UNITED STATESSECURITIES
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, 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 
      (State of Incorporation)
    91-1431894 
      (I.R.S. Employer 
      Identification Number)1102 15th
      Street SW, Suite 102 
      Auburn, Washington
      (Address of Principal Executive Offices)
    98001-6509
      (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. Yes      |X|          No
|_| Indicate by check mark whether the
registrant is an accelerated filer (as defined in Rule 12b-2 of the Exchange Act). Yes |_|             No |X| The number of shares of the
registrants Common Stock outstanding as of November 9, 2004 was 13,433,445. 1   ZONES, INC.


INDEX


PART I. FINANCIAL
INFORMATION

Item
      1
    
    Consolidated
      Financial Statements (unaudited):Consolidated
      Balance SheetsSeptember
      30, 2004 and December 31, 2003
    3Consolidated
      Statements of OperationsThree
      and nine months ended September 30, 2004 and 2003
    4Statements
      of Shareholders EquityNine
      months ended September 30, 2004
    5Consolidated
      Statements of Cash FlowsNine
      months ended September 30, 2004 and 2003
    6Notes
      to Consolidated Financial Statements
    7Item
      2
    
    Managements
      Discussion and Analysis ofFinancial
      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
    25Item
      2
    
    Unregistered
      Sales of Equity Securities and Use of Proceeds
    25Item
      6
    
    Exhibits
    26Signatures
    262
Part I.




Item 1.
Financial Statements



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


September
      30,
      2004
    
    December
      31,
      2003ASSETSCurrent
      assets:Cash
      and cash equivalents
    $
    4,283
    
    $
    5,180Receivables,
      net
    
    61,480
    
    
    59,965Inventories,
      net
    
    17,387
    
    
    11,487Prepaid
      expenses
    
    1,278
    
    
    1,101Deferred
      tax asset
    
    1,327
    
    
    1,327Total
      current assets
    
    85,755
    
    
    79,060Property
      and equipment, net
    
    4,246
    
    
    4,355Goodwill
    
    5,098
    
    
    4,193Deferred
      tax asset
    
    2,992
    
    
    5,110Other assets
    
    180
    
    
    167Total
      assets
    $
    98,271
    
    $
    92,885LIABILITIES
      AND SHAREHOLDERS EQUITYCurrent
      liabilities:Accounts
      payable
    $
    50,781
    
    $
    41,270Accrued
      liabilities
    
    6,360
    
    
    8,223Line
      of credit
    
    2,600
    
    
    7,850Notes
      payable
    
    1,272
    
    
    833Total
      current liabilities
    
    61,013
    
    
    58,176Notes payable
    
    1,511
    
    
    1,667Deferred
      rent
    
    1,023
    
    
    341Total
      liabilities
    
    63,547
    
    
    60,184Commitments
      and contingenciesShareholders
      equity:Common
      stock, no par value, 45,000,000 authorized;13,225,185
      and 13,659,371 shares issued and outstandingat
      September 30, 2004 and December 31, 2003, respectively
    
    38,268
    
    
    39,590Accumulated
      deficit
    
    (3,544
    )
    
    (6,889
    )Total
      shareholders equity
    
    34,724
    
    
    32,701Total
      liabilities and shareholders equity
    $
    98,271
    
    $
    92,885See notes to
consolidated financial statements


3
ZONES, INC. AND
SUBSIDIARIESCONSOLIDATED STATEMENTS OF OPERATIONS(in thousands, except per share data)(unaudited)


Three
      months ended
      September 30,
    
    Nine
      months ended
      September 30,2004
    
    2003
    
    2004
    
    2003Net
      sales
    $
    129,829
    
    $
    112,697
    
    $
    367,943
    
    $
    330,436Cost of
      sales
    
    115,693
    
    
    99,224
    
    
    325,634
    
    
    293,685Gross profit
    
    14,136
    
    
    13,473
    
    
    42,309
    
    
    36,751Selling,
      general and administrative
    
    10,162
    
    
    11,149
    
    
    31,412
    
    
    32,238Advertising
      expenses, net
    
    1,634
    
    
    1,856
    
    
    5,218
    
    
    5,308Income
      (loss) from operations
    
    2,340
    
    
    468
    
    
    5,679
    
    
    (795
    )Interest
      expense
    
    93
    
    
    118
    
    
    277
    
    
    236Other (income)
      expense, net
    
    (44
    )
    
    23
    
    
    (61
    )
    
    0Other
      expense
    
    49
    
    
    141
    
    
    216
    
    
    236Income
      (loss) before taxes
    
    2,291
    
    
    327
    
    
    5,463
    
    
    (1,031
    )Provision
      (benefit) for income taxes
    
    889
    
    
    193
    
    
    2,118
    
    
    (395
    )Net income
      (loss)
    $
    1,402
    
    $
    134
    
    $
    3,345
    
    $
    (636
    )Basic earnings
      (loss) per share
    $
    0.10
    
    $
    0.01
    
    $
    0.25
    
    $
    (0.05
    )Shares
      used in computing basic earnings(loss)
      per share
    
