Pinnacle Data Systems, Inc.

(Exact name of small business issuer in its charter)

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

Securities registered under Section 12(b) of the Exchange Act:

Securities registered under Section 12(g) of the Exchange Act:

None

Indicate by check mark whether the Issuer (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 Issuer was required to file such reports), and (2) has been subject to such filing requirements for the past 90 days.    Yes   x     No   ¨

Check if disclosure of delinquent filers in response to Item 405 of Regulation S-B is not contained in this form, and no disclosure will be contained, to the best of Issuer’s knowledge, in definitive proxy or information statements incorporated by reference in Part III of this Form 10-KSB or any amendment to this Form 10-KSB.   ¨

State Issuer’s revenues for its most recent fiscal year. $34,397,490

The aggregate market value of the voting and non-voting common equity held by non-affiliates, computed on the basis of the closing sale price on the American Stock Exchange of the common shares as of February 11, 2005, was $17,730,738.

On February 11, 2005, the Issuer had outstanding 5,757,806 common shares without par value, which is the Issuer’s only class of common equity.

Documents Incorporated by Reference

Portions of the Registrant’s Definitive Proxy Statement to be filed for its 2005 Annual Meeting of Shareholders are incorporated by reference into Part III of this Annual Report on Form 10-KSB.

TABLE OF CONTENTS

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INFORMATION REGARDING FORWARD-LOOKING STATEMENTS. Portions of this Annual Report on Form 10-KSB (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. The words “believe,” “expect,” “anticipate,” “estimate,” “project,” “should,” and similar expressions identify forward-looking statements that speak only as of the date thereof. 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. The most significant of such risks, uncertainties and other factors are described in Item 6 of this Form 10-KSB and under the section entitled “Risk Factors” on Page 20. The Company undertakes no obligations to publicly update or revise such statements.

 
PART I

 
Item 1. Description of Business

Business Development

Pinnacle Data Systems, Inc. (“PDSi”) is a corporation incorporated under the laws of the State of Ohio in March 1989.

Business of Issuer

Pinnacle Data Systems, Inc. (“PDSi” or the “Company”) provides product lifecycle service solutions to Original Equipment Manufacturers (“OEMs”) in the medical, telecommunications, defense, imaging and computer equipment industries, among others. We offer a full range of computer and computer-related product development and manufacturing services to increase product speed to market and engineered product life, and to provide service and support to units in the field through comprehensive product lifecycle management programs encompassing depot repair, advanced exchange, contact center support and end-of-life control.

Our business model has a foundation of technical service and support programs (“Service”), such as the depot repair and logistics programs we provide the field service organizations of OEMs like Sun Microsystems. The service base provides resources for the development and sale of high-potential engineered computer solutions for specific customers and niche-industry applications (“Product”). For the 2004 year, we reported revenue of $34.4 million, net earnings of $884,000, and total assets of $10.4 million. Approximately 82% of our 2004 revenue was generated from Products and 18% from Services.

Our products are custom-engineered to meet specific customer or niche-industry requirements that generally cannot be met by an off-the-shelf solution. They are sold to OEMs and then typically resold to end-users as components of the OEMs’ final products. Our products are

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usually developed as a result of helping OEMs design, engineer, manufacture, assemble, modify, and/or integrate computer systems or components to fit their specific application needs. Many of our products are based on the high performance computer processing technologies of Sun Microsystems, Inc. (“Sun”), Intel Corporation (“Intel”) and Advanced Micro Devices, Inc. (“AMD”), three of world’s leading producers of computer components and systems. We combine their products and other vendor off-the-shelf computer components or peripherals with technologies that we engineer and develop, such as customized circuit boards, enclosures, power supplies and other engineered components and software. By leveraging our expertise and experience in engineering and integrating our internally developed products with Sun, Intel, AMD and other vendors’ technologies, we are able to offer product solutions with minimal product design and engineering costs to our customers.

Our end-of-life product management service allows our customers to maximize their investment in technology by providing continued support for products no longer in production or supported by the original manufacturer. This allows our customers to eliminate or delay the engineering, software development and re-certification charges required to integrate new technology into their products. For example, when a computer board manufacturer stops manufacturing a particular board, its customer OEMs are left with few alternative sources for the boards they need to continue building or repairing their products. We can provide the boards, purchased from a number of available sources, either new or refurbished, or we can redesign a new board with the same form, fit and function with components that are readily available at the time.

