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 2005 Annual Report on Form 10-K.
The financial statements presented herein as of June 30, 2006, and for the three and six months ended June 30, 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, 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 six months ended June 30, 2005 common stock equivalents of 82,000 would have been anti-dilutive 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, 934,877 of which were available for grant as of June 30, 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, 15,350 of which were available for grant as of June 30, 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 second quarter and six-month period ending June 30, 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).
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 June 30, 2006, the Company had no unrecognized compensation costs related to non-vested stock option awards. The Company recorded $5,015 and $8,671, respectively, of related stock option compensation expense for the second quarter and six-month period ending June 30, 2006.
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 and six months ended June 30, 2005:
| | Three Months
ended
June 30, 2005 | | Six Months
ended
June 30, 2005 | |
Net earnings (loss): | | | | | |
As reported | | $ | 446 | | $ | (4,255 | ) |
Non cash compensation expense | | $ | (106 | ) | $ | (202 | ) |
Pro forma | | $ | 340 | | $ | (4,457 | ) |
Basic earnings (loss) per share: | | | | | |
As reported | | $ | 0.04 | | $ | (0.41 | ) |
Non cash compensation expense | | $ | (0.01 | ) | $ | (0.02 | ) |
Pro Forma | | $ | 0.03 | | $ | (0.43 | ) |
Diluted earnings (loss) per share: | | | | | |
As reported | | $ | 0.04 | | $ | (0.41 | ) |
Non cash compensation expense | | $ | (0.01 | ) | $ | (0.02 | ) |
Pro forma | | $ | 0.03 | | $ | (0.43 | ) |
Stock Options
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 six months ended June 30, 2006:
| | As of June 30, 2006 | |
Risk-free interest rates | | 5.08 | % |
Expected dividend yield | | 0 | |
Expected volatility factor | | 104 | % |
Expected option holding period | | 5 years | |
The following table represents weighted average assumptions for fiscal 2005 grants:
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| | 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 six months ended June 30, 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 | | 6,500 | | $ | 4.63 | | | |
Options exercised | | (221,795 | ) | $ | 3.56 | | | |
Options cancelled | | (153,893 | ) | $ | 7.27 | | | |
Outstanding and exercisable options as of June 30, 2006 | | 1,405,949 | | $ | 4.92 | | 5.76 | |
Shares available for future stock option grants to employees and directors under existing plans were 950,227 as of June 30, 2006. At June 30, 2006, the aggregate intrinsic value of options outstanding and exercisable was $1,514,741. Total intrinsic value of options exercised was $395,285 for the six months ended June 30, 2006. The weighted average grant date fair value of options granted during 2006 was $2.11.
Stock Warrants
The following table represents stock warrants activity for the six months ended June 30, 2006:
| | Number of Shares | | Weighted
Average
Exercise Price | | Weighted Average
Remaining Contract
Life | |
Outstanding warrants as of January 1, 2006 | | 200,000 | | $ | 4.50 | | | |
Warrants granted | | — | | $ | — | | | |
Warrants exercised | | (98,000 | ) | $ | 4.50 | | | |
Warrants cancelled | | — | | $ | — | | | |
Outstanding warrants as of June 30, 2006 | | 102,000 | | $ | 4.50 | | 1.0 | |
| | | | | | | |
Warrants exercisable as of June 30, 2006 | | 102,000 | | $ | 4.50 | | 1.0 | |
Non-Vested Stock
In March and April 2006, the Company awarded 60,000 and 163,000 shares of non-vested stock, respectively, to our management group. The grants vest over 4 years, with 50 percent after year two, 25 percent after year three and 25 percent after year four if the individual is still employed by the Company. During the vesting period, the individual 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 $970,320 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 $907,106 at June 30, 2006. For the three and six month periods ended June 30, 2006, respectively, compensation expense related to restricted stock grants were $60,500 and $63,000.
