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FORM 10-Q

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

(Mark One)

x      Quarterly report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the quarterly period ended:  March 31, 2012

or

o         Transition report pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934

For the transition period from                   to                   

Commission file number: 00029758

DATALINK CORPORATION

(Exact name of registrant as specified in its charter)

10050 Crosstown Circle, Suite 500

EDEN PRAIRIE, MINNESOTA 55344

(Address of Principal Executive Offices)

(952) 944-3462

(Registrant’s Telephone Number, Including Area Code)

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

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such files).  Yes x No o

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer or a smaller reporting company.  See definition of “large accelerated filer,” “accelerated filer” and “small reporting company” in Rule 12b-2 of the Exchange Act.  (Check one):

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

As of May 8, 2012, 18,052,034 shares of the registrant’s common stock, $.001 par value, were outstanding.

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DATALINK CORPORATION

Index

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PART I. FINANCIAL INFORMATION

Item 1.   Financial Statements.

Datalink Corporation

Balance Sheets

(In thousands, except share data)

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

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Datalink Corporation

Statements of Operations

(In thousands, except per share data)

(Unaudited)

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

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Datalink Corporation

Statements of Cash Flows

(In thousands)

(Unaudited)

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

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Datalink Corporation

Notes To Financial Statements

(Unaudited)

1.                                       Basis of Presentation

We have prepared the interim financial statements included in this Form 10-Q without an audit, pursuant to the rules and regulations of the Securities and Exchange Commission (“SEC”).  We have condensed or omitted certain information and footnote disclosures, normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States, pursuant to such rules and regulations.  You should read these financial statements in conjunction with the financial statements and related notes thereto included in our 2011 Annual Report on Form 10-K.

The financial statements presented herein as of March 31, 2012, and for the three months ended March 31, 2012 and 2011, reflect, in the opinion of management, all adjustments (which consist only of normal, recurring adjustments) necessary for a fair presentation of the financial position and the results of operations and cash flows for the periods presented. Management makes estimates and assumptions affecting the amounts of assets, liabilities, revenues and expenses we report, and our disclosure of contingent assets and liabilities at the date of the financial statements.  The results of the interim periods are not necessarily indicative of the results for the full year.  Accordingly, you should read these condensed financial statements in conjunction with the audited financial statements and the related notes included in our 2011 Annual Report on Form 10-K.  Actual results could differ materially from these estimates and assumptions.

Recently Issued Accounting Standards

In May 2011, the FASB issued an update to ASC 820 Fair Value Measurement (“ASC 820”): Amendments to Achieve Common Fair Value Measurement and Disclosure Requirements in U.S. GAAP and International Financial Reporting Standards (“IFRS”).  The update requires an entity with fair value measurement disclosures to provide a consistent definition of fair value and ensure that the fair value measurement and disclosure requirements are similar between U.S. GAAP and IFRS. The guidance changes certain fair value measurement principles and enhances the disclosure requirements, particularly for level 3 fair value measurements.  The update to ASC 820 is effective for fiscal years, and interim periods within those years, beginning after December 15, 2011. Adoption of ASC 820 did not have a material impact on our financial statements.

In June 2011, the FASB issued an update to ASC 220 Fair Comprehensive Income (“ASC 220”): Presentation of Comprehensive Income.  The update eliminates the option to present components of other comprehensive income in the statement of stockholders’ equity. Instead, the new guidance now requires an entity to present all non-owner changes in stockholders’ equity either as a single continuous statement of comprehensive income or as two separate but consecutive statements. The update to ASC 220 is effective for fiscal years, and interim periods within those years beginning, after December 15, 2011. Adoption of ASC 220 did not have a material impact on our financial statements.

