DTLK Datalink Corp.

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

(Mark One)

For the quarterly period ended:  September 30, 2013

or

For the transition period from               to               

Commission file number: 00029758

DATALINK CORPORATION

(Exact name of registrant as specified in its charter)

10050 Crosstown Circle, Suite 500

EDEN PRAIRIE, MINNESOTA 55344

(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  x No  o

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes  x No  o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller reporting company.  See the definitions of “large accelerated filer”, “accelerated filer” and “smaller reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange Act): 

Yes  o   No  x

As of November 5, 2013, 22,671,642 shares of the registrant’s common stock, $.001 par value, were outstanding.

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DATALINK CORPORATION

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The accompanying notes are an integral part of these financial statements.

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The accompanying notes are an integral part of these financial statements.

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Datalink Corporation

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We excluded the following restricted stock grants that have not yet vested from the computation of diluted earnings per share as their effect would have been anti-dilutive:

3.                                       Stock-Based Compensation

Common Stock Offering

On August 8, 2013, we entered into an underwriting agreement relating to the public offering of 3,300,000 shares of our common stock at a price to the public of $11.00 per share, less underwriting discounts. In addition, we granted the underwriters a 30-day option to purchase up to an additional 495,000 shares at $11.00 per share to cover over-allotments, if any. On August 14, 2013, we completed the offering of 3,795,000 shares of common stock at a price to the public of $11.00 per share. The number of shares sold in the offering includes the underwriters’ full exercise of their over-allotment option. We received proceeds from the common stock sold by us, net of offering costs, of approximately $39.0 million.

Restricted Stock:

Total stock-based compensation expense related to restricted stock was $989,000 and $591,000 for the three months ended September 30, 2013 and 2012, respectively.  Total stock-based compensation expense related to restricted stock was $2.5 million and $1.6 million for the nine months ended September 30, 2013 and 2012, respectively.  Unrecognized stock-based compensation expense related to restricted stock was $5.8 million at September 30, 2013, which we will amortize ratably through May 2017.

The following table summarizes our restricted stock activity for the nine months ended September 30, 2013:

Stock Options:

Total stock-based compensation expense related to stock options was $14,000 and $60,000 for the three months ended September 30, 2013 and 2012, respectively.  Total stock-based compensation expense related to stock options was $134,000 and $181,000 for the nine months ended September 30, 2013 and 2012, respectively.  We had no unrecognized stock-based compensation expense related to stock options at September 30, 2013.

The following table represents stock option activity for the nine months ended September 30, 2013:

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Other:

During the three months ended September 30, 2013 and 2012, we recognized expense of $122,000 and $75,000, respectively, related to the issuance of 9,000 shares of fully vested common stock in each period to members of our Board of Directors. During the nine months ended September 30, 2013 and 2012, we recognized expense of $326,000 and $246,000, respectively, related to the issuance of 27,000 shares of fully vested common stock in each period to members of our Board of Directors.

4.                                       Income Taxes

We base the provision for income taxes upon estimated annual effective tax rates in the tax jurisdictions in which we operate.  For the three months ended September 30, 2013 and 2012, our effective tax rate was 28.9% and 41.2%, respectively.  For the nine months ended September 30, 2013 and 2012, our effective tax rate was 39.2% and 40.5%, respectively.  The lower tax rate for the three and nine months ended September 30, 2013 as compared to the same periods in 2012 resulted primarily from the impact of federal graduated tax rates on our estimated annual taxable income. Additionally, we recognized benefits from discrete item adjustments of approximately $101,000 and $5,000 during the three months ended September 30, 2013 and 2012, respectively. These adjustments decreased our effective tax rate to 28.9% and 41.2% for the three months ended September 30, 2013 and 2012, respectively. We recognized benefits from discrete item adjustments of approximately $101,000 and $32,000 during the nine months ended September 30, 2013 and 2012, respectively. These adjustments decreased our effective tax rate to 39.2% and 40.5% for the nine months ended September 30, 2013 and 2012, respectively. We expect our annual effective tax rate for 2013 to be 39.8%.

