FORM 10-Q
SECURITIES AND EXCHANGE COMMISSION
Washington, D.C. 20549
(Mark One)
ý Quarterly report pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the quarterly period ended: June 30, 2005
or
o Transition report pursuant to Section 13 or 15(d) of the
Securities Exchange Act of 1934
For the transition period from to
Commission file number: 00029758
DATALINK CORPORATION
(Exact name of registrant as specified in its charter)
MINNESOTA | | 41-0856543 |
(State or other jurisdiction of Incorporation) | | (IRS Employer Identification Number) |
| | |
8170 UPLAND CIRCLE
CHANHASSEN, MINNESOTA 55317-8589 |
(Address of Principal Executive Offices) |
| | |
(952) 944-3462 |
(Registrant’s Telephone Number, Including Area Code) |
Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.
Yes ý No o
Indicate by check mark whether the registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act):
Yes o No ý
As of August 10, 2005, 10,324,794 shares of the registrant’s common stock, $.001 par value, were outstanding.
FORWARD-LOOKING STATEMENTS
The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for certain forward-looking statements. This report on Form 10-Q contains forward-looking statements, which reflect the Company’s views with respect to future events and financial performance. These forward-looking statements are subject to certain risks and uncertainties, including those identified below, which could cause actual results to differ materially from historical results or those anticipated. The words “aim,” “believe,” “expect,” “anticipate,” “intend,” “estimate” 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 storage, including the effect of economic conditions for technology spending; competition and pricing pressures and timing of our installations that may adversely affect our revenues and profits; the loss of a significant customer; fixed employment costs that may impact profitability if we suffer revenue shortfalls; the impact of our recent cost reduction activities on business retention and future growth; revenue recognition policies that may unpredictably defer reporting of our revenues; our ability to hire and retain sales representatives and new key technical and other personnel; our dependence on key suppliers; our ability to adapt to rapid technological change; risks associated with possible future acquisitions; fluctuations in our quarterly operating results; future changes in applicable accounting rules; and volatility in our stock price.
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PART I. FINANCIAL INFORMATION
Item 1. Financial Statements
Datalink Corporation
Balance Sheets
(In thousands)
| | June 30,
2005 | | December31,
2004 | |
| | (Unaudited) | | | |
Assets | | | | | |
Current assets | | | | | |
Cash and cash equivalents | | $ | 9,319 | | $ | 12,663 | |
Accounts receivable, net | | 13,181 | | 11,485 | |
Inventories | | 2,331 | | 627 | |
Deferred customer support contract costs | | 12,711 | | 10,770 | |
Inventories shipped but not installed | | 2,093 | | 2,343 | |
Other current assets | | 253 | | 284 | |
Total current assets | | 39.888 | | 38,172 | |
Property and equipment, net | | 2,840 | | 3,134 | |
Goodwill | | 5,500 | | 5,500 | |
Intangibles, net | | 94 | | 225 | |
Other assets | | 431 | | 38 | |
Total assets | | $ | 48,753 | | $ | 47,069 | |
| | | | | |
Liabilities and Stockholders’ Equity | | | | | |
Current liabilities | | | | | |
Accounts payable | | $ | 11,675 | | $ | 11,031 | |
Accrued commissions | | 916 | | 1,227 | |
Accrued income tax | | 91 | | 109 | |
Accrued sales and use tax | | 599 | | 510 | |
Accrued expenses, other | | 1,511 | | 1,276 | |
Sublease reserve current | | 717 | | — | |
Deferred revenue from customer support contracts | | 16,747 | | 14,012 | |
Total current liabilities | | 32,256 | | 28,165 | |
Deferred rent | | 318 | | 392 | |
Sublease reserve non-current | | 1,833 | | — | |
Total liabilities | | 34,407 | | 28,557 | |
| | | | | |
Commitments and contingencies | | | | | |
| | | | | |
Stockholders’ equity | | | | | |
Common stock, $.001 par value, 50,000,000 shares authorized, 10,309,205 and 10,282,545 shares issued and outstanding as of June 30, 2005 and December 31, 2004, respectively | | 10 | | 10 | |
Additional paid in capital | | 26,680 | | 26,624 | |
Deferred compensation | | (274 | ) | (307 | ) |
Accumulated deficit | | (12,070 | ) | (7,815 | ) |
Total stockholders’ equity | | 14,346 | | 18,512 | |
Total liabilities and stockholders’ equity | | $ | 48,753 | | $ | 47,069 | |
The accompanying notes are an integral part of these financial statements.
