UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

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

For the quarterly period ended ~~March~~June 3130, 2011

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

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

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

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

On ~~April~~July 2926, 2011, the registrant had outstanding 7,~~864~~871,349 common shares without par value, which is the registrant’s only class of common equity.

PINNACLE DATA SYSTEMS, INC.

FORM 10-Q FOR THE QUARTERLY PERIOD ENDED ~~MARCH~~JUNE 3130, 2011

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			11
ITEM 4 CONTROLS AND PROCEDURES			1517
PART II – OTHER INFORMATION			1618
ITEM 6 EXHIBITS			1618
SIGNATURES			1719
CERTIFICATIONS			1820

PART I – FINANCIAL INFORMATION

ITEM 1

CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

PINNACLE DATA SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

	March 31,2011			December 31,2010
	June 30,2011			December 31,2010
ASSETS	(Unaudited)
CURRENT ASSETS
Cash	$	~~503~~1,292		$	465
Accounts receivable, net of allowance for doubtful accounts of $107 and $106, respectively		5,172			4,469
Accounts receivable, net of allowance for doubtful accounts of $109 and $106, respectively		4,784			4,469
Inventory, net		2,~~820~~698			3,226
Deferred income taxes		~~781~~806			762
Prepaid expenses and other current assets		420			492
Other current assets		374			492
Total current assets		9,~~696~~954			9,414
PROPERTY AND EQUIPMENT
Property and equipment, net		934			685
Property and equipment, cost		6,170			6,056
Goodwill		830			767
Less accumulated depreciation and amortization		(5,455	)		(5,371	)
Deferred income taxes		1,200			929
Total property and equipment, net		715			685
Other assets		179			193
OTHER ASSETS
TOTAL ASSETS	$	13,097		$	11,988
Goodwill		812			767
Deferred income taxes		1,283			929
Other assets		196			193
Total other assets		2,291			1,889
TOTAL ASSETS	$	12,702		$	11,988
LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES
Line of credit	$	—		$	273
Accounts payable		1,~~799~~786			1,404
Accrued wages, payroll taxes and employee benefits		~~496~~552			581
Unearned revenue		~~181~~168			30
Other current liabilities		~~557~~576			743
Total current liabilities		3,~~033~~082			3,031
LONG-TERM LIABILITIES
Other liabilities		491			296
Accrued other		374			296
TOTAL LIABILITIES		3,573			3,327
TOTAL LIABILITIES		3,407			3,327
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; 7,864 shares issued and outstanding		5,790			5,790
Common stock; no par value; 25,000 shares authorized; 7,871 and 7,864 shares issued and outstanding, respectively		5,793			5,790
Additional paid-in capital		12,~~981~~000			1,962
Accumulated other comprehensive income (loss)		(303	)		(90	)
Retained earnings		1,~~554~~734			999
Total stockholders’ equity		9,~~295~~524			8,661
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	1213,~~702~~097		$	11,988

See accompanying notes to condensed consolidated financial statements.

PINNACLE DATA SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(in thousands, except per share)

	For the Three Months EndedMarch 31,
	For the Three Months EndedJune 30,					For the Six Months EndedJune 30,
	2011			2010		2011			2010
Sales	$	6,~~405~~821		$	87,~~812~~968	$	13,226		$	16,780
Cost of sales		4,~~322~~577			65,~~663~~733		8,899			12,396
Gross profit		2,~~083~~244			2,~~149~~235		4,327			4,384
Operating expenses		1,~~824~~895			1,~~728~~835		3,719			3,563
Income from operations		~~259~~349			~~421~~400		608			821
Other expense
Interest expense		1—			2318		1			41
Income before income taxes		~~258~~349			~~398~~382		607			780
Income tax expense (benefit)		~~(297~~169	)		8982		(128	)		171
Net income	$	~~555~~180		$	~~309~~300	$	735		$	609
Weighted average common shares outstanding:
Basic		7,~~864~~867			7,~~825~~826		7,866			7,825
Diluted		8,~~180~~156			7,~~825~~966		8,173			7,891
Earnings per common share:
Basic	$	0.0702		$	0.04	$	0.09		$	0.08
Diluted		0.0702			0.04		0.09			0.08

See accompanying notes to condensed consolidated financial statements.

PINNACLE DATA SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

(Unaudited)

(in thousands)

	Common Stock				AdditionalPaid-~~InCapital~~In Capital		AccumulatedOtherComprehensiveIncome (Loss)			RetainedEarnings(Deficit)			TotalStockholders’Equity
	OutstandingShares		Amount
Balance – December 31, 2009		7,825	$	5,769	$	1,912	$	(29	)	$	(2,064	)	$	5,588
Share-based payment expense		—		—		14		—			—			14
Stock issued		14		8		—		—			—			8
Share-based payment expense		—		—		24		—			—			24
Comprehensive income, net of taxes:
Net income		—		—		—		—			~~309~~609			~~309~~609
Foreign currency translation		—		—		—		(54140	)		—			(54140	)
Total comprehensive income														~~255~~469
Balance – March 31, 2010		7,825	$	5,769	$	1,926	$	(83	)	$	(1,755	)	$	5,857
Balance – June 30, 2010		7,839	$	5,777	$	1,936	$	(169	)	$	(1,455	)	$	6,089
Balance – December 31, 2010		7,864	$	5,790	$	1,962	$	(90	)	$	999		$	8,661
Share-based payment expense		—		—		19		—			—			19
Stock issued		7		3		—		—			—			3
Share-based payment expense		—		—		38		—			—			38
Comprehensive income, net of taxes:
Net income		—		—		—		—			~~555~~735			~~555~~735
Foreign currency translation		—		—		—		6087			—			6087
Total comprehensive income														~~615~~822
Balance – March 31, 2011		7,864	$	5,790	$	1,981	$	(30	)	$	1,554		$	9,295
Balance – June 30, 2011		7,871	$	5,793	$	2,000	$	(3	)	$	1,734		$	9,524

See accompanying notes to condensed consolidated financial statements.

