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: March 31, 2006
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 a large accelerated filer, an accelerated filer or a non-accelerated filer:
Large Accelerated Filer o | | Accelerated Filer o | | Non-Accelerated Filer ý |
Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act):
Yes o No ý
As of May 5, 2006, 10,541,570 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 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)
| | March 31,
2006 | | December 31,
2005 | |
| | (Unaudited) | | | |
Assets | | | | | |
Current assets | | | | | |
Cash and cash equivalents | | $ | 13,525 | | $ | 13,434 | |
Accounts receivable, net | | 21,330 | | 18,673 | |
Inventories | | 987 | | 831 | |
Deferred customer support contract costs | | 20,434 | | 16,500 | |
Inventories shipped but not installed | | 6,741 | | 5,064 | |
Other current assets | | 361 | | 261 | |
Total current assets | | 63,378 | | 54,763 | |
Property and equipment, net | | 2,410 | | 2,476 | |
Goodwill | | 5,500 | | 5,500 | |
Other assets | | 390 | | 404 | |
Total assets | | $ | 71,678 | | $ | 63,143 | |
| | | | | |
Liabilities and Stockholders’ Equity | | | | | |
Current liabilities | | | | | |
Accounts payable | | $ | 21,659 | | $ | 19,660 | |
Accrued commissions | | 1,511 | | 1,359 | |
Accrued income tax | | 51 | | 70 | |
Accrued sales and use tax | | 1,061 | | 645 | |
Accrued expenses, other | | 1,373 | | 1,893 | |
Sublease reserve current | | 389 | | 384 | |
Deferred revenue from customer support contracts | | 26,540 | | 21,367 | |
Total current liabilities | | 52,584 | | 45,378 | |
Deferred rent | | 272 | | 289 | |
Sublease reserve non-current | | 1,595 | | 1,641 | |
Total liabilities | | 54,451 | | 47,308 | |
| | | | | |
Commitments and contingencies | | | | | |
| | | | | |
Stockholders’ equity | | | | | |
Common stock, $.001 par value, 50,000,000 shares authorized, 10,541,570 and 10,404,105 shares issued and outstanding as of March 31, 2006 and December 31, 2005, respectively | | 11 | | 10 | |
Additional paid in capital | | 27,113 | | 26,555 | |
Accumulated deficit | | (9,897 | ) | (10,730 | ) |
Total stockholders’ equity | | 17,227 | | 15,835 | |
Total liabilities and stockholders’ equity | | $ | 71,678 | | $ | 63,143 | |
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
March 31, | |
| | 2006 | | 2005 | |
Net sales: | | | | | |
Products | | $ | 24,944 | | $ | 13,655 | |
Services | | 9,340 | | 7,586 | |
| | 34,284 | | 21,241 | |
Cost of sales: | | | | | |
Cost of products | | 18,640 | | 10,368 | |
Cost of services | | 6,503 | | 5,114 | |
Total cost of sales | | 25,143 | | 15,482 | |
Gross profit | | 9,141 | | 5,759 | |
Operating expenses: | | | | | |
Sales and marketing | | 4,177 | | 3,293 | |
General and administrative | | 2,789 | | 2,546 | |
Engineering | | 1,469 | | 1,128 | |
Charge for sublease reserve | | — | | 3,502 | |
Amortization of intangibles | | — | | 65 | |
| | 8,435 | | 10,534 | |
Earnings (loss) from operations | | 706 | | (4,775 | ) |
Interest income, net | | 127 | | 74 | |
Earnings (loss) before income taxes | | 833 | | (4,701 | ) |
Income taxes | | — | | — | |
Net earnings (loss) | | $ | 833 | | $ | (4,701 | ) |
| | | | | |
Net earnings (loss) per common share: | | | | | |
Basic | | $ | 0.08 | | $ | (0.46 | ) |
Diluted | | $ | 0.08 | | $ | (0.46 | ) |
Weighted average common shares outstanding: | | | | | |
Basic | | 10,447 | | 10,298 | |
Diluted | | 10,702 | | 10,298 | |
The accompanying notes are an integral part of these financial statements.
