|UNITED STATES
SECURITIES AND EXCHANGE COMMISSIONWashington, D.C. 20549FORM 10-Q

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


FOR THE QUARTERLY
PERIOD ENDED SEPTEMBER 30, 2003





OR

[   ]     TRANSITION REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE
            
 SECURITIES EXCHANGE ACT OF 1934 FOR THE TRANSITION PERIOD
            
  FROM__________TO __________


Commission File Number     0-28488



ZONES, INC
(Exact name of registrant as specified in its charter)
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|Washington(State of Incorporation) |  | 91-1431894(I.R.S. EmployerIdentification Number)
|---------------------------------- |  | ------------------------------------------------

|1102 15th Street SW, Suite 102Auburn, Washington(Address of Principal Executive Offices) |  | 98001-6509(Zip Code)
|---------------------------------------------------------------------------------------- |  | --------------------

| | (253) 205-3000(Registrants Telephone  Number,Including Area Code) | 
| | ------------------------------------------------------------------ | 

|707 South Grady WayRenton, Washington(Former Address of Principal Executive Offices) |  | 98055-3233(Former Zip Code)
|------------------------------------------------------------------------------------ |  | ---------------------------

| | (425) 430-3000(Registrants Former TelephoneNumber, Including Area Code) | 
| | ------------------------------------------------------------------------ | 

|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.

YesX   No


Indicate by check mark whether the
registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act).

YesX   No



The number of shares of the
registrants Common Stock outstanding as of November 11, 2003 was 13,654,371.


1
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|ZONES, INC.
INDEX
|-----------------

|PART I. FINANCIAL
INFORMATION
|-----------------------------
|Item 1.                      
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|Item 2.                      
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|Item 3.                      
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|Item 4.                      
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|Item 1.                      
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|Item 6.                      
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|                             

|2


Part I.



Item 1.  Financial
Statements



ZONES, INC. CONSOLIDATED BALANCE
SHEETS(in thousands)(unaudited)
|----------------------------------------------------------------------------------------------------------------

|                                             | September 30,2003 | December 31,2002
|-------------------------------------------- | ----------------- | ----------------
|                                             |                   |                 
|ASSETS                                       |                   |                 
|Current assets:                              |                   |                 
|Cash and cash equivalents                    |                   |                 
|Receivables, net                             |                   |                 
|Inventories, net                             |                   |                 
|Prepaid expenses                             |                   |                 
|Deferred tax asset                           |                   |                 
|                                             |                   |                 
|Total current assets                         |                   |                 
|Property and equipment, net                  |                   |                 
|Goodwill                                     |                   |                 
|Deferred tax asset                           |                   |                 
|Other assets                                 |                   |                 
|                                             |                   |                 
|Total assets                                 |                   |                 
|                                             |                   |                 
|LIABILITIES AND SHAREHOLDERS' EQUITY         |                   |                 
|Current liabilities:                         |                   |                 
|Accounts payable                             |                   |                 
|Accrued liabilities                          |                   |                 
|Line of credit                               |                   |                 
|Current portion of capital lease obligations |                   |                 
|Current portion of deferred rent obligations |                   |                 
|Notes payable                                |                   |                 
|                                             |                   |                 
|Total current liabilities                    |                   |                 
|Notes Payable                                |                   |                 
|Deferred Rent                                |                   |                 
|                                             |                   |                 
|Total liabilities                            |                   |                 
|                                             |                   |                 
|Commitments and contingencies                |                   |                 
|Shareholders' equity:                        |                   |                 
|Common stock                                 |                   |                 
|Accumulated deficit                          |                   |                 
|                                             |                   |                 
|Total shareholders' equity                   |                   |                 
|                                             |                   |                 
|Total liabilities and shareholders' equity   |                   |                 
|                                             |                   |                 

|See notes to
consolidated financial statements


3


ZONES, INC. AND
SUBSIDIARIES CONSOLIDATED STATEMENTS OF OPERATIONS(in thousands, except
per share data)
(unaudited)
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                             | Three months endedSeptember 30, | Nine months endedSeptember 30,
|-------------------------------------------- | ------------------------------- | ------------------------------
|
|                                             |                                 |                               
|Net sales                                    |                                 |                               
|Cost of sales                                |                                 |                               
|                                             |                                 |                               
|Gross profit                                 |                                 |                               
|Selling, general and administrative          |                                 |                               
|Advertising expenses, net                    |                                 |                               
|                                             |                                 |                               
|Income (loss) from operations                |                                 |                               
|                                             |                                 |                               
|Interest expense                             |                                 |                               
|Other (income) expense, net                  |                                 |                               
|                                             |                                 |                               
|Other (income) expense                       |                                 |                               
|                                             |                                 |                               
|Income (loss) before taxes                   |                                 |                               
|Provision (benefit) for income taxes         |                                 |                               
|                                             |                                 |                               
|Net income (loss)                            |                                 |                               
|                                             |                                 |                               
|Basic earnings (loss) per share              |                                 |                               
|                                             |                                 |                               
|Shares  used  in  computing  basic  earnings |                                 |                               
|(loss) per share                             |                                 |                               
|Diluted earnings (loss) per share            |                                 |                               
|                                             |                                 |                               
|Shares used in  computing  diluted  earnings |                                 |                               
|(loss) per share                             |                                 |                               

|See
notes to consolidated financial statements


4


ZONES, INC.
STATEMENTS OF SHAREHOLDERS EQUITY
(in thousands, except share data)
(unaudited)
|-------------------------------------------------------------------------------------------------------------------------------------------------

|                            | Common Stock | Accumulated | 
|--------------------------- | ------------ | ----------- | 
|
|                            |              |             | 
|Balance, January 1, 2003    |              |             | 
|Issuance of common stock    |              |             | 
|Net loss                    |              |             | 
|                            |              |             | 
|Balance, September 30, 2003 |              |             | 
|                            |              |             | 

|See notes to
consolidated financial statements

5


ZONES, INC.
CONSOLIDATED STATEMENTS OF CASH FLOWS 
(in thousands)(unaudited)
|--------------------------------------------------------------------------------------------------------------------------------

|                                                    | Nine months endedSeptember 30,
|--------------------------------------------------- | ------------------------------
|
|                                                    |                               
|Cash flows from operating activities:               |                               
|Net income (loss)                                   |                               
|Adjustments to reconcile net income to net          |                               
|cash provided by (used in) operating activities:    |                               
|Depreciation and amortization                       |                               
|Deferred income taxes                               |                               
|Loss on disposal of assets                          |                               
|Changes in assets and liabilities:                  |                               
|Receivables, net                                    |                               
|Inventories, net                                    |                               
|Prepaid expenses and other assets                   |                               
|Accounts payable                                    |                               
|Accrued and other liabilities                       |                               
|                                                    |                               
|Net cash used in operating activities               |                               
|Cash flows from investing activities:               |                               
|Payment for acquisition, net of cash acquired       |                               
|Purchases of property and equipment                 |                               
|                                                    |                               
|Net cash used in investing activities               |                               
|Cash flows from financing activities:               |                               
|Net borrowing under line of credit arrangement      |                               
|Net change in book overdraft                        |                               
|Net proceeds from sale of common stock              |                               
|Payments on capital leases                          |                               
|                                                    |                               
|Net cash provided by (used in) financing activities |                               
|Net decrease in cash and cash equivalents           |                               
|Cash and cash equivalents at beginning of period    |                               
|                                                    |                               
|Cash and cash equivalents at end of period          |                               
|                                                    |                               
|Non-cash investing and financing activity:          |                               
|Note payable for acquisition of CPCS                |                               

|See notes to consolidated financial statements

6


ZONES, INC. 
NOTES TO CONSOLIDATED FINANCIAL STATEMENTS
(unaudited)



1. Description of
Business


Zones, Inc. (the Company)
and its subsidiaries are single-source direct marketing resellers of name-brand
information technology products to the small to medium sized business market, enterprise
and public sector accounts, while supporting their legacy Mac customers through an inbound
call center promoted by circulation of the Mac Zone catalog and a dedicated website. Zones
sells through outbound and inbound account executives, specialty print and e-catalogs, and
the Internet. Zones offers more than 150,000 products from leading manufacturers including
3COM, Adobe, Apple, Cisco, Epson, HP, IBM, Kingston, Microsoft, Sony and Toshiba.


The Company was incorporated in
November 1988 as a Washington corporation. The Companys headquarters are located in
Auburn, Washington. Buying information is available at http://www.zones.com, or by
calling 800-258-2088. The Companys investor relations information can be accessed
online at www.zones.com/IR.



2. Summary of
Significant Accounting Policies


The accompanying unaudited
consolidated financial statements and notes have been prepared in accordance with the
rules and regulations of the Securities and Exchange Commission and consequently do not
include all of the disclosures normally required by generally accepted accounting
principles. In the opinion of management, the accompanying unaudited consolidated
financial statements contain all adjustments (consisting of normal recurring accruals)
necessary to present fairly the financial position and operating results for the interim
periods. The results of operations for such interim periods are not necessarily indicative
of results for the full year. These financial statements should be read in conjunction
with the audited financial statements and notes thereto contained in the Companys
Annual Report on Form 10-K for the year ended December 31, 2002 as filed with the
Securities and Exchange Commission on February 26, 2003.



