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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549





FORM 10-Q







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

For the quarterly period ended September 30, 2009

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

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 November 12, 2009, the registrant had outstanding 7,825,099 common shares without par value, which is the registrants only
class of common equity.









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PINNACLE DATA SYSTEMS, INC.

FORM 10-Q FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2009

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 |  | 10
|                                                                                                 | 
|ITEM 4    CONTROLS AND
PROCEDURES                                                                |  | 18
|                                                                                                 | 
|PART II  OTHER INFORMATION                                                                      |  | 19
|                                                                                                 | 
|ITEM 6    EXHIBITS                                                                               |  | 19
|                                                                                                 | 
|SIGNATURES                                                                                       |  | 20
|                                                                                                 | 
|CERTIFICATIONS                                                                                   |  |   



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PART I  FINANCIAL INFORMATION



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

PINNACLE DATA SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)



|                                                                                           |  |                   |        |   |                  |   |        |  
|------------------------------------------------------------------------------------------ |  | ----------------- | ------ | - | ---------------- | - | ------ | -
|                                                                                           |  | September 30,2009 |        |   | December 31,2008 |  
|                                                                                           |  | (Unaudited)       |        |   |                  |  
|ASSETS                                                                                     |  |                   |        |   |                  |   |        |  
|                                                                                           |  |                  
|CURRENT ASSETS                                                                             |  |                   |        |   |                  |   |        |  
|Cash                                                                                       |  | $                 | 225    |   |                  | $ | 282    |  
|Accounts receivable, net of allowance for doubtful accounts of $228 and $135, respectively |  |                   | 5,472  |   |                  |   | 11,550 |  
|Inventory, net                                                                             |  |                   | 4,376  |   |                  |   | 5,445  |  
|Prepaid expenses and other current assets                                                  |  |                   | 192    |   |                  |   | 1,793  |  
|                                                                                           |  |                   |        |   |                  |   |        |  
|Total current assets                                                                       |  |                   | 10,265 |   |                  |   | 19,070 |  
|                                                                                           |  |                   |        |   |                  |   |        |  
|                                                                                           |  |                  
|PROPERTY AND EQUIPMENT                                                                     |  |                   |        |   |                  |   |        |  
|Property and equipment, cost                                                               |  |                   | 5,883  |   |                  |   | 5,776  |  
|Less accumulated depreciation and amortization                                             |  |                   | (4,964 | ) |                  |   | (4,717 | )
|                                                                                           |  |                   |        |   |                  |   |        |  
|Total property and equipment, net                                                          |  |                   | 919    |   |                  |   | 1,059  |  
|                                                                                           |  |                   |        |   |                  |   |        |  
|                                                                                           |  |                  
|OTHER ASSETS                                                                               |  |                   |        |   |                  |   |        |  
|Goodwill                                                                                   |  |                   | 838    |   |                  |   | 797    |  
|Other assets                                                                               |  |                   | 387    |   |                  |   | 367    |  
|                                                                                           |  |                   |        |   |                  |   |        |  
|Total other assets                                                                         |  |                   | 1,225  |   |                  |   | 1,164  |  
|                                                                                           |  |                   |        |   |                  |   |        |  
|                                                                                           |  |                  
|TOTAL ASSETS                                                                               |  | $                 | 12,409 |   |                  | $ | 21,293 |  
|                                                                                           |  |                   |        |   |                  |   |        |  
|                                                                                           |  |                  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                       |  |                   |        |   |                  |   |        |  
|                                                                                           |  |                  
|CURRENT LIABILITIES                                                                        |  |                   |        |   |                  |   |        |  
|Line of credit                                                                             |  | $                 | 1,729  |   |                  | $ | 5,408  |  
|Accounts payable                                                                           |  |                   | 2,874  |   |                  |   | 5,156  |  
|Unearned revenue                                                                           |  |                   | 351    |   |                  |   | 138    |  
|Other current liabilities                                                                  |  |                   | 1,200  |   |                  |   | 1,475  |  
|                                                                                           |  |                   |        |   |                  |   |        |  
|Total current liabilities                                                                  |  |                   | 6,154  |   |                  |   | 12,177 |  
|                                                                                           |  |                  
|LONG-TERM LIABILITIES                                                                      |  |                   |        |   |                  |   |        |  
|Accrued other                                                                              |  |                   | 235    |   |                  |   | 221    |  
|                                                                                           |  |                   |        |   |                  |   |        |  
|                                                                                           |  |                  
|TOTAL LIABILITIES                                                                          |  |                   | 6,389  |   |                  |   | 12,398 |  
|                                                                                           |  |                   |        |   |                  |   |        |  
|                                                                                           |  |                  
|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; 7,825 shares issued and outstanding  |  |                   | 5,769  |   |                  |   | 5,769  |  
|Additional paid-in capital                                                                 |  |                   | 1,934  |   |                  |   | 1,797  |  
|Accumulated other comprehensive income (loss)                                              |  |                   | (9     | ) |                  |   | (57    | )
|Retained earnings (deficit)                                                                |  |                   | (1,674 | ) |                  |   | 1,386  |  
|                                                                                           |  |                   |        |   |                  |   |        |  
|Total stockholders equity                                                                 |  |                   | 6,020  |   |                  |   | 8,895  |  
|                                                                                           |  |                   |        |   |                  |   |        |  
|                                                                                           |  |                  
|TOTAL LIABILITIES AND STOCKHOLDERS EQUITY                                                 |  | $                 | 12,409 |   |                  | $ | 21,293 |  
|                                                                                           |  |                   |        |   |                  |   |        |  

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)



|                                                             |  |                                 |        |                                |      |   |        |  |   |        |   |  |   |        |  
|------------------------------------------------------------ |  | ------------------------------- | ------ | ------------------------------ | ---- | - | ------ |  | - | ------ | - |  | - | ------ | -
|                                                             |  | Three MonthsEnded September 30, |        | Nine Months EndedSeptember 30, |     
|                                                             |  | 2009                            |        |                                | 2008 |   | 2009   |  |   | 2008   |  
|Sales                                                        |  | $                               | 7,050  |                                |      | $ | 16,098 |  | $ | 26,975 |   |  | $ | 47,556 |  
|Cost of sales                                                |  |                                 | 5,478  |                                |      |   | 12,871 |  |   | 21,385 |   |  |   | 38,954 |  
|                                                             |  |                                 |        |                                |      |   |        |  |   |        |   |  |   |        |  
|Gross profit                                                 |  |                                 | 1,572  |                                |      |   | 3,227  |  |   | 5,590  |   |  |   | 8,602  |  
|Operating expenses                                           |  |                                 | 2,284  |                                |      |   | 3,122  |  |   | 7,534  |   |  |   | 9,476  |  
|                                                             |  |                                 |        |                                |      |   |        |  |   |        |   |  |   |        |  
|Income (loss) from operations                                |  |                                 | (712   | )                              |      |   | 105    |  |   | (1,944 | ) |  |   | (874   | )
|Other expense                                                |  |                                 |        |                                |      |   |        |  |   |        |   |  |   |        |  
|Interest expense                                             |  |                                 | 40     |                                |      |   | 64     |  |   | 142    |   |  |   | 255    |  
|                                                             |  |                                 |        |                                |      |   |        |  |   |        |   |  |   |        |  
|Income (loss) before income taxes                            |  |                                 | (752   | )                              |      |   | 41     |  |   | (2,086 | ) |  |   | (1,129 | )
|Income tax expense (benefit)                                 |  |                                 | 1,337  |                                |      |   | 30     |  |   | 974    |   |  |   | (432   | )
|                                                             |  |                                 |        |                                |      |   |        |  |   |        |   |  |   |        |  
|Net income (loss)                                            |  | $                               | (2,089 | )                              |      | $ | 11     |  | $ | (3,060 | ) |  | $ | (697   | )
|                                                             |  |                                 |        |                                |      |   |        |  |   |        |   |  |   |        |  
|                                                             |  |                                 |        |                               
|Basic and diluted earnings (loss) per common share           |  | $                               | (0.27  | )                              |      | $ | 0.00   |  | $ | (0.39  | ) |  | $ | (0.09  | )
|                                                             |  |                                 |        |                               
|Basic and diluted weighted average common shares outstanding |  |                                 | 7,825  |                                |      |   | 7,823  |  |   | 7,825  |   |  |   | 7,798  |  

