems, networking and interconnection components and software products. Our data center strategy is supported through multiple trends in the market and involves supporting the market and our customers with a single vendor to provide their data center infrastructure needs. As of December 31, 2012, we have 36 locations, including both leased facilities and home offices, throughout the United States. We historically have derived our greatest percentage of net sales from customers located in the central part of the United States.

We sell support service contracts to most of our customers. In about half of the support service contracts that we sell, our customers purchase support services through us, resulting in customers receiving the benefit of integrated system wide support. We have a qualified, independent support desk that takes calls from customers, diagnoses the issues they are facing and either solves the problem or coordinates with our and/or vendor technical staff to meet the customer's needs. Our support service agreements with our customers include an underlying agreement with the product manufacturer. The manufacturer provides on-site support assistance if necessary. The other half of the support service contracts that we sell to our customers are direct with the product manufacturers. For all support service contracts we sell, we defer revenues and direct costs resulting from these contracts, and amortize these revenues and expenses into operations, over the term of the contracts, which are generally one to three years.

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.

We view the current data center infrastructure market as providing significant opportunity for growth. Currently, our market share is a small part of the overall market. However, the providers of


the data center infrastructure 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 us to sell their products. While these trends provide opportunity for us, 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 scalable capabilities and a leverageable cost structure. Our current strategies are focused on:


Increasing our sales team productivity.


Scaling our existing geographic locations and expanding into new locations.


Expanding our customer support revenues.


Enhancing our consulting and professional services business.


Expanding our managed services portfolios.

To pursue these strategies, we are:


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


Investing in customer-facing teams to acquire 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.


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


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


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


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

All of these plans have various challenges and risks associated with them, including those described under "Risk Factors" in this Annual Report.

Acquisitions

We have completed acquisitions to grow our business in the past and we intend to continue to grow our business by select acquisitions. Our recent acquisitions are described below.

Strategic Technologies, Inc. On October 4, 2012, we purchased substantially all of the assets and liabilities of Strategic Technologies, Inc. ("StraTech") from StraTech and Midas Medici Group Holdings, Inc. ("Midas", parent company of StraTech, and together with StraTech, the "Sellers"). StraTech is an IT services and solutions firm that shares our focus on optimizing enterprise data centers and IT infrastructure through a common product and services portfolio designed to help customers increase business agility. We purchased StraTech for an estimated purchase price of approximately $11.0 million, comprised of a cash payment of approximately $13.2 million, which is offset by a receivable due from the Sellers of approximately $4.2 million, resulting from the preliminary estimated working capital adjustment. In addition, we issued 269,783 shares of our common stock with a value of approximately $2.0 million. Those shares have been deposited in an escrow account as security for certain indemnification obligations of the Sellers. Pursuant to the asset purchase agreement, Sellers are


obligated to pay us an amount equal to the difference between the actual tangible net assets on the closing date and the Sellers' good faith estimated net tangible assets as set forth in the asset purchase agreement. We recorded the receivable due from Sellers of approximately $4.2 million related to this payment at December 31, 2012. Sellers are disputing the amount owed to us in connection with this reconciliation payment. The asset purchase agreement contains an arbitration provision for disputes over the value of tangible net assets. The amount of the receivable we recorded may be impacted by the resolution of the arbitration proceeding. As of the filing of this Form 10-K, no resolution had been reached, and the parties are reviewing the working capital calculations and determining the timing for arbitration.

This acquisition expanded our market share and physical presence across the Eastern seaboard of the United States. The acquisition also allows us to diversify our product offerings from certain manufacturers and expand our high-margin professional and managed services business lines. We expect to experience operational synergies and efficiencies through combined general and administrative corporate functions. Our results for 2012 reflect the addition of StraTech for the fourth quarter. Please see Note 2 to our financial statements for further information.

Midwave Corporation. In October 2011, we entered into an asset purchase agreement with Midwave and its shareholders. Under the asset purchase agreement we purchased and acquired from Midwave substantially all of the assets used in Midwave's business. Midwave is an information technology consulting firm that offers both professional services and sells products to business' information technology organizations utilizing the product portfolios of certain information technology manufacturers, in the specific domains of data center services, networking services, managed services and advisory services. We paid a purchase price of approximately $19.1 million, comprised of a cash payment of approximately $16.1 million delivered at closing and issued 220,988 shares of our common stock with a value of approximately $1.6 million and approximately $1.4 million related to working capital adjustments subsequent to closing.

This acquisition expanded our footprint in Minnesota making us the dominant data center services and infrastructure provider in the region. The acquisition also doubled our Cisco technology and services revenues, expanded our managed services portfolio with the addition of a data center infrastructure monitoring service, added an established security practice including product, services and consulting and doubled the size of our consulting services team. We have realized operational synergies and efficiencies through combined general and administrative corporate functions. Our results for 2011 reflect the addition of Midwave for the fourth quarter. Please see Note 2 to our financial statements for further information.