Principles of
ConsolidationThe accompanying consolidated
financial statements include the accounts of the Company and its subsidiaries.
Intercompany transactions have been eliminated in consolidation.



Property and Equipment

Property and equipment is recorded at
cost. Depreciation is computed based on the straight-line method over the estimated useful
lives of the related assets. Useful lives for computer hardware and software range from 2
to 5 years and other property and equipment from 3 to 10 years. Capital leases are
amortized based on the straight-line method over the estimated useful lives of the related
assets or lease life, whichever is shorter, generally 3 to 10 years. Expenditures for
maintenance and repairs are charged to expense as incurred, while additions, renewals and
improvements are capitalized. Gains or losses from sales or retirements are included in
other income and expense. The Company evaluates the carrying value of long-lived assets
based upon current and anticipated undiscounted cash flows, and recognizes an impairment
when it is probable that such estimated future net cash flows will be less than the asset
carrying value.



Goodwill
In accordance with SFAS No.
142,Goodwill and Other Intangible Assets, goodwill will be tested for
impairment at least annually, or when events indicate that impairment exists.



Stock Compensation
The Company accounted for its stock
option plans by measuring compensation cost using the intrinsic value based method
presented by Accounting Principles Board Option No. 25, Accounting for Stock Issued
to Employees, and related interpretations. No compensation cost is reflected in
consolidated net loss, as all options granted under the plans had an exercise price equal
to the market value of the underlying common stock on the date of grant. Had compensation
cost for the Companys stock option plans been determined based on the fair value at
the grant date of the awards, consistent with the provisions of SFAS 123, the
Companys net income (loss) and income (loss) per share would have increased to the
pro forma amounts indicated below (in thousands, except per share data):

7
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                                                         | Three months ended   September 30, | 
|------------------------------------------------------------------------ | ---------------------------------- | 
|
|Net income - as reported                                                 |                                    | 
|Add:                                                                     |                                    | 
|Total compensation cost included in net income (loss), net of tax        |                                    | 
|Less:                                                                    |                                    | 
|Total compensation cost determined under fair value based method for all |                                    | 
|awards, net of tax                                                       |                                    | 
|                                                                        
|                                                                         |                                    | 
|Net income - pro forma                                                   |                                    | 
|                                                                         |                                    | 
|                                                                        
|Basic and diluted income per share - as reported                         |                                    | 
|Basic and diluted income per share - pro forma                           |                                    | 
|                                                                        
|
|
|Net income (loss) - as reported                                          |                                    | 
|Add:                                                                     |                                    | 
|Total compensation cost included in net income (loss), net of tax        |                                    | 
|Less:                                                                    |                                    | 
|Total compensation cost determined under fair value based method for all |                                    | 
|awards, net of tax                                                       |                                    | 
|                                                                        
|                                                                         |                                    | 
|Net income (loss) - pro forma                                            |                                    | 
|                                                                         |                                    | 
|                                                                        
|Basic and diluted income (loss) per share - as reported                  |                                    | 
|Basic and diluted income (loss) per share - pro forma                    |                                    | 

|The fair value of each option grant
is estimated on the date of grant using the Black-Scholes option-pricing model with the
following weighted-average assumptions used for grants in 2003 and 2002, respectively:
expected volatility of 214% and 238%; risk-free interest rate of 2.87% and 4.08%; and
expected lives of 4 years.


For the three months ended September
30, 2003, 12,879 shares were purchased under the ESPP. The weighted-average fair value at
date of grant was $0.55 for the option value of the shares of common stock issued during
the three months ended September 30, 2003 under the ESPP, and was estimated using the
Black-Scholes option-pricing model. The following weighted average assumptions were
applied: (i) expected dividend yield of 0.0%, (ii) expected volatility rate of 84.0%,
(iii) expected life of three months, and (iv) risk-free three-month interest rate of 0.9%.




Revenue RecognitionThe Company recognizes revenue on
product sales when persuasive evidence of an arrangement exists, delivery has occurred,
prices are fixed or determinable, and collectability is probable. The Company considers
the point of delivery of the product to be when the risks and rewards of ownership have
transferred to the customer. The Company offers limited return rights on its product
sales. At the point of sale, the Company also provides an allowance for sales returns,
which is established based on historical experience.
8



Earnings Per ShareEarnings per share (EPS)
is based on the weighted average number of shares outstanding during the period. Basic EPS
excludes all dilution. Diluted EPS reflects the potential dilution that would occur if
securities or other contracts to issue common stock were exercised or converted into
common stock. The Company excludes all options to purchase common stock from the
calculation of diluted net loss per share if such securities are antidilutive.





Recent Accounting
PronouncementsIn July 2001, the Financial
Accounting Standards Board issued SFAS 143, Accounting for Asset Retirement
Obligations (SFAS 143). SFAS 143 addresses financial accounting and
reporting for obligations associated with the retirement of tangible long-lived assets and
the associated asset retirement costs. It applies to legal obligations associated with the
retirement of long-lived assets that result from the acquisition, construction,
development, and (or) the normal operation of a long-lived asset, except for certain
obligations of lessees. Zones adopted SFAS 143 on January 1, 2003. The adoption of SFAS
143 did not have a significant impact on the Companys results of operations,
financial position or cash flows.


In June 2002, the FASB issued SFAS
No. 146, Accounting for Costs Associated with Exit or Disposal Activities.
This statement addresses financial accounting and reporting for costs associated with exit
or disposal activities and nullifies EITF Issue No. 94-3, Liability Recognition for
Certain Employee Termination Benefits and Other Costs to Exit and Activity (including
Certain Costs Incurred in a Restructuring). This statement requires that a liability
for a cost associated with an exit or disposal activity be recognized at fair value when
the liability is incurred. The provisions of SFAS 146 are effective for exit and disposal
activities initiated after December 31, 2002. The adoption of SFAS 146 did not have a
significant impact on the Companys results of operations, financial position or cash
flows.


In April 2003, the FASB issued SFAS
No. 149, Amendment of Statement 133 on Derivative Instruments and Hedging
Activities. SFAS 149 amends and clarifies financial accounting and reporting for
derivative instruments including certain derivative instruments embedded in other
contracts and for hedging activities under SFAS 133. SFAS 149 is effective for contracts
entered into or modified after June 30, 2003 and for hedging relationships designated
after June 30, 2003. The adoption of SFAS 149 did not have a significant impact on the
Companys results of operations, financial position or cash flows.


In May 2003, the FASB issued SFAS No.
150, Accounting for Certain Financial Instruments with Characteristics of both
Liabilities and Equity. SFAS 150 clarifies the accounting for certain financial
instruments with characteristics of both liabilities and equity and requires that those
instruments be classified as liabilities in statements of financial position. Previously,
many of these financial instruments were classified as equity. SFAS 150 is effective for
all financial instruments entered into or modified after May 31, 2003 and is otherwise
effective at the beginning of the first interim period after June 15, 2003. The adoption
of SFAS 150 did not have a significant impact on the Companys results of operations,
financial position or cash flows.


In November 2002, the FASB issued
Interpretation No. 45, Guarantors Accounting and Disclosure Requirements for
Guarantees, Including Guarantees of Indebtedness of Others  an Interpretation of
FASB Statements No. 5, 57 and 107 and Rescission of FASB Interpretation No. 34
(Interpretation No. 45). This interpretation expands on the existing accounting guidance
and disclosure requirements for most guarantees. It requires that at the time a company
issues a guarantee, the company must disclose that information in its interim and annual
financial statements. The provisions for initial recognition and measurement of the
liability will be applied on a prospective basis to guarantees issued or modified after
December 31, 2002. The adoption of FIN 45 did not have a significant impact on the
Companys results of operations, financial position or cash flows.


