**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D. C. 20549**

 

----

 

**FORM 10-K**

 

**(Mark one)**

 
| **ý** | **ANNUAL REPORT PURSUANT TO  SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934 (NO FEE  REQUIRED)** |
|------------|-------------------------------------------------------------------------------------------------------------------|

 

**FOR THE FISCAL YEAR ENDED DECEMBER 31, 2001**

 

**OR**

 
| **o** | **TRANSITION REPORT PURSUANT TO  SECTION 13 OR 15(D) OF THE SECURITIES EXCHANGE ACT OF 1934. (NO FEE  REQUIRED)** |
|-------|------------------------------------------------------------------------------------------------------------------------|

 

**For The Transition PeriodFrom            To              **

 

# **Commission filenumber: 00029758**

 

----

 

**DATALINK CORPORATION**

(Exact name of registrant asspecified in its charter)

 

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

 

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

 

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

 

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

 

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

 

At March 18, 2002 the latest practicable date, theaggregate market value of the voting and non-voting common equity held bynon-affiliates of the registrant was: $16,635,752.

 

At March 18, 2002 the number of shares outstandingof each of the registrant’s classes of common stock was 8,963,345.

 

**DOCUMENTS INCORPORATED BY REFERENCE**

 

Portions of the Registrant’s Proxy Statement forits 2001 Annual Meeting of Stockholders (the “Proxy Statement”), to be filedwith the Securities and Exchange Commission, are incorporated by reference toPart III of this Form 10-K.

 

 

# **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 data storage, including the effectsof current economic conditions; our hiring and retention plans; our projectedcapital expenditures and liquidity; competition in our markets and ourtechnological capabilities. You may find these statements throughout thisAnnual Report and specifically in the sections entitled “Risk Factors,”“Management’s Discussion and Analysis of Financial Condition and Results ofOperations” and “Business.” Our actual results may differ materially from thoseanticipated in these forward-looking statements as a result of various factors,including all the risks discussed in “Risk Factors” and elsewhere in thisAnnual Report.

 

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

 

**PART I**

**Item 1.  Business.**

 

**Overview**

 

We are the nation’s leading independentinformation storage architect. We partner with customers to analyze, design,implement, and support information storage infrastructures that store, protect,and provide continuous access to information. Our areas of expertise include:
| • |   | Storage  Continuance — We help our customers to have 24 hours a day, 7 days a week  access to information.                                       |
|--------|--------|-------------------------------------------------------------------------------------------------------------------------------------------------------|
| • |   | Storage  Protection — Storage protection architectures provide cost-effective backup  and restore solutions for safeguarding information.        |
| • |   | Storage  Optimization — We help our customers to maximize utilization of storage  technologies and the resources that manage those technologies. |

 

Ourhighly skilled technical services and product management staff tests andcompares data storage technologies available from the leading manufacturers andsoftware developers. Once a product is approved for our solution sets, ourengineers then have the flexibility to choose from the best of these storagetechnologies and products to solve our customers’ growing data storage needs.In addition, we maintain a sales and support staff that ensures the continuedsuccess of our data storage solutions for each customer. We believe thesevalue-added services and our adherence to the highest quality standards haveresulted in superior levels of customer satisfaction.

 

**The Data StorageIndustry**

 

*Growth ofEnterprise Data*

 

In the last decade, there has been a dramaticincrease in the volume of data created, processed and accessed through computersystems. Data-intensive applications such as on-line transaction processing,multimedia products, e-mail, e-commerce, web hosting, data warehousing, datamining and enterprise resource management have fueled demand for additionalstorage capacity. According to various Gartner Dataquest, Inc. andInternational Data Corporation (IDC) sources, independent market researchfirms, the data storage market is expected to grow from $36.7 billion in 2001to over $54.4 billion in 2004.  Thisoverall storage market includes redundant arrays of independent disks, tapestorage, storage management software and components for storage area networksand network attached storage.

 

2

----

 

The significance of this data has changed as well.Organizations have recognized the importance and value of data as a strategicand competitive asset. Employees, customers and suppliers demand uninterruptedaccess to mission-critical data 24 hours a day, 7 days a week. As a result, theability to efficiently store, manage, protect and provide access to this datais fast becoming one of the most important aspects of business-criticaldecision-making, increasing the need for high-performance, scalable andreliable storage devices and systems.

 

To meet the needs for high-end data storage andretrieval, organizations are demanding increasingly sophisticated data storagesolutions. Consequently, we believe that organizations are expected to dedicatean increasing percentage of their information technology budgets to datastorage.

 

*Limitations ofTraditional Direct Attached Data Storage Technologies*

 

Data storage technology has not kept pace withincreasing data management demands or with advancements in computer processingcapabilities. The most basic and prevalent data storage technique has been todirectly attach a storage device, such as a single hard disk or, on moreadvanced systems, a redundant array of independent disks, or RAID system, toindividual servers and workstations. This technique has the benefit of beingsimple. However, in organizations of almost any size, this technique suffersfrom a number of significant drawbacks, including:

 

***Manageability.*** Directly attached data storage isolates data. Itis difficult to utilize data efficiently and effectively if it is scatteredthroughout an organization in isolated pockets. With the tremendous growth inthe volume of data, the high cost of data management is leading organizationsto demand more efficient and effective data management systems. In addition, asorganizations realize the value of their data, they are seeking ways to provideenterprise-wide data access.

 

***Scalability.*** Scalability is the ability of a data storagesystem to handle increasing growth in demand for data storage. Directlyattached data storage solutions are not easily scalable because data storagecan only be increased by adding new storage devices to each separate networkserver. In addition, directly attached data storage systems limit the number ofdata storage devices per network server, greatly increasing the amount ofhardware and time needed to manage data growth.

 

***Availability.*** Organizations today demand that their datastorage systems be accessible and usable at any time throughout theorganization. However, directly attached data storage systems are readilyavailable only to those physically connected to the particular network serverthat generated the data. In addition, these storage solutions often require theshutdown of network servers in order to add additional storage devices.

 

***Reliability.*** As organizations increasingly recognize the valueof data, they seek to protect it from loss. Backing-up and archiving data underdirectly attached storage systems is, however, very expensive and difficult.Installing and operating back-up devices, such as tape drives, on each separatelocal network is both costly and difficult to administer consistently acrossthe enterprise. Even where organizations have installed completely redundantstorage devices for each separate server, directly attached storage systemsrequire the back-up storage devices to be located near the primary storagedevices, leaving organizations vulnerable to site-specific disasters such asfire or flood.

 

***Performance.*** Directly attached data storage systems areconnected to local network servers and use those servers to perform datamanagement tasks. However, large amounts of data moving through servers andacross the local networks to reach backup storage devices impede the ability ofthe network to perform other mission-critical user applications.

 

*The Evolutionof Storage Area Networks*

 

To solve the inherent problems of traditionaldirectly attached storage solutions, new technologies have emerged such as the“storage area network,” commonly referred to in the industry as a SAN. A SAN isa high-speed computer network dedicated to data storage that allows RAID, tapebackup and other storage devices to be shared enterprise-wide and to beadministered centrally through common software. Similar to the way in whichtraditional computer networks permit any end user on the network to access anynetwork server, a SAN creates a “pool” of data storage that can be shared bymultiple servers. Through various configurations similar to those used intraditional computer networks, SANs can connect any server with any storagesystem, and storage systems with each other. We believe this “any-to-any”connectivity will enable large amounts of data to be shared, managed andaccessed among servers and storage systems running different computer operatingsystems or software applications.

 

Use of the SAN architecture is growing rapidlybecause it is designed to meet the growing need to manage data effectively andefficiently. According to Gartner Dataquest, Inc., the use of SAN attachedRAID and SAN components will grow at compounded annual growth rates of 38.5%and 35%, respectively, between 2001 and 2004.

 

3

----

 

**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:

 

***Pressureson Customers.*** Webelieve organizations will increasingly look outside their in-house technicalstaff to independent information storage architects such as Datalink forspecialized expertise. Networked storage architecture design is complex.Although organization-wide data storage solutions, such as SANs, are designedto ease data management functions, these systems are difficult to understandand implement because they integrate diverse operating systems, hardware andsoftware. In-house information technology departments prefer to focus theirefforts on mission-critical applications. Accordingly, they do not want toresearch, design, implement and support their own networked storage solutions.

 

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

 

•      Sophisticateddata storage solutions require the integration of highly specialized productsmade by a variety of manufacturers. A typical SAN, for instance, can utilizecomponents such as routers, hubs, switches, host bus adaptors, storage andbackup devices and storage management software, each from a differentmanufacturer. High-end data storage manufacturers generally focus on theirparticular piece of the overall SAN system, leaving companies like us tointegrate comprehensive networked data storage solutions from the bestavailable components.

 

•      Becauseof the high cost of maintaining a national sales and marketing organization andreduced profit margins, high-end data storage manufacturers increasingly arefocusing their resources on their research and development functions. Thisstrategy requires them to outsource much of their sales and marketing functionsto companies such as Datalink.

 

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

 

***Expertise.*** We have been implementing sophisticated data storagesolutions for over ten years. This experience has given us significantexpertise in understanding and applying data storage technologies and hasallowed us to earn and retain the trust and confidence of our customers andsuppliers.

 

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

 

***QualityCommitment.*** Ourprincipal facility is ISO 9001 registered, and we utilize ISO standardsthroughout our organization. Our customers and suppliers value our consistentlyhigh quality design, development, integration, installation and serviceprocesses.

 

**The DatalinkSolution**

 

We combine our technical expertise, the bestproducts from leading manufacturers and comprehensive service and support tomeet each customer’s specific needs. Our comprehensive data storage servicesinclude:

 

*Analysis*

 

At the beginning of an engagement, we placeconsiderable emphasis on formulating a needs analysis based on each customer’sbusiness initiatives, operating environment and current and anticipated datastorage needs. While our focus is on each customer’s unique situation, we bringto each engagement our extensive product knowledge and the experience we havegained from providing data storage solutions for over ten years to customers innumerous industries.

 

4

----

*Design*

 

Once we have completed our initial analysis, webegin the design phase of the project. Our team of technical services and salesconsultants works together to design a system that meets the customer’s datastorage needs and its 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. Our engineers continually evaluate andtest all available emerging and existing data storage technologies. Theengineers then have the ability to consistently select the best availablehardware and software products for our customers. Because of our established,strong relationships with the major enterprise-class information storagehardware and software suppliers, we often participate in their new productdevelopment, evaluation, introduction, marketing and quality control programs.This collaboration with suppliers enables us to identify innovative newhardware and software products and incorporate them into our system designs.

 

*Integration*

 

We provide integration services to ensure that allcomponents work together consistently without quality degradation. We test datastorage solutions and their components for interoperability and compatibility,primarily at our own testing facilities. This allows us to simulate thecustomer’s operating environment without jeopardizing the customer’s data.

 

*Implementation*

 

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

 

*Training*

 

While our systems are complex, we strive to ensurethat our customers understand them before we complete our project. In addition,we offer manufacturer-certified courses at our regional technology centers. Weare a preferred partner, certified to conduct training courses in the systems ofeach of two major data storage system software developers–LegatoSystems, Inc. and VERITAS Software Corporation.

 

*TechnicalSupport*

 

We provide our customers advanced technicalsupport from a team of technical support analysts and professional engineers. Ourextensive experience in data storage systems enables our staff to deliverexpert configuration and usage assistance, technical advice and prompt incidentdetection and resolution. Most technical support is coordinated through oursupport desk, which is staffed with technical support analysts trained to solvetechnical issues and to assist our engineering staff in troubleshootingescalated problems. The support desk staff also acts as our primary interfacewith suppliers’ technical support organizations.

 

*Maintenance*

 

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

 

**An IntegratedSolution Example**

 

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

 

Forexample, we recently designed and implemented a large, complex SAN architecturefor a corporate client managing over 35 terabytes of data across its businessunits.  Before our work, the client used24 information technology professionals in-house to manage this data.  The client now requires only twoprofessionals to manage the same volume of data.  Our SAN architecture also reduced critical system downtime froman estimated 12 hours per year to one hour each two years.

 

5

----

 

**Our Strategy**

 

Our strategy is to maintain our position as theleading, independent information storage architect and to capture an increasingshare of the growing data storage market. To achieve these objectives, weintend to build upon our record of successfully addressing the evolvingenterprise-class information storage management needs of our customers. Keyelements of our strategy include:

 

*LeveragingMarket Presence*

 

We intend to expand our business by broadening ourrelationships with existing customers and by utilizing our market presence andtechnical expertise to attract new customers. We believe that the longevity ofservice of our sales representatives and engineering staff will continue to becritical to building and maintaining long-term, trusting relationships with ourexisting and prospective customers. In addition, our broad experience in adiverse group of data intensive industries enables us to understand applicationand business issues specific to customers operating within a given industry andto design and implement the appropriate networked storage solution.

 

*Expanding OurPresence*

 

Between 2000 and 2001, we increased the number ofour offices from 19 to 26.  To furtherserve our growing customer base, we also intend to expand our existing officesto add sales and engineering talent.

 

*ProvidingProfessional Consulting and Project Management Services*

 

We intend to continue expanding our ability toprovide our customers with comprehensive professional consulting and projectmanagement services. Utilizing the expertise of our professional technicalstaff, we assist our customers in the total assessment, planning, design,implementation and ongoing management of enterprise-class information storagesolutions.

 

*MakingSelective Acquisitions*

 

We intend to seek and consummate additionalstrategic acquisitions. We believe that appropriate acquisitions will enable usto access a larger group of high-quality engineers and to help us broaden ourcoverage and geographic reach.  Forexample, in November 2000, we acquired the data storage and service business ofOpenSystems.com, Inc.

 

*MaintainingTechnological Leadership*

 

We intend to continue to develop leading-edgeenterprise-class information storage solutions for our customers. We intend tocontinually develop and add expertise to our engineering staff and to improveour working relationships with our suppliers in order to maintain expertise inenterprise-class information storage solution design and implementation.

 

*HiringAdditional Technical Services and Sales Personnel*

 

We intend to continue to recruit high-qualitytechnical services and sales personnel. We also intend to continue to maximizejob satisfaction and retain our existing workforce. Our goal is to remain oneof the most rewarding places to work in our industry.

 

*MaintainingSuperior Service and Support*

 

We intend to maintain and continually improve ourhigh standards for superior technical and sales service and support. We intendto continue use of our ISO 9001 quality system and procedures and to continuerecruiting and retaining experienced sales and technical team members.

 

**Suppliers andProducts**

 

As an independent information storage architect,we do not manufacture any of the data storage components we use. Instead, wecontinually evaluate and test new and emerging technologies from othercompanies to ensure that our solutions incorporate state-of-the-art, high-end,cost-effective networked technologies. This enables us to maintain ourtechnological leadership in enterprise-class storage solutions, to identify newand innovative products and applications and to maintain confidence among ourcustomers and suppliers in our expertise.

 

We have strong, established relationships with themajor enterprise-class information storage hardware and software suppliers. Ourexpertise in open system environments includes UNIX, Windows NT, Linux andNovell NetWare and in-depth knowledge of all major hardware platforms,including Hewlett-Packard Company, International Business Machines Corp.,Silicon Graphics, Inc. and Sun Microsystems, Inc. This expertise hasearned us preferred status with many of our principal suppliers. Preferredstatus often enables us to participate in our suppliers’ new productdevelopment, evaluation, introduction, marketing and quality control programs.These collaborations enable us to identify and market innovative new hardwareand software products, exchange critical information and implement jointcorrective action programs in order to maximize quality. In addition, our closeworking relationships with our principal suppliers foster substantialcross-marketing opportunities.

