Datalink Corporation Q3 2009 Earnings Call Transcript

Datalink Corporation (DTLK)

Q3 2009 Earnings Call

October 14, 2009 5:00 pm ET

Executives

Paul Lidskey – President, Chief Executive Officer & Director

Gregory T. Barnum – Chief Financial Officer & Vice President Finance

Scott Robinson – Chief Technology Officer

Analysts

[Eric Martin]

Glen Hanus – Needham & Company

[Erin Rickers]

Presentation

Operator

My name is Trinity and I’ll be your conference operator today. At this time I would like to welcome everyone to the Datalink third quarter earnings call. All lines have been placed on mute to prevent any background noise. After the speakers’ remarks there will be a question and answer session. (Operator Instructions) I would now like to turn the call over to Paul Lidsky, President and CEO of Datalink.

Paul Lidskey

This is Paul Lidsky, President and Chief Executive Officer of Datalink. I’d like to welcome everyone to this afternoon’s conference call. With me today are Greg Barnum, our Vice President of Finance and Chief Financial Officer and Scott Robinson, our Chief Technology Officer. Let me begin by saying that this is an exciting time to step in to the CEO role at Datalink. The company has always been a leader in the storage solutions industry. Furthermore, the growing acceptance and implementation of virtualization technologies is enabling customers to take some important steps in executing the virtual datacenter vision. Datalink is right by their side with the latest technology and solutions.

Let me also say that while I am new to this position I’ve been a director on Datalink’s board for the past 11 years and I’m very familiar with the company and the storage industry. Additionally, I have over 25 years experience leading companies involved in the same go to market model that is used by Datalink. I’ll now turn the call over to Greg to discuss the third quarter results and our outlook for the fourth quarter. Then, I will provide some additional perspectives on the third quarter and our priorities for the rest of the year.

Gregory T. Barnum

Before I go over the third quarter results, let me first remind everyone that 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 results or those anticipated depending on a variety of factors. Please refer to our filings with the Securities & Exchange Commission for a full discussion of our risk factors.

Third quarter revenues were $42.7 million which was down 14% from revenues of $50 million in the third quarter of 2008 and down 2% from $43.7 million in the second quarter of this year. Third quarter revenues were in line with our guidance and expectations however. Revenues for the nine months ended September 30, 2009 were $126.3 million compared to $147.4 million for the prior nine month period which also represents a 14% decrease.

Our third quarter GAAP net loss was $84,000 or $0.01 per diluted share compared to net earnings of $1.1 million or $0.08 per diluted share in the third quarter of 2008. The GAAP net loss for the nine months ended September 30, 2009 was $397,000 or $0.03 per share compared to net earnings of $2.6 million or $0.20 per diluted share in the first nine months of 2008. Included in the third quarter and nine months of 2009 is a $624,000 or $0.02 per share charge relating to the severance agreement with our former President and CEO.

For the rest of my comments on the income statement I will be referring to non-GAAP amounts and percentages as reported in today’s press release. The primary adjustments that we make to GAAP results are for stock based compensation charges, the amortization of backlog and customer relationship intangibles and the income tax expense relating to these adjustments. On a non-GAAP basis then net earnings for the third quarter of 2009 were $116,000 or $0.01 per share compared to non-GAAP net earnings of $1.3 million or $0.11 per share in the third quarter of 2008. The non-GAAP net earnings for the first nine months of 2009 were $500,000 or $0.04 a share compared to non-GAAP net earnings of $3.4 million or $0.27 per share in 2008.

Included in the non-GAAP results for the third quarter and nine months of ’09 is a $329,000 or $0.01 per share charge related to cash severance paid to our former President and CEO. The difference between the GAAP and non-GAAP charge is the stock based compensation charge which we exclude in our non-GAAP results.

In the third quarter of 2009 our product revenues decreased 2% sequentially to $22.4 million and our service revenues also decreased 2% to $20.3 million. For the third quarter, our overall gross margin was 25.7% compared to 26.7% in the second quarter of 2009. This decrease was primarily due to lower product margins caused by our renewed focus on pursuing new customer account opportunities which will result in some lower than normal gross profit margins during the quarter.

Service gross margins in the third quarter of 2009 was 27.8% compared to 27.9% in the second quarter of ’09. 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 25.5% to 26.5%. For the quarter then we saw revenues consisting of 37% disk, 4% tape, 7% software, 4% storage networking and 48% services which is comparable to the mix we saw in the second quarter of 2009. Our working capital position at the end of September was $23.6 million, a $2 million increase over the second quarter of 2009 and our cash and investment balance at the end of September was $24.2 million.