FASB Interpretation No. 46 (FIN 46),
Consolidation of Variable Interest Entities, an interpretation of ARB No. 51, was issued
on January 17, 2003. FIN 46 provides guidance on the identification and consolidation of
entities (termed variable interest entities) for which control is achieved by
means other than through voting rights. On October 9, 2003, the FASB issued a Staff
Position to defer the application of FIN 46 for variable interest entities existing prior
to February 1, 2003 until the end of the first interim or annual period ending after
December 15, 2003. Management does not believe that the application of FIN 46 will have a
material impact on the Companys results of operations, financial position or cash
flows.
9

In November 2002, the EITF reached
consensus on Issue No. 02-16, Accounting for Consideration Received from a
Vendor by a Customer (Including a Reseller of the Vendors Products). Cash
consideration should generally be considered an adjustment of the prices of the
vendors products and, therefore, characterized as a reduction of cost of sales when
recognized in the resellers income statement unless certain conditions apply. The
Company adopted the provisions of this issue for all agreements modified or entered into
on or after January 1, 2003. The adoption of this issue resulted in the reclassification
of certain amounts historically classified as a reduction of advertising expense to a
reduction of cost of sales on a prospective basis. The adoption of this issue had no
impact on the Companys net income (loss) from operations, shareholders equity
or cash flows. The following table gives pro-forma information as if this issue had been
implemented for all periods presented. The non-GAAP information for the three and nine
months ended September 30, 2003 is presented for comparison purposes only (in thousands):
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                          | Three months ended September 30, 2003
|------------------------- | -------------------------------------
|
|                          |                                      
|Cost of sales             |                                      
|Gross Profit              |                                      
|Advertising expenses, net |                                      

|                          | Three months ended September 30, 2002
|------------------------- | -------------------------------------
|
|                          |                                      
|Cost of sales             |                                      
|Gross Profit              |                                      
|Advertising expenses, net |                                      

|                          | Nine months ended September 30, 2003
|------------------------- | ------------------------------------
|
|                          |                                     
|Cost of sales             |                                     
|Gross Profit              |                                     
|Advertising expenses, net |                                     

|                          | Nine months ended September 30, 2002
|------------------------- | ------------------------------------
|
|                          |                                     
|Cost of sales             |                                     
|Gross Profit              |                                     
|Advertising expenses, net |                                     

|10


3. Earnings Per Share


The Company has 45,000,000 common
shares authorized. The Company has granted options to purchase common shares to employees
and directors of the Company. The options have a dilutive effect on the calculation of
earnings per share. The following is a reconciliation of the numerators and denominators
of the basic and diluted earnings per share computations (in thousands, except per share
data).
|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                            | Three months ended September 30, | Nine months ended September 30,
|------------------------------------------- | -------------------------------- | -------------------------------
|
|                                            |                                  |                                
|Basic earnings per share:                   |                                  |                                
|
|Income available to common shareholders     |                                  |                                
|                                            |                                  |                                
|Weighted average shares outstanding         |                                  |                                
|                                            |                                  |                                
|Basic earnings per share                    |                                  |                                
|                                            |                                  |                                
|
|Diluted earnings per share:                 |                                  |                                
|
|Net income (loss)                           |                                  |                                
|                                            |                                  |                                
|Weighted average shares outstanding         |                                  |                                
|                                            |                                  |                                
|Stock options                               |                                  |                                
|                                            |                                  |                                
|Total common shares and dilutive securities |                                  | 13,721                         
|                                            |                                  |                                
|Diluted earnings per share                  |                                  |                                
|                                            |                                  |                                

|4. Commitments and
Contingencies



Legal Proceedings Various legal claims and actions
considered normal to the Companys business have been asserted and are pending
against the Company. The Company believes that such claims and actions will not have a
material adverse effect upon the Companys financial position or results of
operations.


On November 21, 2002, the Washington
State Department of Revenue (the Department) issued a final determination
regarding the Companys state tax returns for the years 1996, 1997, 1998 and 1999.
The Department upheld the auditors assessment of business and occupation tax on
certain expense reimbursements the Company received from vendors during the audit period.
The Company petitioned the Department for a reconsideration of its determination, which
stayed the payment of the assessment until the petition for reconsideration is resolved.
However, as a result of the determination the Company recorded a charge of $2.1 million
during the fourth quarter of 2002. The Company intends to pursue all of its appeal rights,
but there can be no assurance that the Company will be successful, in whole or in part, in
challenging the determination. Additionally, the Department may also make a similar
assessment for all future periods after 1999. The Company has fully reserved against the
possibility of a similar assessment for the periods after 1999.



LiquidityThe Company believes that its
existing available cash and cash equivalents, operating cash flow and existing credit
facilities will be sufficient to satisfy its operating cash needs for at least the next 12
months at its current revenue and expense levels. However, if the Companys future
revenues decline below the current level, or if working capital erodes and other capital
requirements are greater than currently anticipated, the Company could be required to seek
additional funds through sales of equity, debt or convertible securities or increased
credit facilities. There can be no assurance that additional financing will be available
or that, if available, the financing will be on terms favorable to the Company and its
shareholders.
11


5. Segment Information


SFAS 131, Disclosures About
Segments of an Enterprise and Related Information, requires that public companies
report profits and losses and certain other information on their reportable operating
segments. These segments are based on the method of internal reporting used by the
decision-maker of the Company to allocate resources and assess performance.


The Company is a single-source,
multi-vendor direct marketing reseller of name-brand information technology products to
small to medium sized businesses, enterprise, and the public sector markets. The Company
had previously used a single segment approach to financial disclosure. However, the
Companys decision makers view the subsidiary activities of Corporate PC Source, Inc.
(CPCS) separately for internal reporting. The accounting policies of the
segments are the same as those described in Note 2, Summary of Significant
Accounting Policies. The Company allocates resources to, and evaluates performance
of, its segments based on both sales and operating income. Inter-segment transactions are
eliminated in consolidation. The Company has not disclosed segment information for the
nine months ended September 30, 2003, or the comparative prior year information as it
acquired its subsidiary on March 31, 2003.


A summary of the Companys
operations by segment follows (in thousands):
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                                      | Three months ended September 30, 2003 (unaudited)
|------------------------------------- | -------------------------------------------------
|
|                                      |                                                  
|External customer sales               |                                                  
|Transfer between segments             |                                                  
|                                      |                                                  
|Total net sales                       |                                                  
|                                     
|Depreciation and amortization         |                                                  
|Income from operations                |                                                  
|Net interest income and other expense |                                                  
|Income before income taxes            |                                                  
|                                     
|Total assets                          |                                                  

|                                      | Nine months ended September 30, 2003 (unaudited)
|------------------------------------- | ------------------------------------------------
|
|                                      |                                                 
|External customer sales               |                                                 
|Transfer between segments             |                                                 
|                                      |                                                 
|Total net sales                       |                                                 
|                                     
|Depreciation and amortization         |                                                 
|Income (loss) from operations         |                                                 
|Net interest income and other expense |                                                 
|Income (loss) before income taxes     |                                                 
|                                     
|Total assets                          |                                                 

|(a)    
          The nine months ended September 30, 2003 results for CPCS are only for the six
          month period between April 1, 2003 and September 30, 2003 as it was acquired on
          March 31, 2003.
12

Substantially all of the
Companys net sales for the three and nine months ended September 30, 2003 were made
to customers located in the United States. All of the Companys assets at September
30, 2003 and December 31, 2002 were located within the United States. Sales to one of the
Companys customers represented 5.8% and 11.4% of total sales for the three and nine
months ended September 30, 2003. Net sales to this customer were $6.6 million and $37.7
million for three and nine months ended September 30, 2003, compared to $10.8 million and
$48.3 million for three and nine months ended September 30, 2002. The Companys
contract with this customer expired in June 2003, and the Company expects future sales to
this customer to be significantly lower.



6. Acquisition of
Corporate PC Source, Inc.


On March 31, 2003, the Company
acquired Corporate PC Source, Inc. (CPCS), an Illinois corporation, pursuant
to a Stock Purchase Agreement (SPA) by and among the Company, CPCS and the
shareholders of CPCS. The acquisition of CPCS extends the Companys reach into the
mid-west and eastern United States Fortune 2000 customers.


Upon consummation of the transactions
contemplated by the SPA, CPCS became a wholly owned subsidiary of the Company. Under the
terms of the SPA, at closing the Company paid to the shareholders of CPCS $4,881,000 in
cash and issued notes in the aggregate principle amount of $2,500,000: $2,250,000
non-convertible notes, $250,000 convertible notes. Each non-convertible note has a three
year term, with interest paid quarterly, and one third of the principal amount due and
payable at the end of each of the earn-out periods, which occurs annually on the
transaction date. Each convertible note has a three year term and one-third of the amount
payable at the end of each of the earn-out periods may at any time before the payment
thereof, at the option of the prior shareholders, be converted into the Companys
common shares at $2.50 per share. The Companys general corporate funds were the
source of the funds used for the cash portion of the purchase price. The notes shall bear
interest at the rate the Company pays to its primary lender less 1⁄4%. At September
30, 2003 the rate was 4.75%. In addition, the notes are subject to reduction for failure
to reach a threshold of earnings before income tax, depreciation and amortization, or
EBITDA, which could adjust the purchase price in the future. The Company will measure the
EBITDA thresholds annually on March 31st; the transaction date.


Additionally, the SPA contains a
provision for an earn-out over three years contingent upon CPCS exceeding minimum levels
of EBITDA. The former shareholders of CPCS will receive a percentage of earnings each year
on an escalating scale based on the applicable EBITDA threshold. The Company will measure
the EBITDA thresholds annually on March 31st; the transaction date. The
additional earn-out payments will be accounted for as future purchase price adjustments
under the SPA.


CPCSs results of operations are
included in the Companys consolidated financial statements only for the periods
after the date of closing, March 31, 2003.

