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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 March 31, 2011

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 April 29, 2011, the registrant had outstanding 7,864,349 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 MARCH 31, 2011

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                                                                |  |  | 15 | 
|                                                                                                 | 
|PART II  OTHER INFORMATION                                                                      |  |  | 16 | 
|                                                                                                 | 
|ITEM 6    EXHIBITS                                                                               |  |  | 16 | 
|                                                                                                 | 
|SIGNATURES                                                                                       |  |  | 17 | 
|                                                                                                 | 
|CERTIFICATIONS                                                                                   |  |  | 18 | 



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PART I  FINANCIAL INFORMATION



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

PINNACLE DATA SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)



|                                                                                           |  |               |        |   |                  |   |        |  
|------------------------------------------------------------------------------------------ |  | ------------- | ------ | - | ---------------- | - | ------ | -
|                                                                                           |  | March 31,2011 |        |   | December 31,2010 |  
|ASSETS                                                                                     |  | (Unaudited)   |        |   |                  |  
|CURRENT ASSETS                                                                             |  |               |        |   |                  |   |        |  
|Cash                                                                                       |  | $             | 503    |   |                  | $ | 465    |  
|Accounts receivable, net of allowance for doubtful accounts of $107 and $106, respectively |  |               | 5,172  |   |                  |   | 4,469  |  
|Inventory, net                                                                             |  |               | 2,820  |   |                  |   | 3,226  |  
|Deferred income taxes                                                                      |  |               | 781    |   |                  |   | 762    |  
|Prepaid expenses and other current assets                                                  |  |               | 420    |   |                  |   | 492    |  
|                                                                                           |  |               |        |   |                  |   |        |  
|Total current assets                                                                       |  |               | 9,696  |   |                  |   | 9,414  |  
|                                                                                           |  |               |        |   |                  |   |        |  
|                                                                                           |  |              
|PROPERTY AND EQUIPMENT                                                                     |  |               |        |   |                  |   |        |  
|Property and equipment, cost                                                               |  |               | 6,170  |   |                  |   | 6,056  |  
|Less accumulated depreciation and amortization                                             |  |               | (5,455 | ) |                  |   | (5,371 | )
|                                                                                           |  |               |        |   |                  |   |        |  
|Total property and equipment, net                                                          |  |               | 715    |   |                  |   | 685    |  
|                                                                                           |  |               |        |   |                  |   |        |  
|                                                                                           |  |              
|OTHER ASSETS                                                                               |  |               |        |   |                  |   |        |  
|Goodwill                                                                                   |  |               | 812    |   |                  |   | 767    |  
|Deferred income taxes                                                                      |  |               | 1,283  |   |                  |   | 929    |  
|Other assets                                                                               |  |               | 196    |   |                  |   | 193    |  
|                                                                                           |  |               |        |   |                  |   |        |  
|Total other assets                                                                         |  |               | 2,291  |   |                  |   | 1,889  |  
|                                                                                           |  |               |        |   |                  |   |        |  
|TOTAL ASSETS                                                                               |  | $             | 12,702 |   |                  | $ | 11,988 |  
|                                                                                           |  |               |        |   |                  |   |        |  
|                                                                                           |  |              
|LIABILITIES AND STOCKHOLDERS EQUITY                                                       |  |               |        |   |                  |   |        |  
|                                                                                           |  |              
|CURRENT LIABILITIES                                                                        |  |               |        |   |                  |   |        |  
|Line of credit                                                                             |  | $             |       |   |                  | $ | 273    |  
|Accounts payable                                                                           |  |               | 1,799  |   |                  |   | 1,404  |  
|Accrued wages, payroll taxes and employee benefits                                         |  |               | 496    |   |                  |   | 581    |  
|Unearned revenue                                                                           |  |               | 181    |   |                  |   | 30     |  
|Other current liabilities                                                                  |  |               | 557    |   |                  |   | 743    |  
|                                                                                           |  |               |        |   |                  |   |        |  
|Total current liabilities                                                                  |  |               | 3,033  |   |                  |   | 3,031  |  
|                                                                                           |  |              
|LONG-TERM LIABILITIES                                                                      |  |               |        |   |                  |   |        |  
|Accrued other                                                                              |  |               | 374    |   |                  |   | 296    |  
|                                                                                           |  |               |        |   |                  |   |        |  
|                                                                                           |  |              
|TOTAL LIABILITIES                                                                          |  |               | 3,407  |   |                  |   | 3,327  |  
|                                                                                           |  |               |        |   |                  |   |        |  
|                                                                                           |  |              
|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; 7,864 shares issued and outstanding  |  |               | 5,790  |   |                  |   | 5,790  |  
|Additional paid-in capital                                                                 |  |               | 1,981  |   |                  |   | 1,962  |  
|Accumulated other comprehensive income (loss)                                              |  |               | (30    | ) |                  |   | (90    | )
|Retained earnings                                                                          |  |               | 1,554  |   |                  |   | 999    |  
|                                                                                           |  |               |        |   |                  |   |        |  
|Total stockholders equity                                                                 |  |               | 9,295  |   |                  |   | 8,661  |  
|                                                                                           |  |               |        |   |                  |   |        |  
|                                                                                           |  |              
|TOTAL LIABILITIES AND STOCKHOLDERS EQUITY                                                 |  | $             | 12,702 |   |                  | $ | 11,988 |  
|                                                                                           |  |               |        |   |                  |   |        |  

See accompanying notes to condensed consolidated financial statements.