In September 2011, the FASB issued an update to ASC 350 Intangibles — Goodwill and Other (“ASC 350”): Testing Goodwill for Impairment. The update allows an entity to first assess qualitative factors to determine whether it is necessary to perform the two-step quantitative goodwill impairment test. Under these amendments, an entity would not be required to calculate the fair value of a reporting unit unless the entity determines, based on a qualitative assessment, that it is more likely than not that its fair value is less than its carrying amount. The amendments include a number of events and circumstances for an entity to consider in conducting the qualitative assessment. The update to ASC 350 is effective for fiscal years, and interim periods within those years beginning, after December 15, 2011. Adoption of ASC 350 did not have a material impact on our financial statements.

2.                                       Net Earnings per Share

We compute basic net earnings per share using the weighted average number of shares outstanding.  Diluted earnings per share include the effect of common stock equivalents, if any, for each period.  Diluted per share amounts assume the conversion, exercise or issuance of all potential common stock instruments unless their effect is anti-dilutive.  The following table computes basic and diluted earnings per share:

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We excluded the following restricted stock grants that have not vested and options to purchase shares of common stock from the computation of diluted earnings per share as their effect would have been anti-dilutive:

3.                                       Stock Based Compensation

Common Stock Offering

On March 14, 2011, we completed a public offering of 4,266,500 shares of common stock with a price to the public of $5.75 per share. We issued and sold 3,306,500 shares in the offering and the selling shareholder sold 960,000 shares in the offering. We received proceeds from the common stock sold by us, net of offering costs, of approximately $17.5 million.  We did not receive any proceeds from the shares sold by the selling shareholder.

Restricted Stock:

Total stock-based compensation expense related to restricted stock was $444,000 and $296,000 for the three months ended March 31, 2012 and 2011, respectively.  Unrecognized stock-based compensation expense related restricted stock was $4.7 million at March 31, 2012 which we will amortize ratably through January 2016.

The following table summarizes our restricted stock activity for the three months ended March 31, 2012:

Stock Options:

Total stock-based compensation expense related to stock options was $60,000 and $69,000 for the three months ended March 31, 2012 and 2011, respectively. Unrecognized stock-based compensation expense related to stock options was $316,000 at March 31, 2012, which we will amortize ratably through July 2013.

The following table represents stock option activity for the three months ended March 31, 2012:

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Other:

During the three months ended March 31, 2012 and 2011, we recognized expense of $86,000 and $60,000, respectively, related to the issuance of 9,000 and 9,391 shares, respectively, of fully vested common stock to members of our Board of Directors.

4.                                       Income Taxes

We base the provision for income taxes upon estimated annual effective tax rates in the tax jurisdictions in which we operate.  For the three months ended March 31, 2012 and 2011, our effective tax rate was 40%.  We expect our annual effective tax rate for 2012 to be 40.5%.

As part of the process of preparing financial statements, we estimate federal and state income taxes. Management estimates the actual current tax exposure together with assessing temporary differences resulting from different treatment for tax and accounting purposes. These differences result in deferred tax assets and liabilities, which we include within our balance sheet. Management must then assess the likelihood that we will utilize deferred tax assets to offset future taxable income during the periods in which we may deduct these temporary differences.  For the three months ended March 31, 2012, we recorded income tax expense of $1.4 million with an effective tax rate of 40%.

We assess our uncertain tax positions for tax years that are still open for examination.  As of March 31, 2012 and 2011, we had no unrecognized tax benefits which would affect our effective tax rate if recognized.

We classify interest and penalties arising from the underpayment of income taxes in the statement of income under general and administrative expenses. As of March 31, 2012 and 2011, we had no accrued interest or penalties related to uncertain tax positions. The tax years 2008-2011 remain open to examination by both the U.S. Federal government and by other major income taxing jurisdictions to which we are subject.

Our ability to utilize a portion of our net operating loss carryforwards to offset future taxable income may be subject to certain limitations under Section 382 of the Internal Revenue Code due to changes in our equity ownership.  We do not believe that an ownership change under Section 382 has occurred, and therefore, no such limitations exist.