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Datalink Corporation
Statements of Cash Flows
(In thousands)
(Unaudited)
| | Three Months Ended
March 31, | |
| | 2006 | | 2005 | |
Cash flows from operating activities: | | | | | |
Net earnings (loss) | | $ | 833 | | $ | (4,701 | ) |
Adjustments to reconcile net earnings (loss) to net cash used in operating activities: | | | | | |
Provision for bad debts | | 9 | | 6 | |
Depreciation | | 262 | | 362 | |
Amortization of intangibles | | — | | 66 | |
Deferred rent | | (17 | ) | (37 | ) |
Charge for sublease reserve | | — | | 3,239 | |
Amortization of sublease reserve | | (41 | ) | — | |
Stock compensation expense | | 3 | | 17 | |
Changes in operating assets and liabilities: | | | | | |
Accounts receivable | | (2,666 | ) | 69 | |
Inventories | | (1,833 | ) | (1,544 | ) |
Deferred customer support contract costs/revenues, net | | 1,239 | | 990 | |
Accounts payable | | 1,999 | | 1,884 | |
Accrued expenses | | 29 | | (487 | ) |
Other | | (89 | ) | (505 | ) |
Net cash used in operating activities | | (272 | ) | (641 | ) |
| | | | | |
Cash flows from investing activities: | | | | | |
Purchase of property and equipment | | (196 | ) | (253 | ) |
Net cash used in investing activities | | (196 | ) | (253 | ) |
| | | | | |
Cash flows from financing activities: | | | | | |
Proceeds from issuance of common stock | | 559 | | 22 | |
Net cash provided by financing activities | | 559 | | 22 | |
| | | | | |
Increase (decrease) in cash and cash equivalents | | 91 | | (872 | ) |
Cash and cash equivalents, beginning of period | | 13,434 | | 12,663 | |
Cash and cash equivalents, end of period | | $ | 13,525 | | $ | 11,791 | |
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 and Use of Estimates
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 2005 Annual Report on Form 10-K.
The financial statements presented herein as of March 31, 2006, and for the three months ended March 31, 2006 and 2005, 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.
Management is required to make certain estimates and assumptions which affect the amounts of assets, liabilities, revenues and expenses the Company has reported, and the Company’s disclosure of contingent assets and liabilities at the date of the financial statements. The results of the interim periods are not necessarily indicative of the results for the full year. Accordingly, these condensed financial statements should be read in conjunction with the audited financial statements and the related notes included in the Company’s Annual Report on Form 10-K for the year ended December 31, 2005. Actual results could differ materially from these estimates and assumptions.
2. Inventories
Inventories, including inventories shipped but not installed, principally consist of data storage products and components, that are valued at the lower of cost or market with cost determined on a first-in, first-out (FIFO) method.
3. Net Earnings (Loss) Per Share
Basic net earnings (loss) per share is computed using the weighted average number of shares outstanding. Diluted net earnings per share includes the effect of 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. Due to the net loss for the three months ended March 31, 2005 common stock equivalents of 76,000 would have been anti-dilutive to losses and as a result were excluded from the calculation of diluted loss per share.
4. Stock Based Compensation
Stock Compensation Plans:
Effective May 8, 2001, the Company reserved an aggregate of 3,000,000 shares of common stock for issuance pursuant to the Company’s Incentive Compensation Plan, 1,124,349 of which were available for grant as of March 31, 2006. The terms of the plan allow for a variety of awards including incentive stock options, nonqualified stock options, stock appreciation rights, restricted stock, performance shares, performance units, cash-based awards, phantom shares and other share-based awards as determined by the Company’s Compensation Committee.
