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Executives

Paul F. Lidsky – President, Chief Executive Officer & Director

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

Analysts

Glen Hanus – Needham & Company

Eric Martinuzzi – Craig-Hallum Capital Group, LLC

[Joe Kovar] – CRN

Datalink Corporation (MXB) Q1 2010 Earnings Call April 15, 2010 5:00 PM ET

Operator

At this time I would like to welcome everyone to the first quarter 2010 investor conference 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.

Paul F. Lidsky

This is Paul Lidsky, President and Chief Executive Officer of Datalink. I’d like to welcome everyone to this afternoons’ conference call. With me today is Greg Barnum, our Vice President of Finance and Chief Financial Officer. I’ll now turn the call over to Greg to discuss the first quarter results and our outlook for the second quarter and then I will provide some additional perspectives on the first quarter and our progress on our 2010 initiatives.

Gregory T. Barnum

In today’s 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 Datalink’s filings with the Securities & Exchange Commission for a full discussion of our company’s risk factors.

Turning to the first quarter than, revenue was $62.5 million which was up 57% from revenues of $39.9 million in the first quarter of 2009 and up 21% sequentially from $51.8 million in the fourth quarter of this year. First quarter GAAP net loss was $891,000 or $0.07 per diluted share compared to a net loss of $596,000 or $0.05 per diluted share in the first quarter of last year. For the rest of my comments now on the income statement I will be referring to non-GAAP amounts and percentages as reported in today’s press release.

The primary adjustments to GAAP results are one, the adjustments to the Incentra deferred revenue and cost required by purchase accounting, stock based compensation charges, integration and transaction costs, the amortization of the backlog and customer relationship intangibles and the income tax expenses related to the above non-GAAP adjustments. On a non-GAAP basis, net earnings for the first quarter of 2010 were $107,000 or $0.01 per share compared to a non-GAAP net loss of $273,000 or $0.02 per share in the first quarter of 2009.

In the first quarter of 2010 our revenues increased 58% to $62.9 million compared to the first quarter 2009 and more specifically our product revenues increased 98% to $38.2 million. Our service revenues increased 20% to $24.7 million. We are very encouraged by this trend not only because of the revenue and gross profit produced by this level of product growth but because we expected to see services revenue and gross profit increase over time as a result of the increasing product sales.

Overall, gross margins in the first quarter of 2010 was 23.8%. We saw our product margins decrease to 21.8% in the first quarter from 24.7% in the fourth quarter which was in line with our guidance while service margins decreased slightly to 26.9% in the first quarter from 27.1% in the fourth quarter. As we have indicated before, we expect product margins to decline to the 20% to 22% range as we implement our strategy of selling total solutions in to the datacenter which includes lower margin servers and networking solutions. We anticipate service margins to remain in the range of 27% to 30% and we expect overall gross margins to be in the range of 23% to 25%.

For the quarter we saw revenues consisting of 39% disk, 4% tape, 4% software, 7% networking, 7% servers and 39% services. Our working capital position at the end of March was $14.5 million compared to $14.2 million at the end of the year. Cash and investment balance at the end of March was $11.8 million versus $15.6 million at the end of December. The decrease in cash is primarily due to the payment of the $3 million note relating to the Incentra acquisition which came due on March 31st. There are no additional payments due relating to the acquisition now.

We entered the first quarter of 2010 with a backlog of approximately $43 million. Our backlog number represents firm orders expected to be recognized as revenue within the next 90 days. This compares to a backlog of $29 million at the beginning of the first quarter of 2009. Based on the level of activity that we are currently seeing in our sales opportunity pipeline we expect revenues to be between $68 million and $72 million for the second quarter resulting in a net loss of $0.02 and a profit of $0.02 per diluted share on a GAAP basis. On a non-GAAP basis earnings are anticipated to be in the range of $0.04 to $0.08 per share.