PINNACLE DATA SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)

	For the Three Months EndedMarch 31,
	For the Six Months EndedJune 30,
	2011			2010
CASH FLOWS FROM OPERATING ACTIVITIES
Net income	$	~~555~~735		$	~~309~~609
Adjustments to reconcile net income to net cash provided by operating activities:
Bad debt expense		128			10(32	)
Inventory reserves		51132			~~105~~135
Depreciation and amortization		85174			~~102~~201
Provision (benefit) for deferred income taxes		(~~373~~315	)		—
Share-based payment expense		1938			1424
(Increase) decrease in assets:
Accounts receivable		(~~673~~299	)		~~(1,150~~953	)
Inventory		~~366~~410			10550
Prepaid expenses and other assets		23			256
Other assets		98			202
Increase (decrease) in liabilities:
Accounts payable		~~328~~392			~~533~~(907	)
Unearned revenue		~~151~~138			~~296~~195
Other current liabilities		(218	)		44
Other liabilities		(249	)		(233	)
Total adjustments		~~(240~~547	)		~~220~~1,088
Net cash provided by operating activities		~~315~~1,282			~~529~~1,697
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of property and equipment		(84	)		(55	)
Additions to property and equipment		(176	)		(22	)
Net cash used in investing activities		(84176	)		(5522	)
CASH FLOWS FROM FINANCING ACTIVITIES
Net change in line of credit		(273	)		(12,~~263~~184	)
Net change in outstanding checks		(45	)		~~498~~303
Other		2012			1736
Net cash used in financing activities		(~~208~~306	)		(~~748~~1,845	)
EFFECT OF EXCHANGE RATE ON CASH		1527			(418	)
INCREASE (DECREASE) IN CASH		38827			(~~278~~188	)
Cash at beginning of period		465			323
Cash at end of period	$	~~503~~1,292		$	45135
SUPPLEMENTAL DISCLOSURE OF NON-CASH ACTIVITY:
Acquisitions of equipment through capital lease	$	196		$	40

See accompanying notes to condensed consolidated financial statements.

PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited)

~~March~~June 3130, 2011 and 2010

1. ~~Basis~~Nature of ~~Presentation~~Operations

~~The accompanying condensed consolidated financial statements of~~ Pinnacle Data Systems, Inc. (“PDSi” or the “Company”) is a global provider of electronics repair ~~have~~and ~~been~~reverse ~~prepared~~logistics inservices; ~~accordance~~system ~~with~~integration ~~United~~and ~~States~~original design manufacturer (“~~U.S.~~ODM”) ~~generally~~computing ~~accepted~~design ~~accounting~~and ~~principles~~manufacturing ~~(“GAAP”)~~services; ~~for~~and ~~interim~~embedded ~~financial~~computing ~~information~~products and ~~with~~design services for the ~~instructions~~diversified tocomputing, ~~Form~~telecommunications, imaging, ~~10-Q~~defense/aerospace, ~~and~~medical, ~~Article~~semiconductor 8and ofindustrial ~~Regulation~~automation ~~S-X~~markets. ~~Accordingly, they~~PDSi doprovides ~~not~~a ~~include~~variety ~~all~~of ~~information~~engineering and ~~footnotes~~manufacturing ~~required~~services byfor ~~GAAP~~global ~~for~~original ~~complete~~equipment ~~financial~~manufacturers ~~statements.~~(“OEMs”) ~~The~~requiring ~~financial~~custom ~~information~~product ~~included~~design, system ~~herein~~integration, ~~reflects~~repair ~~all~~programs, ~~normal~~warranty management, and/or ~~recurring~~specialized ~~adjustments,~~production ~~which~~capabilities. ~~are,~~PDSi’s inproduct ~~the~~capabilities ~~opinion~~range offrom ~~management~~board-level designs to globally certified, ~~necessary~~fully ~~for~~integrated ~~a fair~~systems, ~~presentation~~specializing ofin ~~financial~~long-life ~~position~~computer products and ~~results~~unique, ofcustomer-centric ~~operations~~solutions. ~~Operating~~The ~~results~~Company ~~for~~has ~~all~~facilities ~~periods~~in ~~presented~~the ~~are~~United ~~not~~States, ~~necessarily~~Europe ~~indicative~~and Asia. The common shares of ~~the~~PDSi ~~results~~are ~~that~~traded ~~may~~on beNYSE ~~expected~~Amex ~~for~~under the ~~full~~stock ~~year~~symbol “PNS.”

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 were eliminated. Certain prior year amounts have been reclassified to conform to the current presentation.

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. The Company’s most critical estimates include those related to revenue recognition, accounts receivable, inventory, goodwill and income taxes. Although some variability is inherent in these estimates, recorded amounts reflect management’s best estimates based on available facts and circumstances at that time. Management believes the amounts provided are appropriate.

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, 2010 included in the Company’s 2010 Annual Report on Form 10-K.

2. Summary of Significant Accounting Policies

ABasis ~~complete summary~~ of ~~the~~Presentation Company’s significant accounting policies is included in Note 2 to the audited consolidated financial statements included in the Company’s 2010 Annual Report on Form 10-K. There have been no material changes to these policies since December 31, 2010.

The accompanying condensed consolidated financial statements of PDSi have been prepared in accordance with 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 normal and recurring adjustments, 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 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, 2010 included in the Company’s 2010 Annual Report on Form 10-K, which includes a complete summary of the Company’s significant accounting policies in Note 2. There have been no material changes to these policies since December 31, 2010.

