ANNUAL REPORT FOR SMALL BUSINESS ISSUERS SUBJECT

TO THE 1934 ACT REPORTING REQUIREMENTS

U.S. SECURITIES AND EXCHANGE COMMISSION

WASHINGTON, D.C. 20549

FORM 10-KSB

x ANNUAL REPORT PURSUANT TO SECTION 13 OR 15(d)

OF THE SECURITIES EXCHANGE ACT OF 1934

For the fiscal year ended December 31, 2003

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 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.   x

State Issuer’s revenues for its most recent fiscal year. $22,884,018

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 March 5, 2004, was $11,327,859.

On March 5, 2004, the Issuer had outstanding 5,540,796 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 2004 Annual Meeting of Shareholders are incorporated by reference into Part III of this Annual Report on Form 10-KSB.

TABLE OF CONTEN TS

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 the Private Securities Litigation Reform Act of 1995. The words “believe,” “expect,” “anticipate,” “estimate,” “project,” and similar expressions, among others, identify “forward-looking statements”, which speak only as of the date the statement was made. Such forward-looking statements are subject to risks, uncertainties and other factors, which could cause actual results to materially differ from those projected, anticipated or implied. The most significant of such risks, uncertainties and other factors are described in Item 6 of this Form 10-KSB. We undertake no obligation to update or revise any forward-looking statements, whether as a result of new information, future events, or otherwise.

 
 
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

We provide products and technical services, encompassing the development and production of embedded (built-in) computer systems and components, and the testing and repair of computer systems, components and peripherals, to Original Equipment Manufacturers (OEMs) in, among others, the computer, computer peripheral, data storage, digital-imaging, medical diagnostic, process-control, and telecommunications equipment industries. PDSi offers a full range of 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 is a foundation of electronics repair and logistics programs (“Services”) that provide resources for the development and sale of high-potential PDSi-engineered and manufactured embedded hardware solutions for specific customers and niche-industry applications (“Products”). During 2003, we reported revenue of $22.9 million, net earnings of $472,538, and total assets of $8.9 million. Approximately 68% of our 2002 revenue was generated from product sales and 32% was generated from services.

Our products are custom-designed to meet specific customer or niche-industry requirements that generally cannot be met by off-the-shelf products. Our products are sold to OEMs and are typically resold by those OEMs to end-users as components integrated into the OEMs’ final products. Our products are usually developed as a result of our helping OEMs design, engineer, manufacture, assemble, modify, and/or integrate computer systems or components to fit their specific application needs. Initially, or when we go into production, we get paid for the development of our products. Then, we get paid to produce and ship our products to the OEM, followed by payment for servicing our products after their initial warranty expires. Many of our products are based on the high performance computer processing technologies of Sun Microsystems, Inc. (Sun) and Intel Corporation (Intel), two of world’s largest 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, into our finished products. For example, the composition of one of our products may include 50% Sun or Intel content, combined with 20% other vendor off-the-shelf peripheral products such as power supplies and disk storage, with the other 30% made up of products we design, develop and produce, or purchase and modify. These percentages vary from product to product. By leveraging our expertise and experience in engineering and integrating our internally developed products with Sun, Intel and other vendors’ technologies, we are able to offer product solutions with minimal product design and engineering costs to our customers. 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 the North American reseller of Agilent remote diagnostic solutions, selected for our engineering and design capabilities. 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, logistics, and product end-of-life management services. We provide depot testing and repair services for advanced technology systems, printed circuit board assemblies, and other computer peripherals and components, where the damaged or malfunctioning equipment is sent to our designated “depot” location for testing and repair. We also manage “advanced-exchange” repair programs, where we send out a replacement part from the OEM’s inventory stocked at our facility, over-night when necessary, and receive the damaged or malfunctioning part back for testing, repair and replacement in inventory, all usually accomplished within a few days. Our highest volume testing and repair is performed on complex printed circuit boards and electro-mechanical data storage devices for Sun and Hewlett-Packard Company (H-P). Our repair capabilities are extensive. For our largest OEM customers, including Sun and H-P, we maintain and share online information management systems that seamlessly connect our two companies and give us the appearance of being “just another location” of the OEM. Additional revenue is generated from the sale of spare parts and components. Our end-of-life product management service allows our customers to maximize their investment in technology by providing continued support for products no longer 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, many of our customers’ products include Sun or Intel components. When Sun or Intel stop manufacturing those components, OEMs are left with few alternative sources for parts needed to continue building or repairing their products. We can provide the parts, purchased from a number of available sources, either new or refurbished.

