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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549





FORM 10-Q







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

For the quarterly period ended September 30, 2010

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





LOGO

PINNACLE DATA SYSTEMS, INC.

(Exact name of registrant as specified in its charter)







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

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





No change

(Former name, former address, and former fiscal year, if changed since last reports)





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

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

Indicate by check mark whether the registrant is a large accelerated filer, an accelerated filer, a non-accelerated filer, or a smaller
reporting company. See the definitions of large accelerated filer, accelerated filer and smaller reporting company in Rule 12b-2 of the Exchange Act.

Large accelerated filer   ̈        Accelerated
filer   ̈        Non-accelerated
filer   ̈        Smaller reporting company  x

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

On October 27, 2010, the registrant had outstanding 7,845,349 common shares without par value, which is the registrants only class of common equity.









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PINNACLE DATA SYSTEMS, INC.

FORM 10-Q FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2010

TABLE OF
CONTENTS



|                                                                                                 |  |  |    | 
|------------------------------------------------------------------------------------------------ |  |  | -- | 
|PART I  FINANCIAL INFORMATION                                                                   |  |  | 1  | 
|                                                                                                 | 
|ITEM 1    
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS                                           |  |  | 1  | 
|                                                                                                 | 
|ITEM 2    
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |  |  | 11 | 
|                                                                                                 | 
|ITEM 4    CONTROLS AND
PROCEDURES                                                                |  |  | 18 | 
|                                                                                                 | 
|PART II  OTHER INFORMATION                                                                      |  |  | 18 | 
|                                                                                                 | 
|ITEM 6    EXHIBITS                                                                               |  |  | 18 | 
|                                                                                                 | 
|SIGNATURES                                                                                       |  |  | 19 | 
|                                                                                                 | 
|CERTIFICATIONS                                                                                   |  |  | 20 | 



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PART I
 FINANCIAL INFORMATION



|ITEM 1 | CONDENSED CONSOLIDATED FINANCIAL STATEMENTS
|------ | -------------------------------------------

PINNACLE DATA SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)



|                                                                                                                  |  |                   |        |   |                  |   |        |  
|----------------------------------------------------------------------------------------------------------------- |  | ----------------- | ------ | - | ---------------- | - | ------ | -
|                                                                                                                  |  | September 30,2010 |        |   | December 31,2009 |  
|ASSETS                                                                                                            |  | (Unaudited)       |        |   |                  |  
|                                                                                                                  |  |                  
|CURRENT ASSETS                                                                                                    |  |                   |        |   |                  |   |        |  
|Cash                                                                                                              |  | $                 | 124    |   |                  | $ | 323    |  
|Accounts receivable, net of allowance for doubtful accounts of $143 and $232, respectively                        |  |                   | 4,830  |   |                  |   | 5,932  |  
|Inventory, net                                                                                                    |  |                   | 3,385  |   |                  |   | 3,754  |  
|Deferred income taxes                                                                                             |  |                   | 809    |   |                  |   | 22     |  
|Prepaid expenses and other current assets                                                                         |  |                   | 473    |   |                  |   | 503    |  
|                                                                                                                  |  |                   |        |   |                  |   |        |  
|Total current assets                                                                                              |  |                   | 9,621  |   |                  |   | 10,534 |  
|                                                                                                                  |  |                   |        |   |                  |   |        |  
|                                                                                                                  |  |                  
|PROPERTY AND EQUIPMENT                                                                                            |  |                   |        |   |                  |   |        |  
|Property and equipment, cost                                                                                      |  |                   | 6,024  |   |                  |   | 5,899  |  
|Less accumulated depreciation and amortization                                                                    |  |                   | (5,297 | ) |                  |   | (5,038 | )
|                                                                                                                  |  |                   |        |   |                  |   |        |  
|Total property and equipment, net                                                                                 |  |                   | 727    |   |                  |   | 861    |  
|                                                                                                                  |  |                   |        |   |                  |   |        |  
|                                                                                                                  |  |                  
|OTHER ASSETS                                                                                                      |  |                   |        |   |                  |   |        |  
|Goodwill                                                                                                          |  |                   | 780    |   |                  |   | 821    |  
|Other assets                                                                                                      |  |                   | 541    |   |                  |   | 359    |  
|                                                                                                                  |  |                   |        |   |                  |   |        |  
|Total other assets                                                                                                |  |                   | 1,321  |   |                  |   | 1,180  |  
|                                                                                                                  |  |                   |        |   |                  |   |        |  
|TOTAL ASSETS                                                                                                      |  | $                 | 11,669 |   |                  | $ | 12,575 |  
|                                                                                                                  |  |                   |        |   |                  |   |        |  
|                                                                                                                  |  |                  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                              |  |                   |        |   |                  |   |        |  
|                                                                                                                  |  |                  
|CURRENT LIABILITIES                                                                                               |  |                   |        |   |                  |   |        |  
|Line of credit                                                                                                    |  | $                 | 337    |   |                  | $ | 2,413  |  
|Accounts payable                                                                                                  |  |                   | 1,857  |   |                  |   | 2,694  |  
|Accrued wages, payroll taxes and employee benefits                                                                |  |                   | 596    |   |                  |   | 1,014  |  
|Unearned revenue                                                                                                  |  |                   | 147    |   |                  |   | 85     |  
|Other current liabilities                                                                                         |  |                   | 669    |   |                  |   | 555    |  
|                                                                                                                  |  |                   |        |   |                  |   |        |  
|Total current liabilities                                                                                         |  |                   | 3,606  |   |                  |   | 6,761  |  
|                                                                                                                  |  |                  
|LONG-TERM LIABILITIES                                                                                             |  |                   |        |   |                  |   |        |  
|Accrued other                                                                                                     |  |                   | 190    |   |                  |   | 226    |  
|                                                                                                                  |  |                   |        |   |                  |   |        |  
|                                                                                                                  |  |                  
|TOTAL LIABILITIES                                                                                                 |  |                   | 3,796  |   |                  |   | 6,987  |  
|                                                                                                                  |  |                   |        |   |                  |   |        |  
|                                                                                                                  |  |                  
|STOCKHOLDERS EQUITY                                                                                              |  |                   |        |   |                  |   |        |  
|Preferred stock; no par value; 4,000 shares authorized; no shares issued or outstanding                           |  |                   |       |   |                  |   |       |  
|Common stock; no par value; 25,000 shares authorized; 7,844 and 7,825 shares issued and outstanding, respectively |  |                   | 5,779  |   |                  |   | 5,769  |  
|Additional paid-in capital                                                                                        |  |                   | 1,947  |   |                  |   | 1,912  |  
|Accumulated other comprehensive income (loss)                                                                     |  |                   | (71    | ) |                  |   | (29    | )
|Retained earnings (deficit)                                                                                       |  |                   | 218    |   |                  |   | (2,064 | )
|                                                                                                                  |  |                   |        |   |                  |   |        |  
|Total stockholders equity                                                                                        |  |                   | 7,873  |   |                  |   | 5,588  |  
|                                                                                                                  |  |                   |        |   |                  |   |        |  
|                                                                                                                  |  |                  
|TOTAL LIABILITIES AND STOCKHOLDERS EQUITY                                                                        |  | $                 | 11,669 |   |                  | $ | 12,575 |  
|                                                                                                                  |  |                   |        |   |                  |   |        |  

See accompanying notes to condensed consolidated financial statements.



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PINNACLE DATA
SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(in thousands, except per share)



|                                            |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|------------------------------------------- |  | --------------------------------------- | ------ | - | -------------------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                                            |  | For the Three Months EndedSeptember 30, |        |   | For the Nine Months EndedSeptember 30, |  
|                                            |  | 2010                                    |        |   | 2009                                   |   |        | 2010 |  |   | 2009   |  
|Sales                                       |  | $                                       | 6,314  |   |                                        | $ | 7,050  |      |  | $ | 23,094 |   |  | $ | 26,975 |  
|Cost of sales                               |  |                                         | 4,088  |   |                                        |   | 5,478  |      |  |   | 16,484 |   |  |   | 21,385 |  
|                                            |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Gross profit                                |  |                                         | 2,226  |   |                                        |   | 1,572  |      |  |   | 6,610  |   |  |   | 5,590  |  
|Operating expenses                          |  |                                         | 1,732  |   |                                        |   | 2,284  |      |  |   | 5,295  |   |  |   | 7,534  |  
|                                            |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Income (loss) from operations               |  |                                         | 494    |   |                                        |   | (712   | )    |  |   | 1,315  |   |  |   | (1,944 | )
|Other expense                               |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Interest expense                            |  |                                         | 4      |   |                                        |   | 40     |      |  |   | 45     |   |  |   | 142    |  
|                                            |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Income (loss) before income taxes           |  |                                         | 490    |   |                                        |   | (752   | )    |  |   | 1,270  |   |  |   | (2,086 | )
|Income tax expense (benefit)                |  |                                         | (1,183 | ) |                                        |   | 1,337  |      |  |   | (1,012 | ) |  |   | 974    |  
|                                            |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Net income (loss)                           |  | $                                       | 1,673  |   |                                        | $ | (2,089 | )    |  | $ | 2,282  |   |  | $ | (3,060 | )
|                                            |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|                                            |  |                                         |        |  
|Weighted average common shares outstanding: |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Basic                                       |  |                                         | 7,842  |   |                                        |   | 7,825  |      |  |   | 7,831  |   |  |   | 7,825  |  
|Diluted                                     |  |                                         | 8,011  |   |                                        |   | 7,825  |      |  |   | 7,960  |   |  |   | 7,825  |  
|                                            |  |                                         |        |  
|Earnings (loss) per common share:           |  |                                         |        |   |                                        |   |        |      |  |   |        |   |  |   |        |  
|Basic                                       |  | $                                       | 0.21   |   |                                        | $ | (0.27  | )    |  | $ | 0.29   |   |  | $ | (0.39  | )
|Diluted                                     |  |                                         | 0.21   |   |                                        |   | (0.27  | )    |  |   | 0.29   |   |  |   | (0.39  | )

See accompanying notes to
condensed consolidated financial statements.



