UNITED STATES SECURITIES AND
EXCHANGE COMMISSION Washington, D.C. 20549 FORM 10-Q [X]
QUARTERLY
REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934  FOR THE QUARTERLY
PERIOD ENDED JUNE 30, 2004OR [  ]
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
    91-1431894(State
      of Incorporation)
    (I.R.S.
      EmployerIdentification
      Number)1102
      15th Street SW, Suite 102Auburn,
      Washington
    98001-6509(Address
      of Principal Executive Offices)
    (Zip Code) (253) 205-3000
(Registrants 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). Yes   NoX The number of shares of the
registrants Common Stock outstanding as of August 5, 2004 was 13,420,711. 1


ZONES, INC. INDEX PART
      I. FINANCIAL INFORMATIONItem
      1.
    
    Consolidated
      Financial Statements (unaudited):Consolidated
      Balance Sheets June 30, 2004 and December 31, 2003
    
    3Consolidated
      Statements of Operations Three and six months ended June 30, 2004 and 2003
    
    4Statements
      of Shareholders Equity Six months ended June 30, 2004
    
    5Consolidated
      Statements of Cash Flows Six months ended June 30, 2004 and 2003
    
    6Notes
      to Consolidated Financial Statements
    
    7Item
      2.
    
    Managements
      Discussion and Analysis of Financial Condition and Results of Operations
    
    14Item
      3.
    
    Quantitative
      and Qualitative Disclosures About Market Risk
    
    24Item
      4.
    
    Controls
      and Procedures
    
    24PART
      II. OTHER INFORMATIONItem
      1.
    
    Legal
      Proceedings
    
    24Item
      4.
    
    Submission
      of Matters to a vote of Security Holders
    
    25Item
      5(b).
    
    Director
      Nominations
    
    25Item
      6.
    
    Exhibits
      and Reports on Form 8-K
    
    26Signatures
    
    26 2


Part I. Item 1. Financial
Statements ZONES, INC. CONSOLIDATED
BALANCE SHEETS(in thousands)(unaudited) June
      30,
       2004
    
    December
      31,
       2003ASSETSCurrent assets:Cash
      and cash equivalents
    
    
    $
    3,635
    
    $
    5,180Receivables,
      net
    
    
    
    57,234
    
    
    59,965Inventories,
      net
    
    
    
    14,157
    
    
    11,487Prepaid
      expenses
    
    
    
    1,167
    
    
    1,101Deferred
      tax asset
    
    
    
    1,327
    
    
    1,327Total
      current assets
    
    
    
    77,520
    
    
    79,060Property
      and equipment, net
    
    
    
    4,432
    
    
    4,355Goodwill
    
    
    
    3,898
    
    
    4,193Deferred
      tax asset
    
    
    
    3,881
    
    
    5,110Other assets
    
    
    
    194
    
    
    167Total
      assets
    
    
    $
    89,925
    
    $
    92,885LIABILITIES
      AND SHAREHOLDERS EQUITYCurrent liabilities:Accounts
      payable
    
    
    $
    42,445
    
    $
    41,270Accrued
      liabilities
    
    
    
    7,385
    
    
    8,223Line
      of credit
    
    
    
    2,995
    
    
    7,850Notes
      payable
    
    
    
    735
    
    
    833Total
      current liabilities
    
    
    
    53,560
    
    
    58,176Notes payable
    
    
    
    851
    
    
    1,667Deferred
      rent
    
    
    
    852
    
    
    341Total
      liabilities
    
    
    
    55,263
    
    
    60,184Commitments
      and contingenciesShareholders
      equity:Common
      stock
    
    
    
    39,609
    
    
    39,590Accumulated
      deficit
    
    
    
    (4,947
    )
    
    (6,889
    )Total
      shareholders equity
    
    
    
    34,662
    
    
    32,701Total
      liabilities and shareholders equity
    
    
    $
    89,925
    
    $
    92,885 See notes to
consolidated financial statements 3


ZONES, INC. AND
SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONS(in thousands, except per share data)(unaudited) Three
      months ended
      June 30,
    
    Six months
      ended
      June 30,2004
    
    2003
    
    2004
    
    2003Net
      sales
    
    
    $
    124,023
    
    $
    119,106
    
    $
    238,114
    
    $
    217,738Cost of sales
    
    
    
    109,765
    
    
    106,165
    
    
    209,941
    
    
    194,461Gross
      profit
    
    
    
    14,258
    
    
    12,941
    
    
    28,173
    
    
    23,277Selling,
      general and administrative
    
    
    
    10,602
    
    
    10,898
    
    
    21,251
    
    
    21,089Advertising
      expenses, net
    
    
    
    1,693
    
    
    2,255
    
    
    3,584
    
    
    3,451Income (loss)
      from operations
    
    
    
    1,963
    
    
    (212
    )
    
    3,338
    
    
    (1,263
    )Interest
      expense
    
    
    
    97
    
    
    113
    
    
    184
    
    
    118Other (income)
      expense, net
    
    
    
    (7
    )
    
    (10
    )
    
    (17
    )
    
    (23
    )Other
      expense
    
    
    
    90
    
    
    103
    
    
    167
    
    
    95Income (loss)
      before taxes
    
    
    
    1,873
    
    
    (315
    )
    
    3,171
    
    
    (1,358
    )Provision
      (benefit) for income taxes
    
    
    
    720
    
    
    (190
    )
    
    1,229
    
    
    (588
    )Net income
      (loss)
    
    
    $
    1,153
    
    $
    (125
    )
    $
    1,942
    
    $
    (770
    )Basic earnings
      (loss) per share
    
    
    $
    0.08
    
    $
    (0.01
    )
    $
    0.14
    
    $
    (0.06
    )Shares used
      in computing basic earnings(loss) per
      share
    
    
    
    13,669
    
    
    13,627
    
    
    13,666
    
    
    13,633Diluted earnings
      (loss) per share
    
    
    $
    0.08
    
    $
    (0.01
    )
    $
    0.13
    
    $
    (0.06
    )Shares used
      in computing diluted earnings(loss) per
      share
    
    
    
    14,534
    
    
    13,627
    
    
    14,511
    
    
    13,633  See notes to
consolidated financial statements 4


ZONES,
INC.STATEMENTS OF SHAREHOLDERS EQUITY(in
thousands, except share data)(unaudited) Common
      Stock
    
    AccumulatedShares
    
    Amount
    
    Deficit
    
    TotalBalance,
      January 1, 2004
    
    
    
    13,659,371
    
    $
    39,590
    
    $
    (6,889
    )
    $
    32,701Issuance
      of common stock
    
    
    
