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UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549





FORM 10-Q







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

For the quarterly period ended June 30, 2010

or



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

For the transition period from
 to

Commission file number 1-16103





LOGO

PINNACLE DATA SYSTEMS, INC.

(Exact name of registrant as specified in its charter)







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

Registrants telephone number: (614) 748-1150





No change

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





Indicate by check mark whether the registrant (1) has filed all reports required to be filed by Section 13 or 15(d) of the
Securities Exchange Act of 1934 during the preceding 12 months (or for such shorter period that the registrant was required to file such reports), and (2) has been subject to such filing requirements for the past 90
days.    Yes  x    No   ̈

Indicate by check mark whether the registrant has submitted electronically and posted on its corporate Web site, if any, every
Interactive Data File required to be submitted and posted pursuant to Rule 405 of Regulation S-T (§232.405 of this chapter) during the preceding 12 months (or for such shorter period that the registrant was required to submit and post such
files).    Yes   ̈    No   ̈

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

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

Indicate by check mark whether the registrant is a shell company (as defined in Rule 12b-2 of the Exchange
Act).    Yes   ̈    No  x

On July 28, 2010, the registrant had outstanding 7,839,349 common shares without par value, which is the registrants only
class of common equity.









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PINNACLE DATA SYSTEMS, INC.

FORM 10-Q FOR THE QUARTERLY PERIOD ENDED JUNE 30, 2010

TABLE OF CONTENTS



|                                                                                                 |  |   
|------------------------------------------------------------------------------------------------ |  | --
|PART I  FINANCIAL INFORMATION                                                                   |  | 1 
|                                                                                                 | 
|ITEM 1    
CONDENSED CONSOLIDATED FINANCIAL STATEMENTS                                           |  | 1 
|                                                                                                 | 
|ITEM 2    
MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS |  | 9 
|                                                                                                 | 
|ITEM 4    CONTROLS AND
PROCEDURES                                                                |  | 15
|                                                                                                 | 
|PART II  OTHER INFORMATION                                                                      |  | 16
|                                                                                                 | 
|ITEM 6    EXHIBITS                                                                               |  | 16
|                                                                                                 | 
|SIGNATURES                                                                                       |  | 17
|                                                                                                 | 
|CERTIFICATIONS                                                                                   |  | 18



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PART I  FINANCIAL INFORMATION



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

PINNACLE DATA SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)



|                                                                                                                  |  |              |        |   |                  |   |        |  
|----------------------------------------------------------------------------------------------------------------- |  | ------------ | ------ | - | ---------------- | - | ------ | -
|                                                                                                                  |  | June 30,2010 |        |   | December 31,2009 |  
|ASSETS                                                                                                            |  | (Unaudited)  |        |   |                  |  
|                                                                                                                  |  |              |        |   |                  |   |        |  
|                                                                                                                  |  |             
|CURRENT ASSETS                                                                                                    |  |              |        |   |                  |   |        |  
|Cash                                                                                                              |  | $            | 135    |   |                  | $ | 323    |  
|Accounts receivable, net of allowance for doubtful accounts of $129 and $232, respectively                        |  |              | 4,938  |   |                  |   | 5,932  |  
|Inventory, net                                                                                                    |  |              | 3,042  |   |                  |   | 3,754  |  
|Prepaid expenses and other current assets                                                                         |  |              | 300    |   |                  |   | 525    |  
|                                                                                                                  |  |              |        |   |                  |   |        |  
|Total current assets                                                                                              |  |              | 8,415  |   |                  |   | 10,534 |  
|                                                                                                                  |  |              |        |   |                  |   |        |  
|                                                                                                                  |  |             
|PROPERTY AND EQUIPMENT                                                                                            |  |              |        |   |                  |   |        |  
|Property and equipment, cost                                                                                      |  |              | 5,888  |   |                  |   | 5,899  |  
|Less accumulated depreciation and amortization                                                                    |  |              | (5,196 | ) |                  |   | (5,038 | )
|                                                                                                                  |  |              |        |   |                  |   |        |  
|Total property and equipment, net                                                                                 |  |              | 692    |   |                  |   | 861    |  
|                                                                                                                  |  |              |        |   |                  |   |        |  
|                                                                                                                  |  |             
|OTHER ASSETS                                                                                                      |  |              |        |   |                  |   |        |  
|Goodwill                                                                                                          |  |              | 700    |   |                  |   | 821    |  
|Other assets                                                                                                      |  |              | 343    |   |                  |   | 359    |  
|                                                                                                                  |  |              |        |   |                  |   |        |  
|Total other assets                                                                                                |  |              | 1,043  |   |                  |   | 1,180  |  
|                                                                                                                  |  |              |        |   |                  |   |        |  
|TOTAL ASSETS                                                                                                      |  | $            | 10,150 |   |                  | $ | 12,575 |  
|                                                                                                                  |  |              |        |   |                  |   |        |  
|                                                                                                                  |  |             
|LIABILITIES AND STOCKHOLDERS EQUITY                                                                              |  |              |        |   |                  |   |        |  
|                                                                                                                  |  |             
|CURRENT LIABILITIES                                                                                               |  |              |        |   |                  |   |        |  
|Line of credit                                                                                                    |  | $            | 229    |   |                  | $ | 2,413  |  
|Accounts payable                                                                                                  |  |              | 2,029  |   |                  |   | 2,694  |  
|Accrued wages, payroll taxes and employee benefits                                                                |  |              | 685    |   |                  |   | 1,014  |  
|Unearned revenue                                                                                                  |  |              | 280    |   |                  |   | 85     |  
|Other current liabilities                                                                                         |  |              | 653    |   |                  |   | 555    |  
|                                                                                                                  |  |              |        |   |                  |   |        |  
|Total current liabilities                                                                                         |  |              | 3,876  |   |                  |   | 6,761  |  
|                                                                                                                  |  |             
|LONG-TERM LIABILITIES                                                                                             |  |              |        |   |                  |   |        |  
|Accrued other                                                                                                     |  |              | 185    |   |                  |   | 226    |  
|                                                                                                                  |  |              |        |   |                  |   |        |  
|                                                                                                                  |  |             
|TOTAL LIABILITIES                                                                                                 |  |              | 4,061  |   |                  |   | 6,987  |  
|                                                                                                                  |  |              |        |   |                  |   |        |  
|                                                                                                                  |  |             
|STOCKHOLDERS EQUITY                                                                                              |  |              |        |   |                  |   |        |  
|Preferred stock; no par value; 4,000 shares authorized; no shares issued or outstanding                           |  |              |       |   |                  |   |       |  
|Common stock; no par value; 25,000 shares authorized; 7,839 and 7,825 shares issued and outstanding, respectively |  |              | 5,777  |   |                  |   | 5,769  |  
|Additional paid-in capital                                                                                        |  |              | 1,936  |   |                  |   | 1,912  |  
|Accumulated other comprehensive income (loss)                                                                     |  |              | (169   | ) |                  |   | (29    | )
|Retained earnings (deficit)                                                                                       |  |              | (1,455 | ) |                  |   | (2,064 | )
|                                                                                                                  |  |              |        |   |                  |   |        |  
|Total stockholders equity                                                                                        |  |              | 6,089  |   |                  |   | 5,588  |  
|                                                                                                                  |  |              |        |   |                  |   |        |  
|                                                                                                                  |  |             
|TOTAL LIABILITIES AND STOCKHOLDERS EQUITY                                                                        |  | $            | 10,150 |   |                  | $ | 12,575 |  
|                                                                                                                  |  |              |        |   |                  |   |        |  

See accompanying notes to condensed consolidated financial statements.



