** **

**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington, D.C. 20549**

 

#### **FORM 10–Q**

 

 

**ý**        QUARTERLYREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2001

###### ** **

###### **OR**

 

**o**        TRANSITIONREPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934FOR THE TRANSITION PERIOD FROM __________ TO __________

 

**CommissionFile Number     0–28488**

 

**ZONES, INC**

(Exact name of registrant asspecified in its charter)

|                                      |   |                                     |
|-------------------------------------------|--------|------------------------------------------|
| **Washington**                            |   | **91–1431894**                      |
| (State of Incorporation)                  |   | (I.R.S. Employer  Identification Number) |
|                                      |   |                                     |
| **707 South Grady Way**                   |   |                                     |
| **Renton, Washington**                    |   | **98055–3233**                      |
| (Address of Principal  Executive Offices) |   | (Zip Code)                               |

 

**(425) 430–3000**

(Registrant's Telephone

Number, Including Area Code)

 

----

 

 

Indicateby check mark whether the registrant (1) has filed all reports required to befiled by Section 13 or 15(d) of the Securities Exchange Act of 1934 during thepreceding 12 months (or for such shorter period that the registrant wasrequired to file such reports), and (2) has been subject to such filingrequirements for the past 90 days.

 

Yes ý  No o

 

 

 

 

The number of shares of the registrant's Common Stockoutstanding as of September 7, 2001 was 13,536,406.

 

 

**ZONES, INC.**

 

**INDEX**

 
|    | **PART  I.  FINANCIAL INFORMATION**                                                                                |   |
|---------|-------------------------------------------------------------------------------------------------------------------------|--------|
| Item 1. | Consolidated Financial Statements:                                                                                      |   |
|    |                                                                                                                    |   |
|    | Consolidated Balance Sheets September 30, 2001 and December 31, 2000                                                    |   |
|    |                                                                                                                    |   |
|    | Consolidated Statements of Operations and  Comprehensive Income Three and nine months ended September 30, 2001 and 2000 |   |
|    |                                                                                                                    |   |
|    | Statements of Shareholders’ Equity Nine  months ended September 30, 2001                                           |   |
|    |                                                                                                                    |   |
|    | Consolidated Statements of Cash Flows Nine  months ended September 30, 2001 and 2000                                    |   |
|    |                                                                                                                    |   |
|    | Notes to Consolidated Financial Statements                                                                              |   |
|    |                                                                                                                    |   |
| Item 2. | Management’s Discussion and Analysis of  Financial Condition and Results of Operations                             |   |
|    |                                                                                                                    |   |
| Item 3. | Quantitative and Qualitative Disclosures  About Market Risk                                                             |   |
|    |                                                                                                                    |   |
|    |                                                                                                                    |   |
|    | **PART II.  OTHER INFORMATION**                                                                                    |   |
| Item 1. | Legal Proceedings                                                                                                       |   |
|    |                                                                                                                    |   |
| Item 6. | Exhibits and Reports on Form 8-K                                                                                        |   |
|    |                                                                                                                    |   |
|    | Signatures                                                                                                              |   |

** **

 

**Part I.**

 

**Item 1.    FinancialStatements**

** **

**ZONES, INC. ANDSUBSIDIARIES**

**CONSOLIDATEDBALANCE SHEETS**

**(inthousands)**

**(unaudited)**
|                                               |   | **September 30,**

**2001** |   | **December 31,**

**2000** |   |
|----------------------------------------------------|--------|-----------------------------|--------|----------------------------|--------|
| ** **                                         |
|                                               |   |                        |   |                       |   |
| **ASSETS**                                         |   |                        |   |                       |   |
| Current assets:                                    |   |                        |   |                       |   |
| Cash and cash equivalents                          |   | $                           | 6,357  |                       | $      | 3,816 |   |
| Restricted cash                                    |   | 930                         |   | 930                        |   |
| Receivables, net                                   |   | 37,114                      |   | 56,608                     |   |
| Inventories, net                                   |   | 17,203                      |   | 29,050                     |   |
| Prepaid expenses                                   |   | 1,341                       |   | 1,110                      |   |
| Deferred income taxes                              |   | 1,970                       |   | 1,970                      |   |
| Notes Receivable                                   |   | 863                         |   | 1,080                      |   |
| Total current assets                               |   | 65,778                      |   | 94,564                     |   |
| Property and equipment, net                        |   | 8,667                       |   | 11,710                     |   |
| Other assets                                       |   | 5,175                       |   | 4,996                      |   |
| Total assets                                       |   | $                           | 79,620 |                       | $      | 111,270 |   |
|                                               |   |                        |   |                       |   |
| **LIABILITIES AND SHAREHOLDERS' EQUITY**           |   |                        |   |                       |   |
| Current liabilities:                               |   |                        |   |                       |   |
| Accounts payable                                   |   | $                           | 39,487 |                       | $      | 66,267 |   |
| Accrued liabilities and other                      |   | 5,530                       |   | 9,212                      |   |
| Current portion of capital lease  obligations      |   | 1,598                       |   | 1,905                      |   |
| Total current liabilities                          |   | 46,615                      |   | 77,384                     |   |
| Capital lease obligations, net of current  portion |   | 545                         |   | 1,197                      |   |
| Other liabilities                                  |   | 678                         |   | 955                        |   |
| Total liabilities                                  |   | 47,838                      |   | 79,536                     |   |
|                                               |   |                        |   |                       |   |
| Minority interest                                  |   | 129                         |   | 131                        |   |
|                                               |   |                        |   |                       |   |
| Commitments and contingencies                      |   |                        |   |                       |   |
|                                               |   |                        |   |                       |   |
| Shareholders' equity:                              |   |                        |   |                       |   |
| Common stock                                       |   | 39,472                      |   | 39,360                     |   |
| Accumulated deficit                                |   | (7,819                      | )      | (7,757                     | )      |
| Total shareholders' equity                         |   | 31,653                      |   | 31,603                     |   |
| Total liabilities and shareholders' equity         |   | $                           | 79,620 |                       | $      | 111,270 |   |

