** **

**UNITED STATES**

**SECURITIES AND EXCHANGECOMMISSION**

**Washington, D. C. 20549**

 

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**FORM 10-K**

 

**(Mark one)**

 
| **ý** | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE  SECURITIES EXCHANGE ACT OF 1934** |
|------------|------------------------------------------------------------------------------------------------|

 

**FOR THE FISCAL YEAR ENDEDDECEMBER 31, 2004**

 

**OR**

 
| **o** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(D) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|----------------------------------------------------------------------------------------------------|

 

**For The Transition PeriodFrom            To**

 

# **Commission filenumber: 00029758**

 

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**DATALINKCORPORATION**

(Exact name of registrant asspecified in its charter)

 
| **MINNESOTA**                                             | ** ** | **41-0856543**                       |
|-----------------------------------------------------------|------------|--------------------------------------|
| (State or other jurisdiction of incorporation)            |       | (IRS Employer Identification Number) |
|                                                      |       |                                 |
| **8170 UPLAND CIRCLE**                                    |
| **CHANHASSEN, MINNESOTA 55317-8589**                      |
| (Address of Principal Executive Offices)                  |
|                                                      |       |                                 |
| **(952) 944-3462**                                        |
| (Registrant’s Telephone Number, Including Area Code) |

 

Securities registered pursuant toSection 12(b) of the Act: **None**.

 

Securities registered pursuant toSection 12(g) of the Act: **Common Stock,$0.001 par value**.

 

Indicate by check mark whether the registrant(1) has filed all reports required to be filed by Section 13 or15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days. Yes ý  No o

 

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K (§229.405 of this chapter) is notcontained herein, and will not be contained, to the best of registrant’sknowledge, in definitive proxy or information statements incorporated byreference in Part III of this Form 10-K or any amendment to this Form 10-K. ý

 

Indicate by check mark whether the registrant isan accelerated filer (as defined in Rule 12b-2 of the Act). Yes o  No ý

 

Aggregate market value of the voting andnon-voting common equity held by non-affiliates of the registrant at June 30,2004:  $20,069,214.

 

At March 14, 2005, the number of sharesoutstanding of each of the registrant’s classes of common stock was 10,295,113.

 

**DOCUMENTS INCORPORATED BYREFERENCE**

 

Portions of the Registrant’s Proxy Statement forits Annual Meeting of Stockholders to be held in 2005 (the “2004 ProxyStatement”), to be filed with the Securities and Exchange Commission, areincorporated by reference to Part III of this Form 10-K.

 

 

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# **NOTE REGARDINGFORWARD-LOOKING STATEMENTS**

 

This Annual Report contains forward-lookingstatements. We have based these forward looking statements on our currentexpectations and projections about future events, including, among otherthings: the level of continuing demand for storage, including the impactof economic conditions on technology spending; competition and pricingpressures and timing of our installations that may adversely affect ourrevenues and profits; fixed employment costs that may impact profitability ifwe suffer revenue shortfalls;  revenuerecognition policies that may unpredictably defer reporting of our revenues;our ability to hire and retain sales representatives and key technical andother personnel; our dependence on key suppliers; our ability to adapt to rapidtechnological change; risks associated with possible future acquisitions;fluctuations in our quarterly operating results; future changes in applicableaccounting rules; and volatility in our stock price.  You may find these statementsthroughout this Annual Report and specifically in the sections entitled “RiskFactors,” “Management’s Discussion and Analysis of Financial Condition andResults of Operations” and “Business.” Our actual results may differ materiallyfrom those anticipated in these forward-looking statements as a result ofvarious factors, including all the risks discussed in “Risk Factors” andelsewhere in this Annual Report.

 

**We use the terms “aim”, “believe,” “expect,” “plan,”“intend,” “estimate” and “anticipate” and similar expressions to identifyforward-looking statements. These statements reflect our current views withrespect to future events and are based on assumptions subject to risks anduncertainties. We do not intend to update or revise any forward-lookingstatements whether as a result of new information, future events or otherwise.**

 

**PART I**

**Item 1.  Business.**

 

**Overview**

 

We are a leading independentinformation storage architect with operations throughout the United States. We workwith customers to analyze, design, implement, and support information storageinfrastructures that store, protect, and provide continuous access toinformation.  Our areas of expertiseinclude:

 
| • |   | Data  Availability – Datalink architectures are designed to protect against planned  and unplanned downtime and provide fast access to information.  Solutions span fault tolerant storage and  clustering.                                                                                                                               |
|--------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| • |   | Data  Recovery – Data recovery solutions enable companies to recover data,  applications and entire computing environments following a disaster.  Solutions include local and remote backup,  snapshot and replication.                                                                                                                   |
| • |   | Storage  Management – Datalink storage management architectures maximize utilization  of storage technologies and the resources that manage them.  Solutions span storage consolidation,  storage area network (SAN) management, virtualization, storage resource  management (SRM) and automated information lifecycle management (ILM). |
| • |   | Support  and Maintenance – After designing and installing data storage solutions for  its customers, Datalink provides expertise through 24 hours-a-day telephone  problem solving support and when necessary on site maintenance.                                                                                                             |

 

Our highly skilled technical services and productmanagement staff tests and compares data storage technologies available fromthe leading manufacturers and software developers. Once a product is approvedfor our solution sets, our technical staff then has the flexibility to choosefrom the best of these storage technologies to solve our customers’ growingdata storage needs. In addition, we maintain a sales and support staff thatensures the continued success of our data storage solutions for each customer.We believe these value-added services and our adherence to the highest qualitystandards have resulted in superior levels of customer satisfaction.

 

**The Data Storage Industry**

 

InternationalData Corporation (IDC) projects data growth at a compound rate of approximately50% through 2007.  With this ongoinggrowth in creation and storage of data and the increasing strategic importanceof having the data available, we expect the data storage markets in which wecompete to continue to expand.  Datastorage is currently a large market, with spending in 2004 estimated at $34 billionand expected to exceed $40 billion by 2007. Information technology (IT) departments are faced with a dauntingchallenge of rapidly expanding amounts of data to manage coupled withincreasing demands for availability of this data for day-to-day business and tomeet regulatory requirements.  We expectthese issues will continue to generate interest in new data storage solutionsthat allow users to be more productive and to meet the needs of theirorganizations.

 

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Atthe same time, IT headcount is estimated to remain relatively flat over thenext several years, making it necessary for organizations to dramaticallyimprove storage management productivity to avoid being inundated by growingdata storage capacities.  To address thisgrowing gap, we expect that organizations will consolidate their storageinfrastructures and augment them with enhanced software capabilities such asstorage area network management, virtualization, storage resource managementand information lifecycle management.

 

IDC predicts thatdisk-based data protection, modular disk and SAN/NAS convergence, storagemanagement software, and storage services will grow rapidly over the nextseveral years.  IDC estimates that,together, these areas will grow through 2007 at more than double the storageindustry standard rate of growth of 6-8 percent.  Organizationsrecognize the importance and value of data as a strategic and competitiveasset. Employees, customers and suppliers demand uninterrupted access tomission-critical data 24 hours a day, 7 days a week. As a result, the abilityto efficiently store, manage, protect and provide access to this data is fastbecoming one of the most important aspects of business-criticaldecision-making, increasing the need for high-performance, scalable and highlyavailable solutions.

 

  In light of the importance of data tobusinesses, we believe that organizations will dedicate an increasingpercentage of their information technology budgets to data storage.  We believe that capital investment prioritieswill include:

 

•      **Enhanced data protection.**

Increased need for high throughput performance,greater frequency of backups, quick restoration of data and stringent dataavailability requirements are key factors that we expect to drive the migrationto disk-based data protection solutions.  Disk is no longer being used as only a target device for replication andmirroring, but also is being incorporated into traditional backup systems.

 

•      **Implementation of iSCSI technologies.**

iSCSIis a protocol that transfers block-level data over IP networks. Similarly iSCSItakes SCSI commands and encapsulates them into a TCP/IP packet for deliveryover the Internet. The significance of this is in IP’s ability to spanunlimited distances as compared to the distance limitations found intraditional SCSI and fibre channel interconnects. Companies gain the storageadvantages of networked storage (including consolidation, easier management andshared pools of storage) but at a fraction of its cost due to IP SANs’ use of existingEthernet infrastructures. In addition, the IT staff can leverage its existingEthernet training and knowledge base rather than separately learning the fibrechannel protocols. IP storage is still in an early adoption phase. However, we believeit has a vital role in storage infrastructures. We expect enterprises toutilize IP SANs to consolidate stranded servers, globally separated SANs, orsmaller office locations.

 

•      **Continued migration to networked storageinfrastructures.**

We expect that through a variety of storagenetworking technologies, organizations will attain shared (consolidated)storage capabilities.  Consolidatedstorage benefits include increased flexibility in implementing and managingstorage, increased storage device utilization levels, improved quality ofservice, reduced administration costs and increased operational efficiency.

 

•      **Information Life Cycle Management (ILM).**

ILM is a process andmethodology of handling the flow of data from its creation to itsdeletion.  With ILM, the IT departmentestablishes a written policy for classification and data movement.  The storage system automatically moves datafrom one type of storage device to another based on the policy metrics and rules.  This results in a more automated environmentensuring efficient and cost-effective data management.

 

•      **Evolution to modular storage systems.**

We expect that many organizationswill implement modular storage systems as compared to large, monolithic storagesystems.  Smaller versions of their high-end,full-featured counterparts, modular disk systems enable organizations tocost-effectively implement storage, while enjoying the performance andfunctionality of large, enterprise systems.

 

•      **Retention and retrieval ofdata to address Email, regulatory, compliance and litigation support issues.**

Long-term data retention hasbecome the norm with recent industry regulations such as the Sarbanes-OxleyAct, HIPAA (Health Insurance Portability and Accountability Act) and SECsection 17a-4 (electronic communication preservation) mandating the retentionof documents for many years.  Theconsequences can be great if a company does not have the proper retention ofdocuments for compliance, including stiff monetary penalties.

 

2

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•      **Adoption of robust storagemanagement software solutions.**

A number of storage managementsoftware innovations have recently entered the market.  Storage management software enhancements canbe divided into four segments:  storagearea network management, virtualization, storage resource management andautomated resource management.  Weanticipate that advances in each of these areas will enable improved storageavailability, manageability and performance.

 

•      **Acceptance and growing need for storage services.**

We expect three factors to driveIT organizations to increasingly outsource storage-related services(consulting, implementation and support). They include the growing strategic importance of data storage, growing complexityof networked storage environments and increasing scope of spending on storage.

 

**The Datalink Opportunity**

 

The increased need for data storage and thedevelopment of sophisticated, enterprise-class information data storage systemshave created a demand for independent data storage solution providers, such asDatalink. Both potential customers and data storage device manufacturers arelooking to independent storage solutions providers such as Datalink primarilyfor the following reasons:

 

***Pressures on Customers.*** We believe organizations will increasingly lookoutside their in-house technical staff to independent information storagearchitects, such as Datalink, for specialized expertise. Networked storagearchitecture design is complex. Although organization-wide data storagesolutions, such as SANs, are designed to ease data management functions, thesesystems are difficult to understand and implement because they integratediverse operating systems, hardware and software. In addition, there continuesto be a steady influx of new products and technologies introduced to themarket.  In-house information technologydepartments prefer to focus their efforts on mission-critical applications.Accordingly, they often turn to outside storage experts that are able toresearch, design, implement and support networked storage solutions.

 

***Pressures onManufacturers.*** Webelieve manufacturers increasingly rely on channel partners such as us for twoprincipal reasons:

 

•      Sophisticateddata storage solutions require the integration of highly specialized productsmade by a variety of manufacturers. A typical SAN, for instance, can utilizecomponents such as routers, switches, host bus adaptors, storage and backupdevices and storage management software, each from a different manufacturer.High-end data storage manufacturers generally focus on only a portion of theoverall SAN system, leaving companies like us to integrate comprehensivenetworked data storage solutions from the best available products andtechnologies.

 

•       Grossprofit margins have been under severe pressure for many storage companies.  Because of the high cost of maintaining anational sales and marketing organization, and especially in light of economicconditions over the past several years, high-end data storage manufacturersincreasingly are focusing their resources on their research and developmentfunctions. This strategy requires them to leverage their sales and marketingfunctions by partnering with companies such as Datalink.

 

We believe we are uniquely positioned tocapitalize on this significant opportunity for the following reasons:

 

***Expertise.*** We have been implementing sophisticated datastorage solutions for over fifteen years. This experience has given ussignificant expertise in understanding and applying data storage technologiesand has allowed us to earn and retain the trust and confidence of our customersand suppliers.  We invest in and trainresources to differentiate our company, adapt to the ever-changing needs of ourcustomers and capitalize on opportunities.

 

***Independence.*** Unlike many of our competitors, we areindependent of any manufacturer or particular technology. Our customers areincreasingly using open systems computing architectures, which can combineproducts from multiple suppliers. Our customers value our independence and relyon us to choose the best available hardware and software and tailor it to theirindividual needs.

 

**The Datalink Solution**

 

We combine our technical expertise, the bestproducts from leading manufacturers and comprehensive services to meet eachcustomer’s specific needs. Our services include:

 

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*Analysis*

 

At the beginning of an engagement, we placeconsiderable emphasis on formulating a needs analysis based on each customer’sbusiness initiatives, operating environment and current and anticipated datastorage requirements.  While our focus ison each customer’s unique situation, we bring to each engagement our extensiveproduct knowledge and the experience we have gained from providing data storagesolutions for over fifteen years to customers in numerous industries.

 

Datalink’s AssessLinkTM assessment services providecustomers with objective guidance on developing data storage strategies thatoptimize their resources, leverage their existing environments and facilitatecost-effective growth for the future. AssessLink services provide anindependent viewpoint to align people, processes and technologies with businessobjectives.  These services helporganizations maximize current investments, outline recommendations for futurepurchases and provide assurance that storage infrastructures are efficient,reliable and scalable.

 

*Design*

 

Once we have completed our initial analysis, webegin the design phase of the project. Our professional services teams work together to design a system thatmeets the customer’s data storage needs and budget.  Our independence permits us to choose from awide range of technologies in order to fuse together the appropriate hardware,software and services for each project.

 

Datalink’s DesignLinkTM services utilize a customer’sdeveloped detailed business requirements to design the data storage solution.  The engagement begins with a definition ofthe project’s objectives, scope and key milestones.  The Datalink team then prepares an outline ofthe schedule and deliverables.  Followinga thorough analysis, the team prepares a comprehensive blueprint of the storagesolution, including a detailed design schematic, key implementation milestonesand recommendations for handling potential configuration issues to ensure asmooth transition to the new storage environment.

 

*Implementation*

 

Once we design and test a system, we formulate adetailed project implementation plan with our customers to meet their financialand operating objectives and minimize disruption to their operations. Weoversee the timely delivery of hardware and software products to the customer’slocation. We then coordinate the installation with our technical services team,or personnel from the equipment manufacturer, and complete the installation atthe customer’s site.

 

* Support*

 

We provide our customers advanced technicalsupport from a team of customer support and field engineers.  Our extensive experience in data storagesystems enables our staff to deliver expert configuration and usage assistance,technical advice and prompt incident detection and resolution.  The support desk staff also acts as ourprimary interface with suppliers’ technical support organizations.

 

Datalink’s SupportLinkTM support services offer additionalflexible levels of service to help organizations maximize the return on theirstorage technology investments.  Webelieve that SupportLink is one of very few customer service programs thatprovide support across multiple storage product lines and manufacturers.

 

We offer maintenance and repair service optionsunder our service program. We offer a variety of on-site service options,including four hour guaranteed response time service seven days per week, 24hours per day. Our technical staff first assists customers in identifying thesource of system problems and in determining whether there is defectivehardware or software. We contract with a number of our suppliers and otherindependent service organizations to provide any required on-sitemaintenance and repair services.

 

We provide our analysis, design and supportservices to customers through either a stand-alone services engagement or as apart of an overall project that includes a storage solution and services.

 

**Our Strategy**

 

Our strategy is to improve our position as aleading, independent information storage architect and to develop acustomer-focused high performance company with sustainable profitable growth.To achieve these objectives, we intend to build upon our record of successfullyaddressing the evolving enterprise-class information storage management needsof our customers. Key elements of our strategy include:

 

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*Increase Sales Team Productivity*

 

Although we believe that Datalink’s salesproductivity is amongst the highest in the industry, we believe we can increaseit further.  We plan to accelerate thelearning and productivity curve of our newer sales professionals and enhancethe skills of seasoned executives through implementation of techniques and bestpractices learned from our top producers.

 

*Scale Existing Locations*

 

We intend to focus on our existing geographiclocations to increase market share, leverage fixed expenses and provide higherquality service levels.  Datalink willdrive this growth by hiring experienced, quality account executives and storageengineers to gain sales productivity and field engineering utilization.

 

*Expand Customer Support Revenues*

 

We have significantly increased our customersupport capabilities and performance over the last two years and will continueto make this a focus.  Our customersappreciate our quality support initiatives, which, we believe will continue tobe a key differentiator and growth driver for Datalink.

 

*Enhance Our Professional Services Business*

 

There is significant opportunity to sell more of ourstorage services expertise to customers. By improving our assessment, storage audit and implementation servicemethodologies and sales tools, we plan to enhance our solution sellingcapabilities and continue to drive gross margins to higher levels.

 

*Pursue Regional Acquisitions*

 

We believe there is an opportunity to strengthenour resources and presence in key geographies through acquisition of selectregional competitors.

 

**Suppliers and Products**

 

As an independent information storage architect, wedo not manufacture data storage products. Instead, we continually evaluate andtest new and emerging technologies from leading manufacturers to ensure thatour solutions incorporate state-of-the-art, high performance, cost-effectivetechnologies. This enables us to maintain our technological leadership, identifynew and innovative products and applications and objectively help our customersalign their data storage solutions with their business needs.

 

We have strong, established relationships with themajor enterprise-class information storage hardware and software suppliers. Ourexpertise in open system environments includes UNIX, Microsoft Windows, Linuxand Novell NetWare and in-depth knowledge of all major hardware platformsmanufactured by industry leaders, including Hewlett-Packard Company,International Business Machines Corp. and Sun Microsystems, Inc. Thisexpertise has earned us preferred status with many of our principal suppliers.Preferred status often enables us to participate in our suppliers’ new productdevelopment, evaluation, introduction and marketing programs. Thesecollaborations enable us to identify and market innovative new hardware andsoftware products and exchange critical information in order to maximizecustomer satisfaction.

 

Some of our major suppliers and the products they provide are listed:

 
| **Products**       | ** ** | **Suppliers**                                                                                                             |
|--------------------|------------|---------------------------------------------------------------------------------------------------------------------------|
| Primary  Storage   |       | EMC  Corporation  Hitachi Data Systems CorporationNetwork Appliance Inc.Storage Technology Corporation                    |
|               |       |                                                                                                                      |
| Tape  Automation   |       | Advanced  Digital Information Corporation  Quantum Corporation  Spectra Logic Corporation  Storage Technology Corporation |
|               |       |                                                                                                                      |
| Software           |       | Diligent  Technologies Corporation  Legato (a subsidiary of EMC Corporation)  VERITAS Software Corporation                |
|               |       |                                                                                                                      |
| Switches/Directors |       | Brocade  Communications Systems, Inc.  McData Corporation                                                            |

 

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| Fibre  Channel Host Bus Adapters |   | Emulex  Corporation  QLogic Corporation |
|----------------------------------|--------|-----------------------------------------|

 

**Customers**

 

Our customers trust us with theirmost demanding data storage projects. Customer engagements range fromspecialized professional assessment and design services, to complexorganization-wide SAN implementations.  Weserve customers throughout the United States in a diverse group of data intensiveindustries.  Our broad industryexperience enables us to understand application and business issues specific toeach customer and to design and implement appropriate networked storagesolutions. We enjoy strong relationships with our customers, which is reflectedby our significant repeat business.  Spanninga broad array of industries, our customers include Motorola, Inc., The ChicagoBoard of Trade, Tyson Foods, Inc., Harris Corporation, Cingular Wireless, St.Jude Medical, Inc., Washington University in St. Louis and United DefenseIndustries, Inc.

