##### Table of Contents

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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549



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FORM 10-QSB



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



For the quarterly period ended September 25, 2004



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



For the transition period from  to



Commission file number: 1-16103



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PINNACLE DATA SYSTEMS, INC.

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



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



6600 Port Road,
Groveport, Ohio 43125

(Address of principal executive offices)



(614) 748-1150

(Issuers Telephone Number)



No change

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



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



APPLICABLE ONLY TO CORPORATE ISSUERS



State the number of
shares outstanding of each of the issuers classes of common equity, as of the latest practicable date: 5,598,806 common shares, without par value, as of November 9, 2004



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



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##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

INDEX



|               |  |                                                                                            |  |         
|-------------- |  | ------------------------------------------------------------------------------------------ |  | --------
|               |  |                                                                                            |  | Page No.
|               |  |                                                                                           
|PART I         |  | FINANCIAL INFORMATION                                                                      |  | 3       
|               |  |                                                                                           
|Item 1.        |  | Financial Statements                                                                       |  | 3       
|               |  |                                                                                           
|               |  | Balance SheetsSeptember 25, 2004 and December 31, 2003                                     |  | 3-4     
|               |  |                                                                                           
|               |  | Statements of IncomeOne and three quarters ended September 25, 2004 and September 27, 2003 |  | 5       
|               |  |                                                                                           
|               |  | Statements of Cash FlowsThree quarters ended September 25, 2004 and September 27, 2003     |  | 6-7     
|               |  |                                                                                           
|               |  | Notes to Financial Statements                                                              |  | 8-14    
|               |  |                                                                                           
|Item 2.        |  | Managements Discussion and Analysis or Plan of Operation                                  |  | 15-22   
|               |  |                                                                                           
|Item 3.        |  | Controls and Procedures                                                                    |  | 23      
|               |  |                                                                                           
|PART II        |  | OTHER INFORMATION                                                                          |  | 24      
|               |  |                                                                                           
|Item 6.        |  | Exhibits.                                                                                  |  | 24-25   
|               | 
|SIGNATURES     |  | 26                                                                                        
|               | 
|CERTIFICATIONS |  |                                                                                           



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##### Table of Contents

PART I. - FINANCIAL INFORMATION



Item 1. Financial Statements



PINNACLE DATA SYSTEMS, INC.

(DBA PDSi)



BALANCE SHEETS



|                                                                                      |  |                    |            |                   |   |          
|------------------------------------------------------------------------------------- |  | ------------------ | ---------- | ----------------- | - | ---------
|                                                                                      |  | September 25, 2004 |            | December 31, 2003
|                                                                                      |  | (Unaudited)        |            |                  
|ASSETS                                                                                |  |                    |            |                   |   |          
|CURRENT ASSETS                                                                        |  |                    |            |                   |   |          
|Cash                                                                                  |  | $                  | 299,239    |                   | $ | 48,345   
|Accounts receivable, net of allowance for doubtful accounts of $20,000                |  |                    | 5,840,478  |                   |   | 5,126,632
|Inventory                                                                             |  |                    | 4,440,083  |                   |   | 2,023,434
|Other prepaid expenses                                                                |  |                    | 131,367    |                   |   | 197,270  
|Deferred income taxes                                                                 |  |                    | 428,000    |                   |   | 428,000  
|                                                                                      |  |                    |            |                   |   |          
|                                                                                      |  |                    | 11,139,167 |                   |   | 7,823,681
|                                                                                      |  |                    |            |                   |   |          
|PROPERTY AND EQUIPMENT                                                                |  |                    |            |                   |   |          
|Leasehold improvements                                                                |  |                    | 282,709    |                   |   | 226,693  
|Furniture and fixtures                                                                |  |                    | 369,000    |                   |   | 331,991  
|Computer equipment and related software                                               |  |                    | 2,386,475  |                   |   | 2,264,719
|Shop equipment                                                                        |  |                    | 565,648    |                   |   | 494,857  
|                                                                                      |  |                    |            |                   |   |          
|                                                                                      |  |                    | 3,603,832  |                   |   | 3,318,260
|Less accumulated depreciation and amortization                                        |  |                    | 2,648,154  |                   |   | 2,232,379
|                                                                                      |  |                    |            |                   |   |          
|                                                                                      |  |                    | 955,678    |                   |   | 1,085,881
|                                                                                      |  |                    |            |                   |   |          
|OTHER ASSETS                                                                          |  |                    |            |                   |   |          
|Deposits                                                                              |  |                    | 22,166     |                   |   | 20,385   
|License agreement, less accumulated amortization of $41,200 and $32,595, respectively |  |                    | 1,000      |                   |   | 9,606    
|                                                                                      |  |                    |            |                   |   |          
|                                                                                      |  |                    | 23,166     |                   |   | 29,991   
|                                                                                      |  |                    |            |                   |   |          
|                                                                                      |  | $                  | 12,118,011 |                   | $ | 8,939,553
|                                                                                      |  |                    |            |                   |   |          



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



3



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##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

(DBA PDSi)



BALANCE SHEETS



|                                                                                                                              |  |                    |            |                   |   |          
|----------------------------------------------------------------------------------------------------------------------------- |  | ------------------ | ---------- | ----------------- | - | ---------
|                                                                                                                              |  | September 25, 2004 |            | December 31, 2003
|                                                                                                                              |  | (Unaudited)        |            |                  
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                                          |  |                    |            |                   |   |          
|                                                                                                                              |  |                   
|CURRENT LIABILITIES                                                                                                           |  |                    |            |                   |   |          
|Line of credit                                                                                                                |  | $                  | 2,652,441  |                   | $ | 2,486,566
|Accounts payable                                                                                                              |  |                    | 3,901,253  |                   |   | 1,902,047
|Accrued expenses:                                                                                                             |  |                    |            |                   |   |          
|Wages, payroll taxes and benefits                                                                                             |  |                    | 330,863    |                   |   | 351,778  
|Income taxes                                                                                                                  |  |                    | 48,875     |                   |   | 7,379    
|Other                                                                                                                         |  |                    | 149,967    |                   |   | 100,953  
|Unearned revenue                                                                                                              |  |                    | 19,100     |                   |   |         
|                                                                                                                              |  |                    |            |                   |   |          
|                                                                                                                              |  |                    | 7,102,499  |                   |   | 4,848,723
|                                                                                                                              |  |                    |            |                   |   |          
|LONG-TERM LIABILITIES                                                                                                         |  |                    |            |                   |   |          
|Deferred income taxes                                                                                                         |  |                    | 55,000     |                   |   | 55,000   
|                                                                                                                              |  |                    |            |                   |   |          
|                                                                                                                              |  |                    | 55,000     |                   |   | 55,000   
|                                                                                                                              |  |                    |            |                   |   |          
|                                                                                                                              |  |                    | 7,157,499  |                   |   | 4,903,723
|                                                                                                                              |  |                    |            |                   |   |          
|COMMITMENTS AND CONTINGENCIES                                                                                                 |  |                    |           |                   |   |         
|                                                                                                                              |  |                    |            |                   |   |          
|STOCKHOLDERS EQUITY                                                                                                          |  |                    |            |                   |   |          
|Preferred stock; no par value; 4,000,000 shares authorized; no shares issued or outstanding                                   |  |                    |           |                   |   |         
|Common stock; no par value; 25,000,000 shares authorized; 5,588,806 and 5,539,796 shares issued and outstanding, respectively |  |                    | 2,236,482  |                   |   | 2,172,281
|Additional paid-in capital                                                                                                    |  |                    | 502,095    |                   |   | 502,095  
|Retained earnings                                                                                                             |  |                    | 2,221,936  |                   |   | 1,361,454
|                                                                                                                              |  |                    |            |                   |   |          
|                                                                                                                              |  |                    | 4,960,512  |                   |   | 4,035,830
|                                                                                                                              |  |                    |            |                   |   |          
|                                                                                                                              |  | $                  | 12,118,011 |                   | $ | 8,939,553
|                                                                                                                              |  |                    |            |                   |   |          