See accompanying notes to condensed consolidated financial statements.



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PINNACLE DATA SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY

(Unaudited)

(in thousands)



|                                  |  |                   |  |                          |       |                                            |   |       |                           |   |     |                          |  |   |        |   |  |   |        |  
|--------------------------------- |  | ----------------- |  | ------------------------ | ----- | ------------------------------------------ | - | ----- | ------------------------- | - | --- | ------------------------ |  | - | ------ | - |  | - | ------ | -
|                                  |  | Common Stock      |  | AdditionalPaid-InCapital |       | AccumulatedOtherComprehensiveIncome (Loss) |   |       | RetainedEarnings(Deficit) |   |     | TotalStockholdersEquity | 
|                                  |  | OutstandingShares |  | Amount                   |       |                                            |   |      
|Balance  December 31, 2007       |  | 7,689             |  | $                        | 5,485 |                                            | $ | 1,676 |                           | $ |    |                          |  | $ | 1,747  |   |  | $ | 8,908  |  
|Stock options exercised           |  | 16                |  |                          | 13    |                                            |   |      |                           |   |    |                          |  |   |       |   |  |   | 13     |  
|Stock issued                      |  | 120               |  |                          | 271   |                                            |   |      |                           |   |    |                          |  |   |       |   |  |   | 271    |  
|Share-based payment expense       |  |                  |  |                          |      |                                            |   | 75    |                           |   |    |                          |  |   |       |   |  |   | 75     |  
|Comprehensive loss, net of taxes: |  |                   |  |                          |       |                                            |   |       |                           |   |     |                          |  |   |        |   |  |   |        |  
|Net loss                          |  |                  |  |                          |      |                                            |   |      |                           |   |    |                          |  |   | (697   | ) |  |   | (697   | )
|Foreign currency exchange gain    |  |                  |  |                          |      |                                            |   |      |                           |   | (53 | )                        |  |   |       |   |  |   | (53    | )
|                                  |  |                   |  |                          |       |                                            |   |       |                           |   |     |                          |  |   |        |   |  |   |        |  
|Total comprehensive loss          |  |                   |  |                          |       |                                            |   |       |                           |   |     |                          |  |   |        |   |  |   | (750   | )
|                                  |  |                   |  |                          |       |                                            |   |       |                           |   |     |                          |  |   |        |   |  |   |        |  
|Balance  September 30, 2008      |  | 7,825             |  | $                        | 5,769 |                                            | $ | 1,751 |                           | $ | (53 | )                        |  | $ | 1,050  |   |  | $ | 8,517  |  
|                                  |  |                   |  |                          |       |                                            |   |       |                           |   |     |                          |  |   |        |   |  |   |        |  
|                                  |  |                   |  |                          |       |                                           
|Balance  December 31, 2008       |  | 7,825             |  | $                        | 5,769 |                                            | $ | 1,797 |                           | $ | (57 | )                        |  | $ | 1,386  |   |  | $ | 8,895  |  
|Share-based payment expense       |  |                  |  |                          |      |                                            |   | 137   |                           |   |    |                          |  |   |       |   |  |   | 137    |  
|Comprehensive loss, net of taxes: |  |                   |  |                          |       |                                            |   |       |                           |   |     |                          |  |   |        |   |  |   |        |  
|Net loss                          |  |                  |  |                          |      |                                            |   |      |                           |   |    |                          |  |   | (3,060 | ) |  |   | (3,060 | )
|Foreign currency exchange gain    |  |                  |  |                          |      |                                            |   |      |                           |   | 48  |                          |  |   |       |   |  |   | 48     |  
|                                  |  |                   |  |                          |       |                                            |   |       |                           |   |     |                          |  |   |        |   |  |   |        |  
|Total comprehensive loss          |  |                   |  |                          |       |                                            |   |       |                           |   |     |                          |  |   |        |   |  |   | (3,012 | )
|                                  |  |                   |  |                          |       |                                            |   |       |                           |   |     |                          |  |   |        |   |  |   |        |  
|Balance  September 30, 2009      |  | 7,825             |  | $                        | 5,769 |                                            | $ | 1,934 |                           | $ | (9  | )                        |  | $ | (1,674 | ) |  | $ | 6,020  |  
|                                  |  |                   |  |                          |       |                                            |   |       |                           |   |     |                          |  |   |        |   |  |   |        |  

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)



