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ANNUAL REPORT FOR SMALL BUSINESS ISSUERS SUBJECT

TO THE 1934 ACT REPORTING REQUIREMENTS

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U.S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549



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FORM 10-KSB



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|x | ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934
|- | ------------------------------------------------------------------------------------



For the fiscal year ended December 31, 2004



or



| ̈ | 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 1-16103



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Pinnacle Data Systems, Inc.

(Exact name of small business issuer in its charter)



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|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Ohio                                                           |  | 31-1263732                          
|(State or other jurisdiction of incorporation or organization) |  | (I.R.S. Employer Identification No.)
|                                                               | 
|6600 Port Road, Groveport, Ohio                                |  | 43125                               
|(Address of principal executive offices)                       |  | (Zip Code)                          



Issuers
telephone number: (614) 748-1150



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Securities registered under Section 12(b) of the Exchange Act:



|                                 |  |                                          
|-------------------------------- |  | -----------------------------------------
|Title of each class              |  | Name of each exchange on which registered
|Common Shares, without par value |  | American Stock Exchange                  



Securities
registered under Section 12(g) of the Exchange Act:



None



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Indicate by check mark whether the Issuer (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 Issuer was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes  x    No ̈



Check if disclosure of delinquent filers in response to Item 405 of Regulation S-B is not contained in this form, and no
disclosure will be contained, to the best of Issuers knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB. ̈



State Issuers revenues for its most recent fiscal year. $34,397,490



The aggregate market value of the voting and non-voting common equity held by non-affiliates, computed on the basis of the closing sale price on the
American Stock Exchange of the common shares as of February 11, 2005, was $17,730,738.



On February 11, 2005, the Issuer had outstanding 5,757,806 common shares without par value, which is the Issuers only class of common equity.



Documents Incorporated by Reference



Portions of the Registrants Definitive Proxy Statement to be filed for its 2005 Annual Meeting of Shareholders are incorporated by
reference into Part III of this Annual Report on Form 10-KSB.



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TABLE OF CONTENTS



|           |  |                                                                                                                 |  |   
|---------- |  | --------------------------------------------------------------------------------------------------------------- |  | --
|PART I     |  | 1                                                                                                              
|           |  |                                                                                                                
|ITEM 1.    |  | Description of Business                                                                                         |  | 1 
|ITEM 2.    |  | DESCRIPTION OF PROPERTY                                                                                         |  | 9 
|ITEM 3.    |  | LEGAL PROCEEDINGS                                                                                               |  | 9 
|ITEM 4.    |  | SUBMISSION OF MATTERS TO A VOTE OF SECURITY HOLDERS                                                             |  | 9 
|           | 
|PART II    |  | 10                                                                                                             
|           |  |                                                                                                                
|ITEM 5.    |  | MARKET FOR COMMON EQUITY AND RELATED STOCKHOLDER MATTERS                                                        |  | 10
|ITEM 6.    |  | MANAGEMENTS DISCUSSION AND ANALYSIS OR PLAN OF
OPERATION                                                       |  | 12
|ITEM 7.    |  | FINANCIAL STATEMENTS                                                                                            |  | 22
|ITEM 8.    |  | CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING AND FINANCIAL
DISCLOSURE.                           |  | 43
|ITEM 8A.   |  | CONTROLS AND PROCEDURES                                                                                         |  | 43
|ITEM 8B.   |  | OTHER INFORMATION                                                                                               |  | 43
|           | 
|PART III   |  | 44                                                                                                             
|           |  |                                                                                                                
|ITEM 9.    |  | DIRECTORS, EXECUTIVE OFFICERS, PROMOTERS AND CONTROL PERSONS; COMPLIANCE WITH
SECTION 16(A) OF THE EXCHANGE ACT |  | 44
|ITEM 10.   |  | EXECUTIVE COMPENSATION                                                                                          |  | 44
|ITEM 11.   |  | SECURITY OWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED
STOCKHOLDER MATTERS                  |  | 44
|ITEM 12.   |  | CERTAIN RELATIONSHIPS AND RELATED TRANSACTIONS                                                                  |  | 44
|ITEM 13.   |  | EXHIBITS                                                                                                        |  | 45
|ITEM 14.   |  | PRINCIPAL ACCOUNTANT FEES AND SERVICES                                                                          |  | 53
|           | 
|SIGNATURES |  | 54                                                                                                             



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INFORMATION REGARDING FORWARD-LOOKING STATEMENTS. Portions of this Annual Report on Form 10-KSB (including information
incorporated by reference) include forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934. The words believe, expect,
anticipate, estimate, project, should, and similar expressions identify forward-looking statements that speak only as of the date thereof. Investors are cautioned that such statements involve risks and
uncertainties that could cause actual results to differ materially from historical or anticipated results due to many factors. The most significant of such risks, uncertainties and other factors are described in Item 6 of this Form 10-KSB and under
the section entitled Risk Factors on Page 20. The Company undertakes no obligations to publicly update or revise such statements.



PART I



Item 1. Description of Business



Business
Development



Pinnacle Data Systems, Inc. (PDSi) is a
corporation incorporated under the laws of the State of Ohio in March 1989.



Business of Issuer



Pinnacle Data Systems, Inc.
(PDSi or the Company) provides product lifecycle service solutions to Original Equipment Manufacturers (OEMs) in the medical, telecommunications, defense, imaging and computer equipment industries, among others.
We offer a full range of computer and computer-related product development and manufacturing services to increase product speed to market and engineered product life, and to provide service and support to units in the field through comprehensive
product lifecycle management programs encompassing depot repair, advanced exchange, contact center support and end-of-life control.



Our business model has a foundation of technical service and support programs (Service), such as the depot repair and logistics programs we provide the field
service organizations of OEMs like Sun Microsystems. The service base provides resources for the development and sale of high-potential engineered computer solutions for specific customers and niche-industry applications (Product). For
the 2004 year, we reported revenue of $34.4 million, net earnings of $884,000, and total assets of $10.4 million. Approximately 82% of our 2004 revenue was generated from Products and 18% from Services.



Our products are custom-engineered to meet specific customer or niche-industry requirements
that generally cannot be met by an off-the-shelf solution. They are sold to OEMs and then typically resold to end-users as components of the OEMs final products. Our products are



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usually developed as a result of helping OEMs design, engineer, manufacture, assemble, modify, and/or integrate computer systems or components to fit their
specific application needs. Many of our products are based on the high performance computer processing technologies of Sun Microsystems, Inc. (Sun), Intel Corporation (Intel) and Advanced Micro Devices, Inc.
(AMD), three of worlds leading producers of computer components and systems. We combine their products and other vendor off-the-shelf computer components or peripherals with technologies that we engineer and develop, such as
customized circuit boards, enclosures, power supplies and other engineered components and software. By leveraging our expertise and experience in engineering and integrating our internally developed products with Sun, Intel, AMD and other
vendors technologies, we are able to offer product solutions with minimal product design and engineering costs to our customers.



Our end-of-life product management service allows our customers to maximize their investment in technology by providing continued support for products no longer in
production or supported by the original manufacturer. This allows our customers to eliminate or delay the engineering, software development and re-certification charges required to integrate new technology into their products. For example, when a
computer board manufacturer stops manufacturing a particular board, its customer OEMs are left with few alternative sources for the boards they need to continue building or repairing their products. We can provide the boards, purchased from a number
of available sources, either new or refurbished, or we can redesign a new board with the same form, fit and function with components that are readily available at the time.



We are a SunSoft Master Distributor authorized to provide its customers with the right to use Solaris, Sun Microsystems UNIX operating
system. We are an authorized Intel Product Dealer and have earned Intel Premier Provider status for our distinct level of competency with Intel technologies. We are an authorized AMD Solution Provider. We are the North American reseller of Agilent
remote diagnostic solutions, selected for our engineering and design capabilities. We are an authorized HP Business Development Partner. We are also licensed by Microsoft to distribute embedded Microsoft operating systems.



We also offer complete service and support for several OEMs products, as well as our
own, including testing, repair, inventory and logistics services. Depot repair and testing services are provided for advanced technology systems, printed circuit board assemblies, and other computer peripherals and components, where the suspect
non-functioning equipment is sent to our designated depot location for testing and repair, if required. We also manage advanced-exchange repair programs. Our highest volume testing and repair is performed on complex printed circuit
boards and electro-mechanical data storage devices for Sun, Hewlett-Packard Company (H-P) and Silicon Graphics, Inc. (SGI), and on standard PC configurations for a home-based computer learning program. For our largest OEM customers, we maintain and
share online information management systems that seamlessly connect our companies.



We consider our Products and Services segments to be complementary. New product development keeps our engineers and service technicians on the forefront of technologies being sold that generate new service opportunities. Our services
provide a competitive advantage in selling our products since the entire infrastructure is already in place to provide high quality service and support before and after the sale.



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Public Announcement Updates



During 2004, we made a number of public announcements. The current status of each is as
follows:



Pinnacle Data Systems Expands Service Offerings with
Netherlands-Based Kender-Thijssen  We are jointly pursuing turnkey repair and logistics programs with current and potential OEM customers requiring strategic geographic presences in both North America and Europe.



A new relationship with Solid Information Technology Corp.  Disclosed in the first
quarter earnings release, we continue working together to develop and provide PDSi hardware platforms with Solid high availability databases for common customers.



PDSi named a partner provider in Sun Microsystems Network Equipment Provider program  Disclosed in the first quarter earnings
release, this affiliation has resulted in a multi-year contract for lifecycle extension and end-of-life services for a world-leading telecommunications equipment provider. PDSi remains very active in this program.



Authorization as a Hewlett-Packard Business Development Partner  Disclosed in the
second quarter earnings release, this reseller program offers certain discounts to its members and PDSi has sold a number of H-P systems and taken advantage of its benefits.



Membership in the Intel® Communications Alliance  Disclosed in the second quarter earnings release, this membership provides additional marketing and partnering
opportunities in the telecommunications industry with this world-leading computer chip and board manufacturer.



The commencement of a significant hardware management program for a home-based learning program  Disclosed in the second quarter earnings release, this program contributed almost $1.8 million in 2004 sales.



PDSi Earns ISO 13485 Registration to Expand Support for Medical Device
Manufacturers  This accomplishment resulted in a number of new and current customers moving active programs to PDSi. Among them have been some of the worlds leading medical equipment manufacturers.



Sun Microsystems Presents Pinnacle Data Systems with Best in Class Award for Outstanding
Performance in Repair and Logistics Support. - Although Sun repair program revenue declined approximately 17% in 2004, this award has influenced Suns decisions to award us new repair programs that should increase repair program revenue in
2005. Sun has provided a number of new product opportunities that have already generated, or are expected to generate, significant revenue in 2005 and beyond.



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Silicon Graphics Awards Repair to Pinnacle Data Systems  This multi-year agreement designates us as Silicon
Graphics primary source for board repair. Revenue from this program began in the fourth quarter of 2004 and is expected to grow throughout 2005.



Competition



Competition for our custom-engineered products comes from three primary sources: (1) other electronic contract manufacturing companies (ECMs) that provide
similar engineering and manufacturing services, (2) other value-added computer resellers (VARs) and (3) less expensive off-the-shelf products.



We market our customized services and products to specific customers and niche-industries. This reduces competition from larger ECMs (Flextronics, Solectron, Plexus and
others) because of the costs involved for them to run the smaller manufacturing volumes typical of these orders. The level of engineering complexity and after-the-sale service and support on some products reduces competition from VARs of all levels
of size and geographic coverage. We believe we differentiate ourselves from other competitors through the strength of our close relationships with our very large OEM partners (Sun, Intel, AMD, Agilent, H-P and others), our ability to offer and
deliver complete turnkey solutions in relatively short development cycles, our unique product set and our full service-after-the-sale offering. However, a number of our competitors are more established and have substantially greater technical,
manufacturing, marketing and financial resources to develop and market their engineering and manufacturing services or their off-the-shelf products.



The primary competitive factors in the electronic equipment service industry are price, quality and scope of services (based on in-house technical expertise). We compete
with the in-house repair centers of OEMs, Third Party Maintenance providers (TPMs), ECMs and other independent depot repair organizations similar to ours. We believe we differentiate ourselves by offering complete packaged solutions
backed up by a broad scope of repair and logistics service offerings, including our experience with a wide variety of technologies and very large, well-known and demanding OEM customers, flexibility in tailoring our operating procedures to fulfill
stringent quality, documentation and reporting requirements, and offering the most cost-effective solutions to fulfill our customers service needs. However, a number of our competitors are more established and have substantially greater
technical, manufacturing, marketing and financial resources to develop and market similar services.



Suppliers



During 2004, approximately 47% of all inventory purchased was manufactured by or for Sun and was purchased directly from Sun or through Suns distribution channel.
We believe all critical production components and service parts, or suitable substitutes, are readily available in the marketplace from multiple manufacturers and/or suppliers, new or refurbished, as required by our current customers demands.





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Customers



A significant amount of our sales come from a relatively small number of large customers. A major strategic focus continues to be further
growth and diversification of our customer base. In 2004, we provided services and/or products to ten Fortune Global 500 companies and two Fortune 1000 companies compared to eight Fortune Global 500 companies and four Fortune 1000 companies in 2003.



Our four largest customers generated about 52%, 59% and 70% of sales,
respectively, for the years 2004, 2003 and 2002. In 2004, no one customer generated more than 17% of our sales compared to 27% the prior year.



Six, nine and four customers, respectively, generated approximately 82% of our product sales for the years 2004, 2003 and 2002. Two customers generated 73%, 82% and 95%
of sales, respectively, for the years 2004, 2003 and 2002.



Weve made
much progress in diversifying our customer base. However, the Companys relatively small number of customers can create significant sales volatility. If the sales generated by either of our top two service customers declined significantly, or
if product sales of our top product customers declined significantly without additional service or product business to replace it, the results of our operations could be materially and adversely affected.



Patents and Trademarks



Since our products are based on existing technologies and custom-designed components
generally developed under agreements with specific customers, the Company currently owns no patents and has no patents pending.



In 2003, we received notice of the successful registration of the federal trade and service marks for the logo PDSi under Class 9 products and under Class 42
services.



The applications filed in 2001 for federal trade and service marks
for Pinnacle Data Systems have been suspended and are awaiting the final disposition of other pending applications.



License and Royalty Agreements



In April 2004, we entered into a U.S. Business Development Partner Agreement with H-P to buy and resell or sublicense products, services and support including the select
HP Care Pack Services. The agreement expires in May 2005. At the time of expiration, orders already accepted shall be governed under the terms and conditions of the agreement. The agreement may also be terminated earlier upon default by either party
as defined in the agreement. These products were required in an immaterial amount of product sales in 2004, but are expected to be used in a more significant number of sales in future years. In February 2005, the agreement was extended until May
2006.