5.                                       Goodwill and Valuation of Long-Lived Assets

We assess the carrying amount of our goodwill for potential impairment annually or more frequently if events or a change in circumstances indicate that impairment may have occurred.  We perform an impairment test for finite-lived assets, such as intangible assets, and other long-lived assets, such as fixed assets, whenever events or changes in circumstances indicate that the carrying value of such assets may not be recoverable.  Circumstances that could represent triggering events and therefore require an interim impairment test of goodwill or evaluation of our finite-life intangible assets or other long lived assets include the following:  loss of key personnel, unanticipated competition, higher or earlier than expected customer attrition, deterioration of operating performance, significant adverse industry, economic or regulatory changes or a significant decline in market capitalization.

We have only one operating and reporting unit that earns revenues, incurs expenses and makes available discrete financial information for review by our chief operations decision maker.  Accordingly, we complete our goodwill impairment testing on this single reporting unit.

In conducting the annual impairment test of our goodwill, qualitative factors are first examined to determine whether the existence of events or circumstances indicate that it is more likely than not that the fair value of a reporting unit is less than it carrying amount.  If it is determined that it is more likely than not that the fair value of the reporting unit is less than its carrying amount, a two step impairment test is applied.  The first step of the goodwill impairment test, used to identify potential impairment, compares the fair

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value of our market capitalization with the carrying value of our net assets. If our total market capitalization is at or below the carrying value of our net assets, we perform the second step of the goodwill impairment test to measure the amount of impairment loss we record, if any.  We consider goodwill impairment test estimates critical due to the amount of goodwill recorded on our balance sheet and the judgment required in determining fair value amounts.

Goodwill as of March 31, 2012 and December 31, 2011 was $32.4 million.  We conducted our annual goodwill impairment test as of December 31, 2011, our last measurement date.  Based on this analysis, we determined that there was no impairment to goodwill.  We will continue to monitor conditions and changes that could indicate impairment of our recorded goodwill.

At each of March 31, 2012 and 2011, we determined that no triggering events had occurred during the quarter and our finite-lived assets and long-lived assets were not impaired.

Identified intangible assets are summarized as follows:

Amortization expense for identified intangible assets is summarized below:

Based on the identified intangible assets recorded at March 31, 2012, future amortization expense for the next five years is as follows:

6.                                       Investments

The following table summarizes our short-term investments (in thousands):

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As of March 31, 2012 and December 31, 2011, we had no unrealized holding gains/losses on investments.

Our $1.2 million of short term investments are comprised of fully insured certificates of deposits with maturities ranging from three to six months and interest rates ranging from 0.25% to 0.35%.

7.                                       Fair Value Measurements

Fair value is the price that would be received from selling an asset or paid to transfer a liability in an orderly transaction between market participants at the measurement date.  In determining fair value for assets and liabilities required or permitted to be recorded at fair value, we consider the principal or most advantageous market in which it would transact and the assumptions that market participants would use when pricing the asset or liability.  We apply fair value measurements for both financial and nonfinancial assets and liabilities.  We have no nonfinancial assets or liabilities that require measurement at fair value on a recurring basis as of March 31, 2012.

The fair value of our financial instruments, including cash and short-term investments, accounts receivable, accounts payable and accrued liabilities, approximate cost because of their short maturities.

We use the three-level fair value hierarchy that prioritizes the inputs to valuation techniques used to measure fair values.  The hierarchy gives the highest priority to unadjusted quoted prices in active markets for identical assets or liabilities (Level 1 measurements) and the lowest priority to unobservable inputs (Level 3 measurements).  The three levels of the fair value hierarchy are described below:

·                  Level 1 — Unadjusted quoted prices available in active markets for the identical assets or liabilities at the measurement date.

·                  Level 2 — Significant other observable inputs available at the measurement date, other than quoted prices included in Level 1, either directly or indirectly.

·                  Level 3 — Significant unobservable inputs that we cannot corroborate by observable market data and thus reflect the use of significant management judgment.  We generally determine these values using pricing models based on assumptions our management believes other market participants would make.

