Datalink Corporation (NASDAQ:DTLK) Q2 2009 Earnings Call July 16, 2009 5:00 PM ET
Charles B. Westling - President, Chief Executive Officer and Director
Gregory T. Barnum - Vice President, Finance and Chief Financial Officer
Scott Robinson - Chief Technology Officer
Andrew [Waleski] – [No Company Listed]
Glenn Hanus - Needham
Welcome to the Datalink second quarter conference call. (Operator Instructions) Mr. Westling, I’d like to turn the call over to you.
Thank you operator. Good afternoon. This is Charlie Westling, President and Chief Executive Officer of Datalink. I would 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 first turn the call over to Greg to discuss the second quarter results and then Scott will provide an update on technology trends and opportunities we are seeing in the market. Then I will provide some additional perspectives on Q2, our outlook for the third quarter and our priorities for the rest of this year.
Thanks Charlie. Before we start with the second 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 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.
Turning to the second quarter then, second quarter revenues were $43.7 million which is down 12% from revenues of $49.7 million in the second quarter of 2008 and up 10% from $39.9 million in the first quarter of this year. Revenues for the six months ended June 30, 2009 were $83.6 million compared to $97.4 million for the prior six month period, a 14% decrease.
Second quarter GAAP earnings were $283,000 or $0.02 per diluted share compared to net earnings of $1 million or $0.08 per diluted share in the second quarter of 2008. The GAAP net loss for the six months ended June 30, 2009 was $313,000 or $0.03 per share compared to net earnings of $1.5 million or $0.12 per share for the first six months of 2008. 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 to GAAP results relate to 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, net earnings for the second quarter 2009 were $595,000 or $0.05 per share compared to non-GAAP net earnings of $1.3 million or $0.10 per share in the second quarter 2008. The non-GAAP net earnings for the first six months of 2008 were $322,000 or $0.03 per share compared to non-GAAP net earnings of $2 million or $0.16 per share in 2008.
For the second quarter our overall gross margin was 26.7% compared to 26.5% in the first quarter of this year. Our product gross margins increased slightly in the second quarter 2009 to 25.5% compared to 25.2% in the first quarter of this year. Service gross margins in the second quarter of 2009 were 27.9% compared to 27.8% in the first quarter 2009. Going forward we expect service margins to be in the range of 28-30% and we would expect our overall gross margin to be in the range of 25.5-26.5%.
For the quarter we saw revenues consisting of 38% disk, 4% tape, 6% software, 4% storage networking and 48% services which is comparable to the mix we saw in the first quarter of this year. Our working capital position at the end of June was $21.7 million which represents a $700,000 increase over our first quarter working capital. Our cash and investment balance at the end of June was $26.3 million.
Thanks Greg. On our call back in February I laid out some of the challenges we expected our customers to be facing in 2009. I also talked about some of the key technologies we expected to drive new infrastructure. These technologies included de-duplication, storage virtualization, storage consolidation and management and finally server virtualization. We are seeing all of these technologies drive new projects this year but today I want to spend a few minutes talking specifically about the convergence of virtualization technologies into another technology we see emerging; the trend towards virtual data center.
First, what are the business drivers for this trend? Customers are faced with ever-growing challenges related to power, cooling and infrastructure footprint in their data centers. At the same time according to IDC average external storage capacities continue to grow at compound rates of 40% or more. In addition, the performance and availability characteristics for key applications continue to be become more stringent. Simply put, our customers are being challenged to accomplish more and manage more without spending more or hiring more.
Historically, IT has been built in silos where applications are tightly coupled with dedicated infrastructure like servers and storage. In a virtual data center, the applications and users are decoupled from the physical infrastructure. This allows us to share the physical assets and achieve utilization rates way beyond what is possible in the old silo model. This decoupling also gives us great flexibility in the location of the physical assets. This provides an integrated path to robust disaster recovery capabilities and ultimately the vision of cloud computing.
So what are the key technologies enabling this trend? For over 10 years we have been helping customers build shared storage environments leveraging SAN infrastructure and storage virtualization technology to drive significantly improved capacity utilization and improved storage management productivity. In the past couple of years, virtualization software in general and VMware in particular have enabled customers to take some important first steps in executing the vision of the virtual data center.
Application mobility, robust system management and tight integration with remote data replication for disaster recovery are some of the key features now available. Just this year, VMware has extended this vision with vSphere, their latest release of the virtual infrastructure technology. We also see Cisco pushing hard the adoption of fiber channel over Ethernet or SCOE standard in order to drive network consolidation.
Related to this is the industry initiative around converged networks under the Converged Enhanced Ethernet Standard or CEE. Cisco has also launched their Unified Computing Systems initiative that puts them in the broader server business for the first time. We are also seeing virtualization technology being pushed out to the desktop to drive further consolidation. Players like VMware and Citrix are driving this part of the market.
With all these virtual data center related initiatives underway it is becoming clearer we are approaching a significant inflection point in the market. In addition to the companies I have already mentioned, we see many of the other major players responding as well. Examples include Brocade’s acquisition of Foundry to play in the converged Ethernet space; Oracle’s buying Sun to own the consolidated stack from the application all the way through to the back end storage infrastructure. Our expectation is that we will see additional strategic initiatives and consolidation as this trend matures.