 

6

----

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

 
| **Products**                     |   | **Suppliers**                                                                                                     |
|----------------------------------|--------|-------------------------------------------------------------------------------------------------------------------|
| Primary  Storage                 |   | CLARiiON,  a division of EMC Corp.Hitachi Data Systems CorporationLSI Logic CorporationNetwork Appliance Inc.     |
|                             |   |                                                                                                              |
| Tape  Automation                 |   | ATL  Products, Inc. a division of Quantum CorporationSpectra Logic CorporationStorage Technology Corporation |
|                             |   |                                                                                                              |
| Software                         |   | Legato  Systems, Inc.  VERITAS Software Corporation                                                          |
|                             |   |                                                                                                              |
| Switches/Directors               |   | Brocade  Communications Systems, Inc.McData Corporation                                                      |
|                             |   |                                                                                                              |
| Routers                          |   | Cisco  Systems, Inc.  Crossroads Systems, Inc.                                                               |
|                             |   |                                                                                                              |
| Fibre  Channel Host Bus Adaptors |   | Emulex  CorporationJNI Corporation  QLogic Corporation                                                            |
|                             |   |                                                                                                              |
| Network  Attached Storage        |   | Network  Appliance Inc.                                                                                           |
|                             |   |                                                                                                              |
| SCSI  Host Bus Adaptors          |   | Adaptec, Inc.                                                                                                |

 

**Customers**

 

Our customers trust us with their most demandingdata storage projects. Our high-end solutions range from discrete storagedevice installations to extremely complex organization-wide SAN implementationscosting over $5,000,000. We serve customers throughout the United States in adiverse group of data intensive industries. Our broad industry experienceenables us to understand application and business issues specific to eachcustomer and to design and implement appropriate networked storage solutions.We enjoy strong relationships with our customers, which is reflected insignificant repeat business. We derived approximately 75% of our 2001 revenuesfrom customers that previously did business with us. In 2001, 2000 and 1999,Gateway 2000, Inc. represented 9%, 15% and 13% of our revenues,respectively. Our other customers also include BellSouth Telecommunications,Inc., Bank One Corporation, West Group, Motorola, Inc., Acxiom Corporation,Zimmer, Inc., GE Medical Systems, Anheuser-Busch Companies, Inc., CitadelInvestment Group, AON Corporation, Navitaire, Inc., Autotrader.com LLC,Pharmacia & Upjohn Company and MyPoints.com, Inc.

 

**Sales andMarketing**

 

We market and sell our products and servicesthroughout the United States primarily through a direct sales force. Inaddition to our Minneapolis headquarters, we have 25 field sales offices inorder to serve our customers’ needs more efficiently.

 

Our field account executives and inside salesrepresentatives work closely with our engineering 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 andinside sales representative. Our inside sales representatives proactively shareresponsibility with our field account executives in soliciting new and repeatbusiness and in maintaining consistent customer contact. We believe that thelongevity of service of our sales force is a key factor to earning andretaining the trust and confidence of our customers. We believe thisdifferentiates us from many other storage solution providers that have greatersales force turnover.

 

7

----

 

In addition to the efforts of our field accountexecutives and inside sales representatives, we engage in a variety of othermarketing activities designed to attract new business and retain customerloyalty. We regularly attend major trade shows, conduct in-house and outservice training and informational seminars, publish a quarterly newsletter andadvertise our services in several targeted national business publications.

 

**OriginalEquipment Manufacturer Services**

 

We have original equipment manufacturer customersfor whom we assemble and integrate hardware and software products andsubassemblies acquired from our various suppliers. We design customizedenclosures for most of these OEM products. When requested by the customer, weobtain the necessary agency and governmental approvals for the subassemblies wedesign. These approvals may include those relating to safety and radiofrequency emissions and immunity, such as Underwriter’s Laboratory and European“CE” certifications. We fully document all custom subassemblies for ease ofreplication and service. We subject the assembled units to a system level testto ensure performance to specifications in the anticipated end-user computingenvironment. Our integration and assembly operations are also ISO 9001 registered.In accordance with these standards, we have designed our integration andassembly operations with similar quality procedures to those of our hardwaresuppliers. Our close working relationship with our suppliers generally enablesus to:

 

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

 

•                                          reduce costs and the investment in inventory; and

 

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

 

**QualityManagement System**

 

We have a long history of beingcommitted to a strategic quality effort. In the early 1990’s, we adopted the ISO 9001 quality management systemto better identify and meet the needs of our customers, achieve a competitivemarket advantage, and improve overall company performance.  We obtained an ISO 9001 certificate ofregistration in 1996 with successful re-registration in 1999.  In 2000, we embraced the Total QualityManagement philosophy using the Malcolm Baldrige National Quality Awardcriteria to augment our existing quality system.  Today, our hybrid quality system focuses on achieving businessresults through high levels of customer satisfaction, employee satisfaction,profitability and operational excellence.

 

**Competition**

 

The enterprise-class information storage market israpidly evolving and highly competitive. We compete with independent storagesystem suppliers to the high-end networked market, including EMC Corporationand numerous value-added resellers, distributors and consultants. We alsocompete in the storage systems market with general purpose computer suppliers,some of which have significant storage product offerings, including CompaqComputer Corporation, Dell Computer Corporation, Hewlett-Packard Company,International Business Machines Corp., Silicon Graphics, Inc. and SunMicrosystems, Inc. Further, we compete with storage service providers,such as Storage Networks, Inc., who manage, store and backup their customers’data at off-site networked data storage locations. In addition, our customersand prospects may develop in-house storage systems expertise.

 

Some of our competitors include our suppliers.They may dedicate or acquire greater sales and marketing resources in thefuture to provide enterprise-class information storage solutions than atpresent and could terminate their relationships with us. Other suppliers mayalso enter the market and compete with us. We also expect competition willincrease as a result of industry consolidation. Current and potentialcompetitors have established or may establish cooperative relationships amongthemselves or with third parties to increase the ability of their products toaddress the needs of our prospective customers. Accordingly, new competitors oralliances among competitors may emerge and rapidly acquire significant marketshare.

 

**Employees**

 

As of December 31, 2001, we had a total of216 full-time employees. We have no employment agreements with any of ouremployees. None of our employees are unionized or subject to a collectivebargaining agreement. We have experienced no work stoppages and believethat our employee relations are good.

 

8

----

 

**Backlog**

 

We configure products to customer specificationsand generally ship them shortly after we receive our customer’s order.  Customers may change their orders withlittle or no penalty.  We do notrecognize revenue on hardware or software products until we have completed theinstallation or related configuration services in connection with thesale.  Customer constraints and theavailability of engineering resources can have a significant impact on when wecan complete an installation and configuration service.  These factors prevent us from relying onbacklog as a predictor of our future sales levels.

 

**Item 2.  Properties.**

 

Our corporate headquarters including our principaltechnical operations and our integration, assembly and support serviceoperations is located in a 104,000 square foot office and warehouse facility inChanhassen, Minnesota.  Our remaining 25locations including sales and technical staff are small to medium sized officeslocated throughout the United States. Our regional hubs are located in within each of our regions in theNortheast, Southeast, Great Lakes, Midwest, Southwest and West.

 

**Item 3.  Legal Proceedings.**

 

We are not currently involved in any materiallegal proceedings. We also had no material legal proceedings that terminatedduring the fourth quarter of 2001.

 

**Item 4.  Submission of Matters to a Vote of SecurityHolders.**

 

We submitted no matters during the fourth quarterof 2001 to a vote of security holders, through the solicitation of proxies orotherwise.

 

9

----

**MANAGEMENT**

 

The following table lists our current directorsand executive officers:

 
| **Name**             |   | **Age** |   | **Position**                                              |
|----------------------|--------|---------|--------|-----------------------------------------------------------|
| Greg  R. Meland      |   | 48      |   | President,  Chief Executive Officer and Director          |
| Stephen  M. Howe     |   | 43      |   | Vice  President–Sales and Marketing                  |
| Daniel  J. Kinsella  |   | 43      |   | Chief  Financial Officer                                  |
| Scott  D. Robinson   |   | 42      |   | Chief  Technical Officer                                  |
| Helen  J. Torgerson  |   | 51      |   | Vice  President – Technical Services                 |
| Mary  E. West        |   | 53      |   | Vice  President – Human Resources and Administration |
| Charles  B. Westling |   | 43      |   | Vice  President – Corporate and Business Development |
| Robert  M. Price     |   | 71      |   | Chairman  of the Board and Director                       |
| Paul  F. Lidsky*     |   | 48      |   | Director                                                  |
| Margaret  A. Loftus* |   | 57      |   | Director                                                  |
| James  E. Ousley*    |   | 56      |   | Director                                                  |

 

----

*Memberof Audit and Compensation Committees.

 

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

 

Stephen M. Howe joined us in 1989as a field account executive and became Vice President–Sales in 1997. In 1999,Mr. Howe became our Vice President–Sales and Marketing. Between 1982 and1989, he was employed by Teltrend Inc., a telecommunications equipmentmanufacturer, most recently as Assistant Vice President of Operations.Mr. Howe was a sales representative for Hamilton Avnet Corp., anelectronics distributor, between 1980 and 1982.

 

Daniel J. Kinsella joined us in1999 as Chief Financial Officer. Between 1998 and 1999, he was Chief FinancialOfficer of Lloyd’s Barbeque Company. Mr. Kinsella served in variousfinance roles for Grist Mill Company between 1989 and 1998, most recently asits Chief Financial Officer, Treasurer and Secretary. From 1984 to 1989,Mr. Kinsella was the Director of Financial Reporting for Inter–RegionalFinancial Group, Inc. Between 1980 and 1984, he was employed by ToucheRoss & Company, most recently as an audit manager. Mr. Kinsellais a Certified Public Accountant.

 

Scott D. Robinson joined us in1989 as Chief Engineer and became Vice President–Engineering in 1993. In 1999,Mr. Robinson became our Chief Technical Officer. Between 1983 and 1989, hewas employed by Minnesota Mining and Manufacturing Company, most recently as anAdvanced Electrical Engineer in the Digital Imaging Applications Center.Mr. Robinson received his B.S. in Electrical Engineering in 1982 fromMarquette University and his M.S. in Electrical Engineering in 1989 from theUniversity of Minnesota.

 

Helen J. Torgerson joined us in2000 as Vice President–Technical Services. Between 1987 and 2000, she was employed by Hewlett-Packard Company andits affiliate, Agilent Technologies, in various management positions, mostrecently as the Americas Customer Resource Organization Manager.

 

Mary E. West joined us in 2001 asVice President–Human Resources and Administration.  From 1998 to 2001, she worked as an independent human resourcesconsultant. Between 1995 and 1998, Ms. West was employed by Arcadia Financial,Ltd., most recently as the Senior Vice President of Human Resources.  From 1993 to 1994, she was the corporateadministrative director for Nexus, Inc. Ms. West received her M.A. in Human Resources and Industrial Relationsin 1988 from the University of Minnesota Carlson School of Management.

 

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

10

----

 

Robert M. Price was elected asour Chairman of the Board and a director in June 1998. Mr. Price hasbeen President of PSV, Inc., a technology consulting business located inBurnsville, Minnesota, since 1990. Between 1961 and 1990, he served in variousexecutive positions, including as Chairman and Chief Executive Officer, withControl Data Corporation. Mr. Price also serves on the Board of Directorsof Public Service Company of New Mexico, Affinity Technology Group, Inc.and National Center for Social Entrepreneurs. Mr. Price isMr. Meland’s father-in-law.

 

Paul F. Lidsky was elected as adirector in June 1998. Since 1997, Mr. Lidsky has been the Presidentand Chief Executive Officer of OneLink Communications, Inc., atelecommunications company. Between 1992 and 1997, Mr. Lidsky was employedby Norstan, Inc., a comprehensive technology services company, mostrecently as Executive Vice President of Strategy and Business Development.Mr. Lidsky is also a director of OneLink Communications, Inc.

 

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

 

James E. Ousley was elected as adirector in June 1998.  Mr. Ousley ispresident and chief executive officer of Vytek Wireless Inc., a mobilecomputing company.  Since October 2000,he has served as Chairman of Syntegra (USA), a division of British Telecommunicationsplc.  From 1991 and 1999, Mr. Ousley wasPresident and Chief Executive Officer of Control Data Systems, Inc., a leadingsystems integrator and provider of electronic commerce solutions.  Between 1968 and 1991, Mr. Ousley served invarious sales and executive management positions with Control Data Corporation,most recently as President of the Computer Products Group.  Mr. Ousley also serves on the Board ofDirectors for Vytek Wireless, Inc., ActiveCard, S.A., and Bell Microproducts.

 

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

 

# **PART II**

 

**Item 5.  Market for Registrant’s Common Equity andRelated Stockholder Matters.**

 

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

 
|                                  |   | **High** |        | **Low** |   |
|---------------------------------------|--------|----------|-------------|---------|--------|
| **Year Ended December 31, 2000** |   |     |        |    |   |   |
| First Quarter                         |   | $        |  35.06 |    | $      |  18.13 |   |
| Second Quarter                        |   | 20.75    |        | 11.75   |   |
| Third Quarter                         |   | 17.75    |        | 10.75   |   |
| Fourth Quarter                        |   | 13.75    |        | 8.44    |   |
| **Year Ended December 31, 2001** |   |     |        |    |   |   |
| First Quarter                         |   | 12.88    |        | 7.69    |   |
| Second Quarter                        |   | 11.30    |        | 5.43    |   |
| Third Quarter                         |   | 8.39     |        | 3.80    |   |
| Fourth Quarter                        |   | 8.30     |        | 3.05    |   |
|                                       |        |          |             |         |        |  |  |  |

 

On March 18, 2002, the closing price pershare of our common stock was $5.20. We urge potential investors to obtaincurrent market quotations before making any decision to invest in our commonstock. On March 18, 2002, there were approximately 63 holders of record of ourcommon stock. Many of our shares are held by beneficial owners through a smallnumber of holders of record.

 

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

 

11

----

 

**Item 6.  Selected Financial Data.**

 

You should read the information below with our“Management’s Discussion and Analysis of Financial Condition and Results ofOperations” and our financial statements. The data as of December 31, 2001and 2000, and for the years ended December 31, 2001, 2000 and 1999, was derivedfrom our financial statements that are included in this Annual Report. The dataas of December 31, 1999, 1998 and 1997, and for the years ended December31, 1998 and 1997, was derived from our financial statements that are notincluded in this Annual Report. Our independent public accountants, ArthurAndersen LLP, audited our 2001 financial statements. Our previous independentpublic accountants, PricewaterhouseCoopers LLP, audited our 1997 through 2000financial statements. Our historical financial results are not necessarilyindicative of our future operating results.

