**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D. C. 20549**

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FORM 10-K

**(Markone)**
| **x**                                           | ** ** | **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, 2003** |
| **OR**                                          |
| **o**                                           | ** ** | **TRANSITION  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF  1934. (NO FEE REQUIRED)** |

 

**For The Transition PeriodFrom             To              **

**Commission file number:00029758**

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DATALINK CORPORATION

(Exact name of registrantas specified in its charter)
| **MINNESOTA**                                   | ** ** | **41-0856543**                        |
|-------------------------------------------------|------------|---------------------------------------|
| (State or other  jurisdiction of incorporation) |       | (IRS Employer  Identification Number) |

 

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

(Address of PrincipalExecutive Offices)

**(952) 944-3462**

(Registrant’s TelephoneNumber, Including Area Code)

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

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

Indicate by check mark whether the registrant (1) hasfiled all reports required to be filed by Section 13 or 15(d) of theSecurities Exchange Act of 1934 during the preceding 12 months (or for suchshorter period that the registrant was required to file such reports), and (2) hasbeen subject to such filing requirements for the past 90 days. Yes x  No o

Indicate by check mark if disclosure of delinquentfilers pursuant to Item 405 of Regulation S-K (§229.405 of thischapter) is not contained herein, and will not be contained, to the best ofregistrant’s knowledge, in definitive proxy or information statementsincorporated by reference in Part III of this Form 10-K or anyamendment to this Form 10-K. x

At March 11, 2004, the latest practicable date,the aggregate market value of the voting and non-voting common equity held bynon-affiliates of the registrant was: $19,761,239.

At March 11, 2004, the number of sharesoutstanding of each of the registrant’s classes of common stock was 10,258,049.

**DOCUMENTSINCORPORATED BY REFERENCE**

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

 

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**NOTE REGARDING FORWARD-LOOKING STATEMENTS**

This Annual Report contains forward-lookingstatements. We have based these forward looking statements on our currentexpectations and projections about future events, including, among otherthings: the level of continuing demand for storage, including the effect of thedownturn in economic conditions over the past several years; competition andpricing pressures and timing of our installations that may adversely affect ourrevenues and profits; fixed employment costs that may impact profitability ifwe suffer revenue shortfalls; revenue recognition policies that mayunpredictably defer reporting of our revenues; our ability to hire and retainkey technical and other personnel; our dependence on key suppliers; our abilityto adapt to rapid technological change; risks associated with possible futureacquisitions; fluctuations in our quarterly operating results; future changesin applicable accounting rules; and volatility in our stock price. You may findthese statements throughout this Annual Report and specifically in the sectionsentitled “Risk Factors,” “Management’s Discussion and Analysis of FinancialCondition and Results of Operations” and “Business.” Our actual results maydiffer materially from those anticipated in these forward-looking statements asa result of various factors, including all the risks discussed in “Risk Factors”and elsewhere in this Annual Report.

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

**PART I**

**Item1. Business.**

**Overview**

We are the leadingindependent information storage architect in the United States. We work withcustomers to analyze, design, implement, and support information storageinfrastructures that store, protect, and provide continuous access toinformation. Our areas of expertise include:

·       DataAvailability—Datalink architectures are designed to protect against planned andunplanned downtime and provide fast access to information.

**·****     **DataRecovery—Data recovery solutions enable companies to recover data, applicationsand entire computing environments following a disaster. Solutions include localand remote backup, snapshot and replication.

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

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

Our highly skilledtechnical services and product management staff tests and compares data storagetechnologies available from the leading manufacturers and software developers.Once a product is approved for our solution sets, our technical staff then hasthe flexibility to choose from the best of these storage technologies to solveour customers’ growing data storage needs. In addition, we maintain a sales andsupport staff that ensures the continued success of our data storage solutionsfor each customer. We 

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believe these value-addedservices and our adherence to the highest quality standards have resulted insuperior levels of customer satisfaction.

**The Data Storage Industry**

International Data Corporation (IDC)projects data growth at a compound rate of approximately 50% through 2007. Withthe ongoing growth in creation and storage of data and the increasing strategicimportance of having the data available, the data storage markets in which wecompete are expected to continue to expand. Data Storage is a large market withspending in 2003 estimated at $31 billion and expected to exceed $34 billion by2005. Information technology (IT) departments are faced with a dauntingchallenge of rapidly expanding amounts of data to manage coupled withincreasing demands for availability for day to day business and to meetregulatory requirements. We expect these issues will generate increasedinterest in new data storage solutions that allow people to be more productiveand to meet the needs of their organizations.

At the same time, IT headcountis estimated to remain relatively flat, making it necessary for organizationsto dramatically improve storage management productivity to avoid beinginundated by growing data storage capacities. To address this growing gap, weexpect that organizations will consolidate their storage infrastructures andaugment this with enhanced software capabilities like storage area networkmanagement, virtualization, storage resource management and automated resourcemanagement.

IDC predicts that disk-based data protection, modulardisk and SAN/NAS convergence, storage management software, and storage serviceswill grow rapidly over the next several years. IDC estimates that, together, theseareas will grow through 2007 at more than double the storage industry standardrate of growth of 6 percent. Organizationsrecognize the importance and value of data as a strategic and competitiveasset. Employees, customers and suppliers demand uninterrupted access tomission-critical data 24 hours a day, 7 days a week. As a result, the abilityto efficiently store, manage, protect and provide access to this data is fastbecoming one of the most important aspects of business-criticaldecision-making, increasing the need for high-performance, scalable and highlyavailable solutions. Recent difficult economic times have only underscoredorganizations’ needs to use information and access it efficiently todifferentiate themselves and provide superior service.

Consequently,we believe that, as economic conditions improve, organizations will dedicate anincreasing percentage of their information technology budgets to data storage. Webelieve that capital investment priorities will include:

·                    **Enhanced data protection.**

Increased need for high throughput performance,greater frequency of backups, quick restoration of data and stringent dataavailability requirements are key factors that we expect to drive the migrationto disk-based data protection solutions. We believe that disk will not only beused as a target device for replication and mirroring, but will also beincorporated into traditional backup systems.

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

We expect that through avariety of storage networking technologies, organizations will attain shared(consolidated) storage capabilities. Consolidated storage benefits includeincreased flexibility in implementing and managing storage, increased storagedevice utilization levels, improved quality of service, reduced administrationcosts and increased operational efficiency.

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·                    **Integration of lower cost storage networks into large corporatedepartments and small to medium size enterprises.**

We believe that a number of product innovations, alongwith attractive pricing, make entry-level storage area networks a reality forcorporate departments and small to medium size enterprises. We expect that new,lower cost alternatives using faster interconnection technologies such as IP,Fibre Channel and iSCSI will accelerate the migration from direct attachedstorage to networked storage.

·                    **Evolution away from large, monolithic storage systems to modularstorage systems.**

We expect that many organizations will implementmodular storage systems as compared to large, monolithic storage systems. Smallerversions of their high-end, full-featured counterparts, modular disk systemsenable organizations to cost-effectively implement storage, while enjoying theperformance and functionality of large, enterprise systems.

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

A number of storage management software innovationshave recently entered the market. Storage management software enhancements canbe divided into four segments: storage area network management, virtualization,storage resource management and automated resource management. We anticipatethat advances in each of these areas will enable improved storage availability,manageability and performance.

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

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

**The Datalink Opportunity**

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

***Pressures on Customers.***We believe organizations will increasingly look outside their in-housetechnical staff to independent information storage architects, such asDatalink, for specialized expertise. Networked storage architecture design iscomplex. Although organization-wide data storage solutions, such as SANs, aredesigned to ease data management functions, these systems are difficult tounderstand and implement because they integrate diverse operating systems,hardware and software. In addition, there continues to be a steady influx ofnew products and technologies introduced to the market. In-house informationtechnology departments prefer to focus their efforts on mission-criticalapplications. Accordingly, they often turn to outside storage experts that areable to research, design, implement and support networked storage solutions.

***Pressureson Manufacturers.*** We believe manufacturers increasinglyrely on channel partners such as us for two principal reasons:

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

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comprehensive networkeddata storage solutions from the best available products and technologies.

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

We believe we areuniquely positioned to capitalize on this significant opportunity for thefollowing reasons:

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

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

***QualityCommitment.*** Our principal facility is ISO 9001:2000registered, and we utilize ISO standards throughout our organization. Ourcustomers and suppliers value our consistently high quality design,development, integration, installation and service processes.

**The Datalink Solution**

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

*Analysis*

At the beginning of an engagement, we place considerableemphasis on formulating a needs analysis based on each customer’s businessinitiatives, operating environment and current and anticipated data storagerequirements. 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 fifteen years tocustomers in numerous industries.

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

We provide our analysisand design services to customers through either a stand alone servicesengagement or as a part of an overall project to deliver product, support andservices.

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*Design*

Once we have completed our initial analysis, we beginthe design phase of the project. Our team of technical services and salesconsultants work 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.

Datalink’s DesignLinkTM servicesutilize a customer’s developed detailed business requirements to design thedata storage solution. The engagement begins with a definition of the project’sobjectives, scope and key milestones. The Datalink team then prepares anoutline of the schedule and deliverables. Following a thorough analysis, theteam prepares a comprehensive blueprint of the storage solution, including adetailed design schematic, key implementation milestones and recommendationsfor handling potential configuration issues to ensure a smooth transition tothe new storage environment.

*Implementation*

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

*Support*

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

Datalink’s SupportLinkTM support services offeradditional flexible levels of service to help organizations maximize the returnon their storage technology investments. We believe that SupportLink is one ofvery few customer service programs that provide support across multiple storageproduct lines and manufacturers.

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

**OurStrategy**

Our strategy is tomaintain our position as the United States’ leading, independent informationstorage architect and to capture an increasing share of the growing datastorage market. To achieve these objectives, we intend to build upon our recordof successfully addressing the evolving enterprise-class information storagemanagement needs of our customers. Key elements of our strategy include:

*Hiring AdditionalTechnical Services and Sales Personnel*

We intend to continue torecruit high-quality technical and sales personnel to increase our size andexpertise in our chosen geographies. We also intend to continue to maximize jobsatisfaction and retain our existing workforce. Our goal is to remain one ofthe most rewarding places to work in our industry.

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*Delivering NewDifferentiated Product Offerings and Leveraging Strategic Partnerships*

We intend to continue todevelop leading-edge enterprise-class information storage solutions for ourcustomers. We intend to continually develop and add expertise to ourprofessional services team and improve our working relationships with oursuppliers to maintain expertise in enterprise-class information storagesolution design and implementation.

*Expanding ProfessionalServices Offerings*

We intend to continueexpanding our ability to provide our customers with comprehensive professionalservices. Utilizing the expertise of our professional services team, we assistour customers in the assessment, design, implementation and support ofenterprise information storage solutions. We are executing a plan to leverageour data storage expertise by expanding our professional services capabilitiesand offerings.

*MaintainingSuperior Service and Support*

We intend to maintain andcontinually improve our high standards for superior technical and sales serviceand support. We intend to continue use of our ISO 9001:2000 quality system andprocedures and to continue recruiting and retaining experienced sales andprofessional services team members.

*Leveraging MarketPresence*

We intend to expand ourbusiness by broadening our relationships with existing customers and by utilizingour market presence and technical expertise to attract new customers. Webelieve that the longevity of service of our sales and technical staff willcontinue to be critical to building and maintaining long-term, trustingrelationships with our existing and prospective customers. In addition, ourbroad experience in a diverse group of data intensive industries enables us tounderstand application and business issues specific to customers operatingwithin a given industry and to design and implement the appropriate networkedstorage solution or offer our other professional services.

*Building GeographicCapabilities*

We have 15 offices acrossthe United States. In 2003, we reallocated resources to specifically add salesand technical staff in Texas and California to expand our presence and focus inthose areas.

*Making StrategicAcquisitions*

We intend to explore, andwhere appropriate, consummate strategic acquisitions. We continue to believethat appropriate acquisitions will enable us to access a larger group ofhigh-quality technical and sales personnel and to help us broaden our customerbase, coverage and geographic reach.

**Suppliers and Products**

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

We have strong, established relationships with themajor enterprise-class information storage hardware and software suppliers. Ourexpertise in open system environments includes UNIX, Microsoft Windows, Linuxand Novell NetWare and in-depth knowledge of all major hardware platformsmanufactured by industry leaders, including Hewlett-Packard Company,International Business Machines 

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Corp. and Sun Microsystems, Inc.This expertise has earned us preferred status with many of our principalsuppliers. Preferred status often enables us to participate in our suppliers’new product development, evaluation, introduction, marketing and qualitycontrol programs. These collaborations enable us to identify and marketinnovative new hardware and software products, exchange critical informationand implement joint corrective action programs in order to maximize customersatisfaction. In addition, our close working relationships with our principalsuppliers foster substantial cross-marketing opportunities.

Someof our major suppliers and the products they provide are listed:
| **Products**                     | ** ** | **Suppliers**                                                                                              |
|----------------------------------|------------|------------------------------------------------------------------------------------------------------------|
| Primary Storage                  |       | EMC Corporation   Hitachi Data Systems Corporation  Network Appliance Inc.  Storage Technology Corporation |
| Tape Automation                  |       | Quantum Corporation   Spectra Logic Corporation   Storage Technology Corporation                           |
| Software                         |       | DataCore Software  Corporation  Legato Systems, Inc.  VERITAS Software Corporation                    |
| Switches/Directors               |       | Brocade Communications  Systems, Inc.   McData Corporation                                            |
| Fibre Channel  Host Bus Adapters |       | Emulex Corporation   QLogic Corporation                                                                    |

 

**Customers**

Our customers trust uswith their most demanding data storage projects. Our solutions range fromspecialized professional assessment and design engagements, to discrete storagedevice installations to extremely complex organization-wide SAN implementationscosting over $5.0 million. 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 by oursignificant repeat business. Spanning a broad array of industries, ourcustomers include Motorola, Inc., Aon Corporation, The Chicago Board ofTrade, Harris Corporation, Siemens Westinghouse Power Corporation, St. JudeMedical, Inc., Washington University in St. Louis and United DefenseIndustries, Inc.

**Salesand Marketing**

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

Our field account executives and account associateswork closely with our professional services team in evaluating theenterprise-class information storage needs of existing and prospectivecustomers and in designing high quality, cost effective solutions. To ensurequality service, we assign each customer a specific field account executive andaccount associate. We believe that the longevity of service of our sales 

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force is a key factor toearning and retaining the trust and confidence of our customers. We believethis differentiates us from many other storage solution providers.

In addition to the effortsof our field account executives and inside sales representatives, we engage ina variety of other marketing activities designed to attract new business andretain customer loyalty. We regularly execute integrated, demand creation campaigns,gain exposure through online and print trade publications, hold webcasts andinformational seminars and publish a quarterly newsletter.

**Original Equipment Manufacturer Services**

We have an originalequipment manufacturer customer for whom we assemble and integrate hardware andsoftware products and subassemblies acquired from our various suppliers as partof our customer’s storage product offering. We design customized enclosures formost of these OEM products.

**Quality Management System**

We have a long history ofbeing committed to a strategic quality effort. In the early 1990’s, we adoptedthe ISO 9001 quality management system to better identify and meet theneeds of our customers, achieve a competitive market advantage and improveoverall company performance. We obtained an ISO 9001 certificate ofregistration in 1996 with successful re-registration in 1999. In 2003, wesuccessfully upgraded our ISO registration to the new 9001:2000 standards. Today,our quality system focuses on achieving business results through high levels ofcustomer satisfaction, employee satisfaction, continual improvement andoperational excellence.

**Competition**

The enterprise-class information storage market israpidly evolving and highly competitive. Economic conditions over the pastseveral years have increased competitive pressures to reduce prices or offerless robust data storage solutions. We compete with storage system suppliers, andnumerous value-added resellers, distributors and consultants. We also competein the storage systems market with general purpose computer suppliers, some of whomhave significant storage product offerings, including Dell ComputerCorporation, Hewlett-Packard Company, International Business Machines Corp. andSun Microsystems, Inc.

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

**Employees**

As of December 31,2003, we had a total of 129 full-time employees. We have no employmentagreements with any of our employees. None of our employees are unionized orsubject to a collective bargaining agreement. We have experienced no work stoppagesand believe that our employee relations are good.

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**Backlog**

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

**Item 2. Properties.**

Our corporate headquartersincluding our principal technical operations and our integration, assembly andsupport service operations is located in a 104,000 square foot office andwarehouse facility in Chanhassen, Minnesota. As part of our cost reductioninitiatives, we plan to seek a subtenant of all or a portion of ourheadquarters facility. Our other 14 locations including sales and technicalstaff are small to medium sized offices located throughout the United States. Ourregional hubs are located within each of our regions in the East, Central and West.