In August 2000, the Board of Directors adopted the 2000 Director Stock Option Plan (the “Director Plan”). The Company amended the Director Plan in May 2002, October 2002 and April 2004. The terms of the Director Plan allow for grants of restricted stock and stock options to non-employee members of the Board of Directors. The Company has reserved 300,000 shares of common stock for issuance pursuant to the Director Plan, 22,200 of which were available for grant as of March 31, 2006
Effective January 1, 2006, the Company adopted SFAS 123(R) which requires all share-based payments, including grants of stock options, to be recognized in the statement of operations as an operating expense based on their fair values over the requisite service period. SFAS 123(R) supersedes the Company’s previous accounting under Accounting Principles Board Opinion No. 25 “Accounting for Stock Issued to Employees” for periods beginning in fiscal 2006. The Company has applied the provisions of SAB 107 in its adoption of SFAS 123(R). The Company elected to utilize the modified-prospective transition method as permitted by SFAS 123(R). Under this transition method, the Company’s financial statements for prior periods have not been restated to reflect,
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and do not include, the impact of SFAS 123(R). Stock-based compensation expense for the first quarter ended March 31, 2006 includes: (a) compensation expense for all stock-based compensation awards granted prior to, but not yet vested as of January 1, 2006, based on grant-date fair value estimated in accordance with the original provisions of SFAS 123(R), “Accounting for Stock-Based Compensation;” and (b) compensation expense for all stock-based compensation awards granted on or after January 1, 2006, based on grant-date fair value estimated in accordance with the provisions of SFAS 123(R). The Company recorded $3,656 of related stock-based compensation expense for the quarter ended March 31, 2006.
On November 10, 2005, the Financial Accounting Standards Board (“FASB”) issued FASB Staff Position No. SFAS 123(R)-3, “Transition Election Related to Accounting for Tax Effects of Share-Based Payment Awards.” The alternative transition method includes simplified methods to establish the beginning balance of the additional paid-in capital pool (“APIC pool”) related to the tax effects of employee share-based compensation, and to determine the subsequent impact on the APIC pool and Consolidated Statements of Cash Flows of the tax effects of employee share-based compensation awards that are outstanding upon adoption of SFAS 123(R). The Company is in the process of evaluating whether to adopt the provisions of SFAS 123(R)-3.
On December 19, 2005, the Company’s Board of Directors took action to accelerate vesting of all outstanding employee stock options. As of that date, the Company had a total of 1,768,037 employee options outstanding, of which 1,442,912 were vested and 325,125 were unvested. The Board accelerated the vesting schedule of the 325,125 unvested employee options, of which 192,125 (the “underwater options”) had exercise prices in excess of $3.40 per share (the market price on the accelerated vesting date) and 128,000 (the “in the money options”) had exercise prices less than that price. The Company did not accelerate the vesting of options granted to Board members. The Board took the action to accelerate the vesting of the options in order to eliminate approximately $244,000 in compensation expense that the Company would otherwise have incurred over two years beginning in 2006, upon the adoption of FAS 123(R).
As of March 31, 2006, the Company had no unrecognized compensation costs related to non-vested stock option awards.
The following table illustrates the effect on operating results and per share information had the Company accounted for stock-based compensation in accordance with SFAS 123(R) for the three months ended March 31, 2006 and 2005:
| | Three Months Ended March 31, | |
| | 2006 | | 2005 | |
| | (In thousands) | |
Net earnings (loss): | | | | | |
As reported | | $ | 833 | | $ | (4,701 | ) |
Non cash compensation expense | | $ | — | | $ | (96 | ) |
Stock compensation cost on stock based awards granted below fair market value | | $ | — | | $ | — | |
Pro forma | | $ | 833 | | $ | (4,797 | ) |
| | | | | |
Basic earnings (loss) per share: | | | | | |
As reported | | $ | 0.08 | | $ | (0.46 | ) |
Non cash compensation expense | | $ | — | | $ | (0.01 | ) |
Stock compensation cost on stock based awards granted below fair market value | | $ | — | | $ | — | |
Pro forma | | $ | 0.08 | | $ | (0.47 | ) |
| | | | | |
Diluted earnings (loss) per share: | | | | | |
As reported | | $ | 0.08 | | $ | (0.46 | ) |
Non cash compensation expense | | $ | — | | $ | (0.01 | ) |
Stock compensation cost on stock based awards granted below fair market value | | $ | — | | $ | — | |
Pro forma | | $ | 0.08 | | $ | (0.47 | ) |
Stock Options
The Company made two grants of stock options during the quarter ended March 31, 2006. The Company uses the Black-Scholes option pricing model to estimate the fair value of stock-based awards with the following weighted-average assumptions for the indicated periods.
