**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

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**FORM 10-K**

**(Mark one)**

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

 

**FORTHE FISCAL YEAR ENDED DECEMBER 31, 2005**

**OR**

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

 

**ForThe Transition PeriodFrom            To**

**Commissionfile number: 00029758**

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**DATALINK CORPORATION**

(Exact name of registrantas specified in its charter)

| **MINNESOTA**                                   |   | **41-0856543**                        |
|-------------------------------------------------|--------|---------------------------------------|
| (State or other  jurisdiction of incorporation) |   | (IRS Employer  Identification Number) |

 

**8170 UPLAND CIRCLECHANHASSEN, MINNESOTA 55317-8589**

(Address of PrincipalExecutive Offices)

**(952) 944-3462**

(Registrant’s TelephoneNumber, Including Area Code)

Securities registeredpursuant to Section 12(b) of the Act: **None**.

Securities registeredpursuant to Section 12(g) of the Act: **Common Stock, $0.001 par value**.

Indicate by check mark ifthe registrant is a well known seasoned issuer as defined in Rule 405 ofthe Securities Act. Yes o No x

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section 15(d) ofthe Act. Yes o No x

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(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 x No o

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K(§229.405 of this chapter) is not contained herein, and will not be contained,to the best of registrant’s knowledge, in definitive proxy or informationstatements incorporated by reference in Part III of this Form 10-Kor any amendment to this Form 10-K. x

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer or anon-accelerated filer.

| Large accelerated filer o |   | Accelerated filer o |   | Non-accelerated  filer x |
|--------------------------------|--------|---------------------|--------|-------------------------------|

 

Indicate by check markwhether the registrant is a shell company (as defined by Rule 12b-2of the Exchange Act). Yes o No x

Aggregate market value ofthe voting and non-voting common equity held by non-affiliates of theregistrant at June 30, 2005: $19,133,116.

At March 10, 2006, thenumber of shares outstanding of each of the registrant’s classes of commonstock was 10,487,237.

**DOCUMENTS INCORPORATED BYREFERENCE**

Portionsof the Registrant’s Proxy Statement for its Annual Meeting of Stockholders tobe held in 2006 (the “2005 Proxy Statement”), to be filed with the Securitiesand Exchange Commission, are incorporated by reference to Part III of thisForm 10-K.

 

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**NOTE REGARDING FORWARD-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 impact ofeconomic conditions on technology spending; competition and pricing pressuresand timing of our installations that may adversely affect our revenues andprofits; fixed employment costs that may impact profitability if we sufferrevenue shortfalls;  revenue recognitionpolicies that may unpredictably defer reporting of our revenues; our ability tohire and retain sales representatives and key technical and other personnel;our dependence on key suppliers; our ability to adapt to rapid technologicalchange; risks associated with possible future acquisitions; fluctuations in ourquarterly operating results; future changes in applicable accounting rules; andvolatility in our stock price. You may find these statements throughout thisAnnual Report and specifically in the sections entitled “Risk Factors,” “Management’sDiscussion and Analysis of Financial Condition and Results of Operations” and “Business.”Our actual results may differ materially from those anticipated in theseforward-looking statements as a result of various factors, including all therisks discussed in “Risk Factors” and elsewhere in this Annual Report.

We use the terms “aim”, “believe,”“expect,” “plan,” “intend,” “estimate” and “anticipate” and similar expressionsto identify forward-looking statements. These statements reflect our currentviews with respect to future events and are based on assumptions subject torisks and uncertainties. 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 area leading independent information storage architect with operations throughoutthe United States. We work with customers to analyze, design, implement, andsupport information storage infrastructures that store, protect, and providecontinuous access to information. Our areas of expertise include:

·       DataAvailability—Datalink architectures are designed to protect against planned andunplanned downtime and provide fast access to information. Solutions span faulttolerant storage and clustering. 

·       DataRecovery—Data recovery solutions enable companies to recover data, applicationsand entire computing environments following data loss or a disaster. Solutionsinclude local and remote backup, snapshot and replication.

·       StorageManagement—Datalink storage management architectures maximize utilization ofstorage technologies and the resources that manage them. Solutions span storageconsolidation, storage area network (SAN) management, virtualization, storageresource management (SRM) and data lifecycle management and storage security.

·       Supportand Maintenance—After designing and installing data storage solutions for itscustomers, Datalink provides expertise through 24 hours-a-day telephone problemsolving support and when necessary on site maintenance.

We offer a comprehensivesuite of services spanning analysis, design, implementation and support. Ourhighly skilled technical services and product management teams test and comparedata storage technologies available from the leading manufacturers and softwaredevelopers. Once a product is 

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approvedfor our solution sets, our technical services team then has the flexibility tochoose from the best of these storage technologies to solve our customers’growing data storage needs. In addition, our support staff ensures thecontinued success of our data storage solutions for each customer. We believethese value-added services and our adherence to the highest quality standardshave resulted in superior levels of customer satisfaction.

**The Data Storage Industry**

International Data Corporation(IDC) projects data growth at an annual compound rate of approximately 8-10%through 2007. With this ongoing growth in creation and storage of data and theincreasing strategic importance of having the data available, we expect thedata storage markets in which we compete to continue to expand. Data storage iscurrently a large market, with spending in 2005 estimated at $36 billion andexpected to exceed $40 billion by 2007. Information technology (IT) departmentsare faced with a daunting challenge of rapidly expanding amounts of data tomanage coupled with increasing demands for availability of this data for day-to-daybusiness and to meet regulatory requirements. We expect these issues willcontinue to generate interest in new data storage solutions that allow users tobe more productive and to meet the needs of their organizations.

At the same time, IT headcountis estimated to remain relatively flat over the next several years, making itnecessary for organizations to dramatically improve storage managementproductivity to avoid being inundated by growing data storage capacities. Toaddress this growing gap, we expect that organizations will consolidate theirstorage infrastructures and augment them with enhanced software capabilitiessuch as virtualization, storage resource management and data lifecyclemanagement.

IDC predicts that disk-based data protection, modulardisk and SAN/NAS convergence, storage management software, and storage serviceswill grow rapidly over the next several years. IDC estimates that, together,these areas will grow through 2007 at more than double the storage industrystandard 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 theimportance of data to businesses, we believe that organizations will dedicatean increasing percentage of their information technology budgets to datastorage. We believe that capital investment priorities will include:

·       **Enhanced data protection.**Increased need for high throughput performance, greater frequency of backups,quick restoration of data and stringent data availability requirements are keyfactors that we expect to drive the migration to disk-based data protectionsolutions.  Disk is no longer being usedas only a target device for replication and mirroring, but also is beingincorporated into traditional backup systems.

·       **Storage security.**Business requirements surrounding regulatory compliance, data privacy, internalcontrols, and protecting intellectual property have made storage security apriority in many organizations. We expect organizations will increasinglydeploy storage security solutions utilizing encryption capabilities to protectvital data assets.

·       **Continued migration to networked storage infrastructures usingvirtualization technologies.**We expect that through a variety of storage networking and virtualizationtechnologies, organizations will attain shared (consolidated) storagecapabilities. Consolidated and virtualized storage benefits include increasedflexibility in implementing and managing storage, increased 

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storage device utilizationlevels, improved quality of service, reduced administration costs and increasedoperational efficiency.

·       **Evolution to modular storage systems.**We expect that many organizations will implement modular storage systems ascompared to large, monolithic storage systems. Smaller versions of theirhigh-end, full-featured counterparts, modular disk systems enable organizationsto cost-effectively implement storage, while enjoying the performance andfunctionality of large, enterprise systems.

·       **Retention and retrieval of data to address Email, regulatory,compliance and litigation support issues.**Long-term data retention has become the norm with recent industry regulationssuch as the Sarbanes-Oxley Act, HIPAA (Health Insurance Portability andAccountability Act) and SEC section 17a-4 (electronic communicationpreservation) mandating the retention of documents for many years. Theconsequences can be great if a company does not have the proper retention ofdocuments for compliance, including stiff monetary penalties.

·       **Adoption of robust storage management software solutions.**A number of storage management software innovations continue to mature in themarket. Storage management software enhancements span virtualization, storageresource management and data lifecycle management. Newer softwarefunctionalities offer advanced backup reporting and categorization. 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 drive IT organizations to increasingly outsourcestorage-related services (consulting, implementation and support). They includethe growing strategic importance of data storage, growing complexity ofnetworked storage environments and increasing scope of spending on storage.

**The Datalink Opportunity**

The increased need for data storage and the developmentof sophisticated, enterprise-class information data storage systems havecreated 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 onCustomers.***   We believeorganizations will increasingly look outside their in-house technical staff toindependent information storage architects, such as Datalink, for specializedexpertise. Networked storage architecture design is complex. Advancedfunctionalities, such as disk-based backup and recovery, storage security, andvirtualization, further increase the level of complexity. Althoughorganization-wide data storage solutions, such as SANs, are designed to easedata management functions, these systems are difficult to understand andimplement because they integrate diverse operating systems, hardware andsoftware. In addition, there continues to be a steady influx of new productsand technologies introduced to the market. 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 on Manufacturers.***   Webelieve manufacturers increasingly rely on channel partners such as us for twoprincipal reasons:

·        Sophisticateddisk-based backup and recovery solutions require the integration of highlyspecialized products made by a variety of manufacturers. A typical enhanceddata recovery 

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architecture, forinstance, can utilize components such as software, tape libraries, and disksystems, each from a different manufacturer. High-end data storagemanufacturers generally focus on only a portion of the overall enhanced datarecovery system, leaving companies like us to integrate comprehensive networkeddata storage solutions from the best available products and technologies.

·        Grossprofit margins have been under severe pressure for many storage companies. Becauseof the high cost of maintaining a national sales and marketing organization,and especially in light of economic conditions over the past several years,high-end data storage manufacturers increasingly are focusing their resourceson their research and development functions. This strategy requires them toleverage their sales and marketing functions by partnering with companies suchas Datalink.

We believe we are uniquely positioned to capitalize onthis significant opportunity for the following reasons:

***Expertise.***   Wehave been implementing sophisticated data storage solutions for over fifteenyears. This experience has given us significant expertise in understanding andapplying data storage technologies and has allowed us to earn and retain thetrust and confidence of our customers and suppliers. We invest in and trainresources to differentiate our company, adapt to the ever-changing needs of ourcustomers and capitalize on opportunities.

***Independence.***   Unlikemany of our competitors, we are independent of any manufacturer or particulartechnology. Our customers are increasingly using open systems computingarchitectures, which can combine products from multiple manufacturers. Ourcustomers value our independence and rely on us to choose the best available hardwareand software and tailor it to their individual needs.

**The Datalink Solution**

We combine our technicalexpertise, the best products from leading manufacturers and comprehensiveservices to meet each customer’s specific needs. Our services include:

*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 is on each customer’s unique situation,we bring to each engagement our extensive product knowledge and the experiencewe have gained from providing data storage solutions for over fifteen years tocustomers in numerous industries.

Datalink’s AssessLinkTMassessment services provide customers with objective guidance on developingdata storage strategies that optimize their resources, leverage their existingenvironments and facilitate cost-effective growth for the future. AssessLinkservices provide an independent viewpoint to align people, processes andtechnologies with business objectives. These services help organizationsmaximize current investments, outline recommendations for future purchases andprovide assurance that storage infrastructures are efficient, reliable andscalable.

*Design*

Once we have completed our initial analysis, we beginthe design phase of the project. Our professional services teams work togetherto design a system that meets the customer’s data storage needs and budget. Ourindependence permits us to choose from a wide range of technologies in order tofuse together the appropriate hardware, software and services for each project.

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Datalink’s DesignLinkTMservices utilize a customer’s developed detailed business requirements to designthe data storage solution. The engagement begins with a definition of theproject’s objectives, scope and key milestones. The Datalink team then preparesan outline of the schedule and deliverables. Following a thorough analysis, theteam prepares a comprehensive blueprint of the storage solution, including adetailed design schematic, key implementation milestones and recommendationsfor handling potential configuration issues to ensure a smooth transition tothe new storage environment.

*Implementation*

Once we design and test asystem, we formulate a detailed project implementation plan with our customersto meet their financial and operating objectives and minimize disruption totheir operations. We oversee the timely delivery of hardware and software productsto the customer’s location. We then coordinate the installation with ourtechnical services team, or personnel from the equipment manufacturer, andcomplete the installation at the customer’s site using industry best practices.

*Support*

We provide our customers advanced technical supportfrom a team of customer support and field engineers. Our extensive experiencein data storage systems enables our staff to deliver expert configuration andusage assistance, technical advice and prompt incident detection and resolution.The support desk staff also acts as our primary interface with manufacturers’technical support organizations.

Datalink’s SupportLinkTM support services offeradditional flexible levels of service to help organizations maximize the returnon their storage technology investments. We believe that our SupportLinkprogram is one of very few customer service plans that provide support across multiplestorage product lines and manufacturers.

We offer maintenance and repair service options underour service program. We offer a variety of on-site service options,including four hour guaranteed response times seven days per week, 24 hours perday. Our technical staff first assists customers in identifying the source ofsystem problems and in determining whether there is defective hardware orsoftware. We contract with a number of our suppliers and other independentservice organizations to provide any required on-site maintenance andrepair services.

We provide our analysis,design and support services to customers through either a stand-alone servicesengagement or as a part of an overall project that includes a storage solutionand services.

**Our Strategy**

Our strategy is to improveour position as a leading, independent information storage architect and todevelop a customer-focused high performance company with sustainable profitablegrowth. To achieve these objectives, we intend to build upon our record ofsuccessfully addressing the evolving enterprise-class information storagemanagement needs of our customers. Key elements of our strategy include:

*Increase Sales TeamProductivity*

Although we believe thatDatalink’s sales productivity is high, we believe it can be enhanced. We planto accelerate the learning and productivity curve of our newer salesprofessionals and enhance the skills of seasoned executives throughimplementation of techniques and best practices learned from our top producers.

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*Scale ExistingLocations*

We intend to focus on ourexisting geographic locations to increase market share, leverage fixed expensesand provide higher quality service levels. Datalink will drive this growth byhiring experienced, quality account executives and storage engineers to gainsales productivity and field engineering utilization.

*Expand CustomerSupport Revenues*

We have significantlyincreased our customer support capabilities and performance over the lastseveral years and will continue to make this a focus. Our customers appreciateour quality support initiatives, which we believe will continue to be a keydifferentiator and growth driver for Datalink.

*Enhance OurProfessional Services Business*

There is significantopportunity to sell more of our storage services expertise to customers. Byimproving 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 RegionalAcquisitions*

We believe there is anopportunity to strengthen our resources and presence in key geographies throughthe acquisition of select regional competitors.

**Suppliers and Products**

As an independent information storage architect, we donot 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,identify new and innovative products and applications and objectively help ourcustomers align 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.

Someof our major suppliers and the products they provide are listed:

| **Products**    | ** ** | **Suppliers**                                                                                                          |
|-----------------|------------|------------------------------------------------------------------------------------------------------------------------|
| Primary Storage |       | EMC Corporation  Hitachi Data Systems Corporation  Network Appliance Inc.  Sun Microsystems, Inc.                 |
| Tape Automation |       | Advanced Digital  Information Corporation  Quantum Corporation  Spectra Logic Corporation  Sun Microsystems, Inc. |

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| Software                         |   | Diligent Technologies Corporation  EMC Corporation  Symantec Corporation                 |
|----------------------------------|--------|------------------------------------------------------------------------------------------|
| Switches/Directors               |   | Brocade Communications  Systems, Inc.  McData Corporation  Cisco Systems, Inc. |
| Fibre Channel Host  Bus Adapters |   | Emulex Corporation  QLogic Corporation                                                   |

 

**Customers**

Our customers trust uswith their most demanding data storage projects. Customer engagements rangefrom specialized professional assessment and design services, to complexorganization-wide SAN implementations. We serve customers throughout the UnitedStates in a diverse group of data intensive industries. 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 arereflected by our significant repeat business. Spanning a broad array ofindustries, our customers include CBS SportsLine.com, Cingular Wireless, HarrisCorporation, Fidelity National Financial, GMAC-RFC, St. Jude Medical, Inc.,Tyson Foods, Inc., Valero Energy Corporation and World Savings.

**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 13 field sales offices inorder to efficiently serve our customers’ needs.

Our field account executives and account associateswork closely with our technical services team in evaluating theenterprise-class information storage needs of existing and prospectivecustomers and in designing high quality, cost effective solutions. To ensurequality service, we assign each customer a specific field account executive andaccount associate. We believe that the average longevity of service of oursales force, and their close collaboration with our technical services team, isa key factor to earning and retaining the trust and confidence of ourcustomers. We believe this differentiates us from many other storage solutionproviders.

In addition to the effortsof our field account executives, inside account associates, and technicalservices team we engage in a variety of other marketing activities designed toattract new business and retain customer loyalty. We regularly executeintegrated, demand creation campaigns, gain exposure through online and printtrade publications, hold webcasts and informational seminars and publish aquarterly newsletter.