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

Public Announcement Updates

During 2003, we made a number of public announcements. The current status of each is as follows:

HP-UNIX Workstation Repair Program Replaced with Tape Library Repair and Assembly – Disclosed in the first quarter earnings news release, the Workstation Repair Program ended in the second quarter of 2003. In 2003, the H-P Tape Library Programs generated average monthly revenue exceeding the average monthly revenue of the Workstation Repair Program in 2002 by approximately 13%. However, profit margins on the Tape Library Programs are lower. Tape library assembly revenue is included in product revenue and tape library repair revenue is included in service revenue.

PDSi Awarded Membership in the Intel 2003 Premier Provider Program – Disclosed in the second quarter earnings release, our relationship with Intel continues to grow and has resulted in a number of new customer relationships that are currently producing revenue for the Company.

PDSi to Provide System Controllers for Lorad Medical’s Digital Mammography Systems – Lorad, a division of Hologic Inc., became a significant customer in 2003 and this program is continuing into 2004.

Agilent Technologies and Pinnacle Data Systems to Extend Service and Support for Remote Management and Diagnostics Solutions within North America – This partnership provided additional sources of revenue in 2003 and we expect this program to grow significantly in 2004 and beyond.

Pinnacle Data Systems Earns Meritorious Supplier Performance Award from Sun Microsystems, Inc. – Although Sun repair program revenue declined approximately 36% in 2003, this award has influenced Sun’s decisions to award us new repair programs that should increase repair program revenue in 2004. Sun has provided a number of new product opportunities that have already generated or are expected to generate significant revenue in 2004 and beyond.

Pinnacle Data Systems Awarded $1 Million Order for TS1000 Servers – This order shipped in the fourth quarter of 2003.

Pinnacle Data Systems Awarded $3 Million Order for Controller Boards to be Used in Medical Diagnostic Equipment – Approximately 21% of this order shipped in the fourth quarter of 2003. The rest of the order is expected to be shipped in the first half of 2004.

Competition

Competition for our custom-designed products comes from two primary sources: (1) other electronic contract manufacturing companies (“ECMs”) that provide similar design and manufacturing services, (2) less expensive off-the-shelf products in which there is a cost-benefit trade-off decision to be made by the customer.

We market our customization services and customized 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. We believe we differentiate ourselves from other competitors through the strength of our close relationships with our very large OEM partners (Sun, H-P, Alcatel, Bayer Diagnostics and others), our ability to offer and deliver complete turnkey product/service 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 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 (a “one-stop shop”) and experience with very large and well-known 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 their service needs. Many of our competitors have significantly greater manufacturing, financial, technical and marketing resources with which to compete for electronic equipment service business.

Suppliers

During 2003, approximately 25% 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.

Customers

A significant amount of our revenues comes from a relatively small number of customers who are generally very large organizations, individually with hundreds of millions to several billions of dollars in annual revenues. A major strategic focus in 2003 was, and continues to be, further broadening and diversifying our customer base for both products and services. In 2003, our customers included eight Fortune Global 500 companies, three additional Fortune 500 companies and one additional Fortune 1000 company as listed by Fortune Magazine in July 2003. In 2002, our customers included five Fortune Global 500 companies and three additional Fortune 1000 companies as listed by Fortune Magazine in July 2002. In 2003, our four largest customers generated about 59% of our total sales. In 2002, our four largest customers generated about 70% of our total sales. In 2003, no one customer generated more than 27% of our sales. In 2003, nine customers generated 82% of the product sales compared to four customers generating 82% of the product sales in 2002. Two major customers (H-P and Sun) generated 82% of the 2003 service sales compared to the 95% of the service sales they generated in 2002. Having such small numbers of customers generating the majority of our sales creates significant risk. If the sales generated by either of our top two service customers declined significantly, or if product sales to one of our top product customers declined 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 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 is for a term of one year expiring in September 2004. The license is renewable by re-application. 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 $500,000 in 2003 (approximately 3% of total product sales).

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 is 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. These products were required in product sales of approximately $1.1 million in 2003 (approximately 7% of total product sales). 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 is 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. This technology 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 $7.6 million in 2003 and $6.1 million in 2002 (approximately 49% and 72% of total product sales, respectively).

In November 2002, we entered into a Development, Distribution and Software License Agreement with Sun, pursuant to which we are licensed to develop, manufacture and sell products utilizing two Sun-developed software drivers to link our products to Sun computer systems. The license agreement is for a term of 18 months expiring in May 2004. The license is renewable by re-application. The license can also be terminated earlier for any reason or upon default by either party as defined in the Agreement. These drivers were required in an immaterial amount of product sales in 2003 but are expected to be used in a more significant number of sales in future years.

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 $7.3 million in 2003 and $6.0 million in 2002 (approximately 47% and 71% 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 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 is 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. This technology was required in product sales of approximately $900,000 in 2003 and $100,000 in 2002 (approximately 6% and 1% of total product sales, respectively).

