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Table of Contents

 

 

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

 

 

FORM 10-Q

 

 

 

x

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

For the quarterly period ended March 31, 2011

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

 

 

LOGO

PINNACLE DATA SYSTEMS, INC.

(Exact name of registrant as specified in its charter)

 

 

 

Ohio

(State or other jurisdiction of incorporation or organization)

 

31-1263732

(I.R.S. Employer Identification No.)

6600 Port Road, Groveport, Ohio

(Address of principal executive offices)

 

43125

(Zip Code)

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

 

 

No change

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

 

 

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

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

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

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

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

On April 29, 2011, the registrant had outstanding 7,864,349 common shares without par value, which is the registrant’s only class of common equity.

 

 

 


Table of Contents

PINNACLE DATA SYSTEMS, INC.

FORM 10-Q FOR THE QUARTERLY PERIOD ENDED MARCH 31, 2011

TABLE OF CONTENTS

 

PART I – FINANCIAL INFORMATION

     1   

ITEM 1     CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

     1   

ITEM 2     MANAGEMENTS DISCUSSION AND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS

     11   

ITEM 4    CONTROLS AND PROCEDURES

     15   

PART II – OTHER INFORMATION

     16   

ITEM 6    EXHIBITS

     16   

SIGNATURES

     17   

CERTIFICATIONS

     18   


Table of Contents

PART I – FINANCIAL INFORMATION

 

ITEM 1 CONDENSED CONSOLIDATED FINANCIAL STATEMENTS

PINNACLE DATA SYSTEMS, INC.

CONDENSED CONSOLIDATED BALANCE SHEETS

(in thousands)

 

     March 31,
2011
    December 31,
2010
 
ASSETS    (Unaudited)        

CURRENT ASSETS

    

Cash

   $ 503      $ 465   

Accounts receivable, net of allowance for doubtful accounts of $107 and $106, respectively

     5,172        4,469   

Inventory, net

     2,820        3,226   

Deferred income taxes

     781        762   

Prepaid expenses and other current assets

     420        492   
                

Total current assets

     9,696        9,414   
                

PROPERTY AND EQUIPMENT

    

Property and equipment, cost

     6,170        6,056   

Less accumulated depreciation and amortization

     (5,455     (5,371
                

Total property and equipment, net

     715        685   
                

OTHER ASSETS

    

Goodwill

     812        767   

Deferred income taxes

     1,283        929   

Other assets

     196        193   
                

Total other assets

     2,291        1,889   
                

TOTAL ASSETS

   $ 12,702      $ 11,988   
                
LIABILITIES AND STOCKHOLDERS’ EQUITY     

CURRENT LIABILITIES

    

Line of credit

   $ —        $ 273   

Accounts payable

     1,799        1,404   

Accrued wages, payroll taxes and employee benefits

     496        581   

Unearned revenue

     181        30   

Other current liabilities

     557        743   
                

Total current liabilities

     3,033        3,031   

LONG-TERM LIABILITIES

    

Accrued other

     374        296   
                

TOTAL LIABILITIES

     3,407        3,327   
                

STOCKHOLDERS’ EQUITY

    

Preferred stock; no par value; 4,000 shares authorized; no shares issued or outstanding

     —          —     

Common stock; no par value; 25,000 shares authorized; 7,864 shares issued and outstanding

     5,790        5,790   

Additional paid-in capital

     1,981        1,962   

Accumulated other comprehensive income (loss)

     (30     (90

Retained earnings

     1,554        999   
                

Total stockholders’ equity

     9,295        8,661   
                

TOTAL LIABILITIES AND STOCKHOLDERS’ EQUITY

   $ 12,702      $ 11,988   
                

See accompanying notes to condensed consolidated financial statements.

 

1


Table of Contents

PINNACLE DATA SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF OPERATIONS

(Unaudited)

(in thousands, except per share)

 

    For the Three Months Ended
March 31,
 
    2011     2010  

Sales

  $ 6,405      $ 8,812   

Cost of sales

    4,322        6,663   
               

Gross profit

    2,083        2,149   

Operating expenses

    1,824        1,728   
               

Income from operations

    259        421   

Other expense

   

Interest expense

    1        23   
               

Income before income taxes

    258        398   

Income tax expense (benefit)

    (297     89   
               

Net income

  $ 555      $ 309   
               

Weighted average common shares outstanding:

   

Basic

    7,864        7,825   

Diluted

    8,180        7,825   

Earnings per common share:

   

Basic

  $ 0.07      $ 0.04   

Diluted

    0.07        0.04   

See accompanying notes to condensed consolidated financial statements.