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Datalink Corporation
Statements of Operations
(In thousands, except per share data)
(Unaudited)
| | Three Months Ended
June 30, | | Six Months Ended
June 30, | |
| | 2005 | | 2004 | | 2005 | | 2004 | |
Net sales: | | | | | | | | | |
Products | | $ | 19,918 | | $ | 13,918 | | $ | 33,573 | | $ | 27,147 | |
Services | | 8,823 | | 7,545 | | 16,409 | | 14,520 | |
| | 28,741 | | 21,463 | | 49,982 | | 41,667 | |
Cost of sales: | | | | | | | | | |
Cost of products | | 15,153 | | 10,871 | | 25,521 | | 21,313 | |
Cost of services | | 5,974 | | 5,360 | | 11,088 | | 10,114 | |
Total cost of sales | | 21,127 | | 16,231 | | 36,609 | | 31,427 | |
Gross profit | | 7,614 | | 5,232 | | 13,373 | | 10,240 | |
Operating expenses: | | | | | | | | | |
Sales and marketing | | 3,838 | | 2,692 | | 7,131 | | 5,761 | |
General and administrative | | 2,245 | | 2,643 | | 4,791 | | 5,509 | |
Engineering | | 1,078 | | 942 | | 2,206 | | 1,810 | |
Charge for sublease reserve | | — | | — | | 3,502 | | — | |
Restructuring charges | | — | | (63 | ) | — | | (63 | ) |
Amortization of intangibles | | 65 | | 65 | | 130 | | 130 | |
| | 7,226 | | 6,279 | | 17,760 | | 13,147 | |
Earnings (loss) from operations | | 388 | | (1,047 | ) | (4,387 | ) | (2,907 | ) |
Interest income, net | | 58 | | 16 | | 132 | | 36 | |
Net earnings (loss) | | $ | 446 | | $ | (1,031 | ) | $ | (4,255 | ) | $ | (2,871 | ) |
| | | | | | | | | |
Net earnings (loss) per common share: | | | | | | | | | |
Basic | | $ | 0.04 | | $ | (0.10 | ) | $ | (0.41 | ) | $ | (0.28 | ) |
Diluted | | 0.04 | | (0.10 | ) | (0.41 | ) | (0.28 | ) |
Weighted average common shares outstanding: | | | | | | | | | |
Basic | | 10,308 | | 10,265 | | 10,301 | | 10,259 | |
Diluted | | 10,376 | | 10,265 | | 10,301 | | 10,259 | |
The accompanying notes are an integral part of these financial statements.
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Datalink Corporation
Statements of Cash Flows
(In thousands)
(Unaudited)
| | Six Months Ended
June 30, | |
| | 2005 | | 2004 | |
Cash flows from operating activities: | | | | | |
Net loss | | $ | (4,255 | ) | $ | (2,871 | ) |
Adjustments to reconcile net loss to net cash used in operating activities: | | | | | |
Provision for bad debts | | 18 | | 18 | |
Depreciation | | 684 | | 1,009 | |
Amortization of intangibles | | 131 | | 130 | |
Deferred rent | | (74 | ) | (51 | ) |
Charge for sublease reserve | | 3,502 | | — | |
Amortization of sublease reserve | | (516 | ) | — | |
Stock compensation expense | | 33 | | 17 | |
Changes in operating assets and liabilities: | | | | | |
Accounts receivable | | (1,714 | ) | 997 | |
Inventories | | (1,453 | ) | (1,359 | ) |
Deferred customer support contract costs/revenues, net | | 794 | | 841 | |
Accounts payable | | 644 | | (93 | ) |
Accrued expenses | | 13 | | 1,228 | |
Other | | (381 | ) | 122 | |
Net cash used in operating activities | | (2,574 | ) | (12 | ) |
| | | | | |
Cash flows from investing activities: | | | | | |
Purchase of property and equipment | | (826 | ) | (183 | ) |
Net cash used in investing activities | | (826 | ) | (183 | ) |
| | | | | |
Cash flows from financing activities: | | | | | |
Proceeds from issuance of common stock | | 56 | | 81 | |
Net cash provided by financing activities | | 56 | | 81 | |
| | | | | |
Decrease in cash and cash equivalents | | (3,344 | ) | (114 | ) |
Cash and cash equivalents, beginning of period | | 12,663 | | 12,565 | |
Cash and cash equivalents, end of period | | $ | 9,319 | | $ | 12,451 | |
The accompanying notes are an integral part of these financial statements.
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Datalink Corporation
Notes To Financial Statements
(In thousands, except share and per share data)
(Unaudited)
1. Basis of Presentation
The interim financial statements included in this Form 10-Q have been prepared by the Company, without audit, pursuant to the rules and regulations of the Securities and Exchange Commission (SEC). Certain information and footnote disclosures, normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States, have been condensed or omitted, pursuant to such rules and regulations. These financial statements should be read in conjunction with the financial statements and related notes thereto included in the Company’s 2004 Annual Report on Form 10-K.
The financial statements presented herein as of June 30, 2005, and for the three and six months ended June 30, 2005 and 2004, reflect, in the opinion of management, all adjustments (which consist only of normal, recurring adjustments) necessary for a fair presentation of the financial position and the results of operations and cash flows for the periods presented. The results of operations for any interim period are not necessarily indicative of results for the full year.
2. Inventories
Inventories, including inventories shipped but not installed, principally consist of data storage products and components, valued at the lower of cost or market with cost determined on a first-in, first-out (FIFO) method.
3. Basic and Diluted Net Earnings and Loss per Share
Basic net earnings (loss) per share is computed using the weighted average number of shares outstanding. Diluted net earnings (loss) per share includes the effect of potential common stock equivalents, if any, for each period. The number of additional shares is calculated by assuming that outstanding stock options were exercised and that the proceeds from such exercise were used to acquire shares of common stock at the average market price during the reporting period. For the three months ended June 30, 2005, the net earnings per share computation has been increased by 67,000 equivalent shares. Due to the net loss for the three months ended June 30, 2004 and for the six months ended June 30, 2005 and 2004, common stock equivalents of 52,000, 82,000 and 100,000, respectively, would have been anti-dilutive to losses and as a result were excluded from the calculation of diluted net loss per share.