    13,452
    
    
    13,623
    
    
    13,594
    
    
    13,625Diluted
      earnings (loss) per share
    $
    0.10
    
    $
    0.01
    
    $
    0.23
    
    $
    (0.05
    )Shares
      used in computing diluted earnings(loss)
      per share
    
    14,264
    
    
    13,721
    
    
    14,429
    
    
    13,625See 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
    
    14,204
    
    
    26
    
    
    
    
    
    26Common
      stock purchase and retired
    
    (448,390
    )
    
    (1,348
    )
    
    
    
    
    (1,348
    )Net income
    
    
    
    
    
    
    
    3,345
    
    
    3,345Balance,
      September 30, 2004
    
    13,225,185
    
    $
    38,268
    
    $
    (3,544
    )
    $
    34,724See notes to
consolidated financial statements


5
ZONES, INC.CONSOLIDATED
STATEMENTS OF CASH FLOWS(in thousands)(unaudited)

Nine
      months ended
      September 30,2004
    
    2003Cash
      flows from operating activities:Net
      income (loss)
    $
    3,345
    
    $
    (636
    )Adjustments
      to reconcile net income (loss) to netcash
      provided by (used in) operating activities:Depreciation
    
    1,871
    
    
    2,527Deferred
      tax asset
    
    2,118
    
    
    (375
    )Loss
      on disposal of asset
    
    (2
    )(Increase)
      decrease in assets and liabilities:Receivables,
      net
    
    (1,515
    )
    
    (2,840
    )Inventories,
      net
    
    (5,900
    )
    
    445Prepaid
      expenses and other assets
    
    (190
    )
    
    89Accounts
      payable
    
    10,911
    
    
    (3,659
    )Accrued
      liabilities and deferred rent
    
    (1,180
    )
    
    (570
    )Net
      cash provided by (used in) operating activities
    
    9,458
    
    
    (5,019
    )Cash flows
      from investing activities:Payment
      for acquisition, net of cash acquired
    
    
    
    
    (3,716
    )Purchases
      of property and equipment
    
    (1,721
    )
    
    (1,097
    )Net
      cash used in investing activities
    
    (1,721
    )
    
    (4,813
    )Cash flows
      from financing activities:Net
      change in book overdraft
    
    (1,400
    )
    
    1,233Net
      change in line of credit
    
    (5,250
    )
    
    1,333Proceeds
      from sale of common stock
    
    26
    
    
    32Purchase
      of common stock for retirement
    
    (1,348
    )Payments
      of notes payable
    
    (662
    )Payments
      on capital leases
    
    
    
    
    (197
    )Net
      cash provided by (used in) financing activities
    
    (8,634
    )
    
    2,401Net decrease
      in cash and cash equivalents
    
    (897
    )
    
    (7,431
    )Cash and
      cash equivalents at beginning of period
    
    5,180
    
    
    9,048Cash and
      cash equivalents at end of period
    $
    4,283
    
    $
    1,617Non-cash
      investing and financing activity:Note
      payable for acquisition of Corporate PC Source (CPCS)
    
    
    
    $
    2,500Note
      payable to replace earn-out provision of CPCS acquisition
    $
    1,200Non-cash
      reduction to note payable for purchase price adjustment of CPCS
    $
    (295
    )Note
      payable for fixed asset purchase
    $
    39See 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 yearsCapital 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 nine months ended September 30, 2004 are as follows (in thousands):

Balance
      as of January 1, 2003
    $
    Goodwill
      acquired in acquisition of CorporatePC
      Source
    
    4,193Balance
      as of December 31, 2003
    
    4,193Adjustment
      to goodwill for purchase priceadjustment
      of Corporate PC Source
    
    905Impairment
      loss
    
    Balance
      as of September 30, 2004
    $
    5,098The 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) as it did not exceed targeted thresholds for
earnings before interest, tax and depreciation. During the three months ended September
30, 2004, the Company agreed with the former shareholders of CPCS to replace the
contingent earn-out component of the purchase price with a fixed sum of $1.2 million which
resulted in an increase to goodwill (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
      September 30,2004
    
    2003Net
      income - as reported
    $
    1,402
    
    $
    134Add: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
    
    (219
    )
    