1



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PINNACLE DATA SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(in thousands, except per share)



|                                            |  |                                     |       |   |      |   |       | 
|------------------------------------------- |  | ----------------------------------- | ----- | - | ---- | - | ----- | 
|                                            |  | For the Three Months EndedMarch 31, |      
|                                            |  | 2011                                |       |   | 2010 |  
|Sales                                       |  | $                                   | 6,405 |   |      | $ | 8,812 | 
|Cost of sales                               |  |                                     | 4,322 |   |      |   | 6,663 | 
|                                            |  |                                     |       |   |      |   |       | 
|Gross profit                                |  |                                     | 2,083 |   |      |   | 2,149 | 
|Operating expenses                          |  |                                     | 1,824 |   |      |   | 1,728 | 
|                                            |  |                                     |       |   |      |   |       | 
|Income from operations                      |  |                                     | 259   |   |      |   | 421   | 
|Other expense                               |  |                                     |       |   |      |   |       | 
|Interest expense                            |  |                                     | 1     |   |      |   | 23    | 
|                                            |  |                                     |       |   |      |   |       | 
|Income before income taxes                  |  |                                     | 258   |   |      |   | 398   | 
|Income tax expense (benefit)                |  |                                     | (297  | ) |      |   | 89    | 
|                                            |  |                                     |       |   |      |   |       | 
|Net income                                  |  | $                                   | 555   |   |      | $ | 309   | 
|                                            |  |                                     |       |   |      |   |       | 
|                                            |  |                                    
|Weighted average common shares outstanding: |  |                                     |       |   |      |   |       | 
|Basic                                       |  |                                     | 7,864 |   |      |   | 7,825 | 
|Diluted                                     |  |                                     | 8,180 |   |      |   | 7,825 | 
|                                            |  |                                    
|Earnings per common share:                  |  |                                     |       |   |      |   |       | 
|Basic                                       |  | $                                   | 0.07  |   |      | $ | 0.04  | 
|Diluted                                     |  |                                     | 0.07  |   |      |   | 0.04  | 

See accompanying notes
to condensed consolidated financial statements.



2



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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, 2009         |  |                   | 7,825 |  |                          | $ | 5,769 |                                            |  | $ | 1,912                     |  |  | $                        | (29 | ) |  | $ | (2,064 | ) |  | $ | 5,588 |  
|Share-based payment expense         |  |                   |      |  |                          |   |      |                                            |  |   | 14                        |  |  |                          |    |   |  |   |       |   |  |   | 14    |  
|Comprehensive income, net of taxes: |  |                   |       |  |                          |   |       |                                            |  |   |                           |  |  |                          |     |   |  |   |        |   |  |   |       |  
|Net income                          |  |                   |      |  |                          |   |      |                                            |  |   |                          |  |  |                          |    |   |  |   | 309    |   |  |   | 309   |  
|Foreign currency translation        |  |                   |      |  |                          |   |      |                                            |  |   |                          |  |  |                          | (54 | ) |  |   |       |   |  |   | (54   | )
|                                    |  |                   |       |  |                          |   |       |                                            |  |   |                           |  |  |                          |     |   |  |   |        |   |  |   |       |  
|Total comprehensive income          |  |                   |       |  |                          |   |       |                                            |  |   |                           |  |  |                          |     |   |  |   |        |   |  |   | 255   |  
|                                    |  |                   |       |  |                          |   |       |                                            |  |   |                           |  |  |                          |     |   |  |   |        |   |  |   |       |  
|Balance  March 31, 2010            |  |                   | 7,825 |  |                          | $ | 5,769 |                                            |  | $ | 1,926                     |  |  | $                        | (83 | ) |  | $ | (1,755 | ) |  | $ | 5,857 |  
|                                    |  |                   |       |  |                          |   |       |                                            |  |   |                           |  |  |                          |     |   |  |   |        |   |  |   |       |  
|Balance  December 31, 2010         |  |                   | 7,864 |  |                          | $ | 5,790 |                                            |  | $ | 1,962                     |  |  | $                        | (90 | ) |  | $ | 999    |   |  | $ | 8,661 |  
|Share-based payment expense         |  |                   |      |  |                          |   |      |                                            |  |   | 19                        |  |  |                          |    |   |  |   |       |   |  |   | 19    |  
|Comprehensive income, net of taxes: |  |                   |       |  |                          |   |       |                                            |  |   |                           |  |  |                          |     |   |  |   |        |   |  |   |       |  
|Net income                          |  |                   |      |  |                          |   |      |                                            |  |   |                          |  |  |                          |    |   |  |   | 555    |   |  |   | 555   |  
|Foreign currency translation        |  |                   |      |  |                          |   |      |                                            |  |   |                          |  |  |                          | 60  |   |  |   |       |   |  |   | 60    |  
|                                    |  |                   |       |  |                          |   |       |                                            |  |   |                           |  |  |                          |     |   |  |   |        |   |  |   |       |  
|Total comprehensive income          |  |                   |       |  |                          |   |       |                                            |  |   |                           |  |  |                          |     |   |  |   |        |   |  |   | 615   |  
|                                    |  |                   |       |  |                          |   |       |                                            |  |   |                           |  |  |                          |     |   |  |   |        |   |  |   |       |  
|Balance  March 31, 2011            |  |                   | 7,864 |  |                          | $ | 5,790 |                                            |  | $ | 1,981                     |  |  | $                        | (30 | ) |  | $ | 1,554  |   |  | $ | 9,295 |  
|                                    |  |                   |       |  |                          |   |       |                                            |  |   |                           |  |  |                          |     |   |  |   |        |   |  |   |       |  