13

The following unaudited pro forma
information presents the results of the Companys operations as if the acquisition of
CPCS had taken place as of the beginning of the periods presented (amounts in thousands,
except per share data):
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|                    | Three months ended September 30, 2003
|------------------- | -------------------------------------
|
|                    |                                      
|Net sales           |                                      
|Net income (loss)   |                                      
|Earnings per share: |                                      
|Basic               |                                      
|Diluted             |                                      

|                    | Three months ended September 30, 2002
|------------------- | -------------------------------------
|
|                    |                                      
|Net sales           |                                      
|Net income          |                                      
|Earnings per share: |                                      
|Basic               |                                      
|Diluted             |                                      

|                    | Nine months ended September 30, 2003
|------------------- | ------------------------------------
|
|                    |                                     
|Net sales           |                                     
|Net income (loss)   |                                     
|Earnings per share: |                                     
|Basic               |                                     
|Diluted             |                                     

|                    | Nine months ended September 30, 2002
|------------------- | ------------------------------------
|
|                    |                                     
|Net sales           |                                     
|Net income          |                                     
|Earnings per share: |                                     
|Basic               |                                     
|Diluted             |                                     

|Item 2.   Management's Discussion and Analysis of Financial Condition and Results of Operations


The matters described below contain
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 those expressed or implied by such
forward-looking statements. Forward-looking statements may be identified by the use of
forward-looking terminology such as may, will, expect,
estimate, anticipate, continue, or similar terms,
variations of such terms or the negative of those terms, but the absence of such terms
does not mean that a statement is not forward-looking. Potential risks and uncertainties
that may cause actual results to differ materially from those expressed or implied
include, among others, those set forth in this document and those contained in the
Companys Annual Report on Form 10-K for the year ended December 31, 2002, which was
filed on February 26, 2003 with the Securities Exchange Commission.


As used in this quarterly report on
Form 10-Q, unless the context otherwise requires, the terms the Company and
Zones refer to Zones, Inc., a Washington corporation, and its subsidiaries.

14

Risk Factors


There are a number of important
factors that could cause the Companys actual results to differ materially from
historical results or those indicated by any forward-looking statements, including the
risk factors identified below or other factors of which the Company may not yet be aware.


No Assurance of Future
Profitability. The Company has not been profitable in any of the last three fiscal
years or during the first nine months of 2003. In addition, the Companys sales and
operating results are difficult to forecast, and several factors affecting sales and
operating results are outside of the Companys control, such as purchasing cycles of
enterprise customers, the level of corporate investment in new IT related capital
equipment, industry announcements of new products or upgrades, industry consolidation and
general economic conditions. Although the Company has taken a number of steps to reduce
costs, such as by reducing redundant headcount and obtaining a more favorable facilities
lease, there is no assurance that the Company will be able to identify or achieve
additional cost savings or to return to profitability on a consistent basis.


No Assurance as to Sales
Levels. There is no assurance that the Company will be able to sustain its current
sales levels. Sales may decline for any number of reasons, such as a continued decline in
corporate investment in new IT-related equipment, increased competition, changes in
customers buying habits, the loss of significant customers, changes in the selection
of products available for resale by the Company, or general economic conditions. Sales by
the Companys traditional business units have declined over the past year, excluding
the incremental sales due to the March 31, 2003 CPCS acquisition. A further decline in
sales levels could adversely affect the Companys business, financial condition, cash
flows or results of operations.


Major Customer.The
Companys contract with a major customer expired in June 2003. Sales to this customer
represented 5.8% and 10.6% of total sales for the three months ended September 30, 2003
and 2002. Net sales to this customer were $6.6 million for the quarter ended September 30,
2003, compared to $10.8 million for the quarter ended September 30, 2002. While the
Company may continue to receive some level of business from this customer, net sales to
this customer have declined significantly. There are no assurances that the Company will
be able to replace these sales with increased sales to other enterprise or SMB customers.


Risk Associated with CPCS.On
March 31, 2003, the Company acquired all of the outstanding shares of capital stock of
CPCS, an Illinois-based computer products reseller. The Company paid the shareholders of
CPCS $4,881,000 in cash and issued $2,500,000 of notes payable. The purchase price of CPCS
was based in part on the historical financial results of CPCSs operations, and also
included an earn-out feature based upon CPCSs post-acquisition performance. There is
no assurance that CPCSs future sales and profitability will equal or exceed its
historical results. In addition, there are risks associated with the acquisition and the
resulting change of control of CPCS, including, but not limited to, the potential loss of
customers or key employees of CPCS, any of which could have an adverse effect on the
Companys business, financial condition, cash flows or results of operations.


Vendor Support. The Company
has a variety of relationships with its vendors that have in the past contributed
significantly to profit margins. For example, certain product manufacturers and
distributors provide the Company with incentives in the form of rebates, volume incentive
rebates, discounts and trade allowances. In addition, many of the Companys vendors
provide the Company with cooperative advertising funds, which reimburse the Company for
expenses associated with specific forms of advertising. Industry-wide, manufacturers,
distributors and vendors have been reducing these incentives and curtailing these
programs. If these forms of vendor support decline further, or if the Company is otherwise
unable to take advantage of continuing vendor support programs, or if the Company fails to
manage the complexity of these programs, the Companys business, financial condition,
cash flows or results of operations could be adversely affected.


Account Executive Hiring and
Productivity. The Company intends to continue to recruit account executives. The
Company hopes to hire approximately 20 new account executives each month. There are no
assurances that the Company will be able to recruit the quality individuals that it hopes
to recruit and hire, or that the individuals hired will remain with the Company for an
extended period of time. The productivity of account executives has historically been
closely correlated with tenure. If the Company does not retain the account executive,
there can be no assurances of increasing average tenure or increased productivity, or that
if the Company does retain the account executive, there are not assurances that they will
become productive at historical levels. Additionally, the Companys account
executives in the past have been the subject of aggressive hiring by competitors.

15

Increased Expenses of Being a
Public Company. The costs of being a public company have increased significantly since
the enactment of the Sarbanes-Oxley Act of 2002. Legal counsel fees have increased as a
result of increased disclosure requirements and the need to comply with new corporate
governance requirements under the Sarbanes-Oxley Act as well as SEC regulations and Nasdaq
rules. Additionally, independent accountant audit fees have increased, and are expected to
increase even more as requirements associated with corporate governance become effective.
These increasing costs may have an adverse affect on the ability of the Company to restore
and maintain profitability.


Pressure on Margins. The
computer products industry has been characterized by intense price competition and
pressure on profit margins. The slowdown in U.S. corporate IT spending has created an even
more intense competitive landscape that has further disrupted the stability of pricing,
exerting downward pressure both on average selling price and profit margins across all
product lines. Additionally, a number of manufacturers are providing their products direct
to customers. The Company expects intense price competition and margin pressure to
continue. If the Company is unable to maintain or improve gross margins in the future,
this could have an adverse effect on the Companys business, financial condition, or
results of operations.


     Competition.The computer products industry is highly competitive. The Company believes
          that product selection, availability and price are the three most important
          competitive factors. The Company competes with other national direct marketers,
          including CDW Corporation, Insight Enterprises, Inc., PC Connection, Inc. and PC
          Mall, Inc. The Company also competes with product manufacturers, such as Apple,
          Dell, Hewlett Packard and IBM, which sell direct to end-users; specialty
          computer retailers; computer and general merchandise superstores; and consumer
          electronic and office supply stores. Many of the Companys competitors
          compete principally on the basis of price and have lower costs than the Company.
          The Company believes that competition may intensify in the future due to market
          conditions and consolidation. In the future, the Company may face fewer, but
          larger and better-financed competitors as a consequence of such consolidation.
          Additional competition may also arise if other methods of distribution emerge in
          the future. There can be no assurance that the Company will be able to compete
          effectively with existing competitors or new competitors that may enter the
          market, or that the Companys business, financial condition, cash flows or
          results of operations will not be adversely affected by intensified competition.


Liquidity of Stock and Nasdaq
National Market Listing. There is relatively limited trading of the Companys
stock in the public markets, and this may impose significant practical limitations on any
shareholders ability to achieve liquidity at any particular quoted price. Efforts to
sell significant amounts of the Companys stock on the open market may precipitate
significant declines in the prices quoted by market makers. The limitation on shareholder
liquidity resulting from this relatively thin trading level could be further adversely
affected if the Companys stock were to be de-listed from The Nasdaq National Market.
The Company has on two prior occasions received delisting notifications from The Nasdaq
National Market relating to its $1.00 minimum bid price requirement. With respect to both
notices, the Company ultimately received notification from Nasdaq that it had regained
compliance with National Market listing requirements. In the future, if the Companys
stock were to be delisted from trading on the Nasdaq National Market and were not listed
for trading on the Nasdaq SmallCap Market, trading in the Companys common stock
might continue on the OTC Bulletin Board or in a non-Nasdaq over-the-counter market, such
as the pink sheets. Delisting of the Companys common stock would result
in limited release of the market price of the common stock and limited news coverage and
could restrict investors interest in the common stock. Such a delisting could also
adversely affect the trading market, price for and liquidity of the Companys stock,
and the Companys ability to issue additional securities or to secure additional
financing.