**Item 3. Legal Proceedings.**

We are not currentlyinvolved in any material legal proceedings. We also had no material legalproceedings that terminated during the fourth quarter of 2003.

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

We submitted no mattersduring the fourth quarter of 2003 to a vote of security holders, through thesolicitation of proxies or otherwise.

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**PART II**

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

Ourcommon stock has been quoted on the Nasdaq National Market under the symbol “DTLK”since August 6, 1999, the day of our initial public offering. The tablebelow sets forth, for the calendar quarters indicated, the high and low pershare closing sale prices of our common stock as reported by the NasdaqNational Market.
| ** **                             | ** ** | **High**   | ** ** | **Low**    | ** ** |
|----------------------------------------|------------|------------|------------|------------|------------|
| **Year Ended December 31,  2003** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| First Quarter                          |       | $          | 4.15       |       | $          | 3.07 |   |
| Second Quarter                         |       | 4.95       |       | 3.62       |       |
| Third Quarter                          |       | 5.55       |       | 4.16       |       |
| Fourth Quarter                         |       | 4.66       |       | 3.47       |       |
| **Year Ended December 31,  2002** | ** ** |       |       |       |       |   |
| First Quarter                          |       | 7.01       |       | 4.35       |       |
| Second Quarter                         |       | 6.72       |       | 3.31       |       |
| Third Quarter                          |       | 4.17       |       | 2.40       |       |
| Fourth Quarter                         |       | 4.22       |       | 2.37       |       |
| **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 5, 2004, the closing price per share ofour common stock was $4.00. We urge potential investors to obtain currentmarket quotations before making any decision to invest in our common stock. On March 5,2004, there were approximately 81 holders of record of our common stock. Manyof our shares are held by beneficial owners through a small number of holdersof 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.

We did not purchase any of our securities during 2003.

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**Item 6. Selected Financial Data.**

Youshould read the information below with our “Management’s Discussion andAnalysis of Financial Condition and Results of Operations” and our financialstatements. The data as of December 31, 2003 and 2002, and for the yearsended December 31, 2003, 2002 and 2001, was derived from our financialstatements that are included in this Annual Report. The data as of December 31,2001, 2000 and 1999, and for the years ended December 31, 2000 and 1999,was derived from our financial statements that are not included in this AnnualReport. Our independent public accountants, KPMG LLP, audited our 2003 and 2002financial statements. Our previous independent public accountants, ArthurAndersen LLP, audited our 2001 financial statements and PricewaterhouseCoopersLLP audited our 1999 and 2000 financial statements. Our historical financialresults are not necessarily indicative of our future operating results.
| ** **                                                                                   | ** ** | **Year ended December 31,**                                   | ** ** |
|----------------------------------------------------------------------------------------------|------------|--------------------------------------------------------------------|------------|
| ** **                                                                                   | ** ** | **2003**                                                           | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** | **1999** | ** ** |   |
| ** **                                                                                   | ** ** | **(in thousands, except per share data)** | ** ** |   |
| **Statement of Operations Data:**                                                            |       |                                                               |       |   |   |   |   |   |   |   |   |   |
| Net sales:                                                                                   |       |                                                               |       |   |   |   |   |   |   |   |   |   |
| Product sales                                                                                |       | $                                                                  | 61,350     |   | $ | 58,492 |   | $ | 96,188 |   | $ | 118,233 |   | $ | 105,373 |   |   |
| Service sales                                                                                |       | 29,787                                                             |       | 28,008 |   | 28,596 |   | 19,536 |   | 11,230 |   |   |
| Total net sales                                                                              |       | 91,137                                                             |       | 86,500 |   | 124,784 |   | 137,769 |   | 116,603 |   |   |
| Cost of sales:                                                                               |       |                                                               |       |   |   |   |   |   |   |   |   |   |
| Cost of product sales                                                                        |       | 47,477                                                             |       | 44,776 |   | 70,393 |   | 87,321 |   | 77,623 |   |   |
| Cost of services                                                                             |       | 20,198                                                             |       | 20,000 |   | 20,328 |   | 14,148 |   | 8,411 |   |   |
| Total cost of sales                                                                          |       | 67,675                                                             |       | 64,776 |   | 90,721 |   | 101,469 |   | 86,034 |   |   |
| Gross profit                                                                                 |       | 23,462                                                             |       | 21,724 |   | 34,063 |   | 36,300 |   | 30,569 |   |   |
| Operating expenses:                                                                          |       |                                                               |       |   |   |   |   |   |   |   |   |   |
| Sales and marketing                                                                          |       | 10,985                                                             |       | 11,481 |   | 15,836 |   | 15,230 |   | 11,702 |   |   |
| General and administrative                                                                   |       | 10,960                                                             |       | 10,354 |   | 11,221 |   | 8,792 |   | 6,883 |   |   |
| Engineering                                                                                  |       | 4,220                                                              |       | 4,954 |   | 5,259 |   | 3,745 |   | 2,594 |   |   |
| Restructuring charges(1)                                                                     |       | 2,078                                                              |       | — |   | — |   | — |   | — |   |   |
| Amortization of goodwill and other intangibles(2)                                            |       | 724                                                                |       | 1,088 |   | 2,264 |   | 1,026 |   | 807 |   |   |
| Offering costs(3)                                                                            |       | —                                                             |       | — |   | — |   | 381 |   | 173 |   |   |
| Total operating expenses                                                                     |       | 28,967                                                             |       | 27,877 |   | 34,580 |   | 29,174 |   | 22,159 |   |   |
| Operating (loss) income                                                                      |       | (5,505                                                             | )          | (6,153 | ) | (517 | ) | 7,126 |   | 8,410 |   |   |
| Interest income (expense), net                                                               |       | 74                                                                 |       | 117 |   | 127 |   | 311 |   | (141 | ) |   |
| (Loss) income before income taxes and cumulative  effect of a change in accounting principle |       | (5,431                                                             | )          | (6,036 | ) | (390 | ) | 7,437 |   | 8,269 |   |   |
| Income tax (benefit) expense(4)                                                              |       | (276                                                               | )          | (618 | ) | 115 |   | 3,049 |   | 897 |   |   |
| (Loss) income before cumulative effect of a change in  accounting principle                  |       | (5,155                                                             | )          | (5,418 | ) | (505 | ) | 4,388 |   | 7,372 |   |   |
| Cumulative effect of a change in accounting  principle, net of tax                           |       | —                                                             |       | — |   | — |   | (753 | ) | — |   |   |
| Net (loss) income                                                                            |       | $                                                                  | (5,155     | ) | $ | (5,418 | ) | $ | (505 | ) | $ | 3,635 |   | $ | 7,372 |   |   |
| Net (loss) income per  share, basic:                                                         |       |                                                               |       |   |   |   |   |   |   |   |   |   |
| (Loss) income per share before cumulative effect of a  change in accounting principle        |       | $                                                                  | (0.50      | ) | $ | (0.56 | ) | $ | (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                                                                  |       | $                                                                  | (0.50      | ) | $ | (0.56 | ) | $ | (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        |       | $                                                                  | (0.50      | ) | $ | (0.56 | ) | $ | (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                                                                  |       | $                                                                  | (0.50      | ) | $ | (0.56 | ) | $ | (0.06 | ) | $ | 0.40 |   | $ | 0.99 |   |   |
| Weighted average  shares outstanding:                                                        |       |                                                               |       |   |   |   |   |   |   |   |   |   |
| Basic                                                                                        |       | 10,333                                                             |       | 9,687 |   | 8,921 |   | 8,794 |   | 7,295 |   |   |
| Diluted                                                                                      |       | 10,333                                                             |       | 9,687 |   | 8,921 |   | 9,166 |   | 7,437 |   |   |
|                                                                                              |            |                                                                    |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

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| ** **                             | ** ** | **As of December 31,** | ** ** |
|----------------------------------------|------------|---------------------------------------|------------|
| ** **                             | ** ** | **2003**                              | ** ** | **2002** | ** ** | **2001** | ** ** | **2000** | ** ** | **1999** | ** ** |
| ** **                             | ** ** | **(In thousands)**               | ** ** |
| **Balance Sheet Data:**                |       |                                  |       |   |   |   |   |   |   |   |   |
| Cash and cash  equivalents             |       | $                                     | 12,565     |   | $ | 10,334 |   | $ | 5,846 |   | $ | 4,542 |   | $ | 6,515 |   |
| Working capital                        |       | 11,488                                |       | 13,477 |   | 10,729 |   | 11,695 |   | 17,233 |   |
| Total assets                           |       | 36,094                                |       | 44,785 |   | 46,768 |   | 56,472 |   | 42,415 |   |
| Note payable to  former stockholder(5) |       | —                                |       | — |   | 704 |   | 1,409 |   | 2,114 |   |
| Stockholders’ equity              |       | 21,496                                |       | 26,346 |   | 26,114 |   | 26,137 |   | 21,131 |   |
|                                        |            |                                       |            |  |  |  |  |  |  |  |  |  |  |  |  |  |

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

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

(3)          Reflects legal,accounting and other costs associated with our initial and a subsequent publicoffering, which we expensed when we postponed both offerings due to marketconditions. We successfully completed our initial public offering on August 6,1999. We did not complete our second public offering.

(4)          Our 1999 income taxexpense resulted from the taxable income we generated between August 6,1999 (when we terminated our S corporation status) and December 31, 1999,and the tax effect of our merger with DCSI. Our 2002 income tax benefit wasoffset by $1.6 million of expense for avaluation allowance for deferred tax assets. The ultimate realization ofdeferred tax assets is dependent upon the generation of future taxable incomeduring the periods in which those temporary differences become deductible.Based upon the level of taxable losses in 2003 and 2002 and the near-termuncertainty of taxable income, management cannot reasonably predict when or ifthese deductible differences will be realized. See Note 6 of the Notes to ourFinancial Statements.

(5)          Reflectsa $3.0 million promissory note, less payments we have made, issued to one ofour former stockholders in connection with our redemption, effective February 28,1999, of 1,096 shares of common stock. See Note 5 of the Notes to ourFinancial Statements.

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

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

**OVERVIEW**

We are an independent architect of enterprise-classinformation storage infrastructures. We derive our revenues principally fromdesigning and installing data storage systems. Our solutions can includehardware products, such as disk arrays, tape systems and interconnectioncomponents and storage management software products. The market for datastorage products and services is large, estimated at $31 billion in 2003. Wehave 15 locations throughout the United States with the highest concentrationof revenues in the central states.

We sell support service contracts to most of ourcustomers. When customers purchase support services through us, customersreceive the benefit of integrated support. We have a qualified, independentsupport desk to provide routine customer support services covering minorproblems. We fulfill on-site assistance by purchasing support serviceagreements for our customers from our hardware and software 

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vendors or theirdesignated third-party service providers and by arranging on-site supportassistance with the appropriate vendor if necessary. We defer revenues anddirect costs resulting from these contracts, and amortize these revenues andexpenses into operations, over the term of the contracts, which are generallytwelve months.

In the past, we have experienced fluctuations in thetiming of orders from our customers, and we expect to continue to experiencethese fluctuations in the future. These fluctuations have resulted from, amongother things, the time required to design, test and evaluate our data storagesolutions before customers deploy them, the size of customer orders, thecomplexity of our customers’ network environments, necessary system configurationto deploy our solutions and new product introductions by suppliers. Completionof our installation and configuration services may also delay recognition ofrevenues. Economic conditions over the past several years and competition alsoaffect our customers’ decisions to place orders with us. As a result, our netsales may fluctuate from quarter to quarter.

We view the current datastorage market as having significant opportunity for Datalink’s growth. Our keyfocus is on growing our business through the hiring of additional sales andtechnical staff, improving the productivity of our employees and providing newdifferentiated storage solutions and professional services that encompass newtechnologies for our customers. We plan to return the company to profitabilityby growing the size of our sales force while continuing to reduce our overheadcosts such as costs associated with facilities.

**Results of Operations**

The following table shows, for the periods indicated,certain selected financial data expressed as a percentage of net sales.
| ** **                                     | ** ** | **Years Ended December 31,** | ** ** |     |
|------------------------------------------------|------------|---------------------------------------------|------------|----------|
| ** **                                     | ** ** | **2003**                                    | ** ** | **2002** | ** ** | **2001** | ** ** |
| Net sales                                      |       | 100.0                                       | %          | 100.0    | % | 100.0 | % |
| Cost of sales                                  |       | 74.3                                        |       | 74.9     |   | 72.7 |   |
| Gross profit                                   |       | 25.7                                        |       | 25.1     |   | 27.3 |   |
| Operating expenses:                            |       |                                        |       |     |   |   |   |
| Sales and marketing                            |       | 12.1                                        |       | 13.3     |   | 12.7 |   |
| General and administrative                     |       | 12.0                                        |       | 12.0     |   | 9.0 |   |
| Engineering                                    |       | 4.6                                         |       | 5.7      |   | 4.2 |   |
| Restructuring charges                          |       | 2.3                                         |       | —   |   | — |   |
| Amortization of goodwill and other intangibles |       | 0.8                                         |       | 1.2      |   | 1.8 |   |
| Total operating  expenses                      |       | 31.8                                        |       | 32.2     |   | 27.7 |   |
| Operating loss                                 |       | (6.1                                        | )%         | (7.1     | )% | (0.4 | )% |

 

**Comparison of YearsEnded December 31, 2003, 2002 and 2001**

*NetSales.**  *Ourproduct sales increased 4.9% in 2003 from 2002 to $61.4 million, and decreased39.2% in 2002 from 2001 to $58.5 million. Our service sales, which includecustomer support and installation services, increased 6.4% in 2003 from 2002 to$29.8 million, and remained relatively flat from 2001 to 2002 at $28.0 millionin 2002 and $28.6 million in 2001.

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The decline in our product sales since 2001 reflects adifficult operating environment as many companies have chosen to significantlyreduce their spending on information technology. The data storage industry as awhole was negatively impacted by these conditions. Additionally, our sales (andin particular our product sales) are impacted by the number and productivity ofour sales representatives. The number of outside sales representatives declinedby 18.6% from 2001 to 2002 and by 28.0% from 2002 to 2003. The decline reflectsthe impact of closing several offices and turnover. We plan to selectivelyincrease the number of outside sales representatives in the coming quarters. Giventhese developments, we cannot predict if or when our product sales will returnto historically higher levels.

The growth in our service revenues between 2001 and2003 reflects an increase in new maintenance contract sales and contractrenewals by existing customers.

We derived approximately 10%, 5% and 9% of our salesfrom one customer during 2003, 2002 and 2001, respectively. Our largestcustomer recently began to outsource its information technology and services toa third party provider. At this time, we are uncertain whether we will continueto provide either product or customer support for this customer or the thirdparty provider. We cannot be assured that this customer will account for asubstantial portion of our future sales.

*GrossProfit.**  *Ourtotal gross profit as a percentage of net sales increased to 25.7% in 2003 from25.1% in 2002 and decreased from 27.3% in 2001.

Productgross profit as a percentage of product sales decreased to 22.6% in 2003 ascompared to 23.4% in 2002 and 26.8% in 2001. Due to economic conditions overthe past several years, our customers are continuing to seek storage solutionsto meet minimum needs rather than implementing comprehensive infrastructurechanges. Solutions that meet a minimum need generally carry lower productmargins than comprehensive infrastructure changes. In addition, our productgross profit percentage has suffered due to the high level of pricingcompetition in the marketplace. Given these developments, we cannot predict ifor when our product gross profit as a percentage of net sales will return tohistorically higher levels. Charges for excess and obsolete inventory in 2003,2002 and 2001 of $349,000, $188,000 and $344,000, respectively, adverselyaffected our product gross profit.

Service gross profit as a percentage of service salesincreased to 32.2% in 2003 as compared to 28.6% in 2002 and 28.9% in 2001. Theincrease in gross profit rates for services from 2001 to 2003 reflects ourability to obtain higher margins on our integrated support services. 

*Salesand Marketing.**  *Salesand marketing expenses include wages and commissions paid to sales andmarketing personnel, travel costs and advertising, promotion and hiringexpenses. Sales and marketing expenses totaled $11.0 million, or 12.1% of netsales for 2003 compared to $11.5 million, or 13.3% of net sales for 2002 and$15.8 million, or 12.7% of net sales for 2001. The decrease in sales andmarketing expense in absolute dollars is a result of lower bad debt expense anda reduction in our sales management workforce and expenses in 2003 as comparedto 2002 and 2001. The decrease in sales and marketing expense as a percentageof net sales from 2003 as compared to 2002 resulted primarily from higherrevenues combined with reduced expenses in 2003. The increase in sales andmarketing expense as a percentage of net sales from 2002 as compared to 2001resulted primarily from lower sales combined with increased expenses related toinvestments in management for our regional structure. At least initially, thefuture hiring of additional outside sales representatives may increase oursales and marketing expenses without a commensurate increase in sales. 