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In September 2003, by re-application, we renewed an OEM Customer License Agreement for Embedded Systems with Microsoft
Licensing, Inc. (Microsoft) originally issued in 2002, pursuant to which we are licensed to embed binary copies of Microsoft operating systems (as delivered from Microsoft) in our products. The license agreement was for an original term
of one year expiring in September 2004. The license is renewable by re-application. The license has been renewed for a term expiring in November 2005. The license can also be terminated earlier by Microsoft upon default by us as defined in the
Agreement. These operating systems were required in product sales of approximately $900,000 in 2004 and $500,000 in 2003 (approximately 3% and 3% of total product sales, respectively).



In April 2003, we entered into a Regional Reseller Agreement with Agilent Technologies to buy and resell Agilent Remote Management Products
in the United States and Canada. The agreement includes a license to use, execute, reproduce, display and distribute Agilent software in object code for the purpose of integrating Agilents products with our, or our customers, products.
The agreement was for an original term of one year expiring in March 2004. The agreement automatically renews for one-year periods unless written notice of non-renewal is given by either party before the current term ends. The agreement may also be
terminated earlier upon default by either party as defined in the agreement. The agreement was renewed for a term expiring in March 2005. Agilent has given notice that it will not renew the agreement again beyond March 2005. These products were
required in product sales of approximately $2.3 million in 2004 and $1.1 million in 2003 (approximately 8% and 7% of total product sales, respectively). This agreement was entered into to increase product offerings to our current and prospective
customers.



In March 2003, we entered into a Design License Agreement with Sun,
pursuant to which we have a limited licensed to develop, manufacture and sell to one specific customer a product based upon and using the Sun SPARCengine Classic-II Motherboard. The license agreement was for an original term of one year expiring in
March 2004. The license may only be renewed by mutual written agreement signed by both parties. The license can be terminated earlier, for any reason or for specific reasons, by either party as defined in the Agreement. The license was not renewed,
but the agreement provides us the right to continue to use the technology for existing products. This technology, which was not required for any sales in 2004, was required in product sales of approximately $700,000 in 2003 (approximately 4% of
total product sales).



In February 2003, by re-application, we renewed a
Technology License and Distribution Agreement with Sun originally issued in 1994, pursuant to which we are licensed to distribute the Sun Solaris® operating system in our products. The license agreement is for an original term of three years expiring in February 2006. The license automatically
renews for up to two one-year periods unless written notice of non-renewal is given by either party before the current term ends. The license can also be terminated earlier upon default by either party as defined in the Agreement. These operating
systems were required in product sales of approximately $11.9 million in 2004 and $7.6 million in 2003 (approximately 34% and 49% of total product sales, respectively).



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In August 2002, we were authorized by Sun to act as an OEM Technology Partner (OTP), pursuant to which we are
authorized and licensed to buy Sun products at specific discount levels for the purpose of modifying them and/or integrating them into our products for resale to our OEM customers. This authorization can be terminated earlier without cause or upon
default by either party as defined in the terms and conditions of the General Terms and iForce Business Terms exhibits attached to the OTP Letter of Authorization. This designation or its predecessor Master Value-Added Integrator (MVAI) designation
was required in product sales of approximately $11.9 million in 2004 and $7.3 million in 2003 (approximately 35% and 47% of total product sales, respectively).



In April 2002, we entered into a Software and Documentation License Agreement with Intel, pursuant to which we are licensed to incorporate the Intel 82544 Gigabit
Ethernet Controller into our BlueswitchTMand derivative products. The license can be terminated by Intel upon
default by us as defined in the Agreement. This controller was required in an immaterial amount of product sales in both 2004 and 2003 but is expected to be used in a more significant number of sales in future years.



In July 2001, we entered into a Reference Design License Agreement with Sun, pursuant to
which we are licensed to develop, manufacture and sell products based upon and using the Sun ULTRSPARC IIe technology. Training and support fees amounting to $35,000 were paid in connection with the license. The license agreement was for an original
term of three years expiring in July 2004. The license automatically renews for up to two one-year periods unless written notice of non-renewal is given by either party before the current term ends. The license can also be terminated earlier upon
default by either party as defined in the Agreement. The license agreement automatically renewed until July 2005. This technology was required in product sales of approximately $5.1 million in 2004 and $900,000 in 2003 (approximately 15% and 6% of
total product sales, respectively).



In May 1999, we entered into a Reference
Design License Agreement with SME, pursuant to which we are licensed to develop, manufacture and sell products based upon and using the Sun AXmp technology. Training and support fees amounting to $40,000 were paid in connection with the license. The
license agreement is for an original term of seven years expiring in May 2006. The license automatically renews for one-year periods unless written notice of non-renewal is given by either party before the current term ends. The license can also be
terminated earlier upon default by either party as defined in the Agreement. This technology was required in product sales of approximately $5.4 million in 2004 and $2.8 million in 2003 (approximately 16% and 18% of total product sales,
respectively).



In October 1997, we entered into a Development and
Manufacturing License Agreement with SME pursuant to which we are licensed to develop, manufacture and sell products based upon and using the Sun PCI card and Open Boot PROM technology. We do not anticipate that we will develop any new products
based on the technology licensed under this agreement, although we will continue to sell products that we have developed under this license. The license agreement was for an original term of three years expiring in October 2000. However, the license
automatically renews for one-year periods unless written notice of non-renewal is given by either



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party before the current term ends. The license can also be terminated earlier upon default by either party as defined in the Agreement. The license has been
automatically renewed for an additional one-year term expiring October 2005. This technology was required in product sales of approximately $1.2 million in 2004 and $1.4 million in 2003 (approximately 4% and 9% of total product sales, respectively).



In May 1994, we entered into a Microprocessor Platform Design License
Agreement with Sun, acting through its SPARC Technology Business Division, pursuant to which we are licensed to develop, manufacture and sell products based upon and utilizing the Sun SPARC microprocessor technology. The technology of this license
is utilized in customer projects that began prior to 1997. It has not been utilized in any new customer projects since 1996. We do not anticipate that we will develop any new products based on the technology licensed under this agreement, although
we will continue to sell products that we have developed under this license. A license fee in the amount of $35,000 was paid in full upon execution of the license. The license agreement was for an original term of seven years expiring in 2001.
However, the license automatically renews for one-year periods unless written notice of non-renewal is given by either party before the current term ends. The license can also be terminated earlier upon default by either party as defined in the
Agreement. The license has been automatically renewed for an additional one-year term expiring in 2005. This technology was required in product sales of approximately $0 in 2004 and $700,000 in 2003 (approximately 0% and 4% of total product sales,
respectively). This technology was used in various non-recurring projects over the last two years.



We have no outstanding royalty agreements.



Labor Contracts



None of our employees
are subject to collective bargaining agreements. We consider our relationship with our employees to be very good.



Government Approval of Principal Products or Services



Our principal products and services do not generally require government approval, although some of our OEM customers products do
require government approval. For example, medical-imaging equipment for which we sell components to our customers may require Food and Drug Administration (FDA) approval. This may slow the introduction of our customers new products
and sometimes extends the time period between successful customer trials and the resulting production orders. We consider this in our business planning. When required, we help our customers get government approval. We also help them prolong the life
of their products to delay costly government approval processes.



Governmental Regulation Costs



No
federal, state or local laws or regulations in existence or proposed are expected to materially impact our operations or financial position.





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Research and Development



There are research and development expenses in connection with designing new products.
During 2004 and 2003, we incurred approximately $24,000 and $206,000, respectively, for research and development. These expenses were not paid directly by our customers, but are typically recouped over time as part of the cost of the developed
products sold to customers.



Environmental
Compliance Costs



Certain facets of our operations involve the use of
substances regulated under various federal, state and local laws governing the environment. The liability for environmental remediation and related costs can be significant, although the Company has not incurred any to this date. Consequently,
environmental costs and environmental regulations are not presently material to our operations or financial position. Similarly, no other federal, state or local laws or regulations are expected to materially impact our operations or financial
position.



Employees



As of December 31, 2004, we had a total of 106 employees, all of whom were full-time.



Item 2. Description of Property



We lease
approximately 113,000 square feet of office, warehouse, laboratory and production space in a building located at 6600 Port Road, Groveport, Ohio. We entered into a ten-year lease commencing May 1, 1999. The lease contains annual escalators intended
to cover inflationary costs over the life of the lease. Minimum future annual lease payments under the lease as of December 31, 2004 are approximately $589,216. We have the option to extend the term of the lease for an additional five years. The
building is in good condition. While we believe that this current space is adequate for the foreseeable future, we have been granted an option to lease an additional 53,000 square feet of warehouse space in this building at the termination of the
current lessors lease.



Our current policy is not to invest in real
estate or interests in real estate. We do not invest in real estate mortgages or securities of entities primarily engaged in real estate activities.



Item 3. Legal Proceedings



We are not and our
property is not currently a party to any pending legal proceedings.



Item 4. Submission of Matters to a Vote of Security Holders



No matters were submitted to a vote of shareholders during the fourth quarter of 2004.





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PART II



Item 5. Market for Common Equity and Related Stockholder Matters



(a) Market Information. Since September 7, 2000, our common stock has traded on the American Stock Exchange under the stock symbol PNS. Set forth below is the range of high and low sales prices of
the common shares on the American Stock Exchange during 2004 and 2003.



|                                   |  |                       |      |     |   |     
|---------------------------------- |  | --------------------- | ---- | --- | - | ----
|                                   |  | Range of Sales Prices
|                                   |  | High                  |      | Low
|Fiscal Year 2004                   |  |                       |      |     |   |     
|Fourth quarter (ended December 31) |  | $                     | 3.50 |     | $ | 1.90
|Third quarter (ended September 30) |  |                       | 4.54 |     |   | 2.00
|Second quarter (ended June 30)     |  |                       | 5.00 |     |   | 2.21
|First quarter (ended March 31)     |  |                       | 3.23 |     |   | 1.85
|                                   |  |                      
|Fiscal Year 2003                   |  |                       |      |     |   |     
|Fourth quarter (ended December 31) |  | $                     | 3.16 |     | $ | 1.75
|Third quarter (ended September 30) |  |                       | 2.55 |     |   | 1.02
|Second quarter (ended June 30)     |  |                       | 1.30 |     |   | 1.00
|First quarter (ended March 31)     |  |                       | 1.70 |     |   | 0.95



(b) Holders. On
February 11, 2005, there were 86 holders of record of the Shares. Most of the Shares not held by officers and directors are held in street name.



(c) Dividends. During the past two years, we have not paid cash dividends. Payments of dividends are within the discretion of our board of
directors.



(d) Securities Authorized for Issuance Under
Equity Compensation Plans. The following table provides information as of December 31, 2004 with respect to shares of Pinnacle Data Systems, Inc. common stock that may be issued under our existing equity compensation plans, including the
Pinnacle Data Systems, Inc. 1995 Stock Option Plan (the Employee Plan), the stock option agreement, effective September 12, 1997 between Pinnacle Data Systems, Inc., and Thomas OLeary, the stock option agreement, effective
September 12, 1997 between Pinnacle Data Systems, Inc., and Robert Ostrander, the stock option agreement, effective June 23, 1999 between Pinnacle Data Systems, Inc., and Robert Ostrander, and the Pinnacle Data Systems, Inc. 2000 Director Stock
Option Plan (the Director Plan).



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|                                                               |  |                                                                                            |  |                                                                            |  |                                                                                                                                          
|-------------------------------------------------------------- |  | ------------------------------------------------------------------------------------------ |  | -------------------------------------------------------------------------- |  | -----------------------------------------------------------------------------------------------------------------------------------------
|                                                               |  | (a)                                                                                        |  | (b)                                                                        |  | (c)                                                                                                                                      
|Plan Category                                                  |  | Number of securities to be issued upon exercise ofoutstanding options, warrants and rights |  | Weighted-average exercise price of outstanding options,warrants and rights |  | Number of securities remaining available for futureissuance under equity compensation plans (excluding securities reflected in
column (a)
|                                                               |  |                                                                                            | 
|Equity compensation plans approved by security holders (1)     |  | 1,412,950                                                                                  |  | $2.10                                                                      |  | 2,125,200                                                                                                                                
|                                                               |  |                                                                                            | 
|Equity compensation plans not approved by security holders (2) |  | 114,000                                                                                    |  | $0.79                                                                      |  | 0                                                                                                                                        
|                                                               |  |                                                                                            |  |                                                                            |  |                                                                                                                                          
|                                                               |  |                                                                                            | 
|Total                                                          |  | 1,526,950                                                                                  |  | $1.91                                                                      |  | 2,125,200                                                                                                                                
|                                                               |  |                                                                                            |  |                                                                            |  |                                                                                                                                          

---

|(1) | Consists of the Employee Plan and the Director Plan.
|--- | ----------------------------------------------------

|(2) | Consists of the stock option agreement, effective September 12, 1997 between Pinnacle Data Systems, Inc., and Thomas OLeary, the stock option agreement, effective September
12, 1997 between Pinnacle Data Systems, Inc., and Robert Ostrander, and the stock option agreement, effective June 23, 1999 between Pinnacle Data Systems, Inc., and Robert Ostrander. The material features of these agreements are described below.
|--- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Each of the option agreements between the Company and Thomas
OLeary and the Company and Robert Ostrander grants the recipient options to purchase shares of the Companys common stock for a period of 10 years from the date of the grant, although the option is not exercisable until the date that is
one year from the date of the grant. The agreements each provide that if the recipient ceases to be a director of the Company for any reason other than death, the recipient has 90 days from the date of termination to exercise his option. In the
event that the recipient ceases to be a director of the Company due to death, or if the recipient dies within 90 days of his termination as a director of the Company for any reason, the option may be exercised by the recipients representative
within 1 year after the date of death.



The options granted pursuant to the
agreements are not transferable other than by will or the laws of descent and distribution, and the number of options are subject to adjustment, on a proportionate basis, upon the occurrence of certain events relating to the Companys capital
structure. For example, the number of securities to be issued upon exercise of Mr. OLeary and Mr. Ostranders options were adjusted upward as a result of the 2-for-1 stock split effective March 31, 2000 and the 2-for-1 stock split
effective October 31, 2000.



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Item 6. Managements Discussion and Analysis or Plan of Operation



The following discussion should be read in conjunction with the Financial Statements and Notes contained herein.



This annual report, including the following sections, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E
of the Securities Exchange Act of 1934. The words believe, expect, anticipate, estimate, project, should, and similar expressions identify forward-looking statements that speak
only as of the date thereof. Investors are cautioned that such statements involve risks and uncertainties that could cause actual results to differ materially from historical or anticipated results due to many factors. Such factors include,
but are not limited to, adverse changes in general economic conditions, including adverse changes in the specific markets for our products and services, adverse business conditions, decreased or lack of growth in the computing industry, adverse
changes in customer order patterns, including any decline or change in product orders from large customers like the four customers that made up approximately 52% of our revenue during 2004, increased competition, any adverse change in our business
or our relationship with major technology partners, around whose computing platforms large portions of our business are based, lack of acceptance of new products, pricing pressures, lack of adequate financing to take advantage of business
opportunities that may arise, lack of success in technological advancements, risks associated with our new business practices, processes and information systems, and other factors, including those discussed under Risk Factors on page 19
of this report.



