##### Table of Contents





UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549





FORM 10-Q







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

For the quarterly period ended March 31, 2008

or



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

For the transition period from  to

Commission file number: 1-16103





Pinnacle Data Systems, Inc.

(Exact name of registrant as specified in its
charter)







|                                                               |  |                                     
|-------------------------------------------------------------- |  | ------------------------------------
|Ohio                                                           |  | 31-1263732                          
|(State or other jurisdiction of incorporation or organization) |  | (IRS Employer Identification Number)

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)





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

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

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

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

APPLICABLE ONLY TO CORPORATE ISSUERS

On May 14, 2008, the registrant had outstanding 7,817,099 common shares without par value, which
is the Issuers only class of common equity.









---

##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

TABLE OF CONTENTS



|               |  |                                                                                                              |  |         
|-------------- |  | ------------------------------------------------------------------------------------------------------------ |  | --------
|               |  |                                                                                                              |  | Page No.
|PART I         |  | FINANCIAL INFORMATION                                                                                        |  |         
|               |  |                                                                                                             
|Item 1.        |  | Financial Statements                                                                                         |  |         
|               |  |                                                                                                             
|               |  | Condensed Consolidated Balance Sheets as of March 31, 2008 and December 31, 2007                             |  | 3       
|               |  |                                                                                                             
|               |  | Condensed Consolidated Statements of Operations for the three months ended March 31, 2008 and March 31, 2007 |  | 4       
|               |  |                                                                                                             
|               |  | Condensed Consolidated Statements of Cash Flows for the three months ended March 31, 2008 and March 31, 2007 |  | 5       
|               |  |                                                                                                             
|               |  | Notes to Condensed Consolidated Financial Statements                                                         |  | 6       
|               |  |                                                                                                             
|Item 2.        |  | Managements Discussion and Analysis of Financial Condition and Results of Operations                        |  | 13      
|               |  |                                                                                                             
|Item 4.        |  | Controls and Procedures                                                                                      |  | 18      
|               |  |                                                                                                             
|PART II        |  | OTHER INFORMATION                                                                                            |  |         
|               |  |                                                                                                             
|Item 6.        |  | Exhibits                                                                                                     |  | 19      
|               | 
|SIGNATURES     |  | 20                                                                                                          
|               | 
|CERTIFICATIONS |  |                                                                                                             



2



---

##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS



|                                                                                                                              |  |                |            |   |                   |   |            |  
|----------------------------------------------------------------------------------------------------------------------------- |  | -------------- | ---------- | - | ----------------- | - | ---------- | -
|                                                                                                                              |  | March 31, 2008 |            |   | December 31, 2007 |  
|                                                                                                                              |  | (Unaudited)    |            |   |                   |  
|ASSETS                                                                                                                        |  |                |            |   |                   |   |            |  
|CURRENT ASSETS                                                                                                                |  |                |            |   |                   |   |            |  
|Cash                                                                                                                          |  | $              | 285,000    |   |                   | $ | 54,000     |  
|Restricted cash                                                                                                               |  |                |           |   |                   |   | 1,200,000  |  
|Accounts receivable, net of allowance for doubtful accounts of $122,000 and $119,000, respectively                            |  |                | 13,757,000 |   |                   |   | 10,413,000 |  
|Inventory, net                                                                                                                |  |                | 8,956,000  |   |                   |   | 8,587,000  |  
|Prepaid expenses                                                                                                              |  |                | 768,000    |   |                   |   | 612,000    |  
|Deferred income taxes                                                                                                         |  |                | 615,000    |   |                   |   | 580,000    |  
|                                                                                                                              |  |                |            |   |                   |   |            |  
|Total current assets                                                                                                          |  |                | 24,381,000 |   |                   |   | 21,446,000 |  
|                                                                                                                              |  |                |            |   |                   |   |            |  
|PROPERTY AND EQUIPMENT                                                                                                        |  |                |            |   |                   |   |            |  
|Leasehold improvements                                                                                                        |  |                | 718,000    |   |                   |   | 669,000    |  
|Furniture and fixtures                                                                                                        |  |                | 430,000    |   |                   |   | 412,000    |  
|Computer equipment and related software                                                                                       |  |                | 3,405,000  |   |                   |   | 3,402,000  |  
|Shop equipment                                                                                                                |  |                | 775,000    |   |                   |   | 667,000    |  
|                                                                                                                              |  |                |            |   |                   |   |            |  
|Total property and equipment, cost                                                                                            |  |                | 5,328,000  |   |                   |   | 5,150,000  |  
|                                                                                                                              |  |                |            |   |                   |   |            |  
|Less accumulated depreciation and amortization                                                                                |  |                | (4,360,000 | ) |                   |   | (4,223,000 | )
|                                                                                                                              |  |                |            |   |                   |   |            |  
|Total property and equipment, net                                                                                             |  |                | 968,000    |   |                   |   | 927,000    |  
|                                                                                                                              |  |                |            |   |                   |   |            |  
|OTHER ASSETS                                                                                                                  |  |                |            |   |                   |   |            |  
|Intangibles, net                                                                                                              |  |                | 1,144,000  |   |                   |   |           |  
|Deferred income taxes                                                                                                         |  |                | 4,000      |   |                   |   | 38,000     |  
|Other assets                                                                                                                  |  |                | 62,000     |   |                   |   | 62,000     |  
|                                                                                                                              |  |                |            |   |                   |   |            |  
|Total other assets                                                                                                            |  |                | 1,210,000  |   |                   |   | 100,000    |  
|                                                                                                                              |  |                |            |   |                   |   |            |  
|TOTAL ASSETS                                                                                                                  |  | $              | 26,559,000 |   |                   | $ | 22,473,000 |  
|                                                                                                                              |  |                |            |   |                   |   |            |  
|                                                                                                                              |  |               
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                          |  |                |            |   |                   |   |            |  
|CURRENT LIABILITIES                                                                                                           |  |                |            |   |                   |   |            |  
|Line of credit                                                                                                                |  | $              | 7,657,000  |   |                   | $ | 1,585,000  |  
|Short-term note                                                                                                               |  |                |           |   |                   |   | 4,000,000  |  
|Accounts payable                                                                                                              |  |                | 6,874,000  |   |                   |   | 6,178,000  |  
|Accrued expenses:                                                                                                             |  |                |            |   |                   |   |            |  
|Wages, payroll taxes and benefits                                                                                             |  |                | 1,078,000  |   |                   |   | 1,089,000  |  
|Other                                                                                                                         |  |                | 589,000    |   |                   |   | 499,000    |  
|Income taxes                                                                                                                  |  |                | 168,000    |   |                   |   | 77,000     |  
|Unearned revenue                                                                                                              |  |                | 722,000    |   |                   |   | 137,000    |  
|                                                                                                                              |  |                |            |   |                   |   |            |  
|TOTAL LIABILITIES                                                                                                             |  |                | 17,088,000 |   |                   |   | 13,565,000 |  
|                                                                                                                              |  |                |            |   |                   |   |            |  
|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; 7,813,099 and 7,689,048 shares issued and outstanding, respectively |  |                | 5,761,000  |   |                   |   | 5,485,000  |  
|Additional paid-in capital                                                                                                    |  |                | 1,636,000  |   |                   |   | 1,676,000  |  
|Other comprehensive income                                                                                                    |  |                | 63,000     |   |                   |   |           |  
|Retained earnings                                                                                                             |  |                | 2,011,000  |   |                   |   | 1,747,000  |  
|                                                                                                                              |  |                |            |   |                   |   |            |  
|Total stockholders equity                                                                                                    |  |                | 9,471,000  |   |                   |   | 8,908,000  |  
|                                                                                                                              |  |                |            |   |                   |   |            |  
|TOTAL LIABILITIES AND STOCKHOLDERS EQUITY                                                                                    |  | $              | 26,559,000 |   |                   | $ | 22,473,000 |  
|                                                                                                                              |  |                |            |   |                   |   |            |  

