##### Table of Contents

---

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



---



FORM 10-QSB



---



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



For the quarterly period ended June 30, 2005



| ̈ | TRANSITION REPORT UNDER SECTION 13 OR 15(d) OF THE EXCHANGE ACT
|- | ---------------------------------------------------------------



For the transition period from
 to



Commission file number: 1-16103



---



PINNACLE DATA SYSTEMS, INC.

(Exact name of small business issuer as specified in its charter)



---



|                                                               |  |                                  
|-------------------------------------------------------------- |  | ---------------------------------
|Ohio                                                           |  | 31-1263732                       
|(State or other jurisdiction of incorporation or organization) |  | (IRS Employer Identification No.)



6600 Port Road,
Groveport, Ohio 43125

(Address of principal executive offices)



(614) 748-1150

(Issuers Telephone Number)



---



Check whether the issuer (1) filed all reports required to be filed by Section 13 or 15(d) of the Exchange Act during the past 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 ̈



APPLICABLE ONLY TO CORPORATE ISSUERS



State the number of shares outstanding of each of the issuers classes of common equity, as of the latest practicable date 5,906,056
common shares, without par value, as of July 20, 2005.



Transitional Small
Business Disclosure Format (Check one):    Yes ̈No  x



---



---

##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

INDEX



|               |  |                                                                         |  |         
|-------------- |  | ----------------------------------------------------------------------- |  | --------
|               |  |                                                                         |  | Page No.
|PART I         |  | FINANCIAL INFORMATION                                                   |  | 3       
|               |  |                                                                        
|Item 1.        |  | Financial Statements                                                    |  | 3       
|               |  |                                                                        
|               |  | Balance Sheets June 30, 2005 and December 31, 2004                      |  | 3-4     
|               |  |                                                                        
|               |  | Statements of Operations Quarters ended June 30, 2005 and June 26, 2004 |  | 5       
|               |  |                                                                        
|               |  | Statements of Cash Flows Quarters ended June 30, 2005 and June 26, 2004 |  | 6-7     
|               |  |                                                                        
|               |  | Notes to Financial Statements                                           |  | 8-14    
|               |  |                                                                        
|Item 2.        |  | Managements Discussion and Analysis or Plan of Operation               |  | 14-21   
|               |  |                                                                        
|Item 3.        |  | Controls and Procedures                                                 |  | 22      
|               |  |                                                                        
|PART II        |  | OTHER INFORMATION                                                       |  | 23      
|               |  |                                                                        
|Item 4.        |  | Submission of matters to a vote of security holders                     |  | 23      
|               |  |                                                                        
|Item 6.        |  | Exhibits.                                                               |  | 24-25   
|               | 
|SIGNATURES     |  | 26                                                                     
|               | 
|CERTIFICATIONS |  | 27-30                                                                  



2



---

##### Table of Contents

PART 1 FINANCIAL INFORMATION

Item 1. Financial Statements



PINNACLE DATA SYSTEMS, INC.

(DBA PDSi)



BALANCE SHEETS



|                                                                                                 |  |               |            |                   |   |           
|------------------------------------------------------------------------------------------------ |  | ------------- | ---------- | ----------------- | - | ----------
|                                                                                                 |  | June 30, 2005 |            | December 31, 2004
|                                                                                                 |  | (Unaudited)   |            |                  
|ASSETS                                                                                           |  |               |            |                   |   |           
|                                                                                                 |  |              
|CURRENT ASSETS                                                                                   |  |               |            |                   |   |           
|Cash                                                                                             |  | $             | 15,926     |                   | $ | 15,068    
|Accounts receivable, net of allowance for doubtful accounts of $30,000 and $20,000, respectively |  |               | 4,728,894  |                   |   | 4,398,251 
|Inventory                                                                                        |  |               | 5,606,623  |                   |   | 4,080,202 
|Other prepaid expenses                                                                           |  |               | 185,269    |                   |   | 239,720   
|Refundable income taxes                                                                          |  |               | 266,597    |                   |   | 171,248   
|Deferred income taxes                                                                            |  |               | 477,000    |                   |   | 477,000   
|                                                                                                 |  |               |            |                   |   |           
|                                                                                                 |  |               | 11,280,309 |                   |   | 9,381,489 
|                                                                                                 |  |               |            |                   |   |           
|PROPERTY AND EQUIPMENT                                                                           |  |               |            |                   |   |           
|Leasehold improvements                                                                           |  |               | 325,187    |                   |   | 309,920   
|Furniture and fixtures                                                                           |  |               | 389,743    |                   |   | 382,935   
|Computer equipment and related software                                                          |  |               | 2,648,388  |                   |   | 2,481,919 
|Shop equipment                                                                                   |  |               | 585,694    |                   |   | 568,223   
|                                                                                                 |  |               |            |                   |   |           
|                                                                                                 |  |               | 3,949,012  |                   |   | 3,742,997 
|Less accumulated depreciation and amortization                                                   |  |               | 3,017,108  |                   |   | 2,772,203 
|                                                                                                 |  |               |            |                   |   |           
|                                                                                                 |  |               | 931,904    |                   |   | 970,794   
|                                                                                                 |  |               |            |                   |   |           
|OTHER ASSETS                                                                                     |  |               | 23,896     |                   |   | 22,566    
|                                                                                                 |  |               |            |                   |   |           
|                                                                                                 |  | $             | 12,236,109 |                   | $ | 10,374,849
|                                                                                                 |  |               |            |                   |   |           



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



3



---

##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

(DBA PDSi)



BALANCE SHEETS

|                                                                                                                              |  |               |            |                   |   |           
|----------------------------------------------------------------------------------------------------------------------------- |  | ------------- | ---------- | ----------------- | - | ----------
|                                                                                                                              |  | June 30, 2005 |            | December 31, 2004
|                                                                                                                              |  | (Unaudited)   |            |                  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                          |  |               |            |                   |   |           
|                                                                                                                              |  |              
|CURRENT LIABILITIES                                                                                                           |  |               |            |                   |   |           
|Line of credit and short term note                                                                                            |  | $             | 3,236,254  |                   | $ | 2,525,020 
|Accounts payable                                                                                                              |  |               | 2,410,604  |                   |   | 2,176,746 
|Accrued expenses:                                                                                                             |  |               |            |                   |   |           
|Wages, payroll taxes and benefits                                                                                             |  |               | 420,142    |                   |   | 295,681   
|Other                                                                                                                         |  |               | 265,087    |                   |   | 207,398   
|Unearned revenue                                                                                                              |  |               | 74,185     |                   |   | 13,822    
|                                                                                                                              |  |               |            |                   |   |           
|                                                                                                                              |  |               | 6,406,272  |                   |   | 5,218,667 
|                                                                                                                              |  |               |            |                   |   |           
|LONG-TERM LIABILITIES                                                                                                         |  |               |            |                   |   |           
|Deferred income taxes                                                                                                         |  |               | 101,000    |                   |   | 101,000   
|                                                                                                                              |  |               | 6,507,272  |                   |   | 5,319,667 
|                                                                                                                              |  |               |            |                   |   |           
|COMMITMENTS AND CONTINGENCIES                                                                                                 |  |               |           |                   |   |          
|                                                                                                                              |  |               |            |                   |   |           
|STOCKHOLDERS EQUITY                                                                                                          |  |               |            |                   |   |           
|Preferred stock; no par value; 4,000,000 shares authorized; no shares issued or outstanding                                   |  |               |           |                   |   |          
|Common stock; no par value; 25,000,000 shares authorized; 5,870,056 and 5,628,806 shares issued and outstanding, respectively |  |               | 2,594,297  |                   |   | 2,266,482 
|Additional paid-in capital                                                                                                    |  |               | 680,444    |                   |   | 543,095   
|Retained earnings                                                                                                             |  |               | 2,454,096  |                   |   | 2,245,605 
|                                                                                                                              |  |               |            |                   |   |           
|                                                                                                                              |  |               | 5,728,837  |                   |   | 5,055,182 
|                                                                                                                              |  |               |            |                   |   |           
|                                                                                                                              |  | $             | 12,236,109 |                   | $ | 10,374,849
|                                                                                                                              |  |               |            |                   |   |           