As part of the process of preparing financial statements, we estimate federal and state income taxes. Management estimates 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 we include within our balance sheet. Management must then assess the likelihood that we will utilize deferred tax assets to offset future taxable income during the periods in which we may deduct these temporary differences.  For the three and nine months ended September 30, 2013, we recorded income tax expense of $335,000 and $3.1 million, respectively, with effective tax rates of 28.9% and 39.2%.

We assess our uncertain tax positions for tax years that are still open for examination.  As of September 30, 2013 and 2012, we had no unrecognized tax benefits which would affect our effective tax rate if recognized.

We classify interest and penalties arising from the underpayment of income taxes in the statement of operations under general and administrative expenses. As of September 30, 2013 and 2012, we had no accrued interest or penalties related to uncertain tax positions. The tax years 2009-2012 remain open to examination by both the Federal government and by other major income taxing jurisdictions to which we are subject.

Our ability to utilize a portion of our net operating loss carryforwards to offset future taxable income is subject to certain limitations under Section 382 of the Internal Revenue Code due to changes in our equity ownership. We do not believe that an ownership change under Section 382 has occurred, and therefore, no such limitations exist.

5.                                       Acquisitions

On October 4, 2012, we purchased substantially all of the assets and liabilities of Strategic Technologies, Inc. (“StraTech”) from StraTech and Midas Medici Group Holdings, Inc. (“Midas,” parent company of StraTech and, together with StraTech, the “Sellers”). StraTech is an IT services and solutions firm that shares our focus on optimizing enterprise data centers and IT infrastructure through a common product and services portfolio designed to help customers increase business agility. We purchased StraTech for a purchase price of approximately $11.0 million, comprised of a cash payment of approximately $13.2 million, which is offset by a receivable due from the Sellers of approximately $4.2 million resulting from the preliminary estimated working capital adjustment. In addition, we issued 269,783 shares of our common stock with a value of approximately $2.0 million. Those shares have been deposited in an escrow account as security for certain indemnification obligations of the Sellers. Pursuant to the asset purchase agreement, Sellers are obligated to pay us an amount equal to the difference between the actual tangible net assets on the closing date and the Sellers’ good faith estimated net tangible assets as set forth in the asset purchase agreement.  We recorded the receivable due from Sellers of approximately $4.2 million related to this payment at the acquisition date.  Sellers have provided us with a “Notice of Disagreement,” which states that they are disputing the amount owed to us in connection with this reconciliation payment.  The asset purchase agreement contains an arbitration provision for disputes over the value of tangible net assets.  The amount of the receivable we recorded may be impacted by the resolution of the arbitration proceeding.  As of the filing of this Form 10-Q, no resolution has been reached, and the parties are reviewing the working capital calculations and determining the timing for arbitration.

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We estimated the fair value of the assets acquired and liabilities assumed of StraTech primarily using a discounted cash flow approach with respect to identified intangible assets and goodwill.  We based this approach upon our estimates of future cash flows from the acquired assets and liabilities and utilized a discount rate consistent with the inherent risk associated with the acquired assets and liabilities assumed.  As of December 31, 2012, the fair value of the acquired assets was provisional as we had not yet finalized net working capital adjustments that are included within the “Notice of Disagreement” discussed above.  The total purchase price has been allocated to StraTech’s net tangible and identifiable intangible assets based on their estimated fair values as of October 4, 2012, and has been adjusted through September 30, 2013. Adjustments to provisional amounts during the measurement period that were the result of information that existed as of the acquisitions date require the revision of comparative prior period financial information when reissued in subsequent financial statements. Accordingly, our 2012 balance sheet has been retroactively adjusted to account for those changes. The changes resulted in a $313,000 reduction in goodwill and did not impact our income statement.