4. Stock Options
Pro forma earnings (loss) and earnings (loss) per share have been determined as if the Company had used the fair value method of accounting for its stock option grants and employee stock purchase plan share elections consistent with the method of SFAS No. 123. Under this method, compensation expense is recognized over the applicable vesting periods and is based on the shares under option and their related fair values on the grant date.
| | Three Months Ended June 30, | | Six Months Ended June 30, | |
| | (In thousands) | | (In thousands) | |
| | 2005 | | 2004 | | 2005 | | 2004 | |
Net earnings (loss): | | | | | | | | | |
As reported | | $ | 446 | | $ | (1,031 | ) | $ | (4,255 | ) | $ | (2,871 | ) |
Non cash compensation expense | | $ | (106 | ) | $ | (423 | ) | $ | (202 | ) | $ | (1,076 | ) |
Stock compensation cost on stock based awards granted below fair market value | | $ | — | | $ | 2 | | $ | — | | $ | 17 | |
Pro forma | | $ | 340 | | $ | (1,452 | ) | $ | (4,457 | ) | $ | (3,930 | ) |
Basic earnings (loss) per share: | | | | | | | | | |
As reported | | $ | 0.04 | | $ | (0.10 | ) | $ | (0.41 | ) | $ | (0.28 | ) |
Non cash compensation expense | | $ | (0.01 | ) | $ | (0.04 | ) | $ | (0.02 | ) | $ | (0.10 | ) |
Stock compensation cost on stock based awards granted below fair market value | | $ | 0.00 | | $ | 0.00 | | $ | 0.00 | | $ | 0.00 | |
Pro Forma | | $ | 0.03 | | $ | (0.14 | ) | $ | (0.43 | ) | $ | (0.38 | ) |
Diluted earnings (loss) per share: | | | | | | | | | |
As reported | | $ | 0.04 | | $ | (0.10 | ) | $ | (0.41 | ) | $ | (0.28 | ) |
Non cash compensation expense | | $ | (0.01 | ) | $ | (0.04 | ) | $ | (0.02 | ) | $ | (0.10 | ) |
Stock compensation cost on stock based awards granted below fair market value | | $ | 0.00 | | $ | 0.00 | | $ | 0.00 | | $ | 0.00 | |
Pro forma | | $ | 0.03 | | $ | (0.14 | ) | $ | (0.43 | ) | $ | (0.38 | ) |
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5. Goodwill and Intangible Assets
The balance of goodwill at June 30, 2005, and December 31, 2004, was $5.5 million.
Information regarding the Company’s other intangible asset that continues to be amortized is as follows:
| | As of June 30, 2005
(In thousands) | |
| | Carrying
Amount | | Accumulated
Amortization | | Net | |
| | | | | | | |
Customer lists | | $ | 3,374 | | $ | 3,280 | | $ | 94 | |
| | | | | | | | | | |
Amortization expense for the six months ended June 30, 2005, was $130,000. Estimated amortization expense for the remainder of fiscal 2005 is $94,000.
6. Income Taxes
As part of the process of preparing financial statements, the Company is required to estimate income taxes, both state and federal. This process involves management estimating the actual current tax exposure together with assessing temporary differences resulting from different treatment for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which are included within the balance sheet. Management must then assess the likelihood that deferred tax assets will be utilized to offset future taxable income during the periods in which these temporary differences are deductible. As a result of the Company’s cumulative losses and the full utilization of the Company’s loss carry back potential, the Company concluded during the fourth quarter of fiscal 2002 to record a full valuation allowance against the Company’s net deferred tax assets. The valuation allowance at June 30, 2005 was $6.1 million. In addition, the Company expects to provide a full valuation allowance on any future tax benefits until the Company can sustain a level of profitability that demonstrates its ability to realize these assets. No income tax provision has been presented for the quarter ended June 30, 2005 primarily due to the utilization of net operating loss carry forwards.
At December 31, 2004, the Company had federal net operating loss carry forwards of approximately $6.7 million and state net operating loss carry forwards of approximately $13.5 million, which are available to offset future federal and state taxable income. If not used, these net operating loss carry forwards will expire between 2013 and 2024.
7. Borrowing Arrangements
The Company has elected not to pursue a credit facility at this time. With the Company’s current cash position, it believes it has the liquidity to meet its operating needs for the foreseeable future. The Company has no outstanding debt, and if the need should arise to borrow funds, the Company believes that it could obtain a secured facility.
8. Recently Issued Accounting Standards
In May 2005, the FASB issued FASB Statement No. 154, Accounting Changes and Error Corrections. This new standard replaces APB Opinion No. 20, Accounting Changes, and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements. Among other changes, Statement 154 requires retrospective application of a voluntary change in accounting principle with all prior period financial statements presented on the new accounting principle, unless it is impracticable to do so. Statement 154 also requires accounting for a change in method of depreciating or amortizing a long-lived nonfinancial asset as a change in estimate (prospectively) effected by a change in accounting principle. Further, the Statement requires that correction of errors in previously issued financial statements be termed a “restatement.” The new standard is effective for accounting changes and correction of errors made in fiscal years beginning after December 15, 2005. Early adoption of this standard is permitted for accounting changes and correction of errors made in fiscal years beginning after June 1, 2005. The Company does not believe the adoption of FASB Statement 154 will have a material effect on its financial position or results of operations.
In March 2005, the FASB issued FASB Interpretation No.47, or “FIN 47,” which clarifies terminology in FASB Statement No. 143, Accounting for Asset Retirement Obligations. FIN 47 clarifies when an entity has sufficient information to reasonably estimate the fair value of an asset retirement obligation. FIN 47 is effective for the Company in fiscal 2006. The Company does not expect adoption of FIN 47 to have a material impact on its consolidated financial statements.
