Pinnacle Data Systems (PNS) 10-Q 2009 Q3 Quarterly report

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 September 30, 2009

or

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

For the transition period from                    to                    

Commission file number 1-16103

PINNACLE DATA SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

Ohio	31-1263732
(State or other jurisdiction of incorporation or organization)	(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 November 12, 2009, the registrant had outstanding 7,825,099 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 SEPTEMBER 30, 2009

TABLE OF CONTENTS

PART I – FINANCIAL INFORMATION	1
ITEM 1     CONDENSED CONSOLIDATED FINANCIAL STATEMENTS	1
ITEM 2     MANAGEMENT’S DISCUSSIONAND ANALYSISOF FINANCIAL CONDITIONAND RESULTSOF OPERATIONS	10
ITEM 4    CONTROLSAND PROCEDURES	18
PART II – OTHER INFORMATION	19
ITEM 6    EXHIBITS	19
SIGNATURES	20
CERTIFICATIONS

PART I – FINANCIAL INFORMATION

ITEM 1 CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

PINNACLE DATA SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

	September 30, 2009			December 31, 2008
	(Unaudited)
ASSETS
CURRENT ASSETS
Cash	$	225		$	282
Accounts receivable, net of allowance for doubtful accounts of $228 and $135, respectively		5,472			11,550
Inventory, net		4,376			5,445
Prepaid expenses and other current assets		192			1,793
Total current assets		10,265			19,070
PROPERTY AND EQUIPMENT
Property and equipment, cost		5,883			5,776
Less accumulated depreciation and amortization		(4,964	)		(4,717	)
Total property and equipment, net		919			1,059
OTHER ASSETS
Goodwill		838			797
Other assets		387			367
Total other assets		1,225			1,164
TOTAL ASSETS	$	12,409		$	21,293
LIABILITIES AND STOCKHOLDERS’ EQUITY
CURRENT LIABILITIES
Line of credit	$	1,729		$	5,408
Accounts payable		2,874			5,156
Unearned revenue		351			138
Other current liabilities		1,200			1,475
Total current liabilities		6,154			12,177
LONG-TERM LIABILITIES
Accrued other		235			221
TOTAL LIABILITIES		6,389			12,398
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; 7,825 shares issued and outstanding		5,769			5,769
Additional paid-in capital		1,934			1,797
Accumulated other comprehensive income (loss)		(9	)		(57	)
Retained earnings (deficit)		(1,674	)		1,386
Total stockholders’ equity		6,020			8,895
TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY	$	12,409		$	21,293

See accompanying notes to condensed consolidated financial statements.

1

PINNACLE DATA SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(in thousands, except per share)

		Three Months Ended September 30,					Nine Months Ended September 30,
		2009			2008		2009			2008
Sales		$	7,050		$	16,098	$	26,975		$	47,556
Cost of sales			5,478			12,871		21,385			38,954
Gross profit			1,572			3,227		5,590			8,602
Operating expenses			2,284			3,122		7,534			9,476
Income (loss) from operations			(712	)		105		(1,944	)		(874	)
Other expense	��
Interest expense			40			64		142			255
Income (loss) before income taxes			(752	)		41		(2,086	)		(1,129	)
Income tax expense (benefit)			1,337			30		974			(432	)
Net income (loss)		$	(2,089	)	$	11	$	(3,060	)	$	(697	)
Basic and diluted earnings (loss) per common share		$	(0.27	)	$	0.00	$	(0.39	)	$	(0.09	)
Basic and diluted weighted average common shares outstanding			7,825			7,823		7,825			7,798

See accompanying notes to condensed consolidated financial statements.