    (56
    )Net income
      - pro forma
    $
    1,183
    
    $
    78Basic
      income per share - as reported
    $
    0.10
    
    $
    0.01Diluted income
      per share - as reported
    $
    0.10
    
    $
    0.01Basic
      income per share - pro forma
    $
    0.09
    
    $
    0.01Diluted income
      per share - pro forma
    $
    0.08
    
    $
    0.01Nine
      months ended
      September 30,2004
    
    2003Net
      income (loss) - as reported
    $
    3,345
    
    $
    (636
    )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
    
    (527
    )
    
    (232
    )Net income
      (loss) - pro forma
    $
    2,818
    
    $
    (868
    )Basic
      income (loss) per share - as reported
    $
    0.25
    
    $
    (0.05
    )Diluted income
      (loss) per share - as reported
    $
    0.23
    
    $
    (0.05
    )Basic
      income (loss) per share - pro forma
    $
    0.21
    
    $
    (0.06
    )Diluted income
      (loss) per share - pro forma
    $
    0.20
    
    $
    (0.06
    )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 201% and 214%; risk-free
interest rate of 3.41% and 2.87%; 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 team
members 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 September 30,
    
    Nine
      months ended September 30,2004
    
    2003
    
    2004
    
    2003Basic
      earnings per share:Net income
      (loss)
    $
    1,402
    
    $
    134
    
    $
    3,345
    
    $
    (636
    )Weighted
      average shares outstanding
    
    13,452
    
    
    13,623
    
    
    13,594
    
    
    13,625Basic earnings
      (loss) per share
    $
    0.10
    
    $
    0.01
    
    $
    0.25
    
    $
    (0.05
    )Diluted
      earnings per share:Net income
      (loss)
    $
    1,402
    
    $
    134
    
    $
    3,345
    
    $
    (636
    )Weighted
      average shares outstanding
    
    13,452
    
    
    13,623
    
    
    13,594
    
    
    13,625Stock options
    
    812
    
    
    98
    
    
    835Total common
      shares and dilutive securities
    
    14,264
    
    
    13,721
    
    
    14,429
    
    
    13,625Diluted
      earnings (loss) per share
    $
    0.10
    
    $
    0.01
    
    $
    0.23
    
    $
    (0.05
    )For the three and nine months ended
September 30, 2004, and the three months ended September 30, 2003, 1,374,198, 1,574,198
and 1,450,635 shares, respectively, attributable to outstanding stock options excluded
from the calculation of diluted earnings per share because the effect was anti-dilutive.
For the nine months ended September 30, 2003, all outstanding stock options were
considered anti-dilutive as the Company was in a loss position. For the three and nine
month period ended September 30, 2003, the Company had 250,000 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 the remaining balance of $1.7 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 September 30, 2004Zones
    
    CPCS
    
    Eliminations
    
    ConsolidatedExternal
      customer sales
    $
    107,576
    
    $
    22,253
    
    
    
    
    $
    129,829Transfer
      between segments
    
    
    
    
    484
    
    $
    (484
    )
    
    Total
      net sales
    $
    107,576
    
    $
    22,737
    
    $
    (484
    )
    $
    129,829Depreciation
    $
    561
    
    $
    34
    
    $
    7
    
    $
    602Income
      from operations
    $
    1,425
    
    $
    915
    
    
    
    
    $
    2,340Goodwill
    
    
    
    $
    5,098
    
    
    
    
    $
    5,098Total
      assets
    $
    83,929
    
    $
    14,342
    
    
    
    
    $
    98,271Three
      months ended September 30, 2003Zones
    
    CPCS
    
    Eliminations
    
    ConsolidatedExternal
      customer sales
    $
    93,479
    
    $
    19,218
    
    
    
    
    $
    112,697Transfer
      between segments
    
    196
    
    
    27
    
    $
    (223
    )
    
    Total
      net sales
    $
    93,675
    
    $
    19,245
    
    $
    (223
    )
    $
    112,697Depreciation
    $
    819
    
    $
    62
    
    
    
    
    $
    881Income
      from operations
    $
    39
    
    $
    429
    
    
    
    
    $
    468Nine
      months ended September 30, 2004Zones
    
    CPCS
    
    Eliminations
    
    ConsolidatedExternal
      customer sales
    $
    307,177
    
    $
    60,766
    
    
    
    
    $
    367,943Transfer
      between segments
    
    58
    
    
    688
    
    $
    (746
    )
    
    Total
      net sales
    $
    307,235
    
    $
    61,454
    
    $
    (746
    )
    $
    367,943Depreciation
    $
    1,746
    
    $
    118
    
    $
    7
    
    $
    1,871Income
      from operations
    $
    3,488
    
    $
    2,191
    
    
    
    
    $
    5,679Goodwill
    
    
    
    $
    5,098
    
    
    
    
    $
    5,098Total
      assets
    $
    83,929
    
    $
    14,342
    
    
    
    
    $
    98,271Nine
      months ended September 30, 2003Zones
    
    CPCS(a)
    