**Competition**

Datalink primarilycompetes with the direct sales forces of storage OEM’s. Besides Datalink’scurrent technology partners, these OEM competitors include InternationalBusiness Machines Corp., Hewlett-Packard Company, Sun Microsystems, Inc.and Dell Computer Corporation. In addition, we compete with channel partners ofstorage OEM’s. These include MTI Technology Corporation, Forsythe Technology, Inc.,SAN Holdings, and Sirius.

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**Employees**

As of December 31,2005, we had a total of 147 full-time employees. We have no employmentagreements with any of our employees, except for our Chief Financial Officer.None of our employees are unionized or subject to a collective bargainingagreement. We have experienced no work stoppages and believe that ouremployee relations are good.

**Backlog**

We configure products tocustomer specifications and generally ship them shortly after we receive ourcustomer’s order. Customers may change their orders with little or no penalty. Wedo not recognize revenue on hardware or software products until we havecompleted the functionally essential portions of the installation or relatedconfiguration services in connection with the sale. Customer constraints andthe availability of engineering resources can have a significant impact on whenwe can complete an installation and configuration service. These factorsprevent us from relying on backlog as a predictor of our future sales levels.

**Available Information**

We have available awebsite on the Internet. Our address is www.datalink.com. We make available atour website our Annual Reports on Form 10-K, Quarterly Reports on Form 10-Q,Current Reports on Form 8-K, and amendments to those reports filedor furnished pursuant to Section 13(a) or 15(d) of the ExchangeAct as soon as reasonably practicable after we electronically file suchmaterial with, or furnish it to, the SEC.

**Item 1A.**                RiskFactors.

As indicated in thisAnnual Report under the caption “Note Regarding Forward-Looking Statements,”certain information contained in this Annual Report consists of forward-lookingstatements. Important factors that could cause actual results to differmaterially from the forward-looking statements made in this Annual Reportinclude the following:

**Wecannot assure future profitability.**

Although we achievedpositive net income in the fourth quarter of 2004 and for the second, third andfourth quarters of 2005, we have incurred net losses all other quarters sincethe fourth quarter of 2001. We cannot assure that we will return toprofitability in the foreseeable future, or at all. Our continued losses mayadversely affect our stock price.

**Competitioncould prevent us from increasing or sustaining our revenues or profitability.**

The enterprise-class information storage market israpidly evolving and highly competitive. As technologies change rapidly, weexpect that competition will increase in the future. We compete withindependent storage system suppliers to the mid to large enterprise market andnumerous value added resellers, distributors and consultants. We also competein the storage systems market with general purpose computer platform suppliers.Many of our current and potential competitors have significantly greaterfinancial, technical, marketing, purchasing and other resources than we do. Asa result, they may respond more quickly to new or emerging technologies andchanges in customer requirements, devote greater resources to the development,promotion and sale of products and deliver competitive products at lowerend-user prices.

Some of our current and potential competitors includeour suppliers. We are not the exclusive reseller of any data storage product weoffer. Instead, our suppliers market their products through other 

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independent data storagesolution providers, original equipment manufacturers and, often, through theirown internal sales forces. We believe direct competition from our suppliers islikely to increase if, as expected, the data storage industry continues toconsolidate. This consolidation would likely result in fewer suppliers withgreater resources to devote to internal sales and marketing efforts. Inaddition, our suppliers have established and will probably continue toestablish cooperative relationships with other suppliers and other data storagesolution providers. These cooperative relationships are often intended toenable our suppliers to offer comprehensive storage solutions, which competewith those we offer. If our relationships with our suppliers becomeadversarial, it will be more difficult for us to stay ahead of industrydevelopments and provide our customers with the type of service they expectfrom us.

In addition, most of ourcustomers already employ in-house technical staffs. To the extent a customer’sin-house technical staff develops sophisticated storage systems expertise, thecustomer may be less likely to seek our services. Further, we compete withstorage service providers who manage, store and backup their customers’ data atoff-site, networked data storage locations.

**Wederive a significant percentage of our revenues from a small number of customers.**

In 2005, we had nocustomers that accounted for at least 10% of our revenues. However, our topfive customers collectively accounted for 27% of our 2005 revenues. Because weintend to continue to seek out large projects, we expect that a significant percentageof our revenues will continue to come from a small number of customers,although the composition of our key customers is likely to change from year toyear. If we fail to obtain a growing number of large projects each year, ourrevenues and profitability will likely be adversely affected. In addition, ourreliance on large projects makes it more likely that our revenues and profitswill fluctuate unpredictably from quarter to quarter and year to year.Unpredictable revenue and profit fluctuations may make our stock price morevolatile and lead to a decline in our stock price.

**Ourrevenue recognition policies unpredictably defer reporting of our revenues.**

We increasingly sellcomplex enterprise-class information storage solutions, which include installationand configuration services. We do not recognize revenues from our sale ofhardware and software products to our customers until we complete our requiredinstallation or configuration of these products. Installation and configurationof these solutions requires significant coordination with our customers andvendors. Therefore, even if we have shipped all products to our customers, wemay be unable to control the timing of product installation and configuration. Thesedelays can prevent us from recognizing revenue on products we ship and mayadversely affect our quarterly reported revenues. As a result, our stock pricemay decline.

**Ourkey vendors could discontinue their incentive programs, which could adverselyaffect our business.**

Several of our key vendorshave offered incentive programs to us over the past several years based on ourachievement of particular sales levels of their products. These programscontributed to our profitability in 2004 and 2005. We cannot assure that theseprograms will continue. If they do not, we may be unable to achieveprofitability in the future.

**Ourbusiness depends on our ability to hire and retain technical personnel andhighly qualified sales people.**

Our future operatingresults depend upon our ability to attract, retain and motivate qualifiedengineers and sales people with enterprise-class information storage solutionsexperience. If we fail to recruit and retain additional engineering and salespersonnel, or if continued losses require us in the future to terminateemployment of some of these personnel, we will experience greater difficultyrealizing our growth strategy, which could negatively affect our business,financial condition and stock price.

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**Wegenerally do not have employment agreements with our key employees.**

Our future operatingresults depend in significant part upon the continued contributions of ourexecutive officers, managers, salespeople, engineers and other technicalpersonnel, many who have substantial experience in our industry and would be difficultto replace. Except as to our new Chief Financial Officer, we generally do nothave employment, non-competition or nondisclosure agreements with our officersor employees, including our executive officers. Accordingly, our employees mayvoluntarily leave us at any time and work for our competitors. Our growthstrategy depends in part on our ability to retain our current employees andhire new employees. Any failure to retain our key employees will make it muchmore difficult for us to maintain our operations and attain our growthobjectives and could therefore be expected to adversely affect our operatingresults, financial condition and stock price.

**Ourlong sales cycle may cause fluctuating operating results, which may adverselyaffect our stock price.**

Our sales cycle istypically long and unpredictable, making it difficult to plan our business. Economicconditions over the past several years have increased this uncertainty. Ourlong sales cycle requires us to invest resources in potential projects that maynot occur. In addition, our long and unpredictable sales cycle may cause us toexperience significant fluctuations in our future annual and quarterlyoperating results. It can also result in delayed revenues, difficulty inmatching revenues with expenses and increased expenditures. Our business,operating results or financial condition and stock price may suffer as a resultof any of these factors.

**Ifthe data storage industry fails to develop compelling new storage technologies,our business may suffer.**

Rapid and complextechnological change, frequent new product introductions and evolving industrystandards increase demand for our services. Because of this, our future successdepends in part on the data storage industry’s ability to continue to developleading-edge storage technology solutions. Our customers utilize our servicesin part because they know that newer technologies offer them significantbenefits over the older technologies they are using. If the data storageindustry ceases to develop compelling new storage solutions, or if a singledata storage standard becomes widely accepted and implemented, it will be moredifficult to sell new data storage systems to our customers.

**Wemay not be fully compliant with Sarbanes-Oxley regulations.**

Beginning with ouryear-end audit for 2007, Section 404 of the Sarbanes-Oxley Act of 2002will require us to formally assess and attest that our internal controls aresufficient to provide accurate reporting of financial results. We will engageour independent accountants to perform an audit of our assessment and issue anopinion on the sufficiency of our internal controls. We are in the beginningphases of our assessment. Although we expect to incur significant costs toachieve compliance, we do not know if we will be fully compliant with theregulations by the end of 2007. If we are not compliant, we may incuradditional costs to become compliant, we could lose our Nasdaq Stock Marketlisting and our stock price could be unfavorably impacted.

**Controlby our existing stockholders could discourage the potential acquisition of ourbusiness.**

Currently, our executiveofficers and directors beneficially own approximately 38% of our outstandingcommon stock. Acting together, these insiders may be able to elect our entireBoard of Directors and control the outcome of all other matters requiringstockholder approval. This voting concentration may also have the effect ofdelaying or preventing a change in our management or control or otherwisediscourage potential acquirers from attempting to gain control of us. Ifpotential acquirers are deterred, you may lose an opportunity to profit from apossible acquisition premium in our stock price.

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**Our stock price is volatile.**

The market price ofour common stock has fluctuated significantly since our initial publicoffering, and may continue to be volatile. We cannot assure you that our stockprice will increase, or even that it will not decline significantly from theprice you pay. Our stock price may be adversely affected by many factors,including:

·       actualor anticipated fluctuations in our operating results, including those resultingfrom changes in accounting rules;

·       announcementsof technical innovations;

·       newproducts or services offered by us, our suppliers or our competitors;

·       changesin estimates by securities analysts of our future financial performance;

·       ourcompliance with SEC and Nasdaq rules and regulations, including theSarbanes-Oxley Act of 2002; and

·       general market conditions,including the effects of economic conditions over the past several years and warand terrorism threats.

**Ourgoverning documents and Minnesota law may discourage the potential acquisitionsof our business.**

Our Board of Directors mayissue additional shares of capital stock and establish their rights,preferences and classes, in some cases without stockholder approval. Inaddition, we are subject to anti-takeover provisions of Minnesota law. Theseprovisions may deter or discourage takeover attempts and other changes incontrol of us not approved by our Board of Directors. If potential acquirersare deterred, you may lose an opportunity to profit from a possible acquisitionpremium in our stock price.

**Futuregoodwill impairment may unpredictably affect our financial results.**

We perform impairmentanalyses of our goodwill at least annually or when we believe there is animpairment. Future events could cause us to conclude that impairment indicatorsexist and that goodwill associated with our acquired businesses is impaired. Anyresulting impairment loss could have a material adverse impact on our financialcondition and results of operations.

**If wefail to elect an additional independent director to our Board, we may lose ourNasdaq Stock Market listing.**

In March 2006, one ofour directors, Gregory T. Barnum, accepted employment with us as our new ChiefFinancial Officer. At that time, Mr. Barnum resigned from our Board ofDirectors. This action left us with six directors, only three of whom we havedetermined are “independent” under the rules of the Nasdaq Stock Market. Nasdaqrequires that we have a majority of directors who are independent. Inaccordance with Nasdaq rules, we have until our next scheduled annual meeting(in May 2006) to correct this deficiency. Until we do so, Nasdaq will identifyus as a non-compliant company, which could adversely affect our stock price. Wecannot assure that we will timely identify and elect a new independent directoror obtain the resignation of a non-independent director to otherwise complywith the Nasdaq rules. If we fail to timely comply, Nasdaq could remove ourstock from trading, which could adversely affect our stock price.

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**Ourfuture recognition of the expenses associated with stock-based compensation mayadversely affect our stock price.**

In the first quarter of2006, we will adopt SFAS 123(R), which will require us to measure and recognizecompensation expense for all stock-based compensation based on estimated fairvalues. As a result, our operating results for 2006 and future years willcontain a charge for stock-based compensation related to restricted stock andstock options granted to employees and employee stock purchases. This charge isin addition to any stock-based compensation we have recognized in the past. SFAS 123(R)requires the use of an option pricing model to determine the fair value ofshare-based payment awards. Our stock price, as well as assumptions regarding anumber of highly complex and subjective variables, will affect ourdetermination of fair value. We cannot assure that the valuation models weapply will accurately measure the fair value of our stock-based compensation. Ourstock price may be adversely affected by the existence, amount orunpredictability of our future stock-based compensation expense.

**Item 1B.**               UnresolvedStaff Comments.

None.

**Item 2.**                        Properties.

We occupy 49,000 squarefeet of an office and warehouse facility in Chanhassen, Minnesota as ourcorporate headquarters, including our principal technical operations and ourintegration, assembly and support service operations. Our other 13 locationswhich house sales and technical staff are small-to-medium-sized officesthroughout the United States.

**Item 3.**                        LegalProceedings.

We are not currentlyinvolved in any material legal proceedings. We also had no material legalproceedings that terminated during the fourth quarter of 2005.

**Item 4.**                        Submissionof Matters to a Vote of Security Holders.

We submitted no matters during the fourth quarter of2005 to a vote of security holders, through the solicitation of proxies or otherwise.

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**PART II**

**Item 5.**                        Marketfor Registrant’s Common Equity, Related Stockholder Matters and IssuerPurchases of Equity Securities.

Ourcommon is quoted on the Nasdaq National Market under the symbol “DTLK”. Thetable below sets forth, for the calendar quarters indicated, the high and lowper share closing sale prices of our common stock as reported by the NasdaqNational Market.

| ** **                             | ** ** | **High**   | ** ** | **Low**    | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|
| **Year Ended December 31,  2005** | ** ** | ** ** | ** ** | ** ** | ** ** |
| First Quarter                          |       | $          | 3.23       |       | $          | 2.47 |   |
| Second Quarter                         |       | 3.09       |       | 1.86       |       |
| Third Quarter                          |       | 4.30       |       | 2.84       |       |
| Fourth Quarter                         |       | 4.22       |       | 3.01       |       |
| **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       |       |
|                                        |            |            |            |            |            |  |  |

 

On March 24, 2006, the closing price per share ofour common stock was $4.01. We urge potential investors to obtain currentmarket quotations before making any decision to invest in our common stock. On March 3,2006, there were approximately 89 holders of common stock, including recordholders and stockholders whose shares are held by a bank, broker or othernominee. However, we estimate that our shares are held through a small numberof record holders by over 1,536 beneficial owners.

Except for distributions paid to our pre-initialpublic offering corporation stockholders related to S corporation earningsgenerated prior to our initial public offering in 1999, we have paid nodividends on our common stock. We intend to retain future earnings for use inour business, and we do not anticipate paying any cash dividends on our commonstock in the foreseeable future.

We did not purchase any ofour securities during 2005. You can find additional information about ourequity compensation plans in Part III, Item 12 of this Annual Report on Form 10-K.

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**Item 6.**                        SelectedFinancial Data.