The following table represents weighted average assumptions for grants during the quarter ended March 31, 2006:
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| | As of March 31,
2006 | |
Risk-free interest rates | | 4.93 | % |
Expected dividend yield | | 0 | |
Expected volatility factor | | 131 | % |
Expected option holding period | | 5 years | |
The following table represents weighted average assumptions for fiscal 2005 grants:
| | Fiscal 2005 | |
Risk-free interest rates | | 4.32 | % |
Expected dividend yield | | 0 | |
Expected volatility factor | | 71 | % |
Expected option holding period | | 5 years | |
The risk-free rate is based on a treasury instrument whose term is consistent with the expected life of our stock options. The expected volatility, holding period, and forfeitures of options are based on historical experience.
The following table represents stock option activity for the three months ended March 31, 2006:
| | Number of Shares | | Weighted
Average
Exercise Price | | Weighted Average
Remaining Contract
Life | |
Outstanding options as of January 1, 2006 | | 1,775,137 | | $ | 5.07 | | | |
Options granted | | 3,400 | | $ | 4.11 | | | |
Options exercised | | (118,646 | ) | $ | 3.56 | | | |
Options cancelled | | (9,240 | ) | $ | 4.96 | | | |
Outstanding options as of March 31, 2006 | | 1,650,651 | | $ | 5.17 | | 5.32 | |
| | | | | | | |
Options exercisable as of March 31, 2006 | | 1,650,651 | | $ | 5.17 | | 5.32 | |
Shares available for future stock option grants to employees and directors under existing plans were 1,124,349 as of March 31, 2006. At March 31, 2006, the aggregate intrinsic value of options outstanding and exercisable was $951,568. Total intrinsic value of options exercised was $150,367 for the three months ended March 31, 2006.
The following table summarizes the Company’s nonvested stock option activity for the three months ended March 31, 2006:
| | Number of Shares | | Weighted
Average Grant-Date
Fair Value | |
Nonvested stock options at beginning of period | | — | | $ | — | |
Vested | | 3,400 | | $ | 1.08 | |
Cancelled | | — | | $ | — | |
Nonvested stock options at end of period | | — | | $ | — | |
Stock Warrants
The following table represents stock warrants activity for the three months ended March 31, 2006:
| | | | Weighted | | | |
| | | | Average | | Weighted Average | |
| | Number of Shares | | Exercise
Price | | Remaining
Contract Life | |
| | | | | | | |
Outstanding warrants as of January 1, 2006 | | 200,000 | | $ | 4.50 | | | |
Warrants granted | | — | | $ | — | | | |
Warrants exercised | | (26,000 | ) | $ | 4.50 | | | |
Warrants cancelled | | — | | $ | — | | | |
Outstanding warrants as of March 31, 2006 | | 174,000 | | $ | 4.50 | | 1.2 | |
| | | | | | | |
Warrants exercisable as of March 31, 2006 | | 174,000 | | $ | 4.50 | | 1.2 | |
Restricted Stock
In March 2006, the Company awarded 60,000 shares of restricted stock to an executive. The grant vests over 4 years, with 50 percent after year two, 25 percent after year three and 25 percent after year four if the executive is still employed by the Company. During the vesting period, the executive has voting rights and the right to receive dividends. However, the Company will retain the dividends until the shares have vested. The shares may not be sold, assigned, transferred, pledged or otherwise encumbered until they have vested. The Company is amortizing the $246,600 value of the restricted shares on the date of grant ratably over the four year vesting period. Unrecognized compensation expense related to the restricted stock grant was $244,000 at March 31, 2006.
5. 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
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within the balance sheet net of a full valuation allowance. Management must then assess the likelihood that the Company will utilize deferred tax assets 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 has recorded a full valuation allowance against the Company’s net deferred tax assets. The valuation allowance at March 31, 2006 was $4.5 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 March 31, 2006 primarily due to the utilization of net operating loss carry forwards to offset current taxable income. The resulting reduction in the deferred tax asset is offset by a decrease in the valuation allowance.
At December 31, 2005, the Company had federal net operating loss carry forwards of approximately $6.5 million and state net operating loss carry forwards of approximately $13.0 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.