To respond to this trend at Datalink we built audit and assessment services to help our customers take stock of their current environment and plan for this next wave of technology. We have expanded our three main labs in order to test and demonstrate these new solutions for our customers. We continue to invest in our VMware relationship and we have invested in certifications and training to make sure we are positioned to design and deliver these technologies. As a result, we feel that Datalink is well positioned to leverage our core storage, storage networking and virtualization expertise to guide our customers through this transition to the virtual data center.
Let me now turn it back over to Charlie.
Thanks Scott. Looking at the second quarter results we are obviously very pleased to return to profitability during the quarter and to be able to deliver results that came in at the high end of our guidance. We accomplished this despite ongoing challenges in the market as customers remain cautious towards IT and storage spending and they continue to heavily scrutinize their capital outlays and operating expenses in this still very uncertain economy.
Our stronger results in the second quarter reflect progress on a number of fronts. First, we were able to increase our revenues 10% sequentially during Q2 as our services business continues to grow even as product revenues remain well below levels from a year ago. We are seeing the benefits of leveraging our strong customer support capabilities to go deeper into many of our accounts with the opportunity to [lead] support and new customer situations is providing us with avenues for additional growth.
In addition to growing our customer support base, we are doing a very good job of using tools based services offerings to increase our footprint with many of our existing customers and new prospects. We have deployed a number of tools based offerings including back up reporting and management audits, storage capacity planning, virtualization assessments and business continuity and application mapping to create opportunities for our customers to more fully optimize their storage environments.
Not only do these services allow us to get more knowledgeable about the issues that our customers are facing within their storage infrastructures, but they also allow us to identify new projects and product drag-along opportunities that can deliver a significant return on investment. Our activity in this area continues to accelerate as the number of tools-based service engagements we have delivered so far in the first half of this year is up 55% over the comparable six month period from last year.
Second, we continue to bring highly talented storage architects and sales professionals into the organization. Since the beginning of the year we have added several account executives and technical staff in many cases from weaker competitors who are struggling in this economy. This influx of talent has enabled us to continue to raise the bar for all of our people and where appropriate replace lower performing individuals with higher performing members of our team.
Third, we are managing our operating expenses more effectively and the actions that we implemented earlier in the first quarter of this year are making a meaningful difference in reducing our break even sales levels. Our G&A expenses were almost 4% lower in the second quarter versus the first quarter while revenues increased 10% on a sequential basis. Tighter management of travel and entertainment expense, communication costs, facilities and outside services is driving our expense efficiencies and improvements.
Finally, I am pleased to see the results the team is delivering in our virtualization business. As Scott talked about, this continues to be a primary driver of opportunity in the marketplace. Our revenues tied to virtualization solutions during the first six months of this year were up over 50% compared to the same period last year. This growth is the culmination of several initiatives that we have undertaken over the past several months including a heavy emphasis on virtualization training and certifications in the field and a focus on building deeper expertise in backup and recovery and disaster recovery solutions in virtualized environments. We are leveraging our SEC recovery management expertise with VMware and our use of virtualization tools and lab demonstration capabilities to help customers deploy storage virtualization solutions that leverage server based virtualization projects and drive a better ROI on their entire virtualization roadmap.
Let me now turn to our outlook for Q3 and our priorities for the rest of this year. This compares to a backlog of $29 million at the end of the first quarter. Based on the level of activity we are currently seeing in our sales opportunity pipeline, we are cautiously optimistic that customer storage spending levels will improve during the second half of this year. While many customers are continuing to defer larger infrastructure changing projects in favor of smaller, capacity driven upgrades, we are starting to see some larger opportunities emerge in the pipeline.
The challenge and the unknown for us at this point is how quickly some of these projects will be fully funded and implemented as we move through the rest of the year. We also expect to experience some slow down in activity during the third quarter as projects get delayed due to vacations and other data center availability issues that are typical during the summer months of the year.
Combining all of these factors leads us to expect revenues to be between $41-45 million for the third quarter with GAAP results ranging from a loss of $0.01 per diluted share to earnings of $0.04 per share. On a non-GAAP basis, we expect earnings to be between $0.01 and $0.06 per diluted share. As we assess the current state of the market and the emerging technology trends and market opportunities that Scott talked about, we are increasingly focusing our efforts in the following areas:
First, virtualization. We are investing in more resources and go-to-market capabilities to deliver a broader range of virtualization solutions to our customers. We see tremendous opportunities to deliver more services in this area as customers are looking for deeper and broader virtualization expertise to help them realize the full benefits of their server virtualization investments while at the same time utilizing the promise of desktop, storage, networking and ultimately application virtualization technologies to create more efficient data centers. We will continue to build our virtualization capabilities through a combination of organic growth and external investment.
Second, converged networks. As SCOE and other converged networking standards emerge, we are continuing to build on our fiber channel SAN networking skills while adding deeper capabilities with IP Ethernet networking technologies. We are doing this by adding more networking engineering talent to the company, again both through organic and where appropriate external means.