State Tax Uncertainties.The
Company collects and remits sales use tax in states in which it is registered and/or has a
physical presence. Various states have sought to require the collection of state and local
sales taxes on the sales of products shipped to the taxing jurisdictions residents
by direct marketing resellers. The United States Supreme Court held in 1992 that it is
unconstitutional for a state to impose sales or use tax collection obligations on an
out-of-state company whose contacts with the state were limited to the distribution of
catalogs and other advertising materials through the mail and the subsequent delivery of
purchased goods by United States mail or by common carrier. The Company cannot predict the
level of contact, including electronic commerce and Internet activity that might give rise
to future or past tax collection obligations based on that Supreme Court case. Many states
do aggressively pursue out of state businesses, and legislation that would expand the
ability of states to impose sales tax collection obligations on out of state businesses
has been introduced in Congress on many occasions. A change in the law could require the
Company to collect sales taxes or similar taxes on sales into states in which it has no
presence and potentially subject it to a liability for prior year sales, either of which
could have a material adverse effect on the Companys business, financial condition,
and results of operations. Also, the Company has petitioned the Washington State
Department of Revenue for reconsideration of its determination regarding the
Companys tax returns for the years 1996, 1997, 1998 and 1999. The Company recorded a
charge for this determination of $2.1 million in the fourth quarter of 2002, and may have
to pay this amount, plus interest, if the petition is denied. The Department may also make
a similar assessment for all future periods after 1999. The Company has fully reserved
against the possibility of a similar assessment for the periods after 1999.

16

Rapid Technological Change and
Inventory Obsolescence. The computer industry is characterized by rapid technological
change and frequent introductions of new products and product enhancements. To satisfy
customer demand and obtain greater purchase discounts, the Company may be required to
carry significant inventory levels of certain products, which subjects it to increased
risk of inventory obsolescence. The Company participates in first-to-market and
end-of-life-cycle purchase opportunities, both of which carry the risk of inventory
obsolescence. Special purchase products are sometimes acquired without return privileges,
and there can be no assurance that the Company will be able to avoid losses related to
such products. Within the industry, vendors are becoming increasingly restrictive in
guaranteeing return privileges. While the Company seeks to reduce its inventory exposure
through a variety of inventory control procedures and policies, there can be no assurance
that the Company will be able to avoid losses related to obsolete inventory.


Reliance on Vendor
Relationships. The Company acquires products directly from manufacturers as well as
from distributors such as Ingram Micro, Tech Data and others. Certain hardware
manufacturers limit the number of product units available to direct marketing resellers
such as the Company. Substantially all of the Companys contracts and arrangements
with its vendors are terminable without notice or upon short notice. Termination,
interruption or contraction of the Companys relationships with its vendors could
have a material adverse effect on the Companys business, financial condition, cash
flows or results of operations.


Major Shareholder. Firoz H.
Lalji, the Companys Chairman and Chief Executive Officer, beneficially owns 48.2% of
the outstanding shares of the Companys common stock, excluding shares that he may
acquire upon exercise of stock options that he holds. If Mr. Lalji exercises all options
and retains the shares of common stock issued to him upon such exercise, his collective
ownership would increase to 50.0% of the outstanding shares of the Companys common
stock. The voting power of these shares enables Mr. Lalji to significantly influence the
Companys affairs and the vote on corporate matters to be decided by the
Companys shareholders, including the outcome of elections of directors. This
effective voting control may preclude other shareholders from being able to influence
shareholder votes and could impede potential merger transactions or block changes to the
Companys articles of incorporation or bylaws, which could adversely affect the
trading price of the Companys common stock.


Dependence on Key Personnel.
The Companys future success will depend to a significant extent upon its ability to
attract and retain skilled personnel. Although the Companys success will depend on
its ability to hire, train and retain competent personnel in all areas of its business,
there are certain individuals that play a key role within the organization. Loss of any of
these individuals could have an adverse effect on the Companys business, financial
condition, cash flows or results of operations.


Potential Disruption of Business
From Information Systems Failure. The Companys operations are dependent on the
reliability of its information, telecommunication, and other systems, which are used for
sales, distribution, marketing, purchasing, inventory management, order processing,
customer service and general accounting functions. Interruption of the Companys
information systems, Internet or telecommunication systems could have a material adverse
effect on the Companys business, financial condition, and results of operations.


Reliance on Outsourced
Distribution. Airborne Logistics Services, an affiliate of Airborne Express, provides
and operates a warehouse and distribution center for the Company in Wilmington, Ohio under
a renewable contract that expired in August 2003. The contract was extended to November
2003 to finalize negotiations. The Company does not anticipate any substantive changes or
issues with the renewable contract. Any limitation or interruption of the service being
provided by Airborne Logistics could have a material adverse effect on the Companys
business, financial condition, and results of operations. Certain distributors also
participate in the Companys logistics operations through electronic data
interchange. Failure to develop and maintain relationships with these and other vendors
would limit the Companys ability to obtain sufficient quantities of merchandise on
acceptable commercial terms and could have a material adverse effect on the Companys
business, financial condition, cash flows or results of operations.

17

Potential Increases in Postage,
Shipping and Paper Costs. Postage and shipping costs, as well as the cost of paper for
the Companys catalogs, are significant expenses in the operation of the
Companys business. The Company generally mails its catalogs through the U.S. Postal
Service. Any future increases in postage, shipping rates or paper costs could have a
material adverse effect on the Companys business, financial condition, cash flows or
results of operations.



General


The Companys net sales consist
primarily of sales of computer hardware, software, peripherals and accessories, as well as
revenue associated with freight billed to its customers, and reflect the effects of
product returns. Gross profit consists of net sales less product and freight costs.
Selling, general and administrative (SG&A) expenses include advertising
expense net of applicable vendor co-op, warehousing, selling commissions, order
processing, telephone, credit card fees, and other costs such as administrative salaries,
depreciation, rent, and general overhead expenses. Other (income) expense represents
interest expense and net non-operating expenses.



Critical Accounting
Policies


The Companys discussion and
analysis of its financial condition and results of operations are based upon its
consolidated financial statements, which have been prepared in accordance with accounting
principles generally accepted in the United States. The Company believes the following
critical accounting policies affect its more significant judgments and estimates used in
the preparation of its consolidated financial statements, and should be read in
conjunction with its summary of significant accounting policies (see Note 2 of the
Companys Notes to Consolidated Financial Statements). Additionally, during the first
quarter of 2003, the Company adopted EITF 02-16 Issue No. 02-16, Accounting for
Consideration Received from a Vendor by a Customer (Including a Reseller of the
Vendors Products). Due to the adoption of EITF 02-16, the Company recorded
$1.6 million and $3.9 million of vendor consideration as a reduction to cost of sales in
the three and nine months ended September 30, 2003, respectively, that offset advertising
expense in prior periods.


The Companys critical
accounting policies are as follows:



Revenue recognitionValuation of current assets and estimating market inventory obsolescenceAccounting for income taxesGoodwill
Revenue recognition.The Company recognizes revenue on
product sales when persuasive evidence of an arrangement exists, delivery has occurred,
prices are fixed or determinable, and collectability is probable. The Company considers
the point of delivery of the product to be when the risks and rewards of ownership have
transferred to the customer. The Company offers limited return rights on its product
sales. At the point of sale, the Company also provides for an allowance for sales returns,
which is established based on historical experience.


Valuation of current assets and
estimating market inventory obsolescence. The Company uses significant judgment
and estimates in the preparation of its financial statements that affect the carrying
values of its assets and liabilities., The Company evaluates its estimates on an on-going
basis.
18

The Company maintains an allowance
for doubtful accounts based on estimates of future collectibility of its accounts
receivable. The Company regularly analyzes its accounts receivable in evaluating the
adequacy of the allowance for doubtful accounts. The adequacy of the allowance is
determined during the current period based on historical collection experience, customer
credit worthiness based on published information and other known factors.


The Company maintains a valuation
allowance for potentially uncollectible amounts due from its vendors which arise from
product returns, standard vendor price protection programs and vendor rebate programs.
Amounts received from vendors may vary from amounts recorded based on the difference
between the current market price of a product returned and its acquisition price or the
denial of price protection or vendor rebates due to noncompliance with specific attributes
of the vendor programs. The Company regularly reviews its vendor receivables and provides
a valuation allowance based on historical collections and the comparison of amounts
recorded versus subsequently received.


The Company records inventory at
lower of FIFO cost or market. It estimates the amount of unmarketable inventory based on
the difference between the cost of the inventory and the market value, which is based on
assumptions of market demand, current market conditions, most recent actual sales prices
and age and condition of products.



Accounting for income
taxes.The Company is required to estimate
income taxes in the jurisdiction in which it operates. This process involves estimating
actual tax exposure while assessing temporary differences resulting in differing treatment
for tax and accounting purposes. These differences result in deferred tax assets and
liabilities. The Company assesses the likelihood that its deferred tax assets will be
recovered through future taxable income and or other tax planning strategies. The Company
exercised judgment as of September 30, 2003 and did not provide a valuation allowance
against its deferred tax asset believing that it is more likely than not that future
taxable income and tax planning will be sufficient to recover the deferred tax asset.
However, the guidelines provided by SFAS 109 are stringent and if the Company is unable to
provide positive evidence that the deferred tax asset is recoverable, it will be required
to provide a valuation allowance against the deferred tax asset. If a valuation allowance
is deemed to be required, an expense will be recorded within the tax provision in the
Consolidated Statement of Operations. At September 30, 2003, the Company had $8.0 million
in aggregate deferred tax assets.