    11,340
    
    
    19
    
    
    
    
    19Net
      income
    
    
    
    
    
    
    
    
    1,942
    
    1,942Balance,
      June 30, 2004
    
    
    
    13,670,711
    
    $
    39,609
    
    $
    (4,947
    )
    $
    34,662 See notes to
consolidated financial statements 5


ZONES,
INC.CONSOLIDATED STATEMENTS OF CASH FLOWS(in thousands) (unaudited) Six months
      ended June 30,2004
    
    2003Cash
        flows from operating activities:Net
      income (loss)
    
    
    $
    1,942
    
    $
    (770
    )Adjustments
      to reconcile net income (loss) to netcash
      provided by (used in) operating activities:Depreciation
    
    
    
    1,269
    
    
    1,645Deferred
      tax asset
    
    
    
    1,229
    
    
    (568
    )Loss
      on disposal of asset
    
    
    
    (2
    )(Increase)
      decrease in assets and liabilities:Receivables,
      net
    
    
    
    2,731
    
    
    (1,549
    )Inventories,
      net
    
    
    
    (2,670
    )
    
    675Prepaid
      expenses and other assets
    
    
    
    (93
    )
    
    165Accounts
      payable
    
    
    
    2,144
    
    
    (7,434
    )Accrued
      liabilities and deferred rent
    
    
    

    (328
    )
    
    192Net
      cash provided by (used in) operating activities
    
    
    
    6,222
    
    
    (7,644
    )Cash
      flows from investing activities:Payment
      for acquisition, net of cash acquired
    
    
    
    
    
    
    (3,716
    )Purchases
      of property and equipment
    
    
    
    (1,301
    )
    
    (383
    )Net
      cash used in investing activities
    
    
    
    (1,301
    )
    
    (4,099
    )Cash
      flows from financing activities:Net
      change in book overdraft
    
    
    
    (969
    )
    
    2,614Net
      change in line of credit
    
    
    
    (4,855
    )
    
    1,980Proceeds
      from sale of common stock
    
    
    
    19
    
    
    22Payments
      of notes payable
    
    
    
    (662
    )Payments
      on capital leases
    
    
    
    
    
    
    (142
    )Net
      cash provided by (used in) financing activities
    
    
    
    (6,466
    )
    
    4,474Net decrease
        in cash and cash equivalents
      
      
      
      (1,545
      )
      
      (7,269
      )Cash
        and cash equivalents at beginning of period
      
      
      
      5,180
      
      
      9,048Cash and
        cash equivalents at end of period
      
      
      $
      3,635
      
      $
      1,779Non-cash
        investing and financing activity:Note
      payable for acquisition of subsidiary
    
    
    
    
    
    $
    2,500Note
      payable for fixed asset purchase
    
    
    $
    (42
    )Non-cash
      reduction to note payable for purchase price adjustment ofCorporate
        PC Source (CPCS)
      
      
      $
      (295
      ) 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, 2003 as filed with the
Securities and Exchange Commission on February 26, 2004. Principles of
Consolidation The 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. Estimated useful lives are as follows: Estimated
      Useful LivesComputer
      equipment
    
    
    2
      to 5 yearsComputer
      hardware and software under capital leases
    
    
    2
      to 5 yearsComputer
      software/Web development
    
    
    2
      to 5 yearsFurniture
      and fixtures and leasehold improvements
    
    
    3
      to 11 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 2 to 5 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. 7


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. The Company
performs the assessment annually on March 31st. The changes in the carrying amount of
goodwill for the six months ended June 30, 2004 are as follows (in thousands): Balance as
      of January 1, 2004
    
    $
    4,193Goodwill
      acquired
    
    
    Adjustment
      to goodwill for purchase price adjustment of Corporate PC Source
    
    
    (295
    )Impairment
      loss
    
    
    Balance as
      of June 30, 2004
    
    $
    3,898 The Company completed the impairment
review required by SFAS No. 142 on March 31, 2004 and determined that its goodwill was not
impaired. The Company recorded an adjustment to goodwill and to the related note payable
of $295,000 in the quarter ended March 31, 2004 for a purchase price adjustment of
Corporate PC Source (CPCS) (see Note 6). 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 an allowance for sales returns,
which is established based on historical experience. Cost of Sales Cost of sales primarily consists of
the purchase price of product and services sold by the Company. Cost of sales also
includes inbound and outbound shipping charges to the Company, vendor rebates and cash
discounts which are recorded when earned as a reduction to cost of sales, and physical
inventory adjustments. Selling, General and
Administrative Expenses Selling, general and administrative
expenses include payroll, employee benefits, and other headcount-related costs, costs of
fulfillment including warehousing, credit card fees and bad debt costs, facilities,
professional fees and administration costs, and depreciation and amortization. 8


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 income (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 and income per share would have decreased, and the
Companys net loss and loss per share would have increased, to the pro forma amounts
indicated below (in thousands, except per share data): Three
      months ended
      June 30,2004
    
    2003Net
      income (loss) - as reported
    
    
    $
    1,153
    
    $
    (125
    )Add:Total
      compensation cost included in net income (loss), net of taxLess:Total
      compensation cost determined under fair value based method for allawards,
      net of tax
    
    
    
    (179
    )
    
    (65
    )Net income
      (loss) - pro forma
    
    
    $
    974
    
    $
    (190
    )Basic
      income (loss) per share - as reported
    
    
    $
    0.08
    
    $
    (0.01
    )Diluted income
      (loss) per share - as reported
    
    
    $
    0.08
    
    $
    (0.01
    )Basic
      income (loss) per share - pro forma
    
    
    $
    0.07
    
    $
    (0.01
    )Diluted income
      (loss) per share - pro forma
    
    
    $
    0.07
    
    $
    (0.01
    )Six
      months ended
      June 30,2004
    
    2003Net
      income (loss) - as reported
    
    
    $
    1,942
    
    $
    (770
    )Add:Total
      compensation cost included in net income (loss), net of taxLess:Total
      compensation cost determined under fair value based method for allawards,
      net of tax
    
    
    
    (308
    )
    
    (176
    )Net income
      (loss) - pro forma
    
    
    $
    1,634
    
    $
    (946
    )Basic
      income (loss) per share - as reported
    
    
    $
    0.14
    
    $
    (0.06
    )Diluted income
      (loss) per share - as reported
    
    
    $
    0.13
    
    $
    (0.06
    )Basic
      income (loss) per share - pro forma
    
    
    $
    0.12
    
    $
    (0.07
    )Diluted income
      (loss) per share - pro forma
    
    
    $
    0.11
    
    $
    (0.07
    )  The fair value of each option grant
is estimated for the purposes of these pro formas on the date of grant using the
Black-Scholes option-pricing model with the following weighted-average assumptions used
for grants in 2004 and 2003, respectively: expected volatility of 200% and 216%; risk-free
interest rate of 3.36% and 2.74%; and expected lives of 4 years. 9