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PINNACLE DATA
SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY

(Unaudited)

(in thousands)



|                                    |  |                   |       |  |                          |   |       |                                            |  |   |                           |  |  |                          |     |   |  |   |        |   |  |   |        |  
|----------------------------------- |  | ----------------- | ----- |  | ------------------------ | - | ----- | ------------------------------------------ |  | - | ------------------------- |  |  | ------------------------ | --- | - |  | - | ------ | - |  | - | ------ | -
|                                    |  | Common Stock      |       |  | AdditionalPaid-InCapital |   |       | AccumulatedOtherComprehensiveIncome (Loss) |  |   | RetainedEarnings(Deficit) |  |  | TotalStockholdersEquity |    
|                                    |  | OutstandingShares |       |  | Amount                   |   |       |                                            |  |  
|Balance  December 31, 2008         |  |                   | 7,825 |  |                          | $ | 5,769 |                                            |  | $ | 1,797                     |  |  | $                        | (57 | ) |  | $ | 1,386  |   |  | $ | 8,895  |  
|Share-based payment expense         |  |                   |      |  |                          |   |      |                                            |  |   | 137                       |  |  |                          |    |   |  |   |       |   |  |   | 137    |  
|Comprehensive loss, net of taxes:   |  |                   |       |  |                          |   |       |                                            |  |   |                           |  |  |                          |     |   |  |   |        |   |  |   |        |  
|Net loss                            |  |                   |      |  |                          |   |      |                                            |  |   |                          |  |  |                          |    |   |  |   | (3,060 | ) |  |   | (3,060 | )
|Foreign currency translation        |  |                   |      |  |                          |   |      |                                            |  |   |                          |  |  |                          | 48  |   |  |   |       |   |  |   | 48     |  
|                                    |  |                   |       |  |                          |   |       |                                            |  |   |                           |  |  |                          |     |   |  |   |        |   |  |   |        |  
|Total comprehensive loss            |  |                   |       |  |                          |   |       |                                            |  |   |                           |  |  |                          |     |   |  |   |        |   |  |   | (3,012 | )
|                                    |  |                   |       |  |                          |   |       |                                            |  |   |                           |  |  |                          |     |   |  |   |        |   |  |   |        |  
|Balance  September 30, 2009        |  |                   | 7,825 |  |                          | $ | 5,769 |                                            |  | $ | 1,934                     |  |  | $                        | (9  | ) |  | $ | (1,674 | ) |  | $ | 6,020  |  
|                                    |  |                   |       |  |                          |   |       |                                            |  |   |                           |  |  |                          |     |   |  |   |        |   |  |   |        |  
|Balance  December 31, 2009         |  |                   | 7,825 |  |                          | $ | 5,769 |                                            |  | $ | 1,912                     |  |  | $                        | (29 | ) |  | $ | (2,064 | ) |  | $ | 5,588  |  
|Stock issued                        |  |                   | 19    |  |                          |   | 10    |                                            |  |   |                          |  |  |                          |    |   |  |   |       |   |  |   | 10     |  
|Share-based payment expense         |  |                   |      |  |                          |   |      |                                            |  |   | 35                        |  |  |                          |    |   |  |   |       |   |  |   | 35     |  
|Comprehensive income, net of taxes: |  |                   |       |  |                          |   |       |                                            |  |   |                           |  |  |                          |     |   |  |   |        |   |  |   |        |  
|Net income                          |  |                   |      |  |                          |   |      |                                            |  |   |                          |  |  |                          |    |   |  |   | 2,282  |   |  |   | 2,282  |  
|Foreign currency translation        |  |                   |      |  |                          |   |      |                                            |  |   |                          |  |  |                          | (42 | ) |  |   |       |   |  |   | (42    | )
|                                    |  |                   |       |  |                          |   |       |                                            |  |   |                           |  |  |                          |     |   |  |   |        |   |  |   |        |  
|Total comprehensive income          |  |                   |       |  |                          |   |       |                                            |  |   |                           |  |  |                          |     |   |  |   |        |   |  |   | 2,240  |  
|                                    |  |                   |       |  |                          |   |       |                                            |  |   |                           |  |  |                          |     |   |  |   |        |   |  |   |        |  
|Balance  September 30, 2010        |  |                   | 7,844 |  |                          | $ | 5,779 |                                            |  | $ | 1,947                     |  |  | $                        | (71 | ) |  | $ | 218    |   |  | $ | 7,873  |  
|                                    |  |                   |       |  |                          |   |       |                                            |  |   |                           |  |  |                          |     |   |  |   |        |   |  |   |        |  

See accompanying notes to condensed consolidated financial statements.



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PINNACLE DATA
SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)



|                                                                                         |  |                                        |        |   |      |   |        |  
|---------------------------------------------------------------------------------------- |  | -------------------------------------- | ------ | - | ---- | - | ------ | -
|                                                                                         |  | For the Nine Months EndedSeptember 30, |       
|                                                                                         |  | 2010                                   |        |   | 2009 |  
|CASH FLOWS FROM OPERATING ACTIVITIES                                                     |  |                                        |        |   |      |   |        |  
|Net income (loss)                                                                        |  | $                                      | 2,282  |   |      | $ | (3,060 | )
|                                                                                         |  |                                        |        |   |      |   |        |  
|Adjustments to reconcile net income (loss) to net cash provided by operating activities: |  |                                        |        |   |      |   |        |  
|Bad debt expense                                                                         |  |                                        | (19    | ) |      |   | 140    |  
|Inventory reserves                                                                       |  |                                        | 246    |   |      |   | 572    |  
|Depreciation and amortization                                                            |  |                                        | 298    |   |      |   | 423    |  
|Provision for deferred income taxes                                                      |  |                                        | (1,037 | ) |      |   | 1,611  |  
|Share-based payment expense                                                              |  |                                        | 34     |   |      |   | 137    |  
|Decrease in assets:                                                                      |  |                                        |        |   |      |   |        |  
|Accounts receivable                                                                      |  |                                        | 1,111  |   |      |   | 5,977  |  
|Inventory                                                                                |  |                                        | 113    |   |      |   | 507    |  
|Prepaid expenses and other assets                                                        |  |                                        | 16     |   |      |   | 84     |  
|Increase (decrease) in liabilities:                                                      |  |                                        |        |   |      |   |        |  
|Accounts payable                                                                         |  |                                        | (956   | ) |      |   | (2,237 | )
|Unearned revenue                                                                         |  |                                        | 62     |   |      |   | 213    |  
|Other current liabilities                                                                |  |                                        | (317   | ) |      |   | (288   | )
|                                                                                         |  |                                        |        |   |      |   |        |  
|Total adjustments                                                                        |  |                                        | (449   | ) |      |   | 7,139  |  
|                                                                                         |  |                                        |        |   |      |   |        |  
|Net cash provided by operating activities                                                |  |                                        | 1,833  |   |      |   | 4,079  |  
|                                                                                         |  |                                        |        |   |      |   |        |  
|CASH FLOWS FROM INVESTING ACTIVITIES                                                     |  |                                        |        |   |      |   |        |  
|Purchases of property and equipment                                                      |  |                                        | (150   | ) |      |   | (237   | )
|                                                                                         |  |                                        |        |   |      |   |        |  
|Net cash provided by investing activities                                                |  |                                        | (150   | ) |      |   | (237   | )
|                                                                                         |  |                                        |        |   |      |   |        |  
|CASH FLOWS FROM FINANCING ACTIVITIES                                                     |  |                                        |        |   |      |   |        |  
|Net change in line of credit                                                             |  |                                        | (2,076 | ) |      |   | (3,679 | )
|Net change in outstanding checks                                                         |  |                                        | 136    |   |      |   | (73    | )
|Other                                                                                    |  |                                        | 59     |   |      |   | (155   | )
|                                                                                         |  |                                        |        |   |      |   |        |  
|Net cash used in financing activities                                                    |  |                                        | (1,881 | ) |      |   | (3,907 | )
|                                                                                         |  |                                        |        |   |      |   |        |  
|EFFECT OF EXCHANGE RATE ON CASH                                                          |  |                                        | (1     | ) |      |   | 8      |  
|                                                                                         |  |                                        |        |   |      |   |        |  
|DECREASE IN CASH                                                                         |  |                                        | (199   | ) |      |   | (57    | )
|Cash at beginning of period                                                              |  |                                        | 323    |   |      |   | 282    |  
|                                                                                         |  |                                        |        |   |      |   |        |  
|Cash at end of period                                                                    |  | $                                      | 124    |   |      | $ | 225    |  
|                                                                                         |  |                                        |        |   |      |   |        |  

See accompanying notes to condensed consolidated financial statements.