These estimates take in to account the time and dollars we will be investing during the first half of 2010 integrating and training the sales and engineering forces. Starting in the second half we expect to see the full benefit of the acquisitions. With that, let me now turn the call back over to Paul.

Paul F. Lidsky

I’m very pleased with Datalink’s ability in the first quarter to embrace and broaden our portfolio by expanding conversations with existing customers and opening opportunities with new accounts. Ongoing initiatives to increase productivity and profitability are prevalent in all of our efforts. We are focused on our strategic OEM partnerships to ensure tight alignment to make sure we are leveraging our partnerships in every way that we can.

We also note that we must protect our customer base from the threats of competition while increasing our wallet share in those accounts with services and expanded offerings. Our expanded portfolio of products and services coupled with our talented field professionals are the differentiators that allow us to win new accounts and our customer intimacy model makes new customers, long term customers and future advocates for Datalink.

Our focus on strategic partnerships was furthered throughout the quarter with key executive briefings with many of our OEM partners as we continue to adjust our go to market models based on achieving mutual goals. Our network competency was recognized by a successful completion of our CISCO Gold audit and we also earned our advanced certification on datacenter networking and storage from CISCO, allowing us to enter the unified computing services program which incorporates datacenter server initiatives with CISCO.

We successfully completed the integration of the Incentra business at the end of March which was on schedule. We have completed numerous training programs with over 2,300 hundred hours of training completed to further enable our field teams to sell the full portfolio of datacenter products and services that we offer. These programs include storage, network and server training modules so that all teams are crossed trained in every technology needed to deliver our solutions.

This month alone, we have additional sales and technical training scheduled with all of our key strategic partners as well as Datalink subject matter experts who are training our sales and engineering teams on advanced virtualization, storage, network and consolidation solutions. This continued investment will allow us to successfully execute on the datacenter strategy we have talked about previously which over time leads to accelerated growth and competitive differentiation.

I am also pleased to report that in the first quarter we have acquired 100 new accounts compared to 33 in Q1 of ’09. We continue to aggressively pursue new customer accounts through demand generation activities. In the first quarter we had 250 end users participate in local field events around datacenter solutions and our business development demand teams created over 150 appointments for our field professionals.

Year-over-year we won twice as many deals over $500,000. With backlog remaining strong and pipelines of the combined businesses increasing by over 50%, we are well positioned to continue our growth. Finally, let me add that our customer intimacy model is a cornerstone of our go to market strategy. We are committed to expanding our infrastructure support and management operations in the first quarter. We launched initiatives to support new technologies around Dell, Symantec and Sun ORACLE in the server and software space.

Managed services are also expanding and in the first quarter we closed our largest managed services project to date, a $1.6 million deal to support key data infrastructure for a Global 500 customer. Our customers rely on our ability to maintain and continually enhance our technical [inaudible] around the best technologies and solutions available and we continue to deliver. We have the capabilities to deliver tremendous efficiency and productivity gains for our customers and to grow Datalink in the process.

We will continue to focus our efforts on our key initiatives and look forward to continually keeping all of you updated on our progress. With that I’d like to turn the call back to the operator so we can answer your questions.

Question-and-Answer Session

Operator

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

Glen Hanus – Needham & Company

I’ll start on the macro a little bit, could you sort of characterize sort of the March quarter and then June, did you see what you would kind of call normal seasonality in March? And then, your guidance would seem to indicate a sort of normal seasonal pick up in June. Could you give some color around that first?

Gregory T. Barnum

Yes, we saw a strong December and then January sold down and we saw business start to pick up in the second half of February and March like we see every year and we’ve seen business remain fairly strong through the first two weeks of April. So I would say it’s gone back to the pattern like we saw in 2006, 2007 and 2008.

Glen Hanus – Needham & Company

Just in terms of the budgets and spending plans at your customers, could you just talk a little bit, give some color around where you think we are with regard to that?