We are a SunSoft Master Distributor authorized to provide its customers with the right to use Solaris, Sun Microsystem’s UNIX operating system. We are an authorized Intel Product Dealer and have earned Intel Premier Provider status for our distinct level of competency with Intel technologies. We are an authorized AMD Solution Provider. We are the North American reseller of Agilent remote diagnostic solutions, selected for our engineering and design capabilities. We are an authorized HP Business Development Partner. We are also licensed by Microsoft to distribute embedded Microsoft operating systems.

We also offer complete service and support for several OEMs’ products, as well as our own, including testing, repair, inventory and logistics services. Depot repair and testing services are provided for advanced technology systems, printed circuit board assemblies, and other computer peripherals and components, where the suspect non-functioning equipment is sent to our designated depot location for testing and repair, if required. We also manage “advanced-exchange” repair programs. Our highest volume testing and repair is performed on complex printed circuit boards and electro-mechanical data storage devices for Sun, Hewlett-Packard Company (H-P) and Silicon Graphics, Inc. (SGI), and on standard PC configurations for a home-based computer learning program. For our largest OEM customers, we maintain and share online information management systems that seamlessly connect our companies.

We consider our Products and Services segments to be complementary. New product development keeps our engineers and service technicians on the forefront of technologies being sold that generate new service opportunities. Our services provide a competitive advantage in selling our products since the entire infrastructure is already in place to provide high quality service and support before and after the sale.

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Public Announcement Updates

During 2004, we made a number of public announcements. The current status of each is as follows:

Pinnacle Data Systems Expands Service Offerings with Netherlands-Based Kender-Thijssen – We are jointly pursuing turnkey repair and logistics programs with current and potential OEM customers requiring strategic geographic presences in both North America and Europe.

A new relationship with Solid Information Technology Corp. – Disclosed in the first quarter earnings release, we continue working together to develop and provide PDSi hardware platforms with Solid high availability databases for common customers.

PDSi named a partner provider in Sun Microsystems’ Network Equipment Provider program – Disclosed in the first quarter earnings release, this affiliation has resulted in a multi-year contract for lifecycle extension and end-of-life services for a world-leading telecommunications equipment provider. PDSi remains very active in this program.

Authorization as a Hewlett-Packard Business Development Partner – Disclosed in the second quarter earnings release, this reseller program offers certain discounts to its members and PDSi has sold a number of H-P systems and taken advantage of its benefits.

Membership in the Intel ^® Communications Alliance – Disclosed in the second quarter earnings release, this membership provides additional marketing and partnering opportunities in the telecommunications industry with this world-leading computer chip and board manufacturer.

The commencement of a significant hardware management program for a home-based learning program – Disclosed in the second quarter earnings release, this program contributed almost $1.8 million in 2004 sales.

PDSi Earns ISO 13485 Registration to Expand Support for Medical Device Manufacturers – This accomplishment resulted in a number of new and current customers moving active programs to PDSi. Among them have been some of the world’s leading medical equipment manufacturers.

Sun Microsystems Presents Pinnacle Data Systems with Best in Class Award for Outstanding Performance in Repair and Logistics Support. - Although Sun repair program revenue declined approximately 17% in 2004, this award has influenced Sun’s decisions to award us new repair programs that should increase repair program revenue in 2005. Sun has provided a number of new product opportunities that have already generated, or are expected to generate, significant revenue in 2005 and beyond.

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Silicon Graphics Awards Repair to Pinnacle Data Systems – This multi-year agreement designates us as Silicon Graphic’s primary source for board repair. Revenue from this program began in the fourth quarter of 2004 and is expected to grow throughout 2005.

Competition

Competition for our custom-engineered products comes from three primary sources: (1) other electronic contract manufacturing companies (“ECMs”) that provide similar engineering and manufacturing services, (2) other value-added computer resellers (“VARs”) and (3) less expensive off-the-shelf products.

We market our customized services and products to specific customers and niche-industries. This reduces competition from larger ECMs (Flextronics, Solectron, Plexus and others) because of the costs involved for them to run the smaller manufacturing volumes typical of these orders. The level of engineering complexity and after-the-sale service and support on some products reduces competition from VARs of all levels of size and geographic coverage. We believe we differentiate ourselves from other competitors through the strength of our close relationships with our very large OEM partners (Sun, Intel, AMD, Agilent, H-P and others), our ability to offer and deliver complete turnkey solutions in relatively short development cycles, our unique product set and our full service-after-the-sale offering. However, a number of our competitors are more established and have substantially greater technical, manufacturing, marketing and financial resources to develop and market their engineering and manufacturing services or their off-the-shelf products.