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



4



---

##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

(DBA PDSi)



STATEMENTS OF OPERATIONS



|                                         |  |                       |           |                            |               |   |               |  |               |            |  |   |           
|---------------------------------------- |  | --------------------- | --------- | -------------------------- | ------------- | - | ------------- |  | ------------- | ---------- |  | - | ----------
|                                         |  | For the Quarter Ended |           | For the Two Quarters Ended
|                                         |  | June 30, 2005         |           |                            | June 26, 2004 |   | June 30, 2005 |  | June 26, 2004
|                                         |  | (unaudited)           |           | (unaudited)               
|SALES                                    |  |                       |           |                            |               |   |               |  |               |            |  |   |           
|Product sales                            |  | $                     | 4,998,421 |                            |               | $ | 9,774,835     |  | $             | 10,303,281 |  | $ | 15,204,297
|Service sales                            |  |                       | 1,946,234 |                            |               |   | 1,504,759     |  |               | 4,133,875  |  |   | 3,122,969 
|                                         |  |                       |           |                            |               |   |               |  |               |            |  |   |           
|                                         |  |                       | 6,944,655 |                            |               |   | 11,279,594    |  |               | 14,437,156 |  |   | 18,327,266
|                                         |  |                       |           |                            |               |   |               |  |               |            |  |   |           
|COST OF SALES                            |  |                       |           |                            |               |   |               |  |               |            |  |   |           
|Product sales                            |  |                       | 4,386,066 |                            |               |   | 7,648,924     |  |               | 8,868,892  |  |   | 11,495,666
|Service sales                            |  |                       | 914,421   |                            |               |   | 954,935       |  |               | 1,901,503  |  |   | 1,878,777 
|                                         |  |                       |           |                            |               |   |               |  |               |            |  |   |           
|                                         |  |                       | 5,300,487 |                            |               |   | 8,603,859     |  |               | 10,770,395 |  |   | 13,374,443
|                                         |  |                       |           |                            |               |   |               |  |               |            |  |   |           
|GROSS PROFIT                             |  |                       | 1,644,168 |                            |               |   | 2,675,735     |  |               | 3,666,761  |  |   | 4,952,823 
|                                         |  |                       |           |                           
|OPERATING EXPENSES                       |  |                       | 1,674,177 |                            |               |   | 1,798,808     |  |               | 3,271,122  |  |   | 3,440,290 
|                                         |  |                       |           |                            |               |   |               |  |               |            |  |   |           
|INCOME/(LOSS) FROM OPERATIONS            |  |                       | (30,009   | )                          |               |   | 876,927       |  |               | 395,639    |  |   | 1,512,533 
|                                         |  |                       |           |                            |               |   |               |  |               |            |  |   |           
|OTHER EXPENSE                            |  |                       |           |                            |               |   |               |  |               |            |  |   |           
|Interest expense                         |  |                       | 33,296    |                            |               |   | 32,512        |  |               | 61,148     |  |   | 54,654    
|                                         |  |                       |           |                            |               |   |               |  |               |            |  |   |           
|INCOME/(LOSS) BEFORE INCOME TAXES        |  |                       | (63,305   | )                          |               |   | 844,415       |  |               | 334,491    |  |   | 1,457,879 
|                                         |  |                       |           |                           
|INCOME TAX EXPENSE/(BENEFIT)             |  |                       | (25,000   | )                          |               |   | 347,000       |  |               | 126,000    |  |   | 598,000   
|                                         |  |                       |           |                            |               |   |               |  |               |            |  |   |           
|NET INCOME/(LOSS)                        |  | $                     | (38,305   | )                          |               | $ | 497,415       |  | $             | 208,491    |  | $ | 859,879   
|                                         |  |                       |           |                            |               |   |               |  |               |            |  |   |           
|BASIC EARNINGS/(LOSS) PER COMMON SHARE   |  | $                     | (0.01     | )                          |               | $ | 0.09          |  | $             | 0.04       |  | $ | 0.16      
|                                         |  |                       |           |                            |               |   |               |  |               |            |  |   |           
|DILUTED EARNINGS/(LOSS) PER COMMON SHARE |  | $                     | (0.01     | )                          |               | $ | 0.08          |  | $             | 0.03       |  | $ | 0.14      
|                                         |  |                       |           |                            |               |   |               |  |               |            |  |   |           



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



5



---

##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

(DBA PDSi)