|                                                                                         |  |                                |        |   |      |   |        |  
|---------------------------------------------------------------------------------------- |  | ------------------------------ | ------ | - | ---- | - | ------ | -
|                                                                                         |  | Nine Months EndedSeptember 30, |       
|                                                                                         |  | 2009                           |        |   | 2008 |  
|CASH FLOWS FROM OPERATING ACTIVITIES                                                     |  |                                |        |   |      |   |        |  
|Net income (loss)                                                                        |  | $                              | (3,060 | ) |      | $ | (697   | )
|                                                                                         |  |                                |        |   |      |   |        |  
|Adjustments to reconcile net income (loss) to net cash provided by operating activities: |  |                                |        |   |      |   |        |  
|Depreciation and amortization                                                            |  |                                | 423    |   |      |   | 472    |  
|Share-based payment expense                                                              |  |                                | 137    |   |      |   | 75     |  
|Allowance for doubtful accounts                                                          |  |                                | 140    |   |      |   | 48     |  
|Inventory reserves                                                                       |  |                                | 572    |   |      |   | 1,182  |  
|Deferred income taxes valuation allowance                                                |  |                                | 1,611  |   |      |   |       |  
|Provision for deferred income taxes                                                      |  |                                |       |   |      |   | (81    | )
|(Increase) decrease in assets:                                                           |  |                                |        |   |      |   |        |  
|Accounts receivable                                                                      |  |                                | 5,977  |   |      |   | (91    | )
|Inventory                                                                                |  |                                | 507    |   |      |   | 1,016  |  
|Prepaid expenses and other assets                                                        |  |                                | 433    |   |      |   | 1      |  
|Income taxes receivable                                                                  |  |                                | (349   | ) |      |   | (753   | )
|Increase (decrease) in liabilities:                                                      |  |                                |        |   |      |   |        |  
|Accounts payable                                                                         |  |                                | (2,237 | ) |      |   | (132   | )
|Unearned revenue                                                                         |  |                                | 213    |   |      |   | 194    |  
|Other current liabilities                                                                |  |                                | (288   | ) |      |   | (153   | )
|                                                                                         |  |                                |        |   |      |   |        |  
|Total adjustments                                                                        |  |                                | 7,139  |   |      |   | 1,778  |  
|                                                                                         |  |                                |        |   |      |   |        |  
|Net cash provided by operating activities                                                |  |                                | 4,079  |   |      |   | 1,081  |  
|                                                                                         |  |                                |        |   |      |   |        |  
|                                                                                         |  |                               
|CASH FLOWS FROM INVESTING ACTIVITIES                                                     |  |                                |        |   |      |   |        |  
|Purchases of property and equipment                                                      |  |                                | (237   | ) |      |   | (213   | )
|Acquisition, net of cash received                                                        |  |                                |       |   |      |   | (937   | )
|Restricted cash                                                                          |  |                                |       |   |      |   | 1,200  |  
|                                                                                         |  |                                |        |   |      |   |        |  
|Net cash provided by (used in) investing activities                                      |  |                                | (237   | ) |      |   | 50     |  
|                                                                                         |  |                                |        |   |      |   |        |  
|                                                                                         |  |                               
|CASH FLOWS FROM FINANCING ACTIVITIES                                                     |  |                                |        |   |      |   |        |  
|Net change in line of credit                                                             |  |                                | (3,679 | ) |      |   | 3,045  |  
|Payment on short-term note payable                                                       |  |                                |       |   |      |   | (4,000 | )
|Net change in outstanding checks                                                         |  |                                | (73    | ) |      |   | (201   | )
|Other                                                                                    |  |                                | (155   | ) |      |   | 13     |  
|                                                                                         |  |                                |        |   |      |   |        |  
|Net cash used in financing activities                                                    |  |                                | (3,907 | ) |      |   | (1,143 | )
|                                                                                         |  |                                |        |   |      |   |        |  
|                                                                                         |  |                               
|EFFECT OF EXCHANGE RATE ON CASH                                                          |  |                                | 8      |   |      |   | 4      |  
|                                                                                         |  |                                |        |   |      |   |        |  
|                                                                                         |  |                               
|INCREASE (DECREASE) IN CASH                                                              |  |                                | (57    | ) |      |   | (8     | )
|Cash at beginning of period                                                              |  |                                | 282    |   |      |   | 54     |  
|                                                                                         |  |                                |        |   |      |   |        |  
|Cash at end of period                                                                    |  | $                              | 225    |   |      | $ | 46     |  
|                                                                                         |  |                                |        |   |      |   |        |  
|                                                                                         |  |                               
|SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION                                         |  |                                |        |   |      |   |        |  
|Common stock issued for acquisition                                                      |  | $                              |       |   |      | $ | 271    |  
|                                                                                         |  |                                |        |   |      |   |        |  

See accompanying notes to condensed consolidated financial statements.



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PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2009 and 2008

1. Basis of Presentation

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

On February 20, 2008, the Company acquired all of the equity of Aspan B.V., a private limited liability company located in Tiel, the
Netherlands (now known as PDSi B.V., or PDSi Tiel). The acquisition was accounted for under the purchase method of accounting. Accordingly, PDSi Tiels financial position as of December 31, 2008 and results of operations
subsequent to February 16, 2008, the effective date of the transaction, were consolidated with the Companys financial statements. The Companys condensed consolidated financial statements include the accounts of PDSi and PDSi Tiel.
All significant intercompany balances and transactions have been eliminated.

The preparation of financial statements in
conformity with 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.
Certain items in the condensed consolidated financial statements and related notes have been reclassified to conform to the current presentation. The accompanying condensed consolidated financial statements should be read in conjunction with the
audited consolidated financial statements and related notes for the year ended December 31, 2008 included in the Companys 2008 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 2008 Annual Report on Form 10-K. There have been no material changes to these policies since
December 31, 2008.

Inventory

The following table summarizes the Companys inventory as of the dates indicated (net of reserves of $1,904,000 and $2,366,000, respectively, as of September 30, 2009 and December 31,
2008):



|                                |  |                   |       |                  |   |      
|------------------------------- |  | ----------------- | ----- | ---------------- | - | -----
|(in thousands)                  |  | September 30,2009 |       | December 31,2008
|Component parts (raw materials) |  | $                 | 3,886 |                  | $ | 4,696
|Work-in-process                 |  |                   | 286   |                  |   | 577  
|Finished goods                  |  |                   | 204   |                  |   | 172  
|                                |  |                   |       |                  |   |      
|Total inventory                 |  | $                 | 4,376 |                  | $ | 5,445
|                                |  |                   |       |                  |   |      

Goodwill

In connection with the acquisition of PDSi Tiel during 2008, the Company recognized the excess of the purchase price over the fair value of identifiable net assets acquired as goodwill. The Company
assigned the goodwill to a reporting unit in the Service business segment. Goodwill is not amortized, but is evaluated annually for impairment at the reporting unit level. Goodwill of a reporting unit also is tested for impairment on an interim
basis if an event occurs or circumstances change which would more likely than not reduce the fair value of a reporting unit below its carrying amount.

The process of evaluating goodwill for impairment requires several judgments and assumptions to be made to determine the fair value of the reporting units, including the method used to determine fair
value, discount rates, and expected levels of revenues and earnings.



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PINNACLE DATA SYSTEMS, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

Due to the operating losses at the
Company and reporting unit levels for the six months ended June 30, 2009, the Company determined that a triggering event had occurred. Accordingly, the Company performed an interim goodwill impairment test during the second quarter of 2009. The
Company estimated the implied fair value of goodwill using a net present value methodology dependent on significant assumptions related to estimated future discounted cash flows, capitalization rates and tax rates. The estimated future discounted
cash flows used in the Companys model were based on planned growth with an assumed perpetual growth rate. The capitalization rates were based on the Companys current cost of debt and equity capital, and tax rates were maintained at
current levels. Based on the results of the testing, management determined that no impairment had occurred as of the interim test date.

Management determined that no additional interim impairment testing was warranted during the third quarter of 2009 based on profitability at the reporting unit level for the three months ended
September 30, 2009. The Company will perform its annual goodwill impairment testing during the fourth quarter of 2009 based on third quarter 2009 financial information. The Company can provide no assurance that a material impairment charge to
goodwill will not occur in a future period. The Company will continue to monitor events and circumstances in future periods to determine whether additional interim impairment testing is warranted.