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. Data storage is currently a large market, with spending in 2006 estimated at $39 billion and expected to exceed $41 billion by 2007. We have 14 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 manufacturer. The manufacturer provides on-site support assistance if necessary. We defer revenues and direct costs resulting from these contracts, and amortize these revenues and expenses into operations, over the term of the contracts, which are generally twelve months.
The enterprise-class information storage market is rapidly evolving and highly competitive. Our competition includes other independent storage system integrators, high end value added resellers, distributors, consultants and the internal sales force of our suppliers. Our ability to hire and retain qualified outside sales representatives and engineers with enterprise-class information storage experience is critical to effectively competing in the marketplace and achieving our growth strategies.
In the past, we have experienced fluctuations in the timing of orders from our customers, and we expect to continue to experience these fluctuations in the future. These fluctuations have resulted from, among other things, the time required to design, test and evaluate our data storage solutions before customers deploy them, the size of customer orders, the complexity of our customers’ network environments, necessary system configuration to deploy our solutions and new product introductions by suppliers. Completion of our installation and configuration services may also delay recognition of revenues. 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 providing significant opportunity for growth. Currently, Datalink’s market share is a small part of the overall market. However, the providers of the data storage industry’s products and technologies are increasing their utilization of indirect sales approaches to broaden their reach and optimize their margins. Increasingly, they are turning to companies such as Datalink to sell their products. While these trends provide opportunity for Datalink, we must improve our business model to generate sustainable, profitable growth. Our model requires highly skilled sales and technical staff which results in substantial fixed costs for us. We believe the best way to improve our company and create long-term shareholder value is to focus on building scaleable capabilities and a leverageable cost structure. Our current strategies are focused on:
• 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 data storage management and architecture services.
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• Exploring potential regional acquisitions that we believe can strengthen our resources and capabilities in key geographic locations.
To pursue these strategies, we are:
• Improving our training, tools and recruiting efforts for sales and engineering teams to increase productivity.
• Hiring additional customer support staff and enhancing the customer support staff’s communications and call management capabilities.
• Developing more effective delivery capabilities for professional services and 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.
| | Quarter Ended March 31, | |
| | 2006 | | 2005 | |
Net sales | | 100.0 | % | 100.0 | % |
Cost of sales | | 73.3 | | 72.9 | |
Gross profit | | 26.7 | | 27.1 | |
Operating expenses: | | | | | |
Sales and marketing | | 12.2 | | 15.5 | |
General and administrative | | 8.1 | | 12.0 | |
Engineering | | 4.3 | | 5.3 | |
Charge for sublease reserve | | — | | 16.5 | |
Amortization of intangibles | | — | | 0.3 | |
Total operating expenses | | 24.6 | | 49.6 | |
Operating earnings (loss) | | 2.1 | % | (22.5 | )% |
The following table shows, for the periods indicated, revenue and gross profit information for our product and service sales.
| | Quarter Ended March 31, | |
| | 2006 | | 2005 | |
Product sales | | $ | 24,944 | | $ | 13,655 | |
Service sales | | 9,340 | | 7,586 | |
| | | | | |
Product gross profit | | $ | 6,304 | | $ | 3,287 | |
Service gross profit | | 2,837 | | 2,472 | |
| | | | | |
Product gross profit as a percentage of product sales . | | 25.3 | % | 24.1 | % |
Service gross profit as a percentage of service sales | | 30.4 | % | 32.6 | % |
Net Sales. Our total net sales increased by $13.0 million for the three months ended March 31, 2006, or 61.4%, from $21.2 million for the comparable quarter in 2005. Our product sales increased $11.3 million, or 82.7%, to $24.9 million for the three months ended March 31, 2006, from $13.7 million for the comparable quarter in 2005. Our service sales increased $1.8 million, or 23.1%, to $9.3 million for the three months ended March 31, 2006 from $7.6 million for the comparable quarter in 2005.
The increase in our product sales for the three month period ended March 31, 2006 reflects a greater number of customers funding large projects, particularly for enhanced data recovery technology solutions. We had an increase in the customers representing more than $500,000 in quarterly revenues from 5 in the first quarter of 2005 to 9 in the first quarter of 2006. We also had a single product only sale during the quarter for $4.0 million which accounted for 29% of the quarter-over-quarter improvement.