The fair value hierarchy requires the use of observable market data when available. In instances in which the inputs used to measure fair value fall into different levels of the fair value hierarchy, we determine the fair value measurement based on the lowest level input that is significant to the fair value measurement in its entirety. Our assessment of the significance of a particular item to the fair value measurement in its entirety requires judgment, including the consideration of inputs specific to the asset or liability. The following table sets forth, by level within the fair value hierarchy, the accounting of our financial assets and/or liabilities at fair value on a recurring basis as of March 31, 2012 according to the valuation techniques we used to determine their fair value(s).

8.                                       Line of Credit

We have available for use a line of credit not to exceed $10.0 million with Wells Fargo Bank, N.A., which expires on July 31, 2012. As of March 31, 2012, we had no borrowings outstanding on the line of credit. The credit line bears interest at 2.0% above the bank’s three month LIBOR rate and requires us to meet certain financial covenants.  At March 31, 2012, we were in compliance with the covenants.

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Item 2.           Management’s Discussion and Analysis of Financial Condition and Results of Operations.

NOTE REGARDING FORWARD-LOOKING STATEMENTS

The Private Securities Litigation Reform Act of 1995 provides a “safe harbor” for certain forward-looking statements. This Quarterly Report on Form 10-Q contains forward-looking statements regarding us, our business prospects and our results of operations that are subject to certain risks and uncertainties posed by many factors and events that could cause our actual business, prospects and results of operations to differ materially from those that may be anticipated by such forward-looking statements.  The words “aim,” “believe,” “expect,” “anticipate,” “intend,” “estimate” and other expressions which indicate future events and trends identify forward-looking statements.  Actual future results and trends may differ materially from historical results or those anticipated depending upon a variety of factors, including, but not limited to:  the level of continuing demand for data center solutions and services including the effects of current economic and credit conditions and the ability of organizations to outsource data center infrastructure-related services to service providers such as us; the migration of organizations to virtualized server environments, including using a private cloud computing infrastructure; the extent to which customers deploy disk-based backup recovery solutions; the realization of the expected trends identified for advanced network infrastructures; reliance by manufacturers on their data service partners to integrate their specialized products;  continued preferred status with certain principal suppliers; competition and pricing pressures and timing of our installations that may adversely affect our revenues and profits; fixed employment costs that may impact profitability if we suffer revenue shortfalls; our ability to hire and retain key technical and sales personnel;  continued productivity of our sales personnel; our dependence on key suppliers; our ability to adapt to rapid technological change; risks associated with integrating current and possible futures acquisitions; fluctuations in our quarterly operating results; future changes in applicable accounting rules; and volatility in our stock price.  Additional risks, uncertainties and other factors are included in the “Risk Factors” section on our Annual Report on Form 10-K for the year ended December 31, 2011.  Further, our revenues for any particular quarter are not necessarily reflected by our backlog of contracted orders, which also may fluctuate unpredictably. We undertake no obligation to revise any forward-looking statements in order to reflect events or circumstances that may subsequently arise. Readers are urged to carefully review and consider the various disclosures made by us in this report and in our other reports filed with the Securities and Exchange Commission that advises interested parties of the risks and factors that may affect our business.

OVERVIEW

We provide solutions and services that make data centers more efficient, manageable and responsive to changing business needs.  Focused on mid- and large-size companies, we assess, design, deploy and support infrastructures such as servers, storage and networks. We also resell hardware and software from the industry’s leading OEMs as part of our customer offerings. Our portfolio of solutions and services spans four practices: consolidation and virtualization, data storage protection, advanced network infrastructures and business continuity and disaster recovery solutions.  We offer a full suite of practice-specific consulting, analysis, design, implementation, management and support services.