2009 Acquisitions

On December 17, 2009, we acquired the reseller business of Incentra, which designs, procures, implements and supports data center solutions composed of technologies including storage, networking, security and servers from leading manufacturers. We did not acquire Incentra's managed services portfolio and related operations. We accomplished the acquisition through the purchase of substantially all of the assets of Incentra's reseller business pursuant to an Asset Purchase Agreement and have included the financial results of Incentra in our financial statements beginning on the acquisition date.

On October 1, 2009, we acquired the networking solutions division of Minneapolis-based Cross Telecom's ("Cross"), which qualified as a business combination. We completed an asset purchase of $2.0 million paid in cash. Simultaneously, Cross entered into an agreement with us to purchase at least $1.8 million of networking products and services from us over the next three years. Cross has agreed to pay any shortfall between customer purchases and the guaranteed annual purchase amount. The agreement was entered into outside of the acquisition and was assigned no fair value. In September 2010 and 2011, the first and second years of the three year agreement came to an end and there was a


shortfall paid by Cross of $503,000 and $574,000, respectively, which was recorded as other income since we had assumed the revenue targets. In October 2011, we entered into an agreement with Cross to allow for an early buyout of the remaining year of the agreement for which Cross paid $553,000.

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. Effective January 2011, we recognize revenue in accordance with the ASC amended by FASB as summarized in ASU No. 2009-14, Software (Topic 985): Certain Revenue Arrangements That Include Software Elements, and ASU No. 2009-13, Revenue Recognition (Topic 605):
Multiple-Deliverable Revenue Arrangements. We generally recognize software and hardware revenue upon shipment, installation and configuration services upon completion and customer support contracts ratably over the term of the contract. Please see Note 1 to our financial statements in Part II, Item 8 included with this Annual Report on Form 10-K for a more detailed description of our revenue recognition policy.

For 2010 and sales contracts entered into prior to fiscal year 2011, we recognized revenue pursuant to the previous guidance for multiple-element arrangements. Refer to the critical accounting policies in our Annual Report on Form 10-K for the fiscal year ended December 31, 2010 in "Management's Discussion and Analysis of Financial Condition and Results of Operations" under the heading "Critical Accounting Policies and Estimates" for a discussion of the previous accounting policy.

Business Combinations. We have acquired a number of businesses during the last several years, and we expect to acquire additional businesses in the future. In a business combination, we determine the fair value of all acquired assets, including identifiable intangible assets, and all assumed liabilities. We allocate the fair value of the purchase price to the acquired assets and assumed liabilities in amounts equal to the fair value of each asset and liability. We classify any remaining fair value of the acquisition as goodwill. This allocation process requires extensive use of estimates and assumptions, including estimates of future cash flows we expect to generate with the acquired assets. We amortize certain identifiable, finite-life intangible assets, such as service agreements, certifications, trademarks, order backlog and customer relationships, on a straight-line basis over the intangible asset's estimated useful life. The estimated useful life of amortizable identifiable intangible assets ranges from three months to eight years. We do not amortize goodwill or other intangible assets we determine to have indefinite lives. Accordingly, the accounting for acquisitions has had, and will continue to have, a significant impact on our operating results.

During 2012 and 2011, we applied business combination accounting to our acquisitions of StraTech and Midwave. See Note 2 to our financial statements included in this Annual Report on Form 10-K for more information about the application of business combination accounting to these acquisitions.

Valuation of Goodwill. In accordance with FASB ASC Topic 350, Intangibles-Goodwill and Other, we assess the carrying amount of our goodwill for potential impairment annually or more frequently if events or a change in circumstances indicate that impairment may have occurred. We have only one operating and reporting unit that earns revenues, incurs expenses and makes available discrete financial information for review by our chief operations decision maker. Accordingly, we complete our goodwill impairment testing on this single reporting unit.


Testing for goodwill impairment is a two step process. The first step screens for potential impairment. 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. We consider goodwill impairment test estimates critical due to the amount of goodwill recorded on our balance sheets and the judgment required in determining fair value amounts.

Valuation of Long-Lived Assets, Including Finite-Lived Intangibles. In accordance with FASB ASC Topic 360, Property, Plant, and Equipment, we perform an impairment test for finite-lived intangible assets and other long-lived assets, such as property and equipment, whenever events or changes in circumstances indicate that we may not recover the carrying value of such assets.

Stock-Based Compensation. We utilize the fair value method of accounting to account for share-based compensation awards. This 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. We use the Black-Scholes 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 determine the fair value of restricted stock grants based upon the closing price of our stock on the grant date. 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.