1



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PINNACLE DATA SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(in thousands, except per share)



|                                            |  |                                    |       |      |                                  |       |      |  |      |        |  |   |        |  
|------------------------------------------- |  | ---------------------------------- | ----- | ---- | -------------------------------- | ----- | ---- |  | ---- | ------ |  | - | ------ | -
|                                            |  | For the Three Months EndedJune 30, |       |      | For the Six Months EndedJune 30, |      
|                                            |  | 2010                               |       | 2009 |                                  |       | 2010 |  | 2009 |       
|Sales                                       |  | $                                  | 7,968 |      | $                                | 9,038 |      |  | $    | 16,780 |  | $ | 19,925 |  
|Cost of sales                               |  |                                    | 5,733 |      |                                  | 7,054 |      |  |      | 12,396 |  |   | 15,907 |  
|                                            |  |                                    |       |      |                                  |       |      |  |      |        |  |   |        |  
|Gross profit                                |  |                                    | 2,235 |      |                                  | 1,984 |      |  |      | 4,384  |  |   | 4,018  |  
|Operating expenses                          |  |                                    | 1,835 |      |                                  | 2,272 |      |  |      | 3,563  |  |   | 5,250  |  
|                                            |  |                                    |       |      |                                  |       |      |  |      |        |  |   |        |  
|Income (loss) from operations               |  |                                    | 400   |      |                                  | (288  | )    |  |      | 821    |  |   | (1,232 | )
|Other expense                               |  |                                    |       |      |                                  |       |      |  |      |        |  |   |        |  
|Interest expense                            |  |                                    | 18    |      |                                  | 49    |      |  |      | 41     |  |   | 102    |  
|                                            |  |                                    |       |      |                                  |       |      |  |      |        |  |   |        |  
|Income (loss) before income taxes           |  |                                    | 382   |      |                                  | (337  | )    |  |      | 780    |  |   | (1,334 | )
|Income tax expense (benefit)                |  |                                    | 82    |      |                                  | (67   | )    |  |      | 171    |  |   | (363   | )
|                                            |  |                                    |       |      |                                  |       |      |  |      |        |  |   |        |  
|Net income (loss)                           |  | $                                  | 300   |      | $                                | (270  | )    |  | $    | 609    |  | $ | (971   | )
|                                            |  |                                    |       |      |                                  |       |      |  |      |        |  |   |        |  
|                                            |  |                                    |       |     
|Weighted average common shares outstanding: |  |                                    |       |      |                                  |       |      |  |      |        |  |   |        |  
|Basic                                       |  |                                    | 7,826 |      |                                  | 7,825 |      |  |      | 7,825  |  |   | 7,825  |  
|Diluted                                     |  |                                    | 7,966 |      |                                  | 7,825 |      |  |      | 7,891  |  |   | 7,825  |  
|                                            |  |                                    |       |     
|Earnings (loss) per common share:           |  |                                    |       |      |                                  |       |      |  |      |        |  |   |        |  
|Basic                                       |  | $                                  | 0.04  |      | $                                | (0.03 | )    |  | $    | 0.08   |  | $ | (0.12  | )
|Diluted                                     |  |                                    | 0.04  |      |                                  | (0.03 | )    |  |      | 0.08   |  |   | (0.12  | )

See accompanying notes to
condensed consolidated financial statements.



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PINNACLE DATA SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS EQUITY

(Unaudited)

(in thousands)



|                                    |  |                   |  |                          |       |                                            |   |       |                           |   |      |                          |  |   |        |   |  |   |       |  
|----------------------------------- |  | ----------------- |  | ------------------------ | ----- | ------------------------------------------ | - | ----- | ------------------------- | - | ---- | ------------------------ |  | - | ------ | - |  | - | ----- | -
|                                    |  | Common Stock      |  | AdditionalPaid-InCapital |       | AccumulatedOtherComprehensiveIncome (Loss) |   |       | RetainedEarnings(Deficit) |   |      | TotalStockholdersEquity | 
|                                    |  | OutstandingShares |  | Amount                   |       |                                            |   |      
|Balance  December 31, 2008         |  | 7,825             |  | $                        | 5,769 |                                            | $ | 1,797 |                           | $ | (57  | )                        |  | $ | 1,386  |   |  | $ | 8,895 |  
|Share-based payment expense         |  |                  |  |                          |      |                                            |   | 83    |                           |   |     |                          |  |   |       |   |  |   | 83    |  
|Comprehensive loss, net of taxes:   |  |                   |  |                          |       |                                            |   |       |                           |   |      |                          |  |   |        |   |  |   |       |  
|Net loss                            |  |                  |  |                          |      |                                            |   |      |                           |   |     |                          |  |   | (971   | ) |  |   | (971  | )
|Foreign currency translation        |  |                  |  |                          |      |                                            |   |      |                           |   | 11   |                          |  |   |       |   |  |   | 11    |  
|                                    |  |                   |  |                          |       |                                            |   |       |                           |   |      |                          |  |   |        |   |  |   |       |  
|Total comprehensive loss            |  |                   |  |                          |       |                                            |   |       |                           |   |      |                          |  |   |        |   |  |   | (960  | )
|                                    |  |                   |  |                          |       |                                            |   |       |                           |   |      |                          |  |   |        |   |  |   |       |  
|Balance  June 30, 2009             |  | 7,825             |  | $                        | 5,769 |                                            | $ | 1,880 |                           | $ | (46  | )                        |  | $ | 415    |   |  | $ | 8,018 |  
|                                    |  |                   |  |                          |       |                                            |   |       |                           |   |      |                          |  |   |        |   |  |   |       |  
|Balance  December 31, 2009         |  | 7,825             |  | $                        | 5,769 |                                            | $ | 1,912 |                           | $ | (29  | )                        |  | $ | (2,064 | ) |  | $ | 5,588 |  
|Stock issued                        |  | 14                |  |                          | 8     |                                            |   |      |                           |   |     |                          |  |   |       |   |  |   | 8     |  
|Share-based payment expense         |  |                  |  |                          |      |                                            |   | 24    |                           |   |     |                          |  |   |       |   |  |   | 24    |  
|Comprehensive income, net of taxes: |  |                   |  |                          |       |                                            |   |       |                           |   |      |                          |  |   |        |   |  |   |       |  
|Net income                          |  |                  |  |                          |      |                                            |   |      |                           |   |     |                          |  |   | 609    |   |  |   | 609   |  
|Foreign currency translation        |  |                  |  |                          |      |                                            |   |      |                           |   | (140 | )                        |  |   |       |   |  |   | (140  | )
|                                    |  |                   |  |                          |       |                                            |   |       |                           |   |      |                          |  |   |        |   |  |   |       |  
|Total comprehensive income          |  |                   |  |                          |       |                                            |   |       |                           |   |      |                          |  |   |        |   |  |   | 469   |  
|                                    |  |                   |  |                          |       |                                            |   |       |                           |   |      |                          |  |   |        |   |  |   |       |  
|Balance  June 30, 2010             |  | 7,839             |  | $                        | 5,777 |                                            | $ | 1,936 |                           | $ | (169 | )                        |  | $ | (1,455 | ) |  | $ | 6,089 |  
|                                    |  |                   |  |                          |       |                                            |   |       |                           |   |      |                          |  |   |        |   |  |   |       |  