 

**Sales and Marketing**

 

We market and sell our products and servicesthroughout the United States primarily through a direct sales force. Inaddition to our Minneapolis headquarters, we have 14 field sales offices inorder to efficiently serve our customers’ needs.

 

Our field account executives and accountassociates work closely with our professional services team in evaluating theenterprise-class information storage needs of existing and prospective customersand in designing high quality, cost effective solutions. To ensure qualityservice, we assign each customer a specific field account executive and accountassociate.  We believe that the average longevityof service of our sales force is a key factor to earning and retaining thetrust and confidence of our customers. We believe this differentiates us frommany other storage solution providers.

 

In addition to the efforts of our field accountexecutives and inside account associates, we engage in a variety of othermarketing activities designed to attract new business and retain customerloyalty. We regularly execute integrated, demand creation campaigns, gainexposure through online and print trade publications, hold webcasts andinformational seminars and publish a quarterly newsletter.

 

**QualityManagement System**

 

We have a long history of beingcommitted to a strategic quality effort. In the early 1990’s, we adopted the ISO 9001 quality management systemto better identify and meet the needs of our customers, achieve a competitivemarket advantage and improve overall company performance.  We obtained an ISO 9001 certificate ofregistration in 1996 with successful re-registration in 1999.  In 2003, we successfully upgraded our ISOregistration to the new 9001:2000 standards with successful re-registration inDecember 2004.  Today, our quality systemfocuses on achieving business results through high levels of customersatisfaction, employee satisfaction, continual improvement and operationalexcellence.

 

**Competition**

 

Datalink competesin the mid and large enterprise-class information storage solutionsmarket.  Our primary competition is fromother storage system suppliers.  Theseinclude storage resellers and VARs, such as MTI Technology Corporation, ForsytheTechnology, Inc., SAN Holdings, Inc., Stack Computer Services and Adexis (thestorage division of Cranel, Inc.) each of whom sells storage solutions withdifferent technologies.  Additionally, wefrequently compete against the direct sales forces of storage OEMs.  Besides Datalink’s current technologypartners, these OEM competitors include International Business Machines Corp.,Hewlett-Packard Company, Sun Microsystems, Inc. and Dell Computer Corporation.

 

**Employees**

 

As of December 31, 2004, we had a total of 147full-time employees. We have no employment agreements with any of ouremployees. None of our employees are unionized or subject to a collectivebargaining agreement. We have experienced no work stoppages and believethat our employee relations are good.

 

**Backlog**

 

We configure products to customer specificationsand generally ship them shortly after we receive our customer’s order.  Customers may change their orders with littleor no penalty.  We do not recognizerevenue on hardware or software products until we have completed thefunctionally essential portions of the installation or related configurationservices in connection with the sale.  

 

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Customer constraints and the availability of engineering resources canhave a significant impact on when we can complete an installation andconfiguration service.  These factorsprevent us from relying on backlog as a predictor of our future sales levels.

 

**Item 2.  Properties.**

 

Our corporate headquarters including our principaltechnical operations and our integration, assembly and support serviceoperations is located in a 104,000 square foot office and warehouse facility inChanhassen, Minnesota.  On December 15,2004, we agreed to sublease approximately 55,000 of the 104,000 square feet wecurrently occupy as our corporate headquarters. Our other 14 locations which house sales and technical staff are small-to medium-sized offices located throughout the United States.

 

**Item 3.  Legal Proceedings.**

 

We are not currently involved in any materiallegal proceedings. We also had no material legal proceedings that terminatedduring the fourth quarter of 2004.

 

**Item 4.  Submission of Matters toa Vote of Security Holders.**

 

We submitted no matters during the fourth quarterof 2004 to a vote of security holders, through the solicitation of proxies orotherwise.

 

**PART II**

 

**Item 5.  Market for Registrant’sCommon Equity, Related Stockholder Matters and Issuer Purchases of EquitySecurities.**

 

Our common stock has been quoted on the NasdaqNational Market under the symbol “DTLK” since August 6, 1999, the day ofour initial public offering. The table below sets forth, for the calendarquarters indicated, the high and low per share closing sale prices of ourcommon stock as reported by the Nasdaq National Market.

 
| ** **                             | ** ** | **High**   | ** ** | **Low**    | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|
| **Year Ended December 31, 2004**  | ** ** | ** ** | ** ** | ** ** | ** ** |
| First Quarter                          |       | $          | 5.00       |       | $          | 3.83 |   |
| Second Quarter                         |       | 4.10       |       | 3.14       |       |
| Third Quarter                          |       | 3.26       |       | 1.77       |       |
| Fourth Quarter                         |       | 2.94       |       | 1.66       |       |
| **Year Ended  December 31, 2003** |       |       |       |       |       |   |
| First Quarter                          |       | 4.15       |       | 3.07       |       |
| Second Quarter                         |       | 4.95       |       | 3.62       |       |
| Third Quarter                          |       | 5.55       |       | 4.16       |       |
| Fourth Quarter                         |       | 4.66       |       | 3.47       |       |
| **Year Ended  December 31, 2002** |       |       |       |       |       |   |
| First Quarter                          |       | 7.01       |       | 4.35       |       |
| Second Quarter                         |       | 6.72       |       | 3.31       |       |
| Third Quarter                          |       | 4.17       |       | 2.40       |       |
| Fourth Quarter                         |       | 4.22       |       | 2.37       |       |
|                                        |            |            |            |            |            |  |  |  |

 

On March 24, 2005, the closingprice per share of our common stock was $2.91. We urge potential investors toobtain current market quotations before making any decision to invest in ourcommon stock. On March 4, 2005, there were approximately 80 holders of commonstock, including record holders and stockholders whose shares are held by abank, broker or other nominee.  However,we estimate that our shares are held through a small number of record holdersby over 1,500 beneficial owners.

 

Except for distributions paid to our pre-initialpublic offering corporation stockholders related to S corporation earningsgenerated prior to August 6, 1999, we have paid no dividends on our commonstock. We intend to retain future earnings for use in our business, and we donot anticipate paying any cash dividends on our common stock in the foreseeablefuture.

 

We did not purchase any of our securities during2004.  You can find additionalinformation about our equity compensation plans in Part III, Item 12 of theAnnual Report on Form 10-K.

 

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**Item6.  Selected Financial Data.**

 

You should read the information below with our “Management’s Discussionand Analysis of Financial Condition and Results of Operations” and ourfinancial statements. The data as of December 31, 2004 and 2003, and forthe years ended December 31, 2004, 2003 and 2002, was derived from ourfinancial statements that are included in this Annual Report. The data as ofDecember 31, 2002, 2001 and 2000, and for the years ended December 31,2001 and 2000, was derived from our financial statements that are not includedin this Annual Report.

 
| ** **                                                                                   | ** ** | **Year ended December 31,**          | ** ** |
|----------------------------------------------------------------------------------------------|------------|-------------------------------------------|------------|
| ** **                                                                                   | ** ** | **2004**                                  | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                                                                                   | ** ** | **(in thousands, except per share data)** | ** ** |
| **Statement  of Operations Data:**                                                           |       |                                      |       |   |   |   |   |   |   |   |   |
| Net sales:                                                                                   |       |                                      |       |   |   |   |   |   |   |   |   |
| Product sales                                                                                |       | $                                         | 63,235     |   | $ | 61,350 |   | $ | 58,492 |   | $ | 96,188 |   | $ | 118,233 |   |
| Service sales                                                                                |       | 30,048                                    |       | 29,787 |   | 28,008 |   | 28,596 |   | 19,536 |   |
| Total net sales                                                                              |       | 93,283                                    |       | 91,137 |   | 86,500 |   | 124,784 |   | 137,769 |   |
|                                                                                         |       |                                      |       |   |   |   |   |   |   |   |   |
| Cost of sales:                                                                               |       |                                      |       |   |   |   |   |   |   |   |   |
| Cost of product  sales                                                                       |       | 48,568                                    |       | 47,477 |   | 44,776 |   | 70,393 |   | 87,321 |   |
| Cost of services                                                                             |       | 21,175                                    |       | 20,198 |   | 20,000 |   | 20,328 |   | 14,148 |   |
| Total cost of  sales                                                                         |       | 69,743                                    |       | 67,675 |   | 64,776 |   | 90,721 |   | 101,469 |   |
|                                                                                         |       |                                      |       |   |   |   |   |   |   |   |   |
| Gross profit                                                                                 |       | 23,540                                    |       | 23,462 |   | 21,724 |   | 34,063 |   | 36,300 |   |
|                                                                                         |       |                                      |       |   |   |   |   |   |   |   |   |
| Operating  expenses:                                                                         |       |                                      |       |   |   |   |   |   |   |   |   |
| Sales and  marketing                                                                         |       | 12,438                                    |       | 10,985 |   | 11,481 |   | 15,836 |   | 15,230 |   |
| General and  administrative                                                                  |       | 10,366                                    |       | 10,960 |   | 10,354 |   | 11,221 |   | 8,792 |   |
| Engineering                                                                                  |       | 3,764                                     |       | 4,220 |   | 4,954 |   | 5,259 |   | 3,745 |   |
| Restructuring  charges (1)                                                                   |       | (63                                       | )          | 2,078 |   | — |   | — |   | — |   |
| Amortization of  goodwill and other intangibles (2)                                          |       | 261                                       |       | 724 |   | 1,088 |   | 2,264 |   | 1,026 |   |
| Offering costs  (3)                                                                          |       | —                                    |       | — |   | — |   | — |   | 381 |   |
| Total operating  expenses                                                                    |       | 26,766                                    |       | 28,967 |   | 27,877 |   | 34,580 |   | 29,174 |   |
|                                                                                         |       |                                      |       |   |   |   |   |   |   |   |   |
| Operating (loss)  income                                                                     |       | (3,226                                    | )          | (5,505 | ) | (6,153 | ) | (517 | ) | 7,126 |   |
| Interest income,  net                                                                        |       | 83                                        |       | 74 |   | 117 |   | 127 |   | 311 |   |
| (Loss) income  before income taxes and cumulative effect of a change in accounting principle |       | (3,143                                    | )          | (5,431 | ) | (6,036 | ) | (390 | ) | 7,437 |   |
| Income tax  (benefit) expense (4)                                                            |       | —                                    |       | (276 | ) | (618 | ) | 115 |   | 3,049 |   |
| (Loss) income  before cumulative effect of a change in accounting principle                  |       | (3,143                                    | )          | (5,155 | ) | (5,418 | ) | (505 | ) | 4,388 |   |
| Cumulative  effect of a change in accounting principle, net of tax                           |       | —                                    |       | — |   | — |   | — |   | (753 | ) |
| Net (loss)  income                                                                           |       | $                                         | (3,143     | ) | $ | (5,155 | ) | $ | (5,418 | ) | $ | (505 | ) | $ | 3,635 |   |
| Net (loss)  income per share, basic:                                                         |       |                                      |       |   |   |   |   |   |   |   |   |
| (Loss) income  per share before cumulative effect of a change in accounting principle        |       | $                                         | (0.31      | ) | $ | (0.50 | ) | $ | (0.56 | ) | $ | (0.06 | ) | $ | 0.50 |   |
| Loss per share  from the cumulative effect of a change in accounting principle               |       | —                                    |       | — |   | — |   | — |   | (0.09 | ) |
| Net (loss)  income per share                                                                 |       | $                                         | (0.31      | ) | $ | (0.50 | ) | $ | (0.56 | ) | $ | (0.06 | ) | $ | 0.41 |   |
| Net (loss)  income per share, diluted:                                                       |       |                                      |       |   |   |   |   |   |   |   |   |
| (Loss) income  per share before cumulative effect of a change in accounting principle        |       | $                                         | (0.31      | ) | $ | (0.50 | ) | $ | (0.56 | )  | $ | (0.06 | ) | $ | 0.48 |   |
| Loss per share  from the cumulative effect of a change in accounting principle               |       | —                                    |       | — |   | — |   | — |   | (0.08 | ) |
| Net (loss)  income per share                                                                 |       | $                                         | (0.31      | ) | $ | (0.50 | ) | $ | (0.56 | ) | $ | (0.06 | ) | $ | 0.40 |   |
| Weighted average  shares outstanding:                                                        |       |                                      |       |   |   |   |   |   |   |   |   |
| Basic                                                                                        |       | 10,286                                    |       | 10,333 |   | 9,687 |   | 8,921 |   | 8,794 |   |
| Diluted                                                                                      |       | 10,286                                    |       | 10,333 |   | 9,687 |   | 8,921 |   | 9,166 |   |

 

8

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| ** **                              | ** ** | **As of December 31,** | ** ** |
|-----------------------------------------|------------|-----------------------------|------------|
| ** **                              | ** ** | **2004**                    | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** |
| ** **                              | ** ** | **(In thousands)**          | ** ** |
| **Balance  Sheet Data:**                |       |                        |       |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents              |       | $                           | 12,663     |   | $ | 12,565 |   | $ | 10,334 |   | $ | 5,846 |   | $ | 4,542 |   |
| Working capital                         |       | 10,007                      |       | 11,488 |   | 13,477 |   | 10,729 |   | 11,695 |   |
| Total assets                            |       | 47,069                      |       | 36,094 |   | 44,785 |   | 46,768 |   | 56,472 |   |
| Note payable to  former stockholder (5) |       | —                      |       | — |   | — |   | 704 |   | 1,409 |   |
| Stockholders’  equity              |       | 18,512                      |       | 21,496 |   | 26,346 |   | 26,114 |   | 26,137 |   |
|                                         |            |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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(1)            We recorded restructuring expense as a result of costreduction initiatives in the fourth quarter of 2003.  These initiatives included severance expensesfor headcount reductions, office closure expenses and a charge for impairmentof our customer base intangible asset.

 

(2)            With the adoption of SFAS No. 142 on January 1, 2002, weceased amortizing $5.5 million of goodwill.

 

(3)            Reflects legal, accounting and other costs associatedwith our initial and a subsequent public offering, which we expensed when wepostponed both offerings due to market conditions.  We successfully completed our initial publicoffering on August 6, 1999.  We did notcomplete our second public offering.

 

(4)            Our1999 income tax expense resulted from the taxable income we generated betweenAugust 6, 1999 (when we terminated our S corporation status) andDecember 31, 1999, and the tax effect of our merger with DCSI. Our 2002income tax benefit was offset by $1.6 millionof expense for a valuation allowance for deferred tax assets.  The ultimate realization of deferredtax assets depends upon the generation of future taxable income during theperiods in which those temporary differences become deductible. Based upon the level of taxable losses in 2004, 2003and 2002 and the near-term uncertainty of taxable income, management cannotreasonably predict when or if we will realize these deductible differences.

 

(5)            Reflects a $3.0 million promissory note, less payments made,issued to one of our former stockholders in connection with our redemption,effective February 28, 1999, of 1,096 shares of common stock.

 

**Item 7.    Management’sDiscussion and Analysis of Financial Condition and Results of Operation.**

 

You should read the following discussion inconjunction with our financial statements and the related notes included inItem 8. The following information includes forward-looking statements, therealization of which may be affected by certain important factors discussed under“Risk Factors.”

 

**OVERVIEW**

 

We are an independent architect ofenterprise-class information storage infrastructures. We derive our revenuesprincipally from designing, installing and supporting data storage systems. Oursolutions can include hardware products, such as disk arrays, tape systems andinterconnection components and storage management software products.  The market for data storage products and servicesis large, estimated at $34 billion in 2004. We have 15 locations throughout the United States with the highestconcentration of revenues in the central states.

 

Wesell support service contracts to most of our customers.  Whencustomers purchase support services through us, customers receive the benefitof integrated system wide support.  We havea qualified, independent support desk that takes calls from customers,diagnoses the issues they are facing and either solves the problem orcoordinates with Datalink and/or vendor technical staff to meet the customer’sneeds.  Our support service agreementswith our customers include an underlying agreement with the productvendor.  The vendor provides on-sitesupport assistance if necessary. We defer revenues and direct costsresulting from these contracts, and amortize these revenues and expenses intooperations, over the term of the contracts, which are generally twelve months.

 

The enterprise-classinformation storage market is rapidly evolving and highly competitive.  Our competition includes other independentstorage system suppliers, high end market resellers, distributors, consultantsand our suppliers through other independent data storage solution providers,original equipment manufacturers and their own internal sales forces.  Our ability to

 

9

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hire and retain qualified outside salesrepresentatives and engineers with enterprise-class information storageexperience is critical to effectively competing in the marketplace andachieving our growth strategies.

 

In the past, we haveexperienced fluctuations in the timing of orders from our customers, and weexpect to continue to experience these fluctuations in the future.  These fluctuations have resulted from, amongother things, the time required to design, test and evaluate our data storagesolutions before customers deploy them, the size of customer orders, thecomplexity of our customers’ network environments, necessary systemconfiguration to deploy our solutions and new product introductions bysuppliers.  Completion of ourinstallation and configuration services may also delay recognition ofrevenues.  Economic conditions andcompetition also affect our customers’ decisions to place orders with us.  As a result, our net sales may fluctuate fromquarter to quarter.

 

We view the current data storage market as havingsignificant opportunity for Datalink’s growth. Currently, Datalink’s market share is a small part of the overallmarket.  However, the providers of thedata storage industry’s products and technologies are increasing theirutilization of indirect sales approaches to broaden their reach and optimizetheir margins.  Increasingly, they areturning to companies such as Datalink to sell their products.  While these trends provide opportunity forDatalink, we must improve our business model to generate sustainable,profitable growth.  Our model requireshighly skilled sales and technical staff which results in substantial fixedcosts for the Company.  We believe thebest way to improve our company and create long-term shareholder value it to focuson building capabilities that are scaleable and a cost structure that we canbetter leverage.  Our current strategiesare focused on:

•      Increasingproductivity of our sales and technical teams in our existing locations.

•      Growingour customer support revenue and market share. We believe that our customer support services offerings are becomingincreasingly attractive to companies looking for system-wide integratedsupport.

•      Increasingour professional services revenues.  Webelieve there is an opportunity to sell more of our data storage services suchas implementation services, storage environment assessments and on-site manageddata storage services.

•      Exploringpotential regional acquisitions that we perceive can strengthen our resourcesand presence in key geographic locations.

 

To pursue these strategies, our actions include:

•      Improvingour training, tools and recruiting for sales teams to increase productivity.

•      Hiringadditional customer support staff and enhancing communications and technology.

•      Developingmore effective delivery of professional service solutions.

 

All of these plans have various challenges andrisks associated with them, including that:

•      We maynot increase our productivity and may lose, or not successfully recruit andretain key sales, technical or other personnel.

•      Competitionis intense and may adversely impact our profit margin.  Customers have many options for data storageproducts and services.

•      We maynot identify suitable acquisition candidates.

 

**Results of Operations**

 

The following table shows, forthe periods indicated, certain selected financial data expressed as apercentage of net sales.