The following table summarizes the Company’s non-vested stock activity for the six months ended June 30, 2006:
| | Number of Shares | | Weighted Average
Grant-Date Fair Value | |
Non-vested stock at January 1, 2006 | | — | | $ | — | |
Granted | | 223,000 | | $ | 4.35 | |
Shares vested | | — | | $ | — | |
Non-vested stock at June 30, 2006 | | 223,000 | | $ | 4.35 | |
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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 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 June 30, 2006 was $3.7 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. However, management is continuing to assess this matter. Once management determines that the Company has reached a sustained level of profitability and that it is more likely than not that all or a portion of the net deferred tax assets may be realized the Company will reduce the valuation allowance and recognize a tax benefit. No income tax provision has been presented for the quarter and six-month period ending June 30, 2006 primarily due to a reduction in deferred tax assets 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.
6. Recently Issued Accounting Standards
In July 2006, the FASB issued FASB Interpretation No. 48, Accounting for Uncertainty in Income Taxes—an Interpretation of FASB Statement 109 (“FIN 48”), which clarifies the accounting for uncertainty in tax positions. This Interpretation provides that the Company can recognize the tax effects from an uncertain tax position can be recognized in its financial statements only if the position is more likely than not of being sustained on audit, based on the technical merits of the position. The provisions of FIN 48 are effective as of the beginning of fiscal 2007, with the cumulative effect of the change in accounting principle recorded as an adjustment to opening retained earnings. The Company is currently evaluating the impact of adopting FIN 48 on its financial statements.
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 $40 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
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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.
· 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.
· Identifying and meeting with potential acquisition candidates on a regular basis.
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, | |
| | 2006 | | 2005 | | 2006 | | 2005 | |
Net sales | | 100.0 | % | 100.0 | % | 100.0 | % | 100.0 | % |
Cost of sales | | 75.3 | | 73.5 | | 74.4 | | 73.2 | |
Gross profit | | 24.7 | | 26.5 | | 25.6 | | 26.8 | |
Operating expenses: | | | | | | | | | |
Sales and marketing | | 9.8 | | 13.3 | | 10.9 | | 14.3 | |
General and administrative | | 6.4 | | 7.8 | | 7.2 | | 9.6 | |
Engineering | | 3.7 | | 3.8 | | 4.0 | | 4.4 | |
Charge for sublease reserve | | — | | — | | — | | 7.0 | |
Amortization of intangibles | | — | | 0.2 | | — | | 0.3 | |
Total operating expenses | | 19.9 | | 25.2 | | 22.1 | | 35.6 | |
Operating earnings (loss) | | 4.8 | % | 1.3 | % | 3.5 | % | (8.8 | )% |
The following table shows, for the periods indicated, revenue and gross profit information for our product and service sales.
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| | Three Months Ended
June 30, | | Six Months Ended
June 30, | |
| | 2006 | | 2005 | | 2006 | | 2005 | |
Product sales | | $ | 29,280 | | $ | 19,918 | | $ | 54,224 | | $ | 33,573 | |
Service sales | | 10,553 | | 8,823 | | 19,893 | | 16,409 | |
| | | | | | | | | |
Product gross profit | | $ | 6,761 | | $ | 4,765 | | $ | 13,065 | | $ | 8,052 | |
Service gross profit | | 3,090 | | 2,849 | | 5,927 | | 5,321 | |
| | | | | | | | | |
Product gross profit as a percentage of product sales | | 23.1 | % | 23.9 | % | 24.1 | % | 24.0 | % |
Service gross profit as a percentage of service sales | | 29.3 | % | 32.3 | % | 29.8 | % | 32.4 | % |
Net Sales. Our total net sales increased by $11.1 million for the three months ended June 30, 2006, or 38.6%, from $28.7 million for the comparable quarter in 2005. Our total net sales increased $24.1million for the six months ended June 30, 2006, or 48.3% from $50.0 million for the comparable period in 2005. Our product sales increased $9.4 million, or 47.0%, to $29.3 million for the three months ended June 30, 2006, from $19.9 million for the comparable quarter in 2005. Our product sales increased $20.6 million, or 61.5%, to $54.2 million for the six months ended June 30, 2006, from $33.6 million for the six months ended June 30, 2005. Our service sales increased $1.7 million, or 19.6%, to $10.6 million for the three months ended June 30, 2006 from $8.8 million for the comparable quarter in 2005. Our service sales increased $3.5 million, or 21.2%, to $19.9 million for the six months ended June 30, 2006, from $16.4 million for the six months ended June 30, 2005.