Our solutions can include hardware products, such as servers, disk arrays, tape systems, networking and interconnection components and software products.  Our data center strategy is supported through multiple trends in the market and involves supporting the market and our customers with a single vendor to provide their data center infrastructure needs.  As of March 31, 2012, we have 30 locations, including both leased facilities and home offices, throughout the United States.  We historically have derived our greatest percentage of net sales from customers located in the central part of the United States.

We sell support service contracts to most of our customers.  In about half of the support service contracts that we sell, our customers purchase support services through us, resulting in customers receiving the benefit of integrated system wide support.  We have a qualified, independent support desk that takes calls from customers, diagnoses the issues they are facing and either solves the problem or coordinates with our and/or vendor technical staff to meet the customer’s needs.  Our support service agreements with our customers include an underlying agreement with the product manufacturer.  The manufacturer provides on-site support assistance if necessary. The other half of the support service contracts that we sell to our customers are direct with the product manufacturers. For all support service contracts we sell, we defer revenues and direct costs resulting from these contracts, and amortize these revenues and expenses into operations, over the term of the contracts, which are generally twelve months.

The data center infrastructure solutions and services market is rapidly evolving and highly competitive.  Our competition includes other independent storage, server and networking system integrators, high end value-added resellers, distributors, consultants and the internal sales force of our suppliers.  Our ability to hire and retain qualified outside sales representatives and engineers with enterprise-

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class information storage, server and networking experience is critical to effectively compete in the marketplace and achieve our growth strategies.

In the past, we have experienced fluctuations in the timing of orders from our customers, and we expect to continue to experience these fluctuations in the future.  These fluctuations have resulted from, among other things, the time required to design, test and evaluate our data center infrastructure solutions before customers deploy them, the size of customer orders, the complexity of our customers’ network environments, necessary system configuration to deploy our solutions and new product introductions by suppliers.  Current economic conditions and competition also affect our customers’ decisions and timing to place orders with us and the size of those orders.  As a result, our net sales may fluctuate from quarter to quarter.

RESULTS OF OPERATIONS

The following table shows, for the periods indicated, certain selected financial data expressed as a percentage of net sales.

The following table shows, for the periods indicated, revenue and gross profit information for our product and service sales.

Our product sales continue to reflect a diversification in the mix of our offerings. For the three months ended March 31, 2012 and 2011, product sales represented 67% and 65% of net sales, respectively. The increase in our product sales for both 2012 and 2011are a result of the increase in product offerings due to our strategy to service the complete data center.  In addition to storage, our server and network sales have increased as part of our strategy to deliver data center hardware, software and services.  Going forward, we expect our customers will continue to closely scrutinize their expenditures and what impact, if any, current economic conditions may have on the growth and profitability of their business.  We cannot assure that changes in customer spending or economic conditions will positively impact our future product sales.

For the three months ended March 31, 2012 and 2011, our service sales represented 32.6% and 35.1% of net sales, respectively. Service sales increased $8.8 million for the three months ended March 31, 2012, as compared to the same period in 2011.  With the growth in our product sales, we continue to successfully sell our installation and configuration services, customer support contracts and consulting services.  Without continued sustainable growth in our product sales going forward, we would expect our customer support contract sales to suffer and we cannot assure that our future customer support contract sales will not decline.

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In October 2011, we entered into an asset purchase agreement with Midwave Corporation (“Midwave”) and its shareholders.  Under the asset purchase agreement we purchased from Midwave substantially all of the assets of Midwave’s business.  Our 2011 results for both product and service sales include revenues of approximately $13.0 million from the acquisition of Midwave.

We had no single customer account for 10% or greater of our revenues for the three months ended March 31, 2012 or 2011.

Gross Profit.  Our total gross profit as a percentage of net sales decreased to 22.9% for the quarter ended March 31, 2012, as compared to 24.2% for the comparable quarter in 2011.  Product gross profit as a percentage of product sales decreased to 22.0% in the first quarter of 2012 from 24.1% for the comparable quarter in 2011.  Service gross profit as a percentage of service sales increased to 24.9% for the first quarter of 2012 from 24.5% for the comparable quarter in 2011.

