UNITED
        STATES
 SECURITIES
        AND EXCHANGE
        COMMISSION
 Washington,
        D.C. 20549
 FORM
        10-K/A
 
 T
              ANNUAL
                  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                  ACT OF
                  1934
 FOR
          THE FISCAL YEAR ENDED DECEMBER 31, 2006
 
 OR
 
 £
              TRANSITION
                  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                  ACT OF
                  1934 FOR THE TRANSITION PERIOD FROM __________ TO __________
 
 Commission
        File Number     0-28488
 
 ZONES,
        INC
 (Exact
        name of registrant as specified in its charter)
 
 Washington
              
              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
        Telephone
 Number,
        Including Area Code)
 
 Securities
        registered pursuant to Section 12(b) of the Act: Common Stock
 Securities
        registered pursuant to Section 12(g) of the Act: None
 
 Indicate
        by check mark if the registrant is a well-known seasoned issuer, as defined
        in
        Rule 405 of the Securities Act.  Yes£  NoT
 Indicate
        by check mark if the registrant is not required to file reports pursuant
        to
        Section 13 or Section 15(d) of the Act.   Yes £   No
        T
 
 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 T   No£
 Indicate
        by check mark if disclosure of delinquent filers pursuant to item 405 of
        Regulation S-K is not contained herein, and will not be contained, to the
        best
        of the registrant’s knowledge, in definitive proxy or information statements
        incorporated by reference in Part III of this Form 10-K or any amendment
        of this
        Form 10-K. T
 Indicate
        by check mark whether the
        registrant is a large accelerated filer, an accelerated filer, or a
        non-accelerated filer.  See definition of “accelerated filer and large
        accelerated filer” in Rule 12b-2 of the Exchange Act.  (Check
        one):   Large accelerated filer£ Accelerated
        filer £Non-accelerated
        filerT
 
 Indicate
        by check mark whether the registrant is a shell company (as defined in Rule
        12b-2 of the Act). Yes £  No
        T
 
 The
        aggregate market value of the Common Stock held by non-affiliates as of the
        registrant’s most recently completed second quarter, June 30, 2006, was
        approximately $39,820,756, based upon the last sales price per share of $6.37
        as
        reported by the NASDAQ Global Market.
 
 The
        number of shares of the registrant's Common Stock outstanding as of February
        23,
        2007 was 13,159,560.
 
 DOCUMENTS
        INCORPORATED BY
        REFERENCE
 
 Portions
        of the definitive Proxy Statement for the Registrant’s Annual Meeting of
        Shareholders to be held on April 26, 2007 have been incorporated by reference
        into Part III of this Annual Report on Form 10-K.
  
 
  Explanatory
        Note
 
 The
        Company is filing this amendment to its Annual Report on Form 10-K/A (“Form
        10-K/A”) to restate its Consolidated Statements of Cash Flows for the years
        ended December 31, 2006 and 2005 as described in Note 15, Restatement, of
        the
        Notes to Consolidated Financial Statements.   The Consolidated
        Statement of Cash Flows for the fiscal year ended December 31, 2004 has been
        revised for conformity purposes.  The Company has been in discussion
        with the staff of the Securities and Exchange Commission (“SEC”) regarding the
        Company’s classification of its inventory financing cash inflows and outflows
        within the operating and/or financing sections of its Consolidated Statements
        of
        Cash Flows.  Following these discussions, the Company has concluded it
        would restate it’s Consolidated Statements of Cash Flows by reclassifying net
        cash flows related to its inventory financing, disclosed as a separate line
        item, from operating activities to financing
        activities.  Consequently, this reclassification will result in a
        change to cash flows (used in) provided by operating activities with an equal
        and off-setting impact to cash flows (used in) provided by financing
        activities.
 
 This
        restatement does not have any impact on the Company’s previously reported
        overall net change in cash and cash equivalents in its consolidated statements
        of cash flows for any period presented.   This restatement also
        has no impact on net income or net income per share in the previously reported
        consolidated statements of operations for the fiscal years ended December
        31,
        2005 and December 31, 2006 or in the previously reported unaudited condensed
        consolidated statements of operations for the three months ended March 31,
        2006
        and March 31, 2007, the three and six months ended June 30, 2006 and June
        30,
        2007, nor was there any effect on the previously reported consolidated balance
        sheets as of December 31, 2005 and December 31, 2006, the previously reported
        unaudited condensed consolidated balance sheets as of March 31, 2007 and
        June
        30, 2007, or the previously reported consolidated statements of shareholders’
equity for the years ended December 31, 2005 and December 31, 2006.  The
        consolidated statement of cash flows for the fiscal year ended December 31,
        2004
        has been revised to conform to this presentation.
 
 For
        the
        convenience of the reader, this Form 10-K/A sets forth the Company’s original
        Form 10-K as filed with the SEC on March 1, 2007 (the “Original 10-K") in its
        entirety, as amended by, and to reflect, the restatement.  No attempt
        has been made in this Form 10-K/A to update other disclosures presented in
        the
        Original 10-K, except as required to reflect the effects of the
        restatement.  This Form 10-K/A does not reflect events occurring after
        the filing of the Original 10-K or modify or update those disclosures, including
        the exhibits to the Original 10-K affected by subsequent events.  The
        following sections of this Form 10-K/A have been amended to reflect the
        restatement:
 
 §
              Part
                  II, Item 7. Management’s Discussion and Analysis of Financial Condition
                  and Results of Operations (Liquidity and Capital Resources)
 §
              Part
                  II, Item 8. Financial Statements and Supplementary Data (Consolidated
                  Statements of Cash Flows and Note 15 Restatement)
 
 In
        addition, this amendment on Form 10-K/A includes currently dated Sarbanes-Oxley
        Act Section 302 and Section 906 certifications of the Chief Executive Officer
        and Chief Financial Officer, attached hereto as Exhibits 31.1, 31.2, 32.1
        and
        32.2.
 
 This
        Form
        10-K/A should be read in conjunction with our filings made with the SEC
        subsequent to the filing of the Original 10-K for the year ended December
        31,
        2006, including any amendments to those filings.
  2
  ZONES,
        INC.
 FORM
        10-K ANNUAL REPORT
 FOR
        THE YEAR ENDED DECEMBER 31, 2006
 TABLE
        OF CONTENTS
 
 PART
        I
 
 Page
                  No.Item
                  1.
              
              Business
              4Item
                  1A.
              
              Risk
                  Factors
              10Item
                  2.
              
              Properties
              13Item
                  3.
              
              Legal
                  Proceedings
              13Item
                  4.
              
              Submission
                  of Matters to a Vote of Security Holders
              14Item
                  4A.
              
              Executive
                  Officers of the Registrant
              14
 
 PART
        II
 
 Item
                  5.
              
              Market
                  for Registrant’s Common Equity, Related Shareholder Matters and Issuer
                  Purchases of Equity Securities
              14Item
                  6.
              
              Selected
                  Financial Data
              15Item
                  7.
              
              Management’s
                  Discussion and Analysis of Financial Condition and Results of
                  Operations
              17Item
                  7A.
              
              Quantitative
                  and Qualitative Disclosures about Market Risk
              24Item
                  8.
              
              Financial
                  Statements and Supplementary Data
              25Item
                  9.
              
              Changes
                  in and Disagreements with Accountants on Accounting and Financial
                  Disclosure
              25Item
                  9A.
              
              Controls
                  and Procedures
              25Item
                  9B.
              
              Other
                  Information
              25
 
 PART
        III
 
 Item
                  10.
              
              Directors,
                  Executive Officers and Corporate Governance
              25Item
                  11.
              
              Executive
                  Compensation
              25Item
                  12.
              
              Security
                  Ownership of Certain Beneficial Owners and Management and Related
                  Stockholder Matters
              26Item
                  13.
              
              Certain
                  Relationships and Related Transactions, and Director
                  Independence
              26Item
                  14.
              
              Principal
                  Accounting Fees and Services
              26
 
 PART
        IV
 
 Item
                  15.
              
              Exhibits
                  and Financial Statement Schedules
              27Signatures
              29
  3
 Table
            of Contents
  PartI
 
 Item1.       Business
 
 This
        section contains forward-looking statements based on management’s current
        expectations, estimates and projections about the industry in which the Company
        operates, management’s beliefs, and certain assumptions made by management.
        These statements are made pursuant to the safe harbor provision of the Private
        Securities Litigation Reform Act of 1995.All
        statements, trends, analyses and other information contained in this report
        relative to trends in net sales, gross margin and anticipated expense levels,
        as
        well as other statements, including words such as “anticipate,” “believe,”
“plan,” “expect,” “estimate,” “intend,” and other similar expressions,
        constitute forward-looking statements. These forward-looking statements involve
        risks and uncertainties, and actual results may differ materially from those
        anticipated or expressed in such statements. Potential risks and uncertainties
        include, among others, those set forth in Item 1A of this Annual Report.
        Particular attention should be paid to the cautionary statements involving
        future profitability and sales levels, pressure on margins, reliance on vendor
        support and relationships, state tax uncertainties, the industry’s rapid
        technological change and the Company’s exposure to inventory
        obsolescence.  Except as required by law, the Company undertakes no
        obligation to update any forward-looking statements, whether as a result
        of new
        information, future events or otherwise.
 
 General
 
 Zones,
        Inc. (the “Company,” “We”) is a single-source direct marketing reseller of
        name-brand information technology (“IT”) products to the small-to-medium-sized
        business market (“SMB”), enterprise accounts and public sector
        accounts.  Zones sells products through outbound and inbound account
        executives, catalogs and the Internet.  Zones offers more than 150,000
        products from leading manufacturers, including 3Com, Adobe, Apple, Cisco,
        Epson,
        HP, IBM, Kingston, Lenovo, Microsoft, Sony and Toshiba.
 
 Incorporated
        in 1988, Zones, Inc. is headquartered 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.
 
 Industry
        Background
 
 We
        believe that the direct marketing reseller (“DMR”) channel has reached a level
        where most corporate IT customers have selected their vendor of choice, either
        direct through DMRs or indirect through value-added resellers
        (“VAR”).  Future growth of the channel will be predicated on increased
        corporate profit levels, which can support an investment in new
        technology.  Generally, we believe that in 2007 the DMR channel will
        grow at market rate, with our core business with the SMB expected to outpace
        the
        market.  To exceed the market rate of growth overall, individual DMR
        vendors must take market share from their direct and indirect
        competitors.
 
 Customers
        make their IT purchasing decisions primarily based on service offerings,
        product
        selection, availability, convenience and price.  DMRs offer a broad
        product and service selection, purchasing convenience and fast delivery.
        The DMR
        channel serves a fragmented market whose projected annual sales are in the
        multi-billions of dollars.  DMRs are characterized by a low-cost
        structure characterized by few fixed costs, rapid inventory turns, centralized
        sales forces and highly automated internal processes, including the use of
        the
        Internet and electronic data interchange (“EDI”) links with major vendors and
        customers to streamline operations.  Our strategy as a solution
        provider emphasizes a fulfillment model that integrates the procurement and
        resale of technology and related accessory product lines, and is supported
        by
        sales specialists, as well as value-added configuration and logistics
        services.
 
 We
        believe that customer decisions are based on the level of service they expect
        in
        relation to what they are willing to pay.  Most DMRs have evaluated
        other indirect providers to determine which added services will differentiate
        and enable DMRs to gain market share from manufacturers selling direct and
        from
        other VARs. We continuously work with our vendor partners to maintain awareness
        of and to capitalize on new product announcements and purchasing trends.
        In
        particular, we are focused on the shift by commercial business customers
        to
        mobile technologies, their need for additional storage and security, and
        the
        anticipated introduction of new software solutions.
  4
 Table
            of Contents
 
 Our
        Business
 
 Our
        business is the procurement and fulfillment of IT solutions to the SMB,
        enterprise customers and the public sector marketplace.  Our core
        business is focused on providing name-brand products at competitive prices
        to
        the commercial business and public sector markets within the United
        States.  We believe that small business customers, meaning those with
        50 to 100 computer users, are characterized by transactional purchasing,
        in
        contrast to medium-sized business customers, meaning those with 100 to 1000
        computer users, who are relationship-driven with more frequent
        transactions.  We believe that SMB customers have a high adoption rate
        for IT solutions and prefer a single-source provider to handle their procurement
        from end to end.  Enterprise customers, defined as customers within
        the Fortune 2000 and having more than 1000 computer users, generally demand
        a
        much higher level of customer service.   The public sector market
        is made up of three primary customer types:  state and local
        government, federal government and education. These sectors require special
        pricing and participation in bid processes.
 