 

| ** **                   | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------|------------|-----------------------------------|------------|
| ** **                   | ** ** | **2004**                          | ** ** | **2003** | ** ** | **2002** | ** ** |
| Net sales                    |       | 100.0                             | %          | 100.0 | % | 100.0 | % |
| Cost of sales                |       | 74.8                              |       | 74.3 |   | 74.9 |   |
| Gross profit                 |       | 25.2                              |       | 25.7 |   | 25.1 |   |
| Operating  expenses:         |       |                              |       |   |   |   |   |
| Sales and  marketing         |       | 13.3                              |       | 12.1 |   | 13.3 |   |
| General and  administrative  |       | 11.1                              |       | 12.0 |   | 12.0 |   |
| Engineering                  |       | 4.0                               |       | 4.6 |   | 5.7 |   |
| Restructuring  charges       |       | —                            |       | 2.3 |   | — |   |
| Amortization of  intangibles |       | 0.3                               |       | 0.8 |   | 1.2 |   |
| Total operating  expenses    |       | 28.7                              |       | 31.8 |   | 32.2 |   |
| Operating loss               |       | (3.5                              | )%         | (6.1 | )% | (7.1 | )% |

 

10

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**Comparison of Years Ended December 31, 2004, 2003 and 2002**

 

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

 
| ** **                                               | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------|------------|------------------------------|------------|
| ** **                                               | ** ** | **2004**                     | ** ** | **2003** | ** ** | **2002** | ** ** |
| Product sales                                            |       | $                            | 63,235     |   | $ | 61,350 |   | $ | 58,492 |   |
| Service sales                                            |       | 30,048                       |       | 29,787 |   | 28,008 |   |
|                                                     |       |                         |       |   |   |   |   |
| Product gross  profit                                    |       | $                            | 14,667     |   | $ | 13,873 |   | $ | 13,716 |   |
| Service gross  profit .                                  |       | 8,873                        |       | 9,589 |   | 8,008 |   |
|                                                     |       |                         |       |   |   |   |   |
| Product gross  profit as a percentage of product sales . |       | 23.2                         | %          | 22.6 | % | 23.4 | % |
| Service gross  profit as a percentage of service sales   |       | 29.5                         | %          | 32.2 | % | 28.6 | % |

 

*Net Sales.*  Ourproduct sales increased 3.1% in 2004 from 2003 to $63.2 million, and increased 4.9%in 2003 from 2002 to $61.4 million. Our service sales, which include customersupport and installation services, remained relatively flat between 2004 and2003 at $30.0 million as compared to $29.8 million, and increased 6.4% in 2003from 2002 to $29.8 million.

 

The increase in our product sales from 2003 to2004 reflects a greater number of customers funding large projects,particularly for enhanced data recovery technology purchases.  Since 2002, we have increased theproductivity of our sales executives.  Thefollowing table shows the change in our average number of account executivesand the increase in our net sales per average number of account executives.

 
| ** **    | ** ** | **% Change in Average  No. of Account  Executives** | ** ** | **% Change in Net  Sales per Average No.  of Account Executives** | ** ** |
|---------------|------------|-----------------------------------------------------|------------|-------------------------------------------------------------------|------------|
| 2004 vs. 2003 |       | (10                                                 | )%         | 13                                                                | %          |
| 2003 vs. 2002 |       | (29                                                 | )%         | 47                                                                | %          |

 

The decline in the number of account executives reflectsour closure of selected offices and turnover primarily in late calendar 2003.  Based on our current hiring plans we expectthe average number of account executives to increase modestly in 2005.

 

The increase in our product sales from 2002 to 2003reflects an improvement in technology spending particularly with our largeexisting customers.

 

The slight increase in our service revenues between 2003 and 2004reflects a $1.9 million increase in consulting service revenues, offset by a$1.1 million decrease in installation and configuration service revenues and a$360,000 decrease in customer support contract revenues.  In 2003, we completed a particularly largestorage solution installation and configuration project and also were unable torenew a large customer support contract. The increase in our service revenues between 2002 and 2003 reflects anincrease in installation and configuration revenues of $1.4 million primarilydue to a single large installation and configuration project completed in 2003.

 

We derived approximately 3%, 10% and 5% of our sales from our customer,Gateway, Inc., during 2004, 2003 and 2002, respectively.  We cannot be assured that this customer willaccount for a substantial portion of our future sales.  We had no other customers that comprised morethan 10% of our sales in 2002 through 2004.

 

*Gross Profit.*  Our totalgross profit as a percentage of net sales decreased to 25.2% in 2004 from 25.7%in 2003, which was an increase from 25.1% in 2002.

 

Product gross profit as apercentage of product sales increased to 23.2% in 2004 as compared to 22.6% in2003.  This percentage improvementreflects the increase in enhanced data recover technology solution purchasesmade by our customers for which we achieved a higher gross profit.  We have various programs in place with ourvendors that provide economic incentives for achieving various salesperformance targets.  Achieving thesetargets contributed favorably to our 2004 product gross profit.  These vendor incentive programs constantlychange and we negotiate them separately with each vendor.  While we expect the incentive programs tocontinue, the vendors could modify or discontinue them, which would unfavorablyimpact our gross profit margins.

 

11

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Product gross profit as apercentage of net product sales decreased to 22.6% in 2003 as compared to 23.4%in 2002.  Due to economic conditionsduring 2002 and 2003, our customers sought storage solutions to meet minimumneeds rather than implementing comprehensive infrastructure changes.  Solutions that meet a minimum need generallycarry lower product margins than comprehensive infrastructure changes.  In addition, our product gross profitpercentage suffered due to the high level of pricing competition in the marketplace.  Charges for excess and obsolete inventory in2004, 2003 and 2002 of $185,000, $349,000and $188,000, respectively, adversely affected our product gross profit.

 

Service gross profit as a percentageof service sales decreased to 29.5% in 2004 as compared to 32.2% in 2003 and increasedas compared to 28.6% in 2002.  Thepercentage decrease in 2004 as compared to 2003, and the percentage increasefor 2003 over 2002, is primarily due a single large installation andconfiguration project in 2003 on which we achieved a higher than normal grossprofit percentage.  For 2004, we also failedto renew a couple of large customer support contracts.

 

*Sales and Marketing.*  Salesand marketing expenses include wages and commissions paid to sales andmarketing personnel, travel costs and advertising, promotion and hiringexpenses.  Sales and marketing expensestotaled $12.4 million, or 13.3% of net sales for 2004 compared to $11.0million, or 12.1% of net sales for 2003 and $11.5 million, or 13.3% of netsales for 2002.  The increase in salesand marketing expense in absolute dollars is a result of higher commissionexpense of $1.7 million due to a change in compensation plans and higher salesvolume in 2004 as compared to 2003.  Thedecrease in sales and marketing expense in absolute dollars in 2003 as comparedto 2002 is a result of lower bad debt expense of $141,000 and a reduction inour sales management workforce and expenses of $153,000.  The increase in sales and marketing expenseas a percentage of net sales from 2004 as compared to 2003 resulted from theincrease in commission expenses due to compensation plan changes.  The decrease in sales and marketing expenseas a percentage of net sales from 2003 as compared to 2002 resulted primarilyfrom higher revenues combined with reduced expenses in 2003.  As we continue to selectively hire additionaloutside sales representatives, our sales and marketing expenses may increasewithout a commensurate increase in sales.

 

*General and Administrative.*  Generaland administrative expenses include wages for administrative personnel,professional fees, depreciation, communication expenses and rent and relatedfacility expenses. General and administrative expenses decreased to $10.4million, or 11.1% of net sales for 2004 compared to $11.0 million, or 12.0% ofnet sales for 2003 and $10.4 million, or 12.0% in 2002. The decrease in generaland administrative expenses in absolute dollars is due to lower depreciationexpense of $225,000 on our customer relationship management system and reducedfacilities expenses of $412,000 related to our office closures andsubleases.  When comparing 2003 to2002, the increase in general and administrative expenses in absolute dollarsreflects higher property taxes for our Chanhassen facility of $205,000, highertraining expenses to maintain vendor certifications of $99,000 and thesettlement of a sales and use tax audit of $127,000.  Our general and administrative expenses werelower as a percentage of net sales in 2004 as compared to 2003 due to thereduced spending coupled with an increase in sales.  Our general and administrative expenses were flatas a percentage of net sales in 2003 as compared to 2002.

 

*Engineering.*  Engineeringexpenses include employee wages and travel, hiring and training expenses forour professional engineers and technicians. We allocate engineering costsassociated with installation and configuration services and with consultingservices to our cost of service sales.  Engineering expenses decreased to $3.8 million, or4.0% of net sales in 2004 compared to $4.2 million, or 4.6% of net sales in2003 and $5.0 million, or 5.7% of net sales in 2002.  The decrease in engineering expenses inabsolute dollars from 2004 as compared to 2003 is due to an $862,000 compensationsavings associated with a reduction in the number of engineers and engineeringmanagers, offset by an increase in outside consulting expenses of $155,000 anda $71,000 increase in travel and entertainment expenses.

 

The decrease in engineeringexpenses in absolute dollars from 2003 as compared to 2002 reflects an increasein installation and configuration and consulting service revenues of $388,000in 2003 over 2002.  Accordingly, we had acorresponding decline in the proportion of our engineering costs allocated toengineering expenses and an increase in our allocation to cost of service sales.  In 2003, we also had $149,000 less ofengineering travel and entertainment on installation and configuration projectsthan in 2002

 

The decrease in engineering expenses as a percentageof sales for 2004 as compared to 2003 is the result of higher revenues andlower expenses in 2004.  The decrease inengineering expenses as a percentage of sales for 2003 as compared to 2002 isthe result of higher revenues and lower expenses in 2003.

 

*Overall Cost Reduction Initiatives. *Because of the difficulteconomic climate for technology spending that we faced over the past severalyears, and with our recent operating losses, we have actively sought to reducecosts across our business.  In October2003, we announced several cost reduction initiatives and managementchanges.  These changes resulted in afourth quarter 2003 charge of $2.1 million. As part of these cost reduction initiatives, we reduced our staff by16%.  Employee severance charges were$568,000.  We also announced the closureof four offices.  Office closing costsfor lease terminations

 

12

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were $584,000.  The office closures included closing anoffice and terminating personnel from our OpenSystems.com, Inc. acquisition inNovember 2000, resulting in an impairment of our customer base intangibleasset.  The resulting impairment chargeof the asset was $926,000.

 

On December 15, 2004, we agreed to sublease approximately 55,000 of the104,000 square feet we currently occupy as our corporate headquarters inChanhassen, Minnesota.  The initialsublease term is co-terminal with our lease and is for 85 months starting onApril 1, 2005 and ending April 27, 2012. The sublessee will pay us rent ranging from approximately $55,000 permonth at the beginning of the term to approximately $60,000 per month by theend of the term.  We also negotiated withour landlord to sell the 2.5 acre lot adjoining our facility for $200,000.  In the first quarter of 2005, we expect toincur a one-time, non-cash charge of approximately $3.5 million related to thesublease and lot sale.  We expect costsavings of approximately $950,000 per year as a result of the subleaseagreement.

 

*Intangible Amortization.*  Amortizationof intangible assets decreased to $261,000 in 2004 compared to $724,000 in 2003and $1.1 million in 2002.  Theamortization relates primarily to our acquisition of the data storage andservices business of OpenSystems.com, Inc. in November 2000.  We adopted Statement of Financial AccountingStandards (SFAS) 142, Goodwill and Intangible Assets, on January 1, 2002.  This Statement required that we no longeramortize goodwill and intangible assets with indefinite lives, but instead testfor impairment annually or whenever impairment is indicated.  For 2004, we determined that our goodwill wasnot impaired.  However, in the fourthquarter of 2003, we recorded an impairment charge on our OpenSystems.comcustomer base intangible asset in connection with our cost reductioninitiatives.

 

During 2003, we amortized the remaining $76,000 balance of the customerbase intangible asset we acquired in our July 1998 acquisition of DirectConnect Systems, Inc.  In 2002, weamortized the remaining $163,000 balance of the trademark and name intangibleasset we acquired in that acquisition. This is because we do not operate under the Direct Connect Systems nameand realization of future uses became uncertain in the fourth quarter of 2002.  For more information, see Note 2 of the Notesto our Financial Statements.

 

*Operating Loss.* Weincurred operating losses of $3.2 million in 2004 compared to $5.5 million in2003 and $6.2 million in 2002. Since the restructuring in October 2003, ourfinancial results have steadily improved during 2004.  In the fourth quarter of 2004 we generatednet income of $445,000.  However, weexpect to post a net loss in the first quarter ending March 31, 2005.  This relates to the $3.5 million subleasecharge described above, together with normal, increased first quarter recurringcosts for payroll taxes, public reporting compliance and benefit accruals.  We also will incur expenses related toSarbanes-Oxley compliance requirements which will contribute to the expectedfirst-quarter operating loss.  We expectthese compliance and other costs to decline in 2005 after the first quarter.

 

The reduction in our operating losses of $2.3 million for 2004 ascompared to 2003 is a result of $2.1 million of restructuring charges includedin the 2003 operating loss and the favorable impact of our cost reductionefforts in our 2004 operating results. The decrease in our operating losses of $700,000 for 2003 as compared to2002 is due to a 5.4% improvement in sales and a reduction in amortizationexpense, offset by $2.1 million of restructuring charges included in the 2003operating loss.

 

*Income Taxes.*  We had no income tax benefit or expense in2004.  We provided for an income taxbenefit of $276,000 in 2003 and $618,000 in 2002.  The income tax benefit generated for 2003represents a higher than expected federal income tax refund from our 2002 taxreturn.  Included in the income taxprovision for 2002 is a non-cash charge of $1.6 million related to the recordingof a valuation reserve for the deferred tax asset.  Theultimate realization of deferred tax assets is dependent upon carry back toprior periods and upon the generation of future taxable income during theperiods in which those temporary differences become deductible. Based upon the level of taxable losses in 2004, 2003and 2002 and the near-term uncertainty of taxable income, management cannotreasonably predict when or if these deductible differences will be realized.  In addition, we do not have the ability to realize future income tax benefits onfuture losses.

 

**Quarterly Results and Seasonality**

 

The following table sets forthour unaudited quarterly financial data for each quarter of 2004 and 2003. Inour opinion, this unaudited information has been prepared on the same basis asthe audited information and includes all adjustments (including all normalrecurring adjustments) necessary to present fairly the information set forthbelow. The operating results for any quarter are not necessarily indicative ofresults for any future period.

 

13

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| ** **               | ** ** | **Quarters Ended**  | ** ** |
|--------------------------|------------|---------------------|------------|
| ** **               | ** ** | **2004**            | ** ** | **2003** | ** ** |
| ** **               | ** ** | **Mar. 31**         | ** ** | **Jun. 30** | ** ** | **Sep. 30** | ** ** | **Dec. 31** | ** ** | **Mar. 31** | ** ** | **Jun. 30** | ** ** | **Sep. 30** | ** ** | **Dec. 31** | ** ** |
| ** **               |       | **(in  thousands)** |       |
| Net sales                |       | $                   | 20,204     |   | $ | 21,463 |   | $ | 25,633 |   | $ | 25,983 |   | $ | 23,742 |   | $ | 26,371 |   | $ | 19,951 |   | $ | 21,073 |   |
| Gross profit             |       | 5,008               |       | 5,232 |   | 5,868 |   | 7,432 |   | 6,326 |   | 6,821 |   | 5,010 |   | 5,305 |   |
| Operating income  (loss) |       | (1,860              | )          | (1,047 | ) | (735 | ) | 416 |   | (879 | ) | (210 | ) | (2,020 | ) | (2,396 | ) |
| Net income  (loss)       |       | (1,840              | )          | (1,031 | ) | (717 | ) | 445 |   | (860 | ) | (186 | ) | (2,006 | ) | (2,103 | ) |
|                          |            |                     |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

We have experienced, and expect to continue toexperience, quarterly variations in our net sales as a result of a number offactors, including the length of the sales cycle with customers for largestorage system evaluations and purchases, delays in storage systeminstallations or configurations, new product introductions by suppliers andtheir market acceptance, delays in product shipments or other quality controldifficulties, trends in the enterprise-class information storage industry in generalor the geographic and industry specific markets in which we are currently active,or may be in the future.  In addition, economicconditions and competition also affect our customers’ decisions to place orderwith us.  Further, our success in integratingany acquired business or in opening any new field offices could impact our netsales.

 

**Liquidity and Capital Resources**

 

We have financed our operations and capitalrequirements through cash flows generated from operations and the proceeds fromour offerings of our common stock. Our working capital was $10.0 million atDecember 31, 2004 as compared to $11.5 million at December 31, 2003. Ourcurrent ratio was 1.4:1 at December 31, 2004 as compared to 1.5:1 atDecember 31, 2003.  AtDecember 31, 2004, our cash and cash equivalents balance was $12.7million.

 

Cash provided by operating activities for 2004 was$396,000 as compared to $3.2 million in 2003 and $984,000 in 2002.  Significant items which impacted ouroperating cash flows in 2004 were:

•      A $3.0 million increase in accountsreceivable reflecting increasing sales activity versus the prior year.

•      A $2.2 million increase in accruedexpenses and accounts payable due primarily to increased employee bonusincentive accruals.

•      A net $1.0 million increase in deferredcustomer support contracts.  While weamortize the revenues from these contracts over the life of the contract, thecustomer almost always pays for the contracts at the beginning of the contractperiod which favorably impacts our cash flows.

 

  The cashprovided in 2003 resulted primarily from a reduction in our net operatingassets.  This included a $2.0 millionincome tax refund, a $1.9 million reduction in inventory shipped but notinstalled with fewer projects left to be installed at year end, a $441,000reduction in field evaluation inventory and a $3.9 million reduction inaccounts receivable due to an improvement in our days sales outstanding.  These reductions were offset by a $3.5million reduction in accounts payable.  Thecash provided in 2002 resulted primarily from a reduction in our net operatingassets from timing of certain payments and receipts and a reduction in theoverall level of working capital.

 

Cash used in investing activities was $415,000 in2004 and $1.1 million during each of 2003 and 2002.  In 2004, we used this cash to purchasecomputer equipment, complete a data warehouse project and provide furtherenhancements to our business reporting software tool.  In 2003, we used this cash to complete our ownstorage and data recovery project, purchase computer equipment and providefurther enhancements to our customer relationship management informationsystems and our business reporting software tool.  In 2002, we used this cash primarilyto implement our customer relationship management information system.

 

Cash provided by financing activities during 2004,2003 and 2002 was $117,000, $111,000 and $4.7 million, respectively.  In 2004 and 2003, we received $117,000 and$111,000, respectively, from stock sold under our employee stock purchase planand from the exercise of stock options.  In2002, we received $5.3 million from a direct private offering of newlyissued common stock to institutional investors and $186,000 from stock soldunder our employee stock purchase plan. This cash was partially offset by thefinal scheduled payment of $704,000 on a note due to a former stockholder.

 

The revolving credit facility we have had with abank since June 2003, expired in June 2004. We have elected not to pursue a new facility at this time.  We have no outstanding debt, and if the needshould arise to borrow funds, we believe that we could obtain a securedfacility.  For more information, see Note5 of the Notes to our Financial Statements.

 

We have an 11-year non-cancelable operating lease for our corporate headquarters in Chanhassen, Minnesota which expires in 2012.  The lease requires base rental payments of approximately $1.0 million in the first year and $1.3 million for each subsequent year.   On December 15, 2004, we agreed to sublease approximately 55,000 of the 104,000 square feet we then occupied.  The initial term of the sublease is co-terminal with our lease and is for 85 months starting on April 2005 and ending

 

14

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on April 2012.  The sublease requires rent payments ranging from $55,000 per month at the beginning of the term to approximately $60,000 per month by the end of the term.  For more information, see Note 7 of the Notes to our Financial Statements.

 

**ContractualObligations and Commitments**

 

As of December 31, 2004, our contractual cash obligations consisting of future minimum lease payments due under non-cancelable operating leases are as follows:

 

 
| ** ** | ** ** | **(in thousands)**     | ** ** |
|------------|------------|------------------------|------------|
| ** ** | ** ** | **Lease  Obligations** | ** ** | **Sublease  Agreements** | ** ** | **Net Lease  Obligations** | ** ** |
| 2005       |       | $                      | 2,010      |   | $ | (1,172 | ) | $ | 838 |   |
| 2006       |       | 1,900                  |       | (1,147 | ) | 753 |   |
| 2007       |       | 1,575                  |       | (1,130 | ) | 445 |   |
| 2008       |       | 1,310                  |       | (1,053 | ) | 257 |   |
| 2009       |       | 1,307                  |       | (1,053 | ) | 254 |   |
| Thereafter |       | 3,056                  |       | (2,457 | ) | 599 |   |
|       |       | $                      | 11,158     |   | $ | (8,012 | ) | $ | 3,146 |   |

 

On December 15, 2004, we agreed to sublease approximately 55,000 of the104,000 square feet we then occupied as our corporate headquarters inChanhassen, Minnesota.  The initialsublease term is co-terminal with our lease and is 85 months starting on April1, 2005 and ending April 27, 2012.  Thesublessee will pay us rent ranging from approximately $55,000 per month at thebeginning of the term to approximately $60,000 per month by the end of theterm.  The rent includes the costs ofcommon area management, common systems repairs, real estate taxes and standardutilities.  We also negotiated with ourlandlord to sell the 2.5 acre lot adjoining our facility for $200,000, which weoriginally acquired in 2001 for $384,000. We expect to incur the following charges in the first quarter of 2005associated with our sublease and related activities:

 
| **Item**                                                     | ** ** | **Expected  Related Charge** | ** ** |
|--------------------------------------------------------------|------------|------------------------------|------------|
| Rent reserve  (excess of lease expense over sublease income) |       | $                            | 3,075,000  |   |
| Accelerated  depreciation                                    |       | 249,000                      |       |
| Loss on  anticipated land sale                               |       | 184,000                      |       |
|                                                         |       | $                            | 3,508,000  |   |

 

We also estimate our cash expenditures associated with our sublease andthe related activities, net of the anticipated proceeds from our proposed lotsale, at $674,000.  We will capitalizethese cash outlays and amortize them over the lease term.