OVERVIEW



Pinnacle Data Systems, Inc. (PDSi or the Company) provides
product lifecycle service solutions to Original Equipment Manufacturers (OEMs) in the medical, telecommunications, defense, imaging and computer equipment industries, among others. We offer a full range of computer and computer-related product
development and manufacturing services to increase product speed to market and engineered product life, and support units in the field through comprehensive product lifecycle management programs encompassing depot repair, advanced exchange, contact
center support and end-of-life control.



As an outsourced service provider, we
manage the extended product lifecycle required by OEMs in these industries to satisfy a major market need that exists in the computer industry.



Major developers of computer technology and products, like Sun Microsystems, Inc., Intel, Advanced Micro Devices, Hewlett Packard, among others, have a business model in
which the primary target market consists of corporate IT data centers and large scale users of corporate worker desktop or laptop workstations. To capture the next capital dollar spent by this market, the computer manufacturers must offer the latest
technologies and performance features. To do



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this economically and competitively, the manufacturer must maintain economies of scale and, as such, limit their product offerings by generally discontinuing
older products that have been in the market 18-36 months.



Contrast that to the
model employed by OEMs in the medical, telecommunications, defense and imaging equipment industries that embed computer products into their own marketable solutions. Their model involves extensive research and development investment to develop
unique intellectual property, with extensive validation and testing to ensure their products effectiveness and safety, and significant product launches to develop significant market demand. New product development and time to market can span
two to eight years. To financially justify this level of investment, OEMs need to market and sell their products for at least five to ten years, and their customers will want that product to be supported for eight to ten years beyond the time of
purchase to recover their investment. The computers that are embedded in these types of very sophisticated OEM equipment are mission critical, serving as the controller or user interface to the system, but they do not contain the intellectual
property or the competitive advantage of the product. When the computer manufacturer revises their product eight to ten times over the life of the OEMs product life, the OEM must either update the technology in their equipment incurring
significant redesign, product and process engineering, and recertification costs for each revision just to keep up, or they must be able to supply the original technology with only one to two revisions over the life of their product. In the case of
medical equipment manufacturers, updating their product for every revision of the embedded computer is all but impossible to justify over the life of their product; a life that may span up to twenty years.



To solve this problem, major OEMs have historically maintained aggressive control of their
supply chain and after-market support by performing much of the work themselves. This involved designing and manufacturing their own computers, and managing their own inventory, returns and repairs of them.



Over the past decade, the trend has continued to move away from this model. At first, the
OEMs continued to do the design and manage the customer-interfacing activities, only outsourcing the manufacturing to others. Later, they used suppliers to outsource the design and moved toward the customization of off-the-shelf products, while
continuing to manage the logistics and the customer contact. Now, OEMs look to outsource almost any and all functions other than those directly involved with the development of intellectual property.



We have taken advantage of this trend by developing a business model that supports both the
OEMs and the computer manufacturers that serve them. Over the years, we have developed a portfolio of technological competencies, services, selling strategies and program management processes that have allowed it to offer a strong value proposition
to the markets it serves.



Our strategy is to focus on Fortune Global 500
companies, take advantage of the trend toward business process outsourcing, and broaden our scope of service offerings. This has given us a strong foundation and ability to convert significant opportunities. We compete in the contract manufacturing
industry and the value-added computer reseller market, as well as with independent engineering and repair organizations. The combined markets for these services



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exceeds $200 billion and the competition ranges from $10 billion multinational organizations to small local businesses. We compete by offering services of
these different industries in combination with sophisticated and customized program management systems and processes.



We increased sales 50% in 2004 after growing sales 46% in 2003. Earnings grew 87% in 2004, after achieving our second most profitable year in our history in 2003. In
2004, we earned new business from world-leading medical, telecommunications and imaging equipment OEMs. We achieved ISO13485 and TL9000 registration further qualifying us for outsourcing in the medical and telecommunications equipment markets. We
won the repair and logistics programs of a world-leading OEM of high-performance computing, visualization and storage equipment, Silicon Graphics, Inc., and a home-based state-funded computer learning program that currently serves over 6,000
students, as well as earning Sun Microsystems 2004 Best in Class Award for outstanding performance in repair and logistics support. We also forged new partnerships that expand our marketing, technological and geographical capabilities.



We believe we can refine and execute this model and sustain an average annual sales growth
rate of approximately 25% over the next five years, achieving an annual sales level exceeding $100 million and, with additional leverage, significant earnings growth as well. Towards that goal in 2005, we expect sales to increase 20-25% and for the
year to be profitable, as we continue to build our market presence and improve the scalability of our organization.



The following discussions and analyses are for the year ended December 31, 2004 compared to the year ended December 31, 2003.



SALES



Sales for 2004 and 2003 were as follows:



|              |  |      |        |          |   |        |  |     |  
|------------- |  | ---- | ------ | -------- | - | ------ |  | --- | -
|              |  | Year |        | % Change |  
|($ thousands) |  | 2004 |        | 2003     |  
|Total company |  | $    | 34,397 |          | $ | 22,884 |  | 50  | %
|Product       |  |      | 28,351 |          |   | 15,595 |  | 82  | %
|Service       |  |      | 6,046  |          |   | 7,289  |  | -17 | %



The increase in
product sales for 2004 was due to increased shipments to medical, telecommunications and imaging customers, which more than offset lower shipments to defense and industrial control customers. Service sales decreased and were less than projected
because sales to two of our larger repair customers declined in 2004 and certain projected service sales are being reported as product sales due to changes in the customers actual versus projected programs. Services sales in the second half of
2004 were bolstered by the startup of a new OEM repair customer and a new hardware management program.



For 2004, we had three customers that generated revenues of approximately $5,694,000, $5,688,000, and $3,877,000 or 17%, 17%, and 11% respectively, of
total revenue. In the



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statements of operations, approximately $405,000 of the revenues from these customers is included in service sales and $14,853,000 is included in product
sales. In addition, these customers represented 15%, 10%, and 3%, respectively, of accounts receivable at December 31, 2004.



GROSS PROFIT



Gross profits for 2004 and 2003 were as follows:



|              |  |      |       |          |   |       |  |    |  
|------------- |  | ---- | ----- | -------- | - | ----- |  | -- | -
|              |  | Year |       | % Change |  
|($ thousands) |  | 2004 |       | 2003     |  
|Total company |  | $    | 8,015 |          | $ | 6,038 |  | 33 | %
|Product       |  |      | 5,698 |          |   | 3,594 |  | 59 | %
|Service       |  |      | 2,317 |          |   | 2,444 |  | -5 | %



The gross profits
margin percentage for 2004 and 2003 were as follows:



|              |  |      |   |  |      |  
|------------- |  | ---- | - |  | ---- | -
|              |  | Year |  
|              |  | 2004 |   |  | 2003 |  
|Total company |  | 23   | % |  | 26   | %
|Product       |  | 20   | % |  | 23   | %
|Service       |  | 38   | % |  | 34   | %



While the increase in
product sales volume resulted in the increase in gross profit dollars on product sales, product sales to newer customers generally were lower value-added sales and, therefore, had lower margins than the product sales in older customer programs.



The increase in the gross profit margin percentage for service
sales was due to a change in the mix of service programs and partially offset the volume loss effect on gross profit dollars on service sales.



OPERATING AND INTEREST EXPENSES



Operating expenses include selling, general and administrative (SG&A) expenses. Operating and interest expenses for 2004 and 2003 were as follows:



|                 |  |      |       |          |   |       |  |    |  
|---------------- |  | ---- | ----- | -------- | - | ----- |  | -- | -
|                 |  | Year |       | % Change |  
|($ thousands)    |  | 2004 |       | 2003     |  
|SG&A expense     |  | $    | 6,616 |          | $ | 5,147 |  | 29 | %
|Interest expense |  |      | 113   |          |   | 85    |  | 33 | %
|                 |  |      |       |          |   |       |  |    |  
|Total expense    |  |      | 6,729 |          |   | 5,232 |  | 29 | %
|                 |  |      |       |          |   |       |  |    |  





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We increased sales and marketing expenses in the second half of 2004 consistent with our targeted growth
strategy. As a result, operating expenses rose from 2003 levels, as planned. The 29% increase in operating expenses was significantly less than the 50% increase in sales. Operating expenses were 19% of sales in 2004, down from 22% in 2003.



In 2004, an increased use of the credit line due to higher
levels of receivables and inventory to support the higher sales volume combined with higher interest rates resulted in higher interest expense compared to 2003. The average daily balance on the line of credit increased to $2.6 million in 2004 from
$1.9 million in 2003. Interest rates paid on the line of credit ranged from 4.00% to 5.25% in 2004, and from 4.00% to 4.50% in 2003.



INCOME TAXES AND NET INCOME



The effective tax rate used for 2004 was 31%, compared to 41% in 2003, reflecting an increase in foreign sales and the use of the extra-territorial income
tax incentive.



Income before taxes, income taxes and net
income for 2004 and 2003 were as follows:



|                          |  |      |       |      |   |    
|------------------------- |  | ---- | ----- | ---- | - | ---
|                          |  | Year
|($ thousands)             |  | 2004 |       | 2003
|Income beforeincome taxes |  | $    | 1,286 |      | $ | 806
|Income tax expense        |  |      | 402   |      |   | 333
|                          |  |      |       |      |   |    
|Net income                |  |      | 884   |      |   | 473
|                          |  |      |       |      |   |    



Earnings per share for
2004 and 2003 were as follows:



|                                               |  |      |           |      |   |          
|---------------------------------------------- |  | ---- | --------- | ---- | - | ---------
|                                               |  | Year
|                                               |  | 2004 |           | 2003
|EPS:                                           |  |      |           |      |   |          
|Basic                                          |  | $    | 0.16      |      | $ | 0.09     
|Fully diluted                                  |  | $    | 0.14      |      | $ | 0.08     
|Weighted average number of shares outstanding: |  |      |           |      |   |          
|Basic                                          |  |      | 5,572,811 |      |   | 5,526,978
|Fully diluted                                  |  |      | 6,121,675 |      |   | 5,834,551







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The improvement to net income in 2004 reflected the 50% increase in sales and the resulting increase in
gross profit from additional operating leverage, which exceeded the planned increase in selling, general and administrative expenses.



LIQUIDITY AND CAPITAL RESOURCES



A summary of changes in current assets for 2004 and 2003 follows:



|                     |  |          |       |          |   |          |  |     |  
|-------------------- |  | -------- | ----- | -------- | - | -------- |  | --- | -
|($ thousands)        |  | 12/31/04 |       | 12/31/03 |   | % Change | 
|Accounts receivable  |  | $        | 4,398 |          | $ | 5,127    |  | -14 | %
|Inventory            |  |          | 4,080 |          |   | 2,023    |  | 102 | %
|Other current assets |  |          | 903   |          |   | 637      |  | 42  | %
|                     |  |          |       |          |   |          |  |     |  
|Total                |  |          | 9,381 |          |   | 7,787    |  | 20  | %
|                     |  |          |       |          |   |          |  |     |  



A summary of changes
in current liabilities for 2004 and 2003 follows:



|                    |  |          |       |          |   |          |  |    |  
|------------------- |  | -------- | ----- | -------- | - | -------- |  | -- | -
|($ thousands)       |  | 12/31/04 |       | 12/31/03 |   | % Change | 
|Line of credit      |  | $        | 2,525 |          | $ | 2,487    |  | 2  | %
|Accounts payable    |  |          | 2,177 |          |   | 1,866    |  | 17 | %
|Other current liab. |  |          | 517   |          |   | 460      |  | 12 | %
|                    |  |          |       |          |   |          |  |    |  
|Total               |  |          | 5,219 |          |   | 4,813    |  | 8  | %
|                    |  |          |       |          |   |          |  |    |  



During 2004, $94,000
of cash was used by operating activities. Net income before depreciation and amortization, provision for doubtful accounts, inventory reserves, and provision for deferred taxes was $1,707,000. Additional cash was generated by reductions in accounts
receivable of $728,000 and a combined increase in accrued expenses and unearned revenue of $51,000. The amount of cash otherwise generated by operating activities was more than offset by an increase in inventory of $2.4 million, and a combined
increase in prepaid expense and other current assets of $174,000. The increase in inventory was primarily attributable to two new multi-year customer programs that required a substantial investment in inventory in order to conduct those programs. In
both programs, agreements minimize our risk of inventory loss and our revenue includes charges for carrying the extra inventory. Without those two programs, our increase in total inventory over 2004 would have been significantly less than the
increase in total revenue.



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In 2004, we used $344,000 of cash to purchase equipment, including computers and software, primarily to
support new product customers and a new OEM service program. The 50% increase in sales, the planned increases in operating expenses, and the investment in new inventory and fixed assets were mostly financed by our own operations, with only a $38,000
increase to our line of credit balance, representing a 2% increase in the line balance over 2003. We also converted $76,000 of inventory to computer equipment in 2004.



The line of credit, which is our primary source of operational and non-operational funding, is maintained with KeyBank
National Association (KeyBank) and is payable on demand and collateralized by a Blanket Lien on all of our assets. The amount available under the line of credit is subject to borrowing base restrictions and other financial covenants as
outlined in the agreement.



The aforementioned borrowing base
on the line of credit is calculated as 85% of eligible accounts receivable and 50% of inventory value, net of reserves. The line has an overall limit of $6,000,000 as well as a sub-limit of $3,000,000 that can be collateralized by inventory. That
calculation represents the maximum amount that can be drawn on the line of credit. The balance on the line of credit at December 31, 2004 was $2,525,000. The borrowing base calculation on that date was $5,776,000, resulting in an unused capacity of
$3,251,000. We are not currently, and do not expect at this time to be, constrained by our credit limits. We were in compliance with all covenants of the line for the entire year of 2004.



On December 28, 2004, the line of credit was renewed until May 15, 2006. The maximum limit of the line was increased to
$6,000,000 from $5,000,000, with the variable interest rate continuing at prime. As the line of credit is our primary source of financing, it is critical to our short-term liquidity. To maintain a sufficient borrowing base to meet our needs and meet
the covenant requirements of the line, we must maintain sales and gross profit levels with minimum inventory on hand, and effectively manage cash flow from collections to payments. Significant delays or loss of customer orders, or delayed customer
payments, could impact our ability to meet our short-term financial obligations. Inventory reductions also reduce our borrowing base, thereby limiting our capacity for short-term borrowing. This would include reductions in inventory due to changes
in the valuation of our inventory and the setting of appropriate inventory reserves to reflect changes in technology or reduced customer requirements.