 

 

See notes to consolidated financial statements

 

 

 

 

**ZONES, INC. ANDSUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF OPERATIONS ANDCOMPREHENSIVE INCOME**

**(in thousands, except earnings per share)**

**(unaudited)**

** **
|                                                           |   | **Three months ended**

**September 30,** |       | **Nine months ended**

**September 30,** |       |
|----------------------------------------------------------------|--------|-------------------------------------------|------------|------------------------------------------|------------|
|                                                           |   | **2001**                                  |       | **2000**                                 |       | **2001** |   | **2000** |   |
|                                                           |   |                                      | ** ** |                                     | ** ** |   | ** ** |   | ** ** |
| Net sales                                                      |   | $                                         | 120,723    |                                     | $          | 169,671 |   | $ | 427,055 |   | $ | 467,816 |   |
| Cost of sales                                                  |   | 108,551                                   |       | 154,143                                  |       | 385,137 |   | 424,318 |   |
| Gross profit                                                   |   | 12,172                                    |       | 15,528                                   |       | 41,918 |   | 43,498 |   |
|                                                           |   |                                      |       |                                     |       |   |   |   |   |
| Selling, general and administrative                            |   | 12,629                                    |       | 15,409                                   |       | 41,916 |   | 45,692 |   |
| Income (loss) from operations                                  |   | (457                                      | )          | 119                                      |       | 2 |   | (2,194 | ) |
|                                                           |   |                                      |       |                                     |       |   |   |   |   |
| Interest expense                                               |   | 33                                        |       | 357                                      |       | 259 |   | 573 |   |
| Other (income) expense, net                                    |   | (47                                       | )          | (39                                      | )          | (146 | ) | (2,048 | ) |
| Minority interest                                              |   |                                      |       | (5                                       | )          | (2 | ) | (12 | ) |
| Other (income) expense                                         |   | (14                                       | )          | 313                                      |       | 111 |   | (1,487 | ) |
| Loss before taxes                                              |   | (443                                      | )          | (194                                     | )          | (109 | ) | (707 | ) |
| Benefit from income taxes                                      |   | (186                                      | )          | (57                                      | )          | (47 | ) | (256 | ) |
| Net loss before cumulative change                              |   | $                                         | (257       | )                                        | $          | (137 | ) | $ | (62 | ) | $ | (451 | ) |
| Cumulative effect of change in accounting  principle           |   |                                      |       |                                     |       |   |   | $ | (59 | ) |
| Net loss                                                       |   | $                                         | (257       | )                                        | $          | (137 | ) | $ | (62 | ) | $ | (510 | ) |
|                                                           |   |                                      |       |                                     |       |   |   |   |   |
| Other comprehensive income (expense), net  of tax:             |   |                                      |       |                                     |       |   |   |   |   |
| Foreign currency translation adjustment                        |   |                                      |       | 24                                       |       |   |   | 24 |   |
| Comprehensive income (loss)                                    |   | $                                         | (257       | )                                        | $          | (113 | ) | $ | (62 | ) | $ | (486 | ) |
|                                                           |   |                                      |       |                                     |       |   |   |   |   |
| Net loss attributable to basic and diluted  earnings per share |   | $                                         | (257       | )                                        | $          | (137 | ) | $ | (62 | ) | $ | (510 | ) |
|                                                           |   |                                      |       |                                     |       |   |   |   |   |
| Basic loss per share                                           |   | $                                         | (0.02      | )                                        | $          | (0.01 | ) | $ | (0.01 | ) | $ | (0.04 | ) |
|                                                           |   |                                      |       |                                     |       |   |   |   |   |
| Shares used in computing basic loss per  share                 |   | 13,499                                    |       | 13,388                                   |       | 13,471 |   | 13,376 |   |
|                                                           |   |                                      |       |                                     |       |   |   |   |   |
| Diluted loss per share                                         |   | $                                         | (0.02      | )                                        | $          | (0.01 | ) | $ | (0.01 | ) | $ | (0.04 | ) |
|                                                           |   |                                      |       |                                     |       |   |   |   |   |
| Shares used in computing diluted loss per  share               |   | 13,499                                    |       | 13,388                                   |       | 13,471 |   | 13,376 |   |

 

 

 

 

 

 

See notes to consolidated financial statements

**ZONES, INC. ANDSUBSIDIARIES**

**STATEMENTSOF SHAREHOLDERS' EQUITY**

**(in thousands, except share data)**

**(unaudited)**

 

 
|                        |   | **Common Stock** |   | **Retained** |   |        |   |
|-----------------------------|--------|------------------|--------|--------------|--------|-------------|--------|
|                        |   | **Shares**       |   | **Amount**   |   | **Deficit** |   | **Total** |   |
|                        |   |             |   |         |   |        |   |   |   |
| Balance, January 1, 2001    |   | 13,403,658       |   | $            | 39,360 |        | $      | (7,757 | ) | $ | 31,603 |   |
| Issuance of common stock    |   | 93,959           |   | 107          |   |        |   | 107 |   |
| Exercise of stock options   |   | 1,500            |   | 5            |   |        |   | 5 |   |
| Net income                  |   |             |   |         |   | (62         | )      | (62 | ) |
| Balance, September 30, 2001 |   | 13,499,117       |   | $            | 39,472 |        | $      | (7,819 | ) | $ | 31,653 |   |

 

 

 

 

See notes to consolidated financial statements

 

**ZONES, INC. ANDSUBSIDIARIES**

**CONSOLIDATED STATEMENTS OF CASH FLOWS**

**(in thousands)**

**(unaudited)**

 
|                                                                        |   | **Nine months ended**