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



4



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##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

(DBA PDSi)



STATEMENTS OF INCOME



|                                  |  |                       |           |                              |   |                    |  |                    |            |  |   |           
|--------------------------------- |  | --------------------- | --------- | ---------------------------- | - | ------------------ |  | ------------------ | ---------- |  | - | ----------
|                                  |  | For the Quarter Ended |           | For the Three Quarters Ended
|                                  |  | September 25, 2004    |           | September 27, 2003           |   | September 25, 2004 |  | September 27, 2003
|                                  |  | (unaudited)           |           | (unaudited)                 
|SALES                             |  |                       |           |                              |   |                    |  |                    |            |  |   |           
|Product sales                     |  | $                     | 7,555,851 |                              | $ | 3,538,844          |  | $                  | 22,760,147 |  | $ | 9,205,263 
|Service sales                     |  |                       | 1,229,070 |                              |   | 1,652,734          |  |                    | 4,352,039  |  |   | 5,916,805 
|                                  |  |                       |           |                              |   |                    |  |                    |            |  |   |           
|                                  |  |                       | 8,784,921 |                              |   | 5,191,578          |  |                    | 27,112,186 |  |   | 15,122,068
|                                  |  |                       |           |                              |   |                    |  |                    |            |  |   |           
|COST OF SALES                     |  |                       |           |                              |   |                    |  |                    |            |  |   |           
|Product sales                     |  |                       | 6,396,364 |                              |   | 2,556,112          |  |                    | 17,892,031 |  |   | 6,959,704 
|Service sales                     |  |                       | 864,083   |                              |   | 1,116,562          |  |                    | 2,742,860  |  |   | 3,798,285 
|                                  |  |                       |           |                              |   |                    |  |                    |            |  |   |           
|                                  |  |                       | 7,260,447 |                              |   | 3,672,674          |  |                    | 20,634,891 |  |   | 10,757,989
|                                  |  |                       |           |                              |   |                    |  |                    |            |  |   |           
|GROSS PROFIT                      |  |                       | 1,524,474 |                              |   | 1,518,904          |  |                    | 6,477,295  |  |   | 4,364,079 
|                                  |  |                       |           |                             
|OPERATING EXPENSES                |  |                       | 1,500,104 |                              |   | 1,285,113          |  |                    | 4,940,394  |  |   | 3,668,232 
|                                  |  |                       |           |                              |   |                    |  |                    |            |  |   |           
|INCOME FROM OPERATIONS            |  |                       | 24,370    |                              |   | 233,791            |  |                    | 1,536,901  |  |   | 695,847   
|                                  |  |                       |           |                              |   |                    |  |                    |            |  |   |           
|OTHER EXPENSE                     |  |                       |           |                              |   |                    |  |                    |            |  |   |           
|Interest expense                  |  |                       | 23,766    |                              |   | 21,692             |  |                    | 78,419     |  |   | 66,561    
|                                  |  |                       |           |                              |   |                    |  |                    |            |  |   |           
|INCOME BEFORE INCOME TAXES        |  |                       | 604       |                              |   | 212,099            |  |                    | 1,458,482  |  |   | 629,286   
|                                  |  |                       |           |                             
|INCOME TAX EXPENSE                |  |                       |          |                              |   | 90,000             |  |                    | 598,000    |  |   | 253,000   
|                                  |  |                       |           |                              |   |                    |  |                    |            |  |   |           
|NET INCOME                        |  | $                     | 604       |                              | $ | 122,099            |  | $                  | 860,482    |  | $ | 376,286   
|                                  |  |                       |           |                              |   |                    |  |                    |            |  |   |           
|BASIC EARNINGS PER COMMON SHARE   |  | $                     | 0.00      |                              |   | 0.02               |  |                    | 0.15       |  |   | 0.07      
|                                  |  |                       |           |                              |   |                    |  |                    |            |  |   |           
|DILUTED EARNINGS PER COMMON SHARE |  | $                     | 0.00      |                              |   | 0.02               |  |                    | 0.14       |  |   | 0.07      
|                                  |  |                       |           |                              |   |                    |  |                    |            |  |   |           



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



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PINNACLE DATA SYSTEMS, INC.

(DBA PDSi)



