Pinnacle Data Systems (PNS) 10-Q 2010 Q2 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 June 30, 2010

or

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

For the transition period from                    to                    

Commission file number 1-16103

PINNACLE DATA SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

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

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

No change

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

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

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

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

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

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

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

PINNACLE DATA SYSTEMS, INC.

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

TABLE OF CONTENTS

PART I – FINANCIAL INFORMATION	1
ITEM 1     CONDENSED CONSOLIDATED FINANCIAL STATEMENTS	1
ITEM 2     MANAGEMENT’S DISCUSSIONAND ANALYSISOF FINANCIAL CONDITIONAND RESULTSOF OPERATIONS	9
ITEM 4    CONTROLSAND PROCEDURES	15
PART II – OTHER INFORMATION	16
ITEM 6    EXHIBITS	16
SIGNATURES	17
CERTIFICATIONS	18

PART I – FINANCIAL INFORMATION

ITEM 1 CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

PINNACLE DATA SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

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

See accompanying notes to condensed consolidated financial statements.

1

PINNACLE DATA SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(in thousands, except per share)

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

See accompanying notes to condensed consolidated financial statements.

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, 2008	7,825	$	5,769	$	1,797	$	(57	)	$	1,386		$	8,895
Share-based payment expense	—		—		83		—			—			83
Comprehensive loss, net of taxes:
Net loss	—		—		—		—			(971	)		(971	)
Foreign currency translation	—		—		—		11			—			11
Total comprehensive loss													(960	)
Balance – June 30, 2009	7,825	$	5,769	$	1,880	$	(46	)	$	415		$	8,018
Balance – December 31, 2009	7,825	$	5,769	$	1,912	$	(29	)	$	(2,064	)	$	5,588
Stock issued	14		8		—		—			—			8
Share-based payment expense	—		—		24		—			—			24
Comprehensive income, net of taxes:
Net income	—		—		—		—			609			609
Foreign currency translation	—		—		—		(140	)		—			(140	)
Total comprehensive income													469
Balance – June 30, 2010	7,839	$	5,777	$	1,936	$	(169	)	$	(1,455	)	$	6,089

See accompanying notes to condensed consolidated financial statements.

3

PINNACLE DATA SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)

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

See accompanying notes to condensed consolidated financial statements.

4

PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited)

June 30, 2010 and 2009

1. Basis of Presentation

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

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

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

2. Summary of Significant Accounting Policies

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

Inventory

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

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

3. Recently Issued Accounting Standards

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

5

PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

June 30, 2010 and 2009

4. Line of Credit

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

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

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

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

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

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

5. Income Taxes

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

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

6. Earnings (Loss) Per Share

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

6

PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

June 30, 2010 and 2009

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

	Three Months Ended June 30,		Six Months Ended June 30,
(in thousands)	2010	2009	2010	2009
Weighted average common shares outstanding – basic	7,826	7,825	7,825	7,825
Dilutive effect of stock options	140	—	66	—
Weighted average common shares outstanding – diluted	7,966	7,825	7,891	7,825

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

7. Segment Information

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

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

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

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

7

PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

June 30, 2010 and 2009

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

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

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

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

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

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

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

8

ITEM 2 MANAGEMENT’S DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

SAFE HARBOR STATEMENT

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

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

• changes in customer order patterns;

• changes in our business or our relationship with major technology partners or significant customers;

• failure to maintain adequate levels of inventory;

• production components and service parts cease to be readily available in the marketplace;

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

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

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

• lack of success in technological advancements;

• inability to retain certifications, authorizations or licenses to provide certain products and/or services;

• risks associated with our new business practices, processes and information systems;

• impact of judicial rulings or government regulations, including related compliance costs;

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

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

• other factors from time to time described in the Company’s filings with the United States Securities and Exchange Commission (“SEC”).

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

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

Executive Overview

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

9

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

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

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

Results of Operations

Consolidated Operations

Second Quarter – 2010 Compared to 2009

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

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

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

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

Year-to-Date – 2010 Compared to 2009

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

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

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

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

Segment Operations

Product

Second Quarter – 2010 Compared to 2009

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

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

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

Year-to-Date – 2010 Compared to 2009

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

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

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

Service

Second Quarter – 2010 Compared to 2009

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

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

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

Year-to-Date – 2010 Compared to 2009

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

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

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

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Liquidity and Capital Resources

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

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

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

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

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

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

Operating Activities

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

Investing Activities

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

Financing Activities

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

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

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

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

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

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

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

Off-Balance Sheet Arrangements

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

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

Critical Accounting Policies and Recently Issued Accounting Standards

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

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ITEM 4 CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

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

Changes in Internal Control Over Financial Reporting

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

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PART II – OTHER INFORMATION

ITEM 6. EXHIBITS

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

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SIGNATURES

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

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

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