 

2


Table of Contents

PINNACLE DATA SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CHANGES IN STOCKHOLDERS’ EQUITY

(Unaudited)

(in thousands)

 

     Common Stock      Additional
Paid-In
Capital
     Accumulated
Other
Comprehensive
Income (Loss)
    Retained
Earnings
(Deficit)
    Total
Stockholders’
Equity
 
     Outstanding
Shares
     Amount            

Balance – December 31, 2009

     7,825       $ 5,769       $ 1,912       $ (29   $ (2,064   $ 5,588   

Share-based payment expense

     —           —           14         —          —          14   

Comprehensive income, net of taxes:

               

Net income

     —           —           —           —          309        309   

Foreign currency translation

     —           —           —           (54     —          (54
                     

Total comprehensive income

                  255   
                                                   

Balance – March 31, 2010

     7,825       $ 5,769       $ 1,926       $ (83   $ (1,755   $ 5,857   
                                                   

Balance – December 31, 2010

     7,864       $ 5,790       $ 1,962       $ (90   $ 999      $ 8,661   

Share-based payment expense

     —           —           19         —          —          19   

Comprehensive income, net of taxes:

               

Net income

     —           —           —           —          555        555   

Foreign currency translation

     —           —           —           60        —          60   
                     

Total comprehensive income

                  615   
                                                   

Balance – March 31, 2011

     7,864       $ 5,790       $ 1,981       $ (30   $ 1,554      $ 9,295   
                                                   

See accompanying notes to condensed consolidated financial statements.

 

3


Table of Contents

PINNACLE DATA SYSTEMS, INC.

CONDENSED CONSOLIDATED STATEMENTS OF CASH FLOWS

(Unaudited)

(in thousands)

 

     For the Three Months Ended
March 31,
 
     2011     2010  

CASH FLOWS FROM OPERATING ACTIVITIES

    

Net income

   $ 555      $ 309   
                

Adjustments to reconcile net income to net cash provided by operating activities:

    

Bad debt expense

     1        10   

Inventory reserves

     51        105   

Depreciation and amortization

     85        102   

Provision (benefit) for deferred income taxes

     (373     —     

Share-based payment expense

     19        14   

(Increase) decrease in assets:

    

Accounts receivable

     (673     (1,150

Inventory

     366        10   

Prepaid expenses and other assets

     23        256   

Increase (decrease) in liabilities:

    

Accounts payable

     328        533   

Unearned revenue

     151        296   

Other current liabilities

     (218     44   
                

Total adjustments

     (240     220   
                

Net cash provided by operating activities

     315        529   
                

CASH FLOWS FROM INVESTING ACTIVITIES

    

Purchases of property and equipment

     (84     (55
                

Net cash used in investing activities

     (84     (55
                

CASH FLOWS FROM FINANCING ACTIVITIES

    

Net change in line of credit

     (273     (1,263

Net change in outstanding checks

     45        498   

Other

     20        17   
                

Net cash used in financing activities

     (208     (748
                

EFFECT OF EXCHANGE RATE ON CASH

     15        (4
                

INCREASE (DECREASE) IN CASH

     38        (278

Cash at beginning of period

     465        323   
                

Cash at end of period

   $ 503      $ 45   
                

See accompanying notes to condensed consolidated financial statements.

 

4


Table of Contents

PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited)

March 31, 2011 and 2010

1. Basis of Presentation

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

The Company’s condensed consolidated financial statements include the accounts of PDSi and PDSi B.V., a private limited liability company located in Tiel, the Netherlands (“PDSi Tiel”). All significant intercompany balances and transactions were eliminated. Certain prior year amounts have been reclassified to conform to the current presentation.