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Our service sales increase for the three month period ended March 31, 2006 was primarily due to an increase in customer support contracts of $1.6 million and implementation services $245,000. With the growth in our product revenues, we continue to successfully sell our installation and configuration services and customer support contracts.
We derived 24% and 14% of our revenues for the periods ended March 31, 2006 and 2005, respectively, from Cingular Wireless. We cannot be assured that this customer will account for a substantial portion of our future sales.
Gross Profit. Our total gross profit as a percentage of net sales decreased to 26.7% for the quarter ended March 31, 2006, as compared to 27.1% for the comparable quarter in 2005. Product gross profit as a percentage of product sales increased to 25.3% in the first quarter of 2006 from 24.1% for the comparable quarter in 2005. Service gross profit as a percentage of service sales decreased to 30.4% in the first quarter of 2006 from 32.3% for the comparable quarter in 2005.
Our product gross profit as a percentage of product sales is impacted by the mix and type of projects we complete for our customers. The percentage improvement for the first quarter of 2006 reflects the increase in enhanced data recovery technology solution purchases made by our customers for which we achieve a higher gross profit.
Our service gross profit as a percentage of service sales for the three month period ended March 31, 2006 as compared to the same period in 2005 decreased by 1.9%. Because the level of on-site support services (which typically generate higher gross margins than our other services) decreased in the first quarter of 2006, our gross margins correspondingly decreased.
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 $4.2 million, or 12.2% of net sales for the quarter ended March 31, 2006, compared to $3.3 million, or 15.5% of net sales for the first quarter in 2005. Sales and marketing expenses in absolute dollars increased $884,000 for the three month period ended March 31, 2006, as compared to the three month period ended March 31, 2005.
Sales and marketing expenses as a percentage of net sales decreased for the quarter ended March 31, 2006 as compared to the first quarter in 2005. The decrease is a result of efficiency improvements with a higher level of revenue and little change in the number of our account executives during the quarter. The following table shows the change in our average number of account executives and the increase in our net sales per average number of account executives.
| | % Change in Average No. of
Account Executives | | % Change in Net Sales per
Average No. of Account
Executives | |
Q1 2006 vs. Q1 2005 | | 3 | % | 56 | % |
The increase of $884,000 for the three month period ended March 31, 2006, as compared to March 31, 2005 was primarily due to higher commission and payroll tax expenses of $780,000 related to higher revenue and gross profit for the 2006 period.
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 $2.8 million, or 8.1% of net sales for the quarter ended March 31, 2006, compared to $2.5 million, or 12.0% of net sales for the first quarter in 2005. General and administrative expenses in absolute dollars increased $243,000 for the three month period ended March 31, 2006, as compared to the three month period ended March 31, 2005.
General and administrative expenses as a percentage of net sales decreased for the quarter ended March 31, 2006 as compared to the first quarter in 2005. We improved our efficiency, holding fixed costs relatively flat on a quarter-over-quarter basis, despite a substantial increase in revenues. The increase of $243,000 for the three month period ended March 31, 2006, as compared to the same period in 2005 was due to increases in variable compensation of $190,000 due to bonuses for the profitable quarter and rent expense of $62,000. We entered into several new lease agreements for regional offices during the second and third quarters of 2005.
Engineering. Engineering expenses include employee wages and travel, hiring and training expenses for our professional engineers and technicians. Engineering expenses were $1.5 million or 4.3% of net sales for the quarter ended March 31, 2006 compared to $1.1 million, or 5.3% of net sales for the first quarter in 2005. Engineering expenses in absolute dollars increased $341,000 for the three month period ended March 31, 2006, as compared to the three month period ended March 31, 2005.
Engineering expenses as a percentage of net sales decreased for the quarter ended March 31, 2006 as compared to the first quarter in 2005. The decrease is the result of higher revenues in the first quarter of 2006. The increase in engineering expenses of $341,000 for
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the three month period ended March 31, 2006, as compared to March 31, 2005 reflects an increase in salaries and benefits. We added technical staff primarily to enhance our growing customer support and on-site technical staffing businesses.