Earnings Per Share Earnings 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. 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. Certain 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 June 30,
    
    Six months
      ended June 30,2004
    
    2003
    
    2004
    
    2003Basic
      earnings per share:Net income
      (loss)
    
    
    $
    1,153
    
    $
    (125
    )
    $
    1,942
    
    $
    (770
    )Weighted
      average shares outstanding
    
    
    
    13,669
    
    
    13,627
    
    
    13,666
    
    
    13,633Basic earnings
      (loss) per share
    
    
    $
    0.08
    
    $
    (0.01
    )
    $
    0.14
    
    $
    (0.06
    )Diluted
      earnings per share:Net income
      (loss)
    
    
    $
    1,153
    
    $
    (125
    )
    $
    1,942
    
    $
    (770
    )Weighted
      average shares outstanding
    
    
    
    13,669
    
    
    13,627
    
    
    13,666
    
    
    13,633Stock options
    
    
    
    865
    
    
    
    
    
    845Total common
      shares and dilutive securities
    
    
    
    14,534
    
    
    13,627
    
    
    14,511
    
    
    13,627Diluted earnings
      (loss) per share
    
    
    $
    0.08
    
    $
    (0.01
    )
    $
    0.13
    
    $
    (0.06
    )  For the three and six months ended
June 30, 2004, 1,367,069 and 1,377,069 shares, respectively, were attributable to
outstanding stock options were excluded from the calculation of diluted earnings per share
because the effect was anti-dilutive. For the three and six months ended June 30, 2003,
all outstanding stock options were considered anti-dilutive as the Company was in a loss
position. For the periods ended June 30, 2004 and 2003, the Company had 220,552 and
250,000, respectively, of contingent convertible notes outstanding which were not included
in the calculation of earnings per share. 4. Commitments and
Contingencies Legal Proceedings The Company is not currently a party
to any legal proceedings, claims, disputes or litigation. However, because of the nature
and inherent uncertainties of litigation, should the Company become a party to any of
these actions, the Companys business, financial condition, cash flows or results of
operations could be materially affected. Liquidity 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, as well as any amounts
owed to the former shareholders of CPCS and up to $3.0 million authorized in the
Companys stock repurchase program, for at least the next 12 months at its current
level of business. However, if the Companys working capital or 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. 10


5. Segment Information 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s decision makers view the subsidiary activities of 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. 11


A summary of the Companys
operations by segment follows (in thousands): Three months
      ended June 30, 2004Zones
    
    CPCS
    
    Eliminations
    
    ConsolidatedExternal
      customer sales
    
    
    $
    103,309
    
    $
    20,714
    
    
    
    
    $
    124,023Transfer
      between segments
    
    
    
    
    
    
    98
    
    $
    (98
    )
    
    Total
      net sales
    
    
    $
    103,309
    
    $
    20,812
    
    $
    (98
    )
    $
    124,023Depreciation
    
    
    $
    566
    
    $
    34
    
    
    
    
    $
    600Income
      from operations
    
    
    $
    1,336
    
    $
    627
    
    
    
    
    $
    1,963Goodwill
    
    
    
    
    
    $
    3,898
    
    
    
    
    $
    3,898Total
      assets
    
    
    $
    73,544
    
    $
    16,381
    
    
    
    
    $
    89,925Three months
      ended June 30, 2003Zones
    
    CPCS
    
    Eliminations
    
    ConsolidatedExternal
      customer sales
    
    
    $
    101,045
    
    $
    18,061
    
    
    
    
    $
    119,106Transfer
      between segments
    
    
    
    668
    
    
    2
    
    $
    (670
    )
    
    Total
      net sales
    
    
    $
    101,713
    
    $
    18,063
    
    $
    (670
    )
    $
    119,106Depreciation
    
    
    $
    803
    
    $
    63
    
    
    
    
    $
    866Income
      (loss) from operations
    
    
    $
    (589
    )
    $
    377
    
    
    
    
    $
    (212
    )Six months
      ended June 30, 2004Zones
    
    CPCS
    
    Eliminations
    
    ConsolidatedExternal
      customer sales
    
    
    $
    199,397
    
    $
    38,717
    
    
    
    
    $
    238,114Transfer
      between segments
    
    
    
    58
    
    
    204
    
    $
    (262
    )
    
    Total
      net sales
    
    
    $
    199,455
    
    $
    38,921
    
    $
    (262
    )
    $
    238,114Depreciation
    
    
    $
    1,185
    
    $
    84
    
    
    
    
    $
    1,269Income
      from operations
    
    
    $
    2,061
    
    $
    1,277
    
    
    
    
    $
    3,338Goodwill
    
    
    
    
    
    $
    3,898
    
    
    
    
    $
    3,898Total
      assets
    
    
    $
    73,544
    
    $
    16,381
    
    
    
    
    $
    89,925Six months
      ended June 30, 2003Zones
    
    CPCS
      (a)
    
    Eliminations
    
    ConsolidatedExternal
      customer sales
    
    
    $
    199,677
    
    $
    18,061
    
    
    
    
    $
    217,738Transfer
      between segments
    
    
    
    668
    
    
    2
    
    $
    (670
    )
    
    Total
      net sales
    
    
    $
    200,345
    
    $
    18,063
    
    $
    (670
    )
    $
    217,738Depreciation
    
    
    $
    1,582
    
    $
    63
    
    
    
    
    $
    1,645Income
      (loss) from operations
    
    
    $
    (1,640
    )
    $
    377
    
    
    
    
    $
    (1,263
    )Twelve months
      ended December 30, 2003Zones
    
    CPCS(a)
    
    Eliminations
    
    ConsolidatedGoodwill
    
    
    
    
    
    $
    4,193
    
    
    
    
    $
    4,193Total assets
    
    
    $
    75,756
    
    $
    17,129
    
    
    
    
    $
    92,885  (a)
          The six months ended June 30, 2003 results for CPCS are only for the three month
          period ended June 30, 2003 as it was acquired on March 31, 2003.  Substantially all of the
Companys net sales for the three and six months ended June 30, 2004 and June 30,
2003 were made to customers located in the United States. All of the Companys assets
at June 30, 2004 and December 31, 2003 were located within the United States. The Company
had one customer which represented over 10% of total sales for the period ended June 30,
2004. Net sales to this customer were $12.6 million and $23.2 million for the three and
six months ended June 30, 2004, respectively. During the six months ended June 30, 2003 a
former major customer of the Company represented more than 10% of total sales, but did not
represent a major customer in the period ended June 30, 2004. Net sales to the former
major customer were $18.3 million and $31.1 million for three and six months ended June
30, 2003, respectively. The contract with this former customer expired in June of 2003. 12