The preparation of financial statements and related disclosures in conformity with GAAP requires management to make judgments, assumptions and estimates that affect the amounts reported in the condensed consolidated financial statements and accompanying notes. Actual results could differ significantly from those estimates. The Company’s most critical estimates include those related to revenue recognition, accounts receivable, inventory, goodwill and income taxes. Although some variability is inherent in these estimates, recorded amounts reflect management’s best estimates based on available facts and circumstances at that time. Management believes the amounts provided are appropriate.

The accompanying condensed consolidated financial statements should be read in conjunction with the audited consolidated financial statements and accompanying notes for the year ended December 31, 2010 included in the Company’s 2010 Annual Report on Form 10-K.

2. Summary of Significant Accounting Policies

A complete summary of the Company’s significant accounting policies is included in Note 2 to the audited consolidated financial statements included in the Company’s 2010 Annual Report on Form 10-K. There have been no material changes to these policies since December 31, 2010.

Inventory

As of March 31, 2011 and December 31, 2010, the Company provided reserves of $2.0 million and $1.9 million, respectively, to reduce the carrying value of inventory. The following table summarizes the Company’s inventory as of the dates indicated (net of inventory reserves):

 

(in thousands)

   March 31,
2011
     December 31,
2010
 

Component parts (raw materials)

   $ 2,594       $ 2,963   

Work-in-process

     58         110   

Finished goods

     168         153   
                 

Total inventory

   $ 2,820       $ 3,226   
                 

 

5


Table of Contents

PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

March 31, 2011 and 2010

 

3. Line of Credit

On March 24, 2011, the Company entered into a Credit Agreement and a Security Agreement with Wells Fargo Bank, National Association (“Wells Fargo”), providing for a revolving credit facility (the “Line”) with a maximum line of credit of $3.0 million, subject to borrowing base restrictions. The borrowing base is determined as follows: 1) the sum of (a) 85% of the aggregate amount of eligible accounts receivable located within the United States, plus (b) 75% of the aggregate amount of eligible accounts receivable located outside of the United States, plus (c) the lesser of 10% of the aggregate amount of eligible inventory or $500,000.

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

The Credit Agreement also contains certain financial covenants, including a maximum ratio of total liabilities to tangible net worth, minimum net income on a rolling four-quarter basis, and a minimum debt service coverage ratio.

The outstanding balance on the Line bears interest monthly at a fluctuating annual rate of 3% above the Daily One Month London Interbank Offered Rate. The Line matures on March 22, 2013.

The Company may use borrowings under the Credit Agreement for general corporate purposes. Any unused portions of the Line will be subject to unused Line fees. Wells Fargo may terminate the Credit Agreement immediately upon default.

On March 24, 2011, in connection with entering into the Credit Agreement and Security Agreement described above, the Company terminated its prior line of credit agreement with Wells Fargo. On the date of the termination, the Company made a final payment to Wells Fargo of all unpaid interest, fees, costs and expenses under the prior agreement and an additional $30,000 as collateral security for the Company’s obligations to Wells Fargo under the prior agreement (the “Reserve”). Any balance of the Reserve remaining after 45 days from the date of termination will be returned to the Company. The Company did not incur any early termination penalties in connection with the termination of the prior line of credit agreement.

4. Income Taxes

The Company files income tax returns in the U.S. federal jurisdiction, various states and foreign countries. There are no federal or state income tax examinations currently underway for these jurisdictions. Open tax years exist for 2007 and beyond for the Company’s federal income tax returns and for 2006 and beyond for state income tax returns.

The Company maintains a $0.1 million valuation allowance against deferred tax assets related to certain state net operating loss (“NOL”) carryforwards. The Company can provide no assurance that changes in its deferred tax asset valuation allowance will not be required in the future. The Company will continue to monitor events and circumstances to determine whether any change in its valuation allowance is warranted in the future.

Although the Company periodically has considered the potential tax savings associated with pursuing research and development (“R&D”) tax credits, the Company’s then recent operating losses, combined with existing federal U.S. NOL carryforwards, precluded an economical pursuit of such credits. However, based on the positive changes in the Company’s operating results and financial position in 2010, as well as the use of existing NOL carryforwards, management determined during the fourth quarter of 2010 that both the cost of an R&D credit study and the establishment of the necessary infrastructure to be able to claim such credits in the future are justified by the resulting benefits. Accordingly, the Company recorded a net income tax benefit of $0.5 million during the fourth quarter of 2010 for estimated R&D credits for tax years 2001 through 2010 that the Company believed were more likely than not to be sustained upon examination by the Internal Revenue Service. The Company substantially completed the calculation and documentation of these R&D credits during the first quarter of 2011, resulting in an additional net income tax benefit of $0.3 million. The Company will complete the filing of amended tax returns later in 2011.

