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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-Q



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

For the quarterly period ended March 31, 2006



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

For the transition period from  to

Commission file number: 1-16103



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PINNACLE DATA SYSTEMS, INC.

(Exact name of registrant as specified in its charter)



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|                                                               |  |                                  
|-------------------------------------------------------------- |  | ---------------------------------
|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)

No change

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



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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 ̈

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



|                         |  |                    |  |                         
|------------------------ |  | ------------------ |  | ------------------------
|Large accelerated filer ̈ |  | Accelerated filer ̈ |  | Non-accelerated filer  x

Indicate by check mark whether the registrant is a shell company (as defined in Rule12b-2 of the Exchange
Act).    Yes ̈No  x

APPLICABLE ONLY TO CORPORATE ISSUERS

On May 1,
2006, the Issuer had outstanding 6,230,656 common shares without par value, which is the Issuers only class of common equity.



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##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

INDEX



|           |  |                                                                                      |  |         
|---------- |  | ------------------------------------------------------------------------------------ |  | --------
|           |  |                                                                                      |  | Page No.
|PART I     |  | FINANCIAL INFORMATION                                                                |  |         
|           |  |                                                                                     
|Item 1.    |  | Financial Statements                                                                 |  | 3       
|           |  |                                                                                     
|           |  | Balance SheetsMarch 31, 2006 and December 31, 2005                                   |  | 3       
|           |  |                                                                                     
|           |  | Statements of OperationsQuarter ended March 31, 2006 and March 31, 2005              |  | 5       
|           |  |                                                                                     
|           |  | Statements of Cash FlowsQuarter ended March 31, 2006 and March 31, 2005              |  | 6       
|           |  |                                                                                     
|           |  | Notes to Financial Statements                                                        |  | 8       
|           |  |                                                                                     
|Item 2.    |  | Managements Discussion and Analysis of Financial Condition and Results of Operation |  | 16      
|           |  |                                                                                     
|Item 3.    |  | Quantitative and Qualitative Disclosures About Market Risk                           |  | 23      
|           |  |                                                                                     
|Item 4.    |  | Controls and Procedures                                                              |  | 24      
|           |  |                                                                                     
|PART II    |  | OTHER INFORMATION                                                                    |  |         
|           |  |                                                                                     
|Item 6.    |  | Exhibits.                                                                            |  | 25      
|           | 
|SIGNATURES |  | 26                                                                                  



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##### Table of Contents

Part I. FINANCIAL INFORMATION

Item 1. Financial Statements

PINNACLE DATA SYSTEMS, INC.

BALANCE SHEETS



|                                                                                                  |  |               |            |   |                  |   |            |  
|------------------------------------------------------------------------------------------------- |  | ------------- | ---------- | - | ---------------- | - | ---------- | -
|                                                                                                  |  | March 31,2006 |            |   | December 31,2005 |  
|                                                                                                  |  | (Unaudited)   |            |   |                  |  
|ASSETS                                                                                            |  |               |            |   |                  |   |            |  
|CURRENT ASSETS                                                                                    |  |               |            |   |                  |   |            |  
|Cash                                                                                              |  | $             | 813,374    |   |                  | $ | 485,566    |  
|Accounts receivable, net of allowance for doubtful accounts of $100,000 and $70,000, respectively |  |               | 11,394,672 |   |                  |   | 12,555,814 |  
|Inventory                                                                                         |  |               | 10,670,835 |   |                  |   | 9,232,778  |  
|Prepaid expenses                                                                                  |  |               | 540,291    |   |                  |   | 421,273    |  
|Refundable income taxes                                                                           |  |               | 412,555    |   |                  |   |           |  
|Deferred income taxes                                                                             |  |               | 833,000    |   |                  |   | 833,000    |  
|                                                                                                  |  |               |            |   |                  |   |            |  
|                                                                                                  |  |               | 24,664,727 |   |                  |   | 23,528,431 |  
|                                                                                                  |  |               |            |   |                  |   |            |  
|PROPERTY AND EQUIPMENT                                                                            |  |               |            |   |                  |   |            |  
|Leasehold improvements                                                                            |  |               | 351,194    |   |                  |   | 328,777    |  
|Furniture and fixtures                                                                            |  |               | 389,743    |   |                  |   | 389,744    |  
|Computer equipment and related software                                                           |  |               | 2,776,126  |   |                  |   | 2,714,901  |  
|Shop equipment                                                                                    |  |               | 605,606    |   |                  |   | 598,999    |  
|                                                                                                  |  |               |            |   |                  |   |            |  
|                                                                                                  |  |               | 4,122,669  |   |                  |   | 4,032,421  |  
|Less accumulated depreciation and amortization                                                    |  |               | (3,350,440 | ) |                  |   | (3,250,391 | )
|                                                                                                  |  |               |            |   |                  |   |            |  
|                                                                                                  |  |               | 772,229    |   |                  |   | 782,030    |  
|                                                                                                  |  |               |            |   |                  |   |            |  
|OTHER ASSETS                                                                                      |  |               | 108,568    |   |                  |   | 108,568    |  
|                                                                                                  |  |               |            |   |                  |   |            |  
|                                                                                                  |  | $             | 25,545,524 |   |                  | $ | 24,419,029 |  
|                                                                                                  |  |               |            |   |                  |   |            |  

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



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PINNACLE DATA SYSTEMS, INC.

BALANCE SHEETS



|                                                                                                                              |  |               |            |                  |   |           
|----------------------------------------------------------------------------------------------------------------------------- |  | ------------- | ---------- | ---------------- | - | ----------
|                                                                                                                              |  | March 31,2006 |            | December 31,2005
|                                                                                                                              |  | (Unaudited)   |            |                 
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                          |  |               |            |                  |   |           
|CURRENT LIABILITIES                                                                                                           |  |               |            |                  |   |           
|Line of credit                                                                                                                |  | $             | 8,936,641  |                  | $ | 9,335,940 
|Accounts payable                                                                                                              |  |               | 8,023,414  |                  |   | 6,122,181 
|Accrued expenses:                                                                                                             |  |               |            |                  |   |           
|Wages, payroll taxes and benefits                                                                                             |  |               | 1,056,891  |                  |   | 977,808   
|Income taxes                                                                                                                  |  |               |           |                  |   | 366,216   
|Other                                                                                                                         |  |               | 475,904    |                  |   | 652,630   
|Unearned revenue                                                                                                              |  |               | 408,166    |                  |   | 209,288   
|                                                                                                                              |  |               |            |                  |   |           
|                                                                                                                              |  |               | 18,901,016 |                  |   | 17,664,063
|                                                                                                                              |  |               |            |                  |   |           
|LONG-TERM LIABILITIES                                                                                                         |  |               |            |                  |   |           
|Deferred income taxes                                                                                                         |  |               | 63,000     |                  |   | 63,000    
|                                                                                                                              |  |               |            |                  |   |           
|                                                                                                                              |  |               | 18,964,016 |                  |   | 17,727,063
|                                                                                                                              |  |               |            |                  |   |           
|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; 6,216,656 and 5,985,356 shares issued and outstanding, respectively |  |               | 3,157,729  |                  |   | 2,755,030 
|Additional paid-in capital                                                                                                    |  |               | 759,166    |                  |   | 754,137   
|Retained earnings                                                                                                             |  |               | 2,664,613  |                  |   | 3,182,799 
|                                                                                                                              |  |               |            |                  |   |           
|                                                                                                                              |  |               | 6,581,508  |                  |   | 6,691,966 
|                                                                                                                              |  |               |            |                  |   |           
|                                                                                                                              |  | $             | 25,545,524 |                  | $ | 24,419,029
|                                                                                                                              |  |               |            |                  |   |           

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



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PINNACLE DATA SYSTEMS, INC.