3. Recently Issued Accounting Standards

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

4. Line of Credit

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

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

The Line is subject to customary affirmative and negative covenants for credit facilities of this type, including limitations on the Company
with respect to liens, indebtedness, guaranties, investments, distributions, mergers and acquisitions, and dispositions of assets. The Credit Agreement also contains certain financial covenants, including a minimum book net worth, a minimum net
income and maximum capital expenditures. The Company obtained a waiver from Wells Fargo for violation of the minimum book net worth financial covenant as of June 30 and September 30, 2009, and for violation of the minimum net income
financial covenant for the three months ended June 30, 2009 and September 30, 2009. The Line is evidenced by a Revolving Note made by the Company in favor of Wells Fargo and is secured by substantially all of the assets of the Company, as
provided for in the Credit Agreement.

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



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##### Table of Contents

PINNACLE DATA SYSTEMS, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

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

On April 3, 2009, in connection with entering into the Credit Agreement described above, the Company terminated the Amended and Restated Loan Agreement by and between the Company and KeyBank National Association (KeyBank)
dated September 30, 2008 (the Amended and Restated Loan Agreement), and as amended by the First Amendment to Amended and Restated Loan Agreement dated December 24, 2008 (the First Amendment), and the Second
Amendment to Amended and Restated Loan Agreement dated March 26, 2009 (together with the Amended and Restated Loan Agreement and the First Amendment, the Loan Agreement).

The Loan Agreement provided for a demand line credit facility in the principal amount of $5.5 million (the Loan), subject to borrowing base restrictions. The borrowing
base was determined as the sum of: (a) 85% of eligible receivable accounts plus (b) 30% of eligible inventory, but not to exceed $2.5 million. The Loan was evidenced by a Cognovit Promissory Note, and secured by substantially all of the
assets of the Company, as provided for in the Security Agreement entered into between the Company and KeyBank on April 8, 2008.

On the date of the termination, the Company made a final payment of all borrowings outstanding under the Loan Agreement. The Company did not incur any early termination penalties in connection with the termination of the Loan Agreement.

5. Income Taxes

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

The Company can provide no assurance that an increase in or a release of the deferred tax asset valuation allowance will not be required in the future. The Company will continue to
monitor events and circumstances in future periods to determine whether an increase in the valuation allowance is warranted or if the valuation allowance should be released based on sustained future profitability.

6. Earnings (Loss) Per Share

Basic earnings (loss) per share (EPS) represents the amount of earnings (loss) available to each share of common stock outstanding during the reporting period. Diluted EPS represents the amount of earnings (loss) available to each share of
common stock outstanding during the reporting period adjusted for the potential issuance of common shares for stock options, if dilutive. As a result of the Companys net losses for the three-month and nine-month periods ended
September 30, 2009 and the nine-month period ended September 30, 2008, the effect of potential common shares arising from share-based employee compensation plans would have been anti-dilutive and thus were excluded from the computation of
diluted EPS for those periods. In addition, there were no dilutive stock options outstanding during the three months ended September 30, 2008.



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##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

7. Segment Information

The Companys reportable segments are Product and Service. The Product segment includes embedded computing hardware products, ranging
from board-level products to fully integrated systems. The Service segment includes service programs provided to global original equipment manufacturers, including depot repair, warranty management, screening and testing, and remanufacturing. 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 engineering, finance, human resources, quality
systems and executive management. The Company evaluates Product and Service segment performance based on (1) operating results; (2) effectiveness in covering the other administrative expenses of the Company; and (3) contribution to
earnings per share. The Company sells its products and services in the U.S. and internationally and attributes sales based on shipping point.

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



|                              |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|----------------------------- |  | --------------------------- | ------ | - | -------------------------- | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                              |  | Three Months EndedSept. 30, |        |   | Nine Months EndedSept. 30, |  
|(in thousands)                |  | 2009                        |        |   | 2008                       |   |        | 2009 |  |   | 2008   |  
|Sales                         |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Product                       |  | $                           | 4,126  |   |                            | $ | 13,315 |      |  | $ | 19,211 |   |  | $ | 39,117 |  
|Service                       |  |                             | 2,924  |   |                            |   | 2,783  |      |  |   | 7,764  |   |  |   | 8,439  |  
|                              |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Total                         |  | $                           | 7,050  |   |                            | $ | 16,098 |      |  | $ | 26,975 |   |  | $ | 47,556 |  
|                              |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Gross profit                  |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Product                       |  | $                           | 724    |   |                            | $ | 2,562  |      |  | $ | 3,157  |   |  | $ | 6,662  |  
|Service                       |  |                             | 848    |   |                            |   | 665    |      |  |   | 2,433  |   |  |   | 1,940  |  
|                              |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Total                         |  | $                           | 1,572  |   |                            | $ | 3,227  |      |  | $ | 5,590  |   |  | $ | 8,602  |  
|                              |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Income (loss) from operations |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Product                       |  | $                           | 63     |   |                            | $ | 1,577  |      |  | $ | 1,013  |   |  | $ | 3,587  |  
|Service                       |  |                             | 225    |   |                            |   | 263    |      |  |   | 735    |   |  |   | 575    |  
|Other                         |  |                             | (1,000 | ) |                            |   | (1,735 | )    |  |   | (3,692 | ) |  |   | (5,036 | )
|                              |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  
|Total                         |  | $                           | (712   | ) |                            | $ | 105    |      |  | $ | (1,944 | ) |  | $ | (874   | )
|                              |  |                             |        |   |                            |   |        |      |  |   |        |   |  |   |        |  

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



|               |  |                   |        |                  |   |       
|-------------- |  | ----------------- | ------ | ---------------- | - | ------
|(in thousands) |  | September 30,2009 |        | December 31,2008
|Product        |  | $                 | 5,410  |                  | $ | 9,780 
|Service        |  |                   | 5,364  |                  |   | 8,477 
|Other          |  |                   | 1,635  |                  |   | 3,036 
|               |  |                   |        |                  |   |       
|Total          |  | $                 | 12,409 |                  | $ | 21,293
|               |  |                   |        |                  |   |       

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



|               |  |                             |       |                            |   |        |  |      |        |  |   |       
|-------------- |  | --------------------------- | ----- | -------------------------- | - | ------ |  | ---- | ------ |  | - | ------
|               |  | Three MonthsEnded Sept. 30, |       | Nine Months EndedSept. 30,
|(in thousands) |  | 2009                        |       | 2008                       |   | 2009   |  | 2008
|United States  |  | $                           | 6,018 |                            | $ | 14,806 |  | $    | 24,306 |  | $ | 43,853
|International  |  |                             | 1,032 |                            |   | 1,292  |  |      | 2,669  |  |   | 3,703 
|               |  |                             |       |                            |   |        |  |      |        |  |   |       
|Total          |  | $                           | 7,050 |                            | $ | 16,098 |  | $    | 26,975 |  | $ | 47,556
|               |  |                             |       |                            |   |        |  |      |        |  |   |       



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##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

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



|               |  |                   |       |                  |   |      
|-------------- |  | ----------------- | ----- | ---------------- | - | -----
|(in thousands) |  | September 30,2009 |       | December 31,2008
|United States  |  | $                 | 599   |                  | $ | 665  
|International  |  |                   | 1,545 |                  |   | 1,558
|               |  |                   |       |                  |   |      
|Total          |  | $                 | 2,144 |                  | $ | 2,223
|               |  |                   |       |                  |   |      

International long-lived assets include goodwill of $838,000 and $797,000 as of
September 30, 2009 and December 31, 2008, respectively.

