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Datalink Corporation (NASDAQ:DTLK)

Q3 2008 Earnings Call

October 15, 2008 5:00 pm ET

Executives

Charles B. Westling - President, Chief Executive Officer and Director

Gregory T. Barnum - Vice President, Finance and Chief Financial Officer

Scott Robinson - Chief Technology Officer

Analysts

Glenn Hanus - Needham

Clinton Morrison - Feltl

Aaron Rakers - Wachovia

Operator

Welcome to the Datalink third quarter analyst conference call. (Operator Instructions) Mr. Westling, I’d like to turn the call over to you.

Charles Westling

With me today are Greg Barnum, our Vice President of Finance and Chief Financial Officer, and Scott Robinson, our Chief Technology Officer. Let me first turn the call over to Greg to discuss the third quarter results and then I will provide some additional perspectives on Q3 and our outlook for the fourth quarter.

Gregory Barnum

Before we start, let me first cover the Safe Harbor on forward-looking statements. The Private Securities Litigation Reform Act of 1995 provides a Safe Harbor for certain forward-looking statements. In this conference call, we will be discussing our views regarding future events and financial performance. These forward-looking statements are subject to certain risks and uncertainties. Actual future results and trends may differ materially from historical result or those anticipated, depending upon a variety of factors. Please refer to Datalink’s filings with the SEC for a full discussion of our company’s risk factors.

Also let me remind everyone that the third quarter and nine months of 2008 include three months and nine months of the results of operations of MCSI, which we acquired on January 31, 2007. The 2007 third quarter and nine month results include three and eight months of MCSI.

For the quarter, on a GAAP basis, third quarter revenues were $50 million dollars, which is up 9% from revenues of $45.8 million in the third quarter of 2007 and up slightly from $49.7 million in the second quarter of 2008.

Revenues for the nine months ended September 30, 2008 were $147.4 million compared to $127.1 million for the prior year period, which represents a 16% increase.

For the third quarter, our overall gross margin was 27.5% compared to 25.9% in the third quarter of 2007.

Our product gross margins for the third quarter was 25.7% compared to 24.2% in the third quarter of 2007. The increase in product gross margin in the third quarter was due to the continuing effort by our sales force to sell higher margin storage solutions.

Service gross margins in the third quarter of 2008 were 30% compared to 28.38% in Q3 of 2007. On a year-over-year basis, service gross margins increased by 170 basis points, due primarily to the sale of more profitable services to customers that came over with the MSCI acquisition and to an increase in Datalink delivered professional services. On a sequential basis, service gross margins increased 70 basis points, due again to a higher percentage of Datalink delivered professional services.

Going forward, we expect service margins to be in the range of 28% to 30% and we expect overall gross margins to be in the range of 26% to 27%.

For the quarter, we saw revenues consisting of 38% disc, 9% tape, 8% software, 3% storage networking, and 42% services, which is consistent what we saw in the third quarter of 2007.

Third quarter GAAP were approximately $1.1 million or $0.08 per diluted share, which compares to net earnings of $844,000 or $0.07 per share in the third quarter of 2007.

GAAP net earnings for the first nine months of 2008 were $2.6 million or $0.20 per share, which compares to a net loss of $221,000 or $0.02 per share in the first nine months of 2007.

On a non-GAAP basis, net earnings for the third quarter of 2008 were $1.3 million or $0.11 per share, compared to a non-GAAP net earnings of $1.1 million or $0.09 per share in the third quarter of 2007. The non-GAAP net earnings for the first nine months of 2008 were $3.4 million or $0.27 per share, which compares to non-GAAP net earnings of $898,000 or $0.07 per share in the first nine months of 2007.

The non-GAAP results we refer to for the third quarter of 2008 are adjusted for the following items. $35,000 relating to the adjustment to the MCSI deferred revenue liability, which is required by purchase accounting, $251,000 relating to stock-based compensation charges, $178,000 relating to the amortization of backlog and customer relationship intangibles, and $190,000 income tax expense adjustment relating to the above non-GAAP adjustments.

Turning to the balance sheet, our cash and investment balance at the end of September was $25.7 million, which down from $28 million at the end of the second quarter. The decrease in cash is primarily due to the timing of cash receipts during the quarter. In fact, we received two large payments totaling $2 million dollars in the first two days of October that were due in September and we also have another $1.5 million dollar payment that’s on its way as we speak.

For the quarter, we used $2.1 million of cash from operations, which is mainly due to the timing of collections mentioned above. Our DSO at the end of the Q3 decreased to 31 days from 32 days at the beginning of the quarter.

So now with that as a background, let me now turn the call back over to Charlie.