Youshould read the information below with our “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” and our financialstatements. We derived the data as of December 31, 2005 and 2004, and forthe years ended December 31, 2005, 2004 and 2003, from our financialstatements that are included in this Annual Report. We derived the data as of December 31,2003, 2002 and 2001, and for the years ended December 31, 2002 and 2001,from our financial statements not included in this Annual Report.

| ** **                                         | ** ** | **Year ended December 31,**                         | ** ** |
|----------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                         | ** ** | **2005**                                                           | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                         | ** ** | **(in thousands, except per share data)** | ** ** |
| **Statement of Operations Data:**                  |       |                                                               |       |   |   |   |   |   |   |   |   |
| Net sales:                                         |       |                                                               |       |   |   |   |   |   |   |   |   |
| Product sales                                      |       | $                                                                  | 81,582     |   | $ | 63,235 |   | $ | 61,350 |   | $ | 58,492 |   | $ | 96,188 |   |
| Service sales                                      |       | 35,531                                                             |       | 30,048 |   | 29,787 |   | 28,008 |   | 28,596 |   |
| Total net sales                                    |       | 117,113                                                            |       | 93,283 |   | 91,137 |   | 86,500 |   | 124,784 |   |
| Cost of sales:                                     |       |                                                               |       |   |   |   |   |   |   |   |   |
| Cost of product sales                              |       | 62,147                                                             |       | 48,568 |   | 47,477 |   | 44,776 |   | 70,393 |   |
| Cost of services                                   |       | 24,321                                                             |       | 21,175 |   | 20,198 |   | 20,000 |   | 20,328 |   |
| Total cost of  sales                               |       | 86,468                                                             |       | 69,743 |   | 67,675 |   | 64,776 |   | 90,721 |   |
| Gross profit                                       |       | 30,645                                                             |       | 23,540 |   | 23,462 |   | 21,724 |   | 34,063 |   |
| Operating  expenses:                               |       |                                                               |       |   |   |   |   |   |   |   |   |
| Sales and marketing                                |       | 15,062                                                             |       | 12,438 |   | 10,985 |   | 11,481 |   | 15,836 |   |
| General and administrative                         |       | 9,954                                                              |       | 10,366 |   | 10,960 |   | 10,354 |   | 11,221 |   |
| Engineering                                        |       | 5,121                                                              |       | 3,764 |   | 4,220 |   | 4,954 |   | 5,259 |   |
| Charge for sublease reserve (1)                    |       | 3,502                                                              |       | — |   | — |   | — |   | — |   |
| Restructuring charges (2)                          |       | —                                                             |       | (63 | ) | 2,078 |   | — |   | — |   |
| Amortization of goodwill and other intangibles (3) |       | 224                                                                |       | 261 |   | 724 |   | 1,088 |   | 2,264 |   |
| Total operating  expenses                          |       | 33,863                                                             |       | 26,766 |   | 28,967 |   | 27,877 |   | 34,580 |   |
| Operating loss                                     |       | (3,218                                                             | )          | (3,226 | ) | (5,505 | ) | (6,153 | ) | (517 | ) |
| Interest income,  net                              |       | 303                                                                |       | 83 |   | 74 |   | 117 |   | 127 |   |
| Loss before income taxes                           |       | (2,915                                                             | )          | (3,143 | ) | (5,431 | ) | (6,036 | ) | (390 | ) |
| Income tax  (benefit) expense (4)                  |       | —                                                             |       | — |   | (276 | ) | (618 | ) | 115 |   |
| Net loss                                           |       | $                                                                  | (2,915     | ) | $ | (3,143 | ) | $ | (5,155 | ) | $ | (5,418 | ) | $ | (505 | ) |
| Net loss per  common share:                        |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic                                              |       | $                                                                  | (0.28      | ) | $ | (0.31 | ) | $ | (0.50 | ) | $ | (0.56 | ) | $ | (0.06 | ) |
| Diluted                                            |       | $                                                                  | (0.28      | ) | $ | (0.31 | ) | $ | (0.56 | ) | $ | (0.50 | ) | $ | (0.06 | ) |
| Weighted average shares  outstanding:              |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic                                              |       | 10,318                                                             |       | 10,286 |   | 10,333 |   | 9,687 |   | 8,921 |   |
| Diluted                                            |       | 10,318                                                             |       | 10,286 |   | 10,333 |   | 9,687 |   | 8,921 |   |

 

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| ** **                              | ** ** | **As of December 31,** | ** ** |
|-----------------------------------------|------------|---------------------------------------|------------|
| ** **                              | ** ** | **2005**                              | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                              | ** ** | **(In thousands)**               | ** ** |
| **Balance  Sheet Data:**                |       |                                  |       |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents              |       | $                                     | 13,434     |   | $ | 12,663 |   | $ | 12,565 |   | $ | 10,334 |   | $ | 5,846 |   |
| Working capital                         |       | 9,385                                 |       | 10,007 |   | 11,488 |   | 13,477 |   | 10,729 |   |
| Total assets                            |       | 63,143                                |       | 47,069 |   | 36,094 |   | 44,785 |   | 46,768 |   |
| Note payable to  former stockholder (5) |       | —                                |       | — |   | — |   | — |   | 704 |   |
| Stockholders’ equity               |       | 15,835                                |       | 18,512 |   | 21,496 |   | 26,346 |   | 26,114 |   |
|                                         |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          We recorded a charge forsublease reserve of $3.5 million related to the sublease of approximately55,000 of the 104,000 square feet we formerly occupied as part of our corporateheadquarters in Chanhassen, Minnesota and the sale of a lot we owned next toour headquarters.

(2)          We recordedrestructuring expense as a result of cost reduction initiatives in the fourthquarter of 2003. These initiatives included severance expenses for headcountreductions, office closure expenses and a charge for impairment of our customerbase intangible asset.

(3)          With the adoption ofSFAS No. 142 on January 1, 2002, we ceased amortizing $5.5 million ofgoodwill.

(4)          Our 2002 income taxbenefit was offset by $1.6 million ofexpense for a valuation allowance for deferred tax assets. The ultimaterealization of deferred tax assets depends upon the generation of futuretaxable income during the periods in which those temporary differences becomedeductible. Based upon the level of taxable losses in 2005, 2004, 2003 and 2002and the near-term uncertainty of taxable income, management cannot reasonablypredict when or if we will realize these deductible differences.

(5)          Reflectsa $3.0 million promissory note, less payments made, issued to one of our formerstockholders 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 thefollowing discussion in conjunction with our financial statements and therelated notes included in Item 8. The following information includesforward-looking statements, the realization of which may be affected by certainimportant factors discussed under “Risk Factors.”

**OVERVIEW**

We are an independent architect of enterprise-classinformation storage infrastructures. We derive our revenues principally fromdesigning, installing and supporting data storage systems. Our solutions caninclude hardware products, such as disk arrays, tape systems and interconnectioncomponents and storage management software products. The market for datastorage products and services is large. IDC estimates that external diskstorage revenue grew more than 12% year over year and networked storage (SANand NAS) grew nearly 70% year over year. We have 14 locations throughout theUnited States with the highest concentration of revenues in the central states.

We sell support service contracts to most of ourcustomers. When customers purchase support services through us, customersreceive the benefit of integrated system wide support. We have a qualified,independent support desk that takes calls from customers, diagnoses the issuesthey are facing and either solves the problem or coordinates with Datalinkand/or vendor technical staff to meet the customer’s needs. Our support serviceagreements with our customers include an underlying agreement with the productmanufacturer. The manufacturer provides on-site support assistance ifnecessary. We defer revenues and direct costs resulting from these contracts,and amortize these revenues and expenses into operations, over the term of thecontracts, which are generally twelve months.

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The enterprise-class information storage market israpidly evolving and highly competitive. Our competition includes otherindependent storage system integrators, high end value added resellers,distributors, consultants and the internal sales force of our suppliers. Ourability to hire and retain qualified outside sales representatives andengineers with enterprise-class information storage experience is critical toeffectively competing in the marketplace and achieving our growth strategies.

In the past, we have experienced fluctuations in thetiming of orders from our customers, and we expect to continue to experiencethese 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 our installation and configuration services may alsodelay recognition of revenues. Economic conditions and competition also affectour customers’ decisions to place orders with us. As a result, our net salesmay fluctuate from quarter to quarter.

We view the currentdata storage market as providing significant opportunity for growth. Currently,Datalink’s market share is a small part of the overall market. However, theproviders of the data storage industry’s products and technologies areincreasing their utilization of indirect sales approaches to broaden theirreach and optimize their margins. Increasingly, they are turning to companiessuch as Datalink to sell their products. While these trends provide opportunityfor Datalink, we must improve our business model to generate sustainable,profitable growth. Our model requires highly skilled sales and technical staffwhich results in substantial fixed costs for us. We believe the best way toimprove our company and create long-term shareholder value is to focus onbuilding scaleable capabilities and a leverageable cost structure. Our currentstrategies are focused on:

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

·        Growingour customer support revenue and market share. We believe that our customersupport services offerings are becoming increasingly attractive to companieslooking for system-wide integrated support.

·        Increasingour professional services revenues. We believe there is an opportunity to sellmore of our data storage services such as implementation services, storageenvironment assessments and on-site data storage management and architectureservices.

·        Exploringpotential regional acquisitions that we believe can strengthen our resourcesand capabilities in key geographic locations.

To pursue thesestrategies, we are:

·        Improvingour training, tools and recruiting efforts for sales and engineering teams toincrease productivity.

·        Hiringadditional customer support staff and enhancing the customer support staff’scommunications and call management capabilities.

·        Developingmore effective delivery capabilities for professional services and solutions.

All of these planshave various challenges and risks associated with them, including that:

·        Wemay not 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 manyoptions for data storage products and services.

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·        Wemay not identify suitable acquisition candidates.

**Results of Operations**

Thefollowing table shows, for the periods indicated, certain selected financialdata expressed as a percentage of net sales.

| ** **                  | ** ** | **Years Ended December 31,** | ** ** |
|-----------------------------|------------|---------------------------------------------|------------|
| ** **                  | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net sales                   |       | 100.0                                       | %          | 100.0 | % | 100.0 | % |
| Cost of sales               |       | 73.8                                        |       | 74.8 |   | 74.3 |   |
| Gross profit                |       | 26.2                                        |       | 25.2 |   | 25.7 |   |
| Operating  expenses:        |       |                                        |       |   |   |   |   |
| Sales and marketing         |       | 12.8                                        |       | 13.3 |   | 12.1 |   |
| General and administrative  |       | 8.5                                         |       | 11.1 |   | 12.0 |   |
| Engineering                 |       | 4.4                                         |       | 4.0 |   | 4.6 |   |
| Charge for sublease reserve |       | 3.0                                         |       | — |   | — |   |
| Restructuring charges       |       | —                                      |       | — |   | 2.3 |   |
| Amortization of intangibles |       | 0.2                                         |       | 0.3 |   | 0.8 |   |
| Total operating  expenses   |       | 28.9                                        |       | 28.7 |   | 31.8 |   |
| Operating loss              |       | (2.7                                        | %)         | (3.5 | %) | (6.1 | %) |

 

**Comparisonof Years Ended December 31, 2005, 2004 and 2003**

Thefollowing table shows, for the periods indicated, revenue and gross profitinformation for our product and service sales.

| ** **                                               | ** ** | **Years Ended December 31,** | ** ** |
|----------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                               | ** ** | **2005**                                    | ** ** | **2004** | ** ** | **2003** | ** ** |
| Product sales                                            |       | $                                           | 81,582     |   | $ | 63,235 |   | $ | 61,350 |   |
| Service sales                                            |       | 35,531                                      |       | 30,048 |   | 29,787 |   |
| Product gross profit                                     |       | $                                           | 19,435     |   | $ | 14,667 |   | $ | 13,873 |   |
| Service gross  profit .                                  |       | 11,210                                      |       | 8,873 |   | 9,589 |   |
| Product gross profit as a percentage of product  sales . |       | 23.8                                        | %          | 23.2 | % | 22.6 | % |
| Service gross profit as  a percentage of service sales   |       | 31.5                                        | %          | 29.5 | % | 32.2 | % |

 

*NetSales.**  *Ourproduct sales increased 29.0% in 2005 from 2004 to $81.6 million, and increased3.1% in 2004 from 2003 to $63.2 million. Our service sales, which includecustomer support, consulting and installation services, increased 18.2% in 2005from 2004 to $35.5 million, and remained relatively flat between 2004 and 2003at $30.0 million as compared to $29.8 million.

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Theincrease in our product sales in 2005 as compared to 2004 reflects a greaternumber of customers funding large projects, particularly for enhanced datarecovery technology solutions. We had an increase in customers representingmore than $500,000 in annual revenues from 29 in 2004 to 43 in 2005. Since2003, we have continued to increase the productivity 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** | ** ** |
|---------------|------------|-------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------------------------------------|------------|
| 2005 vs. 2004 |       |                                                                    | 11         | %                                                                                                         |       |   | 13 | % |   |
| 2004 vs. 2003 |       |                                                                    | (10        | %)                                                                                                        |       |   | 13 | % |   |

 

The increase in the average number of accountexecutives from 2004 to 2005 reflects our hiring of experienced, qualityaccount executives in key geographic locations. The decline in the number of accountexecutives from 2003 to 2004 reflects our closure of selected offices andturnover primarily in late calendar 2003.

The increase in our service revenues for 2005 over2004 reflects an increase in all categories of our service revenue. Customersupport contract revenues increased $2.2 million or 9%, consulting servicerevenues increased $1.1 million or 81% and installation and configurationservice revenues increased $2.2 million or 64%. With the growth in ourproduct revenues, we continue to successfully sell our installation andconfiguration services. The slight increasein our service revenues between 2003 and 2004 reflects a $1.9 millionincrease in consulting service revenues, offset by a $1.1 million decrease ininstallation and configuration service revenues and a $360,000 decrease incustomer support contract revenues. In 2003, we completed a particularly largestorage solution installation and configuration project, but did not renew alarge customer support contract.

We derived approximately 10% of our sales from ourcustomer, Gateway, Inc., during 2003. We had no other customers thatcomprised more than 10% of our sales in 2003, 2004 or 2005.

*GrossProfit.**  *Ourtotal gross profit as a percentage of net sales increased to 26.2% in 2005 from25.2% in 2004, which was a decrease from 25.7% in 2003.

Product gross profit as a percentage of product salesincreased to 23.8% in 2005 as compared to 23.2% in 2004 and as compared to22.6% in 2003. The percentage improvement in both 2005 and 2004 reflects theincrease in enhanced data recovery technology solution purchases made by ourcustomers for which we achieved a higher gross profit. We have various programsin place with our vendors that provide economic incentives for achievingvarious sales performance targets. Achieving these targets contributedfavorably to our 2005 and 2004 product gross profit. These vendor incentiveprograms constantly change and we negotiate them separately with each vendor. Whilewe expect the incentive programs to continue, the vendors could modify ordiscontinue them, which would unfavorably impact our product gross profitmargins.

Service gross profit as a percentage of service salesincreased to 31.5% in 2005 as compared to 29.5% in 2004 and decreased ascompared to 32.2% in 2003. The percentage increase in 2005 as compared to 2004reflects an improvement in our gross profit percentage for customer supportcontract renewals. The percentage decrease in 2004 as compared to 2003 isprimarily due a single large installation and configuration project in 2003 onwhich we achieved a higher than normal gross profit percentage. For 2004, wealso failed to renew a few large customer support contracts.

*Salesand Marketing.**  *Salesand marketing expenses include wages and commissions paid to sales andmarketing personnel, travel costs and advertising, promotion and hiringexpenses. Sales and marketing expenses totaled $15.1 million, or 12.8% of netsales for 2005 as compared to $12.4 million, or 13.3% of net 

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sales for 2004 and $11.0million, or 12.1% of net sales for 2003. The increase in sales and marketingexpense in absolute dollars is primarily a result of higher commission andbonus expenses of $1.7 million due to the higher sales volume in 2005 ascompared to 2004. The increase in sales and marketing expense in absolutedollars for 2004 as compared to 2003 is also a result of higher commissionexpense of $1.7 million due to a change in compensation plans and highersales volume. The decrease in sales and marketing expense as a percentage ofnet sales from 2005 to 2004 reflects better leverage of our fixed costs asrevenues increased in 2005. The increase in sales and marketing expense as apercentage of net sales from 2004 as compared to 2003 resulted from theincrease in commission expenses due to compensation plan changes. As wecontinue to selectively hire additional outside sales representatives, oursales and marketing expenses may increase without a commensurate increase insales.

*Generaland 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 $9.9million, or 8.5% of net sales for 2005 compared to $10.4 million, or 11.1% ofnet sales for 2004 and $11.0 million, or 12.0% in 2003. The decrease in generaland administrative expenses in absolute dollars for 2005 as compared to 2004 isdue to a decrease  of $507,000 indepreciation expense primarily for our customer relationship management systemand reduced facilities expenses of $950,000 related to the sublease of ourChanhassen facility. This decrease was partially offset by an increase invariable compensation for executives and managers of $701,000 and an increasein accounting, legal and consulting fees of $187,000 for fees related to SECand Sarbanes-Oxley compliance activity. The decrease in general andadministrative expenses in absolute dollars in 2004 compared to 2003 is due tolower depreciation expense primarily for our customer relationship managementsystem of $225,000 and reduced facilities expenses of $412,000 related to ouroffice closures and subleases. Our general and administrative expenses werelower as a percentage of net sales for 2005 as compared to 2004 and for 2004 ascompared to 2003, due to the reduced spending coupled with an increase insales.

*Engineering.**  *Engineeringexpenses include employee wages and travel, hiring and training expenses forour field and customer support engineers and technicians. We allocateengineering costs associated with installation and configuration services andwith consulting services to our cost of service sales. Engineering expenses increased to $5.1 million, or 4.4% of net sales in2005 compared to $3.8 million, or 4.0% of net sales in 2004 and $4.2 million,or 4.6% of net sales in 2003. The increase in engineering expenses in absolutedollars for 2005 as compared to 2004 is due primarily to an increase incompensation expense of $1.0 million related to a 12% increase in headcountcoupled with higher health insurance expenses and variable compensationexpenses. The decrease in engineering expenses in absolute dollars for 2004 ascompared to 2003 is due to $862,000 of compensation savings associated with areduction in the number of engineers and engineering managers, offset by anincrease in outside consulting expenses of $155,000 and a $71,000 increase intravel and entertainment expenses.

The increase in engineering expenses as a percentageof sales for 2005 as compared to 2004 is the result of higher engineeringexpenses despite the growth in revenues. We added personnel resources for ourcustomer support desk staff. The decrease in engineering expenses as apercentage of sales for 2004 as compared to 2003 is the result of higherrevenues and lower expenses in 2004.