2

PINNACLE DATA SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

(Unaudited)

(in thousands)

	Common Stock			Additional Paid-In Capital		Accumulated Other Comprehensive Income (Loss)			Retained Earnings (Deficit)			Total Stockholders’ Equity
	Outstanding Shares	Amount
Balance – December 31, 2007	7,689	$	5,485	$	1,676	$	—		$	1,747		$	8,908
Stock options exercised	16		13		—		—			—			13
Stock issued	120		271		—		—			—			271
Share-based payment expense	—		—		75		—			—			75
Comprehensive loss, net of taxes:
Net loss	—		—		—		—			(697	)		(697	)
Foreign currency exchange gain	—		—		—		(53	)		—			(53	)
Total comprehensive loss													(750	)
Balance – September 30, 2008	7,825	$	5,769	$	1,751	$	(53	)	$	1,050		$	8,517
Balance – December 31, 2008	7,825	$	5,769	$	1,797	$	(57	)	$	1,386		$	8,895
Share-based payment expense	—		—		137		—			—			137
Comprehensive loss, net of taxes:
Net loss	—		—		—		—			(3,060	)		(3,060	)
Foreign currency exchange gain	—		—		—		48			—			48
Total comprehensive loss													(3,012	)
Balance – September 30, 2009	7,825	$	5,769	$	1,934	$	(9	)	$	(1,674	)	$	6,020

See accompanying notes to condensed consolidated financial statements.

3

PINNACLE DATA SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)

	Nine Months Ended September 30,
	2009			2008
CASH FLOWS FROM OPERATING ACTIVITIES
Net income (loss)	$	(3,060	)	$	(697	)
Adjustments to reconcile net income (loss) to net cash provided by operating activities:
Depreciation and amortization		423			472
Share-based payment expense		137			75
Allowance for doubtful accounts		140			48
Inventory reserves		572			1,182
Deferred income taxes valuation allowance		1,611			—
Provision for deferred income taxes		—			(81	)
(Increase) decrease in assets:
Accounts receivable		5,977			(91	)
Inventory		507			1,016
Prepaid expenses and other assets		433			1
Income taxes receivable		(349	)		(753	)
Increase (decrease) in liabilities:
Accounts payable		(2,237	)		(132	)
Unearned revenue		213			194
Other current liabilities		(288	)		(153	)
Total adjustments		7,139			1,778
Net cash provided by operating activities		4,079			1,081
CASH FLOWS FROM INVESTING ACTIVITIES
Purchases of property and equipment		(237	)		(213	)
Acquisition, net of cash received		—			(937	)
Restricted cash		—			1,200
Net cash provided by (used in) investing activities		(237	)		50
CASH FLOWS FROM FINANCING ACTIVITIES
Net change in line of credit		(3,679	)		3,045
Payment on short-term note payable		—			(4,000	)
Net change in outstanding checks		(73	)		(201	)
Other		(155	)		13
Net cash used in financing activities		(3,907	)		(1,143	)
EFFECT OF EXCHANGE RATE ON CASH		8			4
INCREASE (DECREASE) IN CASH		(57	)		(8	)
Cash at beginning of period		282			54
Cash at end of period	$	225		$	46
SUPPLEMENTAL DISCLOSURE OF CASH FLOW INFORMATION
Common stock issued for acquisition	$	—		$	271

See accompanying notes to condensed consolidated financial statements.

4

PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited)

September 30, 2009 and 2008

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.

On February 20, 2008, the Company acquired all of the equity of Aspan B.V., a private limited liability company located in Tiel, the Netherlands (now known as PDSi B.V., or “PDSi Tiel”). The acquisition was accounted for under the purchase method of accounting. Accordingly, PDSi Tiel’s financial position as of December 31, 2008 and results of operations subsequent to February 16, 2008, the effective date of the transaction, were consolidated with the Company’s financial statements. The Company’s condensed consolidated financial statements include the accounts of PDSi and PDSi Tiel. All significant intercompany balances and transactions have been eliminated.

The preparation of financial statements in conformity with 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. Certain items in the condensed consolidated financial statements and related notes 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 related notes for the year ended December 31, 2008 included in the Company’s 2008 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 2008 Annual Report on Form 10-K. There have been no material changes to these policies since December 31, 2008.

Inventory

The following table summarizes the Company’s inventory as of the dates indicated (net of reserves of $1,904,000 and $2,366,000, respectively, as of September 30, 2009 and December 31, 2008):

(in thousands)	September 30, 2009		December 31, 2008
Component parts (raw materials)	$	3,886	$	4,696
Work-in-process		286		577
Finished goods		204		172
Total inventory	$	4,376	$	5,445

Goodwill

In connection with the acquisition of PDSi Tiel during 2008, the Company recognized the excess of the purchase price over the fair value of identifiable net assets acquired as goodwill. The Company assigned the goodwill to a reporting unit in the Service business segment. Goodwill is not amortized, but is evaluated annually for impairment at the reporting unit level. Goodwill of a reporting unit also is tested for impairment on an interim basis if an event occurs or circumstances change which would more likely than not reduce the fair value of a reporting unit below its carrying amount.