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



3



---

##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS



|                                         |  |                            |            |                |   |            |  
|---------------------------------------- |  | -------------------------- | ---------- | -------------- | - | ---------- | -
|                                         |  | For the Three Months Ended |           
|                                         |  | March 31, 2008             |            | March 31, 2007 |  
|                                         |  | (Unaudited)                |           
|SALES                                    |  |                            |            |                |   |            |  
|Product sales                            |  | $                          | 14,309,000 |                | $ | 16,062,000 |  
|Service sales                            |  |                            | 2,884,000  |                |   | 2,423,000  |  
|                                         |  |                            |            |                |   |            |  
|Total sales                              |  |                            | 17,193,000 |                |   | 18,485,000 |  
|                                         |  |                            |            |                |   |            |  
|COST OF SALES                            |  |                            |            |                |   |            |  
|Product sales                            |  |                            | 11,250,000 |                |   | 13,457,000 |  
|Service sales                            |  |                            | 2,212,000  |                |   | 1,665,000  |  
|                                         |  |                            |            |                |   |            |  
|Total cost of sales                      |  |                            | 13,462,000 |                |   | 15,122,000 |  
|                                         |  |                            |            |                |   |            |  
|GROSS PROFIT                             |  |                            | 3,731,000  |                |   | 3,363,000  |  
|OPERATING EXPENSES                       |  |                            | 3,221,000  |                |   | 3,901,000  |  
|                                         |  |                            |            |                |   |            |  
|INCOME (LOSS) FROM OPERATIONS            |  |                            | 510,000    |                |   | (538,000   | )
|                                         |  |                            |            |                |   |            |  
|OTHER EXPENSE                            |  |                            |            |                |   |            |  
|Interest expense                         |  |                            | 91,000     |                |   | 250,000    |  
|                                         |  |                            |            |                |   |            |  
|INCOME (LOSS) BEFORE INCOME TAXES        |  |                            | 419,000    |                |   | (788,000   | )
|INCOME TAX EXPENSE (BENEFIT)             |  |                            | 155,000    |                |   | (307,000   | )
|                                         |  |                            |            |                |   |            |  
|NET INCOME (LOSS)                        |  | $                          | 264,000    |                | $ | (481,000   | )
|                                         |  |                            |            |                |   |            |  
|BASIC EARNINGS (LOSS) PER COMMON SHARE   |  | $                          | 0.03       |                | $ | (0.08      | )
|                                         |  |                            |            |                |   |            |  
|DILUTED EARNINGS (LOSS) PER COMMON SHARE |  | $                          | 0.03       |                | $ | (0.08      | )
|                                         |  |                            |            |                |   |            |  

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



4



---

##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS



|                                                                                                   |  |                            |            |   |                |   |            |  
|-------------------------------------------------------------------------------------------------- |  | -------------------------- | ---------- | - | -------------- | - | ---------- | -
|                                                                                                   |  | For the Three Months Ended |           
|                                                                                                   |  | March 31, 2008             |            |   | March 31, 2007 |  
|CASH FLOWS FROM OPERATING ACTIVITIES                                                               |  |                            |            |   |                |   |            |  
|Net income (loss)                                                                                  |  | $                          | 264,000    |   |                | $ | (481,000   | )
|                                                                                                   |  |                            |            |   |                |   |            |  
|Adjustments to reconcile net income (loss) to net cash (used in) provided by operating activities: |  |                            |            |   |                |   |            |  
|Depreciation and amortization                                                                      |  |                            | 151,000    |   |                |   | 121,000    |  
|Stock-based compensation expense                                                                   |  |                            | (40,000    | ) |                |   | 48,000     |  
|Provision for doubtful accounts                                                                    |  |                            | 16,000     |   |                |   |           |  
|Inventory reserves                                                                                 |  |                            | 134,000    |   |                |   | 54,000     |  
|Decrease (increase) in assets:                                                                     |  |                            |            |   |                |   |            |  
|Accounts receivable                                                                                |  |                            | (2,850,000 | ) |                |   | 2,935,000  |  
|Inventory                                                                                          |  |                            | (234,000   | ) |                |   | 1,463,000  |  
|Prepaid expenses and other assets                                                                  |  |                            | (152,000   | ) |                |   | (39,000    | )
|Income taxes receivable                                                                            |  |                            |           |   |                |   | (279,000   | )
|(Decrease) increase in liabilities:                                                                |  |                            |            |   |                |   |            |  
|Accounts payable                                                                                   |  |                            | 115,000    |   |                |   | (3,973,000 | )
|Accrued expenses and taxes                                                                         |  |                            | (45,000    | ) |                |   | 44,000     |  
|Unearned revenue                                                                                   |  |                            | 585,000    |   |                |   | 235,000    |  
|                                                                                                   |  |                            |            |   |                |   |            |  
|Total adjustments                                                                                  |  |                            | (2,320,000 | ) |                |   | 609,000    |  
|                                                                                                   |  |                            |            |   |                |   |            |  
|Net cash (used in) provided by operating activities                                                |  |                            | (2,056,000 | ) |                |   | 128,000    |  
|                                                                                                   |  |                            |            |   |                |   |            |  
|CASH FLOWS FROM INVESTING ACTIVITIES                                                               |  |                            |            |   |                |   |            |  
|Purchases of property and equipment                                                                |  |                            | (27,000    | ) |                |   | (311,000   | )
|Acquisition of company, net of cash received                                                       |  |                            | (857,000   | ) |                |   |           |  
|Restricted cash                                                                                    |  |                            | 1,200,000  |   |                |   |           |  
|                                                                                                   |  |                            |            |   |                |   |            |  
|Net cash provided by (used in) investing activities                                                |  |                            | 316,000    |   |                |   | (311,000   | )
|                                                                                                   |  |                            |            |   |                |   |            |  
|CASH FLOWS FROM FINANCING ACTIVITIES                                                               |  |                            |            |   |                |   |            |  
|Net proceeds from (payments on) line of credit                                                     |  |                            | 6,072,000  |   |                |   | (142,000   | )
|Payment on short-term note                                                                         |  |                            | (4,000,000 | ) |                |   |           |  
|Outstanding checks in excess of funds on deposit                                                   |  |                            | (118,000   | ) |                |   | 308,000    |  
|Proceeds from stock options exercised                                                              |  |                            | 4,000      |   |                |   | 10,000     |  
|                                                                                                   |  |                            |            |   |                |   |            |  
|Net cash provided by financing activities                                                          |  |                            | 1,958,000  |   |                |   | 176,000    |  
|                                                                                                   |  |                            |            |   |                |   |            |  
|EFFECT OF EXCHANGE RATE ON CASH                                                                    |  |                            | 13,000     |   |                |   |           |  
|                                                                                                   |  |                            |            |   |                |   |            |  
|INCREASE (DECREASE) IN CASH                                                                        |  |                            | 231,000    |   |                |   | (7,000     | )
|                                                                                                   |  |                            |            |   |                |   |            |  
|Cash at beginning of year                                                                          |  |                            | 54,000     |   |                |   | 42,000     |  
|                                                                                                   |  |                            |            |   |                |   |            |  
|Cash at end of year                                                                                |  | $                          | 285,000    |   |                | $ | 35,000     |  
|                                                                                                   |  |                            |            |   |                |   |            |  
|SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION                                                   |  |                            |            |   |                |   |            |  
|Common stock issued for acquisition                                                                |  | $                          | 271,000    |   |                | $ |           |  
|                                                                                                   |  |                            |            |   |                |   |            |  

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



5



---

##### Table of Contents

Pinnacle Data Systems, Inc.