Additional financing may be needed to support the future growth plans of the Company. The Company is evaluating an acquisition strategy that may be
financed by the issuance of additional common or preferred stock that has already been authorized by the shareholders. Those shares may be issued by approval of the Board of Directors. Acquisitions being evaluated provide services similar to those
of the Company that are, or can be made, accretive in a short period of time; that bring large OEM customer relationships with potential additional business for the combined company (that neither company would get on their own); and that bring
resources, in terms of people, processes and systems, that increase the scalability of the combined businesses.



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OFF-BALANCE SHEET ARRANGEMENTS



We have no off-balance sheet arrangements with any obligation under a guarantee contract, or a retained or contingent
interest in assets or similar arrangement that serves as credit, liquidity or market risk support for such assets, or any other obligation, including a contingent obligation, under a contract that would be accounted for as a derivative instrument.



At any given point in time in the normal course of business,
we have numerous outstanding purchase orders with our vendors to purchase inventory for use in the products that we sell to our customers or to use in performing repair services for our customers. Such orders are not recorded as liabilities in our
balance sheet until the material is physically received from the vendors. We have no minimum purchase quantity requirements with any of our vendors.



We lease our operating facility under an operating lease in which we have an obligation to pay rent through 2009. See Note 6 to the financial statements
contained in our Form 10-KSB for the year ended December 31, 2004. Except for that operating lease, we have not entered into any off-balance sheet transactions in 2004 and 2003.



Total rent charged to operations for operating leases and other month-to-month rental obligations for the years ended
December 31, 2004 and 2003 amounted to $689,576 and $616,230, respectively.



CRITICAL ACCOUNTING POLICIES



The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to make judgments, assumptions and estimates that affect the amounts
reported in the Financial Statements and accompanying notes. Note 1 to the Financial Statements in the Annual Report on our Form 10-KSB for the year ended December 31, 2004 describes the significant accounting policies and methods used in the
preparation of the Financial Statements. Estimates are used for, but not limited to, the accounting for allowance for doubtful accounts and inventory reserves. Actual results could differ from these estimates. The following critical accounting
policies are impacted significantly by judgments, assumptions and estimates used in the preparation of the Financial Statements.



For product sales, we recognize revenue upon transference of the title to the products to the customer. For repair sales, we recognize revenue upon
completion of the repair work and either shipment of the item back to the customer or, in the programs in which we also manage the customers inventory on our site, when we return the repaired item to the customers finished goods
inventory. For some repair and maintenance programs, the customer pays a flat fee that covers multiple fiscal periods. In those instances, we recognize revenue over the fiscal periods covered by the billing on a pro-rata basis. Our inventory and
logistics management programs are billed monthly, with revenue recognized upon billing. For non-recurring engineering projects, we recognize revenue on a percentage-of-completion basis.



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The allowance for doubtful accounts is based on our assessment of the collectibility of specific customer
accounts and the aging of the accounts receivable. If there is a deterioration of a major customers credit worthiness or actual defaults are higher than our historical experience, our estimates of the recoverability of amounts due to us could
be adversely affected.



Inventory purchases and commitments are
based upon future demand forecasts. If there is a sudden and significant decrease in demand for our products or there is a higher risk of inventory obsolescence because of rapidly changing technology and customer requirements, we may be required to
increase our inventory allowances and our gross margin would be adversely affected.



RISK FACTORS



If we are unable to compete effectively with existing or new competitors, the loss of our competitive position could result in price reductions, fewer
customer orders, reduced revenues, reduced margins, reduced levels of profitability, and loss of market share. If we are unable to manage our inventory, will not be able to satisfy customer demand. Our reliance on one or a few suppliers for
inventory components could delay shipments and increase our costs. Our future operating results depend on our ability to purchase a sufficient amount of components to meet the demands of our customers. Since we may order components from suppliers in
advance of receipt of customer orders for our products that include these components, we could face a material inventory risk. Our products may have quality issues that could adversely affect our sales and reputation. We are dependent on significant
customers, as noted in the SALES section above.



We
depend on key employees and face competition in hiring and retaining qualified employees. Recent and proposed regulations related to equity compensation could adversely affect our ability to attract and retain key personnel.



We expect our quarterly revenues, cash flows and operating results to
fluctuate due to the fact that our quarterly sales have historically reflected a pattern in which a disproportionate percentage of such quarters total sales occur in the last month and weeks and days of the quarter. This pattern makes
prediction of revenues, earnings and working capital for each financial period especially difficult and uncertain and increases the risk of unanticipated variations in quarterly results and financial condition.



Business interruptions could adversely affect our business. Environmental
regulations and costs could result in significant liabilities for us. Our credit rating is subject to downgrade. Our business may suffer if it is alleged or found that we have infringed the intellectual property rights of others.



Our stock price, like that of other technology companies, can be volatile.
Our stock price can be affected by many factors such as quarterly increases or decreases in our earnings,



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speculation in the investment community about our financial condition or results of operations, technological developments, or the loss of key management or
technical personnel. In addition, general macroeconomic and market conditions unrelated to our financial performance may also affect our stock price.



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Item 7. Financial Statements





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##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

(DBA PDSi)



FINANCIAL REPORT



DECEMBER 31, 2004 AND 2003



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##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

(DBA PDSi)



TABLE OF CONTENTS



|                                                        |  |      
|------------------------------------------------------- |  | -----
|                                                        |  | Page 
|REPORT OF INDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM |  | 25   
|                                                        | 
|FINANCIAL STATEMENTS                                    |  |      
|                                                        | 
|Balance Sheets                                          |  | 26-27
|Statements of Income                                    |  | 28   
|Statements of Changes in Stockholders Equity           |  | 29   
|Statement of Cash Flows                                 |  | 30-31
|Notes to Financial Statements                           |  | 32-42





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Report of Independent Registered Public Accounting Firm



To the Board of Directors and Stockholders

Pinnacle Data Systems, Inc. (dba PDSi)

Groveport, Ohio



We have
audited the accompanying balance sheets of Pinnacle Data Systems, Inc. (the Company) as of December 31, 2004 and 2003, and the related statements of income, stockholders equity, and cash flows for the years then ended. These
financial statements are the responsibility of the Companys management. Our responsibility is to express an opinion on the financial statements based on our audits.



We conducted our audits in accordance with the standards of the Public Company Accounting Oversight Board (United States).
Those standards require that we plan and perform the audit to obtain reasonable assurance about whether the financial statements are free of material misstatement. An audit includes consideration of internal control over financial reporting as a
basis for designing audit procedures that are appropriate in the circumstances, but not for the purpose of expressing an opinion on the effectiveness of the Companys internal control over financial reporting. Accordingly, we express no such
opinion. An audit also includes examining, on a test basis, evidence supporting the amounts and disclosures in the financial statements, assessing the accounting principles used and significant estimates made by management, as well as evaluating the
overall financial statement presentation. We believe that our audits provide a reasonable basis for our opinion.



In our opinion, such financial statements present fairly, in all material respects, the financial position of the Company at December 31, 2004 and 2003,
and the results of its operations and its cash flows for the years then ended in conformity with accounting principles generally accepted in the United States of America. Also, in our opinion, such financial statement schedules, when considered in
relation to the basic financial statements taken as a whole, present fairly in all material respects the information set forth therein.



/s/ DELOITTE & TOUCHE LLP





Columbus, Ohio

February 15, 2005



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PINNACLE DATA SYSTEMS, INC.

(DBA PDSi)



BALANCE SHEETS



December 31, 2004 and 2003



|                                                                                      |  |      |            |      |   |          
|------------------------------------------------------------------------------------- |  | ---- | ---------- | ---- | - | ---------
|ASSETS                                                                                |  | 2004 |            | 2003
|                                                                                      |  |      |            |      |   |          
|CURRENT ASSETS                                                                        |  |      |            |      |   |          
|Cash                                                                                  |  | $    | 15,068     |      | $ | 11,997   
|Accounts receivable, net of allowance for doubtful accounts of $20,000                |  |      | 4,398,251  |      |   | 5,126,632
|Inventory                                                                             |  |      | 4,080,202  |      |   | 2,023,434
|Prepaid expenses                                                                      |  |      | 239,720    |      |   | 197,270  
|Refundable income taxes                                                               |  |      | 171,248    |      |   |         
|Deferred income taxes                                                                 |  |      | 477,000    |      |   | 428,000  
|                                                                                      |  |      |            |      |   |          
|                                                                                      |  |      | 9,381,489  |      |   | 7,787,333
|                                                                                      |  |      |            |      |   |          
|                                                                                      |  |     
|PROPERTY AND EQUIPMENT                                                                |  |      |            |      |   |          
|Leasehold improvements                                                                |  |      | 309,920    |      |   | 226,693  
|Furniture and fixtures                                                                |  |      | 382,935    |      |   | 331,991  
|Computer equipment and related software                                               |  |      | 2,481,919  |      |   | 2,264,719
|Shop equipment                                                                        |  |      | 568,223    |      |   | 494,857  
|                                                                                      |  |      |            |      |   |          
|                                                                                      |  |      | 3,742,997  |      |   | 3,318,260
|Less accumulated depreciation and amortization                                        |  |      | 2,772,203  |      |   | 2,232,379
|                                                                                      |  |      |            |      |   |          
|                                                                                      |  |      | 970,794    |      |   | 1,085,881
|                                                                                      |  |      |            |      |   |          
|                                                                                      |  |     
|OTHER ASSETS                                                                          |  |      |            |      |   |          
|Deposits                                                                              |  |      | 22,166     |      |   | 20,385   
|License agreement, less accumulated amortization of $41,800 and $32,595, respectively |  |      | 400        |      |   | 9,606    
|                                                                                      |  |      |            |      |   |          
|                                                                                      |  |      | 22,566     |      |   | 29,991   
|                                                                                      |  |      |            |      |   |          
|                                                                                      |  | $    | 10,374,849 |      | $ | 8,903,205
|                                                                                      |  |      |            |      |   |          



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



26



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##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

(DBA PDSi)



BALANCE SHEETS



December 31, 2004 and
2003



|                                                                                                                              |  |      |            |      |   |          
|----------------------------------------------------------------------------------------------------------------------------- |  | ---- | ---------- | ---- | - | ---------
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                          |  | 2004 |            | 2003
|CURRENT LIABILITIES                                                                                                           |  |      |            |      |   |          
|Line of credit                                                                                                                |  | $    | 2,525,020  |      | $ | 2,486,566
|Accounts payable                                                                                                              |  |      | 2,176,746  |      |   | 1,865,699
|Accrued expenses:                                                                                                             |  |      |            |      |   |          
|Wages, payroll taxes and benefits                                                                                             |  |      | 295,681    |      |   | 351,778  
|Income taxes                                                                                                                  |  |      |           |      |   | 7,379    
|Unearned revenue                                                                                                              |  |      | 13,822     |      |   |         
|Other                                                                                                                         |  |      | 207,398    |      |   | 100,953  
|                                                                                                                              |  |      |            |      |   |          
|                                                                                                                              |  |      | 5,218,667  |      |   | 4,812,375
|                                                                                                                              |  |      |            |      |   |          
|LONG-TERM LIABILITIES                                                                                                         |  |      |            |      |   |          
|Deferred income taxes                                                                                                         |  |      | 101,000    |      |   | 55,000   
|                                                                                                                              |  |      |            |      |   |          
|                                                                                                                              |  |      | 5,319,667  |      |   | 4,867,375
|                                                                                                                              |  |      |            |      |   |          
|COMMITMENTS AND CONTINGENCIES                                                                                                 |  |      |           |      |   |         
|                                                                                                                              |  |      |            |      |   |          
|STOCKHOLDERS EQUITY                                                                                                          |  |      |            |      |   |          
|Preferred stock; no par value; 4,000,000 shares authorized; no shares issued or outstanding                                   |  |      |           |      |   |         
|Common stock; no par value; 25,000,000 shares authorized; 5,628,806 and 5,539,796 shares issued and outstanding, respectively |  |      | 2,266,482  |      |   | 2,172,281
|Additional paid-in capital                                                                                                    |  |      | 543,095    |      |   | 502,095  
|Retained earnings                                                                                                             |  |      | 2,245,605  |      |   | 1,361,454
|                                                                                                                              |  |      |            |      |   |          
|                                                                                                                              |  |      | 5,055,182  |      |   | 4,035,830
|                                                                                                                              |  |      |            |      |   |          
|                                                                                                                              |  | $    | 10,374,849 |      | $ | 8,903,205
|                                                                                                                              |  |      |            |      |   |          



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



27



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##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

(DBA PDSi)



STATEMENTS OF INCOME



Years Ended December 31, 2004 and 2003



|                                  |  |      |            |      |   |           
|--------------------------------- |  | ---- | ---------- | ---- | - | ----------
|                                  |  | 2004 |            | 2003
|SALES                             |  |      |            |      |   |           
|Product sales                     |  | $    | 28,351,007 |      | $ | 15,595,152
|Service sales                     |  |      | 6,046,483  |      |   | 7,288,866 
|                                  |  |      |            |      |   |           
|                                  |  |      | 34,397,490 |      |   | 22,884,018
|                                  |  |      |            |      |   |           
|COST OF SALES                     |  |      |            |      |   |           
|Product sales                     |  |      | 22,652,817 |      |   | 12,000,903
|Service sales                     |  |      | 3,730,144  |      |   | 4,845,075 
|                                  |  |      |            |      |   |           
|                                  |  |      | 26,382,961 |      |   | 16,845,978
|                                  |  |      |            |      |   |           
|GROSS PROFIT                      |  |      | 8,014,529  |      |   | 6,038,040 
|                                  |  |     
|OPERATING EXPENSES                |  |      | 6,615,741  |      |   | 5,147,325 
|                                  |  |      |            |      |   |           
|INCOME FROM OPERATIONS            |  |      | 1,398,788  |      |   | 890,715   
|                                  |  |      |            |      |   |           
|OTHER EXPENSE                     |  |      |            |      |   |           
|Interest expense                  |  |      | 112,637    |      |   | 85,177    
|                                  |  |      |            |      |   |           
|INCOME BEFORE INCOME TAXES        |  |      | 1,286,151  |      |   | 805,538   
|                                  |  |     
|INCOME TAX EXPENSE                |  |      | 402,000    |      |   | 333,000   
|                                  |  |      |            |      |   |           
|NET INCOME                        |  | $    | 884,151    |      | $ | 472,538   
|                                  |  |      |            |      |   |           
|BASIC EARNINGS PER COMMON SHARE   |  | $    | 0.16       |      | $ | 0.09      
|                                  |  |      |            |      |   |           
|DILUTED EARNINGS PER COMMON SHARE |  | $    | 0.14       |      | $ | 0.08      
|                                  |  |      |            |      |   |           