The Company recorded a liability for unrecognized tax benefits related to R&D credit tax positions to be taken on its various income tax returns. If recognized, the entire amount of these unrecognized tax benefits would favorably impact the Company’s effective tax rate in future periods. The Company had $0.2 million of unrecognized tax benefits as of March 31, 2011, which were recorded in other liabilities on the consolidated balance sheets.

 

6


Table of Contents

PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

March 31, 2011 and 2010

 

The following table summarizes the Company’s income tax expense (benefit) for the three months ended March 31:

 

(in thousands)

   2011     2010  

Current:

    

Federal

   $ 70      $ 67   

Foreign

     (2     3   

State and local

     8        19   
                

Total current expense

     76        89   
                

Deferred:

    

Federal

     (392     —     

Foreign

     19        —     
                

Total deferred expense (benefit)

     (373     —     
                

Total income tax expense (benefit)

   $ (297   $ 89   
                

The following table reconciles tax expense (benefit) computed at the federal statutory rate to amounts reported for financial statement purposes for the three months ended March 31:

 

     2011     2010  

(dollars in thousands)

   Amount     %     Amount     %  

Income tax provision (benefit) at statutory rate

   $ 88        34.0      $ 135        34.0   

R&D credits

     (321     NM        —          —     

Change in valuation allowance

     —          —          (45     (11.3

Foreign rate differential

     (12     (4.7     (2     (0.5

Other, net

     (52     (20.2     1        0.2   
                                

Total

   $ (297     NM      $ 89        22.4   
                                

For the three months ended March 31, 2011, the Company received federal tax refunds totaling $0.2 million, and state income tax payments were immaterial. During the three months ended March 31, 2010, the Company received federal tax refunds totaling $0.2 million and made no state income tax payments. As of March 31, 2011, the Company had state NOL carryforwards of $4.3 million that will expire, if unused, between December 31, 2021 and December 31, 2031. The Company had no federal NOL carryforwards as of March 31, 2011.

 

7


Table of Contents

PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

March 31, 2011 and 2010

 

The following table summarizes the tax effect of temporary differences that give rise to significant portions of the Company’s deferred tax assets and deferred tax liabilities as of the dates indicated:

 

(in thousands)

   March 31,
2011
    December 31,
2010
 

Deferred tax assets

    

R&D credits

   $ 1,104      $ 719   

Inventory reserves

     732        714   

Net operating loss

     107        107   

Depreciation and amortization

     87        113   

Other

     173        177   
                

Gross deferred tax assets

     2,203        1,830   

Less valuation allowance

     (79     (79
                

Deferred tax asset

     2,124        1,751   
                

Deferred tax liabilities

    

Prepaids

     60        60   
                

Gross deferred tax liability

     60        60   
                

Net deferred tax asset

   $ 2,064      $ 1,691   
                

The following table summarizes the classification of the above amounts in the Company’s consolidated balance sheets as of the dates indicated:

 

(in thousands)

   March 31,
2011
     December 31,
2010
 

Current assets

     

Deferred income taxes

   $ 781       $ 762   

Other assets

     

Deferred income taxes

     1,283         929   
                 

Net deferred tax asset

   $ 2,064       $ 1,691   
                 

5. Earnings Per Share

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

The following table presents the Company’s calculation of basic and diluted weighted average common shares outstanding for the three months ended March 31:

 

(in thousands)

   2011      2010  

Weighted average common shares outstanding – basic

     7,864         7,825   

Dilutive effect of stock options

     316         —     
                 

Weighted average common shares outstanding – diluted

     8,180         7,825   
                 

The computation of diluted EPS for the three months ended March 31, 2011 and 2010 excluded options to purchase approximately 406,000 shares and 705,000 shares, respectively, that were anti-dilutive because the exercise price of these options was greater than the average market price of the common shares during the respective periods.