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PINNACLE DATA
SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2010 and 2009

1. Basis of Presentation

The accompanying condensed consolidated financial
statements of Pinnacle Data Systems, Inc. (PDSi or the Company) have been prepared in accordance with United States (U.S.) generally accepted accounting principles (GAAP) for interim financial
information and with the instructions to Form 10-Q and Article 8 of Regulation S-X. Accordingly, they do not include all information and footnotes required by GAAP for complete financial statements. The financial information included herein reflects
all adjustments (all of which are normal and recurring in nature) which are, in the opinion of management, necessary for a fair presentation of financial position and results of operations. Operating results for all periods presented are not
necessarily indicative of the results that may be expected for the full year.

The Companys condensed consolidated
financial statements include the accounts of PDSi and PDSi B.V., a private limited liability company located in Tiel, the Netherlands (PDSi Tiel). All significant intercompany balances and transactions were eliminated.

The preparation of financial statements and related disclosures in conformity with GAAP requires management to make judgments,
assumptions and estimates that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Actual results could differ significantly from those estimates. Certain prior year amounts have been reclassified
to conform to the current presentation. The accompanying condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and accompanying notes for the year ended December 31, 2009
included in the Companys 2009 Annual Report on Form 10-K.

2. Summary of Significant Accounting Policies

A complete summary of the Companys significant accounting policies is included in Note 2 to the audited consolidated financial
statements included in the Companys 2009 Annual Report on Form 10-K. There have been no material changes to these policies since December 31, 2009.

Inventory

The following table summarizes the Companys
inventory as of the dates indicated (net of reserves of $1,811,000 and $2,404,000, respectively, as of September 30, 2010 and December 31, 2009):



|                                |  |                   |       |  |                  |   |       | 
|------------------------------- |  | ----------------- | ----- |  | ---------------- | - | ----- | 
|(in thousands)                  |  | September 30,2010 |       |  | December 31,2009 |  
|Component parts (raw materials) |  | $                 | 3,116 |  |                  | $ | 3,289 | 
|Work-in-process                 |  |                   | 81    |  |                  |   | 19    | 
|Finished goods                  |  |                   | 188   |  |                  |   | 446   | 
|                                |  |                   |       |  |                  |   |       | 
|Total inventory                 |  | $                 | 3,385 |  |                  | $ | 3,754 | 
|                                |  |                   |       |  |                  |   |       | 

3. Recently Issued Accounting Standards

In June 2009, the Financial Accounting Standards Board (FASB) issued a new accounting standard that codified U.S. GAAP (the FASB Codification). Effective for financial statements
issued for interim and annual periods ending after September 15, 2009, the FASB Codification is the source of authoritative U.S. GAAP recognized by the FASB to be applied by nongovernmental entities. Rules and interpretive releases of the
United States Securities and Exchange Commission (SEC) under authority of federal securities laws are also sources of authoritative GAAP for SEC registrants. On the effective date, the FASB Codification superseded all then-existing
non-SEC accounting and reporting standards. All other nongrandfathered non-SEC accounting literature not included in the FASB Codification became nonauthoritative. The Companys adoption of the FASB Codification did not result in a change in
its accounting practices. In accordance with recent SEC guidance, the Company no longer makes specific references to accounting standards. Instead, the Company discloses the current or potential future material impact of recently issued accounting
standards, as applicable. The Company does not expect the adoption of any recently issued accounting standards to have a material impact on its financial position, results of operations or cash flows.



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PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2010 and 2009





4. Line of Credit

On April 3, 2009, the Company entered into a Credit and Security Agreement (the Credit Agreement) with
Wells Fargo Bank, National Association (Wells Fargo), providing for a revolving credit facility (the Line) with a maximum line of credit of $9.0 million, subject to borrowing base restrictions. The borrowing base is
determined as follows: (1) the sum of (a) 85% of the aggregate amount of eligible receivable accounts located within the United States, plus (b) 75% of the aggregate amount of eligible receivable accounts located outside of the United
States, plus (c) the lesser of 10% of the aggregate amount of eligible inventory or $500,000; less (2) the sum of a borrowing base reserve which may be established by Wells Fargo at its sole discretion, plus other indebtedness to Wells
Fargo which may occur outside of the Credit Agreement.

The Line is evidenced by a Revolving Note made by the Company in favor
of Wells Fargo and is secured by substantially all of the assets of the Company, as provided for in the Credit Agreement. The Line is subject to customary affirmative and negative covenants for credit facilities of this type, including limitations
on the Company with respect to liens, indebtedness, guaranties, investments, distributions, mergers and acquisitions, and dispositions of assets.

The Credit Agreement also contains certain financial covenants, including a minimum book net worth, minimum net income and maximum capital expenditures. The Company obtained a waiver from Wells Fargo for
violation of the minimum book net worth financial covenant as of June 30 and September 30, 2009, and for violation of the minimum net income financial covenant for the three months ended June 30 and September 30, 2009. During the
fourth quarter of 2009, the Credit Agreement was revised to adjust the financial covenants based on the Companys financial projections and to include a reduction and block of availability under the borrowing base of $250,000 until such time as
the Company complied with each of the financial covenants described above for both of the fiscal quarters ended December 31, 2009 and March 31, 2010. Based on the Companys results of operations for the quarters ended
December 31, 2009 and March 31, 2010, the $250,000 reduction and block of availability under the borrowing base was removed during the second quarter of 2010.

The outstanding balance on the Line bears interest at an annual rate elected by the Company at the time of each credit advancement, of either: (1) a floating rate equal to the greater of 4% or the
sum of (a) the Wells Fargo daily Base Rate, plus (b) 2.5%; or (2) a fixed rate of the London Interbank Offered Rate plus 5.0%. The maturity date of the Line is April 3, 2012.

The Credit Agreement may be terminated by the Company upon 90 days written notice, or by Wells Fargo immediately upon default. Upon any
such termination, the Company is required to pay Wells Fargo a termination fee.

The Company may use borrowings under the
Credit Agreement for working capital. Any unused portions of the maximum amount of the Line are subject to unused Line fees.

5. Income
Taxes

The Company files income tax returns in the U.S. federal jurisdiction, various states and foreign countries. There
are no federal or state income tax examinations currently underway for these jurisdictions. The Companys federal and state income tax returns for 2006 and beyond are open tax years.

The Company reviewed its net deferred tax assets as of September 30, 2009 to assess the need to establish a valuation allowance due
to the continuing uncertain economic environment and the Companys pre-tax loss for the nine months ended September 30, 2009. The Companys net deferred tax assets primarily consist of temporary differences related to inventory
reserves and federal net operating loss carryforwards. Based on the Companys analysis and application of the required GAAP framework, management established a valuation allowance of $1.6 million against its net deferred tax asset balance as of
September 30, 2009.

During the third quarter of 2010, the Company concluded that its operations had achieved sustainable
profitability, and that future taxable income would more likely than not allow for realization of benefits from existing deferred tax assets. Accordingly, the Company reversed the current valuation allowance against all of its deferred tax assets
excluding a portion related to certain state net operating loss carryforwards. As a result, the year-to-date U.S. effective tax rate for the third quarter of 2010 was approximately 34%, versus an effective rate of approximately 22% applied in the
first six months of 2010. The combined impact of the valuation allowance reversal and the adjustment of the year-to-date U.S. effective tax rate resulted in a $1.3 million net non-cash benefit.

The Company can provide no assurance that a deferred tax asset valuation allowance will not be required in the future. The Company will
continue to monitor events and circumstances to determine whether a valuation allowance is warranted in the future.



6



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##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2010 and 2009





The following
table summarizes the Companys income tax expense (benefit) for the periods indicated:



|                                   |  |                              |        |   |                             |   |       |      |  |   |        |   |  |   |      |  
|---------------------------------- |  | ---------------------------- | ------ | - | --------------------------- | - | ----- | ---- |  | - | ------ | - |  | - | ---- | -
|                                   |  | Three months ended Sept. 30, |        |   | Nine months ended Sept. 30, |  
|(in thousands)                     |  | 2010                         |        |   | 2009                        |   |       | 2010 |  |   | 2009   |  
|Current:                           |  |                              |        |   |                             |   |       |      |  |   |        |   |  |   |      |  
|Federal                            |  | $                            | (368   | ) |                             | $ | (252  | )    |  | $ | (1     | ) |  | $ | (564 | )
|Foreign                            |  |                              | 17     |   |                             |   | (4    | )    |  |   | 35     |   |  |   | (35  | )
|State and local                    |  |                              | (2     | ) |                             |   | (18   | )    |  |   | (9     | ) |  |   | (38  | )
|Valuation allowance                |  |                              |       |   |                             |   | 619   |      |  |   |       |   |  |   | 619  |  
|                                   |  |                              |        |   |                             |   |       |      |  |   |        |   |  |   |      |  
|Total current expense (benefit)    |  |                              | (353   | ) |                             |   | 345   |      |  |   | 25     |   |  |   | (18  | )
|                                   |  |                              |        |   |                             |   |       |      |  |   |        |   |  |   |      |  
|Deferred:                          |  |                              |        |   |                             |   |       |      |  |   |        |   |  |   |      |  
|Federal                            |  |                              | 468    |   |                             |   |      |      |  |   | 286    |   |  |   |     |  
|Foreign                            |  |                              |       |   |                             |   |      |      |  |   |       |   |  |   |     |  
|State and local                    |  |                              | 133    |   |                             |   |      |      |  |   | 133    |   |  |   |     |  
|Valuation allowance                |  |                              | (1,431 | ) |                             |   | 992   |      |  |   | (1,456 | ) |  |   | 992  |  
|                                   |  |                              |        |   |                             |   |       |      |  |   |        |   |  |   |      |  
|Total deferred expense (benefit)   |  |                              | (830   | ) |                             |   | 992   |      |  |   | (1,037 | ) |  |   | 992  |  
|                                   |  |                              |        |   |                             |   |       |      |  |   |        |   |  |   |      |  
|Total income tax expense (benefit) |  | $                            | (1,183 | ) |                             | $ | 1,337 |      |  | $ | (1,012 | ) |  | $ | 974  |  
|                                   |  |                              |        |   |                             |   |       |      |  |   |        |   |  |   |      |  