*Generaland Administrative.**  *Generaland administrative expenses include wages for administrative personnel,professional fees, depreciation, communication expenses and rent and relatedfacility expenses. General and administrative expenses increased to $11.0million, or 12.0% of net sales for 2003 as compared to $10.4 million, or 12.0%in 2002 and $11.2 million, or 9.0% in 2001. When comparing 2003 to 2002, theincrease in general and administrative expenses in absolute dollars reflectshigher property taxes 

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for our Chanhassenfacility, higher training expenses to maintain vendor certifications and thesettlement of a sales and use tax audit. When comparing 2002 to 2001, thedecrease in general and administrative expenses in absolute dollars reflectslower hiring costs due to fewer new employees, lower professional services feesdue to the completion of several process improvement consulting engagements in2001 and reduced depreciation expense. Our general and administrative expenseswere higher as a percentage of net sales in 2003 and 2002 as compared to 2001because of the reduction in sales. 

*Engineering.**  *Engineeringexpenses include employee wages and travel, hiring and training expenses forour professional engineers and technicians. We allocate engineering costsassociated with installation services to our cost of service sales. Engineering expenses decreased to $4.2 million, or4.6% of net sales in 2003 as compared to $5.0 million, or 5.7% of net sales in2002 and $5.3 million, or 4.2% of net sales in 2001. The decrease in engineeringexpenses in absolute dollars from 2003 as compared to 2002 reflects an increasein installations and assessments in 2003 as compared to 2002 and lower traveland entertainment costs associated with the installations. As a result, therewas an increase in engineering costs associated with installation servicesrecorded as cost of service sales. When comparing 2002 to 2001, the engineeringexpenses remained relatively flat in absolute dollars because there were lowercosts associated with a reduction in headcount, lower depreciation expense onour engineering laboratory equipment and lower costs for travel andentertainment due to increased efforts to minimize expenses in these areas. Thedecrease in engineering expenses as a percentage of sales from 2003 as comparedto 2002 is the result of higher revenues and lower expenses in 2003. 

*OverallCost Reduction Initiatives.**  *Becauseof the continuing difficult economic climate for technology spending and ourrecent operating losses, we have actively sought to reduce costs across ourbusiness. In October 2003, we announced several cost reduction initiativesand management changes. These changes resulted in a fourth quarter 2003 chargeof $2.1 million. As part of these cost reduction initiatives, we reduced ourstaff by 16%. Employee severance charges were $568,000. We also announced theclosure of four offices. Office closing costs for lease terminations were$584,000. The office closures included closing an office and terminating personnelfrom our OpenSystems.com, Inc. acquisition in November 2000,resulting in an impairment of our customer base intangible asset. The resultingimpairment charge of the asset was $926,000. Weexpect to gain further fixed expense reductions as we aggressively seekalternatives for reducing facility costs at our Chanhassen location in 2004. Thefourth quarter 2003 restructuring initiative reduced costs, favorably impactingsales and marketing, general and administrative, and engineering expenses. Asof December 31, 2003, the annualized cost savings, compared to the coststructure in place as of the beginning of the fourth quarter, is in excess of$2.7 million. We cannot assure that we achieve this level of annual costsavings.

*Goodwilland Other Intangible Amortization.**  *Amortization of goodwill and otherintangible assets decreased to $724,000 in 2003 compared to $1.1 million in2002 and $2.3 million in 2001. The amortization relates primarily to ouracquisition of the data storage and services business of OpenSystems.com, Inc.in November 2000. Due to the adoption of Statement of Financial AccountingStandards (SFAS) 142, Goodwill and Intangible Assets, our amortization expensedecreased by $1.2 million in 2002 from 2001. This Statement required that we nolonger amortize goodwill and intangible assets with indefinite lives, butinstead test for impairment annually or whenever impairment is indicated. For2003 we determined that our goodwill was not impaired. However, in the fourthquarter of 2003, we recorded an impairment charge on our OpenSystems.comcustomer base intangible asset in connection with our cost reductioninitiatives.

During 2003, we amortized the remaining $76,000balance of the customer base intangible asset we acquired in our July 1998acquisition of Direct Connect Systems, Inc. In 2002, we amortized theremaining $163,000 balance of the trademark and name intangible asset weacquired in that acquisition. This is because we are not operating under theDirect Connect Systems name and realization of future uses became uncertain inthe fourth quarter of 2002. For more information, see Note 2 of the Notes toour Financial Statements.

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*OperatingLoss.**  *Weincurred operating losses of $5.5 million in 2003 compared to $6.2 million in2002 and $517,000 in 2001. The 2003 operating loss includes the $2.1 million ofrestructuring charges recorded in the fourth quarter of 2003. The decrease inoperating income from 2002 as compared to 2001 was principally attributable toour sales decline under difficult economic conditions combined with an increasein our operating expenses designed to position us for future revenue growth andmarket share gains. 

*Income Taxes.**  *We provided for an income tax benefit of $276,000 in2003 and $618,000 in 2002 and income taxes of $115,000 in 2001. The income taxbenefit generated for 2003 represents a higher than expected federal income taxrefund from our 2002 tax return. Included in the income tax provision for 2002is a non-cash charge of $1.6 million related to the recording of a valuationreserve for the deferred tax asset. Theultimate realization of deferred tax assets is dependent upon carry back toprior periods and upon the generation of future taxable income during theperiods in which those temporary differences become deductible. Based upon thelevel of taxable losses in 2003 and 2002 and the near-term uncertainty oftaxable income, management cannot reasonably predict when or if thesedeductible differences will be realized. In addition, we do not have theability to realize future income tax benefits on future losses. 

**Quarterly Results and Seasonality**

Thefollowing table sets forth our unaudited quarterly financial data for eachquarter of 2003 and 2002. In our opinion, this unaudited information has beenprepared on the same basis as the audited information and includes alladjustments (including all normal recurring adjustments) necessary to presentfairly the information set forth below. The operating results for any quarterare not necessarily indicative of results for any future period.
| ** **     | ** ** | **Quarters Ended** | ** ** |
|----------------|------------|-------------------------|------------|
| ** **     | ** ** | **2003**                | ** ** | **2002** | ** ** |
| ** **     | ** ** | **Mar. 31**        | ** ** | **Jun. 30** | ** ** | **Sep. 30** | ** ** | **Dec. 31** | ** ** | **Mar. 31** | ** ** | **Jun. 30** | ** ** | **Sep. 30** | ** ** | **Dec. 31** | ** ** |
| ** **     | ** ** | **(in thousands)** | ** ** |
| Net sales      |       | $                       | 23,742     |   | $ | 26,371 |   | $ | 19,951 |   | $ | 21,073 |   | $ | 21,784 |   | $ | 21,019 |   | $ | 21,858 |   | $ | 21,839 |   |
| Gross profit   |       | 6,326                   |       | 6,821 |   | 5,010 |   | 5,305 |   | 5,503 |   | 5,043 |   | 5,397 |   | 5,781 |   |
| Operating loss |       | (879                    | )          | (210 | ) | (2,020 | ) | (2,396 | ) | (2,094 | ) | (1,978 | ) | (1,560 | ) | (521 | ) |
| Net loss       |       | (860                    | )          | (186 | ) | (2,006 | ) | (2,103 | ) | (1,300 | ) | (1,229 | ) | (962 | ) | (1,927 | ) |
|                |            |                         |            |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |  |

 

We have experienced, andexpect to continue to experience, quarterly variations in our net sales as aresult of a number of factors, including the length of the sales cycle withcustomers for large storage system evaluations and purchases, delays in storagesystem installations or configurations, new product introductions by suppliersand their market acceptance, delays in product shipments or other qualitycontrol difficulties, our ability to integrate any acquired businesses, trendsin the enterprise-class information storage industry in general, the geographicand industry specific market in which we are currently active, or may be in thefuture, and the opening of new field offices. In addition, economic conditionsover the past several years and competition also affect our customers’decisions to place orders with us.

**Liquidity and Capital Resources**

Historically, we have financed our operations andcapital requirements through cash flows generated from operations, supplementalbank borrowings and the proceeds from our offerings of our common stock. Ourworking capital was $11.5 million at December 31, 2003 as compared to$13.5 million at December 31, 2002. Our current ratio was 1.8:1 at December 31,2003 as compared to 1.7:1 at December 31, 2002. At December 31, 2003,our cash and cash equivalents balance was $12.6 million.

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Cash provided by operating activities for 2003 was$3.2 million as compared to $984,000 in 2002 and $5.6 million in 2001. The cashprovided in 2003 resulted primarily from a reduction in our net operatingassets. This included a $2.0 million income tax refund, a $1.9 millionreduction in inventory shipped but not installed with fewer projects left to becompleted at year end, a $441,000 reduction in field evaluation inventory, anda $3.9 million reduction in accounts receivable due to an improvement in ourdays sales outstanding offset by a $3.5 million reduction in accounts payable. Thecash provided in 2002 resulted primarily from a reduction in our net operatingassets from timing of certain payments and receipts and a reduction in theoverall level of working capital. The cash provided in 2001 resulted primarilyfrom a reduction in inventories offset by a decrease in payables. The reductionin inventories for 2001 resulted from our increased efforts to optimize ourinventory levels and to complete the installation of products for customers atyear-end. 

Cash used in investing activities during each of 2003and 2002 was $1.1 million compared to $4.0 million in 2001. In 2003, we usedthis cash to complete our own storage and data recovery project, purchasecomputer equipment and provide further enhancements to our customerrelationship management information systems and our business reporting softwaretool. In 2002, we used this cash primarily to implement our customerrelationship management information system. In 2001, we purchased furniture andfixtures for our new corporate headquarters in Chanhassen, Minnesota and investedin our new information and phone systems and engineering laboratory equipment. 

Cash provided by financing activities during 2003 and2002 was $111,000 and $4.7 million, respectively. Cash used in financingactivities was $369,000 in 2001. In 2003, we received $111,000 from stock soldunder our employee stock purchase plan and from the exercise of stock options. In2002, we received $5.3 million from a direct private offering of newly issuedcommon stock to institutional investors and $186,000 from stock sold under ouremployee stock purchase plan. The cash provided was partially offset by thefinal scheduled payment of $704,000 on a note due to a former stockholder. In2001, we made a scheduled payment of $705,000 on a note due to a formerstockholder, which was partially offset by $363,000 of proceeds from ouremployee stock purchase plan and stock option exercises. 

Effective June 30, 2003, we signed a new creditagreement with a commercial bank that provides for an $8 million revolving lineof credit for financing our working capital needs. The term of the agreementends June 30, 2004. Borrowings under the line of credit are secured by ouraccounts receivable and inventory and are subject to certain financial andoperating covenants, including covenants that require us to maintain a maximumlevel of funded debt-cash flow ratio and a minimum amount of working capital,tangible net worth and debt-net worth ratio. At December 31, 2003, we werein compliance with all covenants under this agreement. We had no outstandingborrowings as of December 31, 2003. For more information, see Note 5 ofthe Notes to our Financial Statements.

Wehave an 11-year non-cancelable operating lease for our corporateheadquarters in Chanhassen, Minnesota which expires in 2012. The lease requiresbase rental payments of approximately $1.0 million in the first year and $1.3million for each subsequent year. For moreinformation, see Note 7 of the Notes to our Financial Statements. We plan toseek one or more subtenants for the facility in order to reduce our fixedoperating expenses.

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**Contractual Obligations and Commitments**

As of December 31,2003, our contractual cash obligations consisting of future minimum leasepayments due under non-cancelable operating leases and severance payments inconjunction with our fourth quarter 2003 restructuring initiatives are asfollows:
| ** ** | ** ** | **Lease   Obligations** | ** ** | **Sublease  Agreements** | ** ** | **Net Lease  Obligations** | ** ** | **Severance  Obligation** | ** ** | **Total** | ** ** |
|------------|------------|------------------------------|------------|--------------------------|------------|---------------------------------|------------|---------------------------|------------|-----------|------------|
| ** ** | ** ** | **(in thousands)**      | ** ** |
| 2004       |       |                         | $          | 2,101                    |       |                            |       | $                         | (120       | )         |       |   | $ | 1,981 |   |   |   | $ | 190 |   |   | $ | 2,171 |   |
| 2005       |       |                         | 1,976      |                     |       |                            | (119       | )                         |       |      | 1,857      |   |   |   | — |   |   | 1,857 |   |
| 2006       |       |                         | 1,878      |                     |       |                            | (94        | )                         |       |      | 1,784      |   |   |   | — |   |   | 1,784 |   |
| 2007       |       |                         | 1,532      |                     |       |                            | (76        | )                         |       |      | 1,456      |   |   |   | — |   |   | 1,456 |   |
| 2008       |       |                         | 1,265      |                     |       |                            | —     |                      |       |      | 1,265      |   |   |   | — |   |   | 1,265 |   |
| Thereafter |       |                         | 4,321      |                     |       |                            | —     |                      |       |      | 4,321      |   |   |   | — |   |   | 4,321 |   |
|       |       |                         | $          | 13,073                   |       |                            |       | $                         | (409       | )         |       |   | $ | 12,664 |   |   |   | $ | 190 |   |   | $ | 12,854 |   |

 

We believe that fundsgenerated from operations, together with the available credit under ourrevolving credit agreement, will be sufficient to finance our currentoperations and planned capital expenditures for at least the next twelvemonths. We are planning for $500,000 to $1.0million of capital expenditures through 2004 primarily related to enhancementsto our management information systems.

**Critical Accounting Policies and Estimates**

The preparation offinancial statements requires us to make estimates and assumptions that affectreported earnings. We evaluate these estimates and assumptions on an on-goingbasis based on historical experience and on other factors that we believe arereasonable. Estimates and assumptions include, but are not limited to, theareas of customer receivables, inventories, investments, income taxes,self-insurance reserves and commitments and contingencies. We believe that thefollowing represent the areas where more critical estimates and assumptions areused in the preparation of the financial statements:

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

***Product sales.******  ***The Company applies theprovisions of Statement of Position (SOP) 97-2, *Software Revenue Recognition*, as amended by SOP 98-4, SOP98-9 and clarified by Staff Accounting Bulletin (SAB) 101, “Revenue Recognitionin Financial Statements” to the hardware, software and services elements of itsdata storage solutions. For software or hardware product sales whereby theCompany does not provide any installation or configuration services, revenue isrecognized upon shipment. For data storage solutions with hardware, softwareand services sold as a bundled arrangement, the Company considers the servicesto be essential to the functionality and revenues are recognized on a completedcontract basis pursuant to American Institute of Certified Public AccountantsSOP 81-1, “Accounting for Performance of Construction Type and CertainProduction Type Contracts.”

The more significant factors considered in determiningwhether the revenue should be accounted for using contract accounting includethe nature of the services (i.e. consideration of whether the services areessential to the functionality of the licensed product), degree of risk,availability of services from other vendors, timing of payments and impact ofacceptance criteria on the realizability of product and services revenues.

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As theCompany has vendor specific objective evidence of the values of its hardware,software and services, it uses the relative fair values of these elements toallocate revenues between product sales and service sales on its data storageprojects.

***Servicesales***.   The Company also sells servicecontracts to most of its customers. These contracts are support serviceagreements. The Company has an internal support desk to provide integratedcustomer support services. The Company fulfills on-site assistance by purchasingsupport service agreements for customers from the hardware and software vendorsor their designated third-party service providers and by arranging on-sitesupport assistance with the appropriate vendor when necessary. When the servicecontracts are sold as part of a data storage solution in a bundled arrangement,the Company uses vendor specific objective evidence to allocate revenue to theservice contract element. The revenues and direct costs resulting from theseservice contracts are deferred and amortized into operations over the term ofthe contracts, which are generally twelve months. The Company is contractuallyobligated to provide or arrange to provide these underlying support services toits customers in the unlikely event that the hardware or software vendor, orits designee, fails to perform according to the terms of its contract.

For consulting services contracts that do not includethe sale of hardware or software product, the Company recognizes revenue as theservices are performed.

Deferred revenue iscomprised of deferrals for maintenance and other services for which payment hasbeen received and for which the service has not yet been performed.

*Inventory.*   Weperiodically review, estimate and adjust our reserves for obsolete orunmarketable inventory equal to the difference between the inventory cost andthe estimated market value based upon assumptions about future demand andmarket conditions. Results could be materially different if demand for ourproducts decreased because of economic or competitive conditions, length ofindustry downturn, or if products become obsolete because of technicaladvancements in the industry.