The primary competitive factors in the electronic equipment service industry are price, quality and scope of services (based on in-house technical expertise). We compete with the in-house repair centers of OEMs, Third Party Maintenance providers (“TPMs”), ECMs and other independent depot repair organizations similar to ours. We believe we differentiate ourselves by offering complete packaged solutions backed up by a broad scope of repair and logistics service offerings, including our experience with a wide variety of technologies and very large, well-known and demanding OEM customers, flexibility in tailoring our operating procedures to fulfill stringent quality, documentation and reporting requirements, and offering the most cost-effective solutions to fulfill our customers’ service needs. However, a number of our competitors are more established and have substantially greater technical, manufacturing, marketing and financial resources to develop and market similar services.

Suppliers

During 2004, approximately 47% of all inventory purchased was manufactured by or for Sun and was purchased directly from Sun or through Sun’s distribution channel. We believe all critical production components and service parts, or suitable substitutes, are readily available in the marketplace from multiple manufacturers and/or suppliers, new or refurbished, as required by our current customers’ demands.

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Customers

A significant amount of our sales come from a relatively small number of large customers. A major strategic focus continues to be further growth and diversification of our customer base. In 2004, we provided services and/or products to ten Fortune Global 500 companies and two Fortune 1000 companies compared to eight Fortune Global 500 companies and four Fortune 1000 companies in 2003.

Our four largest customers generated about 52%, 59% and 70% of sales, respectively, for the years 2004, 2003 and 2002. In 2004, no one customer generated more than 17% of our sales compared to 27% the prior year.

Six, nine and four customers, respectively, generated approximately 82% of our product sales for the years 2004, 2003 and 2002. Two customers generated 73%, 82% and 95% of sales, respectively, for the years 2004, 2003 and 2002.

We’ve made much progress in diversifying our customer base. However, the Company’s relatively small number of customers can create significant sales volatility. If the sales generated by either of our top two service customers declined significantly, or if product sales of our top product customers declined significantly without additional service or product business to replace it, the results of our operations could be materially and adversely affected.

Patents and Trademarks

Since our products are based on existing technologies and custom-designed components generally developed under agreements with specific customers, the Company currently owns no patents and has no patents pending.

In 2003, we received notice of the successful registration of the federal trade and service marks for the logo “PDSi” under Class 9 products and under Class 42 services.

The applications filed in 2001 for federal trade and service marks for “Pinnacle Data Systems” have been suspended and are awaiting the final disposition of other pending applications.

License and Royalty Agreements

In April 2004, we entered into a U.S. Business Development Partner Agreement with H-P to buy and resell or sublicense products, services and support including the select HP Care Pack Services. The agreement expires in May 2005. At the time of expiration, orders already accepted shall be governed under the terms and conditions of the agreement. The agreement may also be terminated earlier upon default by either party as defined in the agreement. These products were required in an immaterial amount of product sales in 2004, but are expected to be used in a more significant number of sales in future years. In February 2005, the agreement was extended until May 2006.

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In September 2003, by re-application, we renewed an OEM Customer License Agreement for Embedded Systems with Microsoft Licensing, Inc. (“Microsoft”) originally issued in 2002, pursuant to which we are licensed to embed binary copies of Microsoft operating systems (as delivered from Microsoft) in our products. The license agreement was for an original term of one year expiring in September 2004. The license is renewable by re-application. The license has been renewed for a term expiring in November 2005. The license can also be terminated earlier by Microsoft upon default by us as defined in the Agreement. These operating systems were required in product sales of approximately $900,000 in 2004 and $500,000 in 2003 (approximately 3% and 3% of total product sales, respectively).

In April 2003, we entered into a Regional Reseller Agreement with Agilent Technologies to buy and resell Agilent Remote Management Products in the United States and Canada. The agreement includes a license to use, execute, reproduce, display and distribute Agilent software in object code for the purpose of integrating Agilent’s products with our, or our customers’, products. The agreement was for an original term of one year expiring in March 2004. The agreement automatically renews for one-year periods unless written notice of non-renewal is given by either party before the current term ends. The agreement may also be terminated earlier upon default by either party as defined in the agreement. The agreement was renewed for a term expiring in March 2005. Agilent has given notice that it will not renew the agreement again beyond March 2005. These products were required in product sales of approximately $2.3 million in 2004 and $1.1 million in 2003 (approximately 8% and 7% of total product sales, respectively). This agreement was entered into to increase product offerings to our current and prospective customers.