STATEMENTS OF CASH FLOWS



Three Quarters Ended September 25, 2004 and September 27, 2003



|                                                                                  |  |             |            |   |             |   |            |  
|--------------------------------------------------------------------------------- |  | ----------- | ---------- | - | ----------- | - | ---------- | -
|                                                                                  |  | 2004        |            |   | 2003        |  
|                                                                                  |  | (Unaudited) |            |   | (Unaudited) |  
|CASH FLOWS FROM OPERATING ACTIVITIES                                              |  |             |            |   |             |   |            |  
|Net income                                                                        |  | $           | 860,482    |   |             | $ | 376,286    |  
|                                                                                  |  |             |            |   |             |   |            |  
|Adjustments to reconcile net income to net cash provided by operating activities: |  |             |            |   |             |   |            |  
|Depreciation and amortization                                                     |  |             | 425,859    |   |             |   | 429,122    |  
|Inventory reserves                                                                |  |             | 178,374    |   |             |   | 196,311    |  
|Loss on disposal of equipment                                                     |  |             | (87        | ) |             |   | (12,800    | )
|(Increase)/decrease in assets:                                                    |  |             |            |   |             |   |            |  
|Accounts receivable                                                               |  |             | (713,848   | ) |             |   | (1,412,889 | )
|Inventory                                                                         |  |             | (2,659,757 | ) |             |   | 449,397    |  
|Prepaid expenses and other assets                                                 |  |             | 64,123     |   |             |   | 179,247    |  
|Increase/(decrease) in liabilities:                                               |  |             |            |   |             |   |            |  
|Accounts payable                                                                  |  |             | 1,999,207  |   |             |   | 571,367    |  
|Accrued expenses and taxes                                                        |  |             | 69,594     |   |             |   | (147,776   | )
|Unearned revenues                                                                 |  |             | 19,100     |   |             |   | 88,119     |  
|                                                                                  |  |             |            |   |             |   |            |  
|Total adjustments                                                                 |  |             | (617,435   | ) |             |   | 340,098    |  
|                                                                                  |  |             |            |   |             |   |            |  
|Net cash provided by operating activities                                         |  |             | 243,047    |   |             |   | 716,384    |  
|                                                                                  |  |             |            |   |             |   |            |  
|CASH FLOWS FROM INVESTING ACTIVITIES                                              |  |             |            |   |             |   |            |  
|Purchases of property and equipment                                               |  |             | (222,394   | ) |             |   | (108,441   | )
|Proceeds from sale of property and equipment                                      |  |             | 165        |   |             |   | 27,000     |  
|                                                                                  |  |             |            |   |             |   |            |  
|Net cash used in investing activities                                             |  |             | (222,229   | ) |             |   | (81,441    | )
|                                                                                  |  |             |            |   |             |   |            |  
|CASH FLOWS FROM FINANCING ACTIVITIES                                              |  |             |            |   |             |   |            |  
|Net change in line of credit                                                      |  |             | 165,875    |   |             |   | (565,095   | )
|Principal payments on long-term debt                                              |  |             |           |   |             |   | (33,333    | )
|Principal payments on capital lease obligation                                    |  |             |           |   |             |   | (18,621    | )
|Proceeds from stock options exercised                                             |  |             | 64,201     |   |             |   | 6,000      |  
|Other proceeds from shareholders                                                  |  |             |           |   |             |   | 589        |  
|                                                                                  |  |             |            |   |             |   |            |  
|Net cash provided by/(used in) financing activities                               |  |             | 230,076    |   |             |   | (610,460   | )
|                                                                                  |  |             |            |   |             |   |            |  



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



6



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PINNACLE DATA SYSTEMS, INC.

(DBA PDSi)



STATEMENTS OF CASH FLOWS (CONTINUED)



Three Quarters Ended September 25, 2004 and September 27, 2003



|                                                                                  |  |      |         |      |   |        
|--------------------------------------------------------------------------------- |  | ---- | ------- | ---- | - | -------
|                                                                                  |  | 2004 |         | 2003
|INCREASE IN CASH                                                                  |  |      | 250,894 |      |   | 24,483 
|                                                                                  |  |     
|CASH - Beginning of period                                                        |  |      | 48,345  |      |   | 35,705 
|                                                                                  |  |      |         |      |   |        
|CASH - End of period                                                              |  | $    | 299,239 |      | $ | 60,188 
|                                                                                  |  |      |         |      |   |        
|SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION                                  |  |      |         |      |   |        
|Interest paid                                                                     |  | $    | 75,505  |      | $ | 67,545 
|                                                                                  |  |      |         |      |   |        
|Income taxes paid, net of refunds                                                 |  | $    | 556,577 |      | $ | 328,963
|                                                                                  |  |      |         |      |   |        
|SUPPLEMENTAL DISCLOSURE OF NONCASH INVESTING AND FINANCING TRANSACTIONS           |  |      |         |      |   |        
|                                                                                  |  |     
|During 2004, the company capitalized $64,734 of inventory as computer equipment.  |  |      |         |      |   |        
|                                                                                  |  |     
|During 2003, the company capitalized $183,514 of inventory as computer equipment. |  |      |         |      |   |        



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



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PINNACLE DATA SYSTEMS, INC.

(DBA PDSi)



NOTES TO FINANCIAL STATEMENTS



(UNAUDITED)



|Note 1. | Organization
|------- | ------------



Nature of Business - Pinnacle Data Systems, Inc. (dba PDSi) (the Company) provides technical services, encompassing the development and production of
computer systems and components, and the testing and repair of computer systems, components and peripherals, to Original Equipment Manufacturers (OEMs) in, among others, the aerospace, computer, computer peripheral, data storage, digital-imaging,
medical diagnostic, process-control, and telecommunications equipment industries. PDSi offers a full range of services to increase product speed to market and engineered product life, and to provide service and support to units in the field through
comprehensive product lifecycle management programs encompassing depot repair, advanced exchange, contact center support and end-of-life control.



|Note 2. | Summary of Significant Accounting Policies
|------- | ------------------------------------------



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



Inventory at September 25, 2004 and December 31, 2003 was comprised of the following (net of inventory reserves):



|                                |  |           |           |            |   |          
|------------------------------- |  | --------- | --------- | ---------- | - | ---------
|                                |  | 9/25/2004 |           | 12/31/2003
|Component parts (raw materials) |  | $         | 3,463,655 |            | $ | 1,501,213
|Work-in-process                 |  |           | 534,359   |            |   | 129,088  
|Finished goods                  |  |           | 442,069   |            |   | 393,133  
|                                |  |           |           |            |   |          
|                                |  | $         | 4,440,083 |            | $ | 2,023,434
|                                |  |           |           |            |   |          



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.



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PINNACLE DATA SYSTEMS, INC.



(DBA PDSi)



NOTES TO FINANCIAL STATEMENTS



(UNAUDITED)



|Note 2. | Summary of Significant Accounting Policies (continued)
|------- | ------------------------------------------------------



The Company divides its fiscal calendar into 4 periods or quarters. It is intended that each quarter consist of thirteen weeks. The first
quarter of each year begins on January 1 and the fourth quarter ends on December 31. Depending on what day of the week January 1 falls, the first quarter may contain a few days less than thirteen full weeks and the fourth quarter may contain a few
days more than thirteen full weeks. The third quarter of 2004 ended on September 25 and contained 91 days. The third quarter of 2003 ended on September 27 and also contained 91 days. The first three quarters of 2004 contained 178 days and the first
three quarters of 2003 contained 179 days.



The balance sheet
as of September 25, 2004 and the statements of income and cash flows for the three quarters ended September 25, 2004 and September 27, 2003 have been prepared by the Company without audit. In the opinion of management, all adjustments, which consist
solely of normal recurring adjustments, necessary to present fairly, in accordance with accounting principles generally accepted in the United States of America, the financial position, statements of income and changes in cash flows for all periods
presented have been made.