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In December 2004, the FASB issued SFAS No. 123R, Share-Based Payment. This statement revises SFAS No. 123, Accounting for Stock-Based Compensation, and requires companies to expense the value of employee stock options and similar awards using the fair value method. The effective date of this standard is for annual periods beginning after June 30, 2005. Although management has not fully analyzed the effect this new statement will have on the Company’s financial statements in the future, the pro forma net income effect of using the fair value method for the past three fiscal years as well as further information on this new statement is presented in Note 2 to the Company’s financial statements on Form 10-K.
Item 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations
OVERVIEW
The following information should be read in conjunction with the unaudited financial statements and the notes thereto included in Item 1 of this Quarterly Report and with the “Forward-Looking Statements” section in this filing and other Company filings with the U.S. Securities and Exchange Commission.
We are an independent architect of enterprise-class information storage infrastructures. We derive our revenues principally from designing, installing and supporting data storage systems. Our solutions can include hardware products, such as disk arrays, tape systems and interconnection components and storage management software products. The market for data storage products and services is large, estimated at $34 billion in 2004. We have 15 locations throughout the United States with the highest concentration of revenues in the central states.
We sell support service contracts to most of our customers. When customers purchase support services through us, customers receive the benefit of integrated system wide support. We have a qualified, independent support desk that takes calls from customers, diagnoses the issues they are facing and either solves the problem or coordinates with Datalink and/or vendor technical staff to meet the customer’s needs. Our support service agreements with our customers include an underlying agreement with the product vendor. The vendor provides on-site support assistance if necessary. We defer revenues and direct costs resulting from these contracts, and amortize these revenues and expenses into operations, over the term of the contracts, which are generally twelve months.
The enterprise-class information storage market is rapidly evolving and highly competitive. Our competition includes other independent storage system suppliers, high end market resellers, distributors, consultants and our suppliers through other independent data storage solution providers, original equipment manufacturers and their own internal sales forces. Our ability to hire and retain qualified outside sales representatives and engineers with enterprise-class information storage experience is critical to effectively competing in the marketplace and achieving our growth strategies.
In the past, we have experienced fluctuations in the timing of orders from our customers, and we expect to continue to experience these fluctuations in the future. These fluctuations have resulted from, among other things, the time required to design, test and evaluate our data storage solutions before customers deploy them, the size of customer orders, the complexity of our customers’ network environments, necessary system configuration to deploy our solutions and new product introductions by suppliers. Completion of our installation and configuration services may also delay recognition of revenues. Economic conditions and competition also affect our customers’ decisions to place orders with us. As a result, our net sales may fluctuate from quarter to quarter.
We view the current data storage market as having significant opportunity for Datalink’s growth. Currently, Datalink’s market share is a small part of the overall market. However, the providers of the data storage industry’s products and technologies are increasing their utilization of indirect sales approaches to broaden their reach and optimize their margins. Increasingly, they are turning to companies such as Datalink to sell their products. While these trends provide opportunity for Datalink, we must improve our business model to generate sustainable, profitable growth. Our model requires highly skilled sales and technical staff which results in substantial fixed costs for us. We believe the best way to improve our company and create long-term shareholder value it to focus on building capabilities that are scaleable and a cost structure that we can leverage. Our current strategies are focused on:
• Increasing productivity of our sales and technical teams in our existing locations.
• Growing our customer support revenue and market share. We believe that our customer support services offerings are becoming increasingly attractive to companies looking for system-wide integrated support.
• Increasing our professional services revenues. We believe there is an opportunity to sell more of our data storage services such as implementation services, storage environment assessments and on-site managed data storage services.
• Exploring potential regional acquisitions that we perceive can strengthen our resources and presence in key geographic locations.
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To pursue these strategies, our actions include:
• Improving our training, tools and recruiting for sales teams to increase productivity.
• Hiring additional customer support staff and enhancing communications and technology.
• Developing more effective delivery of professional service solutions.
All of these plans have various challenges and risks associated with them, including that:
• We may not increase our productivity and may lose, or not successfully recruit and retain key sales, technical or other personnel.
• Competition is intense and may adversely impact our profit margin. Customers have many options for data storage products and services.
• We may not identify suitable acquisition candidates.
RESULTS OF OPERATIONS
The following table shows, for the periods indicated, certain selected financial data expressed as a percentage of net sales.
| | Three Months Ended
June 30, | | Six Months Ended
June 30, | |
| | 2005 | | 2004 | | 2005 | | 2004 | |
Net sales | | 100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % |
Cost of sales | | 73.5 | | 75.6 | | 73.2 | | 75.4 | |
Gross profit | | 26.5 | | 24.4 | | 26.8 | | 24.6 | |
Operating expenses: | | | | | | | | | |
Sales and marketing | | 13.3 | | 12.5 | | 14.3 | | 13.8 | |
General and administrative | | 7.8 | | 12.3 | | 9.6 | | 13.2 | |
Engineering | | 3.8 | | 4.4 | | 4.4 | | 4.4 | |
Charge for sublease reserve | | — | | — | | 7.0 | | — | |
Restructuring charges | | — | | (0.3 | ) | — | | (0.2 | ) |
Amortization of intangibles | | 0.2 | | 0.3 | | 0.3 | | 0.3 | |
Total operating expenses | | 25.2 | | 29.2 | | 35.6 | | 31.5 | |
Operating earnings (loss) | | 1.3 | % | (4.9 | )% | (8.8 | )% | (7.0 | )% |
The following table shows, for the periods indicated, revenue and gross profit information for our product and service sales.