 

We believe that funds generated from operations will be sufficient tofinance our current operations and planned capital expenditures for at leastthe next twelve months.  We believe ifthe need should arise to borrow funds, we could obtain a secured facility. We are planning for $500,000 to $1.0 million of capitalexpenditures through 2005 primarily related to enhancements to our managementinformation systems.

 

### **Critical Accounting Policies and Estimates**

 

The preparation of financial statements requires us tomake estimates and assumptions that affect reported earnings. We evaluate theseestimates and assumptions on an on-going basis based on historical experienceand on other factors that we believe are reasonable. Estimates and assumptionsinclude, but are not limited to, the areas of customer receivables,inventories, investments, income taxes, self-insurance reserves and commitmentsand contingencies.  We believe that thefollowing represent the areas where we use more critical estimates andassumptions in the preparation of our financial statements:

 

*Revenue Recognition.***Werealize revenue from the design, installation and support of data storagesolutions, which may include hardware, software and services.  We recognize revenue when it has met itsobligations for installation or other services and collectability is reasonablyassured.

 

Product Sales.  We sell softwareand hardware products on both a “free-standing” basis without any services andas data storage solutions bundled with our installation and configurationservices (“bundled arrangements”).

 

15

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*Product Sales Without Service**. *Ifwe sell a software or hardware product and do not provide any installation orconfiguration services with it, we recognize the product revenues upon shipment.

 

*Product Sales With Service**. *Ifwe sell a bundled arrangement, then we defer recognizing any revenues on ituntil we finish our installation and/or configuration work.  For the three years ended December 31, 2004,we have accounted for the hardware, software and service elements of ourbundled arrangements by applying the provisions of Statement of Position (SOP)97-2, Software Revenue Recognition, as amended by SOP 98-4 and SOP 98-9.

 

Pursuant to the provisions of SOP 97-2, we apply contractaccounting to our bundled arrangements. In accordance with SOP 81-1, “Accounting for Performance of ConstructionType and Certain Production Type Contracts,” we apply the completed contractmethod.  Factors we have considered inapplying the completed contract method accounting include (i) the relativelyshort duration of our contracts, (ii) the difficulty of estimating our revenueson a percentage-of-completion method and (iii) our use of acceptance provisionson larger bundled arrangements.

 

For 2002, we originally applied the provisions of StaffAccounting Bulletin No. 101 to account for our bundled arrangements.  In 2003, we changed the accounting guidancewe apply based on our determination that the software component of our saleswas more than incidental to our products or services as a whole.  However, the change did not affect therevenue amounts or the timing of our revenue recognition on bundledarrangements for 2002.  This is because,under SAB No. 101, we also recognized revenue on our bundled arrangements onlyafter we completed our installation and configuration services.

 

Service Sales.  In addition to installation and configurationservices that are part of our bundled arrangements described above, our servicesales include customer support contracts and consulting services.  On our balance sheet, deferred revenuerelates to service sales for which our customer has paid us or has beeninvoiced but for which we have not yet performed the applicable services.

 

*Customer Support Contracts. *We sell service contracts to most of ourcustomers.  These contracts are supportservice agreements.  We have an internalsupport desk that provides integrated customer support services, includingconfiguration and usage assistance, technical advice and prompt incidentdetection and resolution.  Our technicalstaff first assists a customer in identifying the source of system problems andin determining whether there is defective hardware or software.  If our customer requires on-site maintenanceor repair services, we arrange for a service call pursuant to underlyingthird-party support service agreements we have with our hardware and softwarevendors.

 

When we sell a servicecontract as part of a bundled arrangement, we use vendor specific objectiveevidence to allocate revenue to the service contract element.  In all cases, we defer revenues and directcosts resulting from our service contracts and amortize them into operationsover the term of the contracts, which are generally twelve months.  We are contractually obligated to provide orarrange to provide these underlying support services to our customers in theunlikely event that the hardware or software vendor, or its designee, fails toperform according to the terms of its contact.

 

*Consulting Services. *Some of our customers engage us toanalyze their existing storage architectures and offer ourrecommendations.  Other customers engageus to assist them on-site with extended data storage projects, to support theirdata storage environments and to help with long-term data storage designchallenges.  For these types ofconsulting services that do not include the sale of hardware or softwareproducts, we recognize revenues as we perform these services.

 

*Gross Reporting of Revenues.*  We report our revenues from the sale ofhardware and software products on a gross, rather than a net, basis.  In reporting our revenues on a gross basis,we considered that:

•      Weare the primary obligor to our customers. We are responsible for fulfillment, including the acceptability of theproducts and services to our customers.

•      Wehave the risk of loss for inventory and credit.

•      Weestablish the prices for our products and services with our customers.

•      Weare responsible for the installation and configuration services ordered by ourcustomers.

 

*Commission Expense.*  We utilize a direct internal sales force togenerate virtually all of our revenues. We pay our sales people a combination of base salary and commissions.  We pay commissions based on the amount ofgross profit generated from the products and services sold.  We match commissions to the appropriatetransactions and recognize commission expense at the time we recognize therelated revenues and gross profit.

 

*Inventory*.  We periodically review, estimate and adjustour reserves for obsolete or unmarketable inventory equal to the differencebetween the inventory cost and the estimated market value based uponassumptions about future demand and market

 

16

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conditions. Results couldbe materially different if demand for our products decreased because ofeconomic or competitive conditions, length of industry downturn, or if productsbecome obsolete because of technical advancements in the industry.

 

*Valuation of Goodwill and Other Intangible Assets**.* On January 1, 2002, we adopted Statement of Financial Accounting Standards (SFAS) 142, “Goodwill and Other Intangible Assets,” and reclassified $652,000 of assembled workforce to goodwill.  As a result, we have ceased to amortize approximately $5.5 million of goodwill. We test goodwill for impairment annually or more frequently if changes in circumstance or the occurrence of events suggests an impairment exists. The test for impairment requires us to make several estimates about fair value, most of which are based on total market capitalization as compared to the carrying value of our net assets. If our total market capitalization is at or below the carrying value of our net assets, it may prompt us to engage a third party valuation firm to perform a valuation of us to further assess whether our goodwill or other intangibles are impaired pursuant to SFAS 142.  We consider our goodwill impairment test estimates critical due to the amount of goodwill recorded on our balance sheet and the judgment required in determining fair value amounts.

 

Other intangible assets consist of customer lists. We amortize customer lists using the straight-line method over an estimated useful life of five years. We review these intangible assets for impairment as changes in circumstance or the occurrence of events suggests the remaining value is not recoverable.

 

*IncomeTaxes*.  We utilizethe asset and liability method of accounting for income taxes.  We recognize deferred tax liabilities orassets for the expected future tax consequences of temporary differencesbetween the book and tax bases of assets and liabilities.  We regularly assess the likelihood that wewill recover our deferred tax assets from future taxable income  We record a valuation allowance to reduce ourdeferred tax assets to the amounts we believe are more likely than not to berealizable.  We consider projected futuretaxable income and ongoing tax planning strategies in assessing the amount ofthe valuation allowance.  If we determineit is more likely than not that we will not realize all or part of our deferredtax assets, we will adjust our earnings for the deferred tax in the period wemake this determination.

 

As a result of our cumulative losses over the past twoyears and the full utilization of our loss carry back potential, we concludedduring the fourth quarter of fiscal 2002 to make a full valuation allowanceagainst our net deferred tax assets.  Thevaluation allowance at December 31, 2004 was $4.7 million. In addition, weexpect to provide a full valuation allowance on any future tax benefits untilwe can sustain a level of profitability that demonstrates our ability to realizethese assets.  

 

**Recent Accounting Pronouncements**

 

In December 2004, theFinancial Accounting Standards Board published FASB Statement No. 123 (revised2004), *Share-Based Payment*.  This statement, which will begin to apply inour third quarter of 2005, requires us to recognize the compensation costrelating to share-based payment transactions, including grants of employeestock options, in our financial statements. We are to measure this cost basedon the fair value of the equity or liability instruments issued. The statementcovers a wide range of share-based compensation arrangements, including stockoptions, restricted share plans, performance-based awards, share appreciationrights and employee share purchase plans. The statement will require us tomeasure the cost of employee services received in exchange for stock optionsbased on the grant-date fair value of the award.  We then will recognize the cost over theperiod we require the employee to provide services for the award.

 

The new statement allowstwo methods for transitioning our expensing of share-based transactions.  We are studying the new statement and havenot yet determined which transition method we will apply.  Under the modified prospective transitionmethod, we would use the fair value-based accounting method for all employeeawards granted, modified or settled after the effective date.  As of the effective date, we would base thecompensation cost for the non-vested portion of awards outstanding as of thatdate on the grant-date fair value of those awards as calculated under ourcurrent accounting methods.  As a result,we would not re-measure the grant-date fair value estimate for the unvestedportion of awards granted prior to the effective date.  As part of this transition method, we wouldalso decide whether to apply the new statement to only our third quarter of2005 and subsequent periods, or to all of 2005. Under the modified retrospective method of transition, we would need torevise our previously issued financial statements to recognize employeecompensation cost for all prior periods we present in our financial statements.

 

**Inflation**

 

We do not believe that inflation has had amaterial effect on our results of operations in recent years. We cannot assureyou that inflation will not adversely affect our business in the future.

 

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**RISK FACTORS**

 

As indicated in this Annual Report under the caption “Note RegardingForward-Looking Statements,” certain information contained in this AnnualReport consists of forward-looking statements. Important factors that could cause actual results to differ materiallyfrom the forward-looking statements made in this Annual Report include thefollowing:

** **

**We have incurred substantial net losses and may not achieveprofitability.**

 

Except for the fourth quarter of 2004, we have incurred net losses eachquarter since the fourth quarter of 2001. We also expect to incur a net loss in the first quarter of 2005.  We cannot assure that we will return toprofitability in the foreseeable future, or at all.  Our continued losses may adversely affect ourstock price.

 

**Competition could prevent us from increasing or sustaining our revenuesor profitability.**

 

The enterprise-class information storage market israpidly evolving and highly competitive. As technologies change rapidly, we expectthat competition will increase in the future. We compete with independentstorage system suppliers to the high-end market and numerous resellers,distributors and consultants. We also compete in the storage systems marketwith general purpose computer suppliers. Many of our current and potentialcompetitors have significantly greater financial, technical, marketing,purchasing and other resources than we do. As a result, they may respond morequickly to new or emerging technologies and changes in customer requirements,devote greater resources to the development, promotion and sale of products anddeliver competitive products at lower end-user prices.

 

Some of our current and potential competitorsinclude our suppliers. We are not the exclusive supplier of any data storageproduct we offer.  Instead, our suppliersmarket their products through other independent data storage solutionproviders, original equipment manufacturers and, often, through their owninternal sales forces. We believe direct competition from our suppliers islikely to increase if, as expected, the data storage industry continues toconsolidate. This consolidation would probably result in fewer suppliers withgreater resources to devote to internal sales and marketing efforts. In addition,our suppliers have established and will probably continue to establishcooperative relationships with other suppliers and other data storage solutionproviders. These cooperative relationships are often intended to enable oursuppliers to offer comprehensive storage solutions, which compete with those weoffer. If our relationships with our suppliers become adversarial, it will bemore difficult for us to stay ahead of industry developments and provide ourcustomers with the type of service they expect from us.

 

In addition, most of our customers already employin-house technical staffs. To the extent a customer’s in-house technical staffdevelops sophisticated storage systems expertise, the customer may be lesslikely to seek our services. Further, we compete with storage service providerswho manage, store and backup their customers’ data at off-site, networked datastorage locations.

 

**We derive a significant percentage of our revenues from a small numberof customers.**

 

In 2004, we had no customers thataccounted for at least 10% of our revenues.  However, our top six customers collectivelyaccounted for 27% of our 2004 revenues. Because we intend to continue to seekout large projects, we expect that a significant percentage of our revenueswill continue to come from a small number of customers, although thecomposition of our key customers is likely to change from year to year. If wefail to obtain a growing number of large projects each year, our revenues andprofitability will likely be adversely affected. In addition, our reliance onlarge projects makes it more likely that our revenues and profits willfluctuate unpredictably from year to year. Unpredictable revenue and profitfluctuations may make our stock price more volatile and lead to a decline inour stock price.

 

### **Our revenue recognitionpolicies unpredictably defer reporting of our revenues.**

 

We increasingly sell complexenterprise-class information storage solutions. We do not recognize revenues from our sale of hardware and softwareproducts to our customers until we complete our required installation orconfiguration of these products. Installation and configuration of these solutions requires significantcoordination with our customers and vendors. Therefore, even if we have shipped all products to our customers, we maybe unable to control the timing of product installation and configuration.  These delays prevent us from recognizingrevenue on products we ship and may adversely affect our quarterly reportedrevenues.  As a result, our stock pricemay decline.

 

**We rely ononly a few key suppliers and would suffer materially if we could not obtaintheir products.**

 

We rely on our close relationships with oursuppliers to provide access to products and new technology necessary to designand implement leading-edge enterprise-class information storage solutions forour customers. We do not have long-term supply contracts with any of oursuppliers. In many instances, we rely upon only two or three suppliers for eachof our key products. Our

 

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reliance on these suppliers leaves us vulnerable to an inadequate supplyof required products, price increases, late deliveries and poor productquality. Disruption or termination of the supply of products from our suppliersfor any reason would likely prevent or delay our shipments to our customers.Our customers expect reliable and prompt service from us. If we cannot obtainnecessary components, or the components we obtain are unreliable or unexpectedlyexpensive, we will not meet our customers’ expectations. If we cannot meet ourcustomers’ expectations, our business will suffer considerably.

 

**Our business depends on our ability to hire and retain technicalpersonnel.**

 

Our future operating results depend upon ourability to attract, retain and motivate qualified engineers withenterprise-class information storage solutions experience. If we fail torecruit and retain additional engineering personnel, or if continued lossesrequire us in the future to terminate employment of some of these personnel, wewill experience greater difficulty realizing our growth strategy, which couldnegatively affect our business, financial condition and stock price.

 

**We generally do not have employment agreements with our key employees.**

 

Ourfuture operating results depend in significant part upon the continuedcontributions of our executive officers, managers, salespeople, engineers andother technical personnel, many who have substantial experience in our industryand would be difficult to replace. In general, we do not have employment,non-competition or nondisclosure agreements with our officers or employees,including our executive officers. Accordingly, our employees may voluntarilyleave us at any time and work for our competitors. Our growth strategy dependsin part on our ability to retain our current employees and hire new employees.Any failure to retain our key employees will make it much more difficult for usto maintain our operations and attain our growth objectives and could thereforebe expected to adversely affect our operating results, financial condition andstock price.

 

**Our long sales cycle may cause fluctuating operating results, which mayadversely affect our stock price.**

 

Oursales cycle is typically long and unpredictable, making it difficult to planour business.  Economic conditions overthe past several years have increased this uncertainty.  Our long sales cycle requires us to investresources in potential projects that may not occur.  In addition, our long and unpredictable salescycle may cause us to experience significant fluctuations in our future annualand quarterly operating results.  It canalso result in delayed revenues, difficulty in matching revenues with expensesand increased expenditures.  Ourbusiness, operating results or financial condition and stock price may sufferas a result of any of these factors.

 

**If the data storage industry fails to develop compelling new storagetechnologies, our business may suffer.**

 

Rapid and complex technological change, frequentnew product introductions and evolving industry standards increase demand forour services. Because of this, our future success depends in part on the datastorage industry’s ability to continue to develop leading-edge storage technologysolutions. Our customers utilize our services in part because they know thatnewer technologies offer them significant benefits over the older technologiesthey are using. If the data storage industry ceases to develop compelling newstorage solutions, or if a single data storage standard becomes widely acceptedand implemented, it will be more difficult to sell new data storage systems toour customers.

 

**Accounting for equity compensation future accounting changes mayadversely impact our expected financial results.**

 

Under current accounting rules,we do not record charges to our financial statements in connection with thegrant at fair market value of employee stock options.  However, these accounting rules will changeduring 2005.  Our new option-relatedexpenses may unpredictably affect our reported results, which may adverselyaffect our stock price.

 

**We may notbe fully compliant with Sarbanes-Oxley regulations**.

 

Beginning with the calendar year end December 31, 2006,we will be required by Section 404 of the Sarbanes-Oxley Act of 2002 toformally assess and attest that our internal controls are sufficient to provideaccurate reporting of financial results. We will engage our independent accountants to perform an audit of ourassessment and issue an opinion on the sufficiency of our internalcontrols.  We are in the beginning phasesof our assessment.  Although we expect toincur significant costs to achieve compliance, we do not know if we will befully compliant with the regulations by the end of 2006.  If we are not compliant, we may incuradditional costs to become compliant and our stock price could be unfavorablyimpacted.

 

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**Control by our existing stockholders could discourage the potential acquisitionof our business.**

 

Currently, our executive officers and directorsbeneficially own approximately 38% of our outstanding common stock. Actingtogether, these insiders may be able to elect our entire Board of Directors andcontrol the outcome of all other matters requiring stockholder approval. Thisvoting concentration may also have the effect of delaying or preventing achange in our management or control or otherwise discourage potential acquirersfrom attempting to gain control of us. If potential acquirers are deterred, youmay lose an opportunity to profit from a possible acquisition premium in ourstock price.

 

**Our stock price is volatile.**

 

The market price of our common stock hasfluctuated significantly since our initial public offering, and may continue tobe volatile. We cannot assure you that our stock price will increase, or eventhat it will not decline significantly from the price you pay. Our stock pricemay be adversely affected by many factors, including:

 
| • | actual  or anticipated fluctuations in our operating results, including those  resulting from changes in accounting rules;           |
|--------|--------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                 |
| • | announcements  of technical innovations;                                                                                             |
|   |                                                                                                                                 |
| • | new  products or services offered by us, our suppliers or our competitors;                                                           |
|   |                                                                                                                                 |
| • | changes  in estimates by securities analysts of our future financial performance; and                                                |
|   |                                                                                                                                 |
| • | general  market conditions, including the effects of economic conditions over the past  several years and war and terrorism threats. |

 

**Our governing documents and Minnesota law may discourage the potentialacquisitions of our business.**

 

Our Board of Directors may issue additional sharesof capital stock and establish their rights, preferences and classes, in somecases without stockholder approval. In addition, we are subject toanti-takeover provisions of Minnesota law. These provisions may deter ordiscourage takeover attempts and other changes in control of us not approved byour Board of Directors. If potential acquirers are deterred, you may lose anopportunity to profit from a possible acquisition premium in our stock price.

 

**Future goodwill impairment may unpredictably affect our financialresults.**

 

Effective January 1, 2002, we no longer amortize goodwill.  Instead, we perform impairment analyses ofour goodwill at least annually or when we believe there is an impairment.  Future events could cause us to conclude thatimpairment indicators exist and that goodwill associated with our acquiredbusinesses is impaired.  Any resultingimpairment loss could have a material adverse impact on our financial conditionand results of operations.

