**UNITED STATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,D. C. 20549**

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**FORM 10-K**

**(Mark one)**

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

**FORTHE FISCAL YEAR ENDED DECEMBER 31, 2006**

**OR**

**o**                                  TRANSITION REPORT PURSUANT TOSECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934

**ForThe Transition PeriodFrom                        To                        **

**Commissionfile number: 00029758**

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**DATALINK CORPORATION**

(Exact name of registrantas specified in its charter)

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

 

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

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

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

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

Indicate by check markwhether the registrant (1) has filed all reports required to be filed by Section 13or 15(d) of the Securities Exchange Act of 1934 during the preceding 12months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements forthe past 90 days. Yes x  No o

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

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

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

 

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

Aggregate market value ofthe voting and non-voting common equity held by non-affiliates of theregistrant at June 30, 2006: $34,687,236.

At March 10, 2007, thenumber of shares outstanding of each of the registrant’s classes of commonstock was 12,401,503.

**DOCUMENTS INCORPORATED BYREFERENCE**

Portionsof the Registrant’s Proxy Statement for its Annual Meeting of Stockholders tobe held in 2007 (the “2006 Proxy Statement”), to be filed with the Securitiesand Exchange Commission, are incorporated by reference to Part III of thisForm 10-K.

 

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**NOTE REGARDINGFORWARD-LOOKING STATEMENTS**

This Annual Report contains forward-lookingstatements. We have based these forward looking statements on our currentexpectations and projections about future events, including, among otherthings: the level of continuing demand for storage, including the impact ofeconomic conditions on technology spending; competition and pricing pressuresand timing of our installations that may adversely affect our revenues andprofits; fixed employment costs that may impact profitability if we sufferrevenue shortfalls; revenue recognition policies that may unpredictably deferreporting of our revenues; our ability to hire and retain sales representativesand key technical and other personnel; our dependence on key suppliers; ourability to adapt to rapid technological change; risks associated with currentand possible future acquisitions; fluctuations in our quarterly operatingresults; future changes in applicable accounting rules; and volatility in ourstock price. You may find these statements throughout this Annual Report andspecifically in the sections entitled “Risk Factors,” “Management’s Discussionand Analysis of Financial Condition and Results of Operations” and “Business.”Our actual results may differ materially from those anticipated in theseforward-looking statements as a result of various factors, including all therisks discussed in “Risk Factors” and elsewhere in this Annual Report.

We use the terms “aim”, “believe,”“expect,” “plan,” “intend,” “estimate” and “anticipate” and similar expressionsto identify forward-looking statements. These statements reflect our currentviews with respect to future events and are based on assumptions subject torisks and uncertainties. We do not intend to update or revise any forward-lookingstatements whether as a result of new information, future events or otherwise.

**PART I**

**Item 1.**                        Business.

**Overview**

We are a leadingindependent information storage architect with operations throughout theUnited States. We work with customers to analyze, design, implement, andsupport information storage infrastructures that store, protect, and providecontinuous access to information. Our areas of expertise include:

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

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

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

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

We offer a comprehensivesuite of services spanning analysis, design, implementation and support. Ourhighly skilled technical services and product management teams test and comparedata storage technologies available from the leading manufacturers and softwaredevelopers. Once a product is approved for our solution sets, our technicalservices team then has the flexibility to choose from the best 

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of thesestorage technologies to solve our customers’ growing data storage needs. Inaddition, our support staff ensures the continued success of our data storagesolutions for each customer. We believe these value-added services and ouradherence to the highest quality standards have resulted in superior levels ofcustomer satisfaction.

**The Data StorageIndustry**

Information technology (IT)departments are faced with a daunting challenge of rapidly expanding amounts ofdata to manage coupled with increasing demands for availability of this datafor day-to-day business and to meet regulatory requirements. We expect theseissues will continue to generate interest in new data storage solutions thatallow users to be more productive and to meet the needs of their organizations.

At the same time, we expect ITheadcount to remain relatively flat over the next several years, making itnecessary for organizations to dramatically improve storage managementproductivity to avoid being inundated by growing data storage capacities. To addressthis growing gap, we expect that organizations will consolidate their storageinfrastructures and augment them with enhanced software capabilities such asvirtualization, archiving and data lifecycle management.

We expect that disk-based data protection, modulardisk and SAN/NAS convergence, storage management software, and storage serviceswill grow rapidly over the next several years. Together, these areas willcontinue to grow faster than the rest of the storage industry. Organizations recognize the importance and valueof data as a strategic and competitive asset. Employees, customers andsuppliers demand uninterrupted access to mission-critical data 24 hours a day,7 days a week. As a result, the ability to efficiently store, manage, protectand provide access to this data is fast becoming one of the most importantaspects of business-critical decision-making, increasing the need forhigh-performance, scalable and highly available solutions.

In light of theimportance of data to businesses, we believe that organizations will dedicatean increasing percentage of their information technology budgets to datastorage. We believe that capital investment priorities will include:

**·****      Enhanceddata protection.**

Increasedneed for high throughput performance, greater frequency of backups, quickrestoration of data and stringent data availability requirements are keyfactors that we expect to drive the migration to disk-based data protectionsolutions. Disk is no longer being used as only a target device for replicationand mirroring, but also is being incorporated into traditional backup systems.

**·**      **Continued migration to networkedstorage infrastructures using virtualization technologies.**

Weexpect that through a variety of storage networking and virtualization technologies,organizations will attain shared (consolidated) storage capabilities. Consolidatedand virtualized storage benefits include increased flexibility in implementingand managing storage, increased storage device utilization levels, improvedquality of service, reduced administration costs and increased operationalefficiency.

**·**      **Evolution to modular storagesystems.**

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

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**·**      **Retention and retrieval of data to address Email, regulatory,compliance and litigation support issues.**

Long-termdata retention has become the norm with recent industry regulations such as theSarbanes-Oxley Act, HIPAA (Health Insurance Portability and Accountability Act)and SEC section 17a-4 (electronic communication preservation) mandatingthe retention of documents for many years. The consequences can be great if acompany does not have the proper retention of documents for compliance,including stiff monetary penalties.

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

Anumber of storage management software innovations continue to mature in themarket. Storage management software enhancements span virtualization, storagemanagement and data lifecycle management. Newer software functionalities offeradvanced backup reporting and data categorization. We anticipate that advancesin each of these areas will enable improved storage availability, manageabilityand performance.

**·**      **Acceptance and growing need forstorage services.**

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

**The DatalinkOpportunity**

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

***Pressures onCustomers.***   We believe organizations willincreasingly look outside their in-house technical staff to independentinformation storage architects, such as Datalink, for specialized expertise.Networked storage architecture design is complex. Advanced functionalities,such as disk-based backup and recovery, storage security, and virtualization,further increase the level of complexity. Although organization-wide datastorage solutions, such as SANs, are designed to ease data managementfunctions, these systems are difficult to understand and implement because theyintegrate diverse operating systems, hardware and software. In addition, therecontinues to be a steady influx of new products and technologies introduced tothe market. In-house information technology departments prefer to focus theirefforts on mission-critical applications. Accordingly, they often turn tooutside storage experts that are able to research, design, implement andsupport networked storage solutions.

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

·       Sophisticateddisk-based backup and recovery solutions require the integration of highlyspecialized products made by a variety of manufacturers. A typical enhanceddata recovery architecture, for instance, can utilize components such assoftware, tape libraries, and disk systems, each from a different manufacturer.High-end data storage manufacturers generally focus on only a portion of theoverall enhanced data recovery system, leaving companies like us to integratecomprehensive networked data storage solutions from the best available productsand technologies.

·       Grossprofit margins have been under pressure for many storage companies. Because ofthe high cost of maintaining a national sales and marketing organization,high-end data storage manufacturers increasingly are focusing their resourceson their research and development 

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functions. Thisstrategy requires them to leverage their sales and marketing functions bypartnering with companies such as Datalink.

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

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

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

**The Datalink Solution**

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

*Analysis*

At the beginning of 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 twenty years to customers in numerous industries.

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

*Design*

Once we have completed ourinitial analysis, we begin the design phase of the project. Our professionalservices teams work together to design a system that meets the customer’s datastorage needs and budget. Our independence permits us to choose from a widerange of technologies in order to fuse together the appropriate hardware,software and services for each project.

Datalink’s DesignLinkTMservices utilize a customer’s developed detailed business requirements todesign the data storage solution. The engagement begins with a definition ofthe project’s objectives, scope and key milestones. The Datalink team thenprepares an outline of the schedule and deliverables. Following a thoroughanalysis, the team prepares a comprehensive blueprint of the storage solution,including a detailed design schematic, key implementation milestones andrecommendations for handling potential configuration issues to ensure a smoothtransition to the new storage environment.

*Implementation*

Once we design and test asystem, we formulate a detailed project implementation plan with our customersto meet their financial and operating objectives and minimize disruption totheir operations. We oversee the timely delivery of hardware and softwareproducts to the customer’s location. We then 

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coordinatethe installation with our technical services team, or personnel from theequipment manufacturer, and complete the installation at the customer’s siteusing industry best practices.

*Support*

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

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

We offer maintenance and repair service options underour service program. We offer a variety of on-site service options, includingfour hour guaranteed response times seven days per week, 24 hours per day. Ourtechnical staff first assists customers in identifying the source of systemproblems and in determining whether there is defective hardware or software. Wecontract with a number of our suppliers and other independent serviceorganizations to provide any required on-site maintenance and repairservices.

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

**Our Strategy**

Our strategy is to improveour position as a leading, independent information storage architect and todevelop a customer-focused, high performance company with sustainableprofitable growth. To achieve these objectives, we intend to build upon ourrecord of successfully addressing the evolving enterprise-class informationstorage management needs of our customers. Key elements of our strategyinclude:

*Increase Sales TeamProductivity*

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

*Scale ExistingLocations*

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

*Expand CustomerSupport Revenues*

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

*Enhance OurProfessional Services Business*

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

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*Pursue RegionalAcquisitions*

We believe there is anopportunity to strengthen our resources and presence in key geographies throughthe acquisition of select regional competitors. On January 31, 2007, weacquired Midrange Computer Solutions Inc. (MCSI), a storage consulting,solutions and service provider based in Chicago, Illinois. The acquisition ofMCSI increases our revenue base by approximately one-third, expands the numberof enterprise accounts we serve and extends our presence geographically in theNortheast, Midwest, and Northern and Southern California.

**Suppliers andProducts**

As an independent information storage architect, we donot manufacture data storage products. Instead, we continually evaluate andtest new and emerging technologies from leading manufacturers to ensure thatour solutions incorporate state-of-the-art, high performance, cost-effectivetechnologies. This enables us to maintain our technological leadership,identify new and innovative products and applications and objectively help ourcustomers align their data storage solutions with their business needs.

We have strong, established relationships with themajor enterprise-class information storage hardware and software suppliers. Ourexpertise in open system environments includes UNIX, Microsoft Windows, Linuxand in-depth knowledge of all major hardware platforms manufactured by industryleaders, including Hewlett-Packard Company, International Business MachinesCorp. and Sun Microsystems, Inc. This expertise has earned us preferredstatus with many of our principal suppliers. Preferred status often enables usto participate in our suppliers’ new product development, evaluation,introduction and marketing programs. These collaborations enable us to identifyand market innovative new hardware and software products and exchange criticalinformation in order to maximize customer satisfaction.

**Some ofour major suppliers and the products they provide are listed:**

| **Products**                          | ** ** | ** **                                                                                                                                                 | ** ** | **Suppliers** |
|---------------------------------------|------------|------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|---------------|
| Disk Storage                          |       | EMC Corporation  Hitachi Data Systems Corporation  Network Appliance Inc.  Sun Microsystems, Inc.  Data Domain  International Business Machines Corp. |
| Tape Automation                       |       | Quantum Corporation  Spectra Logic Corporation  Sun Microsystems, Inc.                                                                                |
| Software                              |       | Diligent Technologies  Corporation  EMC Corporation  Symantec Corporation  FalconStor Software, Inc.                                                  |
| Switches/Directors/Storage Networking |       | Brocade Communications  Systems, Inc.  Cisco Systems, Inc.  Riverbed Technology, Inc.                                                       |
| Fibre Channel Host Bus Adapters       |       | Emulex Corporation  QLogic Corporation                                                                                                                     |

 

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**Customers**

Our customers trust uswith their most demanding data storage projects. Customer engagements rangefrom specialized professional assessment and design services, to complexorganization-wide SAN implementations. We serve customers throughout theUnited States in a diverse group of data intensive industries. Our broadindustry experience enables us to understand application and business issuesspecific to each customer and to design and implement appropriate networkedstorage solutions. We enjoy strong relationships with our customers, which arereflected by our significant repeat business. Spanning a broad array ofindustries, our customers include CBS SportsLine.com, Cingular Wireless LLC,Harris Corporation, Fidelity National Financial, Medtronic Inc., St. JudeMedical, Inc., Valero Energy Corporation and World Savings. CingularWireless LLC accounted for 13.9% of 2006 sales.

**Sales and Marketing**

We market and sell our products and servicesthroughout the United States primarily through a direct sales force. Inaddition to our Minneapolis headquarters, as of December 31, 2006, we had13 field sales offices in order to efficiently serve our customers’ needs.

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

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

**Competition**

Datalink primarily competeswith the direct sales forces of storage OEM’s. Besides Datalink’s currenttechnology partners, these OEM competitors include Hewlett-Packard Company andDell Computer Corporation. In addition, we compete with channel partners ofstorage OEM’s. These include MTI Technology Corporation, ForsytheTechnology, Inc., SAN Holdings, Inc. and Sirius Computer Solutions, Inc.

**Employees**

As of December 31,2006, we had a total of 160 full-time employees. We have no employmentagreements with any of our employees, except for our Chief Financial Officerand our Vice President of Field Operations. In November 2004, we enteredinto change of control severance agreements with Messrs. Meland, Westlingand Ms. West and with each Messrs. Barnum and Beyer under theirrespective employment agreements. None of our employees are unionized orsubject to a collective bargaining agreement. We have experienced no work stoppages andbelieve that our employee relations are good.

**Backlog**

We configure products tocustomer specifications and generally ship them shortly after we receive ourcustomer’s order. Customers may change their orders with little or no penalty. Wedo not recognize 

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revenueon hardware or software products until we have completed our required orcontracted installation or configuration services in connection with the sale. Customerconstraints and the availability of engineering resources can have asignificant impact on when we can complete an installation and configurationservice. These factors prevent us from relying on backlog as a predictor of ourfuture sales levels.

**AvailableInformation**

We have available a website on the Internet. Ouraddress is www.datalink.com. The material on our website is not part of thisreport. We file with the SEC, and make available at our website, our AnnualReports on Form 10-K, Quarterly Reports on Form 10-Q,Current Reports on Form 8-K, and amendments to those reports filedor furnished pursuant to Section 13(a) or 15(d) of the ExchangeAct.

The public may also readand copy any materials we file with the SEC at the SEC’s Public Reference Room at100 F Street NE, Washington, DC 20549. The public may obtain information on theoperation of the Public Reference Room by calling the SEC at 1-800-SEC-0330.The SEC maintains an Internet site that contains reports, proxy and informationstatements and other information regarding issuers that file electronicallywith the SEC. The SEC’s website address is www.sec.gov.

**Item 1A.**                RiskFactors.

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

**We cannot assurefuture profitability.**

Although we achievedpositive net income for fiscal year 2006, for the second, third and fourthquarters of 2005 and for the fourth quarter of 2004, we have incurred netlosses all other quarters since the fourth quarter of 2001. We cannot assurethat we will remain profitable in the foreseeable future, or at all. Anyadditional losses may adversely affect our stock price.

**Competition couldprevent us from increasing or sustaining our revenues or profitability.**

The enterprise-class information storage market israpidly evolving and highly competitive. As technologies change rapidly, weexpect that competition will increase in the future. We compete withindependent storage system suppliers to the mid to large enterprise market andnumerous value added resellers, distributors and consultants. We also competein the storage systems market with computer platform 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 potential competitors includeour suppliers. We are not the exclusive reseller of any data storage product weoffer. Instead, our suppliers market their products through other independentdata storage solution providers, original equipment manufacturers and throughtheir own internal sales forces. We believe direct competition from oursuppliers is likely to increase if, as expected, the data storage industrycontinues to consolidate. This consolidation would likely result in fewersuppliers with greater resources to devote to internal sales and marketingefforts. In addition, our suppliers have established and will probably continueto establish cooperative relationships with other suppliers and other datastorage solution providers. These cooperative relationships are often intendedto enable our suppliers 

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to offer comprehensivestorage solutions, which compete with those we offer. If our relationships withour suppliers become adversarial, it will be more difficult for us to stayahead of industry developments and provide our customers with the type ofservice they expect from 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.