 As
        value-adds to our customers, we offer asset tagging, configuration and other
        third-party services, we also maintain integration of customers’ business needs
        and processes through ZonesConnect, the Company’s robust, automated Web-based
        procurement system.
 
 Our
        Business Strategy
 
 We
        acquire and develop ongoing relationships with commercial and public sector
        accounts primarily through dedicated teams of outbound sales account executives
        (“AE”).  Although outbound telemarketing is our primary customer
        contact, we also reach customers through an integrated marketing and
        merchandising strategy that utilizes e-marketing and direct marketing vehicles,
        catalogs for demand response opportunities and corporate branding, customized
        Web stores for its commercial customers through ZonesConnect, and our recently
        introduced Business Development organization which includes a remote field
        sales
        force.
 
 We
        believe that our ability to grow in 2007 will depend on organic growth within
        our current account portfolio and increased reach, utilizing our growing
        force
        of field sales AEs, into the larger end of medium-sized customers and enterprise
        customers. We believe organic growth will develop as tenure and productivity
        increase in our existing AE base, driving an increase in the share of each
        customer’s total IT purchases.  Additionally, we are committed to our
        2006 decision to add dedicated marketing and sales support staff to focus
        on
        businesses at the smaller end of our SMB customer base, which is believed
        to be
        more transaction oriented. The field sales force will be focused on the
        identification, penetration and closure of new business customers to add
        to the
        existing client portfolio.  Our business model relies on building and
        maintaining relationships with our customers to provide solutions to solve
        their
        needs.
 
 We
        strive
        to offer exemplary customer service in each transaction, which we define
        as Five
        Star Service.  Five Star Service is founded on these
        principles:  exceeding expectations, providing outstanding customer
        service, performing flawless execution, demonstrating the highest level of
        personal integrity, and placing the customer first.  We strive to
        offer the most competitive value based on:
 
 ·
              Price.
                  Zones offers
                  competitive pricing to its customers.
 ·
              Availability.
                  With more
                  than 150,000 products available from more than 2,000 vendors, Zones
                  strives to deliver the products its customers need.
 ·
              Information.
                  The
                  technology industry is constantly changing with new and upgraded
                  products
                  and services, so Zones AEs receive continuous training throughout
                  their
                  careers. This allows them to serve as a knowledgeable extension
                  of each
                  customer's team.
 ·
              Fulfillment.
                  Zones
                  strives to deliver every order complete and on time.
 ·
              Service.
                  Zones offers a
                  breadth of services and sales specialists to support the customer
                  IT
                  relationship. For example, the Company’s customized online order
                  management system, ZonesConnect, helps its customers reduce administrative
                  costs and streamline the purchasing process. With additional services
                  such
                  as asset tagging, imaging, and product upgrades, Zones is a proactive
                  business partner throughout the sales cycle.
 
 Our
        specific areas of concentration for realizing growth in our share of the
        IT-procurement market are:
 
 Business
        Development
        Organization.  To drive market share growth, we have invested
        in client segmentation and geographical expansion, which has led to the
        introduction of the Business Development organization.  This
        organization is responsible for creating an organization of remote,
        geographically dispersed AEs focused on acquisition of new customers and
        development of existing customers.  This field sales force, along with
        its management team, is expected to grow to 20 team members by the end of
        the
        first quarter 2007.  This team will be divided into two populations:
        AEs who will call on the larger end of medium-sized customers and AEs who
        will
        call on enterprise customers.
  5
 Table
            of Contents
 
 AE
        Hiring, Training and
        Development. We continually seek to attract, retain and motivate
        high-quality personnel.  We intend to continue to increase AE
        headcount, but at a lower rate of growth due to our focus on improving the
        success rate of existing AEs.  The increase in success rate should
        lower turnover and, in turn, reduce our expected 2007 hiring
        requirements.  Management focuses on training and coaching AEs on best
        practices, product knowledge and how to access supportive collateral on the
        available marketing and merchandising programs and promotions.  We
        focus on our relationship-based model, in which our AEs develop long-term
        relationships with customers through frequent telephone contact, knowledgeable
        technical advice, individual attention, quality service and convenient one-stop
        shopping.
 
 Expansion
        of Customer Base.Relationships with our commercial business and public sector accounts
        represent future growth opportunities.  We continue to refine our
        customer management program, lead generation and related processes to increase
        and accelerate customer acquisition.  During 2007, we believe our
        customer management program is designed to better understand the purchasing
        patterns and product needs of each customer, and thereby increase operational
        efficiencies in the selling process and minimize loss of revenues during
        account
        transition from one AE to another.
 
 Product
        Breadth and
        Depth.  We are dependant upon relationships with key vendors
        for opportunistic product purchases to enhance margins.  Through a
        strategic mix of products and vendors, we offer our customers a broad selection
        at competitive pricing.  We generally stock 20% of our product
        offerings, which represent 80% of total revenue, in our warehousing
        facilities.  The remaining items are offered to our customers through
        virtual warehousing partnerships with key distributors and vendors via
        electronic data interchange (“EDI”).  We use our warehouses and EDI
        partners to fulfill all our customers’ needs with broad product
        availability.  We place individual orders directly with our EDI
        partners, who then assemble these orders and ship them directly to our
        customers.
 
 Services.We
        offer custom
        configuration services, such as the installation of accessories and expansion
        products, loading of software, imaging for custom applications and configuration
        of network operating systems, as well as IT lifecycle support services and
        supply chain management services. Many of these services are performed at
        our
        distribution centers and benefit our customers by reducing the cost and time
        necessary to deploy new products into their existing technology
        environments.
 
 Sales
        and Marketing
 
 We
        reach
        our customers through an integrated marketing and merchandising strategy
        designed to attract customers through dedicated e-marketing and direct marketing
        vehicles, catalogs for demand-response opportunities and corporate branding,
        and
        customized Web stores for corporate customers using our ZonesConnect
        service.  Throughout the year, marketing refines the characteristics
        of our target customers in each market and creates specific marketing collateral
        to reach that audience.
 
 Outbound
        Telemarketing.  As of December 31, 2006, we had a staff of 342
        sales AEs who actively pursued sales to commercial business accounts and
        public
        sector institutions by establishing one-to-one relationships through outbound
        telemarketing.  The primary targets for AEs in the SMB department are
        the small-to-medium-sized business customers, while enterprise-customer AEs
        focus on companies within the Fortune 2000.  These commissioned AEs
        develop long-term relationships with their accounts through frequent telephone
        contact, knowledgeable technical advice, individual attention, quality service
        and convenient one-stop shopping.
 
 Business
        Development Field
        Sales.  In October 2006, we began investing in a strategy to
        create a remote, geographically dispersed sales force.  Business
        Development management and the field sales AEs will identify and access
        customers within the larger end of the medium-sized-business and
        enterprise-business segments in an effort to increase our existing portfolio
        with new customers.
 
 Extranet
        Commerce.  We offer no-fee dedicated Web stores for our
        customers through ZonesConnect. These dedicated sites provide the customer
        with
        various benefits, including secure online purchasing, license trackers,
        comprehensive product and manufacturer information, order status information,
        multiple shopping baskets, varying ship-to options per order, enhanced search
        and browse capabilities, and historical purchase information. In addition,
        we
        often provide more customized extranet sites for our larger customers with
        specific online procurement needs.
  6
 Table
            of Contents
 
 Internet
        Commerce.  Our electronic commerce site on the Internet,
        Zones.com, provides a sales channel to both supplement and enhance our
        person-to-person sales model and to provide customers detailed product
        information and the convenience of online purchasing.  We drive
        traffic to this site by featuring the Internet address throughout our
        direct-mail vehicles and on our promotional communications and advertising.
        We
        also utilize marketing through e-catalogs, as well as online price promotions
        and affiliations.
 
 Direct
        Mail.  We
        market products through targeted mailings of direct-mail vehicles, such as
        catalogs, product inserts and targeted customer mailings. The Company utilizes
        its direct mail vehicles as part of a customer acquisition and retention
        strategy, as well as a direct marketing tool and branding vehicle to drive
        significant traffic to its online site, Zones.com, and to our sales
        force.  The Company uses cooperative advertising funds, which are
        proof of performance expense reimbursements, to substantially offset the
        costs
        associated with its catalog circulation and other marketing
        activities.  The amount of this type of funding available from our
        vendors fluctuates quarterly both in dollars and as a percentage of
        sales.  Net advertising costs may continue to fluctuate or rise in the
        future as the Company continues to adapt and adjust its catalog circulation,
        Internet and other marketing activities to optimize sales and profitability
        in
        light of changing market conditions.
 
 Database
        Marketing.  Wemaintain
        a proprietary database
        containing approximately 35,000 customer records andwe havebuilt
        a prospecting database ofmore than150,000
        commercial leads.  In
        thecommercialbusiness
        market,weattract
        new customers by providing
        qualified leads toour
        AEs, warming the leads
        with
        catalogs and directmail,and
        building relationships through
        outbound telephone calls.  Retention of customers and account
        development is supported by catalog, direct mail and e-marketingvehicles.  Catalog
        circulation isbased oncustomer
        records,prospective customerinquiries,
        andmailing lists obtained
        from list
        brokers, product manufacturers, trade magazine publishers, association
        memberships and other sources.Weregularly
        analyze and updateourdatabase
        and other available information
        to keep data current andtoenhance
        customer response
        and order rates.
 
 
 Products
        and Merchandising
 
 We
        offer
        customers access to more than 150,000 hardware, software, peripheral and
        accessory products and services, for users of Windows-based and Mac computers,
        from over 2,000 manufacturers through our catalogs, Internet site and sales
        force.
 
 Computers
        and Servers. We
        offer a large selection of desktop, laptop and tablet PC systems and servers
        from leading manufacturers, such as Acer, Apple, Gateway, Hewlett-Packard,
        Intel, Fujitsu, IBM, Lenovo, Panasonic, Sony and Toshiba.
 
 Peripherals
        and Accessories.
        We carry a full line of peripheral products, such as printers, monitors,
        keyboards, handhelds (PDAs), memory, storage devices, projectors, scanners
        and
        digital cameras, as well as various accessories and printing supplies, such
        as
        toner cartridges, storage media and cables. Brands offered include APC, Apple,
        Belkin, Canon, Edge, Epson, Hewlett-Packard, InFocus, Kingston, Kodak, Fuji,
        Lexmark, Logitech, LG, NEC, Nikon, Okidata, palmOne, Planar, Panasonic, Samsung,
        Sony, Targus, Toshiba, ViewSonic, and Xerox.
 
 Networking
        and
        Storage.  We provide networking and network storage products,
        such as switches, hubs, routers, modems, cabling, firewalls, Voice over IP
        (VOIP), wireless devices, tape and disk backup, and SAN and NAS
        solutions.  Brands offered include 3Com, Apple, Avaya, Avocent,
        Belkin, Cisco, D-Link, EMC, Emulex, Hewlett-Packard, Hitachi Data Systems,
        IBM,  Intel,  Iomega, La Cie, Linksys, Netgear, Nortel
        Networks, Overland Storage, QLogic, Polycom, Quantum, Seagate, SonicWALL,
        Sony,
        Tandberg Data (Exabyte), and Western Digital, among others.
 
 Software.
        We sell a wide
        variety of packaged software and licensing programs in business, personal
        productivity, connectivity, utility, language, educational, entertainment
        and
        other categories. We offer products from larger, well-known manufacturers,
        as
        well as numerous specialty products from new and emerging software development
        companies. Brands offered include Adobe, Citrix, Computer Associates, Corel,
        IBM, Microsoft, Novell, Symantec, Quark and VMware, among
        others.
 
 We
        are a
        Microsoft Certified Large Account Reseller, and, as such, can offer our large
        customers multiple methods of purchasing Microsoft software.  This
        enables us to sell Select and Enterprise Agreement contracts designed for
        medium- to large-sized commercial and academic customers.
 
 Our
        category merchandising group determines the manufacturers’ products that will be
        featured in our Internet, catalog and internal ERP offerings and negotiates
        the
        terms and conditions of product coverage.  The merchandising
        department reviews product availability and determines stocking strategy,
        as
        well as reviews its managed stock keeping units (“SKU”), so that we are offering
        differentiating programs and competitive pricing.  Each managed SKU
        also has component and add-on information to assist the AE in the selling
        process.  Our merchants have aligned their processes, pricing,
        stocking strategies, marketing programs, quotas, communication methodology
        and
        training to the priorities set by each sales department.  The
        merchandising group negotiates with manufacturers and distributors to provide
        us
        with incentives in the form of rebates, discounts and trade
        allowances.
  7
 Table
            of Contents
 
 Purchasing
 
 We
        utilize our purchasing and inventory management capabilities to support our
        primary business objective of providing name-brand products at competitive
        prices.  Our purchasing team works to develop and maintain
        relationships with a broad base of reliable, high-quality
        suppliers.  The team works to obtain the lowest overall acquisition
        cost in an effort to enable us to provide competitive pricing to our customers
        while achieving acceptable margins.
 