Looking ahead, we entered the fourth quarter of 2009 with a backlog of approximately $27 million and let me remind you that our backlog represents firm orders that we expect to be recognized as revenue in the next 90 days. This $27 million compares to a backlog of $28 million at the beginning of the third quarter of ’09. Based on the level of activity that we are currently seeing in our sales opportunity pipeline, we expect revenues to be between $45 and $49 million for the fourth quarter with GAAP earnings in the range of breakeven to $0.04 per diluted share and on a non-GAAP basis earnings in the range of $0.03 to $0.07 per diluted share.

Let me now turn the call back over to Paul.

Paul Lidskey

I’d now like to touch on some of the key recent highlights and then detail the company’s growth strategy going forward. After that, we’ll open up the call for questions. As Greg said earlier, third quarter results met our expectations from a top line perspective but were constrained on the bottom line due to severance charges and our renewed focus on pursuing new customer account opportunities which may initially drive lower than normal product margins, an accomplishment we’re pleased with given the difficult selling environment that persists.

Additionally, gross profit margin for our services remains strong and we’re making good progress in reducing our cost structure. Recently we also acquired Cross Telecom’s networking solution organization. This deal is crucial because Cross’ team brings expertise in enterprise data networking, a key skill set needed when helping organizations virtualize their datacenters. We continue to see companies moving aggressively to consolidate their application, server, storage and networking infrastructures and virtualization technology is accelerating this trend. It delivers tremendous efficiency and productivity gains for our customers.

Cross’ capabilities add to our expertise in designing, implementing and managing sophisticated virtualized datacenters, storage and backup and recovery solutions. With the addition of Cross Datalink is also able to help customers build consolidated networks they need to support growing their virtual datacenter infrastructures. Moreover, we are now a CISCO Silver Certified Partner.

Also on the virtualization front, in September we unveiled two new services to help companies more effectively design IT infrastructures for virtual environments. First was the virtual infrastructure audit and the virtual infrastructure assessment. These services provide an end-to-end view of existing servers, applications and storage devices to help customers identify current and potential performance issues as well as make informed design choices based on Datalink recommendations.

Looking at our growth strategy for the remainder of the year and in to 2010, we are intently focused on three things. First, virtualization; combined with the massive growth in data storage demand, the drive to consolidate services created significant demand for virtualization of the datacenter. While Server Virtualization 1.0 was about reducing server hardware footprint, Virtualization 2.0 tackles the issue of how to store and recover the massive amounts of data being churned out by the merit of virtual machines on the network. We’re seeing a significant increase in virtualization projects and we will continue to build our capabilities in this area.

Second, as a management team we are committed to growing the company both organically and through external investment. We’re motivated and have the experience and financial resources to make Datalink materially larger and more profitable through acquisitions. We will continue to explore all opportunities going forward.

Lastly, we are going to continue to focus on the things that are within our control. While we’re starting to see glimpses of the light at the end of the tunnel in terms of an economic recovery, we are certainly still being impacted by a slow selling environment and are taking the necessary measures by controlling costs and conserving cash while driving revenue as hard as we can. Our focus continues to be on the long term. As we previously announced, we’re controlling costs through managing our variable expenses closely.

In summary, Datalink is well positioned at the crossroads of two trends, the explosion of data storage demand and an economic contraction that has made server virtualization a top priority. We have the capabilities to deliver tremendous efficiency and productivity gains to our customers and grow Datalink in the process. With that, I’d like to turn the call back to the operator so that we can take your questions.

Question-and-Answer Session

Operator

(Operator Instructions) Your first question comes from [Eric Martin].

[Eric Martin]

Strategically, I’m curious to know the CISCO Silver Certification, what exactly does that mean?

Paul Lidskey

Silver Certification with CISCO is a level certification for designing and selling and supporting enterprise networking. It is a crucial certification when working with customers because all of our customers expect that anyone that they contract with to design or implement a network will be at least Silver Certified which indicates a level of training and commitment to CISCO that you would otherwise not have. This means that our engineering group within the Cross organization that we acquired has the necessary skills to design the most complex data networking environments as authorized by CISCO. So, it is a very crucial certification to have.

It also provides for a level of discount when purchasing CISCO hardware and software for resale to our customers without which we would not have a competitive ability to provide that fulfillment and our gross margins would suffer as a result. So, that does provide an added benefit there as well.

[Eric Martin]

It sounds like given that the revenue was in the range that you expected but the earnings were not the impact of I guess it was more aggressive pricing on the product side do you see this as short term in nature, is this going to be multi quarter in nature and is it about displacing incumbents or is it about Greenfield opportunities and you just want to be the new vendor there?