Certain information and footnote
disclosures normally included in financial statements prepared in accordance with accounting principles generally accepted in the United States of America have been condensed and omitted. These condensed financial statements should be read in
conjunction with the financial statements and notes thereto included in the Companys December 31, 2003 annual report on Form 10-KSB. The results of operations for the periods ended September 25, 2004 are not necessarily indicative of the
results for the full year.



SFAS No. 150, Accounting for
Certain Financial Instruments with Characteristics of both Liabilities and Equity, requires that an issuer classify a financial instrument that is within its scope as a liability (or an asset in some circumstances), many of which were previously
classified as equity. SFAS No. 150 is effective for interim periods beginning after June 15, 2003. In its October 2003 meeting, the FASB decided to defer the effective date of certain provisions of SFAS No. 150. Management does not expect the
adoption of this accounting pronouncement to have a material impact on the Companys consolidated financial statements.



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PINNACLE DATA SYSTEMS, INC.



(DBA PDSi)



NOTES TO FINANCIAL STATEMENTS



(UNAUDITED)



|Note 2. | Summary of Significant Accounting Policies (continued)
|------- | ------------------------------------------------------



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



|Note 3. | Line of Credit
|------- | --------------



In May 2004, the Company entered into a 120-day $2,000,000 term loan agreement with its bank. As planned, the term loan was paid off in September 2004 by
using the line of credit. The intent and effect of the loan was to temporarily increase the limit of the line of credit from $5,000,000 to $7,000,000. The $2,000,000 of proceeds from the term loan was applied to the outstanding line of credit
balance, reducing its balance by $2,000,000. The incremental $2,000,000 loan had the same interest rate as the line of credit. For the duration of the term loan, the collateralization and covenants of the two loans were combined as if they were one
loan facility. The $2,500,000 inventory collateral sub-limit of the line of credit was increased to $3,500,000 for the duration of the term loan.



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PINNACLE DATA SYSTEMS, INC.



(DBA PDSi)



NOTES TO FINANCIAL STATEMENTS



(UNAUDITED)



|Note 4 | Stock Options
|------ | -------------



During the three quarters ended September 25, 2004, the Companys stock option activities and weighted average exercise prices were as follows:



|                                |  |           |   |  |               |     
|------------------------------- |  | --------- | - |  | ------------- | ----
|                                |  | Shares    |   |  | ExercisePrice
|Outstanding, December 31, 2003  |  | 1,460,500 |   |  | $             | 1.91
|Granted                         |  | 49,000    |   |  |               | 2.22
|Exercised                       |  | (53,000   | ) |  |               | 1.55
|Forfeited                       |  | (60,050   | ) |  |               | 2.07
|                                |  |           |   |  |               |     
|Outstanding, September 25, 2004 |  | 1,396,450 |   |  | $             | 1.92
|                                |  |           |   |  |               |     



The Company accounts
for employee and director stock options using the intrinsic value method. Under this method, no compensation expense was recorded for the first three quarters of 2004 because all stock options were granted at an exercise price equal to or greater
than the fair market value of the Companys stock on the date of the grant. If compensation expense for the Companys stock option grants had been determined based on their estimated fair value at the grant dates, the Companys net
income and earnings per share for the third quarter and three-quarter periods ending September 25, 2004 and September 27, 2003 would have been as follows:



|                                                                                                                                  |  |               |         |   |                |   |         |      |  |   |          |   |  |   |         |  
|--------------------------------------------------------------------------------------------------------------------------------- |  | ------------- | ------- | - | -------------- | - | ------- | ---- |  | - | -------- | - |  | - | ------- | -
|                                                                                                                                  |  | Third Quarter |         |   | Three Quarters |  
|                                                                                                                                  |  | 2004          |         |   | 2003           |   |         | 2004 |  |   | 2003     |  
|Net income, as reported                                                                                                           |  | $             | 604     |   |                | $ | 122,099 |      |  | $ | 860,482  |   |  | $ | 376,286 |  
|Deduct: total stock-based compensation expense determined under the fair value method for all awards, net of related tax
benefits |  |               | (96,795 | ) |                |   | (8,182  | )    |  |   | (234,303 | ) |  |   | (64,033 | )
|                                                                                                                                  |  |               |         |   |                |   |         |      |  |   |          |   |  |   |         |  
|Net income, pro forma                                                                                                             |  |               | (96,191 | ) |                |   | 113,917 |      |  |   | 626,179  |   |  |   | 312,253 |  
|                                                                                                                                  |  |               |         |  
|Earnings per common share, basic:                                                                                                 |  |               |         |   |                |   |         |      |  |   |          |   |  |   |         |  
|As reported                                                                                                                       |  | $             |        |   |                | $ | 0.02    |      |  | $ | 0.15     |   |  | $ | 0.07    |  
|Pro forma                                                                                                                         |  | $             | (0.02   | ) |                | $ | 0.02    |      |  | $ | 0.11     |   |  | $ | 0.06    |  
|Earnings per common share, diluted:                                                                                               |  |               |         |   |                |   |         |      |  |   |          |   |  |   |         |  
|As reported                                                                                                                       |  | $             |        |   |                | $ | 0.02    |      |  | $ | 0.14     |   |  | $ | 0.07    |  
|Pro forma                                                                                                                         |  | $             | (0.02   | ) |                | $ | 0.02    |      |  | $ | 0.10     |   |  | $ | 0.05    |  



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##### Table of Contents

PINNACLE DATA SYSTEMS, INC.



(DBA PDSi)



NOTES TO FINANCIAL STATEMENTS



(UNAUDITED)



|Note 4 | Stock Options (continued)
|------ | -------------------------



The fair value of options granted was estimated on the date of the grant using the Black-Scholes option-pricing model with the following weighted average
assumptions for the three-quarter period ended September 25, 2004:



|                                        |  |       |  
|--------------------------------------- |  | ----- | -
|Risk-free interest rate                 |  | 4.32  | %
|Dividend yield                          |  | 0     | %
|Volatility factor                       |  | 84.45 | %
|Weighted average expected life in years |  | 9.5   |  



|Note 5. | Income Taxes
|------- | ------------



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



|Note 6. | Profit Sharing and 401(k) Savings Plan
|------- | --------------------------------------



The Company maintains a qualified cash or deferred compensation plan under section 401(k) of the Internal Revenue Code. The plan covers all employees age
21 or over with at least three months of service. Under the plan, employees may elect to defer a portion of their salary, subject to Internal Revenue Code limits.



The Company, at its discretion, may match up to 100% of employee contributions up to 6% of wages deferred with an annual
maximum company contribution of $4,500 per employee. The Company elected to make a 15% match of employee contributions in the first three quarters of 2004 in the amount of approximately $27,200. The Company elected not to make matching contributions
for the first three quarters of 2003.