Recent Accounting Pronouncements

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

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


In July 2012, the FASB issued an update to ASC 350: Testing Indefinite-Lived Intangible Assets for Impairment. This update states that an entity has the option first to assess qualitative factors to determine whether the existence of events and circumstances indicates that it is more likely than not that the indefinite-lived intangible asset is impaired. If, after assessing the totality of events and circumstances, an entity concludes that it is not more likely than not that the indefinite-lived intangible asset is impaired, then the entity is not required to take further action. However, if an entity concludes otherwise, then it is required to determine the fair value of the indefinite-lived intangible asset and perform the quantitative impairment test by comparing the fair value with the carrying amount in accordance with ASC 350. Under the guidance in this update, an entity also has the option to bypass the qualitative assessment for any indefinite-lived intangible asset in any period and proceed directly to performing the quantitative impairment test. An entity will be able to resume performing the qualitative assessment in any subsequent period. The amendments to ASC 350 are effective for annual and interim impairment tests performed for fiscal years beginning after September 15, 2012. We do not believe the adoption of this update will have a material impact on our financial statements.

Results of Operations

Our sales increased $111.2 million or 29.3% to $491.2 million for 2012 as compared to 2011. Our gross profit increased $22.4 million or 25.0% to $112.0 million for 2012 as compared to 2011. Our earnings from operations increased $925,000 or 5.5% to $17.7 million for 2012 as compared to 2011. The following table shows, for the periods indicated, certain selected financial data expressed as a percentage of net sales.

                                               Year Ended December 31,
                                              2012        2011      2010
              Net sales                         100.0 %    100.0 %   100.0 %
              Cost of sales                      77.2       76.4      77.0

              Gross profit                       22.8       23.6      23.0

              Operating expenses:
              Sales and marketing                 9.9       10.2      11.0
              General and administrative          3.7        4.1       4.8
              Engineering                         4.7        4.6       5.3
              Other income                          -       (0.3 )    (0.2 )
              Integration costs                   0.1        0.1       0.2
              Amortization of intangibles         0.8        0.5       0.5

              Total operating expenses           19.2       19.2      21.6

              Operating earnings                  3.6 %      4.4 %     1.4 %


Comparison of 2012, 2011 and 2010

Sales, Gross Profit and Gross Profit Percentage:

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

                                                            Year Ended December 31,
                                                         2012        2011        2010
                                                                (in thousands)
Product sales                                          $ 319,041   $ 245,743   $ 180,424
Service sales                                            172,161     134,284     113,255
Product gross profit                                   $  70,755   $  56,306   $  38,332
Service gross profit                                      41,271      33,306      29,304
Product gross profit as a percentage of product
sales                                                       22.2 %      22.9 %      21.2 %
Service gross profit as a percentage of service
sales                                                       24.0 %      24.8 %      25.9 %

Sales. Our product sales increased 29.8% in 2012 from 2011 up to $319.0 million and increased 36.2% in 2011 from 2010 up to $245.7 million. Our service sales, which include customer support, consulting and installation services, increased 28.2% in 2012 over 2011 to $172.2 million and increased 18.6% in 2011 over 2010 to $134.3 million. Our 2012 results for both product sales and service sales include revenues of approximately $13.4 million from the acquisition of StraTech. Additionally, our 2012 results include a full year of revenue from the Midwave acquisition in late 2011. Our 2011 results for both product sale and service sales include revenues of approximately $13.0 million from the acquisition of Midwave.

The increase in our products sales in 2012 as compared to 2011, reflects the impact of our StraTech acquisition in October 2012, continued growth in our customer base including growth in customers with multi-million dollar accounts with us, and market acceptance of our ongoing strategy to service the complete data center, as evidenced by increases in our storage and networking product sales. The increase in our products sales in 2011 as compared to 2010, reflect the impact of our Midwave acquisition in October 2011, the change in our revenue recognition policy and the increase in product offerings due to our transition to servicing the complete data center. Our storage, server and network sales have increased as part of our strategy to deliver data center hardware, software and services. Our more recent product sales 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 businesses. We cannot assure that changes in customer spending or economic conditions will positively impact our future product revenues in 2013.

The increase in our service sales in 2012 as compared to 2011 reflects the impact of our StraTech acquisition in October 2012, accelerating momentum for our virtualized data center solutions, and major new services offerings, including unified monitoring and managed infrastructure services for the entire multi-vendor virtualized data center offerings and new managed services for backup, monitoring, archiving, cloud backup and cloud enablement services to help companies analyze the impact of cloud deployments on their business. The increase in service sales included an increase in customer support contract sales of $25.5 million, or 22.4%, over 2011 and an increase in installation and configuration services of $10.3 million, or 67.8%, over 2011. Our service sales also increased in 2011 over 2010. The increase in service sales included an increase in customer support contract sales of $18.1 million, or 18.9%, over 2010 and an increase in installation and configuration services of $2.8 million, or 22.5%, over 2010. With the growth in our product sales, we continue to successfully sell our installation and configuration services and customer support contracts. Without sustainable growth in our product sales


going forward, we expect that 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 either our product or service sales for the years 2012, 2011 or 2010. However, our top five . . .

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