 
|                                                                                        |   | **Year ended December 31,**          |       |
|---------------------------------------------------------------------------------------------|--------|-------------------------------------------|------------|
|                                                                                        |   | **2001**                                  |       | **2000** |   | **1999** |   | **1998** |   | **1997** |   |
|                                                                                        |   | **(in thousands, except per share data)** | ** ** |
| **Statement of Operations Data:**                                                           |   |                                      |       |   |   |   |   |   |   |   |   |
| Net sales:                                                                                  |   |                                      |       |   |   |   |   |   |   |   |   |
| Product sales                                                                               |   | $                                         | 96,188     |   | $ | 118,233 |   | $ | 105,373 |   | $ | 80,243 |   | $ | 67,849 |   |
| Service sales                                                                               |   | 28,596                                    |       | 19,536 |   | 11,230 |   | 5,849 |   | 2,570 |   |
| Total net sales                                                                             |   | 124,784                                   |       | 137,769 |   | 116,603 |   | 86,092 |   | 70,419 |   |
|                                                                                        |   |                                      |       |   |   |   |   |   |   |   |   |
| Cost of sales:                                                                              |   |                                      |       |   |   |   |   |   |   |   |   |
| Cost of product sales                                                                       |   | 70,393                                    |       | 87,321 |   | 77,623 |   | 60,622 |   | 53,157 |   |
| Cost of services                                                                            |   | 20,328                                    |       | 14,148 |   | 8,411 |   | 3,740 |   | 1,914 |   |
| Total cost of sales                                                                         |   | 90,721                                    |       | 101,469 |   | 86,034 |   | 64,362 |   | 55,071 |   |
|                                                                                        |   |                                      |       |   |   |   |   |   |   |   |   |
| Gross profit                                                                                |   | 34,063                                    |       | 36,300 |   | 30,569 |   | 21,730 |   | 15,348 |   |
|                                                                                        |   |                                      |       |   |   |   |   |   |   |   |   |
| Operating expenses:                                                                         |   |                                      |       |   |   |   |   |   |   |   |   |
| Sales and marketing                                                                         |   | 15,836                                    |       | 15,230 |   | 11,702 |   | 7,655 |   | 5,146 |   |
| General and administrative                                                                  |   | 11,221                                    |       | 8,792 |   | 6,883 |   | 5,027 |   | 3,010 |   |
| Engineering                                                                                 |   | 5,259                                     |       | 3,745 |   | 2,594 |   | 1,362 |   | 926 |   |
| Amortization of goodwill and other intangibles                                              |   | 2,264                                     |       | 1,026 |   | 807 |   | 376 |   | — |   |
| Offering costs (1)                                                                          |   | —                                    |       | 381 |   | 173 |   | 733 |   | — |   |
| Total operating expenses                                                                    |   | 34,580                                    |       | 29,174 |   | 22,159 |   | 15,153 |   | 9,082 |   |
|                                                                                        |   |                                      |       |   |   |   |   |   |   |   |   |
| Operating (loss) income                                                                     |   | (517                                      | )          | 7,126 |   | 8,410 |   | 6,577 |   | 6,266 |   |
| Interest income (expense), net                                                              |   | 127                                       |       | 311 |   | (141 | ) | (281 | ) | (333 | ) |
| (Loss) income before income taxes and cumulative effect  of a change inaccounting principle |   | (390                                      | )          | 7,437 |   | 8,269 |   | 6,296 |   | 5,933 |   |
| Income tax expense (2)                                                                      |   | 115                                       |       | 3,049 |   | 897 |   | 148 |   | — |   |
| (Loss) income before cumulative effect of a change in  accounting principle                 |   | (505                                      | )          | 4,388 |   | 7,372 |   | 6,148 |   | 5,933 |   |
| Cumulative effect of a change in accounting principle,  net of tax (3)                      |   | —                                    |       | (753 | ) | — |   | — |   | — |   |
|                                                                                        |   |                                      |       |   |   |   |   |   |   |   |   |
| Net (loss) income                                                                           |   | $                                         | (505       | ) | $ | 3,635 |   | $ | 7,372 |   | $ | 6,148 |   | $ | 5,933 |   |
|                                                                                        |   |                                      |       |   |   |   |   |   |   |   |   |
| Net (loss) income per share, basic:                                                         |   |                                      |       |   |   |   |   |   |   |   |   |
| (Loss) income per share before cumulative effect of a  change inaccounting principle        |   | $                                         | (0.06      | ) | $ | 0.50 |   | $ | 1.01 |   | $ | 0.88 |   | $ | 0.86 |   |
| Loss per share from the cumulative effect of a change  inaccounting principle (3)           |   | —                                    |       | (0.09 | ) | — |   | — |   | — |   |
| Net (loss) income per share                                                                 |   | $                                         | (0.06      | ) | $ | 0.41 |   | $ | 1.01 |   | $ | 0.88 |   | $ | 0.86 |   |
| Net (loss) income per share, diluted:                                                       |   |                                      |       |   |   |   |   |   |   |   |   |
| (Loss) income per share before cumulative effect of a  change inaccounting principle        |   | $                                         | (0.06      | ) | $ | 0.48 |   | $ | 0.99 |   | $ | 0.88 |   | $ | 0.86 |   |
| Loss per share from the cumulative effect of a change  inaccounting principle (3)           |   | —                                    |       | (0.08 | ) | — |   | — |   | — |   |
| Net (loss) income per share                                                                 |   | $                                         | (0.06      | ) | $ | 0.40 |   | $ | 0.99 |   | $ | 0.88 |   | $ | 0.86 |   |
|                                                                                        |   |                                      |       |   |   |   |   |   |   |   |   |
| Weighted average shares outstanding:                                                        |   |                                      |       |   |   |   |   |   |   |   |   |
|                                                                                        |   |                                      |       |   |   |   |   |   |   |   |   |
| Basic                                                                                       |   | 8,921                                     |       | 8,794 |   | 7,295 |   | 6,993 |   | 6,900 |   |
| Diluted                                                                                     |   | 8,921                                     |       | 9,166 |   | 7,437 |   | 6,993 |   | 6,900 |   |

 

12

----

 
|                                   |   | **As of December 31,** |       |
|----------------------------------------|--------|-----------------------------|------------|
|                                   |   | **2001**                    |       | **2000** |   | **1999** |   | **1998** |   | **1997** |   |
|                                   |   | **(In thousands)**          | ** ** |
| **Balance Sheet Data:**                |   |                        |       |   |   |   |   |   |   |   |   |
| Cash and cash equivalents              |   | $                           | 5,846      |   | $ | 4,542 |   | $ | 6,515 |   | $ | 2,798 |   | $ | 1,163 |   |
| Working capital                        |   | 10,729                      |       | 11,695 |   | 17,233 |   | 6,039 |   | 6,506 |   |
| Total assets                           |   | 46,768                      |       | 56,472 |   | 42,415 |   | 32,144 |   | 18,705 |   |
| Note payable to former stockholder (4) |   | 704                         |       | 1,409 |   | 2,114 |   | — |   | — |   |
| Common stock, subject to put option    |   | —                      |       | — |   | — |   | 19,059 |   | 13,874 |   |
| Stockholders’ equity (deficit)    |   | 26,114                      |       | 26,137 |   | 21,131 |   | (6,979 | ) | (5,999 | ) |
|                                        |        |                             |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

----

(1)                                  Reflects legal, accounting and other costsassociated with our initial and a subsequent public offering, which we expensedwhen we postponed both offerings due to market conditions.  We successfully completed our initial publicoffering on August 6, 1999.  We did notcomplete our second public offering.

 

(2)                                  Our 1998 income tax expense resulted from thetaxable income generated by Direct Connect Systems, Inc., or DCSI, fromthe date of our acquisition (July 15, 1998) through December 31,1998. In January 1999 we merged DCSI into us. Our 1999 income tax expenseresulted from the taxable income we generated between August 6, 1999 (whenwe terminated our S corporation status) and December 31, 1999, and the taxeffect of our merger with DCSI. See Note 4 of the Notes to our ConsolidatedFinancial Statements.

 

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

 

(4)                                  Reflects a $3,020 promissory note, less paymentswe have made, issued to one of our former stockholders in connection with ourredemption, effective February 28, 1999, of 1,096 shares of common stock.See Note 7 of the Notes to our Financial Statements.

 

**Item 7. ****     Management’s Discussion and Analysis of Financial Condition and Resultsof Operation.**

 

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

 

**OVERVIEW**

 

We are an independent architect ofenterprise-class information storage infrastructures. We derive our revenues principallyfrom designing and installing data storage systems. Our solutions can includehardware products, such as disk arrays, tape systems, interconnectioncomponents, and storage management software products. Prior to January 1,2000, we recognized revenues for hardware and software product sales when weshipped the products and software to our customers or after they acceptedproducts under evaluation. However, in December 1999, the SEC staff issuedStaff Accounting Bulletin, or SAB, No. 101, “Revenue Recognition,” whichclarified the SEC staff’s view regarding the recognition and reporting ofrevenues in particular transactions. In light of SAB No. 101, we modifiedour revenue recognition policy related to hardware and software products whenwe provide any installation or configuration services in connection with thesale. We now recognize revenue from hardware and software product sales when wecomplete our installation and configuration services.  This change was effective as of January 1, 2000.  Under the SAB No. 101 transitionprovisions, we accounted for this change in accounting policy prospectively. Asof January 1, 2000, we recorded a charge to earnings of $753,000,representing the cumulative effect, net of income taxes, of this change in ouraccounting policy.

 

As indicated above, our customers frequentlyengage us for assistance in the installation of our solutions. Occasionally,they also engage us for consulting services. We recognize revenues for thiswork as we render these services.

 

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

 

In the past, we have experienced fluctuations in thetiming of orders from our customers, and we expect to continue to 

 

13

----

experience these fluctuations in the future.  These fluctuations have resulted from, among other things, thetime required to design, test and evaluate our data storage solutions beforecustomers deploy them, the size of customer orders, the complexity of ourcustomers’ network environments, necessary system configuration to deploy oursolutions and new product introductions by suppliers.  Completion of our installation and configuration services mayalso delay recognition of revenues. Current economic conditions and competition also affect our customers’decisions to place orders with us.  As aresult, our net sales may fluctuate from quarter to quarter.

 

Prior to our initial public offering inAugust 1999, we were an S corporation. The only income tax expense wereported prior to August 1999 resulted from the C corporation taxableincome of Direct Connect Systems, Inc., or DCSI, allocated to us betweenJuly 1998, when we acquired DCSI, and January 1999, when we mergedDCSI into us. Upon our August 1999 initial public offering, we became a Ccorporation and began reporting income tax expense. This change in tax statuscomplicates comparison of our historical operating results.

 

In November 2000, we acquired certain assets ofthe data storage and services business of OpenSystems.com, Inc., a Walpole,Massachusetts-based firm engaged in the resale and installation of data storagesolutions.

 

**Results ofOperations**

 

The following table shows, for the periodsindicated, certain selected financial data expressed as a percentage of netsales.

 

|                                           |   | **Years Ended December 31,** |   |
|------------------------------------------------|--------|-----------------------------------|--------|
|                                           |   | **2001**                          |   | **2000** |   | **1999** |   |
| Net sales                                      |   | 100.0                             | %      | 100.0 | % | 100.0 | % |
| Cost of sales                                  |   | 72.7                              |   | 73.7 |   | 73.8 |   |
| Gross profit                                   |   | 27.3                              |   | 26.3 |   | 26.2 |   |
| Operating expenses:                            |   |                              |   |   |   |   |   |
| Sales and marketing                            |   | 12.7                              |   | 11.1 |   | 10.0 |   |
| General and administrative                     |   | 9.0                               |   | 6.4 |   | 5.9 |   |
| Engineering                                    |   | 4.2                               |   | 2.7 |   | 2.2 |   |
| Amortization of goodwill and other intangibles |   | 1.8                               |   | 0.7 |   | 0.7 |   |
| Offering costs                                 |   | 0.0                               |   | 0.3 |   | 0.2 |   |
| Total operating expenses                       |   | 27.7                              |   | 21.2 |   | 19.0 |   |
| Operating income                               |   | (0.4%                             | )      | 5.2 | % | 7.2 | % |

 

**Comparison ofYears Ended December 31, 2001, 2000, and 1999**

 

*Net Sales.*  Ourproduct sales decreased 18.6% in 2001 from 2000 to $96.2 million, but increased12.2% in 2000 over 1999 to $118.2 million. Our product sales were $105.4million in 1999.  Our service sales,which include customer support and installation services, increased 46.4% in2001 over 2000 to $28.6 million and increased 74.0% in 2000 over 1999 to $19.5million.  Our service sales in 1999 were$11.2 million.  Our lower product salesin 2001 reflect a decline in overall capital spending by our customers.  We experienced a very difficult andcompetitive operating environment during most of 2001.  This uncertainty was further complicated bythe world events such as the terrorist attacks on the United States inSeptember. The high level of economic uncertainty has led to an overall reductionin capital spending by United States businesses, including spending fortechnology. The growth in our servicerevenues between 1999 and 2001 reflects an increase in new maintenance contractsales and contract renewals by existing customers.  We derived approximately 9%, 13% and 15% of our sales from onecustomer during 2001, 2000 and 1999, respectively.  We cannot assure you that this customer will account for asubstantial portion of our future sales.

 

*Gross Profit.*  Our total gross profit as apercentage of net sales increased to 27.3% in 2001 from 26.3% in 2000 and 26.2%in 1999. Our gross profit improved over these years generally due to ourincreased sales of large, complex storage systems solutions and lower costs forobsolete inventory.  Similarly, productgross profit as a percentage of product sales increased to 26.8% in 2001 ascompared to 26.1% in 2000 and 26.3% in 1999. Service gross profit as a percentage of service sales increased to 28.9%in 2001 from 27.6% in 2000 and 25.1% in 1999. The increase in gross profit rates for services reflects our ability toobtain higher margins on our integrated support services. Charges for excess and obsolete inventory in 2001,2000 and 1999 of $344,000, $1.2 million and $456,000, respectively, adversely affectedour gross profit.  In particular, during2000, we disposed of excess, old generation inventories at liquidation valuessignificantly below our acquisition cost.

 

*Sales and Marketing.*  Sales andmarketing expenses include wages and commissions paid to sales and marketingpersonnel, travel costs, advertising, promotion and hiring expenses. Sales andmarketing expenses increased to $15.8 million in 2001 compared to $15.2 millionin 2000 and $11.7 million in 1999. As a percentage of net sales, our sales andmarketing expenses were 12.7% in 2001, 11.1% in 2000 and 10.0% in 1999.

14

----

 

The increase in sales and marketing expense as a percentage of our netsales and in absolute dollars from 1999 to 2000 resulted primarily from thehiring of additional field account executives as we continued to open new salesoffices and expand our business and the increase in commissions commensuratewith the increase in sales. New field account executives are usually less productiveduring their first two years than more seasoned sales personnel. The increasein sales expense as a percentage of sales andin absolute dollars from 2000 to 2001 resulted primarily from our new regionalstructure.  Under our newstructure, we added regional sales directors and additional field accountexecutives to provide for the future growth and expansion of our business.

 

*General and Administrative.*  Generaland administrative expenses include wages for administrative personnel,professional fees, depreciation, communication expenses and rent and relatedfacility expenses. General and administrative expenses increased to $11.2million in 2001 compared to $8.8 million in 2000 and $6.9 million in 1999. As apercentage of net sales, general and administrative expenses were 9.0% in 2001,6.4% in 2000 and 5.9% in 1999. The increase in general andadministrative expenses in both absolute dollars and as a percentage of netsales reflects the expanded costs of managing our business as well as salesoffice expansion during 2000 and 2001. These increases include higher rents, communication expense and relatedfacility charges for our regional offices and new headquarters.  In 2001, depreciation expense increased aswe added new facilities and information systems.

 

*Engineering.*  Engineering expensesinclude employee wages and travel, hiring and training expenses for ourprofessional engineers and technicians. We allocate engineering costsassociated with installation services to our cost of service sales.  Engineeringexpenses increased to $5.3 million in 2001 compared to $3.7 million in 2000and  $2.6 million in 1999. Engineeringexpenses as a percentage of net sales were 4.2% in 2001, 2.7% in 2000 and 2.2%in 1999.  The increase inengineering expenses in both absolute dollars and as a percentage of net salesis primarily due to our investment in a new regional structure, including thehiring of regional engineering directors and additional field engineers.  We also attribute the increase tocompetitive salary increases for our existing engineers, travel expensesrelated to the geographic expansion of our business and costs for engineeringlaboratory equipment to support the testing and training needs of ourengineering staff.

 

*Goodwill and Other Intangible Amortization.* Amortization of goodwill and other intangible assets increased to $2.3million in 2001 compared to $1.0 million in 2000 and $807,000 in 1999.  These increases relate to our acquisition ofthe data storage and services business of OpenSystems.com, Inc. in November2000.  In 2002, we expect ouramortization expense to decrease by $1.2 million from 2001 due to the adoptionof Statement of Financial Accounting Standards (SFAS) 142, Goodwill andIntangible Assets.  This Statementrequires that we  no longer amortizegoodwill and intangible assets with indefinite lives, but instead test forimpairment annually or whenever impairment is indicated.  For more information, see Note 2 of theNotes to our Financial Statements.

 

*OfferingCosts. *During the second quarter of 2000, we expensedapproximately $381,000 of costs for a proposed second public offering of ourcommon stock, which was withdrawn due to market conditions. We incurredexpenses of approximately $173,000 in the first quarter of 1999 in conjunctionwith our initial public offering. This offering was twice delayed by marketconditions. As required, we expensed these previously deferred costs each timewe determined that the offerings would be delayed more than 90 days.

 

*Operating(Loss) Income.* We incurredan operating loss of $517,000 in 2001 compared to operating income of $7.1million in 2000. Operating income decreased 15.3% in 2000 from $8.4 million in1999. The decrease in operating income was principally attributable to oursales decline under difficult economic conditions combined with an increase inour operating expenses in the anticipation of revenue growth and market sharegains.

 

*Income Taxes.*  UntilAugust 1999, when we became a public company, we were an S corporation andwere not taxed on our income. We provided for income taxes of $115,000 in 2001,$3.1 million in 2000, and $897,000 in 1999. Our 1999 income tax expenseresulted from the taxable income we generated after our August 1999initial public offering and the tax effect of the 1998 merger of DCSI intoDatalink. For more information, see Note 4 of the Notes to our FinancialStatements.  Even though we generated anoperating loss in 2001, we still incurred income tax expense which reflectspermanent differences, such as non-deductible goodwill amortization, betweenour reported and taxable income as well as state taxes.

 

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

 

**QuarterlyResults and Seasonality**

 

The following table sets forth our unauditedquarterly financial data for each quarter of 2001 and 2000. In our opinion,this unaudited information has been prepared on the same basis as the auditedinformation and includes all adjustments (including all normal recurringadjustments) necessary to present fairly the information set forth below. Theoperating results for any quarter are not necessarily indicative of results forany future period.