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PINNACLE DATA SYSTEMS, INC.



(DBA PDSi)



NOTES TO FINANCIAL STATEMENTS



(UNAUDITED)



|Note 7. | Earnings Per Common and Common Equivalent Share
|------- | -----------------------------------------------



Earnings per common and common equivalent share were computed by dividing net earnings by the weighted average number of shares of common stock
outstanding during the quarter



|                                                                |  |                                 |         |                                        |           |                 |   |                   |  |                     |         |                 |           |  |   |     
|--------------------------------------------------------------- |  | ------------------------------- | ------- | -------------------------------------- | --------- | --------------- | - | ----------------- |  | ------------------- | ------- | --------------- | --------- |  | - | ----
|                                                                |  | For the quarter ended 9/25/2004 |         | For the three quarters ended 9/25/2004
|                                                                |  | Income(Numerator)               |         | Shares(Denominator)                    |           | Per-ShareAmount |   | Income(Numerator) |  | Shares(Denominator) |         | Per-ShareAmount
|Basic EPS                                                       |  |                                 |         |                                        |           |                 |   |                   |  |                     |         |                 |           |  |   |     
|Income available to common shareholders                         |  | $                               | 604     |                                        | 5,587,377 |                 | $ | 0.00              |  | $                   | 860,482 |                 | 5,560,779 |  | $ | 0.15
|                                                                |  |                                 |         |                                        |           |                
|Effect of Dilutive Securities                                   |  |                                 |         |                                        |           |                 |   |                   |  |                     |         |                 |           |  |   |     
|Options                                                         |  |                                 |         |                                        | 492,384   |                 |   |                   |  |                     |         |                 | 555,759   |  |   |     
|                                                                |  |                                 |         |                                        |           |                 |   |                   |  |                     |         |                 |           |  |   |     
|Diluted EPS                                                     |  |                                 |         |                                        |           |                 |   |                   |  |                     |         |                 |           |  |   |     
|Income available to common stockholders and assumed conversions |  | $                               | 604     |                                        | 6,079,761 |                 | $ | 0.00              |  | $                   | 860,482 |                 | 6,116,538 |  | $ | 0.14
|                                                                |  |                                 |         |                                        |           |                 |   |                   |  |                     |         |                 |           |  |   |     
|                                                                |  |                                
|                                                                |  | For the quarter ended 9/27/2003 |         | For the three quarters ended 9/27/2003
|                                                                |  | Income(Numerator)               |         | Shares(Denominator)                    |           | Per-ShareAmount |   | Income(Numerator) |  | Shares(Denominator) |         | Per-ShareAmount
|Basic EPS                                                       |  |                                 |         |                                        |           |                 |   |                   |  |                     |         |                 |           |  |   |     
|Income available to common shareholders                         |  | $                               | 122,099 |                                        | 5,530,030 |                 | $ | 0.02              |  | $                   | 376,286 |                 | 5,522,631 |  | $ | 0.07
|                                                                |  |                                 |         |                                        |           |                
|Effect of Dilutive Securities                                   |  |                                 |         |                                        |           |                 |   |                   |  |                     |         |                 |           |  |   |     
|Options                                                         |  |                                 |         |                                        | 327,718   |                 |   |                   |  |                     |         |                 | 242,690   |  |   |     
|                                                                |  |                                 |         |                                        |           |                 |   |                   |  |                     |         |                 |           |  |   |     
|Diluted EPS                                                     |  |                                 |         |                                        |           |                 |   |                   |  |                     |         |                 |           |  |   |     
|Income available to common stockholders and assumed conversions |  | $                               | 122,099 |                                        | 5,857,748 |                 | $ | 0.02              |  | $                   | 376,286 |                 | 5,765,321 |  | $ | 0.07
|                                                                |  |                                 |         |                                        |           |                 |   |                   |  |                     |         |                 |           |  |   |     



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PINNACLE DATA SYSTEMS, INC.



(DBA PDSi)



NOTES TO FINANCIAL STATEMENTS



(UNAUDITED)



|Note 8. | Operating Segments
|------- | ------------------



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



|                              |  |                                         |            |               |   |           |  |   |            |   |  |   |           
|----------------------------- |  | --------------------------------------- | ---------- | ------------- | - | --------- |  | - | ---------- | - |  | - | ----------
|                              |  | Three Quarters Ended September 25, 2004
|                              |  | Product Sales                           |            | Service Sales |   | Other     |  |   | Total     
|Sales                         |  | $                                       | 22,760,147 |               | $ | 4,352,039 |  | $ |           |   |  | $ | 27,112,186
|Gross profit                  |  |                                         | 4,868,117  |               |   | 1,609,178 |  |   |           |   |  |   | 6,477,295 
|Income from operations        |  |                                         | 2,642,248  |               |   | 889,602   |  |   | (1,994,949 | ) |  |   | 1,536,901 
|Depreciation and amortization |  |                                         | 203,810    |               |   | 93,424    |  |   | 128,625    |   |  |   | 425,859   
|Interest expense              |  |                                         |           |               |   |          |  |   | 78,419     |   |  |   | 78,419    
|Total assets                  |  |                                         | 8,311,965  |               |   | 1,590,428 |  |   | 2,215,618  |   |  |   | 12,118,011
|Capital expenditures          |  |                                         | 100,732    |               |   | 161,270   |  |   | 25,126     |   |  |   | 287,128   
|                              | 
|                              |  | Three Quarters Ended September 27, 2003
|                              |  | Product Sales                           |            | Service Sales |   | Other     |  |   | Total     
|Sales                         |  | $                                       | 9,205,263  |               | $ | 5,916,805 |  | $ |           |   |  | $ | 15,122,068
|Gross profit                  |  |                                         | 2,245,559  |               |   | 2,118,520 |  |   |           |   |  |   | 4,364,079 
|Income from operations        |  |                                         | 1,035,977  |               |   | 1,040,867 |  |   | (1,380,997 | ) |  |   | 695,847   
|Depreciation and amortization |  |                                         | 190,153    |               |   | 91,801    |  |   | 147,168    |   |  |   | 429,122   
|Interest expense              |  |                                         |           |               |   |          |  |   | 66,561     |   |  |   | 66,561    
|Total assets                  |  |                                         | 3,095,735  |               |   | 1,730,864 |  |   | 2,539,145  |   |  |   | 7,365,744 
|Capital expenditures          |  |                                         | 206,031    |               |   | 66,988    |  |   | 18,936     |   |  |   | 291,955   



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



The following discussion should be read in conjunction with the Financial Statements and Notes contained herein. This quarterly report, including the following sections, contain forward-looking statements within the
meaning of Section 27A of the Securities Act of 1933, as amended, and Section 21E of the Securities Exchange Act of 1934, as amended, including, but not limited to, statements regarding the Company achieving the $100 million revenue level and being
profitable on an annual basis over the next five years, the Company achieving 2004 fourth quarter sales of the magnitude of the comparable quarter of 2003 and being profitable in the 2004 fourth quarter, the Company achieving over 40% annual sales
growth and 80% annual earnings growth in 2004, the Company achieving record sales and being profitable in 2005, improvement of the Companys service profit margins and annual revenue levels of $2-3 million under a repair services agreement with
a major OEM customer. The words believe, expect, anticipate, estimate, project, and similar expressions identify forward-looking statements that speak only as of the date thereof. The
Company undertakes no obligations to publicly update or revise such statements.



