**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D. C. 20549**

 

----

 

**FORM 10-K**

 

**(Mark one)**

 

| **ý**                                       |   | **ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(D) OF THE  SECURITIES EXCHANGE ACT OF 1934 (NO FEE REQUIRED)**      |
|--------------------------------------------------|--------|-----------------------------------------------------------------------------------------------------------------------|
|                                             |   |                                                                                                                  |
| **FOR THE FISCAL  YEAR ENDED DECEMBER 31, 2002** |
|                                             |   |                                                                                                                  |
| **OR**                                           |
|                                             |   |                                                                                                                  |
| **o**                                            |   | **TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(D) OF  THE SECURITIES EXCHANGE ACT OF 1934. (NO FEE REQUIRED)** |

 

**For The Transition PeriodFrom            To            **

 

# **Commission file number: 00029758**

 

----

 

**DATALINK CORPORATION**

(Exactname of registrant as specified in its charter)

 

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

 

Securitiesregistered pursuant to Section 12(b) of the Act: **None**.

 

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

 

Indicate by check mark whetherthe registrant (1) has filed all reports required to be filed by Section13 or 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 ý  No o

 

Indicate by checkmark if disclosure 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-K or anyamendment to this Form 10-K.  ý

 

At March 11, 2003, the latest practicable date, the aggregate marketvalue of the voting and non-voting common equity held by non-affiliates of theregistrant was: $19,389,210.

 

At March 11, 2003, the number ofshares outstanding of each of the registrant’s classes of common stock was10,216,143.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Portions of the Registrant’sProxy Statement for its Annual Meeting of Stockholders (the “Proxy Statement”),to be filed with the Securities and Exchange Commission, are incorporated byreference to Part III of this Form 10-K.

 

 

----

 

# **NOTE REGARDING FORWARD-LOOKING STATEMENTS**

 

This Annual Report containsforward-looking statements. We have based these forward looking statements onour current expectations and projections about future events, including, amongother things: the level of continuing demand for storage, including theeffects of current economic conditions; competition and pricing pressures andtiming of our installations that may adversely affect our revenues and profits;fixed employment costs that may impact profitability if we suffer revenueshortfalls; revenue recognition policies that may unpredictably defer reportingof our revenues; our ability to hire and retain key technical and otherpersonnel; our dependence on key suppliers; the strain placed on our resourcesby growth and expansion; our ability to adapt to rapid technological change;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’s Discussion and Analysis of Financial Condition and Results ofOperations” and “Business.” Our actual results may differ materially from thoseanticipated in these forward-looking statements as a result of various factors,including all the risks discussed in “Risk Factors” and elsewhere in thisAnnual Report.

 

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

 

**PART I**

**Item 1.  Business.**

 

**Overview**

 

Weare the leading independent information storage architect in the United States.We partner with customers to analyze, design, implement, and supportinformation storage infrastructures that store, protect, and provide continuousaccess to information.  Our areas ofexpertise include:

 

•                                          Storage Continuance — We help our customers tohave 24 hours a day, 7 days a week access to information.

•                                          Storage Protection — We deploy storage protectionarchitectures that provide our customers cost-effective backup and restoresolutions for safeguarding information.

•                                          Storage Optimization — We help our customers tomaximize utilization of storage technologies and the resources that managethose technologies.

 

Our highly skilled technical services and productmanagement staff tests and compares data storage technologies available fromthe leading manufacturers and software developers. Once a product is approvedfor our solution sets, our technical staff then has the flexibility to choosefrom the best of these storage technologies and products to solve ourcustomers’ growing data storage needs. In addition, we maintain a sales andsupport staff that ensures the continued success of our data storage solutionsfor each customer. We believe these value-added services and our adherence tothe highest quality standards have resulted in superior levels of customersatisfaction.

 

**The Data Storage Industry**

 

Despite sluggish spendingpatterns over the last two years, the storage market is large andexpanding.  This is because businessesneed to make continual investments to optimize the effectiveness of theirstorage solutions.  Gartner Dataquestestimates that by 2005, storage will be more than a $39.2 billion market, upfrom $32.8 billion in 2002.  At the sametime, storage is becoming increasingly complex, making it difficult forin-house IT staffs to implement new technologies.  In addition, manufacturers are recently relying less on their owndedicated sales force and more on channel partners, like Datalink, to offertheir storage products to customers.

 

In the storage sector,Gartner Dataquest predicts that disk-based data protection, modular disk andSAN/NAS convergence, storage management software, and storage services willgrow rapidly over the next several years. Gartner Dataquest estimates that, together, these areas will growbetween 2002 and 2005 by 30 percent year-over-year, versus the storage industrystandard of 8 percent, to over $14 billion.

 

1

----

 

The significance of data haschanged as well. Organizations recognize the importance and value of data as astrategic and competitive asset. Employees, customers and suppliers demanduninterrupted access to mission-critical data 24 hours a day, 7 days a week. Asa result, the ability to efficiently store, manage, protect and provide accessto this data is fast becoming one of the most important aspects ofbusiness-critical decision-making, increasing the need for high-performance,scalable and highly available solutions. Recent difficult economic times have only underscored organizations’needs to use information to differentiate themselves and provide superiorservice.

 

Consequently, we believe that, aseconomic conditions improve, organizations will dedicate an increasingpercentage of their information technology budgets to data storage.  We believe that capital investment prioritieswill include:

 

•                  **Migration to high performance disk-based data protectionsolutions.**

Increased need for highthroughput performance, greater frequency of backups, quick restoration of dataand stringent data availability requirements are key factors that we expect todrive the migration to disk-based data protection solutions from use oftape-based systems.   Disk will not onlybe used as a target device for replication and mirroring, but will also beincorporated into traditional backup systems.

 

•                  **Continued migration to networked storage infrastructures.**

Through a variety of storagenetworking technologies, organizations will attain shared (consolidated)storage capabilities.  Consolidatedstorage benefits include increased flexibility in implementing and managing storage,increased storage device utilization levels, improved quality of service,reduced administration costs and increased operational efficiency.

 

•                  **Integration of lower cost storage networks into largecorporate departments and small to medium size enterprises.**

A number of product innovations, along with optimizedpricing, make entry-level storage area networks a reality for corporatedepartments and small to medium size enterprises.  We expect that new, lower cost alternatives using faster interconnectiontechnologies such as IP, Fibre Channel and iSCSI will accelerate the migrationfrom direct attached storage to networked storage.

 

•                  **Evolution away from large, monolithic storage systems tomodular storage systems.**

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

 

•                  **Adoption of robust storage management software solutions.**

A number of storage managementsoftware innovations have recently entered the market.  Storage management software enhancements canbe divided into three segments: storage infrastructure (volumemanagement/virtualization and replication), data management (backup/recoveryand HSM/archive) and enterprise storage resource management (device,media/library and storage resource).  Management advances in each of these areas will enable improved storageavailability, manageability and performance.

 

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

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

 

**The Datalink Opportunity**

 

The increased need for datastorage and the development of sophisticated, enterprise-class information datastorage systems have created a demand for independent data storage solutionproviders, such as Datalink. Both potential customers and data storage devicemanufacturers are looking to independent storage solutions providers such asDatalink primarily for the following reasons:

 

2

----

 

***Pressures on Customers.*** We believe organizations will increasingly lookoutside their in-house technical staff to independent information storage architects,such as Datalink, for specialized expertise. Networked storage architecturedesign is complex. Although organization-wide data storage solutions, such asSANs, are designed to ease data management functions, these systems aredifficult to understand and implement because they integrate diverse operatingsystems, hardware and software. In addition, there continues to be a steadyinflux of new products and technologies introduced to the market.  In-house information technology departmentsprefer to focus their efforts on mission-critical applications. Accordingly, itis frequently better if they do not research, design, implement and supporttheir own networked storage solutions.

 

***Pressures on Manufacturers.*** We believe manufacturers increasingly rely onchannel partners such as us for two principal reasons:

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

 

•                  Gross profit margins have been under severepressure for many storage companies. Because of the high cost of maintaining a national sales and marketingorganization, and especially in light of current economic conditions, high-enddata storage manufacturers increasingly are focusing their resources on theirresearch and development functions. This strategy requires them to leveragetheir sales and marketing functions by partnering with companies such asDatalink.

 

We believe we are uniquelypositioned to capitalize on this significant opportunity for the followingreasons:

 

***Expertise.*** We have been implementing sophisticated datastorage solutions for over fifteen years. This experience has given ussignificant expertise in understanding and applying data storage technologiesand has allowed us to earn and retain the trust and confidence of our customersand suppliers.  Through the economicdownturn, we have continued to invest in and train resources to differentiateour company, adapt to the ever-changing needs of our customers and capitalizeon opportunities.

 

***Independence.*** Unlike many of our competitors, we areindependent of any manufacturer or particular technology. Our customers areincreasingly using open systems computing architectures, which can combineproducts from multiple suppliers. Our customers therefore value ourindependence and rely on us to choose the best available hardware and softwareand tailor it to their individual needs.

 

***Quality Commitment.*** Our principal facility is ISO 9001 registered,and we utilize ISO standards throughout our organization. Our customers andsuppliers value our consistently high quality design, development, integration,installation and service processes.

 

**The Datalink Solution**

 

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

 

*Analysis*

 

At the beginning of anengagement, we place considerable emphasis on formulating a needs analysisbased on each customer’s business initiatives, operating environment andcurrent and anticipated data storage requirements. While our focus is on eachcustomer’s unique situation, we bring to each engagement our extensive productknowledge and the experience we have gained from providing data storagesolutions for over fifteen years to customers in numerous industries.

 

3

----

 

*Design*

 

Once we have completed ourinitial analysis, we begin the design phase of the project. Our team oftechnical services and sales consultants works together to design a system thatmeets the customer’s data storage needs and its budget. Our independencepermits us to choose from a wide range of technologies in order to fusetogether the appropriate hardware, software and services for each project. Ourengineers continually evaluate and test all available emerging and existingdata storage technologies. The engineers then have the ability to consistentlyselect the best available hardware and software products for our customers.Because of our established, strong relationships with the major enterprise-classinformation storage hardware and software suppliers, we often participate intheir new product development, evaluation, introduction, marketing and qualitycontrol programs. This collaboration with suppliers enables us to identifyinnovative new hardware and software products and incorporate them into oursystem designs.

 

*Implementation*

 

Once we design and test a system,we formulate a detailed project management plan with our customers to meettheir financial and operating objectives and minimize disruption to theiroperations. We oversee the timely delivery of hardware and software products tothe customer’s location. We then coordinate the installation with our technicalservices team, or personnel from the equipment manufacturer, and complete theinstallation at the customer’s site.

 

*Support*

 

We provide our customers advancedtechnical support from a team of customer support analysts and professionalengineers. Our extensive experience in data storage systems enables our staffto deliver expert configuration and usage assistance, technical advice andprompt incident detection and resolution. Most technical support is coordinatedthrough our support desk, which is staffed with technical support analyststrained to solve technical issues and to assist our engineering staff introubleshooting escalated problems. The support desk staff also acts as ourprimary interface with suppliers’ technical support organizations.

 

*Maintenance*

 

We offer maintenance and repairservice options under our service program. We offer a variety of on-siteservice options, including four hour guaranteed response time service sevendays per week, 24 hours per day. Our technical staff first assists customers inidentifying the source of system problems and in determining whether there isdefective hardware or software. We contract with a number of our suppliers andother independent service organizations to provide any required on-sitemaintenance and repair services.

 

**An Integrated Solution Example**

 

Theneed to optimize resources, reduce costs, increase productivity, and providecontinuous access to information is required more than ever in today’sbusinesses.  Helping our customers aligninformation storage infrastructures with business needs is at the core of whatwe do.

 

For example, we recently performeda comprehensive storage assessment for a large corporate client managingover 75 terabytes of data across its business units.  Combining bothquantitative and qualitative data collection, our professionalservices team thoroughly examined the organization’s storageinfrastructure and developed an in-depth storage assessment report basedon its findings.  As a result, our client now has an IT informationblueprint identifying storage infrastructure strengths, weaknessesand recommended methods for mitigating risk based on industry best practices. Ultimately, we strive for helping clients align their IT services withtop-line strategic business objectives. Based on the assessment, the client plans to work with us to implementthe plan that we have designed in a phased approach starting with the highestpriority, highest risk areas.

 

4

----

 

**Our Strategy**

 

Our strategy is to maintain ourposition as the United States’ leading, independent information storagearchitect and to capture an increasing share of the growing data storagemarket. 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:

 

*Delivering New Differentiated Product Offerings andLeveraging Strategic Partnerships*

 

We intend to continue to developleading-edge enterprise-class information storage solutions for our customers.We intend to continually develop and add expertise to our technical field andsupport staff and to improve our working relationships with our suppliers inorder to maintain expertise in enterprise-class information storage solutiondesign and implementation.

 

*Expanding Professional Services Offerings*

 

We intend to continue expandingour ability to provide our customers with comprehensive professional consultingand project management services. Utilizing the expertise of our professionaltechnical staff, we assist our customers in the total assessment, planning,design, implementation and ongoing management of enterprise-class informationstorage solutions. We are executing a plan to leverage our data storageexpertise by expanding our professional services capabilities.  This includes enhanced services such ascustomized data storage infrastructure assessments, assisting customers withdata availability management and specialized 24 x 7 customer support.

 

*Leveraging Market Presence*

 

We intend to expand our businessby broadening our relationships with existing customers and by utilizing ourmarket presence and technical expertise to attract new customers. We believethat the longevity of service of our sales and technical staff will continue tobe critical to building and maintaining long-term, trusting relationships withour existing and prospective customers. In addition, our broad experience in adiverse group of data intensive industries enables us to understand applicationand business issues specific to customers operating within a given industry andto design and implement the appropriate networked storage solution.

 

*Maintaining Superior Service and Support*

 

We intend to maintain andcontinually improve our high standards for superior technical and sales serviceand support. We intend to continue use of our ISO 9001 quality system andprocedures and to continue recruiting and retaining experienced sales andtechnical team members.

 

*Building Geographic Capabilities*

 

We have 21 offices across theUnited States.  In 2002, we reallocatedresources to specifically add sales and technical staff in Texas and Californiato expand our presence and focus in those areas.

 

*Hiring Additional Technical Services and Sales Personnel*

 

We intend to continue to recruithigh-quality technical and sales personnel to increase our expertise and toaugment our planned growth in light of current economic conditions. We alsointend to continue to maximize job satisfaction and retain our existingworkforce. Our goal is to remain one of the most rewarding places to work inour industry.

 

*Making Strategic Acquisitions*

 

We intend to cautiously seek andconsummate additional strategic acquisitions. We continue to believe thatappropriate acquisitions will enable us to access a larger group ofhigh-quality technical and sales personnel and to help us broaden our customerbase, coverage and geographic reach. For example, in November 2000, we acquired the data storage and servicebusiness of OpenSystems.com, Inc.

 

5

----

 

**Suppliers and Products**

 

As an independent informationstorage architect, we do not manufacture any of the data storage components weuse. Instead, we continually evaluate and test new and emerging technologiesfrom other companies to ensure that our solutions incorporate state-of-the-art,high-end, cost-effective networked technologies. This enables us to maintainour technological leadership in enterprise-class storage solutions, to identifynew and innovative products and applications and to maintain confidence amongour customers and suppliers in our expertise.

 

Wehave strong, established relationships with the major enterprise-classinformation storage hardware and software suppliers. Our expertise in opensystem environments includes UNIX, Microsoft Windows, Linux and Novell NetWareand in-depth knowledge of all major hardware platforms, includingHewlett-Packard Company, International Business Machines Corp. and SunMicrosystems, Inc. This expertise has earned us preferred status with manyof our principal suppliers. Preferred status often enables us to participate inour suppliers’ new product development, evaluation, introduction, marketing andquality control programs. These collaborations enable us to identify and marketinnovative new hardware and software products, exchange critical informationand implement joint corrective action programs in order to maximize quality. Inaddition, our close working relationships with our principal suppliers fostersubstantial cross-marketing opportunities.

 

Some of our major suppliers andthe products they provide are listed:

 
| **Products**                    |   | **Suppliers**                                                                                       |
|---------------------------------|--------|-----------------------------------------------------------------------------------------------------|
| Primary Storage                 |   | EMC CorporationHitachi Data Systems CorporationNetwork Appliance Inc.Storage Technology Corporation |
|                            |   |                                                                                                |
| Tape Automation                 |   | Quantum CorporationSpectra Logic CorporationStorage Technology Corporation                          |
|                            |   |                                                                                                |
| Software                        |   | DataCore Software Corporation  Legato Systems, Inc.  VERITAS Software Corporation              |
|                            |   |                                                                                                |
| Switches/Directors              |   | Brocade Communications  Systems, Inc.McData Corporation                                        |
|                            |   |                                                                                                |
| Storage Routers                 |   | Cisco Systems, Inc.  Crossroads Systems, Inc.                                                  |
|                            |   |                                                                                                |
| Fibre Channel Host Bus Adaptors |   | Emulex CorporationJNI Corporation  QLogic Corporation                                               |
|                            |   |                                                                                                |
| SCSI Host Bus Adaptors          |   | Adaptec, Inc.                                                                                  |

 

**Customers**

 

Ourcustomers trust us with their most demanding data storage projects. Oursolutions range from discrete storage device installations to extremely complexorganization-wide SAN implementations costing over $5,000,000. We servecustomers throughout the United States in a diverse group of data intensiveindustries. Our broad industry experience enables us to understand applicationand business issues specific to each customer and to design and implementappropriate networked storage solutions. We enjoy strong relationships with ourcustomers, which is reflected in significant repeat business. We derivedapproximately 90% of our 2002 revenues from customers that previously didbusiness with us. In 2002, 2001 and 2000, Gateway, Inc. represented 5%, 9%and 15% of our revenues, respectively. Our other customers include Motorola,Inc., Aon Corporation, Herman Miller, Inc., The Chicago Board of Trade, HarrisCorporation and Siemens Westinghouse Power Corporation.

 

6

----

 

**Sales and Marketing**

 

We market and sell our productsand services throughout the United States primarily through a direct salesforce. In addition to our Minneapolis headquarters, we have 20 field salesoffices in order to efficiently serve our customers’ needs.