**September 30,** |   |
|-----------------------------------------------------------------------------|--------|------------------------------------------|--------|
|                                                                        |   | **2001**                                 |   | **2000** |   |
| Cash flows from operating activities:                                       |   |                                     |   |   |   |
| Net income (loss)                                                           |   | $                                        | (62    | ) | $ | (510 | ) |
| Adjustments to reconcile net income to net  cash from operating activities: |   |                                     |   |   |   |
| Depreciation and amortization                                               |   | 5,248                                    |   | 4,426 |   |
| (Gain) Loss on sale of subsidiaries                                         |   |                                     |   | (1,674 | ) |
| Minority interest                                                           |   | (2                                       | )      | (12 | ) |
| Changes in assets and liabilities:                                          |   |                                     |   |   |   |
| Accounts receivable                                                         |   | 19,494                                   |   | (32,152 | ) |
| Inventory                                                                   |   | 11,848                                   |   | (23,615 | ) |
| Prepaid expenses and other assets                                           |   | (194                                     | )      | (595 | ) |
| Accounts payable                                                            |   | (27,896                                  | )      | 30,825 |   |
| Accrued liabilities                                                         |   | (3,959                                   | )      | 1,691 |   |
| Income taxes                                                                |   | -                                        |   | 1 |   |
| Net cash provided by (used by) operating  activities                        |   | 4,477                                    |   | (21,615 | ) |
|                                                                        |   |                                     |   |   |   |
| Cash flows from investing activities:                                       |   |                                     |   |   |   |
| Proceeds from sale of subsidiaries                                          |   |                                     |   | 500 |   |
| Purchases of property and equipment                                         |   | (2,205                                   | )      | (2,475 | ) |
| Net cash used in investing activities                                       |   | (2,205                                   | )      | (1,975 | ) |
|                                                                        |   |                                     |   |   |   |
| Cash flows from financing activities:                                       |   |                                     |   |   |   |
| Net change in book overdrafts                                               |   | 1,116                                    |   | 1,087 |   |
| Net proceeds from sale of common stock                                      |   | 112                                      |   | 144 |   |
| Net proceeds from capital lease                                             |   | 573                                      |   |   |   |
| Payments on capital leases                                                  |   | (1,532                                   | )      | (1,170 | ) |
| Net cash used by financing activities                                       |   | 269                                      |   | 61 |   |
|                                                                        |   |                                     |   |   |   |
| Net increase (decrease) in cash and cash  equivalents                       |   | 2,541                                    |   | (23,529 | ) |
| Cash and cash equivalents at beginning of  period                           |   | 3,816                                    |   | 25,774 |   |
|                                                                        |   |                                     |   |   |   |
| Cash and cash equivalents at end of period                                  |   | $                                        | 6,357  |   | $ | 2,245 |   |
|                                                                        |   |                                     |   |   |   |
| Supplemental cash flow information:                                         |   |                                     |   |   |   |
| Noncash investing and financing activity:                                   |   |                                     |   |   |   |
| Capital leases to finance purchases of  equipment                           |   |                                     |   | $ | 298 |   |
| Note received on sale of subsidiary                                         |   |                                     |   | $ | 1,400 |   |

 

 

 

 

 

See notes to consolidated financial statements

**ZONES, INC. ANDSUBSIDIARIES**

**NOTES TO CONSOLIDATED FINANCIAL STATEMENTS**

 

**1.  Description of Business**

** **

**Zones, Inc. is a single-source, multi-vendor directreseller of name-brand information technology products and services to the fastgrowing small to medium sized business market, enterprise and government andeducation accounts.  Zones sells theseproducts and services through specialty print and e-catalogs, inbound andoutbound account executives and the Internet. Zones offers more than 150,000 products from leading manufacturersincluding Apple, Compaq, Hewlett-Packard, IBM, Microsoft and Toshiba.**

 

Incorporated in 1988, Zones, Inc., is headquartered in Renton,Washington. Company and buying information is available athttp://www.zones.com, or by calling 800-258-2088.

 

**2.  Summary of Significant Accounting Policies**

 

The accompanying unauditedconsolidated financial statements and notes have been prepared in accordancewith the rules and regulations of the Securities and Exchange Commission andconsequently do not include all of the disclosures normally required bygenerally accepted accounting principles. In the opinion of management, theaccompanying unaudited consolidated financial statements contain alladjustments (consisting of normal recurring accruals) necessary to presentfairly the financial position and operating results for the interimperiods.  The results of operations forsuch interim periods are not necessarily indicative of results for the fullyear.  These financial statements shouldbe read in conjunction with the audited financial statements and notes theretocontained in the Company’s Annual Report on Form 10-K for the year endedDecember 31, 2000 as filed with the Securities and Exchange Commission on March13, 2001.

 

*Principles of Consolidation*

The accompanying consolidated financial statements include the accountsof the Company and of its majority owned subsidiaries. Intercompanytransactions and balances have been eliminated in consolidation.

 

*Earnings Per Share*

Earnings per share (“EPS”) arebased upon the weighted average number of shares outstanding during the period.Basic EPS exclude all dilution.  DilutedEPS reflects the potential dilution that would occur if securities or othercontracts to issue common stock were exercised or converted into commonstock.  The Company excludes all optionsto purchase common from the calculation of diluted net loss per share if suchsecurities are antidilutive.

 

*Recent Accounting Pronouncements*

In June1998, the Financial Accounting Standards Board issued SFAS No. 133, “Accountingfor Derivative Instruments and Hedging Activities.”  Among other provisions, SFAS No. 133 requires that entitiesrecognize all derivatives as either assets or liabilities in the statement offinancial position and measure those instruments at fair value.  Gains and losses resulting from changes inthe fair values of those derivatives would be accounted for depending on theuse of the derivative and whether it qualifies for hedge accounting.  The effective date of SFAS No. 133 wasdelayed by the issuance of SFAS No. 137 until the fiscal years beginningJanuary 1, 2001. In June 2000, SFAS 138 was issued, which amends provisions ofSFAS 133.  The adoption ofthese standards did not have a material impact on the Company’s financialposition, as the Company currently holds no derivatives.