STATEMENTS OF OPERATIONS



|                                         |  |                            |            |   |                            |   |          
|---------------------------------------- |  | -------------------------- | ---------- | - | -------------------------- | - | ---------
|                                         |  | Quarter EndedMarch 31,2006 |            |   | Quarter EndedMarch 31,2005
|                                         |  | (Unaudited)                |            |   | (Unaudited)               
|SALES                                    |  |                            |            |   |                            |   |          
|Product sales                            |  | $                          | 12,408,535 |   |                            | $ | 5,304,860
|Service sales                            |  |                            | 2,550,052  |   |                            |   | 2,187,640
|                                         |  |                            |            |   |                            |   |          
|                                         |  |                            | 14,958,587 |   |                            |   | 7,492,500
|                                         |  |                            |            |   |                            |   |          
|COST OF SALES                            |  |                            |            |   |                            |   |          
|Product sales                            |  |                            | 11,051,962 |   |                            |   | 4,482,826
|Service sales                            |  |                            | 1,079,239  |   |                            |   | 987,081  
|                                         |  |                            |            |   |                            |   |          
|                                         |  |                            | 12,131,201 |   |                            |   | 5,469,907
|                                         |  |                            |            |   |                            |   |          
|GROSS PROFIT                             |  |                            | 2,827,386  |   |                            |   | 2,022,593
|                                         |  |                           
|OPERATING EXPENSES                       |  |                            | 3,527,149  |   |                            |   | 1,596,946
|                                         |  |                            |            |   |                            |   |          
|INCOME (LOSS) FROM OPERATIONS            |  |                            | (699,763   | ) |                            |   | 425,647  
|                                         |  |                            |            |   |                            |   |          
|OTHER EXPENSE                            |  |                            |            |   |                            |   |          
|Interest expense                         |  |                            | 163,423    |   |                            |   | 27,851   
|                                         |  |                            |            |   |                            |   |          
|INCOME (LOSS) BEFORE INCOME TAXES        |  |                            | (863,186   | ) |                            |   | 397,796  
|                                         |  |                           
|INCOME TAX (BENEFIT) EXPENSE             |  |                            | (345,000   | ) |                            |   | 151,000  
|                                         |  |                            |            |   |                            |   |          
|NET INCOME (LOSS)                        |  | $                          | (518,186   | ) |                            | $ | 246,796  
|                                         |  |                            |            |   |                            |   |          
|BASIC EARNINGS (LOSS) PER COMMON SHARE   |  | $                          | (0.09      | ) |                            | $ | 0.04     
|                                         |  |                            |            |   |                            |   |          
|DILUTED EARNINGS (LOSS) PER COMMON SHARE |  | $                          | (0.09      | ) |                            | $ | 0.04     
|                                         |  |                            |            |   |                            |   |          

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



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PINNACLE DATA SYSTEMS, INC.

STATEMENTS OF CASH FLOWS



|                                                                                                   |  |                            |            |   |                            |   |          |  
|-------------------------------------------------------------------------------------------------- |  | -------------------------- | ---------- | - | -------------------------- | - | -------- | -
|                                                                                                   |  | Quarter EndedMarch 31,2006 |            |   | Quarter EndedMarch 31,2005 |  
|                                                                                                   |  | (Unaudited)                |            |   | (Unaudited)                |  
|CASH FLOWS FROM OPERATING ACTIVITIES                                                               |  |                            |            |   |                            |   |          |  
|Net income (loss)                                                                                  |  | $                          | (518,186   | ) |                            | $ | 246,796  |  
|                                                                                                   |  |                            |            |   |                            |   |          |  
|Adjustments to reconcile net income (loss) to net cash provided by (used in) operating activities: |  |                            |            |   |                            |   |          |  
|Depreciation and amortization                                                                      |  |                            | 100,049    |   |                            |   | 121,256  |  
|Stock-based compensation expense                                                                   |  |                            | 5,029      |   |                            |   |         |  
|Provision for doubtful accounts                                                                    |  |                            | 30,000     |   |                            |   |         |  
|Inventory reserves                                                                                 |  |                            | 148,234    |   |                            |   | 94,040   |  
|(Increase)/decrease in assets:                                                                     |  |                            |            |   |                            |   |          |  
|Accounts receivable                                                                                |  |                            | 1,131,142  |   |                            |   | (89,002  | )
|Inventory                                                                                          |  |                            | (1,586,291 | ) |                            |   | (309,042 | )
|Prepaid expenses and other assets                                                                  |  |                            | (119,018   | ) |                            |   | (3,014   | )
|Refundable income taxes                                                                            |  |                            | (412,555   | ) |                            |   | 126,000  |  
|Increase/(decrease) in liabilities:                                                                |  |                            |            |   |                            |   |          |  
|Accounts payable                                                                                   |  |                            | 964,272    |   |                            |   | 417,130  |  
|Accrued expenses and taxes                                                                         |  |                            | (463,859   | ) |                            |   | 82,971   |  
|Unearned revenues                                                                                  |  |                            | 198,878    |   |                            |   | 83,418   |  
|                                                                                                   |  |                            |            |   |                            |   |          |  
|Total adjustments                                                                                  |  |                            | (4,119     | ) |                            |   | 523,757  |  
|                                                                                                   |  |                            |            |   |                            |   |          |  
|Net cash provided by (used in) operating activities                                                |  |                            | (522,305   | ) |                            |   | 770,553  |  
|                                                                                                   |  |                            |            |   |                            |   |          |  
|CASH FLOWS FROM INVESTING ACTIVITIES                                                               |  |                            |            |   |                            |   |          |  
|Purchases of property and equipment                                                                |  |                            | (90,248    | ) |                            |   | (134,101 | )
|                                                                                                   |  |                            |            |   |                            |   |          |  
|Net cash used in investing activities                                                              |  |                            | (90,248    | ) |                            |   | (134,101 | )
|                                                                                                   |  |                            |            |   |                            |   |          |  
|CASH FLOWS FROM FINANCING ACTIVITIES                                                               |  |                            |            |   |                            |   |          |  
|Net change in line of credit                                                                       |  |                            | (399,299   | ) |                            |   | (895,094 | )
|Outstanding checks in excess of funds on deposit                                                   |  |                            | 936,961    |   |                            |   | 60,186   |  
|Principal payments on capital lease obligation                                                     |  |                            |           |   |                            |   | (2,750   | )
|Proceeds from stock options exercised                                                              |  |                            | 402,699    |   |                            |   | 198,922  |  
|                                                                                                   |  |                            |            |   |                            |   |          |  
|Net cash provided by (used in) financing activities                                                |  |                            | 940,361    |   |                            |   | (638,736 | )
|                                                                                                   |  |                            |            |   |                            |   |          |  

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



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PINNACLE DATA SYSTEMS, INC.