See accompanying notes to condensed consolidated financial statements.



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PINNACLE DATA SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)



|                                                                                         |  |                                  |        |   |      |   |        |  
|---------------------------------------------------------------------------------------- |  | -------------------------------- | ------ | - | ---- | - | ------ | -
|                                                                                         |  | For the Six Months EndedJune 30, |       
|                                                                                         |  | 2010                             |        |   | 2009 |  
|CASH FLOWS FROM OPERATING ACTIVITIES                                                     |  |                                  |        |   |      |   |        |  
|Net income (loss)                                                                        |  | $                                | 609    |   |      | $ | (971   | )
|                                                                                         |  |                                  |        |   |      |   |        |  
|Adjustments to reconcile net income (loss) to net cash provided by operating activities: |  |                                  |        |   |      |   |        |  
|Bad debt expense                                                                         |  |                                  | (32    | ) |      |   | 109    |  
|Inventory reserves                                                                       |  |                                  | 135    |   |      |   | 404    |  
|Depreciation and amortization                                                            |  |                                  | 201    |   |      |   | 291    |  
|Share-based payment expense                                                              |  |                                  | 24     |   |      |   | 83     |  
|(Increase) decrease in assets:                                                           |  |                                  |        |   |      |   |        |  
|Accounts receivable                                                                      |  |                                  | 953    |   |      |   | 3,918  |  
|Inventory                                                                                |  |                                  | 550    |   |      |   | 94     |  
|Prepaid expenses and other assets                                                        |  |                                  | 202    |   |      |   | 31     |  
|Increase (decrease) in liabilities:                                                      |  |                                  |        |   |      |   |        |  
|Accounts payable                                                                         |  |                                  | (907   | ) |      |   | (1,082 | )
|Unearned revenue                                                                         |  |                                  | 195    |   |      |   | 496    |  
|Other current liabilities                                                                |  |                                  | (197   | ) |      |   | (533   | )
|                                                                                         |  |                                  |        |   |      |   |        |  
|Total adjustments                                                                        |  |                                  | 1,124  |   |      |   | 3,811  |  
|                                                                                         |  |                                  |        |   |      |   |        |  
|Net cash provided by operating activities                                                |  |                                  | 1,733  |   |      |   | 2,840  |  
|                                                                                         |  |                                  |        |   |      |   |        |  
|CASH FLOWS FROM INVESTING ACTIVITIES                                                     |  |                                  |        |   |      |   |        |  
|Purchases of property and equipment                                                      |  |                                  | (62    | ) |      |   | (155   | )
|                                                                                         |  |                                  |        |   |      |   |        |  
|Net cash provided by investing activities                                                |  |                                  | (62    | ) |      |   | (155   | )
|                                                                                         |  |                                  |        |   |      |   |        |  
|CASH FLOWS FROM FINANCING ACTIVITIES                                                     |  |                                  |        |   |      |   |        |  
|Net change in line of credit                                                             |  |                                  | (2,184 | ) |      |   | (2,431 | )
|Net change in outstanding checks                                                         |  |                                  | 303    |   |      |   | (264   | )
|Other                                                                                    |  |                                  | 40     |   |      |   | (181   | )
|                                                                                         |  |                                  |        |   |      |   |        |  
|Net cash used in financing activities                                                    |  |                                  | (1,841 | ) |      |   | (2,876 | )
|                                                                                         |  |                                  |        |   |      |   |        |  
|EFFECT OF EXCHANGE RATE ON CASH                                                          |  |                                  | (18    | ) |      |   | 3      |  
|                                                                                         |  |                                  |        |   |      |   |        |  
|INCREASE (DECREASE) IN CASH                                                              |  |                                  | (188   | ) |      |   | (188   | )
|Cash at beginning of period                                                              |  |                                  | 323    |   |      |   | 282    |  
|                                                                                         |  |                                  |        |   |      |   |        |  
|Cash at end of period                                                                    |  | $                                | 135    |   |      | $ | 94     |  
|                                                                                         |  |                                  |        |   |      |   |        |  

See accompanying notes to condensed consolidated financial statements.



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PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited)

June 30, 2010 and 2009

1. Basis of Presentation

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

The Companys condensed consolidated financial statements include the accounts of PDSi and PDSi B.V., a private limited liability
company located in Tiel, the Netherlands (PDSi Tiel). All significant intercompany balances and transactions have been eliminated.

The preparation of financial statements and related disclosures in conformity with GAAP requires management to make judgments,
assumptions and estimates that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Actual results could differ significantly from those estimates. Certain prior year amounts have been reclassified
to conform to the current presentation. The accompanying condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and accompanying notes for the year ended December 31, 2009
included in the Companys 2009 Annual Report on Form 10-K.

2. Summary of Significant Accounting Policies

A complete summary of the Companys significant accounting policies is included in Note 2 to the audited consolidated financial
statements included in the Companys 2009 Annual Report on Form 10-K. There have been no material changes to these policies since December 31, 2009.

Inventory

The
following table summarizes the Companys inventory as of the dates indicated (net of reserves of $2,213,000 and $2,404,000, respectively, as of June 30, 2010 and December 31, 2009):



|                                |  |              |       |                  |   |      
|------------------------------- |  | ------------ | ----- | ---------------- | - | -----
|(in thousands)                  |  | June 30,2010 |       | December 31,2009
|Component parts (raw materials) |  | $            | 2,877 |                  | $ | 3,289
|Work-in-process                 |  |              | 5     |                  |   | 19   
|Finished goods                  |  |              | 160   |                  |   | 446  
|                                |  |              |       |                  |   |      
|Total inventory                 |  | $            | 3,042 |                  | $ | 3,754
|                                |  |              |       |                  |   |      

3. Recently Issued Accounting Standards

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



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PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

June 30, 2010 and 2009



4. Line of Credit

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

The Line is evidenced by a Revolving Note made by the Company in favor of Wells Fargo
and is secured by substantially all of the assets of the Company, as provided for in the Credit Agreement. The Line is subject to customary affirmative and negative covenants for credit facilities of this type, including limitations on the Company
with respect to liens, indebtedness, guaranties, investments, distributions, mergers and acquisitions, and dispositions of assets.