The process of evaluating goodwill for impairment requires several judgments and assumptions to be made to determine the fair value of the reporting units, including the method used to determine fair value, discount rates, and expected levels of revenues and earnings.

5

PINNACLE DATA SYSTEMS, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

Due to the operating losses at the Company and reporting unit levels for the six months ended June 30, 2009, the Company determined that a triggering event had occurred. Accordingly, the Company performed an interim goodwill impairment test during the second quarter of 2009. The Company estimated the implied fair value of goodwill using a net present value methodology dependent on significant assumptions related to estimated future discounted cash flows, capitalization rates and tax rates. The estimated future discounted cash flows used in the Company’s model were based on planned growth with an assumed perpetual growth rate. The capitalization rates were based on the Company’s current cost of debt and equity capital, and tax rates were maintained at current levels. Based on the results of the testing, management determined that no impairment had occurred as of the interim test date.

Management determined that no additional interim impairment testing was warranted during the third quarter of 2009 based on profitability at the reporting unit level for the three months ended September 30, 2009. The Company will perform its annual goodwill impairment testing during the fourth quarter of 2009 based on third quarter 2009 financial information. The Company can provide no assurance that a material impairment charge to goodwill will not occur in a future period. The Company will continue to monitor events and circumstances in future periods to determine whether additional interim impairment testing is warranted.

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 will no longer make specific references to accounting standards. Instead, the Company will disclose the current or potential future 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.

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 in its sole discretion, plus other indebtedness to Wells Fargo which may occur outside of the Credit Agreement.

The outstanding balance on the Line bears interest monthly at an annual rate, as elected by the Company at the time of each credit advancement, of either: (1) a floating rate equal to the greater of 4% and 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 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, a 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, 2009 and September 30, 2009. 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 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.

6

PINNACLE DATA SYSTEMS, Inc.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

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.

On April 3, 2009, in connection with entering into the Credit Agreement described above, the Company terminated the Amended and Restated Loan Agreement by and between the Company and KeyBank National Association (“KeyBank”) dated September 30, 2008 (the “Amended and Restated Loan Agreement”), and as amended by the First Amendment to Amended and Restated Loan Agreement dated December 24, 2008 (the “First Amendment”), and the Second Amendment to Amended and Restated Loan Agreement dated March 26, 2009 (together with the Amended and Restated Loan Agreement and the First Amendment, the “Loan Agreement”).

The Loan Agreement provided for a demand line credit facility in the principal amount of $5.5 million (the “Loan”), subject to borrowing base restrictions. The borrowing base was determined as the sum of: (a) 85% of eligible receivable accounts plus (b) 30% of eligible inventory, but not to exceed $2.5 million. The Loan was evidenced by a Cognovit Promissory Note, and secured by substantially all of the assets of the Company, as provided for in the Security Agreement entered into between the Company and KeyBank on April 8, 2008.

On the date of the termination, the Company made a final payment of all borrowings outstanding under the Loan Agreement. The Company did not incur any early termination penalties in connection with the termination of the Loan Agreement.

5. Income Taxes

Due to the continuing uncertain economic environment and the Company’s pre-tax loss for the nine months ended September 30, 2009, the Company reviewed its net deferred tax assets as of September 30, 2009 to assess the need to establish a valuation allowance. 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 determined that a valuation allowance was required as of September 30, 2009. Accordingly, the Company established a valuation allowance of approximately $1.6 million against its net deferred tax asset balance, resulting in non-cash income tax expense of approximately $1.3 million for the quarter ended September 30, 2009 despite recording a loss before income taxes for the period.

The Company can provide no assurance that an increase in or a release of the deferred tax asset valuation allowance will not be required in the future. The Company will continue to monitor events and circumstances in future periods to determine whether an increase in the valuation allowance is warranted or if the valuation allowance should be released based on sustained future profitability.