STATEMENTS OF CASH FLOWS



Two Quarters Ended June 30, 2005 and June 26, 2004



|                                                                                  |  |             |            |   |             |   |            |  
|--------------------------------------------------------------------------------- |  | ----------- | ---------- | - | ----------- | - | ---------- | -
|                                                                                  |  | 2005        |            |   | 2004        |  
|                                                                                  |  | (Unaudited) |            |   | (Unaudited) |  
|CASH FLOWS FROM OPERATING ACTIVITIES                                              |  |             |            |   |             |   |            |  
|Net income                                                                        |  | $           | 208,491    |   |             | $ | 859,879    |  
|                                                                                  |  |             |            |   |             |   |            |  
|Adjustments to reconcile net income to net cash provided by operating activities: |  |             |            |   |             |   |            |  
|Depreciation and amortization                                                     |  |             | 245,305    |   |             |   | 289,982    |  
|Provision for doubtful accounts                                                   |  |             | 10,000     |   |             |   |           |  
|Inventory reserves                                                                |  |             | 185,351    |   |             |   | 119,070    |  
|Loss on disposal of equipment                                                     |  |             |           |   |             |   | (87        | )
|(Increase)/decrease in assets:                                                    |  |             |            |   |             |   |            |  
|Accounts receivable                                                               |  |             | (340,643   | ) |             |   | (779,159   | )
|Inventory                                                                         |  |             | (1,711,772 | ) |             |   | (1,897,676 | )
|Prepaid expenses and other assets                                                 |  |             | 52,722     |   |             |   | 119,485    |  
|Refundable income taxes                                                           |  |             | 42,000     |   |             |   |           |  
|Increase in liabilities:                                                          |  |             |            |   |             |   |            |  
|Accounts payable                                                                  |  |             | 567,381    |   |             |   | 324,697    |  
|Accrued expenses and taxes                                                        |  |             | 187,679    |   |             |   | 501,128    |  
|Unearned revenues                                                                 |  |             | 60,363     |   |             |   | 15,657     |  
|                                                                                  |  |             |            |   |             |   |            |  
|Total adjustments                                                                 |  |             | (701,614   | ) |             |   | (1,306,903 | )
|                                                                                  |  |             |            |   |             |   |            |  
|Net cash used in operating activities                                             |  |             | (493,123   | ) |             |   | (447,024   | )
|                                                                                  |  |             |            |   |             |   |            |  
|CASH FLOWS FROM INVESTING ACTIVITIES                                              |  |             |            |   |             |   |            |  
|Purchases of property and equipment                                               |  |             | (206,015   | ) |             |   | (81,747    | )
|Proceeds from sale of property and equipment                                      |  |             |           |   |             |   | 165        |  
|                                                                                  |  |             |            |   |             |   |            |  
|Net cash used in investing activities                                             |  |             | (206,015   | ) |             |   | (81,582    | )
|                                                                                  |  |             |            |   |             |   |            |  
|CASH FLOWS FROM FINANCING ACTIVITIES                                              |  |             |            |   |             |   |            |  
|Net change in line of credit                                                      |  |             | 711,234    |   |             |   | 452,068    |  
|Outstanding checks in excess of funds on deposit                                  |  |             | (333,524   | ) |             |   | 17,123     |  
|Principal payments on capital lease obligation                                    |  |             | (5,529     | ) |             |   |           |  
|Proceeds from stock options exercised                                             |  |             | 327,815    |   |             |   | 62,139     |  
|                                                                                  |  |             |            |   |             |   |            |  
|Net cash provided by financing activities                                         |  |             | 699,996    |   |             |   | 531,330    |  
|                                                                                  |  |             |            |   |             |   |            |  



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



6



---

##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

(DBA PDSi)



STATEMENTS OF CASH FLOWS (CONTINUED)



Two
Quarters Ended June 30, 2005 and June 26, 2004



|                                                                                  |  |      |         |      |   |        
|--------------------------------------------------------------------------------- |  | ---- | ------- | ---- | - | -------
|                                                                                  |  | 2005 |         | 2004
|INCREASE IN CASH                                                                  |  |      | 858     |      |   | 2,724  
|                                                                                  |  |     
|CASH - Beginning of period                                                        |  |      | 15,068  |      |   | 11,997 
|                                                                                  |  |      |         |      |   |        
|CASH - End of period                                                              |  | $    | 15,926  |      | $ | 14,721 
|                                                                                  |  |      |         |      |   |        
|SUPPLEMENTAL DISCLOSURE OF CASH FLOWINFORMATION                                   |  |      |         |      |   |        
|Interest paid                                                                     |  | $    | 57,490  |      | $ | 53,278 
|                                                                                  |  |      |         |      |   |        
|Income taxes paid, net of refunds                                                 |  | $    | 84,000  |      | $ | 549,577
|                                                                                  |  |      |         |      |   |        
|SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING TRANSACTIONS           |  |      |         |      |   |        
|Inventory capitalized as computer equipment.                                      |  | $    |        |      | $ | 43,293 
|                                                                                  |  |      |         |      |   |        
|Income tax benefit from stock option plans credited to Additional paid-in-capital |  | $    | 137,350 |      | $ |       
|                                                                                  |  |      |         |      |   |        



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



7



---

##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

(DBA PDSi)



NOTES TO FINANCIAL STATEMENTS

(UNAUDITED)



Note 1. Organization



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



Note 2. Summary of Significant Accounting Policies



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



Inventory at June 30, 2005 and December 31, 2004 was
comprised of the following (net of inventory reserves):



|                                |  |               |           |                   |   |          
|------------------------------- |  | ------------- | --------- | ----------------- | - | ---------
|                                |  | June 30, 2005 |           | December 31, 2004
|                                | 
|Component parts (raw materials) |  | $             | 4,317,339 |                   | $ | 3,362,924
|Work-in-process                 |  |               | 429,085   |                   |   | 369,937  
|Finished goods                  |  |               | 860,199   |                   |   | 347,341  
|                                |  |               |           |                   |   |          
|                                |  | $             | 5,606,623 |                   | $ | 4,080,202
|                                |  |               |           |                   |   |          



The carrying values of
component parts and finished goods represent the lower of average cost or managements estimate of its net realizable value. Such value is based on forecasts of product orders and repair/trade-in activity in the ensuing years. Such forecasts
are based on historical information, known contracts, and managements expertise in computer hardware life cycles.



The balance sheet as of June 30, 2005 and the statements of operations and cash flows for the two quarters ended June 30, 2005 and June 26, 2004 have been
prepared by the Company without audit. In the opinion of management, all adjustments, which consist solely of normal recurring adjustments, necessary to present fairly, in accordance with accounting principles generally accepted in the United States
of America, the financial position, statements of operations and changes in cash flows for all periods presented have been made.



8



---

##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

(DBA PDSi)



NOTES TO FINANCIAL STATEMENTS

(UNAUDITED)



Note 2. Summary of Significant Accounting Policies (continued)



Certain information and footnote disclosures normally included in financial statements prepared in accordance with
accounting principles generally accepted in the United States of America have been condensed and omitted. These condensed financial statements should be read in conjunction with the financial statements and notes thereto included in the
Companys December 31, 2004 annual report on Form 10-KSB. The results of operations for the period ended June 30, 2005 are not necessarily indicative of the results for the full year.



The Company accounts for employee and director stock options using the
intrinsic value method. Under this method, no compensation expense was recorded in the first two quarters of 2005 because all stock options were granted at an exercise price equal to or greater than the fair market value of the Companys stock
on the date of the grant. If compensation expense for the Companys stock option grants had been determined based on their estimated fair value at the grant dates, the Companys net income/(loss) and earnings/(loss) per share for the
quarters ending June 30, 2005 and June 26, 2004 would have been as follows:



|                                                                                                                                  |  |                |          |   |              |   |         |      |  |   |          |   |  |   |          |  
|--------------------------------------------------------------------------------------------------------------------------------- |  | -------------- | -------- | - | ------------ | - | ------- | ---- |  | - | -------- | - |  | - | -------- | -
|                                                                                                                                  |  | Second Quarter |          |   | Two Quarters |  
|                                                                                                                                  |  | 2005           |          |   | 2004         |   |         | 2005 |  |   | 2004     |  
|Net income/(loss), as reported                                                                                                    |  | $              | (38,305  | ) |              | $ | 497,415 |      |  | $ | 208,491  |   |  | $ | 859,879  |  
|Deduct: total stock-based compensation expense determined under the fair value method for all awards, net of related tax
benefits |  |                | (147,356 | ) |              |   | (68,754 | )    |  |   | (206,701 | ) |  |   | (137,507 | )
|                                                                                                                                  |  |                |          |   |              |   |         |      |  |   |          |   |  |   |          |  
|Net income/(loss), pro forma                                                                                                      |  |                | (185,661 | ) |              |   | 428,661 |      |  |   | 1,790    |   |  |   | 722,372  |  
|                                                                                                                                  |  |                |          |  
|Earnings/(loss) per common share, basic:                                                                                          |  |                |          |   |              |   |         |      |  |   |          |   |  |   |          |  
|As reported                                                                                                                       |  | $              | (0.01    | ) |              | $ | 0.09    |      |  | $ | 0.04     |   |  | $ | 0.16     |  
|Pro forma                                                                                                                         |  | $              | (0.03    | ) |              | $ | 0.08    |      |  | $ |         |   |  | $ | 0.13     |  
|Earnings/(loss) per common share, diluted:                                                                                        |  |                |          |   |              |   |         |      |  |   |          |   |  |   |          |  
|As reported                                                                                                                       |  | $              | (0.01    | ) |              | $ | 0.08    |      |  | $ | 0.03     |   |  | $ | 0.14     |  
|Pro forma                                                                                                                         |  | $              | (0.03    | ) |              | $ | 0.07    |      |  | $ |         |   |  | $ | 0.12     |  