Gregory T. Barnum

We really had two that had single digit type margins this quarter. I don’t think it’s necessarily a trend and as I said, I think our gross margins will remain in the 25.5% to 26.5% overall. I don’t see them plummeting to 24% or 25%. But, these were to get in to some new accounts so we displaced incumbents there.

[Eric Martin]

So it wasn’t about hanging on to the install basis?

Gregory T. Barnum

These are new accounts.

Paul Lidskey

New accounts. Then, as I think as we said in our earlier remarks, you can expect to see us continue to put an emphasis on increasing the size of our customer base by acquiring new customers. Some of those customers are going to be Greenfield and others are going to be displacing older technology or different technology but it is critical for our company, in order for it to grow, to put an emphasis on making sure that every day we try to make our customer base larger. We’ll continue to report on that but that will be something that you’ll see us do.

[Eric Martin]

Then lastly a couple of housekeeping items, I’m trying to normalize for both my G&A and my tax rate, can you address either of those as far as what to expect for Q4?

Gregory T. Barnum

Well G&A this quarter was $2.9 million, we’ll go on a non-GAAP basis, $2.9 million and we had about $300,000 in there for the CEO severance. So, on a go forward basis G&A should really be in the let’s say $2.6 to $2.7 for the fourth quarter. Tax rate for the year we should use a rate of around 50% to 51%. The reason it is so high this quarter is because our taxable income is low and our permanent differences do not fluctuate with taxable income so the permanent differences which our meals and entertainment and incentive stock option amortization, we have a big impact on our effective tax rate when our taxable income was low like it was this quarter.

[Eric Martin]

50% to 51% for the year?

Gregory T. Barnum

Yes.

Operator

Your next question comes from Glen Hanus – Needham & Company.

Glen Hanus – Needham & Company

That Cross Telecom could you maybe just talk a little bit more about the entity that you acquired there? How many people were there?

Gregory T. Barnum

We acquired seven people, the leader of the organization and six CISCO engineers.

Glen Hanus – Needham & Company

Can you give us a sense maybe how this entity should impact the fourth quarter revenues and operating expenses?

Gregory T. Barnum

Well, it will have an impact of the salaries of the seven people definitely for the fourth quarter and that’s factored in the guidance that we gave out.

Glen Hanus – Needham & Company

Were they generating sort of revenues per employee consistent with Datalink sales groups?

Gregory T. Barnum

No, they were not. We’re taking these seven employees and we’re putting them out with the Datalink sales force to grab more of the total datacenter sale. So, I don’t think you’re going to see a big impact on the revenue line in the first quarter but we think there will be a significant impact over the next 12 months but they are not generating the type of revenue that we do in the storage.

Glen Hanus – Needham & Company

Are they pretty much exclusively selling CISCO gear? And, can you kind of talk about what they’ll be out selling incrementally for you guys?

Gregory T. Barnum

Sure. They are as we said earlier a CISCO Certified engineering organization so I would say that 90% to 95% of their time they will be working in support of the design and sale of CISCO based enterprise networking. Now, they have the skills to do other things in the networking space and as opportunities come along, we’ll take a look at that but the majority of our customers today have CISCO enterprise networking backbones so it is critical that they stay focused in that area and we believe that is where the largest opportunity is for us in the networking space and certainly in the virtual data center space.

Glen Hanus – Needham & Company

Can you talk a little bit more how you’ll integrate them with your existing sales organization? Will they kind of be a specialty separate team for networking or will you train more Datalink people similar to them? Or, how should we think about the sales group and their integration?

Paul Lidskey

Sure, I’ll answer that for you. The team that we acquired begins their work here as a headquarters based tiger team if you will. They are the specialist for the company as we get started. What happens is that sales organizations throughout the United States call in with qualified opportunities. Those opportunities are vetted by the leader of this group and then wherever we see real opportunity, we then engage this engineering team with our local sales and sales engineering organizations throughout the country.

Much of what these engineers can do and the way presales is done remotely, they do it via a web conferencing and conferencing calls and that’s very acceptable. When a large opportunity presents itself we can always put someone on a plane and get them out for a customer call. Now, the next stage of that integration which will take place next year, not in the fourth quarter, what we’d like to do is build a sales pipeline and begin to experience success which I know we will as we get started and then we will begin to do two things. We will cross train our Datalink senior engineers with additional networking expertise and on a region-by-region basis we will add additional CISCO certified network engineers in to our engineering force as required by our opportunities.

Remember that this acquisition was made in support of our virtualized data center strategy based on what we’re seeing in the marketplace as a demand for that capability. So, over time you will see this become a standard capability in all regions that we serve throughout the United States.

Glen Hanus – Needham & Company

You mentioned I think in the press release of this acquisition a $1.8 million service fee or something, could you go over that?