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

Other intangible assets consist of customer lists. Weamortize customer lists using the straight-line method over an estimated usefullife of five years. We review these intangible assets for impairment as changesin circumstance or the occurrence of events suggests the remaining value is notrecoverable. In October 2003, we announced several cost reduction actions.These actions included the closure of an office and terminating personnel weacquired from our OpenSystems.com acquisition in November 2000. As a result, weincurred an impairment of our customer base intangible asset. We estimated theimpact that closure of the office and termination of its personnel would haveon the OpenSystems.com customer accounts and the related expected discountedcash flows, considering the likelihood of retaining the customers without an officepresence. We then compared the undiscounted cash flows with the net book valueof the intangible asset which indicated the asset was impaired. To determinethe impairment charge, we calculated the discounted cash flows and compared themto the net book value of the intangible and determined the resulting impairmentcharge of the asset was $926,000.

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*Income Taxes.*   Weutilize the asset and liability method of accounting for income taxes. Werecognize deferred tax liabilities or assets for the expected future taxconsequences of temporary differences between the book and tax bases of assetsand liabilities. We regularly assess the likelihood that our deferred taxassets will be recovered from future taxable income We record a valuationallowance to reduce our deferred tax assets to the amounts we believe are morelikely than not to be realizable. We consider projected future taxable incomeand ongoing tax planning strategies in assessing the amount of the valuationallowance. If we determine it is more likely than not that we will not realizeall or part of our deferred tax assets, we will adjust our earnings for thedeferred tax in the period we make this determination. As a result of ourcumulative losses over the past two years and the full utilization of our losscarry back potential, we concluded during the fourth quarter of fiscal 2002 tomake a full valuation allowance against our net deferred tax assets. Thevaluation allowance at December 31, 2003 was $2.8 million. In addition, weexpect to provide a full valuation allowance on any future tax benefits untilwe can sustain a level of profitability that demonstrates our ability to realizethese assets. 

**Recent Accounting Pronouncements**

In December 2002, the FASB issued SFAS No. 148,Stock Compensation. SFAS No. 148 provides alternative methods oftransition for a voluntary change to the fair value based method of accountingfor stock-based employee compensation. In addition, SFAS No. 148 amendsthe disclosure requirements of SFAS No. 123 to require prominentdisclosures in both annual and interim financial statements about the method ofaccounting for stock-based employee compensation and the effect of the methodused on reported results. We do not plan to change our method of accounting forstock-based employee compensation.

In December 2002, the EITF issued EITF 00-21,Revenue Arrangements with Multiple Deliverables. This Issue addresses certainaspects of the accounting by a vendor for arrangements under which it willperform multiple revenue-generating activities. In some arrangements, thedifferent revenue-generating activities (deliverables) are sufficientlyseparable, and there exists sufficient evidence of their fair values toseparately account for some or all of the deliverables (that is, there areseparate units of accounting). In other arrangements, some or all of thedeliverables are not independently functional, or there is not sufficientevidence of their fair values to account for them separately. This Issueaddresses when and, if so, how an arrangement involving multiple deliverablesshould be divided into separate units of accounting. This Issue does not changeotherwise applicable revenue recognition criteria. This Issue was applicablefor the Company beginning in July 2003 and did not have an impact onrevenue recognition.

In December 2003, the SECissued Staff Accounting Bulletin (“SAB”) No. 104, Revenue Recognition,which supersedes SAB No. 101, Revenue Recognition in Financial Statements.SAB No. 104 rescinds accounting guidance in SAB No. 101 related tomultiple-element arrangements as this guidance has been superseded as a resultof the issuance of EITF 00-21, “Accounting for Revenue Arrangements withMultiple Deliverables.” The adoption of SAB No. 104 did not have amaterial impact on the Company’s financial position or results of operations.

**Inflation**

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

**RISKFACTORS**

As indicated in thisAnnual Report under the caption “Note Regarding Forward-Looking Statements”,certain information contained in this Annual Report consists of forward-lookingstatements. 

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Importantfactors that could cause actual results to differ materially from theforward-looking statements made in this Annual Report include the following:

**Economic conditions continue to adversely impact ourrevenues and profits.**

Sincemid-2001, we have experienced a difficult and highly competitive economicclimate and operating environment. The high level of economicuncertainty has led to an overall reduction in capital spending, includingspending for technology. Some of our customers have canceled or delayed plannedpurchases. Others have replaced large storage solution installation projectswith smaller, piecemeal projects that carry lower profit margins for us. Competitionfor available business has also affected our margins. As a result, we haveincurred losses for each of the last nine successive quarters. We cannotpredict the continuing effect of economic conditions over the past severalyears on our business. If our revenues and cash flows continue to be adverselyaffected, we may need to further reduce our expenses or personnel. This couldadversely affect our ability to capitalize on future technology spending by ourcustomers at such time as economic conditions improve.

**Competition could prevent us from increasing or sustainingour 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 competitors includeour suppliers. We are not the exclusive supplier of any data storage product weoffer. Instead, our suppliers market their products through other independentdata storage solution providers, original equipment manufacturers and, often,through their own internal sales forces. We believe direct competition from oursuppliers is likely to increase if, as expected, the data storage industry continuesto consolidate. This consolidation would probably result in fewer supplierswith greater resources to devote to internal sales and marketing efforts. Inaddition, our suppliers have established and will probably continue toestablish cooperative relationships with other suppliers and other data storagesolution providers. These cooperative relationships are often intended toenable our suppliers to offer comprehensive storage solutions, which competewith those we offer. If our relationships with our suppliers becomeadversarial, it will be more difficult for us to stay ahead of industrydevelopments and provide our customers with the type of service they expectfrom us.

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

 

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**Future goodwill impairment may unpredictably affectour financial results.**

EffectiveJanuary 1, 2002 under Statement of Financial Accounting Standards No. 142,we no longer amortize goodwill. Instead, we perform impairment analyses of ourgoodwill at least annually or when we believe there is an impairment. Futureevents could cause us to conclude that impairment indicators exist and thatgoodwill associated with our acquired businesses is impaired. Any resultingimpairment loss could have a material adverse impact on our financial conditionand results of operations.

**We derive a significant percentage of our revenuesfrom a small number of customers.**

In 2003, we derived 10% ofour revenues from one customer, and our top five customers collectivelyaccounted for 26% of our revenues. Our largest customer recently began tooutsource its information technology and services to a third party provider. Atthis time, we are uncertain whether we will continue to provide either productor customer support for this customer or the third party provider. We cannotassure you that this customer will account for a substantial portion of ourfuture sales. Because we intend to continue to seek out large projects, weexpect that a significant percentage of our revenues will continue to come froma small 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 be adverselyaffected. In addition, our reliance on large projects makes it more likely thatour revenues and profits will fluctuate unpredictably from year to year.Unpredictable revenue and profit fluctuations may make our stock price morevolatile and lead to a decline in our stock price.

**Our revenue recognition policies unpredictably deferreporting of our revenues.**

We increasingly sellcomplex enterprise-class information storage solutions. We do not recognizerevenues from our sale of hardware and software products to our customers untilwe complete our required installation or configuration of these products. Installationand configuration of these solutions requires significant coordination with ourcustomers and vendors. Therefore, even if we have shipped all products to ourcustomers, we may be unable to control the timing of product installation andconfiguration. These delays prevent us from recognizing revenue on products weship and may adversely affect our quarterly reported revenues. As a result, ourstock price may decline.

**Our cost reduction initiatives may unpredictablyimpact expected financial results.**

In October 2003, weannounced several cost reduction initiatives and management changes. Thesechanges resulted in a fourth quarter 2003 charge of $2.1 million. To reducefacility costs, we plan during 2004 to seek one or more subtenants for ourheadquarters and other locations. These cost reduction initiatives mayaccelerate expenses that we might otherwise incur over a longer period of time,unpredictably impacting our financial results.

**Accounting forequity compensation future accounting changes may adversely impact our expectedfinancial results.**

Under current accountingrules, we do not record charges to our financial statements in connection withthe grant at fair market value of employee stock options. However, we expectthese accounting rules to change. These new option-related expenses mayunpredictably affect our reported results, which may adversely affect our stockprice.

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

We rely on our closerelationships with our suppliers to provide access to products and newtechnology necessary to design and implement leading-edge enterprise-classinformation storage solutions for our customers. We do not have long-termsupply contracts with any of our suppliers. In many instances, 

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we relyupon only one or two suppliers for each of our key products. Our reliance onthese suppliers leaves us vulnerable to an inadequate supply of requiredproducts, price increases, late deliveries and poor product quality. Disruptionor termination of the supply of products from our suppliers for any reasonwould likely prevent or delay our shipments to our customers. Our customersexpect reliable and prompt service from us. If we cannot obtain necessarycomponents, or the components we obtain are unreliable or unexpectedly expensive,we will not meet our customers’ expectations. If we cannot meet our customers’expectations, our business will suffer considerably.

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

Our future operatingresults depend upon our ability to attract, retain and motivate qualifiedengineers with enterprise-class information storage solutions experience. If wefail to recruit and retain additional engineering personnel, or if continuedlosses require us in the future to terminate employment of some of thesepersonnel, we will experience greater difficulty realizing our growth strategy,which could negatively affect our business, financial condition and stockprice.

**We generally do not have employment agreements withour key employees.**

Our future operatingresults depend in significant part upon the continued contributions of ourexecutive officers, managers, salespeople, engineers and other technicalpersonnel, many who have substantial experience in our industry and would bedifficult to replace. In general, we do not have employment, non-competition ornondisclosure agreements with our officers or employees, including ourexecutive officers. Accordingly, our employees may voluntarily leave us at anytime and work for our competitors. Our growth strategy depends in part on ourability to retain our current employees and hire new employees. Any failure toretain our key employees will make it much more difficult for us to maintainour operations and attain our growth objectives and could therefore be expectedto adversely affect our operating results, financial condition and stock price.

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

Our planned growth andexpansion, if realized in light of economic conditions over the past severalyears, would place a significant strain on our administrative, operational andfinancial resources. This growth may also increase demands on our professionaland technical services, sales, marketing and customer service and supportfunctions. Our planned geographic expansion may exacerbate these challenges andrequire us to hire, train, motivate and manage new management, technical, salesand administrative employees. If we manage this planned growth poorly, we maybe unable to continue to provide our customers with the high level of technicalservice and expertise they expect from us. This failure would harm ourreputation, hamper our ability to grow and adversely affect our financialcondition and stock price.

**If the data storage industry fails to developcompelling new storage technologies, our business may suffer.**

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

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

Our sales cycle istypically long and unpredictable, making it difficult to plan our business.Economic conditions over the past several years have increased this uncertainty.Our long sales cycle requires us to invest resources in potential projects thatmay not occur. In addition, our long and unpredictable sales cycle may cause usto experience 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.

**Control by our existing stockholders could discouragethe potential acquisition of our business.**

Currently, our executiveofficers and directors beneficially own approximately 36% of our outstandingcommon stock. Acting together, these insiders may be able to elect our entireBoard of Directors and control the outcome of all other matters requiringstockholder approval. This voting concentration may also have the effect ofdelaying or preventing a change in our management or control or otherwisediscourage potential acquirers from attempting to gain control of us. Ifpotential acquirers are deterred, you may lose an opportunity to profit from apossible acquisition premium in our stock price.

**Our stock price is volatile.**

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

·       actualor anticipated fluctuations in our operating results;

·       announcementsof technical innovations;

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

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

·       generalmarket conditions, including the effects of economic conditions over the pastseveral years and war and terrorism threats.

**Our governing documents and Minnesota law maydiscourage the potential acquisitions of our business.**

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

**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 market riskrelated to changes in interest rates, foreign exchange rates and equity prices.

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*Interestrate risk.**  *As of December 31,2003, we had $12.6 million of cash and money market accounts. A decrease inmarket rates of interest would have no material effect on the value of theseassets or the related interest income due to the nature of money marketaccounts. We have no short or long-term debt.

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

*Equity price risk.**  *We do not own any equity investments. Therefore, weare not currently exposed to any direct equity price risk.

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

**Independent Auditors’ Report**The Board of Directors andShareholdersDatalink Corporation:

We have audited the accompanying balance sheets ofDatalink Corporation as of December 31, 2003 and 2002, and the relatedstatements of operations, stockholders’ equity and cash flows for the yearsthen ended. These financial statements are the responsibility of the Company’smanagement. Our responsibility is to express an opinion on these financialstatements based on our audits. The financial statements of DatalinkCorporation for the year ended December 31, 2001, were audited by otherauditors who have ceased operations. Those auditors expressed an unqualifiedopinion on those financial statements in their report dated February 8,2002.

We conducted our audits in accordance with auditingstandards generally accepted in the United States of America. Those standardsrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether the financial statements are free of material misstatement. An auditincludes examining, on a test basis, evidence supporting the amounts anddisclosures in the financial statements. An audit also includes assessing theaccounting principles used and significant estimates made by management, aswell as evaluating the overall financial statement presentation. We believethat our audits provide a reasonable basis for our opinion.

In our opinion, the 2003 and 2002 financial statementsreferred to above present fairly, in all material respects, the financialposition of Datalink Corporation. as of December 31, 2003 and 2002, andthe results of its operations and its cash flows for the years then ended inconformity with accounting principles generally accepted in the United Statesof America.

As discussed above, the2001 financial statements of Datalink Corporation were audited by otherauditors who have ceased operations. As described in note 3, these financialstatements have been revised to include the transitional disclosures required byStatement of Financial Accounting Standards No. 142, *Goodwill and Other Intangible Assets*,which was adopted by the Company as of January 1, 2002. In our opinion,the disclosures for 2001 in note 3 are appropriate. However, we were notengaged to audit, review, or apply any procedures to the 2001 financialstatements of Datalink Corporation, other than with respect to such disclosuresand, accordingly, we do not express an opinion or any other form of assuranceon the 2001 financial statements taken as a whole.

/s/ KPMG LLP

Minneapolis, Minnesota

February 6, 2004

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*This is a copy of an accountants’ report previouslyissued by Arthur Andersen LLP (“Andersen”). This report has not been reissuedby Andersen. After a reasonable effort, we have been unable to obtain theconsent of Andersen for the incorporation by reference of the report dated February 8,2002 included in our Annual Report on Form 10-K for the year ended December 31,2002. The financial statements for the year ended December 31, 2001 havebeen revised to include the transitional disclosures required by Statement ofFinancial Accounting Standards No. 142, Goodwill and Other IntangibleAssets, which was adopted by the Company as of January 1, 2002. Underthese circumstances Rule 437a under the Securities Act of 1933 permits usto file a Registration Statement without a written consent from Andersen. Weare not able to obtain the written consent of Andersen to incorporate byreference this report into our previously filed registration statements on Form S-8,File number 333-93229 and Form S-3, File number 333-96901. In addition, wewill not be able to obtain the written consent of Andersen for any futureregistration statement we may file as required by Section 7 of theSecurities Act. Accordingly, investors will not be able to sue Andersenpursuant to Section 11 of the Securities Act relating to thoseregistration statements and therefore may have their recovery limited as aresult of the lack of consent. The ability of investors to recover from Andersenmay also be limited as a result of their financial condition or other mattersrelating to the various civil and criminal lawsuits relating to them.*

**Report ofIndependent Public Accountants**

ToDatalink Corporation:

We have audited the accompanying balance sheet ofDatalink Corporation (a Minnesota corporation) as of December 31, 2001,and the related statements of operations, stockholders’ equity and cash flowsfor the year then ended. These financial statements are the responsibility ofthe Company’s management. Our responsibility is to express an opinion on thesefinancial statements based on our audit.

We conducted our audit in accordance with auditingstandards generally accepted in the United States. Those standards require thatwe plan and perform the audit to obtain reasonable assurance about whether thefinancial statements are free of material misstatement. An audit includesexamining, on a test basis, evidence supporting the amounts and disclosures inthe financial statements. An audit also includes assessing the accountingprinciples used and significant estimates made by management, as well as evaluatingthe overall financial statement presentation. We believe that our auditprovides a reasonable basis for our opinion.

In ouropinion, the financial statements referred to above present fairly, in allmaterial respects, the financial position of Datalink Corporation as of December 31,2001, and the results of its operations and its cash flows for the year thenended in conformity with accounting principles generally accepted in the UnitedStates.