 We
        acquire products directly from manufacturers such as Apple, Hewlett-Packard,
        IBM
        and Lenovo, as well as through distributors such as Ingram Micro, Synnex
        and
        Tech Data, among others.  In 2006, we purchased approximately 55.9% of
        our merchandise from distributors, a decrease from 62.6% in 2005.  We
        believe that our overall sourcing strategy enables us to take advantage of
        significant special offers, discounts and supplier reimbursements, while
        also
        minimizing inventory costs.  We believe we have excellent
        relationships with our suppliers and we attempt to take advantage of all
        appropriate discounts.
 
 We
        utilize a blend of stocking and drop-ship procurement in executing our inventory
        management strategy.  We generally stock 20% of our total product
        offerings that represent up to 80% of total net sales.  The remaining
        products are provided to our customers primarily through virtual warehousing
        partnerships with key distributors and manufacturers.  Through these
        relationships, we are able to offer a broad selection of products and to
        provide
        prompt, cost-efficient fulfillment with minimal inventory
        exposure.  This virtual fulfillment model is facilitated through
        industry-standard EDI linkages with suppliers.  All associated
        transactions are managed through and integrated with our ERP system, which
        lowers administrative overhead.
 
 At
        December 31, 2006, we maintained an investment in inventory of $21.4 million,
        and our inventories turned an average of 24 times in 2006.  This
        compares to an investment in inventory of $19.7 million at December 31, 2005,
        and average inventory turns of 26 during 2005.  Our investment in
        inventory grew at December 31, 2006 due to on-hand customer-specific
        inventory.
 
 Order
        Fulfillment and Distribution
 
 We
        distribute products virtually through our EDI arrangement with our vendors,
        as
        well as through our warehouses in Bensenville, Illinois and Seattle,
        Washington.
 
 We
        provide and operate a full-service warehouse and distribution center in
        Bensenville, Illinois to support our nationwide customer base and a customized
        fulfillment center in Seattle, Washington to support our West Coast
        customers.  The warehouse personnel utilize our systems, policies and
        procedures to receive, record and warehouse inventory shipments from product
        suppliers, fill and ship customer orders, and return inventory to product
        suppliers when requested. We also use our warehouse facilities to house special
        buys, constrained product and other high-velocity product. The Bensenville,
        Illinois warehouse is responsible for the returned merchandise that will
        be
        returned to vendors, returned to general inventory, repaired or
        liquidated.  We offer limited return rights within 14 days on our
        product sales, and we maintained an allowance for sales returns, net of cost,
        as
        of December 31, 2006 and 2005 of $101,000 and $108,000, respectively. Our
        returns as a percentage of gross sales decreased slightly to 2.1% in 2006
        compared to 2.2% in 2005.  Product returns are closely monitored to
        identify trends in product offerings, to enhance customer satisfaction and
        to
        reduce overall returns.
 
 Orders
        received are electronically transmitted on a dedicated data line to our
        distribution centers, where a packing slip is printed out for order fulfillment,
        and inventory availability is then automatically updated on all of our
        information systems. All inventory items are barcoded and located in designated
        areas that are easily identified on the packing slip. All items are checked
        with
        bar code scanners prior to final packing, which helps to ensure that orders
        are
        filled correctly. Orders accepted for items in stock by 8:00 p.m. Eastern
        Timecan generally be
        delivered overnight. Upon request, orders may also be shipped for Saturday
        delivery, by ground service or by other overnight delivery
        services.
  8
 Table
            of Contents
 
 Technical
        Support and Customer Service
 
 We
        maintain a staff of dedicated technical support personnel who provide pre-
        and
        post-sale technical support, both for our AEs and customers.  In addition
        to a broad base of A+ certifications, the team also maintains a number of
        distinguished manufacturer certifications, including Cisco CCNA/CCDA, VMware
        VCP, Microsoft MCSE/MCSA, APC Gold, IBM CDAT, EXAct and nSeries, HP Server
        and
        SAN architect (MASE), Symantec Enterprise Vault & Data Protection and many
        other hardware-specific technical certifications.
 
 Pre-sales
        support is utilized primarily by our AEs to assist in optimizing product
        recommendations, assessing compatibility and other technical requirements,
        providing technical consulting and design services, and offering configuration
        and custom imaging support services.  Post-sales support is provided
        primarily to assist customers with their technical questions concerning the
        installation and operation of the products they purchase.
 
 We
        also
        employ a staff of dedicated customer service representatives who respond
        to and
        facilitate inquiries regarding order status and related matters, shipment
        tracking, billing issues and return requests.  These services are
        provided via toll-free telephone support, as well as online tools that allow
        customers to self-serve routine inquiries.  We believe these
        comprehensive support options improve the quality of our recommended technology
        solutions, reduce product returns, increase customer satisfaction and encourage
        repeat business.
 
 Systems
 
 We
        have
        committed  significant resources to the development of sophisticated
        management information, telecommunication, catalog production and other systems,
        which are employed in virtually all aspects of our business, including
        marketing, purchasing, inventory management, order processing, product
        distribution, accounts receivable, customer service and general accounting
        functions.  During 2006, we continued to develop and enhance our sales
        interface for order entry. Our graphical user interface ties all of the core
        systems together to give AEs a common view of customers, products, inventory
        and
        orders, and to streamline order processing as well as to reduce the training
        time for new AEs.  We are continually examining technological advances
        to increase the productivity of our team members.
 
 Team
        Members
 
 At
        December 31, 2006, we had 661 team members: 342 in the sales force, 38 in
        its
        warehousing and distribution, and 281 team members in administrative overhead
        departments. We consider our employee relations to be good.  We also
        have 37 people under outsourced contract in India performing various back-office
        and IT functions in support of our United States operations.  We have
        never had a work stoppage and do not believe that any team members are
        represented by a labor organization.  We emphasize the recruiting and
        training of high-quality personnel and strive to promote to positions of
        increased responsibility from within.
 
 Sales
        Team Education
 We
        provide a balanced training program consisting of classroom and practical
        on-the-job learning within an outbound sales environment.  Our New
        Hire Development takes an integrated approach in developing the new hires’
skills for acquiring and developing customers using a relationship-building
        sales methodology.  AEs learn to utilize various internal and external
        systems and receive hardware and software product education.
 
 Mission
&
        Values
 We
        are
        dedicated to creating a learning organization of empowered individuals to
        serve
        our customers with integrity, commitment and passion.  We strive to
        achieve this by creating a positive and collaborative workplace environment,
        delivering high-speed and quality service to our customers, and adapting
        to
        external changes with flexibility, innovation and leading-edge
        technology.
 
 Seasonality
 
 Sales
        to
        our commercial business customers have not historically experienced significant
        seasonality throughout the year. By contrast, sales to the public sector
        market
        are historically higher in the third quarter than in other quarters due to
        the
        buying patterns of federal government and education customers. If sales to
        public sector customers increase as a percentage of overall sales, we as
        a whole
        may experience increased seasonality in future periods.
  9
 Table
            of Contents
  Trademarks
 
 We
        conduct our business in the United States primarily under the service mark
        Zones® which is registered with the United States Patent and Trademark Office.
        We believe that these and any of our other marks have significant value and
        are
        an important factor in the marketing of our products.
 
 Regulatory
        and Legal Matters
 
 In
        addition to federal, state and local laws applicable to all corporations
        and
        employers in general, the direct marketing business is subject to the Federal
        Trade Commission’s Merchandise Mail Order Rule and related regulations. We are
        also subject to laws and regulations relating to truth-in-advertising, Anti-Spam
        and other fair trade and privacy practices. We have implemented programs
        and
        systems to promote ongoing compliance with these laws and
        regulations.
 
 Available
        Information
 
 We
        make
        available free of charge on our website, at www.zones.com/IR, our annual
        report
        on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K,
        and
        amendments to those reports filed or furnished pursuant to Section 13(a)
        or
        15(d) of the Exchange Act, as soon as reasonably practicable after
        electronically filing or furnishing such material to the Securities and Exchange
        Commission (“SEC”).
 
 Additionally,
        all materials that we file with the SEC can be viewed and copied at the SEC’s
        Public Reference Room at 450 Fifth Street NW, Washington, DC 20549, or via
        the
        SEC’s website at www.sec.gov.  Information on the operation of the
        Public Reference Room can be obtained by calling 1-800-SEC-0330.
  Our
        Audit
        Committee Charter, Compensation Committee Charter and Nominating and Governance
        Committee Charter are also available on our website or upon written or verbal
        request. Requests for copies of any of these documents should be directed
        in
        writing to Zones, Inc. Investor Relations, 1102 15th
        Street
        SW, Suite 102, Auburn, WA 98001-6509.
 
 Item1A.   
Risk
        Factors
 
 There
        are
        a number of important factors that could cause our actual results to differ
        materially from historical results or those indicated by any forward-looking
        statements, including the risk factors identified below and other factors
        of
        which we may or may not yet be aware.
 
 Our
        operating results are difficult to predict and may adversely affect our stock
        price.
 Our
        operating results are difficult to forecast, and there are a number of factors
        outside of our control, including:
 ·
              purchasing
                  cycles of commercial and public sector customers;
 ·
              the
                  level of corporate investment in new IT-related capital equipment;
 ·
              more
                  manufacturers going direct;
 ·
              industry
                  announcements of new products or upgrades;
 ·
              industry
                  consolidation;
 ·
              cost
                  of compliance with new legal and regulatory requirements;
 ·
              general
                  economic conditions; and
 ·
              variability
                  of vendor programs.
 Based
        on
        those and other risks, there can be no assurance that we will be able to
        maintain the profitability we have experienced going forward.
 
 We
        experience variability in our net
        sales and net income on a quarterly basis.
 There
        is
        no assurance that we will sustain our current sales or income
        levels.  Sales and income may decline for any number of reasons,
        including:
 ·
              a
                  decline in corporate profits leading to a change in corporate investment
                  in IT-related equipment;
 ·
              increased
                  competition;
 ·
              more
                  manufacturers going direct;
 ·
              changes
                  in customers’ buying habits;
 ·
              the
                  loss of significant customers;
 ·
              changes
                  in the selection of products available for resale; or
 ·
              general
                  economic conditions.
  10
 Table
            of Contents
 
 A
        decline
        in sales levels could adversely affect our business, financial condition,
        cash
        flows or results of operations.
 
 Our
        narrow gross margins magnify the impact of variations in our operating
        costs.
 There
        is
        intense price competition and pressure on profit margins in the computer
        products industry.  A number of manufacturers are also providing their
        products direct to customers.  Various other factors also may create
        downward pressure on our gross margins, such as the quarter-to-quarter
        variability in vendor programs and an increasing proportion of sales to
        enterprise, public sector or other competitive bid accounts on which margins
        could be lower.  If we are unable to maintain or improve gross margins
        in the future, this could have an adverse effect on our business, financial
        condition, or results of operations.
  Our
        increased investments in our hiring, retaining and productivity of our sales
        force may not improve our profitability or result in expanded market
        share.
 We
        ended
        2006 with 342 account executives compared to 250 in 2005.  We expect
        to continue to increase account executive headcount, but at a lower rate
        of
        growth due to corporate initiatives to lower turnover thus reducing hiring
        requirements in 2007. However, there are no assurances that we will be able
        to
        hire to our expected levels, or recruit the quality individuals that we hope
        to
        hire, or that the individuals hired will remain employed for an extended
        period
        of time, or that we will not lose existing account executives.  The
        productivity of account executives has historically been closely correlated
        with
        tenure.  Even if we do retain our account executives, there are no
        assurances that they will become productive at historical
        levels.  Additionally, there are no assurances that the locations of
        our call centers will continue to attract qualified account executives, or
        that
        we will be able to remotely manage and retain the new account
        executives.
 