 

15

----

 
|                    |   | **Quarters Ended** |       |
|-------------------------|--------|--------------------|------------|
|                    |   | **2001**           | ** ** | **2000** | ** ** |
|                    |   | **Mar. 31**        | ** ** | **Jun. 30** | ** ** | **Sep. 30** | ** ** | **Dec.31** | ** ** | **Mar.31** | ** ** | **Jun.30** | ** ** | **Sep. 30** | ** ** | **Dec. 31** | ** ** |
|                    |   | **(in thousands)** |       |
| Net sales               |   | $                  | 40,899     |   | $ | 26,992 |   | $ | 32,244 |   | $ | 24,649 |   | $ | 27,998 |   | $ | 34,911 |   | $ | 36,292 |   | $ | 38,568 |   |
| Gross profit            |   | 11,069             |       | 7,472 |   | 9,269 |   | 6,253 |   | 7,686 |   | 9,840 |   | 8,639 |   | 10,135 |   |
| Operating income (loss) |   | 1,786              |       | (1,087 | ) | 788 |   | (2,004 | ) | 1,481 |   | 2,261 |   | 2,566 |   | 818 |   |
| Net income (loss)       |   | 1,076              |       | (623 | ) | 290 |   | (1,248 | ) | 166 |   | 1,406 |   | 1,561 |   | 502 |   |
|                         |        |                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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

 

**Liquidity andCapital Resources**

 

Historically, we have financed our operations andcapital requirements through cash flows generated from operations, supplementalbank borrowings and the proceeds from our initial public offering. Our workingcapital was $10.7 million at December 31, 2001 as compared to $11.7million at December 31, 2000. Our current ratio was 1.5:1 atDecember 31, 2001 as compared to 1.4:1 at December 31, 2000. AtDecember 31, 2001, our cash and cash equivalents balance was $5.8 million.

 

Cash provided by operating activities for 2001 was$5.6 million as compared to $10.6 million in 2000 and $3.5 million in 1999. Thecash provided in 2001 resulted primarily from a reduction in inventories of$4.3 million and a reduction in shipped but not installed inventories of $3.9million, offset by a decrease in payables of $4.5 million. The reduction ininventories for 2001 resulted from our increased efforts to optimize ourinventory levels and to complete the installation of products for customers atyear-end.  The cash provided by operating activities in 2000 resulted primarilyfrom our net income and a reduction in accounts receivable and increases inaccounts payable, partially offset by an increase in inventories.  Cash provided by operations in 1999reflected our increasing sales and net income, partially offset by increasedaccounts receivable and inventories due to the increase in net revenues.

 

Cash used in investing activities during 2001 was$4.0 million as compared to $11.4 million in 2000 and $1.1 million in 1999. In2001, we purchased furniture and fixtures for our new corporateheadquarters in Chanhassen, Minnesota and invested in our new information andphone systems and engineering laboratory equipment. Our 2000 uses reflected expenditures for engineering and lab equipment,the purchase of land adjacent to our new corporate headquarters facility and a$500,000 deposit on the new corporate headquarters that we began leasing inJune 2001. The 2000 uses also included $7.5 million to acquire the data storageand services business of OpenSystems.com, Inc. 1999 uses of cash were related to the purchases of computer equipmentand upgrades, leasehold improvements and furniture and fixtures.

 

Cash used in financing activities during 2001 was$342,000 as compared to $1.2 million in 2000. In 2001, we made a scheduled payment of $705,000 on a note due to aformer S corporation stockholder, which was partially offset by $363,000 ofproceeds from our employee stock purchase plan and stock option exercises.  In 2000, we used $884,000 to make a finaldividend distribution to the ten pre-initial public offering stockholders relatedto their tax liabilities.  We also madea scheduled payment of $705,000 on the former S corporation shareholder’snote.  These uses were partially offsetby $388,000 of proceeds from stock purchases under our employee stock purchaseplan.  Cash provided by financingactivities was $1.3 million in 1999. In 1999, net proceeds of $18.2 millionfrom the issuance of common stock related to our public offering were offset,in part, by net repayments of borrowings of $3.2 million and $12.8 million ofdividend distributions paid to our ten pre-initial public offeringstockholders, $3.7 million of which enabled stockholders to pay their incometax liabilities resulting from our S corporation taxable income. The remaining$9.1 million dividend distribution to these stockholders represented allpreviously taxed, but undistributed, S corporation earnings.

 

In February 2002, we amended our credit agreementwith a commercial bank that provides for a $10 million revolving line of 

 

16

----

 

credit for financing potential business acquisitions and a $5 millionrevolving line of credit for financing our working capital needs.  The term of the agreement ends June 30,2002.  Borrowings under the lines ofcredit are secured by our accounts receivable and inventory and are subject tocertain financial and operating covenants, including covenants that require usto maintain a minimum current ratio, debt-net worth ratio, tangible net worthand level of profitability.  We had nooutstanding borrowings as of December 31, 2001.  For more information, see Note 3 of the Notes to our FinancialStatements.

 

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

 

In February 1999, we redeemed 1,095,720shares of common stock held by one of our former stockholders and issued him a$3.0 million note payable in four installments through February 2002. Wemade principal payments of $906,000, $705,000 and $705,000 on this note inAugust 1999, February 2000 and February 2001, respectively.  We made our final payment on this note in February2002, leaving Datalink with no outstanding funded debt.

 

In November 2000, we purchased the data storageand service business of OpenSystems.com, Inc. for $7.0 million cash and 79,177shares of our common stock.  We agreedto pay an additional $2.5 million in cash if particular 2001 revenue targetsfor the acquired business had been met. The revenue targets were not met in 2001, therefore no amounts are due.

 

We believe that funds generated from operations, together with theavailable credit under our revolving credit agreement, will be sufficient tofinance our current operations and planned capital expenditures for at leastthe next twelve months. We are planning for$1.7 to $2.0 million of capital expenditures through 2002 primarily related tothe implementation of our customer relationship management information system.

 

**Critical Accounting Policies**

 

*Revenuerecognition —* As discussed in Note 2 of the Notes to ourFinancial Statements, we recognize revenues from hardware and software productsales only after substantially all installation services have been completedand the product is functioning properly rather than upon shipment.  We believe this policy minimizesmanagement's judgments over the timing and extent of revenue recognition.  Although the policy that we adopted onJanuary 1, 2001 contains very specific guidelines for measuring revenue,certain judgments do affect the application of our revenue policy, such asevaluating multiple element arrangements.

 

*Inventory*— We periodically review, estimate and adjust our reservesfor obsolete or unmarketable inventory equal to the difference between theinventory cost and the estimated market value based upon assumptions aboutfuture demand and market conditions.

 

17

----

 

**RecentAccounting Pronouncements**

 

*Amortization of Goodwill*.  In June 2001, FASB approved for issuanceStatement of Financial Accounting Standards (SFAS) 141, Business Combinations,and SFAS 142, Goodwill and Intangible Assets. For all business combinations initiated after June 30, 2001, theseStatements require the use of the purchase, rather than the pooling, method ofaccounting.  Intangible assets acquiredin a business combination are recorded separately from goodwill if they arise fromcontractual or other legal rights or are separable from the acquired entity andcan be sold, transferred, licensed, rented or exchanged, either individually oras part of a related contract, asset or liability.

 

The Statements also provide that effective January 1,2002, goodwill is no longer amortized. Instead, goodwill and intangible assets with indefinite lives aregenerally tested for impairment annually and whenever there is an impairmentindicator.  All acquired goodwill isassigned to reporting units for purposes of impairment testing.

 

We do not expectto incur any transitional goodwillimpairment losses on our unamortized goodwill balances upon adoption of theseStatements, which totaled $4.8 million at December 31, 2001.  Effective January 1, 2002, we ceasedamortization of our goodwill. Amortization of goodwill was $1.2 million in 2001.  However, we will perform impairment analysesof our goodwill whenever we believe it is impaired.  If the undiscounted cash flows, without interest or tax charges,are less than the carrying value of the assets under impairment review, we willwrite the assets down to fair market value. Future events could cause us to conclude that impairment indicatorsexist and that goodwill associated with our acquired businesses is furtherimpaired.  Any resulting impairment losscould have a material adverse impact on our financial condition and results ofoperations.

 

We will continue to amortize other identified intangibles withdeterminable lives, which totaled $3.2 million at December 31, 2001.

*Long-Lived Assets*.  In July 2001, the FASB issuedSFAS No. 144, “Impairment or Disposal of Long-Lived Assets,” which is effectivefor fiscal years beginning after December 15, 2001. The provisions of thisStatement provide a single accounting model for impairment of long-livedassets. The adoption of SFAS No. 144 on January 1, 2002 did not have a materialimpact on our financial position or results of operations.  However, we will perform impairment analysesof our long-lived assets whenever we believe they are impaired.  If the undiscounted cash flows, withoutinterest or tax charges, are less than the carrying value of the assets underimpairment review, we will write the assets down to fair market value.  Future events could cause us to concludethat impairment indicators exist and that long-lived assets are furtherimpaired.  Any resulting impairment losscould have a material adverse impact on our financial condition and results ofoperations.

 

*Use of Derivatives and Hedging Activities.*  In June1999, the Financial Accounting Standards Board (FASB) issued Statement ofAccounting Standards No. 137, “Accounting for Derivative Instruments andHedging Activities — Deferral of the Effective Date of FASB Statement No.133.”  SFAS No. 133 establishesaccounting and reporting standards for derivative instruments, includingderivative instruments embedded in other contract, and for hedgingactivities.  SFAS 137 as amended by SFASNo. 138 became effective for us in the first quarter of 2001.  The adoption of SFAS 133 did not have anyimpact on our financial position or results of operations.

 

**Inflation**

 

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

 

**RISK FACTORS**

 

**Current economicconditions adversely impact our revenues and profits.**

 

During 2001 and continuing to the present,we have experienced a very difficult and competitive operating environment.  This uncertainty was further complicated bythe world events such as the terrorist attacks on the United States inSeptember 2001.  The high level ofeconomic uncertainty has led to an overall reduction in capital spending,including spending for technology.  Someof our customers have canceled or delayed planned purchases.  Others have replaced large storage solutioninstallation projects with smaller, piecemeal projects that carry lower profitmargins for us.  Competition foravailable business has also affected our margins.  We cannot predict the continuing effect of current economicconditions on our business.  If ourrevenues and cash flows continue to be adversely affected, we may need toreduce our expenses or personnel.  Thiscould adversely affect our ability to capitalize on future technology spendingby our customers at such time as economic conditions improve.

 

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

 

The enterprise-class information storage market israpidly evolving and highly competitive. As technologies change rapidly, weexpect that competition will increase in the future. We compete withindependent storage system suppliers to the high-end market and numerousresellers, distributors and consultants. We also compete in the storage systemsmarket with general purpose computer suppliers. Many of our current andpotential competitors have significantly greater financial, technical,marketing, purchasing and other resources than we do. As a result, they mayrespond more quickly to new or emerging technologies and changes in customerrequirements, devote greater resources to the development, promotion and saleof products and deliver competitive products at lower end-user prices.

 

Some of our current and potential competitorsinclude our suppliers. We are not the exclusive supplier of any data storageproduct we offer.  Instead, oursuppliers market their products through other independent data storage solutionproviders, original

18

----

 

equipment manufacturers and, often, through their own internal salesforces. We believe direct competition from our suppliers is likely to increaseif, as expected, the data storage industry continues to consolidate. Thisconsolidation would probably result in fewer suppliers with greater resourcesto devote to internal sales and marketing efforts. In addition, our suppliershave established and will probably continue to establish cooperativerelationships with other suppliers and other data storage solution providers.These cooperative relationships are often intended to enable our suppliers tooffer comprehensive storage solutions, which compete with those we offer. Ifour relationships with our suppliers become adversarial, it will be moredifficult for us to stay ahead of industry developments and provide ourcustomers with the type of service they expect from us.

 

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

 

**Our growth plansdepend in part on our ability to successfully complete acquisitions.**

 

As part of our growth plan, we intend to continueto pursue strategic acquisitions of businesses that give us access toadditional qualified technical personnel and either expand or complement ourbusiness. To date we have completed two such acquisitions.  However, our last acquisition was inNovember 2000 and we cannot assure any further acquisitions.  If we do not make more suitable acquisitions,we will find it more difficult to realize our growth objectives.

 

If we do make acquisitions, we will face a numberof other risks and challenges, including:

 

•                                        the difficulty of integrating dissimilaroperations or assets;

 

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

 

•                                        diversion of management time and resources;

 

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

 

•                                        potential loss of key employees of an acquiredcompany; and

 

•                                        additional costs associated with obtaining anynecessary financing.

 

These factors and our limited experience innegotiating, consummating and integrating acquisitions could hamper our abilityto realize our growth objectives, and could adversely affect our business,earnings, financial condition and, ultimately, our stock price. Acquisitionsthat use stock as payment, also could result in dilution of our per shareearnings, and of your voting rights.

 

**Our businessdepends on our ability to hire and retain scarce technical personnel.**

 

Our future operating results depend upon ourability to attract, retain and motivate qualified engineers withenterprise-class information storage solutions experience. If we fail torecruit and retain additional engineering personnel, we will experience greaterdifficulty realizing our growth strategy, which could negatively affect ourbusiness, financial condition and stock price.

 

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

 

In 2001, we derived 9% of our revenues from onecustomer, and our top five customers collectively accounted for 21% of ourrevenues. Because we intend to continue to seek out large projects, we expectthat a significant percentage of our revenues will continue to come from asmall number of customers, although the composition of our key customers islikely 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 year toyear. Unpredictable revenue and profit fluctuations may make our stock pricemore volatile and lead to a decline in our stock price.

 

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

 

We increasingly sell complex enterprise-classinformation storage solutions.  We donot recognize revenues from our sale of hardware and software products to ourcustomers until we complete our required installation or configuration of theseproducts.  Installation andconfiguration of these solutions requires significant coordination with ourcustomers and vendors.  Therefore, evenif we have shipped all products to our customers, we may be unable to controlthe timing of product installation and configuration.  These delays prevent us from recognizing revenue on products weship and may adversely affect our quarterly reported revenues.  As a result, our stock price may decline.

 

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

 

Under new SEC accountingrules, we no longer amortize goodwill. Instead, we perform impairment analyses of our goodwill whenever webelieve it is impaired.  Future eventscould cause us to conclude that impairment indicators exist and that goodwillassociated with our acquired businesses is further impaired.  Any resulting impairment loss could have amaterial adverse impact on our financial condition and results of operations.

19

----

 

**We rely on onlya few key suppliers and would suffer materially if we could not obtain theirproducts.**

 

We rely on our close relationships with oursuppliers to provide access to products and new technology necessary to designand implement leading-edge enterprise-class information storage solutions forour customers. We do not have long-term supply contracts with any of oursuppliers. In many instances, we rely upon only one or two suppliers for eachof our key products. Our reliance on these suppliers leaves us vulnerable to aninadequate supply of required products, price increases, late deliveries andpoor product quality. Disruption or termination of the supply of products fromour suppliers for any reason would likely prevent or delay our shipments to ourcustomers. Our customers expect reliable and prompt service from us. If wecannot obtain necessary components, or the components we obtain are unreliableor unexpectedly expensive, we will not meet our customers’ expectations. If wecannot meet our customers’ expectations, our business will suffer considerably.

 

**We generally donot have employment agreements with our key employees.**

 

Ourfuture operating results depend in significant part upon the continuedcontributions of our executive officers, managers, salespeople, engineers andother technical personnel, many who have substantial experience in our industryand would be difficult to replace. In general, we do not have employment,non-competition or nondisclosure agreements with our officers or employees.Accordingly, our employees may voluntarily leave us at any time and work forour competitors. Our growth strategy depends in part on our ability to retainour current 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.  We do not have employment,non-competition or non-disclosure agreements with any of our executive officersor employees, other than non-competition agreements entered into in connectionwith the acquisition of Direct Connect Systems, Inc. and non-competitionagreements assigned to us in connection with the acquisition of certain assetsof OpenSystems.com, Inc.

 

**If we cannoteffectively manage our future growth, our business may suffer.**

 

Our planned growth and expansion, if realized inlight of current economic conditions, would place a significant strain on ouradministrative, operational and financial resources. This growth may alsoincrease demands on our professional and technical services, sales, marketingand customer service and support functions. Our planned geographic expansionmay exacerbate these challenges and require us to hire, train, motivate andmanage new management, technical, sales and administrative employees. If wemanage this planned growth poorly, we may be unable to continue to provide ourcustomers with the high level of technical service and expertise they expectfrom us. This failure would harm our reputation, hamper our ability to grow andadversely affect our financial condition and stock price.