Charles Westling

Reflecting on Q3, overall we delivered a strong quarter and I am very pleased that we continue profitably grow our business in this very challenging environment. The team is executing well. We are taking market share in many accounts and I believe we are well positioned to weather the current and longer term challenges that many of our customers are facing, indeed we all are facing, in this world of economic uncertainty, tremendous market volatility, and credit and capital constraints.

As I look back on the third quarter and year-to-date results, I think it is important to highlight the fact that are team has delivered a revenue increase of more than $20 million dollars for the first nine months of the year, which represents an increase of 16% from the prior year period. More importantly, however, we’ve improved our non-GAAP operating income by over 500%, from $875,000 in the first nine months of 2007 to over $5.3 million dollars in the first nine months of this year.

Here is my list of the top five reasons why we continue to do well in this environment. First, our customer support business continues to be a shining star. Customer support revenues were at a record level in the third quarter and had increased over 30% through the first three quarters of 2008.

We are increasingly winning with support as a point of entry into new accounts and our customer satisfaction levels are consistently higher than industry averages.

Our investment in customer support and the leadership changes that we have made in this area over the past year continue to pay big dividends and further differentiate us from others who resell storage products and technology.

In addition to providing us with more visibility and stickiness into our customer storage environments, support allows us to deliver a more predictable and profitable source of revenues as we manage the company for continued growth.

Second, our sales and engineering teams in the field are doing a better job of identifying, positioning, and delivering storage solutions that meet our customer’s business needs. The increases that we continue to see in product and services gross margins highlight the fact that our sales teams are doing a better job of selling and delivering value. Another reflection of our improving performance in this area is the more balanced mix of customers that we are seeing in our results.

While we continue to grow our revenues, we do not have a single customer who represents 5% of our total revenue so far this year. I expect that as we finish out the year, 2008 will mark the first year in Datalink’s recent history that we will not have a customer represent 5% or more of revenues.

Third, though our practice is focused in initiatives, we are successfully transitioning more and more of our business into emerging areas in storage, which add very compelling returns for our customers. These areas include data de-duplication, systems and storage virtualization, and LAN optimization. It is interesting to note that virtualization de-duplication, and LAN optimization solutions as measured by revenues generated through our key technology providers in these areas have increased almost three fold through the first nine months of the year and represent an addition to customer support, the bulk of our growth in year-over-year revenues.

Fourth, we continue to grow our business and invest more in customer facing headcount while managing our corporate and back office resources and headcount very effectively. Our teams in this part of the business are doing a very good job of supporting the overall growth of the company and our customer base. Our general and administrative expenses are up just 3.3% for the first nine months of 2008, while our revenues have increased 16% during this period. The combination of top line growth, improving gross profit margins, and solid G&A expense management has led to the significant lift in our operating income so far this year.

Fifth, as we are getting better at training and hiring our people, sharing better practices, developing tools and capturing our knowledge and intellectual property across our teams, we have been able to continue to improve the overall productivity of our employees. We strive to be able to generate at least $250,000 to $275,000 of annualized gross profit per employee on average each quarter to allow us to cover our operating expenses and deliver acceptable levels of profits to our shareholders.

We have been consistently in this range so far in each quarter of this year and we saw this metric improve by 14% in Q308 versus Q307.

Let me now turn to our outlook for Q4. During the third quarter, we did start to see the impact of tightening credit conditions for a few of our customers, which resulted in delayed and in some instances scale down purchases.

In terms of backlog, we ended Q2 at $32 million versus $31 million at the end of Q3. All things being equal, this would suggest flat to slightly lower revenues for Q4 versus Q3. On the other hand, as we have gone back and analyzed the seasonality impact of the fourth quarter over each of the past five years, we have seen on average an increase in revenues from Q3 to Q4 of approximately 10%. This would suggest revenues in the range of $55 million for Q4.

As we continue to drill down into our customer base, sales pipeline, and key opportunities for Q4, we see the majority of projects are expected to move forward as planned this quarter.

We also see, in some cases, projects that have a significant risk of being delayed or scaled back. A key swing factor, if the amount of yearend budget plush activity that happens this quarter. At this point, it is too early to tell how much activity and opportunity we will see in this regard.

As we assess all of these variables, we believe that we have an opportunity to deliver another quarter of year-over-year growth and profitability in the fourth quarter; however, not at the historical Q4 growth rates that we have seen in the past. Specifically, we expect revenues for the fourth quarter to be in the range of $49 to $53 million with fully diluted earnings per share of $0.08 to $0.11 on a GAAP basis and $0.19 to $0.14 on a non-GAAP basis. As a point of comparison, in the fourth quarter of 2007, we generated revenues of $50.7 million and fully diluted earnings per share of $0.11 on a GAAP basis and $0.13 on a non-GAAP basis.