 Certain
        of our key vendors provide us
        with incentives and other assistance, and any future decline in these incentives
        and other assistance could materially harm our profit margins and operating
        results.
 We
        have a
        variety of relationships with our vendors that in the past have contributed
        significantly to profit margins.  For example, certain product
        manufacturers and distributors provide us with incentives in the form of
        rebates, volume incentive rebates, cash discounts and trade
        allowances.  Our current vendor programs continue to be refined and
        there are no assurances that we will attain the level of vendor support in
        the
        future that we have obtained in the past.  In addition, many of our
        vendors provide us with cooperative advertising funds, which reimburse us
        for
        expenses associated with specific forms of
        advertising.  Industry-wide, the trend has been for manufacturers,
        distributors and vendors to reduce these incentives and curtail these
        programs.  If these forms of vendor support decline, or if we are
        otherwise unable to take advantage of continuing vendor support programs,
        or if
        we fail to manage the complexity of these programs, our business, financial
        condition, cash flows or results of operations could be adversely
        affected.
  We
        are controlled by a principal stockholder.
 Firoz
        H.
        Lalji, our Chairman and Chief Executive Officer, beneficially owns 52.4%
        of the
        outstanding shares of Zones common stock, excluding shares that he may acquire
        upon exercise of stock options that he holds.  The voting power of
        these shares enables Mr. Lalji to significantly influence our affairs and
        the
        vote on corporate matters to be decided by our 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 our articles
        of
        incorporation or bylaws, which could adversely affect the trading price of
        our
        common stock.  We are also certified as a Minority Business Enterprise
        based on Mr. Lalji’s maintenance of voting control.  The certification
        allows us to compete for certain sales opportunities.  A decrease in
        Mr. Lalji’s level of voting power through the issuance of additional equity
        capital could have an adverse effect on our ability to retain certain customers
        or compete for certain sales opportunities.
  We
        may not be able to compete successfully against existing or future competitors,
        which include some of our largest vendors.
 The
        computer products
        industry is highly competitive. We compete with other national direct marketers,
        including CDW Corporation, Insight Enterprises, Inc. and PC Connection, Inc.
        We
        also compete with product manufacturers, such as Apple, Dell, Hewlett-Packard,
        IBM and Lenovo, which sell direct to end-users, in addition to competition
        with
        specialty computer retailers, computer and general merchandise superstores,
        and
        consumer electronic and office supply stores.  Many of our competitors
        compete principally on the basis of price and have lower costs.  We
        believe that competition may intensify in the future due to market conditions
        and consolidation.  In the future, we may face fewer, but larger or
        better-financed competitors.  Additional competition may also arise if
        other methods of distribution emerge in the future. There can be no assurance
        that we will be able to compete effectively with existing competitors or
        new
        competitors that may enter the market, or that our business, financial
        condition, cash flows or results of operations will not be adversely affected
        by
        intensified competition.
  11
 Table
            of Contents
  We
        are exposed to inventory obsolescence due to the rapid technological changes
        occurring in the personal computer industry.
 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, we may be required
        to
        carry significant inventory levels of certain products, which subject us
        to
        increased risk of inventory obsolescence. We participate 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 we will be able to
        avoid
        losses related to such products.  Within the industry, vendors are
        becoming increasingly restrictive in guaranteeing return
        privileges.  While we seek to reduce our inventory exposure through a
        variety of inventory control procedures and policies, there can be no assurance
        that we will be able to avoid losses related to obsolete inventory.
 
 We
        may not be able to maintain existing or build new vendor relationships, which
        may affect our ability to offer a broad selection of products at competitive
        prices and negatively impact our results of operations.
 We
        acquire products directly from manufacturers, such as Hewlett-Packard, IBM
        and
        Lenovo, as well as from distributors such as Ingram Micro, Synnex, Tech Data
        and
        others.  Certain hardware manufacturers limit the number of product
        units available to DMRs.  Substantially, all of our contracts and
        arrangements with vendors are terminable without notice or upon short notice.
        If
        we do not maintain our existing relationships or build new relationships
        with
        vendors on acceptable terms, including favorable product pricing and vendor
        consideration, we may not be able to offer a broad selection of products
        or
        continue to offer products at competitive prices. Termination, interruption
        or
        contraction of our relationships with our vendors could have a material adverse
        effect on our business, financial condition, cash flows or results of
        operations.
 
 If
        we fail to achieve and maintain adequate internal controls, we may not be
        able
        to produce reliable financial reports in a timely manner or prevent financial
        fraud.
 We
        will
        continue to document and test our internal control procedures on an ongoing
        basis in order to satisfy the requirements of Section 404 of the
        Sarbanes-Oxley Act of 2002, which requires annual management assessments
        of the
        effectiveness of internal controls over financial reporting and a report
        by an
        independent registered public accounting firm addressing such assessments
        if
        applicable. During the course of our testing we may from time to time identify
        deficiencies which we may not be able to remediate. In addition, if we fail
        to
        achieve or maintain the adequacy of our internal controls, as such standards
        are
        modified, supplemented or amended from time to time, we may not be able to
        ensure that we can conclude on an ongoing basis that we have effective internal
        controls over financial reporting in accordance with Section 404 of the
        Sarbanes-Oxley Act of 2002. Effective internal controls, particularly those
        related to revenue recognition, are necessary for us to produce reliable
        financial reports and are important in helping prevent financial fraud. If
        we
        cannot provide reliable financial reports on a timely basis or prevent financial
        fraud, our business and operating results could be harmed, investors could
        lose
        confidence in our reported financial information, and the trading price of
        our
        stock could drop significantly.
  We
        face many uncertainties relating to the collection of state sales and use
        tax.
 We
        collect and remit sales and use taxes in states in which we have voluntarily
        registered and/or have 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 DMRs.  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. We cannot predict the level of contact,
        including electronic commerce and Internet activity, which 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 us to collect
        sales taxes or similar taxes on sales in states in which we have no presence
        and
        could potentially subject us to a liability for prior year sales, either
        of
        which could have a material adverse effect on our business, financial condition,
        and results of operations.
 
 We
        rely on our distribution centers and certain distributors to meet the product
        needs of our customers.
 We
        operate warehouse and distribution centers in Bensenville, Illinois and in
        Seattle, Washington.  There are no assurances that our warehouse
        locations will best support our customer base.  Additionally, certain
        distributors also participate in our logistics operations through electronic
        data interchange.  Failure to develop and maintain relationships with
        these and other vendors would limit our ability to obtain sufficient quantities
        of merchandise on acceptable commercial terms and could have a material adverse
        effect on our business, financial condition, cash flows or results of
        operations.
  12
 Table
            of Contents
  We
        are heavily dependent on commercial delivery services.
 We
        generally ship our products to customers by DHL, Eagle, FedEx, United Parcel
        Service and other commercial delivery services and invoice customers for
        delivery charges. If we are unable to pass on to our customers future increases
        in the cost of commercial delivery services, our profitability could be
        adversely affected. Additionally, strikes or other service interruptions
        by such
        shippers could adversely affect our ability to deliver products on a timely
        basis.
 
 We
        may not be able to attract and retain key personnel.
 Our
        future success will depend to a significant extent upon our ability to attract,
        train and retain skilled personnel.  Although our success will depend
        on personnel in all areas of our business, there are certain individuals
        that
        play key roles within the organization.  Loss of any of these
        individuals could have an adverse effect on our business, financial condition,
        cash flows or results of operations.
 
 We
        may be impacted by the loss of a major customer.
 From
        time
        to time we have customers that represent more than 10% of total sales. For
        the
        years ended December 31, 2006 and 2005, there were no customers that
        individually represented more than 10% of total net sales.  The
        concentration of credit risk associated with any major customer could have
        a
        material adverse effect on our business, financial condition, cash flows
        or
        results of operations.
  Our
        systems are vulnerable to natural disasters or other catastrophic
        events.
 Our
        operations are dependent on the reliability of 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 our information systems,
        Internet or telecommunication systems could have a material adverse effect
        on
        our business, financial condition, cash flows or results of
        operations.
 
 Privacy
        concerns with respect to list development and maintenance may materially
        adversely affect our business.
 If
        third
        parties or our team members are able to penetrate our network security or
        otherwise misappropriate our customers’ personal information or credit card
        information, we could be subject to liability.  We also mail catalogs
        and send electronic messages to names in our proprietary customer database
        and
        to potential customers whose names we obtain from rented or exchanged mailing
        lists. World-wide public concern regarding personal privacy has subjected
        the
        rental and use of customer mailing lists and other customer information to
        increased scrutiny. Any domestic or foreign legislation enacted limiting
        or
        prohibiting these practices could negatively affect our business.
  Our
        stock price may be volatile.
 There
        is
        relatively limited trading of our 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 our 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 our stock were to be delisted from the NASDAQ Global
        Market.  The NASDAQ Global Market imposes a requirement for continued
        listing that the value of shares publicly held, excluding those held by
        directors, officers and beneficial owners, exceed certain minimums.  A
        potential future delisting of our common stock could result in significantly
        reduced circulation of our common stock, more limited press coverage, reduced
        interest by investors in the common stock, adverse effects on the trading
        market, downward pressure on the price for and liquidity of our stock, and
        reduced ability to issue additional securities or to secure additional
        financing.
 
 Item2.       Properties
 
 We
        currently lease approximately 125,000 square feet of space for our corporate
        headquarters, including our telemarketing operations, in Auburn, Washington;
        approximately 27,000 square feet of space for our fulfillment warehouse facility
        in Seattle, Washington; approximately 70,000 square feet of space for our
        logistics warehouse in Bensenville, Illinois; and approximately 23,000 and
        200
        square feet of space for telemarketing sales offices in Portland, Oregon
        and
        Kansas City, Missouri, respectively.
 
 Item3.       Legal
        Proceedings
 
 From
        time
        to time, we are a party to various legal proceedings, claims, disputes or
        litigation arising in the ordinary course of business.  We believe
        that the ultimate outcome of any current proceedings, individually or in
        the
        aggregate, will not have a material adverse effect on our business, financial
        condition, cash flows or results of operations.
  13
 Table
            of Contents
  Item4.       Submission
        of Matters to a
        Vote of Security Holders
 
 None.
 
 Item4A.    Executive
        Officers of the
        Registrant
 
 Firoz
        H. Lalji, age 60, has
        served as the Company’s Chief Executive Officer since May of 1998 and as
        Chairman of the Board since March of 1999. Mr. Lalji was co-founder and has
        served as a director of the Company since March 1990.  Mr. Lalji is
        also President and Chief Executive Officer of Fana Capital Corporation, an
        investment holding company.   From 1981 to 1997, he was President
        and Chief Executive Officer of Kits Cameras, Inc., which operated more than
        140
        camera specialty stores in eight western states.
 
 Christina
        Corley, age 39, was appointed
        President and COO
        of Zones,Inc. in October 2006.  She
        had previously held the positions of Executive Vice President for Zones,
        Inc.
        from April 2005 to October 2006, and served as President of Corporate PC
        Source
        (“CPCS”), a wholly owned subsidiary of the Company, from March 2003 to April
        2005.  Prior to the acquisition of CPCS by the Company, Ms. Corley was
        Chief Executive Officer and President of CPCS from 1999 to 2003. From 1996
        to
        1999, Ms. Corley served as Vice Presidentof Sales and Marketing
        for VisionTek
        Corporation.  From 1994 to 1996, Ms. Corley served as
        the General Manager
        for the Midwest Division of Dataflex Corporation.
 
 Ronald
        P. McFadden, age 50,
        has served as Senior Vice President and Chief Financial Officer of Zones,
        Inc.
        since May 2000. Prior to this position, Mr. McFadden was the Company’s Vice
        President of Finance and Administration since May 1999. He joined the Company
        in
        June 1998, initially serving as Vice President of International Operations.
        From
        1991 to 1998, Mr. McFadden was Chief Financial Officer for Kits Cameras,
        Inc.
        Between 1984 and 1991 he served as Vice President of Finance for Interpace
        Industries.
 
 P.
        Sean Hobday, age 37, was
        appointed Executive Vice President Sales for Zones, Inc. in February
        2005.  Prior to this, Mr. Hobday served as President of Zones
        Corporate Solutions, a wholly owned subsidiary of the Company, since September
        2003.  Prior to that, Mr. Hobday was Vice President of Enterprise
        Sales for the Company since September 2001. From March 2000 to September
        2001,
        Mr. Hobday served as Director of Client Development for the
        Company.  From February 1999 to March 2000, Mr. Hobday served as
        Account Executive for the Company.  From 1996 to 1998, Mr. Hobday
        served as Managing Director of Blue Ice Leisure in Sydney, Australia, an
        Austral-Asian division of First Team Sports.
 
 Tom
        Ducatelli, age 41, joined
        Zones,Inc.in
        October 2006 as the Executive Vice
        President Business Development.  Previously, Ducatelli served as
        Senior Vice President of U.S. Sales at Tech Data Corporation, a $20 billion
        multi-national distributor of IT products. Prior to that, he served as senior
        Vice President of Sales and Business Development for Dallas-based CompuCom
        Systems,Inc.,
        a $1.7 billion IT reseller and
        solution provider he joined in 1994. Prior to CompuCom, Ducatelli spent six
        years as a national sales executive with mid-range computer manufacturer
        Digital
        Equipment Corp.
 
 Anwar
        Jiwani, age 52, has
        served as Senior Vice President and Chief Information Officer since April
        1999.  Prior to this Mr. Jiwani served for 23 years with The Royal
        Bank of Canada.
 