The following table reconciles tax expense (benefit) computed at the federal statutory rate to amounts
reported for financial statement purposes for the periods indicated:



|                                                 |  |                              |        |   |                             |  |      |        |  |   |       |   |  |        |       |   |   |   |        |        |  |  |      |   |  |   |       |   |  |  |      |  
|------------------------------------------------ |  | ---------------------------- | ------ | - | --------------------------- |  | ---- | ------ |  | - | ----- | - |  | ------ | ----- | - | - | - | ------ | ------ |  |  | ---- | - |  | - | ----- | - |  |  | ---- | -
|                                                 |  | Three months ended Sept. 30, |        |   | Nine months ended Sept. 30, | 
|                                                 |  | 2010                         |        |   | 2009                        |  |      | 2010   |  |   | 2009  |  
|(dollars in thousands)                           |  | Amount                       |        |   | %                           |  |      | Amount |  |   | %     |   |  | Amount |       |   | % |   |        | Amount |  |  | %    |  
|Income tax provision (benefit) at statutory rate |  | $                            | 167    |   |                             |  | 34.0 |        |  | $ | (256  | ) |  |        | (34.0 | ) |   | $ | 432    |        |  |  | 34.0 |   |  | $ | (709  | ) |  |  | 34.0 |  
|Valuation allowance                              |  |                              | (1,431 | ) |                             |  | NM   |        |  |   | 1,611 |   |  |        | NM    |   |   |   | (1,456 | )      |  |  | NM   |   |  |   | 1,611 |   |  |  | NM   |  
|Tax effect of permanent differences              |  |                              | 41     |   |                             |  | 8.4  |        |  |   | 8     |   |  |        | 1.1   |   |   |   | 18     |        |  |  | 1.4  |   |  |   | 74    |   |  |  | 3.5  |  
|State income taxes, net of federal               |  |                              | (6     | ) |                             |  | (1.2 | )      |  |   | (14   | ) |  |        | (1.9  | ) |   |   | 11     |        |  |  | 0.9  |   |  |   | (33   | ) |  |  | (1.6 | )
|Foreign rate differential                        |  |                              | (26    | ) |                             |  | (5.3 | )      |  |   | 18    |   |  |        | 2.4   |   |   |   | (43    | )      |  |  | (3.4 | ) |  |   | 20    |   |  |  | 1.0  |  
|Other, net                                       |  |                              | 72     |   |                             |  | 14.7 |        |  |   | (30   | ) |  |        | (4.0  | ) |   |   | 26     |        |  |  | 2.0  |   |  |   | 11    |   |  |  | 0.5  |  
|                                                 |  |                              |        |   |                             |  |      |        |  |   |       |   |  |        |       |   |   |   |        |        |  |  |      |   |  |   |       |   |  |  |      |  
|Total                                            |  | $                            | (1,183 | ) |                             |  | NM   |        |  | $ | 1,337 |   |  |        | NM    |   |   | $ | (1,012 | )      |  |  | NM   |   |  | $ | 974   |   |  |  | NM   |  
|                                                 |  |                              |        |   |                             |  |      |        |  |   |       |   |  |        |       |   |   |   |        |        |  |  |      |   |  |   |       |   |  |  |      |  

For the nine months ended September 30, 2010, the Company paid federal and state income taxes totaling
$230,000 and received refunds totaling $111,000 for federal and state income taxes primarily from the Companys use of a net operating loss carryback for federal purposes. During the year ended December 31, 2009, the Company received
refunds totaling $247,000 for federal and state income taxes primarily from the Companys use of a net operating loss carryback for federal purposes. As of September 30, 2010, the Company had net operating loss carryforwards expiring
through December 31, 2029 for federal and state purposes of approximately $0.5 million and $1.5 million, respectively.



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PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2010 and 2009





The following
table summarizes the tax effect of temporary differences that give rise to significant portions of the Companys deferred tax assets and deferred tax liabilities as of the dates indicated:



|                                |  |                   |       |   |                  |   |        |  
|------------------------------- |  | ----------------- | ----- | - | ---------------- | - | ------ | -
|(in thousands)                  |  | September 30,2010 |       |   | December 31,2009 |  
|Deferred tax assets             |  |                   |       |   |                  |   |        |  
|Inventory reserves              |  | $                 | 675   |   |                  | $ | 893    |  
|Net operating loss              |  |                   | 229   |   |                  |   | 480    |  
|Depreciation and amortization   |  |                   | 123   |   |                  |   | 102    |  
|Allowance for doubtful accounts |  |                   | 50    |   |                  |   | 85     |  
|Uniform capitalization          |  |                   | 40    |   |                  |   | 46     |  
|Other                           |  |                   | 127   |   |                  |   | 99     |  
|                                |  |                   |       |   |                  |   |        |  
|Gross deferred tax assets       |  |                   | 1,244 |   |                  |   | 1,705  |  
|Less valuation allowance        |  |                   | (79   | ) |                  |   | (1,571 | )
|                                |  |                   |       |   |                  |   |        |  
|Deferred tax asset              |  |                   | 1,165 |   |                  |   | 134    |  
|                                |  |                   |       |   |                  |   |        |  
|Deferred tax liabilities        |  |                   |       |   |                  |   |        |  
|Prepaids                        |  |                   | 28    |   |                  |   | 44     |  
|Other                           |  |                   | 13    |   |                  |   | 16     |  
|                                |  |                   |       |   |                  |   |        |  
|Gross deferred tax liability    |  |                   | 41    |   |                  |   | 60     |  
|                                |  |                   |       |   |                  |   |        |  
|Net deferred tax asset          |  | $                 | 1,124 |   |                  | $ | 74     |  
|                                |  |                   |       |   |                  |   |        |  

The following table summarizes the classification of the above amounts in the Companys consolidated
balance sheets as of the dates indicated:



|                       |  |                   |       |  |                  |   |    | 
|---------------------- |  | ----------------- | ----- |  | ---------------- | - | -- | 
|(in thousands)         |  | September 30,2010 |       |  | December 31,2009 |  
|Current assets         |  |                   |       |  |                  |   |    | 
|Deferred income taxes  |  | $                 | 809   |  |                  | $ | 22 | 
|Other assets           |  |                   |       |  |                  |   |    | 
|Deferred income taxes  |  |                   | 315   |  |                  |   | 52 | 
|                       |  |                   |       |  |                  |   |    | 
|Net deferred tax asset |  | $                 | 1,124 |  |                  | $ | 74 | 
|                       |  |                   |       |  |                  |   |    | 



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##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2010 and 2009





6. Earnings (Loss) Per Share

Basic earnings (loss) per share (EPS) represents the amount of earnings (loss) available to each share of common stock
outstanding during the reporting period. Diluted EPS represents the amount of earnings (loss) available to each share of common stock outstanding during the reporting period adjusted for the potential issuance of common shares for stock options, if
dilutive.

The following table presents the Companys calculation of basic and diluted weighted average common shares
outstanding for the periods indicated:



|                                                     |  |                             |       |  |                            |  |       |      |  |  |       |  |  |  |       | 
|---------------------------------------------------- |  | --------------------------- | ----- |  | -------------------------- |  | ----- | ---- |  |  | ----- |  |  |  | ----- | 
|                                                     |  | Three Months EndedSept. 30, |       |  | Nine Months EndedSept. 30, | 
|(in thousands)                                       |  | 2010                        |       |  | 2009                       |  |       | 2010 |  |  | 2009  | 
|Weighted average common shares outstanding  basic   |  |                             | 7,842 |  |                            |  | 7,825 |      |  |  | 7,831 |  |  |  | 7,825 | 
|Dilutive effect of stock options                     |  |                             | 169   |  |                            |  |      |      |  |  | 129   |  |  |  |      | 
|                                                     |  |                             |       |  |                            |  |       |      |  |  |       |  |  |  |       | 
|Weighted average common shares outstanding  diluted |  |                             | 8,011 |  |                            |  | 7,825 |      |  |  | 7,960 |  |  |  | 7,825 | 
|                                                     |  |                             |       |  |                            |  |       |      |  |  |       |  |  |  |       | 

For the three and nine months ended September 30, 2009, the effect of potential common shares arising
from stock options would have been anti-dilutive. As a result, the number of weighted average outstanding common shares outstanding was the same for the basic and diluted EPS calculations for those periods.

7. Segment Information

The Companys reportable segments are Product and Service. PDSi is a global provider of electronics repair and reverse logistics
services, original design manufacturer (ODM) and original equipment manufacturer (OEM) integrated computing services, and embedded computing products and design services for the diversified computing, telecommunications,
imaging, defense/aerospace, medical, semiconductor and industrial automation markets. PDSi provides a variety of engineering and manufacturing services for global OEMs requiring custom product design, system integration, repair programs, warranty
management, and/or specialized production capabilities. PDSis engineering, technical and operational capabilities span the entire product lifecycle allowing the Company to better understand and develop custom solutions for each of its
customers unique requirements.