    Eliminations
    
    ConsolidatedExternal
      customer sales
    $
    293,155
    
    $
    37,281
    
    
    
    
    $
    330,436Transfer
      between segments
    
    864
    
    
    29
    
    $
    (893
    )
    
    Total
      net sales
    $
    294,019
    
    $
    37,310
    
    $
    (893
    )
    $
    330,436Depreciation
    $
    2,402
    
    $
    25
    
    
    
    
    $
    2,527Income
      (loss) from operations
    $
    (1,601
    )
    $
    806
    
    
    
    
    $
    (795
    )Twelve
      months ended December 30, 2003Zones
    
    CPCS
    
    Eliminations
    
    ConsolidatedGoodwill
    
    
    
    $
    4,193
    
    
    
    
    $
    4,193Total assets
    $
    75,756
    
    $
    17,129
    
    
    
    
    $
    92,885(a) The nine months ended September
30, 2003 results for CPCS are only for the six month period from April 1, 2003 to
September 30, 2003, as it was acquired on March 31, 2003.


Substantially all of the
Companys net sales for the three and nine months ended September 30, 2004 and
September 30, 2003 were made to customers located in the United States. All of the
Companys assets at September 30, 2004 and December 31, 2003 were located within the
United States. No one customer represented over 10% of total sales for the three or nine
month period ended September 30, 2004. During the nine months ended September 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 three or nine month period ended September 30, 2004. Net
sales to the former major customer were $6.6 million and $37.7 million for three and nine
months ended September 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. 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. Goodwill of approximately $5.1 million at September 30, 2004 represents the
balance of the excess of the purchase price over the fair value of the net tangible assets
acquired.


During the quarter ended September
30, 2004, the Company renegotiated certain terms of the SPA with the former shareholders
of CPCS. The Company and the former shareholders of CPCS agreed to reduce the amount of
the potential earn out payments to a fixed sum and to cancel each outstanding convertible
promissory note and non-convertible promissory note in exchange for the issuance of an
unsecured, subordinated non-convertible promissory note in a principal amount equal to the
former CPCS shareholders ratio of former shareholdings of such fixed sum (the
New Notes). Under the terms of the Agreement, the Company issued New Notes in
the aggregate principal amount of $2,743,864 to the former shareholders of CPCS. This
aggregate principal is equal to the remaining note payable balance under the original SPA
of $1,543,864, plus the fixed sum of $1,200,000 which increased goodwill.


Interest will accrue on the unpaid
principal amount of the New Notes at the prime rate plus 0.25%. At September 30, 2004 the
rate was 4.75%. The Company will make payments on accrued interest and the outstanding
principal amount on the New Notes on a fixed payment schedule through April 2006.


Prior to the September 27, 2004
renegotiation, under the terms of the March 31, 2003 SPA, the Company paid to the
shareholders of CPCS $4,881,000 in cash and issued notes in the aggregate principal amount
of $2,500,000: $2,250,000 non-convertible notes, $250,000 convertible notes. Each
non-convertible note had a three year term, with interest paid quarterly, and one third of
the principal amount was due and payable at the end of each of the earn-out periods, which
occurred annually on the transaction date. Each convertible note had a three year term and
one-third of the amount outstanding was payable at the end of each of the earn-out
periods, should CPCS have reached 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, have been 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 bore interest at the
rate the Company paid to its primary lender less 0.25%. In addition, the old notes were
subject to reduction for failure of CPCS to reach a threshold of EBITDA, which would have
adjusted the purchase price in the future. The Company measured 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 principal
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 was paid to the former shareholders of CPCS on April 2, 2004.


Additionally, prior to the September
27, 2004 renegotiation,, the SPA contained a provision for an earn-out over three years
contingent upon CPCS exceeding minimum levels of EBITDA. The former shareholders of CPCS
would have received a percentage of earnings each year up to 200% of the applicable EBITDA
target. The targeted EBITDA grew 10% per year after the initial earn-out period. The
maximum payment available was $4.95 million in the initial earn-out period and 10%
annually in the second and third year. No contingent payment would have been required if
CPCS earned less than 70% of the target EBITDA in any of the earn-out periods. The Company
measured the EBITDA targets annually on March 31st.


13
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 would be based exclusively on the ratio of their former
shareholdings. If any contingent payment was made the Company would have recorded 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.


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):


Nine
      months ended September 30, 2003Zones
    
    CPCS
    
    Eliminations
    
    ConsolidatedNet
      sales
    $
    294,019
    
    $
    61,320
    
    $
    (893
    )
    $
    354,446Net income
      (loss)
    $
    (1,081
    )
    $
    880
    
    
    
    
    $
    (201
    )Earnings
      per share:Basic
    $
    (0.08
    )
    $
    0.07
    
    
    
    
    $
    (0.01
    )Diluted
    $
    (0.08
    )
    $
    0.07
    
    
    
    
    $
    (0.01
    )7. Related
Party Disclosure


In June 2004, Fana Capital Corp., a
company owned by an officer of the Company, purchased the property and buildings in which
the Companys headquarters are located, subject to the existing 11-year lease. Under
the terms of the lease 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 this related
party transaction, and also the 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.


