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Datalink: A Pendulum-Like Swing Offers 100% Upside Potential

May 22, 2014 | About:

“Investment markets follow a pendulum-like swing between euphoria and depression, between celebrating positive developments and obsessing over negatives, and thus between overprice and underpriced.

There are a few things of which we can be sure, and this is one: Extreme market behavior will reverse. Those who believe the pendulum will move in one direction forever – or reside at an extreme forever – eventually will lose huge sum. Those who understand the pendulum’s behavior can benefit enormously.”

The above quote comes from Howard Marks (Trades, Portfolio), who founded Oaktree Capital Management. I believe in pendulum-like swing. Currently, Datalink Corporation (NASDAQ:DTLK) has swung to depression. I would like to first shed some light on why Datalink is underpriced today, and then illustrate how Datalink has the opportunity to swing back to euphoria and potentially create 100% return.

A Pendulum-Like Swing to Depression

Datalink is financially stable with $3.18 cash per share. Excluding cash, Datalink trades at $5.7 per share. For the past three years, Datalink earned $0.52, $0.60 and $0.61 GAAP earnings per share in 2013, 2012 and 2011 respectively. With the average earnings, Datalink currently values at about 10x PE multiple excluding cash. Since Datalink has a pristine balance sheet, I believe that Datalink is significantly undervalued.

Company Overview

When we invest in a stock, it is crucial that we strive to understand the underlying business as much as we can. Datalink, which was founded in 1958 and is headquartered in Eden Prairie, Minn., designs, installs and supports data center solutions to mid- and large-size companies. The following chart should give investors more detail about what Datalink does:

Source: Company Presentation

Datalink generated $595 million sales from providing data center solutions and services to Fortune 500 companies with $177 million recurring revenue from support contracts. In fact, the recurring revenue is bigger than Datalink's enterprise value of $144 million. Plus, Datalink has succesfully grown its service revenue from $17.4 million in 2010 to $45.2 million in 2013. Recently, the Advanced Service consulting business, which involves consulting projects in private cloud orchestration and management, data migration, and data center relation, has been awarded a $1.9 million services engagement at a large banking instituition to accomplish its data migration. The growing pipline of Advanced Service activities demonstrated that Datalink has made inroads into offering more relevant services to its customers. More importantly, the Advanced Service practice has an average gross margin of 35% to 40%, which can help Datalink to improve its overall profit margins.

In addition, Datalink focuses on private and hybrid cloud data center solutions. I understand that some investors worry about whether private and hybrid cloud data center solutions will be replaced by public cloud in the future. Hence, Datalink data center services might not be an unsustainable business. However, according to Gartner, the market for data center system support is expected to be $50 billion in 2013. With Datalink taking less than 1% market share, I think that there will always be a market for a niche player like Datalink.

Management Team

Paul Lidsky has been CEO of Datalink since July 20, 2009. He served several senior roles, including COO of Spanlink Communications Inc., CEO of Calabrio, CEO of VigiLanz Corporation, CEO of Spectre Gaming Inc. and CEO of OneLink Communications Inc. His profound leadership experiences enable him to manage Datalink well. According to the latest proxy statement, Paul Lidsky held 3.3% of Datalink's stock, which shows his confidence in the company. In addition, GuruFocus data shows that insiders held 15% ownership, and institutional investors held 72% of outstanding shares. This helps to form a healthy shareholder base.

Why Did Datalink Recently Decline?

After the first quarter 2014 earning release, Datalink has dropped to the 52-week low of $8.97. Its first quarter gross margin declined from 22.7% to 21.2% year-over-year mainly due to the revenue mix. The higher margin storage accounted for 28%, down from 36% in the previous quarter. The lower margin networking and servers represented 22%, up from 18% in the previous quarter. As I listened to the latest earning release, I agreed with the management that the demand for storage was healthy, and the disappointing first quarter 2014 result was more related to a timing issue.

The management team of Datalink talked about how their customers looked into flash and pushed out their purchasing decisions until they had better understanding about which storage technology they would ultimately choose. As I read the blog about Pure Storage, the disruption in flash storage cannot be underestimated, and the sales pitch of Pure Storage below is very powerful:

Saves enough in power, cooling and operating overhead in it’s first 4 years of deployment to pay back customers for the initial purchase price (If you’re still buying high-end disk arrays, be sure to negotiate a power rebate).

After further researching storage technology, I can understand why there is delay in the purchasing decisions. Once storage technology decisions can be made, Datalink, as an indepedent service provider, should be able to benefit since it is free to adapt to any winning storage technology. If the storage business eventually reverts back to its normalized level, I forecast that the profit margins will increase in tandem with the bigger share of storage in the business mix.

A Pendulum-Like Swing to Euphoria

Source: Company Presentation

In the technology industry, many companies are valued at non-GAAP earning multiples. As we can see from the reconciliation between GAAP net earnings and non-GAAP net earnings above, the majority of the adjustments were based on the intangible and integration costs. I expect that when the gross margin of Datalink improved from its forecasted 22% due to the higher-margined storage and advanced service business become a bigger share of the total sales, investors will most likely swing back to euphoria and value Datalink based on its Non-GAAP expected $0.95 EPS in 2015. In combination with the $3.18 cash per share and applying 13x PE, Datalink can be worth about $16 per share, almost double its current stock price of $8.88.


First, Datalink is a small cap stock, which involves low liquidity, significant bid-ask spread difference, and fierce competition from large enterprises with superior resources. Second, if public cloud eventually takes all the market share, the focus of Datalink on private and hybrid cloud might hinder the company's capabilities of serving its customers. Third, Datalink is keen on making acquisitions. If any future acquistions fail, it will materially affect the competitiveness of Datalink.

The Bottom Line

Capturing the pendulum-like swing can be very profitable for well-prepared investors. I believe that Datalink has currently swung to depression with a superior risk/reward profile for investors. For the high-risk tolerance investors, Datalink is worth investing in.

Note: The quote of Howard Marks (Trades, Portfolio) come from the book "The Art of Value Investing: How the World's Best Investors Beat the Market."

Disclosure: I am not a securities broker/dealer or an investment adviser. You are responsible for your own investment decisions. All information contained should be independently verified with the companies mentioned, and readers should always conduct their own research and due diligence and consider obtaining professional advice before making any investment decision.

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Rating: 3.5/5 (11 votes)



Kfh227 - 3 years ago    Report SPAM

Given the shareholder and FCF levels, this indeed looks cheap. Might need to research this one. Good find!

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