 

**Item 7A.  Quantitative andQualitative Disclosures about Market Risk**

 

Our interest income is sensitive to changes in thegeneral level of U.S. interest rates, particularly since the majority of ourinvestments are in short-term instruments. Due to the nature of our short-terminvestments, we do not believe that we have any material market risk exposure.Therefore, no quantitative tabular disclosures are required.

 

The following discusses our exposure to market riskrelated to changes in interest rates, foreign exchange rates and equity prices.

 

*Interest rate risk.*  As of December 31, 2004, wehad $12.7 million of cash and money market accounts. A decrease in market ratesof interest would have no material effect on the value of these assets or therelated interest income due to the nature of money market accounts. We have noshort or long-term debt.

 

*Foreign currency exchange rate risk.*  We marketand sell all of our products in the United States. Therefore, we are notcurrently exposed to any direct foreign currency exchange rate risk.

 

*Equity price risk.*  We do notown any equity investments. Therefore, we are not currently exposed to anydirect equity price risk.

 

 

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**Item 8.  Financial Statements andSupplementary Data.**

 

Reportof Independent Registered Public Accounting Firm

 

**To the Board of Directors**

**Datalink Corporation**

**Chanhassen, Minnesota**

** **

**We have audited the accompanyingbalance sheet of Datalink Corporation as of December 31, 2004 and the relatedstatements of income, changes in stockholders’ equity and cash flows for theyear then ended. These financial statements are the responsibility of theCompany’s management. Our responsibility is to express an opinion on thesefinancial statements based on our audit.**

** **

**We conducted our audit inaccordance with the standards of the Public Company Accounting Oversight Board(United States). Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement. An audit includes examining, on a test basis, evidencesupporting the amounts and disclosures in the financial statements. An auditalso includes assessing the accounting principles used and the significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audit provides a reasonable basisfor our opinion.**

** **

**In our opinion, the financialstatements referred to above present fairly, in all material respects, thefinancial position of Datalink Corporation as of December 31, 2004, and theresults of its operations and its cash flows for the year then ended, inconformity with accounting principles generally accepted in the United Statesof America.**

 
| /s/  McGLADREY & PULLEN, LLP |   |
|----------------------------------|--------|

 

** **

**Minneapolis, Minnesota**

**February 4, 2005**

 

21

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Reportof Independent Registered Public Accounting Firm

 

The Board of Directorsand Stockholders

Datalink Corporation:

 

We have audited theaccompanying balance sheets of Datalink Corporation as of December 31, 2003 andthe related statements of operations, stockholders’ equity and cash flows for eachof the years in the two-year period then ended. These financial statements arethe responsibility of the Company’s management.  Our responsibility is toexpress an opinion on these financial statements based on our audits.

 

We conducted our auditsin accordance with auditing standards generally accepted in the United Statesof America.  Those standards require that we plan and perform the audit toobtain reasonable assurance about whether the financial statements are free ofmaterial misstatement.  An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financialstatements.  An audit also includes assessing the accounting principlesused and significant estimates made by management, as well as evaluating theoverall financial statement presentation.  We believe that our auditsprovide a reasonable basis for our opinion.

 

In our opinion, thefinancial statements referred to above present fairly, in all materialrespects, the financial position of Datalink Corporation as of December 31,2003 and the results of its operations and its cash flows for each of the yearsin the two-year period then ended in conformity with accounting principlesgenerally accepted in the United States of America.

 

 
| /s/  KPMG LLP           |   |
|-------------------------|--------|
|                    |
| Minneapolis,  Minnesota |
| February  6, 2004       |

 

 

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** **

**DATALINK CORPORATION**

**BALANCE SHEETS**

**(In thousands, except share data)**

 
| ** **                                                                                                                                                                   | ** ** | **December 31,** | ** ** |
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                   | ** ** | **2004**              | ** ** | **2003** | ** ** |
| **Assets**                                                                                                                                                                   |       |                  |       |   |   |
| Current assets:                                                                                                                                                              |       |                  |       |   |   |
| Cash and cash  equivalents                                                                                                                                                   |       | $                     | 12,663     |   | $ | 12,565 |   |
| Accounts  receivable, net                                                                                                                                                    |       | 11,485                |       | 8,541 |   |
| Inventories                                                                                                                                                                  |       | 627                   |       | 1,969 |   |
| Deferred  customer support contract costs                                                                                                                                    |       | 10,770                |       | 7,723 |   |
| Inventories  shipped but not installed                                                                                                                                       |       | 2,343                 |       | 2,160 |   |
| Other current  assets                                                                                                                                                        |       | 284                   |       | 329 |   |
| Total current assets                                                                                                                                                         |       | 38,172                |       | 33,287 |   |
| Property and equipment,  net                                                                                                                                                 |       | 3,134                 |       | 4,500 |   |
| Goodwill                                                                                                                                                                     |       | 5,500                 |       | 5,500 |   |
| Intangibles, net                                                                                                                                                             |       | 225                   |       | 485 |   |
| Other, net                                                                                                                                                                   |       | 38                    |       | 45 |   |
| Total assets                                                                                                                                                                 |       | $                     | 47,069     |   | $ | 43,817 |   |
| ** **                                                                                                                                                                   | ** ** | ** **            | ** ** | ** ** | ** ** |
| **Liabilities and Stockholders’ Equity**                                                                                                                                |       |                  |       |   |   |
| Current  liabilities:                                                                                                                                                        |       |                  |       |   |   |
| Accounts payable                                                                                                                                                             |       | $                     | 11,031     |   | $ | 10,139 |   |
| Accrued  commissions                                                                                                                                                         |       | 1,227                 |       | 475 |   |
| Accrued income  taxes                                                                                                                                                        |       | 109                   |       | 72 |   |
| Accrued sales  and use taxes                                                                                                                                                 |       | 510                   |       | 350 |   |
| Accrued  expenses, other                                                                                                                                                     |       | 1,276                 |       | 837 |   |
| Deferred revenue  from customer support contracts                                                                                                                            |       | 14,012                |       | 9,926 |   |
| Total current  liabilities                                                                                                                                                   |       | 28,165                |       | 21,799 |   |
| Deferred rent                                                                                                                                                                |       | 392                   |       | 522 |   |
| Total  liabilities                                                                                                                                                           |       | 28,557                |       | 22,321 |   |
|                                                                                                                                                                         |       |                  |       |   |   |
| Commitments and  contingencies (Note 7, 9 and 11)                                                                                                                            |       |                  |       |   |   |
|                                                                                                                                                                         |       |                  |       |   |   |
| Stockholders’  equity:                                                                                                                                                  |       |                  |       |   |   |
| Common stock,  $0.001 par value, 50,000,000 shares authorized, 10,282,545 and 10,241,963  shares issued and outstanding as of December 31, 2004 and 2003,  respectively |       | 10                    |       | 10 |   |
| Additional  paid-in capital                                                                                                                                                  |       | 26,624                |       | 26,158 |   |
| Unearned  restricted stock                                                                                                                                                   |       | (307                  | )          | — |   |
| Accumulated  deficit                                                                                                                                                         |       | (7,815                | )          | (4,672 | ) |
| Total stockholders’  equity                                                                                                                                             |       | 18,512                |       | 21,496 |   |
| Total  liabilities and stockholders’ equity                                                                                                                             |       | $                     | 47,069     |   | $ | 43,817 |   |
|                                                                                                                                                                              |            |                       |            |  |  |  |  |  |  |  |  |

 

The accompanying notes are anintegral part of these financial statements.

 

23

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**DATALINK CORPORATION**

**STATEMENTS OF OPERATIONS**

**(In thousands, except per sharedata)**

 
| ** **                              | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------|------------|----------------------------------|------------|
| ** **                              | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| Net sales:                              |       |                             |       |   |   |   |   |
| Product sales                           |       | $                                | 63,235     |   | $ | 61,350 |   | $ | 58,492 |   |
| Service sales                           |       | 30,048                           |       | 29,787 |   | 28,008 |   |
| Total net sales                         |       | 93,283                           |       | 91,137 |   | 86,500 |   |
|                                    |       |                             |       |   |   |   |   |
| Cost of sales:                          |       |                             |       |   |   |   |   |
| Cost of product  sales                  |       | 48,568                           |       | 47,477 |   | 44,776 |   |
| Cost of services                        |       | 21,175                           |       | 20,198 |   | 20,000 |   |
| Total cost of  sales                    |       | 69,743                           |       | 67,675 |   | 64,776 |   |
| Gross profit                            |       | 23,540                           |       | 23,462 |   | 21,724 |   |
| Operating expenses:                     |       |                             |       |   |   |   |   |
| Sales and  marketing                    |       | 12,438                           |       | 10,985 |   | 11,481 |   |
| General and  administrative             |       | 10,366                           |       | 10,960 |   | 10,354 |   |
| Engineering                             |       | 3,764                            |       | 4,220 |   | 4,954 |   |
| Restructuring  charges                  |       | (63                              | )          | 2,078 |   | — |   |
| Amortization of  intangibles            |       | 261                              |       | 724 |   | 1,088 |   |
| Operating loss                          |       | (3,226                           | )          | (5,505 | ) | (6,153 | ) |
| Interest income                         |       | 83                               |       | 74 |   | 117 |   |
|                                    |       |                             |       |   |   |   |   |
| Loss before  income taxes               |       | (3,143                           | )          | (5,431 | ) | (6,036 | ) |
| Income tax  benefit                     |       | —                           |       | (276 | ) | (618 | ) |
| Net loss                                |       | $                                | (3,143     | ) | $ | (5,155 | ) | $ | (5,418 | ) |
|                                    |       |                             |       |   |   |   |   |
| Net loss per  share, basic and diluted: |       |                             |       |   |   |   |   |
| Loss per share                          |       | $                                | (0.31      | ) | $ | (0.50 | ) | $ | (0.56 | ) |
|                                    |       |                             |       |   |   |   |   |
| Weighted average  shares outstanding:   |       |                             |       |   |   |   |   |
| Basic and  diluted                      |       | 10,268                           |       | 10,227 |   | 9,687 |   |

 

The accompanying notes are anintegral part of these financial statements.

 

24

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**DATALINK CORPORATION**

**STATEMENTS OF STOCKHOLDERS’EQUITY**

**(In thousands, except per sharedata)**

 
| ** **                                                                      | ** ** | ** ** | ** ** | **Additional  Paid-in Capital** | ** ** | **Unearned  Restricted  Stock** | ** ** | **Retained  Earnings/  (Accumulated Deficit)** | ** ** | **Total** | ** ** |
|---------------------------------------------------------------------------------|------------|------------|------------|---------------------------------|------------|---------------------------------|------------|------------------------------------------------|------------|-----------|------------|
| **Common Stock**                                                                |
| **Shares**                                                                      | ** ** | **Amount** |
| Balances,  December 31, 2001                                               |       | 8,951      |       | $                               | 9          |                            | $          | 20,205                                         |       | $         | —     |   | $ | 5,900 |   | $ | 26,114 |   |
| Net loss                                                                        |       | —     |       | —                          |       | —                          |       | —                                         |       | (5,418    | )          | (5,418 | ) |
| Issuance of  shares in private placement, net of issuance costs (Note 10)       |       | 1,180      |       | 1                               |       | 5,216                           |       | —                                         |       | —    |       | 5,217 |   |
| Compensation  expense related to stock options                                  |       | —     |       | —                          |       | 208                             |       | —                                         |       | —    |       | 208 |   |
| Common shares  issued under employee stock purchase plan and stock option plans |       | 76         |       | —                          |       | 225                             |       | —                                         |       | —    |       | 225 |   |
| Balances,  December 31, 2002                                               |       | 10,207     |       | 10                              |       | 25,854                          |       | —                                         |       | 482       |       | 26,346 |   |
| Net loss                                                                        |       | —     |       | —                          |       | —                          |       | —                                         |       | (5,155    | )          | (5,155 | ) |
| Compensation  expense related to stock options                                  |       | —     |       | —                          |       | 194                             |       | —                                         |       | —    |       | 194 |   |
| Common shares  issued under employee stock purchase plan and stock option plans |       | 35         |       | —                          |       | 111                             |       | —                                         |       | —    |       | 111 |   |
| Balances,  December 31, 2003                                               |       | 10,242     |       | 10                              |       | 26,158                          |       | —                                         |       | (4,672    | )          | 21,496 |   |
| Net loss                                                                        |       | —     |       | —                          |       | —                          |       | —                                         |       | (3,143    | )          | (3,143 | ) |
| Compensation  expense related to stock options                                  |       | —     |       | —                          |       | 17                              |       |                                           |       | —    |       | 17 |   |
| Restricted stock  grant                                                         |       | —     |       | —                          |       | 332                             |       | (307                                           | )          |      |       | 25 |   |
| Common shares  issued under employee stock purchase plan and stock option plans |       | 41         |       | —                          |       | 117                             |       | —                                         |       | —    |       | 117 |   |
| Balances,  December 31, 2004                                               |       | 10,283     |       | $                               | 10         |                            | $          | 26,624                                         |       | $         | (307       | ) | $ | (7,815 | ) | $ | 18,512 |   |

 

 

The accompanying notes are anintegral part of these financial statements.

 

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**DATALINK CORPORATION**

**STATEMENTS OF CASH FLOWS**

**(In thousands)**

 
| ** **                                                                       | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|----------------------------------|------------|
| ** **                                                                       | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| Cash flows from  operating activities:                                           |       |                             |       |   |   |   |   |
| Net loss                                                                         |       | $                                | (3,143     | ) | $ | (5,155 | ) | $ | (5,418 | ) |
| Adjustments to  reconcile net loss to net cash provided by operating activities: |       |                             |       |   |   |   |   |
| Provision  (recoveries) for bad debts                                            |       | (14                              | )          | (34 | ) | 77 |   |
| Depreciation and  amortization                                                   |       | 1,781                            |       | 2,092 |   | 1,981 |   |
| Amortization of  intangibles                                                     |       | 260                              |       | 724 |   | 1,088 |   |
| Impairment of  customer base intangible                                          |       | —                           |       | 926 |   | — |   |
| Deferred income  taxes                                                           |       | —                           |       | — |   | 273 |   |
| Valuation  allowance for deferred income taxes                                   |       | —                           |       | — |   | 1,609 |   |
| Deferred rent                                                                    |       | (130                             | )          | 181 |   | 72 |   |
| Stock  compensation expense                                                      |       | 42                               |       | 194 |   | 208 |   |
| Loss on sale of  assets                                                          |       | —                           |       | 10 |   | — |   |
| Changes in  operating assets and liabilities:                                    |       |                             |       |   |   |   |   |
| Accounts  receivable                                                             |       | (2,930                           | )          | 3,912 |   | 2,631 |   |
| Inventories                                                                      |       | 1,159                            |       | 2,340 |   | 338 |   |
| Deferred  customer support contract costs                                        |       | (3,047                           | )          | 400 |   | (301 | ) |
| Other current assets                                                             |       | 45                               |       | 2,024 |   | (112 | ) |
| Other assets                                                                     |       | 7                                |       | 24 |   | 162 |   |
| Accounts payable                                                                 |       | 892                              |       | (3,528 | ) | (1,543 | ) |
| Accrued expenses                                                                 |       | 1,351                            |       | (117 | ) | (184 | ) |
| Income taxes                                                                     |       | 37                               |       | (146 | ) | (342 | ) |
| Deferred revenue  from customer support contracts                                |       | 4,086                            |       | (631 | ) | 445 |   |
| Net cash  provided by operating activities                                       |       | 396                              |       | 3,216 |   | 984 |   |
| Cash flows from  investing activities:                                           |       |                             |       |   |   |   |   |
| Purchase of  property and equipment                                              |       | (415                             | )          | (1,096 | ) | (1,146 | ) |
| Net cash used in  investing activities                                           |       | (415                             | )          | (1,096 | ) | (1,146 | ) |
| Cash flows from  financing activities:                                           |       |                             |       |   |   |   |   |
| Proceeds from  issuance of common stock, net                                     |       | 117                              |       | 111 |   | 5,354 |   |
| Payments of  notes payable to former stockholder                                 |       | —                           |       | — |   | (704 | ) |
| Net cash  provided by financing activities                                       |       | 117                              |       | 111 |   | 4,650 |   |
| Increase in cash  and cash equivalents                                           |       | 98                               |       | 2,231 |   | 4,488 |   |
| Cash and cash  equivalents, beginning of year                                    |       | 12,565                           |       | 10,334 |   | 5,846 |   |
| Cash and cash  equivalents, end of year                                          |       | $                                | 12,663     |   | $ | 12,565 |   | $ | 10,334 |   |
|                                                                             |       |                             |       |   |   |   |   |
| **Supplementary  Cash Flow Information:**                                        | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| ** **                                                                       | ** ** | ** **                       | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid for  interest                                                          |       | $                                | —     |   | $ | — |   | $ | 45 |   |
| Cash received  for income taxes                                                  |       | 58                               |       | 2,242 |   | 2,160 |   |

 

 

The accompanying notes are anintegral part of these financial statements.

 

26

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**DATALINK CORPORATION**

**NOTES TO FINANCIAL STATEMENTS**

 

***1. Description of Business:***

 

DatalinkCorporation (the “Company”) is an independent architect of enterprise-classinformation storage infrastructures. The Company derives its revenuesprincipally from designing, installing and supporting data storage systems. TheCompany’s solutions can include hardware products, such as disk arrays, tapesystems and interconnection components, and storage management softwareproducts. The Company is frequently engaged to provide assistance in theinstallation of solutions and to provide support services subsequent to theinstallation. Occasionally, the Company is engaged for consulting services.

 

**2. Summary of Significant Accounting Policies:**

 

***Cash and Cash Equivalents:***

 

Cash equivalents consist principally of moneymarket funds with original maturities of three months or less, are readilyconvertible to cash and are stated at cost, which approximates fair value.  The Company maintains its cash in bankdeposit and money market accounts which, at times, may exceed federally insuredlimits.  The Company has not experiencedany losses in such accounts.

 

***AccountsReceivable, net:***

 

Trade receivables are carried at original invoiceamount less an estimate made for doubtful receivables based on a review of alloutstanding amounts on a monthly basis. Management determines the allowance for doubtful accounts by regularlyevaluating individual customer receivables and considering a customer’sfinancial condition and credit history and current economic conditions.  Trade receivables are written off when deemeduncollectible.  Recoveries of tradereceivables previously written off are recorded when received.

 

Accounts receivable are recorded net of thereserve for doubtful accounts of $70,000 and $98,000 at December 31, 2004 and2003, respectively.

 

***Concentration of Credit Risk:***

 

During 2004, 2003 and 2002, net sales to one customer totaled 3%, 10%and 5% of total net sales, respectively. The balance of accounts receivable for this customer as a percentage oftotal accounts receivable as of December 31, 2004 and 2003, respectively is 0%and 3%.

 

***Software Development Costs:***

 

In compliance with the American Institute of Certified PublicAccountants (AICPA) Statement of Position 98-1, Accounting for ComputerSoftware Developed for or Obtained for Internal Use, the company capitalizedcertain costs associated with software developed or obtained for internal use.

 

During 2000, the Company began the implementation of a new customerrelationship management (CRM) application suite which was completed in 2003.  The Company capitalized costs of the implementationof $234,000 in 2003 and $1.3 million in 2002. The system is complete and no further costs are expected.  Amounts are being amortized over a period of3 years from the date they are available for use.  Amortization of software costs were $729,000in 2004, $815,000 in 2003, and $536,000 in 2002.

 

***Inventories:***

 

Inventories, including inventories shipped but notinstalled, principally consist of data storage products and components, thatare valued at the lower of cost or market with cost determined on a first-in,first-out (FIFO) method.  Inventorieshave been reduced by obsolete and slow moving reserves of $71,000 and $211,000at December 31, 2004 and 2003, respectively.

 

***Property and Equipment:***

 

Property and equipment, including purchasedsoftware, are stated at cost. Depreciation and amortization are provided bycharges to operations using the straight-line method over the estimated usefullives of the assets (ranging from 2 to 10 years).