*OverallCost Reduction Initiatives.**  *Becauseof the difficult economic climate for technology spending that we faced overthe past several years, and with our recent operating losses, we have activelysought to reduce costs across our business. In October 2003, we announcedseveral cost reduction initiatives and management changes. These changesresulted in a fourth quarter 2003 charge of $2.1 million. As part of these costreduction initiatives, we reduced our staff by 16% in 2003. Employee severancecharges were $568,000. We also announced the closure of four offices. Officeclosing costs for lease terminations were $584,000. The office closuresincluded closing an office and terminating personnel from our 

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OpenSystems.com, Inc.acquisition in November 2000, resulting in an impairment of our customerbase intangible asset. The resulting impairment charge of the asset was$926,000.

In December 2004, we agreed to subleaseapproximately 55,000 of the 104,000 square feet we then occupied as ourcorporate headquarters in Chanhassen, Minnesota. The initial sublease term isco-terminal with our lease and is for 85 months starting in April 2005 andending in April 2012. The sublessee will pay us rent ranging fromapproximately $55,000 per month at the beginning of the term to approximately$60,000 per month by the end of the term. We also negotiated with our landlordto sell the 2.5 acre lot adjoining our facility for $200,000. In the firstquarter of 2005, we incurred a one-time, non-cash charge of $3.5 millionrelated to the sublease and lot sale. We obtained cost savings of approximately$950,000 in 2005 as a result of the sublease agreement and expect to achievecomparable savings in future years during the sublease term.

*IntangibleAmortization.**  *Amortizationof intangible assets decreased to $224,000 in 2005 from $261,000 in 2004 and$724,000 in 2003. The amortization relates primarily to our acquisition of thedata storage and services business of OpenSystems.com, Inc. in November 2000.We test for impairment of goodwill and intangibles annually or wheneverimpairment is indicated. For 2005 and 2004, we determined that our goodwill wasnot impaired. However, in the fourth quarter of 2003, we recorded an impairmentcharge on our OpenSystems.com customer base intangible asset in connection withour cost reduction initiatives. We fully amortized the remaining customer baseintangible asset in 2005. During 2003, we amortized the remaining $76,000balance of the customer base intangible asset we acquired in our July 1998acquisition of Direct Connect Systems, Inc.

*OperatingLoss.*   We incurred operating losses of $3.2million in 2005 and 2004 and $5.5 million in 2003. Since the restructuring in October 2003,our financial results have steadily improved. Excluding the sublease charge of$3.5 million in the first quarter of 2005, we generated operating income of$284,000 in 2005. In the fourth quarter of 2005, we generated net income of$1.0 million. However, we expect to post a slight net loss to a slight profitfor the first quarter ending March 31, 2006. This relates to an expecteddecrease in sales, typically our slowest quarter, and an expected increase inoperating expenses in the first quarter of 2006 primarily due to normalrecurring costs more heavily weighted to the early part of the year. The highercosts relate to payroll taxes, public reporting and benefit accruals.

The reduction in our operating losses of $2.3 millionfor 2004 as compared to 2003 is a result of $2.1 million of restructuringcharges included in the 2003 operating loss and the favorable impact of ourcost reduction efforts in 2004.

*IncomeTaxes.**  *We hadno income tax benefit or expense in 2005 or 2004. We provided for an income taxbenefit of $276,000 in 2003. The income tax benefit generated for 2003represents a higher than expected federal income tax refund from our 2002 taxreturn. The ultimate realization ofdeferred tax assets, which are currently fully reserved, is dependent uponcarry back to prior periods and upon the generation of future taxable incomeduring the periods in which those temporary differences become deductible.Based upon the level of taxable losses in 2005, 2004 and 2003 and the near-termuncertainty of taxable income, we cannot reasonably predict when or if we willrealize these deductible differences. In addition, we do not have the abilityto realize future income tax benefits on future losses.

21

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**Quarterly Results and Seasonality**

Thefollowing table sets forth our unaudited quarterly financial data for eachquarter of 2005 and 2004. We have prepared this unaudited information on thesame basis as the audited information. In our opinion, we have made alladjustments (including all normal recurring adjustments) necessary to presentfairly the information set forth below. The operating results for any quarterare not necessarily indicative of results for any future period.

| ** **               | ** ** | **Quarters Ended** | ** ** |
|--------------------------|------------|-------------------------|------------|
| ** **               | ** ** | **2005**                | ** ** | **2004** | ** ** |
| ** **               | ** ** | **Mar. 31**        | ** ** | **Jun. 30** | ** ** | **Sep. 30** | ** ** | **Dec. 31** | ** ** | **Mar. 31** | ** ** | **Jun. 30** | ** ** | **Sep. 30** | ** ** | **Dec. 31** | ** ** |
| ** **               | ** ** | **(in thousands)** | ** ** |
| Net sales                |       | $                       | 21,241     |   | $ | 28,741 |   | $ | 31,233 |   | $ | 35,898 |   | $ | 20,204 |   | $ | 21,463 |   | $ | 25,633 |   | $ | 25,983 |   |
| Gross profit             |       | 5,759                   |       | 7,614 |   | 8,057 |   | 9,215 |   | 5,008 |   | 5,232 |   | 5,868 |   | 7,432 |   |
| Operating income  (loss) |       | (4,775                  | )          | 388 |   | 219 |   | 950 |   | (1,860 | ) | (1,047 | ) | (735 | ) | 416 |   |
| Net income (loss)        |       | (4,701                  | )          | 446 |   | 295 |   | 1,045 |   | (1,840 | ) | (1,031 | ) | (717 | ) | 445 |   |
|                          |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

We have experienced, andexpect to continue to experience, quarterly variations in our net sales as aresult of a number of factors, including the length of the sales cycle withcustomers for large storage system evaluations and purchases, delays in storagesystem installations or configurations, new product introductions by suppliersand their market acceptance, delays in product shipments or other qualitycontrol difficulties, trends in the enterprise-class information storageindustry in general or the geographic and industry specific markets in which weare currently active, or may be in the future. In addition, economic conditionsand competition also affect our customers’ decisions to place orders with us. Further,our success in integrating any acquired business or in opening any new fieldoffices could impact our net sales.

**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 $9.4 million at December 31,2005 as compared to $10.0 million at December 31, 2004. Our current ratiowas 1.2:1 at December 31, 2005 as compared to 1.4:1 at December 31,2004. At December 31, 2005, our cash and cash equivalents balance was$13.4 million.

Cash provided byoperating activities for 2005 was $1.7 million as compared to $396,000 in 2004and $3.2 million in 2003. Significant items which impacted our operating cashflows in 2005 were:

·       A$7.2 million increase in accounts receivable reflecting increasing salesactivity over the prior year.

·       An$8.6 million increase in accounts payable reflecting the increase in businesswith our vendors for our increasing sales activity.

·       Anet increase of $2.5 million related to the sublease of part of our Chanhassenfacility. This includes the $3.5 million non-cash charge related to thesublease and lot sale offset by $1.0 million of amortization for the year.

·       A$2.9 million increase in inventories shipped but not installed for our backlogof orders at the beginning of 2006.

·       Anet $1.6 million increase in deferred customer support contracts. While weamortize the revenues from these contracts over the life of the contract, thecustomer typically pays for the contracts at the beginning of the contractperiod which favorably impacts our cash flows.

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The cash providedin 2004 resulted from:

·       A$3.0 million increase in accounts receivable, reflecting increasing salesactivity offset by an increase in accured expenses for employee bonusincentives.

·       A$2.2 million increase in accounts payable due to higher sales activity.

·       Anet increase in $1.0 million in deferred customer support contracts.

The cash provided in 2003 resulted primarily from areduction in our net operating assets. This included a $2.0 million income taxrefund, a $1.9 million reduction in inventory shipped but not installed withfewer projects left to be installed at year end, a $441,000 reduction in fieldevaluation inventory and a $3.9 million reduction in accounts receivable due toan improvement in our days sales outstanding. These reductions were partiallyoffset by a $3.5 million reduction in accounts payable.

Cash used in investing activities was $1.1 million in2005, $415,000 in 2004 and $1.1 million in 2003. In 2005, we used this cash tocomplete the facility build-out related to our Chanhassen sublease, purchasecomputer equipment and provide further enhancements to our web-enabledreporting tools. In 2004, we used this cash to purchase computer equipment,complete a data warehouse project and provide further enhancements to ourbusiness reporting software tool. In 2003, we used this cash to complete ourown storage and data recovery project, purchase computer equipment and providefurther enhancements to our customer relationship management informationsystems and our business reporting software tool.

Cash provided in financing activities in 2005, 2004and 2003 was $148,000, $117,000 and $111,000, respectively, all of which wereceived from stock sold under our employee stock purchase plan and from theexercise of options. We discontinued our employee stock purchase plan in December 2005.

Our bank revolving credit facility expired in June 2004.We have not renewed it or pursued a new facility. We have no outstanding debt,and if the need should arise to borrow funds, we believe that we could obtain asecured facility. For more information, see Note 4 of the Notes to ourFinancial Statements.

Wehave an 11-year non-cancelable operating lease for our corporateheadquarters in Chanhassen, Minnesota which expires in 2012. The lease requiresannual base rental payments of approximately $1.3 million.  In December 2004, we agreed to subleaseapproximately 55,000 of the 104,000 square feet we then occupied. The initialterm of the sublease is co-terminal with our lease and is for 85 monthsstarting in April 2005 and ending in April 2012. The subleaserequires rent payments ranging from $55,000 per month at the beginning of theterm to approximately $60,000 per month by the end of the term. For more information, see Note 6 of the Notes toour Financial Statements.

**ContractualObligations and Commitments**

As of December 31,2005, our contractual cash obligations consisting of future minimum leasepayments due under non-cancelable operating leases are as follows:

| ** ** | ** ** | **(in thousands)** | ** ** |
|------------|------------|-------------------------|------------|
| ** ** | ** ** | **Lease  Obligations**  | ** ** | **Sublease  Agreements** | ** ** | **Net Lease  Obligations** | ** ** |
| 2006       |       |                    | $          | 2,098 |   |   |   | $ | (1,138 | ) |   |   | $ | 960 |   |   |
| 2007       |       |                    | 1,771      |   |   |   | (1,120 | ) |   |   | 651 |   |   |
| 2008       |       |                    | 1,502      |   |   |   | (1,053 | ) |   |   | 449 |   |   |
| 2009       |       |                    | 1,504      |   |   |   | (1,053 | ) |   |   | 451 |   |   |
| 2010       |       |                    | 1,397      |   |   |   | (1,053 | ) |   |   | 344 |   |   |
| Thereafter |       |                    | 1,686      |   |   |   | (1,404 | ) |   |   | 282 |   |   |
|       |       |                    | $          | 9,958 |   |   |   | $ | (6,821 | ) |   |   | $ | 3,137 |   |   |

 

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In December 2004,we agreed to sublease approximately 55,000 of the 104,000 square feet we thenoccupied as our corporate headquarters in Chanhassen, Minnesota. The initialsublease term is co-terminal with our lease and is 85 months starting in April 2005and ending in April 2012. The sublessee pays us rent ranging fromapproximately $55,000 per month at the beginning of the term to approximately$60,000 per month by the end of the term. The rent includes the costs of commonarea management, common systems repairs, real estate taxes and standardutilities. We also negotiated with our landlord to sell the 2.5 acre lotadjoining our facility for $200,000, which we originally acquired in 2001 for$384,000. We incurred the following charges in the first quarter of 2005associated with our sublease and related activities:

| **Item**                                                     | ** ** | ** ** | ** ** | **Sublease Charge** | ** ** |
|--------------------------------------------------------------|------------|------------|------------|--------------------------|------------|
| Rent reserve  (excess of lease expense over sublease income) |       |       | $          | 3,069,000                |       |   |
| Accelerated  depreciation                                    |       |       | 249,000    |                     |       |
| Loss on land sale                                            |       |       | 184,000    |                     |       |
| Total                                                        |       |       | $          | 3,502,000                |       |   |

 

We also incurred cash expenditures, for leaseholdimprovements and transaction fees, associated with our sublease and the relatedactivities, net of the proceeds from our lot sale, at $822,000. We capitalizedthese cash outlays and are amortizing them over the lease term.

We believe that ourcurrent cash balance and funds generated from operations will finance ourcurrent operations and planned capital expenditures for at least the nexttwelve months. We believe if the need should arise to borrow funds, we couldobtain a secured facility. We are planningfor $500,000 to $1.0 million of capital expenditures during 2006 primarilyrelated to enhancements to our management information systems.

**CriticalAccounting 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 the following represent the areas where weuse more critical estimates and assumptions in the preparation of our financialstatements:

*RevenueRecognition.**  *Werealize revenue from the design, installation and support of data storagesolutions, which may include hardware, software and services. We recognizerevenue when we have met our obligations for installation or other services andcollectability is reasonably assured.

*ProductSales.**  *We sellsoftware and hardware products on both a “free-standing” basis without anyservices and as data storage solutions bundled with our installation andconfiguration services (“bundled arrangements”).

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

*ProductSales With Service.**  *If wesell a bundled arrangement, then we defer recognizing any revenues on it untilwe finish our installation and/or configuration work. We account for thehardware, software and service elements of our bundled arrangements by applyingthe provisions of Statement of Position (SOP) 97-2, Software RevenueRecognition, as amended by SOP 98-4 and SOP 98-9.

Pursuant to the provisions of SOP 97-2, we applycontract accounting to our bundled arrangements. In accordance with SOP 81-1,“Accounting for Performance of Construction Type and Certain Production 

24

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Type Contracts,” we applythe completed contract method. Factors we have considered in applying thecompleted contract method accounting include (i) the relatively shortduration of our contracts, (ii) the difficulty of estimating our revenueson a percentage-of-completion method and (iii) our use of acceptanceprovisions on larger bundled arrangements.

*ServiceSales.**  *Inaddition to installation and configuration services that are part of ourbundled arrangements described above, our service sales include customersupport contracts and consulting services. On our balance sheet, deferredrevenue relates to service sales for which our customer has paid us or has beeninvoiced but for which we have not yet performed the applicable services.

*CustomerSupport Contracts.**  *We sellservice contracts to most of our customers. These contracts are support serviceagreements. We have an internal support desk that provides integrated customersupport services, including configuration and usage assistance, technicaladvice and prompt incident detection and resolution. Our technical staff firstassists a customer in identifying the source of system problems and indetermining whether there is defective hardware or software. If our customerrequires on-site maintenance or repair services, we arrange for a service callpursuant to underlying third-party support service agreements we have with ourhardware and software vendors.

When we sell a service contract as part of a bundledarrangement, we use vendor specific objective evidence to allocate revenue tothe service contract element. In all cases, we defer revenues and direct costsresulting from our service contracts and amortize them into operations over theterm of the contracts, which are generally twelve months. We are contractuallyobligated to provide or arrange to provide these underlying support services toour customers in the unlikely event that the hardware or software vendor, orits designee, fails to perform according to the terms of its contact.

*ConsultingServices.**  *Some ofour customers engage us to analyze their existing storage architectures andoffer our recommendations. Other customers engage us to assist them on-sitewith extended data storage projects, to support their data storage environmentsand to help with long-term data storage design challenges. 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 ofRevenues.**  *Wereport our revenues from the sale of hardware and software products on a gross,rather than a net, basis. In reporting our revenues on a gross basis, weconsidered that:

·       Weare the primary obligor to our customers. We are responsible for fulfillment,including the acceptability of the products 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.

*CommissionExpense.**  *Weutilize a direct sales force to generate virtually all of our revenues. We payour sales people a combination of base salary and commissions. We paycommissions based on the amount of gross profit generated from the products andservices sold. We match commissions to the appropriate transactions andrecognize commission expense at the time we recognize the related revenues andgross profit.

*Inventory.**  *We periodically review, estimate and adjust ourreserves for obsolete or unmarketable inventory equal to the difference betweenthe inventory cost and the estimated market value based upon assumptions aboutfuture demand and market conditions. Results could be materially different ifdemand for our products decreased because of economic or competitiveconditions, length of industry downturn, or if products become obsolete becauseof technical advancements in the industry.

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*Valuationof Goodwill and Other Intangible Assets.**  *We test goodwill for impairmentannually or more frequently if changes in circumstance or the occurrence ofevents suggests an impairment exists. The test for impairment requires us tomake several estimates about fair value, most of which are based on totalmarket capitalization as compared to the carrying value of our net assets. If our total market capitalization is at orbelow the carrying value of our net assets, it may prompt us to engage a thirdparty valuation firm to perform a valuation of us to further assess whether ourgoodwill or other intangibles are impaired pursuant to SFAS 142. We consider ourgoodwill impairment test estimates critical due to the amount of goodwillrecorded on our balance sheet and the judgment required in determining fairvalue amounts.

*IncomeTaxes.*   We utilize the asset and liability methodof accounting for income taxes. We recognize deferred tax liabilities or assetsfor the expected future tax consequences of temporary differences between thebook and tax bases of assets and liabilities. We regularly assess thelikelihood that we will recover our deferred tax assets from future taxableincome  We record a valuation allowanceto reduce our deferred tax assets to the amounts we believe are more likelythan not to be realizable. We consider projected future taxable income andongoing tax planning strategies in assessing the amount of the valuationallowance. If we determine it is more likely than not that we will not realizeall or part of our deferred tax assets, we will adjust our earnings for thedeferred tax in the period we make this determination.