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 Three Months EndedMarch 31, |     
|                                                                                  |  | 2011                                |      |   | 2010 |  
|CASH FLOWS FROM OPERATING ACTIVITIES                                              |  |                                     |      |   |      |   |        |  
|Net income                                                                        |  | $                                   | 555  |   |      | $ | 309    |  
|                                                                                  |  |                                     |      |   |      |   |        |  
|Adjustments to reconcile net income to net cash provided by operating activities: |  |                                     |      |   |      |   |        |  
|Bad debt expense                                                                  |  |                                     | 1    |   |      |   | 10     |  
|Inventory reserves                                                                |  |                                     | 51   |   |      |   | 105    |  
|Depreciation and amortization                                                     |  |                                     | 85   |   |      |   | 102    |  
|Provision (benefit) for deferred income taxes                                     |  |                                     | (373 | ) |      |   |       |  
|Share-based payment expense                                                       |  |                                     | 19   |   |      |   | 14     |  
|(Increase) decrease in assets:                                                    |  |                                     |      |   |      |   |        |  
|Accounts receivable                                                               |  |                                     | (673 | ) |      |   | (1,150 | )
|Inventory                                                                         |  |                                     | 366  |   |      |   | 10     |  
|Prepaid expenses and other assets                                                 |  |                                     | 23   |   |      |   | 256    |  
|Increase (decrease) in liabilities:                                               |  |                                     |      |   |      |   |        |  
|Accounts payable                                                                  |  |                                     | 328  |   |      |   | 533    |  
|Unearned revenue                                                                  |  |                                     | 151  |   |      |   | 296    |  
|Other current liabilities                                                         |  |                                     | (218 | ) |      |   | 44     |  
|                                                                                  |  |                                     |      |   |      |   |        |  
|Total adjustments                                                                 |  |                                     | (240 | ) |      |   | 220    |  
|                                                                                  |  |                                     |      |   |      |   |        |  
|Net cash provided by operating activities                                         |  |                                     | 315  |   |      |   | 529    |  
|                                                                                  |  |                                     |      |   |      |   |        |  
|CASH FLOWS FROM INVESTING ACTIVITIES                                              |  |                                     |      |   |      |   |        |  
|Purchases of property and equipment                                               |  |                                     | (84  | ) |      |   | (55    | )
|                                                                                  |  |                                     |      |   |      |   |        |  
|Net cash used in investing activities                                             |  |                                     | (84  | ) |      |   | (55    | )
|                                                                                  |  |                                     |      |   |      |   |        |  
|CASH FLOWS FROM FINANCING ACTIVITIES                                              |  |                                     |      |   |      |   |        |  
|Net change in line of credit                                                      |  |                                     | (273 | ) |      |   | (1,263 | )
|Net change in outstanding checks                                                  |  |                                     | 45   |   |      |   | 498    |  
|Other                                                                             |  |                                     | 20   |   |      |   | 17     |  
|                                                                                  |  |                                     |      |   |      |   |        |  
|Net cash used in financing activities                                             |  |                                     | (208 | ) |      |   | (748   | )
|                                                                                  |  |                                     |      |   |      |   |        |  
|EFFECT OF EXCHANGE RATE ON CASH                                                   |  |                                     | 15   |   |      |   | (4     | )
|                                                                                  |  |                                     |      |   |      |   |        |  
|INCREASE (DECREASE) IN CASH                                                       |  |                                     | 38   |   |      |   | (278   | )
|Cash at beginning of period                                                       |  |                                     | 465  |   |      |   | 323    |  
|                                                                                  |  |                                     |      |   |      |   |        |  
|Cash at end of period                                                             |  | $                                   | 503  |   |      | $ | 45     |  
|                                                                                  |  |                                     |      |   |      |   |        |  

See accompanying notes to condensed consolidated financial statements.



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PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited)

March 31, 2011 and 2010

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 normal and recurring adjustments, 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. Certain prior year amounts have been reclassified to conform to the current presentation.

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. The Companys most critical estimates include
those related to revenue recognition, accounts receivable, inventory, goodwill and income taxes. Although some variability is inherent in these estimates, recorded amounts reflect managements best estimates based on available facts and
circumstances at that time. Management believes the amounts provided are appropriate.

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, 2010 included in the Companys 2010 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 2010 Annual Report on Form
10-K. There have been no material changes to these policies since December 31, 2010.

Inventory

As of March 31, 2011 and December 31, 2010, the Company provided reserves of $2.0 million and $1.9 million, respectively, to
reduce the carrying value of inventory. The following table summarizes the Companys inventory as of the dates indicated (net of inventory reserves):



|                                |  |               |       |  |                  |   |       | 
|------------------------------- |  | ------------- | ----- |  | ---------------- | - | ----- | 
|(in thousands)                  |  | March 31,2011 |       |  | December 31,2010 |  
|Component parts (raw materials) |  | $             | 2,594 |  |                  | $ | 2,963 | 
|Work-in-process                 |  |               | 58    |  |                  |   | 110   | 
|Finished goods                  |  |               | 168   |  |                  |   | 153   | 
|                                |  |               |       |  |                  |   |       | 
|Total inventory                 |  | $             | 2,820 |  |                  | $ | 3,226 | 
|                                |  |               |       |  |                  |   |       | 



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PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

March 31, 2011 and 2010



3. Line of Credit

On March 24, 2011, the Company entered into a Credit Agreement and a Security Agreement with Wells Fargo Bank, National Association (Wells Fargo), providing for a revolving credit
facility (the Line) with a maximum line of credit of $3.0 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 accounts receivable
located within the United States, plus (b) 75% of the aggregate amount of eligible accounts receivable located outside of the United States, plus (c) the lesser of 10% of the aggregate amount of eligible inventory or $500,000.

The Line is evidenced by a Revolving Line of Credit 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 Security 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, mergers and dispositions of assets.