The Credit Agreement also contains certain financial covenants, including a minimum book net worth, minimum net income and maximum
capital expenditures. The Company obtained a waiver from Wells Fargo for violation of the minimum book net worth financial covenant as of June 30 and September 30, 2009, and for violation of the minimum net income financial covenant for
the three months ended June 30 and September 30, 2009. During the fourth quarter of 2009, the Credit Agreement was revised to adjust the financial covenants based on the Companys current financial projections and to include a
reduction and block of availability under the borrowing base of $250,000 until such time as the Company complies with each of the financial covenants described above for both of the fiscal quarters ending December 31, 2009 and March 31,
2010. Based on the Companys results of operations for the quarters ending December 31, 2009 and March 31, 2010, the $250,000 reduction and block of availability under the borrowing base was removed during the second quarter of 2010.

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

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

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

5. Income Taxes

The
Company reviewed its net deferred tax assets as of September 30, 2009 to assess the need to establish a valuation allowance due to the continuing uncertain economic environment and the Companys pre-tax loss for the nine months ended
September 30, 2009. The Companys net deferred tax assets primarily consist of temporary differences related to inventory reserves and federal net operating loss carryforwards. Based on the Companys analysis and application of the
required GAAP framework, management established a valuation allowance of $1,611,000 against its net deferred tax asset balance as of September 30, 2009. The valuation allowance was $1,510,000 as of June 30, 2010.

The Company can provide no assurance that a change in the deferred tax asset valuation allowance will not be required in the future. The
Company will continue to monitor events and circumstances to determine whether a change in the valuation allowance is warranted, or if the valuation allowance should be released based on sustained profitability. It is at least reasonably possible
that a material adjustment to the valuation allowance could occur within a year.

6. Earnings (Loss) Per Share

Basic earnings (loss) per share (EPS) represents the amount of earnings (loss) available to each share of common stock outstanding during
the reporting period. Diluted EPS represents the amount of earnings (loss) available to each share of common stock outstanding during the reporting period adjusted for the potential issuance of common shares for stock options, if dilutive.



6



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##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

June 30, 2010 and 2009



The following table presents the Companys calculation of basic and diluted
weighted average common shares outstanding for the periods indicated:



|                                                     |  |                            |  |                          |  |       |  |      
|---------------------------------------------------- |  | -------------------------- |  | ------------------------ |  | ----- |  | -----
|                                                     |  | Three Months EndedJune 30, |  | Six Months EndedJune 30,
|(in thousands)                                       |  | 2010                       |  | 2009                     |  | 2010  |  | 2009 
|Weighted average common shares outstanding  basic   |  | 7,826                      |  | 7,825                    |  | 7,825 |  | 7,825
|Dilutive effect of stock options                     |  | 140                        |  |                         |  | 66    |  |     
|                                                     |  |                            |  |                          |  |       |  |      
|Weighted average common shares outstanding  diluted |  | 7,966                      |  | 7,825                    |  | 7,891 |  | 7,825
|                                                     |  |                            |  |                          |  |       |  |      

For the three and six months ended June 30, 2009,
the effect of potential common shares arising from stock options would have been anti-dilutive. As a result, the number of weighted average outstanding common shares outstanding was the same for the basic and diluted EPS calculations for those
periods.

7. Segment Information

The Companys reportable segments are Product and Service. The Companys Product segment offers a wide range of technology
platforms, including standard and custom-designed products for the telecommunications, imaging, defense/aerospace, medical, industrial automation and information technology markets. The Companys product capabilities range from board-level
designs to globally certified, fully integrated systems. PDSis specialties include long-life, embedded products and unique, customer-centric solutions. The Companys Service segment provides a variety of engineering and manufacturing
services for global OEMs requiring custom product design, system integration, repair programs, warranty management, and/or specialized production capabilities. With service centers in the United States, Europe and Asia, PDSi ensures seamless support
for solutions all around the world. PDSi also provides depot repair and reverse logistics programs for OEMs with other types of computer equipment.

The Other line item in the following tables reflects the costs and assets of the functional and administrative groups of the
Company that are not allocated to the reportable segments, including finance, information technology, human resources, engineering and executive management. The Company evaluates performance based on the operating results of the Product and Service
segments and based on their effectiveness in covering the other administrative expenses of the Company. The Company sells its products and services in the United States and internationally and attributes sales based on shipping point.

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



|                              |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|----------------------------- |  | -------------------------- | ------ | - | ------------------------ | - | ------ | ---- |  | - | ------ | - |  | - | ------ | -
|                              |  | Three Months EndedJune 30, |        |   | Six Months EndedJune 30, |  
|(in thousands)                |  | 2010                       |        |   | 2009                     |   |        | 2010 |  |   | 2009   |  
|Sales                         |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|Product                       |  | $                          | 4,842  |   |                          | $ | 6,599  |      |  | $ | 10,769 |   |  | $ | 15,085 |  
|Service                       |  |                            | 3,126  |   |                          |   | 2,439  |      |  |   | 6,011  |   |  |   | 4,840  |  
|                              |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|Total                         |  | $                          | 7,968  |   |                          | $ | 9,038  |      |  | $ | 16,780 |   |  | $ | 19,925 |  
|                              |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|Gross profit                  |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|Product                       |  | $                          | 986    |   |                          | $ | 1,211  |      |  | $ | 2,055  |   |  | $ | 2,433  |  
|Service                       |  |                            | 1,249  |   |                          |   | 773    |      |  |   | 2,329  |   |  |   | 1,585  |  
|                              |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|Total                         |  | $                          | 2,235  |   |                          | $ | 1,984  |      |  | $ | 4,384  |   |  | $ | 4,018  |  
|                              |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|Income (loss) from operations |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|Product                       |  | $                          | 660    |   |                          | $ | 660    |      |  | $ | 1,364  |   |  | $ | 950    |  
|Service                       |  |                            | 862    |   |                          |   | 278    |      |  |   | 1,514  |   |  |   | 510    |  
|Other                         |  |                            | (1,122 | ) |                          |   | (1,226 | )    |  |   | (2,057 | ) |  |   | (2,692 | )
|                              |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  
|Total                         |  | $                          | 400    |   |                          | $ | (288   | )    |  | $ | 821    |   |  | $ | (1,232 | )
|                              |  |                            |        |   |                          |   |        |      |  |   |        |   |  |   |        |  



7



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##### Table of Contents

PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

June 30, 2010 and 2009



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



|               |  |              |        |                  |   |       
|-------------- |  | ------------ | ------ | ---------------- | - | ------
|(in thousands) |  | June 30,2010 |        | December 31,2009
|Product        |  | $            | 3,780  |                  | $ | 4,305 
|Service        |  |              | 4,865  |                  |   | 6,314 
|Other          |  |              | 1,505  |                  |   | 1,956 
|               |  |              |        |                  |   |       
|Total          |  | $            | 10,150 |                  | $ | 12,575
|               |  |              |        |                  |   |       