Notes to Condensed Consolidated Financial Statements

(Unaudited)

Note 1. Organization

Nature of Business  Pinnacle Data Systems, Inc. (PDSi, we, or the Company) provides computer design,
development, production, and repair services to Original Equipment Manufacturers (OEMs) and Independent Software Vendors (ISVs) who build computers into their products in industries including medical, telecommunications,
industrial/automation, military/aerospace, and imaging. We also help major computer platform manufacturers respond to customer requirements for customized solutions and extended service life. We specialize in areas where these customers often get
little help from larger outsource firms; solving the challenges associated with complex technologies, low to medium volume production, and long-term service of third party products. Not simply a repair depot or a contract manufacturer, PDSi
represents a more collaborative and flexible outsourcing partner who helps its clients manage costs, meet unplanned demand changes, improve customer satisfaction, and respond aggressively to new trends in the technology market place. With our
innovative and proactive staff of engineering, manufacturing, program management and supply chain specialists, PDSi tailors solutions that meet the particular business and operational needs of each OEM or ISV.

Note 2. Summary of Significant Accounting Policies

The condensed consolidated balance sheet as of March 31, 2008 and the condensed consolidated statements of operations and cash flows for the three month periods ended March 31, 2008 and 2007 have been prepared by the Company
without audit. On February 20, 2008, the Company acquired all of the equity of Aspan BV, a Netherlands private limited liability company (Aspan). The acquisition was accounted for based on the purchase accounting method, and the
financial position and results of operations from February 16, 2008, the effective date of the transaction, have been consolidated with the Companys financial statements. Additional information on the acquisition is in Note 3 of the
condensed consolidated financial statements. 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, condensed consolidated statements of operations and changes in cash flows for all periods presented have been made. Certain prior year amounts have been reclassified to conform to the current years
presentation.

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 consolidated financial statements should be read in conjunction with the financial statements and notes thereto included in the
Companys Annual Report on Form 10-K for the year ended December 31, 2007. The results of operations for the three month period ended March 31, 2008 are not necessarily indicative of the results for the full year.

Inventories  Inventories are valued at average cost, not in excess of market. Inventory at March 31, 2008 and
December 31, 2007 was comprised of the following (net of inventory reserves):



|                                |  |                |           |                   |   |          
|------------------------------- |  | -------------- | --------- | ----------------- | - | ---------
|                                |  | March 31, 2008 |           | December 31, 2007
|Component parts (raw materials) |  | $              | 6,512,000 |                   | $ | 6,428,000
|Work-in-process                 |  |                | 1,369,000 |                   |   | 1,543,000
|Finished goods                  |  |                | 1,075,000 |                   |   | 616,000  
|                                |  |                |           |                   |   |          
|                                |  | $              | 8,956,000 |                   | $ | 8,587,000
|                                |  |                |           |                   |   |          

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. If 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, 2008 and December 31, 2007, the Company provided reserves of approximately $2,230,000 and $2,083,000, respectively, to reduce the carrying value of inventory.



6



---

##### Table of Contents

Pinnacle Data Systems, Inc.

Notes to Condensed Consolidated Financial Statements

(Unaudited)



Allowance for Doubtful
Accounts Accounts receivable is stated in the financial statements at amounts due from customers net of an allowance for doubtful accounts. Credit is extended based on evaluation of customers financial
condition and, generally, collateral is not required. Accounts receivable payment terms vary. The Company assesses the collectibility of the accounts receivable and determines its allowance by considering a number of factors, including the length of
time trade accounts receivable are past due, the Companys previous loss history with each customer, the customers current ability to pay its obligation to the Company, and the condition of the general economy and the industry as a whole.
The Company writes off accounts receivable when they become uncollectible as determined by a continuous review of the customers ability to pay. Payments subsequently received on such receivables are credited to the allowance for doubtful
accounts.

Fair Value of Financial Instruments Effective January 1, 2008, the Company partially adopted
Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS No. 157). SFAS No. 157 applies broadly to financial and non-financial
assets and liabilities reported or disclosed at fair value under existing authoritative accounting pronouncements. In February 2008, FASB issued FASB Staff Position No. FAS 157-2, Effective Date of FASB Statement No.157 (FSP
157-2). FSP 157-2 amended SFAS No. 157, Fair Value Measurements (SFAS No. 157) and delays the effective date of SFAS No. 157 for nonfinancial assets and nonfinancial liabilities, except for items that are
recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), until fiscal years beginning after November 15, 2008, including interim periods within those fiscal years. In accordance with FSP 157-2,
the Company has partially adopted SFAS No. 157, and is currently evaluating the impact of the adoption of FSP 157-2 on its financial position, results of operations, and cash flows. The Companys partial adoption of SFAS No. 157 did
not result in a change to the valuation techniques it had previously used to measure the fair value of its financial assets and liabilities, nor did the Company have additional assets and liabilities that required a fair market valuation.

The estimated fair value of amounts reported in the financial statements had been determined using available market information and
valuation methodologies, as applicable. The methodologies and assumptions used to estimate the fair value of each class of financial instruments are set forth below:



| |  |  | Cash, accounts receivable, accounts payable and other accrued expenses are carried at cost as this approximates fair value due to their short-term nature.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Line of credit and short-term notes have variable rates that reflect currently available terms and conditions for similar debt.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------

Stock-Based Compensation  The Company expenses the compensation cost for stock-based awards granted on or subsequent to
January 1, 2006 over the stock options vesting period, and have valued them based on fair value at the grant date as determined in accordance with Statement of Financial Accounting Standards (SFAS) No. 123 (Revised),
Shared Based Payment. Stock based compensation (recovery) expense recognized for the three month periods ended March 31, 2008 and 2007 was ($40,000) and $48,000, respectively, and was recognized as a component of Operating
Expenses within the Condensed Consolidated Statements of Operations. The recovery of stock based compensation for the three month period ended March 31, 2008 was due to a higher level of pre-vesting forfeitures.

Income Taxes  The Company adopted FASB Interpretation No. 48 Accounting for Uncertainty in Income Taxes,
an interpretation of FASB Statement No. 109 Accounting for Income Taxes (FIN 48) effective January 1, 2007. FIN 48 clarifies the accounting for uncertainty in income taxes recognized in financial statements and
prescribes a recognition threshold and measurement attribute for the financial statement recognition and measurement of a tax position taken or expected to be taken in a tax return. The Company recognizes any interest and penalties related to
uncertain tax positions in income tax expense.

Foreign Currency Translation  The functional currency for the
acquired company, Aspan, is euros. For consolidated reporting purposes, all assets and liabilities of this operation are translated into U.S. dollars using the foreign exchange rate at the end of the reported period; income and expense items are
translated at the weighted-average exchange rates during the reported period; and equity is translated at the historical exchange rate.

Recently Issued Accounting Pronouncement In December 2007, the FASB issued SFAS No. 141(R), Business Combinations (SFAS No. 141(R)). SFAS No. 141(R) states that all business
combinations (whether



7



---

##### Table of Contents

Pinnacle Data Systems, Inc.

Notes to Condensed Consolidated Financial Statements

(Unaudited)



full, partial or step acquisitions) will result in all assets and liabilities of an acquired business being recorded at their fair values. Certain forms of
contingent consideration and certain acquired contingencies will be recorded at fair value at the acquisition date. SFAS No. 141(R) also states acquisition costs will generally be expensed as incurred and restructuring costs will be expensed in
periods after the acquisition date. This statement is effective for financial statements issued for fiscal years beginning after December 15, 2008. The Company is currently evaluating the requirements of SFAS No. 141(R) for future business
combinations.