Use of Estimates

Consolidation Policy

The Company’s condensed consolidated financial statements include the accounts of PDSi and PDSi B.V., a wholly-owned private limited liability company located in Tiel, the Netherlands. All significant intercompany balances and transactions were eliminated. Certain prior year amounts have been reclassified to conform to the current presentation.

Inventory

As of ~~March~~June 3130, 2011 and December 31, 2010, the Company provided reserves of $2.0 million and $1.9 million, respectively, to reduce the carrying value of inventory. The following table summarizes the Company’s inventory as of the dates indicated (net of inventory reserves):

(in thousands)	~~March~~June 3130,2011		December 31,2010
Component parts (raw materials)	$	2,~~594~~368	$	2,963
Work-in-process		58210		110
Finished goods		~~168~~120		153
Total inventory	$	2,~~820~~698	$	3,226

PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

~~March~~June 3130, 2011 and 2010

3. Line of Credit

On March 24, 2011, the Company entered into a Credit Agreement and a Security Agreement with Wells Fargo Bank, National Association (“Wells Fargo”), providing for a revolving credit facility (the “Line”) with a maximum line of credit of $3.0 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 accounts receivable located within the United States, plus (b) 75% of the aggregate amount of eligible accounts receivable located outside of the United States, plus (c) the lesser of 10% of the aggregate amount of eligible inventory or $~~500,000~~0.5 million.

The Line is evidenced by a Revolving Line of Credit 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 Security 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, mergers and dispositions of assets.

The Credit Agreement also contains certain financial covenants, including a maximum ratio of total liabilities to tangible net worth, minimum net income on a rolling four-quarter basis, and a minimum debt service coverage ratio.

The outstanding balance on the Line bears interest monthly at a fluctuating annual rate of 3% above the Daily One Month London Interbank Offered Rate. The Line matures on March 22, 2013.

The Company may use borrowings under the Credit Agreement for general corporate purposes. Any unused portions of the Line will be subject to unused Line fees. Wells Fargo may terminate the Credit Agreement immediately upon default.

On March 24, 2011, in connection with entering into the Credit Agreement and Security Agreement described above, the Company terminated its prior line of credit agreement with Wells Fargo. On the date of the termination, the Company made a final payment to Wells Fargo of all unpaid interest, fees, costs and expenses under the prior agreement and an additional $30,000 as collateral security for the Company’s obligations to Wells Fargo under the prior agreement (the “Reserve”). Any balance of the Reserve remaining after 45 days from the date of termination will be returned to the Company. The Company did not incur any early termination penalties in connection with the termination of the prior line of credit agreement.

4. Income Taxes

The Company files income tax returns in the U.S. federal jurisdiction, various states and foreign countries. There are no federal or state income tax examinations currently underway for these jurisdictions. Open tax years exist for 2007 and beyond for the Company’s federal income tax returns and for 2006 and beyond for state income tax returns.

The Company maintains a $0.1 million valuation allowance against deferred tax assets related to certain state net operating loss (“NOL”) carryforwards. The Company can provide no assurance that changes in its deferred tax asset valuation allowance will not be required in the future. The Company will continue to monitor events and circumstances to determine whether any change in its valuation allowance is warranted in the future.

Although the Company periodically ~~has~~had considered the potential tax savings associated with pursuing research and development (“R&D”) tax credits, the Company’s then recent operating losses, combined with existing federal U.S. NOL carryforwards, precluded an economical pursuit of such credits. However, based on ~~the~~ positive changes in the Company’s operating results and financial position in 2010, as well as the use of existing NOL carryforwards, management determined during the fourth quarter of 2010 that the benefits would outweigh both the cost of an R&D tax credit study and the establishment of the necessary infrastructure to be able to claim such credits in the future ~~are justified by the resulting benefits~~. Accordingly, the Company recorded a net ~~income~~ tax benefit of $0.5 million during the fourth quarter of 2010 for estimated R&D tax credits for tax years 2001 through 2010 that the Company believed were more likely than not to be sustained upon examination by the Internal Revenue Service. The Company substantially completed ~~the~~ the calculation and documentation of these R&D tax credits during the first quarter of 2011, resulting in an additional net ~~income~~ tax benefit of $0.3 million. ~~The~~During the second quarter of 2011, the Company ~~will~~recorded ~~complete~~net tax expense of $0.1 million associated with the ~~filing~~finalization of the amended federal and state tax returns ~~later~~for inprior ~~2011~~years impacted by the R&D tax credit study.

The Company ~~recorded~~maintains a liability for unrecognized tax benefits related to R&D ~~credit~~ tax credit positions to be taken on its various income tax returns. If recognized, the entire amount of these unrecognized tax benefits would favorably impact the Company’s effective tax rate in future periods. The Company had $0.2 million and $0.1 million of unrecognized tax benefits as of ~~March~~June 3130, 2011, and December 31, 2010, respectively, which were recorded in other liabilities on the consolidated balance sheets.

PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

~~March~~June 3130, 2011 and 2010

The following table summarizes the Company’s income tax expense (benefit) for the ~~three~~periods ~~months ended March 31~~indicated:

(in thousands)	2011			2010
	Three months ended June 30,						Six months ended June 30,
Current:
(in thousands)	2011			2010			2011			2010
Federal	$	70		$	67
Current:
Foreign		(2	)		3
Federal	$	68		$	69		$	138		$	136
State and local		8			19
Foreign		30			15			28			18
Total current expense		76			89
State and local		13			(2	)		21			17
Deferred:
Total current expense		111			82			187			171
Federal		(392	)		—
Deferred:
Foreign		19			—
Federal		47			—			(345	)		—
Total deferred expense (benefit)		(373	)		—
Foreign		8			—			27			—
Total income tax expense (benefit)	$	(297	)	$	89
State and local		3			—			3			—
Total deferred expense (benefit)		58			—			(315	)		—
Total income tax expense (benefit)	$	169		$	82		$	(128	)	$	171

The following table reconciles tax expense (benefit) computed at the federal statutory rate to amounts reported for financial statement purposes for the ~~three~~periods ~~months ended March 31~~indicated:

	2011						2010
	Three months ended June 30,												Six months ended June 30,
(dollars in thousands)	Amount			%			Amount			%
	2011						2010						2011						2010
Income tax provision (benefit) at statutory rate	$	88			34.0		$	135			34.0
(dollars in thousands)	Amount			%			Amount			%			Amount			%			Amount			%
R&D credits		(321	)		NM			—			—
Income tax provision at statutory rate	$	118			34.0		$	130			34.0		$	206			34.0		$	265			34.0
Change in valuation allowance		—			—			(45	)		(11.3	)
R&D tax credits		—			—			—			—			(321	)		NM			—			—
Foreign rate differential		(12	)		(4.7	)		(2	)		(0.5	)
R&D related tax impacts		69			19.7			—			—			69			11.4			—			—
Other, net		(52	)		(20.2	)		1			0.2
Valuation allowance		—			—			(51	)		(13.3	)		—			—			(96	)		(12.3	)
Total	$	(297	)		NM		$	89			22.4
Foreign rate differential		(27	)		(7.8	)		(11	)		(2.9	)		(39	)		(6.4	)		(13	)		(1.7	)
Other, net		9			2.5			14			3.7			(43	)		(7.1	)		15			1.9
Total	$	169			48.4		$	82			21.5		$	(128	)		NM		$	171			21.9

For the ~~three~~six months ended ~~March~~June 3130, 2011, the Company received federal tax refunds totaling $0.2 million, and state income tax payments were immaterial. During the ~~three~~six months ended ~~March~~June 3130, 2010, the Company received federal tax refunds totaling $0.2 million and made no state income tax payments. As of ~~March~~June 3130, 2011, the Company ~~had~~ had state NOL carryforwards of $4.32 million that will expire, if unused, between December 31, 2021 and December 31, 2031. The Company had no federal NOL carryforwards as of ~~March~~June 3130, 2011.

PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

~~March~~June 3130, 2011 and 2010

The following table summarizes the tax effect of temporary differences that give rise to significant portions of the Company’s deferred tax assets and deferred tax liabilities as of the dates indicated:

(in thousands)	~~March~~June 3130,2011			December 31,2010
Deferred tax assets
R&D credits	$	1,~~104~~021		$	719
Inventory reserves		~~732~~759			714
Net operating loss		~~107~~103			107
Depreciation and amortization		8777			113
Other		~~173~~185			177
Gross deferred tax assets		2,~~203~~145			1,830
Less valuation allowance		(79	)		(79	)
Deferred tax asset		2,~~124~~066			1,751
Deferred tax liabilities
Prepaids		60			60
Gross deferred tax liability		60			60
Net deferred tax asset	$	2,~~064~~006		$	1,691

The following table summarizes the classification of the above amounts in the Company’s consolidated balance sheets as of the dates indicated:

(in thousands)	~~March~~June 3130,2011		December 31,2010
Current assets
Deferred income taxes	$	~~781~~806	$	762
Other assets
Deferred income taxes		1,~~283~~200		929
Net deferred tax asset	$	2,~~064~~006	$	1,691

5.The ~~Earnings~~tables ~~Per~~above ~~Share~~do not include the unrecognized tax benefit liability described previously.

Basic earnings per share (EPS) represents the amount of earnings available to each share of common stock outstanding during the reporting period. Diluted EPS represents the amount of earnings 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.

The following table presents the Company’s calculation of basic and diluted weighted average common shares outstanding for the three months ended March 31:

(in thousands)	2011		2010
Weighted average common shares outstanding – basic		7,864		7,825
Dilutive effect of stock options		316		—
Weighted average common shares outstanding – diluted		8,180		7,825

The computation of diluted EPS for the three months ended March 31, 2011 and 2010 excluded options to purchase approximately 406,000 shares and 705,000 shares, respectively, that were anti-dilutive because the exercise price of these options was greater than the average market price of the common shares during the respective periods.

PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

~~March~~June 3130, 2011 and 2010

5. Earnings Per Share

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


	Three Months Ended June 30,				Six Months Ended June 30,
(in thousands)	2011		2010		2011		2010
Weighted average common shares outstanding – basic		7,867		7,826		7,866		7,825
Dilutive effect of stock options		289		140		307		66

Weighted average common shares outstanding – diluted		8,156		7,966		8,173		7,891

The computation of diluted EPS for the three and six months ended June 30, 2011 excluded options to purchase approximately 427,000 shares and 412,000 shares, respectively, that were anti-dilutive because the exercise price of these options was greater than the average market price of the common shares during the respective periods (approximately 413,000 shares and 579,000 shares, respectively, for the three and six months ended June 30, 2010).

6. Segment Information

The Company’s reportable segments are Product and Service. PDSi is a global provider of electronics repair and reverse logistics services; ODM and OEM integrated computing services; and embedded computing products and design services for the diversified computing, telecommunications, imaging, defense/aerospace, medical, semiconductor and industrial automation markets. PDSi 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. PDSi’s engineering, technical and operational capabilities span the entire product lifecycle allowing the Company to better understand and develop custom solutions for each of its customer’s unique requirements.