The following table summarizes the final allocation of the purchase price including measurement period adjustments:

The fair value of the acquired assets included a finite-lived intangible asset consisting of customer relationships that have an estimated life of five years and an indefinite-lived asset consisting of goodwill of approximately $5.0 million which will be deductible for tax purposes over a 15 year period.  We are amortizing the finite-lived intangible asset we acquired in the StraTech acquisition over its useful life using an accelerated amortization method, to match the pattern in which the economic benefits of that asset are expected to be consumed. We paid a premium over the fair value of the net tangible and identified intangible assets acquired (i.e., goodwill) because this acquisition expanded our market share and physical presence across the Eastern seaboard of the United States and allows us to diversify our product offerings from certain manufacturers and expand our high-margin professional and managed services business lines. We expect to experience operational synergies and efficiencies through combined general and administrative corporate functions.

The following table provides a reconciliation of the net purchase price for StraTech as compared to the cash payment for purchase:

Integration costs for 2013 and 2012 include salaries, benefits and retention bonuses of exiting employees, some of whom assisted with the initial integration of StraTech.  In addition, transaction costs for 2012 include legal, audit and other outside service fees necessary to complete our acquisition of StraTech, which were expensed.  Total integration and transaction costs were $7,000 and $103,000 for the three months ended September 30, 2013 and 2012, respectively. Total integration and transaction costs were $80,000 and $123,000 for the nine months ended September 30, 2013 and 2012, respectively.

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6.                                       Goodwill and Finite Life Intangible Assets

We assess the carrying amount of our goodwill for potential impairment annually or more frequently if events or a change in circumstances indicate that impairment may have occurred.  We perform an impairment test for finite-lived assets, such as intangible assets, and other long-lived assets, such as fixed assets, whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable.  Circumstances that could represent triggering events and therefore require an interim impairment test of goodwill or evaluation of our finite-life intangible assets or other long-lived assets include the following:  loss of key personnel, unanticipated competition, higher or earlier than expected customer attrition, deterioration of operating performance, significant adverse industry, economic or regulatory changes or a significant decline in market capitalization.

We have only one operating and reporting unit that earns revenues, incurs expenses and makes available discrete financial information for review by our chief operations decision maker.  Accordingly, we complete our goodwill impairment testing on this single reporting unit.

In conducting the annual impairment test of our goodwill, qualitative factors are first examined to determine whether the existence of events, or circumstances, indicate that it is more likely than not that the fair value of a reporting unit is less than its carrying amount.  If it is determined that it is more likely than not that the fair value of the reporting unit is less than its carrying amount, a two-step impairment test is applied.  The first step of the goodwill impairment test, used to identify potential impairment, compares the fair value of our market capitalization with the carrying value of our net assets. If our total market capitalization is at or below the carrying value of our net assets, we perform the second step of the goodwill impairment test to measure the amount of impairment loss we record, if any.  We consider goodwill impairment test estimates critical due to the amount of goodwill recorded on our balance sheet and the judgment required in determining fair value amounts.

Goodwill was $37.5 million as of September 30, 2013 and December 31, 2012 and includes the measurement period adjustments discussed in Note 5 above. We conducted our annual goodwill impairment test as of December 31, 2012, our last measurement date.  Based on this analysis, we determined that there was no impairment to goodwill.  We will continue to monitor conditions and changes that could indicate impairment of our recorded goodwill.

At each of September 30, 2013 and December 31, 2012, we determined that no triggering events had occurred during the quarter and our finite-lived assets and long-lived assets were not impaired.

Identified intangible assets are summarized as follows:

Amortization expense for identified intangible assets is summarized below:

Based on the identified intangible assets recorded at September 30, 2013, future amortization expense for the next five years is as follows:

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7.                                       Short Term Investments

Our short term investments consist principally of commercial paper and corporate bonds. We categorize these investments as trading securities and record them at fair value. We classify investments with maturities of 90 days or less from the date of purchase as cash equivalents; investments with maturities of greater than 90 days from the date or purchase but less than one year generally as short term investments; and investments with maturities of greater than one year from the date of purchase generally as long term investments. The following table summarizes our short term investments (in thousands):

As of December 31, 2012, we had no unrealized holding gains/losses on investments.

Our $45.3 million of short term investments are comprised of commercial paper and corporate bonds with maturities within one year and interest rates ranging from 0.8% to 5.5%.