PDSis product capabilities range from board-level designs to globally certified,
fully integrated systems, specializing in long-life computer products and unique, customer-centric solutions. PDSis capability to perform higher-level repair services in-region allows the Company to customize solutions for its customers so
that they can deliver world-class service levels to their customers with reduced logistics, component replacement and inventory costs.

The Other line item in the following tables reflects the costs and assets of the functional and administrative groups of the Company that are not allocated to the reportable segments,
including finance, information technology, human resources and executive management. The Company evaluates performance based on the operating results of the Product and Service segments and based on their effectiveness in covering the other
administrative expenses of the Company. The Company sells its products and services in the United States and internationally and attributes sales based on shipping point.



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PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2010 and 2009





The following
table summarizes the Companys segment operating results for the periods indicated:



|                              |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|----------------------------- |  | --------------------------- | ------ | - | -------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                              |  | Three Months EndedSept. 30, |        |   | Nine Months EndedSept. 30, |  
|(in thousands)                |  | 2010                        |        |   | 2009                       |   |        | 2010 |  |   | 2009   |  
|Sales                         |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Product                       |  | $                           | 2,343  |   |                            | $ | 4,126  |      |  | $ | 13,112 |   |  | $ | 19,211 |  
|Service                       |  |                             | 3,971  |   |                            |   | 2,924  |      |  |   | 9,982  |   |  |   | 7,764  |  
|                              |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Total                         |  | $                           | 6,314  |   |                            | $ | 7,050  |      |  | $ | 23,094 |   |  | $ | 26,975 |  
|                              |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Gross profit                  |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Product                       |  | $                           | 375    |   |                            | $ | 724    |      |  | $ | 2,430  |   |  | $ | 3,157  |  
|Service                       |  |                             | 1,851  |   |                            |   | 848    |      |  |   | 4,180  |   |  |   | 2,433  |  
|                              |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Total                         |  | $                           | 2,226  |   |                            | $ | 1,572  |      |  | $ | 6,610  |   |  | $ | 5,590  |  
|                              |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Income (loss) from operations |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Product                       |  | $                           | 137    |   |                            | $ | 63     |      |  | $ | 1,501  |   |  | $ | 1,013  |  
|Service                       |  |                             | 1,367  |   |                            |   | 225    |      |  |   | 2,881  |   |  |   | 735    |  
|Other                         |  |                             | (1,010 | ) |                            |   | (1,000 | )    |  |   | (3,067 | ) |  |   | (3,692 | )
|                              |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Total                         |  | $                           | 494    |   |                            | $ | (712   | )    |  | $ | 1,315  |   |  | $ | (1,944 | )
|                              |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  

The following table summarizes segment assets as of the dates indicated:



|               |  |                   |        |  |                  |   |        | 
|-------------- |  | ----------------- | ------ |  | ---------------- | - | ------ | 
|(in thousands) |  | September 30,2010 |        |  | December 31,2009 |  
|Product        |  | $                 | 3,385  |  |                  | $ | 4,305  | 
|Service        |  |                   | 5,696  |  |                  |   | 6,314  | 
|Other          |  |                   | 2,588  |  |                  |   | 1,956  | 
|               |  |                   |        |  |                  |   |        | 
|Total          |  | $                 | 11,669 |  |                  | $ | 12,575 | 
|               |  |                   |        |  |                  |   |        | 

The following table summarizes sales by geographic region for the periods indicated:



|               |  |                             |       |  |                            |   |       |      |  |   |        |  |  |   |        | 
|-------------- |  | --------------------------- | ----- |  | -------------------------- | - | ----- | ---- |  | - | ------ |  |  | - | ------ | 
|               |  | Three Months EndedSept. 30, |       |  | Nine Months EndedSept. 30, |  
|(in thousands) |  | 2010                        |       |  | 2009                       |   |       | 2010 |  |   | 2009   | 
|United States  |  | $                           | 5,537 |  |                            | $ | 6,018 |      |  | $ | 20,713 |  |  | $ | 24,306 | 
|International  |  |                             | 777   |  |                            |   | 1,032 |      |  |   | 2,381  |  |  |   | 2,669  | 
|               |  |                             |       |  |                            |   |       |      |  |   |        |  |  |   |        | 
|Total          |  | $                           | 6,314 |  |                            | $ | 7,050 |      |  | $ | 23,094 |  |  | $ | 26,975 | 
|               |  |                             |       |  |                            |   |       |      |  |   |        |  |  |   |        | 

The following table summarizes long-lived assets by geographic region as of the dates indicated:



|               |  |                   |       |  |                  |   |       | 
|-------------- |  | ----------------- | ----- |  | ---------------- | - | ----- | 
|(in thousands) |  | September 30,2010 |       |  | December 31,2009 |  
|United States  |  | $                 | 1,338 |  |                  | $ | 559   | 
|International  |  |                   | 710   |  |                  |   | 1,482 | 
|               |  |                   |       |  |                  |   |       | 
|Total          |  | $                 | 2,048 |  |                  | $ | 2,041 | 
|               |  |                   |       |  |                  |   |       | 

International long-lived assets include goodwill of $780,000 and $821,000 as of September 30, 2010 and
December 31, 2009, respectively.



10



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##### Table of Contents



|ITEM 2 | MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS
|------ | -------------------------------------------------------------------------------------

SAFE HARBOR STATEMENT

Portions of this Quarterly Report on Form 10-Q (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, including, but not limited to, statements regarding Pinnacle Data Systems, Inc. (PDSi, the Company or we) achieving its financial growth and profitability
goals, or its sales, earnings and profitability expectations for the fiscal year ending December 31, 2010. The words believe, expect, anticipate, estimate, intend, seek,
may and similar expressions identify forward-looking statements that speak only as of the date of this Quarterly Report on Form 10-Q. 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. These factors include, but are not limited to, the following:



| |  |  | changes in general economic conditions, including prolonged or substantial economic downturn, and any related financial difficulties experienced by
original equipment manufacturers, end users, customers, suppliers or others with whom the Company does business;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | changes in customer order patterns;
| | - |  | -----------------------------------



| |  |  | changes in our business or our relationship with major technology partners or significant customers;
| | - |  | ----------------------------------------------------------------------------------------------------



| |  |  | failure to maintain adequate levels of inventory;
| | - |  | -------------------------------------------------



| |  |  | production components and service parts cease to be readily available in the marketplace;
| | - |  | -----------------------------------------------------------------------------------------



| |  |  | lack of adequate financing to meet working capital needs or to take advantage of business and future growth opportunities that may arise;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------



| |  |  | inability of cost reduction initiatives to lead to a realization of savings in labor, facilities or other operational costs;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------



| |  |  | deviation of actual results from estimates and/or assumptions used by the Company in the application of its significant accounting policies;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | lack of success in technological advancements;
| | - |  | ----------------------------------------------



| |  |  | inability to retain certifications, authorizations or licenses to provide certain products and/or services;
| | - |  | -----------------------------------------------------------------------------------------------------------



| |  |  | risks associated with new business practices, processes and information systems;
| | - |  | --------------------------------------------------------------------------------



| |  |  | impact of judicial rulings or government regulations, including related compliance costs;
| | - |  | -----------------------------------------------------------------------------------------



| |  |  | disruption in the business of suppliers, customers or service providers due to adverse weather, casualty events, technological difficulty, acts of
war or terror, or other causes;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | risks associated with doing business internationally, including economic, political and social instability and foreign currency exposure; and
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | other factors from time to time described in the Companys filings with the United States Securities and Exchange Commission (SEC).
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------

The Company undertakes no obligation to publicly update or revise any such statements, except as required
by applicable law.



11



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##### Table of Contents



The following is
managements discussion and analysis of financial condition and results of operations of the Company for the three and nine months ended September 30, 2010 and 2009. This discussion should be read in conjunction with the Companys
audited consolidated financial statements and related notes contained in its 2009 Annual Report on Form 10-K.

Executive Overview

PDSi is a global provider of electronics repair and reverse logistics services, original design manufacturer
(ODM) and original equipment manufacturer (OEM) integrated computing services, and embedded computing products and design services for the diversified computing, telecommunications, imaging, defense/aerospace, medical,
semiconductor and industrial automation markets. PDSi provides a variety of engineering and manufacturing services for global OEMs requiring custom product design, system integration, repair programs, warranty management, and/or specialized
production capabilities. We have facilities in the United States (U.S.), Europe and Asia. More than just an ODM, integrator or reverse logistics provider, PDSis engineering, technical and operational capabilities span the entire
product lifecycle allowing us to better understand and develop custom solutions for each of our customers unique requirements. Our product capabilities range from board-level designs to globally certified, fully integrated systems,
specializing in long-life computer products and unique, customer-centric solutions. Our capability to perform higher-level repair services in-region allows us to customize solutions for our customers so that they can deliver world-class service
levels to their customers with reduced logistics, component replacement and inventory costs. The common shares of PDSi are traded on NYSE Amex under the stock symbol PNS.