Investors are cautioned that such statements involve risks and uncertainties that could cause actual results to differ materially from historical or anticipated results due to many factors. These factors include changes in general economic
conditions, changes in the specific markets for our products and services, adverse business conditions, increased competition, changes in our business or our relationship with major technology partners, 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 adverse changes in customer order patterns, including
any decline or change in product orders from large customers like the three customers that make up approximately 50% of our revenue during the first three quarters of 2004, and other risks described in this quarterly report and from time to time in
the Companys periodic reports and filings with the Securities and Exchange Commission.



The following discussions and analyses are for the quarter and three-quarter periods ended September 25, 2004, compared to the comparable periods ended September 27, 2003.



OVERVIEW



Pinnacle Data Systems, Inc. (PDSi or the Company) provides technical
services, encompassing the development and production of computer systems and components, and the testing and repair of computer systems, components and peripherals, to Original Equipment Manufacturers (OEMs) in, among others, the aerospace,
computer, computer peripheral, data storage, digital-imaging, medical diagnostic, process-control, and telecommunications equipment industries. PDSi offers a full range of services to increase product speed to market and engineered product life, and
to provide service and support to units in the field through comprehensive product lifecycle management programs encompassing depot repair, advanced exchange, contact center support and end-of-life control. Our business model is a foundation of
electronics repair and logistics programs (Services) that provide resources for the development and sale of high-potential PDSi-engineered and manufactured hardware solutions for specific customers and niche-industry applications
(Products).



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##### Table of Contents

For the full year of 2004, we expect record sales and profitability to result from our rather modest, but very effective,
spending in marketing and sales of the past few years. To fuel additional growth to beyond the $100 million revenue level and continue to achieve profitability on an annual basis over the next three to five years, in 2004 we are reorganizing the
management structure under a newly created President and Chief Operating Officer position, increasing our visibility in the marketplace by increasing the size of our marketing and sales team, and making investments in our delivery infrastructure to
increase our scalability. Our past efforts have only begun to tap into the large markets for our services and products.



Our marketing and sales efforts will continue to be on original equipment manufacturers (OEMs) in a number of large and growing industries with special emphasis on
expanding our participation in current accounts across those industries and gaining new accounts in the medical equipment, telecommunications and aerospace/military industries going into 2005.



SALES



Sales for the third quarter and the first three quarters of 2004 and 2003 were as follows:



|              |  |               |       |      |                |          |  |     |      |  |      |        |          |   |        |  |     |  
|------------- |  | ------------- | ----- | ---- | -------------- | -------- |  | --- | ---- |  | ---- | ------ | -------- | - | ------ |  | --- | -
|              |  | Third Quarter |       |      | Three Quarters |         
|($ thousands) |  | 2004          |       | 2003 |                | % Change |  |     | 2004 |  | 2003 |        | % Change |  
|Total company |  | $             | 8,785 |      | $              | 5,192    |  | 69  | %    |  | $    | 27,112 |          | $ | 15,122 |  | 79  | %
|Product       |  |               | 7,556 |      |                | 3,539    |  | 114 | %    |  |      | 22,760 |          |   | 9,205  |  | 147 | %
|Service       |  |               | 1,229 |      |                | 1,653    |  | -26 | %    |  |      | 4,352  |          |   | 5,917  |  | -26 | %



The sales growth in the third quarter
reflected increases in orders from customers across multiple industries, including commercial imaging, medical diagnostic, hardware management service and remote management diagnostic products. The year to date product sales growth was also
significantly impacted by the two largest orders in the companys history, a $3 million order for controller boards for medical diagnostic equipment announced in November of 2003 followed by a $4 million telecommunications equipment order
announced in April of 2004. About 25% of the $3 million order shipped in the fourth quarter of 2003 and both orders were completed in the first half of 2004. Most of our customers continue to place orders or forecast requirements for only about
three months at any given time, which continues to make it difficult to forecast product sales beyond one or two quarters.



Service sales in the third quarter of 2004 declined 26% from the comparable period of 2003, due to the larger than anticipated seasonal decline in repair services. We
began providing repair services for a third major OEM customer near the end of the third quarter, and expect repair volumes for that customer, who is in the high-performance computing, visualization and storage industry, to ramp upward through the
fourth quarter of 2004, eventually to an annual revenue level of $2-3 million, although there are no exclusivity or volume commitments contained in that agreement. The agreement was signed in the third quarter of 2004 and has an initial term of
three years.



We expect overall sales in the fourth quarter of 2004 to be of
the same magnitude of the record (at that time) fourth quarter of 2003.



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##### Table of Contents

For the first three quarters of 2004, we had three customers that generated revenues of approximately $5,229,000,
$4,903,000, and $3,521,000 or 19%, 18%, and 13% respectively, of total revenue. In the statements of income, approximately $13,361,000 of the revenues from these customers is included in product sales and $293,000 is included in service sales. In
addition, these customers represented 12%, 33%, and 3%, respectively, of accounts receivable at September 25, 2004.



GROSS PROFIT



Gross profit for the third quarter and the first three quarters of 2004 and 2003 was as follows:



|              |  |               |       |      |                |          |  |     |      |  |      |       |          |   |       |  |     |  
|------------- |  | ------------- | ----- | ---- | -------------- | -------- |  | --- | ---- |  | ---- | ----- | -------- | - | ----- |  | --- | -
|              |  | Third Quarter |       |      | Three Quarters |         
|($ thousands) |  | 2004          |       | 2003 |                | % Change |  |     | 2004 |  | 2003 |       | % Change |  
|Total company |  | $             | 1,525 |      | $              | 1,519    |  | 0   | %    |  | $    | 6,477 |          | $ | 4,364 |  | 48  | %
|Product       |  |               | 1,160 |      |                | 983      |  | 18  | %    |  |      | 4,868 |          |   | 2,246 |  | 117 | %
|Service       |  |               | 365   |      |                | 536      |  | -32 | %    |  |      | 1,609 |          |   | 2,118 |  | -24 | %



The gross profit margin percentages
for 2004 and 2003 were as follows:



|              |  |               |   |  |                |   |  |      |   |  |      |  
|------------- |  | ------------- | - |  | -------------- | - |  | ---- | - |  | ---- | -
|              |  | Third Quarter |   |  | Three Quarters |  
|              |  | 2004          |   |  | 2003           |   |  | 2004 |   |  | 2003 |  
|Total company |  | 17            | % |  | 29             | % |  | 24   | % |  | 29   | %
|Product       |  | 15            | % |  | 28             | % |  | 21   | % |  | 24   | %
|Service       |  | 30            | % |  | 32             | % |  | 37   | % |  | 36   | %



Gross profit margin percentages on
product sales in the third quarter of 2004 were lower than those in the third quarter of 2003 as higher-volume, lower value-added and lower margin products dominated the product mix of the 2004 quarter. The volume that shipped in the first half of
2004 helped the overall product profit margin percentage for the first three quarters of 2004 to be higher than in the same period in 2003.