The increase in our product sales for the three and six month periods ended June 30, 2006, as compared to the same periods in 2005, reflects a greater number of customers funding large projects, particularly for enhanced data recovery technology solutions. We had an increase in the number of customers representing more than $1.0 million in quarterly revenues from four in the second quarter of 2005 to seven in the second quarter of 2006. Likewise, for the first six months of 2006, we had an increase in the number of customers representing more than $1.0 million in revenues to 13 from six in the first six months of 2005. We also had two large product-only sales during the second quarter for a total of $4.8 million which accounted for 44% of the quarter-over-quarter improvement.
Our service sales increase for the three month period ended June 30, 2006 as compared to the same period in 2005 was due primarily to an increase in customer support contracts of $1.8 million. With the growth in our product revenues for the quarter ended June 30, 2006, as compared to the same period in 2005, we experienced a corresponding growth in our customer support contract revenues. Our services sales increase for the six month period ended June 30, 2006 as compared to the same period in 2005 was due to an increase in customer support contracts of $3.5 million. With the growth in our product revenues for the six months ended June 30, 2006, as compared to the same period in 2005, we experienced a corresponding growth in our customer support contract revenues.
We derived 20% and 7% of our revenues for the three months ended June 30, 2006 and 2005, respectively, from Cingular Wireless. We derived 22% and 8% of our revenues for the six months ended June 30, 2006 and 2005, respectively, from Cingular Wireless. We cannot assure 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 24.7% for the quarter ended June 30, 2006, as compared to 26.5% for the comparable quarter in 2005. Our total gross profit as a percentage of net sales decreased to 25.6% for the six months ended June 30, 2006, as compared to 26.8% for the six months ended June 30, 2005. Product gross profit as a percentage of product sales decreased to 23.1% in the second quarter of 2006 from 23.9% for the comparable quarter in 2005. Product gross profit as a percentage of product sales remained flat at 24.1% for the six months ended June 30, 2006 and 2005. Service gross profit as a percentage of service sales decreased to 29.3% for the second quarter of 2006 from 32.3% for the comparable quarter in 2005. Service gross profit as a percentage of service sales decreased to 29.8% for the six months ended June 30, 2006 from 32.4% for the six months ended June 30, 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. For the three and six month periods ended June 30, 2006 as compared to the same periods in 2005, we had several large product-only orders which typically carry lower gross margins.
Our service gross profit as a percentage of service sales for the three and six month periods ended June 30, 2006 as compared to the same period in 2005 decreased by 3.0% and 2.6%, respectively. Because the level of on-site support services (which typically generate higher gross margins than our other services and customer support contracts) decreased, 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 $3.9 million, or 9.9% of net sales for the quarter ended June 30, 2006 compared to $3.8 million, or 13.4% of net sales for the second quarter in 2005. Sales and marketing
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expenses totaled $8.1 million, or 10.9% of net sales for the six months ended June 30, 2006, compared to $7.1 million, or 14.3% of net sales for the six months ended June 30, 2005.
Sales and marketing expenses in absolute dollars increased $89,000 and $973,000 for the three and six month periods ended June 30, 2006, respectively, as compared to the three and six month periods ended June 30, 2005. Despite the increase in absolute dollars for the three and six month periods ended June 30, 2006 as compared to June 30, 2005, sales and marketing expenses as a percentage of net sales decreased for all comparative periods. This decrease is a result of efficiency improvements with a higher level of revenue and little change in the number of our account executives. 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 (with year-to-date figures representing through the end of the respective second quarter).
| | % Change in Average No. of
Account Executives | | % Change in Net Sales per
Average No. of Account
Executives | |
Q2 2006 vs. Q2 2005 | | (2 | )% | 42 | % |
YTD 2006 vs. YTD 2005 | | 1 | % | 47 | % |
The increase in sales and marketing expenses of $973,000 for the six month period ended June 30, 2006, as compared to the same period in 2005 was primarily due to higher commission expenses of $1.0 million 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 $2.5 million, or 6.4% of net sales for the quarter ended June 30, 2006, compared to $2.2 million, or 7.8% of net sales for the second quarter in 2005. General and administrative expenses were $5.3 million, or 7.2% of net sales for the six months ended June 30, 2006 compared to $4.8 million, or 9.6% of net sales for the six months ended June 30, 2005.