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



|               |  |                            |       |                          |   |       |  |      |        |  |   |       
|-------------- |  | -------------------------- | ----- | ------------------------ | - | ----- |  | ---- | ------ |  | - | ------
|               |  | Three Months EndedJune 30, |       | Six Months EndedJune 30,
|(in thousands) |  | 2010                       |       | 2009                     |   | 2010  |  | 2009
|United States  |  | $                          | 7,135 |                          | $ | 8,252 |  | $    | 15,176 |  | $ | 18,288
|International  |  |                            | 833   |                          |   | 786   |  |      | 1,604  |  |   | 1,637 
|               |  |                            |       |                          |   |       |  |      |        |  |   |       
|Total          |  | $                          | 7,968 |                          | $ | 9,038 |  | $    | 16,780 |  | $ | 19,925
|               |  |                            |       |                          |   |       |  |      |        |  |   |       

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



|               |  |              |       |                  |   |      
|-------------- |  | ------------ | ----- | ---------------- | - | -----
|(in thousands) |  | June 30,2010 |       | December 31,2009
|United States  |  | $            | 490   |                  | $ | 559  
|International  |  |              | 1,245 |                  |   | 1,482
|               |  |              |       |                  |   |      
|Total          |  | $            | 1,735 |                  | $ | 2,041
|               |  |              |       |                  |   |      

International long-lived assets include goodwill of
$700,000 and $821,000 as of June 30, 2010 and December 31, 2009, respectively.



8



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##### Table of Contents

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

SAFE HARBOR STATEMENT

Portions of this Quarterly Report on Form 10-Q (including information incorporated by reference) include forward-looking statements
within the meaning of Section 27A of the Securities Act of 1933 and Section 21E of the Securities Exchange Act of 1934, including, but not limited to, statements regarding Pinnacle Data Systems, Inc. (PDSi or the
Company) achieving its financial growth and profitability goals, or its sales, earnings and profitability expectations for the fiscal year ending December 31, 2010. The words believe, expect,
anticipate, estimate, intend, seek, may and similar expressions identify forward-looking statements that speak only as of the date of this Quarterly Report on Form 10-Q. Investors are
cautioned that such statements involve risks and uncertainties that could cause actual results to differ materially from historical or anticipated results due to many factors. These factors include, but are not limited to, the following:



| |  |  | changes in general economic conditions, including prolonged or substantial economic downturn, and any related financial difficulties experienced by
original equipment manufacturers, end users, customers, suppliers or others with whom the Company does business;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | changes in customer order patterns;
| | - |  | -----------------------------------



| |  |  | changes in our business or our relationship with major technology partners or significant customers;
| | - |  | ----------------------------------------------------------------------------------------------------



| |  |  | failure to maintain adequate levels of inventory;
| | - |  | -------------------------------------------------



| |  |  | production components and service parts cease to be readily available in the marketplace;
| | - |  | -----------------------------------------------------------------------------------------



| |  |  | lack of adequate financing to meet working capital needs or to take advantage of business and future growth opportunities that may arise;
| | - |  | -----------------------------------------------------------------------------------------------------------------------------------------



| |  |  | inability of cost reduction initiatives to lead to a realization of savings in labor, facilities or other operational costs;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------



| |  |  | deviation of actual results from estimates and/or assumptions used by the Company in the application of its significant accounting policies;
| | - |  | --------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | lack of success in technological advancements;
| | - |  | ----------------------------------------------



| |  |  | inability to retain certifications, authorizations or licenses to provide certain products and/or services;
| | - |  | -----------------------------------------------------------------------------------------------------------



| |  |  | risks associated with our new business practices, processes and information systems;
| | - |  | ------------------------------------------------------------------------------------



| |  |  | impact of judicial rulings or government regulations, including related compliance costs;
| | - |  | -----------------------------------------------------------------------------------------



| |  |  | disruption in the business of suppliers, customers or service providers due to adverse weather, casualty events, technological difficulty, acts of
war or terror, or other causes;
| | - |  | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | risks associated with doing business internationally, including economic, political and social instability and foreign currency exposure; and
| | - |  | ---------------------------------------------------------------------------------------------------------------------------------------------



| |  |  | other factors from time to time described in the Companys filings with the United States Securities and Exchange Commission (SEC).
| | - |  | -------------------------------------------------------------------------------------------------------------------------------------

The Company undertakes no obligation to publicly update or revise any such statements, except as required
by applicable law.

The following is managements discussion and analysis of financial condition and results of
operations of the Company for the three and six months ended June 30, 2010 and 2009. This discussion should be read in conjunction with the Companys audited consolidated financial statements and related notes contained in its 2009 Annual
Report on Form 10-K.

Executive Overview

PDSi is a global provider of services and products for original equipment manufacturers (OEMs) of computer hardware products
or products that contain computer hardware. We provide a variety of engineering and manufacturing services for global OEMs requiring custom product design, system integration, repair programs, warranty management, and/or specialized production
capabilities. With service centers in the United States, Europe and Asia, we ensure seamless support for solutions all around the world. We also provide depot repair and reverse logistics programs for OEMs with other types of computer equipment. We
offer a wide range of technology platforms, including standard and custom-designed products for the telecommunications, imaging, defense/aerospace, medical, industrial automation and information technology markets. Our product capabilities range
from board-level designs to globally certified, fully integrated systems. Our specialties include long-life, embedded products and unique, customer-centric solutions. The common shares of PDSi are traded on NYSE Amex under the stock symbol
PNS.



9



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##### Table of Contents

During the fourth quarter of 2009, we announced the implementation of a plan to return to
profitability in 2010 by focusing on our core Service segment business and current Product segment offerings, and by focusing on customer-funded development of new embedded products. We are fully supporting our current products and customer
programs, as well as maintaining the ability to upgrade these products. We have focused our sales and marketing efforts on our Service segment and on specialized product integration programs where our highly valued engineering and operational
expertise give us distinct competitive advantages. This plan aligned PDSis operations with this focused growth strategy, and included reductions and changes in senior and mid-level management to flatten the organizational structure and reduce
overhead costs. While these actions resulted in profitable first and second quarters of 2010, difficult worldwide economic conditions that have persisted since mid-2008, and which have negatively affected our existing multi-national OEM customers
and the industries in which they participate, may continue to materially adversely affect the Companys results of operations, financial condition and cash flows.

During the quarter ended June 30, 2010, the Company reported net income of $300,000, or $0.04 per diluted share, versus a net loss
of $270,000, or $0.03 per diluted share, for the prior year quarter. During the six months ended June 30, 2010, the Company reported net income of $609,000, or $0.08 per diluted share, versus a net loss of $971,000, or $0.12 per diluted share,
for the prior year period. See below for further discussion of consolidated and reportable segment results of operations for the three and six months ended June 30, 2010 and 2009.