 

In addition, our planned geographic expansion, ifrealized in light of current economic conditions, will increase our costs andmake it more difficult to manage our operations. As a result, we may notachieve commercial success or maintain client service and support at historiclevels. If we fail to manage our growth and generate sufficient revenues tooffset the additional costs of geographical expansion, our profitability,financial condition and stock price will likely suffer.

 

**If the datastorage industry fails to develop compelling new storage technologies, ourbusiness may suffer.**

 

Rapid and complex technological change, frequentnew product introductions and evolving industry standards increase demand forour services. Because of this, our future success depends in part on the datastorage industry’s ability to continue to develop leading-edge storagetechnology solutions. Our customers utilize our services in part because theyknow that newer technologies offer them significant benefits over the oldertechnologies they are using. If the data storage industry ceases to developcompelling new storage solutions, or if a single data storage standard becomeswidely accepted and implemented, it will be more difficult to sell new data storagesystems to our customers.

 

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

 

Our sales cycle is typically long andunpredictable, making it difficult to plan our business. Current economic conditionshave 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.

 

20

----

 

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

 

Currently, our executive officers, directors and5% or greater stockholders and their affiliates beneficially own approximately65% of our outstanding common stock. Acting together, these insiders couldelect our entire Board of Directors and control the outcome of all othermatters requiring stockholder approval. This voting concentration may also havethe effect of delaying or preventing a change in our management or control orotherwise discourage potential acquirers from attempting to gain control of us.If potential acquirers are deterred, you may lose an opportunity to profit froma possible acquisition premium in our stock price.

 

**Our stock priceis volatile.**

 

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

 

•                                        actual or anticipated fluctuations in ouroperating results;

 

•                                        announcements of technical innovations;

 

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

 

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

 

•                                        general market conditions.

 

In addition, the stock market has recently experiencedsignificant downward price fluctuations. Over the past several years, companiesin the technology sector, such as Datalink, have experienced more stock pricevolatility than companies in other sectors of the market and may be morevulnerable to price declines in the event of a general market decline.

 

**We may be liablefor warranty claims.**

 

Products we offer may contain defects in hardware,software or workmanship that remain undetected or that may not become apparentuntil after commercial shipment. If a supplier were to fail to meet itswarranty obligations to us, we might be liable to our customers. We do notmaintain insurance for these expenses. We cannot assure you that our supplierswill be willing or able to honor their warranties, that we may not incur ourown uninsured warranty costs or that our repair and maintenance subcontractorswill perform their services in a timely and proper manner.

 

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

 

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

 

**Item 7A.  Quantitative and Qualitative Disclosuresabout 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 marketrisk related to changes in interest rates, foreign exchange rates and equityprices.

 

*Interest rate risk.*  As ofDecember 31, 2001, we had $5.8 million of cash and money market accounts.A decrease in market rates of interest would have no material effect on thevalue of these assets. We have no short or long-term debt with variableinterest rates. Therefore, an increase in market rates would not significantlyaffect our financial results.

 

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

 

*Equity price risk.*  We do not own any equityinvestments. Therefore, we are not currently exposed to any direct equity pricerisk.

 

21

----

 

**Item 8.  Financial Statements and Supplementary Data.**

 

**Report ofIndependent Public Accountants**

 

To Datalink Corporation:

 

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

 

We conducted our audit inaccordance with auditing standards generally accepted in the United States.Those standards require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements. An audit also includesassessing the accounting principles used and significant estimates made bymanagement, as well as evaluating the overall financial statement presentation.We believe that our audit provides a reasonable basis for our opinion.

 

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

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

 

**REPORT OF INDEPENDENT ACCOUNTANTS**

 

Tothe Stockholders and Board of Directors of Datalink Corporation:

 

In our opinion, the accompanying consolidatedbalance sheets and the related consolidated statements of operations, stockholders’equity (deficiency) and cash flows present fairly, in all material respects,the financial position of Datalink Corporation and its subsidiary as ofDecember 31, 2000, and the results of their operations and their cashflows for each of the two years in the period ended December 31, 2000, inconformity with accounting principles generally accepted in the United Statesof America. These financial statements are the responsibility of the Company’smanagement; our responsibility is to express an opinion on these financialstatements based on our audits. We conducted our audits of these statements inaccordance with auditing standards generally accepted in the United States ofAmerica which require that we plan and perform the audit to obtain reasonableassurance about whether the financial statements are free of materialmisstatement. An audit includes examining, on a test basis, evidence supportingthe amounts and disclosures in the financial statements, assessing theaccounting principles used and significant estimates made by management, andevaluating the overall financial statement presentation. We believe that ouraudits provide a reasonable basis for our opinion.

 

As discussed in Note 2 to the consolidatedfinancial statements, the Company adopted the provisions of the Securities andExchange Commission’s Staff Accounting Bulletin No. 101 relating to revenuerecognition.

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

 

22

----

 

**DATALINK CORPORATION**

**BALANCE SHEETS**

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

 
|                                                                                                                                                                     |   | **December 31,** |       |
|--------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-----------------------|------------|
|                                                                                                                                                                     |   | **2001**              |       | **2000** |   |
| **Assets**                                                                                                                                                               |   |                  |       |   |   |
| Current assets:                                                                                                                                                          |   |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                |   | $                     | 5,846      |   | $ | 4,542 |   |
| Accounts receivable, net                                                                                                                                                 |   | 15,127                |       | 16,255 |   |
| Inventories                                                                                                                                                              |   | 3,885                 |       | 8,162 |   |
| Inventories shipped but not installed                                                                                                                                    |   | 2,922                 |       | 6,790 |   |
| Income tax receivable                                                                                                                                                    |   | 1,610                 |       | — |   |
| Deferred income taxes                                                                                                                                                    |   | 1,435                 |       | 2,401 |   |
| Other current assets                                                                                                                                                     |   | 289                   |       | 744 |   |
| Total current assets                                                                                                                                                     |   | 31,114                |       | 38,894 |   |
| Property and equipment, net                                                                                                                                              |   | 6,341                 |       | 6,434 |   |
| Goodwill and other intangibles, net                                                                                                                                      |   | 8,723                 |       | 10,811 |   |
| Other                                                                                                                                                                    |   | 590                   |       | 333 |   |
| Total assets                                                                                                                                                             |   | $                     | 46,768     |   | $ | 56,472 |   |
|                                                                                                                                                                     |   |                  | ** ** |   | ** ** |
| **Liabilities and Stockholders’ Equity**                                                                                                                            |   |                  | ** ** |   | ** ** |
| Current liabilities:                                                                                                                                                     |   |                  |       |   |   |
| Accounts payable                                                                                                                                                         |   | $                     | 15,210     |   | $ | 19,664 |   |
| Accrued commissions                                                                                                                                                      |   | 889                   |       | 1,781 |   |
| Accrued sales and use tax                                                                                                                                                |   | 709                   |       | 1,166 |   |
| Accrued expenses, other                                                                                                                                                  |   | 583                   |       | 1,074 |   |
| Income taxes payable                                                                                                                                                     |   | —                |       | 518 |   |
| Note payable to former stockholder, current portion                                                                                                                      |   | 704                   |       | 705 |   |
| Deferred revenue                                                                                                                                                         |   | 2,290                 |       | 2,291 |   |
|                                                                                                                                                                     |   |                  |       |   |   |
| Total current liabilities                                                                                                                                                |   | 20,385                |       | 27,199 |   |
| Note payable to former stockholder, less current  portion                                                                                                                |   | —                |       | 704 |   |
| Obligation for construction in progress                                                                                                                                  |   | —                |       | 1,968 |   |
| Deferred rent                                                                                                                                                            |   | 269                   |       | — |   |
| Deferred income taxes                                                                                                                                                    |   | —                |       | 464 |   |
| Total current liabilities                                                                                                                                                |   | 20,654                |       | 30,335 |   |
|                                                                                                                                                                     |   |                  |       |   |   |
| Commitments and contingencies (Note 5)                                                                                                                                   |   |                  |       |   |   |
|                                                                                                                                                                     |   |                  |       |   |   |
| Stockholders’ equity:                                                                                                                                               |   |                  |       |   |   |
| Common stock, $0.001 par value, 50,000,000 shares  authorized, 8,951,343 and 8,895,850shares  issued and outstanding as of December 31, 2001 and 2000, respectively |   | 9                     |       | 9 |   |
| Additional paid-in capital                                                                                                                                               |   | 20,205                |       | 19,723 |   |
| Retained earnings                                                                                                                                                        |   | 5,900                 |       | 6,405 |   |
| Total stockholders’ equity                                                                                                                                          |   | 26,114                |       | 26,137 |   |
| Total liabilities and stockholders’ equity                                                                                                                          |   | $                     | 46,768     |   | $ | 56,472 |   |

 

The accompanying notes are an integralpart of these financial statements.

 

23

----

 

**DATALINK CORPORATION**

**STATEMENTS OF OPERATIONS**

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

 
|                                                                                        |   | **Year Ended December 31,** |   |
|---------------------------------------------------------------------------------------------|--------|----------------------------------|--------|
|                                                                                        |   | **2001**                         |   | **2000** |   | **1999** |   |
| Net Sales:                                                                                  |   |                             |   |   |   |   |   |
| Product sales                                                                               |   | $                                | 96,188 |   | $ | 118,233 |   | $ | 105,373 |   |
| Service sales                                                                               |   | 28,596                           |   | 19,536 |   | 11,230 |   |
| Total net sales                                                                             |   | 124,784                          |   | 137,769 |   | 116,603 |   |
|                                                                                        |   |                             |   |   |   |   |   |
| Cost of sales:                                                                              |   |                             |   |   |   |   |   |
| Cost of product sales                                                                       |   | 70,393                           |   | 87,321 |   | 77,623 |   |
| Cost of services                                                                            |   | 20,328                           |   | 14,148 |   | 8,411 |   |
| Total cost of sales                                                                         |   | 90,721                           |   | 101,469 |   | 86,034 |   |
| Gross profit                                                                                |   | 34,063                           |   | 36,300 |   | 30,569 |   |
| Operating expenses:                                                                         |   |                             |   |   |   |   |   |
| Sales and marketing                                                                         |   | 15,836                           |   | 15,230 |   | 11,702 |   |
| General and administrative                                                                  |   | 11,221                           |   | 8,792 |   | 6,883 |   |
| Engineering                                                                                 |   | 5,259                            |   | 3,745 |   | 2,594 |   |
| Amortization of goodwill and other intangibles                                              |   | 2,264                            |   | 1,026 |   | 807 |   |
| Offering costs                                                                              |   | —                           |   | 381 |   | 173 |   |
| Operating (loss) income                                                                     |   | (517                             | )      | 7,126 |   | 8,410 |   |
| Interest income (expense), net                                                              |   | 127                              |   | 311 |   | (141 | ) |
|                                                                                        |   |                             |   |   |   |   |   |
| (Loss) income before income taxes and cumulative effect  of a change inaccounting principle |   | (390                             | )      | 7,437 |   | 8,269 |   |
| Income tax expense                                                                          |   | 115                              |   | 3,049 |   | 897 |   |
| (Loss) income before cumulative effect of a change in  accounting principle                 |   | (505                             | )      | 4,388 |   | 7,372 |   |
| Cumulative impact of change in accounting principle,  net of income taxes                   |   | —                           |   | (753 | ) | — |   |
| Net (loss) income                                                                           |   | $                                | (505   | ) | $ | 3,635 |   | $ | 7,372 |   |
|                                                                                        |   |                             |   |   |   |   |   |
| Net (loss) income per share, basic:                                                         |   |                             |   |   |   |   |   |
| (Loss) income per share before cumulative effect of a  change in accounting principle       |   | $                                | (0.06  | ) | $ | 0.50 |   | $ | 1.01 |   |
| Loss per share from the cumulative effect of a change  in accounting principle              |   | —                           |   | (0.09 | ) | — |   |
| Net (loss) income per share                                                                 |   | $                                | (0.06  | ) | $ | 0.41 |   | $ | 1.01 |   |
|                                                                                        |   |                             |   |   |   |   |   |
| Net (loss) income per share, diluted:                                                       |   |                             |   |   |   |   |   |
| (Loss) income per share before cumulative effect of a  change in accounting principle       |   | $                                | (0.06  | ) | $ | 0.48 |   | $ | 0.99 |   |
| Loss per share from the cumulative effect of a change  in accounting principle              |   | —                           |   | (0.08 | ) | — |   |
| Net (loss) income per share                                                                 |   | $                                | (0.06  | ) | $ | 0.40 |   | $ | 0.99 |   |
|                                                                                        |   |                             |   |   |   |   |   |
| Weighted average shares outstanding:                                                        |   |                             |   |   |   |   |   |
|                                                                                        |   |                             |   |   |   |   |   |
| Basic                                                                                       |   | 8,921                            |   | 8,794 |   | 7,295 |   |
| Diluted                                                                                     |   | 8,921                            |   | 9,166 |   | 7,437 |   |

 

The accompanying notes are anintegral part of these financial statements.

 

24

----

 

**DATALINK CORPORATION**

**STATEMENT OF STOCKHOLDERS’ EQUITY (DEFICIENCY)**

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

 
|                                                                            |   | **Common  Stock** |   |       |   |                            |   |                                          |   |
|---------------------------------------------------------------------------------|--------|-------------------|--------|------------|--------|---------------------------------|--------|-----------------------------------------------|--------|
|                                                                            |   | **Shares**        |   | **Amount** |   | **Additional  Paid-in Capital** |   | **Retained  Earnings  (Accumulated Deficit)** |   | **Total** |   |
| Balances, December 31, 1998                                                |   | 7,100             |   | $          | — |                            | $      | —                                        |   | $ | (6,979 | ) | $ | (6,979 | ) |
| Net income                                                                      |   | —            |   | —     |   | —                          |   | 7,372                                         |   | 7,372 |   |
| Cash dividends of $0.14 per share                                               |   | —            |   | —     |   | —                          |   | (998                                          | )      | (998 | ) |
| Repurchase of common stock                                                      |   | (1,096            | )      | —     |   | —                          |   | (3,020                                        | )      | (3,020 | ) |
| Cash dividends of $0.44 per share                                               |   | —            |   | —     |   | —                          |   | (2,648                                        | )      | (2,648 | ) |
| Accretion of common stock value                                                 |   | —            |   | —     |   | —                          |   | (3,456                                        | )      | (3,456 | ) |
| Termination of put options                                                      |   | —            |   | 6          |   | —                          |   | 22,510                                        |   | 22,516 |   |
| Common shares issued for cash less $2,321 offering  costs                       |   | 2,702             |   | 3          |   | 18,213                          |   | —                                        |   | 18,216 |   |
| Issuance of additional shares in acquisition                                    |   | 67                |   | —     |   | —                          |   | —                                        |   | — |   |
| Distribution of previously taxed, but undistributed S  corporation earnings     |   | —            |   | —     |   | —                          |   | (9,128                                        | )      | (9,128 | ) |
| Cash dividend payable to S corporation stockholders                             |   | —            |   | —     |   | —                          |   | (744                                          | )      | (744 | ) |
| Balances, December 31, 1999                                                |   | 8,773             |   | 9          |   | 18,213                          |   | 2,909                                         |   | 21,131 |   |
| Net income                                                                      |   | —            |   | —     |   | —                          |   | 3,635                                         |   | 3,635 |   |
| Compensation expense related to stock options                                   |   | —            |   | —     |   | 122                             |   | —                                        |   | 122 |   |
| Common shares issued under employee stock purchase plan  and stock option plans |   | 44                |   | —     |   | 388                             |   | —                                        |   | 388 |   |
| Issuance of   shares in acquisition (Note 8)                               |   | 79                |   | —     |   | 1,000                           |   | —                                        |   | 1,000 |   |
| Cash dividend paid to S corporation stockholders                                |   | —            |   | —     |   | —                          |   | (139                                          | )      | (139 | ) |
| Balances, December 31, 2000                                                |   | 8,896             |   | 9          |   | 19,723                          |   | 6,405                                         |   | 26,137 |   |
| Net loss                                                                        |   | —            |   | —     |   | —                          |   | (505                                          | )      | (505 | ) |
| Compensation expense related to stock options                                   |   | —            |   | —     |   | 119                             |   | —                                        |   | 119 |   |
| Common shares issued under employee stock purchase plan  and stock option plans |   | 55                |   | —     |   | 363                             |   | —                                        |   | 363 |   |
| Balances, December 31, 2001                                                |   | 8,951             |   | $          | 9      |                            | $      | 20,205                                        |   | $ | 5,900 |   | $ | 26,114 |   |

 

The accompanying notes are anintegral part of these financial statements.