 

Our field account executives andinside sales representatives work closely with our engineering team inevaluating the enterprise-class information storage needs of existing andprospective customers and in designing high quality, cost effective solutions.To ensure quality service, we assign each customer a specific field accountexecutive and inside sales representative. Our inside sales representativesproactively share responsibility with our field account executives insoliciting new and repeat business and in maintaining consistent customercontact. We believe that the longevity of service of our sales force is a keyfactor to earning and retaining the trust and confidence of our customers. Webelieve this differentiates us from many other storage solution providers thathave greater sales force turnover.

 

In addition to the efforts of ourfield account executives and inside sales representatives, we engage in avariety of other marketing activities designed to attract new business andretain customer loyalty. We regularly execute integrated, demand creationcampaigns, gain exposure through online and print trade publications, holdwebcasts and informational seminars and publish a quarterly newsletter.

 

**Original Equipment Manufacturer Services**

 

We have an original equipmentmanufacturer customer for whom we assemble and integrate hardware and softwareproducts and subassemblies acquired from our various suppliers. We designcustomized enclosures for most of these OEM products. When requested by thecustomer, we obtain the necessary agency and governmental approvals for thesubassemblies we design. These approvals may include those relating to safetyand radio frequency emissions and immunity, such as Underwriter’s Laboratoryand European “CE” certifications. We fully document all custom subassembliesfor ease of replication and service. We subject the assembled units to a systemlevel test to ensure performance to specifications in the anticipated end-usercomputing environment. Our integration and assembly operations are also ISO9001 registered. In accordance with these standards, we have designed ourintegration and assembly operations with similar quality procedures to those ofour hardware suppliers. Our close working relationship with our suppliersgenerally enables us to:

 

•                                          exchange critical information and implement jointcorrective action programs to ensure the quality of our finished products;

 

•                                          reduce costs and the investment in inventory; and

 

•                                          access critical products and subassemblies forlarge or unanticipated orders when required.

 

**Quality Management System**

 

We have a long history of being committed to a strategicquality effort.  In the early 1990’s, weadopted the ISO 9001 quality management system to better identify and meet theneeds of our customers, achieve a competitive market advantage and improveoverall company performance.  Weobtained an ISO 9001 certificate of registration in 1996 with successfulre-registration in 1999.  In 2000, we embracedthe Total Quality Management philosophy using the Malcolm Baldrige NationalQuality Award criteria to complement our existing quality system.  Today, our hybrid quality system focuses onachieving business results through high levels of customer satisfaction,employee satisfaction, profitability and operational excellence.

 

**Competition**

 

The enterprise-class informationstorage market is rapidly evolving and highly competitive. Current economicconditions have increased competitive pressures to reduce prices or offer lessrobust data storage solutions.  Wecompete with independent storage system suppliers to the high-end networkedmarket, including EMC Corporation and numerous value-added resellers,distributors and consultants. We also compete in the storage systems marketwith general purpose computer suppliers, some of which have significant storageproduct offerings, including Dell Computer Corporation, Hewlett-PackardCompany, International Business Machines Corp. and Sun Microsystems, Inc.

 

7

----

 

Some of our competitors includeour suppliers. They may dedicate or acquire greater sales and marketingresources in the future to provide enterprise-class information storagesolutions than at present and could terminate their relationships with us.Other suppliers may also enter the market and compete with us. We also expectcompetition will increase as a result of industry consolidation. Current andpotential competitors have established or may establish cooperativerelationships among themselves or with third parties to increase the ability oftheir products to address the needs of our prospective customers. Accordingly,new competitors or alliances among competitors may emerge and rapidly acquiresignificant market share.

 

**Employees**

 

As of December 31, 2002, wehad a total of 164 full-time employees. We have no employment agreements withany of our employees. None of our employees are unionized or subject to acollective bargaining agreement. We have experienced no work stoppages andbelieve that our employee relations are good.

 

**Backlog**

 

We configure products to customerspecifications and generally ship them shortly after we receive our customer’sorder.  Customers may change theirorders with little or no penalty.  We donot recognize revenue on hardware or software products until we have completedthe functionally essential portions of the installation or relatedconfiguration services in connection with the sale.  Customer constraints and the availability of engineeringresources can have a significant impact on when we can complete an installationand configuration service.  Thesefactors prevent us from relying on backlog as a predictor of our future saleslevels.

 

**Item 2.  Properties.**

 

Our corporate headquartersincluding our principal technical operations and our integration, assembly andsupport service operations is located in a 104,000 square foot office andwarehouse facility in Chanhassen, Minnesota. Our remaining 20 locations including sales and technical staff are smallto medium sized offices located throughout the United States.  Our regional hubs are located within each ofour regions in the Northeast, Southeast, Central and West.

 

**Item 3.  LegalProceedings.**

 

We are not currently involved inany material legal proceedings. We also had no material legal proceedings thatterminated during the fourth quarter of 2002.

 

**Item 4.  Submission ofMatters to a Vote of Security Holders.**

 

We submitted no matters duringthe fourth quarter of 2002 to a vote of security holders, through thesolicitation of proxies or otherwise.

 

8

----

 

**MANAGEMENT**

 

The following table lists ourcurrent directors and executive officers:

 
| **Name**            |   | **Age** |   | **Position**                                               |   |
|---------------------|--------|---------|--------|------------------------------------------------------------|--------|
| Greg R. Meland      |   | 49      |   | President, Chief Executive  Officer and Director           |   |
| Stephen M. Howe     |   | 44      |   | Vice President – Field  Operations                    |   |
| Daniel J. Kinsella  |   | 44      |   | Vice President – Finance and  Chief Financial Officer |   |
| Mary E. West        |   | 54      |   | Vice President – Human  Resources                     |   |
| Charles B. Westling |   | 44      |   | Vice President – Market  Development                  |   |
| Robert M. Price     |   | 72      |   | Chairman of the Board and  Director                        |   |
| Paul F. Lidsky*     |   | 49      |   | Director                                                   |   |
| Margaret A. Loftus* |   | 58      |   | Director                                                   |   |
| James E. Ousley*    |   | 57      |   | Director                                                   |   |

 

----

* Member of Audit and Compensation Committees.

 

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

 

Stephen M. Howe joined us in 1989as a field account executive, became Vice President–Sales in 1997 and VicePresident–Sales and Marketing in 1999. In 2002, Mr. Howe became VicePresident-Field Operations.  Between1982 and 1989, he was employed by Teltrend Inc., a telecommunications equipmentmanufacturer, most recently as Assistant Vice President of Operations.Mr. Howe was a sales representative for Hamilton Avnet Corp., anelectronics distributor, between 1980 and 1982.

 

Daniel J. Kinsella joined us in1999 as Chief Financial Officer. In 2002, Mr. Kinsella became VicePresident-Finance and Chief Financial Officer. Between 1998 and 1999, he was Chief Financial Officer of Lloyd’s BarbequeCompany. Mr. Kinsella served in various finance roles for Grist MillCompany between 1989 and 1998, most recently as its Chief Financial Officer,Treasurer and Secretary. From 1984 to 1989, Mr. Kinsella was the Directorof Financial Reporting for Inter-Regional Financial Group, Inc. Between1980 and 1984, he was employed by Touche Ross & Company, most recentlyas an audit manager. Mr. Kinsella is a Certified Public Accountant.

 

Mary E. West joined us in 2001 asVice President–Human Resources.  From1998 to 2001, she worked as an independent human resources consultant. Between1995 and 1998, Ms. West was employed by Arcadia Financial, Ltd., most recentlyas the Senior Vice President of Human Resources.  From 1993 to 1994, she was the corporate administrative directorfor Nexus, Inc.  Ms. West received herM.A. in Human Resources and Industrial Relations in 1988 from the University ofMinnesota Carlson School of Management.

 

Charles B. Westling joined us in2002 as Vice President–Corporate and Business Development.  In 2002, Mr. Westling became VicePresident–Market Development.  Between2000 and 2001, he was the Executive Vice President of Business Development ofAgiliti, Inc.  Mr. Westling served asSenior Managing Director and Director of Corporate Finance for John G. Kinnardand Company, Incorporated from 1997 to 1999.  From 1990 to 1997, Mr. Westling was a member of the corporate financedepartment at Dain Bosworth Incorporated, serving most recently as a managingdirector and head of technology investment banking.   Mr. Westling received his B.A. in economics from CarletonCollege and earned a Master of Management degree from the J.L. Kellogg GraduateSchool of Management at Northwestern University.

 

Robert M. Price was elected asour Chairman of the Board and a director in June 1998. Mr. Price has beenPresident of PSV, Inc., a technology consulting business located in Burnsville,Minnesota, since 1990. Between 1961 and 1990, he served in various executivepositions, including as Chairman and Chief Executive Officer, with Control DataCorporation. Mr. Price also serves on the Board of Directors of Public ServiceCompany of New Mexico, Affinity Technology Group, Inc. and National Center forSocial Entrepreneurs. Since May 1991, Mr. Price has been a Senior Advisor andProfessor at the Fuqua School of Business at Duke University.  Mr. Price is Mr. Meland’s father-in-law.

 

9

----

 

Paul F. Lidsky was elected as adirector in June 1998. Since November 2002, Mr. Lidsky has been Presidentand Chief Executive Officer of VigiLanz Corporation, a medical softwarecompany.  From 1997 until 2002,Mr. Lidsky was the President and Chief Executive Officer of OneLinkCommunications, Inc., a telecommunications company. Between 1992 and 1997,Mr. Lidsky was employed by Norstan, Inc., a comprehensive technologyservices company, most recently as Executive Vice President of Strategy andBusiness Development.

 

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

 

JamesE. Ousley was elected as a director in June 1998.  Since 2001, Mr. Ousley has been president and chief executiveofficer of Vytek Wireless Inc., a mobile computing company.  From 1999 to 2001, he served as Presidentand Chairman of Syntegra (USA), a global e-Business solutions provider and adivision of British Telecommunications plc. From September 1991 to August 1999, Mr. Ousley was President and ChiefExecutive Officer of Control Data Systems (CDS), which was acquired by BritishTelecommunications in August 1999.   From 1968 to 1991, he held various sales and executive managementpositions with Control Data Corporation, a global computer systems,software/services and peripherals company. Mr. Ousley also serves on the Board of Directors for Vytek Wireless,Inc., ActiveCard, Inc., Bell Microproducts Inc., Norstan, Inc. and SavvisCommunications.

 

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

 

# **PART II**

 

**Item 5.  Market forRegistrant’s Common Equity and Related Stockholder Matters.**

 

Our common stock has been quotedon the Nasdaq National Market under the symbol “DTLK” since August 6,1999, the day of our initial public offering. The table below sets forth, forthe calendar quarters indicated, the high and low per share closing sale pricesof our common stock as reported by the Nasdaq National Market.

 
|                                   |   | **High** |       | **Low** |       |
|----------------------------------------|--------|----------|------------|---------|------------|
| **Year Ended  December 31, 2002** |   |     | ** ** |    | ** ** |
| First Quarter                          |   | $        | 7.01       |    | $          | 4.35 |   |
| Second Quarter                         |   | 6.72     |       | 3.31    |       |
| Third Quarter                          |   | 4.17     |       | 2.40    |       |
| Fourth Quarter                         |   | 4.22     |       | 2.37    |       |
| **Year Ended  December 31, 2001** |   |     |       |    |       |
| First Quarter                          |   | 12.88    |       | 7.69    |       |
| Second Quarter                         |   | 11.30    |       | 5.43    |       |
| Third Quarter                          |   | 8.39     |       | 3.80    |       |
| Fourth Quarter                         |   | 8.30     |       | 3.05    |       |
| **Year Ended  December 31, 2000** |   |     |       |    |       |
| First Quarter                          |   | 35.06    |       | 18.13   |       |
| Second Quarter                         |   | 20.75    |       | 11.75   |       |
| Third Quarter                          |   | 17.75    |       | 10.75   |       |
| Fourth Quarter                         |   | 13.75    |       | 8.44    |       |
|                                        |        |          |            |         |            |  |  |

 

OnFebruary 28, 2003, the closing price per share of our common stock was $3.39.We urge potential investors to obtain current market quotations before makingany decision to invest in our common stock. On February 28, 2003, there wereapproximately 82 holders of record of our common stock.  Many of our shares are held by beneficialowners through a small number of holders of record.

 

Except for distributions paid toour pre-initial public offering corporation stockholders related to Scorporation earnings generated prior to August 6, 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. In addition, we are effectively restrictedunder our credit agreement from paying cash dividends on our common stock.

 

10

----

 

**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. The data as of December 31, 2002 and 2001, and for the yearsended December 31, 2002, 2001 and 2000, was derived from our financialstatements that are included in this Annual Report. The data as of December 31,2000, 1999 and 1998, and for the years ended December 31, 1999 and 1998, wasderived from our financial statements that are not included in this AnnualReport. Our independent public accountants, KPMG LLP, audited our 2002financial statements. Our previous independent public accountants, ArthurAndersen LLP, audited our 2001 financial statements and PricewaterhouseCoopersLLP audited our 1998 through 2000 financial statements. Our historicalfinancial results are not necessarily indicative of our future operatingresults.

 
|                                                                                       |   | **Year ended December 31,**          |   |
|--------------------------------------------------------------------------------------------|--------|-------------------------------------------|--------|
|                                                                                       |   | **2002**                                  |   | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
|                                                                                       |   | **(in thousands, except per share data)** |   |
| **Statement of  Operations Data:**                                                         |   |                                      |   |   |   |   |   |   |   |   |   |
| Net sales:                                                                                 |   |                                      |   |   |   |   |   |   |   |   |   |
| Product sales                                                                              |   | $                                         | 58,492 |   | $ | 96,188 |   | $ | 118,233 |   | $ | 105,373 |   | $ | 80,243 |   |
| Service sales                                                                              |   | 28,008                                    |   | 28,596 |   | 19,536 |   | 11,230 |   | 5,849 |   |
| Total net sales                                                                            |   | 86,500                                    |   | 124,784 |   | 137,769 |   | 116,603 |   | 86,092 |   |
|                                                                                       |   |                                      |   |   |   |   |   |   |   |   |   |
| Cost of sales:                                                                             |   |                                      |   |   |   |   |   |   |   |   |   |
| Cost of product sales                                                                      |   | 44,776                                    |   | 70,393 |   | 87,321 |   | 77,623 |   | 60,622 |   |
| Cost of services                                                                           |   | 20,000                                    |   | 20,328 |   | 14,148 |   | 8,411 |   | 3,740 |   |
| Total cost of sales                                                                        |   | 64,776                                    |   | 90,721 |   | 101,469 |   | 86,034 |   | 64,362 |   |
|                                                                                       |   |                                      |   |   |   |   |   |   |   |   |   |
| Gross profit                                                                               |   | 21,724                                    |   | 34,063 |   | 36,300 |   | 30,569 |   | 21,730 |   |
|                                                                                       |   |                                      |   |   |   |   |   |   |   |   |   |
| Operating expenses:                                                                        |   |                                      |   |   |   |   |   |   |   |   |   |
| Sales and marketing                                                                        |   | 11,481                                    |   | 15,836 |   | 15,230 |   | 11,702 |   | 7,655 |   |
| General and administrative                                                                 |   | 10,354                                    |   | 11,221 |   | 8,792 |   | 6,883 |   | 5,027 |   |
| Engineering                                                                                |   | 4,954                                     |   | 5,259 |   | 3,745 |   | 2,594 |   | 1,362 |   |
| Amortization of goodwill and other intangibles                                             |   | 1,088                                     |   | 2,264 |   | 1,026 |   | 807 |   | 376 |   |
| Offering costs(1)                                                                          |   | —                                    |   | — |   | 381 |   | 173 |   | 733 |   |
| Total operating expenses                                                                   |   | 27,877                                    |   | 34,580 |   | 29,174 |   | 22,159 |   | 15,153 |   |
|                                                                                       |   |                                      |   |   |   |   |   |   |   |   |   |
| Operating (loss) income                                                                    |   | (6,153                                    | )      | (517 | ) | 7,126 |   | 8,410 |   | 6,577 |   |
| Interest income (expense), net                                                             |   | 117                                       |   | 127 |   | 311 |   | (141 | ) | (281 | ) |
| (Loss) income before income taxes and cumulative effect of a change inaccounting principle |   | (6,036                                    | )      | (390 | ) | 7,437 |   | 8,269 |   | 6,296 |   |
| Income tax (benefit) expense(2)                                                            |   | (618                                      | )      | 115 |   | 3,049 |   | 897 |   | 148 |   |
| (Loss) income before cumulative effect of a change in accounting  principle                |   | (5,418                                    | )      | (505 | ) | 4,388 |   | 7,372 |   | 6,148 |   |
| Cumulative effect of a change in accounting principle, net of tax(3)                       |   | —                                    |   | — |   | (753 | ) | — |   | — |   |
| Net (loss) income                                                                          |   | $                                         | (5,418 | ) | $ | (505 | ) | $ | 3,635 |   | $ | 7,372 |   | $ | 6,148 |   |
| Net (loss) income per share, basic:                                                        |   |                                      |   |   |   |   |   |   |   |   |   |
| (Loss) income per share before cumulative effect of a change inaccounting principle        |   | $                                         | (0.56  | ) | $ | (0.06 | ) | $ | 0.50 |   | $ | 1.01 |   | $ | 0.88 |   |
| Loss per share from the cumulative effect of a change inaccounting principle(3)            |   | —                                    |   | — |   | (0.09 | ) | — |   | — |   |
| Net (loss) income per share                                                                |   | $                                         | (0.56  | ) | $ | (0.06 | ) | $ | 0.41 |   | $ | 1.01 |   | $ | 0.88 |   |
| Net (loss) income per share, diluted:                                                      |   |                                      |   |   |   |   |   |   |   |   |   |
| (Loss) income per share before cumulative effect of a change inaccounting principle        |   | $                                         | (0.56  | ) | $ | (0.06 | ) | $ | 0.48 |   | $ | 0.99 |   | $ | 0.88 |   |
| Loss per share from the cumulative effect of a change inaccounting principle(3)            |   | —                                    |   | — |   | (0.08 | ) | — |   | — |   |
| Net (loss) income per share                                                                |   | $                                         | (0.56  | ) | $ | (0.06 | ) | $ | 0.40 |   | $ | 0.99 |   | $ | 0.88 |   |
| Weighted average shares outstanding:                                                       |   |                                      |   |   |   |   |   |   |   |   |   |
| Basic                                                                                      |   | 9,687                                     |   | 8,921 |   | 8,794 |   | 7,295 |   | 6,993 |   |
| Diluted                                                                                    |   | 9,687                                     |   | 8,921 |   | 9,166 |   | 7,437 |   | 6,993 |   |

 

11

----

 
|                                  |   | **As of December 31,** |   |
|---------------------------------------|--------|-----------------------------|--------|
|                                  |   | **2002**                    |   | **2001** |   | **2000** |   | **1999** |   | **1998** |   |
|                                  |   | **(In thousands)**          |   |
| **Balance Sheet  Data:**              |   |                        |   |   |   |   |   |   |   |   |   |
| Cash and cash equivalents             |   | $                           | 10,334 |   | $ | 5,846 |   | $ | 4,542 |   | $ | 6,515 |   | $ | 2,798 |   |
| Working capital                       |   | 13,477                      |   | 10,729 |   | 11,695 |   | 17,233 |   | 6,039 |   |
| Total assets                          |   | 44,785                      |   | 46,768 |   | 56,472 |   | 42,415 |   | 32,144 |   |
| Note payable to former stockholder(4) |   | —                      |   | 704 |   | 1,409 |   | 2,114 |   | — |   |
| Common stock, subject to put option   |   | —                      |   | — |   | — |   | — |   | 19,059 |   |
| Stockholders’ equity (deficit)   |   | 26,346                      |   | 26,114 |   | 26,137 |   | 21,131 |   | (6,979 | ) |
|                                       |        |                             |        |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)                                  Reflects legal, accounting and other costs associatedwith our initial and a subsequent public offering, which we expensed when wepostponed both offerings due to market conditions.  We successfully completed our initial public offering on August6, 1999.  We did not complete our secondpublic offering.