8. Subsequent Events

The Company evaluated subsequent events through November 16, 2009, the date these condensed consolidated financial statements were filed
with the SEC, and determined that none required disclosure.



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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 or the Company) achieving its financial growth and profitability goals, or its sales, earnings and profitability expectations for the fiscal year ending
December 31, 2009. 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 our 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 and nine months ended September 30, 2009 and 2008. This discussion should be read in conjunction with the Companys audited consolidated financial statements and related notes contained in its 2008
Annual Report on Form 10-K.

Executive Overview

PDSi is a global provider of services and products for original equipment manufacturers (OEMs) of computer hardware products and products that contain computer hardware. We serve customers in
the telecommunications, imaging, defense/aerospace, medical, semiconductor, industrial automation and information technology markets. We provide a variety of engineering, manufacturing and reverse logistics services for our global OEM customers,
including custom product design, system integration, repair programs, warranty management and specialized production capabilities. With service centers in the United States, Europe and Asia, PDSi ensures seamless support for the Companys
solutions all around the world. In addition, our product capabilities range from board-level designs to globally certified, fully integrated systems. Our specialties include long-life computer products and unique, customer-centric solutions. The
common shares of PDSi are traded on NYSE Amex under the stock symbol PNS.



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##### Table of Contents

During the first nine months of 2009, ongoing U.S. and global economic conditions continued
to negatively affect our existing multi-national OEM customers, and therefore, our business and operating results. As a result, we expect continued lower sales during the fourth quarter of 2009 compared to 2008, and we have continued to adjust our
cost structure accordingly. We expect to mitigate the impact of lower Product segment sales by focusing on our core Service segment business and current Product segment offerings, reducing our investment in new embedded product development and
sales, and flattening our organization structure to reduce overhead costs. However, we are fully supporting our current products and customer programs, as well as maintaining the ability to upgrade those products for their current use. We will focus
our sales and marketing efforts in the Service segment and on specialized product integration programs where our highly valued engineering and operational expertise give us distinct competitive advantages. Nevertheless, difficult economic conditions
may continue to materially adversely affect the Companys results of operations, financial condition and cash flows.

The
Company reported a net loss of $2,089,000, or $0.27 per diluted share, during the quarter ended September 30, 2009 compared to net income of $11,000, or $0.00 per diluted share, for the prior year quarter. The Company reported a net loss of
$3,060,000, or $0.39 per diluted share, during the nine months ended September 30, 2009 versus a net loss of $697,000, or $0.09 per diluted share, for the prior year period. The current year results include the impact of a non-cash deferred tax
asset valuation allowance of approximately $1.6 million, or $0.21 per diluted share, recorded during the third quarter of 2009. See below for further discussion of consolidated and reportable segment results of operations for the three-month and
nine-month periods ended September 30, 2009 and 2008.

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

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

Consistent with the
Companys goals of developing new business and providing more cost effective in-region services, we successfully completed the acquisition of all of the equity of Aspan B.V., a private limited liability company located in Tiel, the Netherlands
(now known as PDSi B.V., or PDSi Tiel), during the first quarter of 2008. See Note 4 and Note 10 to the consolidated financial statements included in the Companys 2008 Annual Report on Form 10-K for additional information related
to the acquisition of PDSi Tiel and the related private equity financing, respectively.



11



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##### Table of Contents

Results of Operations

Consolidated Operations

Third Quarter  2009 Compared to 2008

The following table summarizes the Companys consolidated results of operations for the periods indicated:



|                                  |  |                                  |        |   |           |       |   |      |   |           |  |       |         |  |     |  
|--------------------------------- |  | -------------------------------- | ------ | - | --------- | ----- | - | ---- | - | --------- |  | ----- | ------- |  | --- | -
|                                  |  | Three Months Ended September 30, |        |   |           |      
|                                  |  | 2009                             |        |   | % ofSales |       |   | 2008 |   | % ofSales |  |       | %Change | 
|Sales                             |  | $                                | 7,050  |   |           | 100.0 | % |      | $ | 16,098    |  | 100.0 | %       |  | -56 | %
|Cost of sales                     |  |                                  | 5,478  |   |           | 77.7  | % |      |   | 12,871    |  | 80.0  | %       |  | -57 | %
|                                  |  |                                  |        |   |           |       |   |      |   |           |  |       |         |  |     |  
|Gross profit                      |  |                                  | 1,572  |   |           | 22.3  | % |      |   | 3,227     |  | 20.0  | %       |  | -51 | %
|Operating expenses                |  |                                  | 2,284  |   |           | 32.4  | % |      |   | 3,122     |  | 19.4  | %       |  | -27 | %
|                                  |  |                                  |        |   |           |       |   |      |   |           |  |       |         |  |     |  
|Income (loss) from operations     |  |                                  | (712   | ) |           | -10.1 | % |      |   | 105       |  | 0.7   | %       |  | NM  |  
|Other expense                     |  |                                  |        |   |           |       |   |      |   |           |  |       |         |  |     |  
|Interest expense                  |  |                                  | 40     |   |           | 0.6   | % |      |   | 64        |  | 0.4   | %       |  | -38 | %
|                                  |  |                                  |        |   |           |       |   |      |   |           |  |       |         |  |     |  
|Income (loss) before income taxes |  |                                  | (752   | ) |           | -10.7 | % |      |   | 41        |  | 0.3   | %       |  | NM  |  
|Income tax expense (benefit)      |  |                                  | 1,337  |   |           | 19.0  | % |      |   | 30        |  | 0.2   | %       |  | NM  |  
|                                  |  |                                  |        |   |           |       |   |      |   |           |  |       |         |  |     |  
|Net income (loss)                 |  | $                                | (2,089 | ) |           | -29.6 | % |      | $ | 11        |  | 0.1   | %       |  | NM  |  
|                                  |  |                                  |        |   |           |       |   |      |   |           |  |       |         |  |     |  

The Company recorded a net loss for the quarter ended September 30, 2009
compared to net income in the prior year quarter. The loss from operations was driven by a 51% decline in gross profit primarily due to lower Product segment sales. In addition, the current year quarter was impacted by the aforementioned non-cash
deferred tax valuation allowance of approximately $1.6 million recorded as income tax expense in the current year. These factors partially were offset by a 27% decrease in operating expenses reflecting cost reduction actions taken over the last
several quarters, a 28% increase in Service segment gross profit driven by higher sales in the U.S, and lower interest expense.

For the third quarter of 2009, the Company had one customer that generated $2.6 million, or 37%, of total sales. Of the revenues from this customer, 78% and 22% were included in Product and Service segment sales, respectively. For the third
quarter of 2008, the Company had two customers that generated $7.3 million and $2.0 million, or 45% and 13%, respectively, of total sales. Of the revenues from these customers, 92% and 8% were included in Product and Service segment sales,
respectively.