 

25

----

 

**DATALINKCORPORATION**

**STATEMENTS OF CASH FLOWS**

**(In thousands)**

 
|                                                                                      |   | **Year Ended  December 31,** |       |
|-------------------------------------------------------------------------------------------|--------|-----------------------------------|------------|
|                                                                                      |   | **2001**                          | ** ** | **2000** | ** ** | **1999** | ** ** |
| Cash flows from operating activities:                                                     |   |                              | ** ** |   | ** ** |   |   |
| Net (loss) income                                                                         |   | $                                 | (505       | ) | $ | 3,635 |   | $ | 7,372 |   |
| Adjustments to reconcile net (loss) income to net cash  provided by operating activities: |   |                              |       |   |   |   |   |
| Provision for bad debts                                                                   |   | 115                               |       | 89 |   | 202 |   |
| Cumulative effect of change in accounting principle                                       |   | —                            |       | 754 |   | — |   |
| Depreciation and amortization                                                             |   | 2,425                             |       | 1,471 |   | 1,040 |   |
| Amortization of intangibles                                                               |   | 2,264                             |       | 1,026 |   | 826 |   |
| Deferred income taxes                                                                     |   | 305                               |       | (1,563 | ) | (716 | ) |
| Deferred rent                                                                             |   | 269                               |       | — |   | — |   |
| Stock compensation expense                                                                |   | 119                               |       | 122 |   | — |   |
| Changes in operating assets and liabilities:                                              |   |                              |       |   |   |   |   |
| Accounts receivable                                                                       |   | 1,013                             |       | (2,825 | ) | (3,844 | ) |
| Inventories                                                                               |   | 8,145                             |       | (1,440 | ) | (2,833 | ) |
| Other current assets                                                                      |   | (45                               | )          | 117 |   | (97 | ) |
| Other assets                                                                              |   | (60                               | )          | (108 | ) | (70 | ) |
| Accounts payable                                                                          |   | (4,454                            | )          | 5,969 |   | 442 |   |
| Accrued expenses                                                                          |   | (1,840                            | )          | 1,704 |   | 622 |   |
| Income taxes                                                                              |   | (2,128                            | )          | 295 |   | 257 |   |
| Deferred revenue                                                                          |   | (1                                | )          | 1,360 |   | 293 |   |
| Net cash provided by operating activities                                                 |   | 5,622                             |       | 10,606 |   | 3,494 |   |
| Cash flows from investing activities:                                                     |   |                              |       |   |   |   |   |
| Purchase of property and equipment                                                        |   | (4,300                            | )          | (3,371 | ) | (1,088 | ) |
| Deposit on lease arrangement                                                              |   | 500                               |       | (500 | ) | — |   |
| Net assets acquired, net of cash acquired                                                 |   | (176                              | )          | (7,495 | ) | — |   |
| Net cash used in investing activities                                                     |   | (3,976                            | )          | (11,366 | ) | (1,088 | ) |
| Cash flows from financing activities:                                                     |   |                              |       |   |   |   |   |
| Proceeds from borrowings on line of credit                                                |   | —                            |       | 5,335 |   | 74,064 |   |
| Principal payments on line of credit                                                      |   | —                            |       | (5,335 | ) | (77,274 | ) |
| Proceeds from issuance of common stock, net                                               |   | 363                               |       | 388 |   | 18,215 |   |
| Distributions paid                                                                        |   | —                            |       | (883 | ) | (12,774 | ) |
| Payments of notes payable to former stockholder                                           |   | (705                              | )          | (705 | ) | (906 | ) |
| Principal payments on capital lease obligations                                           |   | —                            |       | (13 | ) | (14 | ) |
| Net cash (used in) provided by financing activities                                       |   | (342                              | )          | (1,213 | ) | 1,311 |   |
| Increase (decrease) in cash and cash equivalents                                          |   | 1,304                             |       | (1,973 | ) | 3,717 |   |
| Cash and cash equivalents, beginning of period                                            |   | 4,542                             |       | 6,515 |   | 2,798 |   |
| Cash and cash equivalents, end of period                                                  |   | $                                 | 5,846      |   | $ | 4,542 |   | $ | 6,515 |   |
|                                                                                      |   |                              |       |   |   |   |   |
| **Supplementary Cash Flow Information:**                                                  |   |                              | ** ** |   | ** ** |   | ** ** |
|                                                                                      |   |                              | ** ** |   | ** ** |   | ** ** |
| Cash paid for interest                                                                    |   | $                                 | 132        |   | $ | 95 |   | $ | 251 |   |
| Cash paid for income taxes                                                                |   | 1,936                             |       | 4,000 |   | 1,400 |   |
| Significant noncash financing and investing  transactions:                                |   | —                            |       | — |   | — |   |
| Stock issued to purchase certain assets of  OpenSystems.com, Inc.                         |   | —                            |       | 1,000 |   |   |   |
| Stock issued to purchase DCSI                                                             |   | —                            |       | — |   | 67 |   |
| Obligation for construction in progress                                                   |   | (1,968                            | )          | 1,968 |   | — |   |
| Repurchase of stock in exchange for note                                                  |   | —                            |       | — |   | 3,020 |   |

 

The accompanying notes are anintegral part of these financial statements.

 

26

----

 

**DATALINK CORPORATION**

**NOTES TO FINANCIAL STATEMENTS**

 

**1. Descriptionof Business:**

 

DatalinkCorporation (the “Company”) is an independent architect of enterprise-class informationstorage infrastructures. The Company derives its revenues principally fromdesigning and installing data storage systems. The Company’s solutions caninclude hardware products, such as disk arrays, tape systems, interconnectioncomponents, and storage management software products. The Company is frequentlyengaged to provide assistance in the installation of solutions and to providesupport services subsequent to the installation. Occasionally, the Company isengaged for consulting services.

 

The Company views its operations and manages itsbusiness as one segment, the design and installation of high-endenterprise-class information storage solutions. Factors used to identify theCompany’s single operating segment include the organizational structure of theCompany and the financial information available for evaluation by the chiefoperating decision maker in making decisions about how to allocate resourcesand assess performance. During 2001, 2000 and 1999, net sales to one customertotaled 9%, 15% and 13% of total net sales, respectively.

 

**2. Summary ofSignificant Accounting Policies:**

 

***Cash Equivalents:***

 

Cash equivalents consist principally of moneymarket funds with original maturities of three months or less, are readilyconvertible to cash and are stated at cost, which approximates fair value.

 

***AccountsReceivable, net:***

 

Accounts receivable are recorded net of thereserve for doubtful accounts of $164,000 and $75,000 at December 31, 2001 and2000, respectively.

 

***Inventories:***

 

Inventories, including inventories shipped but notinstalled, principally consist of data storage products and components, thatare valued at the lower of cost or market with cost determined on a first-in,first-out (FIFO) method.

 

***Propertyand Equipment:***

 

Property and equipment, including purchasedsoftware, are stated at cost. Depreciation and amortization are provided bycharges to operations using the straight-line method over the estimated usefullives of the assets (ranging from 2 to 10 years). Leasehold improvements areamortized on a straight-line basis over the shorter of their estimated usefullives or the underlying lease term. The costs and related accumulateddepreciation and amortization on asset disposals are removed from the accountsand any gain or loss is included in operations. Major renewals and bettermentsare capitalized, while maintenance and repairs are charged to currentoperations when incurred.

 
|                                           |   | **December 31,** |   |
|------------------------------------------------|--------|-----------------------|--------|
|                                           |   | **2001**              |   | **2000** |   |
|                                           |   | **(In thousands)**    |   |
| Property and equipment:                        |   |                  |   |   |   |
| Land                                           |   | $                     | 384    |   | $ | 384 |   |
| Construction in process                        |   | 588                   |   | 1,968 |   |
| Leasehold improvements                         |   | 538                   |   | 442 |   |
| Equipment                                      |   | 3,732                 |   | 2,950 |   |
| Computers and software                         |   | 5,900                 |   | 4,404 |   |
|                                           |   | 11,142                |   | 10,148 |   |
| Less accumulated depreciation and amortization |   | 4,801                 |   | 3,714 |   |
|                                           |   | $                     | 6,341  |   | $ | 6,434 |   |

 

27

----

 

During 2000, the Company began the implementationof a new customer relationship management (CRM) application suite. The Companycapitalized costs of the implementation of $1.0 million in 2001 and $624,000 in2000.  Amounts are being amortized overa period of 3 years from the date they are available for use.  Amortization of software costs was $139,000in 2001.

 

***Goodwilland Other Intangibles:***

 

Identifiable intangible assets and goodwill areamortized on a straight–line basis over their estimated useful lives of 3to 7 years.

 
|                          |   | **December 31,** |   |
|-------------------------------|--------|-----------------------|--------|
|                          |   | **2001**              |   | **2000** |   |
|                          |   | **(In thousands)**    |   |
| Intangibles:                  |   |                  |   |   |   |
| Customer lists                |   | $                     | 4,300  |   | $ | 4,300 |   |
| Noncompetition agreements     |   | 500                   |   | 500 |   |
| Assembled workforce           |   | 1,190                 |   | 1,190 |   |
| Trademark and tradename       |   | 450                   |   | 450 |   |
| Goodwill                      |   | 6,756                 |   | 6,580 |   |
|                          |   | 13,231                |   | 13,020 |   |
| Less accumulated amortization |   | 4,473                 |   | 2,209 |   |
|                          |   | $                     | 8,723  |   | $ | 10,811 |   |

 

***Valuationof Long-Lived Assets:***

 

The Company periodically (at least quarterly)analyzes its long-lived assets 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.

 

***IncomeTaxes:***

 

Concurrent with the closing of its initial publicoffering on August 6, 1999, the Company terminated its status as an Scorporation. Accordingly, the Company’s income is subject to state and federalincome taxes. The Company calculates income taxes in accordance with theprovisions of SFAS No. 109, “Accounting for Income Taxes,” which requires theuse of the liability method of accounting for income taxes. Under the liabilitymethod, deferred income taxes are recorded to reflect the tax consequences infuture years of temporary differences between the tax bases of assets andliabilities and their financial reporting amounts using enacted tax rates forthe years in which these items are expected to affect taxable income. TheCompany establishes valuation allowances when necessary to reduce deferred taxassets to the amount the Company expects to realize. Income tax expense is thetax payable for the period and the change during the period in deferred taxassets and liabilities.

 

***Useof Estimates:***

 

The preparation of financial statements inconformity with accounting principles generally accepted in the United Statesrequires management to make estimates and assumptions that affect the reportedamounts of assets and liabilities and disclosure of contingent assets andliabilities at the date of the financial statements and the reported amounts ofrevenues and expenses during the reporting period. Actual results could differfrom those estimates.

 

***RevenueRecognition:***

 

In December 1999, the SEC staff issued StaffAccounting Bulletin (“SAB”) No. 101, “Revenue Recognition,” whichclarified the SEC staff’s views regarding the recognition and reporting ofrevenues in certain transactions. In consideration of the views expressed inSAB No. 101 and effective as of January 1, 2000, the Company modifiedits revenue recognition policy related to products when the Company providesany installation or configuration services in connection with the sale. TheCompany now recognizes revenue from hardware and software product sales when itcompletes its installation and configuration services or after the customer hasaccepted products under evaluation. Under the transition provisions outlined inSAB No. 101, the Company accounted for this change in accounting policy prospectivelyas of January 1, 2000 and recorded a charge to earnings on that date of$753,000 representing the cumulative effect, net of income taxes, of the changein accounting policy. Prior to January 1, 2000, the Company recognizedproduct revenue when the hardware and software was shipped to its customers orafter they accepted products under evaluation.

 

28

----

 

The Company recognizes installation and consultingservice revenue as it renders these services.

 

The Company also sells service contracts to mostof its customers.  These contracts aresupport service agreements.  The Companyhas an internal support desk to provide integrated customer supportservices.  The Company fulfills on-siteassistance by purchasing support service agreements for customers from thehardware and software vendors or their designated third-party service providersand by arranging on-site support assistance with the appropriate vendor whennecessary. Revenues and direct costs resulting from these contracts aredeferred and amortized into operations over the term of the contracts, whichare generally twelve months.  TheCompany is contractually obligated to provide or arrange to provide theseunderlying support services to its customers in the unlikely event that thehardware or software vendor, or its designee, fails to perform according to theterms of its contract.

 

The following table presents the estimatedconsolidated results of operations of the Company on an unaudited proformabasis as if SAB No. 101 guidance had been effective in 1999:

 
|                          |   | **1999**                                       |    |
|-------------------------------|--------|------------------------------------------------|---------|
|                          |   | **(In thousands, except per share data)** |    |
| Net sales                     |   | $                                              | 117,770 |   |
| Net income                    |   | $                                              | 7,628   |   |
| Net income per share, basic   |   | $                                              | 1.04    |   |
| Net income per share, diluted |   | $                                              | 1.03    |   |

 

Net sales, gross profit, net income and net incomeper share for the fourth quarter of 1999 would have been approximately $33.3million, $8.8 million, $2.2 million and $0.31, respectively on an unauditedproforma basis if SAB No. 101 had been effective in that period.

 

***OfferingCosts:***

 

The Company initially deferred costs related toits initial public offering incurred during the first quarter of 1999 totaling$173,000.  The Company expensed thesecosts during the first quarter of 1999, respectively, when the offering wasdelayed due to market conditions.

 

On March 7, 2000, the Company filed a registration statement withthe SEC for a second public offering of 2,500,000 shares of its common stock.On May 15, 2000, the Company withdrew this registration statement due to marketconditions. As required, the Company expensed the previously deferred costs of$381,000 related to the offering.

 

***NetIncome (Loss) Per Share:***

 

Basic net income (loss) per share is computedusing the weighted average number of shares outstanding. Diluted net income pershare includes the effect of common stock equivalents, if any, for each period.The impact of stock options have been included in the computation of dilutedincome per share, increasing the weighted average number of shares outstandingby 141,847 and 371,880 shares in 1999 and 2000, respectively. Due to the netloss in 2001, common stock equivalents of 62,564 were anti-dilutive to earningsand as a result were excluded from the calculation of diluted loss per share.

 

***ComprehensiveIncome:***

 

The Company’s comprehensive income is equal to itsnet income for all periods presented.

 

***RecentlyIssued Accounting Standards:***

 

In June 1999, the FASB issued Statement ofAccounting Standards No. 137, “Accounting for Derivative Instruments andHedging Activities — Deferral of the Effective Date of FASB Statement No.133.”  SFAS No. 133 establishesaccounting and reporting standards for derivative instruments, includingderivative instruments embedded in other contracts, and for hedgingactivities.  SFAS 137 as amended by SFASNo. 138 is effective for the Company in the first quarter of the year beginningJanuary 1, 2001.  The adoption of SFAS133 on January 1, 2001 did not have any impact on the Company’s consolidatedfinancial position or results of operations.

 

In June 2001, FASB approved for issuance Statement ofFinancial Accounting Standards (SFAS) 141, Business Combinations, and SFAS 142,Goodwill and Intangible Assets.  For allbusiness combinations initiated after June 30, 2001, these Statements requirethe use of the purchase, rather than the pooling, method of accounting.  Intangible assets acquired in a business

 

29

----

 

combination are recordedseparately from goodwill if they arise from contractual or other legal rightsor are separable from the acquired entity and can be sold, transferred,licensed, rented or exchanged, either individually or as part of a relatedcontract, asset or liability.

 

The Statementsalso provide that effective January 1, 2002, goodwill is no longeramortized.  Instead, goodwill andintangible assets with indefinite lives are generally tested for impairmentannually and whenever there is an impairment indicator.  All acquired goodwill is assigned toreporting units for purposes of impairment testing.

 

The Company does not expect to incur anytransitional goodwill impairment losses on our unamortized goodwill balancesupon adoption of these Statements, which totaled $4.8 million at December 31,2001.  Effective January 1, 2002, theCompany ceased amortization of goodwill. Amortization of goodwill was $1.2 million in 2001.  The Company will continue to amortize otheridentified intangibles with determinable lives, which totaled $3.2 million atDecember 31, 2001.