 
 PartII
 
 Item5.       Market
        for Registrant’s
        Common Equity, Related Shareholder Matters and Issuer Purchases of Equity
        Securities
 
 The
        Company’s Common Stock is quoted on the NASDAQ Global Market under the symbol
        ZONS.  The following table sets forth the range of high and low sales
        prices for the Common Stock as reported by the NASDAQ National
        Market.
 
 Year
                    ended December 31,2006
              
              
              2005High
              
              
              Low
              
              
              High
              
              
              LowFirst
                  quarter
              
              $
              7.73
              
              
              $
              4.90
              
              
              $
              6.55
              
              
              $
              3.18Second
                  quarter
              
              
              7.70
              
              
              
              5.86
              
              
              
              4.15
              
              
              
              2.90Third
                  quarter
              
              
              10.83
              
              
              
              6.08
              
              
              
              4.48
              
              
              
              3.70Fourth
                  quarter
              
              
              14.44
              
              
              
              7.17
              
              
              
              5.50
              
              
              
              4.03
  14
 Table
            of Contents
  As
        of
        March 9, 2007, the Company had approximately 4,000 beneficial holders of
        record
        of its Common Stock.  The Company has never paid, and has no present
        plans to pay, a cash dividend on its Common Stock.  The Company
        intends to retain its earnings to finance the expansion of its
        business.
 
 Securities
        authorized for issuance under equity compensation plans are incorporated
        by
        reference from the Proxy Statement for the Company’s 2007 Annual Meeting of
        Shareholders under the caption “Equity Compensation Plan
        Information.”
 
 Since
        2004, the Company has repurchased a total of 1,441,240 shares of its common
        stock at a total cost of $7.2 million under its repurchase program
        authorized by its Board of Directors.  Share repurchases may be made
        from time to time in both open market and private transactions, as conditions
        warrant, at then prevailing market prices. The following table presents share
        repurchases for the years ended December 31, 2006, 2005 and 2004 (dollars
        in thousands):
 
 
 Year
              
              Total
                    number
                  of
                    shares
                  purchased
              
              
              Amount
                    paid2006
              
              
              568,400
              
              
              $
              3,9882005
              
              
              424,450
              
              
              $
              1,8132004
              
              
              448,390
              
              
              $
              1,348
 
  As
        of
        December 31, 2006, $979,000 in shares of the Company’s common stock
        remained available for repurchase under the program.  In February
        2007, the Board of Directors authorized a continuation of the Company’s share
        repurchase program, pursuant to which the Company increased the total amount
        authorized.  As of February 2007, $3.0 million in shares of the
        Company’s common stock is available for repurchase under the program. The
        current repurchase program is expected to remain in effect through
        February 2008, unless earlier terminated by the Board or
        completed.
  
 Item6.       Selected
        Financial
        Data
 
 The
        following table sets forth the selected historical consolidated income and
        balance sheet data of Zones, Inc. and its subsidiaries.  The balance
        sheet data at December 31, 2006 and 2005 and the statement of operations
        data
        for the years ended December 31, 2006, 2005 and 2004 have been derived from
        the
        audited consolidated financial statements and notes thereto included in this
        Annual Report on Form 10-K/A.  The balance sheet data for the years
        ended December 31, 2004, 2003 and 2002 and the statement of operations data
        for
        the years ended December 31, 2003 and 2002 have been derived from audited
        consolidated financial statements and notes thereto not included in this
        Annual
        Report on Form 10-K/A.
  15
 Table
            of Contents
  This
        information should be read in conjunction with the consolidated financial
        statements and notes thereto included in Item 8 and Item 7 “Management’s
        Discussion and Analysis of Financial Condition and Results of
        Operations.”
  Year
                    ended December 31,2006
                
                
                2005
                
                
                2004
                
                
                
                2003
                2
                
                2002(In
                    thousands, except per share data and operating data)Statement
                    of Operations Data:Net
                    sales
                
                $
                577,027
                
                
                $
                566,553
                
                
                $
                495,563
                
                
                $
                460,772
                
                
                $
                414,643Cost
                    of sales
                
                
                505,508
                
                
                
                505,997
                
                
                
                438,426
                
                
                
                410,078
                
                
                
                371,725Gross
                    profit
                
                
                71,519
                
                
                
                60,556
                
                
                
                57,137
                
                
                
                50,694
                
                
                
                42,918Selling,
                    general and administrative expenses
                
                
                48,434
                
                
                
                43,618
                
                
                
                42,284
                
                
                
                43,252
                
                
                
                40,294Advertising
                    expense
                
                
                7,159
                
                
                
                6,618
                
                
                
                7,082
                
                
                
                6,597
                
                
                
                1,354State
                    tax (benefit) expense1,3
                
                
                
                
                
                
                
                
                
                
                
                
                
                
                (2,103
                )
                
                
                2,145Income
                    (loss) from operations
                
                
                15,926
                
                
                
                10,320
                
                
                
                7,771
                
                
                
                2,948
                
                
                
                (875
                )Other
                    (income) expense, net
                
                
                270
                
                
                
                503
                
                
                
                314
                
                
                
                379
                
                
                
                (58
                )Income
                    (loss) before income taxes
                
                
                15,656
                
                
                
                9,817
                
                
                
                7,457
                
                
                
                2,569
                
                
                
                (817
                )Provision
                    (benefit) from income taxes
                
                
                5,971
                
                
                
                3,766
                
                
                
                2,805
                
                
                
                1,001
                
                
                
                (302
                )Net
                    income (loss)
                
                $
                9,685
                
                
                $
                6,051
                
                
                $
                4,652
                
                
                $
                1,568
                
                
                $
                (515
                )Basic
                    income (loss) per share
                
                $
                0.73
                
                
                $
                0.45
                
                
                $
                0.34
                
                
                $
                0.11
                
                
                $
                (0.04
                )Weighted
                    average shares used in computation of basic income (loss) per
                    share
                
                
                13,195
                
                
                
                13,382
                
                
                
                13,549
                
                
                
                13,644
                
                
                
                13,587Diluted
                    income (loss) per share
                
                $
                0.66
                
                
                $
                0.42
                
                
                $
                0.32
                
                
                $
                0.11
                
                
                $
                (0.04
                )Weighted
                    average shares used in computation of diluted income (loss) per
                    share
                
                
                14,756
                
                
                
                14,527
                
                
                
                14,469
                
                
                
                13,739
                
                
                
                13,587Balance
                    Sheet Data:Working
                    capital
                
                $
                41,675
                
                
                $
                33,398
                
                
                $
                27,024
                
                
                $
                20,884
                
                
                $
                20,587Total
                    assets
                
                
                120,695
                
                
                
                117,354
                
                
                
                102,144
                
                
                
                92,885
                
                
                
                79,952Interest
                    bearing short-term debt
                
                
                
                
                
                
                11,972
                
                
                
                7,372
                
                
                
                8,683
                
                
                
                226Long-term
                    debt, net of current portion
                
                
                6
                
                
                
                21
                
                
                
                1,307
                
                
                
                1,667Total
                    shareholders’ equity
                
                $
                49,482
                
                
                $
                41,317
                
                
                $
                36,551
                
                
                $
                32,701
                
                
                $
                31,097Selected
                    Operating Data (unaudited):Number
                    of shipments
                
                
                406,475
                
                
                
                398,437
                
                
                
                421,836
                
                
                
                473,098
                
                
                
                506,877Average
                    order size 4
                
                $
                1,451
                
                
                $
                1,455
                
                
                $
                1,195
                
                
                $
                982
                
                
                $
                821Sales
                    force, end of period
                
                
                342
                
                
                
                250
                
                
                
                281
                
                
                
                234
                
                
                
                239
 1During
        the fourth quarter of 2003, the
        Company reached final resolution and settled with the Washington State
        Department of Revenue regarding the tax years 1996 through 1999.  The
        Company recorded a benefit for this resolution of $2.1
        million.
 2On
        March 31, 2003, the Company acquired
        Corporate PC Source, Inc. pursuant to a Stock Purchase
        Agreement.  Corporate PC Source’s results of operations are included
        in the Company’s consolidated financial statements for the periods after the
        date of acquisition.
 3During
        the fourth quarter of 2002, the
        Company received the final determination from the Washington State Department
        of
        Revenue regarding the tax years 1996 through 1999.  The Company
        recorded a charge for this determination of $2.1 million.
 4Average
        order size is calculated by dividing gross sales by the number of shipped
        orders.
 
  16
 Table
            of Contents
  Item7.       Management’s
        Discussion and
        Analysis of Financial Condition and Results of Operations
 
 This
        section contains forward-looking statements based on management’s current
        expectations, estimates and projections about the industry in which the Company
        operates, management’s beliefs, and certain assumptions made by management.
        These statements are made pursuant to the safe harbor provision of the Private
        Securities Litigation Reform Act of 1995.All
        statements, trends, analyses and other information contained in this report
        relative to trends in net sales, gross margin and anticipated expense levels,
        as
        well as other statements, including words such as “anticipate,” “believe,”
“plan,” “expect,” “estimate,” “intend.” and other similar expressions,
        constitute forward-looking statements. These forward-looking statements involve
        risks and uncertainties, and actual results may differ materially from those
        anticipated or expressed in such statements. Potential risks and uncertainties
        include, among others, those set forth in Item 1A of this Annual Report.
        Particular attention should be paid to the cautionary statements involving
        future growth; account executive hiring and productivity; increased expenses
        of
        being a public company; pressure on margin; competition; state tax
        uncertainties; rapid technological change and inventory obsolescence; reliance
        on vendor relationships; dependence on personnel; potential disruption of
        business from information systems failure; reliance on outsourced distribution;
        variations in gross profit margin percentages due to vendor programs and
        credits, product and customer mix, pricing strategies, and economic
        conditions.  Except as required by law, the Company undertakes no
        obligation to update any forward-looking statement, whether as a result of
        new
        information, future events or otherwise.
 
 The
        consolidated statements of cash flows for the years ended December 31, 2006
        and
        2005 have been restated to correct the classification of cash flows related
        to
        inventory financing.   The Company had previously considered cash
        flows from inventory financing as operating activities. However, based upon
        discussions with the staff of the SEC following a periodic review of the
        Company
        Form 10-K for the year ended December 31, 2006, the Company has now determined
        that cash flows from inventory financing should be reclassified to cash flows
        from financing activities.  This restatement does not have any impact
        on the Company’s previously reported overall net change in cash and cash
        equivalents in its consolidated statements of cash flows for any period
        presented.   This restatement also has no impact on net income or
        net income per share in the previously reported consolidated statements of
        operations for the fiscal years ended December 31, 2006 and December 31,
        2005,
        nor was there any effect on the previously reported consolidated balance
        sheets
        as of December 31, 2006 and December 31, 2005, or the previously reported
        consolidated statements of shareholders’ equity for the years ended December 31,
        2006 and December 31, 2005.  The consolidated statement of cash flows
        for the fiscal year ended December 31, 2004 has been revised to conform to
        this
        presentation.  See Note 15 to the consolidated financial statements
        for further information.
 
 The
        following discussion and analysis should be read in conjunction with the
        Company’s Selected Consolidated Financial and Operating Data and the
        Consolidated Financial Statements and Notes included in this Annual Report
        on
        Form 10-K/A.
 
 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 salaries including
        commissions, order processing, telephone and credit card fees, and other
        costs
        such as administrative salaries, stock compensation expense, 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. is a direct marketing reseller of technology hardware, software and
        services. The Company procures and fulfills IT solutions for the SMB market
        (between 50 and 1000 computer users), enterprise customers (greater than
        1000
        computer users) and the public sector (education and state and local
        governments). Relationships with SMB, enterprise customers, and public sector
        institutions represented 98.0%, 96.5% and 91.2% of total net sales during
        2006,
        2005 and 2004, respectively. The remaining sales were from inbound customers,
        primarily consumers and small office/home office accounts purchasing mostly
        Mac
        platform products.
 
 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 executed through outbound account executives,
        field sales representatives, 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.
  17
 Table
            of Contents
  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 more than 150,000 hardware, software, peripheral
        and
        accessory products and services for users of Windows-based and Mac platform
        computers from more than 2,000 manufacturers.
 