 

(2)                                  Our1998 income tax expense resulted from the taxable income generated by DirectConnect Systems, Inc., or DCSI, from the date of our acquisition(July 15, 1998) through December 31, 1998. In January 1999 wemerged DCSI into us. Our 1999 income tax expense resulted from the taxableincome we generated between August 6, 1999 (when we terminated our Scorporation status) and December 31, 1999, and the tax effect of ourmerger with DCSI. Our 2002 income tax benefit was offset by $1.6 million of expense for a valuation allowancefor deferred tax assets.  Theultimate realization of deferred tax assets is dependent upon carry back toprior periods and upon the generation of future taxable income during theperiods in which those temporary differences become deductible. Based upon the level of taxable losses in 2002and the near-term uncertainty of taxable income, management cannot reasonablypredict when or if these deductible differences will be realized. SeeNote 4 of the Notes to our Financial Statements.

 

(3)                                  In the first quarter of 2000, we incurred aone-time, non-cash charge of $753,000 representing the cumulative effect, netof income taxes, of the accounting changes we made effective as of January 1,2000, to our revenue recognition policies. See Note 2 of the Notes to our Financial Statements.

 

(4)                                  Reflects a $3.0 million promissory note, lesspayments we have made, issued to one of our former stockholders in connectionwith our redemption, effective February 28, 1999, of 1,096 shares ofcommon stock. See Note 3 of the Notes to our Financial Statements.

 

**Item 7. ****     Management’s Discussion and Analysis of FinancialCondition and Results of Operation.**

 

You should read the followingdiscussion in conjunction with our financial statements and the related notesincluded in Item 8. The following information includes forward-lookingstatements, the realization of which may be affected by certain importantfactors discussed under “Risk Factors.”

 

**OVERVIEW**

 

We are an independent architectof enterprise-class information storage infrastructures. We derive our revenuesprincipally from designing and installing data storage systems. Our solutionscan include hardware products, such as disk arrays, tape systems andinterconnection components and storage management software products. Prior toJanuary 1, 2000, we recognized revenues for hardware and software productsales when we shipped the products and software to our customers or after theyaccepted products under evaluation. However, in December 1999, the SEC staffissued Staff Accounting Bulletin, or SAB, No. 101, “Revenue Recognition,”which clarified the SEC staff’s view regarding the recognition and reporting ofrevenues in particular transactions. In light of SAB No. 101, we modifiedour revenue recognition policy related to hardware and software products whenwe provide any installation or configuration services in connection with thesale. We now recognize revenue from hardware and software product sales when wecomplete our installation and configuration services that are essential to thefunctionality of the delivered hardware and software products or after thecustomer has accepted products under evaluation.  For any remaining installation that is not essential to thefunctionality of delivered product, we account for the remaining installationas a separate unit of accounting and defer revenue based on objective fairvalue for such services. This change was effective as of January 1,2000.  Under the SAB No. 101transition provisions, we accounted for this change in accounting policyprospectively. As of January 1, 2000, we recorded a charge to earnings of$753,000, representing the cumulative effect, net of income taxes, of thischange in our accounting policy.

 

12

----

 

As indicated above, our customersfrequently engage us for assistance in the installation of our solutions.Increasingly, they also engage us for consulting and other professionalservices. We recognize revenues for this work as we render these services.

 

Wesell support service contracts to most of our customers.  Whencustomers purchase support services through us, customers receive the benefitof integrated support.  We have aqualified, independent support desk to provide routine customer supportservices covering minor problems.  Wefulfill on-site assistance by purchasing support service agreements forour customers from our hardware and software vendors or their designatedthird-party service providers and byarranging on-site support assistance with the appropriate vendor if necessary. Wedefer revenues and direct costs resulting from these contracts, and amortizethese revenues and expenses into operations, over the term of the contracts,which are generally twelve months.

 

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

 

In November 2000, we acquiredcertain assets of the data storage and services business of OpenSystems.com,Inc., a Walpole, Massachusetts-based firm engaged in the resale andinstallation of data storage solutions.

 

**Results of Operations**

 

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

 

|                                           |   | **Years Ended December 31,** |   |
|------------------------------------------------|--------|-----------------------------------|--------|
|                                           |   | **2002**                          |   | **2001** |   | **2000** |   |
| Net sales                                      |   | 100.0                             | %      | 100.0 | % | 100.0 | % |
| Cost of sales                                  |   | 74.9                              |   | 72.7 |   | 73.7 |   |
| Gross profit                                   |   | 25.1                              |   | 27.3 |   | 26.3 |   |
| Operating expenses:                            |   |                              |   |   |   |   |   |
| Sales and marketing                            |   | 13.3                              |   | 12.7 |   | 11.1 |   |
| General and administrative                     |   | 12.0                              |   | 9.0 |   | 6.4 |   |
| Engineering                                    |   | 5.7                               |   | 4.2 |   | 2.7 |   |
| Amortization of goodwill and other intangibles |   | 1.2                               |   | 1.8 |   | 0.7 |   |
| Offering costs                                 |   | 0.0                               |   | 0.0 |   | 0.3 |   |
| Total operating expenses                       |   | 32.2                              |   | 27.7 |   | 21.2 |   |
| Operating income (loss)                        |   | (7.1                              | )%     | (0.4 | )% | 5.2 | % |

 

**Comparison of Years Ended December 31, 2002, 2001 and2000**

 

*Net Sales.*  Our product sales decreased39.2% in 2002 from 2001 to $58.5 million, and decreased 18.6% in 2001 from 2000to $96.2 million. Our product sales were $118.2 million in 2000.  Our service sales, which include customersupport and installation services, remained relatively flat from 2001 to 2002at $28.0 million in 2002 and increased 46.4% in 2001 over 2000 to $28.6million.  Our service sales in 2000 were$19.5 million.  The decline in ourproduct sales since 2000 reflects a tremendously difficult operatingenvironment as many companies have chosen to significantly reduce their spendingon information technology.  Thedata storage industry as a whole was negatively impacted by theseconditions.  Given these developments,we cannot predict if or when our product sales will return to historicallyhigher levels.  The growth in our service revenues between 2000 and 2002 reflects anincrease in new maintenance contract sales and contract renewals by existingcustomers.  We derived approximately 5%,9% and 15% of our sales from one customer during 2002, 2001 and 2000,respectively.  We cannot assure you thatthis customer will account for a substantial portion of our future sales.

 

*Gross Profit.*  Our total gross profit as apercentage of net sales decreased to 25.1% in 2002 from 27.3% in 2001 and 26.3%in 2000.  Due to the currenteconomic environment, our customers are continuing to seek storage solutions tomeet minimum needs rather than implementing comprehensive infrastructurechanges.  Solutions that meet a minimumneed generally carry lower margins than comprehensive infrastructure changes.  In addition, our gross profit percentage hassuffered due to the high level of pricing competition in the marketplace.  Given these developments, we cannot predictif or when our

 

13

----

gross profit as a percentage of net sales will return to historicallyhigher levels. Similarly, product grossprofit as a percentage of product sales decreased to 23.4% in 2002 as comparedto 26.8% in 2001 and 26.1% in 2000. Service gross profit as a percentage of service sales in 2002 remainedrelatively flat from 2001 at 28.6%. Service gross profit as a percentage of service sales was 28.9% in 2001and 27.6% in 2000.  The increase ingross profit rates for services from 2000 to 2002 reflects our ability toobtain higher margins on our integrated support services. Charges for excess and obsolete inventory in 2002,2001 and 2000 of $188,000, $344,000 and $1.2 million, respectively, adverselyaffected our product gross profit.  Inparticular, during 2000, we disposed of excess, old generation inventories atliquidation values significantly below our acquisition cost.

 

*                OverallCost Reduction Initiatives*. Because of the continuing difficult economic climate, we have activelysought to reduce costs across our business. Our principal fixed expense is forpersonnel. Through attrition and layoffs, we have reduced employee headcount to164 at December 31, 2002 from 216 at December 31, 2001. We have alsosignificantly reduced and continue to monitor discretionary areas of spending. Asa result of our efforts, our fixed expenses before amortization of intangiblesduring the fourth quarter of 2002 are down by $1.3 million as compared to thefourth quarter of 2001.

 

*Sales and Marketing.*  Salesand marketing expenses include wages and commissions paid to sales andmarketing personnel, travel costs and advertising, promotion and hiringexpenses.  Sales and marketing expensestotaled $11.5 million, or 13.3% of net sales for 2002 compared to $15.8 million,or 12.7% of net sales for 2001 and $15.2 million, or 11.1% of net sales for2000.  The decrease in sales expense inabsolute dollars is a result of a decrease in commissions related to lowersales and gross margins in 2002 as compared to 2001 and 2000 and a decrease intravel and entertainment due to increased efforts to minimize expenses in theseareas.  The increase in sales expense asa percentage of sales from 2002 as compared to 2001 and 2000 resulted primarilyfrom lower sales combined with increased expenses related to investments in managementfor our regional structure.  Theseinvestments were completed in 2001; however, the hiring and related expenseswere not fully realized until the third quarter of 2001.

 

*General and Administrative.*  Generaland administrative expenses include wages for administrative personnel,professional fees, depreciation, communication expenses and rent and relatedfacility expenses. General and administrative expenses decreased to $10.4million, or 12.0% of net sales for 2002 as compared to $11.2 million, or 9.0%in 2001 and  $8.8 million, or 6.4% in2000. When comparing 2002 to 2001, the decrease in general andadministrative expenses in absolute dollars reflects lower hiring costs due tofewer new employees, lower professional services fees due to the completion ofseveral process improvement consulting engagements in 2001 and lowerdepreciation expense. Our general and administrative expenses were higher as apercentage of net sales because of the reduction in sales.

 

*Engineering.*  Engineering expenses includeemployee wages and travel, hiring and training expenses for our professionalengineers and technicians. We allocate engineering costs associated withinstallation services to our cost of service sales.  Engineering expenses remainedrelatively flat at $5.0 million, or 5.7% of net sales in 2002 as compared to$5.3 million, or 4.2% of net sales in 2001. Engineering expenses were $3.7 million, or 2.7% of net sales in2000.  The increase in engineeringexpenses as a percentage of net sales reflects fewer installations in 2002 ascompared to 2001.  As a result, therewere fewer engineering costs associated with installation services recorded ascost of service sales and lower travel and entertainment costs associated withthe installations.  In addition, theengineering expenses remained relatively flat in absolute dollars because therewere lower costs associated with a reduction in headcount, lower depreciationexpense on our engineering laboratory equipment and lower costs for travel andentertainment due to increased efforts to minimize expenses in these areas.

 

*Goodwill and Other Intangible Amortization.* Amortization of goodwill and other intangible assets decreased to $1.1million in 2002 compared to $2.3 million in 2001.  Amortization of goodwill and other intangible assets was $1.0million in 2000.  The amortizationrelates primarily to our acquisition of the data storage and services businessof OpenSystems.com, Inc. in November 2000. Due to the adoption of Statement of Financial Accounting Standards(SFAS) 142, Goodwill and Intangible Assets, our amortization expense decreasedby $1.2 million in 2002 from 2001.  ThisStatement required that we no longer amortize goodwill and intangible assetswith indefinite lives, but instead test for impairment annually or wheneverimpairment is indicated.  In 2002, weamortized the remaining $163,000 balance of the trademark and name intangibleasset we acquired in our July 1998 acquisition of Direct Connect Systems, Inc.because we are not operating under its name and realization of future usesbecame uncertain in the fourth quarter of 2002. For more information, see Note2 of the Notes to our Financial Statements.

 

*Offering Costs. *During the secondquarter of 2000, we expensed approximately $381,000 of costs for a proposedsecond public offering of our common stock, which was withdrawn due to marketconditions.

 

*Operating (Loss) Income.* We incurred an operating loss of $6.2 million in2002 compared to $517,000 in 2001. Operating income was $7.1 million in 2000. Thedecrease in operating income was principally attributable to our sales declineunder difficult economic conditions combined with an increase in our operatingexpenses in the anticipation of revenue growth and

 

14

----

 

market share gains.  Although our revenues remained relatively flat for the fourquarters in 2002, our operating loss decreased from $2.1 million in the firstquarter of 2002 to $521,000 in the fourth quarter of 2002 due to the reductionin operating expenses.  The reductionwas a result of selective reductions in headcount and expense control.

 

*Income Taxes.*  We provided for an income taxbenefit of $618,000 in 2002 and income taxes of $115,000 in 2001 and $3.0million in 2000.  Included in the incometax provision for 2002 is a non-cash charge of $1.6 million related to thecreation of a valuation reserve for the deferred tax asset.  Theultimate realization of deferred tax assets is dependent upon carry back toprior periods and upon the generation of future taxable income during theperiods in which those temporary differences become deductible. Based upon the level of taxable losses in 2002and the near-term uncertainty of taxable income, management cannot reasonablypredict when or if these deductible differences will be realized.  In addition, we do not have the ability to realize future income tax benefits onfuture losses.  Excluding the impact ofthe reserve, our loss per diluted share would have been $.39 per share for theyear ended December 31, 2002. Even though we generated an operating loss in2001, we still incurred income tax expense which reflected permanentdifferences, such as non-deductible goodwill amortization, between our reportedand taxable income as well as state taxes.

 

*Cumulative Effect of Change in Accounting Principle.*  Asdescribed in the overview above, in the first quarter of 2000, we incurred aone-time, non-cash charge of $753,000 representing the cumulative effect, netof income taxes, of the accounting changes we made effective as of January 1,2000, to our revenue recognition policies to comply with the provisions of SECStaff Accounting Bulletin No. 101.  SeeNote 2 of the Notes to our Financial Statements.

 

**Quarterly Results and Seasonality**

 

Thefollowing table sets forth our unaudited quarterly financial data for eachquarter of 2002 and 2001. In our opinion, this unaudited information has beenprepared on the same basis as the audited information and includes 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** |   |
|-------------------------|--------|--------------------|--------|
|                    |   | **2002**           |   | **2001** |   |
|                    |   | **Mar. 31**        |   | **Jun. 30** |   | **Sep. 30** |   | **Dec. 31** |   | **Mar. 31** |   | **Jun. 30** |   | **Sep. 30** |   | **Dec. 31** |   |
|                    |   | **(in thousands)** |   |
| Net sales               |   | $                  | 21,784 |   | $ | 21,019 |   | $ | 21,858 |   | $ | 21,839 |   | $ | 40,899 |   | $ | 26,992 |   | $ | 32,244 |   | $ | 24,649 |   |
| Gross profit            |   | 5,503              |   | 5,043 |   | 5,397 |   | 5,781 |   | 11,069 |   | 7,472 |   | 9,269 |   | 6,253 |   |
| Operating income (loss) |   | (2,094             | )      | (1,978 | ) | (1,560 | ) | (521 | ) | 1,786 |   | (1,087 | ) | 788 |   | (2,004 | ) |
| Net income (loss)       |   | (1,300             | )      | (1,229 | ) | (962 | ) | (1,927 | ) | 1,076 |   | (623 | ) | 290 |   | (1,248 | ) |
|                         |        |                    |        |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

We have experienced, and expectto continue to experience, quarterly variations in our net sales as a result ofa number of factors, including the length of the sales cycle with customers forlarge storage system evaluations and purchases, delays in storage systeminstallations or configurations, new product introductions by suppliers andtheir market acceptance, delays in product shipments or other quality controldifficulties, our ability to integrate any acquired businesses, trends in theenterprise-class information storage industry in general, the geographic andindustry specific market in which we are currently active, or may be in thefuture, and the opening of new field offices. In addition, current economicconditions and competition also affect our customers’ decisions to place orderswith us.

 

15

----

 

**Liquidity and Capital Resources**

 

Historically, we have financedour operations and capital requirements through cash flows generated fromoperations, supplemental bank borrowings and the proceeds from our offerings ofour common stock. Our working capital was $13.5 million at December 31, 2002 ascompared to $10.7 million at December 31, 2001. Our current ratio was1.7:1 at December 31, 2002 as compared to 1.5:1 at December 31, 2001.At December 31, 2002, our cash and cash equivalents balance was $10.3million.

 

Cash provided by operatingactivities for 2002 was $894,000 as compared to $5.6 million in 2001 and $10.6million in 2000. The cash provided in 2002 resulted primarily from a reductionin our net operating assets.  Thereduction in net operating assets reflects timing of certain payments andreceipts and a reduction in the overall level of business.  The cash provided in 2001 resultedprimarily from a reduction in inventories offset by a decrease in payables. Thereduction in inventories for 2001 resulted from our increased efforts tooptimize our inventory levels and to complete the installation of products forcustomers at year-end.  The cash provided by operating activities in 2000resulted primarily from our net income and a reduction in accounts receivableand increases in accounts payable, partially offset by an increase ininventories.