 

8


Table of Contents

PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

March 31, 2011 and 2010

 

6. Segment Information

The Company’s reportable segments are Product and Service. PDSi is a global provider of electronics repair and reverse logistics services; ODM and OEM integrated computing services; and embedded computing products and design services for the diversified computing, telecommunications, imaging, defense/aerospace, medical, semiconductor and industrial automation markets. PDSi provides a variety of engineering and manufacturing services for global OEMs requiring custom product design, system integration, repair programs, warranty management, and/or specialized production capabilities. PDSi’s engineering, technical and operational capabilities span the entire product lifecycle allowing the Company to better understand and develop custom solutions for each of its customer’s unique requirements.

PDSi’s product capabilities range from board-level designs to globally certified, fully integrated systems, specializing in long-life computer products and unique, customer-centric solutions. PDSi’s capability to perform higher-level repair services in-region allows the Company to customize solutions for its customers so that they can deliver world-class service levels to their customers with reduced logistics, component replacement and inventory costs.

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

The following table summarizes the Company’s segment operating results for the three months ended March 31:

 

(in thousands)

   2011     2010  

Sales

    

Product

   $ 2,726      $ 5,927   

Service

     3,679        2,885   
                

Total

   $ 6,405      $ 8,812   
                

Gross profit

    

Product

   $ 564      $ 1,069   

Service

     1,519        1,080   
                

Total

   $ 2,083      $ 2,149   
                

Income (loss) from operations

    

Product

   $ 278      $ 704   

Service

     1,013        652   

Other

     (1,032     (935
                

Total

   $ 259      $ 421   
                

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

 

(in thousands)

   March 31,
2011
     December 31,
2010
 

Product

   $ 3,192       $ 3,280   

Service

     5,569         5,443   

Other

     3,941         3,265   
                 

Total

   $ 12,702       $ 11,988   
                 

 

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PINNACLE DATA SYSTEMS, INC.

Notes to Condensed Consolidated Financial Statements (Unaudited), Continued

March 31, 2011 and 2010

 

The following table summarizes sales by geographic region for the three months ended March 31:

 

(in thousands)

   2011      2010  

United States

   $ 5,603       $ 8,041   

International

     802         771   
                 

Total

   $ 6,405       $ 8,812   
                 

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

     

(in thousands)

   March  31,
2011
     December  31,
2010
 
     

United States

   $ 1,660       $ 1,277   

International

     1,346         1,297   
                 

Total

   $ 3,006       $ 2,574   
                 

International long-lived assets include goodwill of $0.8 million as of March 31, 2011 and December 31, 2010. All international sales and long-lived assets are in the Service segment.

 

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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”, the “Company” or “we”) achieving its financial growth and profitability goals, or its sales, earnings and profitability expectations for the fiscal year ending December 31, 2011. The words “believe,” “expect,” “anticipate,” “estimate,” “intend,” “seek,” “may” and similar expressions identify forward-looking statements that speak only as of the date of this Quarterly Report on Form 10-Q. Investors are cautioned that such statements involve risks and uncertainties that could cause actual results to differ materially from historical or anticipated results due to many factors. These factors include, but are not limited to, the following:

 

   

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

 

   

changes in customer order patterns;

 

   

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

 

   

failure to maintain adequate levels of inventory;

 

   

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

 

   

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

 

   

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

 

   

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

 

   

lack of success in technological advancements;

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

 

   

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

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

The following is management’s discussion and analysis of financial condition and results of operations of the Company for the three months ended March 31, 2011 and 2010. This discussion should be read in conjunction with the Company’s audited consolidated financial statements and related notes contained in its 2010 Annual Report on Form 10-K.