9



---

##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

(DBA PDSi)



NOTES TO FINANCIAL STATEMENTS

(UNAUDITED)



Note 2. Summary of Significant Accounting Policies (continued)



The Company divides its fiscal calendar into 4 periods or quarters. Starting in 2005, the Company adopted a
calendar fiscal schedule, with the four quarters of the year always ending on March 31, June 30, September 30, and December 31. Prior to 2005, the Company intended that each quarter consist of thirteen weeks. The first quarter of each year began on
January 1 and the fourth quarter ended on December 31. Depending on what day of the week January 1 fell, the first quarter might contain a few days less than thirteen full weeks and the fourth quarter might contain a few days more than thirteen full
weeks. The second quarter of 2005 ended on June 30 and contained 91 days. The second quarter of 2004 ended on June 26 and contained 91 days. The first two quarters of 2005 contained 181 days and the first two quarters of 2004 contained 178 days.



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



In December 2004, the FASB issued SFAS No. 123 (Revised), Shared Based Payment. SFAS No. 123(R) replaces SFAS No. 123, Accounting for Stock Based Compensation, and supercedes APB Opinion No. 25, Accounting for Stock
Issued to Employees. SFAS No. 123 (R) requires compensation costs related to share-based payment transactions to be recognized in the financial statements. Compensation costs will be recognized over the vesting period of the award. SFAS No. 123(R)
is effective as of the beginning of the first annual reporting period that begins after June 15, 2005. SFAS No. 123 (R) provides several options regarding its adoption. The Company has not determined the adoption method that it will select.



10



---

##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

(DBA PDSi)



NOTES TO FINANCIAL STATEMENTS

(UNAUDITED)



Note 3. Line of Credit



At June 30, 2005, the Company had a bank line of credit with a limit of $6,000,000 and monthly interest payments at prime. The effective rate was 6.25%.
The Company was obligated for funds drawn against this line of credit in the amount of $3,236,254 and $2,525,020 at June 30, 2005 and December 31, 2004, respectively.



The line is payable on demand and is collateralized by a Blanket Lien on all assets of the Company. The amount
available under the line of credit is subject to borrowing base restrictions as outlined in the agreement. On December 28, 2004, the terms of the bank line of credit with KeyBank were amended to reflect the Companys near term borrowing needs
and the Companys credit risk as rated by KeyBank. The amount available under the line was increased to $6,000,000 from $5,000,000 and is due and renewable by May 15, 2006. The borrowing base calculation on June 30, 2005 was the maximum
$6,000,000, resulting in an unused capacity of $2,763,746.



Note 4 Stock
Options



The Company adopted the Pinnacle Data Systems,
Inc. 1995 Stock Option Plan on December 19, 1995. On May 5, 2005, the Company adopted the 2005 Equity Incentive Plan, which replaced the 1995 plan. During the two quarters ended June 30, 2005, the Companys stock option activities and weighted
average exercise prices were as follows:



|                               |  |           |   |  |               |     
|------------------------------ |  | --------- | - |  | ------------- | ----
|                               |  | Shares    |   |  | ExercisePrice
|Outstanding, December 31, 2004 |  | 1,526,950 |   |  | $             | 2.00
|Granted                        |  | 701,000   |   |  |               | 3.07
|Exercised                      |  | (241,250  | ) |  |               | 1.36
|Forfeited                      |  | (11,300   | ) |  |               | 3.78
|                               |  |           |   |  |               |     
|Outstanding, June 30, 2005     |  | 1,975,400 |   |  | $             | 2.45
|                               |  |           |   |  |               |     



Of the 701,000 options
granted in 2005, 51,000 were granted under the 1995 plan, and 650,000 were granted under the 2005 plan. The fair value of options granted was estimated on the date of the grant using the Black-Scholes option-pricing model with the following weighted
average assumptions for the two quarters ended June 30, 2005:



|                                        |  |       |  
|--------------------------------------- |  | ----- | -
|Risk-free interest rate                 |  | 4.20  | %
|Dividend yield                          |  | 0     | %
|Volatility factor                       |  | 75.48 | %
|Weighted average expected life in years |  | 7     |  



The options granted
during the two quarters had a weighted-average fair value of 2.05.



11



---

##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

(DBA PDSi)



NOTES TO FINANCIAL STATEMENTS

(UNAUDITED)



Note 5. Income Taxes



Income taxes for interim periods were computed using the effective tax rate estimated to be applicable for the full fiscal year, which is subject to
ongoing review and evaluation by management.



Note 6. Earnings/(Loss) Per
Common and Common Equivalent Share



Earnings/(Loss) per
common and common equivalent share were computed by dividing net earnings/(loss) by the weighted average number of shares of common stock outstanding during the quarter.