 

Cash used in investing activitiesduring 2002 was $1.1 million as compared to $4.0 million in 2001 and $11.4million in 2000. In 2002, we used this cash primarily to implement ourcustomer relationship management information system. In 2001, we purchased furniture and fixtures for our newcorporate headquarters in Chanhassen, Minnesota and invested in our newinformation and phone systems and engineering laboratory equipment. Our 2000 uses reflected expenditures forengineering and lab equipment, the purchase of land adjacent to our newcorporate headquarters facility and a $500,000 deposit on the new corporateheadquarters that we began leasing in June 2001. The 2000 uses also included$7.5 million to acquire the data storage and services business ofOpenSystems.com, Inc.

 

Cash provided by financingactivities during 2002 was $4.7 million. Cash used in financing activities was $342,000 in 2001 and $1.2 millionin 2000.  In 2002, we received$5.3 million from a direct private offering of newly issued common stock toinstitutional investors and $186,000 from stock sold under our employee stockpurchase plan. The cash provided was partially offset by the final scheduledpayment of $704,000 on a note due to a former stockholder.  In 2001,we made a scheduled payment of $705,000 on a note due to a former stockholder,which was partially offset by $363,000 of proceeds from our employee stockpurchase plan and stock option exercises. In 2000, we used $884,000 to make a final dividend distribution to theten pre-initial public offering stockholders related to their taxliabilities.  We also made a scheduledpayment of $705,000 on the former shareholder’s note.  These uses were partially offset by $388,000 of proceeds fromstock purchases under our employee stock purchase plan.

 

Effective June 30, 2002, wesigned a new credit agreement with a commercial bank that provides for an $8million revolving line of credit for financing our working capital needs.  The term of the agreement ends June 30,2003.  Borrowings under the line ofcredit are secured by our accounts receivable and inventory and are subject to certainfinancial and operating covenants, including covenants that require us tomaintain a maximum level of funded debt-EBITDA ratio and a minimum amount ofworking capital, tangible net worth and debt-net worth ratio.  At December 31, 2002, we were in compliancewith all covenants under this agreement. We had no outstanding borrowings as of December 31, 2002.  For more information, see Note 3 of theNotes to our Financial Statements.

 

In 2001, we signed an 11-year non-cancelable operating lease for our new corporate headquarters in Chanhassen, Minnesota.  The lease requires base rental payments of approximately $1.0 million in the first year and $1.3 million for each subsequent year.   For more information, see Note 5 of the Notes to our Financial Statements.

 

In February 1999, weredeemed 1,095,720 shares of common stock held by one of our formerstockholders and issued him a $3.0 million note payable in four installmentsthrough February 2002. We made principal payments of $906,000, $705,000and $705,000 on this note in August 1999, February 2000 and February 2001,respectively.  We made our final paymentof $704,000 on this note in February 2002, leaving Datalink with no outstandingdebt.

 

16

----

 

Asof December 31, 2002, our contractual cash obligations consisting offuture minimum lease payments due under non-cancelable operating leases are asfollows:

 

| **Year Ended** |   | **Total**          |   |
|----------------|--------|--------------------|--------|
|           |   | **(In thousands)** |   |
| 2003           |   | $                  | 2,166  |   |
| 2004           |   | 2,076              |   |
| 2005           |   | 1,950              |   |
| 2006           |   | 1,836              |   |
| 2007           |   | 1,523              |   |
| Future         |   | 5,595              |   |
|           |   | $                  | 15,146 |   |

 

We believe that funds generated from operations,together with the available credit under our revolving credit agreement, willbe sufficient to finance our current operations and planned capitalexpenditures for at least the next twelve months. We are planning for $500,000 to $1.0 million of capital expendituresthrough 2003 primarily related to enhancements to our management informationsystems.

 

### **Critical AccountingPolicies 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 commitments andcontingencies.  We believe that thefollowing represent the areas where more critical estimates and assumptions areused in the preparation of the financial statements:

 

*RevenueRecognition*.  Asdiscussed above, we recognize revenues from hardware and software product salesonly after all functionally essential portions of the installation serviceshave been completed and the product is functioning properly rather than upon shipment.We recognize all professional service revenue, including installation andconsulting service revenue, when the service is rendered.  We believe this policy minimizesmanagement’s judgments over the timing and extent of revenue recognition.Revenues from maintenance contracts are recognized ratably over the period ofthe contract. Although this policy that we adopted on January 1, 2000 containsvery specific guidelines for measuring revenue, certain judgments do affect theapplication of our revenue policy, such as evaluating multiple elementarrangements.

 

*Inventory*.  We periodically review, estimate and adjustour reserves for obsolete or unmarketable inventory equal to the differencebetween the inventory cost and the estimated market value based uponassumptions about future demand and market conditions. Results could bematerially different if demand for our products decreased because of economicor competitive conditions, length of industry downturn, or if products becomeobsolete because of technical advancements in the industry.

 

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

 

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

 

*IncomeTaxes*.  We utilize theliability method of accounting for income taxes.  We recognize deferred tax liabilities or assets for the expectedfuture tax consequences of temporary differences between the book and tax basesof assets and 

 

17

----

 

liabilities.  We regularlyassess the likelihood that our deferred tax assets will be recovered fromfuture taxable income  We record avaluation allowance to reduce our deferred tax assets to the amounts we believeto be realizable.  We consider projectedfuture taxable income and ongoing tax planning strategies in assessing theamount of the valuation allowance.  Ifwe determine it is more likely than not that we will not realize all or part ofour deferred tax assets, we will adjust our earnings for the deferred tax inthe period we make this determination. As a result of our cumulative losses over the past two years and thefull utilization of our loss carryback potential, we concluded during thefourth quarter of fiscal 2002 to make a full valuation allowance against ournet deferred tax assets.  The valuationallowance at December 31, 2002 was $1.6 million.  In addition, we expect to provide a full valuation allowance onany future tax benefits until we can sustain a level of profitability thatdemonstrates our ability to utilize these assets.

 

**Recent Accounting Pronouncements**

 

In June 2002, the Financial Accounting Standards Boardissued SFAS No. 146 ‘‘Accounting for Costs Associated with Exit or DisposalActivities.’’ SFAS No. 146 supersedes EITF No. 94-3. The principle differencebetween SFAS No. 146 and EITF No. 94-3 relates to when an entity can recognizea liability related to exit or disposal activities. SFAS No. 146 requires aliability be recognized for a cost associated with an exit or disposal activitywhen the liability is incurred. EITF No. 94-3 allowed a liability, related toan exit or disposal activity, to be recognized at the date an entity commits toan exit plan. The provisions of SFAS No. 146 are effective on January 1, 2002.Accordingly, we will apply this standard to all exit or disposal activitiesinitiated after January 1, 2002.

 

In December 2002, theFASB issued SFAS No. 148, Stock Compensation. SFAS No. 148 provides alternativemethods of transition for a voluntary change to the fair value based method ofaccounting for stock-based employee compensation. In addition, SFAS No. 148amends the disclosure requirements of SFAS No. 123 to require prominentdisclosures in both annual and interim financial statements about the method ofaccounting for stock-based employee compensation and the effect of the methodused on reported results. We do not plan to change our method of accounting forstock-based employee compensation. We will make the required interimdisclosures effective with the quarter ending March 31, 2003.

 

In December 2002,the EITF issued EITF 00 21, Revenue Arrangements with Multiple Deliverables.This Issue addresses certain aspects of the accounting by a vendor forarrangements under which it will perform multiple revenue-generatingactivities.  In some arrangements, thedifferent revenue-generating activities (deliverables) are sufficientlyseparable, and there exists sufficient evidence of their fair values toseparately account for some or all of the deliverables (that is, there areseparate units of accounting).  In otherarrangements, some or all of the deliverables are not independently functional,or there is not sufficient evidence of their fair values to account for themseparately. This Issue addresses when and, if so, how an arrangement involvingmultiple deliverables should be divided into separate units of accounting.  This Issue does not change otherwiseapplicable revenue recognition criteria. This Issue is applicable for us forfiscal 2004 and could have an impact on revenue recognition of future salestransactions.

 

**Inflation**

 

We do not believe that inflationhas had a material effect on our results of operations in recent years. Wecannot assure you that inflation will not adversely affect our business in thefuture.

 

**RISK FACTORS**

** **

**Current economic conditions adversely impact our revenues andprofits.**

 

Since mid-2001, we haveexperienced a very difficult and competitive operating environment.  This uncertainty was further complicated bythe world events such as the terrorist attacks on the United States inSeptember 2001 and the current threat of war in Iraq.  The high level of economic uncertainty has led to an overallreduction in capital spending, including spending for technology.  Some of our customers have canceled ordelayed planned purchases.  Others havereplaced large storage solution installation projects with smaller, piecemealprojects that carry lower profit margins for us.  Competition for available business has also affected ourmargins.  We cannot predict the continuingeffect of current economic conditions on our business.  If our revenues and cash flows continue tobe adversely affected, we may need to further reduce our expenses orpersonnel.  This could adversely affectour ability to capitalize on future technology spending by our customers atsuch time as economic conditions improve.

 

18

----

 

**Competition could prevent us from increasing or sustainingour revenues or profitability.**

 

The enterprise-class informationstorage market is rapidly evolving and highly competitive. As technologieschange rapidly, we expect that competition will increase in the future. Wecompete with independent storage system suppliers to the high-end market andnumerous resellers, distributors and consultants. We also compete in thestorage systems market with general purpose computer suppliers. Many of ourcurrent and potential competitors have significantly greater financial,technical, marketing, purchasing and other resources than we do. As a result,they may respond more quickly to new or emerging technologies and changes incustomer requirements, devote greater resources to the development, promotionand sale of products and deliver competitive products at lower end-user prices.

 

Some of our current and potentialcompetitors include our suppliers. We are not the exclusive supplier of anydata storage product we offer.  Instead,our suppliers market their products through other independent data storage solutionproviders, original equipment manufacturers and, often, through their owninternal sales forces. We believe direct competition from our suppliers islikely to increase if, as expected, the data storage industry continues toconsolidate. This consolidation would probably result in fewer suppliers withgreater resources to devote to internal sales and marketing efforts. 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.

 

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

 

Under new SEC accounting rules, we no longer amortizegoodwill.  Instead, we performimpairment analyses of our goodwill at least annually or when we believe thereis an impairment.  Future events couldcause us to conclude that impairment indicators exist and that goodwillassociated with our acquired businesses is further impaired.  Any resulting impairment loss could have amaterial adverse impact on our financial condition and results of operations.

 

**We derive a significant percentage of our revenues from asmall number of customers.**

 

In2002, we derived 5% of our revenues from one customer, and our top fivecustomers collectively accounted for 19% of our revenues. Because we intend tocontinue to seek out large projects, we expect that a significant percentage ofour revenues will continue to come from a small number of customers, althoughthe composition of our key customers is likely to change from year to year. Ifwe fail to obtain a growing number of large projects each year, our revenuesand profitability will likely be adversely affected. In addition, our relianceon large projects makes it more likely that our revenues and profits willfluctuate unpredictably from year to year. Unpredictable revenue and profitfluctuations may make our stock price more volatile and lead to a decline inour stock price.

 

### **Our revenue recognition policiesunpredictably defer reporting of our revenues.**

 

Weincreasingly sell complex enterprise-class information storage solutions.  We do not recognize revenues from our saleof hardware and software products to our customers until we complete ourrequired installation or configuration of these products.  Installation and configuration of thesesolutions requires significant coordination with our customers andvendors.  Therefore, even if we haveshipped all products to our customers, we may be unable to control the timingof product installation and configuration. These delays prevent us from recognizing revenue on products we ship andmay adversely affect our quarterly reported revenues.  As a result, our stock price may decline.

 

**We rely on only a few key suppliers and would suffermaterially if we could not obtain their products.**

 

We rely on our closerelationships with our suppliers to provide access to products and newtechnology necessary to design and implement leading-edge enterprise-classinformation storage solutions for our customers. We do not have long-termsupply contracts with any of our suppliers. In many instances, we rely upononly one or two suppliers for each of our key products. Our reliance on thesesuppliers leaves us vulnerable to an inadequate supply of required products,price increases, late deliveries and poor product quality. Disruption ortermination of the supply of products from our suppliers for any reason wouldlikely prevent or delay our shipments to our customers. Our customers expectreliable and prompt service from us. If we cannot obtain necessary components,or the components we obtain are unreliable or unexpectedly expensive, we willnot meet our customers’ expectations. If we cannot meet our customers’expectations, our business will suffer considerably.

 

19

----

 

**Our growth plans depend in part on our ability tosuccessfully complete acquisitions.**

 

As part of our growth plan, weintend to continue to pursue strategic acquisitions of businesses that give usaccess to additional qualified technical personnel and either expand orcomplement our business. To date we have completed two such acquisitions.  However, our last acquisition was inNovember 2000 and we cannot assure any further acquisitions.  If we do not make more suitableacquisitions, we will find it more difficult to realize our growth objectives.

 

If we do make acquisitions, wewill face a number of other risks and challenges, including:

 

•                                          the difficulty of integrating dissimilaroperations or assets;

 

•                                          assimilation of new employees who may notinitially contribute at the levels we expect from our other employees;

 

•                                          diversion of management time and resources;

 

•                                          increases in administrative costs, includingamortization of purchased intangible assets;

 

•                                          potential loss of key employees of an acquiredcompany; and

 

•                                          additional costs associated with obtaining anynecessary financing.

 

These factors and our limitedexperience in negotiating, consummating and integrating acquisitions couldhamper our ability to realize our growth objectives, and could adversely affectour business, earnings, financial condition and, ultimately, our stock price.Acquisitions that use stock as payment also could result in dilution of our pershare earnings, and of your voting rights.

 

**Our business depends on our ability to hire and retaintechnical personnel.**

 

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

 

**We generally do not have employment agreements with our keyemployees.**

 

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

 

**If we cannot effectively manage our future growth, ourbusiness may suffer.**

 

Our planned growth andexpansion, if realized in light of current economic conditions, would place asignificant strain on our administrative, operational and financial resources.This growth may also increase demands on our professional and technicalservices, sales, marketing and customer service and support functions. Ourplanned geographic expansion may exacerbate these challenges and require us tohire, train, motivate and manage new management, technical, sales andadministrative employees. If we manage this planned growth poorly, we may beunable to continue to provide our customers with the high level of technicalservice and expertise they expect from us. This failure would harm ourreputation, hamper our ability to grow and adversely affect our financialcondition and stock price.

 

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

 

Rapid and complex technologicalchange, frequent new product introductions and evolving industry standardsincrease demand for our services. Because of this, our future success dependsin 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

 

20

----

 

technologies offer them significant benefits overthe older technologies they are using. If the data storage industry ceases todevelop compelling new storage solutions, or if a single data storage standardbecomes widely accepted and implemented, it will be more difficult to sell newdata storage systems to our customers.

 

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

 

Oursales cycle is typically long and unpredictable, making it difficult to planour business. Current economic conditions have increased this uncertainty.  Our long sales cycle requires us to investresources in potential projects that may not occur. In addition, our long andunpredictable sales cycle may cause us to experience significant fluctuationsin our future annual and quarterly operating results. It can also result indelayed revenues, difficulty in matching revenues with expenses and increasedexpenditures. Our business, operating results or financial condition and stockprice may suffer as a result of any of these factors.

 

**Control by our existing stockholders could discourage thepotential acquisition of our business.**

 

Currently, our executiveofficers, directors and 5% or greater stockholders and their affiliatesbeneficially own approximately 66% of our outstanding common stock. Actingtogether, these insiders could elect our entire Board of Directors and controlthe outcome of all other matters requiring stockholder approval. This voting concentrationmay also have the effect of delaying or preventing a change in our managementor control or otherwise discourage potential acquirers from attempting to gaincontrol of us. If potential acquirers are deterred, you may lose an opportunityto profit from a possible acquisition premium in our stock price.

 

**Our stock price is volatile.**

 

The market price of our commonstock has fluctuated significantly since our initial public offering, and maycontinue to be volatile. We cannot assure you that our stock price willincrease, or even that it will not decline significantly from the price youpay. Our stock price may be adversely affected by many factors, including:

 

•                                          actual or anticipated fluctuations in ouroperating results;

 

•                                          announcements of technical innovations;

 

•                                          new products or services offered by us, oursuppliers or our competitors;

 

•                                          changes in estimates by securities analysts of ourfuture financial performance; and

 

•                                          general market conditions, including the effectsof current economic conditions and war and terrorism threats.

 

In addition, the stock market hasrecently experienced significant downward price fluctuations. Over the pastseveral years, companies in the technology sector, such as Datalink, haveexperienced more stock price volatility than companies in other sectors of themarket and may be more vulnerable to price declines in the event of a generalmarket decline.

 

**Our governing documents and Minnesota law may discourage thepotential acquisitions of our business.**

 

Our Board of Directors may issueadditional shares of capital stock and establish their rights, preferences andclasses, in some cases without stockholder approval. In addition, we aresubject to anti-takeover provisions of Minnesota law. These provisions maydeter or discourage takeover attempts and other changes in control of us notapproved by our Board of Directors. If potential acquirers are deterred, youmay lose an opportunity to profit from a possible acquisition premium in ourstock price.

 

21

----

 

**Item 7A.  Quantitativeand Qualitative Disclosures about Market Risk**

 

Our interest income is sensitiveto changes in the general level of U.S. interest rates, particularly since themajority of our investments are in short-term instruments. Due to the nature ofour short-term investments, we do not believe that we have any material marketrisk exposure. Therefore, no quantitative tabular disclosures are required.

 

The following discusses ourexposure to market risk related to changes in interest rates, foreign exchangerates and equity prices.

 

*Interest rate risk.*  As ofDecember 31, 2002, we had $10.3 million of cash and money market accounts.A decrease in market rates of interest would have no material effect on thevalue of these assets or the related interest income due to the nature of moneymarket accounts. We have no short or long-term debt.

 

*Foreign currencyexchange rate risk.*  We develop and sell all of our products inthe United States. Therefore, we are not currently exposed to any directforeign currency exchange rate risk.