| | Three Months Ended
June 30, | | Six Months Ended
June 30, | |
| | 2005 | | 2004 | | 2005 | | 2004 | |
Product sales | | $ | 19,918 | | $ | 13,918 | | $ | 33,573 | | $ | 27,147 | |
Service sales | | 8,823 | | 7,545 | | 16,409 | | 14,520 | |
| | | | | | | | | |
Product gross profit | | $ | 4,765 | | $ | 3,047 | | $ | 8,052 | | $ | 5,834 | |
Service gross profit | | 2,849 | | 2,185 | | 5,321 | | 4,406 | |
| | | | | | | | | |
Product gross profit as a percentage of product sales | | 23.9 | % | 21.9 | % | 24.0 | % | 21.5 | % |
Service gross profit as a percentage of service sales | | 32.3 | % | 29.0 | % | 32.4 | % | 30.3 | % |
| | | | | | | | | | | | | | |
Net Sales. Our total net sales increased by $7.3 million for the three months ended June 30, 2005, or 33.9%, from $21.5 million for the comparable quarter in 2004. Our total net sales increased $8.3 million for the six months ended June 30, 2005, or 20.0% from $41.7 million for the comparable period in 2004. Our product sales increased $6.0 million, or 43.1%, to $19.9 million for the three months ended June 30, 2005, from $13.9 million for the comparable quarter in 2004. Our product sales increased $6.4 million, or 23.7%, to $33.6 million for the six months ended June 30, 2005, from $27.1 million for the six months ended June 30, 2004. Our service sales increased $1.3 million, or 16.9%, to $8.8 million for the three months ended June 30, 2005 from $7.5 million for the comparable quarter in 2004. Our service sales increased $1.9 million, or 13.0%, to $16.4 million for the six months ended June 30, 2005, from $14.5 million for the six months ended June 30, 2004.
Product sales can be impacted by a variety of factors including the timing of completion of projects and the number and productivity of our sales executives. The increase in product sales for both the three and six month periods ending June 30, 2005, as compared to the same period in 2004 is partially attributable to a 15% increase in the average number of sales executives over the prior year. The
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increase also reflects a 17% improvement in productivity for the three months ended June 30, 2005, and a 4% improvement in productivity for the six months ended June 30, 2005, as compared to the same periods in 2004.
Our service sales increase for the three month period ended June 30, 2005 as compared to the same period in 2004 was due to an increase in on-site support services of $525,000, implementation services of $343,000 and maintenance contracts of $457,000. Our services sales increase for the six month period ended June 30, 2005 as compared to the same period in 2004 was due to an increase in on-site support services of $1.0 million, implementation services of $450,000 and maintenance contracts of $522,000. Our customers are increasingly relying on our storage expertise for their storage projects and infrastructure support.
Gross Profit. Our total gross profit as a percentage of net sales increased to 26.5% for the quarter ended June 30, 2005, as compared to 24.3% for the comparable quarter in 2004. Our total gross profit as a percentage of net sales increased to 26.8% for the six months ended June 30, 2005, as compared to 24.5% for the six months ended June 30, 2004. Product gross profit as a percentage of product sales increased to 23.9% in the second quarter of 2005 from 21.9% for the comparable quarter in 2004. Product gross profit as a percentage of product sales increased to 23.9% for the six months ended June 30, 2005 from 21.5% for the six months ended June 30, 2004. Service gross profit as a percentage of service sales increased to 32.3% for the second quarter of 2005 from 29.0% for the comparable quarter in 2004. Service gross profit as a percentage of service sales increased to 32.4% for the six months ended June 30, 2005 from 30.3% for the six months ended June 30, 2004.
Our product gross profit as a percentage of product sales is impacted by the mix and type of projects we complete for our customers. For the three and six month periods ended June 30, 2005 as compared to the same periods in 2004, we delivered more value-add storage solutions to our customers which typically generate a higher gross profit.
Our service gross profit as a percentage of service sales for the three and six month periods ended June 30, 2005 as compared to the same period in 2004 improved as value-add storage solutions yield higher gross profits for both product and service sales. We have generated higher gross margins with several of our customer support vendors reflecting increasing levels of services provided by Datalink. Additionally, our on-site support services were a higher percentage of sales and since those services generate higher gross margins than our other services, it favorably impacted our 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 $3.8 million, or 13.3% of net sales for the quarter ended June 30, 2005 compared to $2.7 million, or 12.5% of net sales for the second quarter in 2004. Sales and marketing expenses totaled $7.1 million, or 14.3% of net sales for the six months ended June 30, 2005 compared to $5.8 million, or 13.8% of net sales for the six months ended June 30, 2004.
Sales and marketing expenses in absolute dollars increased $1.1 million and $1.4 million for the three and six month periods ended June 30, 2005, respectively, as compared to the three and six month periods ended June 30, 2004 due primarily to an increase in salaries and commission expenses. The increase in salaries is due to the increase in headcount for sales executives. The increase in commission expenses is due to an increase in both revenues and gross profit percentages. Commission expense and other incentive compensation plans are based in part on gross profit dollars and gross profit percentage. In the current year periods, we paid a higher percentage of our gross profit in variable compensation than in the prior year.
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 $2.2 million, or 7.8% of net sales for the quarter ended June 30, 2005, compared to $2.6 million, or 12.3% of net sales for the second quarter in 2004. General and administrative expenses were $4.8 million, or 9.6% of net sales for the six months ended June 30, 2005 compared to $5.5 million, or 13.2% of net sales for the six months ended June 30, 2004.