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. As a result of the Company’s net losses for the three-month and nine-month periods ended September 30, 2009 and the nine-month period ended September 30, 2008, the effect of potential common shares arising from share-based employee compensation plans would have been anti-dilutive and thus were excluded from the computation of diluted EPS for those periods. In addition, there were no dilutive stock options outstanding during the three months ended September 30, 2008.

7

PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

7. Segment Information

The Company’s reportable segments are Product and Service. The Product segment includes embedded computing hardware products, ranging from board-level products to fully integrated systems. The Service segment includes service programs provided to global original equipment manufacturers, including depot repair, warranty management, screening and testing, and remanufacturing. 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 engineering, finance, human resources, quality systems and executive management. The Company evaluates Product and Service segment performance based on (1) operating results; (2) effectiveness in covering the other administrative expenses of the Company; and (3) contribution to earnings per share. The Company sells its products and services in the U.S. 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 Ended Sept. 30,						Nine Months Ended Sept. 30,
(in thousands)	2009			2008			2009			2008
Sales
Product	$	4,126		$	13,315		$	19,211		$	39,117
Service		2,924			2,783			7,764			8,439
Total	$	7,050		$	16,098		$	26,975		$	47,556
Gross profit
Product	$	724		$	2,562		$	3,157		$	6,662
Service		848			665			2,433			1,940
Total	$	1,572		$	3,227		$	5,590		$	8,602
Income (loss) from operations
Product	$	63		$	1,577		$	1,013		$	3,587
Service		225			263			735			575
Other		(1,000	)		(1,735	)		(3,692	)		(5,036	)
Total	$	(712	)	$	105		$	(1,944	)	$	(874	)

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

(in thousands)	September 30, 2009		December 31, 2008
Product	$	5,410	$	9,780
Service		5,364		8,477
Other		1,635		3,036
Total	$	12,409	$	21,293

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

	Three Months Ended Sept. 30,				Nine Months Ended Sept. 30,
(in thousands)	2009		2008		2009		2008
United States	$	6,018	$	14,806	$	24,306	$	43,853
International		1,032		1,292		2,669		3,703
Total	$	7,050	$	16,098	$	26,975	$	47,556

8

PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

September 30, 2009 and 2008

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

(in thousands)	September 30, 2009		December 31, 2008
United States	$	599	$	665
International		1,545		1,558
Total	$	2,144	$	2,223

International long-lived assets include goodwill of $838,000 and $797,000 as of September 30, 2009 and December 31, 2008, respectively.

8. Subsequent Events

The Company evaluated subsequent events through November 16, 2009, the date these condensed consolidated financial statements were filed with the SEC, and determined that none required disclosure.

9

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, 2009. 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 nine months ended September 30, 2009 and 2008. This discussion should be read in conjunction with the Company’s audited consolidated financial statements and related notes contained in its 2008 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 and products that contain computer hardware. We serve customers in the telecommunications, imaging, defense/aerospace, medical, semiconductor, industrial automation and information technology markets. We provide a variety of engineering, manufacturing and reverse logistics services for our global OEM customers, including custom product design, system integration, repair programs, warranty management and specialized production capabilities. With service centers in the United States, Europe and Asia, PDSi ensures seamless support for the Company’s solutions all around the world. In addition, our product capabilities range from board-level designs to globally certified, fully integrated systems. Our specialties include long-life computer products and unique, customer-centric solutions. The common shares of PDSi are traded on NYSE Amex under the stock symbol “PNS.”

10

During the first nine months of 2009, ongoing U.S. and global economic conditions continued to negatively affect our existing multi-national OEM customers, and therefore, our business and operating results. As a result, we expect continued lower sales during the fourth quarter of 2009 compared to 2008, and we have continued to adjust our cost structure accordingly. We expect to mitigate the impact of lower Product segment sales by focusing on our core Service segment business and current Product segment offerings, reducing our investment in new embedded product development and sales, and flattening our organization structure to reduce overhead costs. However, we are fully supporting our current products and customer programs, as well as maintaining the ability to upgrade those products for their current use. We will focus our sales and marketing efforts in the Service segment and on specialized product integration programs where our highly valued engineering and operational expertise give us distinct competitive advantages. Nevertheless, difficult economic conditions may continue to materially adversely affect the Company’s results of operations, financial condition and cash flows.