 

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

 

22

----

 

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

 

Independent Auditors’ Report

The Board of Directors and Shareholders

Datalink Corporation:

 

We have audited theaccompanying balance sheet of Datalink Corporation as of December 31, 2002, andthe related statements of operations, stockholders’ equity and cash flows forthe year then ended. These financial statements and financial statementschedule are the responsibility of the Company’s management.  Our responsibility is to express an opinionon these financial statements based on our audit.  The financial statementsof Datalink Corporation as of December 31, 2001, and for the year then endedwere audited by other auditors who have ceased operations. Those auditorsexpressed an unqualified opinion on those financial statements in their reportdated February 8, 2002.

 

We conducted our audit in accordance with auditing standards generallyaccepted in the United States of America. Those standards require that we plan and perform the audit to obtainreasonable assurance about whether the financial statements are free ofmaterial misstatement.  An auditincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements. An audit also includes assessing the accounting principles used andsignificant estimates made by management, as well as evaluating the overallfinancial statement presentation.  Webelieve that our audit provides a reasonable basis for our opinion.

 

In our opinion, the 2002 financial statements referred to above presentfairly, in all material respects, the financial position of DatalinkCorporation. as of December 31, 2002, and the results of its operations and itscash flows for the year then ended in conformity with accounting principlesgenerally accepted in the United States of America.

 

As discussed above, the 2001 financial statements of DatalinkCorporation as listed in the accompanying index were audited by other auditorswho have ceased operations. As described in note 2, these financial statementshave been revised to include the transitional disclosures required by Statementof Financial Accounting Standards No. 142, *Goodwilland Other Intangible Assets*, which was adopted by the Company as ofJanuary 1, 2002. In our opinion, the disclosures for 2001 in note 2 areappropriate. However, we were not engaged to audit, review, or apply anyprocedures to the 2001 financial statements of Datalink Corporation, other thanwith respect to such disclosures and, accordingly, we do not express an opinionor any other form of assurance on the 2001 financial statements taken as awhole.

 
| /s/ KPMG LLP           |   |
|------------------------|--------|
|                   |
| Minneapolis, Minnesota |
| February 7, 2003       |

 

 

*This is a copy of an accountants’report previously issued by Arthur Andersen LLP (“Andersen”).  This report has not been reissued byAndersen.  After a reasonable effort, wehave been unable to obtain the consent of Andersen for the incorporation byreference of the report dated February 8, 2002 included in our Annual Report onForm 10-K for the year ended December 31, 2002. The financialstatements for the year ended December 31, 2001 has been revised to include thetransistional disclosures required by Statement of Financial AccountingStandards No. 142, Goodwill and Other Intangible Assets, which was adopted bythe Company as of January 1, 2002. Under these circumstances Rule 437a under the Securities Act of 1933permits us to file a Registration Statement without a written consent fromAndersen.  We are not able to obtain thewritten consent of Andersen to incorporate by reference this report into ourpreviously filed registration statements on Form S-8, File number 333-93229 andForm S-3, File number 333-96901.  Inaddition, we will not be able to obtain the written consent of Andersen for anyfuture registration statement we may file as required by Section 7 of theSecurities Act.  Accordingly, investorswill not be able to sue Andersen pursuant to Section 11 of the Securities Actrelating to those registration statements and therefore may have their recoverylimited as a result of the lack of consent. The ability of investors to recover from Andersen may also be limited asa result of their financial condition or other matters relating to the variouscivil and criminal lawsuits relating to them.*

 

23

----

 

**Report of Independent Public Accountants**

 

ToDatalink Corporation:

 

We have audited the accompanyingbalance sheet of Datalink Corporation (a Minnesota corporation) as of December31, 2001, and the related statements of operations, stockholders’ equity andcash flows for the year then ended. These financial statements are theresponsibility of the Company’s management. Our responsibility is to express anopinion on these financial statements based on our audit.

 

We conducted our audit inaccordance with auditing standards generally accepted in the 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 significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audit provides a reasonable basis for our opinion.

 

In our opinion, the financialstatements referred to above present fairly, in all material respects, thefinancial position of Datalink Corporation as of December 31, 2001, and theresults of its operations and its cash flows for the year then ended inconformity with accounting principles generally accepted in the United States.

 
| /s/ Arthur Andersen LLP |   |
|-------------------------|--------|
|                    |
| Minneapolis,  Minnesota |   |
| February  8, 2002       |

 

# **REPORT OF INDEPENDENT ACCOUNTANTS**

 

To the Stockholders and Board of Directors ofDatalink Corporation:

 

In our opinion, the accompanyingstatements of operations, stockholders’ equity and cash flows present fairly,in all material respects, the results of operations and cash flows of DatalinkCorporation and its subsidiary for the year ended December 31, 2000, inconformity with accounting principles generally accepted in the United Statesof America. These financial statements are the responsibility of the Company’smanagement; our responsibility is to express an opinion on these financialstatements based on our audit. We conducted our audit of these statements inaccordance with auditing standards generally accepted in the United States ofAmerica which 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, assessing theaccounting principles used and significant estimates made by management, andevaluating the overall financial statement presentation. We believe that ouraudit provides a reasonable basis for our opinion.

 

As discussed in Note 2 to theconsolidated financial statements, the Company adopted the provisions of theSecurities and Exchange Commission’s Staff Accounting Bulletin No. 101 relatingto revenue recognition.

 
| /s/  PricewaterhouseCoopers LLP |   |
|---------------------------------|--------|
|                            |
| Minneapolis,  Minnesota         |   |
| February  13, 2001              |

 

24

----

 

**DATALINK CORPORATION**

**BALANCE SHEETS**

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

 
|                                                                                                                                                                      |   | **December 31,** |       |
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------|------------|
|                                                                                                                                                                      |   | **2002**              |       | **2001** |   |
| **Assets**                                                                                                                                                                |   |                  |       |   |   |
| Current assets:                                                                                                                                                           |   |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                 |   | $                     | 10,334     |   | $ | 5,846 |   |
| Accounts receivable, net                                                                                                                                                  |   | 12,419                |       | 15,127 |   |
| Inventories                                                                                                                                                               |   | 2,410                 |       | 3,885 |   |
| Inventories shipped but not installed                                                                                                                                     |   | 4,059                 |       | 2,922 |   |
| Income tax receivable                                                                                                                                                     |   | 1,952                 |       | 1,610 |   |
| Deferred income taxes, net                                                                                                                                                |   | —                |       | 1,435 |   |
| Other current assets                                                                                                                                                      |   | 401                   |       | 289 |   |
| Total current assets                                                                                                                                                      |   | 31,575                |       | 31,114 |   |
| Property and equipment, net                                                                                                                                               |   | 5,506                 |       | 6,341 |   |
| Goodwill                                                                                                                                                                  |   | 5,500                 |       | 5,500 |   |
| Intangibles, net                                                                                                                                                          |   | 2,135                 |       | 3,223 |   |
| Other, net                                                                                                                                                                |   | 69                    |       | 590 |   |
| Total assets                                                                                                                                                              |   | $                     | 44,785     |   | $ | 46,768 |   |
|                                                                                                                                                                      |   |                  |       |   |   |
| **Liabilities and  Stockholders’ Equity**                                                                                                                            |   |                  | ** ** |   | ** ** |
| Current liabilities:                                                                                                                                                      |   |                  |       |   |   |
| Accounts payable                                                                                                                                                          |   | $                     | 13,667     |   | $ | 15,210 |   |
| Accrued commissions                                                                                                                                                       |   | 818                   |       | 889 |   |
| Accrued sales and use tax                                                                                                                                                 |   | 496                   |       | 709 |   |
| Accrued expenses, other                                                                                                                                                   |   | 683                   |       | 583 |   |
| Note payable to former stockholder, current portion                                                                                                                       |   | —                |       | 704 |   |
| Deferred revenue                                                                                                                                                          |   | 2,434                 |       | 2,290 |   |
| Total current liabilities                                                                                                                                                 |   | 18,098                |       | 20,385 |   |
| Deferred rent                                                                                                                                                             |   | 341                   |       | 269 |   |
| Total liabilities                                                                                                                                                         |   | 18,439                |       | 20,654 |   |
|                                                                                                                                                                      |   |                  |       |   |   |
| Commitments and contingencies (Note 5)                                                                                                                                    |   |                  |       |   |   |
|                                                                                                                                                                      |   |                  |       |   |   |
| Stockholders’ equity:                                                                                                                                                |   |                  |       |   |   |
| Common stock, $0.001 par value, 50,000,000 shares authorized,  10,206,699 and 8,951,343shares  issued and outstanding as of December 31, 2002 and 2001, respectively |   | 10                    |       | 9 |   |
| Additional paid-in capital                                                                                                                                                |   | 25,854                |       | 20,205 |   |
| Retained earnings                                                                                                                                                         |   | 482                   |       | 5,900 |   |
| Total stockholders’ equity                                                                                                                                           |   | 26,346                |       | 26,114 |   |
| Total liabilities and stockholders’ equity                                                                                                                           |   | $                     | 44,785     |   | $ | 46,768 |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

25

----

 

**DATALINK CORPORATION**

**STATEMENTS OF OPERATIONS**

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

 
|                                                                                       |   | **Year Ended December 31,** |   |
|--------------------------------------------------------------------------------------------|--------|----------------------------------|--------|
|                                                                                       |   | **2002**                         |   | **2001** |   | **2000** |   |
| Net sales:                                                                                 |   |                             |   |   |   |   |   |
| Product sales                                                                              |   | $                                | 58,492 |   | $ | 96,188 |   | $ | 118,233 |   |
| Service sales                                                                              |   | 28,008                           |   | 28,596 |   | 19,536 |   |
| Total net sales                                                                            |   | 86,500                           |   | 124,784 |   | 137,769 |   |
|                                                                                       |   |                             |   |   |   |   |   |
| Cost of sales:                                                                             |   |                             |   |   |   |   |   |
| Cost of product sales                                                                      |   | 44,776                           |   | 70,393 |   | 87,321 |   |
| Cost of services                                                                           |   | 20,000                           |   | 20,328 |   | 14,148 |   |
| Total cost of sales                                                                        |   | 64,776                           |   | 90,721 |   | 101,469 |   |
| Gross profit                                                                               |   | 21,724                           |   | 34,063 |   | 36,300 |   |
| Operating expenses:                                                                        |   |                             |   |   |   |   |   |
| Sales and marketing                                                                        |   | 11,481                           |   | 15,836 |   | 15,230 |   |
| General and administrative                                                                 |   | 10,354                           |   | 11,221 |   | 8,792 |   |
| Engineering                                                                                |   | 4,954                            |   | 5,259 |   | 3,745 |   |
| Amortization of goodwill and other intangibles                                             |   | 1,088                            |   | 2,264 |   | 1,026 |   |
| Offering costs                                                                             |   | —                           |   | — |   | 381 |   |
| Operating (loss) income                                                                    |   | (6,153                           | )      | (517 | ) | 7,126 |   |
| Interest income (expense), net                                                             |   | 117                              |   | 127 |   | 311 |   |
|                                                                                       |   |                             |   |   |   |   |   |
| (Loss) income before income taxes and cumulative effect of a change inaccounting principle |   | (6,036                           | )      | (390 | ) | 7,437 |   |
| Income tax (benefit) expense                                                               |   | (618                             | )      | 115 |   | 3,049 |   |
| (Loss) income before cumulative effect of a change in accounting  principle                |   | (5,418                           | )      | (505 | ) | 4,388 |   |
| Cumulative impact of change in accounting principle, net of income  taxes                  |   | —                           |   | — |   | (753 | ) |
| Net (loss) income                                                                          |   | $                                | (5,418 | ) | $ | (505 | ) | $ | 3,635 |   |
|                                                                                       |   |                             |   |   |   |   |   |
| Net (loss) income per share, basic:                                                        |   |                             |   |   |   |   |   |
| (Loss) income per share before cumulative effect of a change in  accounting principle      |   | $                                | (0.56  | ) | $ | (0.06 | ) | $ | 0.50 |   |
| Loss per share from the cumulative effect of a change in accounting  principle             |   | —                           |   | — |   | (0.09 | ) |
| Net (loss) income per share                                                                |   | $                                | (0.56  | ) | $ | (0.06 | ) | $ | 0.41 |   |
|                                                                                       |   |                             |   |   |   |   |   |
| Net (loss) income per share, diluted:                                                      |   |                             |   |   |   |   |   |
| (Loss) income per share before cumulative effect of a change in  accounting principle      |   | $                                | (0.56  | ) | $ | (0.06 | ) | $ | 0.48 |   |
| Loss per share from the cumulative effect of a change in accounting  principle             |   | —                           |   | — |   | (0.08 | ) |
| Net (loss) income per share                                                                |   | $                                | (0.56  | ) | $ | (0.06 | ) | $ | 0.40 |   |
|                                                                                       |   |                             |   |   |   |   |   |
| Weighted average shares outstanding:                                                       |   |                             |   |   |   |   |   |
|                                                                                       |   |                             |   |   |   |   |   |
| Basic                                                                                      |   | 9,687                            |   | 8,921 |   | 8,794 |   |
| Diluted                                                                                    |   | 9,687                            |   | 8,921 |   | 9,166 |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

26

----

 

**DATALINK CORPORATION**

**STATEMENTS OF STOCKHOLDERS’ EQUITY**

**(In thousands)**

 
|                                                                            |   |              |   | **Additional  Paid-in  Capital** |   | **Retained  Earnings** |   | **Total** |   |
|---------------------------------------------------------------------------------|--------|-------------------|--------|----------------------------------|--------|------------------------|--------|-----------|--------|
|                                                                            |   | **Common  Stock** |   |                             |   |                   |
| **Shares**                                                                      |   | **Amount**        |
| Balances, December 31, 1999                                                |   | 8,773             |   | $                                | 9      |                   | $      | 18,213    |   | $ | 2,909 |   | $ | 21,131 |   |
| Net income                                                                      |   | —            |   | —                           |   | —                 |   | 3,635     |   | 3,635 |   |
| Compensation expense related to stock options                                   |   | —            |   | —                           |   | 137                    |   | —    |   | 137 |   |
| Common shares issued under employee stock purchase plan and stock  option plans |   | 44                |   | —                           |   | 373                    |   | —    |   | 373 |   |
| Issuance of  shares in  acquisition (Note 8)                               |   | 79                |   | —                           |   | 1,000                  |   | —    |   | 1,000 |   |
| Cash dividend paid to S corporation stockholders                                |   | —            |   | —                           |   | —                 |   | (139      | )      | (139 | ) |
| Balances, December 31, 2000                                                |   | 8,896             |   | 9                                |   | 19,723                 |   | 6,405     |   | 26,137 |   |
| Net loss                                                                        |   | —            |   | —                           |   | —                 |   | (505      | )      | (505 | ) |
| Compensation expense related to stock options                                   |   | —            |   | —                           |   | 146                    |   | —    |   | 146 |   |
| Common shares issued under employee stock purchase plan and stock  option plans |   | 55                |   | —                           |   | 336                    |   | —    |   | 336 |   |
| Balances, December 31, 2001                                                |   | 8,951             |   | 9                                |   | 20,205                 |   | 5,900     |   | 26,114 |   |
| Net loss                                                                        |   | —            |   | —                           |   | —                 |   | (5,418    | )      | (5,418 | ) |
| Issuance of shares in private placement, net of issuance costs (Note  7)        |   | 1,180             |   | 1                                |   | 5,216                  |   | —    |   | 5,217 |   |
| Compensation expense related to stock options                                   |   | —            |   | —                           |   | 208                    |   | —    |   | 208 |   |
| Common shares issued under employee stock purchase plan and stock  option plans |   | 76                |   | —                           |   | 225                    |   | —    |   | 225 |   |
| Balances, December 31, 2002                                                |   | 10,207            |   | $                                | 10     |                   | $      | 25,854    |   | $ | 482 |   | $ | 26,346 |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

27

----

 

**DATALINK CORPORATION**

**STATEMENTS OF CASH FLOWS**

**(In thousands)**

 
|                                                                                      |   | **Year Ended  December 31,** |       |
|-------------------------------------------------------------------------------------------|--------|-----------------------------------|------------|
|                                                                                      |   | **2002**                          |       | **2001** |   | **2000** |   |
| Cash flows from operating activities:                                                     |   |                              |       |   |   |   |   |
| Net (loss) income                                                                         |   | $                                 | (5,418     | ) | $ | (505 | ) | $ | 3,635 |   |
| Adjustments to reconcile net (loss) income to net cash provided by  operating activities: |   |                              |       |   |   |   |   |
| Provision for bad debts                                                                   |   | 77                                |       | 115 |   | 89 |   |
| Cumulative effect of change in accounting principle                                       |   | —                            |       | — |   | 753 |   |
| Depreciation and amortization                                                             |   | 1,981                             |       | 2,425 |   | 1,471 |   |
| Amortization of intangibles                                                               |   | 1,088                             |       | 2,264 |   | 1,026 |   |
| Deferred income taxes                                                                     |   | 273                               |       | 305 |   | (1,563 | ) |
| Valuation allowance for deferred income taxes                                             |   | 1,609                             |       | — |   | — |   |
| Deferred rent                                                                             |   | 72                                |       | 269 |   | — |   |
| Stock compensation expense                                                                |   | 118                               |       | 119 |   | 122 |   |
| Changes in operating assets and liabilities:                                              |   |                              |       |   |   |   |   |
| Accounts receivable                                                                       |   | 2,631                             |       | 1,013 |   | (2,825 | ) |
| Inventories                                                                               |   | 338                               |       | 8,145 |   | (1,440 | ) |
| Other current assets                                                                      |   | (112                              | )          | (45 | ) | 118 |   |
| Other assets                                                                              |   | 162                               |       | (60 | ) | (108 | ) |
| Accounts payable                                                                          |   | (1,543                            | )          | (4,454 | ) | 5,969 |   |
| Accrued expenses                                                                          |   | (184                              | )          | (1,840 | ) | 1,704 |   |
| Income taxes                                                                              |   | (342                              | )          | (2,128 | ) | 295 |   |
| Deferred revenue                                                                          |   | 144                               |       | (1 | ) | 1,360 |   |
| Net cash provided by operating activities                                                 |   | 894                               |       | 5,622 |   | 10,606 |   |
| Cash flows from investing activities:                                                     |   |                              |       |   |   |   |   |
| Purchase of property and equipment                                                        |   | (1,146                            | )          | (4,300 | ) | (3,371 | ) |
| Deposit on lease arrangement                                                              |   | —                            |       | 500 |   | (500 | ) |
| Net assets acquired, net of cash acquired                                                 |   | —                            |       | (176 | ) | (7,495 | ) |
| Net cash used in investing activities                                                     |   | (1,146                            | )          | (3,976 | ) | (11,366 | ) |
| Cash flows from financing activities:                                                     |   |                              |       |   |   |   |   |
| Proceeds from borrowings on line of credit                                                |   | —                            |       | — |   | 5,335 |   |
| Principal payments on line of credit                                                      |   | —                            |       | — |   | (5,335 | ) |
| Proceeds from issuance of common stock, net                                               |   | 5,444                             |       | 363 |   | 388 |   |
| Distributions paid                                                                        |   | —                            |       | — |   | (883 | ) |
| Payments of notes payable to former stockholder                                           |   | (704                              | )          | (705 | ) | (705 | ) |
| Principal payments on capital lease obligations                                           |   | —                            |       | — |   | (13 | ) |
| Net cash (used in) provided by financing activities                                       |   | 4,740                             |       | (342 | ) | (1,213 | ) |
| Increase (decrease) in cash and cash equivalents                                          |   | 4,488                             |       | 1,304 |   | (1,973 | ) |
| Cash and cash equivalents, beginning of year                                              |   | 5,846                             |       | 4,542 |   | 6,515 |   |
| Cash and cash equivalents, end of year                                                    |   | $                                 | 10,334     |   | $ | 5,846 |   | $ | 4,542 |   |
|                                                                                      |   |                              |       |   |   |   |   |
| **Supplementary  Cash Flow Information:**                                                 |   |                              | ** ** |   | ** ** |   | ** ** |
|                                                                                      |   |                              | ** ** |   | ** ** |   | ** ** |
| Cash paid for interest                                                                    |   | $                                 | 45         |   | $ | 132 |   | $ | 95 |   |
| Cash (received) paid for income taxes                                                     |   | (2,160                            | )          | 1,936 |   | 4,000 |   |
| Significant noncash financing and investing transactions:                                 |   |                              |       |   |   |   |   |
| Stock issued to purchase certain assets of OpenSystems.com, Inc.                          |   | —                            |       | — |   | 1,000 |   |
| Obligation for construction in progress                                                   |   | —                            |       | (1,968 | ) | 1,968 |   |

 

Theaccompanying notes are an integral part of these financial statements.