**We derive asignificant percentage of our revenues from a small number of customers.**

In 2006, we had onecustomer, Cingular Wireless LLC, that accounted for approximately 13.9% of ourrevenues. In addition, our top five customers collectively accounted for 28% ofour 2006 revenues. In 2005, we had no customers that accounted for at least 10%of our revenues. However, our top five customers collectively accounted for 27%of our 2005 revenues. Because we intend to continue to seek out large projects,we expect that a significant percentage of our revenues will continue to comefrom a small number of customers, although the composition of our key customersis likely to change from year to year. If we fail to obtain a growing number oflarge projects each year, our revenues and profitability will likely beadversely affected. In addition, our reliance on large projects makes it morelikely that our revenues and profits will fluctuate unpredictably from quarterto quarter and year to year. Unpredictable revenue and profit fluctuations maymake our stock price more volatile and lead to a decline in our stock price.

**Our revenuerecognition policies unpredictably defer reporting of our revenues.**

We increasingly sellcomplex enterprise-class information storage solutions, which includeinstallation and configuration services. We do not recognize revenues from oursale of hardware and software products to our customers until we complete ourrequired installation or configuration of these products. Installation andconfiguration of these solutions requires significant coordination with ourcustomers and vendors. Therefore, even if we have shipped all products to ourcustomers, we may be unable to control the timing of product installation andconfiguration. These delays can prevent us from recognizing revenue on productswe ship and may adversely affect our quarterly reported revenues. As a result,our stock price may decline.

**Our key vendorscould discontinue their incentive programs, which could adversely affect ourbusiness.**

Several of our key vendorshave offered incentive programs to us over the past several years based on ourachievement of particular sales levels of their products. These programscontributed to our profitability in 2004, 2005 and 2006. We cannot assure thatthese programs will continue. If they do not, we may be unable to achieveprofitability in the future.

**Our business depends on our ability to hire and retaintechnical personnel and highly qualified sales people.**

Our future operatingresults depend upon our ability to attract, retain and motivate qualifiedengineers and sales people with enterprise-class information storage solutionsexperience. If we fail to recruit and retain additional engineering and salespersonnel, or if losses require us in the future to terminate employment ofsome of these personnel, we will experience greater difficulty realizing ourgrowth strategy, which could negatively affect our business, financialcondition and stock price.

**We generally do nothave employment agreements with our key employees.**

Our future operatingresults depend in significant part upon the continued contributions of ourexecutive officers, managers, salespeople, engineers and other technical personnel,many who have 

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substantialexperience in our industry and would be difficult to replace. Except as to ourChief Financial Officer and new Vice President of Field Operations, wegenerally do not have employment, non-competition or non-solicitation agreementswith our officers or employees, including our executive officers. Accordingly,our employees may voluntarily leave us at any time and work for ourcompetitors. Our growth strategy depends in part on our ability to retain ourcurrent employees and hire new employees. Any failure to retain our keyemployees will make it much more difficult for us to maintain our operationsand attain our growth objectives and could therefore be expected to adverselyaffect our operating results, financial condition and stock price.

**Our long salescycle may cause fluctuating operating results, which may adversely affect ourstock price.**

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

**If the data storageindustry fails to develop compelling new storage technologies, our business maysuffer.**

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

**We will be exposed to risks relating to evaluations ofcontrols required by Section 404 of the Sarbanes-Oxley Act.**

Changing laws, regulationsand standards relating to corporate governance and public disclosure, includingthe Sarbanes-Oxley Act and related regulations implemented by the SEC, arecreating uncertainty for public companies, increasing legal and financialcompliance costs and making some activities more time consuming. We will beevaluating our internal controls systems to allow management to report on, andour independent auditors to attest to, our internal controls. We will beperforming the systems and process evaluation and testing (and any necessaryremediation) required to comply with the management certification and auditorattestation requirements of Section 404 of the Sarbanes-Oxley Act. Whilewe anticipate being able to fully implement the requirements relating tointernal controls and all other aspects of Section 404 by our December 31,2007 deadline, we cannot be certain as to the timing of completion of ourevaluation, testing and remediation actions or the impact of the same on ouroperations. If we are not able to implement the requirements of Section 404in a timely manner or with adequate compliance, we may be subject to sanctionsor investigations by regulatory authorities, including the SEC. This type ofaction could adversely affect our financial results or investors’ confidence inour company and our ability to access capital markets and could cause our stockprice to decline. In addition, the controls and procedures that we willimplement may not comply with all of the relevant rules and regulations ofthe SEC. If we fail to develop and maintain effective controls and procedures,we may be unable to provide the required financial information in a timely andreliable manner. Further, if we acquire any company in the future, we may incursubstantial additional costs to bring the acquired company’s systems intocompliance with Section 404.

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**Control by ourexisting stockholders could discourage the potential acquisition of ourbusiness.**

Currently, our executiveofficers and directors beneficially own approximately 30% of our outstandingcommon stock. Acting together, these insiders may be able to elect our entireBoard of Directors and control the outcome of all other matters requiringstockholder approval. This voting concentration may also have the effect ofdelaying or preventing a change in our management or control or otherwise discouragepotential acquirers from attempting to gain control of us. If potentialacquirers are deterred, you may lose an opportunity to profit from a possibleacquisition premium in our stock price.

**Our stock price isvolatile.**

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

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

·       announcementsof technical innovations;

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

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

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

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

**Our governingdocuments and Minnesota law may discourage the potential acquisitions of ourbusiness.**

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

**Future goodwillimpairment may unpredictably affect our financial results.**

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

**Our future recognition of the expenses associated withstock-based compensation may adversely affect our stock price.**

In the first quarter of2006, we adopted SFAS 123(R), which requires us to measure and recognizecompensation expense for all stock-based compensation based on estimated fairvalues. As a result, our operating results for 2006 and future years willcontain a charge for stock-based compensation related to restricted stock andstock options granted to employees. This charge is in addition to anystock-based compensation we have recognized in the past. SFAS 123(R) requiresthe use of an option pricing model to determine the fair value of share-basedpayment awards. Our stock price, as well as assumptions regarding 

12

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a numberof highly complex and subjective variables, will affect our determination offair value. We cannot assure that the valuation models we apply will accuratelymeasure the fair value of our stock-based compensation. Our stock price may beadversely affected by the existence, amount or unpredictability of our futurestock-based compensation expense.

**We may not successfully integrate or realize thebenefits of the acquisition of Midrange Computer Solutions Inc. (MCSI)**

On January 31,2007, we acquired MCSI. While management believes that acquisitions are anintegral part of our long-term strategy, there are risks and uncertaintiesrelated to acquiring companies. The integration of MCSI is a complex,time-consuming and expensive process that, without proper planning andimplementation, could significantly disrupt our business, controls andprocedures. We may not successfully integrate MCSI and the failure to meet thechallenges involved in integrating the operations of Datalink and MCSIsuccessfully or otherwise to realize any of the anticipated benefits of themerger could seriously harm our business. The challenges involved in thisintegration include, but are not limited to, the following:

·       Successfullycombining product and service offerings.

·       Integratingand coordinating sales and marketing activities.

·       Realizingthe financial, operational and headcount synergies to improve the overallbusiness model of the company.

·       Preservingcustomer, distribution, reseller, OEM, manufacturing, supplier and otherimportant relationships of both Datalink and MCSI and resolving potentialconflicts that may arise.

·       Minimizingthe diversion of management attention from other strategic opportunities andoperational matters.

·       Integratingthe diverse financial systems of both Datalink and MCSI.

·       Addressingdifferences in the business cultures of Datalink and MCSI, maintaining employeemorale and retaining key employees.

The anticipated benefitsof the merger are based on projections and assumptions, including successfulintegration, and not actual experience. In addition to the integration risksdiscussed above, our ability to realize these benefits could be adversely affectedby practical or legal constraints on our ability to combine operations.Finally, if our stock price decreases significantly, this may result in areassessment of our long-lived assets and goodwill (which includes significantlong-lived assets and goodwill related to the acquisition of MCSI) to determineif an impairment is necessary.

**The sublessee for our corporate headquarters may beunable to make their lease payments or default on their lease agreement.**

In December 2004, weagreed to sublease approximately 55,000 of the 104,000 square feet we thenoccupied as our corporate headquarters in Chanhassen, Minnesota. The initialsublease term is co-terminal with our lease and is 85 months starting in April 2005and ending in April 2012. The sublessee pays us rent ranging fromapproximately $55,000 per month at the beginning of the term to approximately$60,000 per month by the end of the term. If the sublessee was unable to maketheir lease payments to us or defaulted on the lease agreement, our operating resultsor financial condition and stock price may suffer as a result.

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**Item 1B.**               UnresolvedStaff Comments.

None.

**Item 2.**                        Properties.

We occupy 49,000 square feet of an office andwarehouse facility in Chanhassen, Minnesota as our corporate headquarters, includingour principal technical operations and our integration, assembly and supportservice operations. As of December 31, 2006, our other 13 locations whichhouse sales and technical staff were small-to-medium-sized offices throughoutthe United States.

In December 2004, we agreed to subleaseapproximately 55,000 of the 104,000 square feet we then occupied as ourcorporate headquarters in Chanhassen, Minnesota. The initial sublease term isco-terminal with our lease and is for 85 months starting in April 2005 andending in April 2012. The sublessee will pay us rent ranging fromapproximately $55,000 per month at the beginning of the term to approximately$60,000 per month by the end of the term. We also negotiated with our landlordto sell the 2.5 acre lot adjoining our facility for $200,000. In the firstquarter of 2005, we incurred a one-time, non-cash charge of $3.5 millionrelated to the sublease and lot sale. We obtained cost savings of approximately$950,000 in 2006 and 2005 as a result of the sublease agreement and expect toachieve comparable savings in future years during the sublease term.

Based on our presentplans, we believe our current facilities, which are in reasonably goodcondition, will be adequate to meet our anticipated needs for at least theremaining term of our lease.

**Item 3.**                        LegalProceedings.

We are not currentlyinvolved in any material legal proceedings. We also had no material legalproceedings that terminated during the fourth quarter of 2006.

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

We submitted no matters during the fourth quarter of2006 to a vote of security holders, through the solicitation of proxies orotherwise.

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**PART II**

**Item 5.        Market for Registrant’s Common Equity,Related Stockholder Matters and Issuer Purchases of Equity Securities.**

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

| ** **                               | ** ** | **High**   | ** ** | **Low**    | ** ** |
|------------------------------------------|------------|------------|------------|------------|------------|
| ***Year  Ended December 31, 2006*** | ** ** | ** ** | ** ** | ** ** | ** ** |
| First Quarter                            |       | $          | 5.48       |       | $          | 3.84 |   |
| Second Quarter                           |       | 7.03       |       | 4.02       |       |
| Third Quarter                            |       | 10.44      |       | 5.18       |       |
| Fourth Quarter                           |       | 12.32      |       | 6.77       |       |
| ***Year  Ended December 31, 2005*** |       |       |       |       |       |
| First Quarter                            |       | 3.23       |       | 2.47       |       |
| Second Quarter                           |       | 3.09       |       | 1.86       |       |
| Third Quarter                            |       | 4.30       |       | 2.84       |       |
| Fourth Quarter                           |       | 4.22       |       | 3.01       |       |
|                                          |            |            |            |            |            |  |  |

 

On March 23, 2007, the closing price per share ofour common stock was $8.23. We urge potential investors to obtain currentmarket quotations before making any decision to invest in our common stock. On March 19,2007, there were approximately 98 holders of common stock, including recordholders and stockholders whose shares are held by a bank, broker or othernominee. However, we estimate that our shares are held through a small numberof record holders by over 2,552 beneficial owners.

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

We did not purchase any ofour securities during 2006 nor did we have any unregistered sales of equitysecurities during 2006. You can find additional information about our equitycompensation plans in Part III, Item 12 of this Annual Report on Form 10-K.

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***StockPerformance Graph***

The Securities andExchange Commission requires that the Company include in this proxy statement aline-graph presentation comparing cumulative stockholder returns on an indexedbasis with the Nasdaq Composite Index and either a nationally recognizedindustry standard or an index of peer companies selected by the Company. TheBoard of Directors previously approved the use of the Russell 2000 Index as itsindustry standard index. The table below compares the cumulative total returnassuming $100 was invested as of December, 13, 2000, in the common stock of theCompany, the Russell 2000 Index and the Nasdaq Composite Index. The graphassumes the reinvestment of all dividends. The Indexes are weighted based onmarket capitalization at the time of each reported data point.

**COMPARISONOF 5 YEAR CUMULATIVE TOTAL RETURN***Among DatalinkCorporation, The NASDAQ Composite IndexAnd The Russell 2000 Index

****

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*** $100 invested on 12/31/01 in stock or index-including reinvestment ofdividends.**

**Fiscal year ending December 31.**

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**Item 6.**                        SelectedFinancial Data.

You should read theinformation below with our “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” and our financial statements. We derivedthe data as of December 31, 2006 and 2005, and for the years ended December 31,2006, 2005 and 2004, from our financial statements that are included in thisAnnual Report. We derived the data as of December 31, 2004, 2003 and 2002,and for the years ended December 31, 2003 and 2002, from our financialstatements not included in this Annual Report.

| ** **                                        | ** ** | **Year ended December 31,**                         | ** ** |
|---------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                        | ** ** | **2006**                                                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                                        | ** ** | **(in thousands, except per share data)** | ** ** |
| **Statement of Operations Data:**                 |       |                                                               |       |   |   |   |   |   |   |   |   |
| Net sales:                                        |       |                                                               |       |   |   |   |   |   |   |   |   |
| Product sales                                     |       | $                                                                  | 102,400    |   | $ | 81,582 |   | $ | 63,235 |   | $ | 61,350 |   | $ | 58,492 |   |
| Service sales                                     |       | 43,583                                                             |       | 35,531 |   | 30,048 |   | 29,787 |   | 28,008 |   |
| Total net sales                                   |       | 145,983                                                            |       | 117,113 |   | 93,283 |   | 91,137 |   | 86,500 |   |
| Cost of sales:                                    |       |                                                               |       |   |   |   |   |   |   |   |   |
| Cost of product sales                             |       | 77,365                                                             |       | 62,147 |   | 48,568 |   | 47,477 |   | 44,776 |   |
| Cost of services                                  |       | 30,521                                                             |       | 24,321 |   | 21,175 |   | 20,198 |   | 20,000 |   |
| Total cost of sales                               |       | 107,886                                                            |       | 86,468 |   | 69,743 |   | 67,675 |   | 64,776 |   |
| Gross profit                                      |       | 38,097                                                             |       | 30,645 |   | 23,540 |   | 23,462 |   | 21,724 |   |
| Operating expenses:                               |       |                                                               |       |   |   |   |   |   |   |   |   |
| Sales and marketing                               |       | 15,985                                                             |       | 15,062 |   | 12,438 |   | 10,985 |   | 11,481 |   |
| General and administrative                        |       | 10,434                                                             |       | 9,954 |   | 10,366 |   | 10,960 |   | 10,354 |   |
| Engineering                                       |       | 6,098                                                              |       | 5,121 |   | 3,764 |   | 4,220 |   | 4,954 |   |
| Charge for sublease reserve(1)                    |       | —                                                             |       | 3,502 |   | — |   | — |   | — |   |
| Restructuring charges(2)                          |       | —                                                             |       | — |   | (63 | ) | 2,078 |   | — |   |
| Amortization of goodwill and other intangibles(3) |       | —                                                             |       | 224 |   | 261 |   | 725 |   | 1,088 |   |
| Total operating  expenses                         |       | 32,517                                                             |       | 33,863 |   | 26,766 |   | 28,967 |   | 27,877 |   |
| Earnings (loss) from operations                   |       | 5,580                                                              |       | (3,218 | ) | (3,226 | ) | (5,505 | ) | (6,153 | ) |
| Interest income,  net                             |       | 714                                                                |       | 303 |   | 83 |   | 74 |   | 117 |   |
| Earnings (loss)  before income taxes              |       | 6,294                                                              |       | (2,915 | ) | (3,143 | ) | (5,431 | ) | (6,036 | ) |
| Income tax (benefit)  expense(4)                  |       | (2,203                                                             | )          | — |   | — |   | (276 | ) | (618 | ) |
| Net earnings  (loss)                              |       | $                                                                  | 8,497      |   | $ | (2,915 | ) | $ | (3,143 | ) | $ | (5,155 | ) | $ | (5,418 | ) |
| Net earnings  (loss) per common share:            |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic                                             |       | $                                                                  | 0.77       |   | $ | (0.28 | ) | $ | (0.31 | ) | $ | (0.50 | ) | $ | (0.56 | ) |
| Diluted                                           |       | $                                                                  | 0.76       |   | $ | (0.28 | ) | $ | (0.31 | ) | $ | (0.56 | ) | $ | (0.50 | ) |
| Weighted average shares  outstanding:             |       |                                                               |       |   |   |   |   |   |   |   |   |
| Basic                                             |       | 11,006                                                             |       | 10,318 |   | 10,286 |   | 10,333 |   | 9,687 |   |
| Diluted                                           |       | 11,127                                                             |       | 10,318 |   | 10,286 |   | 10,333 |   | 9,687 |   |

 

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| ** **                       | ** ** | **As of December 31,** | ** ** |
|----------------------------------|------------|---------------------------------------|------------|
| ** **                       | ** ** | **2006**                              | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** | **2002** | ** ** |
| ** **                       | ** ** | **(In thousands)**               | ** ** |
| **Selected Balance Sheet Data:** |       |                                  |       |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents       |       | $                                     | 22,900     |   | $ | 13,434 |   | $ | 12,663 |   | $ | 12,565 |   | $ | 10,334 |   |
| Working capital                  |       | 19,011                                |       | 9,385 |   | 10,007 |   | 11,488 |   | 13,477 |   |
| Total assets                     |       | 86,849                                |       | 63,143 |   | 47,069 |   | 36,094 |   | 44,785 |   |
| Stockholders’ equity        |       | 27,322                                |       | 15,835 |   | 18,512 |   | 21,496 |   | 26,346 |   |
|                                  |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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(1)          Werecorded a charge for sublease reserve of $3.5 million related to the subleaseof approximately 55,000 of the 104,000 square feet we formerly occupied as partof our corporate headquarters in Chanhassen, Minnesota and the sale of a lot weowned next to our headquarters.