8. Share
Repurchase Program


In July 2004, the 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 open
market or private transactions at then prevailing market prices. Under this repurchase
program, the Company purchased and retired 448,390 shares of its common stock at a total
cost of $1.3 million (an average price of $3.01 per share) during the three month period
ended September 30, 2004. Of the 448,390 shares repurchased, 417,739 shares were purchased
from related parties in two private transactions.




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.


14
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
information technology (IT) related capital equipment, decisions by IT
equipment manufacturers to increase their own direct sales, 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, and intends to continue
exploring additional means of cost reduction, 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 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. A decline in sales
levels could adversely affect the Companys business, financial condition, cash flows
or results of operations.


Pressure on Margins. The
computer products industry has been characterized by intense price competition and
pressure on profit margins. An increasing number of manufacturers are also providing their
products direct to customers. Various other factors also may create downward pressure on
the Companys gross margins, such as an increasing proportion of sales to large,
public sector or other competitive-bid accounts. 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.


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 through November
2004. 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.


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.


Major Shareholder. Firoz H.
Lalji, the Companys Chairman and Chief Executive Officer, beneficially owns 52.0% 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 53.6% 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. The Companys certification as a
Minority Business Enterprise is dependant upon Mr. Laljis maintenance of voting
control and a decrease in his level of voting power could have an adverse effect on the
Companys ability to compete for certain sales opportunities.


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 new
Nasdaq rules. Additionally, independent registered public accounting firm 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.


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.


Major Customer. The Company
had a contract with a major customer, Microsoft Corporation, which expired in June 2003.
Sales to this customer represented less than 10% of total sales for the three and nine
month period ended September 30, 2004, compared to 5.8% and 11.4% of total sales for the
three and nine month period ended September 30, 2003, respectively. While the Company may
continue to receive some level of business from Microsoft, net sales to this customer have
significantly declined.


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. 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.


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.


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 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.


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.


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.


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 Distribution.
Corporate PC Source, the Companys wholly owned subsidiary, provides and operates a
warehouse and distribution center for the Company in Bensonville, Illinios. Any limitation
or interruption of the service 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.


17
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
92.7% and 91.3% of total net sales during the three and nine months ending September 30,
2004, respectively. The remaining sales were from inbound customers, primarily consumers
and small office home office accounts.


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 September 30, 2004, the Company had 571 team members in its
consolidated operations; 281 of whom 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 additional company information available free of charge on
its website, www.zones.com/IR.


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
recognition18

Valuation
of current assets and estimating market inventory obsolescence
Accounting
for income taxes
GoodwillRevenue 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 and 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.


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 at September 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.


19
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.


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
      September 30,
    
    Nine
      months ended
      September 30,2004
    
    2003
    
    2004
    
    2003Net
      sales
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %
    
    
    100.0
    %Cost of
      sales
    
    89.1
    
    
    
    88.0
    
    
    
    88.5
    
    
    
    88.8Gross
      profit
    
    10.9
    
    
    
    11.9
    
    
    
    11.5
    
    
    
    11.2Selling,
      general and administrative expenses
    
    7.8
    
    
    
    9.9
    
    
    
    8.5
    
    
    
    9.8Advertising
      expenses, net
    
    1.3
    
    
    
    1.6
    
    
    
    1.4
    
    
    
    1.6Income
      (loss) from operations
    
    1.8
    
    
    
    0.4
    
    
    
    1.6
    
    
    
    (0.2
    )Other
      (income) expense
    
    0.0
    
    
    
    0.1
    
    
    
    0.1
    
    
    
    0.1Income
      (loss) before income taxes
    
    1.8
    
    
    
    0.3
    
    
    
    1.5
    
    
    
    (0.3
    )Provision
      (benefit) for income taxes
    
    0.7
    
    
    
    0.2
    
    
    
    0.6
    
    
    
    (0.1
    )Net income
      (loss)
    
    1.1
    %
    
    
    0.1
    %
    
    
    0.9
    %
    
    
    (0.2
    )%Selected
      operating data:Number
      of orders
    
    104,000
    
    
    
    109,000
    
    
    
    317,000
    
    
    
    352,000Average
      order size
    $
    1,254
    
    
    $
    1,046
    
    
    $
    1,180
    
    
    $
    949Number
      of B2B account executives, end of period
    
    
    
    
    
    
    
    
    
    253
    
    
    