8.                                       Fair Value Measurements

Fair value is the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  In determining fair value for assets and liabilities required or permitted to be recorded at fair value, we consider the principal or most advantageous market in which it would transact and the assumptions that market participants would use when pricing the asset or liability.  We apply fair value measurements for both financial and nonfinancial assets and liabilities.  We have no nonfinancial assets or liabilities that require measurement at fair value on a recurring basis as of September 30, 2013.

The fair value of our financial instruments, including cash and cash equivalents, short-term investments, accounts receivable, accounts payable, line of credit and accrued liabilities, approximate cost because of their short maturities.

We use the three-level fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair values.  The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements).  The three levels of the fair value hierarchy are described below:

·                   Level 1 — Unadjusted quoted prices available in active markets for the identical assets or liabilities at the measurement date.

·                   Level 2 — Significant other observable inputs available at the measurement date, other than quoted prices included in Level 1, either directly or indirectly.

·                   Level 3 — Significant unobservable inputs that we cannot corroborate by observable market data and thus reflect the use of significant management judgment.  We generally determine these values using pricing models based on assumptions our management believes other market participants would make.

The fair value hierarchy requires the use of observable market data when available.  In instances in which the inputs used to measure fair value fall into different levels of the fair value hierarchy, we determine the fair value measurement based on the lowest level input that is significant to the fair value measurement in its entirety.  Our assessment of the significance of a particular item to the fair value measurement in its entirety requires judgment, including the consideration of inputs specific to the asset or liability.  The following

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table sets forth, by level within the fair value hierarchy, the accounting of our financial assets and/or liabilities at fair value on a recurring basis as of September 30, 2013 and December 31, 2012 according to the valuation techniques we used to determine their fair value(s).

9.                                       Lease Receivables

We occasionally enter into sales-type lease agreements with our customers resulting from the sale of certain products. Our lease receivables are recorded at cost within the accounts receivable and long-term lease receivables balances on our balance sheet and are due in installments over the lives of the leases. Cash received and applied against the receivable balance is recorded within changes in operating assets and liabilities in the net cash provided by operating activities section of the statement of cash flows.  Finance income is derived over the term of the sales-type lease arrangement as the unearned income on financed sales-type leases is earned. Unearned income is amortized over the life of the lease using the interest method.  The present value of net investment in sales-type lease receivables of $1.6 million and $1.0 million at September 30, 2013 and December 31, 2012, respectively, is reflected net of unearned income of $46,000 and $60,000 at September 30, 2013 and December 31, 2012, respectively. As of September 30, 2013, scheduled maturities of minimum lease payments receivable were as follows for the fiscal years ended December 31:

Lease receivables are individually evaluated for impairment. In the event we determine that a lease receivable may not be paid, we include in our allowance an amount for the outstanding balance related to the lease receivable. At September 30, 2013, there were no amounts past due related to lease receivables.

10.                                Line of Credit

On July 17, 2013, we entered into a credit agreement with Castle Pines Capital LLC (“CPC”), an affiliate of Wells Fargo Bank, National Association.  The credit agreement provides for a floor plan line of credit and a revolving facility in a maximum combined aggregate amount of $40 million.  Borrowing under the revolving facility cannot exceed the lesser of (i) $40 million minus the amount outstanding under the floor plan line of credit or (ii) a borrowing base consisting of 85% of certain eligible accounts and 100% of channel financed inventory, subject to CPC’s ability to impose reserves in the future.  The floor plan line of credit finances certain purchases of inventory by us from vendors approved by CPC and the revolving facility is used for working capital purposes and permitted acquisitions.