PDSi’s product capabilities range from board-level designs to globally certified, fully integrated systems, specializing in long-life computer products and unique, customer-centric solutions. PDSi’s capability to perform higher-level repair services in-region allows the Company to customize solutions for its customers so that they can deliver world-class service levels to their customers with reduced logistics, component replacement and inventory costs.

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 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 three months ended March 31:

(in thousands)	2011			2010
Sales
Product	$	2,726		$	5,927
Service		3,679			2,885
Total	$	6,405		$	8,812
Gross profit
Product	$	564		$	1,069
Service		1,519			1,080
Total	$	2,083		$	2,149
Income (loss) from operations
Product	$	278		$	704
Service		1,013			652
Other		(1,032	)		(935	)
Total	$	259		$	421

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

(in thousands)	March 31,2011		December 31,2010
Product	$	3,192	$	3,280
Service		5,569		5,443
Other		3,941		3,265
Total	$	12,702	$	11,988

PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

~~March~~June 3130, 2011 and 2010

The following table summarizes ~~sales~~the byCompany’s ~~geographic~~segment ~~region~~operating results for the ~~three months ended~~ ~~March 31~~periods indicated:

(in thousands)	2011			2010
	Three Months Ended June 30,						Six Months Ended June 30,
United States	$	5,603		$	8,041
(in thousands)	2011			2010			2011			2010
International		802			771
Sales
Total	$	6,405		$	8,812
Product	$	2,164		$	4,842		$	4,890		$	10,769
The following table summarizes long-lived assets by geographic region as of the dates indicated:
Service		4,657			3,126			8,336			6,011
(in thousands)	March 31,2011			December 31,2010
Total	$	6,821		$	7,968		$	13,226		$	16,780
United States	$	1,660		$	1,277
Gross profit
International		1,346			1,297
Product	$	286		$	986		$	850		$	2,055
Total	$	3,006		$	2,574
Service		1,958			1,249			3,477			2,329
Total	$	2,244		$	2,235		$	4,327		$	4,384
Income (loss) from operations
Product	$	45		$	660		$	323		$	1,364
Service		1,382			862			2,395			1,514
Other		(1,078	)		(1,122	)		(2,110	)		(2,057	)
Total	$	349		$	400		$	608		$	821

~~International~~The ~~long-lived~~following ~~assets~~table ~~include~~summarizes ~~goodwill~~segment ofassets ~~$0.8 million~~ as of ~~March 31, 2011 and December 31, 2010. All international sales and long-lived assets are in~~ the ~~Service~~dates ~~segment.~~indicated:


(in thousands)	June 30, 2011		December 31, 2010
Product	$	2,690	$	3,280
Service		5,571		5,443
Other		4,836		3,265

Total	$	13,097	$	11,988

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


	Three Months Ended June 30,				Six Months Ended June 30,
(in thousands)	2011		2010		2011		2010
United States	$	5,764	$	7,135	$	11,367	$	15,176
International		1,057		833		1,859		1,604

Total	$	6,821	$	7,968	$	13,226	$	16,780

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


(in thousands)	June 30, 2011		December 31, 2010
United States	$	1,762	$	1,277
International		1,381		1,297

Total	$	3,143	$	2,574

International long-lived assets include goodwill of $0.8 million as of June 30, 2011 and December 31, 2010. All international sales and long-lived assets are in the Service segment.

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”, the “Company” or “we”) achieving its financial growth and profitability goals, or its sales, earnings and profitability expectations for the fiscal year ending December 31, 2011. 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 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 ~~March~~June 3130, 2011 and 2010. This discussion should be read in conjunction with the Company’s audited consolidated financial statements and related notes contained in its 2010 Annual ~~Report~~ Report on Form 10-K.

Executive Overview

PDSi is a global provider of electronics repair and reverse logistics services; system integration and original design manufacturer (“ODM”) computing design and manufacturing services; and embedded computing products and design services for the diversified computing, telecommunications, imaging, defense/aerospace, medical, semiconductor and industrial automation markets. PDSi provides a variety of engineering and manufacturing services for global original equipment manufacturers (“OEMs”) requiring custom product design, system integration, repair programs, warranty management, and/or specialized production capabilities. We have facilities in the United States (“U.S.”), Europe and Asia. More than just an ODM, integrator or reverse logistics provider, PDSi’s engineering, technical and operational capabilities span the entire product lifecycle allowing us to better understand and develop custom solutions for each of our customer’s unique requirements. Our product capabilities range from board-level designs to globally certified, fully integrated systems, specializing in long-life computer products and unique, customer-centric solutions. Our capability to perform higher-level repair services in-region allows us to customize solutions for our customers so that they can deliver world-class service levels to their customers with reduced logistics, component replacement and inventory costs. The common shares of PDSi are traded on NYSE Amex under the stock symbol “PNS.”

During the quarter ended ~~March~~June 3130, 2011, we recorded net income of $~~555~~180,000, or $0.0702 per diluted share, versus net income of $~~309~~300,000, or $0.04 per diluted share, for the prior year quarter. During the six months ended June 30, 2011, we recorded net income of $735,000, or $0.09 per diluted share, versus net income of $609,000, or $0.08 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 ~~March~~June 3130, 2011 and 2010.