Gregory T. Barnum

Sure. Cross is a telephony company, they sell Avaya phone switches. When they sell these phone switches they need networking expertise to complete the sale and then service the sale on something for maintenance. So, when we purchased this group from Cross they no longer had that expertise in house so we agreed some of these seven people’s time will be spent on helping Cross with the networking expertise that they need to sell the telephony systems and maintain them. So, the seven people, maybe three full time equivalents of that is going to be spending time with Cross helping them solve their problems, sell their products and we’re going to be paid $600,000 a year at least for that. It will be an hourly charge but we’re guaranteed at least $600,000 a year.

Glen Hanus – Needham & Company

Okay, maybe just shifting gears a second can you maybe just elaborate a little bit more what you’re seeing in your customer base from kind of an industry perspective in budgeting for next year and the activity levels and nature of projects you start to anticipate for next year?

Paul Lidskey

So generally what we’re seeing is we have started to see as we headed around I would say around the middle of the third quarter as we head in to the fourth, we’re seeing a couple of things. We’re seeing an increase in our sales pipeline activity which is always a good precursor to future buying patterns. It is an early precursor but we are seeing our pipeline increase. We are seeing the number of customers who are back in the planning stages of large datacenter projects which obviously includes the capabilities of Datalink, that has picked up as well. We went through a period of time this year were there was very little planning going on.

We’ve seen customers who had projects put on hold put them back on and get them reset for next year’s budget. So, we’re seeing a lot of behavior which suggests that our larger corporate customers are getting ready to implement a number of the redesigns and purchases that they had planned this year, we see that happening next year. Those are all very good signs. We are not seeing at this point a big change in actual purchasing patterns at this point in time. Customers are still being very careful with their cash, very careful with their purchases.

We’re still seeing customers make more tactical purchasing decisions than strategic ones and I think that will remain the norm throughout the rest of this year and probably as we head in to the beginning of next. Then, I think we will start to see a lot of these strategic buys, rebuilding of virtualized datacenters, disaster recovery sites and the like, I think we’ll see those start to take hold next year. Let me say, we are encouraged by the signs that we’re seeing after this long period of time of customers beginning to spend the time to get ready to make their new purchases and that’s a good sign.

Operator

Your next question comes from [Erin Rickers].

[Erin Rickers]

I guess I just want to understand a little bit more with what you’re seeing as what you guys term as Virtualization 2.0 deployment. How would you characterize the key trends in that from a technology standpoint on the storage side of the equation and how you guys are positioned there?

Scott Robinson

I think that we’ve seen is just about all of our customers have added some sort of server consolidation initiative and that’s what we’re referring to as Virtualization 1.0. So, just about everybody has done at least some of that and even moved some of that in to production. But, this whole concept of truly integrating that and virtualizing applications and using virtualization technology in DR environments, that sort of thing, we’re really are at the front end of that. Those are the kinds of projects that are starting to pick up.

We’ve got a couple of wins under our belts in this quarter and we’re starting to see activity pick up there. We’re seeing a number of trends come together to enable that. We see certainly the vSphere launch from the VMware as an enabler, we’re seeing some of the conversion networking capabilities come together, we’re seeing some of the software functionality from our key storage vendor partners enable that. So, the enablers are in place, the planning is starting to happen and we’re starting to see projects come to fruition around those capabilities.

[Erin Rickers]

Remind me Scott what you typically see from a growth perspective for data virtualized server environment as you go down this path? Are we exponentially seeing an increase in the data growth within these customer environments?

Scott Robinson

Not necessarily. I think what we’re seeing is that in many cases they are using a different kind of infrastructure so there is a new opportunity. So, that’s where really the opportunity is it is not so much that virtualization in and of itself drives additional storage demand and in fact, if you’re sharing the storage infrastructure the overall storage may be higher so there’s an efficiency play there but they need to use a different kind of infrastructure to achieve those gains.

[Erin Rickers]

Final question for me from a technology standpoint, what are you guys seeing in terms of solid state drives in the enterprise market at this point?

Scott Robinson

We’re not seeing a lot yet, we’re seeing customers kick the tires, we do have a couple of key customers who are using it. I’m very intrigued by where that is going to go and I think we’ll see it ramp up pretty steadily through 2010 but it’s early.

Operator

At this time there are no further questions.

Paul Lidskey

Thanks again everyone for joining us today. Let me reassure you that at Datalink we are committed to growing our company by expanding both our geographic footprint and our capabilities and you will continue to see that take place here. I’m pleased with our recent progress and I look forward to updating all of you in the coming months. Thank you very much.

Operator

Thank you for participating in today’s teleconference. You may now disconnect.

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