GoodwillIn accordance with SFAS No. 142,
Goodwill and Other Intangible Assets, goodwill will be tested for impairment
at least annually, or when events indicate that impairment exists.

19


Results of Operations


The following table presents the
Companys unaudited consolidated results of operations, as a percentage of net sales,
and selected operating data for the periods indicated.
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------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|                                                | Three months ended September 30, | Nine months ended September 30,
|----------------------------------------------- | -------------------------------- | -------------------------------
|
|                                                |                                  |                                
|Net sales                                       |                                  |                                
|Cost of sales                                   |                                  |                                
|                                                |                                  |                                
|Gross profit                                    |                                  |                                
|Selling, general and administrative expenses    |                                  |                                
|Advertising expenses, net                       |                                  |                                
|                                                |                                  |                                
|Income (loss) from operations                   |                                  |                                
|Other (income) expense                          |                                  |                                
|                                                |                                  |                                
|Income (loss) before income taxes               |                                  |                                
|Provision (benefit) for income taxes            |                                  |                                
|                                                |                                  |                                
|Net income (loss)                               |                                  |                                
|                                                |                                  |                                
|                                               
|Selected operating data:                        |                                  |                                
|Number of orders                                |                                  |                                
|Average order size                              |                                  |                                
|Number of B2B account executives, end of period |                                  |                                
|Productivity per employee, annualized           |                                  |                                
|                                               
|Product Mix (% of Net Sales):                   |                                  |                                
|Notebook & PDA's                                |                                  |                                
|Desktops & Servers                              |                                  |                                
|Software                                        |                                  |                                
|Storage                                         |                                  |                                
|NetComm                                         |                                  |                                
|Printers                                        |                                  |                                
|Monitors & Video                                |                                  |                                
|Memory & Processors                             |                                  |                                
|Accessories & Other                             |                                  |                                

|Comparison of Three Month
Periods Ended September 30, 2003 and 2002


Net Sales.Consolidated net
sales for the quarter ended September 30, 2003 increased 10.1% to $112.7 million compared
to $102.4 million in the third quarter of 2002. The increase in sales resulted primarily
from the impact of the CPCS acquisition. CPCS net sales for the three months ended
September 30, 2003 were $19.2 million. The Companys net sales excluding CPCS were
$93.5 million, an 8.7% decline from the same period of the prior year. This decline is
primarily due to the anticipated decline in sales to a major customer. Sales to this major
customer decreased 39.4% to $6.6 million for the quarter ended September 30, 2003 compared
to $10.8 million in the same period of 2002. The contract with this customer expired in
June of 2003. While the Company may continue to receive some level of business from this
customer, it anticipates that net sales to this customer will decline further from the
sales generated in the third quarter of 2003. Net sales to large accounts, including sales
by CPCS, were $51.5 million in the third quarter of 2003 compared to $26.7 million in the
third quarter of 2002. Consolidated outbound sales to the SMB, large and public sector
accounts increased 22.4% to $101.3 million in the third quarter of 2003 from $82.8 million
in the third quarter of 2002. Partly as a result of the Companys decision to begin
collecting sales tax in the States of California and Missouri during the first quarter of
2003, sales by the Companys Mac division decreased 41.7% to $11.4 million for the
three months ended September 30, 2003 compared to $19.6 million in the comparable period
of 2002. The decline in sales from the Mac division was also impacted by increased direct
competition as well as fewer product introductions during the quarter. Sequentially from
the last quarter, sales by the Companys Mac division increased 7.2% from the second
quarter of 2003. This increase is primarily due to the Companys pursuit of specific
verticals utilizing its outbound sales model. The Company will continue to build upon the
preliminary successes of its vertical specific sales teams.
20

Gross Profit. Consolidated
gross profit increased to $13.5 million for the third quarter of 2003, compared to $10.8
million in the third quarter of 2002. Gross profit as a percentage of net sales increased
to 11.9% in the quarter ended September 30, 2003 compared to 10.5% in the third quarter of
2002, and increased sequentially from 10.9% in the second quarter of 2003. Gross profit
margins for the three months ended September 30, 2003 were impacted by vendor programs and
by the Companys January 1, 2003 adoption of Emerging Issues Task Force
(EITF) Issue No. 02-16, Accounting for Consideration Received from a
Vendor by a Customer (Including a Reseller of the Vendors Products). Due to
the adoption of EITF 02-16, the Company recorded $1.6 million of vendor consideration as a
reduction to cost of sales in the third quarter of 2003. Excluding the impact of EITF
02-16, the gross profit margin would have been 10.5% for the third quarter of 2003 which
is flat compared to the same period of 2002. This percentage is a non-GAAP measure that is
being presented for comparison purposes only as the adoption of EITF 02-16 did not impact
prior year gross profit margins. Gross profit margins as a percent of sales will continue
to vary on a quarterly basis due to vendor programs, product mix, pricing strategies,
customer mix, and economic conditions.


Selling, General and
Administrative (SG&A) Expenses.SG&A expense dollars increased to
$11.1 million for the quarter ended September 30, 2003 compared to $10.1 million in the
third quarter of 2002. SG&A expense dollars also increased sequentially from $10.9
million in the second quarter of 2003. During the third quarter of 2003, the Company moved
its corporate headquarters, incurring $495,000 in move related expenses. These expenses
will be mitigated over the duration of the lease due to the lease incentives and reduced
monthly rent expense associated with the new location. Additionally, the SG&A expenses
included $240,000 for legal counsel and financial advisory fees for the Company and the
special committee, arising from the going-private proposal and fees associated with the
special committee evaluation of the going-private proposal. On September 9, 2003, the
Company was notified by the investor group led by the Companys Chairman and CEO,
Firoz Lalji, of the withdrawal of the groups May 20, 2003 offer to acquire all
shares of common stock not owned by the investor group. Aside from these non-recurring
expenses, the Company continues to maintain tight controls on its operational spending. As
a percent of sales, SG&A was 9.9% for the quarter ended September 30, 2003, flat
compared to the third quarter of 2002.


Advertising expenses, net. The
Company produces and distributes catalogs at various intervals throughout the year, as
well as engaging in other activities, to increase the awareness of its brand and as demand
response vehicles. The Companys net cost of advertising increased to $1.9 million in
the three month period ended September 30, 2003 from $411,000 in the comparable 2002
period. This increase is primarily due to the Companys adoption of EITF 02-16,
Accounting for Consideration Received from a Vendor by a Customer (Including a
Reseller of the Vendors Products), under which the Company recorded $1.6
million of vendor consideration as a reduction to cost of sales in the third quarter of
2003 rather than as an offset to advertising expense as in prior periods. Additionally,
advertising expense was impacted by a decline in the amount of cooperative advertising
revenue received from the Companys vendors.


Other Income/Expense.Other
expense was $141,000 for the quarter ended September 30, 2003 compared to other expense of
$4,000 in the third quarter of 2002. The change was primarily due to an increase in
interest expense incurred in the third quarter of 2003 compared with the same period of
2002. During the third quarter of 2003, the Company leveraged its line of credit to
aggressively take early pay discounts and invested in certain purchasing opportunities.
Additionally, the shift in customer mix has reduced the sales on credit card.


Provision/Benefit for Income
Taxes. The provision for income taxes for the quarter ended September 30, 2003 was
$193,000 compared to $87,000 in the comparable period of the prior year. The
Companys effective tax rate expressed as a percentage of income before taxes was
59.1% for the quarter ended September 30, 2003 compared to 41.2% for the quarter ended
September 30, 2002. The tax rate for the three months ended September 30, 2003 was
impacted by the Companys change in estimate of the annual taxable income.
21

Net Income.Net income for the
quarter ended September 30, 2003 was $134,000 compared to net income of $124,000 in the
third quarter of 2002. Basic and diluted income per share was $0.01 for the quarter ended
September 30, 2003 and basic and diluted earnings per share was $0.01 in the third quarter
of 2002.



Comparison of Nine Month
Periods Ended September 30, 2003 and 2002


Net Sales.Consolidated net
sales for the nine months ended September 30, 2002 increased 6.6% to $330.4 million
compared to $310.0 million in the comparable period of 2002. The increase in sales
resulted primarily from the impact of the March 31, 2003 acquisition of CPCS. CPCS net
sales for the six months ended September 30, 2003 were $37.3 million. The Companys
net sales for the nine months ended September 30, 2003 excluding CPCS were $293.2 million,
a 5.4% decline from the same period of the prior year. The decrease in sales resulted
primarily from a decline in sales to a major customer, which decreased 22.0% to $37.7
million for the nine months ended September 30, 2003 compared to $48.3 million in the same
period of 2002. Large account net sales, including sales by CPCS, were $151.3 million for
the nine months ended September 30, 2003 compared to $92.5 million in the comparative
period of 2002. Consolidated outbound sales to the SMB, large and public sector accounts
increased 14.9% to $296.1 million in the first nine months of 2003 from $257.6 million in
the first nine months of 2002. As a result of the Companys decision to begin
collecting sales tax in the States of California and Missouri during the first quarter of
2003, sales by the Companys Mac division decreased 34.4% to $34.3 million for the
nine months ended September 30, 2003 compared to $52.4 million in the comparable period of
2002. The decline in sales from the Mac division was also impacted by increased direct
competition as well as fewer product introductions during the quarter.