In March 2003, we entered into a Design License Agreement with Sun, pursuant to which we have a limited licensed to develop, manufacture and sell to one specific customer a product based upon and using the Sun SPARCengine Classic-II Motherboard. The license agreement was for an original term of one year expiring in March 2004. The license may only be renewed by mutual written agreement signed by both parties. The license can be terminated earlier, for any reason or for specific reasons, by either party as defined in the Agreement. The license was not renewed, but the agreement provides us the right to continue to use the technology for existing products. This technology, which was not required for any sales in 2004, was required in product sales of approximately $700,000 in 2003 (approximately 4% of total product sales).

In February 2003, by re-application, we renewed a Technology License and Distribution Agreement with Sun originally issued in 1994, pursuant to which we are licensed to distribute the Sun Solaris ^® operating system in our products. The license agreement is for an original term of three years expiring in February 2006. The license automatically renews for up to two one-year periods unless written notice of non-renewal is given by either party before the current term ends. The license can also be terminated earlier upon default by either party as defined in the Agreement. These operating systems were required in product sales of approximately $11.9 million in 2004 and $7.6 million in 2003 (approximately 34% and 49% of total product sales, respectively).

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In August 2002, we were authorized by Sun to act as an OEM Technology Partner (“OTP”), pursuant to which we are authorized and licensed to buy Sun products at specific discount levels for the purpose of modifying them and/or integrating them into our products for resale to our OEM customers. This authorization can be terminated earlier without cause or upon default by either party as defined in the terms and conditions of the General Terms and iForce Business Terms exhibits attached to the OTP Letter of Authorization. This designation or its predecessor Master Value-Added Integrator (MVAI) designation was required in product sales of approximately $11.9 million in 2004 and $7.3 million in 2003 (approximately 35% and 47% of total product sales, respectively).

In April 2002, we entered into a Software and Documentation License Agreement with Intel, pursuant to which we are licensed to incorporate the Intel 82544 Gigabit Ethernet Controller into our Blueswitch ^TM and derivative products. The license can be terminated by Intel upon default by us as defined in the Agreement. This controller was required in an immaterial amount of product sales in both 2004 and 2003 but is expected to be used in a more significant number of sales in future years.

In July 2001, we entered into a Reference Design License Agreement with Sun, pursuant to which we are licensed to develop, manufacture and sell products based upon and using the Sun ULTRSPARC IIe technology. Training and support fees amounting to $35,000 were paid in connection with the license. The license agreement was for an original term of three years expiring in July 2004. The license automatically renews for up to two one-year periods unless written notice of non-renewal is given by either party before the current term ends. The license can also be terminated earlier upon default by either party as defined in the Agreement. The license agreement automatically renewed until July 2005. This technology was required in product sales of approximately $5.1 million in 2004 and $900,000 in 2003 (approximately 15% and 6% of total product sales, respectively).

In May 1999, we entered into a Reference Design License Agreement with SME, pursuant to which we are licensed to develop, manufacture and sell products based upon and using the Sun AXmp technology. Training and support fees amounting to $40,000 were paid in connection with the license. The license agreement is for an original term of seven years expiring in May 2006. The license automatically renews for one-year periods unless written notice of non-renewal is given by either party before the current term ends. The license can also be terminated earlier upon default by either party as defined in the Agreement. This technology was required in product sales of approximately $5.4 million in 2004 and $2.8 million in 2003 (approximately 16% and 18% of total product sales, respectively).

In October 1997, we entered into a Development and Manufacturing License Agreement with SME pursuant to which we are licensed to develop, manufacture and sell products based upon and using the Sun PCI card and Open Boot PROM technology. We do not anticipate that we will develop any new products based on the technology licensed under this agreement, although we will continue to sell products that we have developed under this license. The license agreement was for an original term of three years expiring in October 2000. However, the license automatically renews for one-year periods unless written notice of non-renewal is given by either

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party before the current term ends. The license can also be terminated earlier upon default by either party as defined in the Agreement. The license has been automatically renewed for an additional one-year term expiring October 2005. This technology was required in product sales of approximately $1.2 million in 2004 and $1.4 million in 2003 (approximately 4% and 9% of total product sales, respectively).