The Credit Agreement also contains certain
financial covenants, including a maximum ratio of total liabilities to tangible net worth, minimum net income on a rolling four-quarter basis, and a minimum debt service coverage ratio.

The outstanding balance on the Line bears interest monthly at a fluctuating annual rate of 3% above the Daily One Month London Interbank
Offered Rate. The Line matures on March 22, 2013.

The Company may use borrowings under the Credit Agreement for general
corporate purposes. Any unused portions of the Line will be subject to unused Line fees. Wells Fargo may terminate the Credit Agreement immediately upon default.

On March 24, 2011, in connection with entering into the Credit Agreement and Security Agreement described above, the Company terminated its prior line of credit agreement with Wells Fargo. On the
date of the termination, the Company made a final payment to Wells Fargo of all unpaid interest, fees, costs and expenses under the prior agreement and an additional $30,000 as collateral security for the Companys obligations to Wells Fargo
under the prior agreement (the Reserve). Any balance of the Reserve remaining after 45 days from the date of termination will be returned to the Company. The Company did not incur any early termination penalties in connection with the
termination of the prior line of credit agreement.

4. 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. Open tax years exist for 2007 and beyond for the Companys federal income tax returns and for 2006 and beyond for state income tax returns.

The Company maintains a $0.1 million valuation allowance against deferred tax assets related to certain state net operating loss
(NOL) carryforwards. The Company can provide no assurance that changes in its deferred tax asset valuation allowance will not be required in the future. The Company will continue to monitor events and circumstances to determine whether
any change in its valuation allowance is warranted in the future.

Although the Company periodically has considered the
potential tax savings associated with pursuing research and development (R&D) tax credits, the Companys then recent operating losses, combined with existing federal U.S. NOL carryforwards, precluded an economical pursuit of
such credits. However, based on the positive changes in the Companys operating results and financial position in 2010, as well as the use of existing NOL carryforwards, management determined during the fourth quarter of 2010 that both the cost
of an R&D credit study and the establishment of the necessary infrastructure to be able to claim such credits in the future are justified by the resulting benefits. Accordingly, the Company recorded a net income tax benefit of $0.5 million
during the fourth quarter of 2010 for estimated R&D credits for tax years 2001 through 2010 that the Company believed were more likely than not to be sustained upon examination by the Internal Revenue Service. The Company substantially completed
the calculation and documentation of these R&D credits during the first quarter of 2011, resulting in an additional net income tax benefit of $0.3 million. The Company will complete the filing of amended tax returns later in 2011.

The Company recorded a liability for unrecognized tax benefits related to R&D credit tax positions to be taken on its various income
tax returns. If recognized, the entire amount of these unrecognized tax benefits would favorably impact the Companys effective tax rate in future periods. The Company had $0.2 million of unrecognized tax benefits as of March 31, 2011,
which were recorded in other liabilities on the consolidated balance sheets.



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##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

March 31, 2011 and 2010



The following table summarizes the Companys income tax expense (benefit) for the
three months ended March 31:



|                                   |  |      |      |   |      |   |    | 
|---------------------------------- |  | ---- | ---- | - | ---- | - | -- | 
|(in thousands)                     |  | 2011 |      |   | 2010 |  
|Current:                           |  |      |      |   |      |   |    | 
|Federal                            |  | $    | 70   |   |      | $ | 67 | 
|Foreign                            |  |      | (2   | ) |      |   | 3  | 
|State and local                    |  |      | 8    |   |      |   | 19 | 
|                                   |  |      |      |   |      |   |    | 
|Total current expense              |  |      | 76   |   |      |   | 89 | 
|                                   |  |      |      |   |      |   |    | 
|Deferred:                          |  |      |      |   |      |   |    | 
|Federal                            |  |      | (392 | ) |      |   |   | 
|Foreign                            |  |      | 19   |   |      |   |   | 
|                                   |  |      |      |   |      |   |    | 
|Total deferred expense (benefit)   |  |      | (373 | ) |      |   |   | 
|                                   |  |      |      |   |      |   |    | 
|Total income tax expense (benefit) |  | $    | (297 | ) |      | $ | 89 | 
|                                   |  |      |      |   |      |   |    | 

The following table reconciles tax expense (benefit) computed at the federal statutory rate to amounts
reported for financial statement purposes for the three months ended March 31:



|                                                 |  |        |      |   |      |  |       |        |  |   |     |   |  |  |       |  
|------------------------------------------------ |  | ------ | ---- | - | ---- |  | ----- | ------ |  | - | --- | - |  |  | ----- | -
|                                                 |  | 2011   |      |   | 2010 | 
|(dollars in thousands)                           |  | Amount |      |   | %    |  |       | Amount |  |   | %   |  
|Income tax provision (benefit) at statutory rate |  | $      | 88   |   |      |  | 34.0  |        |  | $ | 135 |   |  |  | 34.0  |  
|R&D credits                                      |  |        | (321 | ) |      |  | NM    |        |  |   |    |   |  |  |      |  
|Change in valuation allowance                    |  |        |     |   |      |  |      |        |  |   | (45 | ) |  |  | (11.3 | )
|Foreign rate differential                        |  |        | (12  | ) |      |  | (4.7  | )      |  |   | (2  | ) |  |  | (0.5  | )
|Other, net                                       |  |        | (52  | ) |      |  | (20.2 | )      |  |   | 1   |   |  |  | 0.2   |  
|                                                 |  |        |      |   |      |  |       |        |  |   |     |   |  |  |       |  
|Total                                            |  | $      | (297 | ) |      |  | NM    |        |  | $ | 89  |   |  |  | 22.4  |  
|                                                 |  |        |      |   |      |  |       |        |  |   |     |   |  |  |       |  

For the three months ended March 31, 2011, the Company received federal tax refunds totaling $0.2
million, and state income tax payments were immaterial. During the three months ended March 31, 2010, the Company received federal tax refunds totaling $0.2 million and made no state income tax payments. As of March 31, 2011, the Company
had state NOL carryforwards of $4.3 million that will expire, if unused, between December 31, 2021 and December 31, 2031. The Company had no federal NOL carryforwards as of March 31, 2011.