/s/ Arthur Andersen LLP

Minneapolis,Minnesota

February 8, 2002

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**DATALINKCORPORATIONBALANCE SHEETS(In thousands, except share data)**
| ** **                                                                                                                                                                  | ** ** | **December 31,** | ** ** |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|------------|-----------------------|------------|
| ** **                                                                                                                                                                  | ** ** | **2003**              | ** ** | **2002** | ** ** |
| **Assets**                                                                                                                                                                  |       |                  |       |   |   |
| Current assets:                                                                                                                                                             |       |                  |       |   |   |
| Cash and cash equivalents                                                                                                                                                   |       | $                     | 12,565     |   | $ | 10,334 |   |
| Accounts receivable, net                                                                                                                                                    |       | 8,541                 |       | 12,419 |   |
| Inventories                                                                                                                                                                 |       | 1,969                 |       | 2,410 |   |
| Inventories shipped but not installed                                                                                                                                       |       | 2,160                 |       | 4,059 |   |
| Income tax receivable                                                                                                                                                       |       | —                |       | 1,952 |   |
| Other current assets                                                                                                                                                        |       | 329                   |       | 401 |   |
| Total current assets                                                                                                                                                        |       | 25,564                |       | 31,575 |   |
| Property and  equipment, net                                                                                                                                                |       | 4,500                 |       | 5,506 |   |
| Goodwill                                                                                                                                                                    |       | 5,500                 |       | 5,500 |   |
| Intangibles, net                                                                                                                                                            |       | 485                   |       | 2,135 |   |
| Other, net                                                                                                                                                                  |       | 45                    |       | 69 |   |
| Total assets                                                                                                                                                                |       | $                     | 36,094     |   | $ | 44,785 |   |
| **Liabilities and Stockholders’ Equity**                                                                                                                               | ** ** | ** **            | ** ** | ** ** | ** ** |
| Current  liabilities:                                                                                                                                                       |       |                  |       |   |   |
| Accounts payable                                                                                                                                                            |       | $                     | 10,139     |   | $ | 13,667 |   |
| Accrued commissions                                                                                                                                                         |       | 475                   |       | 818 |   |
| Accrued income taxes                                                                                                                                                        |       | 72                    |       | — |   |
| Accrued sales and use taxes                                                                                                                                                 |       | 350                   |       | 496 |   |
| Accrued expenses, other                                                                                                                                                     |       | 837                   |       | 683 |   |
| Deferred revenue                                                                                                                                                            |       | 2,203                 |       | 2,434 |   |
| Total current liabilities                                                                                                                                                   |       | 14,076                |       | 18,098 |   |
| Deferred rent                                                                                                                                                               |       | 522                   |       | 341 |   |
| Total liabilities                                                                                                                                                           |       | 14,598                |       | 18,439 |   |
| Commitments and  contingencies (Note 7, 9 and 11)                                                                                                                           |       |                  |       |   |   |
| Stockholders’  equity:                                                                                                                                                 |       |                  |       |   |   |
| Common stock, $0.001 par value, 50,000,000 shares  authorized, 10,241,963 and 10,206,699 shares issued and outstanding as of  December 31, 2003 and 2002, respectively |       | 10                    |       | 10 |   |
| Additional paid-in capital                                                                                                                                                  |       | 26,158                |       | 25,854 |   |
| Retained earnings (accumulated deficit)                                                                                                                                     |       | (4,672                | )          | 482 |   |
| Total stockholders’ equity                                                                                                                                             |       | 21,496                |       | 26,346 |   |
| Total liabilities  and stockholders’ equity                                                                                                                            |       | $                     | 36,094     |   | $ | 44,785 |   |

 

The accompanying notes are an integral part of thesefinancial statements.

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**DATALINK CORPORATIONSTATEMENTS OF OPERATIONS(In thousands, except per share data)**
| ** **                                     | ** ** | **Year Ended December 31,** | ** ** |
|------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                     | ** ** | **2003**                                   | ** ** | **2002** | ** ** | **2001** | ** ** |
| Net sales:                                     |       |                                       |       |   |   |   |   |
| Product sales                                  |       | $                                          | 61,350     |   | $ | 58,492 |   | $ | 96,188 |   |
| Service sales                                  |       | 29,787                                     |       | 28,008 |   | 28,596 |   |
| Total net sales                                |       | 91,137                                     |       | 86,500 |   | 124,784 |   |
| Cost of sales:                                 |       |                                       |       |   |   |   |   |
| Cost of product sales                          |       | 47,477                                     |       | 44,776 |   | 70,393 |   |
| Cost of services                               |       | 20,198                                     |       | 20,000 |   | 20,328 |   |
| Total cost of  sales                           |       | 67,675                                     |       | 64,776 |   | 90,721 |   |
| Gross profit                                   |       | 23,462                                     |       | 21,724 |   | 34,063 |   |
| Operating expenses:                            |       |                                       |       |   |   |   |   |
| Sales and marketing                            |       | 10,985                                     |       | 11,481 |   | 15,836 |   |
| General and administrative                     |       | 10,960                                     |       | 10,354 |   | 11,221 |   |
| Engineering                                    |       | 4,220                                      |       | 4,954 |   | 5,259 |   |
| Restructuring charges                          |       | 2,078                                      |       | — |   | — |   |
| Amortization of goodwill and other intangibles |       | 724                                        |       | 1,088 |   | 2,264 |   |
| Operating loss                                 |       | (5,505                                     | )          | (6,153 | ) | (517 | ) |
| Interest income                                |       | 74                                         |       | 117 |   | 127 |   |
| Loss before income taxes                       |       | (5,431                                     | )          | (6,036 | ) | (390 | ) |
| Income tax  (benefit) expense                  |       | (276                                       | )          | (618 | ) | 115 |   |
| Net loss                                       |       | $                                          | (5,155     | ) | $ | (5,418 | ) | $ | (505 | ) |
| Net loss per  share, basic:                    |       |                                       |       |   |   |   |   |
| Loss per share                                 |       | $                                          | (0.50      | ) | $ | (0.56 | ) | $ | (0.06 | ) |
| Net loss per share,  diluted:                  |       |                                       |       |   |   |   |   |
| Loss per share                                 |       | $                                          | (0.50      | ) | $ | (0.56 | ) | $ | (0.06 | ) |
| Weighted average  shares outstanding:          |       |                                       |       |   |   |   |   |
| Basic                                          |       | 10,333                                     |       | 9,687 |   | 8,921 |   |
| Diluted                                        |       | 10,333                                     |       | 9,687 |   | 8,921 |   |

 

The accompanying notes are an integral part of these financialstatements.

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**DATALINKCORPORATIONSTATEMENTS OF STOCKHOLDERS’ EQUITY(In thousands)**
| ** **                                                                      | ** ** | ** **            | ** ** | ** **  | ** ** | ** **       | ** ** | **Retained**  | ** ** | ** ** | ** ** |
|---------------------------------------------------------------------------------|------------|-----------------------|------------|-------------|------------|------------------|------------|---------------|------------|------------|------------|
| ** **                                                                      | ** ** | ** **            | ** ** | ** **  | ** ** | **Additional**   | ** ** | **Earnings/** | ** ** | ** ** | ** ** |
| ** **                                                                      | ** ** | **Common Stock** | ** ** | **Paid-in** | ** ** | **(Accumulated** | ** ** | ** **    | ** ** |
| ** **                                                                      | ** ** | **Shares**            | ** ** | **Amount**  | ** ** | **Capital**      | ** ** | **Deficit)**  | ** ** | **Total**  | ** ** |
| Balances,  December 31, 2000                                               |       | 8,896                 |       |        | $          | 9                |       |          | $          | 19,723     |       |   | $ | 6,405 |   |   | $ | 26,137 |   |
| Net loss                                                                        |       | —                |       |        | —     |             |       | —        |       |       | (505       | ) |   | (505 | ) |
| Compensation  expense related to stock options                                  |       | —                |       |        | —     |             |       | 146           |       |       | —     |   |   | 146 |   |
| Common shares  issued under employee stock purchase plan and stock option plans |       | 55                    |       |        | —     |             |       | 336           |       |       | —     |   |   | 336 |   |
| Balances,  December 31, 2001                                               |       | 8,951                 |       |        | 9          |             |       | 20,205        |       |       | 5,900      |   |   | 26,114 |   |
| Net loss                                                                        |       | —                |       |        | —     |             |       | —        |       |       | (5,418     | ) |   | (5,418 | ) |
| Issuance of  shares in private placement, net of issuance costs (Note 10)       |       | 1,180                 |       |        | 1          |             |       | 5,216         |       |       | —     |   |   | 5,217 |   |
| Compensation  expense related to stock options                                  |       | —                |       |        | —     |             |       | 208           |       |       | —     |   |   | 208 |   |
| Common shares  issued under employee stock purchase plan and stock option plans |       | 76                    |       |        | —     |             |       | 225           |       |       | —     |   |   | 225 |   |
| Balances,  December 31, 2002                                               |       | 10,207                |       |        | 10         |             |       | 25,854        |       |       | 482        |   |   | 26,346 |   |
| Net loss                                                                        |       | —                |       |        | —     |             |       | —        |       |       | (5,155     | ) |   | (5,155 | ) |
| Compensation  expense related to stock options                                  |       | —                |       |        | —     |             |       | 194           |       |       | —     |   |   | 194 |   |
| Common shares  issued under employee stock purchase plan and stock option plans |       | 35                    |       |        | —     |             |       | 111           |       |       | —     |   |   | 111 |   |
| Balances,  December 31, 2003                                               |       | 10,242                |       |        | $          | 10               |       |          | $          | 26,158     |       |   | $ | (4,672 | ) |   | $ | 21,496 |   |

 

The accompanying notes are an integral part of these financialstatements.

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**DATALINKCORPORATIONSTATEMENTS OF CASH FLOWS(In thousands)**
| ** **                                                                       | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                                                       | ** ** | **2003**                                   | ** ** | **2002** | ** ** | **2001** | ** ** |
| Cash flows from  operating activities:                                           |       |                                       |       |   |   |   |   |
| Net loss                                                                         |       | $                                          | (5,155     | ) | $ | (5,418 | ) | $ | (505 | ) |
| Adjustments to  reconcile net loss to net cash provided by operating activities: |       |                                       |       |   |   |   |   |
| Provision (recoveries) for bad debts                                             |       | (34                                        | )          | 77 |   | 115 |   |
| Depreciation and amortization                                                    |       | 2,092                                      |       | 1,981 |   | 2,425 |   |
| Amortization of intangibles                                                      |       | 724                                        |       | 1,088 |   | 2,264 |   |
| Impairment of customer base intangible                                           |       | 926                                        |       | — |   | — |   |
| Deferred income taxes                                                            |       | —                                     |       | 273 |   | 305 |   |
| Valuation allowance for deferred income taxes                                    |       | —                                     |       | 1,609 |   | — |   |
| Deferred rent                                                                    |       | 181                                        |       | 72 |   | 269 |   |
| Stock compensation expense                                                       |       | 194                                        |       | 208 |   | 146 |   |
| Loss on sale of assets                                                           |       | 10                                         |       | — |   | — |   |
| Changes in  operating assets and liabilities:                                    |       |                                       |       |   |   |   |   |
| Accounts receivable                                                              |       | 3,912                                      |       | 2,631 |   | 1,013 |   |
| Inventories                                                                      |       | 2,340                                      |       | 338 |   | 8,145 |   |
| Other current assets                                                             |       | 2,024                                      |       | (112 | ) | (45 | ) |
| Other assets                                                                     |       | 24                                         |       | 162 |   | (60 | ) |
| Accounts payable                                                                 |       | (3,528                                     | )          | (1,543 | ) | (4,454 | ) |
| Accrued expenses                                                                 |       | (117                                       | )          | (184 | ) | (1,840 | ) |
| Income taxes                                                                     |       | (146                                       | )          | (342 | ) | (2,128 | ) |
| Deferred revenue                                                                 |       | (231                                       | )          | 144 |   | (1 | ) |
| Net cash provided by operating activities                                        |       | 3,216                                      |       | 984 |   | 5,649 |   |
| Cash flows from  investing activities:                                           |       |                                       |       |   |   |   |   |
| Purchase of property and equipment                                               |       | (1,096                                     | )          | (1,146 | ) | (4,300 | ) |
| Deposit on lease arrangement                                                     |       | —                                     |       | — |   | 500 |   |
| Net assets acquired, net of cash acquired                                        |       | —                                     |       | — |   | (176 | ) |
| Net cash used in investing activities                                            |       | (1,096                                     | )          | (1,146 | ) | (3,976 | ) |
| Cash flows from  financing activities:                                           |       |                                       |       |   |   |   |   |
| Proceeds from issuance of common stock, net                                      |       | 111                                        |       | 5,354 |   | 336 |   |
| Payments of notes payable to former stockholder                                  |       | —                                     |       | (704 | ) | (705 | ) |
| Net cash (used in) provided by financing activities                              |       | 111                                        |       | 4,650 |   | (369 | ) |
| Increase in cash  and cash equivalents                                           |       | 2,231                                      |       | 4,488 |   | 1,304 |   |
| Cash and cash  equivalents, beginning of year                                    |       | 10,334                                     |       | 5,846 |   | 4,542 |   |
| Cash and cash  equivalents, end of year                                          |       | $                                          | 12,565     |   | $ | 10,334 |   | $ | 5,846 |   |
| **Supplementary  Cash Flow Information:**                                        | ** ** | ** **                                 | ** ** | ** ** | ** ** | ** ** | ** ** |
| Cash paid for interest                                                           |       | $                                          | —     |   | $ | 45 |   | $ | 132 |   |
| Cash (received)  paid for income taxes                                           |       | (2,242                                     | )          | (2,160 | ) | 1,936 |   |
| Significant non-cash  financing and investing transactions:                      |       |                                       |       |   |   |   |   |
| Obligation for  construction in progress                                         |       | —                                     |       | — |   | (1,968 | ) |

 

The accompanying notes are an integral part of these financialstatements.

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**DATALINKCORPORATION**NOTES TO FINANCIAL STATEMENTS

**1. Description ofBusiness:**

Datalink Corporation (the “Company”)is an independent architect of enterprise-class information storageinfrastructures. The Company derives its revenues principally from designing,installing and supporting data storage systems. The Company’s solutions caninclude hardware products, such as disk arrays, tape systems andinterconnection components, and storage management software products. TheCompany is frequently engaged to provide assistance in the installation ofsolutions and to provide support services subsequent to the installation.Occasionally, the Company is engaged for consulting services.

**2. Summary ofSignificant Accounting Policies:**

***Cash Equivalents:***

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

***Accounts Receivable, net:***

Accounts receivable arerecorded net of the reserve for doubtful accounts of $98,000 and $197,000 at December 31,2003 and 2002, respectively.

***Concentration of Credit Risk:***

During 2003, 2002 and2001, net sales to one customer totaled 10%, 5% and 9% of total net sales,respectively. The balance of accounts receivable for this customer as apercentage of total accounts receivable as of December 31, 2003 and 2002,respectively is 3% and 23%, respectively.

***Software Development Costs:***

In compliance with the American Institute of CertifiedPublic Accountants (AICPA) Statement of Position 98-1, Accounting for ComputerSoftware Developed for or Obtained for Internal Use, the Company capitalizescertain costs associated with software developed or obtained for internal usewhen both the preliminary project stage is completed and management hasauthorized further funding for the project which it deems probable ofcompletion and use for the function intended. Capitalized internal-use softwarecosts include only (1) external direct costs of materials and services consumedin developing or obtaining the software, (2) payroll and payroll-related costsfor employees who are directly associated with and who devote time to theproject, and (3) interest cost incurred, when material, while developing thesoftware. Capitalization of such costs ceases no later than the point at whichthe project is substantially complete and ready for its intended purpose.Research and development costs and other computer software maintenance costsrelated to software development are expensed as incurred. The determination ofwhen the software is placed into production and ongoing assessment of therecoverability of these costs requires considerable judgment by management withrespect to certain external factors, including anticipated future revenues,estimated economic life, and changes in hardware and software technology. 

During 2000, the Companybegan the implementation of a new customer relationship management (CRM)application suite. The Company capitalized costs of the implementation of$234,000 in 2003, $1.3 million in 2002 and $1.0 million in 2001. The system iscomplete and no further costs are expected. Amounts are being amortized over aperiod of 3 years from the date they are available for use. Amortization ofsoftware costs were $815,000 in 2003, $536,000 in 2002, and $139,000 in 2001.