In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated Financial
Statementsan amendment of ARB No. 51 (SFAS No. 160). SFAS No. 160 requires a company to clearly identify and present ownership interests in subsidiaries held by parties other than the company in the
consolidated financial statements within the equity section but separate from the companys equity. It also requires that the amount of consolidated net income attributable to the parent and to the noncontrolling interest be clearly identified
and presented on the face of the consolidated statement of income; changes in ownership interest be accounted for similarly, as equity transactions; and when a subsidiary is deconsolidated, any retained noncontrolling equity investment in the former
subsidiary and the gain or loss on the deconsolidation of the subsidiary be measured at fair value. This statement is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. The
Company is currently evaluating the impact of its adoption on its financial position, results of operations, and cash flows.

Note 3. Acquisition

On February 20, 2008, the Company completed the acquisition of all of the equity of Aspan. Consideration given to purchase Aspan
included cash in the amount of $825,000 and 120,051 shares of the Companys common stock valued at $271,000. The stock value was based on the average price of the Companys stock over a reasonable period of time before and after the terms
of the acquisition were agreed to and announced. The costs associated with the acquisition, including legal and accounting fees, totaled $155,000. With this acquisition, the Company further strengthens its global footprint in the repair services
business, as it will enable the Company to better serve current and potential customers with installed bases in the Europe, Middle East, and Africa (EMEA) regions.

This acquisition was accounted for by the purchase method of accounting. Accordingly, the Company has estimated the fair value of assets acquired and
liabilities assumed. The preliminary estimated fair values of the assets acquired and liabilities assumed at the date of the acquisition have been included in the statement of financial position of the Company. However, these preliminary estimated
fair values are subject to adjustment upon completion of final valuation of inventory, deferred assets, and intangibles. Management had made a preliminary allocation of the purchase price based on various preliminary estimates of fair value. Final
purchase price adjustments may vary materially from the Companys preliminary assessment. The preliminary estimated fair market value of the assets acquired and liabilities assumed at the date of acquisition were as follows:



|                                     |  |   |           |  
|------------------------------------ |  | - | --------- | -
|Cash                                 |  | $ | 122,000   |  
|Accounts receivable                  |  |   | 492,000   |  
|Inventory                            |  |   | 250,000   |  
|Deferred income taxes                |  |   | 35,000    |  
|Fixed assets                         |  |   | 143,000   |  
|Amortizable intangibles              |  |   | 435,000   |  
|Goodwill                             |  |   | 639,000   |  
|Accounts payables and other accruals |  |   | (865,000  | )
|                                     |  |   |           |  
|                                     |  | $ | 1,251,000 |  
|                                     |  |   |           |  

The amortizable intangibles represent the fair market value of the lease agreement and customer
relationship, and will be amortized over 2 and 5 year period, respectively.



8



---

##### Table of Contents

Pinnacle Data Systems, Inc.

Notes to Condensed Consolidated Financial Statements

(Unaudited)



Note 4. Debt

Effective April 8, 2008, the Company became a borrower under a revolving credit facility (the Line) by and between the Company and
KeyBank National Association (KeyBank). The Line provides a maximum line of credit of $11,000,000, subject to borrowing base restrictions. The borrowing base is determined as the lesser of 1) $11,000,000 or 2) the sum of (a) 85% of
the aggregate amount of eligible receivable accounts, plus (b) 30% of the aggregate amount of eligible inventory, not to exceed $5,000,000. In addition, the agreement restricts the payments of cash dividends that would cause violations of the
loan covenants. The maturity date of the Line is May 15, 2010. The Line replaced an asset-based revolving credit facility that matured on May 8, 2008 (the AB Line).

The Line is payable on demand and is collateralized by a blanket lien on all of the assets of the Company. As of March 31, 2008, the maximum
available borrowing base on the AB Line was $11,000,000, with unused capacity of $3,343,000. As of March 31, 2008 and December 31, 2007, the outstanding balance on the AB Line was $7,657,000 and $1,585,000, respectively.

The outstanding balance on the Line bears interest monthly at an annual rate equal to either prime rate or the overnight LIBOR plus 2.45%. Use of prime
rate or the overnight LIBOR is at the discretion of the Company. The borrowing rate on the AB Line was 5.6% and 7.8% at the end of the first quarter 2008 and 2007, respectively. The weighted average interest rate was 5.9% and 7.87% during the three
month periods ended March 31, 2008 and 2007, respectively. In addition, the unused AB Line and the unused Line capacity are subject to a commitment fee of 1/8%, payable quarterly in arrears.

The Line is subject to certain financial covenants, including total debt to tangible net worth and operating cash flow to total fixed charge ratio.

On February 10, 2008, the Company paid off the principal amount of $4,000,000 for a promissory note dated September 28, 2006
(the Term Note), as amended and extended that matured on February 15, 2008. The Company used excess availability on the AB Line to pay off the principal amount of the Term Note. The principal amount of the Term Note bore interest at
an annual rate equal to the prime rate less 0.25%. The average borrowing rate on the Term Note was 6.2% and 8.0% during the three month periods ended March 31, 2008 and 2007, respectively.

The average debt balances, including the AB Line and the Term Note, for the first quarter 2008 and for fiscal year 2007 were $5,939,000 and $11,027,000,
respectively. The Company paid interest of $57,000 and $248,000 for the three month periods ended March 31, 2008 and 2007, respectively.

Note 5.
Income Taxes

Income taxes for interim periods were computed using the effective tax rate estimated to be applicable for the full fiscal
year, which is subject to ongoing review and evaluation by management. The Company files income tax returns in the U.S. federal jurisdiction, various states, and foreign countries. There are currently no federal or state income tax examinations
underway for these jurisdictions.



9



---

##### Table of Contents

Pinnacle Data Systems, Inc.

Notes to Condensed Consolidated Financial Statements

(Unaudited)



Note 6. Stock Options

Under the 2005 Equity Incentive Plan, the stock option activity and weighted average exercise prices for the three month periods ended March 31, 2008
and 2007 were as follows:



|                                            |  |                  |   |                |                       |      |                  |           |   |                       |   |     
|------------------------------------------- |  | ---------------- | - | -------------- | --------------------- | ---- | ---------------- | --------- | - | --------------------- | - | ----
|                                            |  | March 31, 2008   |   | March 31, 2007
|                                            |  | Number ofOptions |   |                | WeightedAverage Price |      | Number ofOptions |           |   | WeightedAverage Price
|Outstanding at December 31                  |  | 1,499,200        |   |                | $                     | 2.70 |                  | 1,894,100 |   |                       | $ | 2.71
|Granted                                     |  | 97,000           |   |                | $                     | 1.45 |                  | 225,300   |   |                       | $ | 2.49
|Exercised                                   |  | (4,000           | ) |                | $                     | 1.03 |                  | (4,500    | ) |                       | $ | 2.25
|Forfeited                                   |  | (177,000         | ) |                | $                     | 3.03 |                  | (165,500  | ) |                       | $ | 3.00
|                                            |  |                  |   |                |                       |      |                  |           |   |                       |   |     
|Outstanding at March 31                     |  | 1,415,200        |   |                | $                     | 2.65 |                  | 1,949,400 |   |                       | $ | 2.66
|                                            |  |                  |   |                |                       |      |                  |           |   |                       |   |     
|Exercise price range of options outstanding |  | $0.75 to $5.25   |   | $0.75 to $5.25

The fair value of the stock options granted was estimated on the grant date using the
Black-Scholes option-pricing model. The weighted-average assumptions used in the valuation of grants issued during the three month periods ended March 31, 2008 and 2007 were as follows:



|                                        |  |                          |   |  |                |  
|--------------------------------------- |  | ------------------------ | - |  | -------------- | -
|                                        |  | Three Month Period Ended |  
|                                        |  | March 31, 2008           |   |  | March 31, 2007 |  
|Risk-free interest rate                 |  | 1.9                      | % |  | 4.6            | %
|Dividend yield                          |  | 0.0                      | % |  | 0.0            | %
|Volatility factor                       |  | 67.9                     | % |  | 68.9           | %
|Weighted average expected life in years |  | 6.0                      |   |  | 6.4            |  

For purposes of determining the expected volatility factor, the Company used the historical price
volatility of the Companys stock price over the prior seven-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 three month periods ended March 31, 2008 and 2007 had a weighted-average fair value of $1.45 and $2.49,
respectively.