STATEMENTS OF CASH FLOWS (CONTINUED)



|                                                                                  |  |                            |         |                            |   |        |  
|--------------------------------------------------------------------------------- |  | -------------------------- | ------- | -------------------------- | - | ------ | -
|                                                                                  |  | Quarter EndedMarch 31,2006 |         | Quarter EndedMarch 31,2005 |  
|                                                                                  |  | (Unaudited)                |         | (Unaudited)                |  
|INCREASE (DECREASE) IN CASH                                                       |  |                            | 327,808 |                            |   | (2,284 | )
|                                                                                  |  |                           
|CASH - Beginning of quarter                                                       |  |                            | 485,566 |                            |   | 15,068 |  
|                                                                                  |  |                            |         |                            |   |        |  
|CASH - End of quarter                                                             |  | $                          | 813,374 |                            | $ | 12,784 |  
|                                                                                  |  |                            |         |                            |   |        |  
|SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION                                  |  |                            |         |                            |   |        |  
|                                                                                  |  |                           
|Interest paid                                                                     |  | $                          | 153,507 |                            | $ | 30,567 |  
|                                                                                  |  |                            |         |                            |   |        |  
|Income taxes paid, net of refunds                                                 |  | $                          | 451,000 |                            | $ | 25,000 |  
|                                                                                  |  |                            |         |                            |   |        |  
|SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING TRANSACTIONS           |  |                            |         |                            |   |        |  
|                                                                                  |  |                           
|Income tax benefit from stock option plans credited to Additional paid-in-capital |  | $                          |        |                            | $ | 65,912 |  
|                                                                                  |  |                            |         |                            |   |        |  

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



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PINNACLE DATA SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS

(UNAUDITED)

Note 1. Organization

Nature of Business - Pinnacle Data Systems, Inc. (the Company) provides professional services around the development,
deployment and support of sophisticated computer systems that are, or are in, the products of its world-leading Original Equipment Manufacturer (OEMs) customer base in the computer and network, imaging, medical, telecommunications, and
aerospace equipment industries, among others. The Company offers a full range of engineering, product development, project and program management, integration, manufacturing, and lifecycle support services designed to increase its customers
product speed to market and engineered product life while decreasing overall costs to develop, deploy and service their products.

Effective
August 15, 2005, the Company acquired the assets and certain liabilities of GNP Computers, Inc. (GNP). The former GNP operations are in the process of being fully integrated as part of the Company. The acquired operations include
computer system design, manufacturing, and lifecycle management for OEMs in a broad range of industries. The financial results of the acquired operations from the date of the acquisition are included in the financial results reported for the
Company.

Note 2. Summary of Significant Accounting Policies

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

Inventory at March 31, 2006 and December 31, 2005 was comprised of the following (net of inventory reserves):



|                                |  |                |            |                   |   |          
|------------------------------- |  | -------------- | ---------- | ----------------- | - | ---------
|                                |  | March 31, 2006 |            | December 31, 2005
|Component parts (raw materials) |  | $              | 8,257,233  |                   | $ | 6,848,665
|Work-in-process                 |  |                | 2,125,202  |                   |   | 1,075,489
|Finished goods                  |  |                | 288,400    |                   |   | 1,308,624
|                                |  |                |            |                   |   |          
|                                |  | $              | 10,670,835 |                   | $ | 9,232,778
|                                |  |                |            |                   |   |          

The carrying values of component parts and finished goods represent average cost or
managements estimate of its net realizable value. Such value is based on forecasts of product orders and repair/trade-in activity in the ensuing years. Such forecasts are based on historical information, known contracts, and managements
expertise in computer hardware life cycles. Should demand for the Companys products and repair/trade-in hardware prove to be significantly less than anticipated, the ultimate realizable value of such products could be substantially less than
the amount shown in the balance sheet. At March 31, 2006 and December 31, 2005, the Company provided reserves of approximately $2.9 million and $2.7 million, respectively to reduce the carrying value of inventory.

The balance sheet as of March 31, 2006 and the statements of operations and cash flows for the quarter ended March 31, 2006 and March 31,
2005 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.



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PINNACLE DATA SYSTEMS, INC.

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, 2005 annual report on Form 10-KSB. The results of operations for the periods
ended March 31, 2006 are not necessarily indicative of the results for the full year.

Stock-Based Compensation  In
December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial Accounting Standards (SFAS) No. 123 (Revised), Shared Based Payment. SFAS No. 123(R) replaces SFAS No. 123,
Accounting for Stock Based Compensation, and supersedes Accounting Principles Board (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 used the intrinsic value-based method through 2005.

The Company did not recognize compensation costs related to stock options granted to its employees and non-employee directors that had an exercise price
equal to or above the market value of the underlying common stock on the date of grant in its statement of operations prior to January 1, 2006. Effective January 1, 2006, the Company adopted the fair value recognition provisions of SFAS
No. 123(R) and related interpretations using the modified-prospective transition method. Under that method, compensation cost recognized in the first quarter of 2006 includes (a) compensation cost for all stock-based awards granted prior
to, but not yet vested as of January 1, 2006 based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123 and (b) compensation cost for all stock-based awards granted on or subsequent to
January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R). Results for prior periods have not been restated. Stock based compensation expense recognized for the three months ended
March 31, 2006 was $5,029, which is included in the operating expenses in the accompanying statements of operations.

On
November 10, 2005, and effective November 17, 2005 the Board of Directors approved the acceleration of vesting of unvested stock options previously awarded to employees and officers of the Company under various stock option plans. As a
result of this action, options to purchase approximately 1,186,000 shares of our common stock that would otherwise have vested over the next one to four years became fully vested.

The decision to accelerate the vesting of these options is considered to be in the best interest of our stockholders and, was made primarily to reduce
non-cash compensation expense that would have been recorded in future periods following our adoption of FAS 123(R). Because of the acceleration of the vesting period of such options, it is anticipated the Companys non-cash compensation expense
related to these options will be reduced by approximately $890,000 (pre-tax) over fiscal years 2006 through 2009, based on estimated value calculations using the Black-Scholes methodology.



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PINNACLE DATA SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS

(UNAUDITED)

Note 2. Summary of Significant Accounting Policies (continued)

In November 2005, the FASB, issued FASB Staff Position FAS 123(R)-3, Transition Election to Accounting for the Tax Effect of Share-Based Payment Awards, (FSP). This FSP requires an entity to follow
either the transition guidance for the additional-paid-in-capital pool as prescribed in SFAS No. 123(R) or the alternative transition method as described in the FSP. An entity that adopts SFAS No. 123(R) using the modified prospective
method may make a one-time election to adopt the transition method described in this FSP. An entity may take up to one year from the later of its initial adoption of SFAS No. 123(R) or the effective date of this FSP to evaluate its available
transition alternative and make its one-time election. This FSP became effective in November 2005. The Company is still evaluating whether it will adopt the alternative method for calculating its additional-paid-in-capital pool described in the FSP.