As a result of ourcumulative losses over the past two years and the full utilization of our losscarry back potential, we have made a full valuation allowance against our netdeferred tax assets. The valuation allowance at December 31, 2005 was $4.8million. In addition, we expect to provide a full valuation allowance on anyfuture tax benefits until we can sustain a level of profitability thatdemonstrates our ability to realize these assets. 

**Recent Accounting Pronouncements**

In December 2004, theFinancial Accounting Standards Board published FASB Statement No. 123(revised 2004), *Share-Based Payment* (“SFAS 123(R)”). In March 2005,the U.S. Securities and Exchange Commission issued Staff Accounting BulletinNo. 107 relating to the adoption of SFAS 123(R). SFAS 123(R), which willbegin to apply in our first quarter of 2006, requires us to recognize thecompensation cost relating to share-based payment transactions, includinggrants of employee stock options, in our financial statements. We are tomeasure this cost based on the fair value of the equity or liabilityinstruments issued at the grant date. The cost of employee services received inexchange for an award of liability instruments is measured initially at fairvalue and re-measured subsequently at each reporting date through thesettlement date. SFAS 123(R) covers a wide range of share-basedcompensation arrangements, including stock options, restricted share plans,performance-based awards, share appreciation rights and employee share purchaseplans.

**Inflation**

We do not believe that inflation has had a materialeffect on our results of operations in recent years. We cannot assure you thatinflation will not adversely affect our business in the future.

**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.

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*Interestrate risk.**  *As of December 31,2005, we had $13.4 million of cash and money market accounts. A decrease inmarket rates of interest would have no material effect on the value of theseassets or the related interest income due to the nature of money marketaccounts. We have no short or long-term debt.

*Foreigncurrency exchange rate risk.**  *Wemarket and sell all of our products and services in the United States.Therefore, we are not currently exposed to any direct foreign currency exchangerate risk.

*Equityprice risk.**  *We donot own any equity investments. Therefore, we are not currently exposed to anydirect equity price risk.

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**Item 8.**                        FinancialStatements and Supplementary Data.

Report of Independent Registered Public AccountingFirm

Tothe Board of Directors

DatalinkCorporation

Chanhassen, Minnesota

We have audited the accompanying balance sheets ofDatalink Corporation as of December 31, 2005 and 2004 and the relatedstatements of operations, changes in stockholders’ equity and cash flows foreach of the years in the two year period then ending. These financialstatements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and the significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide 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 31,2005 and 2004, and the results of its operations and its cash flows for each ofthe years in the two year period then ending, in conformity with accountingprinciples generally accepted in the United States of America.

/s/ McGLADREY & PULLEN, LLP

Minneapolis, Minnesota

January 26, 2006

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Report of Independent Registered Public AccountingFirm

TheBoard of Directors and Stockholders

Datalink Corporation:

We have audited the accompanying statements ofoperations, stockholders’ equity and cash flows of Datalink Corporation for theyear ended December 31, 2003. These financial statements are theresponsibility of the Company’s management. Our responsibility is to express an opinion on these financialstatements based on our audit.  

We conducted our audit in accordance with auditingstandards generally accepted in the United States of America.  Those standards require that we plan andperform the audit to obtain reasonable assurance about whether the financialstatements are free of material misstatement. An audit includes examining, on a test basis, evidence supporting theamounts and disclosures in the financial statements.  An audit also includes assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation.  We believe that our audit provides areasonable basis for our opinion.

In our opinion, thefinancial statements referred to above present fairly, in all materialrespects, the results of operations and cash flows of Datalink Corporation forthe year ended December 31, 2003 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 CORPORATIONBALANCE SHEETS(In thousands, except share data)**

| ** **                                                                                                                                                                  | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                  | ** ** | **2005**              | ** ** | **2004** | ** ** |
| **Assets**                                                                                                                                                                  |       |                  |       |   |   |
| Current assets:                                                                                                                                                             |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                   |       | $                     | 13,434     |   | $ | 12,663 |   |
| Accounts receivable, net                                                                                                                                                    |       | 18,673                |       | 11,485 |   |
| Inventories                                                                                                                                                                 |       | 831                   |       | 627 |   |
| Deferred customer support contract costs                                                                                                                                    |       | 16,500                |       | 10,770 |   |
| Inventories shipped but not installed                                                                                                                                       |       | 5,064                 |       | 2,343 |   |
| Other current assets                                                                                                                                                        |       | 261                   |       | 284 |   |
| Total current assets                                                                                                                                                        |       | 54,763                |       | 38,172 |   |
| Property and  equipment, net                                                                                                                                                |       | 2,476                 |       | 3,134 |   |
| Goodwill                                                                                                                                                                    |       | 5,500                 |       | 5,500 |   |
| Intangibles, net                                                                                                                                                            |       | —                |       | 225 |   |
| Other assets                                                                                                                                                                |       | 404                   |       | 38 |   |
| Total assets                                                                                                                                                                |       | $                     | 63,143     |   | $ | 47,069 |   |
| **Liabilities and Stockholders’ Equity**                                                                                                                               | ** ** |                  |       | ** ** | ** ** |
| Current liabilities:                                                                                                                                                        |       |                  |       |   |   |
| Accounts payable                                                                                                                                                            |       | $                     | 19,660     |   | $ | 11,031 |   |
| Accrued commissions                                                                                                                                                         |       | 1,359                 |       | 1,227 |   |
| Accrued income taxes                                                                                                                                                        |       | 70                    |       | 109 |   |
| Accrued sales and use taxes                                                                                                                                                 |       | 645                   |       | 510 |   |
| Accrued expenses, other                                                                                                                                                     |       | 1,893                 |       | 1,276 |   |
| Sublease reserve current                                                                                                                                                    |       | 384                   |       | — |   |
| Deferred revenue from customer support contracts                                                                                                                            |       | 21,367                |       | 14,012 |   |
| Total current liabilities                                                                                                                                                   |       | 45,378                |       | 28,165 |   |
| Deferred rent                                                                                                                                                               |       | 289                   |       | 392 |   |
| Sublease reserve  non-current                                                                                                                                               |       | 1,641                 |       | — |   |
| Total liabilities                                                                                                                                                           |       | 47,308                |       | 28,557 |   |
| Commitments and  contingencies (Notes 6, 7, 9 and 11)                                                                                                                       |       |                  |       |   |   |
| Stockholders’  equity:                                                                                                                                                 |       |                  |       |   |   |
| Common stock, $0.001 par value, 50,000,000 shares  authorized, 10,404,105 and 10,282,545 shares issued and outstanding as of  December 31, 2005 and 2004, respectively |       | 10                    |       | 10 |   |
| Additional paid-in capital                                                                                                                                                  |       | 26,555                |       | 26,624 |   |
| Deferred compensation                                                                                                                                                       |       | —                |       | (307 | ) |
| Accumulated deficit                                                                                                                                                         |       | (10,730               | )          | (7,815 | ) |
| Total stockholders’ equity                                                                                                                                             |       | 15,835                |       | 18,512 |   |
| Total liabilities  and stockholders’ equity                                                                                                                            |       | $                     | 63,143     |   | $ | 47,069 |   |

 

The accompanying notes are an integral part of these financial statements.

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**DATALINK CORPORATIONSTATEMENTS OF OPERATIONS(In thousands, except per share data)**

| ** **                              | ** ** | **Year Ended December 31,** | ** ** |
|-----------------------------------------|------------|--------------------------------------------|------------|
| ** **                              | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Net sales:                              |       |                                       |       |   |   |   |   |
| Product sales                           |       | $                                          | 81,582     |   | $ | 63,235 |   | $ | 61,350 |   |
| Service sales                           |       | 35,531                                     |       | 30,048 |   | 29,787 |   |
| Total net sales                         |       | 117,113                                    |       | 93,283 |   | 91,137 |   |
| Cost of sales:                          |       |                                       |       |   |   |   |   |
| Cost of product sales                   |       | 62,147                                     |       | 48,568 |   | 47,477 |   |
| Cost of services                        |       | 24,321                                     |       | 21,175 |   | 20,198 |   |
| Total cost of  sales                    |       | 86,468                                     |       | 69,743 |   | 67,675 |   |
| Gross profit                            |       | 30,645                                     |       | 23,540 |   | 23,462 |   |
| Operating  expenses:                    |       |                                       |       |   |   |   |   |
| Sales and marketing                     |       | 15,062                                     |       | 12,438 |   | 10,985 |   |
| General and administrative              |       | 9,953                                      |       | 10,366 |   | 10,960 |   |
| Engineering                             |       | 5,121                                      |       | 3,764 |   | 4,220 |   |
| Charge for sublease reserve             |       | 3,502                                      |       | — |   | — |   |
| Restructuring charges                   |       | —                                     |       | (63 | ) | 2,078 |   |
| Amortization of intangibles             |       | 225                                        |       | 261 |   | 724 |   |
| Operating loss                          |       | (3,218                                     | )          | (3,226 | ) | (5,505 | ) |
| Interest income                         |       | 303                                        |       | 83 |   | 74 |   |
| Loss before  income taxes               |       | (2,915                                     | )          | (3,143 | ) | (5,431 | ) |
| Income tax  benefit                     |       | —                                     |       | — |   | (276 | ) |
| Net loss                                |       | $                                          | (2,915     | ) | $ | (3,143 | ) | $ | (5,155 | ) |
| Net loss per  share, basic and diluted: |       |                                       |       |   |   |   |   |
| Loss per share                          |       | $                                          | (0.28      | ) | $ | (0.31 | ) | $ | (0.50 | ) |
| Weighted average  shares outstanding:   |       |                                       |       |   |   |   |   |
| Basic and diluted                       |       | 10,318                                     |       | 10,268 |   | 10,227 |   |

 

The accompanying notes are an integral part of these financial statements.

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**DATALINK CORPORATIONSTATEMENTS OF STOCKHOLDERS’EQUITY(In thousands, except per share data)**

| ** **                                                                      | ** ** | ** **            | ** ** | ** **     | ** ** | ** **               | ** ** | **Retained**     | ** ** | ** **   | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------------|------------|----------------|------------|--------------------------|------------|------------------|------------|--------------|------------|
| ** **                                                                      | ** ** | ** **            | ** ** | ** **     | ** ** | **Unearned**             | ** ** | **Earnings/**    | ** ** | ** **   | ** ** |
| ** **                                                                      | ** ** | **Common Stock** | ** ** | **Additional** | ** ** | **Restricted**           | ** ** | **(Accumulated** | ** ** | ** **   | ** ** |
| ** **                                                                      | ** ** | **Shares**            | ** ** | **Amount**     | ** ** | **Paid-in Capital** | ** ** | **Stock**        | ** ** | **Deficit)** | ** ** | **Total** | ** ** |
| 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 |   |
| Net loss                                                                        |       | —                |       |           | —     |                     |       |             | —     |         |       |   | — |   |   |   | (2,915 | ) |   | (2,915 | ) |
| Restricted stock  grant                                                         |       | 63                    |       |           |       |                     |       |             | (217       | )            |       |   | 307 |   |   |   |   |   |   | 90 |   |
| Common shares  issued under employee stock purchase plan and stock option plans |       | 58                    |       |           | —     |                     |       |             | 148        |         |       |   | — |   |   |   | — |   |   | 148 |   |
| Balances,  December 31, 2005                                               |       | 10,404                |       |           | $          | 10                       |       |             |       | $            | 26,555     |   |   |   | $ | — |   |   |   | $ | (10,730 | ) |   | $ | 15,835 |   |

 

The accompanying notes are an integral part of these financial statements.

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**DATALINK CORPORATIONSTATEMENTS OF CASH FLOWS(In thousands)**

| ** **                                                                       | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                       | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| Cash flows from  operating activities:                                           | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net loss                                                                         |       | $                                          | (2,915     | ) | $ | (3,143 | ) | $ | (5,155 | ) |
| Adjustments to  reconcile net loss to net cash provided by operating activities: |       |                                       |       |   |   |   |   |
| Provision (recoveries) for bad debts                                             |       | 36                                         |       | (14 | ) | (34 | ) |
| Depreciation and amortization                                                    |       | 1,277                                      |       | 1,781 |   | 2,092 |   |
| Amortization of intangibles                                                      |       | 225                                        |       | 260 |   | 724 |   |
| Impairment of customer base intangible                                           |       | —                                     |       | — |   | 926 |   |
| Deferred rent                                                                    |       | (103                                       | )          | (130 | ) | 181 |   |
| Charge for sublease reserve                                                      |       | 3,502                                      |       | — |   | — |   |
| Amortization of sublease reserve                                                 |       | (1,030                                     | )          | — |   | — |   |
| Stock compensation expense                                                       |       | 90                                         |       | 42 |   | 194 |   |
| Loss on sale of assets                                                           |       | —                                     |       | — |   | 10 |   |
| Changes in  operating assets and liabilities:                                    |       |                                       |       |   |   |   |   |
| Accounts receivable                                                              |       | (7,224                                     | )          | (2,930 | ) | 3,912 |   |
| Inventories                                                                      |       | (2,925                                     | )          | 1,159 |   | 2,340 |   |
| Deferred customer support contract costs/revenues,  net                          |       | 1,625                                      |       | 1,039 |   | (231 | ) |
| Accounts payable                                                                 |       | 8,629                                      |       | 892 |   | (3,528 | ) |
| Accrued expenses                                                                 |       | 845                                        |       | 1,351 |   | (117 | ) |
| Other                                                                            |       | (343                                       | )          | 89 |   | 1,902 |   |
| Net cash provided by operating activities                                        |       | 1,689                                      |       | 396 |   | 3,216 |   |
| Cash flows from  investing activities:                                           |       |                                       |       |   |   |   |   |
| Purchase of property and equipment                                               |       | (1,266                                     | )          | (415 | ) | (1,096 | ) |
| Proceeds from sale of property and equipment                                     |       | 200                                        |       | — |   | — |   |
| Net cash used in investing activities                                            |       | (1,066                                     | )          | (415 | ) | (1,096 | ) |
| Cash flows from  financing activities:                                           |       |                                       |       |   |   |   |   |
| Proceeds from issuance of common stock                                           |       | 148                                        |       | 117 |   | 111 |   |
| Net cash provided by financing activities                                        |       | 148                                        |       | 117 |   | 111 |   |
| Increase in cash  and cash equivalents                                           |       | 771                                        |       | 98 |   | 2,231 |   |
| Cash and cash  equivalents, beginning of year                                    |       | 12,663                                     |       | 12,565 |   | 10,334 |   |
| Cash and cash  equivalents, end of year                                          |       | $                                          | 13,434     |   | $ | 12,663 |   | $ | 12,565 |   |
| **Supplementary  cash flow information:**                                        | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash received for  income taxes                                                  |       | —                                     |       | 58 |   | 2,242 |   |
| **Supplementary  non-cash investing and financing activities:**                  |       |                                       |       |   |   |   |   |
| Issuance of restricted  stock                                                    |       | 217                                        |       | — |   | — |   |

 

The accompanying notes are an integral part of these financial statements.

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**DATALINKCORPORATIONNOTES 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. Summaryof Significant Accounting Policies:**

***Cash and Cash Equivalents:***

Cash equivalents consist principally of money marketfunds with original maturities of three months or less, are readily convertibleto cash and are stated at cost, which approximates fair value. The Companymaintains its cash in bank deposit and money market accounts which, at times,may exceed federally insured limits. The Company has not experienced any lossesin such accounts.

***Accounts Receivable, 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 fordoubtful accounts by regularly evaluating individual customer receivables andconsidering a customer’s financial condition and credit history and current economicconditions. Trade receivables are written off when deemed uncollectible. Recoveriesof trade receivables previously written off are recorded when received.

Accounts receivable are recorded net of the reservefor doubtful accounts of $72,000 and $70,000 at December 31, 2005 and2004, respectively.

***Concentration of Credit Risk:***

During 2003, net sales from our customer, Gateway, Inc.,10% of total net sales. The Company had no other customers that comprised morethan 10% of its sales in 2003, 2004 or 2005. The balance of accounts receivablefor this customer as a percentage of total accounts receivable as of December 31,2005 and 2004, respectively is 0% and 0%.

***Software Development Costs:***

In compliance with the American Institute of CertifiedPublic Accountants (AICPA) Statement of Position 98-1, Accounting forComputer Software Developed for or Obtained for Internal Use, the Companycapitalized certain costs associated with software developed or obtained forinternal use.

During 2000, the Company began the implementation of anew customer relationship management (CRM) application suite which wascompleted in 2003. The Company capitalized costs of the implementation of$234,000 in 2003. The system is complete and no further costs are expected. Amountsare being amortized over a period of 3 years from the date they are availablefor use. The Company has also capitalized other software develop costs forenhancements to our business reporting software tool. Amortization of softwarecosts were $543,000 in 2005, $729,000 in 2004, and $815,000 in 2003.