During the fourth quarter of 2009, we announced the implementation of a plan to return to profitability in 2010 by focusing on our core
Service segment business and current Product segment offerings, and by focusing on customer-funded development of new embedded products. We continue to fully support our current products and customer programs while maintaining the ability to upgrade
these products. We have focused our sales and marketing efforts on our Service segment and on specialized product integration programs where our highly valued engineering and operational expertise give us distinct competitive advantages. We also
took actions to align our operations with this focused growth strategy, including reductions and changes in senior and mid-level management to flatten the organizational structure. These actions led to profitable results for each of the first three
quarters of 2010 despite difficult worldwide economic conditions that have persisted since mid-2008, and which have negatively affected our existing multi-national OEM customers and the industries in which they participate. Such economic conditions
could persist and potentially could materially adversely affect our future results of operations, financial condition and cash flows.

We reviewed our net deferred tax assets as of September 30, 2009 to assess the need to establish a valuation allowance due to the continuing uncertain economic environment and our pre-tax loss for
the nine months ended September 30, 2009. Our net deferred tax assets primarily consist of temporary differences related to inventory reserves and federal net operating loss carryforwards. Based on our analysis and application of the required
GAAP framework, we established a valuation allowance of $1.6 million against our net deferred tax asset balance, resulting in non-cash income tax expense of $1.3 million for the quarter ended September 30, 2009 despite recording a loss before
income taxes for the period.

During the third quarter of 2010, we concluded that our operations had achieved sustainable
profitability, and that future taxable income would more likely than not allow for realization of benefits from existing deferred tax assets. Accordingly, we reversed the current valuation allowance against all of our deferred tax assets excluding a
portion related to certain state net operating loss carryforwards. As a result, the year-to-date U.S. effective tax rate for the third quarter of 2010 was approximately 34%, versus an effective rate of approximately 22% applied in the first six
months of 2010. The combined impact of the valuation allowance reversal and the adjustment of the year-to-date U.S. effective tax rate resulted in a $1.3 million net non-cash benefit.

During the quarter ended September 30, 2010, we reported net income of $1,673,000, or $0.21 per diluted share, versus a net loss of
$2,089,000, or $0.27 per diluted share, for the prior year quarter. During the nine months ended September 30, 2010, we reported net income of $2,282,000, or $0.29 per diluted share, versus a net loss of $3,060,000, or $0.39 per diluted share,
for the prior year period. See below for further discussion of consolidated and reportable segment results of operations for the three and nine months ended September 30, 2010 and 2009.

We believe our operating results will continue to show improvement due to several factors. First, as mentioned above, we have reduced the
Companys overhead cost structure to focus resources and investment on developing our core services and current product businesses. In addition, we anticipate organic growth through our existing global service offerings and computer products,
and through specialized product integration programs sold to current and new customers in markets in which higher value is rewarded with higher margins. Gross margins will vary from program to program, and the mix of programs will vary each quarter,
resulting in quarterly gross margin percentage fluctuations. Consequently, it is difficult to predict quarterly gross margins on future sales.



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Results of Operations

Consolidated Operations

Third Quarter  2010 Compared to 2009

The following table summarizes the
Companys consolidated results of operations for the three months ended September 30:



|                                  |  |      |        |   |           |  |       |      |  |   |           |   |  |         |       |   |  |  |     |  
|--------------------------------- |  | ---- | ------ | - | --------- |  | ----- | ---- |  | - | --------- | - |  | ------- | ----- | - |  |  | --- | -
|(dollars in thousands)            |  | 2010 |        |   | % ofSales |  |       | 2009 |  |   | % ofSales |   |  | %Change |      
|Sales                             |  | $    | 6,314  |   |           |  | 100.0 | %    |  | $ | 7,050     |   |  |         | 100.0 | % |  |  | -10 | %
|Cost of sales                     |  |      | 4,088  |   |           |  | 64.7  | %    |  |   | 5,478     |   |  |         | 77.7  | % |  |  | -25 | %
|                                  |  |      |        |   |           |  |       |      |  |   |           |   |  |         |       |   |  |  |     |  
|Gross profit                      |  |      | 2,226  |   |           |  | 35.3  | %    |  |   | 1,572     |   |  |         | 22.3  | % |  |  | 42  | %
|Operating expenses                |  |      | 1,732  |   |           |  | 27.4  | %    |  |   | 2,284     |   |  |         | 32.4  | % |  |  | -24 | %
|                                  |  |      |        |   |           |  |       |      |  |   |           |   |  |         |       |   |  |  |     |  
|Income (loss) from operations     |  |      | 494    |   |           |  | 7.8   | %    |  |   | (712      | ) |  |         | -10.1 | % |  |  | NM  |  
|Other expense                     |  |      |        |   |           |  |       |      |  |   |           |   |  |         |       |   |  |  |     |  
|Interest expense                  |  |      | 4      |   |           |  | 0.1   | %    |  |   | 40        |   |  |         | 0.6   | % |  |  | -90 | %
|                                  |  |      |        |   |           |  |       |      |  |   |           |   |  |         |       |   |  |  |     |  
|Income (loss) before income taxes |  |      | 490    |   |           |  | 7.8   | %    |  |   | (752      | ) |  |         | -10.7 | % |  |  | NM  |  
|Income tax expense (benefit)      |  |      | (1,183 | ) |           |  | -18.7 | %    |  |   | 1,337     |   |  |         | 19.0  | % |  |  | NM  |  
|                                  |  |      |        |   |           |  |       |      |  |   |           |   |  |         |       |   |  |  |     |  
|Net income (loss)                 |  | $    | 1,673  |   |           |  | 26.5  | %    |  | $ | (2,089    | ) |  |         | -29.6 | % |  |  | NM  |  
|                                  |  |      |        |   |           |  |       |      |  |   |           |   |  |         |       |   |  |  |     |  

The turnaround in results for the three months ended September 30, 2010 compared to the prior
year period was driven by several factors. First, Service segment gross profit increased 118% primarily due to a 36% increase in Service sales driven by growth in new programs in both the United States and the Europe, Middle East and Africa
(EMEA) region. This growth in the Service segment was a direct result of actions taken over the past year to focus our sales and marketing efforts where our highly valued engineering and operational expertise give us distinct competitive
advantages in this segment. However, Service growth partially was mitigated by lower Product segment gross profit due to a 43% decline in Product sales. Our focus on specialized design services and product integration has not yet overcome downward
trends that are due to our past focus on standard embedded products. We are continuing to deploy resources to generate a pipeline of new product business to offset this trend. Next, the decline in operating expenses reflects the aforementioned
organizational alignment with our current business strategy. In addition, interest expense declined 88% due to significantly lower average debt balances. Finally, as described previously, during the current quarter we reversed most of the valuation
allowance against deferred tax assets that we established in the prior year quarter, resulting in a $1.3 million net tax benefit during the third quarter of 2010.

For the third quarter of 2010, we had two customers that generated $2.2 million and $1.1 million, or 35% and 18%, respectively, of total sales. Of the revenues from these customers, 27% and 73% were
included in Product and Service segment sales, respectively. For the third quarter of 2009, we had one customer that generated $2.6 million, or 37%, of total sales. Of the revenues from this customer, 78% and 22% were included in Product and Service
segment sales, respectively. We continue to work toward developing a more diversified customer revenue base.



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Year-to-Date  2010
Compared to 2009

The following table summarizes the Companys consolidated results of operations for the nine months ended
September 30:



|                                  |  |      |        |   |           |  |       |      |  |   |           |   |  |         |       |   |  |  |     |  
|--------------------------------- |  | ---- | ------ | - | --------- |  | ----- | ---- |  | - | --------- | - |  | ------- | ----- | - |  |  | --- | -
|(dollars in thousands)            |  | 2010 |        |   | % ofSales |  |       | 2009 |  |   | % ofSales |   |  | %Change |      
|Sales                             |  | $    | 23,094 |   |           |  | 100.0 | %    |  | $ | 26,975    |   |  |         | 100.0 | % |  |  | -14 | %
|Cost of sales                     |  |      | 16,484 |   |           |  | 71.4  | %    |  |   | 21,385    |   |  |         | 79.3  | % |  |  | -23 | %
|                                  |  |      |        |   |           |  |       |      |  |   |           |   |  |         |       |   |  |  |     |  
|Gross profit                      |  |      | 6,610  |   |           |  | 28.6  | %    |  |   | 5,590     |   |  |         | 20.7  | % |  |  | 18  | %
|Operating expenses                |  |      | 5,295  |   |           |  | 22.9  | %    |  |   | 7,534     |   |  |         | 27.9  | % |  |  | -30 | %
|                                  |  |      |        |   |           |  |       |      |  |   |           |   |  |         |       |   |  |  |     |  
|Income (loss) from operations     |  |      | 1,315  |   |           |  | 5.7   | %    |  |   | (1,944    | ) |  |         | -7.2  | % |  |  | NM  |  
|Other expense                     |  |      |        |   |           |  |       |      |  |   |           |   |  |         |       |   |  |  |     |  
|Interest expense                  |  |      | 45     |   |           |  | 0.2   | %    |  |   | 142       |   |  |         | 0.5   | % |  |  | -68 | %
|                                  |  |      |        |   |           |  |       |      |  |   |           |   |  |         |       |   |  |  |     |  
|Income (loss) before income taxes |  |      | 1,270  |   |           |  | 5.5   | %    |  |   | (2,086    | ) |  |         | -7.7  | % |  |  | NM  |  
|Income tax expense                |  |      | (1,012 | ) |           |  | -4.4  | %    |  |   | 974       |   |  |         | 3.6   | % |  |  | NM  |  
|                                  |  |      |        |   |           |  |       |      |  |   |           |   |  |         |       |   |  |  |     |  
|Net income (loss)                 |  | $    | 2,282  |   |           |  | 9.9   | %    |  | $ | (3,060    | ) |  |         | -11.3 | % |  |  | NM  |  
|                                  |  |      |        |   |           |  |       |      |  |   |           |   |  |         |       |   |  |  |     |  

Profitable growth of our Service segment, combined with our reduction in operating expenses and
manufacturing overhead costs as described above, resulted in net income for the nine months ended September 30, 2010 compared to a net loss in the prior year period. Service segment gross profit increased 72% due to a 29% increase in Service
sales attributable to new program growth in both the U.S. and EMEA. However, lower Product segment gross profit, driven by a 32% decline in Product sales, partially offset the Service segment growth. Furthermore, interest expense declined 68% due to
significantly lower average debt balances. Lastly, the aforementioned deferred tax asset valuation allowance reversal in the third quarter of 2010, which was established in the prior year third quarter, resulted in a $1.3 million net tax benefit for
the nine months ended September 30, 2010.