 

In July2001, the Financial Accounting Standards Board issued SFAS 141, "BusinessCombinations" ("FAS 141").  FAS 141 addresses financial accounting and reporting for businesscombinations.  FAS 141 is effective forall business combinations accounted for by the purchase method for which thedate of acquisition is July 1, 2001, or later. The Company does not believe that the adoption of  FAS 141 will have a significant impact onits financial statements.

 

In July 2001, the Financial Accounting StandardsBoard issued SFAS 142, "Goodwill and other intangible assets"("FAS 142"). FAS 142 addresses financial accounting and reporting for acquired goodwill and other intangibleassets.  The provisions of FAS 142 willbe effective for fiscal years beginning after December 15, 2001, except thatcertain provisions of FAS 142 shall be applied to goodwill and other acquiredintangible assets for which the acquisition date is after June 30, 2001. TheCompany does not believe FAS 142 will have a significant impact its financialstatements.

 

In July2001, the Financial Accounting Standards Board issued SFAS 143,"Accounting for Asset Retirement Obligations" ("FAS 143").FAS 143 addresses financial accounting and reporting for obligations associatedwith the retirement of tangible long-lived assets and the associated assetretirement costs. It applies to legal obligations associated with the retirementof long-lived assets that result from the acquisition, construction,development, and (or) the normal operation of a long-lived asset, except forcertain obligations of lessees. The provisions of FAS 143 will be effective forfiscal years beginning after June 15, 2002, however early application ispermitted. The Company does not believe FAS 143 will have a significant impactits financial statements.

 

In August2001, the Financial Accounting Standards Board issued SFAS 144 "Accountingfor the Impairment or Disposal of Long-Lived Assets" ("FAS144"). This Statement addresses financial accounting and reporting for theimpairment or disposal of long-lived assets. This Statement supersedes FASB Statement No. 121, Accounting for theImpairment of Long-Lived Assets and for Long-Lived Assets to Be Disposed Of,and the accounting and reporting provisions of APB Opinion No. 30, Reportingthe Results of Operations -- Reporting the Effects of Disposal of a Segment ofa Business, and Extraordinary, Unusual and Infrequently Occurring Events andTransactions, for the disposal of a segment of a business.  The provisions of FAS 144 will be effectivefor fiscal years beginning after December 15, 2001. The Company is currentlyevaluating the implications of adoption of FAS 144 and anticipates adopting itsprovisions in fiscal year 2002.

 

*Revenue Recognition*

The Company recognizes revenueon product sales at the point in time when the risks and rewards of ownershipof the product have transferred to the customer.  The Company considers this to be at the point of delivery of theproduct.  The Company offers limitedreturn rights on it product sales.  Atthe point of sale, the Company also provides for an allowance for salesreturns, which is established based on historical experience.

 

**3.  Earnings Per Share**

 

The Company has 45,000,000common shares authorized.  The Companyhas granted options to purchase common shares to employees and directors of theCompany.  The options may have adilutive effect on the calculation of earnings per share.  The following is a reconciliation of thenumerators and denominators of the basic and diluted earnings per sharecomputations (in thousands).

 
|                                                   |   | **Three months ended September 30,** |   | **Nine months ended September 30,** |   |
|--------------------------------------------------------|--------|--------------------------------------|--------|-------------------------------------|--------|
|                                                   |   | **2001**                             |   | **2000**                            |   | **2001** |   | **2000** |   |
| **Basic loss per share:**                              |   |                                 |   |                                |   |   |   |   |   |
|                                                   |   |                                 |   |                                |   |   |   |   |   |
| Loss available to common shareholders                  |   | $                                    | (257   | )                                   | $      | (137 | ) | $ | (62 | ) | $ | (510 | ) |
|                                                   |   |                                 |   |                                |   |   |   |   |   |
| Weighted average shares outstanding                    |   | 13,499                               |   | 13,388                              |   | 13,471 |   | 13,376 |   |
|                                                   |   |                                 |   |                                |   |   |   |   |   |
| Basic loss per share                                   |   | $                                    | (0.02  | )                                   | $      | (0.01 | ) | $ | (0.01 | ) | $ | (0.04 | ) |
|                                                   |   |                                 |   |                                |   |   |   |   |   |
| **Diluted loss per share:**                            |   |                                 |   |                                |   |   |   |   |   |
|                                                   |   |                                 |   |                                |   |   |   |   |   |
| Net loss                                               |   | $                                    | (257   | )                                   | $      | (137 | ) | $ | (62 | ) | $ | (510 | ) |
|                                                   |   |                                 |   |                                |   |   |   |   |   |
| Total common shares and dilutive securities            |   | 13,499                               |   | 13,388                              |   | 13,471 |   | 13,376 |   |
|                                                   |   |                                 |   |                                |   |   |   |   |   |
| Dilutive loss per share                                |   | $                                    | (0.02  | )                                   | $      | (0.01 | ) | $ | (0.01 | ) | $ | (0.04 | ) |
|                                                   |   |                                 |   |                                |   |   |   |   |   |
| Net income (loss) as previously reported               |   |                                 |   | $                                   | 50     |   |   |   | $ | (170 | ) |
| Basic and diluted loss per share                       |   |                                 |   | $                                   | 0.00   |   |   |   | $ | (0.01 | ) |
| Net income (loss) as restated for adoption  of SAB 101 |   |                                 |   | $                                   | (137   | ) |   |   | $ | (510 | ) |
| Basic and diluted loss per share                       |   |                                 |   | $                                   | (0.01  | ) |   |   | $ | (0.04 | ) |

 

All options to purchase commonstock were excluded from the computation of diluted earnings per share for thenine months ended September 30, 2000 and 2001 because the effect of the optionson the calculation would have been antidilutive.

 

**4.     Commitments and Contingencies**

 

### *LegalProceedings*

Various legal claims and actions considered normal to the Company’sbusiness have been asserted and are pending against the Company.  The Company believes that such claims andactions will not have a material adverse effect upon the Company’s financialposition or results of operations.