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***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. Inventories have been reduced by obsolete and slowmoving reserves of $100,000 and $71,000 at December 31, 2005 and 2004,respectively.

***Property and Equipment:***

Propertyand equipment, including purchased software, are stated at cost. Depreciationand amortization are provided by charges to operations using the straight-linemethod over the estimated useful lives of the assets (ranging from 2 to 10years). 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,**   | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|
| ** **                                      | ** ** | **2005**                | ** ** | **2004** | ** ** |
| ** **                                      | ** ** | **(In thousands)** | ** ** |
| Property and equipment:                         |       |                    |       |   |   |
| Land                                            |       | $                       | —     |   | $ | 384 |   |
| Construction in process                         |       | 74                      |       | 53 |   |
| Leasehold improvements                          |       | 1,023                   |       | 512 |   |
| Furniture and fixtures                          |       | 2,122                   |       | 2,405 |   |
| Equipment                                       |       | 902                     |       | 901 |   |
| Computers and software                          |       | 9,195                   |       | 8,720 |   |
|                                            |       | 13,316                  |       | 12,975 |   |
| Less accumulated  depreciation and amortization |       | 10,840                  |       | 9,841 |   |
|                                            |       | $                       | 2,476      |   | $ | 3,134 |   |

 

***Goodwill:***

In accordance with Financial Accounting StandardsBoard (FASB) Statement No. 142, goodwill is tested for impairmentannually, and additionally if an event occurs or circumstances change thatwould indicate the carrying amount may be impaired. Impairment testing for goodwillis 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 itsimpairment assessments for December 31, 2005 and 2004, and determined thatno impairment existed.

***Intangibles, net:***

Identifiable intangible assets were amortized on astraight-line basis over their estimated useful lives of 3 to 7 years. InOctober 2003, the Company announced several cost reduction actions. Theseactions included the closing an office and terminating personnel acquired bythe Company from OpenSystems.com in November 2000, resulting in animpairment of the Company’s customer base intangible 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 the undiscounted cash flows with the netbook value of the intangible asset which indicated 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 remainingbalance of the intangible was fully amortized in 2005.

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***Valuation of Long-Lived Assets:***

The Company periodically (at least annually) analyzesits long-lived assets, including identifiable intangible assets with discretelives, for potential impairment, assessing the appropriateness of lives andrecoverability of unamortized balances through measurement of undiscountedoperating cash flows on a basis consistent with generally accepted accountingprinciples.

***Stock Options:***

As permitted by Statement of Financial AccountingStandards (SFAS) No. 123, the Company has elected to continue followingthe guidance of Accounting Principles Board (APB) Opinion No. 25 formeasurement and recognition of stock-based transactions with employees. Nocompensation cost has been recognized for stock options granted to employeesunder the plans where the exercise price of the options granted was equal tothe fair value of the common stock at the date of grant.

Proforma net loss and loss per share have been determined as if the Company hadused the fair value method of accounting for its stock option grants andemployee stock purchase plan share elections consistent with the method of SFASNo. 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.

| ** **                                                                                 | ** ** | **2005**                                                                | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| ** **                                                                                 | ** ** | **(In thousands, except for  per share data)** | ** ** |
| Net loss:                                                                                  |       |                                                                    |       |     |       |     |       |
| As reported                                                                                |       | $                                                                       | (2,915     | )        | $          | (3,143   | )          | $ | (5,155 | ) |
| Non cash compensation expense, net of tax                                                  |       | $                                                                       | (684       | )        | $          | (1,283   | )          | $ | (1,251 | ) |
| Stock compensation cost on stock based awards  granted below fair market value, net of tax |       | $                                                                       | —     |     | $          | 17       |       | $ | 194 |   |
| Pro forma                                                                                  |       | $                                                                       | (3,599     | )        | $          | (4,409   | )          | $ | (6,212 | ) |
| Basic loss per share                                                                       |       |                                                                    |       |     |       |     |       |
| As reported                                                                                |       | $                                                                       | (0.28      | )        | $          | (0.31    | )          | $ | (0.50 | ) |
| Non cash compensation expense                                                              |       | $                                                                       | (0.07      | )        | $          | (0.12    | )          | $ | (0.12 | ) |
| Stock compensation cost on stock based awards  granted below fair market value             |       | $                                                                       | —     |     | $          | —   |       | $ | 0.02 |   |
| Pro forma                                                                                  |       | $                                                                       | (0.35      | )        | $          | (0.43    | )          | $ | (0.60 | ) |
| Diluted loss per share                                                                     |       |                                                                    |       |     |       |     |       |
| As reported                                                                                |       | $                                                                       | (0.28      | )        | $          | (0.31    | )          | $ | (0.50 | ) |
| Non cash compensation expense                                                              |       | $                                                                       | (0.07      | )        | $          | (0.12    | )          | $ | (0.12 | ) |
| Stock compensation cost on stock based awards  granted below fair market value.            |       | $                                                                       | —     |     | $          | —   |       | $ | 0.02 |   |
| Pro forma                                                                                  |       | $                                                                       | (0.35      | )        | $          | (0.43    | )          | $ | (0.60 | ) |

 

Theweighted-average fair values per option at the date of grant were $3.42, $2.47and $3.35 for 2005, 2004 and 2003 respectively. The fair value for the stockoption grants was estimated using the Black-Scholes option pricing model withthe following weighted average assumptions:

| ** **                      | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Risk-free  interest rates       |       | 4.32     | %          | 4.60     | %          | 3.77     | %          |
| Expected dividend  yield        |       | 0        |       | 0        |       | 0        |       |
| Expected  volatility factor     |       | 71       | %          | 86       | %          | 96       | %          |
| Expected option holding  period |       | 5 years  |       | 5 years  |       | 5 years  |       |

 

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During 2005, the Company’s employees elected topurchase 49,032 shares under the Employee Stock Purchase Plan (ESPP). Using theBlack-Scholes pricing model, the weighted average fair value was $1.08 pershare for each election. During the 2004 and 2003 ESPP offering, employeeselected to purchase 35,246 and 23,883 shares respectively. Using theBlack-Scholes pricing model, the weighted average fair value was $0.42 per sharefor each election in 2004 and $0.40 per share for each election in 2003.

In December 2004, the Financial AccountingStandards Board published FASB Statement No. 123 (revised 2004), *Share-Based Payment* (“FAS 123(R)”). In March 2005, the U.S. Securities andExchange Commission issued Staff Accounting Bulletin No. 107 relating tothe adoption of SFAS 123(R). SFAS 123(R), which will begin to apply in theCompany’s first quarter of 2006, 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 then will recognize the cost over the period itrequires the employee to provide services for the award. SFAS 123(R) iseffective for the Company as of January 1, 2006. The Company is evaluatingthe adoption criteria outlined in SFAS 123(R). However, the pro forma effect onnet income using the fair value method for the past three years is presented inthe table above. The pro forma information may not be indicative of the actualeffect on net income when SFAS 123(R) is adopted as such effect isdependent upon many factors, including the number of stock options granted inthe future as well as their related terms.

On December 19, 2005, the Company’s Board ofDirectors took action to accelerate vesting of all outstanding employee stockoptions. As of that date, the Company had a total of 1,768,037 employee optionsoutstanding, of which 1,442,912 were vested and 325,125 were unvested. TheBoard accelerated the vesting schedule of the 325,125 unvested employeeoptions, of which 197,125 (the “underwater options”) had exercise prices inexcess of $3.40 per share and 128,000 (the “in the money options”) had exerciseprices less than the current market price on the accelerated vesting date. TheCompany did not accelerate the vesting of options granted to Board members.

Summaryinformation related to these options, as outstanding on December 19, 2005,is shown below:

| **Employees**         | ** ** | ** ** | ** ** | **Total** | ** ** | **Vested** | ** ** | **Unvested** | ** ** |
|-----------------------|------------|------------|------------|-----------|------------|------------|------------|--------------|------------|
| Underwater  options   |       | 1,155,637  |       | 958,512   |       | 197,125    |       |
| In the money  options |       | 612,400    |       | 484,400   |       | 128,000    |       |
| Total options         |       | 1,768,037  |       | 1,442,912 |       | 325,125    |       |

 

The Board took the action to accelerate the vesting ofthe options in order to eliminate approximately $244,000 in compensation expensethat the Company would otherwise have incurred over two years beginning in2006, upon the adoption of FAS 123(R). Under FAS 123(R), the Company would haverecognized the expense associated with these options grants as the optionsvested. The Company also recorded compensation expense of $2,300 during 2005,related to the 128,000 unvested in the money options, because of the likelihoodthat certain employees may terminate employment with the Company prior to whenthe options would have vested under the original vesting schedule.

***Income Taxes:***

The Company calculates income taxes in accordance withthe 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 

37

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consequences in futureyears of temporary differences between the tax bases of assets and liabilitiesand their financial reporting amounts using enacted tax rates for the years inwhich these items are expected to affect taxable income. The Companyestablishes valuation allowances when necessary to reduce deferred tax assetsto the amount the Company expects are more likely than not to realize. Incometax (benefit) expense is the tax payable (receivable) for the period and thechange during the period in deferred tax assets and liabilities.

***Use of Estimates:***

The preparation of financial statements in conformitywith accounting principles generally accepted in the United States requiresmanagement to make estimates and assumptions that affect the reported amountsof assets and liabilities and disclosure of contingent assets and liabilitiesat the date of the financial statements and the reported amounts of revenuesand expenses during the reporting period. Significant items subject toestimates and assumptions include the valuation for deferred tax assets,reserve for doubtful accounts, reserve for obsolete and slow moving (excess)inventory and valuation of long-lived assets. Actual results could differ fromthose estimates.

***Revenue Recognition:***

*RevenueRecognition.**  *TheCompany realizes revenue from the design, installation and support of datastorage solutions, which may include hardware, software and services. TheCompany recognizes revenue when it has met its obligations for installation orother services and collectability is reasonably assured.

*ProductSales.**  *TheCompany sells software and hardware products on both a “free-standing” basiswithout any services and as data storage solutions bundled with itsinstallation and configuration services (“bundled arrangements”).

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

*ProductSales With Service.**  *If theCompany sells a bundled arrangement, then the Company defers recognizing anyrevenues on it until the Company finishes its installation and/or configurationwork. The Company accounts for the hardware, software and service elements ofits bundled arrangements by applying the provisions of Statement of Position(SOP) 97-2, Software Revenue Recognition, as amended by SOP 98-4and SOP 98-9.

Pursuant to the provisions of SOP 97-2, theCompany applies contract accounting to its bundled arrangements. In accordancewith SOP 81-1, “Accounting for Performance of Construction Type andCertain Production Type Contracts,” the Company applies the completed contractmethod. Factors the Company has considered in applying the completed contractmethod accounting include (i) the relatively short duration of itscontracts, (ii) the difficulty of estimating its revenues on apercentage-of-completion method and (iii) its use of acceptance provisionson larger bundled arrangements.

*ServiceSales.**  *Inaddition to installation and configuration services that are part of theCompany’s bundled arrangements described above, the Company’s service salesinclude customer support contracts and consulting services. On the Company’sbalance sheet, deferred revenue relates to service sales for which the Company’scustomer has paid the Company or has been invoiced but for which the Companyhas not yet performed the applicable services.

*CustomerSupport Contracts.**  *TheCompany sells service contracts to most of its customers. These contracts aresupport service agreements. The Company has an internal support desk thatprovides integrated customer support services, including configuration andusage assistance, technical advice and prompt incident detection and resolution.The Company’s technical staff first assists a customer in 

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identifying the source ofsystem problems and in determining whether there is defective hardware orsoftware. If the Company’s customer requires on-site maintenance or repairservices, the Company arranges for a service call pursuant to underlyingthird-party support service agreements the Company has with its hardware andsoftware vendors.

When the Company sells a service contract as part of abundled arrangement, it uses vendor specific objective evidence to allocaterevenue to the service contract element. In all cases, the Company defersrevenues and direct costs resulting from its service contracts and amortizesthem into operations over the term of the contracts, which are generally twelvemonths. The Company is contractually obligated to provide or arrange to providethese underlying support services to its customers in the unlikely event thatthe hardware or software vendor, or its designee, fails to perform according tothe terms of its contact.

*ConsultingServices.**  *Some ofthe Company’s customers engage the Company to analyze their existing storagearchitectures and offer its recommendations. Other customers engage the Companyto 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 of consulting services that do not include the saleof hardware or software products, the Company recognizes revenues as itperforms these services.

***Net Income (Loss) Per Share:***

Basic net income (loss) per share is computed usingthe weighted average number of shares outstanding. Diluted net income per shareincludes the effect of common stock equivalents, if any, for each period. Thenumber of additional shares is calculated by assuming that outstanding stockoptions were exercised and that the proceeds from such exercise were used toacquire shares of common stock at the average market price during the reportingperiod. Due to the net loss in 2005, 2004 and 2003, potential common shares of172,028, 80,756 and 105,931, respectively, would have been anti-dilutive tolosses and as a result were excluded from the calculation of diluted loss pershare.

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

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

***Fair Value of Financial Instruments:***

At December 31,2005 and 2004, the carrying values of current financial instruments such ascash and cash equivalents, accounts receivable, accounts payable, other currentassets, accrued liabilities and other current liabilities, approximated theirmarket values, based on the short-term maturities of these instruments.

**3. Intangibles, net:**

Informationregarding the Company’s other intangible assets that continue to be amortizedare as follows:

| ** **               | ** ** | **As of December 31,** | ** ** |
|--------------------------|------------|---------------------------------------|------------|
| ** **               | ** ** | **2005**                              | ** ** | **2004** | ** ** |
| Customer lists:          |       |                                  |       |   |   |
| Carrying amount.         |       | $                                     | 3,374      |   | $ | 3,374 |   |
| Accumulated amortization |       | (3,374                                | )          | (3,149 | ) |
|                     |       | $                                     | —     |   | $ | 225 |   |

 

Amortization expense for the years ended December 31,2005, 2004 and 2003 was $225,000, $261,000 and $724,000, respectively. Theintangible assets as of December 31, 2005 are fully amortized.

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**4. Borrowing Arrangements:**

TheCompany’s bank revolving credit facility expired on June 30, 2004. TheCompany has elected not to pursue a new facility at this time. With the Company’scurrent cash position, it believes it has the liquidity to meet its operatingneeds for the foreseeable future. The Company has no outstanding debt, and ifthe need should arise to borrow funds, the Company believes that it couldobtain a secured facility.

**5. Income Taxes:**

The benefit from income taxes in 2003 consisted primarilyof current federal income taxes.

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

| ** **                                    | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Tax benefit at  U.S. statutory rates          |       | (34.0    | )%         | (34.0    | )%         | (34.0    | )%         |
| State tax benefit,  net of federal tax effect |       | (4.6     | )          | (6.3     | )          | (4.6     | )          |
| Nondeductible  expenses                       |       | 2.9      |       | 2.8      |       | 11.3     |       |
| Change in  valuation allowance and other      |       | 35.7     |       | 37.5     |       | 22.3     |       |
| Effective tax rate                            |       | 0        | %          | 0        | %          | (5.0     | )%         |

 

Significantcomponents of the Company’s deferred tax assets and liabilities are as follows:

| ** **                                 | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                 | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **                                 | ** ** | **(In thousands)**                    | ** ** |
| Current deferred tax  asset:               |       |                                       |       |   |   |   |   |
| Allowance for doubtful accounts            |       | $                                          | 50         |   | $ | 58 |   | $ | 79 |   |
| Compensation accrual                       |       | 88                                         |       | 56 |   | 49 |   |
| Inventories                                |       | 48                                         |       | 31 |   | 92 |   |
| Deferred revenue                           |       | 515                                        |       | 238 |   | 195 |   |
| Restructuring reserve                      |       | —                                     |       | — |   | 77 |   |
| Other                                      |       | 16                                         |       | — |   | — |   |
| Total current deferred tax asset           |       | 717                                        |       | 383 |   | 492 |   |
| Long-term deferred tax  asset (liability): |       |                                       |       |   |   |   |   |
| Net operating loss carryovers              |       | 2,798                                      |       | 3,006 |   | 1,924 |   |
| Intangibles                                |       | 696                                        |       | 844 |   | 955 |   |
| Property and equipment                     |       | (166                                       | )          | 424 |   | (575 | ) |
| Sublease reserve                           |       | 782                                        |       | — |   | — |   |
| Other                                      |       | —                                     |       | 21 |   | 7 |   |
| Total gross deferred tax asset             |       | 4,827                                      |       | 4,678 |   | 2,803 |   |
| Valuation  allowance                       |       | (4,827                                     | )          | (4,678 | ) | (2,803 | ) |
| Net deferred tax asset                     |       | $                                          | —     |   | $ | — |   | $ | — |   |

 

The valuation allowance for deferred tax assets as of December 31,2005, 2004 and 2003 was $4.8 million, $4.7 million and $2.8 million,respectively. The net change in the total valuation allowance for the yearsended December 31, 2005, 2004 and 2003 was an increase of $149,000, $1.9million and $1.2 million, respectively.