 

28

----

 

**DATALINK CORPORATION**

**NOTES TO FINANCIAL STATEMENTS**

 

**1. Description of Business:**

 

Datalink Corporation (the“Company”) is an independent architect of enterprise-class information storageinfrastructures. The Company derives its revenues principally from designingand installing data storage systems. The Company’s solutions can includehardware products, such as disk arrays, tape systems and interconnectioncomponents, and storage management software products. The Company is frequentlyengaged to provide assistance in the installation of solutions and to providesupport services subsequent to the installation. Occasionally, the Company isengaged for consulting services.

 

The Company views its operationsand manages its business as one segment, the design and installation ofenterprise-class information storage solutions. Factors used to identify theCompany’s single operating segment include the organizational structure of theCompany and the financial information available for evaluation by the chiefoperating decision maker in making decisions about how to allocate resourcesand assess performance. During 2002, 2001 and 2000, net sales to one customertotaled 5%, 9% and 15% of total net sales, respectively.

 

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

 

***Cash Equivalents:***

 

Cash equivalents consistprincipally of money market funds with original maturities of three months orless, are readily convertible to cash and are stated at cost, whichapproximates fair value.

 

***Accounts Receivable, net:***

 

Accounts receivable are recordednet of the reserve for doubtful accounts of $197,000 and $164,000 at December31, 2002 and 2001, respectively.

 

***Inventories:***

 

Inventories, includinginventories shipped but not installed, principally consist of data storageproducts and components, that are valued at the lower of cost or market withcost determined on a first-in, first-out (FIFO) method.

 

***Property and Equipment:***

 

Property and equipment, includingpurchased software, are stated at cost. Depreciation and amortization areprovided by charges to operations using the straight-line method over theestimated useful lives of the assets (ranging from 2 to 10 years). Leaseholdimprovements are amortized on a straight-line basis over the shorter of theirestimated useful lives or the underlying lease term. The costs and relatedaccumulated depreciation and amortization on asset disposals are removed fromthe accounts and any gain or loss is included in operations. Major renewals andbetterments are capitalized, while maintenance and repairs are charged tocurrent operations when incurred.

 
|                                           |   | **December 31,** |   |
|------------------------------------------------|--------|-----------------------|--------|
|                                           |   | **2002**              |   | **2001** |   |
|                                           |   | **(In thousands)**    |   |
| Property and equipment:                        |   |                  |   |   |   |
| Land                                           |   | $                     | 384    |   | $ | 384 |   |
| Construction in process                        |   | 200                   |   | 588 |   |
| Leasehold improvements                         |   | 538                   |   | 538 |   |
| Equipment                                      |   | 3,343                 |   | 3,732 |   |
| Computers and software                         |   | 7,383                 |   | 5,900 |   |
|                                           |   | 11,848                |   | 11,142 |   |
| Less accumulated depreciation and amortization |   | 6,342                 |   | 4,801 |   |
|                                           |   | $                     | 5,506  |   | $ | 6,341 |   |

 

During 2000, the Company beganthe implementation of a new customer relationship management (CRM) applicationsuite. The Company capitalized costs of the implementation of $801,000 in 2002,$1.0 million in 2001 and $624,000 in 2000.

 

29

----

 

Amountsare being amortized over a period of 3 years from the date they are availablefor use.  Amortization of software costswas $922,000 in 2002, $139,000 in 2001 and $0 in 2000.

 

***Goodwill:***

 

On January 1, 2002, newaccounting rules for business combinations and accounting for goodwill andother intangibles (SFAS 141 and 142) became effective for the Company.  The Company adopted SFAS 142 on January 1,2002 and accordingly evaluated its existing intangible assets and goodwill thatwere acquired in prior business combinations and determined there was noimpairment upon adoption. Goodwill is no longer being amortized againstearnings and goodwill balances are subject to an impairment review on an annualbasis or sooner if indicators of potential impairment exist.  In addition, the new rules further definedthe classes of intangible assets which caused the Company to reclassify the$652,000 unamortized balance of an intangible asset represented by theestimated value of assembled workforce to goodwill as of January 1, 2002.  The value of assembled workforce at December31, 2001 was also reclassified in these financial statements for comparativepurposes.

 

The following table presents a reconciliation of net income (loss) andincome (loss) per share adjusted for the exclusion of goodwill, net of tax:

 

|                                                 |   | **Year Ended  December 31** |   |
|------------------------------------------------------|--------|-----------------------------|--------|
|                                                 |   | **2002**                    |   | **2001** |   | **2000** |   |
| Reported net income (loss)                           |   | $                           | (5,418 | ) | $ | (505 | ) | $ | 3,635 |   |
| Add:  Goodwill amortization,  net of tax        |   | —                      |   | 951 |   | 480 |   |
| Adjusted net income (loss)                           |   | $                           | (5,418 | ) | $ | 446 |   | $ | 4,115 |   |
|                                                 |   |                        |   |   |   |   |   |
| Reported basic and diluted earnings (loss) per share |   | $                           | (0.56  | ) | $ | (0.06 | ) | $ | 0.40 |   |
| Add:  Goodwill amortization,  net of tax        |   | —                      |   | 0.11 |   | 0.05 |   |
| Adjusted basic and diluted earnings (loss) per share |   | $                           | (0.56  | ) | $ | 0.05 |   | $ | 0.45 |   |

 

***Intangibles, net:***

 

Identifiable intangible assetsare amortized on a straight-line basis over their estimated useful livesof 3 to 7 years.  Informationregarding the Company’s other intangible assets that continue to be amortizedare as follows:

 
|               |   | **As of December 31, 2002** |   |
|--------------------|--------|-----------------------------|--------|
|               |   | **Carrying  Amount**        |   | **Accumulated  Amortization** |   | **Net** |   |
| Customer lists     |   | $                           | 4,300  |   | $ | 2,165 |   | $ | 2,135 |   |
| Trademark and name |   | 450                         |   | 450 |   | — |   |
|               |   | $                           | 4,750  |   | $ | 2,615 |   | $ | 2,135 |   |

 
|               |   | **As of December 31, 2001** |   |
|--------------------|--------|-----------------------------|--------|
|               |   | **Carrying  Amount**        |   | **Accumulated  Amortization** |   | **Net** |   |
| Customer lists     |   | $                           | 4,300  |   | $ | 1,305 |   | $ | 2,995 |   |
| Trademark and name |   | 450                         |   | 222 |   | 228 |   |
|               |   | $                           | 4,750  |   | $ | 1,527 |   | $ | 3,223 |   |

 

30

----

 

Amortization expense for the years ended December 31,2002, 2001 and 2000 was $1.1 million, $2.3 million and $1.0 million, respectively.  Estimated amortization expense for thesucceeding fiscal years based on the intangible assets as of December 31, 2002is as follows:

 
|   |   | **(In thousands)** |   |
|--------|--------|--------------------|--------|
| 2003   |   | $                  | 860    |   |
| 2004   |   | 860                |   |
| 2005   |   | 415                |   |
| Total  |   | $                  | 2,135  |   |

 

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

 

The Company periodically (atleast annually) analyzes its long-lived assets for potential impairment,assessing the appropriateness of lives and recoverability of unamortizedbalances through measurement of undiscounted operating cash flows on a basis consistentwith generally accepted accounting principles.

 

***Income Taxes:***

 

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

 

***Use of Estimates:***

 

The preparation of financialstatements in conformity with accounting principles generally accepted in theUnited States requires management to make estimates and assumptions that affectthe reported amounts of assets and liabilities and disclosure of contingentassets and liabilities at the date of the financial statements and the reportedamounts of revenues and expenses during the reporting period. Actual resultscould differ from those estimates.

 

***Revenue Recognition:***

 

In December 1999,the SEC staff issued Staff Accounting Bulletin (“SAB”) No. 101, “RevenueRecognition,” which clarified the SEC staff’s views regarding the recognitionand reporting of revenues in certain transactions. In consideration of theviews expressed in SAB No. 101 and effective as of January 1, 2000,the Company modified its revenue recognition policy related to products whenthe Company provides any installation or configuration services in connectionwith the sale. The Company now recognizes revenue from hardware and softwareproduct sales when it completes its installation and configuration servicesthat are essential to the functionality of the delivered hardware and softwareproducts or after the customer has accepted products under evaluation. For anyremaining installation that is not essential to the functionality of deliveredproduct, the Company accounts for the remaining installation as a separate unitof accounting and defers revenue based on objective fair value for suchservices. Under the transition provisions outlined in SAB No. 101, theCompany accounted for this change in accounting policy prospectively as ofJanuary 1, 2000 and recorded a charge to earnings on that date of $753,000representing the cumulative effect, net of income taxes, of the change inaccounting policy. Prior to January 1, 2000, the Company recognizedproduct revenue when the hardware and software was shipped to its customers orafter they accepted products under evaluation.

 

The Companyrecognizes installation and consulting service revenue as it renders theseservices.

 

The Company also sells service contracts to most of its customers. These contracts are support service agreements.  The Company has aninternal support desk to provide integrated customer support services. The Company fulfills on-site assistance by purchasing support serviceagreements for customers from the hardware and software vendors or theirdesignated third-party service providers and by arranging on-site supportassistance with the appropriate vendor when necessary. Revenues and directcosts resulting from these contracts are deferred and amortized into operationsover the term of the contracts, which are generally twelve months.  TheCompany is contractually obligated to provide or arrange to provide theseunderlying support services to its customers in the unlikely event that thehardware or software vendor, or its designee, fails to perform according to theterms of its contract.

 

31

----

 

***Offering Costs:***

 

On March 7, 2000, theCompany filed a registration statement with the SEC for a second publicoffering of 2,500,000 shares of its common stock. On May 15, 2000, the Companywithdrew this registration statement due to market conditions. As required, theCompany expensed the previously deferred costs of $381,000 related to theoffering.

 

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

 

Basic net income (loss) per shareis computed using the weighted average number of shares outstanding. Dilutednet income per share includes the effect of common stock equivalents, if any,for each period. The number of additional shares is calculated by assuming thatoutstanding stock options were exercised and that the proceeds from suchexercise were used to acquire shares of common stock at the average marketprice during the reporting period.  Theimpact of stock options have been included in the computation of diluted incomeper share, increasing the weighted average number of shares outstanding by371,880 shares in 2000. Due to the net loss in 2001 and 2002, common stockequivalents of 62,564 and 62,536, respectively would have been anti-dilutive tolosses and as a result were excluded from the calculation of diluted loss pershare.

 

***Comprehensive Income:***

 

The Company’s comprehensiveincome is equal to its net income for all periods presented.

 

***Recently Issued Accounting Standards:***

 

In June 2002, the Financial Accounting Standards Boardissued SFAS No. 146 ‘‘Accounting for Costs Associated with Exit or DisposalActivities.’’ SFAS No. 146 supersedes EITF No. 94-3. The principle differencebetween SFAS No. 146 and EITF No. 94-3 relates to when an entity can recognizea liability related to exit or disposal activities. SFAS No. 146 requires aliability be recognized for a cost associated with an exit or disposal activitywhen the liability is incurred. EITF No. 94-3 allowed a liability, related toan exit or disposal activity, to be recognized at the date an entity commits toan exit plan. The provisions of SFAS No. 146 are effective on January 1, 2003.Accordingly, the Company will apply this standard to all exit or disposalactivities initiated after December 31, 2002.

 

In December 2002, the FASB issued SFAS No. 148, StockCompensation. SFAS No. 148 provides alternative methods of transition for avoluntary change to the fair value based method of accounting for stock-basedemployee compensation. In addition, SFAS No. 148 amends the disclosure requirementsof SFAS No. 123 to require prominent disclosures in both annual and interimfinancial statements about the method of accounting for stock-based employeecompensation and the effect of the method used on reported results. The Companydoes not plan to change its method of accounting for stock-based employeecompensation. The Company will make the required interim disclosures effectivewith the quarter ending March 31, 2003.

 

In December 2002, the EITF issued EITF 00 21, RevenueArrangements with Multiple Deliverables. This Issue addresses certain aspectsof the accounting by a vendor for arrangements under which it will performmultiple revenue-generating activities. In some arrangements, the different revenue-generating activities(deliverables) are sufficiently separable, and there exists sufficient evidenceof their fair values to separately account for some or all of the deliverables(that is, there are separate units of accounting).  In other arrangements, some or all of the deliverables are notindependently functional, or there is not sufficient evidence of their fairvalues to account for them separately. This Issue addresses when and, if so,how an arrangement involving multiple deliverables should be divided intoseparate units of accounting.  ThisIssue does not change otherwise applicable revenue recognition criteria. ThisIssue is applicable for the Company for fiscal 2004 and could have an impact onrevenue recognition of future sales transactions.

 

***Reclassifications:***

 

Certain 2001 amounts have beenreclassified to conform to current year presentation.

 

32

----

 

**3. Borrowing Arrangements:**

 

Effective June 30, 2002, the Company entered into a revolving creditagreement (the “Credit Agreement”) with a bank.  Under the terms of the Credit Agreement, the Company may borrowup to $8 million to be used for financing working capital needs.  The term of the agreement ends June 30,2003.  Borrowings under the CreditAgreement are collateralized by the accounts receivable and inventory of theCompany. The Credit Agreement includes various covenants, includingrequirements to maintain a maximum level of debt-cash flow ratio and a minimumamount of working capital, tangible net worth and debt-net worth ratio.  At December 31, 2002, the Company was incompliance with the covenants in the Credit Agreement.  The Company had no outstanding borrowingsunder the Credit Agreement as of December 31, 2002.

 

Effective February 28, 1999,the Company redeemed 1,095,720 shares of common stock held by a formerstockholder.  The Company issued a $3million note payable to this former stockholder. The note provided for intereston the outstanding balance at the prime rate beginning August 28, 1999. Aprincipal payment of $906,000 was made on August 28, 1999.  Two principal payments of $705,000 each weremade on February 28, 2000 and 2001 with the remaining principal balance of$704,000 was paid on February 28, 2002. As of December 31, 2002 and2001, the Company was the owner and beneficiary of a term life insurance policywith a face value of $0 million and $704,000, respectively insuring the life ofthis stockholder.

 

**4. Income Taxes:**

 

The provision for (benefit from)income taxes from consisted of the following:

 
|                                            |   | **Year Ended December 31,** |   |
|-------------------------------------------------|--------|----------------------------------|--------|
|                                            |   | **2002**                         |   | **2001** |   | **2000** |   |
|                                            |   | **(In thousands)**               |   |
| Current income tax expense (benefit):           |   |                             |   |   |   |   |   |
| Federal                                         |   | $                                | (1,976 | ) | $ | (186 | ) | $ | 4,072 |   |
| State                                           |   | (525                             | )      | (4 | ) | 540 |   |
| Total                                           |   | (2,501                           | )      | (190 | ) | 4,612 |   |
| Deferred income tax expense (benefit):          |   |                             |   |   |   |   |   |
| Federal                                         |   | 1,551                            |   | 250 |   | (1,380 | ) |
| State                                           |   | 332                              |   | 55 |   | (183 | ) |
| Total                                           |   | 1,883                            |   | 305 |   | (1,563 | ) |
| Total provision for (benefit from) income taxes |   | $                                | (618   | ) | $ | 115 |   | $ | 3,049 |   |

 

The reconciliation of the U.S.federal statutory tax rate to the Company’s effective income tax rate is asfollows:

 
|                                                   |   | **2002** |   | **2001** |   | **2000** |   |
|--------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Tax expense (benefit) at U.S. statutory rates          |   | (34.0    | )%     | (34.0    | )%     | 34.0     | %      |
| State tax expense (benefit), net of federal tax effect |   | (3.7     | )      | (4.5     | )      | 4.5      |   |
| Nondeductible expenses                                 |   | 0.8      |   | —   |   | —   |   |
| Change in valuation allowance                          |   | 26.7     |   | —   |   | —   |   |
| Other, primarily goodwill amortization                 |   | 0.0      |   | 68.0     |   | 2.5      |   |
| Effective tax rate                                     |   | (10.2    | )%     | 29.5     | %      | 41.0     | %      |

 

33

----

 

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

 

|                             |   | **Year Ended December 31,** |   |
|----------------------------------|--------|----------------------------------|--------|
|                             |   | **2002**                         |   | **2001** |   |
|                             |   | **(In thousands)**               |   |
| Current deferred tax asset:      |   |                             |   |   |   |
| Allowance for doubtful accounts  |   | $                                | 117    |   | $ | 105 |   |
| Compensation accrual             |   | 57                               |   | — |   |
| Inventories                      |   | 176                              |   | 123 |   |
| Deferred revenue                 |   | 485                              |   | 1,198 |   |
| Other                            |   | 6                                |   | 9 |   |
| Total current deferred tax asset |   | 841                              |   | 1,435 |   |
| Long-term deferred tax asset:    |   |                             |   |   |   |
| Net operating loss carryovers    |   | 325                              |   | — |   |
| Intangibles                      |   | 564                              |   | 417 |   |
| Property and equipment           |   | (121                             | )      | 31 |   |
| Total gross deferred tax asset   |   | 1,609                            |   | 1,883 |   |
| Valuation allowance              |   | (1,609                           | )      | — |   |
| Net deferred tax asset           |   | $                                | — |   | $ | 1,883 |   |

 

Thevaluation allowance for deferred tax assets as of December 31, 2002 and 2001was $1,609 and $0, respectively.  Thenet change in the total valuation allowance for the years ended December 31,2002 and 2001 was an increase of $1,609 and $0, respectively.