Executive Overview

PDSi is a global provider of electronics repair and reverse logistics services; system integration and original design manufacturer (“ODM”) computing design and manufacturing services; and embedded computing products and design services for the diversified computing, telecommunications, imaging, defense/aerospace, medical, semiconductor and industrial automation markets. PDSi provides a variety of engineering and manufacturing services for global original equipment manufacturers (“OEMs”) requiring custom product design, system integration, repair programs, warranty management, and/or specialized production capabilities. We have facilities in the United States (“U.S.”), Europe and Asia. More than just an ODM, integrator or reverse logistics provider, PDSi’s engineering, technical and operational capabilities span the entire product lifecycle allowing us to better understand and develop custom solutions for each of our customer’s unique requirements. Our product capabilities range from board-level designs to globally certified, fully integrated systems, specializing in long-life computer products and unique, customer-centric solutions. Our capability to perform higher-level repair services in-region allows us to customize solutions for our customers so that they can deliver world-class service levels to their customers with reduced logistics, component replacement and inventory costs. The common shares of PDSi are traded on NYSE Amex under the stock symbol “PNS.”

 

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During the quarter ended March 31, 2011, we recorded net income of $555,000, or $0.07 per diluted share, versus net income of $309,000, or $0.04 per diluted share, for the prior year quarter. See below for further discussion of consolidated and reportable segment results of operations for the three months ended March 31, 2011 and 2010.

Although we periodically have considered the potential tax savings associated with pursuing research and development (“R&D”) tax credits, our then recent operating losses, combined with existing federal U.S. net operating loss (“NOL”) carryforwards, precluded an economical pursuit of such credits. However, based on the positive changes in the Company’s operating results and financial position in 2010, as well as the use of existing NOL carryforwards, management determined during the fourth quarter of 2010 that both the cost of an R&D credit study and the establishment of the necessary infrastructure to be able to claim such credits in the future are justified by the resulting benefits. Accordingly, the Company recorded a net income tax benefit of $0.5 million during the fourth quarter of 2010 for estimated R&D credits for tax years 2001 through 2010 that the Company believed were more likely than not to be sustained upon examination by the Internal Revenue Service. The Company substantially completed the calculation and documentation of these R&D credits during the first quarter of 2011, resulting in an additional net income tax benefit of $0.3 million.

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

Results of Operations

Consolidated Operations

First Quarter – 2011 Compared to 2010

The following table summarizes the Company’s consolidated results of operations for the three months ended March 31:

 

(dollars in thousands)

   2011     % of
Sales
    2010      % of
Sales
    %
Change
 

Sales

   $ 6,405        100.0   $ 8,812         100.0     -27

Cost of sales

     4,322        67.5     6,663         75.6     -35
                       

Gross profit

     2,083        32.5     2,149         24.4     -3

Operating expenses

     1,824        28.5     1,728         19.6     6
                       

Income from operations

     259        4.0     421         4.8     -38

Other expense

           

Interest expense

     1        0.0     23         0.3     -96
                       

Income before income taxes

     258        4.0     398         4.5     -35

Income tax expense (benefit)

     (297     -4.7     89         1.0     NM   
                       

Net income

   $ 555        8.7   $ 309         3.5     80
                       

The increase in net income for the three months ended March 31, 2011 compared to the prior year quarter primarily was due to the aforementioned net income tax benefit of $0.3 million related to R&D credits. Strong growth in the Service segment offset the impact of lower sales in the Product segment, while both segments posted higher gross profit margins primarily due to shifts in mix toward higher margin business. Service segment gross profit increased 41% primarily due to a 28% increase in Service sales driven by the growth of business in both the U.S. and the Europe, Middle East and Africa (“EMEA”) region for both new customers and new programs within existing customers. Product segment gross profit fell 47% due to a 54% decrease in sales, mostly to OEMs in the telecommunications sector that had particularly strong activity in early 2010. Increased operating expenses reflect investments in personnel needed to support and grow the business.

For the first quarter of 2011, the Company had three customers that generated $1.3 million, $1.2 million and $1.0 million, or 21%, 18% and 15%, respectively, of total sales. Of the revenues from these customers, 31% and 69% were included in Product and Service segment sales, respectively. For the first quarter of 2010, the Company had three customers that generated $2.5 million, $1.5 million and $1.4 million, or 28%, 17% and 16%, respectively, of total sales. Of the revenues from these customers, 86% and 14% were included in Product and Service segment sales, respectively.