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PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

March 31, 2011 and 2010



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)                |  | March 31,2011 |       |   | December 31,2010 |  
|Deferred tax assets           |  |               |       |   |                  |   |       |  
|R&D credits                   |  | $             | 1,104 |   |                  | $ | 719   |  
|Inventory reserves            |  |               | 732   |   |                  |   | 714   |  
|Net operating loss            |  |               | 107   |   |                  |   | 107   |  
|Depreciation and amortization |  |               | 87    |   |                  |   | 113   |  
|Other                         |  |               | 173   |   |                  |   | 177   |  
|                              |  |               |       |   |                  |   |       |  
|Gross deferred tax assets     |  |               | 2,203 |   |                  |   | 1,830 |  
|Less valuation allowance      |  |               | (79   | ) |                  |   | (79   | )
|                              |  |               |       |   |                  |   |       |  
|Deferred tax asset            |  |               | 2,124 |   |                  |   | 1,751 |  
|                              |  |               |       |   |                  |   |       |  
|Deferred tax liabilities      |  |               |       |   |                  |   |       |  
|Prepaids                      |  |               | 60    |   |                  |   | 60    |  
|                              |  |               |       |   |                  |   |       |  
|Gross deferred tax liability  |  |               | 60    |   |                  |   | 60    |  
|                              |  |               |       |   |                  |   |       |  
|Net deferred tax asset        |  | $             | 2,064 |   |                  | $ | 1,691 |  
|                              |  |               |       |   |                  |   |       |  

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



|                       |  |               |       |  |                  |   |       | 
|---------------------- |  | ------------- | ----- |  | ---------------- | - | ----- | 
|(in thousands)         |  | March 31,2011 |       |  | December 31,2010 |  
|Current assets         |  |               |       |  |                  |   |       | 
|Deferred income taxes  |  | $             | 781   |  |                  | $ | 762   | 
|Other assets           |  |               |       |  |                  |   |       | 
|Deferred income taxes  |  |               | 1,283 |  |                  |   | 929   | 
|                       |  |               |       |  |                  |   |       | 
|Net deferred tax asset |  | $             | 2,064 |  |                  | $ | 1,691 | 
|                       |  |               |       |  |                  |   |       | 

5. Earnings Per Share

Basic earnings per share (EPS) represents the amount of earnings available to each share of common stock outstanding during the reporting period. Diluted EPS represents the amount of earnings 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 three months ended March 31:



|                                                     |  |      |       |  |      |  |       | 
|---------------------------------------------------- |  | ---- | ----- |  | ---- |  | ----- | 
|(in thousands)                                       |  | 2011 |       |  | 2010 | 
|Weighted average common shares outstanding  basic   |  |      | 7,864 |  |      |  | 7,825 | 
|Dilutive effect of stock options                     |  |      | 316   |  |      |  |      | 
|                                                     |  |      |       |  |      |  |       | 
|Weighted average common shares outstanding  diluted |  |      | 8,180 |  |      |  | 7,825 | 
|                                                     |  |      |       |  |      |  |       | 

The computation of diluted EPS for the three months ended March 31, 2011 and 2010 excluded options to
purchase approximately 406,000 shares and 705,000 shares, respectively, that were anti-dilutive because the exercise price of these options was greater than the average market price of the common shares during the respective periods.



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##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

March 31, 2011 and 2010



6. Segment Information

The Companys reportable segments are Product and Service. PDSi is a global provider of electronics repair and reverse logistics services; ODM and 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.

The following table summarizes the
Companys segment operating results for the three months ended March 31:



|                              |  |      |        |   |      |   |       |  
|----------------------------- |  | ---- | ------ | - | ---- | - | ----- | -
|(in thousands)                |  | 2011 |        |   | 2010 |  
|Sales                         |  |      |        |   |      |   |       |  
|Product                       |  | $    | 2,726  |   |      | $ | 5,927 |  
|Service                       |  |      | 3,679  |   |      |   | 2,885 |  
|                              |  |      |        |   |      |   |       |  
|Total                         |  | $    | 6,405  |   |      | $ | 8,812 |  
|                              |  |      |        |   |      |   |       |  
|Gross profit                  |  |      |        |   |      |   |       |  
|Product                       |  | $    | 564    |   |      | $ | 1,069 |  
|Service                       |  |      | 1,519  |   |      |   | 1,080 |  
|                              |  |      |        |   |      |   |       |  
|Total                         |  | $    | 2,083  |   |      | $ | 2,149 |  
|                              |  |      |        |   |      |   |       |  
|Income (loss) from operations |  |      |        |   |      |   |       |  
|Product                       |  | $    | 278    |   |      | $ | 704   |  
|Service                       |  |      | 1,013  |   |      |   | 652   |  
|Other                         |  |      | (1,032 | ) |      |   | (935  | )
|                              |  |      |        |   |      |   |       |  
|Total                         |  | $    | 259    |   |      | $ | 421   |  
|                              |  |      |        |   |      |   |       |  

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



|               |  |               |        |  |                  |   |        | 
|-------------- |  | ------------- | ------ |  | ---------------- | - | ------ | 
|(in thousands) |  | March 31,2011 |        |  | December 31,2010 |  
|Product        |  | $             | 3,192  |  |                  | $ | 3,280  | 
|Service        |  |               | 5,569  |  |                  |   | 5,443  | 
|Other          |  |               | 3,941  |  |                  |   | 3,265  | 
|               |  |               |        |  |                  |   |        | 
|Total          |  | $             | 12,702 |  |                  | $ | 11,988 | 
|               |  |               |        |  |                  |   |        | 