 The
        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, cooperative advertising reimbursements, advertising expenses,
        personnel costs, productivity per team member, accounts receivables aging,
        inventory aging, liquidity and cash resources.   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 December
        31,
        2006, the Company had 661 team members in its consolidated operations, 342
        of
        whom were 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 of America, and requires management to make use of certain
        estimates and assumptions that affect the reported amounts of assets and
        liabilities and disclosure of contingent assets and liabilities as of the
        date
        of the financial statements and the reported amounts of revenues and expenses
        during the reported periods. The Company bases its estimates on historical
        experience and on various other assumptions that are believed to be reasonable
        under the circumstances, the results of which form the basis for making
        judgments about carrying values of assets and liabilities that are not readily
        apparent from other sources. Actual results could differ from those estimates,
        and revisions to estimates are included in the results for the period in
        which
        the actual amounts become known.
 
 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 therefore 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.
 The
        Company recognizes revenue on product sales when persuasive evidence of an
        arrangement exists, delivery has occurred, prices are fixed or determinable,
        and
        ability to collect 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’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, when 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.
        The
        Company offers limited return rights on its product sales.  At the
        point of sale, the Company provides for an allowance for sales returns, which
        is
        established based on historical experience.  Amounts billed for
        shipping and handling are recorded as revenue.  Pursuant to EITF 99-19
“Reporting Revenue Gross as a Principal versus Net as an Agent,” when the
        Company sets prices, has inventory risk and has credit risk, revenues are
        recorded gross.  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 gross in revenues and
        cost of
        sales when the Company sets prices and has inventory risk and credit risk.
        If
        any of those criteria are not present, revenue and cost of sales are recorded
        net. The Company’s warranty sales are generally recorded net.  When
        the sale is recorded, the Company has no further obligation to
        fulfill.  The Company only recognizes revenue when all criteria of
        Staff Accounting Bulletin No. 104 (“SAB 104”), "Revenue Recognition" have been
        met.
  Additionally,
        the Company offers limited return rights within 14 days on its product sales.
        The Company has demonstrated the ability to make reasonable and reliable
        estimates of product returns 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, net of cost, of $101,000 and $108,000 at December 31,
        2006
        and 2005, respectively.
  18
 Table
            of Contents
  Valuation
        of Current Assets,
        Allowance for Doubtful Accounts 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. On an on-going basis, the Company evaluates its
        estimates.
 
 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 that 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, 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 considered future taxable
        income in
        assessing the need for a valuation allowance against its deferred tax assets.
        The Company believes that all net deferred tax assets shown on its balance
        sheet
        as of December 31, 2006, are more likely than not to be realized in the
        future and no valuation allowance is necessary. In the event that actual
        results
        differ from those estimates or that those estimates are adjusted in future
        periods, the Company may need to record a valuation allowance, which would
        reduce deferred tax assets and the results of operations in the period the
        change is made.
 
 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 31.  The Company completed the impairment review required by
        SFAS No. 142 on March 31, 2006 and determined that its goodwill was not
        impaired.  There have been no significant business changes since the
        last assessment.
 
 Results
        of Operations
 The
        following table sets forth, for the periods indicated, selected items from
        the
        Company’s Consolidated Statements of Operations expressed as a percentage of net
        sales.
 
 Year
                    ended December 31,2006
              
              
              2005
              
              
              2004Net
                  sales
              
              
              100.0
              %
              
              
              100.0
              %
              
              
              100.0
              %Cost
                  of sales
              
              
              87.6
              
              
              
              89.3
              
              
              
              88.5Gross
                  profit
              
              
              12.4
              
              
              
              10.7
              
              
              
              11.5SG&A
                    expenses
              
              
              8.4
              
              
              
              7.7
              
              
              
              8.5Advertising
                    expense
              
              
              1.2
              
              
              
              1.2
              
              
              
              1.4Income
                  from operations
              
              
              2.8
              
              
              
              1.8
              
              
              
              1.6Other
                  expense, net
              
              
              0.1
              
              
              
              0.1
              
              
              
              0.1Income
                  before income taxes
              
              
              2.7
              
              
              
              1.7
              
              
              
              1.5Provision
                  for income taxes
              
              
              1.0
              
              
              
              0.7
              
              
              
              0.6Net
                  income
              
              
              1.7
              %
              
              
              1.0
              %
              
              
              0.9
              %Product
                  Mix:Notebook
                  & PDAs
              
              
              12.4
              %
              
              
              15.3
              %
              
              
              14.7
              %Desktops
                  & Servers
              
              
              20.3
              
              
              
              20.1
              
              
              
              21.3Software
              
              
              17.7
              
              
              
              15.9
              
              
              
              16.8Storage
              
              
              9.1
              
              
              
              9.1
              
              
              
              8.7NetComm
              
              
              4.9
              
              
              
              4.2
              
              
              
              4.4Printers
              
              
              8.2
              
              
              
              11.3
              
              
              
              9.6Monitors
                  & Video
              
              
              10.4
              
              
              
              9.6
              
              
              
              10.3Memory
                  & Processors
              
              
              6.2
              
              
              
              5.4
              
              
              
              5.0Accessories
                  & Other
              
              
              10.8
              
              
              
              9.1
              
              
              
              9.2Total
              
              
              100.0
              %
              
              
              100.0
              %
              
              
              100.0
              %
  19
 Table
            of Contents
  Comparison
        of Years Ended December 31, 2006 and 2005
 
 Net
        Sales.Consolidated net sales increased 1.8% to $577.0 million
        in 2006 compared to $566.6 million in 2005.  Consolidated outbound
        sales to commercial and public sector accounts increased 3.4% to $565.3 million
        in 2006 from $547.0 million in 2005.  Sales to the Company’s SMB
        customers increased 18.1% to $222.1 million in 2006, compared to $188.2 million
        in 2005. The Company’s 2007 SMB growth initiatives will focus on small 50-to-100
        seat customers, as well as assisting AEs to reach their expected productivity
        levels as tenure increases.  Sales to the Company’s enterprise
        customers decreased 4.0% to $301.8 million for the year ended December 31,
        2006,
        compared to $314.5 million in 2005.  During 2005, one customer
        represented $48.5 million of enterprise net sales related to a specific one-time
        product roll-out during the second half of the year.  The Company’s
        2007 enterprise customer sales initiative includes the formation of a field
        sales force to supplement the outbound call center sales force.  Net
        sales to public sector customers decreased 5.9% to $39.2 million in 2006
        from
        $41.6 million in 2005.  Inbound sales to the Company’s legacy
        Mac-platform consumer and small office/home office (“SOHO”) customers declined
        37.3% to $14.0 million, or 2.4% of net sales.
 
 Gross
        Profit. Consolidated
        gross profit increased to $71.5 million in 2006 compared to $60.6 million
        in
        2005.  Gross profit as a percentage of net sales increased to 12.4% in
        2006, compared to 10.7% in 2005.  The change is due to an increase in
        the gross profit earned on total net sales as compared to 2005, and an increase
        in the amount of vendor programs recorded in 2006.  Gross profit
        margins as a percent of sales will continue to vary due to changes in vendor
        programs, product and customer mix, pricing strategies and economic conditions.
        The Company expects its gross profit margin to decline in 2007 from historical
        levels due to the Company’s field sales initiative and expected sales increases
        to existing large customers as large enterprise customers tend to record
        lower
        gross profit sales.  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 that of other companies that categorize warehousing
        and
        distribution network costs as a cost of sales.
 
 Selling,
        General and Administrative
        Expenses. SG&A expenses increased to $48.4 million for 2006 from
        $43.6 million in 2005, and increased as a percentage of net sales to 8.4%
        in
        2006, compared 7.7% in 2005. The increase in SG&A expenses was due to the
        following:
 
 ·
              Salaries,
                  wages and benefits increased $4.4 million during 2006 as compared
                  to the
                  prior year. The increase was primarily due to increased headcount.
                  The
                  Company focused on growing its sales account executive headcount,
                  particularly with the addition of its Portland, Oregon call center.
                  Also,
                  the Company recorded increased expenses associated with incentive
                  compensation programs and commissions paid as a result of the increased
                  sales volume and profitability, and stock compensation expense.
 ·
              The
                  Company’s state tax expense decreased $411,000 in 2006 as compared to the
                  prior year.  This primarily relates to decreased Business and
                  Occupation tax (an excise tax based on gross receipts) to the State
                  of
                  Washington.
 ·
              Facilities
                  expense increased $254,000 for the year ended December 31, 2006
                  due to the
                  additional rent expense associated with the Portland, Oregon call
                  center,
                  which was opened in the first quarter of 2006.
 ·
              The
                  Company’s professional fees increased $485,000 during
                  2006.  This is primarily due to an increase in consulting fees
                  associated with the Company’s outsourcing arrangement in India, as well as
                  recruiting fees associated with the additional sales account executive
                  headcount.
 ·
              Depreciation
                  expense declined $164,000 for the year ended December 31, 2006
                  as compared
                  to 2005. This decline was primarily due to more of the Company’s assets
                  becoming fully depreciated.
 
 For
        the
        periods ending December 31, 2006 and 2005, warehousing and distribution network
        costs totaled $2.1 million and $2.2 million, respectively.  With
        regard to 2007, the Company’s initiative to create a field sales force will
        increase the Company’s SG&A expenses and it is anticipated that the existing
        operations will subsidize this investment until it reaches breakeven by the
        end
        of the year.
  20
 Table
            of Contents
 
 Advertising
        Expenses,
        Net.  The Company produces and distributes catalogs at various
        intervals throughout the year, and also engages in other activities, to increase
        the awareness of its brand and stimulate demand response.  The
        Company’s net cost of advertising increased to $7.2 million in 2006 from $6.6
        million in 2005.
 ·
              Gross
                  advertising expense increased to $8.9 million for fiscal year 2006
                  compared to $7.0 million in fiscal year 2005. The increase was
                  primarily
                  due to expenses related to corporate and customer events.
 ·
              The
                  Company’s gross advertising reimbursements also increased to $1.7 million
                  in 2006 from $429,000 in 2005.  The Company’s advertising
                  expense increases were offset by the corresponding reimbursement
                  increase,
                  which was used to pay for incremental marketing activities.
 
 Interest
        Expense.Interest expense was $419,000 in 2006, compared to
        $594,000 in 2005.  The Company’s use of its line of credit to fund the
        expansion of accounts receivable and inventory incurred interest expense
        of
        $383,000 and $480,000 for the periods ended December 31, 2006 and 2005,
        respectively.  The interest rate on the working capital line is tied
        to the Prime Rate.  The effects of increases in the Prime Rate during
        2006 where offset by a reduction in the Company’s usage of the working capital
        line of credit compared to 2005.  The remaining expense was due to
        interest owed on the outstanding note payable to the former shareholders
        of
        CPCS, which was paid off in April 2006.
 
 Other
        Income.  Other income was $149,000 in 2006, compared to $91,000
        in 2005.
 
 Income
        Tax
        Provision.  The income tax provision for 2006 was $5.9 million,
        compared to $3.8 million during 2005.  The effective tax rates
        expressed as a percent of income were 38.1% and 38.4% for the years ended
        December 31, 2006 and 2005, respectively.
 
 Net
        Income. Net income for
        fiscal year 2006 was $9.7 million, or $0.66 per diluted share, as compared
        to
        net income of $6.1 million, or $0.42 per diluted share, for fiscal year
        2005.
 
 Comparison
        of Years Ended December 31, 2005 and 2004
 
 Net
        Sales.Consolidated net sales increased 14.3% to $566.6
        million in 2005 compared to $495.6 million in 2004.  The increase in
        sales resulted primarily from an increase in sales to its outbound customers.
        Consolidated outbound sales to commercial and public sector accounts increased
        21.1% to $547.0 million in 2005 from $451.7 million in 2004, and they now
        represent 96.5% of the Company’s total net sales.  Sales to the
        Company’s SMB customers increased 13.1% to $188.2 million in 2005, compared to
        $168.9 million in 2004.  Sales to the Company’s enterprise customers
        increased 29.3% to $314.5 million for the year ended December 31, 2005, compared
        to $243.2 million in 2004.  One customer represented $48.5 million of
        enterprise net sales related to a specific one-time product roll-out which
        occurred during the second half of 2005.  Net sales to public sector
        customers increased 4.9% to $41.6 million in 2005 from $39.7 million in
        2004.  Inbound sales to the Company’s legacy Mac-platform consumer and
        small office/home office (“SOHO”) customers declined 55.4% to $22.3 million, or
        3.9% of net sales.  This decline was anticipated as the Company’s
        focus is on outbound sales customers who respond to the relationship-based
        selling model.
 
 Gross
        Profit. Consolidated
        gross profit increased to $60.6 million in 2005 compared to $57.1 million
        in
        2004 primarily due to increased sales volume.  Gross profit as a
        percentage of net sales decreased to 10.7% in 2005, compared to 11.5% in
        2004,
        due primarily to strategic cost concessions to a customer in support of
        significant sales in the second half of 2005.  Gross profit margins as
        a percent of sales will continue to vary due to changes in vendor programs,
        product mix, pricing strategies, customer mix and economic conditions. 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 that of other companies that
        categorize warehousing and distribution network costs as a cost of
        sales.
 