Although we periodically ~~have~~had considered the potential tax savings associated with pursuing research and development (“R&D”) tax credits, our then recent operating losses, combined with existing federal U.S. net operating loss (“NOL”) carryforwards, precluded an economical pursuit of such credits. However, based on ~~the~~ positive changes in ~~the~~our ~~Company’s~~ operating results and financial position in 2010, as well as the use of existing NOL carryforwards, ~~management~~we determined during the fourth quarter of 2010 that the benefits would outweigh both the cost of an R&D tax credit study and the establishment of the necessary infrastructure to be able to claim such credits in the future ~~are justified by the resulting benefits~~. Accordingly, ~~the~~we ~~Company~~ recorded a net ~~income~~ tax benefit of $0.5 million during the fourth quarter of 2010 for estimated R&D tax credits for tax years 2001 through 2010 that ~~the~~we ~~Company~~ believed were more likely than not to be sustained upon examination by the Internal Revenue Service. ~~The~~We ~~Company~~ substantially completed the calculation and documentation of these R&D tax credits during the first quarter of 2011, resulting in an additional net ~~income~~ tax benefit of $0.3 million. During the second quarter of 2011, we recorded net tax expense of $0.1 million associated with the finalization of the amended federal and state tax returns for prior years impacted by the R&D tax credit study.

We believe our operating results will continue to show improvement due to several factors. First, 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 through 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.

Results of Operations

Consolidated Operations

~~First~~Second Quarter – 2011 Compared to 2010

The following table summarizes the Company’s consolidated results of operations for the three months ended ~~March~~ June 3130:

(dollars in thousands)	2011			% ofSales			2010		% ofSales			%Change
Sales	$	6,~~405~~821			100.0	%	$	87,~~812~~968		100.0	%		-2714	%
Cost of sales		4,~~322~~577			67.51	%		65,~~663~~733		7572.60	%		-3520	%
Gross profit		2,~~083~~244			32.59	%		2,~~149~~235		2428.40	%		-30	%
Operating expenses		1,~~824~~895			2827.58	%		1,~~728~~835		1923.60	%		63	%
Income from operations		~~259~~349			45.01	%		~~421~~400		45.80	%		-3813	%
Other expense
Interest expense		1—			0.0	%		2318		0.32	%		-96100	%
Income before income taxes		~~258~~349			45.01	%		~~398~~382		4.58	%		-359	%
Income tax expense (benefit)		(297	)		-4.7	%		89		1.0	%		NM
Income tax expense		169			2.4	%		82		1.0	%		106	%
Net income	$	~~555~~180			82.76	%	$	~~309~~300		3.58	%		80-40	%

The ~~increase~~decrease in net income for the three months ended ~~March~~June 3130, 2011 compared to the prior ~~year~~ year quarter primarily was due to the aforementioned net ~~income~~ tax ~~benefit~~expense of $0.31 million ~~related~~associated towith the finalization of the amended federal and state tax returns for prior years impacted by the R&D ~~credits.~~tax ~~Strong~~credit ~~growth~~study as well as increased operating expenses, reflecting investments in ~~the~~personnel ~~Service~~necessary ~~segment~~to ~~offset~~support and grow the ~~impact~~business. ofStrong ~~lower~~growth in sales and gross profit in the ~~Product~~Service segment, ~~while~~offset ~~both~~the ~~segments~~impact ~~posted~~on ~~higher~~ gross profit ~~margins~~of ~~primarily~~lower ~~due~~sales ~~to shifts~~ in ~~mix~~the ~~toward~~Product ~~higher margin business~~segment. Service segment gross profit increased 4157% primarily due to a 2849% increase in Service sales driven by the growth of business in ~~both~~ the U.S. and ~~the~~ Europe, ~~Middle East and Africa (“EMEA”) region~~ for both new customers and new programs within existing customers. ~~Product~~Interest ~~segment~~expense ~~gross~~was ~~profit~~zero ~~fell~~as ~~47% due to a 54% decrease in sales, mostly to OEMs in~~ the ~~telecommunications~~Company ~~sector~~did ~~that~~not ~~had particularly~~utilize ~~strong~~its ~~activity~~line inof ~~early~~credit ~~2010.~~during ~~Increased~~the ~~operating~~second ~~expenses~~quarter ~~reflect~~of ~~investments in personnel needed to support and grow the business~~2011.

For the ~~first~~second quarter of 2011, the Company had three customers that generated $1.37 million, $1.26 million and $1.02 million, or 2125%, 1824% and 1518%, respectively, of total sales. Of the revenues from these customers, 31% and 69% were included in Product and Service segment sales, respectively. For the ~~first~~second quarter of 2010, the Company had three customers that generated $2.5 million, $10.59 million and $10.49 million, or 2832%, 1711% and 1611%, respectively, of total sales. Of the revenues from these customers, 8653% and 1447% were included in Product and Service segment sales, respectively. Major customer relationships consist of multiple product or service programs in various stages of their lifecycle. The Company continues to work toward developing a more diversified customer revenue base across both its Product and Service segments.

Year-to-Date – 2011 Compared to 2010

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


(dollars in thousands)	2011			% of Sales			2010		% of Sales			% Change
Sales	$	13,226			100.0	%	$	16,780		100.0	%		-21	%
Cost of sales		8,899			67.3	%		12,396		73.9	%		-28	%

Gross profit		4,327			32.7	%		4,384		26.1	%		-1	%
Operating expenses		3,719			28.1	%		3,563		21.2	%		4	%

Income from operations		608			4.6	%		821		4.9	%		-26	%
Other expense
Interest expense		1			0.0	%		41		0.2	%		-98	%

Income before income taxes		607			4.6	%		780		4.6	%		-22	%
Income tax expense (benefit)		(128	)		-1.1	%		171		1.0	%		NM

Net income	$	735			5.6	%	$	609		3.6	%		21	%

Higher net income for the first six months of 2011 compared to the prior year period primarily was due to the aforementioned net income tax benefit of $0.2 million related to R&D tax credit adjustments during the first and second quarters of 2011. In addition, strong growth in the Service segment offset the impact of lower sales in the Product segment, with an increase in overall gross profit as a percentage of sales to 33% in 2011 from 26% in 2010 driven by the shift in mix toward higher margin Service segment business. Service segment gross profit increased 49% primarily due to a 39% increase in Service sales driven by the growth of business in the U.S. and Europe for both new customers and new programs within existing customers. The increased operating expenses primarily reflect investments in personnel needed to support and grow the business. Interest expense was reduced to virtually zero due to minimal usage of the Company’s line of credit over the first half of 2011.