    208Productivity
      per employee, annualized
    
    
    
    
    
    
    
    
    $
    909,000
    
    
    $
    805,000Product
      Mix (% of Net Sales):Notebook
      & PDAs
    
    12.7
    %
    
    
    14.3
    %
    
    
    15.1
    %
    
    
    15.6
    %Desktops
      & Servers
    
    19.5
    
    
    
    19.8
    %
    
    
    20.0
    
    
    
    20.1
    %Software
    
    20.9
    
    
    
    16.9
    %
    
    
    17.8
    
    
    
    13.8
    %Storage
    
    7.7
    
    
    
    10.4
    %
    
    
    8.6
    
    
    
    10.8
    %NetComm
    
    4.8
    
    
    
    5.8
    %
    
    
    4.6
    
    
    
    5.6
    %Printers
    
    8.8
    
    
    
    8.0
    %
    
    
    9.3
    
    
    
    8.3
    %Monitors
      & Video
    
    11.1
    
    
    
    8.5
    %
    
    
    10.4
    
    
    
    9.7
    %Memory
      & Processors
    
    5.4
    
    
    
    6.7
    %
    
    
    4.9
    
    
    
    5.9
    %Accessories
      & Other
    
    9.1
    
    
    
    9.6
    %
    
    
    9.3
    
    
    
    10.2
    %Comparison of Three
Month Periods Ended September 30, 2004 and 2003


Net Sales.Consolidated net
sales for the quarter ended September 30, 2004 increased 15.2% to $129.8 million compared
to $112.7 million in the third 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 September 30, 2004 increased
16.0% to $22.3 million from $19.2 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 18.8% to $120.3 million in the third quarter of 2004 from $101.3
million in the third quarter of 2003. The increase was driven by an increase in public
sector sales. Sales to the public sector were $18.1 million during the three months ended
September 30, 2004 compared to $9.4 million in the prior year. Sales for the three months
ended September 30, 2003 included $6.6 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 to $9.5
million for the three months ended September 30, 2004 compared to $11.4 million in the
comparable period of 2003, and declined as a percent of total sales to 7.3% from 10.2% in
the prior year.


20
Gross Profit. Consolidated
gross profit increased to $14.1 million for the third quarter of 2004, compared to $13.5
million in the third quarter of 2003. Gross profit as a percentage of net sales decreased
to 10.9% in the quarter ended September 30, 2004 compared to 11.9% in the third quarter of
2003, and decreased sequentially from 11.5% in the second quarter of 2004. Gross profit
margins for the three months ended September 30, 2004 were impacted by a shift in customer
and product mix that decreased overall margins. In particular, software as a percentage of
sales increased to 20.9% during the third quarter of 2004 from 17.8% in the same period of
last year. In general, software sales have a lower margin than other product lines sold by
the Company. The Company anticipates the dollar amount of vendor consideration categorized
as costs of sales to remain relatively 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.


Selling, General and
Administrative (SG&A) Expenses.SG&A expense dollars decreased to
$10.2 million for the quarter ended September 30, 2004 compared to $11.1 million in the
third quarter of 2003. The decline was primarily due to a reduction in depreciation and
facilities expenses. Depreciation expense declined to $595,000 in the third quarter of
2004 from $882,000 in the third quarter of 2003. Facilities expense declined to $551,000
for the three months ended September 30, 2004 from $823,000 in the prior year due to the
Companys decision to move its headquarters in September of 2003 to a lower cost
facility. 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 21.6% to 253 at September 30,
2004 compared to 208 in the prior year period. As a percent of sales, SG&A was 7.8%
for the quarter ended September 30, 2004 compared to 9.9% for the third quarter of 2003.
The decline in SG&A as a percentage of sales was both a function of a decline in
overall dollars as well as increased sales volumes. For the three month periods ending
September 30, 2004 and 2003, warehousing and distribution network costs totaled $484,000
and $403,000 respectively. The increase was due to the Companys transition of its
warehousing operations to a new facility in Chicago, Illinois operated by its wholly owned
subsidiary, CPCS.


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 $1.6 million in
the three month period ended September 30, 2004 from $1.9 million in the comparable 2003
period. Gross advertising expense decreased to $1.8 million for the third quarter of 2004
compared to $2.3 million in the third quarter of 2003. These declines primarily relate to
a reduction in the circulation of the Companys catalogs. The Company produced and
distributed 1.9 million catalogs during the third quarter of 2004 compared to 2.5 million
in the third 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 $198,000 in 2004 from $401,000 in 2003. The decline primarily related to a
decline in 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 $49,000 for the quarter ended September 30, 2004 compared to $141,000 in the third
quarter of 2003. The expense was primarily due to interest expense incurred during the
quarter. The Company leverages its line of credit to aggressively take early pay
discounts. Additionally, third quarter 2003 had $36,000 of interest expense associated
with the Washington State tax audit which was settled in December of 2003.