 Selling,
        General and Administrative
        Expenses. SG&A expenses increased 3.2% to $43.6 million for 2005 from
        $42.3 million in 2004, and declined as a percentage of net sales to 7.7%
        in
        2005, compared to 8.5% in 2004.  The increase in SG&A expenses was
        impacted by the Company’s increase in sales volume, as well as the
        following:
 
 ·
              Salaries,
                  wages and benefits increased $1.0 million during 2005 as compared
                  to the
                  prior year. The increase was primarily due to increased incentive
                  programs
                  and commissions paid as a result of the increased sales volume.
  21
 Table
            of Contents
 
 ·
              The
                  Company’s state tax expense increased $437,000 in 2005 as compared to the
                  prior year.  This primarily relates to increased sales to
                  customers in Washington State, a state in which Business and Occupation
                  tax (an excise tax based on gross receipts) is remitted.
 ·
              The
                  Company’s professional fees increased $434,000 during
                  2005.  This is primarily due to an increase in consulting fees
                  associated with its outsourcing arrangement in India.
 ·
              Depreciation
                  expense declined $456,000 for the year ended December 31, 2005
                  as compared
                  to 2004. This decline was primarily due to the Company’s decision to make
                  enhancements to its fully depreciated enterprise systems rather
                  than
                  purchasing a new product.
 ·
              Credit
                  card processing fees during 2005 declined $257,000 as compared
                  to 2004.
                  This decline is due to the Company’s increase in outbound sales, which
                  tend to purchase on open account versus credit card.
 
 For
        the
        periods ending December 31, 2005 and 2004, warehousing and distribution network
        costs totaled $2.2 million and $1.9 million, respectively.
 
 Advertising
        Expenses,
        Net.  The Company produces and distributes catalogs at various
        intervals throughout the year, and also engages in other activities, to increase
        the awareness of its brand and stimulate demand response.  The
        Company’s net cost of advertising decreased to $6.6 million in 2005 from $7.1
        million in 2004.
 ·
              Gross
                  advertising expense decreased to $7.0 million for fiscal year 2005
                  compared to $7.6 million in fiscal year 2004. The decline was primarily
                  due to a reduction in circulation of the Company’s
                  catalogs.  During 2005, the Company produced and distributed 5.0
                  million catalogs, compared to 7.7 million in 2004.
 ·
              The
                  Company’s gross advertising reimbursements also decreased to $429,000 in
                  2005 from $564,000 in 2004.
 
 Interest
        Expense.Interest expense was $594,000 in 2005, compared to
        $404,000 in 2004.  The Company’s use of its line of credit to fund the
        expansion of accounts receivable and inventory incurred interest expense
        of
        $480,000 and $305,000 for the periods ended December 31, 2005 and 2004,
        respectively.  The interest rate on the working capital line is tied
        to the Prime Rate.  The Prime Rate increased to 7.0% at December 31,
        2005, compared to 5.0% at December 31, 2004.  The remaining expense
        was due to interest owed on the outstanding note payable to the former
        shareholders of CPCS.
 
 Other
        Income.  Other income was $91,000 in 2005, compared to $90,000
        in 2004.
 
 Income
        Tax
        Provision.  The income tax provision for 2005 was $3.8 million,
        compared to $2.8 million during 2004.  The effective tax rates
        expressed as a percent of income were 38.4% and 37.6% for the years ended
        December 31, 2005 and 2004, respectively.
 
 Net
        Income. Net income for
        fiscal year 2005 was $6.1 million, or $0.42 per diluted share, as compared
        to
        net income of $4.7 million, or $0.32 per diluted share, for fiscal year
        2004.
 
 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
 Working
        Capital.
 The
        Company’s total assets were $120.7 million at December 31, 2006, of which $111.4
        million were current assets.  At December 31, 2006 and 2005, the
        Company had cash and cash equivalents of $9.2 million and $3.2 million,
        respectively, and had working capital of $41.7 million and $33.4 million,
        respectively. The increase in working capital was primarily a result of the
        Company’s operating results which led to decreases in the Company’s usage of its
        line of credit, and the repayment of outstanding notes payable which reduced
        its
        current liabilities.
 
 Stock
        Repurchase Program.
 Since
        2004, the Company has repurchased a total of 1,441,240 shares of its common
        stock at a total cost of $7.2 million under its repurchase program
        authorized by its Board of Directors.  Share repurchases may be made
        from time to time in both open market and private transactions, as conditions
        warrant, at then prevailing market prices. The following table represents
        share
        repurchases for the years ended December 31, 2006, 2005 and 2004 (dollars
        in thousands):
 
 
 Period
              
              Total
                    number of
                  shares
                    purchased
              
              
              Amount
                    paid2006
              
              
              568,400
              
              
              $
              3,9882005
              
              
              424,450
              
              
              $
              1,8122004
              
              
              448,390
              
              
              $
              1,348
  22
 Table
            of Contents
  As
        of
        December 31, 2006, $979,000 in shares of the Company’s common stock
        remained available for repurchase under the program.  In February
        2007, the Board of Directors authorized a continuation of the Company’s share
        repurchase program, pursuant to which the Company increased the total amount
        authorized.  As of February 2007, $3.0 million in shares of the
        Company’s common stock is available for repurchase under the program. The
        current repurchase program is expected to remain in effect through
        February 2008, unless earlier terminated by the Board or
        completed.
  Approximately
        92% of the Company’s sales are processed on open account terms offered to its
        customers, which increases the Company’s accounts receivable
        balance.  To finance these sales, the Company leverages its secured
        line of credit for timing differences in cash inflows and cash outflows to
        invest in the growth of its business.  The secured line of credit is
        utilized from time to time to invest in capital purchases, to purchase inventory
        for general stock as well as for certain customers, and to take full advantage
        of available early pay discounts.
  At
        December 31, 2006, 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 it 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 under the flooring
        facility, 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 December 31, 2006, the Company was
        compliant with all covenants of this facility.  At December 31, 2006,
        there were no amounts owed for working capital advances, and $14.4 million
        was
        owed to this financial institution for flooring arrangements related to
        inventory purchases.
  The
        Company believes that its existing available cash and cash equivalents,
        operating cash flow, and existing credit facilities will be sufficient to
        satisfy its operating cash needs, and up to the remaining balance of $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 reduce or curtail
        its
        stock repurchase program and seek additional funds through sales of equity,
        debt
        or convertible securities, or through 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.
 
 Cash
        Flows.
 The
        primary factors that affected fiscal year 2006 cash flow from operations
        were
        account and vendor receivables, inventories, and the increase in accrued
        liabilities and deferred rent.  Account and vendor receivables
        decreased $4.8 million due to aggressive collection
        efforts.  Inventory increased by $1.6 million.  The change
        in the inventory balance is due to the Company’s purchasing
        cycles.  Accrued liabilities and deferred rent increased $4.3
        million.  This increase was primarily due to accrued incentive
        compensation.
 
 Net
        cash
        used in investing activities was $1.8 million for the year ended December
        31,
        2006.  Cash outlays for capital expenditures were $1.8 million for the
        years ended December 31, 2006 and 2005.  Capital expenditures were
        primarily for leasehold improvements for the Company’s corporate headquarters
        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
        most
        significant components of the Company’s financing activities are the
        purchase of the Company’s common stock under its share repurchase
        program, net change in the Company’s secured line of credit, net change in
        the use of inventory financing and net change in book overdraft.  For
        the year ended December 31, 2006, the Company repurchased $4.0 million of
        its
        common stock under its share repurchase program.  Net changes in the
        Company’s line of credit and book overdraft were a decrease of $10.7 million and
        $2.9 million, respectively.  The net change in the Company’s inventory
        financing was an increase of $5.9 million due to purchasing and payment
        cycles.  The Company’s financing activities for the year ended
        December 31, 2006 also included the payment of an amount due on the note
        payable
        issued in its acquisition of CPCS.  The Company paid the final payment
        during the second quarter of 2006.  For the years ended December 31,
        2006 and 2005, the Company paid the former shareholders of CPCS $1.3 million
        each year.
  23
 Table
            of Contents
  Contractual
        Obligations
 The
        following table summarizes our contractual payment obligations and commitments
        as of December 31, 2006:
 
 Payments
                  Due by PeriodTotal
              
              
              Less
                    than 1 year
              
              
              1-3
                    years
              
              
              3-5
                    years
              
              
              More
                    than 5 yearsOperating
                  Leases (a)
              
              $
              16,665
              
              
              $
              2,236
              
              
              $
              4,480
              
              
              $
              3,870
              
              
              $
              6,079Purchase
                  Obligations (b)
              
              
              9,508
              
              
              
              9,508Total
              
              $
              26,173
              
              
              $
              11,744
              
              
              $
              4,480
              
              
              $
              3,870
              
              
              $
              6,079
 
 
 (a)
              Represents
                  the Company’s commitments under operating leases associated with contracts
                  that expire at various times.  One of the commitments is the
                  Company’s Auburn, Washington headquarters, which is leased from a related
                  party.
 (b)
              Purchase
                  obligations represents the amount of open purchase orders the Company
                  has
                  outstanding with its vendors. These obligations may be canceled
                  prior to
                  shipment at the Company’s discretion.
 
 Other
        Matters
 New
        Accounting
        Pronouncements.
 In
        September 2006, the FASB issued SFAS No. 157 (SFAS 157), Fair Value Measurements. SFAS
        157 defines fair value, establishes a framework for measuring fair value
        and
        expands disclosures about fair-value measurements required under other
        accounting pronouncements, but does not change existing guidance as to whether
        or not an instrument is carried at fair value. SFAS 157 is effective for
        the
        Company’s fiscal year 2008. The Company is currently evaluating the impact of
        adopting SFAS 157.
 
 In
        September 2006, the SEC released Staff Accounting Bulletin 108 (SAB 108),
Considering the Effects
        of Prior
        Year Misstatements when Quantifying Misstatements in Current Year Financial
        Statements. The intent of
        SAB 108 is to reduce diversity in practice for the method companies use to
        quantify financial statement misstatements, including the effect of prior
        year
        uncorrected errors. SAB 108 establishes an approach that requires
        quantification of financial statement errors using both an income statement
        and
        a cumulative balance sheet approach. SAB 108 is effective for fiscal years
        beginning after November 15, 2006, and the Company will adopt the new
        requirements on January 1, 2007.The Company does not believe that the
        adoption of SAB 108 will have a significant effect on its financial
        statements.
 
 In
        July
        2006, the FASB issued FASB Interpretation No. 48 (FIN 48), Accounting for Uncertainty
        in Income
        Taxes: an Interpretation of FASB Statement No. 109, Accounting for
        Income
        Taxes.  FIN 48clarifies
        the
        accounting for uncertainty in income taxes recognized in a company’s financial
        statements and prescribes a recognition threshold and measurement attribute
        for
        the financial statement recognition and measurement of a tax position taken
        or
        expected to be taken in an income tax return. FIN 48 also provides guidance
        on
        derecognition, classification, interest and penalties, accounting in interim
        periods, disclosure and transition.  Only tax positions that meet the
        more-likely-than-not recognition threshold at the adoption date will be
        recognized or continue to be recognized. The cumulative effect of applying
        Interpretation 48 will be reported as an adjustment to retained earnings
        at the
        beginning of the period in which it is adopted.  FIN 48 will be
        adopted by the Company on January 1, 2007. The Company currentlydoes not believe
        that
        the adoption of Interpretation 48 will have a significant effect on its
        financial statements.
 
 In
        June
        2006, the FASB ratified the consensus reached on Emerging Issues Task Force
        (EITF) Issue No. 06-03, “How Sales Taxes Collected
        from
        Customers and Remitted to Governmental Authorities Should Be Presented in
        the
        Income Statement (that is, Gross Versus Net Presentation).”The EITF
        reached a consensus that the presentation of taxes on either a gross or net
        basis is an accounting policy decision that requires disclosure. EITF 06-03
        is
        effective for the first interim or annual reporting period beginning after
        December 15, 2006. Amounts collected from members, which under common trade
        practices are referred to as sales taxes, are and have been recorded on a
        net
        basis. The Company has no intention of modifying this accounting policy.
        Therefore, the adoption of EITF 06-03 will not have any effect on the Company’s
        financial statements.
 