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##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

March 31, 2011 and 2010



The following table summarizes sales by geographic region for the three months ended
March 31:



|                                                                                                 |  |                |       |  |                   |   |       | 
|------------------------------------------------------------------------------------------------ |  | -------------- | ----- |  | ----------------- | - | ----- | 
|(in thousands)                                                                                   |  | 2011           |       |  | 2010              |  
|United States                                                                                    |  | $              | 5,603 |  |                   | $ | 8,041 | 
|International                                                                                    |  |                | 802   |  |                   |   | 771   | 
|                                                                                                 |  |                |       |  |                   |   |       | 
|Total                                                                                            |  | $              | 6,405 |  |                   | $ | 8,812 | 
|                                                                                                 |  |                |       |  |                   |   |       | 
|                                                                                                 |  |               
|The following table summarizes long-lived assets by geographic region as of the dates indicated: |  |                |       |  |                   |   |       | 
|                                                                                                 |  |               
|(in thousands)                                                                                   |  | March 
31,2011 |       |  | December 
31,2010 |  
|                                                                                                 | 
|United States                                                                                    |  | $              | 1,660 |  |                   | $ | 1,277 | 
|International                                                                                    |  |                | 1,346 |  |                   |   | 1,297 | 
|                                                                                                 |  |                |       |  |                   |   |       | 
|Total                                                                                            |  | $              | 3,006 |  |                   | $ | 2,574 | 
|                                                                                                 |  |                |       |  |                   |   |       | 

International long-lived assets include goodwill of $0.8 million as of March 31, 2011 and
December 31, 2010. All international sales and long-lived assets are in the Service segment.



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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, 2011. 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.

The following is managements discussion and analysis of financial condition and results of
operations of the Company for the three months ended March 31, 2011 and 2010. This discussion should be read in conjunction with the Companys audited consolidated financial statements and related notes contained in its 2010 Annual Report
on Form 10-K.

Executive Overview

PDSi is a global provider of electronics repair and reverse logistics services; system integration and original design manufacturer (ODM) computing design and manufacturing 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 original equipment manufacturers (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.



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##### Table of Contents

During the quarter ended March 31, 2011, we recorded net income of $555,000, or $0.07
per diluted share, versus net income of $309,000, or $0.04 per diluted share, for the prior year quarter. See below for further discussion of consolidated and reportable segment results of operations for the three months ended March 31, 2011
and 2010.

Although we periodically have considered the potential tax savings associated with pursuing research and
development (R&D) tax credits, our then recent operating losses, combined with existing federal U.S. net operating loss (NOL) carryforwards, precluded an economical pursuit of such credits. However, based on the positive
changes in the Companys operating results and financial position in 2010, as well as the use of existing NOL carryforwards, management determined during the fourth quarter of 2010 that both the cost of an R&D credit study and the
establishment of the necessary infrastructure to be able to claim such credits in the future are justified by the resulting benefits. Accordingly, the Company recorded a net income tax benefit of $0.5 million during the fourth quarter of 2010 for
estimated R&D credits for tax years 2001 through 2010 that the Company believed were more likely than not to be sustained upon examination by the Internal Revenue Service. The Company substantially completed the calculation and documentation of
these R&D credits during the first quarter of 2011, resulting in an additional net income tax benefit of $0.3 million.

We
believe our operating results will continue to show improvement due to several factors. First, 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.

Results of Operations

Consolidated Operations

First Quarter  2011 Compared to 2010

The following table summarizes the Companys consolidated results of operations for the three months ended
March 31:



|                             |  |      |       |   |           |  |       |      |  |   |           |  |  |         |       |   |  |  |     |  
|---------------------------- |  | ---- | ----- | - | --------- |  | ----- | ---- |  | - | --------- |  |  | ------- | ----- | - |  |  | --- | -
|(dollars in thousands)       |  | 2011 |       |   | % ofSales |  |       | 2010 |  |   | % ofSales |  |  | %Change |      
|Sales                        |  | $    | 6,405 |   |           |  | 100.0 | %    |  | $ | 8,812     |  |  |         | 100.0 | % |  |  | -27 | %
|Cost of sales                |  |      | 4,322 |   |           |  | 67.5  | %    |  |   | 6,663     |  |  |         | 75.6  | % |  |  | -35 | %
|                             |  |      |       |   |           |  |       |      |  |   |           |  |  |         |       |   |  |  |     |  
|Gross profit                 |  |      | 2,083 |   |           |  | 32.5  | %    |  |   | 2,149     |  |  |         | 24.4  | % |  |  | -3  | %
|Operating expenses           |  |      | 1,824 |   |           |  | 28.5  | %    |  |   | 1,728     |  |  |         | 19.6  | % |  |  | 6   | %
|                             |  |      |       |   |           |  |       |      |  |   |           |  |  |         |       |   |  |  |     |  
|Income from operations       |  |      | 259   |   |           |  | 4.0   | %    |  |   | 421       |  |  |         | 4.8   | % |  |  | -38 | %
|Other expense                |  |      |       |   |           |  |       |      |  |   |           |  |  |         |       |   |  |  |     |  
|Interest expense             |  |      | 1     |   |           |  | 0.0   | %    |  |   | 23        |  |  |         | 0.3   | % |  |  | -96 | %
|                             |  |      |       |   |           |  |       |      |  |   |           |  |  |         |       |   |  |  |     |  
|Income before income taxes   |  |      | 258   |   |           |  | 4.0   | %    |  |   | 398       |  |  |         | 4.5   | % |  |  | -35 | %
|Income tax expense (benefit) |  |      | (297  | ) |           |  | -4.7  | %    |  |   | 89        |  |  |         | 1.0   | % |  |  | NM  |  
|                             |  |      |       |   |           |  |       |      |  |   |           |  |  |         |       |   |  |  |     |  
|Net income                   |  | $    | 555   |   |           |  | 8.7   | %    |  | $ | 309       |  |  |         | 3.5   | % |  |  | 80  | %
|                             |  |      |       |   |           |  |       |      |  |   |           |  |  |         |       |   |  |  |     |  