The Company reported a net loss of $2,089,000, or $0.27 per diluted share, during the quarter ended September 30, 2009 compared to net income of $11,000, or $0.00 per diluted share, for the prior year quarter. The Company reported a net loss of $3,060,000, or $0.39 per diluted share, during the nine months ended September 30, 2009 versus a net loss of $697,000, or $0.09 per diluted share, for the prior year period. The current year results include the impact of a non-cash deferred tax asset valuation allowance of approximately $1.6 million, or $0.21 per diluted share, recorded during the third quarter of 2009. See below for further discussion of consolidated and reportable segment results of operations for the three-month and nine-month periods ended September 30, 2009 and 2008.

Due to the continuing uncertain economic environment and the Company’s pre-tax loss for the nine months ended September 30, 2009, the Company reviewed its net deferred tax assets as of September 30, 2009 to assess the need to establish a valuation allowance. 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 determined that a valuation allowance was required as of September 30, 2009. Accordingly, the Company established a valuation allowance of approximately $1.6 million against its net deferred tax asset balance, resulting in non-cash income tax expense of approximately $1.3 million for the quarter ended September 30, 2009 despite recording a loss before income taxes for the period.

We believe our operating results will improve as gross profit and operating margins increase due to several factors. First, 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. In addition, we have managed the Company’s overhead cost structure to focus resources and investment on developing our core services and current product businesses. Gross margins will vary from program to program, and the mix of programs will vary each quarter, driving 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 up over the next few years.

Consistent with the Company’s goals of developing new business and providing more cost effective in-region services, we successfully completed the acquisition of all of the equity of Aspan B.V., a private limited liability company located in Tiel, the Netherlands (now known as PDSi B.V., or “PDSi Tiel”), during the first quarter of 2008. See Note 4 and Note 10 to the consolidated financial statements included in the Company’s 2008 Annual Report on Form 10-K for additional information related to the acquisition of PDSi Tiel and the related private equity financing, respectively.

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Results of Operations

Consolidated Operations

Third Quarter – 2009 Compared to 2008

The following table summarizes the Company’s consolidated results of operations for the periods indicated:

	Three Months Ended September 30,
	2009			% of Sales		2008		% of Sales		% Change
Sales	$	7,050		100.0	%	$	16,098	100.0	%	-56	%
Cost of sales		5,478		77.7	%		12,871	80.0	%	-57	%
Gross profit		1,572		22.3	%		3,227	20.0	%	-51	%
Operating expenses		2,284		32.4	%		3,122	19.4	%	-27	%
Income (loss) from operations		(712	)	-10.1	%		105	0.7	%	NM
Other expense
Interest expense		40		0.6	%		64	0.4	%	-38	%
Income (loss) before income taxes		(752	)	-10.7	%		41	0.3	%	NM
Income tax expense (benefit)		1,337		19.0	%		30	0.2	%	NM
Net income (loss)	$	(2,089	)	-29.6	%	$	11	0.1	%	NM

The Company recorded a net loss for the quarter ended September 30, 2009 compared to net income in the prior year quarter. The loss from operations was driven by a 51% decline in gross profit primarily due to lower Product segment sales. In addition, the current year quarter was impacted by the aforementioned non-cash deferred tax valuation allowance of approximately $1.6 million recorded as income tax expense in the current year. These factors partially were offset by a 27% decrease in operating expenses reflecting cost reduction actions taken over the last several quarters, a 28% increase in Service segment gross profit driven by higher sales in the U.S, and lower interest expense.

For the third quarter of 2009, the Company had one customer that generated $2.6 million, or 37%, of total sales. Of the revenues from this customer, 78% and 22% were included in Product and Service segment sales, respectively. For the third quarter of 2008, the Company had two customers that generated $7.3 million and $2.0 million, or 45% and 13%, respectively, of total sales. Of the revenues from these customers, 92% and 8% were included in Product and Service segment sales, respectively.