The combination of our core storage depth and strength with additional capabilities across virtualization and converged networking technology and solutions will allow us to deliver more value to our customers as they more fully embrace the benefits of virtualized data centers and cloud computing in the future.
In closing, I believe we have made good progress so far this year in strengthening our platform in this very challenging environment and I am excited about our opportunities to deliver more value to our customers in the future.
With that, operator let’s go to the Q&A portion of the call.
(Operator Instructions) The first question comes from the line of Andrew [Waleski] – [No Company Listed].
Andrew [Waleski] – [No Company Listed]
Could you talk about linearity during the quarter specifically from a product perspective?
It was a typical quarter that we usually see. We went into the quarter with $29 million of backlog and of that $29 million about $12-13 million of that would be product. We left the quarter with $28 million again the same type of ratio. So we entered and left about the same amount of product in our backlog. So it was a typical quarter for us which is pretty linear.
Andrew [Waleski] – [No Company Listed]
It looks like disk revenues are up about 22% sequentially. Could you provide any color on that and kind of what drove that?
I don’t think that reflects any specific trend as much as just the timing of some specific deals.
The next question comes from Glenn Hanus – Needham.
Glenn Hanus - Needham
Maybe you could just talk a little bit more about what you are seeing out there in customer purchasing patterns and budgets sort of set and people working on projects and close rates are kind of the issue. Maybe you could just expand on your comments you made at the beginning of the call on that topic.
I think we are seeing a more stable environment relative to what we saw earlier in the year. I think what that translates into is a little more clarity on projects and initiatives that customers are driving and trying to fund and get done this year. I sort of look at the pipeline and what we are seeing today which is a little different than what we saw earlier in the year. Earlier in the year in our pipeline we saw a lot of conceptual opportunities. Higher level initiatives that we had some level of discussion with our customers about but frankly before we really got too deeply into really clarifying and defining a lot of those initiatives they kind of got put off to the side.
What we are seeing now is some of those conceptual, higher level opportunities get more clarified and more crystallized in the form of specific projects with better, well developed metrics, size and scoping around the project. As I indicated in my comments now with more clarity around those initiatives our challenge and our opportunity will be to push through those more clearly defined projects into funding, budgeting, closing and deploying mode through the rest of the year. A long winded way of saying we are seeing a little bit better clarity and structure around what our customers are trying to do.
Glenn Hanus - Needham
Would you look for what we might call normal summer seasonality here followed by kind of a normal fourth quarter talking sequentially?
That is what it feels like right now.
Glenn Hanus - Needham
How about, it came up in the 3Par call the other night, now you do revenue recognition on installation if I recall. They had some push outs because of data center readiness issues essentially. Are you seeing those kinds of issues? Some of it ties to power availability and just larger data centers being able to fully install some of the larger systems.
That tends to be pretty customer specific and obviously size and scope of the project specific. We saw a little bit more of that maybe in the first quarter and early second quarter. I don’t think as we came through the rest of the second quarter we had a large number of real large projects that were not closed because we couldn’t get into the data center or we had issues or delays getting in. So that is a metric for looking at the market, at least in our sample database, and it doesn’t appear to be quite as difficult an issue today as it was. Now having said that, that is where the seasonality of Q3 comes into play because you start to throw in vacations and other variables that can and do tend to push some larger projects out. Obviously based on the way we recognize, if things get pushed one week plus or minus at the end of the quarter that could impact the revenue we recognize in the quarter.
Glenn Hanus - Needham
Can you comment at all on the impact to your business and possibly other channel players, EMC’s dedupe acquisition?
I think certainly it has thrown a certain amount of confusion into the market about how this is going to play out. I think that may have an effect of slowing some deals down temporarily. I think there is still a lot of momentum in that space. Obviously a couple of big players are willing to spend a lot of money to get them. I see our guys starting to pick up the activity. Our pipeline for these types of projects continues to be strong. I wouldn’t be surprised if there is a little bit of delay based on some confusion but I think now this is settled I think we will get back to more of a normal deal flow situation.
Glenn Hanus - Needham
So you don’t expect EMC’s ownership of that to impact your relationship and ability to sell that product or other channel disruption?
I would say it is too early to tell. We have a relationship with EMC. We expect to leverage that as it relates to Data Domain. We have a relationship with NetApp so either way we already had an existing relationship with either of those vendors so our goal is to continue to leverage our EMC relationship to drive data domain business.
And bring the best solutions based on all considerations to our customers.
Glenn Hanus - Needham
On the operating expense front, I think I had modeled down a tick now for the next couple of quarters. How should we think about operating expenses here going forward?
I would model them to be more even or flat going forward. The reason for that is as Charlie mentioned in his comments we are investing in more field force as we go forward here so we are using some of our strength in the balance sheet to take opportunity to grab good employees.
At this time there are no callers in queue.
Thank you everyone for your interest in Datalink and for your participation on today’s call. We look forward to updating you on our progress during our next conference call. Thanks very much.
That concludes today’s conference. You may now disconnect.
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