In May 1994, we entered into a Microprocessor Platform Design License Agreement with Sun, acting through its SPARC Technology Business Division, pursuant to which we are licensed to develop, manufacture and sell products based upon and utilizing the Sun SPARC microprocessor technology. The technology of this license is utilized in customer projects that began prior to 1997. It has not been utilized in any new customer projects since 1996. We do not anticipate that we will develop any new products based on the technology licensed under this agreement, although we will continue to sell products that we have developed under this license. A license fee in the amount of $35,000 was paid in full upon execution of the license. The license agreement was for an original term of seven years expiring in 2001. However, the license automatically renews for one-year periods unless written notice of non-renewal is given by either party before the current term ends. The license can also be terminated earlier upon default by either party as defined in the Agreement. The license has been automatically renewed for an additional one-year term expiring in 2005. This technology was required in product sales of approximately $0 in 2004 and $700,000 in 2003 (approximately 0% and 4% of total product sales, respectively). This technology was used in various non-recurring projects over the last two years.

We have no outstanding royalty agreements.

Labor Contracts

None of our employees are subject to collective bargaining agreements. We consider our relationship with our employees to be very good.

Government Approval of Principal Products or Services

Our principal products and services do not generally require government approval, although some of our OEM customers’ products do require government approval. For example, medical-imaging equipment for which we sell components to our customers may require Food and Drug Administration (“FDA”) approval. This may slow the introduction of our customers’ new products and sometimes extends the time period between successful customer trials and the resulting production orders. We consider this in our business planning. When required, we help our customers get government approval. We also help them prolong the life of their products to delay costly government approval processes.

Governmental Regulation Costs

No federal, state or local laws or regulations in existence or proposed are expected to materially impact our operations or financial position.

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Research and Development

There are research and development expenses in connection with designing new products. During 2004 and 2003, we incurred approximately $24,000 and $206,000, respectively, for research and development. These expenses were not paid directly by our customers, but are typically recouped over time as part of the cost of the developed products sold to customers.

Environmental Compliance Costs

Certain facets of our operations involve the use of substances regulated under various federal, state and local laws governing the environment. The liability for environmental remediation and related costs can be significant, although the Company has not incurred any to this date. Consequently, environmental costs and environmental regulations are not presently material to our operations or financial position. Similarly, no other federal, state or local laws or regulations are expected to materially impact our operations or financial position.

Employees

As of December 31, 2004, we had a total of 106 employees, all of whom were full-time.

 
Item 2. Description of Property

We lease approximately 113,000 square feet of office, warehouse, laboratory and production space in a building located at 6600 Port Road, Groveport, Ohio. We entered into a ten-year lease commencing May 1, 1999. The lease contains annual escalators intended to cover inflationary costs over the life of the lease. Minimum future annual lease payments under the lease as of December 31, 2004 are approximately $589,216. We have the option to extend the term of the lease for an additional five years. The building is in good condition. While we believe that this current space is adequate for the foreseeable future, we have been granted an option to lease an additional 53,000 square feet of warehouse space in this building at the termination of the current lessor’s lease.

Our current policy is not to invest in real estate or interests in real estate. We do not invest in real estate mortgages or securities of entities primarily engaged in real estate activities.

 
Item 3. Legal Proceedings

We are not and our property is not currently a party to any pending legal proceedings.

 
Item 4. Submission of Matters to a Vote of Security Holders

No matters were submitted to a vote of shareholders during the fourth quarter of 2004.

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PART II

 
Item 5. Market for Common Equity and Related Stockholder Matters

(a) Market Information . Since September 7, 2000, our common stock has traded on the American Stock Exchange under the stock symbol “PNS.” Set forth below is the range of high and low sales prices of the common shares on the American Stock Exchange during 2004 and 2003.

(b) Holders . On February 11, 2005, there were 86 holders of record of the Shares. Most of the Shares not held by officers and directors are held in street name.

(c) Dividends . During the past two years, we have not paid cash dividends. Payments of dividends are within the discretion of our board of directors.

(d) Securities Authorized for Issuance Under Equity Compensation Plans . The following table provides information as of December 31, 2004 with respect to shares of Pinnacle Data Systems, Inc. common stock that may be issued under our existing equity compensation plans, including the Pinnacle Data Systems, Inc. 1995 Stock Option Plan (the “Employee Plan”), the stock option agreement, effective September 12, 1997 between Pinnacle Data Systems, Inc., and Thomas O’Leary, the stock option agreement, effective September 12, 1997 between Pinnacle Data Systems, Inc., and Robert Ostrander, the stock option agreement, effective June 23, 1999 between Pinnacle Data Systems, Inc., and Robert Ostrander, and the Pinnacle Data Systems, Inc. 2000 Director Stock Option Plan (the “Director Plan”).

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