|                                                                       |  |                                 |         |   |                                      |           |                  |   |       |                    |  |                      |         |                  |           |  |   |     
|---------------------------------------------------------------------- |  | ------------------------------- | ------- | - | ------------------------------------ | --------- | ---------------- | - | ----- | ------------------ |  | -------------------- | ------- | ---------------- | --------- |  | - | ----
|                                                                       |  | For the quarter ended 6/30/2005 |         |   | For the two quarters ended 6/30/2005
|                                                                       |  | Income/(Loss) (Numerator)       |         |   | Shares (Denominator)                 |           | Per-Share Amount |   |       | Income (Numerator) |  | Shares (Denominator) |         | Per-Share Amount
|                                                                       |  |                                 |         |   |                                     
|Basic EPS                                                              |  |                                 |         |   |                                      |           |                  |   |       |                    |  |                      |         |                  |           |  |   |     
|Income/(Loss) available to common shareholders                         |  | $                               | (38,305 | ) |                                      | 5,833,753 |                  | $ | (0.01 | )                  |  | $                    | 208,491 |                  | 5,780,083 |  | $ | 0.04
|                                                                       |  |                                 |         |   |                                      |          
|Effect of Dilutive Securities                                          |  |                                 |         |   |                                      |           |                  |   |       |                    |  |                      |         |                  |           |  |   |     
|Options                                                                |  |                                 |         |   |                                      | 0         |                  |   |       |                    |  |                      |         |                  | 492,831   |  |   |     
|                                                                       |  |                                 |         |   |                                      |           |                  |   |       |                    |  |                      |         |                  |           |  |   |     
|Diluted EPS                                                            |  |                                 |         |   |                                      |           |                  |   |       |                    |  |                      |         |                  |           |  |   |     
|Income/(Loss) available to common stockholders and assumed conversions |  | $                               | (38,305 | ) |                                      | 5,833,753 |                  | $ | (0.01 | )                  |  | $                    | 208,491 |                  | 6,272,914 |  | $ | 0.03
|                                                                       |  |                                 |         |   |                                      |           |                  |   |       |                    |  |                      |         |                  |           |  |   |     
|                                                                       |  |                                
|                                                                       |  | For the quarter ended 6/26/2004 |         |   | For the two quarters ended 6/26/2004
|                                                                       |  | Income (Numerator)              |         |   | Shares (Denominator)                 |           | Per-Share Amount |   |       | Income (Numerator) |  | Shares (Denominator) |         | Per-Share Amount
|                                                                       |  |                                 |         |   |                                     
|Basic EPS                                                              |  |                                 |         |   |                                      |           |                  |   |       |                    |  |                      |         |                  |           |  |   |     
|Income available to common shareholders                                |  | $                               | 497,415 |   |                                      | 5,553,813 |                  | $ | 0.09  |                    |  | $                    | 859,879 |                  | 5,547,181 |  | $ | 0.16
|                                                                       |  |                                 |         |   |                                      |          
|Effect of Dilutive Securities                                          |  |                                 |         |   |                                      |           |                  |   |       |                    |  |                      |         |                  |           |  |   |     
|Options                                                                |  |                                 |         |   |                                      | 637,411   |                  |   |       |                    |  |                      |         |                  | 547,183   |  |   |     
|                                                                       |  |                                 |         |   |                                      |           |                  |   |       |                    |  |                      |         |                  |           |  |   |     
|Diluted EPS                                                            |  |                                 |         |   |                                      |           |                  |   |       |                    |  |                      |         |                  |           |  |   |     
|Income available to common stockholders and assumed conversions        |  | $                               | 497,415 |   |                                      | 6,191,224 |                  | $ | 0.08  |                    |  | $                    | 859,879 |                  | 6,094,364 |  | $ | 0.14
|                                                                       |  |                                 |         |   |                                      |           |                  |   |       |                    |  |                      |         |                  |           |  |   |     



12



---

##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

(DBA PDSi)



NOTES TO FINANCIAL STATEMENTS

(UNAUDITED)



Note 7. Operating Segments



The Other column listed below reflects items that are not allocated to segments. These items primarily represent assets and expenses for
various administrative functions within the Company.



|                              |  |                                  |            |               |   |           |  |   |            |   |  |   |           
|----------------------------- |  | -------------------------------- | ---------- | ------------- | - | --------- |  | - | ---------- | - |  | - | ----------
|                              |  | Two Quarters Ended June 30, 2005 |            |               |  
|                              |  | Product Sales                    |            | Service Sales |   | Other     |  |   | Total     
|Sales                         |  | $                                | 10,303,281 |               | $ | 4,133,875 |  | $ |           |   |  | $ | 14,437,156
|Gross profit                  |  |                                  | 1,434,389  |               |   | 2,232,372 |  |   |           |   |  |   | 3,666,761 
|Income from operations        |  |                                  | 190,010    |               |   | 1,783,643 |  |   | (1,578,014 | ) |  |   | 395,639   
|Depreciation and amortization |  |                                  | 120,043    |               |   | 58,020    |  |   | 67,243     |   |  |   | 245,306   
|Interest expense              |  |                                  |           |               |   |          |  |   | 61,148     |   |  |   | 61,148    
|Total assets                  |  |                                  | 7,319,641  |               |   | 2,668,321 |  |   | 2,248,147  |   |  |   | 12,236,109
|Capital expenditures          |  |                                  | 53,018     |               |   | 31,871    |  |   | 121,126    |   |  |   | 206,015   
|                              |  |                                 
|                              |  | Two Quarters Ended June 26, 2004 |            |               |  
|                              |  | Product Sales                    |            | Service Sales |   | Other     |  |   | Total     
|Sales                         |  | $                                | 15,204,297 |               | $ | 3,122,969 |  | $ |           |   |  | $ | 18,327,266
|Gross profit                  |  |                                  | 3,708,631  |               |   | 1,244,192 |  |   |           |   |  |   | 4,952,823 
|Income from operations        |  |                                  | 2,016,341  |               |   | 668,549   |  |   | (1,172,357 | ) |  |   | 1,512,533 
|Depreciation and amortization |  |                                  | 142,727    |               |   | 60,639    |  |   | 86,616     |   |  |   | 289,982   
|Interest expense              |  |                                  |           |               |   |          |  |   | 54,654     |   |  |   | 54,654    
|Total assets                  |  |                                  | 8,540,631  |               |   | 701,298   |  |   | 1,893,967  |   |  |   | 11,135,896
|Capital expenditures          |  |                                  | 76,462     |               |   | 39,294    |  |   | 9,284      |   |  |   | 125,040   



13



---

##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

(DBA PDSi)



NOTES TO FINANCIAL STATEMENTS

(UNAUDITED)



Note 8. Subsequent Event



On July 1, 2005, the Company signed a non-binding letter of intent to acquire the assets and assume certain liabilities of privately-held GNP Computers,
Inc. The Company is actively engaged in due diligence on the acquisition. A Form 8-K was filed with the Securities and Exchange Commission on July 8, 2005.



Item 2. Managements Discussion and Analysis or Plan of Operation



The following discussion should be read in conjunction with the Financial Statements and Notes contained herein. This quarterly report, including the
following sections, contains forward-looking statements within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including, but not limited to, statements regarding the increase in sales
in the second half of 2005, the increase in service sales in the fourth quarter of 2005, the Companys profitability in 2005 and regarding the closing of the acquisition of GNP Computers, whether in the third fiscal quarter of 2005 or
otherwise. The words believe, expect, anticipate, estimate, project, should and similar expressions identify forward-looking statements that speak only as of the date thereof.
Investors are cautioned that such statements involve risks and uncertainties that could cause actual results to differ materially from historical or anticipated results due to many factors. These factors include changes in general economic
conditions, changes in the specific markets for the Companys products and services, adverse business conditions, changes in customer order patterns, increased competition, changes in the Companys business or its relationship with major
technology partners or significant customers, pricing pressures, lack of adequate financing to take advantage of business opportunities that may arise, lack of success in technological advancements, risks associated with the Companys new
business practices, processes and information systems, a material adverse change in GNP Computers business or the discovery of other information which would affect the viability of post-closing operations, and the inability to obtain any
necessary consents, restructure debt obligations, overcome integration issues and resolve business terms relating to the GNP Computers transaction, and other risks described in this quarterly report and from time to time in the Companys
periodic reports and filings with the Securities and Exchange Commission. The Company undertakes no obligations to publicly update or revise such statements.



14



---

##### Table of Contents

The following discussions and analyses are for the quarter and two quarters ended June 30, 2005 compared to the
quarter and two quarters ended June 26, 2004.