(2)          Werecorded restructuring expense as a result of cost reduction initiatives in thefourth quarter of 2003. These initiatives included severance expenses forheadcount reductions, office closure expenses and a charge for impairment ofour customer base intangible asset.

(3)          Withthe adoption of SFAS No. 142 on January 1, 2002, we ceased amortizing$5.5 million of goodwill.

(4)          Our 2002 income taxbenefit was offset by $1.6 million of expense for a valuation allowance fordeferred tax assets. We continued to record a full valuation allowance againstour deferred tax assets for 2003, 2004 and 2005 due to the uncertainty of therealization and timing of the benefits of those deferred tax assets as we hadnot achieved a sufficient level of sustained profitability. During 2006,management concluded that we had attained a sufficient level of sustainedprofitability and recorded a tax benefit of $2.2 million resulting principallyfrom the reversal of our income tax valuation allowance.

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

You should read thefollowing discussion in conjunction with our financial statements and therelated notes included in Item 8. The following information includesforward-looking statements, the realization of which may be affected by certainimportant factors discussed under “Risk Factors.”

**OVERVIEW**

We are an independent architect of enterprise-classinformation storage infrastructures. We derive our revenues principally fromdesigning, installing and supporting data storage systems. Our solutions caninclude hardware products, such as disk arrays, tape systems andinterconnection components and storage management software products. The marketfor data storage products and services is large. IDC estimates that digitalinformation will occupy more than six times its current quantity, or 988billion gigabytes, by 2010. As of December 31, 2006, we had 14 locationsthroughout the United States with the highest concentration of revenues in thecentral states.

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

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

In the past, we have experienced fluctuations in thetiming of orders from our customers, and we expect to continue to experiencethese fluctuations in the future. These fluctuations have resulted from, amongother things, the time required to design, test and evaluate our data storagesolutions before customers deploy them, the size of customer orders, thecomplexity of our customers’ network environments, necessary systemconfiguration to deploy our solutions and new product introductions bysuppliers. Completion of our installation and configuration services may alsodelay recognition of revenues. Economic conditions and competition also affectour customers’ decisions to place orders with us. As a result, our net salesmay fluctuate from quarter to quarter.

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

·       Increasing productivity ofour sales and technical teams in our existing locations.

·       Deepening our presence inexisting enterprise accounts and penetrating new enterprise accounts.

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·       Growing our customersupport revenue and market share. We believe that our customer support servicesofferings are becoming increasingly attractive to companies looking forsystem-wide integrated support.

·       Increasing our professionalservices revenues. We believe there is an opportunity to sell more of our datastorage services such as implementation services, storage environmentassessments and on-site data storage management and architecture services.

·       Exploring potentialregional acquisitions that we believe can strengthen our resources andcapabilities in key geographic locations. On January 31, 2007, we acquiredMidrange Computer Solutions Inc., a storage consulting, solutions and serviceprovider based in Chicago, Illinois.

To pursue thesestrategies, we are:

·       Improving our training,tools and recruiting efforts for sales and engineering teams to increase productivity.

·       Hiring additional customersupport staff and enhancing the customer support staff’s communications andcall management capabilities.

·       Developing more effectivedelivery capabilities for professional services and solutions.

·       Focusing on successfullyintegrating Datalink and MCSI.

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

·       We may not increase ourproductivity and may lose, or not successfully recruit and retain key sales,technical or other personnel.

·       Competition is intense andmay adversely impact our profit margin. Customers have many options for datastorage products and services.

·       Wemay not successfully integrate MCSI and the failure to meet the challengesinvolved in integrating the operations of Datalink and MCSI successfully orotherwise to realize any of the anticipated benefits of the merger couldseriously harm our business.

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**Results ofOperations**

Oursales for 2006 increased $28.9 million or 24.7% to $146.0 million for 2006 ascompared to 2005. Our gross margin increased $7.5 million or 24.3% to $38.1million for 2006 as compared to 2005. Our earnings from operations increased$5.3 million from $284,000 in 2005, excluding the sublease charge of $3.5million in the first quarter of 2005, to $5.6 million in 2006. The followingtable shows, for the periods indicated, certain selected financial dataexpressed as a percentage of net sales.

| ** **                   | ** ** | **Years Ended December 31,** | ** ** |
|------------------------------|------------|---------------------------------------------|------------|
| ** **                   | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net sales                    |       | 100.0                                       | %          | 100.0 | % | 100.0 | % |
| Cost of sales                |       | 73.9                                        |       | 73.8 |   | 74.8 |   |
| Gross profit                 |       | 26.1                                        |       | 26.2 |   | 25.2 |   |
| Operating expenses:          |       |                                        |       |   |   |   |   |
| Sales and marketing          |       | 10.9                                        |       | 12.8 |   | 13.3 |   |
| General and  administrative  |       | 7.2                                         |       | 8.5 |   | 11.1 |   |
| Engineering                  |       | 4.2                                         |       | 4.4 |   | 4.0 |   |
| Charge for sublease  reserve |       | —                                      |       | 3.0 |   | — |   |
| Amortization of intangibles  |       | —                                      |       | 0.2 |   | 0.3 |   |
| Total operating expenses     |       | 22.3                                        |       | 28.9 |   | 28.7 |   |
| Operating earnings (loss)    |       | 3.8                                         | %          | (2.7 | )% | (3.5 | )% |

 

**Comparison of YearsEnded December 31, 2006, 2005 and 2004**

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

| ** **                                             | ** ** | **Years Ended December 31,** | ** ** |
|--------------------------------------------------------|------------|---------------------------------------------|------------|
| ** **                                             | ** ** | **2006**                                    | ** ** | **2005** | ** ** | **2004** | ** ** |
| Product sales                                          |       | $                                           | 102,400    |   | $ | 81,582 |   | $ | 63,235 |   |
| Service sales                                          |       | 43,583                                      |       | 35,531 |   | 30,048 |   |
| Product gross profit                                   |       | $                                           | 25,035     |   | $ | 19,435 |   | $ | 14,667 |   |
| Service gross  profit                                  |       | 13,062                                      |       | 11,210 |   | 8,873 |   |
| Product gross profit as a percentage of product  sales |       | 24.4                                        | %          | 23.8 | % | 23.2 | % |
| Service gross profit as  a percentage of service sales |       | 30.0                                        | %          | 31.5 | % | 29.5 | % |

 

*NetSales.**  *Ourproduct sales increased 25.5% in 2006 from 2005 to $102.4 million, andincreased 29.0% in 2005 from 2004 to $81.6 million. Our service sales, whichinclude customer support, consulting and installation services, increased 22.7%in 2006 from 2005 to $43.6 million, and increased 18.2% in 2005 from 2004 to$35.5 million.

The increase in ourproduct sales in 2006 as compared to 2005 and 2005 as compared to 2004 reflectsa greater number of customers funding large projects, particularly for enhanceddata recovery technology solutions. We had an increase in customersrepresenting more than $1 million in annual revenues from 14 in 2004 and20 in 2005 to 24 in 2006. We continue to increase the productivity of our salesexecutives. The following table shows the change in our average number ofaccount executives and the increase in our net sales per average number ofaccount executives.

| ** **    | ** ** | **% Change in Average  No. of Account  Executives** | ** ** | **% Change in Net**

**Sales per Average No.  of Account Executives** | ** ** |
|---------------|------------|------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------|------------|
| 2006 vs. 2005 |       |                                                                         | (1         | )%                                                                                                            |       |   | 26 | % |   |
| 2005 vs. 2004 |       |                                                                         | 11         | %                                                                                                             |       |   | 13 | % |   |

 

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The decline in the number of account executives from2005 to 2006 reflects some selected changes in personnel mid year 2006. Theincrease in the average number of account executives from 2004 to 2005 reflectsour hiring of experienced, quality account executives in key geographiclocations.

The increase in our service revenues for 2006 over2005 reflects an increase in our customer support contract revenues and ourinstallation and configuration service revenues, offset by a decrease in ourconsulting service revenues. Customer support contract revenues increased $8.3million or 31.4%, consulting service revenues decreased $1.3 million or 53.1%and installation and configuration service revenues increased $1.1 million or16.3%. With the growth in our product revenues, we continue to successfullysell our installation and configuration services and customer support contracts.The decrease in our consulting revenues between 2005 and 2006 reflects thecompletion of a long term professional services contract at the end of 2005. Theincrease in our service revenues for 2005 over 2004 include an increase incustomer support contract revenues of $2.2 million or 9%, an increase inconsulting service revenues of $1.1 million or 81% and an increase ininstallation and configuration service revenues of $2.2 million or 64%. Thegrowth in our product revenues from 2004 to 2005 resulted in continued growthin our services revenues.

We derived approximately 13.9% of our sales from ourcustomer, Cingular Wireless LLC, during 2006. We cannot provide assurance thatthis customer will account for a substantial portion of our future sales. Wehad no other customers that comprised more than 10% of our sales in 2004, 2005or 2006.

*GrossProfit.**  *Ourtotal gross profit as a percentage of net sales remained flat at 26.1% in 2006as compared to 26.2% in 2005, which was an increase from 25.2% in 2004.

Product gross profit as a percentage of product salesincreased to 24.4% in 2006 as compared to 23.8% in 2005 and as compared to23.2% in 2004. The percentage improvement in both 2006 and 2005 reflects theincrease in enhanced data recovery technology solution purchases made by ourcustomers for which we achieved a higher gross profit. We have various programsin place with our vendors that provide economic incentives for achievingvarious sales performance targets. Achieving these targets contributedfavorably to our product gross profit in 2006, 2005 and 2004. These vendorincentive programs constantly change and we negotiate them separately with eachvendor. While we expect the incentive programs to continue, the vendors couldmodify or discontinue them, which would unfavorably impact our product grossprofit margins.

Service gross profit as a percentage of service salesdecreased to 30.0% in 2006 as compared to 31.5% in 2005 and increased ascompared to 29.5% in 2004. The percentage decrease in 2006 as compared to 2005reflects the completion of a long term professional services contract at theend of 2005 which carried a higher gross profit percentage. The percentageincrease in 2005 as compared to 2004 reflects an improvement in our grossprofit percentage for customer support contract renewals.

*Salesand Marketing.**  *Salesand marketing expenses include wages and commissions paid to sales andmarketing personnel, travel costs and advertising, promotion and hiringexpenses. Sales and marketing expenses totaled $16.0 million, or 10.9% of netsales for 2005 as compared to $15.1 million, or 12.8% of net sales for 2005 and$12.4 million, or 13.3% of net sales for 2004. The increase in sales andmarketing expense in absolute dollars for 2006 over 2005 is primarily a resultof higher commission expense of $1.5 million in 2006 as compared to 2005. Theincrease in sales and marketing expense in absolute dollars for 2005 over 2004is primarily a result of higher commission and bonus expenses of $1.7 milliondue to the higher sales volume in 2005 as compared to 2004. The decrease insales and marketing expense as a percentage of net sales from 2006 to 2005 andfrom 2005 to 2004 reflects better leverage of our fixed costs as revenuesincreased in both 2006 and 2005. As we continue to selectively hire additionaloutside sales representatives, our sales and marketing expenses may increasewithout a commensurate increase in sales.

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*Generaland Administrative.**  *Generaland administrative expenses include wages for administrative personnel,professional fees, depreciation, communication expenses and rent and relatedfacility expenses. General and administrative expenses increased to $10.4million, or 7.2% of net sales for 2006 compared to $9.9 million, or 8.5% of netsales for 2005 and $10.4 million, or 11.1% in 2004. The increase in general andadministrative expenses in absolute dollars for 2006 as compared to 2005 is dueto an increase of $294,000 in facilities expenses for several new leaseagreements for regional offices entered into during the second and thirdquarter of 2005, an increase of $135,000 for board compensation expense and anincrease of $50,000 for sales and use tax expense for several state audits. Thedecrease in general and administrative expenses in absolute dollars for 2005 ascompared to 2004 is due to a decrease of $507,000 in depreciation expenseprimarily for our customer relationship management system and reducedfacilities expenses of $950,000 related to the sublease of our Chanhassenfacility. This decrease was partially offset by an increase in variablecompensation for executives and managers of $701,000 and an increase inaccounting, legal and consulting fees of $187,000 for fees related to SEC andSarbanes-Oxley compliance activity. Our general and administrative expenseswere lower as a percentage of net sales for 2006 as compared to 2005, and for2005 as compared to 2004, due to more controlled spending coupled with anincrease in revenues.

*Engineering.**  *Engineeringexpenses include employee wages and travel, hiring and training expenses forour field and customer support engineers and technicians. We allocateengineering costs associated with installation and configuration services andwith consulting services to our cost of service sales. Engineering expenses increased to $6.1 million, or 4.2% of net sales in2006 compared to $5.1 million, or 4.4% of net sales in 2005 and $3.8 million,or 4.0% of net sales in 2004. The increase in engineering expenses in absolutedollars for 2006 as compared to 2005 is due primarily to a $908,000 increase incompensation expense related to a 30% increase in headcount coupled with higherhealth insurance expenses. The increase in engineering expenses in absolutedollars for 2005 as compared to 2004 is due primarily to an increase incompensation expense of $1.0 million related to a 12% increase in headcountcoupled with higher health insurance expenses and variable compensationexpenses.

The decrease in engineering expenses as a percentageof sales for 2006 as compared to 2005 is the result of more controlled spendingcoupled with an increase in revenues. The increase in engineering expenses as apercentage of sales for 2005 as compared to 2004 is the result of higher engineeringexpenses despite the growth in revenues. In 2005, we added personnel resourcesfor our customer support desk staff.

*SubleaseArrangements.**  *In December 2004,we agreed to sublease approximately 55,000 of the 104,000 square feet we thenoccupied as our corporate headquarters in Chanhassen, Minnesota. The initialsublease term is co-terminal with our lease and is for 85 months starting in April 2005and ending in April 2012. The sublessee will pay us rent ranging fromapproximately $55,000 per month at the beginning of the term to approximately$60,000 per month by the end of the term. We also negotiated with our landlordto sell the 2.5 acre lot adjoining our facility for $200,000. In the firstquarter of 2005, we incurred a one-time, non-cash charge of $3.5 millionrelated to the sublease and lot sale. We obtained cost savings of approximately$950,000 in 2006 and 2005 as a result of the sublease agreement and expect toachieve comparable savings in future years during the sublease term.

*IntangibleAmortization.**  *Wehad no expense related to the amortization of intangible assets in 2006. Amortizationof intangible assets decreased to $224,000 in 2005 from $261,000 in 2004. Theamortization relates primarily to our acquisition of the data storage andservices business of OpenSystems.com, Inc. in November 2000. We testfor impairment of goodwill and intangibles annually or whenever impairment isindicated. For 2005 and 2004, we determined that our goodwill was not impaired.We fully amortized the customer base intangible asset in 2005. On January 31,2007 we entered into an agreement and plan of merger with Midrange ComputerSystems Inc. (MCSI) a storage consulting, solutions and service provider basedin Chicago, Illinois. We are currently in the process of determining the fairvalue of the assets acquired and liabilities assumed and therefore have not yetdetermined the allocation of the purchase price.

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*OperatingEarnings (Loss).*   We realized operating earningsof $5.6 million in 2006 and incurred operating losses of $3.2 million in 2005and 2004. Excluding the sublease charge of $3.5 million in the first quarter of2005, we generated operating income of $284,000 in 2005. Our operating earningsincrease is a result of higher revenues and gross margins, partially offset byhigher operating expenses.