Our product gross profit as a percentage of product sales is impacted by the mix and type of projects we complete for our customers.  The first quarter 2012 product gross profit decreased 2.1% as compared to the same period in 2011. We have experienced a decrease in our product gross profit percentage as we saw an increase in our networking and server business, which historically has carried lower gross margins.  The product gross margin percentages we achieved in the first quarters of 2012 and 2011 fall within the range of product gross margin percentages we expect as our strategy continues to mature.  Our product gross profit is also impacted by various vendor incentive programs that provide economic incentives for achieving various sales performance targets and early payment of invoices.  Vendor incentives were $1.9 million and $1.3 million, respectively, for the three-month periods ended March 31, 2012 and 2011. As a percentage of product cost of goods sold, vendor incentives were 3.0% and 3.1%, respectively, for the periods ending March 31, 2012 and 2011.  Several of our vendors have tightened eligibility for their programs in the current economic climate and may further change or terminate their programs at any time.  Accordingly, we cannot assure that we will achieve and receive similar vendor incentives in the future.  We expect that as we continue implementing our strategy to sell comprehensive data center solutions with servers and networking products that our product gross margins for the remainder of 2012 will be between 21% and 23%.

Service gross profit as a percentage of service sales for the three months ended March 31, 2012 increased 0.4% as compared to the same period in 2011.  This increase is primarily due to a slight improvement in the gross margin percentage for our installation and professional services as we sold more professional services that were delivered by our technical engineering groups which generally carry higher margins.  We expect that service gross margins will be within the 24% to 27% range for the remainder of fiscal year 2012.

Sales and Marketing.  Sales and marketing expenses include wages and commissions paid to sales and marketing personnel, travel costs and advertising, promotion and hiring expenses.  Sales and marketing expenses totaled $12.6 million, or 10.5% of net sales for the quarter ended March 31, 2012, compared to $9.2 million, or 10.7% of net sales for the first quarter in 2011.

Sales and marketing expenses increased $3.4 million for the three-month period ended March 31, 2012, as compared to the same period in 2011.  This increase is primarily due to an increase in commission expense of $2.0 million, which is commensurate with the increase in sales.

General and Administrative.  General and administrative expenses include wages for administrative personnel, professional fees, depreciation, communication expenses and rent and related facility expenses.  General and administrative expenses were $4.7 million, or 4.0% of net sales for the quarter ended March 31, 2012, compared to $3.8 million, or 4.5% of net sales for the first quarter in 2011.

General and administrative expenses increased $895,000 for the three months ended March 31, 2012, as compared to the same period in 2011.  The increase in general and administrative expenses was primarily due to variable compensation for bonuses of $103,000 and approximately $197,000 in salaries and benefits for headcount additions to support our growth in business and $131,000 in rent and facility expenses.

Engineering.  Engineering expenses include employee wages, bonuses and travel, hiring and training expenses for our field and customer support engineers and technicians.  We allocate engineering costs associated with installation and configuration services and with consulting services to our cost of services sales.  Engineering expenses were $5.8 million, or 4.9% of net sales for the quarter ended March 31, 2012, compared to $4.4 million, or 5.1% of net sales for the first quarter in 2011.

Engineering expenses increased $1.4 million for the three months ended March 31, 2012, as compared to the same period in 2011.  The increase in engineering expenses is primarily due to an increase in salaries and benefits of $2.0 million and travel expenses of $192,000 associated with the increase in engineering headcount from our Midwave acquisition.  We also had $204,000 of placement fees to support hiring efforts in our regions.  This was partially offset by $1.6 million as an increased amount of our engineering costs were allocated to our cost of service sales commensurate with the increase in our professional services sales.

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Integration and Transaction Costs.  We had $20,000 and $0 of integration and transaction costs for the three months ended March 31, 2012 and 2011, respectively.  Integration and transaction expenses in 2012 for the Midwave acquisition included audit and other outside consulting fees.