 

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Segment Operations

Product

First Quarter – 2011 Compared to 2010

The following table summarizes the Company’s gross profit for the Product segment for the three months ended March 31:

 

(dollars in thousands)

   2011      % of
Sales
    2010      % of
Sales
    %
Change
 

Sales

   $ 2,726         100.0   $ 5,927         100.0     -54

Cost of sales

     2,162         79.3     4,858         82.0     -55
                        

Gross profit

   $ 564         20.7   $ 1,069         18.0     -47
                        

A 54% decrease in Product sales, including $2.8 million lower sales to OEMs in the telecommunications industry that had particularly strong activity in early 2010, drove the decline in Product segment gross profit. However, the continued shift in sales mix to higher margin products, in conjunction with management of manufacturing overhead costs to levels consistent with lower Product revenues, resulted in a 21% gross margin in the first quarter of 2011 compared to 18% in the comparable quarter of 2010.

Service

First Quarter – 2011 Compared to 2010

The following table summarizes the Company’s gross profit for the Service segment for the three months ended March 31:

 

(dollars in thousands)

   2011      % of
Sales
    2010      % of
Sales
    %
Change
 

Sales

   $ 3,679         100.0   $ 2,885         100.0     28

Cost of sales

     2,160         58.7     1,805         62.6     20
                        

Gross profit

   $ 1,519         41.3   $ 1,080         37.4     41
                        

Gross profit in the Service segment increased primarily due to the growth of business in both the U.S. and EMEA for both new customers and new programs within existing customers. The continuing shift toward higher margin programs and gains in operating leverage on the 28% sales growth drove an increase in gross profit as a percentage of sales to 41% in the first quarter of 2011 from 37% in the comparable quarter of 2010.

Liquidity and Capital Resources

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

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

 

(in thousands)

   March 31,
2011
    December 31,
2010
 

Line of credit

   $ —        $ 273   
                

Stockholders’ equity, excluding accumulated other comprehensive income (loss)

     9,325        8,751   

Accumulated other comprehensive income (loss)

     (30     (90
                

Total stockholders’ equity

     9,295        8,661   
                

Total capital

   $ 9,295      $ 8,934   
                

 

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

The following table summarizes the Company’s condensed consolidated cash flows for the three months ended March 31:

 

(in thousands)

   2011     2010  

Net cash provided by operating activities

   $ 315      $ 529   

Net cash used in investing activities

     (84     (55

Net cash used in financing activities

     (208     (748

Effect of exchange rate on cash

     15        (4
                

Increase (decrease) in cash

     38        (278

Cash at beginning of period

     465        323   
                

Cash at end of period

   $ 503      $ 45   
                

Operating Activities

Net cash provided by operating activities was $0.3 million and $0.5 million for the three months ended March 31, 2011 and 2010, respectively. Net income adjusted for the effects of non-cash items, which primarily include deferred income taxes, inventory reserves and depreciation expense, resulted in cash inflows of $0.3 million and $0.5 million in the first three months of 2011 and 2010, respectively. Changes in working capital resulted in a net neutral impact for the first three months of 2011 and 2010.

Investing Activities

Net cash used in investing activities represents purchases of property and equipment.

Financing Activities

Net cash used in financing activities was $0.2 million and $0.7 million for the first three months of 2011 and 2010, respectively. Financing activity in both periods primarily reflects net repayments on the Company’s line of credit. All cash generated by U.S. operations after funding investing activities is applied to any existing balance on the line of credit.

On March 24, 2011, we entered into a Credit Agreement and a Security Agreement with Wells Fargo Bank, National Association (“Wells Fargo”), providing for a revolving credit facility (the “Line”) with a maximum line of credit of $3.0 million, subject to borrowing base restrictions. The borrowing base is determined as follows: 1) the sum of (a) 85% of the aggregate amount of eligible accounts receivable located within the United States, plus (b) 75% of the aggregate amount of eligible accounts receivable located outside of the United States, plus (c) the lesser of 10% of the aggregate amount of eligible inventory or $500,000.

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

The Credit Agreement also contains certain financial covenants, including a maximum ratio of total liabilities to tangible net worth, minimum net income on a rolling four-quarter basis, and a minimum debt service coverage ratio.

The outstanding balance on the Line bears interest monthly at a fluctuating annual rate of 3% above the Daily One Month London Interbank Offered Rate. The Line matures on March 22, 2013.