General and administrative expenses as a percentage of net sales decreased for the three and six month periods ended June 30, 2006 as compared to June 30, 2005. We improved our efficiency, holding fixed costs relatively flat on a period-over-period basis, despite a substantial increase in revenues.
General and administrative expenses in absolute dollars increased $296,000 for the three month period ended June 30, 2006, as compared to the same period in 2005. The increase was due in part to higher training expenses of $64,000 to complete vendor certification coursework, an increase in restricted stock compensation expense of $44,000 and higher rent expense of $65,000. We entered into several new lease agreements for regional offices during the second and third quarter of 2005. General and administrative expenses in absolute dollars increased $539,000 for the six month period ended June 30, 2006, as compared to the same period in 2005. The increase was due to: higher variable compensation expenses of $194,000 for bonuses based on the profitable first half, sales and use tax expenses of $125,000 for several state audits and rent expense of $210,000.
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 3.7% of net sales for the quarter ended June 30, 2006 compared to $1.1 million, or 3.8% of net sales for the second quarter in 2005. Engineering expenses were $2.9 million, or 4.0% of net sales for the six months ended June 30, 2006 compared to $2.2 million, or 4.4% of net sales for the six months ended June 30, 2005.
Engineering expenses as a percentage of net sales decreased for both the three and six month periods ended June 30, 2006 as compared to the same periods in 2005. The decrease is the result of efficiency improvement, as the moderate increase in engineering expenses was offset by the substantial increase in revenues.
Engineering expenses in absolute dollars increased $395,000 for the three month period ended June 30, 2006 as compared to the same period in 2005. The increase is due to higher salaries and benefits. We added technical staff primarily directed to enhance our growing customer support business and to enhance our pre-sale engineering capabilities. We also experienced a decrease in on-site consulting revenues of $352,000. Accordingly we had a corresponding increase in the proportion of our engineering costs allocated to engineering expenses and a decrease in our allocation to cost of service sales. Engineering expenses in absolute dollars increased $736,000 for the six month period ended June 30, 2006 as compared to the same period in 2005. The increase in engineering expenses is also due to an increase in salaries and benefits for the addition of technical staff to enhance our growing customer support and pre-sale engineering capabilities. We also experienced a decrease in on-site consulting revenues of $580,000. Accordingly we had a corresponding increase in the proportion of our engineering costs allocated to engineering expenses and a decrease in our allocation of cost of services sales.
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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 three and six month period ended June 30, 2006, as compared to $65,000 and $130,000, respectively, for the three and six month periods ending June 30, 2005. Intangible amortization was 0.2% and 0.3% of net sales for the three and six month period ended June 30, 2005. We amortized the remaining balance of the customer base intangible in November 2005.
Operating Earnings (Loss). We had operating earnings of $1.9 million for the three months ended June 30, 2006 as compared to operating earnings of $388,000 for the three months ended June 30, 2005. We had operating earnings of $2.6 million for the six months ended June 30, 2006 as compared to an operating loss of $4.4 million for the six months ended June 30, 2005. Excluding the $3.5 million sublease charge, our operating loss for the six months ended June 30, 2005 was $885,000. The $1.5 million and $3.5 million improvements in operating earnings for the three and six month periods ended June 30, 2006 as compared to the same period in 2005 is a result of the significant increase in our revenues coupled with relatively flat fixed expenses on a period-over-period basis.
Income Taxes. We had no income tax expense for the three and six month periods ending June 30, 2006 due to a reduction in the deferred tax asset offset by a decrease in the valuation allowance. We had no income tax benefit for the three and six month periods ending June 30, 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. However, management is continuing to assess this matter. If management determines that we have reached a sustained level of profitability and that it is more likely than not that we may realize all or a portion of the net deferred tax assets we will reduce the valuation allowance and recognize a tax benefit.