 

27

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Leasehold improvements are amortized on a straight-line basis over theshorter of their estimated useful lives or the underlying lease term. The costsand related accumulated depreciation and amortization on asset disposals areremoved from the accounts and any gain or loss is included in operations. Majorrenewals and betterments are capitalized, while maintenance and repairs arecharged to current operations when incurred.

 
| ** **                                      | ** ** | **December 31,** | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **2004**              | ** ** | **2003** | ** ** |
| ** **                                      | ** ** | **(In thousands)**    | ** ** |
| Property and  equipment:                        |       |                  |       |   |   |
| Land                                            |       | $                     | 384        |   | $ | 384 |   |
| Construction in  process                        |       | 53                    |       | 186 |   |
| Leasehold  improvements                         |       | 512                   |       | 488 |   |
| Furniture and  fixtures                         |       | 2,405                 |       | 2,404 |   |
| Equipment                                       |       | 901                   |       | 901 |   |
| Computers and  software                         |       | 8,720                 |       | 8,197 |   |
|                                            |       | 12,975                |       | 12,560 |   |
| Less accumulated  depreciation and amortization |       | 9,841                 |       | 8,060 |   |
|                                            |       | $                     | 3,134      |   | $ | 4,500 |   |

 

***Goodwill:***

 

In accordance with Financial Accounting StandardsBoard (FASB) Statement No. 142, goodwill is tested for impairment annually, andadditionally if an event occurs or circumstances change that would indicate thecarrying amount may be impaired. Impairment testing for goodwill is done at a reporting-unit level.  An impairment loss would generally berecognized when the carrying amount of the reporting unit’s net assets exceedsthe estimated fair value of the reporting unit. The Company completed its impairment assessments for December 31, 2004and 2003, and determined that no impairment existed.

 

***Intangibles, net:***

 

Identifiable intangible assetsare amortized on a straight-line basis over their estimated useful livesof 3 to 7 years.  In October 2003, theCompany announced several cost reduction actions.  These actions included the closing an officeand terminating personnel acquired by the Company from OpenSystems.com inNovember 2000, resulting in an impairment of the Company’s customer baseintangible asset.  The Company estimatedthe impact that closure of this office and termination of its personnel wouldhave on the OpenSystems.com customer accounts and the related expected cashflows, considering the likelihood of retaining the customers without an officepresence.  The Company then compared theundiscounted cash flows with the net book value of the intangible asset whichindicated the asset was impaired.  Todetermine the impairment charge of $926,000, the Company calculated thediscounted cash flows and compared them to the net book value of the intangibleand determined the resulting impairment charge of the asset.  The remaining balance of the intangible atDecember 31, 2004 of $224,000 will be fully amortized in 2005.

 

***Valuation of Long-LivedAssets:***

 

The Company periodically (at least annually)analyzes its long-lived assets, including identifiable intangible assets withdiscrete lives, for potential impairment, assessing the appropriateness oflives and recoverability of unamortized balances through measurement ofundiscounted operating cash flows on a basis consistent with generally acceptedaccounting principles.

 

***Stock Options:***

 

As permitted by Statement of Financial AccountingStandards (SFAS) No. 123, the Company has elected to continue following theguidance of Accounting Principles Board (APB) Opinion No. 25 for measurement andrecognition of stock-based transactions with employees.  No compensation cost has been recognized forstock options granted to employees under the plans where the exercise price ofthe options granted was equal to the fair value of the common stock at the dateof grant.

 

Pro forma net loss and loss per share have beendetermined as if the Company had used the fair value method of accounting forits stock option grants and employee stock purchase plan share electionsconsistent with the method of SFAS No. 123. Under this method, compensation expense is recognized over theapplicable vesting periods and is based on the shares under option and theirrelated fair values on the grant date.

 

28

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| ** **                                                                                  | ** ** | **2004**                                      | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------------------------------------------------------------------------------------|------------|-----------------------------------------------|------------|----------|------------|----------|------------|
| ** **                                                                                  | ** ** | **(In thousands, except for per share data)** | ** ** |
| Net loss:                                                                                   |       |                                          |       |     |       |     |       |
| As reported                                                                                 |       | $                                             | (3,143     | )        | $          | (5,155   | )          | $ | (5,418 | ) |
| Non cash  compensation expense, net of tax                                                  |       | $                                             | (1,283     | )        | $          | (1,251   | )          | $ | (2,467 | ) |
| Stock  compensation cost on stock based awards granted below fair market value, net  of tax |       | $                                             | 17         |     | $          | 184      |       | $ | 187 |   |
| Pro forma                                                                                   |       | $                                             | (4,409     | )        | $          | (6,222   | )          | $ | (7,698 | ) |
| Basic loss per  share                                                                       |       |                                          |       |     |       |     |       |
| As reported                                                                                 |       | $                                             | (0.31      | )        | $          | (0.50    | )          | $ | (0.56 | ) |
| Non cash  compensation expense                                                              |       | $                                             | (0.12      | )        | $          | (0.12    | )          | $ | (0.25 | ) |
| Stock compensation  cost on stock based awards granted below fair market value              |       | $                                             | —     |     | $          | 0.02     |       | $ | 0.02 |   |
| Pro forma                                                                                   |       | $                                             | (0.43      | )        | $          | (0.60    | )          | $ | (0.79 | ) |
| Diluted loss per  share                                                                     |       |                                          |       |     |       |     |       |
| As reported                                                                                 |       | $                                             | (0.31      | )        | $          | (0.50    | )          | $ | (0.56 | ) |
| Non cash  compensation expense                                                              |       | $                                             | (0.12      | )        | $          | (0.12    | )          | $ | (0.25 | ) |
| Stock  compensation cost on stock based awards granted below fair market value.             |       | $                                             | —     |     | $          | 0.02     |       | $ | 0.02 |   |
| Pro forma                                                                                   |       | $                                             | (0.43      | )        | $          | (0.60    | )          | $ | (0.79 | ) |

 

The weighted-average fair valuesper option at the date of grant were $2.47, $3.35 and $4.35 for 2004, 2003 and 2002respectively. The fair value for the stock option grants was estimated usingthe Black-Scholes option pricing model with the following weighted averageassumptions:

 
| ** **                      | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Risk-free  interest rates       |       | 4.60%    |       | 3.77%    |       | 5.09%    |       |
| Expected  dividend yield        |       | 0        |       | 0        |       | 0        |       |
| Expected  volatility factor     |       | 86%      |       | 96%      |       | 99%      |       |
| Expected option  holding period |       | 5 years  |       | 5 years  |       | 5 years  |       |

 

During 2004, theCompany’s employees elected to purchase 35,246 shares under the Employee StockPurchase Plan (ESPP).  Using theBlack-Scholes pricing model, the weighted average fair value was $0.42 pershare for each election.  During the 2003and 2002 ESPP offering, employees elected to purchase 23,883 and 59,504 sharesrespectively.  Using the Black-Scholes pricingmodel, the weighted average fair value was $0.40 per share for each election in2003 and $0.54 per share for each election in 2002.

 

In December 2004, theFinancial Accounting Standards Board published FASB Statement No. 123 (revised2004), *Share-Based Payment*.  This statement, which will begin to apply inthe Company’s third quarter of 2005, requires the Company to recognize thecompensation cost relating to share-based payment transactions, includinggrants of employee stock options, in its financial statements. The Company willmeasure this cost based on the fair value of the equity or liabilityinstruments issued. The statement covers a wide range of share-basedcompensation arrangements, including stock options, restricted share plans,performance-based awards, share appreciation rights and employee share purchaseplans. The statement will require the Company to measure the cost of employeeservices received in exchange for stock options based on the grant-date fairvalue of the award.  The Company thenwill recognize the cost over the period it required the employee to provideservices for the award. 

 

The new statement allowstwo methods for transitioning the Company’s expensing of share-basedtransactions.  The Company is studyingthe new statement and has not yet determined which transition method it willapply.  Under the modified prospectivetransition method, the Company would use the fair value-based accounting methodfor all employee awards granted, modified or settled after the effective date.  As of the effective date, the Company wouldbase the compensation cost for the non-vested portion of awards outstanding asof that date on the grant-date fair value of those awards as calculated underits current accounting methods.  As aresult, the Company would not re-measure the grant-date fair value estimate forthe unvested portion of awards granted prior to the effective date.  As part of this transition method, theCompany would also decide whether to apply the new statement to only its thirdquarter of 2005 and subsequent periods, or to all of 2005.  Under the modified retrospective method oftransition, the Company would need to revise its previously issued financialstatements to recognize employee compensation cost for all prior periods itpresents in its financial statements.

 

29

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***Income Taxes:***

 

The Company calculates income taxes in accordancewith the provisions of SFAS No. 109, “Accounting for Income Taxes,” whichrequires the use of the asset and liability method of accounting for incometaxes. Under the liability method, deferred income taxes are recorded toreflect the tax consequences in future years of temporary differences betweenthe tax bases of assets and liabilities and their financial reporting amountsusing enacted tax rates for the years in which these items are expected toaffect taxable income. The Company establishes valuation allowances whennecessary to reduce deferred tax assets to the amount the Company expects aremore likely than not to realize. Income tax (benefit) expense is the tax payable(receivable) for the period and the change during the period in deferred taxassets and liabilities.

 

***Use of Estimates:***

 

The preparation of financial statements inconformity with accounting principles generally accepted in the United Statesrequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting period.  Significant items subject to estimates andassumptions include the valuation for deferred tax assets, reserve for doubtfulaccounts, reserve for obsolete and slow moving (excess) inventory and valuationof long-lived assets.   Actual results could differ from thoseestimates.

 

***Revenue Recognition:***

 

*Revenue Recognition.***TheCompany realizes revenue from the design, installation and support of datastorage solutions, which may include hardware, software and services.  The Company recognizes revenue when it hasmet its obligations for installation or other services and collectability isreasonably assured.

 

Product Sales.  The Company sellssoftware and hardware products on both a “free-standing” basis without anyservices and as data storage solutions bundled with our installation andconfiguration services (“bundled arrangements”).

 

*Product Sales Without Service**. *Ifthe Company sells a software or hardware product and does not provide anyinstallation or configuration services with it, it recognizes the productrevenues upon shipment

 

*Product Sales With Service**. *Ifthe Company sells a bundled arrangement, then it defers recognizing anyrevenues on it until the Company finishes the installation and/or configurationwork.  For the three years ended December31, 2004, the Company has accounted for the hardware, software and serviceelements of our bundled arrangements by applying the provisions of Statement ofPosition (SOP) 97-2, Software Revenue Recognition, as amended by SOP 98-4 andSOP 98-9.

 

Pursuant to the provisions of SOP 97-2, the Companyapplied contract accounting to our bundled arrangements.  In accordance with SOP 81-1, “Accounting forPerformance of Construction Type and Certain Production Type Contracts,” theCompany applied the completed contract method. Factors the Company has considered in applying the completed contractmethod accounting include (i) the relatively short duration of its contracts,(ii) the difficulty of estimating it’s revenues on a percentage-of-completionmethod and (iii) it’s use of acceptance provisions on larger bundledarrangements.

 

For 2002, the Company originally applied the provisionsof Staff Accounting Bulletin No. 101 to account for its bundledarrangements.  In 2003, the Companychanged the accounting guidance it applied based on its determination that thesoftware component of its sales was more than incidental to its products orservices as a whole.  However, the changedid not affect the revenue amounts or the timing of the Company’s revenuerecognition on bundled arrangements for 2002. This is because, under SAB No. 101, the Company also recognized revenueon its bundled arrangements only after it completed its installation andconfiguration services.

 

Service Sales.  In addition to installation and configurationservices that are part of our bundled arrangements described above, the Company’sservice sales include customer support contracts and consulting services.  On the Company’s balance sheet, deferredrevenue relates to service sales for which the Company’s customer has paid themor has been invoiced but for which it has not yet performed the applicableservices.

 

*Customer Support Contracts. *The Company sells service contracts tomost of its customers.  These contractsare support service agreements.  TheCompany has an internal support desk that provides integrated customer supportservices, including configuration and usage assistance, technical advice andprompt incident detection and resolution. The Company’s technical staff first assists a customer in identifyingthe source of system problems and in determining whether there is defectivehardware or software.  If the Company’scustomer requires on-site maintenance or repair services, the Company arrangesfor a service call pursuant to underlying third-party support serviceagreements it has with its hardware and software vendors.

 

30

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When the Company sells aservice contract as part of a bundled arrangement, the Company uses vendorspecific objective evidence to allocate revenue to the service contractelement.  In all cases, the Companydefers revenues and direct costs resulting from its service contracts andamortizes them into operations over the term of the contracts, which aregenerally twelve months.  The Company iscontractually obligated to provide or arrange to provide these underlyingsupport services to its customers in the unlikely event that the hardware or softwarevendor, or its designee, fails to perform according to the terms of itscontact.

 

*Consulting Services. *Some of the Company’s customers engagethem to analyze their existing storage architectures and offer its recommendations.  Other customers engage the Company to assistthem on-site with extended data storage projects, to support their data storageenvironments and to help with long-term data storage design challenges.  For these types of consulting services thatdo not include the sale of hardware or software products, the Company recognizesrevenues as it performs these services.

 

***Net Income (Loss) PerShare:***

 

Basic net income (loss) per share is computedusing the weighted average number of shares outstanding. Diluted net income pershare includes the effect of common stock equivalents, if any, for each period.The number of additional shares is calculated by assuming that outstandingstock options were exercised and that the proceeds from such exercise were usedto acquire shares of common stock at the average market price during thereporting period.  Due to the net loss in2004, 2003 and 2002, potential common shares of 80,756, 105,931 and 62,536,respectively, would have been anti-dilutive to losses and as a result wereexcluded from the calculation of diluted loss per share.

 

***Comprehensive Income(Loss):***

 

The Company’s comprehensive income (loss) is equalto its net loss for all periods presented.

 

*Fair Value of Financial Instruments.* At December 31, 2004 and 2003, thecarrying values of current financial instruments such as cash and cashequivalents, accounts receivable, accounts payable, other current assets,accrued liabilities and other current liabilities, approximated their marketvalues, based on the short-term maturities of these instruments.

 

**3. Intangibles, net:**

 

Information regarding the Company’s other intangibleassets that continue to be amortized are as follows:

 
| ** **                 | ** ** | **As of December 31,** | ** ** |
|----------------------------|------------|------------------------|------------|
| ** **                 | ** ** | **2004**               | ** ** | **2003** | ** ** |
| Customer lists:            |       |                   |       |   |   |
| Carrying amount            |       | $                      | 3,374      |   | $ | 3,374 |   |
| Accumulated  amortization. |       | (3,150                 | )          | (2,889 | ) |
|                       |       | $                      | 224        |   | $ | 485 |   |

 

Amortization expense forthe years ended December 31, 2004, 2003 and 2002 was $261,000, $724,000 and $1.1million, respectively.  The intangibleassets as of December 31, 2004 of $224,000 will become fully amortized in 2005.

 

**4. Borrowing Arrangements:**

 

The revolving credit facility the Company has had with a bank since June30, 2003, expired on June 30, 2004.  TheCompany has elected not to pursue a new facility at this time.  With the Company's current cash position, itbelieves it has the liquidity to meet its operating needs for the foreseeablefuture.  The Company has no outstandingdebt, and if the need should arise to borrow funds, the Company believes that itcould obtain a secured facility.

 

**5. Income Taxes:**

 

The benefit from income taxes consisted of thefollowing:

 
| ** **                       | ** ** | **Year Ended December 31,** | ** **   |
|----------------------------------|------------|----------------------------------|--------------|
| ** **                       | ** ** | **2004**                         | ** **   | **2003** | ** ** | **2002** | ** ** |
| ** **                       | ** ** | **(In thousands)**               | ** **   |
| Current income  tax benefit:     |       |                             |         |   |   |   |   |
| Federal                          |       | $                                |  — |   | $ | (276 | ) | $ | (1,976 | ) |
| State                            |       | —                           |         | — |   | (525 | ) |
| Total                            |       | —                           |         | (276 | ) | (2,501 | ) |
| Deferred income  tax expense:    |       |                             |         |   |   |   |   |
| Federal                          |       | —                           |         | — |   | 1,551 |   |
| State                            |       | —                           |         | — |   | 332 |   |
| Total                            |       | —                           |         | — |   | 1,883 |   |
| Total benefit  from income taxes |       | $                                |  — |   | $ |  (276 | ) | $ | (618 | ) |

 

31

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The reconciliation of the U.S. federal statutory tax rate to the Company’seffective income tax rate is as follows:

 
| ** **                                    | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
|-----------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Tax benefit at  U.S. statutory rates          |       | (34.0    | )%         | (34.0    | )%         | (34.0    | )%         |
| State tax  benefit, net of federal tax effect |       | (6.3     | )          | (4.6     | )          | (3.7     | )          |
| Nondeductible  expenses                       |       | 2.8      |       | 11.3     |       | 0.8      |       |
| Change in  valuation allowance and other      |       | 37.5     |       | 22.3     |       | 26.7     |       |
| Effective tax  rate                           |       | 0        | %          | (5.0%    | )          | (10.2%   | )          |

 

Significant components of theCompany’s deferred tax assets and liabilities are as follows:

 
| ** **                        | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------|------------|----------------------------------|------------|
| ** **                        | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
|                              |       | **(In thousands)**               |       |
| Current deferred  tax asset:      |       |                             |       |   |   |   |   |
| Allowance for  doubtful accounts  |       | $                                | 58         |   | $ | 79 |   | $ | 117 |   |
| Compensation  accrual             |       | 56                               |       | 49 |   | 57 |   |
| Inventories                       |       | 31                               |       | 92 |   | 176 |   |
| Deferred revenue                  |       | 238                              |       | 195 |   | 485 |   |
| Restructuring  reserve            |       | —                           |       | 77 |   | — |   |
| Other                             |       | —                           |       | — |   | 6 |   |
| Total current  deferred tax asset |       | 383                              |       | 492 |   | 841 |   |
| Long-term  deferred tax asset:    |       |                             |       |   |   |   |   |
| Net operating  loss carryovers    |       | 3,006                            |       | 1,924 |   | 325 |   |
| Intangibles                       |       | 844                              |       | 955 |   | 564 |   |
| Property and  equipment           |       | 424                              |       | (575 | ) | (121 | ) |
| Other                             |       | 21                               |       | 7 |   | — |   |
| Total gross  deferred tax asset   |       | 4,678                            |       | 2,803 |   | 1,609 |   |
| Valuation  allowance              |       | (4,678                           | )          | (2,803 | ) | (1,609 | ) |
| Net deferred tax  asset           |       | $                                | —     |   | $ | — |   | $ | — |   |

 

The valuation allowance fordeferred tax assets as of December 31, 2004, 2003 and 2002 was $4.7 million, $2.8million and $1.6 million, respectively. The net change in the total valuation allowance for the years endedDecember 31, 2004, 2003 and 2002 was an increase of $1.9 million, $1.2 millionand $1.6 million, respectively.

 

In assessing the recoverability of deferred tax assets, managementconsiders whether it is more likely than not that some portion or all of thedeferred tax assets will be realized. The ultimate realization of deferred taxassets is dependent upon the generation of future taxable income during theperiods in which those temporary differences become deductible. Managementconsiders the scheduled reversal of deferred tax liabilities, carry backpotential and projected future taxable income and tax planning strategies inmaking this assessment.  In the futurewhen management believes it can reasonably estimate future operating resultsand those estimated results reflect taxable income, the amount of deferred taxassets considered realizable would be adjusted by a reduction in the valuationallowance.

 

At December 31, 2004, the Company had federal net operating loss carry forwardsof approximately $6.7 million and state net operating loss carry forwards ofapproximately $13.5 million, which are available to offset future federal and statetaxable income.  If not used, these netoperating loss carry forwards will expire between 2013 and 2024.