OVERVIEW



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



We will continue to implement our targeted growth strategy in 2005 by investing in sales, marketing and a more scalable organization. Positive contributions from these
efforts are anticipated throughout the rest of the year. We anticipate that sales in the second half of 2005 will be stronger than in the second half of 2004 or the first half 2005, due in part to the backlog of product orders existing at the end of
the second quarter. As in past years, we expect service sales to experience a seasonal decline in the third quarter and pick up again in the fourth quarter of 2005. We expect 2005 to be a profitable year. During this period of significant
investment, as we transition to that higher growth, more scalable, operating platform, we remain focused on improvement in annual results.



On July 12, 2005, Silicon Graphics, Inc. (SGI), one of our significant repair customers, announced it had received notice of default from a holder of convertible
subordinated debentures that may file suit to accelerate the full payment of principal and interest on the notes, which could trigger automatic defaults on additional outstanding debt instruments issued by this highly leveraged customer. On June 30,
2005, we held assets including $1.2 million of inventory and $370,000 of receivables related to the repair programs for this customer. Because of the nature of the program, we do not believe that these assets are significantly impaired and has not
reserved for losses related to the SGI business.



SALES



Sales for the second quarter and the first two quarters of
2005 and 2004 were as follows:



|              |  |                |       |      |              |          |  |     |      |  |      |        |          |   |        |  |     |  
|------------- |  | -------------- | ----- | ---- | ------------ | -------- |  | --- | ---- |  | ---- | ------ | -------- | - | ------ |  | --- | -
|              |  | Second Quarter |       |      | Two Quarters |         
|($ thousands) |  | 2005           |       | 2004 |              | % Change |  |     | 2005 |  | 2004 |        | % Change |  
|Total company |  | $              | 6,944 |      | $            | 11,280   |  | -38 | %    |  | $    | 14,437 |          | $ | 18,327 |  | -21 | %
|Product       |  |                | 4,998 |      |              | 9,775    |  | -49 | %    |  |      | 10,303 |          |   | 15,204 |  | -32 | %
|Service       |  |                | 1,946 |      |              | 1,505    |  | 29  | %    |  |      | 4,134  |          |   | 3,123  |  | 32  | %



The second quarter of 2005 was
impacted by slower than anticipated orders for current product and service programs and longer closure rates for new product programs. We believe this slowdown to be economy-based. The record second quarter and record first half of 2004



15



---

##### Table of Contents

benefited from two record product orders, one for a medical equipment manufacturer and another for a telecommunications
equipment provider. Service sales were higher in 2005 due to new repair and hardware management programs.



For the first two quarters of 2005, we had two customers that generated revenues of approximately $2,918,000 and $1,804,000 or 20% and 12% respectively, of total revenue. In the statements of operations, approximately
$4,618,000 of the revenues from these customers is included in product sales and $104,000 is included in service sales. In addition, each of these customers represented 16% of accounts receivable at June 30, 2005.



GROSS PROFIT



Gross profit for the second quarter and the first two quarters of 2005 and 2004 was as
follows:



|              |  |                |       |      |              |          |  |     |      |  |      |       |          |   |       |  |     |  
|------------- |  | -------------- | ----- | ---- | ------------ | -------- |  | --- | ---- |  | ---- | ----- | -------- | - | ----- |  | --- | -
|              |  | Second Quarter |       |      | Two Quarters |         
|($ thousands) |  | 2005           |       | 2004 |              | % Change |  |     | 2005 |  | 2004 |       | % Change |  
|Total company |  | $              | 1,644 |      | $            | 2,676    |  | -39 | %    |  | $    | 3,667 |          | $ | 4,953 |  | -26 | %
|Product       |  |                | 612   |      |              | 2,126    |  | -71 | %    |  |      | 1,435 |          |   | 3,709 |  | -61 | %
|Service       |  |                | 1,032 |      |              | 550      |  | 88  | %    |  |      | 2,232 |          |   | 1,244 |  | 79  | %



The gross profit margin percentages
for 2005 and 2004 were as follows:



|              |  |                |   |  |              |   |  |      |   |  |      |  
|------------- |  | -------------- | - |  | ------------ | - |  | ---- | - |  | ---- | -
|              |  | Second Quarter |   |  | Two Quarters |  
|              |  | 2005           |   |  | 2004         |   |  | 2005 |   |  | 2004 |  
|Total company |  | 24             | % |  | 24           | % |  | 25   | % |  | 27   | %
|Product       |  | 12             | % |  | 22           | % |  | 14   | % |  | 24   | %
|Service       |  | 53             | % |  | 37           | % |  | 54   | % |  | 40   | %



Product sales to newer customers in
2005 generally were lower value-added sales and, therefore, had lower margins than the product sales in older customer programs, resulting in the decrease in both the gross profit dollars and percentage on product sales.



The increased gross profit dollars and percentage on service sales reflected the higher sales
volumes and increased operating leverage.



OPERATING EXPENSES AND INTEREST EXPENSES



Operating expenses,
including selling, general and administrative, research and development, and interest expenses for the second quarter and the first two quarters of 2005 and 2004 were as follows:



|                   |  |                |       |      |              |          |  |    |      |  |      |       |          |   |       |  |    |  
|------------------ |  | -------------- | ----- | ---- | ------------ | -------- |  | -- | ---- |  | ---- | ----- | -------- | - | ----- |  | -- | -
|                   |  | Second Quarter |       |      | Two Quarters |         
|($ thousands)      |  | 2005           |       | 2004 |              | % Change |  |    | 2005 |  | 2004 |       | % Change |  
|Operating expenses |  | $              | 1,674 |      | $            | 1,799    |  | -7 | %    |  | $    | 3,271 |          | $ | 3,440 |  | -5 | %
|Interest expense   |  |                | 33    |      |              | 33       |  | 0  | %    |  |      | 61    |          |   | 55    |  | 11 | %
|                   |  |                |       |      |              |          |  |    |      |  |      |       |          |   |       |  |    |  
|Total expense      |  |                | 1,707 |      |              | 1,832    |  | -7 | %    |  |      | 3,332 |          |   | 3,495 |  | -5 | %
|                   |  |                |       |      |              |          |  |    |      |  |      |       |          |   |       |  |    |  



16



---

##### Table of Contents

For the first half of 2005, operating expenses declined from the first half of 2004 as profitability-based expenses
decreases more than offset increased investment in sales, marketing and infrastructure growth. In the first half of 2005, operating expenses were 23% of sales generated compared to 19% in the first half of 2004. We expect to continue increasing our
marketing and selling expenses in the near future in order to increase market share and achieve our long-term growth goals.



INCOME TAXES AND NET INCOME/(LOSS)



Income taxes for the interim periods were computed using the effective tax rate estimated to be applicable for the full fiscal year, which is subject to ongoing review
and evaluation by management. The effective tax rate for the second quarter and first half of 2005 was 38%, compared to 41% in the comparable periods of 2004.