*Income Taxes.**  *We had an income tax benefit of $2.2 million in 2006.We had no income tax benefit or expense in 2005 or 2004. Prior to fiscal 2006,we recorded a full valuation allowance against our deferred tax assets due tothe uncertainty of the realization and timing of the benefits from thosedeferred tax assets as we had not achieved a sufficient level of sustainedprofitability. During 2006, we utilized approximately $4.8 million of our netoperating loss carryforwards. Furthermore, we concluded that we had attained asufficient level of sustained profitability to reverse the remaining valuationallowance of $2.8 million. We utilized approximately $200,000 of our federalnet operating loss carryforwards for the year ending December 31, 2005. For2006, we recorded approximately $392,000 as a credit to equity for tax benefitsassociated with the exercises of stock options during 2006. In future earnings periods,we will report income taxes at normalized rates.

**Quarterly Resultsand Seasonality**

Thefollowing table sets forth our unaudited quarterly financial data for eachquarter of 2006 and 2005. We have prepared this unaudited information on thesame basis as the audited information. In our opinion, we have made alladjustments (including all normal recurring adjustments) necessary to presentfairly the information set forth below. The operating results for any quarterare not necessarily indicative of results for any future period.

| ** **                 | ** ** | **Quarters Ended** | ** ** |
|----------------------------|------------|-------------------------|------------|
| ** **                 | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                 | ** ** | **Mar. 31**        | ** ** | **Jun. 30** | ** ** | **Sep. 30** | ** ** | **Dec. 31** | ** ** | **Mar. 31** | ** ** | **Jun. 30** | ** ** | **Sep. 30** | ** ** | **Dec. 31** | ** ** |
| ** **                 | ** ** | **(in thousands)** | ** ** |
| Net sales                  |       | $                       | 34,284     |   | $ | 39,833 |   | $ | 33,173 |   | $ | 38,693 |   | $ | 21,241 |   | $ | 28,741 |   | $ | 31,233 |   | $ | 35,898 |   |
| Gross profit               |       | 9,141                   |       | 9,851 |   | 8,927 |   | 10,178 |   | 5,759 |   | 7,614 |   | 8,057 |   | 9,215 |   |
| Operating  earnings (loss) |       | 706                     |       | 1,910 |   | 1,067 |   | 1,915 |   | (4,775 | ) | 388 |   | 219 |   | 950 |   |
| Net earnings (loss)        |       | 833                     |       | 2,033 |   | 1,256 |   | 4,375 |   | (4,701 | ) | 446 |   | 295 |   | 1,045 |   |
|                            |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

**Liquidity andCapital Resources**

We have financed our operations and capitalrequirements through cash flows generated from operations and the proceeds fromour offerings of our common stock. Our working capital was $19.0 millionat December 31, 2006 as compared to $9.4 million at December 31,2005. Our current ratio was 1.3:1 at December 31, 2006 as compared to1.2:1 at December 31, 2005. At December 31, 2006, our cash and cashequivalents balance was $22.9 million.

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Cash provided byoperating activities for 2006 was $7.3 million as compared to $1.7 million in2005 and $396,000 in 2004. Cash provided by operating activities for 2006 wasprimarily impacted by:

·       Netearnings for the year of $8.5 million.

·       Anet $2.7 million increase in deferred customer support contracts. While weamortize the revenues from these contracts over the life of the contract, thecustomer typically pays for the contracts at the beginning of the contractperiod which favorably impacts our cash flows.

·       A$3.6 million increase in accounts receivable reflecting increasing salesactivity over the prior year.

·       A$2.8 million increase in deferred income taxes resulting from the reversal ofour valuation allowance for net deferred tax assets.

Cash provided byoperating activities for 2005 was primarily impacted by:

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

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

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

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

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

Cash provided byoperating activities for 2004 was primarily impacted by:

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

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

·       Anet increase in $1.0 million in deferred customer support contracts. While weamortize the revenues from these contracts over the life of the contract, thecustomer typically pays for the contracts at the beginning of the contractperiod which favorably impacts our cash flows.

Cash used in investing activities was $562,000 in2006, $1.1 million in 2005 and $415,000 in 2004. In 2006, we used this cash topurchase computer equipment and provide further enhancements to our businessreporting tools. In 2005, we used this cash to complete the facility build-outrelated to our Chanhassen sublease, purchase computer equipment and providefurther enhancements to our web-enabled reporting tools. In 2004, we used thiscash to purchase computer equipment, complete a data warehouse project and providefurther enhancements to our business reporting software tool.

Cash provided in financing activities in 2006, 2005and 2004 was $2.7 million, $148,000 and $117,000, respectively, all of which wereceived from stock sold under our employee stock purchase plan and from theexercise of options and warrants. We discontinued our employee stock purchaseplan in December 2005.

Our bank revolving credit facility expired in June 2004.We have not renewed it or pursued a new facility. We have no outstanding debt,and if the need should arise to borrow funds, we believe that we could obtain asecured facility.

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

On January 31, 2007,we entered into an agreement and plan of merger with Midrange Computer SystemsInc. (MCSI), a storage consulting, solutions and service provider based inChicago, Illinois. We paid a purchase price of $14 million for MCSI, consistingof $5.0 million cash ($4.5 million of which we paid at closing to theShareholders and $500,000 of which we deposited in escrow) and 1,163,384 sharesof our common stock (1,047,459 shares of which we issued at closing to theShareholders and 116,384 shares of which we deposited in escrow). Based upon apost-closing audit, we will reduce the purchase price by the shortfall, if any,against the agreed upon minimum net assets at the time of closing.

**ContractualObligations and Commitments**

As of December 31,2006, our contractual cash obligations consist of future minimum lease paymentsdue under non-cancelable operating leases as follows:

| ** ** | ** ** | **Lease**               | ** ** | **Sublease**   | ** ** | **Net Lease** | ** ** |
|------------|------------|-------------------------|------------|----------------|------------|--------------------|------------|
| ** ** | ** ** | **Obligations**         | ** ** | **Agreements** | ** ** | **Obligations**    | ** ** |
| ** ** | ** ** | **(in thousands)** | ** ** |
| 2007       |       |                    | $          | 1,854          |       |               |       | $ | (789 | ) |   |   | $ | 1,065 |   |   |
| 2008       |       |                    | 1,569      |           |       |               | (719       | ) |   |   | 850 |   |   |
| 2009       |       |                    | 1,549      |           |       |               | (719       | ) |   |   | 830 |   |   |
| 2010       |       |                    | 1,398      |           |       |               | (719       | ) |   |   | 679 |   |   |
| 2011       |       |                    | 1,264      |           |       |               | (719       | ) |   |   | 545 |   |   |
| Thereafter |       |                    | 422        |           |       |               | (239       | ) |   |   | 183 |   |   |
|       |       |                    | $          | 8,056          |       |               |       | $ | (3,904 | ) |   |   | $ | 4,152 |   |   |

 

From time to time we enter into purchase commitmentswith our suppliers under customary purchase order terms. Any significant lossesimplicit in these contracts would be recognized in accordance with generallyaccepted accounting principles. At December 31, 2006 no such lossesexisted.

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

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

 

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

We believe that ourcurrent cash balance and funds generated from operations will finance ourcurrent operations and planned capital expenditures for at least the nexttwelve months. We believe if the need should arise to borrow funds, we couldobtain a secured facility. We are planningfor $500,000 to $1.0 million of capital expenditures during 2007 primarilyrelated to enhancements to our management information systems.

**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 commitmentsand contingencies. We believe that the following represent the areas where weuse more critical estimates and assumptions in the preparation of our financialstatements:

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

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

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

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

Pursuant to the provisions of SOP 97-2, we applycontract accounting to our bundled arrangements. In accordance with SOP 81-1,“Accounting for Performance of Construction Type and Certain Production TypeContracts,” we apply the completed contract method. Factors we have consideredin applying the completed contract method accounting include (i) therelatively short duration of our contracts, (ii) the difficulty ofestimating our revenues on a percentage-of-completion method and (iii) ouruse of acceptance provisions on larger bundled arrangements.

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

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

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

*ConsultingServices.**  *Some ofour customers engage us to analyze their existing storage architectures andoffer our recommendations. Other customers engage us to assist them on-sitewith extended data storage projects, to support their data storage environmentsand to help with long-term data storage design challenges. For these types ofconsulting services that do not include the sale of hardware or softwareproducts, we recognize revenues as we perform these services.

*Gross Reporting ofRevenues.**  *Wereport our revenues from the sale of hardware and software products on a gross,rather than a net, basis. In reporting our revenues on a gross basis, weconsidered that:

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

·       Wehave the risk of loss for inventory and credit.

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

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

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

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

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

*DeferredIncome Taxes.*   We utilize the asset and liabilitymethod of accounting for income taxes. We recognize deferred tax liabilities orassets for the expected future tax consequences of temporary differencesbetween the book and tax bases of assets and liabilities. We regularly assessthe likelihood that we will recover our deferred tax assets from future taxableincome In 2002, we recorded a valuation allowance to reduce our deferred taxassets to the amount we believed was more likely than not to be realizable. Weconsidered projected future taxable income and ongoing tax planning strategiesin assessing the amount of the valuation allowance. During 2006, management concluded that we had attained a sufficientlevel of sustained profitability to reverse our remaining $2.8 millionvaluation allowance. In future earnings periods, we will report income taxes atnormalized rates.

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*Stock Based Compensation.**  *We adopted the provisions of FASB No. 123R,Share Based Payment on January 1, 2006. FASB 123R requires us to measureand recognize in our statements of operations the expense associated with allshare-based payment awards made to employees and directors based on estimatedfair values. We utilize the Black-Scholes option valuation model to measure theamount of compensation expense we recognize for each option award. There areseveral assumptions that we must make when using the Black-Scholes model suchas the expected term of each option, the expected volatility of the stock priceduring the expected term of the option, the expected dividends payable and therisk free interest rate expected during the option term. Of these assumptions,the expected term of the options and expected volatility of our common stockare the most difficult to estimate since they are based on the exercisebehavior of employees and the expected future performance of our stock. Anincrease in the volatility of our stock price or an increase in the averageperiod before exercise will increase the amount of compensation expense relatedto awards granted after December 31, 2006. The fair value of non-vestedstock awards is determined based on the fair value of the stock on the date ofgrant.

**Recent AccountingPronouncements**

In July 2006, the FASB issued FASB InterpretationNo. 48, Accounting for Uncertainty in Income Taxes—a Interpretation ofFASB Statement 109 (FIN 48), which clarifies the accounting for uncertainty intax positions. This Interpretation provides that a company can recognize thetax effects from an uncertain tax position in its financial statements only ifthe position is more likely than not of being sustained on audit, based on thetechnical merits of the position. The provisions of FIN 48 are effective as ofthe beginning of fiscal 2007, with the cumulative effect of the change inaccounting principle recorded as an adjustment to opening retained earnings. Wehave completed a preliminary evaluation of the impact of adopting FIN 48 on ourfinancial statements and do not believe it will have a material impact.

In September 2006, the FASB issued SFAS No. 157,Fair Value Measurements (SFAS 157), which provides guidance on how to measureassets and liabilities that use fair value. SFAS 157 will apply wheneveranother U.S. GAAP standard requires (or permits) measurement of assets orliabilities at fair value, but does not expand the use of fair value to any newcircumstances. This standard also will require additional disclosures in bothannual and quarterly reports. SFAS 157 will be effective for financialstatements issued for fiscal years beginning after November 15, 2007. Weintend to adopt the standard beginning in the first quarter of 2008. We arecurrently evaluating the impact of adopting SFAS 157 on our financialstatements and do not believe it will have a material impact.

In September 2006, the SEC staff issued StaffAccounting Bulletin (SAB) No. 108, Considering the Effects of Prior YearMisstatements when Quantifying Misstatements in Current Year FinancialStatements (SAB 108). SAB 108 was issued in order to eliminate the diversity ofpractice in how public companies quantify misstatements of financialstatements, including misstatements not material to prior years’ financialstatements. We applied the provisions of SAB 108 in connection with thepreparation of our 2006 annual financial statements. The adoption of SAB 108did not have a material impact our financial statements.

In September 2006, the FASB issued SFAS No. 158,Employers’ Accounting for Defined Benefit Pension and Other PostretirementPlans, an amendment of FASB Statements No. 87, 88, 106, and 132(R) (SFAS158). Part of this Statement is effective as of December 31, 2006,and requires companies with defined benefit pension plans and otherpostretirement benefit plans to recognize prospectively the funded status ofthose plans on their balance sheet from the effective date. Because we do nothave any defined benefit pension plans or other postretirement benefit plans,the adoption of SFAS 158 does not have an impact on our financial statements.

In February 2007, theFASB issued SFAS No. 159, “The Fair Value Option for Financial Assets andFinancial Liabilities—Including an amendment of FASB Statement No. 115.”SFAS No. 159 permits 

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companiesto measure many financial instruments and certain other items at fair value atspecified election dates. Unrealized gains and losses on these items will bereported in earnings at each subsequent reporting date. The fair value optionmay be applied instrument by instrument (with a few exceptions), is irrevocableand is applied only to entire instruments and not to portions of instruments.SFAS No. 159 is effective for fiscal years beginning after November 15,2007. We are currently assessing the impact of SFAS No. 159 on ourfinancial statements and do not believe it will have a material impact.

**Inflation**

We do not believe thatinflation has had a material effect on our results of operations in recentyears. We cannot assure you that inflation will not adversely affect ourbusiness in the future.

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

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

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

*Interestrate risk.**  *As of December 31,2006, we had $22.9 million of cash and money market accounts. A decrease inmarket rates of interest would have no material effect on the value of theseassets or the related interest income due to the nature of money marketaccounts. We have no short or long-term debt.

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

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

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

**Report ofIndependent Registered Public Accounting Firm**

To the Board of Directors and Shareholders ofDatalink CorporationChanhassen, Minnesota

We have audited the accompanying balance sheets ofDatalink Corporation as of December 31, 2006 and 2005 and the relatedstatements of operations, stockholders’ equity and cash flows for each of theyears in the three year period ended December 31, 2006. These financialstatements are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements based onour audits.

We conducted our audits in accordance with thestandards of the Public Company Accounting Oversight Board (United States).Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and the significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audits provide a reasonable basis for our opinion.

In our opinion, the financial statements referred toabove present fairly, in all material respects, the financial position ofDatalink Corporation as of December 31, 2006 and 2005, and the results ofits operations and its cash flows for each of the years in the three yearperiod ended December 31, 2006, in conformity with accounting principlesgenerally accepted in the United States of America.

As described in Note 9 to the financial statements,effective January 1, 2006, the Company adopted Statement of FinancialAccounting Standards (SFAS) No. 123(R), Share-Based Payment.
| /s/ MCGLADREY &  PULLEN, LLP |   |
|---------------------------------------|--------|
| Minneapolis, Minnesota                |
| March 29, 2007                   |

 

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

| ** **                                                                                                                                                                  | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                  | ** ** | **2006**              | ** ** | **2005** | ** ** |
| **Assets**                                                                                                                                                                  |       |                  |       |   |   |
| Current assets:                                                                                                                                                             |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                   |       | $                     | 22,900     |   | $ | 13,434 |   |
| Accounts receivable, net                                                                                                                                                    |       | 22,195                |       | 18,673 |   |
| Inventories                                                                                                                                                                 |       | 1,593                 |       | 831 |   |
| Deferred customer support contract costs                                                                                                                                    |       | 25,876                |       | 16,500 |   |
| Inventories shipped but not installed                                                                                                                                       |       | 3,502                 |       | 5,064 |   |
| Current deferred income taxes                                                                                                                                               |       | 1,442                 |       | — |   |
| Other current assets                                                                                                                                                        |       | 225                   |       | 261 |   |
| Total current assets                                                                                                                                                        |       | 77,733                |       | 54,763 |   |
| Property and  equipment, net                                                                                                                                                |       | 1,942                 |       | 2,476 |   |
| Goodwill                                                                                                                                                                    |       | 5,500                 |       | 5,500 |   |
| Deferred income  taxes                                                                                                                                                      |       | 1,320                 |       | — |   |
| Other assets                                                                                                                                                                |       | 354                   |       | 404 |   |
| Total assets                                                                                                                                                                |       | $                     | 86,849     |   | $ | 63,143 |   |
| **Liabilities and Stockholders’ Equity**                                                                                                                               | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current liabilities:                                                                                                                                                        |       |                  |       |   |   |
| Accounts payable                                                                                                                                                            |       | $                     | 19,753     |   | $ | 19,660 |   |
| Accrued commissions                                                                                                                                                         |       | 1,734                 |       | 1,359 |   |
| Accrued income taxes                                                                                                                                                        |       | 200                   |       | 70 |   |
| Accrued sales and use taxes                                                                                                                                                 |       | 785                   |       | 645 |   |
| Accrued expenses, other                                                                                                                                                     |       | 1,775                 |       | 1,893 |   |
| Sublease reserve current                                                                                                                                                    |       | 360                   |       | 384 |   |
| Deferred revenue from customer support contracts                                                                                                                            |       | 33,472                |       | 21,367 |   |
| Total current liabilities                                                                                                                                                   |       | 58,079                |       | 45,378 |   |
| Deferred rent                                                                                                                                                               |       | 167                   |       | 289 |   |
| Sublease reserve  non-current                                                                                                                                               |       | 1,281                 |       | 1,641 |   |
| Total liabilities                                                                                                                                                           |       | 59,527                |       | 47,308 |   |
| Commitments and  contingencies (Notes 6, 7, 8, 9 and 11)                                                                                                                    |       |                  |       |   |   |
| Stockholders’  equity:                                                                                                                                                 |       |                  |       |   |   |
| Common stock, $0.001 par value, 50,000,000 shares  authorized, 11,228,890 and 10,404,105 shares issued and outstanding as of  December 31, 2006 and 2005, respectively |       | 11                    |       | 10 |   |
| Additional paid-in capital                                                                                                                                                  |       | 29,544                |       | 26,555 |   |
| Accumulated deficit                                                                                                                                                         |       | (2,233                | )          | (10,730 | ) |
| Total stockholders’ equity                                                                                                                                             |       | 27,322                |       | 15,835 |   |
| Total liabilities  and stockholders’ equity                                                                                                                            |       | $                     | 86,849     |   | $ | 63,143 |   |