 

### *Other*

As previously discussed, the Washington State Department of Revenue(the “Department”) is currently examining the Company’s state tax returns forthe years 1996, 1997, 1998 and 1999. The Company has not received a final report, however, the Department hasindicated that it intends to propose an assessment of up to $2.3 million plusinterest.  Based on discussions with theDepartment, the Company disagrees with substantially all of the deficiencieswhich may be assessed and intends to contest such deficiencies through theadministrative appeals process and, if necessary, litigation.  There can be no assurance that the Companywill be successful, in whole or in part, in challenging the proposeddeficiencies.  If the Company is notsuccessful in challenging the proposed deficiencies, the additional taxes theCompany would be required to pay could have a material adverse impact on theCompany.

 

**5.  Segment Information**

 

SFAS No. 131, “DisclosuresAbout Segments of an Enterprise and Related Information,” requires that publiccompanies report profits and losses and certain other information on theirreportable operating segments.  Thesesegments are based on the method of internal reporting used by thedecision-maker of the Company to allocate resources and assess its performance.

 

In fiscal year 2000, theCompany reported its subsidiary, touchMarketing.com, and its two distinctoperating units as separate segments. On January 2, 2001, the Companydiscontinued its touchMarketing.com subsidiary.  Accordingly, no separate segment for this exists in fiscal year2001.  As of the third quarter of 2001,the Company replaced its operating unit approach with a single-segmentapproach.  Additionally, in conjunctionwith the replacement of its reporting approach, the Company no longer separatesits internal functions by operating units. The Company’s reportable segment is a single-source, multi-vendor directreseller of name-brand information technology products and services to small tomedium sized businesses, enterprise, and government and education markets.  The Company does, however, monitor revenueby sales channel (outbound, representing customers over 100 seats, andinbound/micro business, representing inbound call center and businesses under100 seats) and product mix (CPUs, Networking, Servers, Services, Software,Printers/Monitors/Scanners, Storage/Memory and Accessories/Other).

 

(in thousands)
|                          |   | **Three months ended September 30,** |    | **Nine months ended September 30,** |   |
|-------------------------------|--------|--------------------------------------|---------|-------------------------------------|--------|
|                          |   | **2001**                             |    | **2000**                            |   | **2001** |   | **2000** |   |
| **Sales Channel**             |   |                                 |    |                                |   |   |   |   |   |
| Outbound                      |   | $                                    | 94,119  |                                | $      | 125,297 |   | $ | 344,830 |   | $ | 321,845 |   |
| Inbound/Micro Business        |   | 26,603                               |    | 44,341                              |   | 82,225 |   | 145,918 |   |
|                          |   | $                                    | 120,722 |                                | $      | 169,638 |   | $ | 427,055 |   | $ | 467,763 |   |
|                          |   |                                 |    |                                |   |   |   |   |   |
| **Product Mix**               |   |                                 |    |                                |   |   |   |   |   |
| CPU's                         |   | $                                    | 42,345  |                                | $      | 68,369 |   | $ | 152,998 |   | $ | 189,976 |   |
| Networking                    |   | 7,837                                |    | 5,962                               |   | 24,574 |   | 16,461 |   |
| Servers                       |   | 6,401                                |    | 7,186                               |   | 25,428 |   | 16,127 |   |
| Services                      |   | 875                                  |    | 664                                 |   | 3,393 |   | 2,121 |   |
| Software                      |   | 15,950                               |    | 17,791                              |   | 49,339 |   | 56,519 |   |
| Printer / Monitors / Scanners |   | 19,365                               |    | 27,505                              |   | 67,513 |   | 76,972 |   |
| Storage / Memory              |   | 17,411                               |    | 24,737                              |   | 66,391 |   | 61,947 |   |
| Accessories / Other           |   | 10,537                               |    | 17,424                              |   | 37,419 |   | 47,640 |   |
|                          |   | $                                    | 120,722 |                                | $      | 169,638 |   | $ | 427,055 |   | $ | 467,763 |   |

 

 

 

Substantially, all of theCompany’s net sales for the three and nine months ended September 30, 2001 weremade to customers located in the United States.  All of the Company’s assets at September 30, 2001 and December31, 2000 were located within the United States.  One of the Company’s customers represented over 10% of totalrevenue for the three and nine month periods ended September 30, 2001.  Net revenue from this customer was $33.2million for quarter ended September 30, 2001 and $127.6 million for the ninemonths ended September 30, 2001. The Company expects a decline in revenue fromthis customer over future quarters, but the amount of decline cannot beprojected.

 

 

**Item 2.    Management’sDiscussion and Analysis of Financial Condition and Results of Operations**

 

The matters described belowcontain forward-looking statements which involve known and unknown risks,uncertainties, and other factors that may cause actual results, performance,achievements of the Company or industry trends, to differ materially from thoseexpressed or implied by such forward-looking statements.  Forward-looking statements may be identifiedby the use of forward-looking terminology such as “may,” “will,” “expect,” “estimate,”“anticipate,” “continue,” or similar terms, variations of such terms or thenegative of those terms, but the absence of such terms does not mean that astatement is not forward-looking.

 

Factors that could affect theCompany’s actual results include, but are not limited to: (i) future growth,(ii) dependence on sales of Mac products, (iii) vendor support, (iv)competition, (v) pressure on margins, (vi) variability of operating results,(vii) changing methods of distribution, (viii) potential disruption ofbusiness, (ix) potential increases in postage, shipping, and paper costs, (x)reliance on vendor relationships, (xi) state sales or use tax uncertainties,(xii) dependence on personnel, (xiii) reliance on outsourced distribution,(xiv) reliance on major customers, (xv) rapid technological change andinventory obsolescence, and other risks and uncertainties detailed in theCompany’s filing with the SEC. The following discussion and analysis should beread in conjunction with the Risk Factors and other information contained inthe Company’s Annual Report on Form 10-K for the year ended December 31, 2000,which was filed on March 13, 2001 with the Securities Exchange Commission.