 

In assessing the recoverabilityof deferred tax assets, management considers whether it is more likely than notthat some portion or all of the deferred tax assets will be realized. Theultimate realization of deferred tax assets is dependent upon carry back toprior periods and upon the generation of future taxable income during theperiods in which those temporary differences become deductible. Managementconsiders the scheduled reversal of deferred tax liabilities, carry backpotential and projected future taxable income and tax planning strategies inmaking this assessment.  Based upon thelevel of taxable losses in recent years and uncertainty of future taxableincome, management believes that it is more likely than not that the Companywill not realize the benefits of these deductible differences at December 31,2002.

 

At December 31, 2002, the Companyhad state net operating loss carryforwards of approximately $5,037 which areavailable to offset future state taxable income.  If not used, these net operating loss carryforwards will expirebetween 2012 and 2021.

 

Subsequently recognized tax benefits relating to the $1,609 valuationallowance for deferred tax assets as of December 31, 2002 would be reported inthe statement of operations as an income tax benefit of $1,609.

 

**5. Lease Commitments:**

 

The Company has 21 officelocations throughout the United States. Some of these locations are leased facilities under non-cancelableoperating lease agreements.

 

In August 2000, the Companypurchased the land adjacent to its new corporate headquarters for$384,000.  At December 31, 2000, theconstruction in progress of $2.0 million represents payments made by thedeveloper for the construction of the Company’s new corporateheadquarters.  A correspondingobligation for construction in progress of $2.0 million was recorded as aliability as of December 31, 2000.  Uponcompletion of the building and commencement of the lease term in June 2001, theasset and related obligation were removed from the Company’s balance sheet inaccordance with accounting for the building as an operating lease.  The building functions as the Company’scorporate headquarters including the principal technical operations and theintegration, assembly and support service operations.  It is located in a 104,000 square foot office and warehousefacility in Chanhassen, Minnesota.

 

The Company’s remaining 20locations including sales and technical staff are small to medium sizedoffices.  Regional hubs are locatedwithin each of the Company’s regions in the Northeast, Southeast, Central andWest.

 

34

----

 

Asof December 31, 2002, future minimum lease payments due under non-cancelableoperating leases are as follows:

 

| **Year Ended** |   | **Total**          |   |
|----------------|--------|--------------------|--------|
|           |   | **(In thousands)** |   |
| 2003           |   | $                  | 2,166  |   |
| 2004           |   | 2,076              |   |
| 2005           |   | 1,950              |   |
| 2006           |   | 1,836              |   |
| 2007           |   | 1,523              |   |
| Future         |   | 5,595              |   |
|           |   | $                  | 15,146 |   |

 

Totalrent expense, including certain lessor operating costs charged to the Company,is as follows:

 
|          |   | **Year Ended December 31,** |   |
|---------------|--------|----------------------------------|--------|
|          |   | **2002**                         |   | **2001** |   | **2000** |   |
|          |   | **(In thousands)**               |   |
| Related party |   | $                                | — |   | $ | 112 |   | $ | 323 |   |
| Other         |   | 2,399                            |   | 2,080 |   | 792 |   |
|          |   | $                                | 2,399  |   | $ | 2,192 |   | $ | 1,115 |   |

 

**6. Employee Benefit Plan:**

 

The Company has a definedcontribution retirement plan for eligible employees. Employees may contributeup to 15% of their pretax compensation to the 401(k) portion of the plan. TheCompany is required to match 50% of an employee’s contribution up to the first6% of an employee’s eligible compensation. The cost of the Company’scontributions to the 401(k) portion of the plan for 2002, 2001 and 2000,was  $356,000, $428,000 and $349,000,respectively.

 

**7. Stockholders’ Equity:**

 

***Private Placement****:*

 

In May 2002, the Company sold an aggregate of1,180,000 shares of Common Stock, plus five-year warrants to purchase anadditional 200,000 shares at an exercise price of $4.50 per share, to fiveinstitutional investors for $5.3 million. The Company allocatedan amount to the value of the warrants utilizing a fair value estimate derivedfrom the Black Scholes option pricing model assuming a volatility of 102%, thewarrant life of 5 years and a risk-free interest rate of 4.76%. Based on thisfair value estimate, the Company allocated approximately $863,000 to thewarrants and $4,437,000 to the Common Stock. Based upon representations made bythe purchasers to the Company, the Company relied on Section 4(2) of theSecurities Act of 1933, as amended, for an exemption from registration of theissuance of these securities.

 

***Stock Compensation Plans:***

 

Effective May 8, 2001, theCompany reserved an aggregate of 3,000,000 shares of common stock for issuancepursuant to the Company’s Incentive Compensation Plan (the “Incentive Plan”),1,230,697 of which were available for grant as of December 31, 2002. The termsof the plan 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 reserved250,000 shares of common stock for issuance pursuant to the Company’s EmployeeStock Purchase Plan. Under terms of the Employee Stock Purchase Plan, eligibleemployees may designate up to 15% of their compensation to be withheld throughpayroll deductions and will be granted an option to purchase a designatednumber of shares of common stock at a purchase price 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.

 

In August 2000, the Board ofDirectors adopted the 2000 Director Stock Option Plan (the “Director Plan”).  The Company amended the Director Plan in Mayand October 2002.  The terms of theDirector Plan allow for stock option grants to

 

35

----

 

non-employeemembers of the Board of Directors.  TheCompany has reserved 300,000 shares of common stock for issuance pursuant tothe Director Plan.

 

***Stock Options:***

 

The following table summarizesactivity under the Company’s stock option plans:

 
|                                        |   | **Outstanding Options** |   |
|---------------------------------------------|--------|-------------------------|--------|
|                                        |   | **Number of Shares**    |   | **Range of  Exercise Prices** |   | **Weighted****Average  Exercise Price** |   |
| Balance, December 31, 1999                  |   | 742,225                 |   | $7.50  - $19.63 |   | $ | 8.02 |   |
| Options granted                             |   | 488,432                 |   | $8.50  - $25.38 |   | $ | 15.98 |   |
| Options exercised                           |   | (29,951                 | )      | $7.50 |   | $ | 7.50 |   |
| Options cancelled                           |   | (148,915                | )      | $7.50  - $25.38 |   | $ | 11.82 |   |
| Balance, December 31, 2000                  |   | 1,051,791               |   | $7.50  - $25.38 |   | $ | 11.19 |   |
| Options granted                             |   | 1,028,400               |   | $1.60  - $15.25 |   | $ | 7.05 |   |
| Options exercised                           |   | (11,530                 | )      | $7.50 |   | $ | 7.50 |   |
| Options cancelled                           |   | (251,638                | )      | $3.46  - $20.88 |   | $ | 10.35 |   |
| Balance, December 31, 2001                  |   | 1,817,023               |   | $1.60  - $25.38 |   | $ | 9.00 |   |
| Options granted                             |   | 345,095                 |   | $1.44  - $6.42 |   | $ | 4.35 |   |
| Options cancelled                           |   | (392,815                | )      | $3.46  - $25.38 |   | $ | 9.08 |   |
| Balance, December 31, 2002                  |   | 1,769,303               |   | $1.44  - $25.38 |   | $ | 8.07 |   |
|                                        |   |                    |   |   |   |   |   |
| Options exercisable as of December 31, 2002 |   | 720,070                 |   | $1.44  - $25.38 |   | $ | 9.08 |   |

 

Thefollowing is a summary of options outstanding at December 31, 2002:

 

| **Stock  Options** |   | **Range of  Exercise Price Per  Share** |   | **Weighted  Average  Exercise  Price Per Share** |   | **Weighted  Average  Remaining Contractual  Life (Years)** |   |
|--------------------|--------|-----------------------------------------|--------|--------------------------------------------------|--------|------------------------------------------------------------|--------|
| 13,750             |   | $0.00  - $2.53                          |   | $                                                | 1.83   |                                                       | 9.6    |   |
| 444,092            |   | $2.54  - $5.07                          |   | $                                                | 3.60   |                                                       | 9.0    |   |
| 565,484            |   | $5.08  - $7.60                          |   | $                                                | 7.03   |                                                       | 7.3    |   |
| 445,516            |   | $7.61  - $10.14                         |   | $                                                | 8.78   |                                                       | 8.0    |   |
| 72,275             |   | $10.15  - $12.68                        |   | $                                                | 11.78  |                                                       | 7.4    |   |
| 57,062             |   | $12.69  - $15.22                        |   | $                                                | 14.50  |                                                       | 7.4    |   |
| 18,150             |   | $15.23  - $17.75                        |   | $                                                | 15.82  |                                                       | 7.3    |   |
| 151,224            |   | $17.76  - $20.84                        |   | $                                                | 18.29  |                                                       | 7.0    |   |
| 1,750              |   | $20.84  - $25.38                        |   | $                                                | 25.38  |                                                       | 0.2    |   |
| 1,769,303          |   | $0.00  - $25.38                         |   | $                                                | 8.07   |                                                       | 7.9    |   |

 

36

----

 

The following is a summary of options granted atan exercise price that differs from the market price of the stock on the grantdate:

 
|                                        |   | **Stock  Options  Granted** |   | **Weighted  Average  Exercise Price Per  Share** |   | **Weighted  Average  Exercise Price Per  Share** |   |
|---------------------------------------------|--------|-----------------------------|--------|--------------------------------------------------|--------|--------------------------------------------------|--------|
| December 31, 2000                           |   |                        |   |                                             |   |                                             |   |
| Option price equals fair market value       |   | 387,982                     |   | $8.50  - $25.38                                  |   | $                                                | 12.29  |   |
| Option price greater than fair market value |   | 4,500                       |   | $19.88                                           |   | $                                                | 15.05  |   |
| Option price less than fair market value    |   | 95,950                      |   | $10.69  - $20.00                                 |   | $                                                | 13.35  |   |
| Options granted                             |   | 488,432                     |   | $8.50  - $25.38                                  |   | $                                                | 15.98  |   |
|                                        |   |                        |   |                                             |   |                                             |   |
| December 31, 2001                           |   |                        |   |                                             |   |                                             |   |
| Option price equals fair market value       |   | 977,900                     |   | $3.46  - $11.63                                  |   | $                                                | 6.92   |   |
| Option price less than fair market value    |   | 50,500                      |   | $1.60  - $15.25                                  |   | $                                                | 9.34   |   |
| Options granted                             |   | 1,028,400                   |   | $1.60  - $15.25                                  |   | $                                                | 7.05   |   |
|                                        |   |                        |   |                                             |   |                                             |   |
| December 31, 2002                           |   |                        |   |                                             |   |                                             |   |
| Option price equals fair market value       |   | 297,845                     |   | $2.90  - $6.42                                   |   | $                                                | 4.52   |   |
| Option price less than fair market value    |   | 47,250                      |   | $1.44  - $4.24                                   |   | $                                                | 3.19   |   |
| Options granted                             |   | 345,095                     |   | $1.44  - $6.42                                   |   | $                                                | 4.35   |   |

 

In accordance with SFAS No. 123,“Accounting for Stock-Based Compensation,” the Company accounts for stock-basedcompensation to employees using the intrinsic value method prescribed inAccounting Principles Board Opinion No. 25, “Accounting for Stock Issued toEmployee,” and related interpretations. Accordingly, compensation cost forstock options granted to employees is measured as the excess, if any, of thefair value of the Company’s common stock at the date of the grant over theamount an employee must pay to acquire the stock.

 

During 2000 and 1999, the Companyissued 135,850 options with an exercise price below the fair market value ofcommon stock at the date of grant.  Theintrinsic value of the options is being recorded to compensation expense overthe vesting period, generally four years. During 2002 and 2001, $118,000 and $119,000, respectively, ofcompensation expense was recorded related to these options.  As of December 31, 2002 and 2001, there was$128,000 and $246,000, respectively, of compensation expense related to theseoptions that will be recognized in future periods. During 2002 and 2001, theCompany issued 47,250 and 49,750 options, respectively, to directors below thefair market value of common stock at the date of grant.  The compensation expense recorded was$90,000 and $27,000 in 2002 and 2001, respectively.  Because the options vest immediately, all compensation expensewas recorded in the period of the grant.

 

Pro forma net income (loss) andearnings (loss) per share have been determined as if the Company had used thefair value method of accounting for its stock option grants and employee stockpurchase plan share elections consistent with the method of SFAS No. 123.  Under this method, compensation expense isrecognized over the applicable vesting periods and is based on the shares underoption and their related fair values on the grant date.

 

|                          |   | **2002**                                       |   | **2001** |   | **2000** |   |
|-------------------------------|--------|------------------------------------------------|--------|----------|--------|----------|--------|
|                          |   | **(In thousands, except for  per share data)** |   |
| Net income:                   |   |                                           |   |     |   |     |   |
| As reported                   |   | $                                              | (5,418 | )        | $      | (505     | )      | $ | 3,635 |   |
| Non cash compensation expense |   | $                                              | (415   | )        | $      | (960     | )      | $ | (664 | ) |
| Pro forma                     |   | $                                              | (5,833 | )        | $      | (1,465   | )      | $ | 2,971 |   |
| Basic earnings per share      |   |                                           |   |     |   |     |   |
| As reported                   |   | $                                              | (0.56  | )        | $      | (0.06    | )      | $ | 0.41 |   |
| Non cash compensation expense |   | $                                              | (0.04  | )        | $      | (0.10    | )      | $ | (0.07 | ) |
| Pro forma                     |   | $                                              | (0.60  | )        | $      | (0.16    | )      | $ | 0.34 |   |
| Diluted earnings per share    |   |                                           |   |     |   |     |   |
| As reported                   |   | $                                              | (0.56  | )        | $      | (0.06    | )      | $ | 0.40 |   |
| Non cash compensation expense |   | $                                              | (0.04  | )        | $      | (0.10    | )      | $ | (0.06 | ) |
| Pro forma                     |   | $                                              | (0.60  | )        | $      | (0.16    | )      | $ | 0.34 |   |

 

37

----

 

Theweighted-average fair values per option at the date of grant were $7.05 and$4.35 for 2001 and 2002, respectively. The fair value for the stock optiongrants was estimated using the Black-Scholes option pricing model with thefollowing weighted average assumptions:

 
|                           |   | **2002** |   | **2001**     |   | **2000**     |   |
|--------------------------------|--------|----------|--------|--------------|--------|--------------|--------|
| Risk-free interest rates       |   | 4.76     | %      | 4.31% - 5.73 | %      | 5.36% - 6.57 | %      |
| Expected dividend yield        |   | 0        |   | 0            |   | 0            |   |
| Expected volatility factor     |   | 102      | %      | 107          | %      | 95           | %      |
| Expected option holding period |   | 5  years |   | 5  years     |   | 5  years     |   |

 

**8. OpenSystems.com, Inc. Acquisition**

 

On November 10, 2000, the Company acquired certainassets of the data storage and service business of OpenSystems.com, Inc., aWalpole, Massachusetts-based firm engaged in the resale and installation ofdata storage solutions.  Under the termsof the sale agreement, the Company agreed to pay $7 million in cash and issue79,177 shares of its common stock for these assets. Additionally, the Companywould have been required to pay $2.5 million of cash consideration to theseller if certain revenue targets were met in 2001.  Since the revenue targets were not met in 2001, no payment wasmade. The acquisition was accounted for using the purchase method ofaccounting.

 

The followingunaudited pro forma condensed results of operations have been prepared to giveeffect to the acquisition of the data and service business of OpenSystems.comas if the acquisition occurred as of January 1, 2000:

 

|                          |   | **Year Ended  December 31, 2000** |    |
|-------------------------------|--------|----------------------------------------|---------|
| Net sales                     |   | $                                      | 156,742 |   |
| Net income                    |   | $                                      | 5,833   |   |
| Net income per share, basic   |   | $                                      | 0.66    |   |
| Net income per share, diluted |   | $                                      | 0.64    |   |

 

Theunaudited pro forma condensed results of operations are not necessarilyindicative of results that would have occurred had the acquisitions been ineffect for the periods presented, nor are they necessarily indicative of theresults that will be obtained in the future.