The increase in net income for the three months ended March 31, 2011 compared to the prior
year quarter primarily was due to the aforementioned net income tax benefit of $0.3 million related to R&D credits. Strong growth in the Service segment offset the impact of lower sales in the Product segment, while both segments posted higher
gross profit margins primarily due to shifts in mix toward higher margin business. Service segment gross profit increased 41% primarily due to a 28% increase in Service sales driven by the growth of business in both the U.S. and the Europe, Middle
East and Africa (EMEA) region for both new customers and new programs within existing customers. Product segment gross profit fell 47% due to a 54% decrease in sales, mostly to OEMs in the telecommunications sector that had particularly
strong activity in early 2010. Increased operating expenses reflect investments in personnel needed to support and grow the business.

For the first quarter of 2011, the Company had three customers that generated $1.3 million, $1.2 million and $1.0 million, or 21%, 18% and 15%, respectively, of total sales. Of the revenues from these
customers, 31% and 69% were included in Product and Service segment sales, respectively. For the first quarter of 2010, the Company had three customers that generated $2.5 million, $1.5 million and $1.4 million, or 28%, 17% and 16%, respectively, of
total sales. Of the revenues from these customers, 86% and 14% were included in Product and Service segment sales, respectively.



12



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##### Table of Contents

Segment Operations

Product

First Quarter  2011 Compared to 2010

The following table summarizes the Companys gross profit for the Product segment for the three months ended March 31:



|                       |  |      |       |  |           |  |       |      |  |   |           |  |  |         |       |   |  |  |     |  
|---------------------- |  | ---- | ----- |  | --------- |  | ----- | ---- |  | - | --------- |  |  | ------- | ----- | - |  |  | --- | -
|(dollars in thousands) |  | 2011 |       |  | % ofSales |  |       | 2010 |  |   | % ofSales |  |  | %Change |      
|Sales                  |  | $    | 2,726 |  |           |  | 100.0 | %    |  | $ | 5,927     |  |  |         | 100.0 | % |  |  | -54 | %
|Cost of sales          |  |      | 2,162 |  |           |  | 79.3  | %    |  |   | 4,858     |  |  |         | 82.0  | % |  |  | -55 | %
|                       |  |      |       |  |           |  |       |      |  |   |           |  |  |         |       |   |  |  |     |  
|Gross profit           |  | $    | 564   |  |           |  | 20.7  | %    |  | $ | 1,069     |  |  |         | 18.0  | % |  |  | -47 | %
|                       |  |      |       |  |           |  |       |      |  |   |           |  |  |         |       |   |  |  |     |  

A 54% decrease in Product sales, including $2.8 million lower sales to OEMs in the
telecommunications industry that had particularly strong activity in early 2010, drove the decline in Product segment gross profit. However, the continued shift in sales mix to higher margin products, in conjunction with management of manufacturing
overhead costs to levels consistent with lower Product revenues, resulted in a 21% gross margin in the first quarter of 2011 compared to 18% in the comparable quarter of 2010.

Service

First Quarter  2011 Compared to 2010

The following table summarizes the Companys gross profit for the Service segment for the three months ended March 31:



|                       |  |      |       |  |           |  |       |      |  |   |           |  |  |         |       |   |  |  |    |  
|---------------------- |  | ---- | ----- |  | --------- |  | ----- | ---- |  | - | --------- |  |  | ------- | ----- | - |  |  | -- | -
|(dollars in thousands) |  | 2011 |       |  | % ofSales |  |       | 2010 |  |   | % ofSales |  |  | %Change |      
|Sales                  |  | $    | 3,679 |  |           |  | 100.0 | %    |  | $ | 2,885     |  |  |         | 100.0 | % |  |  | 28 | %
|Cost of sales          |  |      | 2,160 |  |           |  | 58.7  | %    |  |   | 1,805     |  |  |         | 62.6  | % |  |  | 20 | %
|                       |  |      |       |  |           |  |       |      |  |   |           |  |  |         |       |   |  |  |    |  
|Gross profit           |  | $    | 1,519 |  |           |  | 41.3  | %    |  | $ | 1,080     |  |  |         | 37.4  | % |  |  | 41 | %
|                       |  |      |       |  |           |  |       |      |  |   |           |  |  |         |       |   |  |  |    |  

Gross profit in the Service segment increased primarily due to the growth of business in both the
U.S. and EMEA for both new customers and new programs within existing customers. The continuing shift toward higher margin programs and gains in operating leverage on the 28% sales growth drove an increase in gross profit as a percentage of sales to
41% in the first quarter of 2011 from 37% in the comparable quarter of 2010.