 

**General**

 

The Company’s revenues consist primarily ofsales of computer hardware, software, services, peripherals and accessories, aswell as revenue associated with freight billed to its customers.  Net revenues reflect the effects of productreturns.  Gross profit consists of netsales less product and freight costs. Selling, general and administrative(“SG&A”) expenses include advertising expense net of vendor co-op,warehousing, selling commissions, order processing, telephone, credit cardfees, and other costs such as administrative salaries, depreciation, rent, andgeneral overhead expenses.  Otherexpense represents interest expense, net non-operating expense and minorityinterests in the Company's domestic and former foreign subsidiaries.

#  

# **Results of Operations**

 

The following table presentsthe Company’s unaudited consolidated results of operations, as a percentage ofnet sales, and selected domestic operating data for the periods indicated.  This information has been prepared by theCompany on a basis consistent with the Company’s unaudited consolidatedfinancial statements and, in the opinion of management, includes alladjustments, consisting only of normal recurring accruals, necessary for a fairpresentation of the results of such periods.

 
|                                                  |   | **Three months ended**

**September 30,** |   | **Nine months ended**

**September 30,** |   |
|-------------------------------------------------------|--------|-------------------------------------------|--------|------------------------------------------|--------|
|                                                  |   | **2001**                                  |   | **2000**                                 |   | **2001** |   | **2000** |   |
| Net sales                                             |   | 100.0                                     | %      | 100.0                                    | %      | 100.0 | % | 100.0 | % |
| Cost of sales                                         |   | 89.9                                      |   | 90.8                                     |   | 90.2 |   | 90.7 |   |
| Gross profit                                          |   | 10.1                                      |   | 9.2                                      |   | 9.8 |   | 9.3 |   |
| Selling, general and administrative  expenses         |   | 10.5                                      |   | 9.1                                      |   | 9.8 |   | 9.8 |   |
| Income (loss) from operations                         |   | (0.4                                      | )      | 0.1                                      |   | 0.0 |   | (0.5 | ) |
| Other (income) expense                                |   | 0.0                                       |   | 0.2                                      |   | 0.0 |   | (0.3 | ) |
| Income (loss) before income taxes                     |   | (0.4                                      | )      | (0.1                                     | )      | 0.0 |   | (0.2 | ) |
| Provision for (benefit from) income taxes             |   | (0.2                                      | )      | 0.0                                      |   | 0.0 |   | (0.1 | ) |
| Net income (loss)                                     |   | (0.2)                                     | %      | (0.1)                                    | %      | 0.0 | % | (0.1) | % |
|                                                  |   |                                      |   |                                     |   |   |   |   |   |
| **Selected domestic operating data:**                 |   |                                      |   |                                     |   |   |   |   |   |
| Catalog circulation                                   |   | 4,050,000                                 |   | 3,875,000                                |   | 11,125,000 |   | 13,927,000 |   |
| E-media circulation                                   |   | 2,400,000                                 |   | 4,000,000                                |   | 8,200,000 |   | 13,700,000 |   |
| Number of orders                                      |   | 139,000                                   |   | 212,000                                  |   | 467,000 |   | 675,000 |   |
| Average order size                                    |   | $                                         | 864    |                                     | $      | 826 |   | $ | 924 |   | $ | 710 |   |
| Number of outbound account executives, end  of period |   | 207                                       |   | 270                                      |   |   |   |   |   |
|                                                       |        |                                           |        |                                          |        |  |  |  |  |  |  |  |  |

 

### *Comparisonof Three Month Periods Ended September 30, 2001 and 2000*

 

*Net Revenue. *Net revenue for the quarter ended September 30,2001 decreased 28.8% to $120.7 million compared to $169.7 million in the thirdquarter of 2000. The decrease in revenue resulted primarily from the impact ofthe pervasive economic downturn that has drastically reduced IT spending bybusinesses, and as a result of the Company’s planned discontinuation ofmarketing and advertising to the PC consumer. Sales by the Company’s outboundsales team to the SMB, enterprise and government and education accountsdecreased 24.9% to $94.1 million in the third quarter of 2001 from $125.3million in the third quarter of 2000. The Company’s current efforts are toexpand its portfolio of enterprise accounts, and focus on the productivity ofits commercial accounts sales force. Sales by the Company’s inbound and microbusiness, businesses consisting of less than 100 seats, decreased 40.0% to$26.6 million for the three months ended September 30, 2001 compared to $44.3million in the comparable period in 2000.

 

The Company realized anincrease in average order size to $864 for the three months ended September 30,2001 from $826 in the third quarter of 2000.PC platform sales accounted for 74.2% of totalsales for the quarter ended September 30, 2001 compared to 70.6% in the thirdquarter of 2000.  Net PC platform salesfor the three months ended September 30, 2001 decreased 25.2% to $89.6 millionin the third quarter of 2001 from $119.8 million a year ago.  Net Mac platform sales decreased 37.6% to$31.1 million for the three months ended September 30, 2001 from $49.9 millionin 2000.

 

The fastest growing productcategories in terms of sales dollars and the respective growth rates in thethird quarter of 2001 compared to the third quarter of 2000 were:

 
| **Product Category** |   | **Growth Rate** |   |
|----------------------|--------|-----------------|--------|
| Licensing            |   | 61.5            | %      |
| Services             |   | 26.4            | %      |
| Networking Hardware  |   | 26.1            | %      |

 

*Gross Profit.* Grossprofit dollar contribution decreased to $12.2 million for the third quarter of2001, down 21.6% from the third quarter of 2000.  However, gross profit as a percentage of net sales increased to10.1% in the quarter ended September 30, 2001 compared to 9.2% in the thirdquarter of 2000. This increase in gross profit percentage is primarily due tothe continued shift in revenue mix to higher margin products and services.