Pro forma information regarding net income and earnings per share for 2005 and prior is required by SFAS No. 123(R), and has been
determined as if the Company had accounted for its employee stock options under the fair value method of that Statement. The Company utilized the intrinsic value-based method for accounting for employee stock options or similar equity instruments in
2005 and prior; therefore, the Company did not record any compensation cost in the statements of income for stock-based employee compensation awards.

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



|                                                                                                                                  |  |                   |          |   |                   |   |         |  
|--------------------------------------------------------------------------------------------------------------------------------- |  | ----------------- | -------- | - | ----------------- | - | ------- | -
|                                                                                                                                  |  | First Quarter2006 |          |   | First Quarter2005 |  
|Net income (loss), as reported                                                                                                    |  | $                 | (518,186 | ) |                   | $ | 246,796 |  
|Deduct: total stock-based compensation expense determined under the fair value method for all awards, net of related tax
benefits |  |                   |         |   |                   |   | (59,345 | )
|                                                                                                                                  |  |                   |          |   |                   |   |         |  
|Net income (loss), pro forma                                                                                                      |  |                   | (518,186 | ) |                   |   | 187,451 |  
|                                                                                                                                  |  |                  
|Earnings (loss) per common share, basic:                                                                                          |  |                   |          |   |                   |   |         |  
|As reported                                                                                                                       |  | $                 | (0.09    | ) |                   | $ | 0.04    |  
|Pro forma                                                                                                                         |  | $                 | (0.09    | ) |                   | $ | 0.03    |  
|Earnings (loss) per common share, diluted:                                                                                        |  |                   |          |   |                   |   |         |  
|As reported                                                                                                                       |  | $                 | (0.09    | ) |                   | $ | 0.04    |  
|Pro forma                                                                                                                         |  | $                 | (0.09    | ) |                   | $ | 0.03    |  



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##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS

(UNAUDITED)

Note 3. Line of Credit

At
March 31, 2006, the Company had a bank line of credit with KeyBank National Association (KeyBank), with a limit of $11,000,000 and bearing monthly interest payments at prime, which was 7.75% at March 31, 2006. The Company was
obligated for funds drawn against this line of credit in the amount of $8,936,641 and $9,335,940 at March, 31, 2006 and December 31, 2005, 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. In anticipation of its acquisition of GNP, on August 9, 2005, 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 $11,000,000 from $6,000,000 and is due and renewable by May 15, 2007. The borrowing base calculation on March 31, 2006 was the maximum $11,000,000, resulting in an unused
capacity of $2,063,359. As of March 31, 2006, the Company was in compliance with all covenants on the line.

Note 4. 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 5. Stock Options

The Company adopted the Pinnacle Data Systems, Inc. 1995 Stock Option Plan on December 19, 1995 (the 1995 Plan). On May 5, 2005, the
shareholders approved and the Company adopted the 2005 Equity Incentive Plan (the 2005 Plan), which replaced the 1995 Plan. During the quarters ended March 31, 2006 and March 31, 2005, the Companys stock option activities
and weighted average exercise prices were as follows:



|                                            |  |                                 |  |                       |      |                   |           |                       |   |     
|------------------------------------------- |  | ------------------------------- |  | --------------------- | ---- | ----------------- | --------- | --------------------- | - | ----
|                                            |  | For the quarter ended March 31,
|                                            |  | 2006                            |  | 2005                 
|Stock Option Agreements                     |  | Number ofOptions                |  | WeightedAverage Price |      | Number of Options |           | WeightedAverage Price
|Outstanding at December 31                  |  | 2,118,900                       |  | $                     | 2.54 |                   | 1,526,950 |                       | $ | 2.00
|Granted                                     |  | 160,000                         |  | $                     | 3.35 |                   | 21,000    |                       | $ | 3.06
|Exercised                                   |  | 231,300                         |  | $                     | 1.74 |                   | 135,600   |                       | $ | 1.47
|Forfeited                                   |  | 200                             |  | $                     | 3.88 |                   | 350       |                       | $ | 3.22
|                                            |  |                                 |  |                       |      |                   |           |                       |   |     
|Outstanding at March 31                     |  | 2,047,400                       |  | $                     | 2.69 |                   | 1,412,000 |                       | $ | 2.07
|                                            |  |                                 |  |                       |      |                   |           |                       |   |     
|Exercise price range of options outstanding |  | $0.75 to $5.25                  |  | $0.63 to $5.25       



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##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS

(UNAUDITED)

Note 5. Stock Options (continued)

All of the 160,000 options granted in 2006 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 quarters ended March 31st:



|                                        |  |       |   |  |       |  
|--------------------------------------- |  | ----- | - |  | ----- | -
|                                        |  | 2006  |   |  | 2005  |  
|Risk-free interest rate                 |  | 4.50  | % |  | 4.40  | %
|Dividend yield                          |  | 0     | % |  | 0     | %
|Volatility factor                       |  | 64.35 | % |  | 83.00 | %
|Weighted average expected life in years |  | 6.4   |   |  | 9.0   |  

For purposes of determining the expected volatility factor, the Company used the historical price
volatility of the Companys stock price over the prior two year period. The approximate risk-free interest rate was based on the implied yield available on U.S. Treasury zero-coupon issues with remaining terms equivalent to the expected term on
the options granted. The Company does not expect to pay dividends on its common stock, therefore, a dividend yield of zero was used in the option-pricing model. The expected term of stock options granted is the period of time the options are
expected to remain outstanding. Due to limited historical exercise data, the Company used the simplified method as provided in Staff Accounting Bulletin (SAB) 107 to estimate the expected term. Using this method, the expected term is
calculated as the mid-point between the vesting date and the contractual term or expiration date. The options granted during the quarter ended March 31, 2006 and 2005 had a weighted-average fair value of $2.15 and $2.53, respectively.

Note 6. Earnings Per Common and Common Equivalent Share

Earnings per common and common equivalent share were computed by dividing net earnings by the weighted average number of shares of common stock
outstanding during the quarter. For the quarter ended March 31, 2006, no conversion of common stock equivalents has been assumed in the calculation since the effect would be anti-dilutive. As a result, the number of weighted average outstanding
common shares as well as the amount of net loss per share is the same for basic and diluted net loss per share calculations for the quarter ended March 31, 2006.



|                                        |  |                                      |          |   |                     |           |                 |   |       |  
|--------------------------------------- |  | ------------------------------------ | -------- | - | ------------------- | --------- | --------------- | - | ----- | -
|                                        |  | For the quarter ended March 31, 2006 |         
|                                        |  | Income(Numerator)                    |          |   | Shares(Denominator) |           | Per-ShareAmount |  
|Basic and Diluted EPS                   |  |                                      |          |   |                     |           |                 |   |       |  
|Income available to common shareholders |  | $                                    | (518,186 | ) |                     | 6,062,282 |                 | $ | (0.09 | )
|                                        |  |                                      |          |   |                     |           |                 |   |       |  



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##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS

(UNAUDITED)

Note 6. Earnings Per Common and Common Equivalent Share (continued)