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



28



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##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

(DBA PDSi)



STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY



Years Ended December 31, 2004 and 2003



|                                             |  |                   |   |                          |        |                  |  |                            |         |  |   |           |  |   |          
|-------------------------------------------- |  | ----------------- | - | ------------------------ | ------ | ---------------- |  | -------------------------- | ------- |  | - | --------- |  | - | ---------
|                                             |  | Common Stock      |   | AdditionalPaid-InCapital |        | RetainedEarnings |  | Total Stockholders Equity
|                                             |  | OutstandingShares |   |                          | Amount |                  |  |                           
|BALANCE - December 31, 2002                  |  | 5,518,870         |   |                          | $      | 2,161,656        |  | $                          | 501,506 |  | $ | 888,916   |  | $ | 3,552,078
|Options and warrants exercised               |  | 32,000            |   |                          |        | 10,625           |  |                            |        |  |   |          |  |   | 10,625   
|Treasury stock redeemed                      |  | (11,074           | ) |                          |        |                 |  |                            |        |  |   |          |  |   |         
|Other proceeds from shareholders             |  |                  |   |                          |        |                 |  |                            | 589     |  |   |          |  |   | 589      
|Net income                                   |  |                  |   |                          |        |                 |  |                            |        |  |   | 472,538   |  |   | 472,538  
|                                             |  |                   |   |                          |        |                  |  |                            |         |  |   |           |  |   |          
|BALANCE - December 31, 2003                  |  | 5,539,796         |   |                          |        | 2,172,281        |  |                            | 502,095 |  |   | 1,361,454 |  |   | 4,035,830
|                                             |  |                   |   |                          |        |                  |  |                            |         |  |   |           |  |   |          
|Options and warrants exercised               |  | 93,000            |   |                          |        | 94,201           |  |                            |        |  |   |          |  |   | 94,201   
|Treasury stock redeemed                      |  | (3,990            | ) |                          |        |                 |  |                            |        |  |   |          |  |   |         
|Tax benefits from employee stock option plan |  |                  |   |                          |        |                 |  |                            | 41,000  |  |   |          |  |   | 41,000   
|Net income                                   |  |                  |   |                          |        |                 |  |                            |        |  |   | 884,151   |  |   | 884,151  
|                                             |  |                   |   |                          |        |                  |  |                            |         |  |   |           |  |   |          
|BALANCE - December 31, 2004                  |  | 5,628,806         |   |                          | $      | 2,266,482        |  | $                          | 543,095 |  | $ | 2,245,605 |  | $ | 5,055,182
|                                             |  |                   |   |                          |        |                  |  |                            |         |  |   |           |  |   |          



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



29



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##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

(DBA PDSi)



STATEMENTS OF CASH FLOWS



Years Ended December 31, 2004 and 2003



|                                                                                            |  |      |            |   |      |   |            |  
|------------------------------------------------------------------------------------------- |  | ---- | ---------- | - | ---- | - | ---------- | -
|                                                                                            |  | 2004 |            |   | 2003 |  
|CASH FLOWS FROM OPERATING ACTIVITIES                                                        |  |      |            |   |      |   |            |  
|Net income                                                                                  |  | $    | 884,151    |   |      | $ | 472,538    |  
|                                                                                            |  |      |            |   |      |   |            |  
|Adjustments to reconcile net income to net cash provided by/(used in) operating activities: |  |      |            |   |      |   |            |  
|Depreciation and amortization                                                               |  |      | 554,226    |   |      |   | 575,173    |  
|Provision for doubtful accounts                                                             |  |      |           |   |      |   | 5,000      |  
|Inventory reserves                                                                          |  |      | 271,610    |   |      |   | 264,221    |  
|Provision for deferred taxes                                                                |  |      | (3,000     | ) |      |   | 48,000     |  
|Loss on disposal of property and equipment                                                  |  |      | 1,620      |   |      |   | 2,296      |  
|(Increase)/decrease in assets:                                                              |  |      |            |   |      |   |            |  
|Accounts receivable                                                                         |  |      | 728,381    |   |      |   | (3,043,940 | )
|Inventory                                                                                   |  |      | (2,404,650 | ) |      |   | 272,858    |  
|Prepaid expenses and other assets                                                           |  |      | (44,231    | ) |      |   | 124,930    |  
|Refundable income taxes                                                                     |  |      | (130,248   | ) |      |   |           |  
|Increase/(decrease) in liabilities:                                                         |  |      |            |   |      |   |            |  
|Accounts payable                                                                            |  |      | (3,467     | ) |      |   | 1,151,099  |  
|Accrued expenses and taxes                                                                  |  |      | 37,440     |   |      |   | (46,136    | )
|Unearned revenues                                                                           |  |      | 13,822     |   |      |   |           |  
|                                                                                            |  |      |            |   |      |   |            |  
|Total adjustments                                                                           |  |      | (978,497   | ) |      |   | (646,499   | )
|                                                                                            |  |      |            |   |      |   |            |  
|Net cash used in operating activities                                                       |  |      | (94,346    | ) |      |   | (173,961   | )
|                                                                                            |  |      |            |   |      |   |            |  
|CASH FLOWS FROM INVESTING ACTIVITIES                                                        |  |      |            |   |      |   |            |  
|Purchases of property and equipment                                                         |  |      | (344,465   | ) |      |   | (152,244   | )
|Proceeds from sale of property and equipment                                                |  |      | 165        |   |      |   | 27,000     |  
|                                                                                            |  |      |            |   |      |   |            |  
|Net cash used in investing activities                                                       |  |      | (344,300   | ) |      |   | (125,244   | )
|                                                                                            |  |      |            |   |      |   |            |  
|CASH FLOWS FROM FINANCING ACTIVITIES                                                        |  |      |            |   |      |   |            |  
|Net change in line of credit                                                                |  |      | 38,454     |   |      |   | 384,697    |  
|Outstanding checks in excess of funds on deposit                                            |  |      | 314,514    |   |      |   | (39,322    | )
|Principal payments on long-term debt                                                        |  |      |           |   |      |   | (33,333    | )
|Principal payments on capital lease obligation                                              |  |      | (5,452     | ) |      |   | (22,759    | )
|Proceeds from stock options exercised                                                       |  |      | 94,201     |   |      |   | 10,625     |  
|Other proceeds from shareholders                                                            |  |      |           |   |      |   | 589        |  
|                                                                                            |  |      |            |   |      |   |            |  
|Net cash provided by financing activities                                                   |  |      | 441,717    |   |      |   | 300,497    |  
|                                                                                            |  |      |            |   |      |   |            |  



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



30



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##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

(DBA PDSi)



STATEMENTS OF CASH FLOWS (CONTINUED)



Years Ended December 31, 2004 and 2003



|                                                                                          |  |      |         |      |   |        
|----------------------------------------------------------------------------------------- |  | ---- | ------- | ---- | - | -------
|                                                                                          |  | 2004 |         | 2003
|INCREASE IN CASH                                                                          |  |      | 3,071   |      |   | 1,292  
|                                                                                          |  |     
|CASH - Beginning of year                                                                  |  |      | 11,997  |      |   | 10,705 
|                                                                                          |  |      |         |      |   |        
|CASH - End of year                                                                        |  | $    | 15,068  |      | $ | 11,997 
|                                                                                          |  |      |         |      |   |        
|SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION                                          |  |      |         |      |   |        
|Interest paid                                                                             |  | $    | 104,151 |      | $ | 81,880 
|                                                                                          |  |      |         |      |   |        
|Income taxes paid, net of refunds                                                         |  | $    | 481,438 |      | $ | 355,063
|                                                                                          |  |      |         |      |   |        
|SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING TRANSACTIONS                   |  |      |         |      |   |        
|Inventory capitalized as computer equipment.                                              |  | $    | 76,272  |      | $ | 189,545
|                                                                                          |  |      |         |      |   |        
|Equipment acquired through capital lease.                                                 |  | $    | 10,981  |      |   |        
|                                                                                          |  |      |         |      |   |        
|Income tax benefit from employee stock option plan credited to Additional paid-in-capital |  | $    | 41,000  |      |   |        
|                                                                                          |  |      |         |      |   |        



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



31



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##### Table of Contents

NOTES TO FINANCIAL STATEMENTS



Note 1. Summary
of Significant Accounting Policies



| | A. | Nature of Business - Pinnacle Data Systems, Inc. (dba PDSi) (the Company) provides product lifecycle service solutions to Original Equipment Manufacturers (OEMs) in the medical,
telecommunications, defense, imaging and computer equipment markets, among others. PDSi offer a full range of computer and computer-related product development and manufacturing services to increase product speed to market and engineered product
life, and to provide service and support to units in the field through comprehensive product lifecycle management programs encompassing depot repair, advanced exchange, contact center support and end-of-life control.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | B. | Use of Estimates - The preparation of financial statements in conformity with accounting principles generally accepted in the United States of America requires management to make
estimates and assumptions that affect the reported amounts of assets and liabilities at the date of the financial statements and the reported amounts of revenues and expenses during the reporting period. Actual results could differ from those
estimates.
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | C. | Concentration of Credit Risk  Financial instruments, which potentially subject the Company to a concentration of credit risk, principally consist of accounts receivable. The
Company grants credit to its customers, which are varied in terms of size, geographic location and financial strength. Customer balances are continually monitored to minimize the risk of loss.
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



For 2004, the Company had three customers that generated revenues of
approximately $5,694,000, $5,688,000, and $3,877,000 or 17%, 17%, and 11% respectively, of total revenue. In the statements of income, approximately $405,000 of the revenues from these customers is included in service sales and $14,853,000 is
included in product sales. In addition, these customers represented 15%, 10%, and 3%, respectively, of accounts receivable at December 31, 2004.



For 2003, the Company had four customers that generated revenues of approximately $5,986,000, $3,048,000, $2,337,000 and $2,242,000 or 26%, 13%, 10% and
10%, respectively, of total revenue. In the statements of income, approximately $4,531,000 of the revenues from these customers is included in service sales and $9,082,000 is included in product sales. In addition, these customers represented 11%,
23%, 16%, and 24%, respectively, of accounts receivable at December 31, 2003.



| | D. | Revenue Recognition  For product sales, we recognize revenue upon transference of the title to the products to the customer. For repair sales, we recognize revenue upon
completion of the repair work and either shipment of the item back to the customer or, in the programs in which we also manage the customers inventory on our site, when we return the repaired item to the customers finished goods
inventory. For some repair and maintenance programs, the customer pays a flat fee that covers multiple fiscal periods. In those instances, we recognize revenue over the fiscal periods covered by the billing on a pro-rata basis. Our inventory and
logistics management programs are billed monthly, with revenue recognized upon billing. For non-recurring engineering projects, we recognize revenue on a percentage-of-completion basis.
| | -- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | E. | Inventories - Inventories are valued at average cost, not in excess of market.
| | -- | ------------------------------------------------------------------------------



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Inventory at December 31, 2004 and 2003 was comprised of the following (net of inventory reserves):



|                                |  |      |           |      |   |          
|------------------------------- |  | ---- | --------- | ---- | - | ---------
|                                |  | 2004 |           | 2003
|Component parts (raw materials) |  | $    | 3,362,924 |      | $ | 1,501,213
|Work-in-process                 |  |      | 369,937   |      |   | 129,088  
|Finished goods                  |  |      | 347,341   |      |   | 393,133  
|                                |  |      |           |      |   |          
|                                |  | $    | 4,080,202 |      | $ | 2,023,434
|                                |  |      |           |      |   |          



The carrying values of
component parts and finished goods represent average cost or managements estimate of its net realizable value. Such value is based on forecasts of product orders and repair/trade-in activity in the ensuing years. Such forecasts are based on
historical information, known contracts, and managements expertise in computer hardware life cycles. Should demand for the Companys products and repair/trade-in hardware prove to be significantly less than anticipated, the ultimate
realizable value of such products could be substantially less than the amount shown in the balance sheet. At December 31, 2004 and 2003, the Company provided reserves of approximately $1,027,000 and $799,000, respectively, to reduce the carrying
value of inventory.



| | F. | Statement of Cash Flows  For purposes of the statement of cash flows, the Company considers all short-term instruments purchased with a maturity of three months or less to be
cash equivalents. There were no cash equivalents at December 31, 2004 or 2003.
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | G. | Property and Equipment - Property and equipment are recorded at cost. Depreciation and amortization are provided on the straight-line method for financial reporting purposes over
the estimated useful lives of the respective assets. Expenditures for maintenance and repairs are charged to operations as incurred, while expenditures for additions and improvements are capitalized. Furniture and fixtures, computer equipment and
related software, and shop equipment are depreciated over useful lives ranging from 3 to 7 years. Leasehold improvements are being amortized over the shorter of useful life or remaining lease term. Technology licenses are amortized over their terms
of three years. Depreciation and amortization expense amounted to $554,226 and $575,173 for the years ended December 31, 2004 and 2003, respectively.
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



Annually, or more frequently if events or circumstances change, a determination is made by management to ascertain whether
property and equipment have been impaired based on the sum of expected future undiscounted cash flows from operating activities. If the estimated net cash flows are less than the carrying amount of such assets, the Company will recognize an
impairment loss in an amount necessary to write down the assets to a fair value.



| | H. | Advertising - All of the Companys advertising costs are of the nondirect-response type. The Company expenses all advertising costs as incurred or at the time the advertising
takes place. The Company incurred approximately $83,000 and $14,000 in advertising costs in 2004 and 2003, respectively.
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | I. | Life Insurance - The Company has purchased, and is the beneficiary, of three term life insurance policies on key employees of the Company. The total amount of coverage at December
31, 2004 was $11,500,000.
| | -- | -------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | J. | Stock-Based Compensation - The Company has implemented Statement of Financial Accounting Standards (SFAS) No. 123, Accounting for Stock-Based
Compensation. This standard encourages
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



33



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##### Table of Contents

the adoption of the fair value-based method of accounting for employee stock options or similar equity instruments, but continues to allow the Company to
measure compensation cost for those equity instruments using the intrinsic value-based method of accounting prescribed by Accounting Principles Board Opinion No. 25, Accounting for Stock Issued to Employees. Under the fair value-based
method, compensation cost is measured at the grant date based on the estimated fair value of the award. Under the intrinsic value-based method, compensation cost is the excess, if any, of the quoted market price of the stock at the grant date or
other measurement date over the amount the employee must pay to acquire the stock. The Company intends to continue the use of the intrinsic value-based method until required to change to the fair value-based method as required by SFAS No 123(R)
issued in December 2004 (see Note 1.L.).



Pro forma
information regarding net income and earnings per share is required by SFAS No. 123, and has been determined as if the Company had accounted for its employee stock options under the fair value method of that Statement. The Company is continuing to
utilize the intrinsic value-based method for accounting for employee stock options or similar equity instruments; therefore, the Company has not recorded any compensation cost in the statements of income for stock-based employee compensation awards.