General and administrative expenses in absolute dollars decreased $398,000 and $718,000 for the three and six month periods ended June 30, 2005, respectively, as compared to the three and six month periods ended June 30, 2004. The decrease in general and administrative expenses is primarily due to lower rent expenses and common area charges as a result of our sub-lease arrangements. During the first quarter of 2005, we subleased 55,000 of the 104,000 square feet we occupy at our corporate headquarters in Chanhassen, Minnesota. In addition, depreciation for our customer relationship management system decreased also driving lower expenses in 2005.
Engineering. Engineering expenses include employee wages and travel, hiring and training expenses for our professional engineers and technicians. Engineering expenses were $1.1 million or 3.8% of net sales for the quarter ended June 30, 2005 compared to $942,000, or 4.4% of net sales for the second quarter in 2004. Engineering expenses were $2.2 million, or 4.4% of net sales for the six months ended June 30, 2005 compared to $1.8 million, or 4.4% of net sales for the six months ended June 30, 2004.
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Engineering expenses in absolute dollars increased $136,000 and $396,000 for the three and six month periods ended June 30, 2005, respectively, as compared to the three and six month periods ended June 30, 2004. The increase in engineering expenses is due to an increase in salaries and benefits due to the addition of technical staff primarily directed to enhance our growing customer support and on-site technical staffing businesses.
Charge for Sublease Reserve. On December 15, 2004, we agreed to sublease approximately 55,000 of the 104,000 square feet we currently occupy as our corporate headquarters in Chanhassen, Minnesota. The initial sublease is co-terminal with our lease and is for 85 months starting on April 1, 2005 and ending April 27, 2012. The sublessee will pay us rent ranging from approximately $55,000 per month at the beginning of the term to approximately $60,000 per month by the end of the term. We also negotiated with our landlord to sell the 2.5 acre lot adjoining our facility for $200,000. In January 2005, we discontinued use of the sublease area and we incurred a one-time, non-cash charge of $3.5 million related to the sublease and lot sale. We expect cost savings of approximately $950,000 per year as a result of the sublease agreement.
Intangible Amortization. Amortization of intangible assets was $65,000 or 0.2% of net sales for the quarter ended June 30, 2005, as compared to $65,000 or 0.3% of net sales for the second quarter in 2004. Amortization of intangible assets was $130,000 or 0.3% for the six months ended June 30, 2005 and 2004. The remaining balance of the customer base intangible will be fully amortized by November 2005.
Operating Earnings (Loss). We had operating earnings of $446,000 for the three months ended June 30, 2005 as compared to an operating loss of $1.0 million for the three months ended June 30, 2004. We incurred an operating loss of $4.3 million for the six months ended June 30, 2005 as compared to an operating loss of $2.9 million for the six months ended June 30, 2004. Excluding the $3.5 million sublease charge, our operating loss for the six months ended June 30, 2005 was $753,000. The increase in operating earnings of $1.5 million for the three months ended June 30, 2005 as compared to the same period in 2004 is due to an increase in revenue coupled with a 220 basis point improvement in gross margins, offset by an increase in commission expenses. The $2.1 million reduction in operating loss (excluding our sublease charge) for the six months ended June 30, 2005 as compared to the same period in 2004 is due to an increase in revenue coupled with a 230 basis point improvement in gross margins, offset by an increase in commission expenses.
Income Taxes. No income tax provision has been presented for the quarter ended June 30, 2005 primarily due to the utilization of net operating loss carry forwards. We had no income tax benefit for the six months ended June 30, 2005, and the three and six month periods ended June 30, 2004 as the net operating loss carry forwards are offset by increases in the valuation reserve for deferred income taxes. The ultimate realization of deferred tax assets is dependent upon carry back to prior periods and upon the generation of future taxable income during the periods in which those temporary differences become deductible. Based upon the level of taxable losses in 2004, 2003 and 2002 and the near-term uncertainty of taxable income, management cannot reasonably predict when or if these deductible differences will be realized. In addition, we do not have the ability to realize future income tax benefits on future losses. We expect to provide a full valuation allowance on any future tax benefits until we can sustain a level of profitability that demonstrates to us that recoverability of such tax assets is more likely than not.
LIQUIDITY AND CAPITAL RESOURCES
Net cash used in operating activities was $2.6 million for the six months ended June 30, 2005 as compared to $12,000 for the six months ended June 30, 2004. Significant items which impacted our operating cash flows as of June 30, 2005 were:
• $3.5 million one-time non-cash charge related to the sublease and lot sale for a portion of our corporate headquarters in Chanhassen, Minnesota. Our operating loss for the first half of 2005 of $4.3 million included this non-cash item.
• A $794,000 net increase in deferred customer support contracts. While we amortize the revenues from these contracts over the life of the contract, the customer almost always pays for the contracts at the beginning of the contract period which favorably impacts our cash flows.
• A net use of approximately $3.2 million in working capital. This was primarily related to increases in inventory related to customer orders and increases in accounts receivable related to several large customer orders.
Net cash used in investing activities was $826,000 for the six months ended June 30, 2005. We used this cash primarily to upgrade our computer equipment and to add leasehold improvements related to our sublease agreement. We are planning for $500,000 of capital expenditures for the remainder of 2005 related primarily to further enhancements to our management information systems.
Net cash provided by financing activities was $56,000 for the six months ended June 30, 2005, from stock sold under our employee stock purchase plan. Net cash provided by financing activities was $81,000 for the six months ended June 30, 2004.
We have no outstanding debt, and if the need should arise to borrow funds, we believe that we could obtain a secured facility.