 

In July 2001, the FASB issued SFAS No. 144,“Impairment or Disposal of Long-Lived Assets,” which is effective for fiscalyears beginning after December 15, 2001. The provisions of this Statementprovide a single accounting model for impairment of long-lived assets. The adoptionof SFAS No. 144 on January 1, 2002 did not have a material impact on theCompany’s financial position or its results of operations.

 

**3. BorrowingArrangements:**

 

Effective June 30, 2000, the Company entered intoa revolving credit agreement (the “Credit Agreement”) with a bank.  Under the terms of the Credit Agreement, theCompany may borrow up to $10 million to be used for financing potentialacquisitions, and $5 million for financing working capital needs. Borrowingsunder the Credit Agreement are collateralized by the accounts receivable andinventory of the Company and generally bear interest at the prime rate minusone percent. The Credit Agreement includes various covenants, includingrequirements to maintain a minimum current ratio, debt-net worth ratio,tangible net worth and level of profitability. The credit agreement was amendedas of February 13, 2002 to modify existing covenants.  There were no borrowings under the credit agreement as ofDecember 31, 2001.

 

**4. Income Taxes:**

 

Significant components of the provision for incometaxes are as follows:

 
|                           |   | **Year Ended December 31,** |   |
|--------------------------------|--------|----------------------------------|--------|
|                           |   | **2001**                         |   | **2000** |   | **1999** |   |
|                           |   | **(In thousands)**               |
| Current:                       |   |                             |   |   |   |   |   |
| Federal                        |   | $                                | (186   | ) | $ | 4,072 |   | $ | 1,267 |   |
| State                          |   | (4                               | )      | 540 |   | 346 |   |
| Total current tax provision    |   | (190                             | )      | 4,612 |   | 1,613 |   |
| Deferred:                      |   |                             |   |   |   |   |   |
| Federal                        |   | 250                              |   | (1,380 | ) | (61 | ) |
| State                          |   | 55                               |   | (183 | ) | 11 |   |
| Change in tax status–DCSI |   | —                           |   | — |   | (580 | ) |
| Termination of S corporation   |   | —                           |   | — |   | (86 | ) |
| Total deferred tax benefit     |   | 305                              |   | (1,563 | ) | (716 | ) |
| Total income taxes             |   | $                                | 115    |   | $ | 3,049 |   | $ | 897 |   |

 

The above table excludes a $523,000 income taxbenefit allocated to and offset against the cumulative effect of a change inaccounting principle in 2000 as discussed in Note 2.

 

In July 1998, the Company acquired the capitalstock of Direct Connect Systems, Inc. (“DCSI”).  As of December 31, 1998, DCSI was a C corporation andaccordingly, was subject to corporate income taxes. A provision for taxesresulting from the taxable income of DCSI for the period from July 15,1998 through December 31, 1998 is included in the Company’s financialstatements. Effective January 4, 1999, DCSI merged into the Company and,therefore, became part of the S corporation. Accordingly, effectiveJanuary 4, 1999 at the time the Company was an S-corporation, none of theconsolidated income of the Company was subject to corporate income taxes.  This resulted in a one-time tax benefit of$580,000 which is recorded as an offset against the Company’s net income taxexpense for the year ended December 31, 1999.  On August 6, 1999, the Company terminated its status as an Scorporation and established an $86,000 net 

 

30

----

 

deferred tax asset and recorded a related income tax benefit.

 

Significant components of the Company’s deferredtax assets and liabilities are as follows:

 
|                                             |   | **Year Ended December 31,** | ** ** |
|--------------------------------------------------|--------|----------------------------------|------------|
|                                             |   | **2001**                         | ** ** | **2000** | ** ** |
|                                             |   | **(In thousands)**               |       |
| Current deferred tax asset:                      |   |                             |       |   |   |
| Deferred revenue                                 |   | $                                | 1,198      |   | $ | 2,135 |   |
| Inventories                                      |   | 123                              |       | 102 |   |
| Accounts receivable allowances                   |   | 105                              |       | 106 |   |
| Other                                            |   | 9                                |       | 58 |   |
| Total current deferred tax asset                 |   | 1,435                            |       | 2,401 |   |
| Long-term deferred tax asset (liabilities):      |   |                             |       |   |   |
| Intangibles                                      |   | 417                              |       | (95 | ) |
| Property and equipment                           |   | 31                               |       | (118 | ) |
| Total long-term deferred tax asset (liabilities) |   | 448                              |       | (213 | ) |
| Net deferred tax asset                           |   | $                                | 1,883      |   | $ | 2,188 |   |

 

The reconciliation of the U.S. federal statutory tax rate to theCompany’s effective income tax rate is as follows:

 

|                                                   |   | **2001** |   | **2000** |   | **1999** |   |
|--------------------------------------------------------|--------|----------|--------|----------|--------|----------|--------|
| Tax at U.S. statutory rates                            |   | 34.0     | %      | 34.0     | %      | 34.0     | %      |
| State income taxes, net of Federal benefit             |   | 4.5      |   | 4.5      |   | 4.9      |   |
| Taxable income allocated to S corporation stockholders |   | —   |   | —   |   | (22.9    | )      |
| Effect of changes in tax status on deferred taxes      |   | —   |   | —   |   | (8.7     | )      |
| Other, primarily goodwill amortization                 |   | (68.0    | )      | 2.5      |   | 3.5      |   |
| Effective tax rate                                     |   | (29.5%   | )      | 41.0     | %      | 10.8     | %      |

 

**5. LeaseCommitments:**

 

The Company has 26 office locations throughout theUnited States.  Some of these locationsare leased facilities under non-cancelable operating lease agreements.

 

In August 2000, the Company purchased the landadjacent to its new corporate headquarters for $384,000.  At December 31, 2000, the construction inprogress of $2.0 million represents payments made by the developer for theconstruction of the Company’s new corporate headquarters to be leased by theCompany beginning in June 2001.  Acorresponding obligation for construction in progress of $2.0 million wasrecorded as a liability as of December 31, 2000.  Upon completion of the building and commencement of the leaseterm in June 2001, the asset and related obligation were removed from theCompany’s balance sheet in accordance with accounting for the building as anoperating lease.  The building functionsas the Company’s corporate headquarters including the principal technicaloperations and the integration, assembly and support service operations.  It is located in a 104,000 square footoffice and warehouse facility in Chanhassen, Minnesota.

 

The Company’s remaining 25 locations includingsales and technical staff are small to medium sized offices.  Regional hubs are located within each of theCompany's regions in the Northeast, Southeast, Great Lakes, Midwest, Southwest,and West.

 

As of December 31, 2001, future minimum leasepayments due under non-cancelable operating leases are as follows:

 

| **Year Ended** |   | **Total**          |   |
|----------------|--------|--------------------|--------|
|           |   | **(In thousands)** |   |
| 2002           |   | $                  | 2,121  |   |
| 2003           |   | 2,172              |   |
| 2004           |   | 2,020              |   |
| 2005           |   | 1,894              |   |
| 2006           |   | 1,779              |   |
| Future         |   | 7,177              |   |
|           |   | $                  | 17,163 |   |

 

31

 

Total rent expense, including certain lessoroperating costs charged to the Company, is as follows:

 
|          |   | **Year Ended December 31,** |   |
|---------------|--------|----------------------------------|--------|
|          |   | **2001**                         |   | **2000** |   | **1999** |   |
|          |   | **(In thousands)**               |   |
| Related party |   | $                                | 112    |   | $ | 323 |   | $ | 317 |   |
| Other         |   | 2,080                            |   | 792 |   | 438 |   |
|          |   | $                                | 2,192  |   | $ | 1,115 |   | $ | 755 |   |

 

**6. EmployeeBenefit Plan:**

 

The Company has a defined contribution retirementplan for eligible employees. Employees may contribute up to 15% of their pretaxcompensation to the 401(k) portion of the plan. The Company is required tomatch 50% of an employee’s contribution up to the first 6% of an employee’seligible compensation. The cost of the Company’s contributions to the 401(k)portion of the plan for 2001, 2000 and 1999, was  $428,000, $349,000 and $270,000, respectively.

 

Prior to the initial public offering on August 6,1999 at the discretion of the Board of Directors, the Company was also able tomake profit sharing contributions to the plan, to the extent permitted by theInternal Revenue Code. The cost of the Company’s profit sharing contributionsto the plan for 1999 was $317,000.

 

**7. Stockholders’Equity:**

 

***CommonStock Buy-Sell Agreement:***

 

Prior to the Company’s initial public offering(the “Offering”), the Company and all of its stockholders had entered intoStock Purchase Agreements (the “Agreements”) that restricted the right of eachstockholder to dispose of or encumber any shares of the Company’s common stockand dictated terms for transfer of the shares. Upon the death, disability ortermination of employment, each stockholder was required to put his or hershares to the Company, and the Company was obligated to purchase all sharesowned by that stockholder at a price determined pursuant to terms of theAgreements. In connection therewith, the value of the common stock subject toput options had been accreted to the value determined according to terms of theAgreements. Effective August 6, 1999, in conjunction with the Offering,the put options were terminated and the carrying value of the common stocksubject to the put options totaling $22.5 million was reclassified tostockholders’ equity.

 

Effective February 28, 1999, the Companyredeemed 1,095,720 shares held by a former stockholder under terms of theAgreements. Pursuant to the terms of the Agreements, the Company issued a $3million note payable to this former stockholder. The note provides for intereston the outstanding balance at the prime rate beginning August 28, 1999. Aprincipal payment of $906,000 was made on August 28, 1999.  Two principal payments of $705,000 each weremade on February 28, 2000 and 2001 with the remaining principal balance due inone installment of $704,000 plus any accrued interest on February 28,2002. As of December 31, 1999, 2000 and 2001, the Company is the owner andbeneficiary of a term life insurance policy with a face value of $2.1 million,$1.4 million, and $704,000, respectively insuring the life of this stockholder.

 

***StockCompensation Plans:***

 

Effective May 8, 2001, the Company reserved anaggregate of 3,000,000 shares of common stock for issuance pursuant to theCompany’s Incentive Compensation Plan (the “Incentive Plan”), 1,183,727 ofwhich were available for grant as of December 31, 2001. The terms of the planallow for a variety of awards including incentive stock options, nonqualifiedstock options, stock appreciation rights, restricted stock, performance shares,performance units, cash-based awards, phantom shares and other share–basedawards as determined by the Company’s Compensation Committee (the “Committee”).

 

The Company has also reserved 250,000 shares ofcommon stock for issuance pursuant to the Company’s Employee Stock PurchasePlan. Under terms of the Employee Stock Purchase Plan, eligible employees maydesignate up to 15% of their compensation to be withheld through payrolldeductions and will be granted an option to purchase a designated number ofshares of common stock at a 

 

32

----

 

purchase price determined by the Committee, but at no less than 85% ofthe lower of the market price on the first or last day of the purchase period.

 

In August 2000, the Board of Directors adopted the2000 Director Stock Option Plan (the “Director Plan”), subject to shareholderapproval.  The terms of the DirectorPlan allow for stock option grants to non-employee members of the Board ofDirectors.  The Company has reserved300,000 shares of common stock for issuance pursuant to the Company’s 2000Director Stock Option Plan. During 2001 and 2000, the Company granted 49,750and 7,500 stock options to Directors with an exercise price below the fairmarket value of common stock at the date of grant.  The compensation expense recorded was $27,000 and $15,000 in 2001and 2000, respectively.

 

 

***StockOptions:***

 

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

 
|                                        |   | **Outstanding Options** |   |
|---------------------------------------------|--------|-------------------------|--------|
|                                        |   | **Number of Shares**    |   | **Range of****Exercise Prices** |   | **Weighted****Average****Exercise Price** |   |
| Balance, December 31, 1998                  |   | —                  |   | — |   | — |   |
| Options granted                             |   | 824,350                 |   | $7.50 - $19.63 |   | $ | 7.96 |   |
| Options exercised                           |   | —                  |   | — |   | — |   |
| Options cancelled                           |   | (82,125                 | )      | $7.50 |   | $ | 7.50 |   |
| Balance, December 31, 1999                  |   | 742,225                 |   | $7.50 - $19.63 |   | $ | 8.02 |   |
| Options granted                             |   | 488,432                 |   | $8.50 - $25.38 |   | $ | 15.98 |   |
| Options exercised                           |   | (29,951                 | )      | $7.50 |   | $ | 7.50 |   |
| Options cancelled                           |   | (148,915                | )      | $7.50 - $25.38 |   | $ | 11.82 |   |
| Balance, December 31, 2000                  |   | 1,051,791               |   | $7.50 - $25.38 |   | $ | 11.19 |   |
| Options granted                             |   | 1,027,650               |   | $2.60 - $15.25 |   | $ | 7.05 |   |
| Options exercised                           |   | (11,530                 | )      | $7.50 |   | $ | 7.50 |   |
| Options cancelled                           |   | (251,638                | )      | $3.46 - $20.88 |   | $ | 10.35 |   |
| Balance, December 31, 2001                  |   | 1,816,273               |   | $2.60 - $25.38 |   | $ | 10.05 |   |
|                                        |   |                    |   |   |   |   |   |
| Options exercisable as of December 31, 2001 |   | 404,518                 |   | $2.60 - $25.38 |   | $ | 8.24 |   |

 

The following is a summary of options outstandingat December 31, 2001:

 

| **Stock  Options** |   | **Range of   Exercise Price Per   Share** |   | **Weighted  Average Exercise   Price Per Share** |   | **Weighted  Average   Remaining Contractual   Life (Years)** |   |
|--------------------|--------|-------------------------------------------|--------|--------------------------------------------------|--------|--------------------------------------------------------------|--------|
| 322,804            |   | $ 2.60 - $5.08                            |   | $                                                | 3.47   |                                                         | 9.8    |   |
| 529,147            |   | $ 5.09 - $7.61                            |   | $                                                | 7.32   |                                                         | 7.9    |   |
| 552,335            |   | $ 7.62 - $10.15                           |   | $                                                | 8.83   |                                                         | 9.1    |   |
| 118,025            |   | $ 10.16 - $12.69                          |   | $                                                | 11.78  |                                                         | 8.4    |   |
| 61,550             |   | $ 12.70 - $15.23                          |   | $                                                | 14.48  |                                                         | 8.5    |   |
| 34,200             |   | $ 15.24 - $17.76                          |   | $                                                | 16.14  |                                                         | 8.2    |   |
| 194,712            |   | $ 17.77 - $20.30                          |   | $                                                | 18.31  |                                                         | 8.0    |   |
| 3,500              |   | $ 20.31 - $25.38                          |   | $                                                | 25.38  |                                                         | 8.2    |   |
| 1,816,273          |   | $ 2.60 - $25.38                           |   | $                                                | 10.05  |                                                         | 8.7    |   |

 

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

 

33

----

 

|                                        |   | **Stock  Options  Granted** |   | **Weighted  Average  Exercise Price Per  Share** |   | **Weighted  Average  Exercise Price Per  Share** |        |
|---------------------------------------------|--------|-----------------------------|--------|--------------------------------------------------|--------|--------------------------------------------------|-------------|
| December 31, 1999                           |   |                        |   |                                             |   |                                             |        |
| Option price equals fair market value       |   | 776,950                     |   | $7.50 - $17.50                                   |   | $                                                |  7.67  |   |
| Option price less than fair market value    |   | 47,400                      |   | $10.88 - $19.63                                  |   | $                                                |  12.73 |   |
| Options granted                             |   | 824,350                     |   | $7.50 - $19.63                                   |   | $                                                |  8.13  |   |
|                                        |   |                        |   |                                             |   |                                             |        |
| December 31, 2000                           |   |                        |   |                                             |   |                                             |        |
| Option price equals fair market value       |   | 387,982                     |   | $8.50 - $25.38                                   |   | $                                                |  12.29 |   |
| Option price greater than fair market value |   | 4,500                       |   | $19.88                                           |   | $                                                |  15.05 |   |
| Option price less than fair market value    |   | 95,950                      |   | $10.69 - $20.00                                  |   | $                                                |  13.35 |   |
| Options granted                             |   | 488,432                     |   | $8.50 - $25.37                                   |   | $                                                |  12.53 |   |
|                                        |   |                        |   |                                             |   |                                             |        |
| December 31, 2001                           |   |                        |   |                                             |   |                                             |        |
| Option price equals fair market value       |   | 977,900                     |   | $3.46 - $11.63                                   |   | $                                                |  6.92  |   |
| Option price less than fair market value    |   | 49,750                      |   | $2.60 - $15.25                                   |   | $                                                |  9.46  |   |
| Options granted                             |   | 1,027,650                   |   | $2.60 - $15.25                                   |   | $                                                |  7.05  |   |

 

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

 

During 2000 and 1999, the Company issued 135,850options with an exercise price below the fair market value of common stock atthe date of grant.  The intrinsic valueof the options is being recorded to compensation expense over the vestingperiod, generally four years.  During2001 and 2000, $119,000 and $122,000, respectively, of compensation expense wasrecorded related to these options.  Asof December 31, 2001 and 2000, there was $246,000 and $365,000, respectively,of compensation expense related to these options that will be recognized infuture periods.