For purposes of pro forma disclosures, the estimated fair
value of the options is amortized to expense over the options vesting period. The Companys pro forma income and earnings per share are as follows for the year ended:



|                                                               |  |      |         |      |   |        
|-------------------------------------------------------------- |  | ---- | ------- | ---- | - | -------
|                                                               |  | 2004 |         | 2003
|Net income - as reported                                       |  | $    | 884,151 |      | $ | 472,538
|Stock-based employee compensation expense - pro forma          |  |      | 337,311 |      |   | 112,020
|                                                               |  |      |         |      |   |        
|Net income - pro forma                                         |  | $    | 546,840 |      | $ | 360,518
|Basic earnings per common share-as reported                    |  | $    | .16     |      | $ | .09    
|Diluted earnings per common share-as reported                  |  |      | .14     |      |   | .08    
|Basic earnings per common share-pro forma                      |  | $    | .10     |      | $ | .07    
|Diluted earnings per common share-pro forma                    |  |      | .09     |      |   | .06    
|Weighted-average fair value of options granted during the year |  | $    | 1.97    |      | $ | 1.85   



| | K. | Research and Development  Research and development costs are charged to operations when incurred. The amounts of research and development expense were $23,823 and $681,468.
| | -- | -----------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| | L. | Product Warranty Policy  The Company provides a limited warranty for defects in material or workmanship on its products and its repair services. The warranty periods currently
in effect range from one to two years. The warranty involves repairing or replacing any defective component returned within the warranty period. The warranty is limited to the original customer. The historical warranty cost of material has been
nominal, as most components used in the Companys products are warranted by the component supplier. In 2003, the Company experienced higher warranty costs than the historical levels, due to defects in components used in one customer product for
a limited period of time. Engineering changes eliminated the problem for units built and sold after the changes. A limited number of units with those known defects remained under warranty at December 31, 2004.
| | -- | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



34



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##### Table of Contents

The following summarizes the Companys warranty liability for 2004:



|                      |  |   |         |  
|--------------------- |  | - | ------- | -
|Beginning balance     |  | $ | 21,293  |  
|Additions to balance  |  |   | 10,000  |  
|Reductions to balance |  |   | (12,742 | )
|                      |  |   |         |  
|Ending balance        |  | $ | 18,551  |  
|                      |  |   |         |  



| | M. | RECENTLY ISSUED FINANCIAL ACCOUNTING STANDARDSSFAS No. 150, Accounting for Certain Financial Instruments with Characteristics of both Liabilities and Equity, requires that an
issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances), many of which were previously classified as equity. SFAS No. 150 is effective for interim periods beginning after June 15, 2003. In
its October 2003 meeting, the FASB decided to defer the effective date of certain provisions of SFAS No. 150. Management does not expect the adoption of this accounting pronouncement will have a material impact on the Companys consolidated
financial statements.
| | -- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



In November 2002, the
FASB issued FASB Interpretation (FIN) No. 45, Guarantors Accounting and Disclosure Requirements for Guarantees, Including Indirect Guarantees of Indebtedness of Others, an interpretation of FASB Statements No. 5, 57 and 107 and
Rescission of FASB Interpretation No. 34. FIN 45 clarifies the requirements of SFAS No. 5, Accounting for Contingencies, relating to the guarantors accounting for, and disclosure of, the issuance of certain types of guarantees. FIN 45 is
effective for guarantees issued or modified starting January 1, 2003 and requires the additional disclosures for the periods ended after December 15, 2002. The adoption of FIN 45 did not have a material impact on the Companys financial
condition or results of operations.



In December 2003, the
FASB issued FIN 46 (Revised), Consolidation of Variable Interest Entities. FIN 46 clarifies the application of Accounting Research Bulletin No. 51, Consolidated Financial Statements, to certain entities in which equity investors do not have the
characteristics of a controlling financial interest or do not have sufficient equity at risk for the entity to finance its activities without additional subordinated financial support from other parties. FIN 46 requires a variable interest entity to
be consolidated by a company, if that company is subject to a majority of the risk of loss from the variable interest entitys activities or entitled to receive a majority of the entitys residual returns or both. FIN 46 also requires
disclosures about variable interest entities that a company is not required to consolidate but in which it has a significant variable interest. The consolidation requirements of FIN 46 apply in the first fiscal year or interim period ending after
December 15, 2004. The adoption of FIN 46 is not expected to have a material impact on the Companys consolidated financial statements.



In December 2004, the FASB issued SFAS No. 123 (Revised), Shared Based Payment. SFAS No. 123(R) replaces SFAS No. 123, Accounting for Stock Based
Compensation, and supercedes APB Opinion No. 25, Accounting for Stock Issued to Employees. SFAS No. 123(R) requires compensation costs related to share-based payment transactions to be recognized in the financial statements. Compensation costs will
be recognized over the vesting period of the award. SFAS No. 123(R) is effective as of the beginning of the first interim or annual reporting period that begins after December 15, 2005. The impact of SFAS No. 123 is to record the additional
compensation expenses on the financial statements that is currently disclosed in Note 1.J.



| | N. | Reclassifications  Certain insignificant amounts for the year 2003 have been reclassified to conform with the 2004 presentation.
| | -- | ---------------------------------------------------------------------------------------------------------------------------------



35



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##### Table of Contents

Note 2. Line of Credit



At December 31, 2004, the Company had a bank line of credit with a limit of $6,000,000 and monthly interest payments at prime. The effective rate was
5.25%. The Company was obligated for funds drawn against this line of credit in the amount of $2,525,020 and $2,486,566 at December 31, 2004 and 2003, respectively.



The line is payable on demand and is collateralized by a Blanket Lien on all assets of the Company. The amount
available under the line of credit is subject to borrowing base restrictions as outlined in the agreement. On December 28, 2004, the terms of the bank line of credit with KeyBank were amended to reflect the Companys near term borrowing needs
and the Companys credit risk as rated by KeyBank. The amount available under the line was increased to $6,000,000 from $5,000,000 and is due and renewable by May 15, 2006. The unused capacity at December 31, 2004 was approximately $3,251,000.



Note 3. Stock Options and Warrants



The Company adopted the Pinnacle Data Systems, Inc., 1995 Stock Option Plan
(the Plan) on December 19, 1995. Any employee who is granted a discretionary option upon vesting, may purchase Company common stock over a ten-year period, at the fair market value at time of grant. (If the grantee owns more than 10% of the
Companys stock at the time of the grant, the purchase price shall be at least 110% of the fair market value and the options expire five years from the date of grant.) The aggregate number of common shares of the Company, which could have been
granted under the plan, was 1,200,000 shares. Incentive options available under the plan must be granted by December 19, 2005. On February 16, 2000, the Board of Directors amended the Pinnacle Data Systems, Inc., 1995 Stock Option Plan, which was
subsequently approved by the shareholders on June 24, 2000, to increase the number of shares reserved for issuance pursuant to options to 2,400,000 common shares. Under the 1995 Stock Option Plan, 388,250 shares were reserved for future grants at
December 31, 2004.



On March 22, 2000, the Company adopted the
Pinnacle Data Systems, Inc., 2000 Director Stock Option Plan (Director Plan), which was subsequently approved by the shareholders on June 24, 2000. Under the Director Plan, 500,000 shares are reserved for issuance to Directors who are not employees
of the Company (Outside Director). Any Outside Director who has been granted a discretionary option may upon vesting, purchase Company common stock over a ten-year period, at the fair market value at time of grant. Before the adoption of the
Director Plan, previous issuance of stock options to Outside Directors was made by entering into individual stock option agreements. Under the 2000 Director Stock Option Plan, 324,000 shares were reserved for future grants at December 31, 2004.



Although the Board of Directors has the authority to set
other terms, the options are generally exercisable one year from the date of grant.



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##### Table of Contents

The following table is a summary of option activity:



|                                            |                  |                |                              |                |                  |  |                              |  |   |     
|------------------------------------------- | ---------------- | -------------- | ---------------------------- | -------------- | ---------------- |  | ---------------------------- |  | - | ----
|Stock Option Plan                           |                  | 2004           |                              | 2003          
|                                            | Number ofOptions |                | WeightedAverageExercisePrice |                | Number ofOptions |  | WeightedAverageExercisePrice
|Employee Stock Option Agreements            |                  |                |                              |                |                  |  |                              |  |   |     
|Outstanding, beginning of year              |                  | 1,170,500      |                              | $              | 1.92             |  | 1,038,650                    |  | $ | 1.84
|Granted                                     |                  | 211,500        |                              |                | 2.28             |  | 178,000                      |  |   | 2.26
|Exercised                                   |                  | 73,000         |                              |                | 0.90             |  | 32,000                       |  |   | 0.85
|Forfeited                                   |                  | 52,050         |                              |                | 2.24             |  | 14,150                       |  |   | 2.83
|                                            |                  |                |                              |                |                  |  |                              |  |   |     
|Outstanding, end of year                    |                  | 1,256,950      |                              | $              | 2.02             |  | 1,170,500                    |  | $ | 1.92
|                                            |                  |                |                              |                |                  |  |                              |  |   |     
|Exercise price range of options outstanding |                  | $0.63 to $5.25 |                              | $0.63 to $5.25
|                                            |                  |                |                              |               
|Director Stock Option Agreements            |                  |                |                              |                |                  |  |                              |  |   |     
|Outstanding, beginning of year              |                  | 290,000        |                              | $              | 1.88             |  | 230,000                      |  | $ | 1.81
|Granted                                     |                  | 20,000         |                              |                | 2.63             |  | 60,000                       |  |   | 2.11
|Exercised                                   |                  | 20,000         |                              |                | 2.35             |  |                             |  |   |    
|Forfeited                                   |                  | 20,000         |                              |                | 1.82             |  |                             |  |   |    
|                                            |                  |                |                              |                |                  |  |                              |  |   |     
|Outstanding, end of year                    |                  | 270,000        |                              | $              | 1.90             |  | 290,000                      |  | $ | 1.88
|                                            |                  |                |                              |                |                  |  |                              |  |   |     
|Exercise price range of options outstanding |                  | $0.75 to $3.88 |                              | $0.75 to $3.88



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##### Table of Contents

The following table summarizes information concerning outstanding and exercisable options at December 31,
2004:



|                        |  |                     |  |                                                      |  |                                         |     
|----------------------- |  | ------------------- |  | ---------------------------------------------------- |  | --------------------------------------- | ----
|                        |  | Options Outstanding
|Range of Exercise Price |  | NumberOutstanding   |  | Weighted-averageRemaining ContractualLife (in years) |  | Weighted-averageExercise PricePer Share
|$0.63 - 0.83            |  | 386,200             |  | 2.85                                                 |  | $                                       | 0.75
|$0.97 - 1.38            |  | 159,550             |  | 4.49                                                 |  |                                         | 1.03
|$1.82 - 2.63            |  | 758,100             |  | 7.54                                                 |  |                                         | 2.28
|$3.07 - 4.26            |  | 220,100             |  | 5.24                                                 |  |                                         | 3.89
|$4.69 - 5.25            |  | 3,000               |  | 5.79                                                 |  |                                         | 4.88
|                        |  |                     |  |                                                      |  |                                         |     
|Total                   |  | 1,526,950           |  | 5.70                                                 |  | $                                       | 2.00
|                        |  |                     |  |                                                      |  |                                         |     



|                        |  |                     |  |                                         |     
|----------------------- |  | ------------------- |  | --------------------------------------- | ----
|                        |  | Options Exercisable
|Range of Exercise Price |  | NumberExercisable   |  | Weighted-averageExercise PricePer Share
|$0.63 - 0.83            |  | 386,200             |  | $                                       | 0.75
|$0.97 - 1.38            |  | 159,550             |  |                                         | 1.03
|$1.82 - 2.63            |  | 550,600             |  |                                         | 2.29
|$3.07 - 4.26            |  | 220,100             |  |                                         | 3.89
|$4.69 - 5.25            |  | 3,000               |  |                                         | 4.88
|                        |  |                     |  |                                         |     
|Total                   |  | 1,319,450           |  | $                                       | 1.96
|                        |  |                     |  |                                         |     



At December 31, 2003,
1,197,500 outstanding options were exercisable. The weighted-average exercise price for outstanding options was $1.85 at December 31, 2003.



The options outstanding at December 31, 2004 are exercisable through periods ranging from January 2005 through November 2014.



The fair value of each option grant disclosed in Note 1.J. is estimated on
the grant date using the Black-Scholes option pricing model with the following weighted average assumptions for the year ended:



|                                        |  |       |   |  |       |  
|--------------------------------------- |  | ----- | - |  | ----- | -
|                                        |  | 2004  |   |  | 2003  |  
|Risk-free interest rate                 |  | 4.3   | % |  | 4.5   | %
|Dividend yield                          |  | 0     | % |  | 0     | %
|Volatility factor                       |  | 88.61 | % |  | 84.29 | %
|Weighted average expected life in years |  | 9     |   |  | 9     |  



The Black-Scholes
option pricing model was developed for use in estimating the fair value of traded options that have no vesting restrictions and are fully transferable. In addition, option pricing models require input of highly subjective assumptions including the
expected stock price volatility. The Company uses projected volatility rates that are based upon historical volatility rates trended into the



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##### Table of Contents

future. Because the Companys stock options have characteristics significantly different from those traded options, and because changes in the
subjective input assumptions can materially affect the fair value estimate, in managements opinion, the existing models do not necessarily provide an accurate measure of the fair value of the Companys options.



Note 4. Operating Leases



The Company leases its operating facility under an operating lease that
expires in 2009. The Company has an option to extend the lease for an additional five years beyond the expiration date in 2009.



Minimum future lease payments under the operating lease as of December 31, 2004 are as follows:



|     |  |   |          
|---- |  | - | ---------
|2005 |  | $ | 589,216  
|2006 |  |   | 589,216  
|2007 |  |   | 589,216  
|2008 |  |   | 589,216  
|2009 |  |   | 196,406  
|     |  |   |          
|     |  | $ | 2,553,270
|     |  |   |          



Total rent charged to
operations for operating leases and other month-to-month rental obligations for the years ended December 31, 2004 and 2003 amounted to $689,576 and $616,230, respectively. The ten-year operating lease on the facilities at 6600 Port Road, Groveport,
Ohio, contains annual escalators intended to cover inflationary costs over the life of the lease.



Note 5. Profit Sharing and 401(k) Savings Plan



The Company maintains a qualified cash or deferred compensation plan under section 401(k) of the Internal Revenue Code. The plan covers all employees age 21 or over with three months of service. Under the plan,
employees may elect to defer a portion of their salary, subject to Internal Revenue Code limits.