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Year-to-Date – 2009 Compared to 2008

The following table summarizes the Company’s consolidated results of operations for the periods indicated:

	Nine Months Ended September 30,
	2009			% of Sales		2008			% of Sales		% Change
Sales	$	26,975		100.0	%	$	47,556		100.0	%	-43	%
Cost of sales		21,385		79.3	%		38,954		81.9	%	-45	%
Gross profit		5,590		20.7	%		8,602		18.1	%	-35	%
Operating expenses		7,534		27.9	%		9,476		19.9	%	-20	%
Income (loss) from operations		(1,944	)	-7.2	%		(874	)	-1.8	%	NM
Other expense
Interest expense		142		0.5	%		255		0.5	%	-44	%
Income (loss) before income taxes		(2,086	)	-7.7	%		(1,129	)	-2.4	%	NM
Income tax expense (benefit)		974		3.6	%		(432	)	-0.9	%	NM
Net income (loss)	$	(3,060	)	-11.3	%	$	(697	)	-1.5	%	NM

The higher net loss for the nine months ended September 30, 2009 compared to the prior year period was driven by a 53% decline in Product segment gross profit due to a comparable decrease in sales. In addition, the current year includes the impact of the aforementioned non-cash deferred tax valuation allowance of approximately $1.6 million recorded as income tax expense during the third quarter of 2009. The prior year period also includes the impact of a one-time non-cash inventory valuation adjustment totaling $720,000 pre-tax in the second quarter of 2008. Reduced operating expenses, a 25% increase in Service segment gross profit and lower interest expense partially offset the decline in Product segment performance during the first nine months of 2009.

For the first nine months of 2009, the Company had two customers that generated $9.1 million and $4.3 million, or 34% and 16%, respectively, of total sales. Of the revenues from these customers, 86% and 14% were included in Product and Service segment sales, respectively. For the first nine months of 2008, the Company had two customers that generated $20.4 million and $7.0 million, or 43% and 15%, respectively, of total sales. Of the revenues from these customers, 90% and 10% were included in Product and Service segment sales, respectively.

Segment Operations

Product

Third Quarter – 2009 Compared to 2008

The following table summarizes the Company’s gross profit for the Product segment for the periods indicated:

	Three Months Ended September 30,
	2009		% of Sales		2008		% of Sales		% Change
Sales	$	4,126	100.0	%	$	13,315	100.0	%	-69	%
Cost of sales		3,402	82.5	%		10,753	80.8	%	-68	%
Gross profit	$	724	17.5	%	$	2,562	19.2	%	-72	%

Product segment gross profit decreased primarily due to lower sales driven by softening demand from existing large accounts in the imaging and telecommunications industries. This factor, combined with our reduced focus on lower margin business, accounted for approximately $4.8 million of the decline in Product sales. In addition, gross profit as a percentage of sales declined due to lower fixed cost coverage despite an improved mix of business toward higher margin products, reductions in overhead expenses in response to reduced sales levels, and margin improvements on existing products.

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Year-to-Date – 2009 Compared to 2008

The following table summarizes the Company’s gross profit for the Product segment for the periods indicated:

	Nine Months Ended September 30,
	2009		% of Sales		2008		% of Sales		% Change
Sales	$	19,211	100.0	%	$	39,117	100.0	%	-51	%
Cost of sales		16,054	83.6	%		32,455	83.0	%	-51	%
Gross profit	$	3,157	16.4	%	$	6,662	17.0	%	-53	%

Product segment gross profit declined primarily due to lower sales attributable to softening demand from existing large accounts in the imaging and telecommunications industries. This factor, combined with our reduced focus on lower margin business, accounted for approximately $14.0 million of the decline in Product sales. Lower demand in the telecommunications sector further contributed to the shortfall. The prior year period also includes the impact of the inventory valuation adjustment in the second quarter of 2008 described previously. Excluding this adjustment, gross profit as a percentage of sales declined to 16% in 2009 from an adjusted 19% in 2008, reflecting the timing of overhead cost reductions in the current year in response to lower overall sales levels. In addition, a favorable product mix in the first quarter of 2008 included a high-margin end-of-life sale to a large OEM.