Charge for Sublease Reserve. In December 2004, we agreed to sublease approximately 55,000 of the 104,000 square feet we then occupied as our corporate headquarters in Chanhassen, Minnesota. The initial sublease term is co-terminal with our lease and is for 85 months starting in April 2005 and ending in April 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 the first quarter of 2005, we incurred a one-time, non-cash charge of $3.5 million related to the sublease and lot sale.
Intangible Amortization. We had no amortization of intangible assets for the quarter ended March 31, 2006, as compared to $65,000 or 0.3% of net sales for the first quarter in 2005. The remaining balance of the customer base intangible was amortized in November 2005.
Operating Earnings (Loss). We had operating earnings of $706,000 for the three months ended March 31. 2006 as compared to an operating loss of $4.7 million for the three months ended March 31, 2005. Excluding the $3.5 million sublease charge, our operating loss for the three months ended March 31, 2005 was $1.2 million. The $1.9 million improvement in operating earnings (excluding our sublease charge) is a result of the significant increase in our revenues coupled with relatively flat fixed expenses on a quarter-over-quarter basis.
Income Taxes. We had no income tax expense for the three months ending March 31, 2006 due to the utilization of net operating loss carryforwards to offset current taxable income and the reduction in the deferred tax asset being offset by a decrease in the valuation allowance. We had no income tax benefit for the three months ended March 31, 2005 as the net operating loss carryforward was offset by an increase 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 2005, 2004 and 2003 and the near-term uncertainty of future taxable income, we cannot reasonably predict when or if we will realize these deductible differences. In addition, we do not have the ability to realize future income tax benefits on future losses.
LIQUIDITY AND CAPITAL RESOURCES
Net cash used in operating activities was $272,000 for the three months ended March 31, 2006 as compared to $641,000 for the three months ended March 31, 2005. Significant items which impacted our operating cash flows as March 31, 2006 were:
• Our operating earnings for the quarter of $706,000.
• A $1.2 million 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 $2.5 million in working capital primarily related to accounts receivable increases reflecting our higher level of revenues for the quarter and timing related to the receipt of orders during the quarter.
Net cash used in investing activities was $196,000 for the three months ended March 31, 2006. We used this cash primarily for upgraded computer equipment and a project to upgrade our intranet. We are planning for $500,000 of capital expenditures for the remainder of 2006 related primarily to enhancements to our management information systems.
Net cash provided by financing activities was $559,000 for the three months ended March 31, 2006, from the exercise of employee stock options during the quarter. Net cash provided by financing activities was $22,000 for the three months ended March 31, 2005, from stock sold under our employee stock purchase plan. We discontinued our employee stock purchase plan in December 2005.
We have elected not to pursue a credit facility at this time. With our current cash position, we believe we have the liquidity to meet our operating needs for the foreseeable future. We have no outstanding debt, and if the need should arise to borrow funds, we believe that we could obtain a secured facility.
Our contractual cash obligations consist of future minimum lease payments due under non-cancelable operating leases. These obligations are as of March 31, 2006, for the remainder of 2006 and each of the full years thereafter as follows:
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| | | | (in thousands) | | | |
| | Lease
Obligations | | Sublease
Income | | Net Lease
Obligations | |
2006 | | $ | 1,912 | | $ | (1,117) | | $ | 795 | |
2007 | | 1,815 | | (1,120 | ) | 695 | |
2008 | | 1,546 | | (1,053 | ) | 493 | |
2009 | | 1,549 | | (1,053 | ) | 496 | |
2010 | | 1,397 | | (1,053 | ) | 344 | |
Thereafter | | 1,686 | | (1,404 | ) | 282 | |
| | $ | 9,905 | | $ | (6,800 | ) | $ | 3,105 | |
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, income taxes, self-insurance reserves and commitments and contingencies.
Our significant accounting policies and estimates are summarized in our annual financial statements. Some of our accounting policies require management to exercise significant judgment in selecting the appropriate assumptions for calculating financial estimates. Such judgments are subject to an inherent degree of uncertainty. These judgments are based on our historical experience, known trends in our industry, terms of existing contracts and other information from outside sources, as appropriate. We believe these estimates and assumptions are reasonable based on the facts and circumstances as of March 31, 2006. However, actual results may differ from these estimates under different assumptions and circumstances.