The Company, at its discretion, may match up to 15% of employee contributions up to 6% of wages deferred with an annual maximum contribution of $1,950 per
employee. The Company made matching contributions of $32,045 in 2004. The Company elected not to make a matching contribution for 2003.



Note 6. Income Taxes



Deferred income taxes arise from temporary differences resulting from income and expense items reported for financial accounting and tax reporting
purposes in different periods. Deferred taxes are classified as current or long-term, depending on the classification of the assets and liabilities to which they relate. Deferred taxes arising from temporary differences that are not related to an
asset or liability are classified as current or long-term depending on the periods in which the temporary differences are expected to reverse.



39



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##### Table of Contents

Net deferred tax assets in the accompanying balance sheets include the following components:



|                                |  |      |         |      |   |        
|------------------------------- |  | ---- | ------- | ---- | - | -------
|                                |  | 2004 |         | 2003
|Assets                          |  |      |         |      |   |        
|Inventory reserves              |  | $    | 411,000 |      | $ | 316,000
|Allowance for doubtful accounts |  |      | 8,000   |      |   | 8,000  
|Uniform capitalization          |  |      | 51,000  |      |   | 32,000 
|Bonus accrual                   |  |      |        |      |   | 72,000 
|Warranty accrual                |  |      | 7,000   |      |   |       
|                                |  |      |         |      |   |        
|                                |  | $    | 477,000 |      | $ | 428,000
|                                |  |      |         |      |   |        
|Liabilities                     |  |      |         |      |   |        
|Depreciation                    |  | $    | 101,000 |      | $ | 55,000 
|                                |  |      |         |      |   |        
|                                |  | $    | 101,000 |      | $ | 55,000 
|                                |  |      |         |      |   |        



The components of the
tax expense for the year ended December 31, were as follows:



|                |  |      |         |   |      |   |        
|--------------- |  | ---- | ------- | - | ---- | - | -------
|                |  | 2004 |         |   | 2003
|Current:        |  |      |         |   |      |   |        
|Federal         |  | $    | 341,000 |   |      | $ | 254,000
|State and local |  |      | 64,000  |   |      |   | 31,000 
|                |  |      |         |   |      |   |        
|                |  |      | 405,000 |   |      |   | 285,000
|                |  |      |         |   |      |   |        
|Deferred:       |  |      |         |   |      |   |        
|Federal         |  |      |        |   |      |   | 30,000 
|State and local |  |      | (3,000  | ) |      |   | 18,000 
|                |  |      |         |   |      |   |        
|                |  |      | (3,000  | ) |      |   | 48,000 
|                |  |      |         |   |      |   |        
|Total           |  | $    | 402,000 |   |      | $ | 333,000
|                |  |      |         |   |      |   |        



The following sets
forth the differences between the provision for income taxes computed at the federal statutory rate of 34% and that reported for financial statement purposes:



|                                                        |  |      |         |   |      |   |        
|------------------------------------------------------- |  | ---- | ------- | - | ---- | - | -------
|                                                        |  | 2004 |         |   | 2003
|Income tax provision at statutory rate                  |  | $    | 437,000 |   |      | $ | 274,000
|Add:                                                    |  |      |         |   |      |   |        
|Tax effect of permanent differences                     |  |      | (49,000 | ) |      |   | 10,000 
|State income taxes, net of federal income tax provision |  |      | 40,000  |   |      |   | 49,000 
|Other                                                   |  |      | (26,000 | ) |      |   | 0      
|                                                        |  |      |         |   |      |   |        
|Total income tax provision                              |  | $    | 402,000 |   |      | $ | 333,000
|                                                        |  |      |         |   |      |   |        



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##### Table of Contents

Note 7. Earnings Per Common and Common Equivalent Share



Earnings per common and common equivalent share were computed by dividing
net earnings by the weighted average number of shares of common stock outstanding during the year.



|                                                                |  |                         |         |                     |           |                 |   |     
|--------------------------------------------------------------- |  | ----------------------- | ------- | ------------------- | --------- | --------------- | - | ----
|                                                                |  | For the Year Ended 2004
|                                                                |  | Income(Numerator)       |         | Shares(Denominator) |           | Per-ShareAmount
|Basic EPS                                                       |  |                         |         |                     |           |                 |   |     
|Income available to common stockholders                         |  | $                       | 884,151 |                     | 5,572,811 |                 | $ | 0.16
|Effect of Dilutive Securities                                   |  |                         |         |                     |           |                 |   |     
|Options                                                         |  |                         | 0       |                     | 548,864   |                 |   |     
|                                                                |  |                         |         |                     |           |                 |   |     
|Diluted EPS                                                     |  |                         |         |                     |           |                 |   |     
|Income available to common stockholders and assumed conversions |  | $                       | 884,151 |                     | 6,121,675 |                 | $ | 0.14
|                                                                |  |                         |         |                     |           |                 |   |     
|                                                                | 
|                                                                |  | For the Year Ended 2003
|                                                                |  | Income(Numerator)       |         | Shares(Denominator) |           | Per-ShareAmount
|Basic EPS                                                       |  |                         |         |                     |           |                 |   |     
|Income available to common stockholders                         |  | $                       | 472,538 |                     | 5,526,978 |                 | $ | 0.09
|Effect of Dilutive Securities                                   |  |                         |         |                     |           |                 |   |     
|Options                                                         |  |                         | 0       |                     | 307,573   |                 |   |     
|                                                                |  |                         |         |                     |           |                 |   |     
|Diluted EPS                                                     |  |                         |         |                     |           |                 |   |     
|Income available to common stockholders and assumed conversions |  | $                       | 472,538 |                     | 5,834,551 |                 | $ | 0.08
|                                                                |  |                         |         |                     |           |                 |   |     



The number of
anti-dilutive options for December 31, 2004 and 2003 were 223,100 and 823,750, respectively.



Note 8. Operating Segments



The Companys reportable segments are Product and Service and are described in Item 1 of the Companys form 10KSB, including a discussion of principle markets and distribution. The Other column listed below reflects
working groups of the Company that are not allocated to segments, such as engineering, finance, human resources, quality systems, and executive management. These items primarily represent assets and expenses for various administrative functions
within the Company. The Company evaluates performance based on operating earnings of the product and service segments and its coverage of the other administrative expenses of the Company.



41



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##### Table of Contents

Segment information for the years ended December 31, 2004 and 2003, was as follows:



|                              |  |         |            |         |   |           |  |   |            |   |  |   |           
|----------------------------- |  | ------- | ---------- | ------- | - | --------- |  | - | ---------- | - |  | - | ----------
|                              |  | 2004   
|                              |  | Product |            | Service |   | Other     |  |   | Total     
|Sales                         |  | $       | 28,351,007 |         | $ | 6,046,483 |  | $ |           |   |  | $ | 34,397,490
|Gross profit                  |  |         | 5,698,190  |         |   | 2,316,339 |  |   |           |   |  |   | 8,014,529 
|Operating earnings (loss)     |  |         | 2,759,841  |         |   | 1,336,882 |  |   | (2,697,935 | ) |  |   | 1,398,788 
|Depreciation and amortization |  |         | 261,570    |         |   | 126,722   |  |   | 165,934    |   |  |   | 554,226   
|Interest expense              |  |         |           |         |   |          |  |   | 112,637    |   |  |   | 112,637   
|Total assets                  |  |         | 6,311,306  |         |   | 1,928,303 |  |   | 2,135,240  |   |  |   | 10,374,849
|Capital expenditures          |  |         | 171,832    |         |   | 211,468   |  |   | 37,437     |   |  |   | 420,737   
|                              | 
|                              |  | 2003   
|                              |  | Product |            | Service |   | Other     |  |   | Total     
|Sales                         |  | $       | 15,595,152 |         | $ | 7,288,866 |  | $ |           |   |  | $ | 22,884,018
|Gross profit                  |  |         | 3,594,249  |         |   | 2,443,791 |  |   |           |   |  |   | 6,038,040 
|Operating earnings (loss)     |  |         | 1,653,883  |         |   | 1,274,128 |  |   | (2,037,296 | ) |  |   | 890,715   
|Depreciation and amortization |  |         | 260,479    |         |   | 121,813   |  |   | 192,881    |   |  |   | 575,173   
|Interest expense              |  |         |           |         |   |          |  |   | 85,177     |   |  |   | 85,177    
|Total assets                  |  |         | 5,723,996  |         |   | 1,123,461 |  |   | 2,055,748  |   |  |   | 8,903,205 
|Capital expenditures          |  |         | 255,840    |         |   | 66,588    |  |   | 19,361     |   |  |   | 341,789   



42



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##### Table of Contents

Item 8. Changes in and Disagreements with Accountants on Accounting and Financial Disclosure



None.



Item 8A. Controls and Procedures



The
Companys Chief Executive Officer and Chief Financial Officer have evaluated the effectiveness of the Companys disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) under the Exchange Act) as of the end of the
period covered by this annual report (the Evaluation Date). Based upon this evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of the Evaluation Date, the disclosure controls and procedures are
effective in ensuring that information required to be disclosed by the Company in the reports that it files or submits under the Securities and Exchange Act of 1934, as amended, is recorded, processed, summarized and reported within the time period
specified by the Securities and Exchange Commissions rules and forms.



In
2004, the Company added an internal audit function with a direct line of communication to the Companys Audit Committee. The internal audit function completed a six-month initial review and assessment of the Companys internal controls
based on the internal control framework of the Committee of Sponsoring Organizations (COSO) published in 1992 by the Treadway Commission. As of the Evaluation Date, there were no significant changes in the Companys internal controls that could
significantly affect the Companys disclosure controls and procedures subsequent to the date of their evaluation, nor were there any reportable significant deficiencies or material weaknesses in the Companys internal controls. As a
result, no corrective actions were required or undertaken.



Item 8B. Other Information



None.



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##### Table of Contents

PART III



Item 9. Directors, Executive Officers, Promoters and Control Persons; Compliance with Section 16(a) of the Exchange Act



Information about our directors, nominees for directors and our executive officers is incorporated by reference to our proxy statement for our year 2005 annual meeting of
shareholders to be filed with the Securities and Exchange Commission pursuant to Regulation 14A of the Exchange Act, under the caption: Proposal One: Election of Directors.



Item 10. Executive Compensation



Information
regarding executive compensation is incorporated by reference to our proxy statement for our year 2005 annual meeting of shareholders, to be filed with the Securities and Exchange Commission pursuant to Regulation 14A of the Exchange Act, under the
captions: Executive Compensation and Principal Holders of Voting Securities.



Item 11. Security Ownership of Certain Beneficial Owners and Management and Related Stockholder Matters



Information regarding security ownership of beneficial owners and management is incorporated by reference to our proxy statement for our year 2005 annual meeting of
shareholders, to be filed with the Securities and Exchange Commission pursuant to Regulation 14A of the Exchange Act, under the captions: Executive Compensation and Principal Holders of Voting Securities.



Item 12. Certain Relationships and Related Transactions



Information about certain relationships and related transactions is incorporated by reference to our proxy statement for our year 2005 annual meeting of shareholders, to be filed with the Securities and Exchange Commission pursuant to
Regulation 14A of the Exchange Act, under the caption: Proposal One: Election of Directors.



44



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##### Table of Contents

Item 13. Exhibits



The following
is a listing of Exhibits either filed with this report or incorporated by reference:



|           |  |                                                                                                                |  |                                                                                                             
|---------- |  | -------------------------------------------------------------------------------------------------------------- |  | ------------------------------------------------------------------------------------------------------------
|ExhibitNo. |  | Description of Exhibit                                                                                         |  | If Incorporated by Reference, Document with which Exhibit was Previously Filed with the SEC                 
|3(a)       |  | Amended and Restated Articles of Incorporation                                                                 |  | Registration Statement on Form 10-SB filed with the Securities and Exchange Commission on December 13, 1999.
|           |  |                                                                                                               
|3(b)       |  | Amendments to Amended and Restated Articles of Incorporation, adopted June 26, 2000                            |  | Form SB-2 filed with the Securities and Exchange Commission September 21, 2000.                             
|           |  |                                                                                                               
|3(c)       |  | Amendment to the Companys Amended and Restated Articles of Incorporation adopted May 23, 2001                 |  | Quarterly Report on Form 10-QSB filed with the Securities and Exchange Commission on August 13, 2001.       
|           |  |                                                                                                               
|3(d)       |  | Amended and Restated Code of Regulations                                                                       |  | Registration Statement on Form 10-SB filed with the Securities and Exchange Commission on December 13, 1999.
|           |  |                                                                                                               
|3(e)       |  | Amendment to Amended and Restated Code of Regulations                                                          |  | Annual Report on Form 10-KSB filed with the Securities and Exchange Commission on March 30, 2000.           
|           |  |                                                                                                               
|3(f)       |  | Amendments to Amended and Restated Code of Regulations, adopted June 26, 2000                                  |  | Form SB-2 filed with the Securities and Exchange Commission September 21, 2000.                             
|           |  |                                                                                                               
|4          |  | Instruments defining the rights of security holders, including indentures                                      |  | Form SB-2 filed with the Securities and Exchange Commission September 21, 2000.                             
|           |  |                                                                                                               
|10(a)      |  | Technology license agreement between Pinnacle Data Systems, Inc. and Sun Microsystems, Inc. dated May 12, 1994 |  | Registration Statement on Form 10-SB filed with the Securities and Exchange Commission on December 13, 1999.



45



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##### Table of Contents

|            |  |                                                                                                                                       |  |                                                                                                             
|----------- |  | ------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description of Exhibit                                                                                                                |  | If Incorporated by Reference, Document with which Exhibit was Previously Filed with the SEC                 
|10(b)       |  | Pinnacle Data Systems, Inc. 1995 Stock Option Plan dated December 19, 1995                                                            |  | Registration Statement on Form 10-SB filed with the Securities and Exchange Commission on December 13, 1999.
|            |  |                                                                                                                                      
|10(c)       |  | Development and manufacturing license agreement between Pinnacle Data Systems, Inc. and Sun Microsystems, Inc. dated October 27, 1997 |  | Registration Statement on Form 10-SB filed with the Securities and Exchange Commission on December 13, 1999.
|            |  |                                                                                                                                      
|10(d)       |  | Lease agreement between Pinnacle Data Systems, Inc. and Duke Realty Limited Partnership dated March 9, 1999                           |  | Registration Statement on Form 10-SB filed with the Securities and Exchange Commission on December 13, 1999.
|            |  |                                                                                                                                      
|10(e)       |  | Repair services agreement between Pinnacle Data Systems, Inc. and Sun Microsystems, Inc. dated March 29, 1999                         |  | Registration Statement on Form 10-SB filed with the Securities and Exchange Commission on December 13, 1999.
|            |  |                                                                                                                                      
|10(f)       |  | Reference Design License Agreement between Pinnacle Data Systems, Inc. and Sun Microsystems, Inc. dated May 11, 1999                  |  | Annual Report on Form 10-KSB filed with the Securities and Exchange Commission on March 20, 2002.           
|            |  |                                                                                                                                      
|10(g)       |  | First Lease Amendment between Pinnacle Data Systems, Inc. and Duke Realty Limited Partnership dated January 5, 2000                   |  | Annual Report on Form 10-KSB filed with the Securities and Exchange Commission on March 30, 2000.           
|            |  |                                                                                                                                      
|10(h)       |  | Amendment No. 1 to Pinnacle Data Systems, Inc. 1995 stock option plan dated February 16, 2000                                         |  | Annual Report on Form 10-KSB filed with the Securities and Exchange Commission on March 30, 2000.           