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. Goodwill of approximately $3.9 million at June 30, 2004 represents
the balance of the excess of the purchase price over the fair value of the net tangible
assets acquired. Through this acquisition, the Company added complementary product and
service offerings to Enterprise size customers by expanding its market opportunities into
the Midwest. These opportunities, along with the ability to acquire CPCSs workforce,
were significant contributing factors to the establishment of the purchase price,
resulting in the recognition of a significant amount of goodwill. 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
outstanding is payable at the end of each of the earn-out periods, should CPCS reach a
threshold of earnings before income tax, depreciation and amortization
(EBITDA), they 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 0.25%. At June 30, 2004 the rate was 4.50%. In
addition, the notes are subject to reduction for failure of CPCS to reach a threshold of
EBITDA, which could adjust the purchase price in the future. The Company measures the
EBITDA thresholds annually on March 31st; which is the end of each earn-out
period. At the end of the first earn-out
period, March 31, 2004, CPCS did not reach threshold EBITDA. Therefore, the principle
amount of the notes was adjusted by $295,000, and goodwill was reduced by the adjustment.
The amount due on the non-convertible notes payable at the end of the first earn-out
period was $662,000, which subsequently has been paid to the former shareholders of CPCS. 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
up to 200% of the applicable EBITDA target. The targeted EBITDA grows 10% per year after
the initial earn-out period. The maximum payment available was $4.95 million in the
initial earn-out period and will grow 10% annually in the second and third year. No
contingent payment would be required if CPCS earns less than 70% of the target EBITDA in
any of the earn-out periods. The Company measures the EBITDA targets annually on March
31st. The first earn-out period ended on
March 31, 2004. During this first earn-out period, CPCS did not meet the minimum level of
annual EBITDA required in order for the former shareholders of CPCS to be owed an earn-out
payment. Any contingent payments made to the
former shareholders of CPCS will be based exclusively on the ratio of their former
shareholdings. If any contingent payment is made the Company will record these payments as
a purchase price adjustment to goodwill. Their continued employment with CPCS is not a
requirement for receipt of any future contingent payments. 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): Six months
      ended June 30, 2003Zones
    
    CPCS
    
    Eliminations
    
    ConsolidatedNet
      sales
    
    
    $
    200,345
    
    $
    42,075
    
    $
    (670
    )
    $
    241,750Net
      income (loss)
    
    
    $
    (921
    )
    $
    587
    
    
    
    
    $
    (334
    )Earnings
      per share:Basic
    
    
    $
    (0.07
    )
    $
    0.04
    
    
    
    
    $
    (0.03
    )Diluted
    
    
    $
    (0.07
    )
    $
    0.04
    
    
    
    
    $
    (0.03
    )  7. Related Party
Disclosure In June 2004, Fana Capital Corp., a
company owned by an officer of the Company, purchased the facilities that the Company has
an existing 11 year lease on the property and buildings in which its headquarters are
located. Under the terms of the agreement, the Company will pay lease payments aggregating
from $1.0 million to $1.2 million per year, plus real estate taxes, insurance, and common
area maintenance charges. The Companys Audit Committee reviewed and approved the
related party transaction, and also its potential corporate opportunity, recognizing that
in the future the Company may have to renew and re-negotiate its lease and that such
renewal and re-negotiation would also present a related party transaction subject to
further Audit Committee review and consideration. 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, 2003, which was
filed on February 26, 2004 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. 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 only recently achieved profitability. 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 maintain profitability going forward. 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 decline in corporate
investment in Information Technology-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. A decline
in sales levels could adversely affect the Companys business, financial condition,
cash flows or results of operations. 14


Major Customer. One of the
Companys customers, IBM Global Services, represents 10.2% and 9.7% of total sales
for the three and six months ended June 30, 2004, respectively. The loss of this customer
could have a material adverse effect on the Company. Additionally, the Company had a
contract with a major customer, the Microsoft Corporation, which expired in June 2003, and
sales to this customer represented less than 10% of total sales for the three and six
month period ended June 30, 2004, but represented 15.4% and 14.3% of total sales for the
three and six month period ended June 30, 2003, respectively. While the Company may
continue to receive some level of business from Microsoft, net sales to them has declined
significantly. 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 that will
be funded from the Companys general corporate funds or its working capital facility.
CPCS did not exceed its historical results in its first annual evaluation. 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. Even if the Company retains the account executives, there
are no assurances that they will become productive at historical levels. Additionally, in
the past the Companys account executives have been the subject of aggressive hiring
by competitors. 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 new
Nasdaq rules. Additionally, independent registered public accountant audit fees have
increased, and are expected to increase even more as requirements associated with
corporate governance and internal controls and attestation become effective. These
increasing costs may have an adverse effect on the ability of the Company to maintain
profitability. Pressure on Margins. The
computer products industry has been characterized by intense price competition and
pressure on profit margins. Additionally, a number of manufacturers are providing their
products direct to customers. As a percentage of net sales, the Companys gross
margin may be more volatile due to the 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). 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. 15


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 volume could be exacerbated 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. Even though the Company has
regained compliance with National Market listing requirements, a potential future
delisting of the Companys common stock could result in significantly reduced
circulation of its common stock, more limited press coverage, reduced interest by
investors, adverse effects on the trading market, price for and liquidity of the
Companys stock, and reduced ability to issue additional securities or to secure
additional financing. State Tax Uncertainties.  The
Company collects and remits sales and use taxes 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 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 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 could 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. 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 DMRs 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. 16