Income/(loss) before taxes, income tax expense/(benefit) and net income/(loss) for the second quarter and the first two quarters of 2005 and 2004 were as follows:



|                             |  |                |     |   |              |   |          |  |      |      |  |      |     |          |   |       |  |     |  
|---------------------------- |  | -------------- | --- | - | ------------ | - | -------- |  | ---- | ---- |  | ---- | --- | -------- | - | ----- |  | --- | -
|                             |  | Second Quarter |     |   | Two Quarters |  
|($ thousands)                |  | 2005           |     |   | 2004         |   | % Change |  |      | 2005 |  | 2004 |     | % Change |  
|Income/(loss) before taxes   |  | $              | (63 | ) |              | $ | 844      |  | -107 | %    |  | $    | 334 |          | $ | 1,458 |  | -77 | %
|Income tax expense/(benefit) |  |                | (25 | ) |              |   | 347      |  | -107 | %    |  |      | 126 |          |   | 598   |  | -79 | %
|                             |  |                |     |   |              |   |          |  |      |      |  |      |     |          |   |       |  |     |  
|Net income/(loss)            |  |                | (38 | ) |              |   | 497      |  | -108 | %    |  |      | 208 |          |   | 860   |  | -76 | %
|                             |  |                |     |   |              |   |          |  |      |      |  |      |     |          |   |       |  |     |  



Earnings/(loss) per share for the
second quarter and the first two quarters of 2005 and 2004 were as follows:



|                                               |  |                |           |              |      |   |           |  |      |           |  |   |          
|---------------------------------------------- |  | -------------- | --------- | ------------ | ---- | - | --------- |  | ---- | --------- |  | - | ---------
|                                               |  | Second Quarter |           | Two Quarters
|                                               |  | 2005           |           |              | 2004 |   | 2005      |  | 2004
|Basic EPS                                      |  | $              | (0.01     | )            |      | $ | 0.09      |  | $    | 0.04      |  | $ | 0.16     
|Fully diluted EPS                              |  | $              | (0.01     | )            |      | $ | 0.08      |  | $    | 0.03      |  | $ | 0.14     
|                                               |  |                |           |             
|Weighted average number of shares outstanding: |  |                |           |              |      |   |           |  |      |           |  |   |          
|Basic                                          |  |                | 5,833,753 |              |      |   | 5,553,813 |  |      | 5,780,083 |  |   | 5,547,181
|Fully diluted                                  |  |                | 5,833,753 |              |      |   | 6,191,224 |  |      | 6,272,914 |  |   | 6,094,364



The decline in net income in the
second quarter and first two quarters of 2005 resulted from the decline in product revenue, the decline in profit margins on product sales, and the reinvestment of profits into our growth programs.



17



---

##### Table of Contents

LIQUIDITY AND CAPITAL RESOURCES



A summary of changes in current assets for the first two quarters is as follows:



|                     |  |              |        |                  |   |          |  |    |  
|-------------------- |  | ------------ | ------ | ---------------- | - | -------- |  | -- | -
|($ thousands)        |  | June 30,2005 |        | December 31,2004 |   | % Change | 
|Accounts receivable  |  | $            | 4,729  |                  | $ | 4,398    |  | 8  | %
|Inventory            |  |              | 5,607  |                  |   | 4,080    |  | 37 | %
|Other current assets |  |              | 944    |                  |   | 903      |  | 5  | %
|                     |  |              |        |                  |   |          |  |    |  
|Total                |  | $            | 11,280 |                  | $ | 9,381    |  | 20 | %
|                     |  |              |        |                  |   |          |  |    |  



A summary of changes in current
liabilities for the first two quarters is as follows:



|                          |  |              |       |                  |   |          |  |    |  
|------------------------- |  | ------------ | ----- | ---------------- | - | -------- |  | -- | -
|($ thousands)             |  | June 30,2005 |       | December 31,2004 |   | % Change | 
|Line of credit            |  | $            | 3,236 |                  | $ | 2,525    |  | 28 | %
|Accounts payable          |  |              | 2,411 |                  |   | 2,177    |  | 11 | %
|Other current liabilities |  |              | 759   |                  |   | 517      |  | 47 | %
|                          |  |              |       |                  |   |          |  |    |  
|Total                     |  | $            | 6,406 |                  | $ | 5,219    |  | 23 | %
|                          |  |              |       |                  |   |          |  |    |  



During the first two quarters of 2005,
$493,000 of cash was used by operating activities. Net income before depreciation, provision for doubtful accounts and inventory reserve increases was $650,000. Cash was used by an increase in accounts receivable of $341,000 and an increase in
inventory of $1.7 million. Additional cash was generated by a decrease in prepaid expenses and other current assets of $95,000 and increases in accounts payable of $567,000, and other current liabilities of $248,000. The increased inventory total
reflects a continued buildup begun in the fourth quarter of 2004 to support two multi-year customer programs that require a substantial investment in inventory. In both programs, agreements substantially reduce our risk of inventory loss and our
revenue includes extra charges for carrying the inventory.



For the first two
quarters of 2005, we used $206,000 of cash to purchase equipment, including computers and software.



We drew a net additional $711,000 on our line of credit to provide the cash used by operations and fixed asset purchases. In addition to the cash generated by operations, we received $328,000 from employee and
director stock option exercises.



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



The aforementioned borrowing base on the line of credit is calculated as 85% of eligible accounts receivable and 50% of inventory value, net of reserves. The line has an overall limit of $6,000,000 as well as a
sub-limit of $3,000,000 that can be collateralized by inventory. That calculation represents the maximum amount that can be drawn on the line of credit. The balance on the line of credit at June 30, 2005 was $3,236,000. The borrowing base
calculation on that date was the maximum $6,000,000, resulting in an unused capacity of $2,764,000. We were in compliance with all covenants of the line at June 30, 2005.



18



---

##### Table of Contents

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



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



On July 6, 2005, we announced the execution of a non-binding Letter of Intent to acquire the assets and assume certain liabilities of
privately-held GNP Computers, Inc. (GNP). GNP is similar to PDSi in that it offers computer system design, manufacturing and lifecycle management for OEMs in a broad range of industries. There are some overlap in customers and capabilities,
but GNP provides product programs to similar customers that we do not currently serve, as well as more mature product development and manufacturing capabilities that complement our current product and service lines. We are actively engaged in due
diligence on this acquisition and currently anticipate closing the transaction during the third quarter of 2005.



OFF-BALANCE SHEET ARRANGEMENTS



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



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



CRITICAL ACCOUNTING POLICIES



The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to
make judgments, assumptions and estimates that affect the amounts reported in the Financial Statements and



19



---

##### Table of Contents

accompanying notes. Note 1 to the Financial Statements in the Annual Report on our Form 10-KSB for the year ended
December 31, 2004 describes the significant accounting policies and methods used in the preparation of the Financial Statements. Estimates are used for, but not limited to, the accounting for allowance for doubtful accounts and inventory reserves.
Actual results could differ from these estimates. The following critical accounting policies are impacted significantly by judgments, assumptions and estimates used in the preparation of the Financial Statements.



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



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



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



RISK FACTORS



Investors should carefully consider the risks described below before making an investment decision. The risks and uncertainties described below are not the only ones we
face. Additional risks not presently known to us or that we currently believe are immaterial may also impair our business operations. If any of the following risks actually occurs, our business, financial condition or operating results could be
seriously impaired. This section should be read in conjunction with the Financial Statements and Notes thereto, and Managements Discussion and Analysis of Financial Condition and Results of Operations contained in this quarterly report.