For the quarter ended March 31, 2005, common stock options are included in the diluted earnings per share calculation, when dilutive, as calculated below:



|                                                                |  |                                      |         |                     |           |                 |   |     
|--------------------------------------------------------------- |  | ------------------------------------ | ------- | ------------------- | --------- | --------------- | - | ----
|                                                                |  | For the quarter ended March 31, 2005
|                                                                |  | Income(Numerator)                    |         | Shares(Denominator) |           | Per-ShareAmount
|Basic EPS                                                       |  |                                      |         |                     |           |                 |   |     
|Income available to common shareholders                         |  | $                                    | 246,796 |                     | 5,725,817 |                 | $ | 0.04
|Effect of Dilutive Securities Options                           |  |                                      |         |                     | 529,761   |                 |   |     
|                                                                |  |                                      |         |                     |           |                 |   |     
|Diluted EPS                                                     |  |                                      |         |                     |           |                 |   |     
|Income available to common stockholders and assumed conversions |  | $                                    | 246,796 |                     | 6,255,578 |                 | $ | 0.04
|                                                                |  |                                      |         |                     |           |                 |   |     

Note 7. Operating Segments

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

Segment information for the quarters ended March 31, 2006 and 2005, was as follows:



|                              |  |                              |            |         |   |           |  |   |            |   |  |   |            |  
|----------------------------- |  | ---------------------------- | ---------- | ------- | - | --------- |  | - | ---------- | - |  | - | ---------- | -
|                              |  | Quarter Ended March 31, 2006 |           
|                              |  | Product                      |            | Service |   | Other     |  |   | Total      |  
|Sales                         |  | $                            | 12,408,535 |         | $ | 2,550,052 |  | $ |           |   |  | $ | 14,958,587 |  
|Gross profit                  |  |                              | 1,356,573  |         |   | 1,470,813 |  |   |           |   |  |   | 2,827,386  |  
|Operating earnings (loss)     |  |                              | 208,784    |         |   | 1,121,614 |  |   | (2,030,161 | ) |  |   | (699,763   | )
|Depreciation and amortization |  |                              | 36,768     |         |   | 30,287    |  |   | 32,994     |   |  |   | 100,049    |  
|Interest expense              |  |                              |           |         |   |          |  |   | 163,423    |   |  |   | 163,423    |  
|Total assets                  |  |                              | 20,552,108 |         |   | 1,974,004 |  |   | 3,019,412  |   |  |   | 25,545,524 |  
|Capital expenditures          |  |                              | 17,980     |         |   |          |  |   | 72,268     |   |  |   | 90,248     |  



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##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS

(UNAUDITED)

Note 7. Operating Segments (continued)



|                              |  |                              |           |         |   |           |  |   |           |   |  |   |           
|----------------------------- |  | ---------------------------- | --------- | ------- | - | --------- |  | - | --------- | - |  | - | ----------
|                              |  | Quarter Ended March 31, 2005
|                              |  | Product                      |           | Service |   | Other     |  |   | Total    
|Sales                         |  | $                            | 5,304,860 |         | $ | 2,187,640 |  | $ |          |   |  | $ | 7,492,500 
|Gross profit                  |  |                              | 822,034   |         |   | 1,200,559 |  |   |          |   |  |   | 2,022,593 
|Operating earnings (loss)     |  |                              | 224,998   |         |   | 982,078   |  |   | (781,429  | ) |  |   | 425,647   
|Depreciation and amortization |  |                              | 58,328    |         |   | 29,373    |  |   | 33,555    |   |  |   | 121,256   
|Interest expense              |  |                              |          |         |   |          |  |   | 27,851    |   |  |   | 27,851    
|Total assets                  |  |                              | 5,692,255 |         |   | 2,765,447 |  |   | 2,174,638 |   |  |   | 10,632,340
|Capital expenditures          |  |                              | 874       |         |   | 19,405    |  |   | 113,822   |   |  |   | 134,101   

Note 8. Pro-forma Combined Statement of Operations

On August 12, 2005, we entered into an asset purchase agreement with GNP Computers, Inc. (GNP) and GNPs principal shareholder in
which the Company acquired all of the assets and certain liabilities of GNP. The assets totaled approximately $8.7 million, of which $8.3 million was receivables and inventory. Thus far, the acquisition has been accretive due to the fact the leased
square footage of the acquired facility and the number of employees were significantly reduced immediately prior to the transaction, thereby improving the cost structure of the operation, and because there was a significant backlog of orders that
could not be fulfilled prior to the acquisition due to a lack of financing. None of the acquired customers are under contractual obligation to GNP to meet minimum order quantities before the acquisition and they are not under any of those kinds of
obligations with the Company today. Customers could stop placing orders at any time. The liabilities assumed upon the acquisition consisted of a $2.3 million asset-based line of credit, payables and other accrued liabilities of approximately $6.4
million, which included the transaction fees for both parties. Simultaneously with the acquisition, the Company paid off the asset-based line of credit.

The market value of the assets was essentially equal to the total of the assumed liabilities and capitalized transaction expenses. As a result, no goodwill was recorded on the transaction and no long term debt was
assumed or incurred. The results of the operations of the California operation subsequent to August 15, 2005 are included in the Companys statements of operations.

The pro forma data is presented for informational purposes only and may not necessarily reflect future results of operations or what the results of
operations would have been had the Company and GNP been operating as combined entities for the periods presented.

The accompanying
unaudited pro forma combined statements of operations are based on the historical financial statements of the Company and GNP after giving effect to its acquisition by the Company. The Company completed the acquisition of substantially all of the
assets and assumed certain liabilities of GNP on August 15, 2005.



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##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

NOTES TO FINANCIAL STATEMENTS

(UNAUDITED)

Note 8. Pro-forma Combined Statement of Operations (continued)

The unaudited pro forma combined statements of operations for the quarter ended March 31, 2005 is presented as if the acquisition of GNP had occurred on January 1, 2005.



|                                               |  |                              |           |     |   |            |                      |  |   |           |   |  |   |            |  
|---------------------------------------------- |  | ---------------------------- | --------- | --- | - | ---------- | -------------------- |  | - | --------- | - |  | - | ---------- | -
|                                               |  | Quarter Ended March 31, 2005 |          
|                                               |  | Pinnacle                     |           | GNP |   |            | Pro FormaAdjustments |  |   | Pro Forma |  
|Sales                                          |  | $                            | 7,492,500 |     | $ | 5,514,949  |                      |  |   |           |   |  | $ | 13,007,449 |  
|Net income (loss)                              |  |                              | 246,796   |     |   | (1,150,079 | )                    |  | $ | 64,626    | a |  |   | (838,657   | )
|Basic/Diluted earnings (loss) per common share |  | $                            | 0.04      |     |   |            |                      |  |   |           |   |  | $ | (0.15      | )

Pro-Forma Adjustments to the Combined Statements of Operations:

(a) Operating expenses  decrease in depreciation expense as a result of purchase accounting.