The amounts outstanding under the revolving facility will bear interest at a per annum rate of 2.0% above Wells Fargo’s one-month LIBOR rate (approximately 0.18% at September 30, 2013).  Advances under the floor plan line of credit will not bear interest so long as they are paid by the applicable payment due date and advances that remain outstanding after the applicable payment due date will bear interest at a per annum rate of LIBOR plus 4%.  We are obligated to pay quarterly to CPC an unused commitment fee equal to 0.50% per annum on the average daily unused amount of the combined facility, with usage including the sum of any advances under

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either the floor plan line of credit or the revolving facility.  The combined facility and certain bank product obligations owed to Wells Fargo or its affiliates are secured by substantially all of our personal property. The credit agreement terminates on July 17, 2016 and we will be obligated to pay certain prepayment fees if the credit agreement is terminated prior to that date.

The credit agreement contains customary representations, warranties, covenants and events of default, including but not limited to, covenants restricting our ability to (i) grant liens on our assets, (ii) make certain fundamental changes, including merging or consolidating with another entity or making any material change in the nature of our business, (iii) make certain dividends or distributions, (iv) make certain loans or investments, (v) guarantee or become liable in any way on certain liabilities or obligations of any other person or entity, or (vi) incur certain indebtedness. Our prior credit agreement (as discussed below) included similar restrictions.

The credit agreement contains certain covenants regarding our financial performance, including (i) a minimum tangible net worth of at least $20 million, (ii) a maximum funded debt to EBITDA of no more than 3.00 to 1.00, and (iii) a minimum quarterly net income of at least $250,000.

The credit agreement replaced the credit facility we had in place with Wells Fargo, which was terminated upon the effectiveness of the credit agreement.  We did not incur any early termination fees or penalties in connection with the termination of the prior credit agreement.  Wells Fargo serves and may continue to serve as our transfer agent and has performed and may continue to perform commercial banking and financial services for us for which they have received and may continue to receive customary fees.  The prior credit agreement provided for a revolving line of credit for a total maximum borrowing amount of $20.0 million.

We had outstanding advances of $6.0 million on the prior credit agreement at December 31, 2012. At September 30, 2013, we had no outstanding advances on the prior credit agreement or the revolving facility, but had outstanding advances of $12.3 million on the floor plan line of credit related to the purchase of inventory from a vendor.

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OVERVIEW

We provide independent, comprehensive solutions and services that make data centers more efficient, manageable and responsive to changing business needs.  Focused on mid- and large-size companies, we consult, assess, design, deploy, implement support, and manage critical data center infrastructures such as servers, storage, networks and cloud.  Our solutions ensure that our customer’s information technology strategies align with business needs and maximize efficiency.  Each solution is built using a customized platform of hardware and software from multiple technology vendors.  We leverage hardware and software from industry leading original equipment manufacturers as part of our data center offerings and provide ongoing support for all of the solutions and services we offer. Our portfolio of solutions and services spans five practices: consolidation and virtualization, data storage and protection, advanced network infrastructures, business continuity and cloud enablement.  We offer a full suite of practice-specific consulting, analysis, design, implementation, management, and support services.

Our solutions can include hardware products, such as servers, disk arrays, tape systems, networking and interconnection components and software products.  Our data center strategy is supported through multiple trends in the market and involves supporting the market and our customers with a single vendor to provide their data center infrastructure needs.  As of September 30, 2013, we have 36 locations, including both leased facilities and home offices, throughout the United States.  We historically have derived our greatest percentage of net sales from customers located in the central part of the United States.

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

The data center infrastructure solutions and services market is rapidly evolving and highly competitive.  Our competition includes other independent storage, server and networking system integrators, high end value-added resellers, distributors, consultants and the internal sales force of our suppliers.  Our ability to hire and retain qualified outside sales representatives and engineers with enterprise-class information storage, server and networking experience is critical to effectively competing in the marketplace and achieving our growth strategies.

In the past, we have experienced fluctuations in the timing of orders from our customers, and we expect to continue to experience these fluctuations in the future.  These fluctuations have resulted from, among other things, the time required to design, test and evaluate our data center infrastructure solutions before customers deploy them, the size of customer orders, the complexity of our customers’ network environments, necessary system configuration to deploy our solutions and new product introductions by suppliers.  Current economic conditions and competition also affect our customers’ decisions and timing to place orders with us and the size of those orders.  As a result, our net sales may fluctuate from quarter to quarter.

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

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