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##### Table of Contents

Year-to-Date  2009 Compared to 2008

The following table summarizes the Companys consolidated results of operations for the periods indicated:



|                                  |  |                                 |        |   |           |       |   |      |   |        |           |  |       |         |  |     |  
|--------------------------------- |  | ------------------------------- | ------ | - | --------- | ----- | - | ---- | - | ------ | --------- |  | ----- | ------- |  | --- | -
|                                  |  | Nine Months Ended September 30, |        |   |           |      
|                                  |  | 2009                            |        |   | % ofSales |       |   | 2008 |   |        | % ofSales |  |       | %Change | 
|Sales                             |  | $                               | 26,975 |   |           | 100.0 | % |      | $ | 47,556 |           |  | 100.0 | %       |  | -43 | %
|Cost of sales                     |  |                                 | 21,385 |   |           | 79.3  | % |      |   | 38,954 |           |  | 81.9  | %       |  | -45 | %
|                                  |  |                                 |        |   |           |       |   |      |   |        |           |  |       |         |  |     |  
|Gross profit                      |  |                                 | 5,590  |   |           | 20.7  | % |      |   | 8,602  |           |  | 18.1  | %       |  | -35 | %
|Operating expenses                |  |                                 | 7,534  |   |           | 27.9  | % |      |   | 9,476  |           |  | 19.9  | %       |  | -20 | %
|                                  |  |                                 |        |   |           |       |   |      |   |        |           |  |       |         |  |     |  
|Income (loss) from operations     |  |                                 | (1,944 | ) |           | -7.2  | % |      |   | (874   | )         |  | -1.8  | %       |  | NM  |  
|Other expense                     |  |                                 |        |   |           |       |   |      |   |        |           |  |       |         |  |     |  
|Interest expense                  |  |                                 | 142    |   |           | 0.5   | % |      |   | 255    |           |  | 0.5   | %       |  | -44 | %
|                                  |  |                                 |        |   |           |       |   |      |   |        |           |  |       |         |  |     |  
|Income (loss) before income taxes |  |                                 | (2,086 | ) |           | -7.7  | % |      |   | (1,129 | )         |  | -2.4  | %       |  | NM  |  
|Income tax expense (benefit)      |  |                                 | 974    |   |           | 3.6   | % |      |   | (432   | )         |  | -0.9  | %       |  | NM  |  
|                                  |  |                                 |        |   |           |       |   |      |   |        |           |  |       |         |  |     |  
|Net income (loss)                 |  | $                               | (3,060 | ) |           | -11.3 | % |      | $ | (697   | )         |  | -1.5  | %       |  | NM  |  
|                                  |  |                                 |        |   |           |       |   |      |   |        |           |  |       |         |  |     |  

The higher net loss for the nine months ended September 30, 2009 compared to the
prior year period was driven by a 53% decline in Product segment gross profit due to a comparable decrease in sales. In addition, the current year includes the impact of the aforementioned non-cash deferred tax valuation allowance of approximately
$1.6 million recorded as income tax expense during the third quarter of 2009. The prior year period also includes the impact of a one-time non-cash inventory valuation adjustment totaling $720,000 pre-tax in the second quarter of 2008. Reduced
operating expenses, a 25% increase in Service segment gross profit and lower interest expense partially offset the decline in Product segment performance during the first nine months of 2009.

For the first nine months of 2009, the Company had two customers that generated $9.1 million and $4.3 million, or 34% and 16%, respectively, of total sales. Of the revenues from
these customers, 86% and 14% were included in Product and Service segment sales, respectively. For the first nine months of 2008, the Company had two customers that generated $20.4 million and $7.0 million, or 43% and 15%, respectively, of total
sales. Of the revenues from these customers, 90% and 10% were included in Product and Service segment sales, respectively.

Segment
Operations

Product

Third Quarter  2009 Compared to 2008

The following table summarizes the Companys gross profit for the
Product segment for the periods indicated:



|              |  |                                  |       |           |       |   |      |   |           |  |       |         |  |     |  
|------------- |  | -------------------------------- | ----- | --------- | ----- | - | ---- | - | --------- |  | ----- | ------- |  | --- | -
|              |  | Three Months Ended September 30, |       |           |       |  
|              |  | 2009                             |       | % ofSales |       |   | 2008 |   | % ofSales |  |       | %Change | 
|Sales         |  | $                                | 4,126 |           | 100.0 | % |      | $ | 13,315    |  | 100.0 | %       |  | -69 | %
|Cost of sales |  |                                  | 3,402 |           | 82.5  | % |      |   | 10,753    |  | 80.8  | %       |  | -68 | %
|              |  |                                  |       |           |       |   |      |   |           |  |       |         |  |     |  
|Gross profit  |  | $                                | 724   |           | 17.5  | % |      | $ | 2,562     |  | 19.2  | %       |  | -72 | %
|              |  |                                  |       |           |       |   |      |   |           |  |       |         |  |     |  

Product segment gross profit decreased primarily due to lower sales driven by
softening demand from existing large accounts in the imaging and telecommunications industries. This factor, combined with our reduced focus on lower margin business, accounted for approximately $4.8 million of the decline in Product sales. In
addition, gross profit as a percentage of sales declined due to lower fixed cost coverage despite an improved mix of business toward higher margin products, reductions in overhead expenses in response to reduced sales levels, and margin improvements
on existing products.



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##### Table of Contents

Year-to-Date  2009 Compared to 2008

The following table summarizes the Companys gross profit for the Product segment for the periods indicated:



|              |  |                                 |        |           |       |   |      |   |           |  |       |         |  |     |  
|------------- |  | ------------------------------- | ------ | --------- | ----- | - | ---- | - | --------- |  | ----- | ------- |  | --- | -
|              |  | Nine Months Ended September 30, |        |           |       |  
|              |  | 2009                            |        | % ofSales |       |   | 2008 |   | % ofSales |  |       | %Change | 
|Sales         |  | $                               | 19,211 |           | 100.0 | % |      | $ | 39,117    |  | 100.0 | %       |  | -51 | %
|Cost of sales |  |                                 | 16,054 |           | 83.6  | % |      |   | 32,455    |  | 83.0  | %       |  | -51 | %
|              |  |                                 |        |           |       |   |      |   |           |  |       |         |  |     |  
|Gross profit  |  | $                               | 3,157  |           | 16.4  | % |      | $ | 6,662     |  | 17.0  | %       |  | -53 | %
|              |  |                                 |        |           |       |   |      |   |           |  |       |         |  |     |  

Product segment gross profit declined primarily due to lower sales attributable to
softening demand from existing large accounts in the imaging and telecommunications industries. This factor, combined with our reduced focus on lower margin business, accounted for approximately $14.0 million of the decline in Product sales. Lower
demand in the telecommunications sector further contributed to the shortfall. The prior year period also includes the impact of the inventory valuation adjustment in the second quarter of 2008 described previously. Excluding this adjustment, gross
profit as a percentage of sales declined to 16% in 2009 from an adjusted 19% in 2008, reflecting the timing of overhead cost reductions in the current year in response to lower overall sales levels. In addition, a favorable product mix in the first
quarter of 2008 included a high-margin end-of-life sale to a large OEM.