Note 9. Subsequent Event

On
May 8, 2006, Silicon Graphics, Inc. (SGI) announced that it has reached an agreement with all of its Senior Secured bank lenders and with holders of a significant amount of its Senior Secured debt on the terms of a reorganization
plan, filing voluntary petitions under chapter 11 of the U.S. Bankruptcy Code. As of May 8, 2006, the Company has $616,000 in outstanding accounts receivable and $426,000 of inventory related to a repair service agreement with SGI. The
Companys management is currently working with SGI to determine whether SGI will assume or reject the current executory contract post-petition. To assume the contract, all pre-petition receivables must be paid within the terms of the contract
and slow-moving parts inventory must be re-purchased by SGI. The rejection of the contract will most likely result in a significant portion of the receivables not being collected and the impairment of some portion of the inventory. The impaired
value of the Companys accounts receivable and inventory related to SGI cannot be determined at this time.



15



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##### Table of Contents

Item 2. Managements Discussion and Analysis of Financial Condition and Results 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 Company achieving sequential quarterly sales increases throughout the rest of 2006. The words
believe, expect, anticipate, estimate, project, plan, intend, 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 the
specific markets for our products and services, changes in customer order patterns from their historic patterns, changes in our business or our relationship with major technology partners, lack of adequate financing to take advantage of business
opportunities that may arise, lack of success in technological advancements, and risks associated with our new business practices, processes and information systems. For more details, please refer to the Companys Securities and Exchange
Commission filings, including its most recent Annual Report on Form 10-KSB.

OVERVIEW

Pinnacle Data Systems, Inc. (we or the Company) provides professional services around the development, deployment and support of
sophisticated computer systems that are, or are in, the products of its world-leading Original Equipment Manufacturer (OEM) customer base in the computer and network, imaging, medical, telecommunications, and aerospace equipment
industries, among others. The Company offers a full range of engineering, product development, project and program management, integration, manufacturing, and lifecycle support services designed to increase its customers products speed to
market and engineered product life while decreasing overall costs to develop, deploy and service their products.

Our business strategy is
to collaborate with the worlds leading OEMs by managing the critical business activities required to successfully deploy information technology (IT) solutions. Our approach includes redefining the outsourced IT solution for OEMs
that embed information technologies by offering comprehensive, global and information-laden solutions to fill critical supply-chain, engineering and logistics needs, and differentiating our offerings from other market choices through tangible value
propositions based on collaborative execution and business intelligence deliverables. Unlike contract manufacturers, we are skilled at offering hybrid solutions using commercially available technologies combined with proprietary implementations.
Unlike distributors, we are technology agnostic and capable of complex engineering programs. Unlike technology providers, we bring quantitative technical knowledge and engineered platforms to its custom solution development process. We intend to
develop a new brand category to address needs of OEMs, to consolidate weaker niche players through acquisition, establish a professional services model to parallel that and provide its offerings in international markets.

On August 12, 2005, we entered into an asset purchase agreement with GNP Computers, Inc. (GNP) and GNPs principal shareholder in
which we acquired all of the assets and assumed certain liabilities of GNP. The assets totaled approximately $8.7 million, of which $8.3 million was receivables and inventory. Thus far, the acquisition has been accretive due to the fact that the
leased square footage of the acquired facility and the number of employees were significantly reduced immediately prior to the transaction, thereby improving the cost structure of the operation, and because there was a significant backlog of orders
that could not be fulfilled prior to the acquisition due to a lack of financing. None of the acquired customers were under contractual



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##### Table of Contents

obligation to GNP to meet minimum order quantities before the acquisition and they are not under any of those kinds of obligations with us today. They could
stop placing orders at any time, however based on our current relationships with this customer base, we have no indication that they will stop placing orders at this time. The liabilities assumed upon the acquisition consisted of a $2.3 million
asset based line of credit, payables and other accrued liabilities of approximately $6.4 million, which included the transaction fees for both parties. Simultaneously with the acquisition, we paid off the asset-based line of credit. In order to
facilitate the acquisition, on August 9, 2005, we increased our asset-based line of credit with KeyBank to $11 million from $6 million.

The market value of the assets was essentially equal to the total of the assumed liabilities and capitalized transaction expenses. As a result, no goodwill was recorded on the transaction and no long term debt was assumed or incurred. The
results of the operations of the California operation subsequent to August 15, 2005 are included in our statements of operations.

As a
result of the acquisition and the expected organic growth of the combined organizations, we anticipate another record sales year in 2006. Further integration of the two businesses and infrastructure development for growth in the future will occur
simultaneously throughout the year. We plan to spend $1 million or more in information technology and systems in 2006 to integrate the businesses and build a platform for future growth, with about half of that amount being capitalized as fixed
assets. We will continue evaluating viable acquisition opportunities that meet our established criteria, including strategic fit and projected accretive performance in less than a year. However, we are not currently planning any additional
acquisitions before the second half 2006.

The following discussions and analyses are for the quarter ended March 31, 2006,
compared to the comparable period ended March 31, 2005.

SALES

Sales for the first quarter of 2006 and 2005 were as follows:



|              |  |      |        |      |   |          |  |     |  
|------------- |  | ---- | ------ | ---- | - | -------- |  | --- | -
|($ thousands) |  | 2006 |        | 2005 |   | % Change | 
|Total Company |  | $    | 14,959 |      | $ | 7,493    |  | 100 | %
|Product       |  |      | 12,409 |      |   | 5,305    |  | 134 | %
|Service       |  |      | 2,550  |      |   | 2,188    |  | 17  | %

The increase in product sales in the first quarter was directly attributable to the acquisition of
the GNP customers, which generated approximately $5.5 million in product sales in the first quarter of 2005. Organic growth for the quarter increased approximately $2 million over the unaudited combined sales of the two entities in 2005, or about
15%.

As discussed in the Overview of this section, we expect annual record sales in 2006 due to the 2005 acquisition and the organic growth
of the combined companies.

For the first quarter of 2006, we had two customers that generated revenues of approximately $3.6 million and
$1.5 million or 24% and 10% respectively, of total revenue. In the statements of operations, all of the revenues from these customers are included in product sales. In addition, these customers represented 31% and 11%, respectively, of accounts
receivable at March 31, 2006.



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##### Table of Contents

GROSS PROFIT

Gross profit for the first quarter of 2006 and 2005 was as follows:



|              |  |      |       |      |   |          |  |    |  
|------------- |  | ---- | ----- | ---- | - | -------- |  | -- | -
|($ thousands) |  | 2006 |       | 2005 |   | % Change | 
|Total Company |  | $    | 2,827 |      | $ | 2,023    |  | 40 | %
|Product       |  |      | 1,356 |      |   | 822      |  | 65 | %
|Service       |  |      | 1,471 |      |   | 1,201    |  | 22 | %

The gross profit margin percentages for 2006 and 2005 were as follows:



|              |  |      |   |  |      |  
|------------- |  | ---- | - |  | ---- | -
|              |  | 2006 |   |  | 2005 |  
|Total Company |  | 19   | % |  | 27   | %
|Product       |  | 11   | % |  | 15   | %
|Service       |  | 58   | % |  | 55   | %

The increase in gross profit dollars on product sales in the first quarter was the result of new
programs and the 2005 acquisition, which was partially offset by a change in product mix coupled with an inventory write-down of approximately $100,000 due to the implementation of Restriction of Hazardous Substances (RoHS) standards in the European
Union effective July 1, 2006.

The increase in gross profit dollars on service sales in the first quarter of 2006 is attributable to
the mix of services delivered.