Paul F. Lidsky

I think that our increase in our pipeline certainly indicates that the activity that is needed to generate additional sales is improving. As we’re talking with our customers they’re certainly working on a number of multimillion dollar deals and deals over $500,000 more in the past year for technology refresh, for data continuity, business continuity, so yes, we’re seeing an uplift in that activity.

I will temper that by saying that I continue to see that while customers are feeling better about the economy and better about what’s going on with their own businesses, they are still not releasing orders at the speed at which they did before all this began. So, we’re still seeing extra scrutiny on orders, we’re still seeing customers look to consolidate and virtualize what they have before they spend more money on their datacenters and I think that’s going to continue throughout the first half of the year. But, with this increase in overall activity, we should be able to see a resulting increase in customer purchases as we head towards the back half of the year.

Glen Hanus – Needham & Company

So pretty much on track with what you would have expected sort of a quarter ago?

Paul F. Lidsky

Yes, and I think it’s fairly consistent with how I was answering that question then. I’m pleased that we’re on track that way and I would tell you that our sales force is certainly seeing that basically in all the territories in the United States that we serve.

Glen Hanus – Needham & Company

Maybe you could talk a little more company specifically what do you see as sort of your biggest challenges and opportunities now in completing the integration with the sales forces?

Paul F. Lidsky

I think the biggest challenge that we’re going to face is as we talked earlier in this meeting, we’ve spent a lot of time, energy and money beginning the cross training of our teams so that teams that were more comfortable with enterprise server and networking become equally so with storage and vice versa for our legacy storage teams. The good news is that those teams have taken very aggressively to the training and I think now the biggest challenge is keeping that going and turning that in to sales momentum.

I think as we go through the next quarter I believe that we’ll be able to point to some specific examples of success that talk to the cross selling by teams. I think that for this year I’m going to say that that is going to be our biggest challenge because when that is successfully accomplished and everyone in the company is aggressively selling a full complement of datacenter solutions we’re going to be a bigger better company.

Glen Hanus – Needham & Company

Then in terms of the buyers and their activity, are you seeing more consolidation among individuals on the IT side so that your consolidated solution approach and sales approach is contacting one individual or are there still lots of barriers between the server guys and the network guys, and etc.?

Paul F. Lidsky

I think the answer to that, it depends on the size of the customer. We have a number of customers, mid tier enterprise customers who have been very positive about a message that says less vendors, more consolidation, more expertise in integrating storage and server and networking. When you get in to the very large enterprises, they are more likely still to have individual departments handling that and so there the value proposition for them is not so much hey you can just give one vendor everything, the value proposition is that inside the datacenter you no longer as the customer have to be able to manage all those technologies yourself because typically your networking partner often won’t have any storage expertise or very little and vice versa.

So what happens is the datacenter leadership is managing a lot of this technology integration themselves and kind of walking through the process without a lot of leadership. So what we are hearing even from our largest customers is you can do the integration for us, that’s a skill set we need and that’s a skill set we don’t have as we begin to virtualize our datacenters. So that’s the value proposition for them and in the mid tier the more less vendors is better.

Glen Hanus – Needham & Company

Lastly, maybe you can discuss a little bit more your managed services business. You mentioned a large contract there, what specifically are you doing and what do you see as the opportunity?

Paul F. Lidsky

Our managed services has components of having people taking over datacenters for customers. So we’re putting trained people in who understand integrated datacenters. So, it’s not only the staff but it’s ongoing monitoring, automated backup and recovery and we’re going to continue to enhance those programs as we go throughout the year. What we would like to eventually arrive at is a set of managed services which scale for our smaller customers all the way up to our larger ones and that’s kind of something that we plan to work on for later in the year. Right now it’s more a combination of staff as well as monitoring.

Operator

Your next question comes from Eric Martinuzzi – Craig-Hallum Capital Group, LLC.