In closing, I am confident that we are well positioned to continue to profitably grow our business in these challenging times. We will continue to manage our expenses smartly, making sure that we have the flexibility to run the business effectively in the event that external market conditions deteriorate further faster.

We will also take advantage of our relative strength in this difficult environment by investing in more sales and engineering pallet in locations where we can accelerate our market share.

I believe that our ability to execute on our key initiatives and continue to deliver superior value for our customers, will enable us to be successful in the near term and beyond.

Let’s now go to the Q&A portion of the call.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from Glenn Hanus – Needham & Company.

Glenn Hanus – Needham & Company

Charlie, can you take a stab and kind of roughly quantify how much of storage spend is required versus optional? How would you break that up, what people absolutely have to do and what are sort of more optional?

Charles Westling

That’s a tough question, Glen. I’ll take a shot at it and maybe Scott Robinson can provide some perspective as well. I think that with the continued growth of Data at 40-50-60% per year, which really is not swelling and the reality that companies are not aggressively hiring IT staff, storage staff, at this point, that the need for technology and the best technology to manage that gap becomes clearer and clearer and more significant for our customers. I think that to the extent that there are places or points within the storage environment where the capacity simply has run out. We’re backed up, jobs are starting to impede on production, data creation, and it starts to back up on the business, there are situations where customers are having to invest in more capacity. So some of that I would put in the category of really not discretionary, it’s either invest and have the capacity or the business starts to bottleneck itself and slow down. With the emerging technology de-duplication, virtualization, those things that can allow for that capacity to be more effectively utilized and better managed, I think that also is becoming increasingly part of the required as opposed to discretionary part of the pie. What is perhaps more discretionary right now are some of the technologies and opportunities on the fringes outside the core of the data center, outside the core of the environment. Those be even more compelling I think are getting more and more scrutinized and in some cases tend to be areas where people will push them off or decide not to invest going forward, especially in this environment. So it’s a hard question to calibrate. I don’t know if it’s 90% of what we’re seeing is really capacity utilization, just have got to manage the data that continues to grow type of a spend and 10 to 15% is new or emerging technology that might be more of a quantum leap into a newer environment or newer world orders. Maybe I’ll have Scott provide some perspective on that as well. Scott?

Scott Robinson

Hi Glen, this is Scott. What I would reiterate what Charlie said is that capacity, even in an economic downturn, the capacity requirement continue to march on unabated. So customers have to figure out how to do that, how to handle that in some fashion. Now what you may see is incremental capacity upgrades to existing infrastructure versus new infrastructure. So that just remains to be seen. Although what Charlie talked about in our call is that we are seeing growth in things like de-duplication. Things like storage for virtual environments. At least up until now, the ROI for those kinds of projects is compelling enough to drive customers to make significant changes in their environments. So we think that those are pretty compelling and we’re hopeful that we’ll be able to continue to drive that kind of new infrastructure. If customers decide to try to extend their existing infrastructure, what happens then is it drives a larger support opportunity, because those support costs go up fairly dramatically once you get past the warranty periods for storage infrastructure. So we’re looking to have offerings to take that direction as well.

Glenn Hanus – Needham & Company

Can you give us a little more color around the credit impacts? Is that primarily with a few of your smaller customers or where do you see that in your customer base and how is that manifest itself as you go through a purchase, a sales cycle?

Charles Westling

It’s hard to just paintbrush it, Glen. I guess we have seen it in a couple of instances in some of the financial sector. In one instance, a fairly large opportunity that had very compelling economics yet the CEO decided not to move forward with the project. Having said that though, our finance and banking exposure is not real significant to our business; it’s far less than 10%. So that particular segment, we’re not overly dependent upon it. It goes back to what I said before about balance. That would be a good term to use as it relates to the industries that we service while it’s a pretty horizontal and balanced industry mix that we have. So it’s hard to say it’s an industry or a series of companies within an industry where we’re seeing credit crunch or impact have a difference in their storage spending. It really is customer specific and the other comment I’d make is that a large number of our customers are very strong, strong balance sheets, very profitable, fortune thousand type customers, that while people are certainly more scrutinizing and cautious about how they’re spending CapEx, from just a financial strength of the customer perspective, I think continue to be fairly well positioned to weather the storm.

Operator

Your next question comes from Clinton Morrison – Feltl.

Clinton Morrison – Feltl

Can you comment a little bit on the channel. Obviously things are kind of tight out there and thinking specifically about potential disc counts and as part of looking at the end of the year, this budget flush, do we get the, you know, your equipment suppliers giving you a little extra incentive so that they can boost their bottom line too or what do we anticipate there?