Note 7. Earnings (Loss) Per Common and Common Equivalent Share

Earnings (loss) per common and common equivalent shares (EPS) was computed by dividing net income (loss) by the weighted average number of
shares of common stock outstanding during the period. For the three month period ended March 31, 2007, no conversion of common stock equivalents was assumed in the calculation since the effect would be anti-dilutive. As a result, the number of
weighted average outstanding common shares and EPS were the same for basic and diluted EPS calculations for the period noted above.



10



---

##### Table of Contents

Pinnacle Data Systems, Inc.

Notes to Condensed Consolidated Financial Statements

(Unaudited)



The following table presents EPS for the three month
periods ended March 31, 2008 and 2007.



|                                              |  |                          |           |                |   |           |  
|--------------------------------------------- |  | ------------------------ | --------- | -------------- | - | --------- | -
|                                              |  | Three Month Period Ended |          
|                                              |  | March 31, 2008           |           | March 31, 2007 |  
|Net income (loss)                             |  | $                        | 264,000   |                | $ | (481,000  | )
|                                              |  |                          |           |                |   |           |  
|Determination of common shares:               |  |                          |           |                |   |           |  
|Average common shares outstanding             |  |                          | 7,747,137 |                |   | 6,364,048 |  
|Assumed conversions of dilutive stock options |  |                          | 31,251    |                |   |          |  
|                                              |  |                          |           |                |   |           |  
|Diluted average common shares outstanding     |  |                          | 7,778,388 |                |   | 6,364,048 |  
|Basic earnings (loss) per common share:       |  | $                        | 0.03      |                | $ | (0.08     | )
|Diluted earnings (loss) per common share:     |  | $                        | 0.03      |                | $ | (0.08     | )

Note 8. Capital Structure

The common stock activity for the three months ended March 31, 2008 was as follows:



|                                |  |                   |  |        |          
|------------------------------- |  | ----------------- |  | ------ | ---------
|                                |  | Common Stock     
|                                |  | OutstandingShares |  | Amount
|Balance as of December 31, 2007 |  | 7,689,048         |  | $      | 5,485,000
|Options exercised               |  | 4,000             |  |        | 5,000    
|Shares issued in acquisition    |  | 120,051           |  |        | 271,000  
|                                |  |                   |  |        |          
|Balance as of March 31, 2008    |  | 7,813,099         |  | $      | 5,761,000
|                                |  |                   |  |        |          

Note 9. Other Comprehensive Income (Loss)

The components of other comprehensive income (loss) for the three month periods ended March 31, 2008 and 2007 consisted of the following:



|                                                    |  |                          |         |                |   |          |  
|--------------------------------------------------- |  | ------------------------ | ------- | -------------- | - | -------- | -
|                                                    |  | Three Month Period Ended |        
|                                                    |  | March 31, 2008           |         | March 31, 2007 |  
|Net income (loss)                                   |  | $                        | 264,000 |                | $ | (481,000 | )
|Foreign currency translation adjustment, net of tax |  |                          | 63,000  |                |   |         |  
|                                                    |  |                          |         |                |   |          |  
|Comprehensive income (loss)                         |  | $                        | 327,000 |                | $ | (481,000 | )
|                                                    |  |                          |         |                |   |          |  



11



---

##### Table of Contents

Pinnacle Data Systems, Inc.

Notes to Condensed Consolidated Financial Statements

(Unaudited)



Note 10. Operating Segments

The Companys reportable segments are Product and Service. A description of the segments may be found in Item 1 of the Companys Form 10-K
for December 31, 2007, which includes a discussion of principal markets and distribution. The row noted as Other reflects the costs and assets of the functional and administrative groups of the Company that are not allocated to the
reportable segments, which include engineering, finance, human resources, quality systems, and executive management. The Company evaluates performance based on operating earnings of the Product and Service segments and these segments
effectiveness to cover the other administrative expenses of the Company. Segment information for the three month periods ended March 31, 2008 and 2007 were as follows:



|                                    |  |                          |            |   |                   |   |            |  
|----------------------------------- |  | ------------------------ | ---------- | - | ----------------- | - | ---------- | -
|                                    |  | Three Month Period Ended |           
|                                    |  | March 31, 2008           |            |   | March 31, 2007    |  
|Sales                               |  |                          |            |   |                   |   |            |  
|Product                             |  | $                        | 14,309,000 |   |                   | $ | 16,062,000 |  
|Services                            |  |                          | 2,884,000  |   |                   |   | 2,423,000  |  
|                                    |  |                          |            |   |                   |   |            |  
|Total sales                         |  | $                        | 17,193,000 |   |                   | $ | 18,485,000 |  
|                                    |  |                          |            |   |                   |   |            |  
|Gross profit                        |  |                          |            |   |                   |   |            |  
|Product                             |  | $                        | 3,059,000  |   |                   | $ | 2,605,000  |  
|Services                            |  |                          | 672,000    |   |                   |   | 758,000    |  
|                                    |  |                          |            |   |                   |   |            |  
|Total gross profit                  |  | $                        | 3,731,000  |   |                   | $ | 3,363,000  |  
|                                    |  |                          |            |   |                   |   |            |  
|Income (loss) from operations       |  |                          |            |   |                   |   |            |  
|Product                             |  | $                        | 1,960,000  |   |                   | $ | 1,222,000  |  
|Services                            |  |                          | 128,000    |   |                   |   | 452,000    |  
|Other                               |  |                          | (1,578,000 | ) |                   |   | (2,212,000 | )
|                                    |  |                          |            |   |                   |   |            |  
|Total income (loss) from operations |  | $                        | 510,000    |   |                   | $ | (538,000   | )
|                                    |  |                          |            |   |                   |   |            |  
|                                    | 
|                                    |  | As of                    |           
|                                    |  | March 31, 2008           |            |   | December 31, 2007 |  
|Total assets                        |  |                          |            |   |                   |   |            |  
|Product                             |  | $                        | 14,071,000 |   |                   | $ | 14,516,000 |  
|Services                            |  |                          | 9,795,000  |   |                   |   | 6,347,000  |  
|Other                               |  |                          | 2,693,000  |   |                   |   | 1,610,000  |  
|                                    |  |                          |            |   |                   |   |            |  
|Total assets                        |  | $                        | 26,559,000 |   |                   | $ | 22,473,000 |  
|                                    |  |                          |            |   |                   |   |            |  



12



---

##### Table of Contents

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

The following discussion should be read in conjunction with the Condensed Consolidated 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. The words believe,
expect, anticipate, may, 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 without limitation changes in general economic conditions, changes in the specific markets for our products and services,
adverse business conditions, changes in customer order patterns, increased competition, changes in our business or our relationship with major technology partners or significant customers, pricing pressures, lack of adequate financing to take
advantage of business opportunities that may arise, lack of success in technological advancements, risks associated with our new business practices, processes and information systems, and other factors. For more details, please refer to the
Companys Securities and Exchange Commission filings, including its most recent Annual Report on Form 10-K for December 31, 2007.