 

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

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

| ** **                                   | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                   | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Net sales:                                   |       |                                       |       |   |   |   |   |
| Product sales                                |       | $                                          | 102,400    |   | $ | 81,582 |   | $ | 63,235 |   |
| Service sales                                |       | 43,583                                     |       | 35,531 |   | 30,048 |   |
| Total net sales                              |       | 145,983                                    |       | 117,113 |   | 93,283 |   |
| Cost of sales:                               |       |                                       |       |   |   |   |   |
| Cost of product sales                        |       | 77,365                                     |       | 62,147 |   | 48,568 |   |
| Cost of services                             |       | 30,521                                     |       | 24,321 |   | 21,175 |   |
| Total cost of  sales                         |       | 107,886                                    |       | 86,468 |   | 69,743 |   |
| Gross profit                                 |       | 38,097                                     |       | 30,645 |   | 23,540 |   |
| Operating expenses:                          |       |                                       |       |   |   |   |   |
| Sales and marketing                          |       | 15,985                                     |       | 15,062 |   | 12,438 |   |
| General and administrative                   |       | 10,434                                     |       | 9,953 |   | 10,366 |   |
| Engineering                                  |       | 6,098                                      |       | 5,121 |   | 3,764 |   |
| Charge for sublease reserve                  |       | —                                     |       | 3,502 |   | — |   |
| Restructuring charges                        |       | —                                     |       | — |   | (63 | ) |
| Amortization of intangibles                  |       | —                                     |       | 225 |   | 261 |   |
| Earnings (loss)  from operations             |       | 5,580                                      |       | (3,218 | ) | (3,226 | ) |
| Interest income                              |       | 714                                        |       | 303 |   | 83 |   |
| Net earnings  (loss) before income taxes     |       | 6,294                                      |       | (2,915 | ) | (3,143 | ) |
| Income tax  benefit                          |       | (2,203                                     | )          | — |   | — |   |
| Net earnings  (loss)                         |       | $                                          | 8,497      |   | $ | (2,915 | ) | $ | (3,143 | ) |
| Net earnings  (loss) per common share:       |       |                                       |       |   |   |   |   |
| Basic                                        |       | $                                          | 0.77       |   | $ | (0.28 | ) | $ | (0.31 | ) |
| Diluted                                      |       | $                                          | 0.76       |   | $ | (0.28 | ) | $ | (0.31 | ) |
| Weighted average  common shares outstanding: |       |                                       |       |   |   |   |   |
| Basic                                        |       | 11,006                                     |       | 10,318 |   | 10,268 |   |
| Diluted                                      |       | 11,127                                     |       | 10,318 |   | 10,268 |   |

 

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

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

| ** **                                                                      | ** ** | ** **            | ** ** | ** **     | ** ** | ** **               | ** ** | ** **       | ** ** | **Retained**  | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------------|------------|----------------|------------|--------------------------|------------|------------------|------------|---------------|------------|------------|------------|
| ** **                                                                      | ** ** | ** **            | ** ** | ** **     | ** ** | ** **               | ** ** | ** **       | ** ** | **Earnings/** | ** ** | ** ** | ** ** |
| ** **                                                                      | ** ** | **Common Stock** | ** ** | **Additional** | ** ** | **Nonvested**            | ** ** | **(Accumulated** | ** ** | ** **    | ** ** |
| ** **                                                                      | ** ** | **Shares**            | ** ** | **Amount**     | ** ** | **Paid-in Capital** | ** ** | **Stock**        | ** ** | **Deficit)**  | ** ** | **Total**  | ** ** |
| Balances, December 31, 2003                                                |       |                  | 10,242     |           |       |                     | $          | 10               |       |          |       | $          | 26,158     |   |   |   | $ | — |   |   |   | $ | (4,672 | ) |   | $ | 21,496 |   |
| Net loss                                                                        |       |                  | —     |           |       |                     | —     |             |       |          | —     |       |       |   | — |   |   |   | (3,143 | ) |   | (3,143 | ) |
| Compensation expense related to stock options                                   |       |                  | —     |           |       |                     | —     |             |       |          | 17         |       |       |   | — |   |   |   | — |   |   | 17 |   |
| Restricted stock grant                                                          |       |                  |       |           |       |                     |       |             |       |          | 332        |       |       |   | (307 | ) |   |   |   |   |   | 25 |   |
| Common shares issued under employee stock purchase  plan and stock option plans |       |                  | 41         |           |       |                     | —     |             |       |          | 117        |       |       |   | — |   |   |   | — |   |   | 117 |   |
| Balances, December 31, 2004                                                |       |                  | 10,283     |           |       |                     | 10         |             |       |          | 26,624     |       |       |   | (307 | ) |   |   | (7,815 | ) |   | 18,512 |   |
| Net loss                                                                        |       |                  | —     |           |       |                     | —     |             |       |          | —     |       |       |   | — |   |   |   | (2,915 | ) |   | (2,915 | ) |
| Restricted stock grant                                                          |       |                  | 63         |           |       |                     | —     |             |       |          | (217       | )          |       |   | 307 |   |   |   |   |   |   | 90 |   |
| Common shares issued under employee stock purchase  plan and stock option plans |       |                  | 58         |           |       |                     | —     |             |       |          | 148        |       |       |   | — |   |   |   | — |   |   | 148 |   |
| Balances, December 31, 2005                                                |       |                  | 10,404     |           |       |                     | 10         |             |       |          | 26,555     |       |       |   | — |   |   |   | (10,730 | ) |   | 15,835 |   |
| Net earnings                                                                    |       |                  | —     |           |       |                     | —     |             |       |          | —     |       |       |   | — |   |   |   | 8,497 |   |   | 8,497 |   |
| Stock option and restricted stock grants                                        |       |                  | 254        |           |       |                     | —     |             |       |          | 293        |       |       |   | — |   |   |   | — |   |   | 293 |   |
| Common shares issued under exercise of warrants                                 |       |                  | 200        |           |       |                     | —     |             |       |          | 900        |       |       |   | — |   |   |   | — |   |   | 900 |   |
| Tax benefit from stock based compensation                                       |       |                  | —     |           |       |                     | —     |             |       |          | 392        |       |       |   | — |   |   |   | — |   |   | 392 |   |
| Common shares issued under employee stock purchase  plan and stock option plans |       |                  | 371        |           |       |                     | 1          |             |       |          | 1,404      |       |       |   | — |   |   |   | — |   |   | 1,405 |   |
| Balances,  December 31, 2006                                               |       |                  | 11,229     |           |       |                     | $          | 11               |       |          |       | $          | 29,544     |   |   |   | $ | — |   |   |   | $ | (2,233 | ) |   | $ | 27,322 |   |

 

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

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**DATALINKCORPORATIONSTATEMENTS OF CASH FLOWS(In thousands)**

| ** **                                                                                  | ** ** | **Year Ended December 31,** | ** ** |
|---------------------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                                  | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| Cash flows from  operating activities:                                                      | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Net earnings (loss)                                                                         |       | $                                          | 8,497      |   | $ | (2,915 | ) | $ | (3,143 | ) |
| Adjustments to  reconcile net earnings (loss) to net cash provided by operating activities: |       |                                       |       |   |   |   |   |
| Provision (recoveries) for bad debts                                                        |       | 36                                         |       | 36 |   | (14 | ) |
| Depreciation and amortization                                                               |       | 985                                        |       | 1,277 |   | 1,781 |   |
| Amortization of intangibles                                                                 |       | —                                     |       | 225 |   | 260 |   |
| Deferred income taxes                                                                       |       | (2,762                                     | )          | — |   | — |   |
| Deferred rent                                                                               |       | (122                                       | )          | (103 | ) | (130 | ) |
| Charge for sublease reserve                                                                 |       | —                                     |       | 3,502 |   | — |   |
| Amortization of sublease reserve                                                            |       | (384                                       | )          | (1,030 | ) | — |   |
| Stock compensation expense                                                                  |       | 293                                        |       | 90 |   | 42 |   |
| Loss on disposal of assets                                                                  |       | 111                                        |       | — |   | — |   |
| Changes in  operating assets and liabilities:                                               |       |                                       |       |   |   |   |   |
| Accounts receivable                                                                         |       | (3,558                                     | )          | (7,224 | ) | (2,930 | ) |
| Inventories                                                                                 |       | 800                                        |       | (2,925 | ) | 1,159 |   |
| Deferred customer support contract costs/revenues,  net                                     |       | 2,729                                      |       | 1,625 |   | 1,039 |   |
| Accounts payable                                                                            |       | 93                                         |       | 8,629 |   | 892 |   |
| Accrued expenses                                                                            |       | 527                                        |       | 845 |   | 1,351 |   |
| Other                                                                                       |       | 86                                         |       | (343 | ) | 89 |   |
| Net cash provided by operating activities                                                   |       | 7,331                                      |       | 1,689 |   | 396 |   |
| Cash flows from  investing activities:                                                      |       |                                       |       |   |   |   |   |
| Purchase of property and equipment                                                          |       | (562                                       | )          | (1,266 | ) | (415 | ) |
| Proceeds from sale of property and equipment                                                |       | —                                     |       | 200 |   | — |   |
| Net cash used in investing activities                                                       |       | (562                                       | )          | (1,066 | ) | (415 | ) |
| Cash flows from  financing activities:                                                      |       |                                       |       |   |   |   |   |
| Tax benefit from stock based compensation                                                   |       | 392                                        |       | — |   | — |   |
| Proceeds from issuance of common stock                                                      |       | 2,305                                      |       | 148 |   | 117 |   |
| Net cash provided by financing activities                                                   |       | 2,697                                      |       | 148 |   | 117 |   |
| Increase in cash  and cash equivalents                                                      |       | 9,466                                      |       | 771 |   | 98 |   |
| Cash and cash  equivalents, beginning of year                                               |       | 13,434                                     |       | 12,663 |   | 12,565 |   |
| Cash and cash  equivalents, end of year                                                     |       | $                                          | 22,900     |   | $ | 13,434 |   | $ | 12,663 |   |
| **Supplementary  cash flow information:**                                                   | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash received (paid) for income taxes                                                       |       | (154                                       | )          | — |   | 58 |   |
| **Supplementary  non-cash investing and financing activities:**                             |       |                                       |       |   |   |   |   |
| Issuance of  restricted stock                                                               |       | —                                     |       | 217 |   | — |   |

 

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

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**DATALINKCORPORATIONNOTES TO FINANCIAL STATEMENTS**

***1.   Descriptionof Business:***

DatalinkCorporation (the “Company”) is an independent architect of enterprise-classinformation storage infrastructures. We derive our revenues principally fromdesigning, installing and supporting data storage systems. Our solutions caninclude hardware products, such as disk arrays, tape systems andinterconnection components, and storage management software products. We arefrequently engaged to provide assistance in the installation of solutions andto provide support services subsequent to the installation. Occasionally, weare engaged for consulting services.

**2.   Summary ofSignificant Accounting Policies:**

***Cash and 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. We maintain our cash in bank deposit and money marketaccounts which, at times, may exceed federally insured limits. We have notexperienced any losses in such accounts.

***Accounts Receivable, net:***

We carry trade receivables at original invoice amountless an estimate made for doubtful receivables based on a review of alloutstanding amounts on a monthly basis. Management determines the allowance fordoubtful accounts by regularly evaluating individual customer receivables andconsidering a customer’s financial condition and credit history and currenteconomic conditions. We write off trade receivables when deemed uncollectible. Werecord recoveries of trade receivables previously written off when received.

We recorded accountsreceivable net of the reserve for doubtful accounts of $108,000 and $72,000 at December 31,2006 and 2005, respectively.

***Concentration of Credit Risk:***

During 2006, net salesfrom our customer Cingular Wireless LLC, were approximately 13.9% of total netsales. The balance of accounts receivable for this customer as a percentage oftotal accounts receivable as of December 31, 2006 and 2005, respectively,was 0% and 2%. We had no other customers that comprised more than 10% of oursales in 2004, 2005 or 2006.

***Inventories:***

Inventories, includinginventories shipped but not installed, principally consist of data storageproducts and components, valued at the lower of cost or market with costdetermined on a first-in, first-out (FIFO) method. We reduced inventories forobsolete and slow moving reserves of $51,000 and $100,000 at December 31,2006 and 2005, respectively.

***Property and Equipment:***

Propertyand equipment, including purchased software, are stated at cost. Depreciationand amortization are provided by charges to operations using the straight-linemethod over the estimated useful lives of the assets (ranging from 2 to 10years). We amortize leasehold improvements on a 

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straight-line basis over the shorter of theirestimated useful lives or the underlying lease term. We remove the costs andrelated accumulated depreciation and amortization on asset disposals from theaccounts and include any gain or loss in operations. Major renewals andbetterments are capitalized, while maintenance and repairs are charged tocurrent operations when incurred.

| ** **                                      | ** ** | **December 31,**   | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|
| ** **                                      | ** ** | **2006**                | ** ** | **2005** | ** ** |
| ** **                                      | ** ** | **(In thousands)** | ** ** |
| Property and equipment:                         |       |                    |       |   |   |
| Construction in process                         |       | $                       | —     |   | $ | 74 |   |
| Leasehold improvements                          |       | 1,038                   |       | 1,023 |   |
| Furniture and fixtures                          |       | 1,742                   |       | 2,122 |   |
| Equipment                                       |       | 2,050                   |       | 902 |   |
| Computers and software                          |       | 4,837                   |       | 9,195 |   |
|                                            |       | 9,667                   |       | 13,316 |   |
| Less accumulated  depreciation and amortization |       | 7,725                   |       | 10,840 |   |
|                                            |       | $                       | 1,942      |   | $ | 2,476 |   |

 

***Goodwill:***

In accordance withFinancial Accounting Standards Board (FASB) Statement No. 142, we testgoodwill for impairment annually, and additionally if an event occurs orcircumstances change that would indicate the carrying amount may be impaired. Weperform impairment testing for goodwill at a reporting-unit level. We wouldgenerally recognize an impairment loss when the carrying amount of thereporting unit’s net assets exceeds the estimated fair value of the reportingunit. We completed our impairment assessments for December 31, 2006 and2005, and determined that no impairment existed.

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

We periodically (at leastannually) analyze our long-lived assets, including identifiable intangibleassets with discrete lives, for potential impairment, assessing theappropriateness of lives and recoverability of unamortized balances throughmeasurement of undiscounted operating cash flows on a basis consistent withgenerally accepted accounting principles. During 2006, 2005 and 2004 wedetermined that no impairment had occurred.

***Stock Compensation Plans:***

Effective January 1, 2006, we adopted SFAS 123(R) whichrequires all share-based payments, including grants of stock options, to berecognized in the statement of operations as an operating expense based ontheir fair values over the requisite service period. SFAS 123(R) supersedesour previous accounting under Accounting Principles Board Opinion No. 25 “Accountingfor Stock Issued to Employees” for periods beginning in fiscal 2006. We haveapplied the provisions of SAB 107 in our adoption of SFAS 123(R). We elected toutilize the modified-prospective transition method as permitted by SFAS 123(R).Under this transition method, we have not restated our financial statements forprior periods to reflect, and they do not include, the impact of SFAS 123(R). Stock-basedcompensation expense for 2006 includes compensation expense for all stock-basedcompensation awards granted on or after January 1, 2006, based ongrant-date fair value estimated in accordance with the provisions of SFAS 123(R).There was no compensation expense for stock-based compensation awards grantedprior to January 1, 2006 as all such awards were fully vested at the dateof adoption of SFAS 123(R).