Amortization of Intangibles.  We had $619,000 of intangible asset amortization expenses for the three-months ended March 31, 2012 as compared to intangible amortization expenses of $382,000 for the same three months in 2011.  The increase in amortization of intangibles expenses in 2012 as compared to 2011 are primarily due to the acquisition of Midwave in October 2011. The finite-lived intangibles we acquired in our acquisition of Midwave consisted of covenants not to compete, order backlog and customer relationships having estimated lives of 3 years, 3 months and 5 years, respectively

Earnings from Operations.  We had earnings from operations of $3.6 million compared to earnings from operations of $3.0 million for the three months ended March 31, 2012 and 2011, respectively.  The earnings from operations for the three month period ended March 31, 2012 and 2011 are a result of the financial leverage we achieved by keeping operating expenses relatively flat and realizing substantial growth in our revenues and gross margins as part of our data center strategy.

Income Taxes.  We had income tax expense of $1.4 million and $1.3 million for the three months ended March 31, 2012 and 2011, respectively.  Our estimated effective tax rate for the first quarters of 2012 and 2011 was 40% and 42%, respectively. For the balance of 2012, we expect to report an income tax provision using an effective tax rate of approximately 40.5%.

LIQUIDITY AND CAPITAL RESOURCES

Net cash provided by operating activities was $5.7 million for the three months ended March 31, 2012 as compared to net cash provided by operating activities of $2.6 million for the three months ended March 31, 2011.  The increase in cash provided by operations was due primarily to our net earnings for the quarter of $2.2 million and non-cash add backs including depreciation of $339,000 and amortization of finite lived intangibles of $619,000.  Net cash provided by operating activities for the three months ended March 31, 2011 was primarily due to net earnings for the quarter of $1.7 million.

Net cash provided in investing activities was $978,000 for the three months ended March 31, 2012.  For the three months ended March 31, 2012, the sale of $2.3 million in investments was offset by the purchase of $1.3 million in property and equipment.  Net cash used in investing activities was $2.2 million related to the purchase of investments for the three months ended March 31, 2011.  For the remainder of 2012, we are planning for capital expenditures of up to $700,000 related to enhancements to our management information systems and upgraded computer equipment.

Net cash used by financing activities was $86,000 for the three months ended March 31, 2012. Net cash provided by financing activities was $18.0 million for the three months ended March 31, 2011, which is primarily from proceeds from our second public stock offering.  On March 14, 2011, we completed a public offering of 4,266,500 shares of common stock with a price to the public of $5.75 per share. We issued and sold 3,306,500 shares in the offering and the selling shareholder sold 960,000 shares in the offering. We received proceeds from the common stock sold by us, net of offering costs, of approximately $17.5 million.  We did not receive any proceeds from the shares sold by the selling shareholder.

On March 31, 2011, we entered into a Credit Agreement with Wells Fargo Bank, N.A. The Credit Agreement provides for a line of credit not to exceed $10.0 million for general working capital purposes.  The line of credit is secured by substantially all of our personal property and expires on July 31, 2012.  Borrowings under the line of credit are limited to three times the aggregate of our EBITDA (as defined in the Credit Agreement) for the trailing two fiscal quarters. The Credit Agreement also requires that we have working capital of not less than $15.0 million at each fiscal quarter-end, and certain levels of net income after taxes. As of March 31, 2012, we had no borrowings outstanding on the line of credit and could borrow the full $10.0 million available.

OFF-BALANCE SHEET ARRANGMENTS

We do not have any special purpose entities or off-balance sheet arrangements.

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CONTRACTUAL OBLIGATIONS AND COMMITMENTS

Other than the discussion below, there have been no material changes to our contractual obligations outside the normal course of business.