We expect our gross profit dollars to increase as a result of the expected increases in sales. Gross margin
percentages vary from program to program, and results vary from quarter to quarter due to changes in the mix of program sales in a given quarter. Consequently, it is difficult to predict how gross margin percentages will vary in the future.

On May 8, 2006, Silicon Graphics, Inc. (SGI) announced that it has reached an agreement with all of its Senior Secured
bank lenders and with holders of a significant amount of its Senior Secured debt on the terms of a reorganization plan, filing voluntary petitions under chapter 11 of the U.S. Bankruptcy Code. As of May 8, 2006, the Company has $616,000 in
outstanding accounts receivable and $426,000 of inventory related to a repair service agreement with SGI. The Companys management is currently working with SGI to determine whether SGI will assume or reject the current executory contract
post-petition. To assume the contract, all pre-petition receivables must be paid within the terms of the contract and slow-moving parts inventory must be re-purchased by SGI. The rejection of the contract will most likely result in a significant
portion of the receivables not being collected and the impairment of some portion of the inventory. The impaired value of the Companys accounts receivable and inventory related to SGI cannot be determined at this time.



18



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##### Table of Contents

OPERATING EXPENSES AND INTEREST EXPENSES

Operating expenses, including selling, general and administrative, and interest expenses for the first quarter of 2006 and 2005 were as follows:



|                   |  |      |       |      |   |          |  |     |  
|------------------ |  | ---- | ----- | ---- | - | -------- |  | --- | -
|($ thousands)      |  | 2006 |       | 2005 |   | % Change | 
|Operating expenses |  | $    | 3,527 |      | $ | 1,597    |  | 121 | %
|Interest expense   |  |      | 163   |      |   | 28       |  | 482 | %
|                   |  |      |       |      |   |          |  |     |  
|Total expense      |  | $    | 3,690 |      | $ | 1,625    |  | 127 | %

Operating expenses as a percent of sales for the first quarter 2006 and 2005 were 24% and 21%,
respectively. The increase in the operating expenses for the first quarter of 2006 resulted primarily from the 2005 acquisition of GNP along with the planned increase in sales.

Operating expenses for 2006 also include a one-time charge of approximately $400,000 for severance expenses relating primarily to the previously announced
resignation of Chris Winslow, the Companys former President and Chief Operating Officer.

As stated in the Overview section, we intend
to spend $1 million or more in 2006, with approximately half of the expenses used to develop sales and support infrastructure, largely in the form of information technology and systems.

The increase in interest expense in the first quarter was due to the use of the line of credit to finance the assets and liabilities of the GNP
acquisition. With our growth in the number of customers and in sales, we expect interest expense will be higher in the near future as we use the line of credit to support the additional accounts receivable and inventory related to the higher sales
volume.

INCOME TAXES (BENEFIT) AND NET INCOME (LOSS)

Income taxes (benefit) 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 first quarter of 2006 was 40%, compared to 38% in the comparable period of 2005.

Income (loss) before taxes, income taxes (benefit) and net income (loss) for the first quarter of 2006 and 2005 were as follows:



|                           |  |      |      |   |      |   |          |  |      |  
|-------------------------- |  | ---- | ---- | - | ---- | - | -------- |  | ---- | -
|($ thousands)              |  | 2006 |      |   | 2005 |   | % Change | 
|Income (loss) before taxes |  | $    | (863 | ) |      | $ | 398      |  | -317 | %
|Income taxes (benefit)     |  |      | (345 | ) |      |   | 151      |  | -328 | %
|                           |  |      |      |   |      |   |          |  |      |  
|Net income (loss)          |  | $    | (518 | ) |      | $ | 247      |  | -310 | %



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##### Table of Contents

Earnings per share for the first quarter of 2006 and 2005 were as follows:



|                                               |  |      |           |   |      |   |          
|---------------------------------------------- |  | ---- | --------- | - | ---- | - | ---------
|                                               |  | 2006 |           |   | 2005
|Basic EPS                                      |  | $    | (0.09     | ) |      | $ | 0.04     
|Fully diluted EPS                              |  | $    | (0.09     | ) |      | $ | 0.04     
|                                               |  |     
|Weighted average number of shares outstanding: |  |      |           |   |      |   |          
|Basic                                          |  |      | 6,062,282 |   |      |   | 5,725,817
|Fully diluted                                  |  |      | 6,062,282 |   |      |   | 6,255,578

Basic and diluted earning per share were the same in 2006, as the effect of the stock options
outstanding were anti-dilutive.

The reduction in net income for the first quarter ended March 31, 2006 is a result of the change in
sales mix and increased operating expenses mentioned above.

LIQUIDITY AND CAPITAL RESOURCES

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



|                     |  |         |        |          |   |          |  |    |  
|-------------------- |  | ------- | ------ | -------- | - | -------- |  | -- | -
|($ thousands)        |  | 3/31/06 |        | 12/31/05 |   | % Change | 
|Accounts receivable  |  | $       | 11,395 |          | $ | 12,556   |  | -9 | %
|Inventory            |  |         | 10,671 |          |   | 9,233    |  | 16 | %
|Other current assets |  |         | 2,599  |          |   | 1,740    |  | 49 | %
|                     |  |         |        |          |   |          |  |    |  
|Total                |  | $       | 24,665 |          | $ | 23,529   |  | 5  | %
|                     |  |         |        |          |   |          |  |    |  

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



|                          |  |         |        |          |   |          |  |     |  
|------------------------- |  | ------- | ------ | -------- | - | -------- |  | --- | -
|($ thousands)             |  | 3/31/06 |        | 12/31/05 |   | % Change | 
|Line of credit            |  | $       | 8,937  |          | $ | 9,336    |  | -4  | %
|Accounts payable          |  |         | 8,023  |          |   | 6,122    |  | 31  | %
|Other current liabilities |  |         | 1,941  |          |   | 2,206    |  | -12 | %
|                          |  |         |        |          |   |          |  |     |  
|Total                     |  | $       | 18,901 |          | $ | 17,664   |  | 7   | %
|                          |  |         |        |          |   |          |  |     |  

During the first quarter of 2006, approximately $522,000 of cash was used for operating
activities. Net loss without the effects of the depreciation expense, inventory reserves, stock-based compensation expense and the accounts receivable reserve increase was $235,000. Changes in working capital that decreased the availability of cash
during the quarter included increases in inventory of approximately $1,586,000, refundable income taxes of approximately $413,000 and accrued expenses and taxes of approximately $464,000. Additional adjustments to working capital, which increased
the availability of cash, included increases of the collection of accounts receivable of approximately $1,131,000 and in accounts payable of approximately $964,000.



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For the first quarter of 2006, the Company used approximately $90,000 of cash in investing activities to
purchase equipment, including computer equipment and leasehold improvements.

For the first quarter of 2006, we had net cash provided by
financing activities of approximately $940,000, consisting of approximately $937,000 of outstanding checks to be applied against the line of credit, approximately $403,000 from the exercise of stock options offset by the paydown of the line of
credit of approximately $400,000.