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



20



---

##### Table of Contents

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



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



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



Our stock price, like that of other technology companies, can be volatile. Our stock price can be affected by many factors such as quarterly increases or decreases in our earnings, speculation in the investment community about our financial
condition or results of operations, technological developments, or the loss of key management or technical personnel. In addition, general macroeconomic and market conditions unrelated to our financial performance may also affect our stock price.



21



---

##### Table of Contents

Item 3. Controls and Procedures



Based on the
evaluation of the Companys disclosure controls and procedures as of the end of the period covered by this quarterly report, each of John D. Bair, the Chief Executive Officer of the Company, and Michael R. Sayre, the Chief Financial Officer of
the Company, have concluded that the Companys disclosure controls and procedures are effective in ensuring that information required to be disclosed by the Company in the reports that it files or submits under the Securities Exchange Act of
1934, as amended, is recorded, processed, summarized and reported within the time periods specified by the Securities and Exchange Commissions rules and forms.



There were no significant changes in the Companys internal controls over financial reporting or in other factors that could
significantly affect these controls subsequent to the date of their evaluation, including any corrective actions with regard to significant deficiencies and material weaknesses.



22



---

##### Table of Contents

PART II  OTHER INFORMATION



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



The annual meeting of shareholders was held on May 5, 2005. Of the 5,757,806 shares entitled to vote at the meeting, 5,227,306 shares were voted. The results were as follows:



Proposal number 1  Election of Directors



(Term expiring in the year 2007):



|                       |  |           |  |         
|---------------------- |  | --------- |  | --------
|                       |  | FOR       |  | WITHHOLD
|Carl J. Aschinger, Jr. |  | 5,036,867 |  | 190,439 
|Hugh C. Cathey         |  | 5,034,467 |  | 192,839 



Proposal number 2
 Amendment to the Companys Amended and Restated Code of Regulations to delete Article Nine consistent with the Companys Articles of Incorporation:



|          |  |  |  |         |  |  |  |          |  |  |  |          
|--------- |  |  |  | ------- |  |  |  | -------- |  |  |  | ---------
|FOR       |  |  |  | AGAINST |  |  |  | WITHHOLD |  |  |  | NON-VOTES
|3,014,292 |  |  |  | 453,221 |  |  |  | 87,732   |  |  |  | 1,672,061



Proposal number 3
 Amendment to the Companys Amended and Restated Code of Regulations to delete Article Eleven:



|          |  |  |  |         |  |  |  |          |  |  |  |          
|--------- |  |  |  | ------- |  |  |  | -------- |  |  |  | ---------
|FOR       |  |  |  | AGAINST |  |  |  | WITHHOLD |  |  |  | NON-VOTES
|3,011,752 |  |  |  | 449,561 |  |  |  | 93,932   |  |  |  | 1,672,061



Proposal number 4
 Approval and adoption of the Companys 2005 Equity Incentive Plan:



|          |  |  |  |         |  |  |  |          |  |  |  |          
|--------- |  |  |  | ------- |  |  |  | -------- |  |  |  | ---------
|FOR       |  |  |  | AGAINST |  |  |  | WITHHOLD |  |  |  | NON-VOTES
|2,876,131 |  |  |  | 560,767 |  |  |  | 118,347  |  |  |  | 1,672,061



The following
directors continued in office with terms ending in 2006:



John
D. Bair

Thomas M. OLeary

Michael R. Sayre

Christopher L. Winslow



23



---

##### Table of Contents

Item 6. Exhibits.



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



|            |  |                                                                                                |  |                                                                                                             
|----------- |  | ---------------------------------------------------------------------------------------------- |  | ------------------------------------------------------------------------------------------------------------
|Exhibit No. |  | Description of Exhibit                                                                         |  | If Incorporated by Reference, Document with which Exhibit was Previously Filed with the SEC                 
|3(a)        |  | Amended and restated articles of incorporation                                                 |  | Registration Statement on Form 10-SB filed with the Securities and Exchange Commission on December 13, 1999.
|            |  |                                                                                               
|3(b)        |  | Amendments to Amended and Restated Articles of Incorporation, adopted June 26, 2000            |  | Form SB-2 filed with the Securities and Exchange Commission September 21, 2000.                             
|            |  |                                                                                               
|3(c)        |  | Amendment to the Companys Amended and Restated Articles of Incorporation adopted May 23, 2001 |  | Quarterly Report on Form 10-QSB filed with the Securities and Exchange Commission on August 13, 2001.       
|            |  |                                                                                               
|3(d)        |  | Amended and Restated Code of Regulations                                                       |  | Registration Statement on Form 10-SB filed with the Securities and Exchange Commission on December 13, 1999.
|            |  |                                                                                               
|3(e)        |  | Amendment to Amended and Restated Code of Regulations                                          |  | Annual Report on Form 10-KSB filed with the Securities and Exchange Commission on March 30, 2000.           
|            |  |                                                                                               
|3(f)        |  | Amendments to Amended and Restated Code of Regulations, adopted June 26, 2000                  |  | Form SB-2 filed with the Securities and Exchange Commission September 21, 2000.                             
|            |  |                                                                                               
|4           |  | Instruments defining the rights of security holders, including indentures                      |  | Form SB-2 filed with the Securities and Exchange Commission September 21, 2000.                             



24



---

##### Table of Contents

|            |  |                                                                                                                                                                                |  |                                                                                            
|----------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | -------------------------------------------------------------------------------------------
|Exhibit No. |  | Description of Exhibit                                                                                                                                                         |  | If Incorporated by Reference, Document with which Exhibit was Previously Filed with the SEC
|31(a)       |  | Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Quarterly Report on Form 10-QSB of Pinnacle Data Systems, Inc. for the quarter ended June 30, 2005. |  | Contained herein.                                                                          
|            |  |                                                                                                                                                                               
|31(b)       |  | Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Quarterly Report on Form 10-QSB of Pinnacle Data Systems, Inc. for the quarter ended June 30, 2005. |  | Contained herein.                                                                          
|            |  |                                                                                                                                                                               
|32(a)       |  | Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 of Quarterly Report on Form 10-QSB of Pinnacle Data Systems, Inc. for the quarter ended June 30, 2005. |  | Contained herein.                                                                          
|            |  |                                                                                                                                                                               
|32(b)       |  | Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 of Quarterly Report on Form 10-QSB of Pinnacle Data Systems, Inc. for the quarter ended June 30, 2005. |  | Contained herein.                                                                          



25



---

##### Table of Contents

SIGNATURES



In accordance with the requirements of
the Exchange Act, the registrant caused this report to be signed on its behalf by the undersigned, thereunto duly authorized.



|                    |  |                                                                    
|------------------- |  | -------------------------------------------------------------------
|                    |  | PINNACLE DATA SYSTEMS, INC.                                        
|                    | 
|Date: July 27, 2005 |  | /s/ Michael R. Sayre                                               
|                    |  | Michael Sayre, Executive Vice President and Chief
Financial Officer
|                    | 
|Date: July 27, 2005 |  | /s/ Thomas J. Carr                                                 
|                    |  | Thomas J. Carr, Controller                                         





26