Gross Profit. Consolidated
gross profit increased to $36.8 million for the nine months ended September 30, 2003,
compared to $32.1 million in the comparable period of 2002. Gross profit as a percentage
of net sales increased to 11.2% in the first nine months of 2003 compared to 10.4% in the
first nine months of 2002. Gross profit margins for the first nine months of 2003 were
impacted by the Companys January 1, 2003 adoption of Emerging Issues Task Force
(EITF) Issue No. 02-16, Accounting for Consideration Received from a
Vendor by a Customer (Including a Reseller of the Vendors Products). Due to
the adoption of EITF 02-16, the Company recorded $3.9 million of vendor consideration as a
reduction to cost of sales in the first nine months of 2003. Excluding the impact of EITF
02-16, the gross profit margin would have declined to 10.0% for the nine months ended
September 30, 2003. This percentage is a non-GAAP measure that is being presented for
comparison purposes only as the adoption of EITF 02-16 did not impact prior year gross
profit margins. The decline in comparable gross profit margins is primarily due to changes
in vendor programs and a shift in customer mix. Gross profit margins as a percent of sales
will continue to vary on a quarterly basis due to vendor programs, product mix, pricing
strategies, customer mix, and economic conditions.


Selling, General and
Administrative (SG&A) Expenses.SG&A expense dollars increased to
$32.2 million for the nine months ended September 30, 2003 compared to $30.1 million in
the nine months ended September 30, 2002. The Company moved its corporate headquarters in
the third quarter of 2003 and incurred $495,000 in move related expenses. These expenses
will be mitigated over the duration of the lease due to the lease incentives and reduced
monthly rent expense associated with the new location. Additionally, SG&A dollars
included $364,000 for legal counsel and financial advisory fees for the Company and the
special committee, arising from the going-private proposal and fees associated with the
special committee evaluation of the going-private proposal. On September 9, 2003, the
Company was notified by the investor group led by the Companys Chairman and CEO,
Firoz Lalji, of the withdrawal of the groups May 20, 2003 offer to acquire all
shares of common stock not owned by the investor group. The Company continues to maintain
tight controls on its discretionary spending. As a percent of sales, SG&A was 9.8% for
the nine months ended September 30, 2003 compared to 9.7% for the comparable period of
2002.


Advertising expenses, net. The
Company produces and distributes catalogs at various intervals throughout the year, as
well as engaging in other activities, to increase the awareness of its brand and as demand
response vehicles. The Companys net cost of advertising increased to $5.3 million in
the nine month period ended September 30, 2003 from $1.1 million in the comparable 2002
period. This increase is primarily due to the Companys adoption of EITF 02-16,
Accounting for Consideration Received from a Vendor by a Customer (Including a
Reseller of the Vendors Products), under which the Company recorded $3.9
million of vendor consideration as a reduction to cost of sales in the first nine months
of 2003 rather than as an offset to advertising expense as in prior periods. Additionally,
advertising expense was impacted by a decline in the amount of cooperative advertising
revenue received from the Companys vendors.
22

Other Income/Expense.Other
expense was $236,000 for the nine months ended September 30, 2003 compared to other income
of $9,000 in the nine months ended September 30, 2002. The change was primarily due to an
increase in interest expense incurred in 2003 compared with the same period of 2002. The
Company leveraged its line of credit to aggressively take early pay discounts and invested
in certain purchasing opportunities, as well as the March 31, 2003 purchase of CPCS.
Additionally, the shift in customer mix has reduced the sales on credit card.


Provision/Benefit for Income
Taxes. The benefit for income taxes for the nine months ended September 30, 2003 was
$395,000 as compared to a provision of $374,000 in the comparable period of the prior
year. The Companys effective tax rate expressed as a percentage of income (loss)
before taxes was 38.3% for the nine months ended September 30, 2003 compared to 39.3% for
the nine months ended September 30, 2002.


Net Income/Loss.Net loss for
the nine months ended September 30, 2003 was $636,000 compared to net income of $577,000
in the comparable period of 2002. Basic and diluted loss per share were $0.05 for the nine
months ended September 30, 2003 and basic and diluted earnings per share was $0.04 for the
nine months ended September 30, 2002.



Trends


The Company continued to experience
positive contributions to operating results from CPCS, which was acquired on March 31,
2003. CPCS has historically been a profitable company with a successful management team.
The Company believes that future contributions by CPCS will help mitigate weakness in
sales due to economic pressures as well as the expiration of the contract with a major
customer. The Company is cautiously optimistic about the remainder of 2003 and heading
into 2004. Although the Companys net sales may decline or increase slightly during
the balance of 2003 in relation to historical patterns, the Company believes it is in a
position to leverage its existing infrastructure to take advantage of any increase in IT
spending. In anticipation of a continued static environment, the Company is focusing on
the key elements of its business: diversification of sales, improvement in gross profit
margin, and continued control of discretionary expenses.


The Company markets its products
across several sectors to drive sales growth, while striving to become one of the leading
business to business direct marketing resellers of IT infrastructure solutions.
Its outbound sales force, in conjunction with the small business group, actively pursues the
small to medium sized business customer. The small business group is the training ground
for less tenured account executives. The Company aggressively invests in new account
executives, subject to current market conditions. The Company plans to continue to invest
in the business by hiring and training additional account executives as circumstances
allow in future quarters.The Company is building a niche in the large customer business arena, and believes it is
in a position to fulfill their business level needs efficiently and profitably.During the third quarter of 2003, the Company created a new subsidiary dedicated to
fulfilling the needs of its large customers. Zones Corporate Solutions, or ZCS, will be a
wholly owned subsidiary headquartered at the Auburn facility. ZCS has the ability to
accommodate the demanding needs of large customers; in particular ZCS will collect and
remit sales tax on their customers behalf in additional states.The Company was notified of its large account reseller (LAR) status and its
ability to act as an enterprise software advisor, enabling the Company to sell Select and
EA contracts to its customers. This enhances the Companys single source procurement
options; offering solutions to customers of all sizes.The Company believes it has growth potential in its Public Sector division and it is
pursuing education, state and local government initiatives.The Companys Mac sales division is supported by a loyal customer base. During 2003,
the Company has seen declines in its Mac sales division due to its decision to begin
collecting sales tax in the States of California and Missouri, as well as increased
competition, including manufacturer direct initiatives and fewer product introductions.
The legacy Mac business was primarily inbound customers in a demand response model. Over
the past months, the Company began pursuing the specific verticals utilizing its outbound
sales model to supplement its demand response model. The Company will continue to build
upon the preliminary successes of its vertical specific sales teams.23

The economic downturn in the IT
market, concurrent with vendor programs that continue to be refined, has led to an intense
focus on the key drivers of gross profit margin. Several initiatives have been implemented
intended to grow the Companys gross profit margin percentage. The initiatives are
driven by several factors including: product mix and related vendor programs, attach
rates, freight, purchasing power, account executive education, pricing strategies as well
early pay discounts. Gross profit margins will continue to vary based on each of these
factors. The Company expects to continue experiencing pricing pressures in pursuit of
increasing its market share.


During the first quarter of 2003, the
Company adopted EITF 02-16, Accounting for Consideration Received from a Vendor by a
Customer (Including a Reseller of the Vendors Products), under which the
Company recorded $1.6 million and $3.9 million of vendor consideration as a reduction to
cost of sales in the third quarter of 2003 and the nine months ended September 30, 2003,
respectively, rather than as an offset to advertising expense as in prior periods. The
adoption of this issue had no impact on net income (loss) from operations, shareholders
equity or cash flows of the Company. EITF 02-16 only impacts contracts signed or revised
on or after January 1, 2003. As new contracts are signed, or existing contracts are
modified, there may be a shift towards increased gross profit margins and a concurrent
growth in the net cost of advertising. Vendor allowances will vary on a quarterly basis
due to changes in vendor programs.


The Company constantly reviews all
internal processes in an effort to create efficiencies and maintain tight controls over
all discretionary expenses, including advertising expenses, which has been a focal point
for the past several quarters due to the existing economic conditions. The Company has
experienced increased scrutiny and costs associated with being a public company. It
anticipates total SG&A costs to continue to rise due to these increasing costs.
SG&A will also be impacted by the Companys investment in the hiring and training
of new account executives. The Company believes that the costs associated with the
investment in additional headcount will be offset in future quarters as the account
executives mature and become increasingly productive. The Company continues to see cost
savings due to reductions of support functions used to support its legacy infrastructure
associated with a demand response model and catalog distribution.