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Thefollowing table illustrates the effect on operating results and per shareinformation had we accounted for stock-based compensation in accordance withSFAS 123(R) for 2005 and 2004:

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

 

We usethe Black-Scholes option pricing model to estimate the fair value of stockoptions. The weighted-average fair values per option at the date of grant were$1.34, $3.42 and $2.47 for 2006, 2005 and 2004, respectively. We estimated thefair value for the stock option grants with the following weighted averageassumptions:

| ** **                      | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Risk-free  interest rates       |       | 5.08     | %          | 4.32     | %          | 4.60     | %          |
| Expected dividend  yield        |       | 0        |       | 0        |       | 0        |       |
| Expected  volatility factor     |       | 104      | %          | 71       | %          | 86       | %          |
| Expected option holding  period |       | 5 years  |       | 5 years  |       | 5 years  |       |

 

The risk-free rate isbased on a treasury instrument whose term is consistent with the expected lifeof our stock options. The expected volatility, holding period, and dividendyield are based on historical experience. We determined the fair value ofnonvested stock grants based on the fair value of the stock on the date ofgrant.

***Income Taxes:***

We calculate income taxesin accordance with the provisions of SFAS No. 109, “Accounting for IncomeTaxes,” which requires the use of the asset and liability method of accountingfor income taxes. Under the liability method, we record deferred income taxesto reflect the tax consequences in future years of temporary differencesbetween the tax bases of assets and liabilities and their financial reportingamounts using enacted tax rates for the years in which we expect these items toaffect taxable income. We establish valuation allowances when necessary toreduce deferred tax assets to the amount we expect are more likely than not tobe realized. Income tax (benefit) expense is the tax payable (receivable) forthe period and the change during the period in deferred tax assets andliabilities.

***Use of Estimates:***

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period. Significant items subject to estimates and assumptionsinclude the valuation allowance for deferred tax 

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assets,reserve for doubtful accounts, reserve for obsolete and slow moving (excess)inventory and valuation of long-lived assets. Actual results could differ fromthose estimates.

***Revenue Recognition:***

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

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

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

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

Pursuant to the provisions of SOP 97-2, we applycontract accounting to bundled arrangements. In accordance with SOP 81-1,“Accounting for Performance of Construction Type and Certain Production TypeContracts,” we apply the completed contract method. Factors we have consideredin applying the completed contract method of accounting include (i) therelatively short duration of our contracts, (ii) the difficulty ofestimating our revenues on a percentage-of-completion method and (iii) ouruse of acceptance provisions on larger bundled arrangements.

Shipping revenues are recognized as a component ofproduct sales and shipping expenses are recognized as a component of cost ofproducts sold

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

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

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

*Consulting Services.**  *Some of our customers engage us to analyze theirexisting storage architectures and offer our recommendations. Other customersengage us to assist them on-site with extended data storage projects, tosupport their data storage environments and to help with long-term data storagedesign 

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challenges. Forthese types of consulting services that do not include the sale of hardware orsoftware products, we recognize revenues as we perform these services.

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

We compute basic netearnings (loss) per share using the weighted average number of sharesoutstanding. Diluted net earnings per share includes the effect of common stockequivalents, if any, for each period. We calculate the number of additionalshares by assuming exercise of outstanding stock options and use of theproceeds from such exercise to acquire shares of common stock at the averagemarket price during the reporting period. Due to the net loss in 2005 and 2004,we excluded potential common shares of 172,028 and 80,756, respectively, thatwould have been anti-dilutive to losses from the calculation of diluted lossper share. In 2006, we included the potentially dilutive common shares of 346,498in the dilutive earnings per share computation.

***Comprehensive Earnings (Loss):***

Our comprehensive earnings(loss) is equal to our net earnings (loss) for all periods presented.

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

At December 31, 2006and 2005, the carrying values of current financial instruments such as cash andcash equivalents, accounts receivable, accounts payable, other current assets,accrued liabilities and other current liabilities, approximated their marketvalues, based on the short-term maturities of these instruments.

**3.   Intangibles,net:**

Amortization expenserelated to indentifiable intangible assets for 2005 and 2004 was $225,000 and$261,000, respectively. We fully amortized all intangible assets as of December 31,2005.

**4.   BorrowingArrangements:**

Our bank revolving creditfacility expired on June 30, 2004. We have elected not to pursue a newfacility at this time. With our current cash position, we believe we have theliquidity to meet our operating needs for the foreseeable future. We have nooutstanding debt, and if the need should arise to borrow funds, we believe thatwe could obtain a secured facility.

**5.   IncomeTaxes:**

Thereconciliation of the U.S. federal statutory tax rate to our effective incometax rate is as follows:

| ** **                                              | ** ** | **2006** | ** ** | **2005** | ** ** | **2004** | ** ** |
|---------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Tax expense  (benefit) at U.S. statutory rates          |       | 34.0     | %          | (34.0    | )%         | (34.0    | )%         |
| State tax expense  (benefit), net of federal tax effect |       | 4.6      |       | (4.6     | )          | (6.3     | )          |
| Nondeductible  expenses                                 |       | 3.1      |       | 2.9      |       | 2.8      |       |
| Benefit of net  operating loss carryforward             |       | (36.2    | )          | (7.1     | )          | —   |       |
| Change in  valuation allowance                          |       | (40.5    | )          | 42.8     |       | 37.5     |       |
| Effective tax rate                                      |       | (35.0    | )%         | 0.0      | %          | 0.0      | %          |

 

40

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Significantcomponents of our deferred tax assets and liabilities are as follows:

| ** **                                 | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                 | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **                                 | ** ** | **(In thousands)**                    | ** ** |
| Current deferred tax  asset:               |       |                                       |       |   |   |   |   |
| Allowance for doubtful accounts            |       | $                                          | 64         |   | $ | 50 |   | $ | 58 |   |
| Compensation accrual                       |       | 146                                        |       | 88 |   | 56 |   |
| Inventories                                |       | 26                                         |       | 48 |   | 31 |   |
| Deferred revenue                           |       | 420                                        |       | 515 |   | 238 |   |
| Net operating loss carryovers              |       | 643                                        |       | — |   | — |   |
| Minimum tax credit carryover               |       | 125                                        |       | — |   | — |   |
| Other                                      |       | 18                                         |       | 16 |   | — |   |
| Total current deferred tax asset           |       | 1,442                                      |       | 717 |   | 383 |   |
| Long-term deferred tax  asset (liability): |       |                                       |       |   |   |   |   |
| Net operating loss carryovers              |       | 266                                        |       | 2,798 |   | 3,006 |   |
| Intangibles                                |       | 462                                        |       | 696 |   | 844 |   |
| Property and equipment                     |       | (42                                        | )          | (166 | ) | 424 |   |
| Sublease reserve                           |       | 634                                        |       | 782 |   | — |   |
| Other                                      |       | —                                     |       | — |   | 21 |   |
| Total long-term deferred tax asset         |       | 1,320                                      |       | 4,110 |   | 4,295 |   |
| Total deferred  tax asset                  |       | 2,762                                      |       | 4,827 |   | 4,678 |   |
| Valuation  allowance                       |       | —                                     |       | (4,827 | ) | (4,678 | ) |
| Net deferred tax asset                     |       | $                                          | 2,762      |   | $ | — |   | $ | — |   |

 

Thetax benefit for the year ended December 31, 2006 consists of thefollowing:

| ** **                  | ** ** | **2006**                | ** ** |
|-----------------------------|------------|-------------------------|------------|
| ** **                  | ** ** | **(in thousands)** | ** ** |
| Current income  tax expense |       |                    | 167        |   |   |
| Deferred tax  benefit       |       |                    | (2,370     | ) |   |
| Income tax benefit          |       |                    | (2,203     | ) |   |

 

The valuation allowance for deferred tax assets as of December 31,2006, 2005 and 2004 was $0, $4.8 million and $4.7 million,respectively. The net change in the total valuation allowance as of December 31,2006 was a decrease of $4.8 million and the net change in valuation allowancefor 2005 and 2004 was an increase of $149,000, $1.9 million, respectively.

In assessing the recoverability of deferred taxassets, management considers whether it is more likely than not that we willrealize some portion or all of the deferred tax assets. The ultimaterealization of deferred tax assets is dependent upon the generation of futuretaxable income during the periods in which those temporary differences becomedeductible. Prior to fiscal 2006, we recorded a full valuation allowanceagainst our deferred tax assets due to the uncertainty of the realization andtiming of the benefits from those deferred tax assets, as we had not achieved asufficient level of sustained profitability. In 2006, management concluded thatwe had attained a sufficient level of sustained profitability to allow thereversal of our remaining $2.8 million valuation allowance. We utilizedapproximately $4.8 million and $200,000 of our federal net operating losscarryforwards for 2006 and 2005, respectively. For 2006, we recordedapproximately $392,000 to equity for tax benefits associated with the exercisesof stock options.

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At December 31, 2006,we had federal net operating loss carry forwards of approximately $1.9 millionand state net operating loss carry forwards of approximately $6.4 million,which are available to offset future federal and state taxable income. If notused, these net operating loss carry forwards will expire between 2013 and2024. Federal net operating losses expire as follows:

| **Year  Generated** | ** ** | ** ** | ** ** | **Amount  Generated** | ** ** | **Amount Used** | ** ** | **Remaining  Amount** | ** ** | **Expiration   Year** | ** ** |
|---------------------|------------|------------|------------|-----------------------|------------|----------------------|------------|-----------------------|------------|----------------------------|------------|
| 2003                |       |       | $          | 4,110                 |       |                 |       | $                     | (4,110     | )                          |       |   | $ | — |   |   |   | 2023 |   |   |
| 2004                |       |       | 2,832      |                  |       |                 | (941       | )                     |       |                       | 1,891      |   |   |   | 2024 |   |   |
| Total               |       |       | $          | 6,942                 |       |                 |       | $                     | (5,051     | )                          |       |   | $ | 1,891 |   |   |   |   |   |   |

 

**6.   Lease Commitments:**

Our corporate headquartersincluding the principal technical operations and the integration, assembly andsupport services operations are located in an office and warehouse facility inChanhassen, Minnesota. As of December 31, 2006, our remaining 13locations, including sales and technical staff, are small to medium sizedoffices. Regional hubs are located within each of our regions in the East,Central and West.

As of December 31,2006, future minimum lease payments due under non-cancelable operating leasesare as follows:

| ** ** | ** ** | **Lease  Obligations**  | ** ** | **Sublease  Agreements** | ** ** | **Net Lease  Obligations** | ** ** |
|------------|------------|-------------------------|------------|--------------------------|------------|---------------------------------|------------|
| ** ** | ** ** | **(In thousands)** | ** ** |
| 2007       |       |                    | $          | 1,854                    |       |                            |       | $ | (789 | ) |   |   | $ | 1,065 |   |   |
| 2008       |       |                    | 1,569      |                     |       |                            | (719       | ) |   |   | 850 |   |   |
| 2009       |       |                    | 1,549      |                     |       |                            | (719       | ) |   |   | 830 |   |   |
| 2010       |       |                    | 1,398      |                     |       |                            | (719       | ) |   |   | 679 |   |   |
| 2011       |       |                    | 1,264      |                     |       |                            | (719       | ) |   |   | 545 |   |   |
| Thereafter |       |                    | 422        |                     |       |                            | (239       | ) |   |   | 183 |   |   |
|       |       |                    | $          | 8,056                    |       |                            |       | $ | (3,904 | ) |   |   | $ | 4,152 |   |   |

 

In December 2004, weagreed to sublease approximately 55,000 of the 104,000 square feet we thenoccupied as our corporate headquarters in Chanhassen, Minnesota. The initialsublease term is co-terminal with the original lease ending in April 2012.The sublessee pays us rent ranging from approximately $55,000 per month at thebeginning of the term to approximately $60,000 per month by the end of the term.The rent includes the costs of common area management, common systems repairs,real estate taxes and standard utilities. We also negotiated with our landlordto sell the 2.5 acre lot adjoining our facility for $200,000 which we hadoriginally acquired in 2001 for $384,000. In January 2005, we discontinueduse of the sublease area and we incurred a one-time, non-cash charge of $3.5million related to the sublease and lot sale.

Totalrent expense, net of sublease income of $663,000 and $649,000 in 2006 and 2005,respectively, is as follows:

|              | ** ** | **Year Ended December 31,** | ** ** |
|--------------|------------|--------------------------------------------|------------|
| ** **   | ** ** | **2006**                                   | ** ** | **2005** | ** ** | **2004** | ** ** |
| ** **   | ** ** | **(In thousands)**                    | ** ** |
| Rent expense |       | $                                          | 1,422      |   | $ | 1,288 |   | $ | 1,929 |   |
|              |            |                                            |            |  |  |  |  |  |  |  |

 

**7.   Restructuring Charges:**

In October 2003, weannounced several cost reduction initiatives and management changes. Thesechanges resulted in a fourth quarter 2003 charge of $2.1 million. As part ofthese cost reduction initiatives, 

42

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wereduced our staff by 16% and announced the closure of four offices. We had$202,000 of remaining accruals as of December 31, 2003, primarily for aseverance agreement to a former officer, to be paid in 2004. In July 2004,we ceased paying the remaining severance accrual to this officer in exchangefor consenting to the officer’s new employment with another firm and recognizeda reduction in the accrual of $63,000. We had no restructuring expense activityin 2006 and 2005.

**8.   Employee Benefit Plan:**

We have a definedcontribution retirement plan for eligible employees. Employees may contributeup to 15% of their pretax compensation to the 401(k) portion of the plan.We matched 50% of an employee’s contribution up to the first 6% of an employee’seligible compensation in 2003, ceasing the match in January 2004. Wereinstated the match in April 2006. The cost of our contributions to the401(k) portion of the plan for 2006, 2005 and 2004, was $276,000, $0 and$22,000, respectively.

**9.   Stockholders’ Equity:**

***Stock CompensationPlans:***

Effective May 8,2001, we reserved an aggregate of 3,000,000 shares of common stock for issuancepursuant to our Incentive Compensation Plan (the “Incentive Plan”), 1,237,136of which were available for grant as of December 31, 2006. The terms ofthe plan allow for a variety of awards including incentive stock options,nonqualified stock options, stock appreciation rights, non-vested stock,performance shares, performance units, cash-based awards, phantom shares andother share-based awards as determined the Compensation Committee (the “Committee”).

In August 2000, theBoard of Directors adopted the 2000 Director Stock Option Plan (the “DirectorPlan”). We amended the Director Plan in May 2002, October 2002, April 2004and May 2006. The terms of the Director Plan allow for stock option grantsto non-employee members of the Board of Directors. We have reserved 300,000shares of common stock for issuance pursuant to the Director Plan, 5,537 ofwhich were available for grant as of December 31, 2006.

We also reserved 250,000shares of common stock for issuance pursuant to our Employee Stock PurchasePlan. Under terms of the Employee Stock Purchase Plan, eligible employees coulddesignate up to 15% of their compensation to be withheld through payrolldeductions and be granted an option to purchase a designated number of sharesof common stock at a purchase price determined by the Committee, but at no lessthan 85% of the lower of the market price on the first or last day of thepurchase period.  We terminated theEmployee Stock Purchase Plan as of December 31, 2005.

***Non-vested StockPlans:***

In March and April 2006,we awarded 60,000 and 163,000 shares of non-vested stock, respectively, toexecutive and senior management. The non-vested stock vests over 4 years, with50 percent after year two, 25 percent after year three and 25 percent afteryear four if the individual is still employed by us. During the vesting period,the individual has voting rights and the right to receive dividends. However,we will retain the dividends until the shares have vested. The shares may notbe sold, assigned, transferred, pledged or otherwise encumbered until they havevested. We are amortizing the $970,000 fair value of the non-vested shares onthe date of grant ratably over the four year vesting period.  Unrecognized compensation expense related tothe non-vested stock grant was $786,000 at December 31, 2006 which isexpected to be recognized over 3.25 years. For 2006, compensation expenserelated to these non-vested stock grants was $185,000.

In August 2004, weawarded 165,000 shares of non-vested stock to certain executives. Shares vestedupon the earlier of our reaching, and publicly announcing, certain financial orbusiness milestones or five years, assuming employment through the date of themilestone. All of the 2004 non-vested stock grants 

43

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havevested due to our achievement of the financial and business milestones during2005 and we have no remaining unamortized deferred compensation expenses. Werecognized non-cash expense of $25,000 and $257,000, in 2004 and 2005respectively, based on value of the non-vested shares vested when milestoneswere reached.

In June, September and December 2006, we issued3,750, 4,449 and 5,364 shares of common stock to members of the Board ofDirectors which were fully vested upon grant. For 2006, total compensationexpense for these awards was approximately $101,000.