EXECUTIVE
OVERVIEW

Pinnacle Data Systems, Inc. (PDSi, we, our, or the Company) is a provider of
computer design, development, production, and repair services to original equipment manufacturers (OEMs) and independent software vendors (ISVs). Industries served currently include medical, telecommunications,
industrial/automation, military/aerospace, and imaging. The Company also helps major computer platform manufacturers respond to their customers requirements for customized solutions and extended service life. We specialize in areas where these
customers often get little help from larger outsource firms, solving the challenges associated with complex technologies, low to medium volume production, and long-term service of third party products. Not simply a repair depot or a contract
manufacturer, PDSi represents a more collaborative and flexible outsourcing partner who helps its clients manage costs, meet unplanned demand changes, improve customer satisfaction, and respond aggressively to new trends in the technology market
place. With our innovative and proactive staff of engineering, manufacturing, program management and supply chain specialists, PDSi tailors solutions that meet the particular business and operational needs of each OEM or ISV.

During first quarter 2008, the Company completed the acquisition of all of the equity of Aspan BV, a Netherlands private limited liability company
(Aspan). With this acquisition, the Company further strengthens its global footprint in the repair services business, as it will enable the Company to better serve current and potential customers in the Europe, Middle East, and Africa
(EMEA) regions. This operation will serve primarily as a repair depot for computer boards, storage devices, and other critical peripherals. Consideration given to purchase Aspan totaled $1.1 million, and included cash of $0.8 million and
120,051 shares of the Companys common stock valued at $0.3 million. The cost associated with the acquisition included legal, accounting, and other fees totaling approximately $0.2 million.

DISCUSSION AND ANALYSIS ON OPERATING RESULTS

The
following is a discussion and analysis of the financial condition and results of operations of the Company comparing the three month period ended March 31, 2008 (first quarter 2008) with the three month period ended March 31,
2007 (first quarter 2007). The following discussion should be read in conjunction with the Condensed Consolidated Financial Statements of the Company and the Notes thereto contained herein.



13



---

##### Table of Contents

SALES

Sales for the three month periods ended March 31, 2008 and 2007 were as follows:



|                 |  |                          |        |                |   |          |  |     |   
|---------------- |  | ------------------------ | ------ | -------------- | - | -------- |  | --- | --
|                 |  | Three Month Period Ended |       
|($ in thousands) |  | March 31, 2008           |        | March 31, 2007 |   | % Change | 
|Total sales      |  | $                        | 17,193 |                | $ | 18,485   |  | (7  | )%
|Product          |  | $                        | 14,309 |                | $ | 16,062   |  | (11 | )%
|Services         |  | $                        | 2,884  |                | $ | 2,423    |  | 19  | % 

The decrease in product sales from first quarter 2007 to first quarter 2008 was primarily as a
result of the Companys strategic decision to shed sales that contribute lower profit margins and focus on higher margin programs. The favorable result of this decision can be seen in the gross profit margin achieved in first quarter 2008. The
increase in service sales from first quarter 2007 to first quarter 2008 was primarily due to higher repair service business in the EMEA region, some of which was attributed to the Aspan acquisition.

For the first quarter 2008, the Company had two customers that generated revenues of approximately $6.1 million and $4.2 million or 35% and 24% of total
revenue, respectively. In addition, these customers represented 33% and 13%, respectively, of accounts receivable at March 31, 2008.

For the first quarter 2007, the Company had two customers that generated revenues of approximately $5.6 million and $4.0 million or 29% and 22% of total revenue, respectively. In addition, these customers represented 27% and 21%,
respectively, of accounts receivable at March 31, 2007.

GROSS PROFIT

Gross profit for the three month periods ended March 31, 2008 and 2007 were as follows:



|                   |  |                          |       |                |   |          |  |     |   
|------------------ |  | ------------------------ | ----- | -------------- | - | -------- |  | --- | --
|                   |  | Three Month Period Ended |      
|($ in thousands)   |  | March 31, 2008           |       | March 31, 2007 |   | % Change | 
|Total gross profit |  | $                        | 3,731 |                | $ | 3,363    |  | 11  | % 
|Product            |  | $                        | 3,059 |                | $ | 2,605    |  | 17  | % 
|Services           |  | $                        | 672   |                | $ | 758      |  | (11 | )%

The gross profit margin percentages for the three month periods ended March 31, 2008 and 2007
were as follows:



|                   |  |                          |   |  |                |  
|------------------ |  | ------------------------ | - |  | -------------- | -
|                   |  | Three Month Period Ended |  
|                   |  | March 31, 2008           |   |  | March 31, 2007 |  
|Total gross profit |  | 22                       | % |  | 18             | %
|Product            |  | 21                       | % |  | 16             | %
|Services           |  | 23                       | % |  | 31             | %

Gross margin as a percentage of sales on product sales increased from 16% for first quarter 2007
to 21% for first quarter 2008, and was primarily attributable to the reduction of lower margin business and the increase in more profitable business, including programs that supported customers last time buys of prior generation products. The
Company continues to focus on its profitable growth strategy and continues to pursue higher value-added business with better margin potential. The decline in gross profit on service sales was caused by an increase in lower margin storage device
repair programs in the sales mix, especially in the EMEA region where the Company split its service profits with Aspan. With the acquisition of Aspan, the Company will benefit by receiving the entire profit margin on this service business.

The Company continues to believe that as sales revenues increase through the organic growth of existing customers and other additional
global businesses, the results of operations will be positively affected. Gross margins vary from program to program, and the mix of programs will vary, causing the gross margin percentages to vary from quarter to quarter. Consequently, it is
difficult to predict gross margin results for the future revenues.



14



---

##### Table of Contents

OPERATING EXPENSES AND INTEREST EXPENSES

Operating expenses, which include selling, general and administrative (SG&A) expenses, and interest expense for the three month periods
ended March 31, 2008 and 2007 were as follows:



|                   |  |                          |       |                |   |          |  |     |   
|------------------ |  | ------------------------ | ----- | -------------- | - | -------- |  | --- | --
|                   |  | Three Month Period Ended |      
|($ in thousands)   |  | March 31, 2008           |       | March 31, 2007 |   | % Change | 
|Operating expenses |  | $                        | 3,221 |                | $ | 3,901    |  | (17 | )%
|Interest expense   |  |                          | 91    |                |   | 250      |  | (64 | )%
|                   |  |                          |       |                |   |          |  |     |   
|Total expense      |  | $                        | 3,312 |                | $ | 4,151    |  | (20 | )%
|                   |  |                          |       |                |   |          |  |     |   

The Company improved its cost structure through reductions in personnel and corresponding benefits
costs, as well as lower facility and travel expenses. As a percentage of sales, operating expenses declined from 21% for first quarter 2007 to 19% for first quarter 2008.

The decrease in interest expense from first quarter 2007 to first quarter 2008 was due to lower interest rates and a lower average debt balance carried to support the working capital requirements of the Company during
first quarter 2008.

INCOME TAX EXPENSE (BENEFIT) AND NET INCOME (LOSS)

Income tax expense (benefit) for the interim periods was computed using the effective tax rate estimated to be applicable for the full fiscal year, which
is subject to an on-going review and evaluation by management. The effective tax rate was 37% and 39% for the three month periods ended March 31, 2008 and 2007, respectively.