The decline in the service sales gross profit margin for the third quarter of 2004 is due to the lower sales volume. We expect service profit margins to improve as the
repair volumes of the two large service customers return to more normal levels and new large service customers program volume ramps up in the fourth quarter.



OPERATING EXPENSES AND INTEREST EXPENSES



Operating expenses, including selling, general and administrative (SG&A), research and development (R&D), and interest expenses for
the third quarter and the first three quarters of 2004 and 2003 were as follows:



|                   |  |               |       |      |                |          |  |    |      |  |      |       |          |   |       |  |    |  
|------------------ |  | ------------- | ----- | ---- | -------------- | -------- |  | -- | ---- |  | ---- | ----- | -------- | - | ----- |  | -- | -
|                   |  | Third Quarter |       |      | Three Quarters |         
|($ thousands)      |  | 2004          |       | 2003 |                | % Change |  |    | 2004 |  | 2003 |       | % Change |  
|Operating expenses |  | $             | 1,500 |      | $              | 1,285    |  | 17 | %    |  | $    | 4,940 |          | $ | 3,668 |  | 35 | %
|Interest expense   |  |               | 24    |      |                | 22       |  | 9  | %    |  |      | 79    |          |   | 67    |  | 18 | %
|                   |  |               |       |      |                |          |  |    |      |  |      |       |          |   |       |  |    |  
|Total expense      |  |               | 1,524 |      |                | 1,307    |  | 17 | %    |  |      | 5,019 |          |   | 3,735 |  | 34 | %
|                   |  |               |       |      |                |          |  |    |      |  |      |       |          |   |       |  |    |  



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For the third quarter and first three quarters of 2004, operating expenses, including selling, general and administrative
(SG&A) expenses, increased due to costs directly tied to our increasing sales and profitability and our investment in the companys growth. For the first three quarters of 2004, operating expenses were 18% of sales generated compared to 24%
in the first three quarters of 2003. We expect to continue increasing our marketing and selling expenses in order to increase market share and achieve our long-term growth goals



INCOME TAXES AND NET INCOME



Income taxes for the interim periods were computed using the effective tax rate estimated to be applicable for the full fiscal year, which
is subject to ongoing review and evaluation by management. The effective tax rate for the third quarter and first three quarters of 2004 was 41%, compared to 39% in the comparable periods of 2003.



Income before taxes, income taxes and net income for the third quarter and the first three
quarters of 2004 and 2003 were as follows:



|                    |  |               |   |      |                |          |  |      |      |  |      |       |          |   |     |  |     |  
|------------------- |  | ------------- | - | ---- | -------------- | -------- |  | ---- | ---- |  | ---- | ----- | -------- | - | --- |  | --- | -
|                    |  | Third Quarter |   |      | Three Quarters |         
|($ thousands)       |  | 2004          |   | 2003 |                | % Change |  |      | 2004 |  | 2003 |       | % Change |  
|Income before taxes |  | $             | 1 |      | $              | 212      |  | -100 | %    |  | $    | 1,458 |          | $ | 629 |  | 132 | %
|Income taxes        |  |               |  |      |                | 90       |  | -100 | %    |  |      | 598   |          |   | 253 |  | 136 | %
|                    |  |               |   |      |                |          |  |      |      |  |      |       |          |   |     |  |     |  
|Net income          |  |               | 1 |      |                | 122      |  | -99  | %    |  |      | 860   |          |   | 376 |  | 129 | %
|                    |  |               |   |      |                |          |  |      |      |  |      |       |          |   |     |  |     |  



Earnings per share for the third
quarter and the first three quarters of 2004 and 2003 were as follows:



|                                               |  |               |           |                |   |           |  |      |           |  |   |          
|---------------------------------------------- |  | ------------- | --------- | -------------- | - | --------- |  | ---- | --------- |  | - | ---------
|                                               |  | Third Quarter |           | Three Quarters
|                                               |  | 2004          |           | 2003           |   | 2004      |  | 2003
|Basic EPS                                      |  | $             | 0.00      |                | $ | 0.02      |  | $    | 0.15      |  | $ | 0.07     
|Fully diluted EPS                              |  | $             | 0.00      |                | $ | 0.02      |  | $    | 0.14      |  | $ | 0.07     
|                                               |  |               |           |               
|Weighted average number of shares outstanding: |  |               |           |                |   |           |  |      |           |  |   |          
|Basic                                          |  |               | 5,587,377 |                |   | 5,530,030 |  |      | 5,560,779 |  |   | 5,522,631
|Fully diluted                                  |  |               | 6,079,761 |                |   | 5,857,748 |  |      | 6,116,538 |  |   | 5,765,321



The decline in net income in the third
quarter resulted from the decline in service revenue and the reinvestment of profits into our growth programs.



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##### Table of Contents

The improvement to date to net income in 2004 resulted directly from increases in product sales and greater leverage on
operating expenses. We expect to be profitable in the fourth quarter of 2004. Quarterly sales and earnings could vary either up or down from comparable prior year quarterly results.