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)                                                                |  | March 31,2011 |       |   | December 31,2010 |  
|Line of credit                                                                |  | $             |      |   |                  | $ | 273   |  
|                                                                              |  |               |       |   |                  |   |       |  
|Stockholders equity, excluding accumulated other comprehensive income (loss) |  |               | 9,325 |   |                  |   | 8,751 |  
|Accumulated other comprehensive income (loss)                                 |  |               | (30   | ) |                  |   | (90   | )
|                                                                              |  |               |       |   |                  |   |       |  
|Total stockholders equity                                                    |  |               | 9,295 |   |                  |   | 8,661 |  
|                                                                              |  |               |       |   |                  |   |       |  
|Total capital                                                                 |  | $             | 9,295 |   |                  | $ | 8,934 |  
|                                                                              |  |               |       |   |                  |   |       |  



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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 three months ended March 31:



|                                          |  |      |      |   |      |   |      |  
|----------------------------------------- |  | ---- | ---- | - | ---- | - | ---- | -
|(in thousands)                            |  | 2011 |      |   | 2010 |  
|Net cash provided by operating activities |  | $    | 315  |   |      | $ | 529  |  
|Net cash used in investing activities     |  |      | (84  | ) |      |   | (55  | )
|Net cash used in financing activities     |  |      | (208 | ) |      |   | (748 | )
|Effect of exchange rate on cash           |  |      | 15   |   |      |   | (4   | )
|                                          |  |      |      |   |      |   |      |  
|Increase (decrease) in cash               |  |      | 38   |   |      |   | (278 | )
|Cash at beginning of period               |  |      | 465  |   |      |   | 323  |  
|                                          |  |      |      |   |      |   |      |  
|Cash at end of period                     |  | $    | 503  |   |      | $ | 45   |  
|                                          |  |      |      |   |      |   |      |  

Operating Activities

Net cash provided by operating activities was $0.3 million and $0.5 million for the three months ended March 31, 2011 and 2010, respectively. Net income adjusted for the effects of non-cash items,
which primarily include deferred income taxes, inventory reserves and depreciation expense, resulted in cash inflows of $0.3 million and $0.5 million in the first three months of 2011 and 2010, respectively. Changes in working capital resulted in a
net neutral impact for the first three months of 2011 and 2010.

Investing Activities

Net cash used in investing activities represents purchases of property and equipment.

Financing Activities

Net cash used in financing activities was $0.2
million and $0.7 million for the first three months of 2011 and 2010, 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 any existing balance on the line of credit.

On March 24, 2011, we entered into a
Credit Agreement and a Security Agreement with Wells Fargo Bank, National Association (Wells Fargo), providing for a revolving credit facility (the Line) with a maximum line of credit of $3.0 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 accounts receivable located within the United States, plus (b) 75% of the aggregate amount of eligible accounts
receivable located outside of the United States, plus (c) the lesser of 10% of the aggregate amount of eligible inventory or $500,000.

The Line is evidenced by a Revolving Line of Credit 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 Security
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, mergers and dispositions of assets.

The Credit Agreement also contains certain financial covenants, including a maximum ratio of total liabilities to tangible
net worth, minimum net income on a rolling four-quarter basis, and a minimum debt service coverage ratio.

The outstanding
balance on the Line bears interest monthly at a fluctuating annual rate of 3% above the Daily One Month London Interbank Offered Rate. The Line matures on March 22, 2013.

The Company may use borrowings under the Credit Agreement for general corporate purposes. Any unused portions of the Line will be subject to unused Line fees. Wells Fargo may terminate the Credit
Agreement immediately upon default.

On March 24, 2011, in connection with entering into the Credit Agreement and
Security Agreement described above, we terminated our prior line of credit agreement with Wells Fargo. On the date of the termination, the Company made a final payment to Wells Fargo of all unpaid interest, fees, costs and expenses under the prior
agreement and an additional $30,000 as collateral security for the Companys obligations to Wells Fargo under the prior agreement (the Reserve). Any balance of the Reserve remaining after 45 days from the date of termination will be
returned to the Company. The Company did not incur any early termination penalties in connection with the termination of the prior line of credit agreement.



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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 condensed 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, or when pulled from on-site vendor managed inventory. We have no minimum purchase quantity requirements
with any of our 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 2010 Annual Report on Form 10-K describes the significant accounting policies and methods used by the Company. We do not expect the adoption of any recently issued accounting standards to have a material impact on our consolidated
financial position, results of operations or cash flows. Our critical accounting policies have not changed materially from those disclosed in the Companys 2010 Annual Report on Form 10-K.



|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 first fiscal quarter that has materially affected, or is reasonably likely to materially
affect, the Companys internal control over financial reporting.



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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
|            |  |                                                                                                                                                                                                        
|10.38       |  | Credit Agreement between Pinnacle Data Systems, Inc. and Wells Fargo Bank, National Association, dated March 24, 2011                                                                                   |  | Current Report on Form 8-K filed with the SEC on March 29, 2011                            
|            |  |                                                                                                                                                                                                        
|10.39       |  | Security Agreement between Pinnacle Data Systems, Inc. and Wells Fargo Bank, National Association, dated March 24, 2011                                                                                 |  | Current Report on Form 8-K filed with the SEC on March 29, 2011                            
|            |  |                                                                                                                                                                                                        
|10.40       |  | Revolving Line of Credit Note between Pinnacle Data Systems, Inc. and Wells Fargo Bank, National Association, dated March 24, 2011                                                                      |  | Current Report on Form 8-K filed with the SEC on March 29, 2011                            
|            |  |                                                                                                                                                                                                        
|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 March 31, 2011 |  | 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 March 31, 2011 |  | 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 March 31, 2011 |  | 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 March 31, 2011 |  | 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: May 4, 2011 |  |  |  | /s/    John D. Bair                         
|                  |  |  |  | John D. Bair Chief Executive Officer        
|                  |  | 
|Date: May 4, 2011 |  |  |  | /s/    Nicholas J. Tomashot                 
|                  |  |  |  | Nicholas J. Tomashot Chief
Financial Officer



17