For the first nine months of 2010, we had three customers that generated $7.6
million, $2.8 million and $2.4 million, or 33%, 12% and 10%, respectively, of total sales. Of the revenues from these customers, 47% and 53% were included in Product and Service segment sales, respectively. For the first nine months of 2009, we had
two customers that generated $9.1 million and $4.3 million, or 34% and 16%, respectively, of total sales. Of the revenues from these customers, 86% and 14% were included in Product and Service segment sales, respectively. As mentioned above, we
continue to work toward better customer diversification.

Segment Operations

Product

Third Quarter
 2010 Compared to 2009

The following table summarizes the Companys gross profit for the Product segment
for the three months ended September 30:



|                       |  |      |       |  |           |  |       |      |  |   |           |  |  |         |       |   |  |  |     |  
|---------------------- |  | ---- | ----- |  | --------- |  | ----- | ---- |  | - | --------- |  |  | ------- | ----- | - |  |  | --- | -
|(dollars in thousands) |  | 2010 |       |  | % ofSales |  |       | 2009 |  |   | % ofSales |  |  | %Change |      
|Sales                  |  | $    | 2,343 |  |           |  | 100.0 | %    |  | $ | 4,126     |  |  |         | 100.0 | % |  |  | -43 | %
|Cost of sales          |  |      | 1,968 |  |           |  | 84.0  | %    |  |   | 3,402     |  |  |         | 82.5  | % |  |  | -42 | %
|                       |  |      |       |  |           |  |       |      |  |   |           |  |  |         |       |   |  |  |     |  
|Gross profit           |  | $    | 375   |  |           |  | 16.0  | %    |  | $ | 724       |  |  |         | 17.5  | % |  |  | -48 | %
|                       |  |      |       |  |           |  |       |      |  |   |           |  |  |         |       |   |  |  |     |  

Lower Product segment gross profit primarily was due to a 43% decrease in Product sales. Most of
the revenue shortfall was attributable to a $1.6 million decline in sales to large OEMs in the diversified computing, imaging and telecommunications sectors, partially offset by growth in smaller accounts in various industries. The deterioration in
gross profit as a percentage of sales to 16% in 2010 from 18% in 2009 reflects reduced fixed cost operating leverage associated with the decrease in revenue levels.



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Year-to-Date  2010
Compared to 2009

The following table summarizes the Companys gross profit for the Product segment for the nine
months ended September 30:



|                       |  |      |        |  |           |  |       |      |  |   |           |  |  |         |       |   |  |  |     |  
|---------------------- |  | ---- | ------ |  | --------- |  | ----- | ---- |  | - | --------- |  |  | ------- | ----- | - |  |  | --- | -
|(dollars in thousands) |  | 2010 |        |  | % ofSales |  |       | 2009 |  |   | % ofSales |  |  | %Change |      
|Sales                  |  | $    | 13,112 |  |           |  | 100.0 | %    |  | $ | 19,211    |  |  |         | 100.0 | % |  |  | -32 | %
|Cost of sales          |  |      | 10,682 |  |           |  | 81.5  | %    |  |   | 16,054    |  |  |         | 83.6  | % |  |  | -33 | %
|                       |  |      |        |  |           |  |       |      |  |   |           |  |  |         |       |   |  |  |     |  
|Gross profit           |  | $    | 2,430  |  |           |  | 18.5  | %    |  | $ | 3,157     |  |  |         | 16.4  | % |  |  | -23 | %
|                       |  |      |        |  |           |  |       |      |  |   |           |  |  |         |       |   |  |  |     |  

The decline in Product segment gross profit primarily was due to a 32% decrease in Product
revenue, including a $6.3 million decline in sales to large OEMs in the diversified computing, imaging and medical industries. Strong growth in the telecommunications sector, which increased $0.6 million, partially offset the overall decline in
Product sales. A continued shift in sales mix to higher margin business, as well as actions taken over the past year to reduce overhead costs consistent with lower Product revenue levels, resulted in an 19% gross margin in 2010 compared to 16% in
2009.

Service

Third Quarter  2010 Compared to 2009

The following table summarizes the Companys gross profit for the Service segment for the three months ended September 30:



|                       |  |      |       |  |           |  |       |      |  |   |           |  |  |         |       |   |  |  |     |  
|---------------------- |  | ---- | ----- |  | --------- |  | ----- | ---- |  | - | --------- |  |  | ------- | ----- | - |  |  | --- | -
|(dollars in thousands) |  | 2010 |       |  | % ofSales |  |       | 2009 |  |   | % ofSales |  |  | %Change |      
|Sales                  |  | $    | 3,971 |  |           |  | 100.0 | %    |  | $ | 2,924     |  |  |         | 100.0 | % |  |  | 36  | %
|Cost of sales          |  |      | 2,120 |  |           |  | 53.4  | %    |  |   | 2,076     |  |  |         | 71.0  | % |  |  | 2   | %
|                       |  |      |       |  |           |  |       |      |  |   |           |  |  |         |       |   |  |  |     |  
|Gross profit           |  | $    | 1,851 |  |           |  | 46.6  | %    |  | $ | 848       |  |  |         | 29.0  | % |  |  | 118 | %
|                       |  |      |       |  |           |  |       |      |  |   |           |  |  |         |       |   |  |  |     |  

Higher Service segment gross profit primarily was due to a 36% increase in Service sales driven by
growth in programs ramped recently in both the U.S. and EMEA. The increase in gross profit as a percentage of sales to 47% in 2010 from 29% in 2009 was driven by operating leverage on increased revenues and ongoing improvements in the operational
efficiency of the Service segment. This improvement reflects our strategic focus on this business and our efforts to further reduce the cost of our supply chain through our commitment to lean manufacturing principles.

Year-to-Date  2010 Compared to 2009

The following table summarizes the Companys gross profit for the Service segment for the nine months ended September 30:



|                       |  |      |       |  |           |  |       |      |  |   |           |  |  |         |       |   |  |  |    |  
|---------------------- |  | ---- | ----- |  | --------- |  | ----- | ---- |  | - | --------- |  |  | ------- | ----- | - |  |  | -- | -
|(dollars in thousands) |  | 2010 |       |  | % ofSales |  |       | 2009 |  |   | % ofSales |  |  | %Change |      
|Sales                  |  | $    | 9,982 |  |           |  | 100.0 | %    |  | $ | 7,764     |  |  |         | 100.0 | % |  |  | 29 | %
|Cost of sales          |  |      | 5,802 |  |           |  | 58.1  | %    |  |   | 5,331     |  |  |         | 68.7  | % |  |  | 9  | %
|                       |  |      |       |  |           |  |       |      |  |   |           |  |  |         |       |   |  |  |    |  
|Gross profit           |  | $    | 4,180 |  |           |  | 41.9  | %    |  | $ | 2,433     |  |  |         | 31.3  | % |  |  | 72 | %
|                       |  |      |       |  |           |  |       |      |  |   |           |  |  |         |       |   |  |  |    |  

The improvement in Service segment gross profit was driven by new program growth in both the U.S.
and EMEA, which led to a 29% increase in Service sales. Continuing gains in operating leverage on increased sales and improved efficiency drove the increase in gross profit as a percentage of sales to 42% in 2010 from 31% in 2009.



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Liquidity and Capital Resources

Liquidity and capital resources demonstrate the overall financial strength of the Company and its ability to generate cash
flows from operations and borrow funds at competitive rates to meet operating and growth needs.

Our current capital structure
consists of a line of credit and stockholders equity. The following table summarizes the Companys capital structure as of the dates indicated:



|                                                                              |  |                   |       |   |                  |   |       |  
|----------------------------------------------------------------------------- |  | ----------------- | ----- | - | ---------------- | - | ----- | -
|(in thousands)                                                                |  | September 30,2010 |       |   | December 31,2009 |  
|Line of credit                                                                |  | $                 | 337   |   |                  | $ | 2,413 |  
|                                                                              |  |                   |       |   |                  |   |       |  
|Stockholders equity, excluding accumulated other comprehensive income (loss) |  |                   | 7,944 |   |                  |   | 5,617 |  
|Accumulated other comprehensive income (loss)                                 |  |                   | (71   | ) |                  |   | (29   | )
|                                                                              |  |                   |       |   |                  |   |       |  
|Total stockholders equity                                                    |  |                   | 7,873 |   |                  |   | 5,588 |  
|                                                                              |  |                   |       |   |                  |   |       |  
|Total capital                                                                 |  | $                 | 8,210 |   |                  | $ | 8,001 |  
|                                                                              |  |                   |       |   |                  |   |       |  

Based on the Companys historical cash flow, current financial results and unused available capacity on
the line of credit, we believe we have access to adequate resources to provide sufficient liquidity for the operations of the Company over the next year. See further discussion in Financing Activities below.