Thefollowing table summarizes our non-vested stock activity as of December 31,2006:

| ** **                                  | ** ** | **Number of Shares** | ** ** | **Weighted Average  Grant-Date Fair Value** | ** ** |
|---------------------------------------------|------------|--------------------------------|------------|------------------------------------------------------------|------------|
| Non-vested stock  at January 1, 2004   |       |                           | —     |                                                       |       |   | $ | — |   |   |
| Granted                                     |       |                           | 165,000    |                                                       |       |   | $ | 2.01 |   |   |
| Shares vested                               |       |                           | —     |                                                       |       |   | $ | — |   |   |
| Non-vested stock  at January 1, 2005   |       |                           | 165,000    |                                                       |       |   | $ | 2.01 |   |   |
| Granted                                     |       |                           | —     |                                                       |       |   | $ | — |   |   |
| Shares vested                               |       |                           | (165,000   | )                                                          |       |   | $ | 2.01 |   |   |
| Non-vested stock  at January 1, 2006   |       |                           | —     |                                                       |       |   | $ | — |   |   |
| Granted                                     |       |                           | 223,000    |                                                       |       |   | $ | 4.35 |   |   |
| Shares vested                               |       |                           | —     |                                                       |       |   | $ | — |   |   |
| Non-vested stock at  December 31, 2006 |       |                           | 223,000    |                                                       |       |   | $ | 4.35 |   |   |

 

***Stock Options:***

Thefollowing table summarizes activity under our stock option plans:

|                                                   | ** ** | **Outstanding Options**   | ** ** |
|---------------------------------------------------|------------|--------------------------------|------------|
| ** **                                        | ** ** | **Number of Shares** | ** ** | **Range of   Exercise Prices** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
| Balance, December 31,  2003                  |       |                           | 1,633,285  |   |   | $1.44 - $25.38 |   |   | $ | 6.19 |   |   |
| Options granted                                   |       |                           | 386,208    |   |   | $2.05 - $4.89 |   |   | $ | 3.82 |   |   |
| Options exercised                                 |       |                           | (7,762     | ) |   | $3.46 - $3.46 |   |   | $ | 3.46 |   |   |
| Options cancelled                                 |       |                           | (193,032   | ) |   | $3.06 - $18.13 |   |   | $ | 7.34 |   |   |
| Balance,  December 31, 2004                  |       |                           | 1,818,696  |   |   | $1.44 - $18.13 |   |   | $ | 5.11 |   |   |
| Options granted                                   |       |                           | 26,600     |   |   | $3.01 - $4.07 |   |   | $ | 3.42 |   |   |
| Options exercised                                 |       |                           | (6,434     | ) |   | $3.32 - $3.46 |   |   | $ | 3.38 |   |   |
| Options cancelled                                 |       |                           | (63,725    | ) |   | $3.06 - $18.13 |   |   | $ | 5.93 |   |   |
| Balance,  December 31, 2005                  |       |                           | 1,775,137  |   |   | $1.44 - $18.13 |   |   | $ | 5.07 |   |   |
| Options granted                                   |       |                           | 6,500      |   |   | $4.11 - 5.21 |   |   | $ | 4.63 |   |   |
| Options exercised                                 |       |                           | (371,316   | ) |   | $1.44 - 8.91 |   |   | $ | 3.69 |   |   |
| Options cancelled                                 |       |                           | (159,893   | ) |   | $2.01 - 18.13 |   |   | $ | 7.16 |   |   |
| Balance,  December 31, 2006                  |       |                           | 1,250,428  |   |   | $1.44 - $18.13 |   |   | $ | 5.00 |   |   |
| Options  exercisable as of December 31, 2006 |       |                           | 1,250,428  |   |   | $1.44 - $18.13 |   |   | 5.00 |   |   |
| Options exercisable as  of December 31, 2005 |       |                           | 1,775,137  |   |   | $1.44 - $18.13 |   |   | $ | 5.07 |   |   |
| Options exercisable as  of December 31, 2004 |       |                           | 1,035,250  |   |   | $1.44 - $18.13 |   |   | $ | 6.64 |   |   |

 

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Thefollowing is a summary of options outstanding and exercisable at December 31,2006:

| ** ** | Stock  Options | ** ** | ** ** | **Range of   Exercise Price Per   Share** | ** **                            | **Weighted Average  Exercise   Price Per Share** | ** ** | **Weighted Average   Remaining Contractual   Life (Years)** | ** ** |
|------------|----------------|------------|------------|--------------------------------------------------------------------|---------------------------------------|----------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------|------------|
|       | 778,104        |       |       |                                                               | $  1.44 - $  6.00 |                                                                 |       |                                                                                 | $          | 3.87 |   |   |   | 6.3 |   |   |
|       | 403,657        |       |       |                                                               | $  6.01 - $  9.81 |                                                                 |       |                                                                                 | $          | 7.95 |   |   |   | 3.4 |   |   |
|       | 36,750         |       |       |                                                               | $  9.82 - $15.25            |                                                                 |       |                                                                                 | $          | 13.47 |   |   |   | 3.6 |   |   |
|       | 31,917         |       |       |                                                               | $15.26 - $18.13                       |                                                                 |       |                                                                                 | $          | 18.03 |   |   |   | 3.1 |   |   |
|       | 1,250,428      |       |       |                                                               | $  1.44  - $18.13           |                                                                 |       |                                                                                 | $          | 5.00 |   |   |   | 5.6 |   |   |

 

At December 31, 2006, the aggregate intrinsicvalue of options outstanding and exercisable was $3,600,008. Total intrinsicvalue of options exercised was $1,371,235, $21,761 and $39,832 for 2006, 2005and 2004, respectively. The weighted average grant date fair value of optionsgranted during 2006 was $1.33.

In December 2005, our Board of Directors tookaction to accelerate vesting of all outstanding employee stock options. At thattime, we had 1,768,037 employee options outstanding, of which 1,442,912 werevested and 325,125 were unvested. The Board accelerated the vesting schedule ofthe 325,125 unvested employee options, of which 192,125 (the “underwateroptions”) had exercise prices in excess of $3.40 per share (the market price onthe accelerated vesting date) and 128,000 (the “in the money options”) hadexercise prices less than that price. We did not accelerate the vesting ofoptions granted to Board members. The Board took the action to accelerate thevesting of the options in order to eliminate approximately $244,000 incompensation expense that we would otherwise have incurred over two yearsbeginning in 2006, upon the adoption of SFAS 123(R).

As of December 31,2006, we had no unrecognized compensation costs related to non-vested stockoption awards. We recorded $9,000 of related stock option compensation expensefor the year-ended December 31, 2006.

***Employee Stock Purchase Plan:***

During 2005, our employeespurchased 49,032 shares under the Employee Stock Purchase Plan (ESPP). Usingthe Black-Scholes pricing model, the weighted average fair value was $1.08 pershare for each election. During the 2004 employees elected to purchase 35,246shares under the plan. Using the Black-Scholes pricing model, the weightedaverage fair value was $0.42 per share for each election in 2004. The Company’sEmployee Stock Purchase Plan was terminated as of December 31, 2005.

***Stock Warrants***

Thefollowing table represents stock warrants activity as of December 31,2006:

|                                                    | ** ** | **Number of Shares** | ** ** | **Weighted  Average  Exercise Price** | ** ** |
|----------------------------------------------------|------------|--------------------------------|------------|--------------------------------------------|------------|
| Outstanding  warrants as of December 31, 2005 |       |                           | 200,000    |                                       |       |   | $ | 4.50 |   |   |
| Warrants granted                                   |       |                           | —     |                                       |       |   | $ | — |   |   |
| Warrants exercised                                 |       |                           | (200,000   | )                                          |       |   | $ | 4.50 |   |   |
| Warrants cancelled                                 |       |                           | —     |                                       |       |   | $ | — |   |   |
| Outstanding warrants as  of December 31, 2006 |       |                           | —     |                                       |       |   | $ | — |   |   |

 

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

|                                            | ** ** | **March 31**       | ** ** | **June 30** | ** ** | **Sept 30** | ** ** | **Dec 31** | ** ** |
|--------------------------------------------|------------|-------------------------|------------|------------------|------------|------------------|------------|-----------------|------------|
| ** **                                 | ** ** | **(In thousands)** | ** ** |
| ***2006***                                 |       |                    |       |             |       |             |       |            |       |   |   |
| Net sales                                  |       |                    | $          | 34,284           |       |             | $          | 39,833          |       | $ | 33,173 |   | $ | 38,693 |   |
| Gross profit                               |       |                    | 9,141      |             |       | 9,851            |       | 8,927           |       | 10,178 |   |
| Operating earnings                         |       |                    | 706        |             |       | 1,910            |       | 1,049           |       | 1,915 |   |
| Net earnings                               |       |                    | 833        |             |       | 2,033            |       | 1,256           |       | 4,375 |   |
| Net earnings per  share—basic         |       |                    | 0.08       |             |       | 0.19             |       | 0.12            |       | 0.40 |   |
| Net earnings per  share—diluted       |       |                    | 0.08       |             |       | 0.18             |       | 0.11            |       | 0.38 |   |
| ***2005***                                 |       |                    |       |             |       |             |       |            |       |   |   |
| Net sales                                  |       |                    | $          | 21,241           |       |             | $          | 28,741          |       | $ | 31,233 |   | $ | 35,898 |   |
| Gross profit                               |       |                    | 5,759      |             |       | 7,614            |       | 8,057           |       | 9,215 |   |
| Operating earnings  (loss)                 |       |                    | (4,775     | )                |       | 388              |       | 219             |       | 950 |   |
| Net earnings (loss)                        |       |                    | (4,701     | )                |       | 446              |       | 295             |       | 1,045 |   |
| Net earnings (loss) per  share—basic  |       |                    | (0.46      | )                |       | 0.04             |       | 0.03            |       | .10 |   |
| Net earnings (loss) per share—diluted |       |                    | (0.46      | )                |       | 0.04             |       | 0.03            |       | .10 |   |

 

**11.   Recently Issued Accounting Standards**

In July 2006, theFASB issued FASB Interpretation No. 48, Accounting for Uncertainty inIncome Taxes—an Interpretation of FASB Statement 109 (FIN 48), which clarifiesthe accounting for uncertainty in tax positions. This Interpretation providesthat we can recognize the tax effects from an uncertain tax position in ourfinancial statements only if the position is more likely than not of beingsustained on audit, based on the technical merits of the position. Theprovisions of FIN 48 are effective as of the beginning of fiscal 2007, with thecumulative effect of the change in accounting principle recorded as anadjustment to opening retained earnings. We have completed a preliminaryevaluation of the impact of adopting FIN 48 on our financial statements and donot believe it will have a material impact on our financial statements.

In September 2006,the FASB issued SFAS No. 157, Fair Value Measurements (SFAS 157), whichprovides guidance on how to measure assets and liabilities that use fair value.SFAS 157 will apply whenever another U.S. GAAP standard requires (or permits)measurement of assets or liabilities at fair value, but does not expand the useof fair value to any new circumstances. This standard also will requireadditional disclosures in both annual and quarterly reports.  SFAS 157 will be effective for financialstatements issued for fiscal years beginning after November 15, 2007. Weintend to adopt the standard beginning in the first quarter of 2008. We arecurrently evaluating the impact of adopting SFAS 157 on our financialstatements and do not believe it will have a material impact on our financialstatements..

In September 2006,the SEC staff issued Staff Accounting Bulletin (SAB) No. 108, Consideringthe Effects of Prior Year Misstatements when Quantifying Misstatements inCurrent Year Financial Statements (SAB 108). SAB 108 was issued in order toeliminate the diversity of practice in how public companies quantifymisstatements of financial statements, including misstatements that were notmaterial to prior years’ financial statements. We applied the provisions of SAB108 in connection with the preparation of our annual financial statements for2006. The adoption of SAB 108 did not have a material impact on our financialstatements.

In September 2006,the FASB issued SFAS No. 158, Employers’ Accounting for Defined BenefitPension and Other Postretirement Plans, an amendment of FASB Statements No. 87,88, 106, and 132(R) (SFAS 158). Part of this Statement iseffective as of December 31, 2006, and requires companies that havedefined benefit pension plans and other postretirement benefit plans torecognize the funded status of those plans on the balance sheet on aprospective basis from the effective date. Because we do not have any definedbenefit pension plans or other postretirement benefit plans, the adoption ofSFAS 158 did not have a material impact on our financial statements.

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In February 2007, theFASB issued SFAS No. 159, “The Fair Value Option for Financial Assets andFinancial Liabilities—Including an amendment of FASB Statement No. 115.”SFAS No. 159 permits companies to measure many financial instruments andcertain other items at fair value at specified election dates. Unrealized gainsand losses on these items will be reported in earnings at each subsequentreporting date. The fair value option may be applied instrument by instrument(with a few exceptions), is irrevocable and is applied only to entireinstruments and not to portions of instruments. SFAS No. 159 is effectivefor fiscal years beginning after November 15, 2007. We are currentlyassessing the impact of SFAS No. 159 on our financial statements and donot believe it will have a material impact on our financial statements.

**12.   SubsequentEvents (Unaudited)**

On January 31, 2007,we entered into an agreement and plan of merger with Midrange Computer SystemsInc. (MCSI), a storage consulting, solutions and service provider based inChicago, Illinois. We paid a purchase price of $14 million for MCSI, consistingof $5.0 million cash ($4.5 million of which we paid at closing to theshareholders and $500,000 of which we deposited in escrow) and 1,163,384 sharesof our common stock (1,047,459 shares of which we issued at closing to theshareholders and 116,384 shares of which we deposited in escrow). Based upon apost-closing audit, we will reduce the purchase price by the shortfall, if any,against the agreed upon minimum net assets at the time of closing. We arecurrently in the process of determining the fair value of the assets acquiredand liabilities assumed and therefore have not yet determined the allocation ofthe purchase price.

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

None.

**Item 9A.**                Controlsand Procedures

(a)   Evaluationof disclosure controls and procedures

We maintain disclosure controls and procedures thatare designed to ensure that information required to be disclosed in our SECreports is recorded, processed, summarized and reported within the time periodsspecified in the Securities and Exchange Commission’s rules and forms. Ourdisclosure controls and procedures are also designed to accumulate andcommunicate information to our management, including our Chief ExecutiveOfficer and our Chief Financial Officer, as appropriate, to allow for timely decisionsregarding required disclosure. In designing and evaluating our disclosurecontrols and procedures, we recognize that any controls and procedures, nomatter how well designed and operated, can provide only reasonable assurance ofachieving the desired control objectives. Accordingly, management must applyits judgment in evaluating the cost-benefit relationship of possible controlsand procedures.

Within the 90 daysprior to the filing of this report, we carried out an evaluation under thesupervision and with the participation of our management, including our ChiefExecutive Officer and our Chief Financial Officer, of the effectiveness of thedesign and operation of our disclosure controls and procedures pursuant toRule 13a-15(b) under the Securities Exchange Act of 1934. Basedon their review of our disclosure controls and procedures, the Chief ExecutiveOfficer and the Chief Financial Officer have concluded that our disclosurecontrols and procedures are effective at the reasonable assurance level in timelyalerting them to material information relating to us that is required to beincluded in our periodic SEC filings.

(b)   Changes ininternal control

There has been no changein our internal controls over financial reporting during our most recent fiscalquarter that has materially affected, or is reasonably likely to materiallyaffect, our internal controls over financial reporting.

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**PART III**

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

Thefollowing is information concerning our current directors and executiveofficers:

| **Name**                      | ** ** | ** ** | ** ** | **Age**                                                | ** ** | **Position** |
|-------------------------------|------------|------------|------------|--------------------------------------------------------|------------|--------------|
| Charles B. Westling           |       | 48         |       | President, Chief Executive Officer and Director        |
| Gregory T. Barnum             |       | 52         |       | Vice President of Finance and Chief Financial  Officer |
| Robert R. Beyer               |       | 46         |       | Vice President of Field Operations                     |
| Mary E. West                  |       | 58         |       | Vice President—Human Resources                    |
| Greg R. Meland                |       | 53         |       | Chairman of the Board and Director                     |
| Brent G. Blackey(1)(3)        |       | 48         |       | Director                                               |
| Paul F. Lidsky(1)(2)          |       | 53         |       | Director                                               |
| Margaret A. Loftus(3)         |       | 62         |       | Director                                               |
| J. Patrick O’Halloran(2) |       | 50         |       | Director                                               |
| James E. Ousley(1)(2)         |       | 61         |       | Director                                               |
| Robert M.  Price(3)           |       | 76         |       | Director                                               |

 

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(1)          Member of AuditCommittee.

(2)          Member of theCompensation Committee

(3)          Member of the GovernanceCommittee

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

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

Robert R. Beyer joined us in February 2007 asVice President—Field Operations. Between 2005 and 2006, Mr. Beyer servedas Senior Vice President of Customer Support Services and General Manager atMcData Corporation. Between 1998 and 2005, Mr. Beyer served as Group VicePresident of Global Services for Computer Network Technology. Between 1992 and1998, Mr. Beyer was with NCR Corporation, serving most recently as AreaVice President of High Availability Services. Mr. Beyer received hisMaster in Business Administration degree from the University of St. Thomas andB.S. in electrical engineering from South Dakota State University.

Mary E. West joined us in 2001 as Vice President—HumanResources. From 1998 to 2001, she worked as an independent human resourcesconsultant. Between 1995 and 1998, Ms. West was employed 

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by Arcadia Financial,Ltd., most recently as the Senior Vice President of Human Resources. From 1993to 1994, she was the corporate administrative director for Nexus, Inc.Ms. West received her M.A. in Human Resources and Industrial Relationsfrom the University of Minnesota, Carlson School of Management.