Charles Westling

I think that we’ll likely see, Clint, an environment where people are going to continue to be very aggressive, that they’re going to try to close as much of business as they can in the end of the year. They’re going to try as much as they can to take deals off the street. I don’t see that pattern of behavior changing differently than other past fourth quarters. I think the variable is what the customers will do on their side. I think it will be a very compelling and attractive buying environment, but whether or not customers in this environment will behave as they have over the last several years and spend to budget and use excess or unspent budget to take advantage of some of those economics. Like I said in my commentary, I think it’s a little bit early to just broad brush or make any assumptions there.

Clinton Morrison – Feltl

I realize figuring out what your customer is going to do is tough. I was looking for insight on your suppliers and it sounds like you believe they’re going to be somewhat generous in trying to push equipment into the market.

Charles Westling

This is clearly an environment where people are pushing hard for market share.

Clinton Morrison – Feltl

So hopefully that translates into reasonably healthy margins. You feel comfortable with your margins because of that environment.

Charles Westling

That will help us. We also on our side have to continue to sell the value and wrap the services around the product so that we can achieve the kind of margins that we’re achieving.

Clinton Morrison – Feltl

Mechanical, looks like you had a big jump in shares outstanding. Was there a bunch of redemptions? You’ve been kind of flat for a number of quarter and all the sudden a big jump. Any comment there?

Charles Westling

There were some restricted shares that we issued throughout the year that just got issued on the books in the quarter, but no it wasn’t an issue, it was just a catch-up entry more than an issuance during the quarter. Restricted shares and stock options we granted earlier in the year.

Operator

Your next question comes from Aaron Rakers – Wachovia.

Aaron Rakers – Wachovia

A couple questions. The first question, to kind of seg-way off the prior one. You’re kind of taking it a different way when you talk to customers in this environment, would you say that they’re more open or less open to looking at some of the new alternative technologies coming into the space. You know, be it from new vendors, some of the newer smaller guys within the disc storage market.

Scott Robinson

Aaron, this is Scott. I would say we have not seen any decline in the openness of customers to look at some of this new technology. As Charlie said in our comments, that’s driven a lot of our growth and up until this point, we’re not seeing them pull back from looking at that technology. What I said earlier too, I think it really rings true that some of these things are pretty compelling where they’re talking about de-duplication, where they’re talking about virtualization initiatives within customers. Customers are in the middle of some of these initiatives. The ROI is fairly compelling and at this point we have not seen customers pull back from those projects in a significant way outside of selected financial services customers. So whether that starts to happen, I can’t tell you, but so far we’ve seen pretty good activity.

Aaron Rakers – Wachovia

Right. I appreciate that, Scott. The other way I’m thinking about it is in this environment if we go back in the prior downturn, was this an environment where customers tend to retrench to kind of a main state, a bigger players into the market, or would they be increasingly open to say a go equal logic or a compellent or what have you in this space.

Scott Robinson

One of the key things that I think is different this time from the last time is back in 2001, 2002, a lot of customers had upgraded their infrastructure for Y2K. So they had just gone through a cycle of a lot of new infrastructure and so they were better positioned to hunker down and do incremental upgrades at that time. So we saw a bigger downturn then than I think we will see this time, because customers have not made it. There’s not been a wave of major upgrades over the last couple of years. It’s been more of a steady pace of infrastructure upgrade. So I don’t think we’ll see that kind of a downturn, but we’re being cautious about it.

Aaron Rakers – Wachovia

That’s helpful. When you look at the customer environments today, where do you typically see your customers running out from the utilization perspective?

Scott Robinson

I don’t know if I’ve got a hard number for that, but I would say that we’re seeing customers in that 50 to 70% utilization rate pretty typically.

Aaron Rakers – Wachovia

That’s a lot higher than what I would think. Final question, lots being said about data de-duplication and you guys obviously benefiting from that. Just your sense, what the competitive landscape is starting to look like there in that market. Obviously Data Domain continues to be very well positioned, but are you starting to see alternatives coming to the market and grab the attention of some of your customers?

Scott Robinson

Yes, I think we’re starting to see some of the other players get more established. I think Data Domain was out there early and they continue to be one of the key players in that space, but absolutely, with our Quantum relationship, Quantum, Sepaton, Net Technology. We’re seeing all of them get some traction.

Operator

There are no more questions in the queue at this time.

Charles Westling

Thank you all for your interest in Datalink and for your participation on today’s call. We look forward to updating you on our progress against our key initiatives and our efforts to continually profit, profitably grow our business our next conference call. Thanks everybody.

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