In December 1999, we entered into a Reference Design License Agreement with Sun Microelectronics (“SME”), a division of Sun, pursuant to which we are licensed to develop, manufacture and sell products based upon and using the Sun CP1400 board technology. The license agreement is for an original term of seven years expiring in December 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 an insignificant amount of sales in 2003 and approximately $700,000 in 2002 (approximately 0% and 8% of total product sales, respectively). The products requiring this technology are no longer in production.

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 $2.8 million in 2003 and $1.3 million in 2002 (approximately 18% and 15% 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 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 2004. This technology was required in product sales of approximately $1.4 million in 2003 and $1.4 million in 2002 (approximately 9% and 17% 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 2004. This technology was required in product sales of approximately $700,000 in 2003 and $1.0 million in 2002 (approximately 4% and 11% 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.

Research and Development

There are research and development expenses in connection with designing new products. During 2003 and 2002, we incurred approximately $206,000 and $681,000, 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, 2003, we had a total of 97 employees, 96 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. 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 2003.

 
PART II

(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 2003 and 2002.

(b) Holders . On March 5, 2004, there were 93 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, 2003 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”).

Each of the option agreements between the Company and Thomas O’Leary and the Company and Robert Ostrander grants the recipient options to purchase shares of the Company’s common stock for a period of 10 years from the date of the grant, although the option is not exercisable until the date that is one year from the date of the grant. The agreements each provide that if the recipient ceases to be a director of the Company for any reason other than death, the recipient has 90 days from the date of termination to exercise his option. In the event that the recipient ceases to be a director of the Company due to death, or if the recipient dies within 90 days of his termination as a director of the Company for any reason, the option may be exercised by the recipient’s representative within 1 year after the date of death.

The options granted pursuant to the agreements are not transferable other than by will or the laws of descent and distribution, and the number of options are subject to adjustment, on a proportionate basis, upon the occurrence of certain events relating to the Company’s capital structure. For example, the number of securities to be issued upon exercise of Mr. O’Leary and Mr. Ostrander’s options were adjusted upward as a result of the 2-for-1 stock split effective March 31, 2000 and the 2-for-1 stock split effective October 31, 2000.

 
Item 6. Management’s Discussion and Analysis of Financial Condition and Results of Operations

The following discussion should be read in conjunction with the Financial Statements and Notes contained herein.

This annual report, including the following sections contain forward-looking statements within the meaning of the Private Securities Litigation Reform Act of 1995. The words “believe,” “expect,” “anticipate,” “estimate,” “project,” 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. Such factors include, but are not limited to, adverse changes in general economic conditions, including adverse changes in the specific markets for our products and services, adverse business conditions, decreased or lack of growth in the computing industry, adverse changes in customer order patterns, including any decline or change in product orders from large customers like the four customers that made up approximately 59% of our revenue during 2003, increased competition, any adverse change in our business or our relationship with major technology partners, around whose computing platforms large portions of our business are based, lack of acceptance of new products, pricing pressures, lack of adequate financing to take advantage of business opportunities that may arise, lack of success in technological advancements, risks associated with our new business practices, processes and information systems, and other factors, including those discussed under “Risk Factors” on page 20 of this report.

OVERVIEW

Pinnacle Data Systems, Inc. (“PDSi” or the “Company”) provides products and technical services, encompassing the development and production of embedded (built-in) computer systems and components, and the testing and repair of computer systems, components and peripherals, to Original Equipment Manufacturers (OEMs) in, among others, the computer, computer peripheral, data storage, digital-imaging, medical diagnostic, process-control, and telecommunications equipment industries. PDSi offers a full range of 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 is a foundation of electronics repair and logistics programs (“Services”) that provide resources for the development and sale of high-potential PDSi-engineered and manufactured embedded hardware solutions for specific customers and niche-industry applications (“Products”).

After six years of profitable and accelerating growth (1995-2000), in 2001, capital spending in our customer’s markets virtually came to a standstill and we reported the worst results in the history of our company. In 2002, we shifted our focus from the product development to the services side of our business model and redeployed the majority of our resources to work on

repair programs. By emphasizing the services side and only working on the product development projects that had the very highest probability for success, we returned to quarterly profitability. In 2003, the strength of the services business continued; the successful development projects of 2002 and the improving economy combined to increase product sales 86% and total sales 46%; and the Company achieved its second highest annual earnings in its history.