For the first six months of 2011, the Company had three customers that generated $3.0 million, $2.8 million and $2.2 million, or 23%, 21% and 17%, respectively, of total sales. Of the revenues from these customers, 31% and 69% were included in Product and Service segment sales, respectively. 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.

Segment Operations

Product

~~First~~Second Quarter – 2011 Compared to 2010

The following table summarizes the Company’s gross profit for the Product segment for the three months ended ~~March~~June 3130:

(dollars in thousands)	2011		% ofSales			2010		% ofSales			%Change
Sales	$	2,~~726~~164		100.0	%	$	54,~~927~~842		100.0	%		-5455	%
Cost of sales		21,~~162~~878		7986.38	%		43,~~858~~856		8279.06	%		-5551	%
Gross profit	$	~~564~~286		2013.72	%	$	~~1,069~~986		1820.04	%		-4771	%

AThe 54decline in Product segment gross profit was driven by a 55% decrease in ~~Product~~ sales,. ~~including~~This ~~$2.8~~decline ~~million~~primarily was attributable to significantly lower sales to ~~OEMs~~telecommunications inand ~~the telecommunications~~defense ~~industry~~OEMs that had ~~particularly~~very strong activity in ~~early 2010, drove~~ the ~~decline~~prior inyear ~~Product~~quarter, ~~segment~~along ~~gross~~with ~~profit.~~declines ~~However,~~at ~~the~~larger ~~continued~~imaging ~~shift~~and inother ~~sales~~OEM ~~mix~~customers tothat ~~higher~~had ~~margin~~occurred ~~products,~~over inthe ~~conjunction~~course ~~with management~~ of ~~manufacturing~~2010. ~~overhead~~Reduced ~~costs~~operating toleverage ~~levels~~on ~~consistent with~~ lower ~~Product~~sales ~~revenues,~~levels resulted in a 2113% gross margin in the ~~first~~second quarter of 2011 compared to 1820% in the comparable quarter of 2010.

Year-to-Date – 2011 Compared to 2010

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


(dollars in thousands)	2011		% of Sales			2010		% of Sales			% Change
Sales	$	4,890		100.0	%	$	10,769		100.0	%		-55	%
Cost of sales		4,040		82.6	%		8,714		80.9	%		-54	%

Gross profit	$	850		17.4	%	$	2,055		19.1	%		-59	%

A 55% decrease in Product sales, including $3.7 million lower sales to OEMs in the telecommunications industry that had especially strong activity in 2010, drove the decline in Product segment gross profit. Lower gross margins, which fell to 17% for the first six months of 2011 compared to 19% in the comparable period of 2010, were mitigated by a continued shift in sales mix to higher margin products and management of manufacturing overhead costs to levels consistent with lower Product revenues.

Service

~~First~~Second Quarter – 2011 Compared to 2010

The following table summarizes the Company’s gross profit for the Service segment for the three months ended ~~March~~June 3130:

(dollars in thousands)	2011		% ofSales			2010		% ofSales			%Change
Sales	$	34,~~679~~657		100.0	%	$	23,~~885~~126		100.0	%		2849	%
Cost of sales		2,~~160~~699		58.70	%		1,~~805~~877		6260.60	%		2044	%
Gross profit	$	1,~~519~~958		4142.30	%	$	1,~~080~~249		3740.40	%		4157	%

Gross profit in the Service segment increased primarily due to the growth of business in ~~both~~ the U.S. and Europe ~~EMEA~~ for both new customers and new programs within existing customers. The continuing shift toward higher margin programs and gains in operating leverage on ~~the 28~~49% sales growth drove an increase in gross profit as a percentage of sales to 41 42% in the second ~~first~~ quarter of 2011 from 3740% in the comparable quarter of 2010.

Year-to-Date – 2011 Compared to 2010

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


(dollars in thousands)	2011		% of Sales			2010		% of Sales			% Change
Sales	$	8,336		100.0	%	$	6,011		100.0	%		39	%
Cost of sales		4,859		58.3	%		3,682		61.3	%		32	%

Gross profit	$	3,477		41.7	%	$	2,329		38.7	%		49	%

The improvement in Service segment gross profit was driven by a 39% increase in Service sales, reflecting business growth in the U.S. and Europe for both new customers and new programs within existing customers. Gross profit as a percentage of sales increased to 42% in the first six months of 2011 from 39% in the comparable period of 2010 due to a continuing shift toward higher margin programs and gains in operating leverage.

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.

Our 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)	~~March~~June 3130,2011			December 31,2010
Line of credit	$	—		$	273
Stockholders’ equity, excluding accumulated other comprehensive income (loss)		9,~~325~~527			8,751
Accumulated other comprehensive income (loss)		(303	)		(90	)
Total stockholders’ equity		9,~~295~~524			8,661
Total capital	$	9,~~295~~524		$	8,934

Based on the Company’s historical cash flow, current financial results and unused available 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 ~~three~~six months ended ~~March~~June 3130:

(in thousands)	2011			2010
Net cash provided by operating activities	$	~~315~~1,282		$	~~529~~1,697
Net cash used in investing activities		(84176	)		(5522	)
Net cash used in financing activities		(~~208~~306	)		(~~748~~1,845	)
Effect of exchange rate on cash		1527			(418	)
Increase (decrease) in cash		38827			(~~278~~188	)
Cash at beginning of period		465			323
Cash at end of period	$	~~503~~1,292		$	45135

Operating Activities

Net cash provided by operating activities was $01.3 million and $01.57 million for the ~~three~~six months ended ~~March~~June 3130, 2011 and 2010, respectively. Net income adjusted for the effects of non-cash items, ~~which~~ which primarily include deferred income taxes, inventory reserves and depreciation expense, resulted in cash inflows of $0.38 million and $0.59 million in the first ~~three~~six months of 2011 and 2010, respectively. Changes in working capital resulted in a$0.5 ~~net~~million ~~neutral~~in ~~impact~~cash provided for the first ~~three~~six months of 2011 ~~and~~compared to $0.8 million for the comparable period of 2010.