46



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##### Table of Contents

|            |  |                                                                                                                                       |  |                                                                                                  
|----------- |  | ------------------------------------------------------------------------------------------------------------------------------------- |  | -------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description of Exhibit                                                                                                                |  | If Incorporated by Reference, Document with which Exhibit was Previously Filed with the SEC      
|10(i)       |  | Pinnacle Data Systems, Inc. 2000 Directors Stock Option Plan dated March 22, 2000                                                     |  | Annual Report on Form 10-KSB filed with the Securities and Exchange Commission on March 30, 2000.
|            |  |                                                                                                                                      
|10(j)       |  | Business Loan Agreement between Pinnacle Data Systems, Inc. and key Bank National Association dated August 10, 2000                   |  | Annual Report on Form 10-KSB filed with the Securities and Exchange Commission on March 30, 2001.
|            |  |                                                                                                                                      
|10(k)       |  | Employment agreement between Pinnacle Data Systems, Inc. and John D. Bair dated January 1, 2001                                       |  | Annual Report on Form 10-KSB filed with the Securities and Exchange Commission on March 30, 2001.
|            |  |                                                                                                                                      
|10(l)       |  | O.E.M. Supply Agreement between Pinnacle Data Systems, Inc. and Alcatel USA Sourcing L.P. dated February 12, 2001                     |  | Annual Report on Form 10-KSB filed with the Securities and Exchange Commission on March 20, 2002.
|            |  |                                                                                                                                      
|10(m)       |  | Divisional Service Agreement between Pinnacle Data Systems, Inc. and Hewlett-Packard Company dated September 1, 2001                  |  | Annual Report on Form 10-KSB filed with the Securities and Exchange Commission on March 20, 2002.
|            |  |                                                                                                                                      
|10(n)       |  | Direct Connect VS Supplier Services Agreement between Pinnacle Data Systems, Inc. and Hewlett-Packard Company dated September 1, 2001 |  | Annual Report on Form 10-KSB filed with the Securities and Exchange Commission on March 20, 2002.
|            |  |                                                                                                                                      
|10(o)       |  | Employment agreement between Pinnacle Data Systems, Inc. and C. Robert Hahn dated September 1, 2001                                   |  | Annual Report on Form 10-KSB filed with the Securities and Exchange Commission on March 20, 2002.
|            |  |                                                                                                                                      
|10(p)       |  | Employment agreement between Pinnacle Data Systems, Inc. and Michael R. Sayre dated September 1, 2001                                 |  | Annual Report on Form 10-KSB filed with the Securities and Exchange Commission on March 20, 2002.



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|            |  |                                                                                                                                           |  |                                                                                                  
|----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------- |  | -------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description of Exhibit                                                                                                                    |  | If Incorporated by Reference, Document with which Exhibit was Previously Filed with the SEC      
|10(q)       |  | Employment agreement between Pinnacle Data Systems, Inc. and Christopher L. Winslow dated September 1, 2001                               |  | Annual Report on Form 10-KSB filed with the Securities and Exchange Commission on March 20, 2002.
|            |  |                                                                                                                                          
|10(r)       |  | Amendment to Promissory Note between Pinnacle Data Systems, Inc. and Key Bank National Association dated February 21, 2002                |  | Annual Report on Form 10-KSB filed with the Securities and Exchange Commission on March 20, 2002.
|            |  |                                                                                                                                          
|10(s)       |  | First Amendment Agreement to Loan Agreement between Pinnacle Data Systems, Inc. and Key Bank National Association dated February 21, 2002 |  | Annual Report on Form 10-KSB filed with the Securities and Exchange Commission on March 20, 2002.
|            |  |                                                                                                                                          
|10(t)       |  | Second Amendment Agreement to Loan Agreement between Pinnacle Data Systems, Inc. and Key Bank National Association dated March 7, 2002    |  | Annual Report on Form 10-KSB filed with the Securities and Exchange Commission on March 20, 2002.
|            |  |                                                                                                                                          
|10(u)       |  | Third Amendment Agreement to Loan Agreement between Pinnacle Data Systems, Inc. and Key Bank National Association dated April 23, 2002    |  | Annual Report on Form 10-KSB filed with the Securities and Exchange Commission on March 28, 2003.
|            |  |                                                                                                                                          
|10(v)       |  | Fourth Amendment Agreement to Loan Agreement between Pinnacle Data Systems, Inc. and Key Bank National Association dated July 31, 2002    |  | Annual Report on Form 10-KSB filed with the Securities and Exchange Commission on March 28, 2003.



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|            |  |                                                                                                                                      |  |                                                                                                   
|----------- |  | ------------------------------------------------------------------------------------------------------------------------------------ |  | --------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description of Exhibit                                                                                                               |  | If Incorporated by Reference, Document with which Exhibit was Previously Filed with the SEC       
|10(w)       |  | OEM Technology Partner agreement between Pinnacle Data Systems, Inc. and Sun Microsystems, Inc. dated August 1, 2002                 |  | Annual Report on Form 10-KSB filed with the Securities and Exchange Commission on March 28, 2003. 
|            |  |                                                                                                                                     
|10(x)       |  | Amendment to Supplier Services Agreement between Pinnacle Data Systems, Inc. and Hewlett-Packard Company dated November 5, 2002      |  | Annual Report on Form 10-KSB filed with the Securities and Exchange Commission on March 28, 2003. 
|            |  |                                                                                                                                     
|10(y)       |  | Renewal of Loan Agreement between Pinnacle Data Systems, Inc, and Key Bank National Association dated April 1, 2003                  |  | Quarterly Report on Form 10-QSB filed with the Securities and Exchange Commission on May 14, 2003.
|            |  |                                                                                                                                     
|10(z)       |  | Fifth Amendment Agreement to Loan Agreement between Pinnacle Data Systems, Inc. and Key Bank National Association dated May 12, 2003 |  | Quarterly Report on Form 10-QSB filed with the Securities and Exchange Commission on May 14, 2003.
|            |  |                                                                                                                                     
|10(aa)      |  | Business Loan Agreement between Pinnacle Data Systems, Inc. and KeyBank National Association dated November 26, 2003                 |  | Annual Report on Form 10-KSB filed with the Securities and Exchange Commission on March 24, 2004. 
|            |  |                                                                                                                                     
|10(ab)      |  | Promissory Note between Pinnacle Data Systems, Inc. and KeyBank National Association dated November 26, 2003                         |  | Annual Report on Form 10-KSB filed with the Securities and Exchange Commission on March 24, 2004. 
|            |  |                                                                                                                                     
|10(ac)      |  | Commercial Security Agreement between Pinnacle Data Systems, Inc. and KeyBank National Association dated November 26, 2003           |  | Annual Report on Form 10-KSB filed with the Securities and Exchange Commission on March 24, 2004. 



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|            |  |                                                                                                                                                                       |  |                                                                                                        
|----------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description of Exhibit                                                                                                                                                |  | If Incorporated by Reference, Document with which Exhibit was Previously Filed with the SEC            
|10(ad)      |  | Libor 1 Month Exhibit between Pinnacle Data Systems, Inc. and KeyBank National Association dated November 26, 2003                                                    |  | Annual Report on Form 10-KSB filed with the Securities and Exchange Commission on March 24, 2004.      
|            |  |                                                                                                                                                                      
|10(ae)      |  | Amendment to Loan Agreement and Allonge to Variable Rate Promissory Note between Pinnacle Data Systems, Inc. and KeyBank National Association dated November 26, 2003 |  | Annual Report on Form 10-KSB filed with the Securities and Exchange Commission on March 24, 2004.      
|            |  |                                                                                                                                                                      
|10(af)      |  | Promissory Note between Pinnacle Data Systems, Inc. and KeyBank National Association dated May 7, 2004                                                                |  | Quarterly Report on Form 10-QSB filed with the Securities and Exchange Commission on May 17, 2004.     
|            |  |                                                                                                                                                                      
|10(ag)      |  | Repair Service Agreement between Pinnacle Data Systems, Inc. and Silicon Graphics, Inc., dated August 4, 2004                                                         |  | Quarterly Report on Form 10-QSB filed with the Securities and Exchange Commission on November 12, 2004.
|            |  |                                                                                                                                                                      
|10(ah)      |  | Notice of Final Agreement between Pinnacle Data Systems, Inc. and KeyBank National Association dated December 28, 2004                                                |  | Contained herein.                                                                                      
|            |  |                                                                                                                                                                      
|10(ai)      |  | Promissory Note between Pinnacle Data Systems, Inc. and KeyBank National Association dated December 28, 2004                                                          |  | Contained herein.                                                                                      
|            |  |                                                                                                                                                                      
|10(aj)      |  | Commercial Security Agreement between Pinnacle Data Systems Inc. and Keybank National Association dated December 28, 2004                                             |  | Contained herein.                                                                                      



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|            |  |                                                                                                                                                                             |  |                                                                                            
|----------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------------------------------------------------------------------------------------
|Exhibit No. |  | Description of Exhibit                                                                                                                                                      |  | If Incorporated by Reference, Document with which Exhibit was Previously Filed with the SEC
|10(ak)      |  | Change in Terms Agreement between Pinnacle Data Systems, Inc. and Keybank National Association dated December 28, 2004                                                      |  | Contained herein.                                                                          
|            |  |                                                                                                                                                                            
|10(al)      |  | Libor 1 Month Exhibit between Pinnacle Data Systems, Inc. and Keybank National Association dated December 31, 2004                                                          |  | Contained herein.                                                                          
|            |  |                                                                                                                                                                            
|23          |  | Consent of Independent Registered Public Accounting Firm                                                                                                                    |  | Contained herein.                                                                          
|            |  |                                                                                                                                                                            
|24          |  | Powers of Attorney                                                                                                                                                          |  | Contained herein.                                                                          
|            |  |                                                                                                                                                                            
|31(a)       |  | Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Annual Report on Form 10-KSB of Pinnacle Data Systems, Inc. for the year ended December 31, 2004 |  | Contained herein.                                                                          
|            |  |                                                                                                                                                                            
|31(b)       |  | Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Annual Report on Form 10-KSB of Pinnacle Data Systems, Inc. for the year ended December 31, 2004 |  | Contained herein.                                                                          
|            |  |                                                                                                                                                                            
|32(a)       |  | Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 of Annual Report on Form 10-KSB of Pinnacle Data Systems, Inc. for the year ended December 31, 2004 |  | Contained herein.                                                                          



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|            |  |                                                                                                                                                                             |  |                                                                                            
|----------- |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------------------------------------------------------------------------------------
|Exhibit No. |  | Description of Exhibit                                                                                                                                                      |  | If Incorporated by Reference, Document with which Exhibit was Previously Filed with the SEC
|32(b)       |  | Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 of Annual Report on Form 10-KSB of Pinnacle Data Systems, Inc. for the year ended December 31, 2004 |  | Contained herein.                                                                          



The exhibits filed
with this report in response to Item 13 are submitted as a separate section of this report following the signatures.



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Item 14. Principal Accountant Fees and Services



Information regarding the Companys principal accountant fees and services is incorporated by reference to our proxy statement for our year 2005 annual meeting of shareholders, to be filed with the Securities and Exchange Commission
pursuant to Regulation 14A of the Exchange Act, under the caption: Independent Auditors.



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SIGNATURES



In accordance with Section 13 or
15(d) of the Securities Exchange Act of 1934, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.



|                         |  |                             |  |                                      
|------------------------ |  | --------------------------- |  | -------------------------------------
|                         |  | PINNACLE DATA SYSTEMS, INC.
|                         |  |                            
|Date : February 23, 2005 |  | By                          |  | /s/ John D. Bair                     
|                         |  |                             |  | John D. Bair, Chief Executive Officer



Pursuant to the requirements of the
Securities Exchange Act of 1934, this report has been signed below by the following persons on behalf of the Registrant and in the capacities and on the dates indicated.



|                                     |  |                                                                                                                                       |  |                  
|------------------------------------ |  | ------------------------------------------------------------------------------------------------------------------------------------- |  | -----------------
|Signature                            |  | Title                                                                                                                                 |  | Date             
|                                     |  |                                                                                                                                      
|/s/ John D. BairJohn D. Bair         |  | Chairman, Chief Executive Officer (principal executive officer) and Director                                                          |  | February 23, 2005
|                                     |  |                                                                                                                                      
|/s/ Michael R. SayreMichael R. Sayre |  | Executive Vice President, Chief Financial Officer and Treasurer, (principal financial and principal accounting officer), and Director |  | February 23, 2005
|                                     |  |                                                                                                                                      
|Christopher L. Winslow*              |  | President, Chief Operating Officer and Director                                                                                       |  | February 23, 2005
|Christopher L. Winslow               |  |                                                                                                                                      
|                                     |  |                                                                                                                                      
|Carl Aschinger*                      |  | Director                                                                                                                              |  | February 23, 2005
|Carl Aschinger                       |  |                                                                                                                                       |  |                  
|                                     |  |                                                                                                                                      
|Hugh C. Cathey*                      |  | Director                                                                                                                              |  | February 23, 2005
|Hugh C. Cathey                       |  |                                                                                                                                       |  |                  
|                                     |  |                                                                                                                                      
|Paul H. Lambert*                     |  | Director                                                                                                                              |  | February 23, 2005
|Paul H. Lambert                      |  |                                                                                                                                       |  |                  
|                                     |  |                                                                                                                                      
|Thomas M. OLeary*                   |  | Director                                                                                                                              |  | February 23, 2005
|Thomas M. OLeary                    |  |                                                                                                                                       |  |                  
|                                     |  |                                                                                                                                      
|Robert V.R. Ostrander*               |  | Director                                                                                                                              |  | February 23, 2005
|Robert V.R. Ostrander                |  |                                                                                                                                       |  |                  

---

|* | The undersigned, by signing his name hereto, does sign this document on behalf of the person indicated above pursuant to a Power of Attorney duly executed by such person.
|- | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------



|   |  |                  |  |                  
|-- |  | ---------------- |  | -----------------
|By |  | /s/ John D. Bair |  | February 23, 2005
|   |  | John D. Bair,    |  |                  
|   |  | Attorney-in-Fact |  |                  



54