 

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

 
|                                       |   | **March 31**       |       | **June 30** |       | **Sept 30** |       | **Dec 31** |       |
|--------------------------------------------|--------|--------------------|------------|-------------|------------|-------------|------------|------------|------------|
|                                       |   | **(In thousands)** |       |
| **2002**                                   |   |               | ** ** |        | ** ** |        | ** ** |       | ** ** |
| Net sales                                  |   | $                  | 21,784     |        | $          | 21,019      |       | $          | 21,858     |   | $ | 21,839 |   |
| Gross profit                               |   | 5,503              |       | 5,043       |       | 5,397       |       | 5,781      |       |
| Operating loss                             |   | (2,094             | )          | (1,978      | )          | (1,560      | )          | (521       | )          |
| Net loss                                   |   | (1,300             | )          | (1,229      | )          | (962        | )          | (1,927     | )          |
| Net loss per share — basic            |   | (0.15              | )          | (0.13       | )          | (0.09       | )          | (0.19      | )          |
| Net loss per share — diluted          |   | (0.15              | )          | (0.13       | )          | (0.09       | )          | (0.19      | )          |
|                                       |   |               |       |        |       |        |       |       |       |
| **2001**                                   |   |               | ** ** |        | ** ** |        | ** ** |       | ** ** |
| Net sales                                  |   | $                  | 40,899     |        | $          | 26,992      |       | $          | 32,244     |   | $ | 24,649 |   |
| Gross profit                               |   | 11,069             |       | 7,472       |       | 9,269       |       | 6,253      |       |
| Operating income (loss)                    |   | 1,786              |       | (1,087      | )          | 788         |       | (2,004     | )          |
| Net income (loss)                          |   | 1,076              |       | (623        | )          | 290         |       | (1,248     | )          |
| Net income (loss) per share — basic   |   | 0.12               |       | (0.07       | )          | 0.03        |       | (0.14      | )          |
| Net income (loss) per share — diluted |   | 0.12               |       | (0.07       | )          | 0.03        |       | (0.14      | )          |

 

**Item 9.****           Changes in and Disagreements With Accountants on Accounting andFinancial Disclosure.**

 

None.

 

38

----

 

# **PART III**

 

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

 

The information regardingexecutive officers required by Item 401 of Regulation S-K is included in“Executive Officers of the Registrant” in Part I of this form and isincorporated herein by reference. In addition, we will furnish to theSecurities and Exchange Commission a definitive Proxy Statement (the “2002Proxy Statement”) not later than 120 days after the close of the fiscal yearended December 31, 2002. The information required by Item 405 ofRegulation S-K is incorporated herein by reference to the Proxy Statement.

 

**Item 11.  ExecutiveCompensation.**

 

The information set forth underthe caption “Executive Compensation” in the Company’s 2002 Proxy Statement isincorporated herein by reference.

 

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

 

The information set forth underthe caption “Outstanding Voting Securities and Voting Rights” in the Company’s2002 Proxy Statement is incorporated herein by reference.

 

**Item 13.  CertainRelationships and Related Transactions.**

 

The information required by thissection is incorporated by reference from the information in the sectionentitled “Certain Relationships and Related Transactions” in the Company’s 2002Proxy Statement.

 

**Item 14.Controls and Procedures.**

 

*DisclosureControls and Procedures*. Within the 90 days prior to the filing of this report, we carried out anevaluation, under the supervision and with the participation of our management,including our President and Chief Executive Officer and our Chief FinancialOfficer, of the effectiveness of the design and operation of our disclosurecontrols and procedures pursuant to Rule 13a-15b under the Securities ExchangeAct of 1934. Based on their review of our disclosure controls and procedures,the President and Chief Executive Officer and the Chief Financial Officer haveconcluded that our disclosure controls and procedures are effective in timelyalerting them to material information relating to us that is required to beincluded in our periodic SEC filings.

 

*InternalControls and Procedures*. There were no significant changes in internal controls or in otherfactors that could significantly affect these controls subsequent to the dateof their evaluation, including any corrective actions with regard tosignificant deficiencies and material weaknesses.

 

**PART IV**

 

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

 

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

 

**1.****                                    Financial Statements**

 

Referenceis made to the Index to Financial Statements of Datalink Corporation, underItem 8 in Part II of this Form 10-K.

 

**2.****                                    Financial Statement Schedules.**

 

Thefollowing financial statement schedule of Datalink Corporation, for the yearsended 2002, 2001 and 2000 is filed as part of this Annual Report and should beread in conjunction with the Financial Statements of Datalink Corporation.

 

39

----

 

DATALINK CORPORATION

SCHEDULE II VALUATION AND QUALIFYING ACCOUNTS

FOR THE YEARS ENDED DECEMBER 31, 2002, 2001 AND2000

 
| **Description**                               |   | **Period** |   | **Balance at  Beginning  of Period** |    | **Additions** |   | **Deductions(1)** |   | **Balance  at End  of Period** |   |
|-----------------------------------------------|--------|------------|--------|--------------------------------------|---------|---------------|--------|-------------------|--------|--------------------------------|--------|
| Allowance for Doubtful Accounts               |   | 2002       |   | $                                    | 164,394 |          | $      | 106,784           |   | $                              | 73,810 |   | $ | 197,368 |   |
|                                          |   | 2001       |   | 75,037                               |    | 115,000       |   | 25,643            |   | 164,394                        |   |
|                                          |   | 2000       |   | 75,000                               |    | 88,771        |   | 88,734            |   | 75,037                         |   |
|                                          |   |       |   |                                 |    |          |   |              |   |                           |   |
| Allowance for Inventory Obsolescence          |   | 2002       |   | $                                    | 245,559 |          | $      | 187,500           |   | $                              | 28,058 |   | $ | 405,001 |   |
|                                          |   | 2001       |   | 264,748                              |    | 344,000       |   | 363,189           |   | 245,559                        |   |
|                                          |   | 2000       |   | 482,961                              |    | 1,175,889     |   | 1,394,002         |   | 264,748                        |   |
|                                          |   |       |   |                                 |    |          |   |              |   |                           |   |
| Allowance for Valuation of Deferred Tax Asset |   | 2002       |   | $                                    | —  |          | $      | 1,609,000         |   | $                              | — |   | $ | 1,609,000 |   |

 

----

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

 

40

----

 

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

 
| **Exhibit Number** |   | **Title**                                                                                                                                                                          |   | **Method of Filing** |
|--------------------|--------|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------|
| 3.1                |   | Amended and Restated Articles  of Incorporation of the Company                                                                                                                     |   | 1                    |
| 3.2                |   | Restated Bylaws of the Company                                                                                                                                                     |   | 1                    |
| 4.1                |   | Form of Common Stock  Certificate                                                                                                                                                  |   | 1                    |
| 10.1               |   | Employee Stock Purchase Plan                                                                                                                                                       |   | 1                    |
| 10.2               |   | 1999 Incentive Compensation  Plan, as amended on December 18, 2000                                                                                                                 |   | 4                    |
| 10.3               |   | Credit Agreement with Norwest  Bank Minneapolis, N.A.                                                                                                                              |   | 1                    |
| 10.4               |   | Form of Indemnification  Agreement                                                                                                                                                 |   | 1                    |
| 10.5               |   | Lease Agreement with Washington  Avenue L.L.P.                                                                                                                                     |   | 1                    |
| 10.6               |   | Deferred Compensation Agreement  with Stanley I. Clothier                                                                                                                          |   | 1                    |
| 10.7               |   | Agreement and Plan of  Reorganization with Direct Connect Systems, Inc. (excluding Schedules  and Exhibits which the Registrant will provide to the Commission upon  request) |   | 1                    |
| 10.8               |   | Second Lease Agreement with  Washington Avenue L.L.P.                                                                                                                              |   | 1                    |
| 10.9               |   | Lease Extension Agreement with  Washington Avenue L.L.P.                                                                                                                           |   | 1                    |
| 10.11              |   | Asset Purchase Agreement dated  November 10, 2000 with OpenSystems.com, Inc. (excluding Schedules and  Exhibits which the Registrant will provide to The Commission upon request)  |   | 2                    |
| 10.12              |   | Building Lease with Hoyt/DTLK  LLC                                                                                                                                                 |   | 3                    |
| 10.13              |   | Building Lease date April 27,  2001 with Hoyt/DTLK LLC                                                                                                                             |   | 5                    |
| 10.18              |   | 2000 Director Stock Option Plan                                                                                                                                                    |   | 4                    |
| 10.19              |   | Credit agreement dated June 30,  2002 with Wells Fargo Bank Minneapolis, National Association                                                                                      |   | 6                    |
| 10.20              |   | 2002 Amendments to the 2000  Director Stock Option Plan                                                                                                                            |   | Filed  herewith      |
| 23.1               |   | Consent of KPMG LLP                                                                                                                                                                |   | Filed  herewith      |
| 23.2               |   | Consent of  PricewaterhouseCoopers LLP                                                                                                                                             |   | Filed  herewith      |
| 99.1               |   | Certifications by the Chief  Executive Officer and Chief Financial Officer pursuant to Section 906 of the  Sarbanes-Oxley Act of 2002                                              |   | Filed  herewith      |

 

----

1)                                      Incorporated by reference to the exhibit of thesame number in the Company’s Registration Statement on Form S-1, Reg.No. 333-55935

 

2)                                      Incorporated by reference to the exhibit of the samenumber in the Company’s September 30, 2000 Form 10-Q.

 

3)                                      Incorporated by reference to the exhibit of thesame number in the Company’s 2000 Form 10-K.

 

4)                                      Incorporated by reference to the Company’s 2000Proxy Statement.

 

5)                                      Incorporated by reference to the exhibit of thesame number in the Company’s March 31, 2001 Form 10-Q.

 

6)                                      Incorporated by reference to the exhibit of thesame number in the Company’s June 30, 2002 Form 10-Q.

 

(b)                                 Reports of Form 8-K.

 

No reports on Form 8-K were filedduring the last quarter of the period covered by this report.

 

41

----

 

FINANCIAL STATEMENT SCHEDULES:

 

 

**INDEPENDENT AUDITORS’ REPORT ON SCHEDULE**

 

The Board of Directors and Shareholders

Datalink Corporation:

 

Under the date of February 7, 2003, we reported on thebalance sheet of Datalink Corporation as of December 31, 2002 and the relatedstatements of operations, stockholders’ equity and, cash flows for the yearthen ended. In connection with our audit of the aforementioned financialstatements, we also have audited the related financial statement schedule forthe year ended December 31, 2002 as listed in the accompanying index.  The financial statement schedule is theresponsibility of the Company’s management. Our responsibility is to express an opinion on the financial statementschedule based on our audit. Thefinancial statements of Datalink Corporation as of December 31, 2001, and forthe year then ended were audited by other auditors who have ceased operations.Those auditors expressed an unqualified opinion on those financial statementsin their report dated February 8, 2002.

 

In our opinion, such financial statement schedule forthe year ended December 31, 2002, when considered in relation to the basicfinancial statements taken as a whole, presents fairly, in all materialrespects, the information set forth therein.

 
| /s/ KPMG LLP           |   |
|------------------------|--------|
|                   |
| Minneapolis, Minnesota |
| February 7, 2003       |

 

 

*The followingreport is a copy of a report previously issued by Arthur Andersen LLP (“Andersen”),which report has not been reissued by Andersen.*

Report of IndependentPublic Accountants

 

We have audited inaccordance with auditing standards generally accepted in the United States, thefinancial statements of Datalink Corporation as of December 31, 2001 and forthe year then ended included in this Form 10-K, and have issued our reportthereon dated February 8, 2002.  Ouraudit was made for the purpose of forming an opinion on those statements takenas a whole.  The Schedule II – Valuationand Qualifying Accounts of Registrant is the responsibility of the Company’smanagement and is presented for purposes of complying with the Securities andExchange Commission’s rules and are not part of the basic financial statements.  The information for the year ended December31, 2001 in the Schedule II — Valuation and Qualifying Accounts of Registranthas been subjected to the auditing procedures applied in the audit of the basicfinancial statements and, in our opinion, fairly states in all material respectsthe financial data required to be set forth therein in relation to the basicfinancial statements taken as a whole.

 
| /s/ Arthur Andersen LLP |   |
|-------------------------|--------|
|                    |
| Minneapolis, Minnesota  |   |
| February 8, 2002        |

 

42

----

 

REPORT OF INDEPENDENT ACCOUNTANTS

 

Tothe Board of Directors

andStockholders of

DatalinkCorporation

 

Our report on the consolidatedfinancial statements of Datalink Corporation has been included in this AnnualReport on Form 10-K under Item 8.  Inconnection with our audit of such financial statements, we have also auditedthe related financial statement schedule listed in item 14 of this AnnualReport on Form 10-K.

 

In our opinion, the financialstatement schedule referred to above, when considered in relation to the basicfinancial statements taken as a whole, presents fairly, in all materialrespects, the information required to be included therein.

 
| /s/ PricewaterhouseCoopers LLP |   |
|--------------------------------|--------|
|                           |
| Minneapolis, Minnesota         |   |
| February 13, 2001              |

 

43

----

 

**SIGNATURES**

 

Pursuantto the requirements of Section 13 or 15(d) of the Securities Exchange Actof 1934, the registrant has duly caused this Annual Report on Form 10-K to besigned on its behalf by the undersigned, thereunto duly authorized.

 
|                 | DATALINK CORPORATION |                                         |
|----------------------|----------------------|----------------------------------------------|
| Date: March 21, 2003 |                 |                                         |
|                 | By:                  | /s/ Greg R. Meland                      |
|                 |                 | Greg R. Meland, Chief Executive  Officer     |
|                 |                 |                                         |
|                 |  By:            | /s/ Daniel J. Kinsella                       |
|                 |                 | Daniel J. Kinsella, 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/ Greg R. Meland        |   | President and Chief Executive  Officer and Director (Principal Executive Officer)   |   | March 21, 2003 |
|                      |   |                                                                                |   |           |
| /s/ Daniel J. Kinsella    |   | Vice President - Finance and  Chief Financial Officer (Principal Financial Officer) |   | March 21, 2003 |
|                      |   |                                                                                |   |           |
| /s/ Denise M. Westenfield |   | Corporate Controller (Principal  Accounting Officer)                                |   | March 21, 2003 |
|                      |   |                                                                                |   |           |
| /s/ Paul F. Lidsky        |   | Director                                                                            |   | March 21, 2003 |
|                      |   |                                                                                |   |           |
| /s/ Margaret A. Loftus    |   | Director                                                                            |   | March 21, 2003 |
|                      |   |                                                                                |   |           |
| /s/ James E. Ousley       |   | Director                                                                            |   | March 21, 2003 |
|                      |   |                                                                                |   |           |
| /s/ Robert M. Price       |   | Director                                                                            |   | March 21, 2003 |

 

44

----

 

**CERTIFICATIONPURSUANT TOSECTION 302 OF THE SARBANES-OXLEY ACT OF 2002**

 

I, Greg R. Meland, certify that:

 

1.                                       Ihave reviewed this annual report on Form 10-K of Datalink Corporation (the“Registrant”);

 

2.                                       Basedon my knowledge, this annual report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this annual report;

 

3.                                       Basedon my knowledge, the financial statements, and other financial informationincluded in this annual report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the Registrant asof, and for, the periods presented in this annual report;

 

4.                                       TheRegistrant’s other certifying officer and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the Registrant and we have:

 

(a)                                  designedsuch disclosure controls and procedures to ensure that material informationrelating to the Registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this annual report is being prepared;

 

(b)                                 evaluatedthe effectiveness of the Registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this annual report (the“Evaluation Date”); and

 

(c)                                  presentedin this annual report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5.                                       TheRegistrant’s other certifying officer and I have disclosed, based on our mostrecent evaluation, to the Registrant’s auditors and the audit committee ofRegistrant’s board of directors (or persons performing the equivalentfunction):

 

(a)                                  allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the Registrant’s ability to record, process, summarizeand report financial data and have identified for the Registrant’s auditors anymaterial weaknesses in internal controls; and

 

(b)                                 anyfraud, whether or not material, that involves management or other employees whohave a significant role in the Registrant’s internal controls; and

 

6.                                       TheRegistrant’s other certifying officer and I have indicated in this annualreport whether or not there were significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 
| Date:  | March 21, 2003. |   |                                                          |
|--------|-----------------|--------|---------------------------------------------------------------|
|   |            |   |                                                          |
|   |            | By     |        /s/ Greg  R. Meland |   |
|   |            |   | Greg R. Meland,  President and  Chief Executive Officer       |

 

45

----

 

**CERTIFICATIONPURSUANT TOSECTION 302 OF THE SARBANES-OXLEY ACT OF 2002**

 

I, Daniel J. Kinsella, certify that:

 

1.                                       Ihave reviewed this annual report on Form 10-K of Datalink Corporation (the“Registrant”);

 

2.                                       Basedon my knowledge, this annual report does not contain any untrue statement of amaterial fact or omit to state a material fact necessary to make the statementsmade, in light of the circumstances under which such statements were made, notmisleading with respect to the period covered by this annual report;

 

3.                                       Basedon my knowledge, the financial statements, and other financial informationincluded in this annual report, fairly present in all material respects thefinancial condition, results of operations and cash flows of the Registrant asof, and for, the periods presented in this annual report;

 

4.                                       TheRegistrant’s other certifying officer and I are responsible for establishingand maintaining disclosure controls and procedures (as defined in Exchange ActRules 13a-14 and 15d-14) for the Registrant and we have:

 

(a)                                  designedsuch disclosure controls and procedures to ensure that material informationrelating to the Registrant, including its consolidated subsidiaries, is madeknown to us by others within those entities, particularly during the period inwhich this annual report is being prepared;

 

(b)                                 evaluatedthe effectiveness of the Registrant’s disclosure controls and procedures as ofa date within 90 days prior to the filing date of this annual report (the“Evaluation Date”); and

 

(c)                                  presentedin this annual report our conclusions about the effectiveness of the disclosurecontrols and procedures based on our evaluation as of the Evaluation Date;

 

5.                                       TheRegistrant’s other certifying officer and I have disclosed, based on our mostrecent evaluation, to the Registrant’s auditors and the audit committee ofRegistrant’s board of directors (or persons performing the equivalentfunction):

 

(a)                                  allsignificant deficiencies in the design or operation of internal controls whichcould adversely affect the Registrant’s ability to record, process, summarizeand report financial data and have identified for the Registrant’s auditors anymaterial weaknesses in internal controls; and

 

(b)                                 anyfraud, whether or not material, that involves management or other employees whohave a significant role in the Registrant’s internal controls; and

 

6.                                       TheRegistrant’s other certifying officer and I have indicated in this annualreport whether or not there were significant changes in internal controls or inother factors that could significantly affect internal controls subsequent tothe date of our most recent evaluation, including any corrective actions withregard to significant deficiencies and material weaknesses.

 
| Date:  | March 21, 2003. |   |                                                                                                          |
|--------|-----------------|--------|---------------------------------------------------------------------------------------------------------------|
|   |            |   |                                                                                                          |
|   |            | By     |        /s/ Daniel  J. Kinsella                                             |   |
|   |            |   | Daniel J. Kinsella,  Vice President – Finance and  Chief Financial Officer (Principal Financial Officer) |   |

 

46

----