21
Provision/Benefit for Income
Taxes. The provision for income taxes for the quarter ended September 30, 2004 was
$889,000 compared to a provision of $193,000 in the comparable period of the prior year.
The Companys effective tax rate expressed as a percentage of income before taxes was
38.8% for the quarter ended September 30, 2004 compared to 59.0% for the quarter ended
September 30, 2003. 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.


Net Income.Net income for the
quarter ended September 30, 2004 was $1.4 million compared to net income of $134,000 in
the third quarter of 2003. Basic and diluted income per share was $0.10 for the quarter
ended September 30, 2004 compared to basic and diluted income per share of $0.01 in the
third quarter of 2003.


Comparison of Nine
Month Periods Ended September 30, 2004 and 2003


Net Sales.Consolidated net
sales for the nine months ended September 30, 2004 increased 11.4% to $367.9 million
compared to $330.4 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 nine months
ended September 30, 2004 were $60.8 million compared to the six months ended September 30,
2003 of $37.3 million. The Companys net sales for the nine months ended September
30, 2004 excluding CPCS were $307.2 million, a 4.8% increase from the same period of the
prior year. In the nine month period ended September 30, 2003, the Company had sales to a
former major customer of $37.7 million, whose contract with the Company expired in June of
2003. Consolidated outbound sales to the SMB, large and public sector accounts increased
13.4% to $335.9 million in the first nine months of 2004 from $296.1 million in 2003.
Inbound demand response sales to the legacy consumer and SOHO customers decreased by 6.7%
during the first nine months of 2004 to $32.1 million compared to $34.3 million in the
comparable period of 2003, and declined as a percent of total sales to 8.7% from 10.4%.


Gross Profit. Consolidated
gross profit increased to $42.3 million for the nine months ended September 30, 2004,
compared to $36.8 million in the comparable period of 2003. The increase was due the
Companys margin enhancing initiatives, such as pricing strategies, customer mix and
a focus on higher margin accessory items, and the margin reclassification associated with
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). Gross profit margins year over year were increased $2.1
million due to the reclassification for EITF 02-16, whereby the Company recorded $6.0
million of vendor consideration as a reduction to cost of sales in the first nine months
of 2004 compared to $3.9 million in the first nine months of 2003. Gross profit as a
percentage of net sales increased to 11.5% in the first nine months of 2004 compared to
11.1% in the first nine months 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 decreased
slightly to $31.4 million for the nine months ended September 30, 2004 compared to $32.2
million in the nine months ended September 30, 2003. The decrease was primarily due to the
Companys reduction of fixed costs. The declines in fixed costs were associated with
reductions in depreciation and facilities. Depreciation expense declined to $1.9 million
in the first nine months of 2004 from $2.5 million in 2003. Facilities expense declined to
$1.6 million for the nine months ended September 30, 2004 from $2.0 million in the prior
year due to the Companys decision to move its headquarters in September of 2003 to a
lower cost facility. For the nine month periods ending September 30, 2004 and 2003,
warehousing and distribution network costs remained flat at $1.3 million, even with
additional costs incurred during 2004 to transition its warehousing operations to a new
facility in Chicago, Illinois operated by its wholly owned subsidiary, CPCS. 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 21.6% to 253 at September 30, 2004 compared to
208 at September 30, 2003. As a percent of sales, SG&A was 8.5% for the nine months
ended September 30, 2004 compared to 9.8% for the comparable period of 2003.


22
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 slightly to $5.2
million in the nine month period ended September 30, 2004 from $5.3 million in the
comparable 2003 period. Gross advertising expense decreased to $5.6 million for the first
nine months of 2004 compared to $7.8 million in the first nine months of 2003. The decline
primarily relates to a reduction in the circulation of the Companys catalogs. The
Company produced and distributed 5.7 million catalogs during the nine months ended
September 30, 2004 compared to 8.4 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 $399,000 in 2004
from $2.5 million in 2003. The decline primarily related to the Companys adoption of
EITF 02-16, under which the Company recorded $6.0 million of vendor consideration as a
reduction to cost of sales in the first nine months of 2004 compared to $3.9 million in
the first nine months of 2003. Additionally, advertising expense was impacted by a decline
in 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 $216,000 for the nine months ended September 30, 2004 compared to $236,000 in the nine
months ended September 30, 2003. Other expense was primarily interest expense associated
with the Companys working capital line of credit. The Company leverages its line of
credit to aggressively take early pay discounts. Additionally, the nine months ended
September 30, 2003 had $36,000 of interest expense associated with the Washington State
tax audit which was settled in December of 2003.