Income (loss) before taxes, income tax expense (benefit) and net income (loss) for the three month periods ended March 31, 2008 and 2007 were as
follows:



|                             |  |                          |     |                |   |      |          |  |      |   
|---------------------------- |  | ------------------------ | --- | -------------- | - | ---- | -------- |  | ---- | --
|                             |  | Three Month Period Ended |    
|($ in thousands)             |  | March 31, 2008           |     | March 31, 2007 |   |      | % Change | 
|Income (loss) before taxes   |  | $                        | 419 |                | $ | (788 | )        |  | 153  | % 
|Income tax expense (benefit) |  |                          | 155 |                |   | (307 | )        |  | (150 | )%
|                             |  |                          |     |                |   |      |          |  |      |   
|Net income (loss)            |  | $                        | 264 |                | $ | (481 | )        |  | 155  | % 
|                             |  |                          |     |                |   |      |          |  |      |   

Earnings (loss) per share (EPS) for the three month periods ended March 31, 2008
and 2007 were as follows:



|                                               |  |                          |           |                |   |           |  
|---------------------------------------------- |  | ------------------------ | --------- | -------------- | - | --------- | -
|                                               |  | Three Month Period Ended |          
|                                               |  | March 31, 2008           |           | March 31, 2007 |  
|Basic earnings (loss) per common share:        |  | $                        | 0.03      |                | $ | (0.08     | )
|Diluted earnings (loss) per common share:      |  | $                        | 0.03      |                | $ | (0.08     | )
|                                               |  |                         
|Weighted average number of shares outstanding: |  |                          |           |                |   |           |  
|Basic                                          |  |                          | 7,747,137 |                |   | 6,364,048 |  
|Diluted                                        |  |                          | 7,778,388 |                |   | 6,364,048 |  

The Company reported net income of $0.3 million, or $0.03 per share for first quarter 2008
compared to a net loss of $(0.5) million, or $(0.08) per share for first quarter 2007.

For the three month period ended March 31,
2007, no conversion of common stock equivalents has been assumed in the calculation of loss per share, as the effect would be anti-dilutive. As a result, the number of weighted average outstanding common shares and EPS are the same for basic and
diluted EPS calculations for such period.



15



---

##### Table of Contents

LIQUIDITY AND CAPITAL RESOURCES

A summary of changes in current assets for the periods ended March 31, 2008 and December 31, 2007 is as follows:



|                     |  |                |        |                   |   |          |  |     |   
|-------------------- |  | -------------- | ------ | ----------------- | - | -------- |  | --- | --
|($ in thousands)     |  | March 31, 2008 |        | December 31, 2007 |   | % Change | 
|Accounts receivable  |  | $              | 13,757 |                   | $ | 10,413   |  | 32  | % 
|Inventory            |  |                | 8,956  |                   |   | 8,587    |  | 4   | % 
|Other current assets |  |                | 1,668  |                   |   | 2,446    |  | (32 | )%
|                     |  |                |        |                   |   |          |  |     |   
|Total current assets |  | $              | 24,381 |                   | $ | 21,446   |  | 14  | % 
|                     |  |                |        |                   |   |          |  |     |   

A summary of changes in current liabilities for the periods ended March 31, 2008 and
December 31, 2007 is as follows:



|                          |  |                |        |                   |   |          |  |      |   
|------------------------- |  | -------------- | ------ | ----------------- | - | -------- |  | ---- | --
|($ in thousands)          |  | March 31, 2008 |        | December 31, 2007 |   | % Change | 
|Line of credit            |  | $              | 7,657  |                   | $ | 1,585    |  | 383  | % 
|Short-term note           |  |                |       |                   |   | 4,000    |  | (100 | )%
|Accounts payable          |  |                | 6,874  |                   |   | 6,178    |  | 11   | % 
|Other current liabilities |  |                | 2,557  |                   |   | 1,802    |  | 42   | % 
|                          |  |                |        |                   |   |          |  |      |   
|Total current liabilities |  | $              | 17,088 |                   | $ | 13,565   |  | 26   | % 
|                          |  |                |        |                   |   |          |  |      |   

During the three month period ended March 31, 2008, the net cash used in operating activities
was $2.1 million. During the three month period ended March 31, 2007, the net cash provided by operating activities was $0.1 million. Net income (loss), as adjusted for the effects of the non-cash items, which include depreciation expense,
stock-based compensation expense, accounts receivable reserves, if applicable, and inventory reserves, provided cash from operating activities of $0.5 million for the three month period ended March 31, 2008, and used cash from operating
activities of $0.3 million for the three month period ended March 31, 2007. Change in the working capital components required a net cash outflow of $2.6 million for the three month period ended March 31, 2008, and provided a net cash
inflow of $0.4 million for the three month period ended March 31, 2007. During first quarter 2008, the Company had large volume of sales shipped and billed in the last month of the quarter, causing the accounts receivable to be higher at the
end of the quarter.

The net cash provided by investing activities was $0.3 million for the three month period ended March 31, 2008.
The Company used a portion of the $1.2 million raised in a private equity financing completed in December 2007 that was held in escrow at December 31, 2007 to acquire substantially all of the equity of Aspan. The Aspan acquisition required a
net outflow of cash of $0.9 million. The net cash used in investing activities was $0.3 million for the three month periods ended March 31, 2007. The Companys use of cash in investing activities was for the purchase of equipment,
including computer equipment and leasehold improvements in the three month periods ended March 31, 2008 and 2007.

During the three
month periods ended March 31, 2008 and 2007, the net cash provided by financing activities was $1.9 million and $0.2 million, respectively. In the three month period ended March 31, 2008, the Company used funding from the line of credit to
pay the $4.0 million short-term note as discussed below. The remaining line of credit proceeds supported the working capital requirements of the Company.

Effective April 8, 2008, the Company replaced its asset-based revolving credit facility (the AB Line) that was to mature on May 8, 2008 with a revolving credit facility (the Line) by
and between the Company and KeyBank National Association (KeyBank). The Line provides a maximum line of credit of $11.0 million, subject to borrowing base restrictions. The borrowing base is determined as the lesser of 1) $11.0 million
or 2) the sum of (a) 85% of the aggregate amount of eligible receivable accounts, plus (b) 30% of the aggregate amount of eligible inventory, not to exceed $5.0 million. The maturity date of the Line is May 15, 2010.

The Line, which is the Companys primary source of operational and non-operational funding, is collateralized by a blanket lien on all of the assets
of the Company. As of March 31, 2008, the maximum available borrowing base on the AB Line was $11.0 million, with unused capacity of $3.3 million. As of March 31, 2008 and December 31, 2007, the outstanding balance on the AB Line was
$7.7 million and $1.6 million, respectively.

The outstanding balance on the Line bears interest monthly at an annual rate equal to either
prime rate or the overnight LIBOR plus 2.45%. Use of prime rate or the overnight LIBOR is at the discretion of the Company. The



16



---

##### Table of Contents

borrowing rate on the AB Line was 5.6% and 7.8% at the end of the first quarter 2008 and 2007, respectively. The weighted average interest rate was 5.9% and
7.87% during the three month periods ended March 31, 2008 and 2007, respectively. In addition, the unused AB Line and the unused Line capacity are subject to a commitment fee of 1/8%, payable quarterly in arrears.

The Line is subject to certain financial covenants, including total debt to tangible net worth and operating cash flow to total fixed charge ratio.