Service

Third Quarter – 2009 Compared to 2008

The following table summarizes the Company’s gross profit for the Service segment for the periods indicated:

	Three Months Ended September 30,
	2009		% of Sales		2008		% of Sales		% Change
Sales	$	2,924	100.0	%	$	2,783	100.0	%	5	%
Cost of sales		2,076	71.0	%		2,118	76.1	%	-2	%
Gross profit	$	848	29.0	%	$	665	23.9	%	28	%

Higher Service segment gross profit primarily was driven by the increase in overall sales. In addition, ongoing operational efficiency gains, our continued shift toward higher margin sales, and improved margins on existing business contributed to the improvement in gross profit as a percentage of sales.

Year-to-Date – 2009 Compared to 2008

The following table summarizes the Company’s gross profit for the Service segment for the periods indicated:

	Nine Months Ended September 30,
	2009		% of Sales		2008		% of Sales		% Change
Sales	$	7,764	100.0	%	$	8,439	100.0	%	-8	%
Cost of sales		5,331	68.7	%		6,499	77.0	%	-18	%
Gross profit	$	2,433	31.3	%	$	1,940	23.0	%	25	%

The increase in Service segment gross profit primarily was due to ongoing improvements in the operational efficiency of this segment, combined with our continued shift toward higher margin sales and improved margins on existing business. Lower Service sales were driven by customers working off service spares inventories in the first half of 2009 in response to slower global economic activity, partially offset by the 5% year-over-year increase in sales in the third quarter of 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)	September 30, 2009			December 31, 2008
Line of credit	$	1,729		$	5,408
Stockholders’ equity, excluding accumulated other comprehensive income (loss)		6,029			8,952
Accumulated other comprehensive income (loss)		(9	)		(57	)
Total stockholders’ equity		6,020			8,895
Total capital	$	7,749		$	14,303

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 tables summarize the Company’s condensed consolidated cash flows for the nine months ended September 30:

(in thousands)	2009			2008
Net cash provided by operating activities	$	4,079		$	1,081
Net cash provided by (used in) investing activities		(237	)		50
Net cash used in financing activities		(3,907	)		(1,143	)
Effect of exchange rate on cash		8			4
Increase (decrease) in cash		(57	)		(8	)
Cash at beginning of period		282			54
Cash at end of period	$	225		$	46

Operating Activities

Net cash provided by operating activities was $4.1 million for the first nine months of 2009 compared to $1.1 million for the comparable period of 2008. Net income (loss) adjusted for the effects of non-cash items, which primarily include provision for deferred income taxes, depreciation expense and inventory reserves, totaled ($0.2) million and $1.0 million in the first nine months of 2009 and 2008, respectively. Changes in working capital provided net cash of $4.3 million for the first nine months of 2009 compared to $0.1 million for the comparable period of 2008. Lower accounts receivable, inventory and accounts payable in 2009 generally reflect declining sales volumes and overall business activity compared to the prior year period.

Investing Activities

Net cash used in investing activities was $0.2 million for the first nine months of 2009 compared to net cash provided by investing activities of $0.1 million for the comparable period of 2008. The Company used $1.2 million in proceeds from a private equity transaction to acquire PDSi Tiel in February 2008. The private equity funds were placed in escrow in December 2007 and classified as restricted cash. During the first quarter of 2008 the restricted cash was released, and $0.9 million was paid to acquire PDSi Tiel.

Financing Activities

Net cash used in financing activities was $3.9 million for the first nine months of 2009 compared to $1.1 million for the comparable period of 2008. Financing activity in the current year period primarily related to net repayments on the Company’s lines of credit. In the prior year period, the net $1.1 million in cash used in financing activities included the Company’s repayment of a $4.0 million short-term note and $3.0 million in net borrowings on its line of credit to support the Company’s working capital requirements.

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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 in its sole discretion, plus other indebtedness to Wells Fargo which may occur outside of the Credit Agreement.

The outstanding balance on the Line bears interest monthly at an annual rate, as elected by the Company at the time of each credit advancement, of either: (1) a floating rate equal to the greater of 4% and 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 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, a 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. 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 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.