 

32

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**6. Lease Commitments:**

 

The Company’s corporate headquarters including theprincipal technical operations and the integration, assembly and supportservices operations are located in a 104,000 square foot office and warehousefacility in Chanhassen, Minnesota.  TheCompany’s remaining 14 locations including sales and technical staff, are smallto medium sized offices.  Regional hubsare located within each of the Company’s regions in the East, Central and West.

 

As of December 31, 2004,future minimum lease payments due under non-cancelable operating leases are asfollows:

 
| ** ** | ** ** | **(In thousands)**     | ** ** |
|------------|------------|------------------------|------------|
| ** ** | ** ** | **Lease  Obligations** | ** ** | **Sublease  Agreements** | ** ** | **Net Lease  Obligations** | ** ** |
| 2005       |       | $                      | 2,010      |   | $ | (1,172 | ) | $ | 838 |   |
| 2006       |       | 1,900                  |       | (1,147 | ) | 753 |   |
| 2007       |       | 1,575                  |       | (1,130 | ) | 445 |   |
| 2008       |       | 1,310                  |       | (1,053 | ) | 257 |   |
| 2009       |       | 1,307                  |       | (1,053 | ) | 254 |   |
| Thereafter |       | 3,056                  |       | (2,457 | ) | 599 |   |
|       |       | $                      | 11,158     |   | $ | (8,012 | ) | $ | 3,146 |   |

 

On December 15, 2004, the Company agreed to sublease approximately55,000 of the 104,000 square feet it then occupied as its corporateheadquarters in Chanhassen, Minnesota. The initial sublease term is co-terminal with the original lease and is85 months starting in April 2005 and ending in April 2012.  The sublease will pay the Company rentranging from approximately $55,000 per month at the beginning of the term toapproximately $60,000 per month by the end of the term.  The rent includes the costs of common areamanagement, common systems repairs, real estate taxes and standardutilities.  The Company also negotiatedwith its landlord to sell the 2.5 acre lot adjoining the Company’s facility for$200,000 which the Company was originally acquired in 2001 for $384,000.  The Company estimates the following chargeswill be taken in the first quarter of 2005 associated with the sublease andrelated activities:

 
| **Item**                                                     | ** ** | **Expected Related Charge** | ** ** |
|--------------------------------------------------------------|------------|-----------------------------|------------|
| Rent reserve  (excess of lease expense over sublease income) |       | $                           | 3,075,000  |   |
| Accelerated  depreciation                                    |       | 241,000                     |       |
| Loss on  anticipated land sale                               |       | 184,000                     |       |
|                                                         |       | $                           | 3,500,000  |   |

 

The Company estimates its cash expenditures associated with thesublease and the related activities, net of the anticipated proceeds from theproposed lot sale, at $675,000.  Thesecash outlays will be capitalized and amortized over the lease term.

 

Total rent expense charged to theCompany, is as follows:

 
| ** **   | ** ** | **Year Ended December 31,** | ** ** |
|--------------|------------|----------------------------------|------------|
| ** **   | ** ** | **2004**                         | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **   | ** ** | **(In thousands)**               | ** ** |
| Rent expense |       | $                                | 1,929      |   | $ | 2,427 |   | $ | 2,399 |   |
|              |            |                                  |            |  |  |  |  |  |  |  |

 

**7. Restructuring Charges:**

 

In October 2003, the Company announced several cost reductioninitiatives and management changes. These changes resulted in a fourth quarter 2003 charge of $2.1million.  As part of these cost reductioninitiatives, the Company reduced its staff by 16%.  Employee severance charges were$568,000.  The Company also announced theclosure of four offices.  Office closingcosts for lease terminations were $584,000. The office closures included an office with a significant amount ofcustomers obtained in the Company’s OpenSystems.com acquisition in November2000, resulting in an impairment of this customer base intangible asset.  The resulting impairment charge of the assetwas $926,000.  The Company had $202,000of remaining accruals as of December 31, 2003, primarily for a severanceagreement to a former officer, to be paid in 2004.  In July 2004, the Company ceased paying theremaining severance accrual to this officer in exchange for consenting to theofficer’s new employment with another firm.

 

33

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Restructuring expense activity as of December 31, 2004 was as follows:

 
| ** **                              | ** ** | **(in thousands)** | ** ** |
|-----------------------------------------|------------|--------------------|------------|
| ** **                              | ** ** | **Severance**      | ** ** | **Lease/Office  closures** | ** ** | **Total** | ** ** |
| Beginning  balance, December 31, 2003 . |       | $                  | 190        |   | $ | 12 |   | $ | 202 |   |
| Expense reversals                       |       | (48                | )          | (15 | ) | (63 | ) |
| Cash  receipts/(payments)               |       | (142               | )          | 3 |   | (139 | ) |
| Ending balance,  December 31, 2004      |       | $                  | —     |   | $ | —- |   | $ | — |   |

 

**8. Employee Benefit Plan:**

 

The Company has a defined contribution retirementplan for eligible employees. Employees may contribute up to 15% of their pretaxcompensation to the 401(k) portion of the plan. The Company matched 50% of anemployee’s contribution up to the first 6% of an employee’s eligiblecompensation in 2003 and 2002, ceasing the match in January 2004. The cost ofthe Company’s contributions to the 401(k) portion of the plan for 2004, 2003and 2002, was $22,000, $352,000 and $356,000, respectively.

 

**9. Stockholders’ Equity:**

 

***PrivatePlacement****:*

 

In May 2002, the Companysold an aggregate of 1,180,000 shares of Common Stock, plus five-year warrants,to purchase an additional 200,000 shares at an exercise price of $4.50 pershare, to five institutional investors for $5.3 million.  The Company allocated an amount to the value of the warrants utilizing afair value estimate derived from the Black-Scholes option pricing modelassuming a volatility of 102%, the warrant life of 5 years and a risk-freeinterest rate of 4.76%. Based on this fair value estimate, the Companyallocated approximately $863,000 to the warrants and $4,437,000 to the CommonStock.

 

***Restricted Stock Plans:***

 

In August 2004, the Companyawarded 165,000 shares of restricted stock to certain executives.  The grants vest five years from the date ofgrant if the executives are still employed by the Company.  Shares can vest earlier upon the Companyreaching, and publicly announcing certain financial or business milestones,assuming employment through the date of the milestone.  During the vesting period, the executiveshave voting rights and the right to receive dividends.  However, the Company will retain thedividends until the shares have vested. The shares may not be sold, assigned, transferred, pledged or otherwiseencumbered until they have vested.  TheCompany is amortizing the $332,000 value of the restricted shares on the dateof grant ratably over the five year vesting period or earlier if the milestonesnoted above are reached.  The unamortizedbalance of deferred compensation on restricted stock in included as a separatecomponent of stockholders’ equity.

 

***Stock Compensation Plans:***

 

EffectiveMay 8, 2001, the Company reserved an aggregate of 3,000,000 shares of commonstock for issuance pursuant to the Company’s Incentive Compensation Plan (the “IncentivePlan”), 1,429,104 of which were available for grant as of December 31, 2004.The terms of the plan allow for a variety of awards including incentive stockoptions, nonqualified stock options, stock appreciation rights, restrictedstock, performance shares, performance units, cash-based awards, phantom sharesand other share-based awards as determined by the Company’s CompensationCommittee (the “Committee”).

 

The Company has also reserved 250,000 shares ofcommon stock for issuance pursuant to the Company’s Employee Stock PurchasePlan. Under terms of the Employee Stock Purchase Plan, eligible employees maydesignate up to 15% of their compensation to be withheld through payrolldeductions and will be granted an option to purchase a designated number ofshares of common stock at a purchase price determined by the Committee, but atno less than 85% of the lower of the market price on the first or last day ofthe purchase period.

 

In August 2000, the Board of Directors adopted the2000 Director Stock Option Plan (the “Director Plan”).  The Company amended the Director Plan in May2002, October 2002 and April 2004.  Theterms of the Director Plan allow for stock option grants to non-employeemembers of the Board of Directors.  TheCompany has reserved 300,000 shares of common stock for issuance pursuant tothe Director Plan, 52,200 of which were available for grant as of December 31,2004.

 

34

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***StockOptions:***

 

The following table summarizes activity under theCompany’s stock option plans:

 
| ** **                                   | ** ** | **Outstanding Options** | ** ** |
|----------------------------------------------|------------|-------------------------|------------|
| ** **                                   | ** ** | **Number of Shares**    | ** ** | **Range of  Exercise Prices** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| Balance,  December 31, 2001                  |       | 1,817,023               |       | $ 1.60 - $ 25.38 |   | $ |  9.00 |   |
| Options granted                              |       | 345,095                 |       | $ 1.44 - $ 6.42 |   | $ |  4.35 |   |
| Options  exercised                           |       | —                  |       | $ 0.00 |   | $ |  0.00 |   |
| Options  cancelled                           |       | (392,815                | )          | $ 3.46 - $ 25.38 |   | $ |  9.08 |   |
| Balance,  December 31, 2002                  |       | 1,769,303               |       | $ 1.44   - $ 25.38 |   | $ |  8.07 |   |
| Options granted                              |       | 499,350                 |       | $ 1.80   - $ 5.00 |   | $ |  3.35 |   |
| Options  exercised                           |       | (8,343                  | )          | $ 3.46   – $ 4.36 |   | $ |  3.55 |   |
| Options  cancelled                           |       | (627,025                | )          | $ 2.90   - $ 25.38 |   | $ |  9.31 |   |
| Balance,  December 31, 2003                  |       | 1,633,285               |       | $ 1.44   - $ 18.13 |   | $ |  6.19 |   |
| Options granted                              |       | 386,205                 |       | $ 2.05   - $ 4.89 |   | $ |  3.82 |   |
| Options  exercised                           |       | (7,762                  | )          | $ 3.46   – $ 3.46 |   | $ |  3.46 |   |
| Options  cancelled                           |       | (193,032                | )          | $ 3.06   - $ 18.13 |   | $ |  7.34 |   |
| Balance,  December 31, 2004                  |       | 1,818,696               |       | $ 1.44   - $ 18.13 |   | $ |  5.11 |   |
|                                         |       |                    |       | - |   |   |   |
| Options  exercisable as of December 31, 2004 |       | 1,035,250               |       | $ 1.44   - $ 18.13 |   | $ |  6.64 |   |
| Options  exercisable as of December 31, 2003 |       | 886,289                 |       | $ 1.44   - $ 18.13 |   | $ |  7.41 |   |
|                                              |            |                         |            |  |  |  |  |  |  |

 

The following is a summary ofoptions outstanding at December 31, 2004:

 
| **Stock  Options** | ** ** | **Range of  Exercise Price Per Share** | ** ** | **Weighted Average  Exercise  Price Per Share** | ** ** | **Weighted Average  Remaining Contractual  Life (Years)** | ** ** |
|--------------------|------------|---------------------------------------------|------------|-------------------------------------------------|------------|-----------------------------------------------------------|------------|
| 1,177,206          |       | $1.44 - $6.42                               |       | $                                               | 3.79       |                                                      | 8.1        |   |
| 565,620            |       | $6.43 - $9.94                               |       | $                                               | 7.92       |                                                      | 5.2        |   |
| 24,750             |       | $9.95 - $15.19                              |       | $                                               | 12.61      |                                                      | 5.7        |   |
| 51,120             |       | $15.20 - $18.13                             |       | $                                               | 17.39      |                                                      | 5.2        |   |
| 1,818,696          |       | $1.44 - $18.13                              |       | $                                               | 5.58       |                                                      | 7.1        |   |

 

The following is a summary of options granted at an exercise price thatdiffers from the market price of the stock on the grant date:

 
| ** **                                | ** ** | **Stock Options  Granted** | ** ** | **Weighted Average  Exercise Price Per  Share** | ** **   | **Weighted Average  Exercise Price Per  Share** | ** ** |
|-------------------------------------------|------------|----------------------------|------------|-------------------------------------------------|--------------|-------------------------------------------------|------------|
| December 31,  2002                        |       |                       |       |                                            |         |                                            |       |
| Option price  equals fair market value    |       | 297,845                    |       | $                                               | 2.90 - $6.42 |                                            | $          | 4.52 |   |
| Option price  less than fair market value |       | 47,250                     |       | $                                               | 1.44 - $4.24 |                                            | $          | 3.19 |   |
| Options granted                           |       | 345,095                    |       | $                                               | 1.44 - $6.42 |                                            | $          | 4.35 |   |
|                                      |       |                       |       |                                            |         |                                            |       |
| December 31,  2003                        |       |                       |       |                                            |         |                                            |       |
| Option price  equals fair market value    |       | 449,600                    |       | $                                               | 3.32 - $5.00 |                                            | $          | 3.46 |   |
| Option price  less than fair market value |       | 49,750                     |       | $                                               | 1.80 - $3.84 |                                            | $          | 2.39 |   |
| Options granted                           |       | 499,350                    |       | $                                               | 1.80 - $5.00 |                                            | $          | 3.35 |   |
| December 31,  2004                        |       |                       |       |                                            |         |                                            |       |
| Option price  equals fair market value    |       | 386,205                    |       | $                                               | 2.05 - $4.89 |                                            | $          | 2.68 |   |
| Option price  less than fair market value |       | —                     |       | —                                          |         | $                                               | —     |   |
| Options granted                           |       | 386,205                    |       | $                                               | 2.05 - $4.89 |                                            | $          | 2.68 |   |

 

The Company accounts for stock-based compensationto employees using the intrinsic value method as prescribed in AccountingPrinciples Board Opinion No. 25, “Accounting for Stock Issued to Employee,” andrelated interpretations. Accordingly, compensation cost for stock optionsgranted to employees is measured as the excess, if any, of the fair value ofthe Company’s common stock at the date of the grant over the amount an employeemust pay to acquire the stock.

 

35

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During 2000 and 1999, the Company issued 135,850options with an exercise price below the fair market value of common stock atthe date of grant.  The intrinsic valueof those options is being recorded to compensation expense over the vestingperiod, generally four years.  During 2004,2003 and 2002, $17,000, $111,000 and $118,000, respectively, of compensationexpense was recorded related to these options. As of December 31, 2004, 2003 and 2002, there was $0, $17,000 and $128,000,respectively, of compensation expense related to these options to be recognizedin future periods. During 2004, 2003 and 2002, the Company issued 0, 46,750 and47,250 options, respectively, to directors below the fair market value ofcommon stock at the date of grant.  The compensationexpense on such options recorded was $0, $83,000 and $90,000 in 2004, 2003 and2002, respectively.  Because the optionsvest immediately, all compensation expense was recorded in the period of thegrant.

 

**10. Litigation**

 

The Company is not currently involved in any materiallegal proceedings.  The Company also hadno material legal proceedings that terminated during the fourth quarter of 2004.

** **

**11. Quarterly Financial Information (unaudited)**

 
| ** **                                   | ** ** | **March 31**       | ** ** | **June 30** | ** ** | **Sept 30** | ** ** | **Dec 31** | ** ** |
|----------------------------------------------|------------|--------------------|------------|-------------|------------|-------------|------------|------------|------------|
| ** **                                   | ** ** | **(In thousands)** | ** ** |
| **2004**                                     | ** ** | ** **         | ** ** | ** **  | ** ** | ** **  | ** ** | ** ** | ** ** |
| Net sales                                    |       | $                  | 20,204     |        | $          | 21,463      |       | $          | 25,633     |   | $ | 25,983 |   |
| Gross profit                                 |       | 5,008              |       | 5,232       |       | 5,868       |       | 7,432      |       |
| Operating loss                               |       | (1,860             | )          | (1,047      | )          | (735        | )          | 416        |       |
| Net loss                                     |       | (1,840             | )          | (1,031      | )          | (717        | )          | 445        |       |
| Net loss per  share — basic and diluted |       | (0.18              | )          | (0.10       | )          | (0.07       | )          | .04        |       |
|                                         |       |               |       |        |       |        |       |       |       |
| **2003**                                     | ** ** | ** **         | ** ** | ** **  | ** ** | ** **  | ** ** | ** ** | ** ** |
| Net sales                                    |       | $                  | 23,742     |        | $          | 26,371      |       | $          | 19,951     |   | $ | 21,073 |   |
| Gross profit                                 |       | 6,326              |       | 6,821       |       | 5,010       |       | 5,305      |       |
| Operating loss                               |       | (879               | )          | (210        | )          | (2,020      | )          | (2,396     | )          |
| Net loss                                     |       | (860               | )          | (186        | )          | (2,006      | )          | (2,103     | )          |
| Net loss per  share — basic and diluted |       | (0.08              | )          | (0.02       | )          | (0.20       | )          | (0.20      | )          |

 

**Item 9.    Changes in and Disagreements withAccountants on Accounting and Financial Disclosure.**

 

On November 19, 2004, we terminated KPMG LLP as our principalaccountants and engaged McGladrey & Pullen, LLP as our new principalaccountants.  Our audit committeeapproved the decision to change accountants. During 2003 and through thesubsequent interim period through November 19, 2004, we had no disagreementswith KPMG LLP on any matter of accounting principles or practices, financialstatement disclosure, or auditing scope of procedure, which disagreements, ifnot resolved to the satisfaction of KPMG LLP, would have caused it to makereference to the subject matter of the disagreement in connection with itsreports. The audit report of KPMG LLP on our consolidated financial statementsas of and for the year ended December 31, 2002 and December 31, 2003 did notcontain any adverse opinion or disclaimer of opinion, nor was it qualified ormodified as to uncertainty, audit scope, or accounting principles. During 2002and 2003 and through the subsequent interim period through November 19, 2004,we did not consult with McGladrey & Pullen, LLP regarding the applicationof accounting principles to a specific transaction, either completed orproposed, or the type of audit opinion that might be rendered on ourconsolidated financial statements.

 

**Item 9A.  Controls and Procedures**

 

We maintain disclosure controls and procedures that are designed toensure that information required to be disclosed in our SEC reports isrecorded, processed, summarized and reported within the time periods specifiedin the Securities and Exchange Commission’s rules and forms.  Our disclosure controls and procedures arealso designed to accumulate and communicate information to our management,including our Chief Executive Officer and our Chief Financial Officer, asappropriate, to allow for timely decisions regarding required disclosure.  In designing and evaluating our disclosurecontrols and procedures, we recognize that any controls and procedures, nomatter how well designed and operated, can provide only reasonable assurance ofachieving the desired control objectives. Accordingly, management must apply its judgment in evaluating thecost-benefit relationship of possible controls and procedures.

 

36

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Within the 90 days prior to the filing of this report, we carried out anevaluation under the supervision and with the participation of our management,including our Chief Executive Officer and our Chief Financial Officer, of theeffectiveness of the design and operation of our disclosure controls andprocedures pursuant to Rule 13a-15b under the Securities Exchange Act of1934.  Based on their review of ourdisclosure controls and procedures, the Chief Executive Officer and the ChiefFinancial Officer have concluded that our disclosure controls and proceduresare effective at the reasonable assurance level in timely alerting them tomaterial information relating to us that is required to be included in ourperiodic SEC filings.

 

There has been no change in our internal controls over financialreporting during our most recent fiscal quarter that has materially affected,or is reasonably likely to materially affect, our internal controls overfinancial reporting.

 

**PART III**

 

**Item 10.  Directors and ExecutiveOfficers of the Registrant.**

 

The following is information concerning ourcurrent directors and executive officers:

 
| **Name**             | ** ** | **Age** | ** ** | **Position**                                              | ** ** |
|----------------------|------------|---------|------------|-----------------------------------------------------------|------------|
| Greg R. Meland       |       | 51      |       | Chief Executive Officer and Director                      |       |
| Charles B.  Westling |       | 46      |       | President, Chief Operating Officer                        |       |
| Daniel J.  Kinsella  |       | 46      |       | Vice President – Finance and Chief Financial Officer |       |
| Mary E. West         |       | 56      |       | Vice President – Human Resources                     |       |
| Robert M. Price      |       | 74      |       | Chairman of the Board and Director                        |       |
| Paul F. Lidsky*      |       | 51      |       | Director                                                  |       |
| Margaret A.  Loftus* |       | 60      |       | Director                                                  |       |
| James E. Ousley*     |       | 59      |       | Director                                                  |       |

 

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*Memberof Audit and Compensation Committees.