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

Results of Operations

Consolidated Operations

Second Quarter  2010 Compared to 2009

The following table summarizes the Companys consolidated results of operations for the three months ended June 30:



|                                  |  |      |       |           |       |   |      |   |       |           |  |       |         |  |     |  
|--------------------------------- |  | ---- | ----- | --------- | ----- | - | ---- | - | ----- | --------- |  | ----- | ------- |  | --- | -
|(dollars in thousands)            |  | 2010 |       | % ofSales |       |   | 2009 |   |       | % ofSales |  |       | %Change | 
|Sales                             |  | $    | 7,968 |           | 100.0 | % |      |   | 9,038 |           |  | 100.0 | %       |  | -12 | %
|Cost of sales                     |  |      | 5,733 |           | 72.0  | % |      |   | 7,054 |           |  | 78.0  | %       |  | -19 | %
|                                  |  |      |       |           |       |   |      |   |       |           |  |       |         |  |     |  
|Gross profit                      |  |      | 2,235 |           | 28.0  | % |      |   | 1,984 |           |  | 22.0  | %       |  | 13  | %
|Operating expenses                |  |      | 1,835 |           | 23.0  | % |      |   | 2,272 |           |  | 25.1  | %       |  | -19 | %
|                                  |  |      |       |           |       |   |      |   |       |           |  |       |         |  |     |  
|Income (loss) from operations     |  |      | 400   |           | 5.0   | % |      |   | (288  | )         |  | -3.2  | %       |  | NM  |  
|Other expense                     |  |      |       |           |       |   |      |   |       |           |  |       |         |  |     |  
|Interest expense                  |  |      | 18    |           | 0.2   | % |      |   | 49    |           |  | 0.5   | %       |  | -63 | %
|                                  |  |      |       |           |       |   |      |   |       |           |  |       |         |  |     |  
|Income (loss) before income taxes |  |      | 382   |           | 4.8   | % |      |   | (337  | )         |  | -3.7  | %       |  | NM  |  
|Income tax expense (benefit)      |  |      | 82    |           | 1.0   | % |      |   | (67   | )         |  | -0.7  | %       |  | NM  |  
|                                  |  |      |       |           |       |   |      |   |       |           |  |       |         |  |     |  
|Net income (loss)                 |  | $    | 300   |           | 3.8   | % |      | $ | (270  | )         |  | -3.0  | %       |  | NM  |  
|                                  |  |      |       |           |       |   |      |   |       |           |  |       |         |  |     |  

The Company recorded net income for the three months ended June 30, 2010 compared to a net
loss in the prior year period primarily due to a reduction in operating expenses and manufacturing overhead costs and a favorable shift in mix toward higher margin Service and Product sales. The reduction in expenses reflects the aforementioned
actions taken throughout 2009 to reduce the Companys overhead cost structure, including employee costs and facilities expenses, to a level commensurate with current sales levels. In addition, Service segment gross profit increased 62%
primarily due to a 20% increase in Service sales driven by growth in new programs in both the United States and the Europe, Middle East and Africa (EMEA) region. Lastly, interest expense declined 57% due to significantly lower average
debt balances. The improvement in results of operations partially was mitigated by lower Product segment gross profit due to a 27% decline in Product sales.



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##### Table of Contents

For the second quarter of 2010, the Company had three customers that generated $2.5 million,
$0.9 million and $0.9 million, or 32%, 11% and 11%, respectively, of total sales. Of the revenues from these customers, 53% and 47% were included in Product and Service segment sales, respectively. For the second quarter of 2009, the Company had two
customers that generated $2.4 million and $2.1 million, or 26% and 23%, respectively, of total sales. Of the revenues from these customers, 85% and 15% were included in Product and Service segment sales, respectively. The Company continues to work
toward developing a more diversified customer revenue base.

Year-to-Date  2010 Compared to 2009

The following table summarizes the Companys consolidated results of operations for the six months ended June 30:



|                                  |  |      |        |           |       |   |      |   |        |           |  |       |         |  |     |  
|--------------------------------- |  | ---- | ------ | --------- | ----- | - | ---- | - | ------ | --------- |  | ----- | ------- |  | --- | -
|(dollars in thousands)            |  | 2010 |        | % ofSales |       |   | 2009 |   |        | % ofSales |  |       | %Change | 
|Sales                             |  | $    | 16,780 |           | 100.0 | % |      | $ | 19,925 |           |  | 100.0 | %       |  | -16 | %
|Cost of sales                     |  |      | 12,396 |           | 73.9  | % |      |   | 15,907 |           |  | 79.8  | %       |  | -22 | %
|                                  |  |      |        |           |       |   |      |   |        |           |  |       |         |  |     |  
|Gross profit                      |  |      | 4,384  |           | 26.1  | % |      |   | 4,018  |           |  | 20.2  | %       |  | 9   | %
|Operating expenses                |  |      | 3,563  |           | 21.2  | % |      |   | 5,250  |           |  | 26.3  | %       |  | -32 | %
|                                  |  |      |        |           |       |   |      |   |        |           |  |       |         |  |     |  
|Income (loss) from operations     |  |      | 821    |           | 4.9   | % |      |   | (1,232 | )         |  | -6.2  | %       |  | NM  |  
|Other expense                     |  |      |        |           |       |   |      |   |        |           |  |       |         |  |     |  
|Interest expense                  |  |      | 41     |           | 0.2   | % |      |   | 102    |           |  | 0.5   | %       |  | -60 | %
|                                  |  |      |        |           |       |   |      |   |        |           |  |       |         |  |     |  
|Income (loss) before income taxes |  |      | 780    |           | 4.6   | % |      |   | (1,334 | )         |  | -6.7  | %       |  | NM  |  
|Income tax expense (benefit)      |  |      | 171    |           | 1.0   | % |      |   | (363   | )         |  | -1.8  | %       |  | NM  |  
|                                  |  |      |        |           |       |   |      |   |        |           |  |       |         |  |     |  
|Net income (loss)                 |  | $    | 609    |           | 3.6   | % |      | $ | (971   | )         |  | -4.9  | %       |  | NM  |  
|                                  |  |      |        |           |       |   |      |   |        |           |  |       |         |  |     |  

The Companys reduction in operating expenses and manufacturing overhead costs as described
above was the primary driver that resulted in net income for the six months ended June 30, 2010 compared to a net loss in the prior year period. Furthermore, Service segment gross profit increased 47% due to a 24% increase in Service sales
attributable to new program growth in both the U.S. and EMEA. Finally, interest expense declined 59% due to significantly lower average debt balances. However, lower Product segment gross profit driven by a 29% decline in Product sales partially
offset the overall improvement in results.