We believe that the following represent the areas where we use more critical estimates and assumptions in the preparation of our financial statements:
Revenue Recognition. We realize revenue from the design, installation and support of data storage solutions, which may include hardware, software and services. We recognize revenue when we have met our obligations for installation or other services and collectability is reasonably assured.
Product Sales. We sell software and hardware products on both a “free-standing” basis without any services and as data storage solutions bundled with our installation and configuration services (“bundled arrangements”).
Product Sales Without Service. If we sell a software or hardware product and do not provide any installation or configuration services with it, we recognize the product revenues upon shipment.
Product Sales With Service. If we sell a bundled arrangement, then we defer recognizing any revenues on it until we finish our installation and/or configuration work. We account for the hardware, software and service elements of our bundled arrangements by applying the provisions of Statement of Position (SOP) 97-2, Software Revenue Recognition, as amended by SOP 98-4 and SOP 98-9.
Pursuant to the provisions of SOP 97-2, we apply contract accounting to our bundled arrangements. In accordance with SOP 81-1, “Accounting for Performance of Construction Type and Certain Production Type Contracts,” we apply the completed contract method. Factors we have considered in applying the completed contract method accounting include (i) the relatively short duration of our contracts, (ii) the difficulty of estimating our revenues on a percentage-of-completion method and (iii) our use of acceptance provisions on larger bundled arrangements.
Service Sales. In addition to installation and configuration services that are part of our bundled arrangements described above, our service sales include customer support contracts and consulting services. On our balance sheet, deferred revenue relates to service sales for which our customer has paid us or has been invoiced but for which we have not yet performed the applicable services.
Customer Support Contracts. We sell service contracts to most of our customers. These contracts are support service agreements. We have an internal support desk that provides integrated customer support services, including configuration and usage assistance, technical advice and prompt incident detection and resolution. Our technical staff first assists a customer in identifying the source of system problems and in determining whether there is defective hardware or software. If
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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 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, length of 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 va lue amounts.
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 we will recover our deferred tax assets from future taxable income We record a valuation allowance to reduce our deferred tax assets to the amounts we believe are more likely than not 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 deferred tax in the period we make this determination.
As a result of our cumulative losses over the past two years and the full utilization of our loss carry back potential, we have made a full valuation allowance against our net deferred tax assets. The valuation allowance at December 31, 2005 was $4.8 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.
Stock Based Compensation. We adopted the provisions of SFAS 123R, Share- Based Payment on January 1, 2006. SFAS 123R 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 utilize the Black-Scholes option valuation model to measure the amount of compensation expense to be recognized for each option award. There are several assumptions that must be made when using the Black-Scholes model such as the expected term of each option, the expected volatility of the stock price during
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the expected term of the option, forfeitures, the expected dividends to be paid and the risk free interest rate expected during the option term. We have reviewed each of these assumptions carefully and we determined our best estimate for these variables. Of these assumptions, the expected term of the option and expected volatility of our common stock are the most difficult to estimate since they are based on the exercise behavior of employees and the expected performance of our stock. An increase in the volatility of our stock will increase the amount of compensation expense on new awards. An increase in the holding period of options will also cause an increase in compensation expense. Dividend yields and risk-free interest rates are less difficult to estimate, but an increase in the dividend yield will cause a decrease in expense and an increase in the risk-free interest rate will increase compensation expense.
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 that these are exposed to no material market risk. The following discusses our exposure to market risk related to changes in interest rates, foreign exchange rates and equity prices.
Interest rate risk. As of March 31, 2006, we had $13.5 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.
Changes in internal control over financial reporting. There were no changes in our internal controls over financial reporting that occurred during the period covered by this report that have materially affected, or are reasonably likely to materially affect, our internal controls over financial reporting.
Evaluation of 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 first quarter of 2006.
Item 1A. Risk Factors.
There has not been a material change to the risk factors as set forth in our annual report on Form 10-K for the fiscal year ended December 31, 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.
None
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:May 12, 2006 | Datalink Corporation |
| | |
| | |
| By: | /s/ Gregory T. Barnum | |
| Gregory T. Barnum, Vice President Finance and |
| Chief Financial Officer | |
| | | | |
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