Major Shareholder. Firoz H.
Lalji, the Companys Chairman and Chief Executive Officer, beneficially owns 48.0% 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 50.3% 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. During the first quarter of 2004, the Company exercised its early
termination provision with Airborne Logistics Services and provided six months notice of
its intent to move its warehouse and distribution center to Illinois. The Companys
subsidiary, CPCS, will operate its new warehouse and distribution center from their
corporate headquarters in Illinois. Any limitation or interruption of the service being
provided by Airborne Logistics Services during the transition could have a material
adverse effect on the Companys business, financial condition, and results of
operations. Additionally, 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. 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, net of product returns. Gross
profit consists of net sales less product and freight costs. Selling, general and
administrative (SG&A) expenses include warehousing and distribution costs,
selling commissions, order processing, telephone and credit card fees and other costs such
as administrative salaries, depreciation, rent and general overhead expenses. Advertising
expense is marketing costs associated with vendor programs, net of vendor cooperative
advertising expense reimbursements allowable under EITF 02-16 Accounting for
Consideration Received from a Vendor by a Customer (Including a Reseller of the
Vendors Products). Other expense represents interest expense net of
non-operating income. Overview Zones Inc. and its subsidiaries are
direct marketing resellers of technology hardware, software and services. The Company
procures and fulfills IT solutions to the small to medium business, large corporate
customer and the public sector market place. Relationships with small to medium sized
businesses (SMB), large customers and public sector institutions represented
91.7% and 90.5% of total net sales during the three and six months ending June 30, 2004,
respectively. The remaining sales were from inbound customers, primarily consumers and
small office home office accounts. 17


The Company reaches its customers
through an integrated marketing and merchandising strategy designed to attract and retain
customers. This strategy involves a relationship-based selling model utilized by outbound
account executives, customized web stores for corporate customers through ZonesConnect, a
state of the art internet portal at www.zones.com, dedicated e-marketing and direct
marketing vehicles and catalogs for demand response opportunities and corporate branding. The Company utilizes its purchasing
and inventory management capabilities to support its primary business objective of
providing name brand products at competitive prices. The Company offers over 150,000
hardware, software, peripheral and accessory products and services for users of PC and Mac
platform computers from over 2,000 manufacturers. The corporate management team
regularly reviews the Companys performance using a variety of financial and
non-financial metrics including, but not limited to, net sales, gross margin, co-op
advertising reimbursements, advertising expenses, personnel costs, productivity per
employee, average order size, accounts receivables aging, inventory turnover, liquidity
and cash resources.   Company management compares the various metrics against
goals and budgets, and takes appropriate action to enhance Company performance. The Company is dedicated to creating
a learning community of empowered individuals to serve its customers with integrity,
commitment and passion. At June 30, 2004, the Company had 556 team members in its
consolidated operations; 274 of which are inbound and outbound account executives. The
majority of the Companys team members work at its corporate headquarters in Auburn,
Washington. The Company makes available free of charge on its website,
www.zones.com/IR, additional company information. 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). The Companys critical
accounting policies are as follows: 
Revenue
recognition  
Valuation
of current assets and estimating market inventory obsolescence  
Accounting
for income taxes  
Goodwill  Revenue recognition. The Company recognizes revenues from
sales transactions when both risk of loss and title to products sold pass to the customer.
The Companys shipping terms dictate that the passage of title occurs upon receipt of
products by the customer except for the last seven calendar days of each fiscal quarter
where all shipments are insured in the name of the customer. For these seven days, passage
of risk of loss and title occur at the shipping point. The majority of the Companys
net sales relate to physical products. These sales are recognized on a gross basis with
the selling price to the customer recorded as net sales and the acquisition cost of the
product recorded as cost of sales. Third party extended warranties,
third party software maintenance products and third party services sold by the Company
(for which the Company is not the primary obligor) are recognized in accordance with SEC
Staff Accounting Bulletin No. 101 and No. 104, Revenue Recognition and
EITF 99-19, Reporting Revenue Gross as a Principal versus Net as an Agent.
Pursuant to EITF 99-19, when the Company sets prices, has inventory risk, and credit risk,
revenues are recorded gross. If any of those criteria are not present, revenue and cost of
sales are recorded net. When the sale is recorded, the Company has no further obligation
to fulfill. 18


Additionally, the Company offers
limited return rights within fourteen days on its product sales. The Company has
demonstrated the ability to make reasonable and reliable estimates of product returns in
accordance with Statement of Financial Accounting Standards No. 48, Revenue
Recognition When Right of Return Exists, based on significant historical experience.
If actual credits were to deviate significantly from the Companys estimates, its
results of operations could be adversely affected. The Company had allowances for sales
returns of $66,000 for the periods ended June 30, 2004 and 2003. Valuation of current assets and
estimation of 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. 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 uncollectable amounts due from its vendors which arise from
product returns, standard vendor price protection programs, cooperative advertisement
reimbursements 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, cooperative
reimbursement 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 states in which it is registered and/or has a physical presence. 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 June 30, 2004, 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 strategies will be sufficient
to realize the deferred tax asset. The Company based this decision on the cumulative
profitability of the past three years and the anticipated taxable income in the future.
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. 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. The Company performs
the assessment annually on March 31st. The Company completed the impairment review
required by SFAS No. 142 on March 31, 2004 and determined that its goodwill was not
impaired. 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. Three months
      ended 
      June 30,
    
    Six months
      ended 
      June 30,2004
    
    2003
    
    2004
    
    2003Net
      sales
    
    
    
    100.0
    %
    
    100.0
    %
    
    100.0
    %
    
    100.0
    %Cost of sales
    
    
    
    88.5
    
    
    89.1
    
    
    88.2
    
    
    89.3Gross
      profit
    
    
    
    11.5
    
    
    10.9
    
    
    11.8
    
    
    10.7Selling,
      general and administrative expenses
    
    
    
    8.5
    
    
    9.1
    
    
    8.9
    
    
    9.7Advertising
      expenses, net
    
    
    
    1.4
    
    
    1.9
    
    
    1.5
    
    
    1.6Income (loss)
      from operations
    
    
    
    1.6
    
    
    (0.2
    )
    
    1.4
    
    
    (0.6
    )Other
      (income) expense
    
    
    
    0.1
    
    
    0.1
    
    
    0.1
    
    
    0.0Income (loss)
      before income taxes
    
    
    
    1.5
    
    
    (0.3
    )
    
    1.3
    
    
    (0.6
    )Provision
      (benefit) for income taxes
    
    
    
    0.6
    
    
    (0.2
    )
    
    0.5
    
    
    (0.3
    )Net income
      (loss)
    
    
    
    0.9
    %
    
    (0.1
    )%
    
    0.8
    %
    
    (0.3
    )%Selected
      operating data:Number of
      orders
    
    
    
    101,000
    
    
    119,000
    
    
    213,000
    
    
    473,000Average
      order size
    
    
    $
    1,222
    
    $
    1,011
    
    $
    1,143
    
    $
    982Number of
      B2B account executives, end of period
    
    
    
    
    
    
    
    
    
    241
    
    
    185Productivity
      per employee, annualized
    
    
    
    
    
    
    
    
    $
    892,000
    
    $
    812,000Product
      Mix (% of Net Sales):Notebook
      & PDAs
    
    
    