Service

Third Quarter  2009 Compared to 2008

The following table summarizes the Companys gross profit for the Service segment for the periods indicated:



|              |  |                                  |       |           |       |   |      |   |           |  |       |         |  |    |  
|------------- |  | -------------------------------- | ----- | --------- | ----- | - | ---- | - | --------- |  | ----- | ------- |  | -- | -
|              |  | Three Months Ended September 30, |       |           |       |  
|              |  | 2009                             |       | % ofSales |       |   | 2008 |   | % ofSales |  |       | %Change | 
|Sales         |  | $                                | 2,924 |           | 100.0 | % |      | $ | 2,783     |  | 100.0 | %       |  | 5  | %
|Cost of sales |  |                                  | 2,076 |           | 71.0  | % |      |   | 2,118     |  | 76.1  | %       |  | -2 | %
|              |  |                                  |       |           |       |   |      |   |           |  |       |         |  |    |  
|Gross profit  |  | $                                | 848   |           | 29.0  | % |      | $ | 665       |  | 23.9  | %       |  | 28 | %
|              |  |                                  |       |           |       |   |      |   |           |  |       |         |  |    |  

Higher Service segment gross profit primarily was driven by the increase in overall
sales. In addition, ongoing operational efficiency gains, our continued shift toward higher margin sales, and improved margins on existing business contributed to the improvement in gross profit as a percentage of sales.

Year-to-Date  2009 Compared to 2008

The following table summarizes the Companys gross profit for the Service segment for the periods indicated:



|              |  |                                 |       |           |       |   |      |   |           |  |       |         |  |     |  
|------------- |  | ------------------------------- | ----- | --------- | ----- | - | ---- | - | --------- |  | ----- | ------- |  | --- | -
|              |  | Nine Months Ended September 30, |       |           |       |  
|              |  | 2009                            |       | % ofSales |       |   | 2008 |   | % ofSales |  |       | %Change | 
|Sales         |  | $                               | 7,764 |           | 100.0 | % |      | $ | 8,439     |  | 100.0 | %       |  | -8  | %
|Cost of sales |  |                                 | 5,331 |           | 68.7  | % |      |   | 6,499     |  | 77.0  | %       |  | -18 | %
|              |  |                                 |       |           |       |   |      |   |           |  |       |         |  |     |  
|Gross profit  |  | $                               | 2,433 |           | 31.3  | % |      | $ | 1,940     |  | 23.0  | %       |  | 25  | %
|              |  |                                 |       |           |       |   |      |   |           |  |       |         |  |     |  

The increase in Service segment gross profit primarily was due to ongoing
improvements in the operational efficiency of this segment, combined with our continued shift toward higher margin sales and improved margins on existing business. Lower Service sales were driven by customers working off service spares inventories
in the first half of 2009 in response to slower global economic activity, partially offset by the 5% year-over-year increase in sales in the third quarter of 2009.



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Liquidity and Capital Resources

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

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



|                                                                              |  |                   |       |   |                  |   |        |  
|----------------------------------------------------------------------------- |  | ----------------- | ----- | - | ---------------- | - | ------ | -
|(in thousands)                                                                |  | September 30,2009 |       |   | December 31,2008 |  
|Line of credit                                                                |  | $                 | 1,729 |   |                  | $ | 5,408  |  
|                                                                              |  |                   |       |   |                  |   |        |  
|                                                                              |  |                  
|Stockholders equity, excluding accumulated other comprehensive income (loss) |  |                   | 6,029 |   |                  |   | 8,952  |  
|Accumulated other comprehensive income (loss)                                 |  |                   | (9    | ) |                  |   | (57    | )
|                                                                              |  |                   |       |   |                  |   |        |  
|Total stockholders equity                                                    |  |                   | 6,020 |   |                  |   | 8,895  |  
|                                                                              |  |                   |       |   |                  |   |        |  
|Total capital                                                                 |  | $                 | 7,749 |   |                  | $ | 14,303 |  
|                                                                              |  |                   |       |   |                  |   |        |  

Based on the Companys historical cash flow, current financial results and
unused 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 tables summarize the Companys condensed consolidated cash flows for the nine months ended September 30:



|                                                    |  |      |        |   |      |   |        |  
|--------------------------------------------------- |  | ---- | ------ | - | ---- | - | ------ | -
|(in thousands)                                      |  | 2009 |        |   | 2008 |  
|Net cash provided by operating activities           |  | $    | 4,079  |   |      | $ | 1,081  |  
|Net cash provided by (used in) investing activities |  |      | (237   | ) |      |   | 50     |  
|Net cash used in financing activities               |  |      | (3,907 | ) |      |   | (1,143 | )
|Effect of exchange rate on cash                     |  |      | 8      |   |      |   | 4      |  
|                                                    |  |      |        |   |      |   |        |  
|Increase (decrease) in cash                         |  |      | (57    | ) |      |   | (8     | )
|Cash at beginning of period                         |  |      | 282    |   |      |   | 54     |  
|                                                    |  |      |        |   |      |   |        |  
|Cash at end of period                               |  | $    | 225    |   |      | $ | 46     |  
|                                                    |  |      |        |   |      |   |        |  

Operating Activities

Net cash provided by operating activities was $4.1 million for the first nine months of 2009 compared to $1.1 million for the comparable period of 2008. Net income (loss) adjusted
for the effects of non-cash items, which primarily include provision for deferred income taxes, depreciation expense and inventory reserves, totaled ($0.2) million and $1.0 million in the first nine months of 2009 and 2008, respectively. Changes in
working capital provided net cash of $4.3 million for the first nine months of 2009 compared to $0.1 million for the comparable period of 2008. Lower accounts receivable, inventory and accounts payable in 2009 generally reflect declining sales
volumes and overall business activity compared to the prior year period.

Investing Activities

Net cash used in investing activities was $0.2 million for the first nine months of 2009 compared to net cash provided by investing
activities of $0.1 million for the comparable period of 2008. The Company used $1.2 million in proceeds from a private equity transaction to acquire PDSi Tiel in February 2008. The private equity funds were placed in escrow in December 2007 and
classified as restricted cash. During the first quarter of 2008 the restricted cash was released, and $0.9 million was paid to acquire PDSi Tiel.

Financing Activities

Net cash used in financing activities was $3.9 million for the first nine months
of 2009 compared to $1.1 million for the comparable period of 2008. Financing activity in the current year period primarily related to net repayments on the Companys lines of credit. In the prior year period, the net $1.1 million in cash used
in financing activities included the Companys repayment of a $4.0 million short-term note and $3.0 million in net borrowings on its line of credit to support the Companys working capital requirements.



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##### Table of Contents

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

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

The Line is subject to customary affirmative and negative covenants for credit facilities of this type, including limitations on the Company with respect to liens, indebtedness, guaranties, investments,
distributions, mergers and acquisitions, and dispositions of assets. The Credit Agreement also contains certain financial covenants, including a minimum book net worth, a minimum net income and maximum capital expenditures. The Company obtained a
waiver from Wells Fargo for violation of the minimum book net worth financial covenant as of June 30 and September 30, 2009, and for violation of the minimum net income financial covenant for the three months ended June 30 and
September 30, 2009. The Line is evidenced by a Revolving Note made by the Company in favor of Wells Fargo and is secured by substantially all of the assets of the Company, as provided for in the Credit Agreement.