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Our contractual cash obligations consist of future minimum lease payments due under non-cancelable operating leases. These obligations are as of June 30, 2005, for the remainder of 2005 and each of the full years thereafter as follows:
| | (in thousands) | |
| | Lease
Obligations | | Sublease
Agreements | | Net Lease
Obligations | |
Remainder of 2005 | | $ | 1,006 | | $ | (580 | ) | $ | 426 | |
2006 | | 1,915 | | (1,138 | ) | 777 | |
2007 | | 1,583 | | (1,120 | ) | 463 | |
2008 | | 1,310 | | (1,053 | ) | 257 | |
2009 | | 1,306 | | (1,053 | ) | 253 | |
Thereafter | | 3,056 | | (2,457 | ) | 599 | |
| | $ | 10,176 | | $ | (7,401 | ) | $ | 2,775 | |
| | | | | | | | | | | |
CRITICAL ACCOUNTING POLICIES AND ESTIMATES
The preparation of financial statements requires us to make estimates and assumptions that affect reported earnings. We evaluate these estimates and assumptions on an on-going basis based on historical experience and on other factors that we believe are reasonable. Estimates and assumptions include, but are not limited to, the areas of customer receivables, inventories, investments, income taxes, self-insurance reserves and commitments and contingencies. We believe that the following represent the areas where we use more critical estimates and assumptions in the preparation of our financial statements:
Revenue Recognition. We realize revenue from the design, installation and support of data storage solutions, which may include hardware, software and services. We recognize revenue when 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.
For 2002, we originally applied the provisions of Staff Accounting Bulletin No. 101 to account for our bundled arrangements. In 2003, we changed the accounting guidance we apply based on our determination that the software component of our sales was more than incidental to our products or services as a whole. However, the change did not affect the revenue amounts or the timing of our revenue recognition on bundled arrangements for 2002. This is because, under SAB No. 101, we also recognized revenue on our bundled arrangements only after we completed our installation and configuration services.
Service Sales. In addition to installation and configuration services that are part of our bundled arrangements described above, our service sales include customer support contracts and consulting services. On our balance sheet, deferred revenue relates to service sales for which our customer has paid us or has been invoiced but for which we have not yet performed the applicable services.
Customer Support Contracts. We sell service contracts to most of our customers. These contracts are support service agreements. We have an internal support desk that provides integrated customer support services, including configuration and usage assistance, technical advice and prompt incident detection and resolution. Our technical staff first assists a
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customer in identifying the source of system problems and in determining whether there is defective hardware or software. If our customer requires on-site maintenance or repair services, we arrange for a service call pursuant to underlying third-party support service agreements we have with our hardware and software vendors.
When we sell a service contract as part of a bundled arrangement, we use vendor specific objective evidence to allocate revenue to the service contract element. In all cases, we defer revenues and direct costs resulting from our service contracts and amortize them into operations over the term of the contracts, which are generally twelve months. We are contractually obligated to provide or arrange to provide these underlying support services to our customers in the unlikely event that the hardware or software vendor, or its designee, fails to perform according to the terms of its contact.
Consulting Services. Some of our customers engage us to analyze their existing storage architectures and offer our recommendations. Other customers engage us to assist them on-site with extended data storage projects, to support their data storage environments and to help with long-term data storage design challenges. For these types of consulting services that do not include the sale of hardware or software products, we recognize revenues as we perform these services.
Gross Reporting of Revenues. We report our revenues from the sale of hardware and software products on a gross, rather than a net, basis. In reporting our revenues on a gross basis, we considered that:
• We are the primary obligor to our customers. We are responsible for fulfillment, including the acceptability of the products and services to our customers.
• We have the risk of loss for inventory and credit.
• We establish the prices for our products and services with our customers.
• We are responsible for the installation and configuration services ordered by our customers.
Commission Expense. We utilize a direct internal sales force to generate virtually all of our revenues. We pay our sales people a combination of base salary and commissions. We pay commissions based on the amount of gross profit generated from the products and services sold. We match commissions to the appropriate transactions and recognize commission expense at the time we recognize the related revenues and gross profit.
Inventory. We periodically review, estimate and adjust our reserves for obsolete or unmarketable inventory equal to the difference between the inventory cost and the estimated market value based upon assumptions about future demand and market conditions. Results could be materially different if demand for our products decreased because of economic or competitive conditions, or the length of our industry downturn, or if products become obsolete because of technical advancements in the industry.
Valuation of Goodwill and Other Intangible Assets. We test goodwill for impairment annually or more frequently if changes in circumstance or the occurrence of events suggests an impairment exists. The test for impairment requires us to make several estimates about fair value, most of which are based on total market capitalization as compared to the carrying value of our net assets. If our total market capitalization is at or below the carrying value of our net assets, it may prompt us to engage a third party valuation firm to perform a valuation of us to further assess whether our goodwill or other intangibles are impaired pursuant to SFAS 142. We consider our goodwill impairment test estimates critical due to the amount of goodwill recorded on our balance sheet and the judgment required in determining fair value amounts.
Other intangible assets consist of customer lists. We amortize customer lists using the straight-line method over an estimated useful life of five years. We review these intangible assets for impairment as changes in circumstance or the occurrence of events suggests the remaining value is not recoverable.
Income Taxes. We utilize the asset and liability method of accounting for income taxes. We recognize deferred tax liabilities or assets for the expected future tax consequences of temporary differences between the book and tax bases of assets and liabilities. We regularly assess the likelihood that our deferred tax assets will be recovered from future taxable income. We record a valuation allowance to reduce our deferred tax assets to the amounts we believe to be realizable. We consider projected future taxable income and ongoing tax planning strategies in assessing the amount of the valuation allowance. If we determine it is more likely than not that we will not realize all or part of our deferred tax assets, we will adjust our earnings for the increase in the deferred tax valuation allowance in the period we make this determination.