 

*Selling,General and Administrative Expenses. *SG&Aexpense dollars decreased 18.0% to $12.6 million for the quarter endedSeptember 30, 2001 from $15.4 million in the third quarter of 2000, andsequentially, SG&A expense dollars decreased 10.4% from $14.1 million inthe second quarter of 2001. The Company pared its discretionary expenses duringthe quarter in an effort to realign them to current market conditions. As apercent of sales, SG&A increased to 10.5% for the quarter ended September30, 2001 from 9.1% in the third quarter of 2000 due to the decline in salesvolume.

 

The Company produces and distributes catalogsat various intervals throughout the year. The Company's net cost of advertising decreased to $461,000 in the threemonth period ended September 30, 2001 from $875,000 in the comparable 2000period.  This decrease in net cost isprimarily due to the discontinuation of the PC Zone catalog and accompanyingon-line advertising expense associated with the PC consumer customer segment.

 

*Other Income/Expense. *Otherincome was $14,000 for the quarter ended September 30, 2001 compared to otherexpense of $313,000 in the third quarter of 2000. The change was primarily dueto interest expense in the third quarter of 2000.

 

*Income Tax Benefit.*  The income tax benefit for the quarter ended September 30, 2001was $186,000 as compared to a recorded benefit of $57,000 in the comparableperiod of the prior year.  The Company’seffective tax rate expressed as a percentage of income before taxes was 41.9%for the quarter ended September 30, 2001.

 

*Net Loss. *Net loss for the quarter ended September 30,2001 was $257,000 compared to net loss of $137,000 in the third quarter of2000.  Basic and diluted loss per sharewas $0.02 for the quarter ended September 30, 2001 and basic and diluted lossper share was $0.01 in the third quarter of 2000.

 

### *Comparisonof Nine Month Periods Ended September 30, 2001 and 2000*

 

*Net Revenue. *Net revenue for the nine months ended September30, 2001 decreased 8.7% to $427.1 million compared to $467.8 million in thecomparable period of 2000. The decrease in revenue resulted primarily from theimpact of the pervasive economic downturn that has drastically reduced ITspending by businesses, and from the Company’s planned discontinuation ofmarketing and advertising to the PC consumer during the second quarter of 2001.  Sales by the Company’s outbound sales teamto the SMB, enterprise and government and education accounts increased 7.1% to$344.8 million in the nine months ended September 2001 from $321.8 million inthe comparable quarter of 2000.  TheCompany’s current efforts are to expand its portfolio of enterprise accounts,and focus on the productivity of its commercial accounts sales force. Thisincrease was offset by sales to the Company’s inbound and micro businesscustomers that decreased 43.7% to $82.2 million for the nine months endedSeptember 30, 2001 compared to $145.9 million in the comparable period in 2000.

 

The Company realized anincrease in average order size to $924 for the nine months ended September 30,2001 from $710 in the comparable nine months of 2000.  PC platform sales accounted for 76.2% of total sales for the ninemonths ended September 30, 2001 compared to 63.9% in the comparable nine monthsof 2000.  Net PC platform sales for thenine months ended September 30, 2001 increased 8.8% to $325.5 million from$299.1 million a year ago.  Net Macplatform sales decreased 39.8% to $101.6 million for the nine months endedSeptember 30, 2001 from $168.8 million in 2000.

 

 

 

The fastest growing productcategories in terms of sales dollars and the respective growth rates in thenine months ended September 30, 2001 compared to the same period a year agowere:

 
| **Product Category** |   | **Growth Rate** |   |
|----------------------|--------|-----------------|--------|
| Licensing            |   | 66.0            | %      |
| Services             |   | 57.0            | %      |
| Servers              |   | 54.7            | %      |
| Networking Hardware  |   | 46.5            | %      |

 

*Gross Profit.* Gross profit dollar contribution decreased to $41.9 million for the ninemonths ended September 30, 2001, from $43.5 million in the same period of theprior year.  Gross profit as apercentage of net sales increased to 9.8% in the nine months ended September30, 2001 compared to 9.3% in the comparable period of 2000.

 

*Selling, General and AdministrativeExpenses. *SG&Aexpense dollars decreased 8.3% to $41.9 million for the nine months endedSeptember 30, 2001 from $45.7 million in the comparable period a year ago. The Companycontinued to rationalize its operating costs during the turbulent economic andoperating environment experienced in the first half of 2001. As a percent ofsales, SG&A remained flat at 9.8% for the nine months ended September 30,2000 and 2001.

 

The Company produces anddistributes catalogs at various intervals throughout the year.  The Company's net cost of advertisingdecreased to $2.1 million in the nine month period ended September 30, 2001from $2.6 million in the comparable 2000 period.

 

*Other Income/Expense. *Otherexpense was $111,000 for the nine months ended September 30, 2001 compared toother income of $1.5 million in the nine months ended September 30, 2000.  The Company realized a one-time gain ondisposition of two of its investments in its international subsidiaries for thenine months ended September 30, 2000 of $1.7 million.

 

*Income Tax Benefit.*  The income tax benefit for the nine months ended September 30,2001 was $47,000 as compared to a recorded benefit of $256,000 in the nine monthcomparable period of 2000.  TheCompany’s effective tax rate, as a percentage of income before taxes, was 43.1%for the nine months ended September 30, 2001.

 

*Net Loss.*Net lossfor the nine months ended September 30, 2001 was $62,000 compared to a net lossof $510,000 in the comparable period of 2000. Basic and diluted loss per share were $0.01 for the nine months endedSeptember 30, 2001 and basic and diluted loss per share was $0.04 for the ninemonths ended September 30, 2000.

 

# **Trends**

 

The Company’s transition to amulti-vendor, business to business, Information Technology (“IT”) reseller tothe SMB, enterprise and government and education customer base has created asingular focus that will keep it moving forward and growing in order to remaincompetitive in today’s economic landscape. The Company has been affected by the slowdown in U.S. corporate ITspending, creating a more intense landscape that is disrupting the stability ofpricing and exerting pressure on margins across most product lines.  The industry remains susceptible to furtherdeclension in PC product lines sales as the sales mix shifts to software thatwill extend the life of existing PC’s.