In 2003, we focused our product development efforts on products with the highest potential for profitable sales during the economic recovery period (predominantly customer-specific products) and cultivated long-term business relationships to provide product opportunities well into the future. In recognition of our technical expertise with Intel Corporation (Intel) products, we were awarded Intel Premier Provider status in 2003. This immediately led to new product opportunities; some leveraging our Sun SPARC expertise by requiring the integration of the two companies’ technologies. Our broad engineering capabilities also landed us an agreement to be the North American Reseller for Agilent’s Remote Management Diagnostics products; a relationship that resulted in significant revenues in 2003 and that we expect to take to new levels in 2004 and beyond. As the economy expands and capital spending increases, sales of products we design and manufacture represent our largest opportunity for growth.

We continued to devote significant effort to growing our service base by expanding the number of active programs with both current and new Fortune Global 500 technology OEM customers. For example, successful repair programs for Hewlett-Packard (H-P) servers and tape library equipment over the past two years led to the award of additional business in 2003, including the assembling and testing of new tape library units for H-P. We were also awarded a 2003 Sun Microsystems (Sun) Supplier Award for Meritorious Performance based on the repair service levels we provide Sun, raising our status as a preferred supplier for additional Sun repair programs. This award already helped win additional Sun repair work in 2004.

We exited 2003 with improved top and bottom lines and entered 2004 with:

In 2004, we expect increased sales in both products and services and continued profitability to result from our rather modest, but very fruitful, spending in marketing and sales of the past few years. To fuel additional growth in 2004 and beyond, our plans include increasing our visibility in the marketplace by increasing the size of our marketing and sales team and making investments in our delivery infrastructure as required. Our past efforts have only begun to tap into the large markets for our services and products.

On the product side of the business, our marketing and sales efforts will continue to be on original equipment manufacturers (OEMs) in the medical diagnostic, commercial imaging, process control and telecommunications equipment industries-all very large markets that show definite signs of recovery. In addition, we will aggressively market Agilent’s remote diagnostics products, which are generating interest in new “design and build” programs with both current and prospective OEM customers.

The following discussions and analyses are for the year ended December 31, 2003 compared to the year ended December 31, 2002.  

SALES

Sales for 2003 and 2002 were as follows:

The increase in product sales for 2003 was due to the addition of new product customers, for whom we began new build programs in late 2002 and 2003. The sales from these new programs comprised slightly more than half of total product sales. We believe that the increase in our customer base and in overall product sales reflects successful 2002 customer trials and the recent improvement in the economy and capital spending in general.

During the first quarter of 2003, H-P informed us that in the second quarter of 2003, the H-P-UNIX workstation repair program would be consolidated into printed circuit assembly repair operations in California. However, H-P expanded its tape library programs with us to include additional repair volume that substantially replaced the lost workstation repair sales. In 2003, other service sales also included $410,000 of engineering services compared to $36,000 in 2002. As was the case in 2002, H-P service sales represented slightly more than half of all service sales in 2003.

For 2003, the Company had four customers that generated revenues of approximately $5,986,000, $3,048,000, $2,337,000, and $2,242,000 or 26%, 13%, 10%, and 10% respectively, of total revenue. In the statements of operations, approximately $4,531,000 of the revenues from these customers is included in service sales and $9,082,000 is included in product sales. In addition, these customers represented 11%, 23%, 16%, and 24%, respectively, of accounts receivable at December 31, 2003.

GROSS PROFIT

Gross profits for 2003 and 2002 were as follows:

The gross profits margin percentage for 2003 and 2002 were as follows:

Product sales to new customers generally were lower value-added sales and, therefore, had lower margins on materials than the product sales to existing customers, but their additional contribution to overhead costs resulted in a slightly higher gross profit margin percentage for product sales in 2003, compared to 2002.

The decline in the service gross  
profit margin percentage in 2003 was attributable to component sales at cost and some additional expenses associated with the transfer of the H-P board business in the second quarter, as well as a lower margin mix of service program work in 2003.

SELLING, GENERAL AND ADMINISTRATIVE (SG&A) AND INTEREST EXPENSES

SG&A and interest expenses for 2003 and 2002 were as follows:

The increase in SG&A expenses in 2003, which include R&D expense, was mostly attributable to incentive programs which helped lead to increases in sales and the return to profitability in 2003. The 14% increase in SG&A expenses was significantly less than the 46% increase in sales.

In 2003, a decreased use of the credit line due to the accumulation of six quarters of profits resulted in lower interest expense compared to 2002. Interest rates paid on the line of credit ranged from 4.00% to 4.50% in 2003, and from 3.90% to 5.00% in 2002. The average daily balance on the line of credit declined to $1.9 million in 2003 from $2.4 million in 2002.

INCOME TAXES AND NET INCOME/(LOSS)

The effective tax rate used for both 2003 and 2002 was 39%.

Income/(loss) before taxes, income taxes and net income/(loss) for 2003 and 2002 were as follows: