The following discussion should be read in conjunction with the Financial Statements and Notes contained herein. This Annual Report, including the following sections, contains 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 the Company achieving its financial growth and profitability goals, or its sales, earnings and profitability expectations for fiscal year 2008. The words “believe,” “expect,” “anticipate,” “estimate,” “intend,” “seek,” “may,” 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. These factors include changes in general economic conditions, changes in the specific markets for our products and services, adverse business conditions, changes in customer order patterns, increased competition, changes in our business or our relationship with major technology partners or significant customers, 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.

Restatement of Financial Statements

Pinnacle Data Systems, Inc. (“PDSi,” “we,” “our,” or the “Company”) has restated herein our financial statements for the fiscal year ended December 31, 2006 to decrease deferred tax assets and additional paid-in capital by $333,000; this restatement had no impact on the 2006 net loss per share. Additionally, the Company increased income tax expense by $117,000 resulting in a net loss per share of $0.32 compared to a $0.30 net loss per share as previously reported. For 2006, the restatement adjustments were deemed not to be material, and continue not to be material to the 2006 financial results. However, correcting the cumulative effect of the prior year misstatements through the current year income statement would materially misstate current year income and therefore, the Company adjusted the 2006 financial statements. The Company previously reported in the Current Report on Form 8-K on March 12, 2008 results that did not consider this restatement. As such, the affect of the decrease in 2007 income tax expense resulted in a correction to the Company’s reported 2007 diluted earnings per share from $0.07 to $0.08 for the full year.

Based on the interpretations of the Securities Exchange and Commission Staff Accounting Bulletin No. 108, and because amendments of the Company’s previously filed Annual Reports on Form 10-K for the 2006 period affected by the restatement would, in large part, repeat the disclosure contained in this report, the Company has not amended and does not plan to amend these or any other prior filings. For a full description of the restatement, see Note 3, “Restatement of Financial Statements” of “Notes of Financial Statements” included under Part II, Item 8 of this Annual Report on Form 10-K.

EXECUTIVE OVERVIEW

The Company is a provider of computer design, development, production, and repair services to original equipment manufacturers (“OEMs”) and independent software vendors (“ISVs”). Industries served currently include medical, telecommunications, industrial/automation, military/aerospace, and imaging. The Company also helps major computer platform manufacturers respond to their customers’ requirements for customized solutions and extended service life. We specialize in areas where these customers often get little help from larger outsource firms, solving the challenges associated with complex technologies, low to medium volume production, and long-term service of third party products. Not simply a repair depot or a contract manufacturer, PDSi represents a more collaborative and flexible outsourcing partner who helps its clients manage costs, meet unplanned demand changes, improve customer satisfaction, and respond aggressively to new trends in the technology market place. With our innovative and proactive staff of engineering, manufacturing, program management and supply chain specialists, PDSi tailors solutions that meet the particular business and operational needs of each OEM or ISV.

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During the twelve months ended December 31, 2007 (“fiscal year 2007”), the Company achieved favorable operating results due to solid organic growth and benefits from the Operational Improvement Plan as completed earlier in fiscal year 2007, as discussed below. In addition, the Company continues efforts to improve operating margins. As the Company continues to address its scalability needs to meet customer requirements and to achieve profitable sales growth, the Company evaluates and challenges existing business that consistently performs below expected results. The Company is seeking new opportunities that are more in line with the Company’s performance goals, and where the customer recognizes and values the Company as a partner and enabler to the customer’s specialized product and services needs. The Company expects to strengthen its sales force using independent manufacturer’s sales representatives around the world. The strategic use of independent manufacturer’s sales representatives will improve the Company’s market and geographical coverage of its products and services.

A $2.5 million private equity financing was successfully completed on December 20, 2007. The company issued 1.25 million common shares and warrants to purchase 375,000 additional shares of common stock in a private placement with selected institutional investors. The warrants will be exercisable after six months and for a period of five years from the closing date of the financing. Approximately $1.2 million of the proceeds were used to purchase all of the equity of Aspan B.V., a Netherlands private limited liability company (“Aspan”) in February 2008, and the remaining amount will be used to invest in the infrastructure of PDSi’s growing business. Additional information on the private equity financing is discussed in Note 11 to the Financial Statements.

During fiscal year 2007, the Company outsourced repair services for its customers in the EMEA and APAC regions to Aspan and established an operation in Hong Kong. Through its Hong Kong operation, the Company has begun providing repair services in the APAC region with staffing provided through a Joint Cooperation Agreement with E.C. Fix Technology Limited. In 2008, the Company will provide repair services through its three operations located in North America (Groveport, Ohio, USA), EMEA (Tiel, Gelderland, the Netherlands) and APAC (Tsuen Wan, New Territories, Hong Kong)

During fiscal year 2006, the Company upgraded its headquarters facility in Groveport, Ohio, opened a warehouse and logistics facility in Groveport, Ohio, and consolidated the Company’s Monrovia, California operations into the Groveport, Ohio facilities (the “Operational Improvement Plan” or the “Plan”). The Company invested approximately $0.4 million in 2006 to increase and improve its production, warehouse, and logistics capabilities in Ohio. In addition, the Company incurred $1.6 million in costs during the twelve month period ended December 31, 2006 to substantially complete the consolidation. The costs included $0.2 million for termination and severance benefits for associates, an accrual of $1.2 million for the estimated outstanding lease costs for the facility in Monrovia, California that provides no future economic benefit to the Company, and $0.2 million for other closure costs including travel, training, and relocation of associates and production lines. In fiscal year 2007, the Company completed amendments to the original Monrovia, California lease agreement, which eliminated any future obligations under the lease agreement after November 30, 2007.

While the Company continues to evaluate viable acquisition opportunities, with the exception of the acquisition of Aspan, the Company does not anticipate any acquisitions in 2008.

DISCUSSION AND ANALYSIS OF OPERATING RESULTS

The following discusses and analyzes the financial condition and results of operations for the years ended December 31, 2007 (“2007” or “fiscal year 2007”) and December 31, 2006 (“2006” or “fiscal year 2006”). The discussion should be read in conjunction with the financial statements of the Company and the notes thereto included elsewhere in this Annual Report on Form 10-K.

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Sales for 2007 were $73.4 million compared to $75.9 million in 2006, a decrease of 3%. In 2007, over $20 million in high-volume low-margin sales that occurred in 2006 were replaced with approximately $17 million in increased revenues from existing and new higher margin programs. The increase in service sales was due to a ramp-up during the year of revenues from new storage-device repair programs in the North America and EMEA regions. The Company continues to focus on its international repair opportunities. This increase in service sales was offset by lower billings on established domestic service accounts. The Company’s results were affected by fluctuation in its customers’ product lines and programs, and the demands of their market. The Company anticipates sales in the first half of 2008 to be comparable to the first half of 2007.

For 2007, the Company had two customers that generated total revenues of approximately $28.5 million and $8.8 million, or 40% and 12%, respectively, of total revenues. In the statements of operations, approximately 8% of the revenues from these customers were included in Service sales and 92% were included in Product sales. In addition, these customers represented 43% and 16%, respectively, of accounts receivable at December 31, 2007.

For 2006, the Company had two customers that generated total revenues of approximately $17.4 million and $15.0 million, or 23% and 20% respectively, of total revenues. In the statements of operations, approximately 5% of the revenues from these customers were included in Service sales and 95% were included in Product sales. In addition, these customers represented 24% and 33%, respectively, of accounts receivable at December 31, 2006.

While the Company continues to seek new opportunities with our existing customers, the Company anticipates growth from new customers, including both domestic and international customers, leading to additional customer diversification over time.

GROSS PROFIT

Gross profit for 2007 and 2006 were as follows:

The gross profit margin percentage for 2007 and 2006 were as follows:

The increase in overall gross profit margin as a percentage of sales from 2006 to 2007 was primarily attributable to the reduction of lower margin business and the increase in more profitable business including programs that supported customer’s last time buys of prior generation products. The Company produces business from both existing and new programs. The Company continues to focus on its profitable growth strategy and continues to pursue higher value-added business with better margin potential. The decline in gross profit on service sales was caused by an increase in lower margin storage device repair programs in the sales mix, especially in the EMEA region where the Company split its service profits with Aspan. With the acquisition of Aspan, which occurred in February 2008, the Company will benefit by receiving the entire profit margin on this service business.