 

In light of the current economic conditions, the Company has scaled itsoperations to better suit perceived market demand.  It has also responded to changes in customerbuying trends by restructuring its sales organization for increasedproductivity.  The Company continues todrive sales to higher margin products and services.  It acquires new customers by sending catalogs, direct mailpieces, e-media and other lead generation marketing tools.  The Company’s lead generation function hasbeen enhanced by the creation of a specific sales team that appropriatelydirects each lead to ensure the customer is receiving the optimal salesexperience.  The Company manages itscontinuous customer touch programs to help retain its customers through accountexecutive relationship, loyalty programs, targeted promotions and theZonesConnect extranet sites.

### * *

### ***Industry***

 

The market for computerproducts is characterized by rapid changes and frequent introductions of newproducts and product enhancements. These changes result in rapid price fluctuations and have led tocontinued average selling price reductions and lower margin dollars pertransaction.  In order to remaincompetitive, the Company may be required to reduce its prices.  Such a reduction in prices could have amaterial adverse effect on the Company’s future results of operations.

 

# **Inflation**

 

The Company does not believethat inflation has had a material impact on its results of operations.  However, there can be no assurance thatinflation will not have such an effect in future periods.

 

# **Liquidity and Capital Resources**

 

As of September 30, 2001, theCompany had total assets of $79.6 million, of which $65.8 million were currentassets.  At September 30, 2001 andDecember 31, 2000 the Company had cash and cash equivalents, and restrictedcash of $7.3 million and $4.7 million, respectively, and working capital of$19.2 million and $17.2 million, respectively.

 

Net cash provided by operatingactivities was $4.5 million for the nine months ended September 30, 2001compared to cash used by operating activities of $21.6 million for the ninemonths ended September 30, 2000.  Cashinflows for the nine months ended September 30, 2001 were primarily due todecreases in accounts receivable and inventory offset by a decline in accountspayable. In the nine months ended September 30, 2001, accounts receivabledecreased $19.5 million, inventory decreased by $11.8 million and accountspayable decreased by $27.9 million from December 31, 2000.

 

Cash outlays for capital expenditureswere $2.2 million and $2.5 million in the nine months ended September 30, 2001and 2000, respectively.  Theseexpenditures were primarily for continued improvement, and other enhancements,of the Company’s information systems.

 

Thenet amount of accounts payable outstanding at September 30, 2001 was $39.5million of which $11.5 million was drawn from a $35.0 million flooring facilityand working capital line, collateralized by inventory and accountsreceivable.  The facility containsvarious restrictive covenants relating to profitability, tangible net worth, leverage,dispositions and use of collateral, other asset dispositions, and merger andconsolidation of the Company.

 

The Company believes that itsexisting available cash and cash equivalents, operating cash flow and existingcredit facilities will be sufficient to satisfy its operating cash needs for atleast the next 12 months at its current revenue level.  However, if the Company’s future revenuesdecline below the current level, or if working capital erodes and other capitalrequirements are greater than currently anticipated, the Company could berequired to seek additional funds through sales of equity, debt or convertiblesecurities or increased credit facilities. There can be no assurance that additional financing will be available orthat, if available, the financing will be on terms favorable to the Company andits shareholders.

 

**Other Matters**

 

As previously discussed, theWashington State Department of Revenue (the “Department”) is currentlyexamining the Company’s state tax returns for the years 1996, 1997, 1998 and1999.  The Company has not received afinal report, however, the Department has indicated that it intends to proposean assessment of up to $2.3 million plus interest.  Based on discussions with the Department, the Company disagreeswith substantially all of the deficiencies which may be assessed and intends tocontest such deficiencies through the administrative appeals process and, ifnecessary, litigation.  There can be noassurance that the Company will be successful, in whole or in part, inchallenging the proposed deficiencies. If the Company is not successful in challenging the proposeddeficiencies, the additional taxes the Company would be required to pay couldhave a material adverse impact on the Company.

 

**Item 3. Quantitative and Qualitative Disclosures About Market Risk**

 

## **The Company is subject to the riskof fluctuating interest rates in the normal course of business, primarily as aresult of its short-term borrowing and investment activities, which generallybear interest at variable rates. Because the short-term borrowings and investments have maturities ofthree months or less, the Company believes that the risk of material loss islow.**

 

 

**PartII.**

 

**Item1.    Legal Proceedings**

 

Various claims and actions of atype commonly encountered in the Company's industry have been asserted and arepending against the Company. The Company believes that such claims and actionswill not have a material adverse effect upon the Company's financial positionor results of operations.

 

**Item 6.    Exhibitsand Reports on Form 8-K**

(a)           Exhibits

 

                10.1         EmploymentAgreement dated as of February 1, 2001 between the Registrant and Scott F.Koerner

 

(b)           Reports on Form 8-K

 

No Reports onForm 8-K were filed during the quarter ended September 30, 2001.

 

 

 

 

 

Signatures

 

 

Pursuant to the requirements ofthe Securities Exchange Act of 1934, the registrant has duly caused this reportto be signed on its behalf by the undersigned:

 

 

 
|                         |   | ZONES, INC                                            |
|------------------------------|--------|-------------------------------------------------------|
|                         |   |                                                  |
|                         |   |                                                  |
| Date:  November 9, 2001 |   |                                                  |
|                         |   |                                                  |
|                         | By:    | /S/     FIROZ H. LALJI            |
|                         |   |                                                  |
|                         |   | Firoz H. Lalji, Chairman and  Chief Executive Officer |
|                         |   |                                                  |
|                         |   |                                                  |
|                         |   | /S/     RONALD P. MCFADDEN        |
|                         |   | Ronald P. McFadden, Chief  Financial Officer          |
|                         |   |                                                  |