    14.7
    %
    
    15.4
    %
    
    16.4
    %
    
    14.6
    %Desktops
      & Servers
    
    
    
    20.9
    
    
    21.3
    
    
    20.2
    
    
    18.2Software
    
    
    
    16.9
    
    
    11.1
    
    
    16.1
    
    
    10.9Storage
    
    
    
    9.0
    
    
    11.2
    
    
    9.0
    
    
    9.8NetComm
    
    
    
    4.7
    
    
    5.0
    
    
    4.5
    
    
    5.0Printers
    
    
    
    9.5
    
    
    8.8
    
    
    9.7
    
    
    7.6Monitors
      & Video
    
    
    
    9.7
    
    
    10.6
    
    
    10.0
    
    
    9.4Memory &
      Processors
    
    
    
    4.7
    
    
    5.8
    
    
    4.7
    
    
    5.0Accessories
      & Other
    
    
    
    9.9
    
    
    10.8
    
    
    9.4
    
    
    9.4  Comparison of Three Month
Periods Ended June 30, 2004 and 2003 Net Sales.Consolidated net
sales for the quarter ended June 30, 2004 increased 4.1% to $124.0 million compared to
$119.1 million in the second quarter of 2003. The consolidated net sales for both three
month periods include sales from the Companys subsidiary, CPCS, which was acquired
on March 31, 2003. CPCS net sales for the three months ended June 30, 2004 increased 14.1%
to $20.6 million from $18.1 million for the same period of the prior year. Consolidated
outbound sales, including sales by CPCS, to the SMB, large and public sector accounts
increased 4.8% to $113.7 million in the second quarter of 2004 from $108.4 million in the
second quarter of 2003. Sales for the three months ended June 30, 2003 included $18.1
million of sales to a former major customer, whose contract with the Company expired in
June of 2003. Inbound demand response sales to the legacy consumer and small office home
office (SOHO) customers declined slightly to $10.4 million for the three
months ended June 30, 2004 compared to $10.7 million in the comparable period of 2003, and
declined as a percent of total sales to 8.3% from 9.0%. Gross Profit.   Consolidated
gross profit increased to $14.3 million for the second quarter of 2004, compared to $12.9
million in the second quarter of 2003. Gross profit as a percentage of net sales increased
to 11.5% in the quarter ended June 30, 2004 compared to 10.9% in the second quarter of
2003, but decreased sequentially from 12.2% in the first quarter of 2004. Gross profit
margins for the three months ended June 30, 2004 were impacted by an increased mix of
higher margin products, customer mix, vendor programs and by 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
EITF 02-16, the Company recorded $2.1 million of vendor consideration as a reduction to
cost of sales in the second quarter of 2004 compared to $1.7 million in the second quarter
of 2003. The Company anticipates the dollar amount of vendor consideration categorized as
costs of sales to remain flat. However, as a percentage of net sales, the Companys
gross margin may be more volatile due to the adoption of EITF 02-16, as well as product
mix, pricing strategies, customer mix and economic conditions. Lastly, the Company
categorizes its warehousing and distribution network costs in selling, general and
administrative expenses. Due to this classification, the Companys gross profit may
not be comparable to a company that includes its warehousing and distribution network
costs as a cost of sales. 20


Selling, General and
Administrative (SG&A) Expenses.  SG&A expense dollars decreased
slightly to $10.6 million for the quarter ended June 30, 2004 compared to $10.9 million in
the second quarter of 2003. The decline is primarily due to a reduction in depreciation
expense. Depreciation expense declined to $600,000 in the second quarter of 2004 from
$866,000 in the second quarter of 2003. The Company continued its efforts to maintain
tight controls on its operational spending, while investing in its future through the
hiring of account executives. The Company increased its outbound account executive
headcount 30.3% to 241 at June 30, 2004 compared to 185 in the prior year period. The
Company continues to forecast a net 90 headcount increase by the end of 2004. As a percent
of sales, SG&A was 8.5% for the quarter ended June 30, 2004 compared to 9.1% for the
second quarter of 2003. The decline in SG&A as a percentage of sales is primarily due
to increased sales volumes. For the three month periods ending June 30, 2004 and 2003,
warehousing and distribution network costs totaled $393,000 and $455,000 respectively. The
decline is due to a decline in total orders processed. The number of orders fell to
101,000 in the second quarter of 2004 from 119,000 in the comparable period of 2003. The
Company is moving its warehousing operations to a new facility in Chicago, Illinois which
will be operated by its wholly owned subsidiary, Corporate PC Source. The Company expects
to complete the transition to its new warehousing facility by the end of the third quarter
of 2004. The Company expects to incur approximately $250,000 in additional expenses during
the third quarter of 2004 to complete the transition. 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 decreased to $1.7 million in
the three month period ended June 30, 2004 from $2.3 million in the comparable 2003
period. Gross advertising expense decreased to $1.8 million for the second quarter of 2004
compared to $2.7 million in the second quarter of 2003. These declines primarily relates
to a reduction in the circulation of the Companys catalogs. The Company produced and
distributed 1.9 million catalogs during the second quarter of 2004 compared to 2.8 million
in the second quarter of 2003. Additionally, the Company eliminated unproductive marketing
costs, including a reduction in the headcount to produce its catalog, and redesigned the
format of its catalog reducing paper and printing costs. The Companys vendor
cooperative advertising reimbursements, which reduce the gross advertising expense,
decreased to $105,000 in 2004 from $430,000 in 2003. The decline primarily relates to the
Companys adoption of EITF 02-16, under which the Company recorded $2.1 million of
vendor consideration as a reduction to cost of sales in the second quarter of 2004
compared to $1.7 million in the second quarter of 2003. Additionally, advertising expense
was impacted by a decline in the amount of cooperative advertising reimbursements received
from the Companys vendors. Vendors have reduced the total dollars available for
general cooperative advertising reimbursements, creating increased competition for
potential revenue. The Company believes that this competitive environment will continue. Other Expense.  Other expense
was $90,000 for the quarter ended June 30, 2004 compared to $103,000 in the second quarter
of 2003. The expense is primarily due to interest expense incurred during the quarter. The
Company leverages its line of credit to aggressively take early pay discounts. The
increased expense during the second quarter of 2003 primarily relates to the cash payment
in accordance with the March 31, 2003 acquisition of CPCS to its former shareholders.
Additionally, the shift in customer mix has reduced the amount of sales on credit cards,
which increases the number of days sales outstanding. Provision/Benefit for Income
Taxes.   The provision for income taxes for the quarter ended June 30, 2004 was $720,000
compared to a benefit of $190,000 in the comparable period of the prior year. The
Companys effective tax rate expressed as a percentage of income (loss) before taxes
was 38.5% for the quarter ended June 30, 2004 compared to 60.3% for the quarter ended June
30, 2003. The tax rate for the three months ended June 30, 2003 was impacted by the
Companys change in estimate of the annual taxable income. 21