As a result of our cumulative losses and the full utilization of our loss carry back potential, we concluded during the fourth quarter of fiscal 2002 to record a full valuation allowance against our net deferred tax assets. The valuation allowance at June 30, 2005 was $6.1 million. In addition, we expect to provide a full valuation allowance on any future tax benefits until we can sustain a level of profitability that demonstrates our ability to realize these assets.
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RECENTLY ISSUED ACCOUNTING STANDARDS
In May 2005, the FASB issued FASB Statement No. 154, Accounting Changes and Error Corrections. This new standard replaces APB Opinion No. 20, Accounting Changes, and FASB Statement No. 3, Reporting Accounting Changes in Interim Financial Statements. Among other changes, Statement 154 requires retrospective application of a voluntary change in accounting principle with all prior period financial statements presented on the new accounting principle, unless it is impracticable to do so. Statement 154 also requires accounting for a change in method of depreciating or amortizing a long-lived nonfinancial asset as a change in estimate (prospectively) effected by a change in accounting principle. Further, the Statement requires that correction of errors in previously issued financial statements be termed a “restatement.” The new standard is effective for accounting changes and correction of errors made in fiscal years beginning after December 15, 2005. Early adoption of this standard is permitted for accounting changes and correction of errors made in fiscal years beginning after June 1, 2005. We do not believe the adoption of FASB Statement 154 will have a material effect on our financial position or results of operations.
In March 2005, the FASB issued FASB Interpretation No.47, or “FIN 47,” which clarifies terminology in FASB Statement No. 143, Accounting for Asset Retirement Obligations. FIN 47 clarifies when an entity has sufficient information to reasonably estimate the fair value of an asset retirement obligation. FIN 47 is effective for us in fiscal 2006. We do not expect adoption of FIN 47 to have a material impact on our consolidated financial statements.
In December 2004, the FASB issued SFAS No. 123R, Share-Based Payment. This statement revises SFAS No. 123, Accounting for Stock-Based Compensation, and requires companies to expense the value of employee stock options and similar awards using the fair value method. The effective date of this standard is for annual periods beginning after June 30, 2005. Although management has not fully analyzed the effect this new statement will have on our financial statements in the future, the pro forma net income effect of using the fair value method for the past three fiscal years as well as further information on this new statement is presented in Note 2 to our financial statements on Form 10-K.
Item 3. Quantitative and Qualitative Disclosures About Market Risk.
All of our operations are based in the U.S. and all of our transactions are denominated in U.S. dollars. Our interest income is sensitive to changes in the general level of U.S. interest rates. However, due to the nature of our short-term investments, we have concluded they have no material market risk. The following is a discussion of our exposure to market risk related to changes in interest rates, foreign exchange rates and equity prices.
Interest rate risk. As of June 30, 2005, we had $9.3 million of cash and money market accounts. A decrease in market rates of interest on these accounts would have no material effect on the value of our assets or the related interest income. We have no short or long-term debt.
Foreign currency exchange rate risk. We market and sell all of our products in the United States. Therefore, we are not currently exposed to any direct foreign currency exchange rate risk.
Equity price risk. We do not own any equity investments. Therefore, we are not currently exposed to any direct equity price risk.
Item 4. Disclosure Controls and Procedures.
As of the end of the period covered by this report, we conducted an evaluation, under the supervision and with the participation of our Chief Executive Officer and our Chief Financial Officer, of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities and Exchange Act of 1934 (the “Exchange Act”)). Based on this evaluation, our Chief Executive Officer and our Chief Financial Officer concluded that our disclosure controls and procedures are effective to ensure that information required to be disclosed by us in reports that we file or submit under the Exchange Act is recorded, processed, summarized and reported within the time periods specified in Securities and Exchange Commission rules and forms. There was no change in our internal control over financial reporting during our most recently competed fiscal quarter that has materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.
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PART II. OTHER INFORMATION
Item 1. Legal Proceedings.
As of the date of this filing, we are not involved in any material legal proceedings. We also were not involved in any material legal proceedings that were terminated during the second quarter of 2005.
Item 2. Changes in Securities and Use of Proceeds.
None
Item 3. Defaults Upon Senior Securities.
None
Item 4. Submission of Matters to a vote of Security Holders.
At the Annual Meeting of Shareholders held on May 5, 2005, Paul F. Lidsky, Margaret A. Loftus, Greg R. Meland, James E. Ousley and Robert M. Price were re-elected as directors with the following votes:
| | For | | Withheld | |
| | | | | |
Paul F. Lidsky | | 9,758,135 | | 206,086 | |
Margaret A. Loftus | | 9,758,135 | | 206,086 | |
Greg R. Meland | | 9,864,911 | | 99,310 | |
James E. Ousley | | 9,745,868 | | 218,353 | |
Robert M. Price | | 9,852,644 | | 111,577 | |
No other matters were voted upon at the meeting.
Item 5. Other Information
None
Item 6. Exhibits
(a) Exhibits
31.1 Certifications by the President and Chief Executive Officer and Vice President Finance and Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002.
32.1 Certifications by the President and Chief Executive Officer and Vice President Finance and Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002. (This Exhibit is “furnished” pursuant to SEC rules, but is deemed not “filed”.)
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SIGNATURES
Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.
Dated: August 12, 2005 | Datalink Corporation |
| |
| |
| By: | /s/ Daniel J. Kinsella | |
| Daniel J. Kinsella, Vice President Finance and
Chief Financial Officer |
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