Eric Martinuzzi – Craig-Hallum Capital Group, LLC

A year ago was a much different time, the revenue mix was actually you sold less of the product than you did of the services. Now, it’s back it looks like to about a 60/40 revenue mix. I’m not going to ask for dollar amounts but just on a percentage basis where do you see 2010? What would you consider kind of a full year revenue mix between the product and service side?

Gregory T. Barnum

We’d like it to stay around that 60/40, 55/45 at the lowest. In order to grow our service revenue it’s very important to sell product because that drags along maintenance. So when it starts to flip on your then your maintenance is going to start to slow down so we need product to grow faster than services.

Eric Martinuzzi – Craig-Hallum Capital Group, LLC

Then given the good product sales here in Q1, I know you’ve just come through this pretty substantial integration of the two entities, you’re forecasting sequential growth here and I know typically the back half of the year we should see some continued product strength there. What are you looking at as far as headcount goes now sort of March 31 versus two or three quarters out?

Gregory T. Barnum

Our current headcount is around 325 people which is about 10 under our plan for the year. I don’t see us hiring much more than that so we would end the year with under 340 employees, somewhere in that range.

Eric Martinuzzi – Craig-Hallum Capital Group, LLC

And the mix of sales versus service and support?

Gregory T. Barnum

Well, we like to keep that ratio at over one. So in that neighborhood of for every one sales rep we have about one to 1.2 engineers of technical.

Eric Martinuzzi – Craig-Hallum Capital Group, LLC

As far as the op ex goes, in my own model I had layered in a little bit more expenses for Q1. I was expecting some onetime I guess maybe no recurring is probably not accurate but some larger expenses for Q1, that was about $14.8 million adjusted op ex in Q1. Where do you see that trending for the foreseeable future?

Gregory T. Barnum

Well, we were under headcount in Q1 and we did have the extra expenses of social security and 401K match and audit so they sort of offset each other. So the answer to your question is I think the $14.8 is a pretty good base going forward assuming you have $15 million of gross profit. So as your gross profit grows we’re going to pay more commission but the base of $14.8 is a pretty good base to build off of.

Eric Martinuzzi – Craig-Hallum Capital Group, LLC

Then stepping back to the macro trends that are driving your market, I’m familiar with two, on the storage side obviously just the overall growth of data and then the continued demand for virtualization, services tied to virtualization, with the acquisition of Incentra, are there other trends that you guys benefit from or maybe other trends that work the other way on you?

Paul F. Lidsky

I think there’s always been a trend on the network side, at least that I’ve experienced over the years and I think that people will see here is that as customers are building out datacenters and more importantly business continuity components of the datacenters, they’re going to increase their network requirements. They’re going to reevaluate and then oftentimes invest in new switching technology as part of that. So there so should be a continual interest and an opportunity for the network hardware and deployment skills that we have as a company.

I think that on the server side what we’re seeing in the server industry is that – especially with Sun is that you have a lot of customers who over the past 12 months sat on the sidelines needing technology refresh but not sure quite what to do with the ORACLE Sun announcements and now that that is past us, we’ve had some customers who have gone back and dusted off their technology refresh and are moving forward with that and so we’re going to see think a pick up but not to the degrees that they were a couple of years ago.

I think that a lot of customers, partly due to the marketing that takes place by Dell and CISCO and others, are reevaluating the need for a proprietary server platform when they can now get very powerful Intel based platforms to do much of the work they did in the past. What we’re starting to see is a lot of customers asking us about alternatives whereas about 18 to 24 months ago those customers knew what they were going to do, they were going to buy more Sun equipment.

So I think we’re going to have to wait a bit longer Eric to see how our customers react to all of this and how those trends begin to settle out. But clearly, if you look at enterprise servers as a group, we’re obviously getting a fair amount of demand from our customers for solutions in that area. I just don’t think any of us have from a reseller perspective a crystal ball here yet that tells us how those different aspects will play out.

Operator

Your next question comes from [Joe Kovar] – CRN.

[Joe Kovar] – CRN

I have two questions, the first one is first of all congratulations on the 57% bump in revenue but, I was wondering if you took out the acquisition of Incentra how would revenue grown? In other words the legacy Datalink revenue?

Gregory T. Barnum

That’s a tough question to answer because we’ve done an excellent job of integrating. So, we’ve reassigned some accounts, our engineers are working with their sales reps and vice versa. If I was to just strictly go by how much revenue did a Datalink sales rep that was around last year sell and how much did an Incentra rep from last year sell, you would see in the ballpark of we would have saw organic growth at a little over 20% and we would have seen sequential growth at about [23%]. That’s the best I can do for you and it’s going to get fuzzier and fuzzier every quarter.

[Joe Kovar] – CRN

The other question I had was I notice you guys did pick up the CISCO datacenter unified computing authorized technology partner designation. Does that mean that UCS is going to be a big part of what Datalink does going forward? How big a part of the business will that be for Datalink?

Paul F. Lidsky

I think at this point it’s hard for us to quantify the revenue and resulting GP that derives from that primarily because most of our customers, not all, but most of our customers are talking about CISCO alternatives in the Datacenter but not many of them have begun to fully deploy and CISCO hasn’t delivered everything yet. So our feeling in getting involved in the ATP program early was we wanted to be on the front end of the CISCO datacenter solutions offerings. If nothing else, it enhances our relationship and reputation with our customers and of course, CISCO being a major player in the market we felt it was prudent for us to be a partner of theirs and to invest to become a significant partner rather than just sit on the outside watching.

So we’ve done all the right things to position ourselves. I believe that CISCO will be successful with their strategy in the datacenter and I would tell you that my observation from attending a number of the end user conferences that I referenced in my section of the presentation today, customers were very interested as a group. We usually had rooms of 50 to 70 people at a time and when CISCO got up to talk about their datacenter strategies, all of the customers paid close attention and we got an awful lot of questions.

I think that it’s the right thing for us to do. It’s forward thinking for Datalink but, I don’t think at this point that it contributes a significant amount of business as we look at 2010, at least not until the fourth quarter.

Operator

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

Glen Hanus – Needham & Company

I’m just wondering on the competitive front if you can talk about how your acquisition and your new business initiatives here have changed the competitive landscape for you?

Paul F. Lidsky

I think the actual players themselves of course are not affected by it but I would tell you that our relationship with our strategic OEM partners which was already at a very high level got better primarily because we’re just more relevant because of the expanded sales force. We’re more relevant because we have more footprint so we are getting from our major manufacturers more investment dollars put in to the company, more support for education and training.

For instance, an example, one of our major OEMs put on a private class for all of our Incentra people for storage, 42 at a time just to get us off the ground quickly in our Incentra territory. So, we’re seeing the OEMs respond very positively and I think over time that’s also going to drive the product growth that Greg talked about earlier. I think as we look around in our markets our local competitors, our regional competitors have all taken note of the fact that we’re places we weren’t before and we’re much stronger than we were in the past.

If nothing else we’re attracting people who want to come work for us. That’s been one of the good things that came out of this just from a standpoint of competitive. But, other than that I think it’s pretty much business as usual, we’re just in more places competing with more vendors than we had in the past. When you look there are two groups of competitors, there’s the other VARs in the industry and then there are the OEMs themselves.

The competitive stance with the OEMs hasn’t changed, the only thing I would say there is that OEMs that don’t do a lot of business with us, many of them have reached out to see if they can increase their business relationship again, because of our size and our footprint. That’s kind of what’s been happening with the competitive landscape. Not a lot of major changes at this point.

Operator

There are no further questions in queue at this time.

Paul F. Lidsky

Thanks again everybody for joining us this afternoon. I look forward to giving you an update on all of our progress on our next conference call. Have a good afternoon.

Operator

This does conclude today’s first quarter 2010 investor conference call. You may now disconnect.

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