Net Income/Loss.  Net income
for the quarter ended June 30, 2004 was $1.2 million compared to a net loss of $125,000 in
the second quarter of 2003. Basic and diluted income per share was $0.08 for the quarter
ended June 30, 2004 compared to basic and diluted loss per share of $0.01 in the second
quarter of 2003. Comparison of Six Month
Periods Ended June 30, 2004 and 2003 Net Sales.Consolidated net
sales for the six months ended June 30, 2004 increased 9.4% to $238.1 million compared to
$217.7 million in the comparable period of 2003. The increase in sales resulted primarily
from the increased sales included in results for CPCS, the Companys subsidiary
acquired on March 31, 2003. CPCS net sales for the six months ended June 30, 2004 were
$38.5 million compared to the three months ended June 30, 2003 of $18.1 million. The
Companys net sales for the six months ended June 30, 2004 excluding CPCS were $199.6
million, flat from the same period of the prior year. In the six month period ended June
30, 2003, the Company had sales to a former major customer of $31.1 million. Consolidated
outbound sales to the SMB, large and public sector accounts increased 10.7% to $215.6
million in the first half of 2004 from $194.8 million in the first half of 2003. Inbound
demand response sales to the legacy consumer and SOHO customers decreased slightly during
the first half of 2004 to $22.5 million compared to $22.9 million in the comparable period
of 2003, and declined as a percent of total sales to 9.5% from 10.5%. Gross Profit.   Consolidated
gross profit increased to $28.2 million for the six months ended June 30, 2004, compared
to $23.3 million in the comparable period of 2003. Gross profit margins were increased
$2.1 million due to the reclass for EITF 02-16, whereby the Company recorded $4.3 million
of vendor consideration as a reduction to cost of sales in the first half of 2004 compared
to $2.2 million in the first half of 2003. The remaining increase is generally a result of
the Companys focus on key gross margin enhancing initiatives. Gross profit as a
percentage of net sales increased to 11.8% in the first half of 2004 compared to 10.7% in
the first half of 2003. 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. Lastly, the Company categorizes it warehousing and
distribution network costs in selling, general and administrative expenses. Due to this
classification, the Companys gross profit may not be comparable to a company whose
warehousing and distribution network costs are a component of cost of sales. Selling, General and
Administrative (SG&A) Expenses.  SG&A expense dollars increased
slightly to $21.3 million for the six months ended June 30, 2004 compared to $21.1 million
in the six months ended June 30, 2003. The increase is primarily due to the Companys
acquisition of CPCS on March 31, 2003, net of decreases in the Companys fixed costs.
SG&A expenses for the first half of 2004 include six months of CPCS expenses whereas
the first half of 2003 only include three months of expenses due to the timing of the
acquisition transaction. The declines in fixed costs are associated with reductions in
depreciation and facilities. For the six month periods ending June 30, 2004 and 2003,
warehousing and distribution network costs totaled $801,000 and $924,000 respectively. The
Company continues to maintain tight controls on its discretionary spending. As a percent
of sales, SG&A was 8.9% for the six months ended June 30, 2004 compared to 9.7% for
the comparable period of 2003. 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 slightly to $3.6
million in the six month period ended June 30, 2004 from $3.5 million in the comparable
2003 period. Gross advertising expense decreased to $3.8 million for the first half of
2004 compared to $5.5 million in the first half of 2003. The decline primarily relates to
a reduction in the circulation of the Companys catalogs. The Company produced and
distributed 3.8 million catalogs during the six months ended June 30, 2004 compared to 5.7
million in the corresponding period of 2003. The Company also eliminated unproductive
marketing costs during 2004, including a reduction in the headcount to produce its
catalog, and redesigned the format of its catalog reducing paper and printing costs. The
Companys vendor cooperative advertising reimbursements, which reduce the gross
advertising expense, decreased to $200,000 in 2004 from $2.1 million in 2003. The decline
primarily relates to the Companys adoption of EITF 02-16, under which the Company
recorded $4.3 million of vendor consideration as a reduction to cost of sales in the first
half of 2004 compared to $2.2 million in the first half of 2003. Additionally, advertising
expense was impacted by a decline in the amount of cooperative advertising reimbursements
received from the Companys vendors. Vendors have reduced the total dollars available
for general cooperative advertising reimbursements, creating increased competition for
potential revenue. The Company believes that this competitive environment will continue. 22


Other Expense.  Other expense
was $167,000 for the six months ended June 30, 2004 compared to $95,000 in the six months
ended June 30, 2003. The change was primarily due to an increase in interest expense
incurred in 2004 compared with the same period of 2003. The Company leverages its line of
credit to aggressively take early pay discounts. Provision/Benefit for Income
Taxes.   The provision for income taxes for the six months ended June 30, 2004 was $1.2
million compared to a benefit of $588,000 in the comparable period of the prior year. The
Companys effective tax rate expressed as a percentage of income (loss) before taxes
was 38.8% for the six months ended June 30, 2004 compared to 43.3% for the six months
ended June 30, 2003. The tax rate for the six months ended June 30, 2003 was impacted by
the Companys change in estimate of the annual taxable income. Net Income/Loss.  Net income
for the six months ended June 30, 2004 was $1.9 million compared to a net loss of $770,000
in the comparable period of 2003. Basic and diluted earnings per share were $0.14 and
$0.13, respectively, for the six months ended June 30, 2004 and basic and diluted loss per
share was $0.06 for the six months ended June 30, 2003. 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 June 30, 2004, the Company had
total assets of $89.2 million, of which $76.8 million were current assets. At June 30,
2004 and December 31, 2003 the Company had cash and cash equivalents of $3.6 million and
$5.2 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 decreased to 42 days at June 30, 2004
compared to 43 days at December 31, 2003. The Companys working capital was $24.0
million and $20.9 million at June 30, 2004 and December 31, 2003, respectively. The
Company has also committed to a stock repurchase program under which the Company may
repurchase up to $3.0 million in shares of the Companys common stock over the next
twelve months in either open market or private transactions at then prevailing market
prices. Net cash provided by operating
activities was $6.2 million for the six months ended June 30, 2004 compared to cash used
in operating activities of $7.6 million for the six months ended June 30, 2003. Cash
inflows for the six months ended June 30, 2004 were primarily due to increases in
inventory, offset by decreases in accounts receivable. At June 30, 2004, inventory
increased by $2.7 million, while net accounts receivable decreased by $2.7 million. The
increase in inventory is primarily due to purchases associated with extended roll-outs for
the Companys large customers, while the decline in accounts receivable is generally
due to aggressive collection efforts. Cash outlays for capital expenditures
were $1.3 million at June 30, 2004 compared to cash used by investing activities of $4.1
million at June 30, 2003. The capital expenditures during 2004 were primarily for
leasehold improvements for the Companys new corporate headquarters, costs to
transition the Companys warehousing facility to its subsidiary, CPCS, from a third
party vendor and continued improvement, and other enhancements, of the Companys
information systems. The Company anticipates approximately $335,000 in capital
expenditures associated with the transition of its warehouse facility. The Company will
continue to upgrade its internal information systems as a means to increase operational
efficiencies. The six months ended June 30, 2003 had capital expenditures of $383,000 and
cash payments, net of cash received, for the Companys acquisition of CPCS on March
31, 2003 of $3.7 million. 23