For the first six months of 2010, the Company had three customers that generated
$5.3 million, $2.1 million and $2.0 million, or 32%, 13% and 12%, respectively, of total sales. Of the revenues from these customers, 75% and 25% were included in Product and Service segment sales, respectively. For the first six months of 2009, the
Company had two customers that generated $6.5 million and $3.8 million, or 33% and 19%, respectively, of total sales. Of the revenues from these customers, 86% and 14% were included in Product and Service segment sales, respectively. As mentioned
above, the Company continues to work toward better customer diversification.

Segment Operations

Product

Second Quarter
 2010 Compared to 2009

The following table summarizes the Companys gross profit for the Product segment
for the three months ended June 30:



|                       |  |      |       |           |       |   |      |   |           |  |       |         |  |     |  
|---------------------- |  | ---- | ----- | --------- | ----- | - | ---- | - | --------- |  | ----- | ------- |  | --- | -
|(dollars in thousands) |  | 2010 |       | % ofSales |       |   | 2009 |   | % ofSales |  |       | %Change | 
|Sales                  |  | $    | 4,842 |           | 100.0 | % |      | $ | 6,599     |  | 100.0 | %       |  | -27 | %
|Cost of sales          |  |      | 3,856 |           | 79.6  | % |      |   | 5,388     |  | 81.6  | %       |  | -28 | %
|                       |  |      |       |           |       |   |      |   |           |  |       |         |  |     |  
|Gross profit           |  | $    | 986   |           | 20.4  | % |      | $ | 1,211     |  | 18.4  | %       |  | -19 | %
|                       |  |      |       |           |       |   |      |   |           |  |       |         |  |     |  



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##### Table of Contents

Lower Product segment gross profit primarily was due to a 27% decrease in Product sales.
Most of the revenue decline was attributable to a $2.2 million drop in sales to large OEMs in the medical and imaging industries, partially offset by growth in the defense and telecommunications sectors. The improvement in gross profit as a
percentage of sales to 20% in 2010 from 18% in 2009 was driven by a shift in sales mix to higher margin products and actions taken to reduce overhead costs consistent with lower Product revenue levels.

Year-to-Date  2010 Compared to 2009

The following table summarizes the Companys gross profit for the Product segment for the six months ended June 30:



|                       |  |      |        |           |       |   |      |   |           |  |       |         |  |     |  
|---------------------- |  | ---- | ------ | --------- | ----- | - | ---- | - | --------- |  | ----- | ------- |  | --- | -
|(dollars in thousands) |  | 2010 |        | % ofSales |       |   | 2009 |   | % ofSales |  |       | %Change | 
|Sales                  |  | $    | 10,769 |           | 100.0 | % |      | $ | 15,085    |  | 100.0 | %       |  | -29 | %
|Cost of sales          |  |      | 8,714  |           | 80.9  | % |      |   | 12,652    |  | 83.9  | %       |  | -31 | %
|                       |  |      |        |           |       |   |      |   |           |  |       |         |  |     |  
|Gross profit           |  | $    | 2,055  |           | 19.1  | % |      | $ | 2,433     |  | 16.1  | %       |  | -16 | %
|                       |  |      |        |           |       |   |      |   |           |  |       |         |  |     |  

The decline in Product segment gross profit primarily was due to a 29% decrease in Product
revenue, including a $5.2 million decline in sales to large OEMs in the medical and imaging industries. Strong growth in the telecommunications sector, which increased $1.1 million, partially offset the overall decline in Product sales. Improved
gross profit as a percentage of sales, up to 19% in 2010 from 16% in 2009, reflects a continued shift in sales mix to higher margin business as well as actions taken to reduce overhead costs consistent with lower Product revenue levels.

Service

Second Quarter
 2010 Compared to 2009

The following table summarizes the Companys gross profit for the Service segment for the three
months ended June 30:



|                       |  |      |       |           |       |   |      |   |           |  |       |         |  |    |  
|---------------------- |  | ---- | ----- | --------- | ----- | - | ---- | - | --------- |  | ----- | ------- |  | -- | -
|(dollars in thousands) |  | 2010 |       | % ofSales |       |   | 2009 |   | % ofSales |  |       | %Change | 
|Sales                  |  | $    | 3,126 |           | 100.0 | % |      | $ | 2,439     |  | 100.0 | %       |  | 28 | %
|Cost of sales          |  |      | 1,877 |           | 60.0  | % |      |   | 1,666     |  | 68.3  | %       |  | 13 | %
|                       |  |      |       |           |       |   |      |   |           |  |       |         |  |    |  
|Gross profit           |  | $    | 1,249 |           | 40.0  | % |      | $ | 773       |  | 31.7  | %       |  | 62 | %
|                       |  |      |       |           |       |   |      |   |           |  |       |         |  |    |  

Higher Service segment gross profit primarily was due to a 28% increase in Service sales driven by
growth in programs ramped recently in both the U.S. and EMEA. The increase in gross profit as a percentage of sales to 40% in 2010 from 32% in 2009 principally was attributable to ongoing improvements in the operational efficiency of this segment.

Year-to-Date  2010 Compared to 2009

The following table summarizes the Companys gross profit for the Service segment for the six months ended June 30:



|                       |  |      |       |           |       |   |      |   |           |  |       |         |  |    |  
|---------------------- |  | ---- | ----- | --------- | ----- | - | ---- | - | --------- |  | ----- | ------- |  | -- | -
|(dollars in thousands) |  | 2010 |       | % ofSales |       |   | 2009 |   | % ofSales |  |       | %Change | 
|Sales                  |  | $    | 6,011 |           | 100.0 | % |      | $ | 4,840     |  | 100.0 | %       |  | 24 | %
|Cost of sales          |  |      | 3,682 |           | 61.3  | % |      |   | 3,255     |  | 67.3  | %       |  | 13 | %
|                       |  |      |       |           |       |   |      |   |           |  |       |         |  |    |  
|Gross profit           |  | $    | 2,329 |           | 38.7  | % |      | $ | 1,585     |  | 32.7  | %       |  | 47 | %
|                       |  |      |       |           |       |   |      |   |           |  |       |         |  |    |  

The improvement in Service segment gross profit was driven by a 24% increase in Service sales
fueled by new program growth in both the U.S. and EMEA. Continuing gains in operating efficiency drove the increase in gross profit as a percentage of sales to 39% in 2010 from 33% in 2009.



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Liquidity and Capital Resources

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

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



|                                                                              |  |              |       |   |                  |   |       |  
|----------------------------------------------------------------------------- |  | ------------ | ----- | - | ---------------- | - | ----- | -
|(in thousands)                                                                |  | June 30,2010 |       |   | December 31,2009 |  
|Line of credit                                                                |  | $            | 229   |   |                  | $ | 2,413 |  
|                                                                              |  |              |       |   |                  |   |       |  
|Stockholders equity, excluding accumulated other comprehensive income (loss) |  |              | 6,258 |   |                  |   | 5,617 |  
|Accumulated other comprehensive income (loss)                                 |  |              | (169  | ) |                  |   | (29   | )
|                                                                              |  |              |       |   |                  |   |       |  
|Total stockholders equity                                                    |  |              | 6,089 |   |                  |   | 5,588 |  
|                                                                              |  |              |       |   |                  |   |       |  
|Total capital                                                                 |  | $            | 6,318 |   |                  | $ | 8,001 |  
|                                                                              |  |              |       |   |                  |   |       |  

Based on the Companys historical cash flow, current financial results and unused capacity on the line
of credit, we believe we have access to adequate resources to provide sufficient liquidity for the operations of the Company over the next year. See further discussion in Financing Activities below.