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The overall increase in product gross margin was due to the elimination of lower margin sales, as discussed above, cost benefits from the completion of the Plan, and new programs at higher profit margins.

The Company continues to believe that as sales revenues and gross profit margins increase through the organic growth of existing customers and other additional global business, the results of operations will be positively affected. Gross margins will vary from program to program, and the mix of programs will vary from quarter to quarter causing the gross margin percentages to vary from quarter to quarter. Consequently, it is difficult to predict quarterly gross margin results on future sales.

The decrease in SG&A expenses from 2006 to 2007 was primarily caused by fiscal year 2006 one-time charges of $2.3 million. During fiscal year 2007, the Company improved its cost structure by reducing salaried personnel, travel and outside professional services costs. In 2006, the Company recorded $1.6 million for costs associated with the Plan, as discussed in the Executive Overview. In addition, an allowance was established to cover the outstanding receivable balance of one of the Company’s customers, Silicon Graphics, Inc. (“SGI”), who filed a voluntary petition for relief under Chapter 11 of the U.S. Bankruptcy Code in May 2006. The Company settled this claim for 70% of the Company’s pre-petition claims on outstanding receivables and charged $188,000 to bad debt expense for SGI in 2006. For additional discussion, refer to Note 2 of the Financial Statements contained herein. In addition, in 2006, SG&A expenses included one-time charges of approximately $0.4 million for severance expenses, primarily related to the resignation of the Company’s former President and Chief Operating Officer. Finally, during 2006, the Company incurred an inventory write-down of approximately $130,000 due to the implementation of Restriction of Hazardous Substances (RoHS) standards in the European Union effective July 1, 2006.

The increase in interest expense for the twelve month period ended December 31, 2007 compared to the twelve month period ended December 31, 2006 was due to the higher average bank debt balance carried to support the working capital requirements of the Company’s business early in the year. During 2007, the Company’s improved performance in managing inventory levels and collecting accounts receivable significantly lowered the Company’s borrowing requirements in the second half of 2007.

INCOME TAX EXPENSE (BENEFIT) AND NET INCOME (LOSS)

The effective tax rates used for fiscal year 2007 and fiscal year 2006 were 53% and (37%), respectively. The increase in the tax rate for fiscal year 2007 as compared to fiscal year 2006 is primarily due to a decrease in gross deferred tax assets that had been previously recorded at a higher tax rate and the tax effect of tax/book differences that included stock option expense deducted for book purposes, but not for tax purposes until the stock option is exercised. The decrease in value of the deferred tax assets required a charge to income tax expense. The change in the current tax rate was due to a change in the projected state tax rates and change in state apportionment factors. The Company expects that the benefit of the net state tax rate reduction will lower its rate going forward.

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Income (loss) before taxes, income tax expense (benefit), and net income (loss) for 2007 and 2006 were as follows:

Earnings (loss) per share for 2007 and 2006 were as follows:

The items discussed elsewhere in the Management’s Discussion and Analysis of Financial Condition and Results of Operations section affected the earnings per share for the periods noted. During 2007, the Company was able to improve the mix of its business from a margin perspective and lowered certain operating expenses, which improved overall operating results. In 2006, although the Company had sales growth due to solid organic growth in programs with existing customers coupled with the business acquired in 2005, much of the growth was in the Company’s lower margin programs and the Company incurred additional costs associated with the Plan as well as other one-time charges.

The Company continues to address its scalability needs to meet customer requirements and to achieve profitable sales growth. The Company continues to evaluate and challenge existing businesses that consistently perform below expected results and is taking a strategic approach to new opportunities. The Company will continue to focus on opportunities where the customer recognizes and values the Company as a partner and enabler to the customer’s specialized product and services needs.