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***Inventories:***

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

***Property and Equipment:***

Propertyand equipment, including purchased software, are stated at cost. Depreciationand amortization are provided by charges to operations using the straight-linemethod over the estimated useful lives of the assets (ranging from 2 to 10years). Leasehold improvements are amortized on a straight-line basis over theshorter of their estimated useful lives or the underlying lease term. The costsand related accumulated depreciation and amortization on asset disposals areremoved from the accounts and any gain or loss is included in operations. Majorrenewals and betterments are capitalized, while maintenance and repairs arecharged to current operations when incurred.
| ** **                                      | ** ** | **December 31,**   | ** ** |
|-------------------------------------------------|------------|-------------------------|------------|
| ** **                                      | ** ** | **2003**                | ** ** | **2002** | ** ** |
| ** **                                      | ** ** | **(In thousands)** | ** ** |
| Property and equipment:                         |       |                    |       |   |   |
| Land                                            |       | $                       | 384        |   | $ | 384 |   |
| Construction in process                         |       | 186                     |       | 200 |   |
| Leasehold improvements                          |       | 488                     |       | 538 |   |
| Furniture and fixtures                          |       | 2,404                   |       | 2,487 |   |
| Equipment                                       |       | 901                     |       | 856 |   |
| Computers and software                          |       | 8,197                   |       | 7,383 |   |
|                                            |       | 12,560                  |       | 11,848 |   |
| Less accumulated  depreciation and amortization |       | 8,060                   |       | 6,342 |   |
|                                            |       | $                       | 4,500      |   | $ | 5,506 |   |

 

***Goodwill:***

The Company adoptedStatement of Financial Accounting Standards (SFAS) No. 142, Goodwill andOther Intangibles Assets, under which goodwill is no longer amortized on January 1,2002. See Note 3. As of January 1, 2002 the Company had net unamortizedgoodwill of $5.5 million. The Company evaluated its existing intangible assetsand goodwill that were acquired in prior business combinations and determinedthere was no impairment upon adoption. Goodwill is no longer being amortizedagainst earnings and goodwill balances are subject to an impairment review onan annual basis or sooner if indicators of potential impairment exist. Inaddition, the new rules further defined the classes of intangible assetswhich caused the Company to reclassify the $652,000 unamortized balance of anintangible asset represented by the estimated value of assembled workforce togoodwill as of January 1, 2002. The Company completed its annualimpairment testing of goodwill during the fourth quarter of 2003 and concludedthat no impairment existed. The value of assembled workforce at December 31,2001 was also reclassified in these financial statements for comparativepurposes.

***Intangibles, net:***

Identifiable intangibleassets are amortized on a straight-line basis over their estimated usefullives of 3 to 7 years. In October 2003, the Company announced several costreduction actions. These actions included closing an office and terminating personnelacquired by the Company from OpenSystems.com in November 2000, resultingin an impairment of the Company’s customer base intangible asset. The Companyestimated the impact that closure of this office and termination of itspersonnel would have on the OpenSystems.com customer accounts and the relatedexpected cash flows, considering the likelihood 

33

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ofretaining the customers without an office presence. The Company then comparedthe undiscounted cash flows with the net book value of the intangible assetwhich indicated the asset was impaired. To determine the impairment charge of$926,000, the Company calculated the discounted cash flows and compared them tothe net book value of the intangible and determined the resulting impairmentcharge of the asset.

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

The Company periodically(at least annually) analyzes its long-lived assets, including identifiable intangibleassets with discrete lives, for potential impairment, assessing theappropriateness of lives and recoverability of unamortized balances throughmeasurement of undiscounted operating cash flows on a basis consistent withgenerally accepted accounting principles.

***Stock Options:***

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

Proforma net loss and loss per share have been determined as if the Company hadused the fair value method of accounting for its stock option grants andemployee stock purchase plan share elections consistent with the method of SFASNo. 123. Under this method, compensation expense is recognized over theapplicable vesting periods and is based on the shares under option and theirrelated fair values on the grant date.
| ** **                                                                                 | ** ** | **2003**                                                                    | ** ** | **2002** | ** ** | **2001** | ** ** |
|--------------------------------------------------------------------------------------------|------------|-----------------------------------------------------------------------------|------------|----------|------------|----------|------------|
| ** **                                                                                 | ** ** | **(In thousands, except for per share data)** | ** ** |
| Net loss:                                                                                  |       |                                                                        |       |     |       |     |       |
| As reported                                                                                |       | $                                                                           | (5,155     | )        | $          | (5,418   | )          | $ | (505 | ) |
| Non cash compensation expense, net of tax                                                  |       | $                                                                           | (1,251     | )        | $          | (2,467   | )          | $ | (2,215 | ) |
| Stock compensation cost on stock based awards  granted below fair market value, net of tax |       | $                                                                           | 184        |     | $          | 187      |       | $ | 102 |   |
| Pro forma                                                                                  |       | $                                                                           | (6,222     | )        | $          | (7,698   | )          | $ | (2,618 | ) |
| Basic loss per share                                                                       |       |                                                                        |       |     |       |     |       |
| As reported                                                                                |       | $                                                                           | (0.50      | )        | $          | (0.56    | )          | $ | (0.06 | ) |
| Non cash compensation expense                                                              |       | $                                                                           | (0.12      | )        | $          | (0.25    | )          | $ | (0.24 | ) |
| Stock compensation cost on stock based awards  granted below fair market value             |       | $                                                                           | 0.02       |     | $          | 0.02     |       | $ | 0.01 |   |
| Pro forma                                                                                  |       | $                                                                           | (0.60      | )        | $          | (0.79    | )          | $ | (0.29 | ) |
| Diluted loss per share                                                                     |       |                                                                        |       |     |       |     |       |
| As reported                                                                                |       | $                                                                           | (0.50      | )        | $          | (0.56    | )          | $ | (0.06 | ) |
| Non cash compensation expense                                                              |       | $                                                                           | (0.12      | )        | $          | (0.25    | )          | $ | (0.24 | ) |
| Stock compensation cost on stock based awards  granted below fair market value             |       | $                                                                           | 0.02       |     | $          | 0.02     |       | $ | 0.01 |   |
| Pro forma                                                                                  |       | $                                                                           | (0.60      | )        | $          | (0.79    | )          | $ | (0.29 | ) |

 

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Theweighted-average fair values per option at the date of grant were $3.35, $4.35and $7.05 for 2003, 2002 and 2001 respectively. The fair value for the stockoption grants was estimated using the Black-Scholes option pricing model withthe following weighted average assumptions:
| ** **                      | ** ** | **2003** | ** ** | **2002** | ** ** | **2001**       | ** ** |
|---------------------------------|------------|----------|------------|----------|------------|----------------|------------|
| Risk-free  interest rates       |       | 3.77%    |       | 4.76%    |       | 4.31%  - 5.73% |       |
| Expected dividend  yield        |       | 0        |       | 0        |       | 0              |       |
| Expected  volatility factor     |       | 96%      |       | 102%     |       | 107%           |       |
| Expected option holding  period |       | 5 years  |       | 5 years  |       | 5 years        |       |

 

During the 2003, theCompany’s employees elected to purchase 23,883 shares under the Employee StockPurchase Plan (ESPP). Using the Black-Scholes pricing model, the weightedaverage fair value was $0.40 per share for each election. During the 2002 and2001 ESPP offering, employees elected to purchase 59,504 and 61,879,respectively. Using the Black-Scholes pricing model, the weighted average fairvalue was $0.54 per share for each election in 2002 and $0.19 per share foreach election in 2001.

***Income Taxes:***

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

***Use of Estimates:***

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period. Actual results could differ from those estimates.

***Revenue Recognition:***

The Company realizes revenue from the design,installation and support of data storage solutions, which may include hardware,software and services. The Company recognizes revenue when it has received anorder from the customer, persuasive evidence of an arrangement exists, deliveryhas occurred, the sales price is fixed or determinable, obligations forinstallation or other services are complete and collectability is reasonablyassured. The following summarizes the major terms of our contractualrelationships with our customers and the manner in which we account for salestransactions.

***Productsales.***   The Company applies the provisions ofStatement of Position (SOP) 97-2, *SoftwareRevenue Recognition*, and related interpretations to the hardware,software and services elements of its data storage solutions. For software orhardware product sales whereby the Company does not provide any installation orconfiguration services, revenue is recognized upon shipment. For data storagesolutions with hardware, software and services sold as a bundled arrangement,the Company considers the services to be essential to the functionality andrevenues are recognized on a completed contract basis pursuant to AmericanInstitute of Certified Public Accountants SOP 81-1, “Accounting forPerformance of Construction Type and Certain Production Type Contracts.”  As the Company has vendor specific 

35

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objective evidence of thevalues of its hardware, software and services, it uses the relative fair valuesof these elements to allocate revenues between product sales and service saleson its data storage projects.

***Servicesales.***   For consulting services contractsthat do not include the sale of hardware or software product, the Companyrecognizes revenue as the services are performed

The Company also sells service contracts to most ofits customers. These contracts are support service agreements. The Company hasan internal support desk to provide integrated customer support services. TheCompany fulfills on-site assistance by purchasing support service agreementsfor customers from the hardware and software vendors or their designated third-partyservice providers and by arranging on-site support assistance with theappropriate vendor when necessary. When the service contracts are sold as partof a data storage solution in a bundled arrangement, the Company uses vendorspecific objective evidence to allocate revenue to the service contractelement. The revenues and direct costs resulting from these service contractsare deferred and amortized into operations over the term of the contracts,which are generally twelve months. The Company is contractually obligated toprovide or arrange to provide these underlying support services to itscustomers in the unlikely event that the hardware or software vendor, or itsdesignee, fails to perform according to the terms of its contract.

Deferred revenue iscomprised of deferrals for maintenance and other services for which payment hasbeen received and for which the service has not yet been performed.

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

Basic net income (loss) per share is computed usingthe weighted average number of shares outstanding. Diluted net income per shareincludes the effect of common stock equivalents, if any, for each period. Thenumber of additional shares is calculated by assuming that outstanding stockoptions were exercised and that the proceeds from such exercise were used toacquire shares of common stock at the average market price during the reportingperiod. Due to the net loss in 2003, 2002 and 2001, potential common shares of105,931, 62,536 and 62,564, respectively, would have been anti-dilutive tolosses and as a result were excluded from the calculation of diluted loss pershare.

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

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

***Recently Issued Accounting Standards:***

In December 2002, the FASB issued SFAS No. 148,Stock Compensation. SFAS No. 148 provides alternative methods oftransition for a voluntary change to the fair value based method of accountingfor stock-based employee compensation. In addition, SFAS No. 148 amendsthe disclosure requirements of SFAS No. 123 to require prominentdisclosures in both annual and interim financial statements about the method ofaccounting for stock-based employee compensation and the effect of the methodused on reported results. The Company does not plan to change its method ofaccounting for stock-based employee compensation.

In December 2002, the EITF issued EITF 00-21,Revenue Arrangements with Multiple Deliverables. This Issue addresses certainaspects of the accounting by a vendor for arrangements under which it willperform multiple revenue-generating activities. In some arrangements, thedifferent revenue-generating activities (deliverables) are sufficientlyseparable, and there exists sufficient evidence of their fair values toseparately account for some or all of the deliverables (that is, there areseparate units of accounting). In other arrangements, some or all of thedeliverables are not independently functional, or there is not sufficientevidence of their fair values to account for them separately. This Issueaddresses when and, if so, how an arrangement involving multiple deliverablesshould be divided into separate units of accounting. 

36

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This Issue does not changeotherwise applicable revenue recognition criteria. This Issue was applicablefor the Company beginning in July 2003 and did not have an impact onrevenue recognition.

In December 2003, theSEC issued Staff Accounting Bulletin (“SAB”) No. 104, Revenue Recognition,which supersedes SAB No. 101, Revenue Recognition in Financial Statements.SAB No. 104 rescinds accounting guidance in SAB No. 101 related tomultiple-element arrangements as this guidance has been superseded as a resultof the issuance of EITF 00-21, “Accounting for Revenue Arrangements withMultiple Deliverables.”  The adoption ofSAB No. 104 did not have a material impact on the Company’s financialposition or results of operations.

***Reclassifications:***

Certain 2001 amounts havebeen reclassified to conform to current year presentation.

**3. Goodwill:**

Thefollowing table presents a reconciliation of net loss and income (loss) pershare adjusted for the exclusion of goodwill, net of tax:
| ** **                                            | ** ** | **Year Ended December 31** | ** ** |
|-------------------------------------------------------|------------|--------------------------------------|------------|
| ** **                                            | ** ** | **2003**                             | ** ** | **2002** | ** ** | **2001** | ** ** |
| Reported net loss                                     |       | $                                    | (5,155     | ) | $ | (5,418 | ) | $ | (505 | ) |
| Add: Goodwill  amortization, net of tax               |       | —                               |       | — |   | 951 |   |
| Adjusted net  income (loss)                           |       | $                                    | (5,155     | ) | $ | (5,418 | ) | $ | 446 |   |
| Reported basic and diluted loss per share             |       | $                                    | (0.50      | ) | $ | (0.56 | ) | $ | (0.06 | ) |
| Add: Goodwill  amortization, net of tax               |       | —                               |       | — |   | 0.11 |   |
| Adjusted basic and  diluted earnings (loss) per share |       | $                                    | (0.50      | ) | $ | (0.56 | ) | $ | 0.05 |   |

 

**4. Intangibles,net:**

Informationregarding the Company’s other intangible assets that continue to be amortizedare as follows:
| ** **                | ** ** | **As of December 31,** | ** ** |
|---------------------------|------------|---------------------------------------|------------|
| ** **                | ** ** | **2003**                              | ** ** | **2002** | ** ** |
| Customer lists            |       |                                  |       |   |   |
| Carrying amount           |       | $                                     | 3,374      |   | $ | 4,300 |   |
| Accumulated amortization. |       | 2,889                                 |       | 2,165 |   |
| Net                       |       | $                                     | 485        |   | $ | 2,135 |   |

 

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Amortizationexpense for the years ended December 31, 2003, 2002 and 2001 was $724,000,$1.1 million and $2.3 million, respectively. Estimated amortization expense forthe succeeding fiscal years based on the intangible assets as of December 31,2003 is as follows:
| ** ** | ** ** | **(In thousands)** | ** ** |
|------------|------------|-------------------------|------------|
| 2004       |       |                    | $          | 261 |   |   |
| 2005       |       |                    | 224        |   |   |
| Total      |       |                    | $          | 485 |   |   |

 

**5. BorrowingArrangements:**

Effective June 30, 2003, the Company entered intoa revolving credit agreement (the “Credit Agreement”) with a bank. Under theterms of the Credit Agreement, the Company may borrow up to $8 million to beused for financing working capital needs. The term of the agreement ends June 30,2004. Borrowings under the Credit Agreement are collateralized by the accountsreceivable and inventory of the Company. The Credit Agreement includes variouscovenants, including requirements to maintain a maximum level of debt-cash flowratio and a minimum amount of working capital, tangible net worth and debt-networth ratio. At December 31, 2003, the Company was in compliance with thecovenants in the Credit Agreement. The Company had no outstanding borrowingsunder the Credit Agreement as of December 31, 2003.

Effective February 28, 1999, the Company redeemed1,095,720 shares of common stock held by a former stockholder. The Companyissued a $3 million note payable to this former stockholder. The note providedfor interest on the outstanding balance at the prime rate beginning August 28,1999. A principal payment of $906,000 was made on August 28, 1999. Twoprincipal payments of $705,000 each were made on February 28, 2000 and2001. The remaining principal balance of $704,000 was paid on February 28,2002.

**6. Income Taxes:**

Theprovision for (benefit from) income taxes consisted of the following:
| ** **                                       | ** ** | **Year Ended December 31,** | ** ** |
|--------------------------------------------------|------------|--------------------------------------------|------------|
| ** **                                       | ** ** | **2003**                                   | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                                       | ** ** | **(In thousands)**                    | ** ** |
| Current income tax  benefit:                     |       |                                       |       |   |   |   |   |
| Federal                                          |       | $                                          | (276       | ) | $ | (1,976 | ) | $ | (186 | ) |
| State                                            |       | —                                     |       | (525 | ) | (4 | ) |
| Total                                            |       | (276                                       | )          | (2,501 | ) | (190 | ) |
| Deferred income tax  expense:                    |       |                                       |       |   |   |   |   |
| Federal                                          |       | —                                     |       | 1,551 |   | 250 |   |
| State                                            |       | —                                     |       | 332 |   | 55 |   |
| Total                                            |       | —                                     |       | 1,883 |   | 305 |   |
| Total provision for  (benefit from) income taxes |       | $                                          | (276       | ) | $ | (618 | ) | $ | 115 |   |

 

38

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Thereconciliation of the U.S. federal statutory tax rate to the Company’seffective income tax rate is as follows:
| ** **                                    | ** ** | **2003** | ** ** | **2002** | ** ** | **2001** | ** ** |
|-----------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Tax benefit at  U.S. statutory rates          |       | (34.0    | )%         | (34.0    | )%         | (34.0    | )%         |
| State tax  benefit, net of federal tax effect |       | (4.6     | )          | (3.7     | )          | (4.5     | )          |
| Nondeductible  expenses                       |       | 11.3     |       | 0.8      |       | —   |       |
| Change in  valuation allowance                |       | 22.3     |       | 26.7     |       | —   |       |
| Other, primarily  goodwill amortization       |       | —   |       | —   |       | 68.0     |       |
| Effective tax rate                            |       | (5.0     | )%         | (10.2    | )%         | 29.5     | %          |

 

Significantcomponents of the Company’s deferred tax assets and liabilities are as follows:
| ** **                       | ** ** | **Year Ended December 31,** | ** ** |
|----------------------------------|------------|--------------------------------------------|------------|
| ** **                       | ** ** | **2003**                                   | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **                       | ** ** | **(In thousands)**                    | ** ** |
| Current deferred tax  asset:     |       |                                       |       |   |   |   |   |
| Allowance for doubtful accounts  |       | $                                          | 79         |   | $ | 117 |   | $ | 105 |   |
| Compensation accrual             |       | 49                                         |       | 57 |   | — |   |
| Inventories                      |       | 92                                         |       | 176 |   | 123 |   |
| Deferred revenue                 |       | 195                                        |       | 485 |   | 1,198 |   |
| Restructuring reserve            |       | 77                                         |       | — |   | — |   |
| Other                            |       | —                                     |       | 6 |   | 9 |   |
| Total current deferred tax asset |       | 492                                        |       | 841 |   | 1,435 |   |
| Long-term deferred tax  asset:   |       |                                       |       |   |   |   |   |
| Net operating loss carryovers    |       | 1,924                                      |       | 325 |   | — |   |
| Intangibles                      |       | 955                                        |       | 564 |   | 417 |   |
| Property and equipment           |       | (575                                       | )          | (121 | ) | 31 |   |
| Other                            |       | 7                                          |       | — |   | — |   |
| Total gross deferred tax asset   |       | 2,803                                      |       | 1,609 |   | 1,883 |   |
| Valuation  allowance             |       | (2,803                                     | )          | (1,609 | ) | — |   |
| Net deferred tax asset           |       | $                                          | —     |   | $ | — |   | $ | 1,883 |   |

 

The valuation allowance for deferred tax assets as of December 31,2003, 2002 and 2001 was $2.8 million, $1.6 million and $0, respectively. Thenet change in the total valuation allowance for the years ended December 31,2003, 2002 and 2001 was an increase of $1.2 million, $1.6 million and $0,respectively.

In assessing the recoverability of deferred taxassets, management considers whether it is more likely than not that someportion or all of the deferred tax assets will be realized. The ultimaterealization of deferred tax assets is dependent upon the generation of futuretaxable income during the periods in which those temporary differences becomedeductible. Management considers the scheduled reversal of deferred taxliabilities, carry back potential and projected future taxable income and taxplanning strategies in making this assessment. Based upon the level of taxablelosses in recent years and uncertainty of future taxable income, managementbelieves that it is more likely than not that the Company will not realize thebenefits of these deductible differences at December 31, 2003.

At December 31, 2003,the Company had federal net operating loss carry forwards of approximately $4.0million and state net operating loss carry forwards of approximately $11.0million, which are available to offset future federal and state taxable income.If not used, these net operating loss carry forwards will expire between 2013and 2023.

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**7. LeaseCommitments:**

The Company’s corporate headquarters including theprincipal technical operations and the integration, assembly and supportservices operations are located in a 104,000 square foot office and warehousefacility in Chanhassen, Minnesota. The Company’s remaining 14 locationsincluding sales and technical staff, are small to medium sized offices. Regionalhubs are located within each of the Company’s regions in the East, Central andWest.

As of December 31,2003, future minimum lease payments due under non-cancelable operating leasesare as follows:
| ** ** | ** ** | **Lease  Obligations**  | ** ** | **Sublease  Agreements** | ** ** | **Net Lease  Obligations** | ** ** |
|------------|------------|-------------------------|------------|--------------------------|------------|---------------------------------|------------|
| ** ** | ** ** | **(In thousands)** | ** ** |
| 2004       |       |                    | $          | 2,101                    |       |                            |       | $ | (120 | ) |   |   | $ | 1,981 |   |   |
| 2005       |       |                    | 1,976      |                     |       |                            | (119       | ) |   |   | 1,857 |   |   |
| 2006       |       |                    | 1,878      |                     |       |                            | (94        | ) |   |   | 1,784 |   |   |
| 2007       |       |                    | 1,532      |                     |       |                            | (76        | ) |   |   | 1,456 |   |   |
| 2008       |       |                    | 1,265      |                     |       |                            | —     |   |   |   | 1,265 |   |   |
| Thereafter |       |                    | 4,321      |                     |       |                            | —     |   |   |   | 4,321 |   |   |
|       |       |                    | $          | 13,073                   |       |                            |       | $ | (409 | ) |   |   | $ | 12,664 |   |   |

 

Totalrent expense, charged to the Company, is as follows:
| ** **    | ** ** | **Year Ended December 31,** | ** ** |
|---------------|------------|--------------------------------------------|------------|
| ** **    | ** ** | **2003**                                   | ** ** | **2002** | ** ** | **2001** | ** ** |
| ** **    | ** ** | **(In thousands)**                    | ** ** |
| Related party |       | $                                          | —     |   | $ | — |   | $ | 112 |   |
| Other         |       | 2,427                                      |       | 2,399 |   | 2,080 |   |
|          |       | $                                          | 2,427      |   | $ | 2,399 |   | $ | 2,192 |   |

 

**8. Restructuring Charges:**

In October 2003, the Company announced several costreduction initiatives and management changes. These changes resulted in afourth quarter 2003 charge of $2.1 million. As part of these cost reductioninitiatives, the Company reduced its staff by 16%. Employee severance chargeswere $568,000. The Company also announced the closure of four offices. Officeclosing costs for lease terminations were $584,000. The office closuresincluded an office with a significant amount of customers obtained in theCompany’s OpenSystems.com acquisition in November 2000, resulting in animpairment of this customer base intangible asset. The resulting impairmentcharge of the asset was $926,000. During 2004, the Company expects to pay allremaining severance amounts accrued at December 31, 2003. The Companyexpects to settle the remaining accrual for lease terminations and officeclosures by the end of the first quarter of 2004.

Restructuringexpense activity for fiscal 2003 was as follows:
| ** **        | ** ** | **(in thousands)** | ** ** |
|-------------------|------------|-------------------------|------------|
| ** **        | ** ** | **Severance**           | ** ** | **Lease/Office  closures** | ** ** | **Intangible asset  impairment** | ** ** | **Total** | ** ** |
| Beginning balance |       |                    | $          | — |   |   |   | $ | — |   |   |   | $ | — |   |   | $ | — |   |
| Expense accruals  |       |                    | 568        |   |   |   | 584 |   |   |   | 926 |   |   | 2,078 |   |
| Cash payments     |       |                    | (378       | ) |   |   | (572 | ) |   |   | — |   |   | (950 | ) |
| Asset write-off   |       |                    | —     |   |   |   | — |   |   |   | (926 | ) |   | (926 | ) |
| Ending balance    |       |                    | $          | 190 |   |   |   | $ | 12 |   |   |   | $ | — |   |   | $ | 202 |   |

 

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**9. Employee BenefitPlan:**

The Company has a definedcontribution retirement plan for eligible employees. Employees may contributeup to 15% of their pretax compensation to the 401(k) portion of the plan. TheCompany matches 50% of an employee’s contribution up to the first 6% of anemployee’s eligible compensation. The cost of the Company’s contributions tothe 401(k) portion of the plan for 2003, 2002 and 2001, was $352,000, $356,000and $428,000, respectively.

**10. Stockholders’Equity:**

***Private Placement:***

In May 2002, the Company sold an aggregate of1,180,000 shares of Common Stock, plus five-year warrants, to purchase anadditional 200,000 shares at an exercise price of $4.50 per share, to fiveinstitutional investors for $5.3 million. The Company allocated an amount tothe value of the warrants utilizing a fair value estimate derived from theBlack-Scholes option pricing model assuming a volatility of 102%, the warrantlife of 5 years and a risk-free interest rate of 4.76%. Based on this fairvalue estimate, the Company allocated approximately $863,000 to the warrantsand $4,437,000 to the Common Stock.

***Stock Compensation Plans:***

Effective May 8, 2001, the Company reserved anaggregate of 3,000,000 shares of common stock for issuance pursuant to theCompany’s Incentive Compensation Plan (the “Incentive Plan”), 1,543,716 ofwhich were available for grant as of December 31, 2003. The terms of theplan allow for a variety of awards including incentive stock options,nonqualified stock options, stock appreciation rights, restricted stock,performance shares, performance units, cash-based awards, phantom shares andother share-based awards as determined by the Company’s CompensationCommittee (the “Committee”).

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

In August 2000, theBoard of Directors adopted the 2000 Director Stock Option Plan (the “DirectorPlan”). The Company amended the Director Plan in May and October 2002.The terms of the Director Plan allow for stock option grants to non-employeemembers of the Board of Directors. The Company has reserved 300,000 shares ofcommon stock for issuance pursuant to the Director Plan, 123,000 of which wereavailable for grant as of December 31, 2003.

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***Stock Options:***

Thefollowing table summarizes activity under the Company’s stock option plans:
| ** **                                        | ** ** | **Outstanding Options**   | ** ** |
|---------------------------------------------------|------------|--------------------------------|------------|
| ** **                                        | ** ** | **Number of Shares** | ** ** | **Range of   Exercise Prices** | ** ** | **Weighted   Average   Exercise Price** | ** ** |
| Balance,  December 31, 2000                  |       |                           | 1,051,791  |   |   | $ | 7.50 - $25.38 |   |   | $ | 11.19 |   |   |
| Options granted                                   |       |                           | 1,028,400  |   |   | $ | 1.60 - $15.25 |   |   | $ | 7.05 |   |   |
| Options exercised                                 |       |                           | (11,530    | ) |   | $ | 7.50 |   |   | $ | 7.50 |   |   |
| Options cancelled                                 |       |                           | (251,638   | ) |   | $ | 3.46 - $20.88 |   |   | $ | 10.35 |   |   |
| Balance,  December 31, 2001                  |       |                           | 1,817,023  |   |   | $ | 1.60 - $25.38 |   |   | $ | 9.00 |   |   |
| Options granted                                   |       |                           | 345,095    |   |   | $ | 1.44 - $6.42 |   |   | $ | 4.35 |   |   |
| Options exercised                                 |       |                           | —     |   |   | $ | 0.00 |   |   | $ | 0.00 |   |   |
| Options cancelled                                 |       |                           | (392,815   | ) |   | $ | 3.46 - $25.38 |   |   | $ | 9.08 |   |   |
| Balance,  December 31, 2002                  |       |                           | 1,769,303  |   |   | $ | 1.44 - $25.38 |   |   | $ | 8.07 |   |   |
| Options granted                                   |       |                           | 499,350    |   |   | $ | 1.80 - $5.00 |   |   | $ | 3.35 |   |   |
| Options exercised                                 |       |                           | (8,343     | ) |   | $ | 3.46 - $4.36 |   |   | $ | 3.55 |   |   |
| Options cancelled                                 |       |                           | (627,025   | ) |   | $ | 2.90 - $25.38 |   |   | $ | 9.31 |   |   |
| Balance,  December 31, 2003                  |       |                           | 1,633,285  |   |   | $ | 1.44 - $18.13 |   |   | $ | 6.19 |   |   |
| Options  exercisable as of December 31, 2003 |       |                           | 886,289    |   |   | $ | 1.44 - $18.13 |   |   | $ | 7.41 |   |   |

 

Thefollowing is a summary of options outstanding at December 31, 2003:
| **Stock  Options** | ** ** | **Range of   Exercise Price Per   Share** | ** **     | **Weighted Average  Exercise   Price Per Share** | ** ** | **Weighted Average   Remaining Contractual   Life (Years)** | ** ** |
|--------------------|------------|--------------------------------------------------------------------|----------------|----------------------------------------------------------------------|------------|--------------------------------------------------------------------------------------|------------|
| 869,352            |       | $                                                                  | 1.44 - $6.42   |                                                                 |       | $                                                                                    | 3.73       |   |   |   | 8.4 |   |   |
| 668,813            |       | $                                                                  | 6.43 - $9.94   |                                                                 |       | $                                                                                    | 7.83       |   |   |   | 5.6 |   |   |
| 31,737             |       | $                                                                  | 9.95 - $15.19  |                                                                 |       | $                                                                                    | 12.44      |   |   |   | 5.3 |   |   |
| 63,383             |       | $                                                                  | 15.20 - $25.38 |                                                                 |       | $                                                                                    | 17.42      |   |   |   | 5.3 |   |   |
| 1,633,285          |       | $                                                                  | 0.00 - $25.38  |                                                                 |       | $                                                                                    | 7.41       |   |   |   | 7.1 |   |   |

 

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Thefollowing is a summary of options granted at an exercise price that differsfrom the market price of the stock on the grant date:
| ** **                               | ** ** | **Stock Options  Granted** | ** ** | **Weighted Average  Exercise Price Per  Share** | ** ** | **Weighted Average  Exercise Price Per  Share** | ** ** |
|------------------------------------------|------------|---------------------------------|------------|----------------------------------------------------------------|------------|----------------------------------------------------------------|------------|
| December 31,  2001                  |       |                            |       |                                                           |       |                                                           |       |   |   |   |   |   |   |
| Option price equals fair market value    |       |                            | 977,900    |                                                           |       |                                                           | $          | 3.46 - $11.63 |   |   |   | $ | 6.92 |   |   |
| Option price less than fair market value |       |                            | 50,500     |                                                           |       |                                                           | $          | 1.60 - $15.25 |   |   |   | $ | 9.34 |   |   |
| Options granted                          |       |                            | 1,028,400  |                                                           |       |                                                           | $          | 1.60 - $15.25 |   |   |   | $ | 7.05 |   |   |
| December 31,  2002                  |       |                            |       |                                                           |       |                                                           |       |   |   |   |   |   |   |
| Option price equals fair market value    |       |                            | 297,845    |                                                           |       |                                                           | $          | 2.90 - $6.42 |   |   |   | $ | 4.52 |   |   |
| Option price less than fair market value |       |                            | 47,250     |                                                           |       |                                                           | $          | 1.44 - $4.24 |   |   |   | $ | 3.19 |   |   |
| Options granted                          |       |                            | 345,095    |                                                           |       |                                                           | $          | 1.44 - $6.42 |   |   |   | $ | 4.35 |   |   |
| December 31,  2003                  |       |                            |       |                                                           |       |                                                           |       |   |   |   |   |   |   |
| Option price equals fair market value    |       |                            | 449,600    |                                                           |       |                                                           | $          | 3.32 - $5.00 |   |   |   | $ | 3.46 |   |   |
| Option price less than fair market value |       |                            | 49,750     |                                                           |       |                                                           | $          | 1.80 - $3.84 |   |   |   | $ | 2.39 |   |   |
| Options granted                          |       |                            | 499,350    |                                                           |       |                                                           | $          | 1.80 - $5.00 |   |   |   | $ | 3.35 |   |   |

 

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

During 2000 and 1999, theCompany issued 135,850 options with an exercise price below the fair marketvalue of common stock at the date of grant. The intrinsic value of the optionsis being recorded to compensation expense over the vesting period, generallyfour years. During 2003, 2002 and 2001, $111,000, $118,000 and $119,000,respectively, of compensation expense was recorded related to these options. Asof December 31, 2003, 2002 and 2001, there was $17,000, $128,000 and$246,000, respectively, of compensation expense related to these options thatwill be recognized in future periods. During 2003, 2002 and 2001, the Companyissued 46,750, 47,250 and 49,750 options, respectively, to directors below thefair market value of common stock at the date of grant. The compensationexpense recorded was $83,000, $90,000 and $27,000 in 2003, 2002 and 2001,respectively. Because the options vest immediately, all compensation expensewas recorded in the period of the grant.

**11. Litigation**

The Company is notcurrently involved in any material legal proceedings. The Company also had nomaterial legal proceedings that terminated during the fourth quarter of 2003.

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**12. Quarterly Financial Information (unaudited)**
| **2003**                         | ** ** | ** **              | ** ** | **March 31** | ** ** | **June 30** | ** ** | **Sept 30** | ** ** | **Dec 31** | ** ** |
|----------------------------------|------------|-------------------------|------------|-------------------|------------|------------------|------------|------------------|------------|-----------------|------------|
| ** **                       | ** ** | **(In thousands)** | ** ** |
| Net sales                        |       | $                       | 23,742     |              | $          | 26,371           |       | $                | 19,951     |            | $          | 21,073 |   |
| Gross profit                     |       | 6,326                   |       | 6,821             |       | 5,010            |       | 5,305            |       |
| Operating loss                   |       | (879                    | )          | (210              | )          | (2,020           | )          | (2,396           | )          |
| Net loss                         |       | (860                    | )          | (186              | )          | (2,006           | )          | (2,103           | )          |
| Net loss per  share—basic   |       | (0.08                   | )          | (0.02             | )          | (0.20            | )          | (0.20            | )          |
| Net loss per  share—diluted |       | (0.08                   | )          | (0.02             | )          | (0.20            | )          | (0.20            | )          |
|                                  |            |                         |            |                   |            |                  |            |                  |            |                 |            |  |  |  |  |

 
| **2002**                         | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
|----------------------------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|------------|
| Net sales                        |       | $          | 21,784     |       | $          | 21,019     |       | $          | 21,858     |       | $          | 21,839 |   |
| Gross profit                     |       | 5,503      |       | 5,043      |       | 5,397      |       | 5,781      |       |
| Operating loss                   |       | (2,094     | )          | (1,978     | )          | (1,560     | )          | (521       | )          |
| Net loss                         |       | (1,300     | )          | (1,229     | )          | (962       | )          | (1,927     | )          |
| Net loss per  share—basic   |       | (0.15      | )          | (0.13      | )          | (0.09      | )          | (0.19      | )          |
| Net loss per  share—diluted |       | (0.15      | )          | (0.13      | )          | (0.09      | )          | (0.19      | )          |
|                                  |            |            |            |            |            |            |            |            |            |            |            |  |  |  |  |

 

**Item 9. Changes in and Disagreements with Accountantson Accounting and Financial Disclosure.**

None.

**Item 9A. Controls and Procedures**

*DisclosureControls and Procedures**  *Withinthe 90 days prior to the filing of this report, we carried out an evaluationunder the supervision and with the participation of our management, includingour Chief Executive Officer, our President and Chief Operating Officer and ourChief Financial Officer, of the effectiveness of the design and operation ofour disclosure controls and procedures pursuant to Rule 13a-15bunder the Securities Exchange Act of 1934. Based on their review of ourdisclosure controls and procedures, the Chief Executive Officer, the Presidentand Chief Operating Officer and the Chief Financial Officer have concluded thatour disclosure controls and procedures are effective in timely alerting them tomaterial information relating to us that is required to be included in ourperiodic SEC filings.

*Internal Controls andProcedures.**  *Therewere no significant changes in internal controls or in other factors that couldsignificantly affect these controls subsequent to the date of their evaluationincluding any corrective actions with regard to significant deficiencies andmaterial weaknesses.

 

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**PART III**

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

The following is information concerning our currentdirectors and executive officers:
| **Name**            | ** ** | ** ** | ** ** | **Age**                                                  | ** ** | **Position** |
|---------------------|------------|------------|------------|----------------------------------------------------------|------------|--------------|
| Greg R. Meland      |       | 50         |       | Chief Executive Officer  and Director                    |
| Charles B. Westling |       | 45         |       | President, Chief  Operating Officer                      |
| Daniel J. Kinsella  |       | 45         |       | Vice President—Finance  and Chief Financial Officer |
| Mary E. West        |       | 55         |       | Vice President—Human  Resources                     |
| Robert M. Price     |       | 73         |       | Chairman of the Board  and Director                      |
| Paul F. Lidsky*     |       | 50         |       | Director                                                 |
| Margaret A. Loftus* |       | 59         |       | Director                                                 |
| James E. Ousley*    |       | 58         |       | Director                                                 |

----

*                    Member ofAudit and Compensation Committees.

Greg R. Meland joined us in 1991 as our Vice Presidentof Sales and Engineering. He became President and Chief Executive Officer in1993. Between 1979 and 1991, Mr. Meland served in various sales andmarketing positions with the Imprimis disk drive subsidiary of Control DataCorporation (which was sold to Seagate in 1989), most recently as the NorthCentral U.S. Director of Sales.

Charles B. Westling joined us in 2002 as VicePresident—Corporate and Business Development. In 2002, Mr. Westling becameVice President—Market Development. In 2003, Mr. Westling became Presidentand Chief Operating Officer. Between 2000 and 2001, he was the Executive VicePresident of Business Development of Agiliti, Inc. Mr. Westlingserved as Senior Managing Director and Director of Corporate Finance for JohnG. Kinnard and Company, Incorporated from 1997 to 1999. From 1990 to 1997, Mr. Westlingwas a member of the corporate finance department at Dain Bosworth Incorporated,serving most recently as a managing director and head of technology investmentbanking. Mr. Westling received his B.A. in economics from Carleton Collegeand earned a Master of Management degree from the J.L. Kellogg Graduate Schoolof Management at Northwestern University.

Daniel J. Kinsella joined us in 1999 as ChiefFinancial Officer. In 2002, Mr. Kinsella became Vice President—Financeand 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. Kinsellawas the Director of Financial Reporting for Inter-Regional FinancialGroup, Inc. Between 1980 and 1984, he was employed by Touche Ross &Company, most recently as an audit manager. Mr. Kinsella is a CertifiedPublic Accountant.

Mary E. West joined us in 2001 as Vice President—HumanResources. From 1998 to 2001, she worked as an independent human resourcesconsultant. Between 1995 and 1998, Ms. West was employed by ArcadiaFinancial, Ltd., most recently as the Senior Vice President of Human Resources.From 1993 to 1994, she was the corporate administrative director for Nexus, Inc.Ms. West received her M.A. in Human Resources and Industrial Relations in1988 from the University of Minnesota Carlson School of Management.

Robert M. Price was elected as our Chairman of theBoard and a director in June 1998. Mr. Price has been President ofPSV, Inc., a technology consulting business located in Burnsville,Minnesota, since 1990. Between 1961 and 1990, he served in various executivepositions, including as Chairman and Chief Executive Officer, with Control DataCorporation. Mr. Price also serves on the Board of Directors of PublicService Company of New Mexico, Affinity Technology Group, Inc. and NationalCenter for Social 

45

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Entrepreneurs. Since May 1991,Mr. Price has been a Senior Advisor and Professor at the Fuqua School ofBusiness at Duke University. Mr. Price is Mr. Meland’s father-in-law.

Paul F. Lidsky was elected as a director in June 1998.Between 2003 and 2004, Mr. Lidsky was President and Chief ExecutiveOfficer of Computer Telephony Solutions, a telecommunications software companyspecializing in call centers. From 2002 to 2003, Mr. Lidsky was Presidentand Chief Executive Officer of VigiLanz Corporation, a medical software company.From 1997 until 2002, Mr. Lidsky was the President and Chief ExecutiveOfficer of OneLink Communications, Inc., a software company that providesbusiness intelligence solutions to the telecommunications carriers. Between1985 and 1997, Mr. Lidsky was employed by Norstan, Inc., acomprehensive technology services company, most recently as Executive VicePresident of Strategy and Business Development. Mr. Lidsky also serves onthe Board of Directors for VigiLanz Corporation.

Margaret A. Loftus was elected as a director in June 1998.Ms. Loftus is an owner of Loftus Brown-Wescott, Inc., abusiness consulting firm, which she co-founded in 1989. Between 1976 and 1989,she was employed by Cray Research, Inc., most recently as Vice Presidentof Software. Ms. Loftus also serves on the Board of Directors for AnalystsInternational Corporation and several private technology companies.

James E. Ousley was elected as a director in June 1998.Since 2001, Mr. Ousley has been president and chief executive officer ofVytek Wireless Inc., a mobile computing company. From 1999 to 2001, he servedas President and Chairman of Syntegra (USA), a global e-Business solutionsprovider and a division of British Telecommunications plc. From September 1991to August 1999, Mr. Ousley was President and Chief Executive Officerof Control Data Systems (CDS), which was acquired by British Telecommunicationsin August 1999. From 1968 to 1991, he held various sales and executivemanagement positions with Control Data Corporation, a global computer systems,software/services and peripherals company. Mr. Ousley also serves on theBoard of Directors for Vytek Wireless, Inc., ActiveCard, Inc., BellMicroproducts Inc., Norstan, Inc. and Savvis Communications Corporation.

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

We will furnish to the Securities and ExchangeCommission a definitive Proxy Statement (the “2003 Proxy Statement”) not laterthan 120 days after the close of the fiscal year ended December 31, 2003. Theremaining information required by Items 401 and 405 of Regulation S-Kis incorporated herein by reference to the Proxy Statement.

We have adopted a Code ofEthics that applies to our officers, including our principal executive,financial and accounting officers, and our directors and employees. We arefiling the Code of Ethics as an exhibit to this Annual Report. We intend tomake all required disclosures concerning any amendments to, or waivers from,our Code of Ethics by filing of Current Reports the cover of Form 8-K.

**Item 11. Executive Compensation.**

The information set forthunder the caption “Executive Compensation” in the Company’s 2003 ProxyStatement is incorporated herein by reference.

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

The information set forthunder the caption “Outstanding Voting Securities and Voting Rights” in theCompany’s 2003 Proxy Statement is incorporated herein by reference.

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

The information requiredby this section is incorporated by reference from the information in thesection entitled “Certain Relationships and Related Transactions” in theCompany’s 2003 Proxy Statement.

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

The information requiredby this section is incorporated by reference from the information in thesection entitled “Auditing Matters” in the Company’s 2003 Proxy Statement.

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

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

**1.****                 FinancialStatements**

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

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

The following financial statement schedule of DatalinkCorporation, for the years ended 2003, 2002 and 2001 is filed as part of thisAnnual Report and should be read in conjunction with the Financial Statementsof Datalink Corporation.

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**DATALINKCORPORATIONSCHEDULE II VALUATION AND QUALIFYING ACCOUNTSFOR THE YEARS ENDED DECEMBER 31, 2003, 2002 AND 2001**
| **Description**                               | ** ** | ** ** | ** ** | **Period** | ** ** | **Balance at  Beginning   of Period** | ** ** | **Additions** | ** ** | **Deductions(1)** | ** ** | **Balance  at End  of Period** | ** ** |
|-----------------------------------------------|------------|------------|------------|------------|------------|------------------------------------------------------|------------|---------------|------------|-------------------|------------|------------------------------------------|------------|
| Allowance for  Doubtful Accounts              |       | 2003       |       | $          | 197,368    |                                                 | $          | (34,026       | )          |              | $          | 65,535                                   |       |   | $ | 97,807 |   |
|                                          |       | 2002       |       | 164,394    |       | 77,000                                               |       |          | 44,026     |              |       | 197,368                                  |       |
|                                          |       | 2001       |       | 75,037     |       | 115,000                                              |       |          | 25,643     |              |       | 164,394                                  |       |
| Allowance for Inventory Obsolescence          |       | 2003       |       | $          | 405,001    |                                                 | $          | 348,816       |       |              | $          | 543,707                                  |       |   | $ | 211,110 |   |
|                                          |       | 2002       |       | 245,559    |       | 187,500                                              |       |          | 28,058     |              |       | 405,001                                  |       |
|                                          |       | 2001       |       | 264,748    |       | 344,000                                              |       |          | 363,189    |              |       | 245,559                                  |       |
| Allowance for Valuation of Deferred Tax Asset |       | 2003       |       | $          | 1,609,000  |                                                 | $          | 1,194,454     |       |              | $          | —                                   |       |   | $ | 2,802,954 |   |
|                                          |       | 2002       |       | —     |       | 1,609,000                                            |       |          | —     |              |       | 1,609,000                                |       |

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(1)   Deductionsreflect write-offs of customer accounts receivable, net of recoveries ordisposals of inventories.

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**INDEPENDENTAUDITORS’ REPORT ON SCHEDULE**

The Board of Directors and ShareholdersDatalink Corporation:

Under the date of February 6, 2004, we reportedon the balance sheets of Datalink Corporation as of December 31, 2003 and2002 and the related statements of operations, stockholders’ equity and, cashflows for the years then ended. In connection with our audits of theaforementioned financial statements, we also have audited the related financialstatement schedule for the years ended December 31, 2003 and 2002. Thefinancial statement schedule is the responsibility of the Company’s management.Our responsibility is to express an opinion on the financial statement schedulebased on our audits. The financial statements of Datalink Corporation for theyear ended December 31, 2001, were audited by other auditors who haveceased operations. Those auditors expressed an unqualified opinion on thosefinancial statements in their report dated February 8, 2002.

In our opinion, such financialstatement schedule for the years ended December 31, 2003 and 2002, whenconsidered in relation to the basic financial statements taken as a whole,presents fairly, in all material respects, the information set forth therein.

/s/ KPMG LLP

Minneapolis, MinnesotaFebruary 6, 2004

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*The following report is acopy of a report previously issued by Arthur Andersen LLP (“Andersen”), whichreport has not been reissued by Andersen.*

Report of Independent Public Accountants

Wehave audited in accordance with auditing standards generally accepted in theUnited States, the financial statements of Datalink Corporation as of December 31,2001 and for the year then ended included in this Form 10-K, and haveissued our report thereon dated February 8, 2002. Our audit was made forthe purpose of forming an opinion on those statements taken as a whole. TheSchedule II—Valuation and Qualifying Accounts of Registrant is theresponsibility of the Company’s management and is presented for purposes ofcomplying with the Securities and Exchange Commission’s rules and are notpart of the basic financial statements. The information for the year ended December 31,2001 in the Schedule II—Valuation and Qualifying Accounts of Registranthas been subjected to the auditing procedures applied in the audit of the basicfinancial statements and, in our opinion, fairly states in all materialrespects the financial data required to be set forth therein in relation to thebasic financial statements taken as a whole.

/s/Arthur Andersen LLP

Minneapolis, MinnesotaFebruary 8, 2002

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

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1)               Incorporated byreference to the exhibit of the same number in the Company’s RegistrationStatement on Form S-1, Reg. No. 333-55935

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

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

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

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

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

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

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

(b)   Reports of Form 8-K.

On October 15, 2003, we filed a Form 8-Kto report a change in the date for announcement of our operating results forquarter ended September 30, 2003. On October 20, 2003, we filed a Form 8-Kto report our 2003 third quarter operating results and announce particular costreduction initiatives.

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**SIGNATURES**

Pursuantto the requirements of Section 13 or 15(d) of the Securities ExchangeAct of 1934, the registrant has duly caused this Annual Report on Form 10-Kto be signed on its behalf by the undersigned, thereunto duly authorized.
|                       | DATALINK CORPORATION |
|----------------------------|----------------------|
| Date: March 19,  2004 |                 |
|                       | By:                  | /s/ Greg R. Meland |
|                       |                 | Greg R. Meland, *Chief Executive Officer* |
|                       | By:                  | /s/ Daniel J. Kinsella |
|                       |                 | Daniel J. Kinsella, *Vice  President—Finance  and Chief Financial Officer* |
|                            |                      |  |  |

 

Pursuantto the requirements of the Securities Act of 1934, this report has been signedbelow by the following persons on behalf of the registrant and in thecapacities and on the dates indicated.
| ** **                | **Signature** | ** **                                                                             | ** ** | ** **           | **Title** | ** ** | ** ** | ** ** | **Date** | ** ** |
|---------------------------|---------------|----------------------------------------------------------------------------------------|------------|----------------------|-----------|------------|------------|------------|----------|------------|
| /s/ Greg R. Meland        |          | Chief Executive Officer and Director (Principal  Executive Officer)                    |       | March 19,  2004 |
|                      |          |                                                                                   |       |                 |
| /s/ Daniel J. Kinsella    |          | Vice President—Finance  and Chief Financial Officer (Principal Financial Officer) |       | March 19,  2004 |
|                      |          |                                                                                   |       |                 |
| /s/ Denise M. Westenfield |          | Corporate Controller (Principal Accounting Officer)                                    |       | March 19,  2004 |
|                      |          |                                                                                   |       |                 |
| /s/ Paul F. Lidsky        |          | Director                                                                               |       | March 19,  2004 |
|                      |          |                                                                                   |       |                 |
| /s/ Margaret A. Loftus    |          | Director                                                                               |       | March 19,  2004 |
|                      |          |                                                                                   |       |                 |
| /s/ James E. Ousley       |          | Director                                                                               |       | March 19,  2004 |
|                      |          |                                                                                   |       |                 |
| /s/ Robert M. Price       |          | Director                                                                               |       | March 19,  2004 |

 

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