In assessing the recoverability of deferred taxassets, management considers whether it is more likely than not that someportion or all of the deferred tax assets will be realized. The ultimaterealization of deferred tax assets is dependent upon the generation of futuretaxable income during the periods in which 

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those temporarydifferences become deductible. Management considers the scheduled reversal ofdeferred tax liabilities, carry back potential and projected future taxableincome and tax planning strategies in making 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 31,2005, the Company had federal net operating loss carry forwards ofapproximately $6.5 million and state net operating loss carry forwards ofapproximately $13.0 million, which are available to offset future federal andstate taxable income. If not used, these net operating loss carry forwards willexpire between 2013 and 2024. Federal net operating losses expire as follows:

| **Year Generated** | ** ** | ** ** | ** ** | **Amount  Generated** | ** ** | **Amount  Used** | ** ** | **Remaining Amount** | ** ** | **Expiration  Year** | ** ** |
|-------------------------|------------|------------|------------|-----------------------|------------|------------------|------------|---------------------------|------------|----------------------|------------|
| 2003                    |       | $          | 4,110,013  |                  | $          | (479,252         | )          |                      | $          | 3,630,761            |       |   |   | 2023 |   |   |
| 2004                    |       | 2,831,920  |       |                  |       |             | 2,831,920  |                      |       |                 | 2024       |   |   |
| Total                   |       | $          | 6,941,933  |                  | $          | (479,252         | )          |                      | $          | 6,462,681            |       |   |   |   |   |   |

 

**6. Lease Commitments:**

The Company’s corporate headquarters including theprincipal technical operations and the integration, assembly and supportservices operations are located in an office and warehouse facility inChanhassen, Minnesota. The Company’s remaining 13 locations including sales andtechnical staff, are small to medium sized offices. Regional hubs are locatedwithin each of the Company’s regions in the East, Central and West.

As of December 31,2005, future minimum lease payments due under non-cancelable operating leases areas follows:

| ** ** | ** ** | **(In thousands)** | ** ** |
|------------|------------|-------------------------|------------|
| ** ** | ** ** | **Lease  Obligations**  | ** ** | **Sublease  Agreements** | ** ** | **Net Lease  Obligations** | ** ** |
| 2006       |       |                    | $          | 2,098 |   |   |   | $ | (1,138 | ) |   |   | $ | 960 |   |   |
| 2007       |       |                    | 1,771      |   |   |   | (1,120 | ) |   |   | 651 |   |   |
| 2008       |       |                    | 1,502      |   |   |   | (1,053 | ) |   |   | 449 |   |   |
| 2009       |       |                    | 1,504      |   |   |   | (1,053 | ) |   |   | 451 |   |   |
| 2010       |       |                    | 1,397      |   |   |   | (1,053 | ) |   |   | 344 |   |   |
| Thereafter |       |                    | 1,686      |   |   |   | (1,404 | ) |   |   | 282 |   |   |
|       |       |                    | $          | 9,958 |   |   |   | $ | (6,821 | ) |   |   | $ | 3,137 |   |   |

 

In December 2004, the Company agreed to subleaseapproximately 55,000 of the 104,000 square feet it then occupied as itscorporate headquarters in Chanhassen, Minnesota. The initial sublease term isco-terminal with the original lease and is 85 months starting in April 2005and ending in April 2012. The sublessee pays the Company rent ranging fromapproximately $55,000 per month at the beginning of the term to approximately$60,000 per month by the end of the term. The rent includes the costs of commonarea management, common systems repairs, real estate taxes and standardutilities. The Company also negotiated with its landlord to sell the 2.5 acrelot adjoining the Company’s facility for $200,000 which the Company hadoriginally acquired in 2001 for $384,000. In January 2005, the Companydiscontinued use of the sublease area and the Company incurred a one-time,non-cash charge of $3.5 million related to the sublease and lot sale.

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Totalrent expense charged to the Company, net of sublease income of $649,000 in 2005is as follows:

| ** **   | ** ** | **Year Ended December 31,** | ** ** |
|--------------|------------|--------------------------------------------|------------|
| ** **   | ** ** | **2005**                                   | ** ** | **2004** | ** ** | **2003** | ** ** |
| ** **   | ** ** | **(In thousands)**                    | ** ** |
| Rent expense |       | $                                          | 1,288      |   | $ | 1,929 |   | $ | 2,427 |   |
|              |            |                                            |            |  |  |  |  |  |  |  |

 

**7. Restructuring Charges:**

In October 2003, theCompany announced several cost reduction initiatives and management changes.These changes resulted in a fourth quarter 2003 charge of $2.1 million. As partof these cost reduction initiatives, the Company reduced its staff by 16%.Employee severance charges were $568,000. The Company also announced theclosure of four offices. Office closing costs 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 inNovember 2000, resulting in an impairment of this customer base intangibleasset. The resulting impairment charge of the asset was $926,000. The Companyhad $202,000 of remaining accruals as of December 31, 2003, primarily fora severance agreement to a former officer, to be paid in 2004. InJuly 2004, the Company ceased paying the remaining severance accrual tothis officer in exchange for consenting to the officer’s new employment withanother firm. The Company had no restructuring expense activity in 2005.

**8. Employee Benefit Plan:**

TheCompany has a defined contribution retirement plan for eligible employees.Employees may contribute up to 15% of their pretax compensation to the 401(k) portionof the plan. The Company matched 50% of an employee’s contribution up to thefirst 6% of an employee’s eligible compensation in 2003, ceasing the match in January 2004.The cost of the Company’s contributions to the 401(k) portion of the planfor 2005, 2004 and 2003, was $0, $22,000 and $352,000, respectively.

**9. Stockholders’ Equity:**

***Restricted Stock Plans:***

In August 2004, the Company awarded 165,000shares of restricted stock to certain executives. Shares vested upon theearlier of the Company reaching, and publicly announcing, certain financial orbusiness milestones or five years, assuming employment through the date of themilestone. All restricted stock grants have vested due to the Company achievingthe financial and business milestones during 2005 and the Company has noremaining unamortized deferred compensation expenses. The Company recognizednon-cash expense of $25,000 and $257,000, in 2004 and 2005 respectively, basedon value of the restricted shares vested when milestones were reached.

***Stock Compensation Plans:***

Effective May 8, 2001, the Company reserved anaggregate of 3,000,000 shares of common stock for issuance pursuant to theCompany’s Incentive Compensation Plan (the “Incentive Plan”), 1,059,863 ofwhich were available for grant as of December 31, 2005. The terms of theplan allow for a variety of awards including incentive stock options,nonqualified stock options, stock appreciation rights, restricted stock,performance shares, performance units, cash-based awards, phantom shares andother share-based awards as determined by the Company’s CompensationCommittee (the “Committee”).

The Company has also reserved 250,000 shares of commonstock for issuance pursuant to the Company’s Employee Stock Purchase Plan.Under terms of the Employee Stock Purchase Plan, eligible employees may designateup to 15% of their compensation to be withheld through payroll deductions andwill be granted an option to purchase a designated number of shares of commonstock at a purchase price 

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determined by theCommittee, but at no less than 85% of the lower of the market price on thefirst or last day of the purchase period.  The Company terminated the Employee StockPurchase Plan as of December 31, 2005.

In August 2000, the Board of Directors adoptedthe 2000 Director Stock Option Plan (the “Director Plan”). The Company amendedthe Director Plan in May 2002, October 2002 and April 2004. Theterms of the Director Plan allow for stock option grants to non-employeemembers of the Board of Directors. The Company has reserved 300,000 shares ofcommon stock for issuance pursuant to the Director Plan, 25,600 of which wereavailable for grant as of December 31, 2005.

***Stock Options:***

The following tablesummarizes activity under the Company’s stock option plans:

| ** **                                        | ** ** | **Outstanding Options**   | ** ** |
|---------------------------------------------------|------------|--------------------------------|------------|
| ** **                                        | ** ** | **Number of Shares** | ** ** | **Range of   Exercise Prices** | ** ** | **Weighted   Average   Exercise Price** | ** ** |
| 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 - $25.38 |   |   | $ | 6.19 |   |   |
| Options granted                                   |       |                           | 386,208    |   |   | $ | 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 granted                                   |       |                           | 26,600     |   |   | $ | 3.01 -   $4.07 |   |   | $ | 3.42 |   |   |
| Options exercised                                 |       |                           | (6,434     | ) |   | $ | 3.32 -   $3.46 |   |   | $ | 3.38 |   |   |
| Options cancelled                                 |       |                           | (63,725    | ) |   | $ | 3.06 - $18.13 |   |   | $ | 5.93 |   |   |
| Balance,  December 31, 2005                  |       |                           | 1,775,137  |   |   | $ | 1.44 - $18.13 |   |   | $ | 5.07 |   |   |
| Options exercisable as of December 31, 2005  |       |                           | 1,775,137  |   |   | $ | 1.44 - $18.13 |   |   | $ | 5.07 |   |   |
| Options exercisable as  of December 31, 2004 |       |                           | 1,035,250  |   |   | $ | 1.44 - $18.13 |   |   | $ | 6.64 |   |   |

 

Thefollowing is a summary of options outstanding at December 31, 2005:

| **Stock  Options** | ** ** | **Range of    Exercise Price Per  Share** | ** ** | **     Weighted Average       Exercise   Price Per Share** | ** ** | **Weighted Average    Remaining Contractual   Life (Years)** | ** ** |
|--------------------|------------|------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------------|------------|
|               | 1,162,422  |                                                                         |       |                                                                                                                             | $          | 1.44 - $6.42                                                                               |       |   |   | $ | 3.79 |   |   |   | 7.2 |   |   |
|               | 537,345    |                                                                         |       |                                                                                                                             | $          | 6.43 - $9.94                                                                               |       |   |   | $ | 7.88 |   |   |   | 4.2 |   |   |
|               | 24,750     |                                                                         |       |                                                                                                                             | $          | 9.95 - $15.19                                                                              |       |   |   | $ | 12.61 |   |   |   | 4.7 |   |   |
|               | 50,620     |                                                                         |       |                                                                                                                             | $          | 15.20 - $18.13                                                                             |       |   |   | $ | 17.38 |   |   |   | 4.2 |   |   |
|               | 1,775,137  |                                                                         |       |                                                                                                                             | $          | 1.44 - $18.13                                                                              |       |   |   | $ | 5.07 |   |   |   | 6.2 |   |   |

 

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Thefollowing is a summary of options granted at an exercise price that differsfrom 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,  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    |       |                            | 386,208    |                                                           |       |                                                           | $          | 2.05 - $4.89 |   |   |   | $ | 3.82 |   |   |
| Option price less than fair market value |       |                            | —     |                                                           |       |                                                           | —     |   |   |   | — |   |   |
| Options granted                          |       |                            | 386,208    |                                                           |       |                                                           | $          | 2.05 - $4.89 |   |   |   | $ | 3.82 |   |   |
| December 31,  2005                  |       |                            |       |                                                           |       |                                                           |       |   |   |   |   |   |   |
| Option price equals fair market value    |       |                            | 26,600     |                                                           |       |                                                           | $          | 3.01 - $4.07 |   |   |   | $ | 3.42 |   |   |
| Option price less than fair market value |       |                            | —     |                                                           |       |                                                           | —     |   |   |   | — |   |   |
| Options granted                          |       |                            | 26,600     |                                                           |       |                                                           | $          | 3.01 - $4.07 |   |   |   | $ | 3.42 |   |   |

 

The Company accounts for stock-based compensation toemployees using the intrinsic value method as prescribed in AccountingPrinciples Board Opinion No. 25, “Accounting for Stock Issued to Employee,”and related 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.

During 2000 and 1999, theCompany issued 135,850 options with an exercise price below the fair marketvalue of common stock at the date of grant. The intrinsic value of thoseoptions is being recorded to compensation expense over the vesting period,generally four years. During 2005, 2004 and 2003, $0, $17,000 and $111,000,respectively, of compensation expense was recorded related to these options. Asof December 31, 2005, 2004 and 2003, there was $0, $0 and $17,000,respectively, of compensation expense related to these options to be recognizedin future periods. During 2005, 2004 and 2003, the Company issued 0, 0 and46,750 options, respectively, to directors below the fair market value ofcommon stock at the date of grant. The compensation expense on such optionsrecorded was $0, $0 and $83,000 in 2005, 2004 and 2003, respectively. Becausethe options vest immediately, all compensation expense was recorded in theperiod of the grant.

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

| **2005**                                    | ** ** | ** **              | ** ** | **March 31** | ** ** | **June 30** | ** ** | **Sept 30** | ** ** | **Dec 31** | ** ** |
|---------------------------------------------|------------|-------------------------|------------|-------------------|------------|------------------|------------|------------------|------------|-----------------|------------|
| ** **                                  | ** ** | **(In thousands)** | ** ** |
| Net sales                                   |       | $                       | 21,241     |              | $          | 28,741           |       | $                | 31,233     |            | $          | 35,898 |   |
| Gross profit                                |       | 5,759                   |       | 7,614             |       | 8,057            |       | 9,215            |       |
| Operating  earnings (loss)                  |       | (4,775                  | )          | 388               |       | 219              |       | 950              |       |
| Net earnings  (loss)                        |       | (4,701                  | )          | 446               |       | 295              |       | 1,045            |       |
| Net earnings  (loss) per share—basic   |       | (0.46                   | )          | .04               |       | .03              |       | .10              |       |
| Net earnings  (loss) per share—diluted |       | (0.46                   | )          | .04               |       | .03              |       | .10              |       |
| **2004**                                    | ** ** | ** **              | ** ** | ** **        | ** ** | ** **       | ** ** | ** **       | ** ** | ** **      | ** ** |
| Net sales                                   |       | $                       | 20,204     |              | $          | 21,463           |       | $                | 25,633     |            | $          | 25,983 |   |
| Gross profit                                |       | 5,008                   |       | 5,232             |       | 5,868            |       | 7,432            |       |
| Operating  earnings (loss)                  |       | (1,860                  | )          | (1,047            | )          | (735             | )          | 416              |       |
| Net earnings  (loss)                        |       | (1,840                  | )          | (1,031            | )          | (717             | )          | 445              |       |
| Net earnings  (loss) per share—basic   |       | (0.18                   | )          | (0.10             | )          | (0.07            | )          | .04              |       |
| Net earnings (loss) per  share—diluted |       | (0.18                   | )          | (0.10             | )          | (0.07            | )          | .04              |       |

 

**11.Recently Issued Accounting Standards**

In November 2004, the FASB issued SFAS No. 151,Inventory Costs, an amendment of ARB No. 43, Chapter 4. The amendmentsmade by the SFAS No. 151 require that abnormal amounts of idle facilityexpense, freight, handling costs and wasted materials (spoilage) be recognizedas current-period charges. This Statement requires that allocation of fixedproduction overhead to inventory based on the normal capacity of productionfacilities. SFAS No. 151 is effective for inventory costs incurred duringfiscal years beginning after June 15, 2005. The Company does not believethe adoption of SFAS No. 151 will have a material effect on its financialposition or results of operations.

In March 2005, theFASB issued Interpretation No.47, or “FIN 47,” which clarifies terminology inFASB Statement No. 143, *Accounting forAsset Retirement Obligations*. FIN 47 clarifies when an entity hassufficient information to reasonably estimate the fair value of an assetretirement obligation. FIN 47 is effective for the Company in fiscal 2006. Wedo not believe the adoption of FIN 47 will have a material impact on ourfinancial statements.

**Item 9.**                        Changesin and Disagreements with Accountants on Accounting and Financial Disclosure.

On November 19, 2004,we terminated the appointment of KPMG LLP as our principal accountants andengaged McGladrey & Pullen, LLP as our new principal accountants. Ouraudit committee approved the decision to change accountants. During 2003 andthrough the subsequent interim period through November 19, 2004, we had nodisagreements with KPMG LLP on any matter of accounting principles orpractices, financial statement disclosure, or auditing scope of procedure,which disagreements, if not resolved to the satisfaction of KPMG LLP, wouldhave caused it to make reference to the subject matter of the disagreement inconnection with its reports. The audit report of KPMG LLP on our consolidatedfinancial statements as of and for the year ended December 31, 2003 didnot contain any adverse opinion or disclaimer of opinion, nor was it qualifiedor modified as to uncertainty, audit scope, or accounting principles. During2003 and through the subsequent interim period through November 19, 2004,we did not consult with McGladrey & Pullen, LLP regarding theapplication of accounting principles to a specific transaction, eithercompleted or proposed, or the type of audit opinion that might be rendered onour consolidated financial statements.