The following table summarizes the Companys condensed consolidated cash flows for the nine months ended September 30:



|                                          |  |      |        |   |      |   |        |  
|----------------------------------------- |  | ---- | ------ | - | ---- | - | ------ | -
|(in thousands)                            |  | 2010 |        |   | 2009 |  
|Net cash provided by operating activities |  | $    | 1,833  |   |      | $ | 4,079  |  
|Net cash used in investing activities     |  |      | (150   | ) |      |   | (237   | )
|Net cash used in financing activities     |  |      | (1,881 | ) |      |   | (3,907 | )
|Effect of exchange rate on cash           |  |      | (1     | ) |      |   | 8      |  
|                                          |  |      |        |   |      |   |        |  
|Decrease in cash                          |  |      | (199   | ) |      |   | (57    | )
|Cash at beginning of period               |  |      | 323    |   |      |   | 282    |  
|                                          |  |      |        |   |      |   |        |  
|Cash at end of period                     |  | $    | 124    |   |      | $ | 225    |  
|                                          |  |      |        |   |      |   |        |  

Operating Activities

Net cash provided by operating activities was $1.8 million and $4.1 million for the nine months ended September 30, 2010 and 2009, respectively. Net income (loss) adjusted for the effects of non-cash
items, which primarily include inventory reserves, depreciation expense and deferred income taxes, resulted in cash inflows of $1.8 million and cash outflows of $0.2 million in the first nine months of 2010 and 2009, respectively. Changes in working
capital resulted in no cash provided for the first nine months of 2010 compared to $4.3 million for the comparable period of 2009. Higher cash provided by operating activities in the prior year period primarily was driven by a reduction in net
working capital in 2009 in response to declining sales volumes.

Investing Activities

Net cash used in investing activities represents purchases of property and equipment and was not significant for the nine months ended
September 30, 2010 and 2009.

Financing Activities

Net cash used in financing activities was $1.9 million and $3.9 million for the first nine months of 2010 and 2009, respectively. Financing activity in both periods primarily reflects net repayments on
the Companys line of credit. All cash generated by U.S. operations after funding investing activities is applied to the line of credit.



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On April 3, 2009,
we entered into a Credit and Security Agreement (the Credit Agreement) with Wells Fargo Bank, National Association (Wells Fargo), providing for a revolving credit facility (the Line) with a maximum line of credit
of $9.0 million, subject to borrowing base restrictions. The borrowing base is determined as follows: (1) the sum of (a) 85% of the aggregate amount of eligible receivable accounts located within the United States, plus (b) 75% of the
aggregate amount of eligible receivable accounts located outside of the United States, plus (c) the lesser of 10% of the aggregate amount of eligible inventory or $500,000; less (2) the sum of a borrowing base reserve which may be
established by Wells Fargo at its sole discretion, plus other indebtedness to Wells Fargo which may occur outside of the Credit Agreement.

The Line is evidenced by a Revolving Note made by the Company in favor of Wells Fargo and is secured by substantially all of the assets of the Company, as provided for in the Credit Agreement. The Line is
subject to customary affirmative and negative covenants for credit facilities of this type, including limitations on the Company with respect to liens, indebtedness, guaranties, investments, distributions, mergers and acquisitions, and dispositions
of assets.

The Credit Agreement also contains certain financial covenants, including a minimum book net worth, minimum net
income and maximum capital expenditures. The Company obtained a waiver from Wells Fargo for violation of the minimum book net worth financial covenant as of June 30 and September 30, 2009, and for violation of the minimum net income
financial covenant for the three months ended June 30 and September 30, 2009. During the fourth quarter of 2009, the Credit Agreement was revised to adjust the financial covenants based on the Companys financial projections and to
include a reduction and block of availability under the borrowing base of $250,000 until such time as the Company complied with each of the financial covenants described above for both of the fiscal quarters ended December 31, 2009 and
March 31, 2010. Based on the Companys results of operations for the quarters ended December 31, 2009 and March 31, 2010, the $250,000 reduction and block of availability under the borrowing base was removed during the second
quarter of 2010.

The outstanding balance on the Line bears interest at an annual rate elected by the Company at the time of
each credit advancement, of either: (1) a floating rate equal to the greater of 4% or the sum of (a) the Wells Fargo daily Base Rate, plus (b) 2.5%; or (2) a fixed rate of the London Interbank Offered Rate plus 5.0%. The maturity
date of the Line is April 3, 2012.

The Credit Agreement may be terminated by the Company upon 90 days written notice, or
by Wells Fargo immediately upon default. Upon any such termination, the Company is required to pay Wells Fargo a termination fee.

The Company may use borrowings under the Credit Agreement for working capital. Any unused portions of the maximum amount of the Line are subject to unused Line fees.

Off-Balance Sheet Arrangements

We have no off-balance sheet arrangements with (1) any obligation under a guarantee contract; (2) a retained or contingent interest in assets or similar arrangement that serves as credit,
liquidity or market risk support for such assets; or (3) any other obligation, including a contingent obligation, under a contract that would be accounted for as a derivative instrument or arising out of a variable interest.

During the normal course of business, we may have numerous outstanding purchase orders with vendors to purchase inventory for use in
products that are sold to our customers or are used in performing repair services for our customers. We do not record such orders as liabilities on the consolidated balance sheets until the material is placed on a common carrier or delivered to the
Companys facilities, depending on terms of the arrangement. We have no minimum purchase quantity requirements with any of its vendors.

Critical Accounting Policies and Recently Issued Accounting Standards

The preparation of financial statements and related disclosures in conformity with United States generally accepted accounting principles (GAAP) requires management to make judgments,
assumptions and estimates that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ significantly from those estimates. Our most critical estimates include those related to revenue
recognition, accounts receivable, inventory, goodwill and income taxes. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP, with no need for judgment in application. In addition, there are areas in
which managements judgment in selecting an available alternative would not produce a materially different result. Note 2 to the audited consolidated financial statements included in the Companys 2009 Annual Report on Form 10-K describes
the significant accounting policies and methods used by the Company. See Part I  Financial Information, Item 1  Condensed Consolidated Financial Statements, Note 3  Recently Issued Accounting Standards for information
regarding recently issued accounting standards. Our critical accounting policies have not changed materially from those disclosed in the Companys 2009 Annual Report on Form 10-K.



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|ITEM 4 | CONTROLS AND PROCEDURES
|------ | -----------------------

Evaluation of
Disclosure Controls and Procedures

The Companys management, with the participation of the 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) of the Securities Exchange Act of 1934) as of the end of the period covered by this
quarterly report (the Evaluation Date). The disclosure controls and procedures are to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934, as
amended, is recorded, processed, summarized and reported within the time periods specified by the SECs rules and forms, and to ensure that information required to be disclosed by the Company in the reports it files or submits under the
Securities Exchange Act of 1934 is accumulated and communicated to the Companys management, including the Chief Executive Officer and Chief Financial Officer, or persons performing similar functions, as appropriate, to allow timely decisions
regarding required disclosure. 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 were effective.

Changes in Internal Control Over Financial Reporting

No change was made in the Companys internal control over financial reporting during the Companys third fiscal quarter that has materially affected, or is reasonably likely to materially
affect, the Companys internal control over financial reporting.

PART II  OTHER INFORMATION



|ITEM 6. | EXHIBITS
|------- | --------



|            |  |                                                                                                                                                                                                             |  |                                                                                            
|----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------------------------------------------------------------------------------------
|Exhibit No. |  | Description of Exhibit                                                                                                                                                                                      |  | If incorporated by reference, document with which
Exhibit was previously filed with the SEC
|31.1        |  | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Quarterly Report on Form 10-Q of Pinnacle Data Systems,
Inc. for the quarter ended September 30, 2010 |  | Contained herein                                                                           
|            |  |                                                                                                                                                                                                            
|31.2        |  | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Quarterly Report on Form 10-Q of Pinnacle Data Systems,
Inc. for the quarter ended September 30, 2010 |  | Contained herein                                                                           
|            |  |                                                                                                                                                                                                            
|32.1        |  | Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 of Quarterly Report on Form 10-Q of Pinnacle Data Systems,
Inc. for the quarter ended September 30, 2010 |  | Contained herein                                                                           
|            |  |                                                                                                                                                                                                            
|32.2        |  | Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 of Quarterly Report on Form 10-Q of Pinnacle Data Systems,
Inc. for the quarter ended September 30, 2010 |  | Contained herein                                                                           



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SIGNATURES

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



|                       |  |  |  |                                             
|---------------------- |  |  |  | --------------------------------------------
|                       |  |  |  | PINNACLE DATA SYSTEMS, INC.                 
|                       |  | 
|Date: October 29, 2010 |  |  |  | /s/    John D. Bair                         
|                       |  |  |  | John D. Bair Chief Executive Officer        
|                       |  | 
|Date: October 29, 2010 |  |  |  | /s/    Nicholas J. Tomashot                 
|                       |  |  |  | Nicholas J. Tomashot Chief
Financial Officer



19