Provision/Benefit for Income
Taxes. The provision for income taxes for the nine months ended September 30, 2004 was
$2.1 million compared to a benefit of $395,000 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 nine months ended September 30, 2004 compared to 38.3% for the
nine months ended September 30, 2003.


Net Income/Loss.Net income
for the nine months ended September 30, 2004 was $3.3 million compared to a net loss of
$636,000 in the comparable period of 2003. Basic and diluted earnings per share were $0.25
and $0.23, respectively, for the nine months ended September 30, 2004 and basic and
diluted loss per share was $0.05 for the nine months ended September 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 September 30, 2004, the Company
had total assets of $98.3 million, of which $85.8 million were current assets. At
September 30, 2004 and December 31, 2003 the Company had cash and cash equivalents of $4.3
million and $5.2 million, respectively. The Company utilized its cash position to
aggressively take advantage of favorable discount terms offered by certain vendors. The
Companys accounts receivable days outstanding remained constant at 43 days for
September 30, 2004 compared to December 31, 2003. The Companys working capital was
$24.7 million and $20.9 million at September 30, 2004 and December 31, 2003, respectively.
The Company committed to a stock repurchase program in July of 2004 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. During the three months ended September 30, 2004, the Company
purchased and retired 448,390 shares of its common stock at a total cost of $1.3 million
(an average price of $3.01 per share) during the three month period ended September 30,
2004.


23
Net cash provided by operating
activities was $9.5 million for the nine months ended September 30, 2004 compared to cash
used in operating activities of $5.0 million for the nine months ended September 30, 2003.
Cash inflows for the nine months ended September 30, 2004 were primarily due to increases
in accounts payable and the use of net operating loss carry-forwards reducing its current
federal income tax obligation, offset by increases in inventory. At September 30, 2004,
accounts payable increased by $10.9 million and the Company utilized $2.1 million of its
net operating loss carry-forward, while net inventory increased by $5.9 million. The
increase in inventory and accounts payable was primarily due to purchases associated with
extended roll-outs for the Companys large customers.


Cash outlays for investing activities
were $1.7 million at September 30, 2004 compared to $4.8 million at September 30, 2003.
The investing activities during 2004 were for capital expenditures 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 intends to continue to upgrade its internal information systems as a means to
increase operational efficiencies. The nine months ended September 30, 2003 had capital
expenditures of $1.1 million and cash payments, net of cash received, for the
Companys acquisition of CPCS on March 31, 2003 of $3.7 million.


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 on
April 2, 2004.


At September 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 has an annual automatic renewal which occurs on
November 26 of each fiscal year. Either party can terminate this agreement with 60 days
written notice prior to the renewal date.  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 September 30, 2004, the Company was compliant with all covenants of this facility. At
September 30, 2004, $2.6 million of working capital advances were outstanding and accounts
payable of $13.9 million was owed to this financial institution related to inventory
purchases.


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 the remaining balance of $1.7 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.


24
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.




Item 2.
Unregistered Sales of Equity Securities and Use of Proceeds


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 open market or private transactions at then prevailing
market prices.


The following table sets forth
information on the Companys common stock repurchase program for the quarter ended
September 30, 2004:

Period
    
    
    
    
    
    Total
      number of shares
      purchased as part of a
      publicly announced 
      plan or program
    
    Maximum
      amount 
      that may yet be 
      purchased under the
      plan or programTotal number
      of shares 
      purchased
    Average
      
      price paid
      per shareJuly
      1, 2004 throughJuly
      31, 2004
    
    0
    
    $
    
    
    0
    
    $
    3,000,000August
      1, 2004 throughAugust
      31, 2004
    
    448,390
    
    $
    3.01
    
    448,390
    
    $
    1,651,886September
      1, 2004 throughSeptember
      30, 2004
    
    0
    
    $
    
    
    0
    
    $
    1,651,88625
Item 6.
Exhibits


(a)
ExhibitsExhibit
      No.
    
    Description
    
    Filed 
      Herewith
    
    Incorporated
      by ReferenceForm
    
    Exhibit
      No.
    
    File No.
    
    Filing Date31.1
    
    Certification
      of Chief Executive Officer pursuant to
    
    XSection
      302 of the Sarbanes-Oxley Act of 2002 and theregulations
      promulgated thereunder31.2
    
    Certification
      of Chief Financial Officer pursuant to
    
    XSection
      302 of the Sarbanes-Oxley Act of 2002 and theregulations
      promulgated thereunder32.1
    
    Certification
      of Chief Executive Officer pursuant to
    
    XSection
      906 of the Sarbanes-Oxley Act of 2002 and theregulations
      promulgated thereunder32.2
    
    Certification
      of Chief Financial Officer pursuant to
    
    XSection
      906 of the Sarbanes-Oxley Act of 2002 and theregulations
      promulgated thereunder


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: November 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
      Officer26