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

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

On
April 3, 2009, in connection with entering into the Credit Agreement described above, the Company terminated the Amended and Restated Loan Agreement by and between the Company and KeyBank National Association (KeyBank) dated
September 30, 2008 (the Amended and Restated Loan Agreement), and as amended by the First Amendment to Amended and Restated Loan Agreement dated December 24, 2008 (the First Amendment), and the Second Amendment to
Amended and Restated Loan Agreement dated March 26, 2009 (together with the Amended and Restated Loan Agreement and the First Amendment, the Loan Agreement).

The Loan Agreement provided for a demand line credit facility in the principal amount of $5.5 million (the Loan), subject to borrowing base restrictions. The borrowing
base was determined as the sum of: (a) 85% of eligible receivable accounts plus (b) 30% of eligible inventory, but not to exceed $2.5 million. The Loan was evidenced by a Cognovit Promissory Note, and secured by substantially all of the
assets of the Company, as provided for in the Security Agreement entered into between the Company and KeyBank on April 8, 2008.

On the date of the termination, the Company made a final payment of all borrowings outstanding under the Loan Agreement. The Company did not incur any early termination penalties in connection with the termination of the Loan Agreement.

Off-Balance Sheet Arrangements

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



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##### Table of Contents

Critical Accounting Policies and Recently Issued Accounting Standards

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 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. 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 2008 Annual Report on Form 10-K
describes the significant accounting policies and methods used by the Company. See Part I  Financial Information, Item 1  Condensed Consolidated Financial Statements, Note 3  Recently Issued Accounting Standards for a
summary of recently issued accounting standards. The Companys critical accounting policies have not changed materially from those disclosed in the Companys 2008 Annual Report on Form 10-K. However, disclosed below are the results of the
Companys interim goodwill impairment test performed as of June 30, 2009.

Goodwill

In connection with the acquisition of PDSi Tiel during 2008, the Company recognized the excess of the purchase price over the fair value of
identifiable net assets acquired as goodwill. The Company assigned the goodwill to a reporting unit in the Service business segment. Goodwill is not amortized, but is evaluated annually for impairment at the reporting unit level. Goodwill of a
reporting unit also is tested for impairment on an interim basis if an event occurs or circumstances change which would more likely than not reduce the fair value of a reporting unit below its carrying amount.

The process of evaluating goodwill for impairment requires several judgments and assumptions to be made to determine the fair value of the
reporting units, including the method used to determine fair value, discount rates, and expected levels of revenues and earnings.

Due to the operating losses at the Company and reporting unit levels for the six months ended June 30, 2009, the Company determined that a triggering event had occurred. Accordingly, the Company performed an interim goodwill impairment
test during the second quarter of 2009. The Company estimated the implied fair value of goodwill using a net present value methodology dependent on significant assumptions related to estimated future discounted cash flows, capitalization rates and
tax rates. The estimated future discounted cash flows used in the Companys model were based on planned growth with an assumed perpetual growth rate. The capitalization rates were based on the Companys current cost of debt and equity
capital, and tax rates were maintained at current levels. Based on the results of the testing, management determined that no impairment had occurred as of the interim test date.

Management determined that no additional interim impairment testing was warranted during the third quarter of 2009 based on profitability at the reporting unit level for the three
months ended September 30, 2009. The Company will perform its annual goodwill impairment testing during the fourth quarter of 2009 based on third quarter 2009 financial information. The Company can provide no assurance that a material
impairment charge to goodwill will not occur in a future period. The Company will continue to monitor events and circumstances in future periods to determine whether additional interim impairment testing is warranted.



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##### Table of Contents

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

Evaluation of
Disclosure Controls and Procedures

The Companys management, with the participation of the Chief Executive Officer
and Chief Financial Officer, have evaluated the effectiveness of the Companys disclosure controls and procedures (as defined in Rules 13a-15(e) and 15d-15(e) of the Securities Exchange Act of 1934) as of the end of the period covered by this
quarterly report (the Evaluation Date). The disclosure controls and procedures are to ensure that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of 1934, as
amended, is recorded, processed, summarized and reported within the time periods specified by the SECs rules and forms, and to ensure that information required to be disclosed by the Company in the reports it files or submits under the
Securities Exchange Act of 1934 is accumulated and communicated to the Companys management, including the Chief Executive Officer and Chief Financial Officer, or persons performing similar functions, as appropriate, to allow timely decisions
regarding required disclosure. Based upon this evaluation, the Chief Executive Officer and Chief Financial Officer have concluded that, as of the Evaluation Date, the disclosure controls and procedures were effective.

Changes in Internal Control Over Financial Reporting

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



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##### Table of Contents

PART II  OTHER INFORMATION



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



|            |  |                                                                                                                                                                                                             |  |                                                                                           
|----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | ------------------------------------------------------------------------------------------
|Exhibit No. |  | Description of Exhibit                                                                                                                                                                                      |  | If incorporated by reference, document with which Exhibit waspreviously filed with the
SEC
|4           |  | Instruments defining the rights of security holders, including indentures                                                                                                                                   |  | Registration Statement on Form 10-SB filed with the SEC on December 13, 1999              
|            |  |                                                                                                                                                                                                            
|10.1        |  | Credit and Security Agreement between Pinnacle Data Systems, Inc. and Wells Fargo Bank, National Association dated April 3, 2009                                                                            |  | Current Report on Form 8-K filed with the SEC on April 9, 2009                            
|            |  |                                                                                                                                                                                                            
|10.2        |  | Revolving Note between Pinnacle Data Systems, Inc. and Wells Fargo Bank, National Association dated April 3, 2009                                                                                           |  | Current Report on Form 8-K filed with the SEC on April 9, 2009                            
|            |  |                                                                                                                                                                                                            
|31.1        |  | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Quarterly Report on Form 10-Q of Pinnacle Data Systems,
Inc. for the quarter ended September 30, 2009 |  | Contained herein                                                                          
|            |  |                                                                                                                                                                                                            
|31.2        |  | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Quarterly Report on Form 10-Q of Pinnacle Data Systems,
Inc. for the quarter ended September 30, 2009 |  | Contained herein                                                                          
|            |  |                                                                                                                                                                                                            
|32.1        |  | Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 of Quarterly Report on Form 10-Q of Pinnacle Data Systems,
Inc. for the quarter ended September 30, 2009 |  | Contained herein                                                                          
|            |  |                                                                                                                                                                                                            
|32.2        |  | Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 of Quarterly Report on Form 10-Q of Pinnacle Data Systems,
Inc. for the quarter ended September 30, 2009 |  | Contained herein                                                                          



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##### Table of Contents

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: November 16, 2009 |  |  |  | /s/    John D. Bair                               
|                        |  |  |  | John D. Bair President and Chief Executive Officer
|                        |  | 
|Date: November 16, 2009 |  |  |  | /s/    Nicholas J. Tomashot                       
|                        |  |  |  | Nicholas J. Tomashot Chief
Financial Officer      



20