Summary of PINNACLE DATA SYSTEMS INC

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:

Х 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;

Х changes in customer order patterns;

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

Х failure to maintain adequate levels of inventory;

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

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

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

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

Х lack of success in technological advancements;

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

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

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

Х 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;

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

Х 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, 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 specialized embedded computing products and manufacturing services for original equipment manufacturers ("OEMs") of computer hardware products and products that contain computer hardware. The common shares of PDSi are traded on NYSE Amex under the stock symbol "PNS." We offer a wide range of technology platforms, including standard and custom-designed products for the defense/aerospace, telecommunications, 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. We also provide a variety of engineering, manufacturing and reverse logistics services for our global product 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, as well as depot repair and reverse logistics programs for the OEMs of other types of computer equipment.

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During the first six 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 2009 compared to 2008, and have adjusted our cost structure accordingly. We expect to mitigate the impact of lower sales by continuing to focus on higher margin embedded products sold into the defense industry and service business, both of which are less affected by these economic conditions, as well as through labor and facilities cost reduction initiatives. However, 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 $270,000, or $0.03 per diluted share, during the quarter ended June 30, 2009 compared to a net loss of $972,000, or $0.12 per diluted share, for the prior year quarter. The Company reported a net loss of $971,000, or $0.12 per diluted share, during the six months ended June 30, 2009 versus a net loss of $708,000, or $0.09 per diluted share, for the prior year period. See below for further discussion of consolidated and reportable segment results of operations for the three-month and six-month periods ended June 30, 2009 and 2008.

The Company is continuing to take actions to improve operating efficiencies and future results of operations. During the first quarter of 2009, we divided our business development and engineering organizations into two primary groups - the Embedded Products Group and the Services Group. This strategy allows us to vertically align our resources, with each group targeting specific industries and customers with a defined set of products and services. In addition, we believe our alignment of sales and technical resources provides more focus on development of new business opportunities, while providing our customers with better service and responsiveness. This realignment of resources did not change the Company's reportable segments.

We believe our operating results will improve as gross profit margins increase due to several factors. First, we expect the continued decline of lower margin integration business. In addition, we anticipate organic growth through new embedded product and related service offerings sold to current and new customers in markets in which higher value is rewarded with higher margins. Lastly, we expect our global service business to continue to grow. 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.

While the Company continues to evaluate viable acquisition opportunities, currently we do not anticipate any acquisitions in 2009.

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