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**Item 9A.**                Controlsand Procedures

We maintain disclosure controls and procedures thatare designed to ensure that information required to be disclosed in our SECreports is recorded, processed, summarized and reported within the time periodsspecified in the Securities and Exchange Commission’s rules and forms. Ourdisclosure controls and procedures are also designed to accumulate andcommunicate information to our management, including our Chief ExecutiveOfficer and our Chief Financial Officer, as appropriate, to allow for timelydecisions regarding required disclosure. In designing and evaluating ourdisclosure controls and procedures, we recognize that any controls andprocedures, no matter how well designed and operated, can provide onlyreasonable assurance of achieving the desired control objectives. Accordingly,management must apply its judgment in evaluating the cost-benefit relationshipof possible controls and procedures.

Within the 90 days prior to the filing of this report,we carried out an evaluation under the supervision and with the participationof our management, including our Chief Executive Officer and our ChiefFinancial Officer, of the effectiveness of the design and operation of ourdisclosure controls and procedures pursuant to Rule 13a-15b underthe Securities Exchange Act of 1934. Based on their review of our disclosurecontrols and procedures, the Chief Executive Officer and the Chief FinancialOfficer have concluded that our disclosure controls and procedures areeffective at the reasonable assurance level in timely alerting them to materialinformation relating to us that is required to be included in our periodic SECfilings.

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

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**PART III**

**Item 10.**                 Directorsand Executive Officers of the Registrant.

Thefollowing is information concerning our current directors and executiveofficers:

| **Name**            | ** ** | ** ** | ** ** | **Age**                                                | ** ** | ** ** | **Position** | ** ** |
|---------------------|------------|------------|------------|--------------------------------------------------------|------------|------------|--------------|------------|
| Charles B. Westling |       | 47         |       | President, Chief  Executive Officer and Director       |
| Gregory T. Barnum   |       | 51         |       | Vice President of  Finance and Chief Financial Officer |
| Mary E. West        |       | 57         |       | Vice President—Human  Resources                   |
| Greg R. Meland      |       | 52         |       | Chairman of the Board  and Director                    |
| Paul F. Lidsky*     |       | 52         |       | Director                                               |
| Margaret A. Loftus* |       | 61         |       | Director                                               |
| James E. Ousley*    |       | 60         |       | Director                                               |
| Robert M. Price     |       | 75         |       | Director                                               |

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*                    Member ofAudit and Compensation Committees.

Charles B. Westling joined us in 2002 as VicePresident—Corporate and Business Development and later became Vice President—MarketDevelopment. In 2003, Mr. Westling became President and Chief OperatingOfficer. In 2005, Mr. Westling became President and Chief ExecutiveOfficer. He was elected as a director in 2006. Between 2000 and 2001, he wasthe Executive Vice President of Business Development of Agiliti, Inc.Mr. Westling served as Senior Managing Director and Director of CorporateFinance for John G. Kinnard and Company, Incorporated from 1997 to 1999.  From 1990 to 1997, Mr. Westling was amember of the corporate finance department at Dain Bosworth Incorporated,serving most recently as a managing director and head of technology investmentbanking.  Mr. Westling received hisB.A. in economics from Carleton College and earned a Master of Managementdegree from the J.L. Kellogg Graduate School of Management at NorthwesternUniversity.

Gregory T. Barnum joined us initially as a director inJanuary 2006 and as an executive officer in March 2006. Mr. Barnumresigned as a director in connection with becoming an employee. Between 1997and 2005, Mr. Barnum was Vice President of Finance, Chief FinancialOfficer and Corporate Secretary for Computer Network Technology Corporation. Between1992 and 1997, Mr. Barnum was Senior Vice President of Finance andAdministration, Chief Financial Officer and Corporate Secretary for TricordSystems, Inc. Between 1988 and 1992, Mr. Barnum was Executive VicePresident, Finance, Chief Financial Officer, Treasurer and Corporate Secretaryfor Cray Computer Corporation.

Mary E. West joined us in 2001 as Vice President—HumanResources. From 1998 to 2001, she worked as an independent human resourcesconsultant. Between 1995 and 1998, Ms. West was employed by ArcadiaFinancial, Ltd., most recently as the Senior Vice President of Human Resources.From 1993 to 1994, she was the corporate administrative director for Nexus, Inc.Ms. West received her M.A. in Human Resources and Industrial Relationsfrom the University of Minnesota Carlson School of Management.

Greg R. Meland joined us in 1991 as our Vice Presidentof Sales and Engineering. He became President and Chief Executive Officer in1993. In 2005, he became our Chairman of the Board. Between 1979 and 1991, Mr. Melandserved in various sales and marketing positions with the Imprimis disk drivesubsidiary of Control Data Corporation (which was sold to Seagate in 1989),most recently as the North Central U.S. Director of Sales.

Paul F. Lidsky was elected as a director in June 1998.Since 2005, Mr. Lidsky has served as Chief Operating Officer for SpanlinkCommunications, Inc. Between 2003 and 2004, Mr. Lidsky was Presidentand Chief Executive Officer of Computer Telephony Solutions, atelecommunications software company specializing in call centers. From 2002 to2003, Mr. Lidsky was President and Chief Executive Officer of VigiLanzCorporation, a medical software company. From 1997 until 2002, Mr. Lidskywas the President 

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and Chief ExecutiveOfficer of OneLink Communications, Inc., a software company that providesbusiness intelligence solutions to the telecommunications carriers. Between1985 and 1997, Mr. Lidsky was employed by Norstan, Inc., acomprehensive technology services company, most recently as Executive VicePresident of Strategy and Business Development. Mr. Lidsky also serves onthe Board of Directors for VigiLanz Corporation.

Margaret A. Loftus was elected as a director in June 1998.Since 2005, Ms. Loftus has served as an independent consultant. Between1989 and 2005, Ms. Loftus was an owner of Loftus Brown-Wescott, Inc.,a business consulting firm. Between 1976 and 1989, she was employed by CrayResearch, Inc., most recently as Vice President of Software. Ms. Loftusalso serves on the Board of Directors for Analysts International Corporationand several private technology companies.

James E. Ousley was elected as a director in June 1998.Between 2002 and 2004, Mr. Ousley was President and Chief ExecutiveOfficer of Vytek Wireless Inc., a mobile computing company which was acquiredby Calamp, Inc. From 1999 to 2001, he served as President and Chairman ofSyntegra (USA), a global e-Business solutions provider and a division ofBritish Telecommunications plc. 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 sales andexecutive management positions with Control Data Corporation, a global computersystems, software/services and peripherals company. Mr. Ousley also serveson the Board of Directors for ActiveIdentity Inc., Bell MicroproductsInc., and Savvis Communications Corporation.

Robert M. Price was elected as a director in June 1998and served as Chairman of the Board between 1998 and 2005. Mr. Price hasbeen President of PSV, Inc., a technology consulting business located inBurnsville, Minnesota, since 1990. Between 1961 and 1990, he served in variousexecutive positions, including as Chairman and Chief Executive Officer, withControl Data Corporation. Mr. Price also serves on the Board of Directorsof Public Service Company of New Mexico, Affinity Technology Group, Inc.and National Center for Social Entrepreneurs. Since 1991, Mr. Price hasbeen a Senior Advisor and Professor at the Fuqua School of Business at DukeUniversity, and is now an Adjunct Professor of the Pratt School of Engineeringat Duke University. Mr. Price is Mr. Meland’s father-in-law.

Our directors hold office until the next annualmeeting of shareholders or until their successors are duly elected orappointed.

We will furnish to the Securities and ExchangeCommission a definitive Proxy Statement (the “2005 Proxy Statement”) not laterthan 120 days after the close of the fiscal year ended December 31, 2005. Theremaining information required by Items 401 and 405 of Regulation S-K isincorporated herein by reference to the Proxy Statement.

We have adopted a Code ofEthics that applies to our officers, including our principal executive,financial and accounting officers, and our directors and employees. We intendto make all required disclosures concerning any amendments to, or waivers from,our Code of Ethics by the filing of Current Reports under the cover of From 8-K.

**Item 11.**                 ExecutiveCompensation.

The information set forthunder the caption “Executive Compensation” in our 2005 Proxy Statement isincorporated herein by reference.

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**Item 12.**                 SecurityOwnership of Certain Beneficial Owners and Management and Related StockholderMatters.

Theinformation set forth under the caption “Outstanding Voting Securities andVoting Rights” in our 2005 Proxy Statement is incorporated 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) |       |                                                    | 1,775,137  |   |   |   | $ | 5.07 |   |   |   | 1,085,463 |   |   |
| Equity  compensation plans not approved by security holders   |       |                                                    | —     |   |   |   | — |   |   |   | — |   |   |
| Totals                                                        |       |                                                    | 1,775,137  |   |   |   | $ | 5.07 |   |   |   | 1,085,463 |   |   |
|                                                               |            |                                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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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.**                 CertainRelationships and Related Transactions.

The information requiredby this section is incorporated by reference from the information in thesection entitled “Certain Relationships and Related Transactions” in our 2005Proxy Statement.

**Item 14.**                 PrincipalAccounting Fees and Services.

The information requiredby this section is incorporated by reference from the information in thesection entitled “Auditing Matters” in our 2005 Proxy Statement.

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

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

**1.****                 FinancialStatements**

Reference is made to the Index to Financial Statementsof Datalink Corporation, under Item 8 in Part II of this Form 10-K.

**2.****                 FinancialStatement Schedules.**

The following financial statement schedule of DatalinkCorporation for the years ended 2005, 2004 and 2003 is filed as part of thisAnnual Report and should be read in conjunction with the Financial Statementsof Datalink Corporation.

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**DATALINK CORPORATIONSCHEDULE II VALUATION AND QUALIFYING ACCOUNTSFOR THE YEARS ENDED DECEMBER 31, 2005, 2004 AND 2003**

| **Description**                                  | ** ** | ** ** | ** ** | **Period** | ** ** | **Balance at  Beginning   of Period** | ** ** | **Additions** | ** ** | **Deductions (1)** | ** ** | **Balance   at End  of Period** | ** ** |
|--------------------------------------------------|------------|------------|------------|------------|------------|------------------------------------------------------|------------|---------------|------------|-------------------------|------------|------------------------------------------------|------------|
| Allowance for  Doubtful Accounts                 |       |       | 2005       |       |       | $                                                    | 70,128     |          | $          | 15,000                  |       |                                           | $          | 13,463 |   |   | $ | 71,665 |   |
|                                             |       |       | 2004       |       |       | 97,807                                               |       | (14,000       | )          |                    | 13,679     |                                           |       | 70,128 |   |
|                                             |       |       | 2003       |       |       | 197,368                                              |       | (34,026       | )          |                    | 65,535     |                                           |       | 97,807 |   |
| Allowance for  Inventory Obsolescence       |       |       | 2005       |       |       | $                                                    | 71,303     |          | $          | 69,665                  |       |                                           | $          | 41,128 |   |   | $ | 99,840 |   |
|                                             |       |       | 2004       |       |       | 211,110                                              |       | 185,437       |       |                    | 325,244    |                                           |       | 71,303 |   |
|                                             |       |       | 2003       |       |       | 405,001                                              |       | 348,816       |       |                    | 543,707    |                                           |       | 211,110 |   |
| Allowance for  Valuation of   Deferred Tax Asset |       |       | 2005       |       |       | $                                                    | 4,678,611  |          | $          | 148,756                 |       |                                           | $          | — |   |   | $ | 4,827,367 |   |
|                                             |       |       | 2004       |       |       | 2,802,954                                            |       | 1,875,657     |       |                    | —     |                                           |       | 4,678,611 |   |
|                                             |       |       | 2003       |       |       | 1,609,000                                            |       | 1,194,454     |       |                    | —     |                                           |       | 2,802,954 |   |

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(1)          Deductions reflectwrite-offs of customer accounts receivable, net of recoveries or disposals ofinventories.

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRMON FINANCIAL STATEMENT SCHEDULE**

Tothe Board of Directors

DatalinkCorporation

Chanhassen, Minnesota

Our audits of the 2005 and2004 financial statements were conducted in accordance with the standards ofthe Public Company Accounting Oversight Board (United States) and were made forthe purpose of forming an opinion on the basic 2005 and 2004 financialstatements of Datalink Corporation taken as a whole. The supplemental ScheduleII is presented for purposes of complying with the Securities and ExchangeCommission’s rules and is not a part of the basic financial statements. The2005 and 2004 information contained in the schedule has been subjected to theauditing procedures applied in our audits of the basic 2005 and 2004 financialstatements and in our opinion, is fairly stated in all material respects inrelation to the basic 2005 and 2004 financial statements taken as a whole.

/s/ McGLADREY & PULLEN, LLP

Minneapolis, Minnesota

January 26, 2006

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**REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTINGFIRM ONFINANCIAL STATEMENT SCHEDULE**

TheBoard of Directors and Stockholders

Datalink Corporation:

Under the date of February 6, 2004, we reportedon the statements of operations, stockholders’ equity and cash flows ofDatalink Corporation for the year ended December 31, 2003. In connectionwith our audit of the aforementioned financial statements, we also have auditedthe related financial statement schedule for the year ended December 31,2003.  The financial statement scheduleis the responsibility of the Company’s management.  Our responsibility is to express an opinionon the financial statement schedule based on our audit. 

In our opinion, suchfinancial statement schedule for the year ended December 31, 2003, whenconsidered in relation to the basic financial statements taken as a whole,presents fairly, in all material respects, the information set forth therein.

/s/ KPMG LLP

Minneapolis, Minnesota

February 6, 2004

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**3. Exhibits.**   The following exhibits are filed aspart 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.                                                                                                        |   | 12 |
|            | 10.26      |      |       | Vacant Land Purchase Agreement                                                                                                                                                              |   | 12 |
|            | 10.27      |      |       | Correction to Restricted Stock Award Agreements  dated August 13, 2004                                                                                                                 |   | 13 |
|            | 10.28      |      |       | Employment Agreement dated March 14, 2006 with  Gregory T. Barnum                                                                                                                      |   | 14 |
|            | 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 byreference to the exhibit of the same number in our Registration Statement on Form S-1,Reg. No. 333-55935

2)               Incorporated byreference to the exhibit of the same number in our September 30, 2000 Form 10-Q.

3)               Incorporated byreference to the exhibit of the same number in our 2000 Form 10-K.

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4)               Incorporated byreference to our 2000 Proxy Statement.

5)               Incorporated byreference to the exhibit of the same number in our March 31, 2001 Form 10-Q.

6)               Incorporated byreference to the exhibit of the same number in our June 30, 2002 Form 10-Q.

7)               Incorporated byreference to the exhibit of the same number in our 2002 Form 10-K.

8)               Incorporated byreference to the exhibit of the same number in our June 30, 2003 Form 10-Q.

9)               Incorporated byreference to the exhibit of the same number in our March 31, 2004 Form 10-Q.

10)        Incorporated by referenceto the exhibit of the same number in our September 30, 2004 Form 10-Q.

11)        Incorporated by referenceto the exhibit of the same number in our 2003 Form 10-K.

12)        Incorporated by referenceto the exhibit of the same number in our 2004 Form 10-K.

13)        Incorporated by referenceto the exhibit of the same number in our September 30, 2005 Form 10-Q.

14)        Incorporated by referenceto the exhibit of the same number in our Form 8-K filed on March 17,2006.

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this Annual Report on Form 10-Kto be signed on its behalf by the undersigned, thereunto duly authorized.

|                           |   | DATALINK CORPORATION |
|---------------------------|--------|----------------------|
| Date: March 31, 2006 |   |                 |   |   |
|                      |   | By:                  |   | /s/ CHARLES B. WESTLING |
|                      |   |                 |   | Charles B. Westling, President and Chief Executive  Officer |
|                      |   | By:                  |   | /s/ GREGORY T. BARNUM |
|                      |   |                 |   | Gregory T. Barnum, Vice President of Finance and  Chief Financial Officer |

 

Pursuantto the requirements of the Securities Act of 1934, this report has been signedbelow by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.

| Signature                                | ** ** | **Title**                                            | ** ** | **Date**            |
|------------------------------------------|------------|------------------------------------------------------|------------|---------------------|
| /s/ CHARLES B. WESTLING   |       | President, Chief  Executive Officer and Director     |       | March 31, 2006 |
|                                     |       | (Principal Executive Officer)                        |       |                |
| /s/ GREGORY T. BARNUM     |       | Vice President of  Finance and Chief Financial       |       | March 31, 2006 |
|                                     |       | Officer (Principal Financial Officer)                |       |                |
| /s/ Denise M. Westenfield |       | Corporate Controller  (Principal Accounting Officer) |       | March 31, 2006 |
| /s/ Greg R. Meland                       |       | Chairman of the Board  and Director                  |       | March 31, 2006 |
| /s/ Paul F. Lidsky                       |       | Director                                             |       | March 31, 2006 |
| /s/ Margaret A. Loftus                   |       | Director                                             |       | March 31, 2006 |
| /s/ James E. Ousley                      |       | Director                                             |       | March 31, 2006 |
| /s/ Robert M. Price                      |       | Director                                             |       | March 31, 2006 |

 

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