The following table summarizes the Companys condensed consolidated cash flows for the six months ended June 30:



|                                          |  |      |        |   |      |   |        |  
|----------------------------------------- |  | ---- | ------ | - | ---- | - | ------ | -
|(in thousands)                            |  | 2010 |        |   | 2009 |  
|Net cash provided by operating activities |  | $    | 1,733  |   |      | $ | 2,840  |  
|Net cash used in investing activities     |  |      | (62    | ) |      |   | (155   | )
|Net cash used in financing activities     |  |      | (1,841 | ) |      |   | (2,876 | )
|Effect of exchange rate on cash           |  |      | (18    | ) |      |   | 3      |  
|                                          |  |      |        |   |      |   |        |  
|Increase (decrease) in cash               |  |      | (188   | ) |      |   | (188   | )
|Cash at beginning of period               |  |      | 323    |   |      |   | 282    |  
|                                          |  |      |        |   |      |   |        |  
|Cash at end of period                     |  | $    | 135    |   |      | $ | 94     |  
|                                          |  |      |        |   |      |   |        |  

Operating Activities

Net cash provided by operating activities was $1.7 million and $2.8 million for the six months ended June 30, 2010 and 2009,
respectively. Net income (loss) adjusted for the effects of non-cash items, which primarily include inventory reserves and depreciation expense, resulted in cash inflows of $0.9 million and cash outflows of $0.1 million in the first six months of
2010 and 2009, respectively. Changes in working capital resulted in $0.8 million in cash provided for the first six months of 2010 compared to $2.9 million for the comparable period of 2009. Higher cash provided by operating activities in the prior
year period primarily was driven by a reduction in net working capital in 2009 due to declining sales volumes.

Investing Activities

Net cash used in investing activities represents purchases of property and equipment and was not significant for the
six months ended June 30, 2010 and 2009.

Financing Activities

Net cash used in financing activities was $1.8 million and $2.9 million for the first six months of 2010 and 2009, respectively. Financing
activity in both periods primarily reflects net repayments on the Companys line of credit. All cash generated by U.S. operations after funding investing activities is applied to the line of credit.



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##### Table of Contents

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

The Line is evidenced by
a Revolving Note made by the Company in favor of Wells Fargo and is secured by substantially all of the assets of the Company, as provided for in the Credit Agreement. The Line is subject to customary affirmative and negative covenants for credit
facilities of this type, including limitations on the Company with respect to liens, indebtedness, guaranties, investments, distributions, mergers and acquisitions, and dispositions of assets.

The Credit Agreement also contains certain financial covenants, including a minimum book net worth, minimum net income and maximum
capital expenditures. The Company obtained a waiver from Wells Fargo for violation of the minimum book net worth financial covenant as of June 30 and September 30, 2009, and for violation of the minimum net income financial covenant for
the three months ended June 30 and September 30, 2009. During the fourth quarter of 2009, the Credit Agreement was revised to adjust the financial covenants based on the Companys current financial projections and to include a
reduction and block of availability under the borrowing base of $250,000 until such time as the Company complies with each of the financial covenants described above for both of the fiscal quarters ending December 31, 2009 and June 30,
2010. Based on the Companys results of operations for the quarters ending December 31, 2009 and June 30, 2010, the $250,000 reduction and block of availability under the borrowing base was removed during the second quarter of 2010.

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

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

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

Off-Balance Sheet Arrangements

The Company has no off-balance sheet arrangements with (1) any obligation under a guarantee contract; (2) a retained or
contingent interest in assets or similar arrangement that serves as credit, liquidity or market risk support for such assets; or (3) any other obligation, including a contingent obligation, under a contract that would be accounted for as a
derivative instrument or arising out of a variable interest.

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

Critical Accounting Policies and Recently Issued Accounting Standards

The preparation of financial statements and related disclosures in conformity with United States generally accepted accounting principles
(GAAP) requires management to make judgments, assumptions and estimates that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ significantly from those estimates. The
Companys most critical estimates include those related to revenue recognition, accounts receivable, inventory, goodwill and income taxes. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP,
with no need for judgment in application. In addition, there are areas in which managements judgment in selecting an available alternative would not produce a materially different result. Note 2 to the audited consolidated financial statements
included in the Companys 2009 Annual Report on Form 10-K describes the significant accounting policies and methods used by the Company. See Part I  Financial Information, Item 1  Condensed Consolidated Financial Statements,
Note 3  Recently Issued Accounting Standards for information regarding recently issued accounting standards. The Companys critical accounting policies have not changed materially from those disclosed in the Companys 2009 Annual
Report on Form 10-K.



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##### Table of Contents

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

Evaluation of
Disclosure Controls and Procedures

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

Changes in Internal Control Over Financial Reporting

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



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##### Table of Contents

PART II  OTHER INFORMATION



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



|            |  |                                                                                                                                                                                                        |  |                                                                                            
|----------- |  | ------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------ |  | -------------------------------------------------------------------------------------------
|Exhibit No. |  | Description of Exhibit                                                                                                                                                                                 |  | If incorporated by reference, document with which
Exhibit was previously filed with the SEC
|31.1        |  | Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Quarterly Report on Form 10-Q of Pinnacle Data
Systems, Inc. for the quarter ended June 30, 2010 |  | Contained herein                                                                           
|            |  |                                                                                                                                                                                                       
|31.2        |  | Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Quarterly Report on Form 10-Q of Pinnacle Data
Systems, Inc. for the quarter ended June 30, 2010 |  | Contained herein                                                                           
|            |  |                                                                                                                                                                                                       
|32.1        |  | Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 of Quarterly Report on Form 10-Q of Pinnacle Data
Systems, Inc. for the quarter ended June 30, 2010 |  | Contained herein                                                                           
|            |  |                                                                                                                                                                                                       
|32.2        |  | Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 of Quarterly Report on Form 10-Q of Pinnacle Data
Systems, Inc. for the quarter ended June 30, 2010 |  | Contained herein                                                                           



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##### Table of Contents

SIGNATURES

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



|                    |  |  |  |                                             
|------------------- |  |  |  | --------------------------------------------
|                    |  |  |  | PINNACLE DATA SYSTEMS, INC.                 
|                    |  | 
|Date: July 30, 2010 |  |  |  | /s/    John D. Bair                         
|                    |  |  |  | John D. Bair
Chief Executive Officer        
|                    |  | 
|Date: July 30, 2010 |  |  |  | /s/    Nicholas J. Tomashot                 
|                    |  |  |  | Nicholas J. Tomashot Chief
Financial Officer



17