Greg R. Meland joined us in 1991 as our Vice Presidentof Sales and Engineering. He served as our President and Chief ExecutiveOfficer between 1993 and 2003, and as our Chief Executive officer until 2005. In2005, he became our Chairman of the Board. Between 1979 and 1991, Mr. Melandserved in various sales and marketing positions with the Imprimis disk drivesubsidiary of Control Data Corporation (which was sold to Seagate in 1989),most recently as the North Central U.S. Director of Sales.

Brent G. Blackey was elected as a director in April 2006.Since 2004, Mr. Blackey has served as President and Chief OperatingOfficer for Holiday Companies. Between 2002 and 2004, Mr. Blackey was aSenior Partner at Ernst & Young LLP. Prior to 2002, Mr. Blackeyserved most recently as a Senior Partner at Arthur Andersen LLP. Mr. Blackeyalso serves on the University of Minnesota, Carlson School of Management Boardof Overseers.

Paul F. Lidsky was elected as a director in June 1998.Since 2005, Mr. Lidsky has served as Chief Operating Officer for SpanlinkCommunications, Inc. Between 2003 and 2004, Mr. Lidsky was Presidentand Chief Executive Officer of Computer Telephony Solutions. From 2002 to 2003,Mr. Lidsky was President and Chief Executive Officer of VigiLanzCorporation. From 1997 until 2002, Mr. Lidsky was the President and ChiefExecutive Officer of OneLink Communications, Inc. Between 1985 and 1997, Mr. Lidskywas employed by Norstan, Inc., most recently as Executive Vice Presidentof Strategy and Business Development.

Margaret A. Loftuswas elected as a director in June 1998. Since 2005, Ms. Loftus hasserved as an independent consultant. Between 1989 and 2005, Ms. Loftus wasan owner of Loftus Brown-Wescott, Inc., a business consulting firm.Between 1976 and 1989, she was employed by Cray Research, Inc., mostrecently as Vice President of Software. Ms. Loftus also serves on theBoard of Directors for Analysts International Corporation and several privatetechnology companies.

J. Patrick O’Halloran was elected as a director in August 2006.Since January 2005, Mr. O’Halloran has served as Chief ExecutiveOfficer for Entiera. Between 1983 and 2004, Mr. O’Halloran served in arange of senior management positions at Accenture Ltd., most recently asPartner.

James E. Ousley was elected as a director in June 1998.Between 2002 and 2004, Mr. Ousley was President and Chief ExecutiveOfficer of Vytek Wireless Inc., which was acquired by Calamp, Inc. From1999 to 2001, he served as President and Chairman of Syntegra (USA), a divisionof British Telecommunications plc. From 1991 to 1999, Mr. Ousley wasPresident and Chief Executive Officer of Control Data Systems (CDS), which wasacquired by British Telecommunications in August 1999. From 1968 to 1991,he held various sales and executive management positions with Control DataCorporation. Mr. Ousley also serves on the Board of Directors forActidentity, Inc., Bell Microproducts Inc. and Savvis, Inc.

Robert M. Price was elected as a director in June 1998and served as Chairman of the Board between 1998 and 2005. Mr. Price hasbeen President of PSV, Inc., since 1990. Between 1961 and 1990, he servedin various executive positions, including as Chairman and Chief ExecutiveOfficer, with Control Data Corporation. From 1991 to 2005, Mr. Price was aSenior Advisor and Professor at the Fuqua School of Business at DukeUniversity, and is now Adjunct Professor of the Pratt School of Engineering atDuke University. Mr. Price is Mr. Meland’s father-in-law. Mr. Pricealso serves on the Board of Directors of Public Service Company of New Mexico,Affinity Technology Group, Inc. and National Center for SocialEntrepreneurs.

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

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We will furnish to the Securities and ExchangeCommission a definitive Proxy Statement (the “2006 Proxy Statement”) not laterthan 120 days after the close of the fiscal year ended December 31, 2006.The remaining information required by Items 401 and 405 of Regulation S-K isincorporated herein by reference to the Proxy Statement.

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

**Item 11.**                 ExecutiveCompensation.

The information set forthunder the caption “Summary Compensation Table” in our 2006 Proxy Statement isincorporated herein by reference.

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

The information set forth under the caption “EquityCompensation Plan Information at Fiscal Year Ended December 31, 2006” inour 2006 Proxy Statement is incorporated herein by reference.

| ** **                                                       | ** ** | **Equity Compensation Plan Information** | ** ** |
|------------------------------------------------------------------|------------|---------------------------------------------------------|------------|
| **Plan Category**                                           | ** ** | ** **                                              | ** ** | **Number of securities  to be issued upon  exercise of  outstanding options,  warrants and rights** | ** ** | **Weighted-average  exercise of outstanding  options, warrants and  rights** | ** ** | **Number of securities  remaining available  for future issuance  under equity  compensation plans  (excluding securities  reflected in the first  column)** | ** ** |
| Equity  compensation plans approved by security holders(1)       |       |                                                    | 1,250,428  |   |   |   | $ | 5.00 |   |   |   | 1,242,673 |   |   |
| Equity compensation  plans not approved by security holders |       |                                                    | —     |   |   |   | — |   |   |   | — |   |   |
| Totals                                                           |       |                                                    | 1,250,428  |   |   |   | $ | 5.00 |   |   |   | 1,242,673 |   |   |
|                                                                  |            |                                                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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

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

The information requiredby this section is incorporated by reference from the information in thesection entitled “Related Party Transactions and Recent Transactions” in our2006 Proxy Statement.

**Item 14.**                 PrincipalAccountant Fees and Services.

The information requiredby this section is incorporated by reference from the information in thesection entitled “Auditing Matters” in our 2006 Proxy Statement.

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

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

**1.      FinancialStatements**

Reference is made to theIndex to Financial Statements of Datalink Corporation, under Item 8 in Part IIof this Form 10-K.

**2.      FinancialStatement Schedules.**

Thefollowing financial statement schedule of Datalink Corporation for the yearsended 2006, 2005 and 2004 is filed as part of this Annual Report and should beread in conjunction with the Financial Statements of Datalink Corporation.

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**DATALINK CORPORATIONSCHEDULE II VALUATION AND QUALIFYING ACCOUNTSFOR THE YEARS ENDED DECEMBER 31, 2006, 2005 AND 2004**

| Description                                    | ** ** | ** ** | ** ** | **Period** | ** ** | **Balance at  Beginning   of Period** | ** ** | **Additions** | ** ** | **Deductions(1)** | ** ** | **Balance  at End  of Period** | ** ** |
|------------------------------------------------|------------|------------|------------|------------|------------|------------------------------------------------------|------------|---------------|------------|-------------------|------------|------------------------------------------|------------|
| Allowance for Doubtful  Accounts               |       |       | 2006       |       |       | $                                                    | 71,665     |          | $          | 57,928            |       |                                     | $          | 21,339 |   |   | $ | 108,254 |   |
|                                                |       |       | 2005       |       |       | 70,128                                               |       | 15,000        |       |              | 13,463     |                                     |       | 71,665 |   |
|                                                |       |       | 2004       |       |       | 97,807                                               |       | (14,000       | )          |              | 13,679     |                                     |       | 70,128 |   |
| Allowance for Inventory Obsolescence           |       |       | 2006       |       |       | $                                                    | 99,840     |          | $          | 47,022            |       |                                     | $          | 96,036 |   |   | $ | 50,826 |   |
|                                           |       |       | 2005       |       |       | 71,303                                               |       | 69,665        |       |              | 41,128     |                                     |       | 99,840 |   |
|                                           |       |       | 2004       |       |       | 211,110                                              |       | 185,437       |       |              | 325,244    |                                     |       | 71,303 |   |
| Allowance for Valuation of  Deferred Tax Asset |       |       | 2006       |       |       | $                                                    | 4,827,367  |          | $          | —            |       |                                     | $          | 4,827,367 |   |   | $ | — |   |
|                                                |       |       | 2005       |       |       | 4,678,611                                            |       | 148,756       |       |              | —     |                                     |       | 4,827,367 |   |
|                                                |       |       | 2004       |       |       | 2,802,954                                            |       | 1,875,657     |       |              | —     |                                     |       | 4,678,611 |   |

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(1)          Deductions reflectwrite-offs of customer accounts receivable, net of recoveries, disposals ofinventories and reversal of allowance for valuation of deferred tax asset.

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**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRMON FINANCIAL STATEMENT SCHEDULE**

To the Board of DirectorsDatalink CorporationChanhassen, Minnesota

Our audits were conductedin accordance with the standards of the Public Company Accounting OversightBoard (United States) and were made for the purpose of forming an opinion onthe basic financial statements of Datalink Corporation taken as a whole. Thesupplemental Schedule II is presented for purposes of complying with theSecurities and Exchange Commission’s rules and is not a part of the basicfinancial statements. This schedule has been subjected to the auditingprocedures applied in our audits of the basic financial statements and in ouropinion, is fairly stated in all material respects in relation to the basicfinancial statements taken as a whole.
| /s/ MCGLADREY & PULLEN, LLP |   |
|--------------------------------------|--------|
| Minneapolis, Minnesota               |
| March 29, 2007                  |

 

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**3.    Exhibits.****  **Thefollowing exhibits are filed as part of this Form 10-K:
| Exhibit   Number | ** ** | ** **                                                                                                                                                                                                                              | ** ** | **Title**      | ** ** | **Method of Filing** |
|------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|----------------|------------|----------------------|
| 2.1              |       | Agreement and Plan of Merger dated January 20,  2007 by and among Midrange Computer Solutions, Inc., Dan Kalin, Michael  Spindler, Wayne Szczepanski and Lodi Vercelli and Datalink Corporation and  Datalink Acquisition LLC |       | 15             |
| 3.1              |       | Amended and Restated Articles of Incorporation of  the Company                                                                                                                                                                          |       | 1              |
| 3.2              |       | Restated Bylaws of the Company                                                                                                                                                                                                          |       | 1              |
| 4.1              |       | Form of Common Stock Certificate                                                                                                                                                                                                   |       | 1              |
| 10.1             |       | Employee Stock Purchase Plan                                                                                                                                                                                                            |       | 1              |
| 10.2             |       | 1999 Incentive Compensation Plan, as amended on  December 18, 2000                                                                                                                                                                 |       | 4              |
| 10.3             |       | Credit Agreement with Norwest Bank Minneapolis, N.A.                                                                                                                                                                                    |       | 1              |
| 10.4             |       | Form of Indemnification Agreement                                                                                                                                                                                                  |       | 1              |
| 10.5             |       | Lease Agreement with Washington Avenue L.L.P.                                                                                                                                                                                           |       | 1              |
| 10.6             |       | Deferred Compensation Agreement with Stanley I.  Clothier                                                                                                                                                                               |       | 1              |
| 10.7             |       | Agreement and Plan of Reorganization with Direct  Connect Systems, Inc. (excluding Schedules and Exhibits which the  Registrant will provide to the Commission upon request)                                                       |       | 1              |
| 10.8             |       | Second Lease Agreement with Washington Avenue L.L.P.                                                                                                                                                                                    |       | 1              |
| 10.9             |       | Lease Extension Agreement with Washington Avenue  L.L.P.                                                                                                                                                                                |       | 1              |
| 10.11            |       | Asset Purchase Agreement dated November 10,  2000 with OpenSystems.com, Inc. (excluding Schedules and Exhibits which  the Registrant will provide to The Commission upon request)                                             |       | 2              |
| 10.12            |       | Building Lease with Hoyt/DTLK LLC                                                                                                                                                                                                       |       | 3              |
| 10.13            |       | Building Lease date April 27, 2001 with  Hoyt/DTLK LLC                                                                                                                                                                             |       | 5              |
| 10.18            |       | 2000 Director Stock Option Plan                                                                                                                                                                                                         |       | 4              |
| 10.19            |       | Credit agreement dated June 30, 2002 with Wells  Fargo Bank Minneapolis, National Association                                                                                                                                      |       | 6              |
| 10.20            |       | 2002 Amendments to the 2000 Director Stock Option  Plan                                                                                                                                                                                 |       | 7              |
| 10.21            |       | Credit agreement dated June 30, 2003 with Wells  Fargo Bank Minneapolis, National Association                                                                                                                                      |       | 8              |
| 10.22            |       | Amended and Restated 2000 Director Stock Option Plan                                                                                                                                                                                    |       | 9              |
| 10.23            |       | Restricted Stock Award Agreement                                                                                                                                                                                                        |       | 10             |
| 10.24            |       | Change of Control Severance Agreement                                                                                                                                                                                                   |       | 10             |
| 10.25            |       | Sublease Agreement dated December 15, 2004 with  Checkpoint Security, Inc.                                                                                                                                                    |       | 12             |
| 10.26            |       | Vacant Land Purchase Agreement                                                                                                                                                                                                          |       | 12             |
| 10.27            |       | Correction to Restricted Stock Award Agreements  dated August 13, 2004                                                                                                                                                             |       | 13             |
| 10.28            |       | Employment Agreement dated March 14, 2006 with  Gregory T. Barnum                                                                                                                                                                  |       | 14             |
| 10.29            |       | Employment Agreement dated February 16, 2007  with Robert R. Beyer                                                                                                                                                                 |       | 16             |
| 14.1             |       | Code of Ethics                                                                                                                                                                                                                          |       | 11             |
| 23.1             |       | Consent of McGladrey & Pullen, LLP                                                                                                                                                                                             |       | Filed herewith |
| 31.1             |       | Certifications by the Chief Executive Officer and  Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley  Act of 2002                                                                                              |       | Filed herewith |

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| 32.1 |   | Certifications by the Chief Executive Officer and  Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley  Act of 2002 |   | Filed herewith |
|------|--------|--------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------|
| 99.1 |   | Audit Committee Charter (Revised November 12,  2004)                                                                                  |   | 10             |
| 99.2 |   | Audit Committee Charter (Revised May 4, 2006)                                                                                         |   | Filed herewith |

 

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       (1) Incorporated by reference to the exhibit of the same number in ourRegistration Statement on Form S-1, Reg. No. 333-55935

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

       (3) Incorporated by reference to the exhibit of the same number in our2000 Form 10-K.

       (4) Incorporated by reference to our 2000 Proxy Statement.

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

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

       (7) Incorporated by reference to the exhibit of the same number in our2002 Form 10-K.

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

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

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

(11) Incorporated by reference to the exhibit of the same number in our2003 Form 10-K.

(12) Incorporated by reference to the exhibit of the same number in our2004 Form 10-K.

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

(14) Incorporated by reference to the exhibit of the same number in our Form 8-Kfiled on March 17, 2006.

(15) Incorporated by reference to the exhibit of the same number in our Form 8-Kfiled on February 5, 2007.

(16) Incorporated by reference to the exhibit of the same number in our Form 8-Kfiled on February 20, 2007.

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**SIGNATURES**

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

|                            | DATALINK  CORPORATION |
|----------------------------|-----------------------|
| Date: March 29,  2007 |                  |   |   |   |
|                       |                  |   | By: | /s/ CHARLES  B. WESTLING |
|                       |                  |   |   | Charles B. Westling,*President and Chief Executive Officer* |
|                       |                  |   | By: | /s/ GREGORY T. BARNUM |
|                       |                  |   |   | Gregory T. Barnum,*Vice President of Finance and Chief Financial Officer* |
|                            |                       |  |  |  |  |

 

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

|                                 | **Signature** | ** **                                             | ** ** | ** **           | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|---------------------------------|---------------|--------------------------------------------------------|------------|----------------------|-----------|------------|------------|------------|----------|------------|
| /s/ CHARLES  B. WESTLING        |          | President, Chief  Executive Officer and Director       |       | March 29, 2007  |
|                            |          | (Principal Executive  Officer)                         |       |                 |
| /s/ GREGORY  T. BARNUM          |          | Vice President of  Finance and Chief Financial Officer |       | March 29, 2007  |
|                            |          | (Principal Financial  Officer)                         |       |                 |
| /s/ DENISE  M. WESTENFIELD      |          | Corporate  Controller (Principal Accounting Officer)   |       | March 29, 2007  |
| /s/ GREG  R. MELAND             |          | Chairman of the  Board and Director                    |       | March 29, 2007  |
| /s/ BRENT  G. BLACKEY           |          | Director                                               |       | March 29, 2007  |
| /s/ PAUL  F. LIDSKY             |          | Director                                               |       | March 29, 2007  |
| /s/ MARGARET  A. LOFTUS         |          | Director                                               |       | March 29, 2007  |
| /s/ J. PATRICK  O’HALLORAN |          | Director                                               |       | March 29, 2007  |
| /s/ JAMES  E. OUSLEY            |          | Director                                               |       | March 29, 2007  |
| /s/  ROBERT M. PRICE            |          | Director                                               |       | March 29,  2007 |

 

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