On February 10, 2008, the Company paid off the principal amount of $4.0 million for a promissory note dated September 28, 2006
(the Term Note), as amended and extended that matured on February 15, 2008. The Company used excess availability on the AB Line to pay off the principal amount of the Term Note. The principal amount of the Term Note bore interest at
an annual rate equal to the prime rate less 0.25%. The average borrowing rate on the Term Note was 6.2% and 8.0% during the three month periods ended March 31, 2008 and 2007, respectively.

The average debt balances, including the AB Line and the Term Note, for the first quarter 2008 and for fiscal year 2007 were $5.9 million and $11.0
million, respectively.

The Companys ability to meet the terms and covenants of the Line will be dependent upon the Companys
future performance, which will be subject to general economic conditions and financial operations. There can be no assurance that the Companys future performance will not be affected negatively by changes in the above factors to such a degree
that it affects the Companys ability to meet the terms and covenants of the Line.

Additional financing may be required to support
the future growth plans of the Company. The future growth plans of the Company include an acquisition strategy that may include acquiring companies that are in a similar or complementary business as the Company. The Companys acquisition
strategy may be financed by the issuance of additional common or preferred stock that has been previously authorized by the shareholders. The issuance of these noted shares requires the approval of the Board of Directors. The Company is evaluating
acquisition targets based on similar or complementary services as currently provided by the Company that will be accretive within one year thereafter. The acquisition targets may provide large OEM customer relationships that have a potential for
additional business through the synergies of the combined company (which may not be attainable by either company on their own) and/or bring resources, in terms of people, processes and/or systems, that increase the scalability of the combined
businesses.

OFF-BALANCE SHEET ARRANGEMENTS

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

At any given point in time in the normal course of business, the Company has numerous outstanding purchase orders with vendors to purchase inventory for
use in the products that are sold to the Companys customers or are used in performing repair services for the Companys customers. Such orders are not recorded as liabilities in the balance sheet until the material is placed on a common
carrier or delivered to the Companys facilities, depending on terms of the arrangement. The Company has no minimum purchase quantity requirements with any of its vendors.

RECENT ACCOUNTING PRONOUNCEMENTS

In December 2007, the FASB issued SFAS No. 141(R),
Business Combinations (SFAS No. 141(R)). SFAS No. 141(R) states that all business combinations (whether full, partial or step acquisitions) will result in all assets and liabilities of an acquired business being
recorded at their fair values. Certain forms of contingent consideration and certain acquired contingencies will be recorded at fair value at the acquisition date. SFAS No. 141(R) also states acquisition costs will generally be expensed as
incurred and restructuring costs will be expensed in periods after the acquisition date. This statement is effective for financial statements issued for fiscal years beginning after December 15, 2008. The Company is currently evaluating the
requirements of SFAS No. 141(R) for future business combinations.



17



---

##### Table of Contents

In December 2007, the FASB issued SFAS No. 160, Noncontrolling Interests in Consolidated
Financial Statementsan amendment of ARB No. 51 (SFAS No. 160). SFAS No. 160 requires a company to clearly identify and present ownership interests in subsidiaries held by parties other than the company in the
consolidated financial statements within the equity section but separate from the companys equity. It also requires that the amount of consolidated net income attributable to the parent and to the noncontrolling interest be clearly identified
and presented on the face of the consolidated statement of income; changes in ownership interest be accounted for similarly, as equity transactions; and when a subsidiary is deconsolidated, any retained noncontrolling equity investment in the former
subsidiary and the gain or loss on the deconsolidation of the subsidiary be measured at fair value. This statement is effective for fiscal years, and interim periods within those fiscal years, beginning on or after December 15, 2008. The
Company is currently evaluating the impact of its adoption on its financial position, results of operations, and cash flows.

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 2 to the Financial Statements contained in the Companys
Annual Report on Form 10-K for the year ended December 31, 2007 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.

Effective January 1, 2008,
the Company partially adopted Financial Accounting Standards Board (FASB) Statement of Financial Accounting Standards No. 157, Fair Value Measurements (SFAS No. 157). SFAS No. 157 applies broadly to
financial and non-financial assets and liabilities reported or disclosed at fair value under existing authoritative accounting pronouncements. In February 2008, FASB issued FASB Staff Position No. FAS 157-2, Effective Date of FASB Statement
No.157 (FSP 157-2). FSP 157-2 amended SFAS No. 157, Fair Value Measurements (SFAS No. 157) and delays the effective date of SFAS No. 157 for nonfinancial assets and nonfinancial liabilities,
except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually), until fiscal years beginning after November 15, 2008, including interim periods within those fiscal years. In
accordance with FSP 157-2, the Company has partially adopted SFAS No. 157, and is currently evaluating the impact of the adoption of FSP 157-2 on its financial position, results of operations, and cash flows. The Companys partial adoption
of SFAS No. 157 did not result in a change to the valuation techniques it had previously used to measure the fair value of its financial assets and liabilities, nor did the Company have additional assets and liabilities that required a fair
market valuation.

The estimated fair value of amounts reported in the financial statements had been determined using available market
information and valuation methodologies, as applicable. The methodologies and assumptions used to estimate the fair value of each class of financial instruments are set forth below:



| |  |  | Cash, accounts receivable, accounts payable and other accrued expenses are carried at cost as this approximates fair value due to their short-term nature.
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | Line of credit and short-term notes have variable rates that reflect currently available terms and conditions for similar debt.
| | - |  | -------------------------------------------------------------------------------------------------------------------------------



|Item 4. | Controls and Procedures.
|------- | ------------------------

Management, including the
Chief Executive Officer/Interim Chief Financial Officer of the Company, has conducted an evaluation of the effectiveness of the Companys disclosure controls and procedures (as defined in Rules 13a-15(e) or 15d-15(e) of the Securities
Exchange Act of 1934) as of the end of the period covered by this quarterly report (the Evaluation Date). Based on such evaluation, the Chief Executive Officer/Interim Chief Financial Officer have concluded that as of the Evaluation
Date, the Companys disclosure controls and procedures are effective to ensure that the 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 in the Securities and Exchange Commissions rules and forms, and to ensure that the information required to be disclosed by the Company in the reports it files or
submits under the Securities Exchange Act of 1934 is accumulated and communicated to the Companys management, including the Chief Executive Officer/Interim Chief



18



---

##### Table of Contents

Financial Officer, or persons performing similar functions, as appropriate, to allow timely decisions regarding required disclosure. There have not been
any changes in the Companys internal control over financial reporting that have materially affected or are reasonably likely to materially affect, the Companys internal control over financial reporting.

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.                            
|            |  |                                                                                                                                                                             
|4           |  | Instruments defining the rights of security holders, including indentures                                                                                                    |  | Form SB-2 filed with the Securities and Exchange Commission on September 21, 2000.                          
|            |  |                                                                                                                                                                             
|31(a)       |  | Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Quarterly Report on Form 10-Q of Pinnacle Data Systems, Inc. for the quarter ended March 31, 2008 |  | Contained herein.                                                                                           
|            |  |                                                                                                                                                                             
|32(a)       |  | Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 of Quarterly Report on Form 10-Q of Pinnacle Data Systems, Inc. for the quarter ended March 31, 2008 |  | Contained herein.                                                                                           



19



---

##### Table of Contents

SIGNATURES

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



|                   |  |  |  |                                                                       
|------------------ |  |  |  | ----------------------------------------------------------------------
|                   |  |  |  |                                                                       
|                   |  |  |  | PINNACLE DATA SYSTEMS, INC.                                           
|                   |  | 
|Date: May 15, 2008 |  |  |  | /s/ Michael R. Sayre                                                  
|                   |  |  |  | Michael Sayre,                                                        
|                   |  |  |  | President, Chief Executive Officer and Interim Chief Financial Officer



20