The Company may use borrowings under the Credit Agreement for general corporate purposes. Any unused portions of the Line will be subject to unused Line fees. Wells Fargo may terminate the Credit Agreement immediately upon default.

On March 24, 2011, in connection with entering into the Credit Agreement and Security Agreement described above, we terminated our prior line of credit agreement with Wells Fargo. On the date of the termination, the Company made a final payment to Wells Fargo of all unpaid interest, fees, costs and expenses under the prior agreement and an additional $30,000 as collateral security for the Company’s obligations to Wells Fargo under the prior agreement (the “Reserve”). Any balance of the Reserve remaining after 45 days from the date of termination will be returned to the Company. The Company did not incur any early termination penalties in connection with the termination of the prior line of credit agreement.

 

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Off-Balance Sheet Arrangements

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

During the normal course of business, we may have numerous outstanding purchase orders with vendors to purchase inventory for use in products that are sold to our customers or are used in performing repair services for our customers. We do not record such orders as liabilities on the condensed consolidated balance sheets until the material is placed on a common carrier or delivered to the Company’s facilities, depending on terms of the arrangement, or when pulled from on-site vendor managed inventory. We have no minimum purchase quantity requirements with any of our vendors.

Critical Accounting Policies and Recently Issued Accounting Standards

The preparation of financial statements and related disclosures in conformity with United States generally accepted accounting principles (“GAAP”) requires management to make judgments, assumptions and estimates that affect the amounts reported in the consolidated financial statements and accompanying notes. Actual results could differ significantly from those estimates. Our most critical estimates include those related to revenue recognition, accounts receivable, inventory, goodwill and income taxes. In many cases, the accounting treatment of a particular transaction is specifically dictated by GAAP, with no need for judgment in application. In addition, there are areas in which management’s judgment in selecting an available alternative would not produce a materially different result. Note 2 to the audited consolidated financial statements included in the Company’s 2010 Annual Report on Form 10-K describes the significant accounting policies and methods used by the Company. We do not expect the adoption of any recently issued accounting standards to have a material impact on our consolidated financial position, results of operations or cash flows. Our critical accounting policies have not changed materially from those disclosed in the Company’s 2010 Annual Report on Form 10-K.

 

ITEM 4 CONTROLS AND PROCEDURES

Evaluation of Disclosure Controls and Procedures

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

Changes in Internal Control Over Financial Reporting

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

 

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PART II – OTHER INFORMATION

 

ITEM 6. EXHIBITS

 

Exhibit

No.

  

Description of Exhibit

  

If incorporated by reference, document with which

Exhibit was previously filed with the SEC

10.38   

Credit Agreement between Pinnacle Data Systems, Inc. and Wells Fargo Bank, National Association, dated March 24, 2011

   Current Report on Form 8-K filed with the SEC on March 29, 2011
10.39   

Security Agreement between Pinnacle Data Systems, Inc. and Wells Fargo Bank, National Association, dated March 24, 2011

   Current Report on Form 8-K filed with the SEC on March 29, 2011
10.40   

Revolving Line of Credit Note between Pinnacle Data Systems, Inc. and Wells Fargo Bank, National Association, dated March 24, 2011

   Current Report on Form 8-K filed with the SEC on March 29, 2011
31.1   

Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Quarterly Report on Form 10-Q of Pinnacle Data Systems, Inc. for the quarter ended March 31, 2011

   Contained herein
31.2   

Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 of Quarterly Report on Form 10-Q of Pinnacle Data Systems, Inc. for the quarter ended March 31, 2011

   Contained herein
32.1   

Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 of Quarterly Report on Form 10-Q of Pinnacle Data Systems, Inc. for the quarter ended March 31, 2011

   Contained herein
32.2   

Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 of Quarterly Report on Form 10-Q of Pinnacle Data Systems, Inc. for the quarter ended March 31, 2011

   Contained herein

 

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SIGNATURES

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

 

   

PINNACLE DATA SYSTEMS, INC.

Date: May 4, 2011

   

/s/    John D. Bair

   

John D. Bair

Chief Executive Officer

Date: May 4, 2011

   

/s/    Nicholas J. Tomashot

   

Nicholas J. Tomashot

Chief Financial Officer

 

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