During the second quarter of 2003,
the Company received a proposal from an investor group led by its President and CEO, Firoz
Lalji, to acquire all Zones common shares not owned by the investor group for a cash price
of $1.00 per share. The Companys Board of Directors appointed a special committee of
directors unaffiliated with the investor group to review this proposal with the assistance
of independent financial and legal advisors. On September 9, 2003, it was announced that
the offer from the investor group was withdrawn. Zones will remain a publicly traded
company on the Nasdaq National Market and will continue to be compliant with all SEC and
Nasdaq reporting requirements. This decision should have no impact on the Companys
shareholders, customers or vendor partners. The Company will continue to work hard to
enhance shareholder value, give exemplary customer service and provide a great work
environment to its team members.



Inflation


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



Liquidity and Capital
Resources


As of September 30, 2003, the Company
had total assets of $89.8 million, of which $75.5 million were current assets. At
September 30, 2003 and December 31, 2002 the Company had cash and cash equivalents of $1.6
million and $9.0 million, respectively. The Company utilized its cash position to
aggressively take advantage of favorable discount terms offered by certain vendors. Cash
has also been impacted by the reduction in credit card sales as a percent of total sales.
The Companys accounts receivable days outstanding increased to 47 days at September
30, 2003 compared to 43 days at December 31, 2002. The Companys working capital was
$18.0 million and $20.6 million at September 30, 2003 and December 31, 2002, respectively.
The decline in working capital is primarily due to the March 31, 2003 acquisition of CPCS.
24

Net cash used by operating activities
was $5.0 million for the nine months ended September 30, 2003 compared to cash used by
operating activities of $1.1 million for the nine months ended September 30, 2002. Cash
outflows for the nine months ended September 30, 2003 were primarily due to increases in
accounts receivable primarily due to a shift in customer mix leading to a reduction in
credit card sales, offset by increases in accounts payable. At September 30, 2003, net
accounts receivable increased $2.8 million and accounts payable increased $3.7 million,
net of $1.2 million of cash overdraft from December 31, 2002.


Cash outlays for capital expenditures
were $1.1 million and $1.3 million in the nine months ended September 30, 2003 and 2002,
respectively. The Company moved its corporate headquarters during the third quarter of
2003 which required tenant improvements above those in the tenant allowance. The
Companys capital expenditures were $451,000, which is mitigated by lease incentives
at the new facilities. Based on historical expenditures, the lease incentive will provide
a cash savings of $1.7 million in the first year of the tenancy in the new facility. The
additional capital expenditures during 2003, and prior year expenditures, were primarily
for continued improvement, and other enhancements, of the Companys information
systems. The Company will continue to upgrade its internal information systems as a means
to increase operational efficiencies. Lastly, payments for the acquisition of CPCS, net of
cash acquired, were $3.7 million for the period ending September 30, 2003.


At September 30, 2003, the Company
had $40.0 million available under a secured line of credit with a major financial
institution.  The credit facility is collateralized by accounts receivable and
inventory and can be utilized as both a working capital line of credit and a flooring
facility used to purchase inventory from several suppliers under certain terms and
conditions.  This credit facility expires on November 26, 2004.  The working
capital and inventory advances bear interest at a rate of Prime + 0.50%. Inventory
advances do not bear interest if paid within terms, usually 30 days from advance
date.  The facility contains various restrictive covenants relating to tangible net
worth, leverage, dispositions and use of collateral, other asset dispositions, and merger
and consolidation of the Company. At September 30, 2003, the Company was compliant with
all covenants of this facility. At September 30, 2003, $3.5 million of working capital
advances were outstanding and accounts payable of $17.8 million was owed to this financial
institution related to inventory purchases.


The Company believes that its
existing available cash and cash equivalents, operating cash flow and existing credit
facilities will be sufficient to satisfy its operating cash needs for at least the next 12
months at its current revenue and expense levels. However, if the Companys future
revenues decline below the current level, or if working capital erodes and other capital
requirements are greater than currently anticipated, the Company could be required to seek
additional funds through sales of equity, debt or convertible securities or increased
credit facilities. There can be no assurance that additional financing will be available
or that, if available, the financing will be on terms favorable to the Company and its
shareholders.

25


Contractual Obligations


The following table summarizes our
contractual payment obligations and commitments as of September 30, 2003:
|-------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------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|                     | Payments Due by Period
|-------------------- | ----------------------
|                     | Total                 
|                     |                       
|Long-Term Debt (a)   |                       
|Capital Leases (b)   |                       
|Operating Leases (c) |                       
|                     |                       
|Grand Totals         |                       

| | (a) | Long-term debt reflects the notes payable recorded in connection to the
          Companys March 31, 2003 acquisition of CPCS. Actual amount to be paid out
          subject to reduction (see page 13).
| | --- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| | (b) | Represents the Companys commitments under capital leases.
| | --- | ----------------------------------------------------------

| | (c) | Represents the Companys commitments under operating leases and are
          associated with contracts that expire at various times.
| | --- | -------------------------------------------------------------------------------------------------------------------------------------

|Item 3. Quantitative and
Qualitative Disclosures About Market Risk


The Company is subject to the risk of
fluctuating interest rates in the normal course of business, primarily as a result of its
short-term borrowing and investment activities, which generally bear interest at variable
rates. Because the short-term borrowings and investments have maturities of three months
or less, the Company believes that the risk of material loss is low.



Item 4. Controls and
Procedures


Under the supervision and with the
participation of our management, including our Chief Executive Officer and Chief Financial
Officer, we evaluated the effectiveness of our disclosure controls and procedures, as such
term is defined in Rule 13a-15(e) promulgated under the Securities Exchange Act of 1934,
as amended. Based on this evaluation, our Chief Executive Officer and Chief Financial
Officer concluded that our disclosure controls and procedures were effective as of the end
of the period covered by this quarterly report.



Part II.



Item 1. Legal Proceedings


Various claims and actions of a type
commonly encountered in the Companys industry have been asserted and are pending
against the Company. The Company believes that such claims and actions will not have a
material adverse effect upon the Companys financial position or results of
operations.


On November 21, 2002, the Washington
State Department of Revenue (the Department) issued a final determination
regarding the Companys state tax returns for the years 1996, 1997, 1998 and 1999.
The Department upheld the auditors assessment of business and occupation tax on
certain expense reimbursements the Company received from vendors during the audit period.
The Company petitioned the Department for a reconsideration of its determination, which
stayed the payment of the assessment until the petition for reconsideration is resolved.
However, as a result of the determination by the Department, the Company recorded a charge
of $2.1 million during the fourth quarter of 2002. The Company intends to pursue all of
its appeal rights, but there can be no assurance that the Company will be successful, in
whole or in part, in challenging the determination. Additionally, the Department may also
make a similar assessment for all future periods after 1999. The Company has fully
reserved against the possibility of a similar assessment for the periods after 1999.
26


Item
6.    Exhibits and Reports on Form 8-K



(a)           Exhibits
|------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------

|ExhibitNo. | Description                                                                                                                                                                                                                                                                                                                                                                                     | FiledHerewith | Incorporated by reference |         
|---------- | ----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------- | ------------- | ------------------------- | --------
|           |                                                                                                                                                                                                                                                                                                                                                                                                 |               | Form ExhibitNo.           | File No.
|10.1       | Amended and Restated Indemnification Agreement                                                                                                                                                                                                                                                                                                                                                  | X             |                           |         
|          
|31.1       | Certification of Chief Executive Officer pursuant
         to Section 302 of the Sarbanes-Oxley Act of 2002
         and the regulations promulgated thereunder                                                                                                                                                                                                                                 | X             |                           |         
|          
|31.2       | Certification of Chief Financial Officer pursuant
         to Section 302 of the Sarbanes-Oxley Act of 2002
         and the regulations promulgated thereunder                                                                                                                                                                                                                                 | X             |                           |         
|          
|32.1       | Certification of Chief Executive Officer pursuant
         to Section 906 of the Sarbanes-Oxley Act of 2002
         and the regulations promulgated thereunder                                                                                                                                                                                                                                 | X             |                           |         
|          
|32.2       | Certification of Chief Financial Officer pursuant
         to Section 906 of the Sarbanes-Oxley Act of 2002
         and the regulations promulgated thereunder                                                                                                                                                                                                                                 | X             |                           |         
|          
|           | On July 25, 2003, the Company furnished a report on form 8-K containing the Company's press release regarding its second
         quarter 2003 results from operations.                                                                                                                                                                                                                        
|          
|           | On September 9, 2003, the Company furnished a report on form 8-K containing the Company's press release announcing that it
         had been notified by the investor group led by the Company's Chairman and CEO, Firoz Lalji, of the withdrawal of the group's
         May 20, 2003 offer to acquire all shares of common stock not owned by the investor group for $1.00 per share in cash.
|          
|           | No other Reports on Form 8-K were furnished during the quarter ended September 30, 2003.                                                                                                                                                                                                                                                                                                       

|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:
|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------

| |                          | ZONES, INC.                                                                               
| | ------------------------ | ------------------------------------------------------------------------------------------
|
| | Date:  November 13, 2003 |                                                                                           
| |                          | By:    /S/   FIROZ H. LALJI
          Firoz H. Lalji, Chairman and Chief Executive Officer
|
|
| |                          | /S/   RONALD P. MCFADDEN
          Ronald P. McFadden, Chief Financial Officer            

|27
|--