As a result of our acquisition of certain assets of Midwave in October 2011, as tenant, we are the successor in interest to a lease (“Original Lease”) dated August 9, 2010. The Original Lease was for 20,851 square feet of office space. In December 2011, we entered into a First Amendment to Lease (the “Amendment”) to the Original Lease for approximately 32,906 additional square feet of office space (“Expansion Space”), which provided us with approximately 54,000 total square feet available for our operations. On March 1, 2012, we began to occupy the Expansion Space.  The Expansion Space results in additional future obligations of $2.8 million, of which $162,000 is due in less than one year, $799,000 is due in one to three years, $832,000 is due in three to five years, and $1.0 million is due in more than five years.

CRITICAL ACCOUNTING POLICIES AND ESTIMATES

We have identified our critical accounting policies in our Annual Report on Form 10-K for the fiscal year ended December 31, 2011 in “Management’s Discussion and Analysis of Financial Condition and Results of Operations” under the heading “Critical Accounting Policies and Estimates.”  There have been no significant changes in critical accounting policies for the three months ended March 31, 2012 as compared to those disclosed in the our Annual Report on Form 10-K for the year ended December 31, 2011.

Item 3.   Quantitative and Qualitative Disclosures About Market Risk.

There have been no material changes since December 31, 2011 in our market risk.  For further information on market risk, refer to Part II, Item 7A, Quantitative and Qualitative Disclosures, in our 2011 Annual Report on Form 10-K.

Item 4.   Disclosure Controls and Procedures.

Evaluation of Disclosure Controls and Procedures

As of the end of the period covered by this Quarterly Report on Form 10-Q, our management has evaluated, under the supervision and with the participation of our Chief Executive Officer and Chief Financial Officer, the effectiveness of our disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Securities Exchange Act of 1934).  Disclosure controls and procedures are designed to ensure that information required to be disclosed in our reports filed under the Securities Exchange Act of 1934 is recorded, processed, summarized and reported within the time periods specified in the SEC’s rules and forms and that such information is accumulated and communicated to our management, including our Chief Executive Officer and Chief Financial Officer, to allow timely decisions regarding required disclosure. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of March 31, 2012.

Changes in Internal Control Over Financial Reporting

There were no changes in our internal control over financial reporting during the quarter ended March 31, 2012 that have materially affected, or are reasonably likely to materially affect, our internal control over financial reporting.

PART II. OTHER INFORMATION

Item 1.   Legal Proceedings.

We are involved in certain legal actions, all of which have arisen in the ordinary course of business.  Management believes that the ultimate resolution of such matters is unlikely to have a material adverse effect on our consolidated results of operation and/or financial condition.

Item 1A.  Risk Factors.

There have been no material changes from the risk factors we previously disclosed in “Part I—Item 1A. Risk Factors” in our Annual Report on Form 10-K for the year ended December 31, 2011.

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Item 2.  Unregistered Sales of Equity Securities and Use of Proceeds.

None

Item 3.  Defaults Upon Senior Securities.

None

Item 4.  Mine Safety Disclosures.

Not applicable

Item 5.  Other Information.

None

Item 6.  Exhibits.

The exhibits filed as part of this Quarterly Report on Form 10-Q are listed in the Exhibit Index immediately following the signatures to this report.

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SIGNATURES

Pursuant to the requirements of the Securities Exchange Act of 1934, the Registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized.

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EXHIBIT INDEX

(1)               Incorporated by reference to the exhibit of the same number in our Registration Statement on Form S-1, filed on June 3, 1998 (File No. 333-55935).

(2)               Incorporated by reference to exhibit 3.2 in our Form 8-K filed on February 18, 2011 (File No. 0-29758).

*Pursuant to Rule 406T of Regulation S-T, the Interactive Data Files on Exhibit 101 hereto are deemed not filed or part of a registration statement or prospectus for purposes of Sections 11 or 12 of the Securities Act of 1933, as amended, are deemed not filed for purposes of Section 18 of the Securities and Exchange Act of 1934, as amended, and otherwise are not subject to liability under those sections.

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