LIQUIDITY AND CAPITAL RESOURCES



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



|                     |  |         |        |          |   |          |  |     |  
|-------------------- |  | ------- | ------ | -------- | - | -------- |  | --- | -
|($ thousands)        |  | 9/25/04 |        | 12/31/03 |   | % Change | 
|Accounts receivable  |  | $       | 5,841  |          | $ | 5,127    |  | 14  | %
|Inventory            |  |         | 4,440  |          |   | 2,024    |  | 119 | %
|Other current assets |  |         | 858    |          |   | 673      |  | 27  | %
|                     |  |         |        |          |   |          |  |     |  
|Total                |  | $       | 11,139 |          | $ | 7,824    |  | 42  | %
|                     |  |         |        |          |   |          |  |     |  



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



|                          |  |         |       |          |   |          |  |     |  
|------------------------- |  | ------- | ----- | -------- | - | -------- |  | --- | -
|($ thousands)             |  | 9/25/04 |       | 12/31/03 |   | % Change | 
|Line of credit            |  | $       | 2,652 |          | $ | 2,487    |  | 7   | %
|Accounts payable          |  |         | 3,901 |          |   | 1,902    |  | 105 | %
|Other current liabilities |  |         | 549   |          |   | 460      |  | 19  | %
|                          |  |         |       |          |   |          |  |     |  
|Total                     |  | $       | 7,102 |          | $ | 4,849    |  | 46  | %
|                          |  |         |       |          |   |          |  |     |  



During the first three quarters of
2004, $243,000 of cash was generated by operating activities. Net income before depreciation and inventory reserve increases was $1,463,000. Cash was used by an increase in accounts receivable of $714,000 and an increase in inventory of $2.7
million. Additional cash was generated by a decrease in prepaid expenses and other current assets of $66,000, increases in accounts payable of $2 million and in other current liabilities of $89,000. The increase in accounts receivable reflects the
higher revenue level of the third quarter of 2004 compared to the fourth quarter of 2003, particularly the last month of each quarter. The increased inventory total reflects the higher number of ongoing customer programs at September 25, 2004
compared to December 31, 2003. In contrast to the two large orders shipped in the first half of 2004, the new product and service programs require relatively more inventory to support those programs on an ongoing basis.



For the first three quarters of 2004, we used $222,000 of cash generated by operating
activities to purchase equipment, including computers and software. We also transferred $65,000 of equipment to fixed assets from inventory. Much of the investment in new equipment was made to support the new OEM service program.



We drew a net additional $166,000 on our line of credit to provide the cash used by
operations and fixed asset purchases.



The line of credit, which is our primary
source of operational and non-operational funding, is maintained with KeyBank National Association (KeyBank) and is payable on demand and collateralized by substantially all of our assets. The amount available under the line of credit is subject to
borrowing base restrictions and other financial covenants as outlined in the agreement. In addition, the agreement restricts the payment of cash dividends.



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The aforementioned borrowing base on the line of credit is calculated as 85% of eligible accounts receivable and 50% of
inventory value, net of reserves. The line has an overall limit of $5,000,000 as well as a sub-limit of $2,500,000 that can be collateralized by inventory. That calculation represents the maximum amount that can be drawn on the line of credit.



In order to fund working capital to fulfill the second quarter customer
product orders referenced above, in May 2004, we entered into an additional 120-day $2,000,000 term loan agreement with the bank. The term loan was paid off in September 2004 as scheduled. The intent and effect of the loan was to temporarily
increase the limit of the line of credit from $5,000,000 to $7,000,000. The $2,000,000 of proceeds from the term loan was applied to the outstanding line of credit balance, reducing its balance by $2,000,000. The incremental $2,000,000 loan had the
same interest rate as the line of credit. For the duration of the term loan, the collateralization and covenants of the two loans were combined as if they are one loan facility. The $2,500,000 inventory collateral sub-limit of the line of credit was
increased to $3,500,000 for the duration of the term loan. The resulting balance on the original line of credit at September 25, 2004 was $2,652,000. The borrowing base on that date was the maximum $5,000,000, resulting in an unused capacity (the
excess of the borrowing base calculation over the amount drawn) of $2,348,000. We were in compliance with all covenants of the line for the quarter ended September 25, 2004.



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



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



OFF-BALANCE SHEET ARRANGEMENTS



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



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



CRITICAL ACCOUNTING POLICIES



The preparation of financial statements and related disclosures in conformity with accounting principles generally accepted in the United States requires management to
make judgments, assumptions and estimates that affect the amounts reported in the Financial Statements and accompanying notes. Note 1 to the Financial Statements in the Annual Report on our Form 10-KSB for the year ended December 31, 2003 describes
the significant accounting policies and methods used in the preparation of the Financial Statements. Estimates are used for, but not limited to, the accounting for allowance for doubtful accounts and inventory reserves. Actual results could differ
from these estimates. The following critical accounting policies are impacted significantly by judgments, assumptions and estimates used in the preparation of the Financial Statements.



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



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



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



RISK FACTORS



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



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



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



We expect our quarterly revenues, cash flows and operating results
to fluctuate due to the large size and timing of some orders that can materially affect our financial statements from quarter to quarter, either obscuring or presenting trends that do or do not exist. In addition, our quarterly sales have
historically reflected a pattern in which a disproportionate percentage of such quarters total sales occur in the last month and weeks and days of the quarter. This pattern also makes prediction of revenues, earnings and working capital for
each financial period especially difficult and uncertain and increases the risk of unanticipated variations in quarterly results and financial condition.



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



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



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Item 3. Controls and Procedures.



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



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



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PART II  OTHER INFORMATION



Item 6. Exhibits.



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



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



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|            |  |                                                                                                                                                                                     |  |                                                                                            
|----------- |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- |  | -------------------------------------------------------------------------------------------
|Exhibit No. |  | Description of Exhibit                                                                                                                                                              |  | If Incorporated by Reference, Document with which Exhibit was Previously
Filed with the SEC
|10(ag)      |  | Repair Service Agreement between Pinnacle Data Systems, Inc. and Silicon Graphics, Inc., dated August 4, 2004.                                                                      |  | Contained herein.                                                                          
|            |  |                                                                                                                                                                                    
|31(a)       |  | Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Quarterly Report on Form 10-QSB of Pinnacle Data Systems, Inc. for the quarter ended September 25, 2004. |  | Contained herein.                                                                          
|            |  |                                                                                                                                                                                    
|31(b)       |  | Certification pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Quarterly Report on Form 10-QSB of Pinnacle Data Systems, Inc. for the quarter ended September 25, 2004. |  | Contained herein.                                                                          
|            |  |                                                                                                                                                                                    
|32(a)       |  | Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 of Quarterly Report on Form 10-QSB of Pinnacle Data Systems, Inc. for the quarter ended September 25, 2004. |  | Contained herein.                                                                          
|            |  |                                                                                                                                                                                    
|32(b)       |  | Certification pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 of Quarterly Report on Form 10-QSB of Pinnacle Data Systems, Inc. for the quarter ended September 25, 2004. |  | Contained herein.                                                                          



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SIGNATURES



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



|                        |  |                                        
|----------------------- |  | ---------------------------------------
|                        |  | PINNACLE DATA SYSTEMS, INC.            
|                        | 
|Date: November 12, 2004 |  | /s/ Michael R. Sayre                   
|                        |  | Michael Sayre, Executive Vice President
|                        |  | and Chief Financial Officer            
|                        | 
|Date: November 12, 2004 |  | /s/ Thomas J. Carr                     
|                        |  | Thomas J. Carr, Controller             



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