The Companys financing
activities included the payment of a note payable issued in its March 31, 2003 acquisition
of CPCS. The amount due on the non-convertible notes payable at the end of the first of
three earn-out periods was $662,000, which was paid to the former shareholders of CPCS
during the second quarter of 2004. At June 30, 2004, 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%. The
Companys line of credit is defined by quick turnover, large amounts and short
maturities. All amounts owed under the Companys line of credit are due on demand.
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 June 30, 2004, the Company was compliant with all
covenants of this facility. At June 30, 2004, $3.0 million of working capital advances
were outstanding and accounts payable of $15.1 million was owed to this financial
institution related to inventory purchases. In July of 2004, the
Companys Board of Directors authorized a share repurchase program under which the
Company may repurchase up to $3.0 million in shares of the Companys common stock
over the next twelve months in either open market or private transactions at then
prevailing market prices. The Company believes that its
existing available cash and cash equivalents, 2004 operating cash flow and existing credit
facilities will be sufficient to satisfy its operating cash needs, as well as any amounts
owed to the former shareholders of CPCS and up to $3.0 million authorized in the
Companys stock repurchase program, for at least the next 12 months at its current
level of business. However, if the Companys working capital or 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. 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 the Companys management, including its Chief Executive Officer and
Chief Financial Officer, the Company evaluated the effectiveness of its 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, the Companys
Chief Executive Officer and Chief Financial Officer concluded that its disclosure controls
and procedures were effective as of the end of the period covered by this quarterly
report. There were no changes in the
Companys internal controls or in any other factors which could significantly affect
those controls, subsequent to the date of the most recent evaluation of the Companys
internal controls by the Company, including any corrective actions with regard to any
significant deficiencies or material weaknesses. Part II. Item 1. Legal Proceedings The Company is not currently a party
to any legal proceedings, claims, disputes or litigation. However, because of the nature
and inherent uncertainties of litigation, should the Company become a party to any of
these actions, the Companys business, financial condition, cash flows or results of
operations could be materially affected. 24


Item 4. Submission of
Matters to a vote of Security Holders (a)
          The Company held its annual meeting of shareholders on April 29, 2004.  (b)
          Four matters were voted upon and approved by the shareholders. The presentation
          below describes the matters voted upon and the results of the shareholders vote.  1.          Election of Directors Nominee
    
    Votes For
    
    Against
    
    WithheldJohn H. Bauer
    
    11,757,400
    
    
    
    
    759,468John T. Carleton
    
    11,591,284
    
    
    
    
    925,584Firoz H.
      Lalji
    
    11,734,324
    
    
    
    
    782,544Kathleen
      S. Pushor
    
    11,757,200
    
    
    
    
    759,668Richard E.
      Carter
    
    11,620,210
    
    
    
    
    896,658William C.
      Keiper
    
    11,729,424
    
    
    
    
    787,444  2.    Ratification
of Appointment of PricewaterhouseCoopers LLP as the Companys           independent
registered public accounting firm Votes For
    
    Votes Against
    
    Abstentions12,485,058
    
    26,210
    
    5,600  3. Amend the Companys
  2003 Equity Incentive Plan Votes For
    
    Votes Against
    
    Abstentions7,622,146
    
    1,023,167
    
    13,230 4. Amend the Companys
  1999 Director Stock Option Plan Votes For
    
    Votes Against
    
    Abstentions7,612,429
    
    1,030,334
    
    15,780  Item 5(b). Director
Nominations The Companys procedures by
which security holders may recommend nominees to the Companys Board of Directors
have not changed since their first disclosure in the Companys Form 10-K filed with
the SEC on February 26, 2004. 25


Item 6. Exhibits and
Reports on Form 8-K (a)
Exhibits  Exhibit
      No.
    
    
    Description
    
    
    Filed
      Herewith
    
    Incorporated
      by ReferenceForm Exhibit
      No.
    
    
    File No.
    
    
    Filing Date10.1
    
    
    Subordination,
      Non-Disturbance, and Attornment
    
    
    XAgreement
      dated June 22, 2004 between US BankNational
      Association, Zones, Inc. and Fana AuburnLLC31.1
    
    
    Certification
      of Chief Executive Officer pursuant
    
    
    Xto
      Section 302 of the Sarbanes-Oxley Act of 2002and
      the regulations promulgated thereunder31.2
    
    
    Certification
      of Chief Financial Officer pursuant
    
    
    Xto
      Section 302 of the Sarbanes-Oxley Act of 2002and
      the regulations promulgated thereunder32.1
    
    
    Certification
      of Chief Executive Officer pursuant
    
    
    Xto
      Section 906 of the Sarbanes-Oxley Act of 2002and
      the regulations promulgated thereunder32.2
    
    
    Certification
      of Chief Financial Officer pursuant
    
    
    Xto
      Section 906 of the Sarbanes-Oxley Act of 2002and
      the regulations promulgated thereunder  (b)
Reports
on Form 8-K  On
April 30, 2004, the Company furnished a report on form 8-K containing the Companys
press release regarding its first quarter 2004 results from operations.  No
other Reports on Form 8-K were furnished during the quarter ended June 30, 2004.  Signatures Pursuant to the requirements of the
Securities Exchange Act of 1934, the registrant has duly caused this report to be signed
on its behalf by the undersigned thereunto duly authorized: Date: August 10, 2004

    ZONES, INC.

By:   /S/     FIROZ H. LALJI
         
         Firoz H. Lalji, Chairman and Chief Executive 
         Officer
         /S/     RONALD P. MCFADDEN
         
         Ronald P. McFadden, Chief Financial Officer  26