 

Had compensation expense for the Company’sstock-based compensation plans been determined based on the fair value at thegrant dates consistent with the method of SFAS No. 123, the Company’s netincome (loss) and basic income (loss) per share would have been reduced to thepro forma amounts indicated below:

|                       |   |                                          |   |     |   |     |   |
|----------------------------|--------|-----------------------------------------------|--------|----------|--------|----------|--------|
|                       |   | **2001**                                      |   | **2000** |   | **1999** |   |
|                       |   | **(In thousands, except for per share data)** |   |
| Net income:                |   |                                          |   |     |   |     |   |
| As reported                |   | $                                             | (505   | )        | $      | 3,635    |   | $ | 7,372 |   |
| Pro forma                  |   | $                                             | (1,383 | )        | $      | 3,023    |   | $ | 6,821 |   |
| Basic earnings per share   |   |                                          |   |     |   |     |   |
| As reported                |   | $                                             | (0.06  | )        | $      | 0.41     |   | $ | 1.01 |   |
| Pro forma                  |   | $                                             | (0.16  | )        | $      | 0.34     |   | $ | 0.94 |   |
| Diluted earnings per share |   |                                          |   |     |   |     |   |
| As reported                |   | $                                             | (0.06  | )        | $      | 0.40     |   | $ | 0.99 |   |
| Pro forma                  |   | $                                             | (0.16  | )        | $      | 0.33     |   | $ | 0.92 |   |

 

The weighted-average fair values per option at thedate of grant were $12.53 and $7.05 for 2000 and 2001, respectively. The fairvalue was estimated using the Black-Scholes option pricing model with thefollowing weighted average assumptions:
|                           |   |         |   |         |   |         |   |
|--------------------------------|--------|--------------|--------|--------------|--------|--------------|--------|
|                           |   | **2001**     |   | **2000**     |   | **1999**     |   |
| Risk-free interest rates       |   | 4.31% - 5.73 | %      | 5.36% - 6.57 | %      | 5.97% - 6.49 | %      |
| Expected dividend yield        |   | 0            |   | 0            |   | 0            |   |
| Expected volatility factor     |   | 107          | %      | 95           | %      | 80           | %      |
| Expected option holding period |   | 5 years      |   | 5 years      |   | 5 years      |   |

 

34

----

 

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

 

On November 10, 2000, the Company acquired certain assets of the datastorage and service business of OpenSystems.com, Inc., a Walpole,Massachusetts-based firm engaged in the resale and installation of data storagesolutions.  Under the terms of the saleagreement, the Company agreed to pay $7 million in cash and issue 79,177 sharesof its common stock for these assets. Additionally, the Company would have beenrequired to pay $2.5 million of cash consideration to the seller if certainrevenue targets were met in 2001.  Sincethe revenue targets were not met in 2001, no payment was made.

 

The acquisition was accounted for using thepurchase method of accounting. Accordingly, the Company allocated the purchaseprice to the estimated fair value of the assets acquired and liabilitiesassumed.  The results of operations ofOpenSystems.com, Inc. have been included with the operating results of theCompany beginning November 13, 2000. The following table presents the purchase price allocation of theacquired, identifiable intangible assets:

 

| Cash and fair value of  Company’s common stock issued |   | $      | 8,000  |   |
|------------------------------------------------------------|--------|--------|--------|--------|
| Direct acquisition costs                                   |   | 495    |   |
| Total purchase price                                       |   | $      | 8,495  |   |
|                                                       |   |   |   |   |
| Estimated fair value of tangible assets acquired           |   | $      | 70     |   |
| Estimated fair value of identifiable intangible assets     |   | 4,300  |   |
| Goodwill                                                   |   | 4,125  |   |
|                                                       |   | $      | 8,495  |   |

 

The purchase price allocated to intangible assetsand goodwill and their respective amortization periods are as follows:

 

|                |   | **Allocation**     |   | **Estimated Life** |    |
|---------------------|--------|--------------------|--------|--------------------|---------|
|                |   | **(In thousands)** |   |
| Customer base       |   | $                  | 3,600  |               | 5 years |   |
| Assembled workforce |   | 700                |   | 4 years            |    |
| Goodwill            |   | 4,125              |   | 7 years            |    |
|                     |        |                    |        |                    |         |  |

 

The following unaudited pro forma condensedresults of operations have been prepared to give effect to the acquisition ofthe data and service business of OpenSystems.com as if the acquisition occurredas of January 1, 1999:

 

|                          |   | **Year Ended December 31,** |    |
|-------------------------------|--------|----------------------------------|---------|
|                          |   | **2000**                         |    | **1999** |   |
| Net sales                     |   | $                                | 156,742 |   | $ | 126,165 |   |
| Net income                    |   | $                                | 5,833   |   | $ | 6,515 |   |
| Net income per share, basic   |   | $                                | 0.66    |   | $ | 0.89 |   |
| Net income per share, diluted |   | $                                | 0.64    |   | $ | 0.88 |   |

 

The unaudited pro forma condensed results of operations are notnecessarily indicative of results that would have occurred had the acquisitionsbeen in effect for the periods presented, nor are they necessarily indicativeof the results that will be obtained in the future.

 

35

----

 

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

 

| **2001**                                                                |   |               | **March 31** |       | **June 30** |       | **Sept 30** |       | **Dec 31** |       |
|-------------------------------------------------------------------------|--------|--------------------|--------------|------------|-------------|------------|-------------|------------|------------|------------|
|                                                                    |   | **(In thousands)** | ** **   |
| Net sales                                                               |   | $                  | 40,899       |       | $           | 26,992     |        | $          | 32,244     |       | $ | 24,649 |   |
| Gross profit                                                            |   | 11,069             |         | 7,472      |        | 9,269      |        | 6,253      |       |
| Operating income (loss)                                                 |   | 1,786              |         | (1,087     | )           | 788        |        | (2,004     | )          |
| Net income (loss)                                                       |   | 1,076              |         | (623       | )           | 290        |        | (1,248     | )          |
| Net income per share — basic                                       |   | 0.12               |         | (0.07      | )           | 0.03       |        | (0.14      | )          |
| Net income per share — diluted                                     |   | 0.12               |         | (0.07      | )           | 0.03       |        | (0.14      | )          |
|                                                                    |   |               |         |       |        |       |        |       |       |
| **2000**                                                                |   |               |         | ** ** |        | ** ** |        | ** ** |       | ** ** |
| Net sales                                                               |   | $                  | 27,998       |       | $           | 34,911     |        | $          | 36,292     |       | $ | 38,568 |   |
| Gross profit                                                            |   | 7,686              |         | 9,840      |        | 8,639      |        | 10,135     |       |
| Operating income                                                        |   | 1,481              |         | 2,261      |        | 2,566      |        | 818        |       |
| Cumulative impact of change in accounting principle,  net of income tax |   | (753               | )            | —     |        | —     |        | —     |       |
| Net income                                                              |   | 166                |         | 1,406      |        | 1,561      |        | 502        |       |
| Net income per share — basic                                       |   | 0.10               |         | 0.16       |        | 0.18       |        | 0.06       |       |
| Net income per share — diluted                                     |   | 0.10               |         | 0.15       |        | 0.17       |        | 0.06       |       |

** **

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

 

None.

 

36

----

 

# **PART III**

 

**Item 10.  Directors and Executive Officers of theRegistrant.**

 

The information regarding executive officersrequired by Item 401 of Regulation S-K is included in “Executive Officers ofthe Registrant” in Part I of this form and is incorporated herein by reference.In addition, we will furnish to the Securities and Exchange Commission adefinitive Proxy Statement (the “2001 Proxy Statement”) not later than 120 daysafter the close of the fiscal year ended December 31, 2001. The informationrequired by Item 405 of Regulation S-K is incorporated herein by reference tothe Proxy Statement.

 

**Item 11.  Executive Compensation.**

 

The information set forth under the caption“Executive Compensation” in the Company’s 2001 Proxy Statement is incorporatedherein by reference.

 

**Item 12.  Security Ownership of Certain BeneficialOwners and Management.**

 

The information set forth under the caption“Outstanding Voting Securities and Voting Rights” in the Company’s 2001 ProxyStatement is incorporated herein by reference.

 

**Item 13.  Certain Relationships and RelatedTransactions.**

 

The information required by this section isincorporated by reference from the information in the section entitled “CertainRelationships and Related Transactions” in the Company’s 2001 Proxy Statement.

 

**PART IV**

 

**Item 14.  Exhibits, Financial Statement Schedules, andReports on Form 8-K.**

 

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

 

**1.            FinancialStatements**

 

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

 

**2.            FinancialStatement Schedules.**

 

The following financial statementschedule of Datalink Corporation, for the years ended 1999, 2000 and 2001 isfiled as part of this Annual Report and should be read in conjunction with theFinancial Statements of Datalink Corporation.

 

DATALINKCORPORATION

SCHEDULEII VALUATION AND QUALIFYING ACCOUNTS

FORTHE YEARS ENDED DECEMBER 31, 1999, 2000 AND 2001

 
| **Description**                      |   | **Period** |   | **Balance at  Beginning   of Period** |    | **Additions** |   | **Deductions  (1)** |   | **Balance at    End of Period** |    |
|--------------------------------------|--------|------------|--------|---------------------------------------|---------|---------------|--------|---------------------|--------|---------------------------------|---------|
| Allowance for Doubtful Accounts      |   | 2001       |   | $                                     | 75,037  |          | $      | 115,000             |   | $                               | 25,643  |   | $ | 164,394 |   |
|                                 |   | 2000       |   | 75,000                                |    | 88,771        |   | 88,734              |   | 75,037                          |    |
|                                 |   | 1999       |   | 84,214                                |    | 201,676       |   | 210,890             |   | 75,000                          |    |
|                                 |   |       |   |                                  |    |          |   |                |   |                            |    |
| Allowance for Inventory Obsolescence |   | 2001       |   | $                                     | 264,748 |          | $      | 344,000             |   | $                               | 363,189 |   | $ | 245,559 |   |
|                                 |   | 2000       |   | 482,961                               |    | 1,175,889     |   | 1,394,002           |   | 264,748                         |    |
|                                 |   | 1999       |   | 40,000                                |    | 455,728       |   | 12,867              |   | 482,961                         |    |

 

----

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

 

37

----

 

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

 
| **Exhibit Number** |   | **Title**                                                                                                                                                                         |   | **Method of Filing** |
|--------------------|--------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|----------------------|
| 3.1                |   | Amended and Restated Articles of Incorporation of the Company                                                                                                                     |   | 1                    |
| 3.2                |   | Restated Bylaws of the Company                                                                                                                                                    |   | 1                    |
| 4.1                |   | Form of Common Stock Certificate                                                                                                                                                  |   | 1                    |
| 10.1               |   | Employee Stock Purchase Plan                                                                                                                                                      |   | 1                    |
| 10.2               |   | 1999 Incentive Compensation Plan, as amended on December 18, 2000                                                                                                                 |   | 4                    |
| 10.3               |   | Credit Agreement with Norwest Bank Minneapolis, N.A.                                                                                                                              |   | 1                    |
| 10.4               |   | Form of Indemnification Agreement                                                                                                                                                 |   | 1                    |
| 10.5               |   | Lease Agreement with Washington Avenue L.L.P.                                                                                                                                     |   | 1                    |
| 10.6               |   | Deferred Compensation Agreement with Stanley I. Clothier                                                                                                                          |   | 1                    |
| 10.7               |   | Agreement and Plan of Reorganization with Direct Connect  Systems, Inc. (excluding Schedules and Exhibits which the Registrant  will provide to the Commission upon request) |   | 1                    |
| 10.8               |   | Second Lease Agreement with Washington Avenue L.L.P.                                                                                                                              |   | 1                    |
| 10.9               |   | Lease Extension Agreement with Washington Avenue L.L.P.                                                                                                                           |   | 1                    |
| 10.10              |   | Credit Agreement with Wells Fargo Bank Minneapolis, N.A.                                                                                                                          |   | 3                    |
| 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                    |
| 10.14              |   | First amendment to credit agreement dated December 31, 2000 with Wells  Fargo Bank Minneapolis, National Association                                                              |   | 5                    |
| 10.15              |   | Second amendment to credit agreement dated June 20, 2001 with Wells  Fargo Bank Minneapolis, National Association                                                                 |   | 6                    |
| 10.16              |   | Third amendment to credit agreement dated August 31, 2001 with Wells  Fargo Bank Minneapolis, National Association                                                                |   | 7                    |
| 10.17              |   | Fourth amendment to credit agreement dated February 13, 2002 with  Wells Fargo Bank, National Association                                                                         |   | Filed herewith       |
| 10.18              |   | 2000 Director Stock Option Plan                                                                                                                                                   |   | 4                    |
| 16.1               |   | Letter from Hansen, Jergenson, Nergaard & Co., LLP regarding  change in certifying accountant                                                                            |   | 1                    |
| 23.1               |   | Consent of PricewaterhouseCoopers LLP                                                                                                                                             |   | Filed herewith       |
| 23.2               |   | Consent of Arthur Andersen LLP                                                                                                                                                    |   | Filed herewith       |
| 99.1               |   | Letter to SEC regarding Arthur Andersen LLP                                                                                                                                       |   | Filed herewith       |

 

----

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

 

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

 

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

 

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

 

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

 

6)             Incorporated by reference to the exhibit of the samenumber in the Company’s June 30, 2001 Form 10-Q.

 

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

 

                (b)           Reports of Form 8-K.

 

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

 

38

----

 

FINANCIAL STATEMENT SCHEDULES:

 

Report of IndependentPublic Accountants

 

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

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

 

REPORTOF INDEPENDENT ACCOUNTANTS

 

To the Board of Directors

and Stockholders of

Datalink Corporation

 

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

 

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

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

 

39

----

 

**SIGNATURES**

 

Pursuant to the requirements of Section 13 or15(d) of the Securities Exchange Act of 1934, the registrant has dulycaused this amendment on Form 10-K/A to the Annual Report on Form 10-K to besigned on its behalf by the undersigned, thereunto duly authorized.

 
|                  | DATALINK  CORPORATION |                                         |
|-----------------------|-----------------------|----------------------------------------------|
| Date:  March 25, 2002 |                  |                                         |
|                  | By:                   | /s/  Greg R. Meland                          |
|                  |                  | Greg  R. Meland, Chief Executive Officer     |
|                  |                  |                                         |
|                  |  By:             | /s/  Daniel J. Kinsella                      |
|                  |                  | Daniel  J. Kinsella, Chief Financial Officer |

 

Pursuant to the requirements of the Securities Actof 1934, this report has been signed below by the following persons on behalfof the registrant and in the capacities and on the dates indicated.

 
| **Signature**              |   | **Title**                                                                         |   | **Date**        |
|----------------------------|--------|-----------------------------------------------------------------------------------|--------|-----------------|
| /s/  Greg R. Meland        |   | President  and Chief Executive Officer and Director (Principal Executive Officer) |   | March  25, 2002 |
|                       |   |                                                                              |   |            |
| /s/  Daniel J. Kinsella    |   | Chief  Financial Officer (Principal Financial Officer)                            |   | March  25, 2002 |
|                       |   |                                                                              |   |            |
| /s/  Denise M. Westenfield |   | Corporate  Controller (Principal Accounting Officer)                              |   | March  25, 2002 |
|                       |   |                                                                              |   |            |
| /s/  Paul F. Lidsky        |   | Director                                                                          |   | March  25, 2002 |
|                       |   |                                                                              |   |            |
| /s/  Margaret A. Loftus    |   | Director                                                                          |   | March  25, 2002 |
|                       |   |                                                                              |   |            |
| /s/  James E. Ousley       |   | Director                                                                          |   | March  25, 2002 |
|                       |   |                                                                              |   |            |
| /s/  Robert M. Price       |   | Director                                                                          |   | March  25, 2002 |

 

 

40

----