LIQUIDITY AND CAPITAL RESOURCES
Net cash provided by operating activities was $2.5 million for the six months ended June 30, 2006 as compared to net cash used in operating activities of $2.6 million for the six months ended June 30, 2005. Significant items which impacted our operating cash flows as of June 30, 2006 were:
· Net earnings of $2.9 million.
· A $1.4 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 $1.7 million in working capital. This was primarily due to an increase in inventory related to customer orders and a decrease in accounts payable which was partially offset by a decrease in accounts receivable related to lower than normal days sales outstanding of 35 at the end of the quarter.
Net cash used in investing activities was $342,000 for the six months ended June 30, 2006. We used this cash primarily for upgraded computer equipment and a project to upgrade our intranet. We are planning for $350,000 of capital expenditures for the remainder of 2006 related primarily to further enhancements to our management information systems.
Net cash provided by financing activities was $1.3 million for the six months ended June 30, 2006, from the exercise of stock options and warrants. 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. 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 June 30, 2006, for the remainder of 2006 and each of the full years thereafter as follows:
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| | (in thousands) | |
| | Lease
Obligations | | Sublease
Agreements | | Net Lease
Obligations | |
2006 | | $ | 1,188 | | $ | (571 | ) | $ | 617 | |
2007 | | 1,854 | | (1,120 | ) | 734 | |
2008 | | 1,569 | | (1,053 | ) | 516 | |
2009 | | 1,549 | | (1,053 | ) | 496 | |
2010 | | 1,397 | | (1,053 | ) | 344 | |
Thereafter | | 1,686 | | (1,404 | ) | 282 | |
| | $ | 9,243 | | $ | (6,254 | ) | $ | 2,989 | |
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 June 30, 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 val ue 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. However, management is continuing to assess this matter. If management determines that we have reached a sustained level of profitability and that it is more likely than not that we may realize all or a portion of the net deferred tax assets we will reduce the valuation allowance and recognize a tax benefit.
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
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amount of compensation expense we recognize for each option award. We make several assumptions when using the Black-Scholes model such as the expected term of each option, the expected volatility of the stock price during 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 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, 2006, we had $16.8 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.
Evaluation of disclosure controls and procedures. Under the supervision and with the participation of our Chief Executive Officer and our Chief Financial Officer, we conducted an evaluation of the effectiveness of the design and option 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”)), as of the end of the period covered by this Quarterly Report on Form 10-Q (the “Evaluation Date”).
The purpose of this evaluation is to determine if, as of the Evaluation Date, our disclosure controls and procedures were operating effectively such that the information relating to Datalink Corporation, required to be disclosed in our Securities and Exchange Commissions (“SEC”) reports (i) was recorded, processed, summarized and reported within the time periods specified in SEC rules and forms, and (ii) was accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, as appropriate to allow timely decisions regarding required disclosures.
Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that, as of the Evaluation Date, our disclosure controls and procedures were operating effectively.
Changes in internal control over financial reporting. 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 2006.
Item 1A. Risk Factors.
Except as provided below, 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.
Dependence on a Significant Customer. We derived 20% and 22% of our revenues for the three and six months, respectively, ended June 30, 2006, from Cingular Wireless. We cannot assure that this customer will account for a substantial portion of our future sales.
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 4, 2006, our shareholders elected Brent G. Blackey, Paul F. Lidsky, Margaret A. Loftus, Greg R. Meland, James E. Ousley, Robert M. Price and Charles B. Westling as directors with the following votes:
| | For | | Withheld | |
| | | | | |
Brent G. Blackey | | 6,306,812 | | 14,250 | |
Paul F. Lidsky | | 5,945,143 | | 375,919 | |
Margaret A. Loftus | | 5,945,143 | | 375,919 | |
Greg R. Meland | | 5,810,590 | | 510,472 | |
James E. Ousley | | 5,896,159 | | 424,903 | |
Robert M. Price | | 5,813,890 | | 507,172 | |
Charles B. Westling | | 5,851,002 | | 470,060 | |
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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