Investing Activities

Net cash used in investing activities represents ~~purchases~~additions ofto property and equipment. Increased activity in 2011 primarily relates to acquisitions of equipment needed to support growth and added capability in the Service segment.

Financing Activities

Net cash used in financing activities was $0.2 3 million and $01.78 million for the first ~~three~~six months of 2011 and 2010, 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 any existing balance on the line of credit.

On15 March 24, 2011, we entered into a Credit Agreement and a Security Agreement with Wells Fargo Bank, National Association (“Wells Fargo”), providing for a revolving credit facility (the “Line”) with a maximum line of credit of $3.0 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 accounts receivable located within the United States, plus (b) 75% of the aggregate amount of eligible accounts receivable located outside of the United States, plus (c) the lesser of 10% of the aggregate amount of eligible inventory or $500,000.

On March 24, 2011, we entered into a Credit Agreement and a Security Agreement with Wells Fargo Bank, National Association (“Wells Fargo”), providing for a revolving credit facility (the “Line”) with a maximum line of credit of $3.0 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 accounts receivable located within the United States, plus (b) 75% of the aggregate amount of eligible accounts receivable located outside of the United States, plus (c) the lesser of 10% of the aggregate amount of eligible inventory or $0.5 million.

The outstanding balance on the Line bears interest monthly at a fluctuating annual rate of 3% above the Daily One Month London Interbank Offered Rate. The Line matures on March 22, 2013.

On March 24, 2011, in connection with entering into the Credit Agreement and Security Agreement described above, we terminated our prior line of credit agreement with Wells Fargo. On the date of the termination, the Company made a final payment to Wells Fargo of all unpaid interest, fees, costs and expenses under the prior agreement and an additional $30,000 as collateral security for the Company’s obligations to Wells Fargo under the prior agreement (the “Reserve”). Any balance of the Reserve remaining after 45 days from the date of termination will be returned to the Company. The Company did not incur any early termination penalties in connection with the termination of the prior line of credit agreement.

Off-Balance Sheet Arrangements

We have 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, we may have numerous outstanding purchase orders with vendors to purchase inventory for use in products that are sold to our customers or are used in performing repair services for our customers. We do not record such orders as liabilities on the condensed 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, or when pulled from on-site vendor managed inventory. We have no minimum purchase quantity requirements with any of our 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. Our 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 2010 Annual Report on Form 10-K describes the significant accounting policies and methods used by the Company. We do not expect the adoption of any recently issued accounting standards to have a material impact on our consolidated financial position, results of operations or cash flows. Our critical accounting policies have not changed materially from those disclosed in the Company’s 2010 Annual Report on Form 10-K.

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 ~~first~~second fiscal quarter that has materially affected, or is reasonably likely to materially affect, the Company’s internal control over financial reporting.

1517

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
10.38	Credit Agreement between Pinnacle Data Systems, Inc. and Wells Fargo Bank, National Association, dated March 24, 2011	Current Report on Form 8-K filed with the SEC on March 29, 2011
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, 2011	Contained herein
10.39	Security Agreement between Pinnacle Data Systems, Inc. and Wells Fargo Bank, National Association, dated March 24, 2011	Current Report on Form 8-K filed with the SEC on March 29, 2011
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, 2011	Contained herein
10.40	Revolving Line of Credit Note between Pinnacle Data Systems, Inc. and Wells Fargo Bank, National Association, dated March 24, 2011	Current Report on Form 8-K filed with the SEC on March 29, 2011
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, 2011	Contained herein
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 March 31, 2011	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, 2011	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 March 31, 2011	Contained herein
101.INS*	XBRL Instance Document	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 March 31, 2011	Contained herein
101.SCH*	XBRL Taxonomy Extension Schema Document	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 March 31, 2011	Contained herein
101.CAL*	XBRL Taxonomy Extension Calculation Linkbase Document	Contained herein
101.DEF*	XBRL Taxonomy Definition Linkbase Document	Contained herein
101.LAB*	XBRL Taxonomy Extension Label Linkbase Document	Contained herein
101.PRE*	XBRL Taxonomy Extension Presentation Linkbase Document	Contained herein

16* XBRL (“Extensible Business Reporting Language”) information is furnished and not filed; is not a part of a registration statement or prospectus for purposes of sections 11 or 12 of the Securities Act of 1933; is deemed not filed for purposes of section 18 of the Securities Exchange Act of 1934; and otherwise is not subject to liability under these sections.

SIGNATURES

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

				PINNACLE DATA SYSTEMS, INC.
Date: May 4, 2011				/s/ John D. Bair
Date: July 29, 2011				/s/ John D. Bair
				John D. Bair Chief Executive Officer
				John D. Bair
Date: May 4, 2011				/s/ Nicholas J. Tomashot
				Chief Executive Officer
				Nicholas J. Tomashot Chief Financial Officer
Date: July 29, 2011				/s/ Nicholas J. Tomashot
				Nicholas J. Tomashot
				Chief Financial Officer

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