On April 3, 2009, in connection with entering into the Credit Agreement described above, the Company terminated the Amended and Restated Loan Agreement by and between the Company and KeyBank National Association (“KeyBank”) dated September 30, 2008 (the “Amended and Restated Loan Agreement”), and as amended by the First Amendment to Amended and Restated Loan Agreement dated December 24, 2008 (the “First Amendment”), and the Second Amendment to Amended and Restated Loan Agreement dated March 26, 2009 (together with the Amended and Restated Loan Agreement and the First Amendment, the “Loan Agreement”).

The Loan Agreement provided for a demand line credit facility in the principal amount of $5.5 million (the “Loan”), subject to borrowing base restrictions. The borrowing base was determined as the sum of: (a) 85% of eligible receivable accounts plus (b) 30% of eligible inventory, but not to exceed $2.5 million. The Loan was evidenced by a Cognovit Promissory Note, and secured by substantially all of the assets of the Company, as provided for in the Security Agreement entered into between the Company and KeyBank on April 8, 2008.

On the date of the termination, the Company made a final payment of all borrowings outstanding under the Loan Agreement. The Company did not incur any early termination penalties in connection with the termination of the Loan Agreement.

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.

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Critical Accounting Policies and Recently Issued Accounting Standards

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 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 2008 Annual Report on Form 10-K describes the significant accounting policies and methods used by the Company. SeePart I – Financial Information, Item 1 – Condensed Consolidated Financial Statements, Note 3 – Recently Issued Accounting Standards for a summary of recently issued accounting standards. The Company’s critical accounting policies have not changed materially from those disclosed in the Company’s 2008 Annual Report on Form 10-K. However, disclosed below are the results of the Company’s interim goodwill impairment test performed as of June 30, 2009.

Goodwill

In connection with the acquisition of PDSi Tiel during 2008, the Company recognized the excess of the purchase price over the fair value of identifiable net assets acquired as goodwill. The Company assigned the goodwill to a reporting unit in the Service business segment. Goodwill is not amortized, but is evaluated annually for impairment at the reporting unit level. Goodwill of a reporting unit also is tested for impairment on an interim basis if an event occurs or circumstances change which would more likely than not reduce the fair value of a reporting unit below its carrying amount.

The process of evaluating goodwill for impairment requires several judgments and assumptions to be made to determine the fair value of the reporting units, including the method used to determine fair value, discount rates, and expected levels of revenues and earnings.

Due to the operating losses at the Company and reporting unit levels for the six months ended June 30, 2009, the Company determined that a triggering event had occurred. Accordingly, the Company performed an interim goodwill impairment test during the second quarter of 2009. The Company estimated the implied fair value of goodwill using a net present value methodology dependent on significant assumptions related to estimated future discounted cash flows, capitalization rates and tax rates. The estimated future discounted cash flows used in the Company’s model were based on planned growth with an assumed perpetual growth rate. The capitalization rates were based on the Company’s current cost of debt and equity capital, and tax rates were maintained at current levels. Based on the results of the testing, management determined that no impairment had occurred as of the interim test date.

Management determined that no additional interim impairment testing was warranted during the third quarter of 2009 based on profitability at the reporting unit level for the three months ended September 30, 2009. The Company will perform its annual goodwill impairment testing during the fourth quarter of 2009 based on third quarter 2009 financial information. The Company can provide no assurance that a material impairment charge to goodwill will not occur in a future period. The Company will continue to monitor events and circumstances in future periods to determine whether additional interim impairment testing is warranted.

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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 third 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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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
4	Instruments defining the rights of security holders, including indentures	Registration Statement on Form 10-SB filed with the SEC on December 13, 1999
10.1	Credit and Security Agreement between Pinnacle Data Systems, Inc. and Wells Fargo Bank, National Association dated April 3, 2009	Current Report on Form 8-K filed with the SEC on April 9, 2009
10.2	Revolving Note between Pinnacle Data Systems, Inc. and Wells Fargo Bank, National Association dated April 3, 2009	Current Report on Form 8-K filed with the SEC on April 9, 2009
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 September 30, 2009	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 September 30, 2009	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 September 30, 2009	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 September 30, 2009	Contained herein

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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: November 16, 2009	/s/    John D. Bair
	John D. Bair President and Chief Executive Officer
Date: November 16, 2009	/s/    Nicholas J. Tomashot
	Nicholas J. Tomashot Chief Financial Officer

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