The line of credit, which is our primary source of operational and non-operational funding, is maintained
with KeyBank and is a revolving credit facility collateralized by a Blanket Lien on all 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 agreement restricts the payments of cash dividends that would cause violations of the loan covenants.

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 $11 million as well as a sub-limit of $5.5 million that can be collateralized by
inventory. That calculation represents the maximum amount that can be drawn on the line of credit.

In anticipation of our acquisition of
GNP, on August 9, 2005, the terms of the bank line of credit with KeyBank were amended to reflect our near term borrowing needs and our credit risk as rated by KeyBank. The amount available under the line was increased to $11 million from $6
million and is due and renewable by May 15, 2007. The balance on the line of credit at March 31, 2006 and December 31, 2005 was approximately $8.9 million and $9.3 million, respectively. The borrowing base calculation on both dates
was the maximum $11 million, resulting in an unused capacity of approximately $2.1 million and $1.7, million respectively. To accommodate the additional debt assumed in the GNP acquisition, on December 29, 2005, the Total Debt to Tangible Net
Worth Ratio loan covenant on the line of credit was increased to a maximum of 3.0 to 1.0 from 2.0 to 1.0. The covenant maximum will become 2.5 to 1.0 for the quarter ending June 30, 2006. The Company was in compliance with the revised covenant
on March 31, 2006.

Additional financing may be needed to support the future growth plans of the Company. We have already begun
execution of an acquisition strategy that may be financed by the issuance of additional common or preferred stock that has already been authorized by the shareholders. Those shares may be issued by approval of the Board of Directors. Acquisitions
being evaluated should provide services similar to ours that will be accretive upon the acquisition date or within a short period of time thereafter; that bring large OEM customer relationships with potential additional business for the combined
company (which may not be attainable by either company on their own); and bring resources, in terms of people, processes and/or systems, that increase the scalability of the combined businesses.

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.



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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 typically
placed on a common carrier. 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 generally accepted accounting principles in the
United States requires management to make judgments, assumptions and estimates that affect the amounts reported in the Financial Statements and accompanying notes. Note 1 to the Financial Statements in the Annual Report on our most recent Form
10-KSB 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 in the month in which the services are being provided, 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, implementation of materials standards and customer requirements, we may be required to increase our inventory allowances and our gross margin
would be adversely affected.

In December 2004, the Financial Accounting Standards Board (FASB) issued Statement of Financial
Accounting Standards (SFAS) No. 123 (Revised), Shared Based Payment. SFAS No. 123(R) replaces SFAS No. 123, Accounting for Stock Based Compensation, and supersedes Accounting Principles Board
(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. We used the intrinsic value-based method through 2005.



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We did not recognize compensation costs related to stock options granted to its employees and
non-employee directors that had an exercise price equal to or above the market value of the underlying common stock on the date of grant in its statement of operations prior to January 1, 2006. Effective January 1, 2006, we adopted the
fair value recognition provisions of SFAS No. 123(R) and related interpretations using the modified-prospective transition method. Under that method, compensation cost recognized in the first quarter of 2006 includes (a) compensation cost
for all stock-based awards granted prior to, but not yet vested as of January 1, 2006 based on the grant date fair value estimated in accordance with the original provisions of SFAS No. 123 and (b) compensation cost for all
stock-based awards granted on or subsequent to January 1, 2006, based on the grant date fair value estimated in accordance with the provisions of SFAS No. 123(R). Results for prior periods have not been restated.

We currently use the Black-Scholes option-pricing model to determine the fair value of stock options. The determination of the fair value of stock-based
payment awards on the date of grant using an option-pricing model is affected by our stock price as well as assumptions regarding a number of complex and subjective variables. These variables include our expected stock price volatility over the term
of the awards, actual and projected employee stock option exercise behaviors, the risk-free interest rate and expected dividends.

For
purposes of determining the expected volatility factor, we used the historical price volatility of the Companys stock price over the prior two year period. The approximate risk-free interest rate was based on the implied yield available on
U.S. Treasury zero-coupon issues with remaining terms equivalent to the expected term on the options granted. We do not expect to pay dividends on the Companys common stock, therefore, a dividend yield of zero was used in the option-pricing
model. The expected term of stock options granted is the period of time the options are expected to remain outstanding. Due to limited historical exercise data, we used the simplified method as provided in Staff Accounting Bulletin (SAB)
107 to estimate the expected term. Using this method, the expected term is calculated as the mid-point between the vesting date and the contractual term or expiration date.

Various estimates were used in recording the acquisition of the assets and assumption of the liabilities of GNP. Exact amounts of future payments for
items such as GNP taxes, interest and penalties, and for professional fees are not yet known, but are contractually capped in the Asset Purchase Agreement of August 12, 2005. The exact amounts actually paid may be different from the estimates
used in recording the transaction. Approximately $300,000 of estimated assumed liabilities were reduced in the fourth quarter of 2005, and included as a reduction of SG&A expenses of that amount in that quarter.

Item 3. Quantitative and Qualitative Disclosures About Market Risk.

We do not engage in commodity trading
activities and do not enter into derivative financial instruments for speculative trading purposes. We also do not engage in transactions in foreign currencies that would expose us to additional market risk. In the normal course of business, our
operations are exposed to interest rate risk. Our primary interest rate risk exposure relates to (i) our ability to refinance our line of credit at market rates, and (ii) the impact of interest rate movements on our ability to meet
interest expense requirements and financial covenants under our debt instruments.

As of March 31, 2006, we had outstanding borrowings
of approximately $8.9 million under our line of credit. The line of credit requires monthly interest payments at prime, which was 7.75% at March 31, 2006. A 100 basis point increase in the interest rate would result in an additional annual
expense of approximately $90,000.



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Item 4. 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 (the Evaluation Date) the Companys Chief Executive Officer and President, and Interim Chief Financial Officer as of the Evaluation Date, has 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.

As
of the Evaluation Date, 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.



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Part II OTHER INFORMATION

Item 6. 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                                                                                                                                    |  | Form 10-KSB filed with the Securities and Exchange Commission on March 30, 2006.                            
|            |  |                                                                                                                                                                            
|10(am)      |  | Employment agreement between Pinnacle Data Systems, Inc. and John D. Bair dated March 20, 2006.                                                                             |  | Current Report on Form 8-K/A filed with the Securities and Exchange Commission on March 23, 2006.           
|            |  |                                                                                                                                                                            
|10(ao)      |  | Employment agreement between Pinnacle Data Systems, Inc, and Michael R. Sayre dated March 20, 2006.                                                                         |  | Current Report on Form 8-K/A filed with the Securities and Exchange Commission on March 23, 2006.           
|            |  |                                                                                                                                                                            
|31(a)       |  | Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Annual Report on Form 10-KSB of Pinnacle Data Systems, Inc. for the quarter ended March 31, 2006 |  | Contained herein.                                                                                           
|            |  |                                                                                                                                                                            
|32(a)       |  | Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 of Annual Report on Form 10-KSB of Pinnacle Data Systems, Inc. for the quarter ended March 31, 2006 |  | Contained herein.                                                                                           



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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: May 12, 2006 |  | /s/ Michael R. Sayre                  
|                   |  | Michael Sayre, Chief Executive Officer
|                   |  | and Interim Chief Financial Officer   



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