 

Greg R. Meland joined us in 1991as our Vice President of Sales and Engineering. He became President and ChiefExecutive Officer in 1993. Between 1979 and 1991, Mr. Meland served invarious sales and marketing positions with the Imprimis disk drive subsidiaryof Control Data Corporation (which was sold to Seagate in 1989), most recentlyas the North Central U.S. Director of Sales.

 

Charles B.Westling joined us in 2002 as Vice President—Corporateand Business Development.  In 2002, Mr.Westling became Vice President—Market Development.  In 2003, Mr. Westling became President andChief Operating Officer.  Between 2000and 2001, he was the Executive Vice President of Business Development ofAgiliti, Inc.  Mr. Westling served asSenior Managing Director and Director of Corporate Finance for John G. Kinnardand Company, Incorporated from 1997 to 1999.  From 1990 to 1997, Mr. Westling was a member of the corporate financedepartment at Dain Bosworth Incorporated, serving most recently as a managingdirector and head of technology investment banking.   Mr. Westling received his B.A. in economicsfrom Carleton College and earned a Master of Management degree from the J.L.Kellogg Graduate School of Management at Northwestern University.

 

Daniel J. Kinsella joined us in1999 as Chief Financial Officer. In 2002, Mr. Kinsella became VicePresident-Finance and Chief Financial Officer. Between 1998 and 1999, he was Chief Financial Officer of Lloyd’sBarbeque Company. Mr. Kinsella served in various finance roles for GristMill Company between 1989 and 1998, most recently as its Chief FinancialOfficer, Treasurer and Secretary. From 1984 to 1989, Mr. Kinsella was theDirector of Financial Reporting for Inter-Regional FinancialGroup, Inc. Between 1980 and 1984, he was employed by Touche Ross &Company, most recently as an audit manager. Mr. Kinsella is a CertifiedPublic Accountant.

 

Mary E. West joined us in 2001 asVice President—Human Resources.  From1998 to 2001, she worked as an independent human resources consultant. Between1995 and 1998, Ms. West was employed by Arcadia Financial, Ltd., most recentlyas the Senior Vice President of Human Resources.  From 1993 to 1994, she was the corporateadministrative director for Nexus, Inc. Ms. West received her M.A. in Human Resources and Industrial Relationsin 1988 from the University of Minnesota Carlson School of Management.

 

Robert M. Price was elected asour Chairman of the Board and a director in June 1998. Mr. Price hasbeen President of PSV, Inc., a technology consulting business located inBurnsville, Minnesota, since 1990. Between 1961 and 1990, he served in

 

37

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various executive positions, including as Chairman and Chief ExecutiveOfficer, with Control Data Corporation. Mr. Price also serves on the Boardof Directors of Public Service Company of New Mexico, Affinity TechnologyGroup, Inc. and National Center for Social Entrepreneurs. Since May 1991,Mr. Price has been a Senior Advisor and Professor at the Fuqua School ofBusiness at Duke University. Mr. Price is Mr. Meland’s father-in-law.

 

Paul F. Lidsky was elected as adirector in June 1998. Between 2003 and 2004, Mr. Lidsky was President andChief Executive Officer of Computer Telephony Solutions, a telecommunicationssoftware company specializing in call centers. From 2002 to 2003, Mr. Lidsky was President and Chief Executive Officerof VigiLanz Corporation, a medical software company.  From 1997 until 2002, Mr. Lidsky was thePresident and Chief Executive Officer of OneLink Communications, Inc., asoftware company that provides business intelligence solutions to thetelecommunications carriers. Between 1985 and 1997, Mr. Lidsky wasemployed by Norstan, Inc., a comprehensive technology services company,most recently as Executive Vice President of Strategy and BusinessDevelopment.  Mr. Lidsky also serves onthe Board of Directors for VigiLanz Corporation.

 

Margaret A. Loftus was elected asa director in June 1998. Ms. Loftus is an owner of Loftus Brown-Wescott, Inc.,a business consulting firm, which she co-founded in 1989. Between 1976 and1989, she was employed by Cray Research, Inc., most recently as VicePresident of Software. Ms. Loftus also serves on the Board of Directorsfor Analysts International Corporation and several private technologycompanies.

 

James E. Ousley was elected as adirector in June 1998.  Between 2002 and2004, Mr. Ousley was President and Chief Executive Officer of Vytek WirelessInc., a mobile computing company.  From1999 to 2001, he served as President and Chairman of Syntegra (USA), a globale-Business solutions provider and a division of British Telecommunicationsplc.  From 1991 to 1999, Mr. Ousley wasPresident and Chief Executive Officer of Control Data Systems (CDS), which wasacquired by British Telecommunications in August 1999.    From 1968 to 1991, he held various salesand executive management positions with Control Data Corporation, a globalcomputer systems, software/services and peripherals company.  Mr. Ousley also serves on the Board of Directorsfor ActiveCard, Inc., Bell Microproducts Inc., CaLamp Corporation and SavvisCommunications Corporation.

 

Our directors hold office untilthe next annual meeting of shareholders or until their successors are dulyelected or appointed.

 

We will furnish to the Securitiesand Exchange Commission a definitive Proxy Statement (the “2004 Proxy Statement”)not later than 120 days after the close of the fiscal year ended December 31,2004.  The remaining information requiredby Items 401 and 405 of Regulation S-K is incorporated herein by reference tothe Proxy Statement.

 

We have adopted a Code of Ethicsthat applies to our officers, including our principal executive, financial andaccounting officers, and our directors and employees.  We intend to make all required disclosuresconcerning any amendments to, or waivers from, our Code of Ethics by the filingof Current Reports under the cover of From 8-K.

 

**Item 11.  Executive Compensation.**

 

The information set forth under the caption “ExecutiveCompensation” in the Company’s 2004 Proxy Statement is incorporated herein byreference.

 

**Item 12. Security Ownership of Certain Beneficial Owners and Management andRelated Stockholder Matters.**

 

The information set forth under the caption “OutstandingVoting Securities and Voting Rights” in the Company’s 2004 Proxy Statement isincorporated herein by reference.

 
| ** **                                                  | ** ** | **Equity Compensation Plan Information**                                                            | ** ** |
|-------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------|------------|
| **Plan Category**                                           | ** ** | **Number of securities  to be issued upon  exercise of  outstanding options,  warrants and rights** | ** ** | **Weighted-average  exercise of outstanding  options, warrants and  rights** | ** ** | **Number of securities  remaining available for  future issuance under  equity compensation  plans (excluding  securities reflected in  the first column)** | ** ** |
| Equity compensation plans approved by security holders  (1) |       | 1,818,696                                                                                           |       | $ | 5.11 |   | 1,481,304 |   |
| Equity compensation plans not approved by security  holders |       |                                                                                                |       | — |   | — |   |
| Totals                                                      |       | 1,818,696                                                                                           |       | $ | 5.11 |   | 1,481,304 |   |

 

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(1)           Theseequity compensation plans consist of our Incentive Compensation Plan and our2000 Director Stock Option Plan, each as amended.

 

**Item 13.  Certain Relationshipsand Related Transactions.**

 

The information required by this section isincorporated by reference from the information in the section entitled “CertainRelationships and Related Transactions” in the Company’s 2004 Proxy Statement.

 

**Item 14. Principal Accounting Fees and Services.**

 

The information required by this section isincorporated by reference from the information in the section entitled “AuditingMatters” in the Company’s 2004 Proxy Statement.

 

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**Item 15.  Exhibits, FinancialStatement Schedules, and Reports on Form 8-K.**

 

(a)           The following documents are filed as part of this report:

 

**1.            Financial Statements**

 

Reference is made to the Index toFinancial Statements of Datalink Corporation, under Item 8 in Part II of thisForm 10-K.

 

**2.            Financial Statement Schedules.**

 

The following financial statementschedule of Datalink Corporation for the years ended 2004, 2003 and 2002 isfiled as part of this Annual Report and should be read in conjunction with theFinancial Statements of Datalink Corporation.

 

**DATALINKCORPORATION**

**SCHEDULE IIVALUATION AND QUALIFYING ACCOUNTS**

**FOR THEYEARS ENDED DECEMBER 31, 2004, 2003 AND 2002**

 
| **Description**                                | ** ** | **Period** | ** ** | **Balance at  Beginning  of Period** | ** ** | **Additions** | ** ** | **Deductions (1)** | ** ** | **Balance  at End  of Period** | ** ** |
|------------------------------------------------|------------|------------|------------|--------------------------------------|------------|---------------|------------|--------------------|------------|--------------------------------|------------|
| Allowance for  Doubtful Accounts               |       | 2004       |       | $                                    | 97,807     |          | $          | (14,000            | )          | $                              | 13,679     |   | $ | 70,128 |   |
|                                           |       | 2003       |       | 197,368                              |       | (34,026       | )          | 65,535             |       | 97,807                         |       |
|                                           |       | 2002       |       | 164,394                              |       | 77,000        |       | 44,026             |       | 197,368                        |       |
|                                           |       |       |       |                                 |       |          |       |               |       |                           |       |
| Allowance for  Inventory Obsolescence          |       | 2004       |       | $                                    | 211,110    |          | $          | 185,437            |       | $                              | 325,244    |   | $ | 71,303 |   |
|                                           |       | 2003       |       | 405,001                              |       | 348,816       |       | 543,707            |       | 211,110                        |       |
|                                           |       | 2002       |       | 245,559                              |       | 187,500       |       | 28,058             |       | 405,001                        |       |
|                                           |       |       |       |                                 |       |          |       |               |       |                           |       |
| Allowance for Valuation  of Deferred Tax Asset |       | 2004       |       | $                                    | 2,802,954  |          | $          | 1,875,657          |       | $                              | —     |   | $ | 4,678,611 |   |
|                                           |       | 2003       |       | 1,609,000                            |       | 1,194,454     |       | —             |       | 2,802,954                      |       |
|                                           |       | 2002       |       | —                               |       | 1,609,000     |       | —             |       | 1,609,000                      |       |
|                                                |            |            |            |                                      |            |               |            |                    |            |                                |            |  |  |  |  |  |  |  |  |  |

 

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(1)           Deductions reflect write-offs of customer accountsreceivable, net of recoveries or disposals of inventories.

 

39

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**REPORT OF INDEPENDENTREGISTERED PUBLIC ACCOUNTING FIRM ON FINANCIAL STATEMENT SCHEDULE**

 

To the Board of Directors

Datalink Corporation

Chanhassen, Minnesota

 

Our audits were conducted in accordance with the standards of the PublicCompany Accounting Oversight Board (United States) and were made for thepurpose of forming an opinion on the basic financial statements of DatalinkCorporation taken as a whole.  The supplementalSchedule II is presented for purposes of complying with the Securities andExchange Commission’s rules and is not a part of the basic consolidatedfinancial statements.  This schedule hasbeen subjected to the auditing procedures applied in our audits of the basicconsolidated financial statements and in our opinion, is fairly stated in allmaterial respects in relation to the basic consolidated financial statementstaken as a whole.

 
| /s/  McGLADREY & PULLEN, LLP |   |
|----------------------------------|--------|

 

 

Minneapolis, Minnesota

February 4, 2005

 

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**REPORT OF INDEPENDENTREGISTERED PUBLIC ACCOUNTING FIRM ON FINANCIAL STATEMENT SCHEDULE**

 

 

The Board of Directorsand Stockholders

Datalink Corporation:

 

Underthe date of February 6, 2004, we reported on the balance sheets of DatalinkCorporation as of December 31, 2003 and the related statements of operations,stockholders’ equity and cash flows for each of the years in the two-yearperiod then ended. In connection with our audits of the aforementionedfinancial statements, we also have audited the related financial statementschedule for the years ended December 31, 2003 and 2002.  The financialstatement schedule is the responsibility of the Company’s management.  Ourresponsibility is to express an opinion on the financial statement schedulebased on our audits.

 

Inour opinion, such financial statement schedule for the years ended December 31,2003 and 2002, when considered in relation to the basic financial statementstaken as a whole, presents fairly, in all material respects, the informationset forth therein.

 
| /s/ KPMG LLP           |   |
|------------------------|--------|
|                   |
| Minneapolis, Minnesota |
| February 6, 2004       |

 

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**3.             Exhibits.**The following exhibits are filed as part of this Form 10-K:

 
| **Exhibit Number** | ** ** | **Title**                                                                                                                                                                         | ** ** | **Method of Filing** |
|--------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------------|
| 3.1                |       | Amended and Restated Articles of Incorporation of the Company                                                                                                                     |       | (1)                  |
| 3.2                |       | Restated Bylaws of the Company                                                                                                                                                    |       | (1)                  |
| 4.1                |       | Form of Common Stock Certificate                                                                                                                                                  |       | (1)                  |
| 10.1               |       | Employee Stock Purchase Plan                                                                                                                                                      |       | (1)                  |
| 10.2               |       | 1999 Incentive Compensation Plan, as amended on December 18, 2000                                                                                                                 |       | (4)                  |
| 10.3               |       | Credit Agreement with Norwest Bank Minneapolis, N.A.                                                                                                                              |       | (1)                  |
| 10.4               |       | Form of Indemnification Agreement                                                                                                                                                 |       | (1)                  |
| 10.5               |       | Lease Agreement with Washington Avenue L.L.P.                                                                                                                                     |       | (1)                  |
| 10.6               |       | Deferred Compensation Agreement with Stanley I. Clothier                                                                                                                          |       | (1)                  |
| 10.7               |       | Agreement and Plan of Reorganization with Direct Connect  Systems, Inc. (excluding Schedules and Exhibits which the Registrant  will provide to the Commission upon request) |       | (1)                  |
| 10.8               |       | Second Lease Agreement with Washington Avenue L.L.P.                                                                                                                              |       | (1)                  |
| 10.9               |       | Lease Extension Agreement with Washington Avenue L.L.P.                                                                                                                           |       | (1)                  |
| 10.11              |       | Asset Purchase Agreement dated November 10, 2000 with OpenSystems.com,  Inc. (excluding Schedules and Exhibits which the Registrant will provide to  The Commission upon request) |       | (2)                  |
| 10.12              |       | Building Lease with Hoyt/DTLK LLC                                                                                                                                                 |       | (3)                  |
| 10.13              |       | Building Lease date April 27, 2001 with Hoyt/DTLK LLC                                                                                                                             |       | (5)                  |
| 10.18              |       | 2000 Director Stock Option Plan                                                                                                                                                   |       | (4)                  |
| 10.19              |       | Credit agreement dated June 30, 2002 with Wells Fargo Bank  Minneapolis, National Association                                                                                     |       | (6)                  |
| 10.20              |       | 2002 Amendments to the 2000 Director Stock Option Plan                                                                                                                            |       | (7)                  |
| 10.21              |       | Credit agreement dated June 30, 2003 with Wells Fargo Bank  Minneapolis, National Association                                                                                     |       | (8)                  |
| 10.22              |       | Amended and Restated 2000 Director Stock Option Plan                                                                                                                              |       | (9)                  |
| 10.23              |       | Restricted Stock Award Agreement                                                                                                                                                  |       | (10)                 |
| 10.24              |       | Change of Control Severance Agreement                                                                                                                                             |       | 10)                  |
| 10.25              |       | Sublease Agreement dated December 15, 2004 with Checkpoint Security,  Inc.                                                                                                        |       | Filed herewith       |
| 10.26              |       | Vacant Land Purchase Agreement                                                                                                                                                    |       | Filed herewith       |
| 14.1               |       | Code of Ethics                                                                                                                                                                    |       | (11)                 |
| 23.1               |       | Consent of McGladrey & Pullen, LLP                                                                                                                                            |       | Filed herewith       |
| 23.2               |       | Consent of KPMG LLP                                                                                                                                                               |       | Filed herewith       |
| 31.1               |       | Certifications by the Chief Executive Officer and Chief Financial  Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002                                              |       | Filed herewith       |
| 32.1               |       | Certifications by the Chief Executive Officer and Chief Financial  Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002                                              |       | Filed herewith       |
| 99.1               |       | Audit Committee Charter (Revised November 12, 2004)                                                                                                                               |       | (10)                 |

 

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| (1)    | Incorporated  by reference to the exhibit of the same number in the Company’s Registration  Statement on Form S-1, Reg. No. 333-55935 |
|--------|------------------------------------------------------------------------------------------------------------------------------------------------------|
|   |                                                                                                                                                 |
| (2)    | Incorporated  by reference to the exhibit of the same number in the Company’s September 30,  2000 Form 10-Q.                                    |
|   |                                                                                                                                                 |
| (3)    | Incorporated  by reference to the exhibit of the same number in the Company’s 2000 Form  10-K.                                                  |
|   |                                                                                                                                                 |
| (4)    | Incorporated  by reference to the Company’s 2000 Proxy Statement.                                                                               |
|   |                                                                                                                                                 |
| (5)    | Incorporated  by reference to the exhibit of the same number in the Company’s March 31,  2001 Form 10-Q.                                        |
|   |                                                                                                                                                 |
| (6)    | Incorporated  by reference to the exhibit of the same number in the Company’s June 30, 2002  Form 10-Q.                                         |
|   |                                                                                                                                                 |
| (7)    | Incorporated  by reference to the exhibit of the same number in the Company’s 2002 Form  10-K.                                                  |
|   |                                                                                                                                                 |
| (8)    | Incorporated  by reference to the exhibit of the same number in the Company’s June 30, 2003  Form 10-Q.                                         |
|   |                                                                                                                                                 |
| (9)    | Incorporated  by reference to the exhibit of the same number in the Company’s March 31,  2004 Form 10-Q.                                        |

 

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(10)         Incorporated by reference to the exhibit of the same numberin the Company’s September 30, 2004 Form 10-Q.

 

(11)         Incorporatedby reference to the exhibit of the same number in the Company’s 2003 Form 10-K.

 

 

**SIGNATURES**

 

Pursuant to the requirements ofSection 13 or 15(d) of the Securities Exchange Act of 1934, the registranthas duly caused this Annual Report on Form 10-K to be signed on its behalf bythe undersigned, thereunto duly authorized.

 
|                  | DATALINK CORPORATION |                                                                            |   |
|-----------------------|----------------------|---------------------------------------------------------------------------------|--------|
| Date:  March 31, 2005 |                 |                                                                            |
|                  | By:                  | /s/  Greg R. Meland                                                             |
|                  |                 | Greg  R. Meland, Chief Executive Officer                                        |
|                  |                 |                                                                            |
|                  | By:                  | /s/  Daniel J. Kinsella                                                         |
|                  |                 | Daniel  J. Kinsella, Vice President – Finance  and Chief Financial Officer |

 

Pursuant to the requirements ofthe Securities Act of 1934, this report has been signed below by the followingpersons on behalf of the registrant and in the capacities and on the datesindicated.

 
| **Signature**              | ** ** | **Title**                                                                  | ** ** | **Date**        |
|----------------------------|------------|----------------------------------------------------------------------------|------------|-----------------|
| /s/  Greg R. Meland        |       | Chief  Executive Officer and Director (Principal Executive Officer)        |       | March  31, 2005 |
|                       |       |                                                                       |       |            |
| /s/  Daniel J. Kinsella    |       | Vice  President - Finance and Chief Financial Officer (Principal Financial |       | March  31, 2005 |
|                       |       | Officer)                                                                   |       |            |
|                       |       |                                                                       |       |            |
| /s/  Denise M. Westenfield |       | Corporate  Controller (Principal Accounting Officer)                       |       | March  31, 2005 |
|                       |       |                                                                       |       |            |
| /s/  Paul F. Lidsky        |       | Director                                                                   |       | March  31, 2005 |
|                       |       |                                                                       |       |            |
| /s/  Margaret A. Loftus    |       | Director                                                                   |       | March  31, 2005 |
|                       |       |                                                                       |       |            |
| /s/  James E. Ousley       |       | Director                                                                   |       | March  31, 2005 |
|                       |       |                                                                       |       |            |
| /s/  Robert M. Price       |       | Director                                                                   |       | March  31, 2005 |

 

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