 Item7A.   
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. The
        Company invests cash balances in excess of operating requirements in short-term
        securities, generally with maturities of 90 days or less. In addition, the
        Company's unsecured credit agreement provides for borrowings which bear interest
        at variable rates based on the prime rate. The Company had no interest-bearing
        borrowings outstanding pursuant to the credit agreement as of December 31,
        2006.
        The Company believes that the effect, if any, of reasonably possible near-term
        changes in interest rates on the Company's financial position, results of
        operations and cash flows should not be material.
  24
 Table
            of Contents
  Item8.       Financial
        Statements and
        Supplementary Data
 The
        information required by this item is included in this report beginning at
        page
        29.
 
 Item9.       Changes
        in and Disagreements
        with Accountants on Accounting and Financial Disclosure
 None.
 
 Item9A.   
Control
        and
        Procedures
 At
        the
        end of the period covered by this report, the Company carried out an evaluation,
        under the supervision and with the participation of the Company's management,
        including the Company’s Chief Executive Officer and Chief Financial Officer, of
        the Company’s disclosure controls and procedures pursuant to Exchange Act Rule
        13 a-15(e). Based upon that evaluation, the Chief Executive Officer and Chief
        Financial Officer concluded that the Company’s disclosure controls and
        procedures are effective.
 
 During
        the fourth quarter of 2006, there were no changes in the Company’s internal
        control over financial reporting that have materially affected, or are
        reasonable likely to materially affect, the Company’s internal control over
        financial reporting.
 
 Item9B.   
Other
        Information
 None.
 
 PartIII
 
 Item10.     Directors,
        Executive
        Officers and Corporate Governance
 The
        information required by this item is contained in, and incorporated by reference
        from, the Proxy Statement for the Company’s 2007 Annual Meeting of Shareholder
        under the caption “Proposal No. 1: Election of Directors,” and “Section 16(a)
        Beneficial Ownership Reporting Compliance.”  See also the information
        concerning executive officers of the Company included in Item 4A of Part
        I in
        this Report.
 
 The
        Board
        of Directors has determined that John Bauer qualifies as an “audit committee
        financial expert” as such term is defined by the SEC and that Mr. Bauer meets
        the independence criteria set forth in the applicable rules of Nasdaq and
        the
        SEC for Audit Committee Membership.
  The
        Company’s Code of Business Conduct and Ethics has been approved by its Board of
        Directors and applies to all of its team members and directors, including
        its
        principal executive officer, principal financial officer and principal
        accounting officer. The Company’s Code of Business Conduct and Ethics covers all
        areas of professional conduct including, but not limited to, conflicts of
        interest, disclosure obligations, insider trading, confidential information,
        as
        well as compliance with all laws, rules and regulations applicable to its
        business.
  A
        copy of
        the Company’s Code of Business Conduct and Ethics is available at its website at
www.zones.com/IR.
        In the event that an amendment to, or a waiver from, a provision of the
        Company’s Code of Business Conduct and Ethics that applies to any of its
        officers or directors is necessary, the Company intends to post such information
        on its website at www.zones.com/IR.
  The
        Company will provide without charge to any person, upon request of such person,
        a copy of its Code of Business Conduct and Ethics. Requests should be directed
        in writing to Zones, Inc. Investor Relations, 1102 15th
        Street
        SW, Suite 102, Auburn, WA 98001-6509.
 
 Item11.     Executive
        Compensation
 The
        information required by this item is contained in, and incorporated by reference
        from, the Proxy Statement for the Company’s 2007 Annual Meeting of Shareholders
        under the caption “Executive Compensation.”
  25
 Table
            of Contents
  Item12.     Security
        Ownership of
        Certain Beneficial Owners and Management and Related Stockholder
        Matters
 The
        information required by this item is contained in, and incorporated by reference
        from, the Proxy Statement for the Company’s 2007 Annual Meeting of Shareholders
        under the caption “Stock Ownership of Management and Certain Other
        Holders.”
 
 Item13.     Certain
        Relationships and
        Related Transactions, and Director Independence
 The
        information required by this item is contained in, and incorporated by reference
        from, the Proxy Statement for the Company’s 2007 Annual Meeting of Shareholders
        under the caption “Certain Relationships and Related Transactions.”
 
 Item14.     Principal
        Accountant Fees
        and Services
 The
        information required by this item is contained in, and incorporated by reference
        from, the Proxy Statement for the Company’s 2007 Annual Meeting of Shareholders
        under the caption “Principal Accounting Firm Fees
  26
 Table
            of Contents
  Part
        IV
 
 Item15.     Exhibits
        and Financial
        Statement Schedules
 (a)
              1.
                  Financial Statements:
 The
        financial statements of Zones, Inc. and the Report of Independent Registered
        Public Accounting Firm is included herein beginning on page 29.
 
 2.  Financial
        Statement Schedules:
 
 See
        Schedule II, Valuation and Qualifying Accounts
 
 3.  Exhibits:
 
 Exhibit
                  No.
              Description
              Filed
                  Herewith
              Incorporated
                  by
                  ReferenceForm
              Exhibit
                  No.
              File
                  No.
              Filing
                  Date3.1
              Restated
                  Articles of Incorporation
                  of Multiple Zones International, Inc.
              
              S-1
              3.1
              333-04458
              6/5/963.2
              Articles
                  of Amendment of Multiple
                  Zones, Inc.
              
              S-8
              4.2
              333-110750
              11/25/033.3
              Amended
                  and Restated Bylaws of
                  Multiple Zones International, Inc.
              
              10-K
              3.1
              000-28488
              3/4/054.1
              Form
                  of Common Stock Certificate
                  of Zones, Inc.10.1
              Multiple
                  Zones International, Inc.
                  Amended and Restated 1993 Stock Incentive Plan*
              
              10-K
              10.1
              000-28488
              3/4/0510.2
              Multiple
                  Zones International, Inc.Amended and
                  Restated1999 Director
                  Stock
                  Option Plan*
              
              14-A
              Appendix
                  A
              000-28488
              3/25/0410.3
              Form
                  of Stock Option Agreement
                  (used for grants to executive officers afterMarch 31,
                  1996)*
              
              S-1
              10.4
              333-04458
              6/5/9610.4
              Form
                  of Stock Option Agreement
                  (used for grants to outside directors)*
              
              S-1
              10.16
              333-04458
              6/5/9610.5
              Multiple
                  Zones International, Inc.
                  401(k) Plan*
              
              S-1
              10.5
              333-04458
              6/5/9610.6
              Multiple
                  Zones International, Inc.
                  Employee Stock Purchase Plan*
              
              S-1
              10.6
              333-04458
              6/5/9610.7
              Amendment
                  of 1996 Employee Stock
                  Purchase Plan
              
              10-Q
              10.3
              000-28488
              8/14/0310.8
              Form
                  of Indemnification Agreement
                  between Multiple Zones International, Inc. and certain executive
                  officers
                  and outside directors*
              
              S-1
              10.15
              333-04458
              6/5/9610.9
              Amended
                  and Restated
                  Indemnification Agreement
              
              10-Q
              10.1
              000-28488
              11/14/0310.10
              Loan
                  and SecurityAgreement
                  dated November 25, 2002
                  between Zones, Inc.and
                  TransAmerica Commercial
                  Finance
              
              10-K
              10.20
              000-28488
              2/26/0310.11
              Amended
                  and Restated Loan and
                  Security Agreement datedApril 11,
                  2003between Zones,
                  Inc.,
                  Corporate PC Source, Inc. and
                  Transamerica Commercial Finance Corporation
              
              10-Q
              10.1
              000-28488
              8/14/0310.12
              Zones,
                  Inc.2003Equity
                  IncentivePlan*
              
              14-A
              
              000-28488
              3/20/0310.13
              Stock
                  Purchase Agreement, datedMarch 31,
                  2003, by and
                  among
                  Zones,Inc.
                  and Corporate PC Source, Inc.
                  and Christina Corley, RobertFrauenheim,
                  individually and as
                  Trustee of the Robert FrauenheimDeclaration
                  of Trust datedSeptember
                  17,
                  1997, and Daniel
                  Frauenheim.
              
              8-K
              2.1
              000-28488
              4/3/0310.14
              Office
                  lease dated June 9, 2003
                  between Zones, Inc and Fana Auburn LLC
              
              10-Q
              10.2
              000-28488
              8/14/0310.15
              Form
                  of Stock Option Agreement
                  (used for grantsunder the
                  2003 Stock Equity
                  Plan)*
              
              10-K
              10.25
              000-28488
              2/26/0410.16
              Commercial
                  Lease Agreement dated
                  March 19, 2004 between Corporate PC Source and AMB Property II,
                  L.P.
              
              10-Q
              10.4
              000-28488
              5/13/04
  27
 Table
            of Contents
  
 10.17
              Amendment
                  No. 2 to Amended and
                  Restated Loan and Security Agreement dated January 9, 2004 between
                  Zones
                  Inc. and its subsidiaries, and Transamerica Commercial Finance
                  Corporation
              
              10-Q
              10.5
              000-28488
              5/13/0410.18
              Subordination,
                  Non-disturbance,
                  and Attornment Agreement dated June 22, 2004 between US Bank National
                  Association, Zones, Inc. and Fana Auburn LLC
              
              10-Q
              10.1
              000-28488
              8/11/0410.19
              Interest
                  Termination and
                  Settlement Agreement, dated September 27, 2004, by and among Zones,
                  Inc.
                  and Christina Corley, Robert Frauenheim, individually and as Trustee
                  of
                  the Robert Frauenheim Declarations of Trust dated September 17,
                  1997, and
                  Daniel Frauenheim
              
              8-K
              10.1
              000-28488
              9/29/0410.20
              Form
                  of Unsecured, Subordinated
                  Promissory Note
              
              8-K
              10.2
              000-28488
              9/29/0410.21
              Summary
                  of Zones, Inc. Board
                  Meeting Fees and Basic Compensation
              
              10-Q
              10.1
              000-28488
              8/10/0510.22
              Notice
                  of Grant of Director Stock
                  Option pursuant to the Zones, Inc 2003 Equity Incentive
                  Plan
              
              10-Q
              10.2
              000-28488
              8/10/0510.23
              Office
                  Lease dated September 2005
                  between Zones, Inc. and the Trustees Under the Will and of the
                  Estate of
                  James Campbell, Deceased
              
              10-Q
              10.1
              000-28488
              11/9/0510.24
              Office
                  Lease dated December 2005
                  between Zones, Inc. andMontgomeryParkI,
                  LLC
              
              10-K
              10.28
              000-28488
              2/24/0610.25
              Amendment
                  to Office Lease between Zones, Inc and Fana Auburn LLC
              
              10-Q
              10.1
              000-28488
              5/12/0610.26
              Summary
                  of the Zones, Inc. Senior
                  Management Bonus Program*
              
              8-K
              99.2
              000-28488
              2/12/0710.27
              Summary
                  of the Zones, Inc.
                  Executive Vice President Bonus Program*
              
              8-K
              99.1
              000-28488
              2/12/0721.1
              Subsidiaries
                  of the
                  Registrant
              X23.1
              Consent
                  ofGrant Thornton
                  LLP,Independent
                  Registered Public
                  Accounting Firm
              X23.2
              Consent
                  ofPricewaterhouseCoopers
                  LLP,Independent
                  Registered Public Accounting Firm
              X31.1
              Certification
                  of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
                  Act of 2002 and the regulations promulgated thereunder
              X31.2
              Certification
                  of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
                  Act of 2002 and the regulations promulgated thereunder
              X32.1
              Certification
                  of Chief Executive Officerpursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and the
                  regulations promulgated thereunder
              X32.2
              Certification
                  of Chief Financial
                  Officer
                  pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and the
                  regulations promulgated thereunder
              X*
              Management
                  contract or
                  compensatory plan or arrangement
  28
 Table
            of Contents
  SIGNATURES
 
 Pursuant
        to the requirements of Section 13 or 15(d) 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.
 
 ZONES,
        INC.
 
 Date:  December
                  20, 2007By:
              /S/     FIROZ
                  H. LALJIFiroz
                  H. Lalji, Chairman and Chief Executive Officer/S/     RONALD
                  P. MCFADDENRonald
                  P. McFadden, Chief Financial
                  Officer
 
 Each
        person whose individual signature appears below hereby authorizes and appoints
        Firoz H. Lalji and Ronald P. McFadden, and each of them, with full power
        of
        substitution and resubstitution and full power to act without the other,
        as his
        or her true and lawful attorney-in-fact and agent to act in his or her name,
        place and stead and to execute in the name and on behalf of each person,
        individually and in each capacity stated below, and to file, any and all
        amendments to this Report, and to file the same, with all exhibits thereto,
        and
        other documents in connection therewith, with the Securities and Exchange
        Commission, granting unto said attorneys-in-fact and agents, and each of
        them,
        full power and authority to do and perform each and every act and thing,
        ratifying and confirming all that said attorneys-in-fact and agents or any
        of
        them or their or his or her substitute or substitutes may lawfully do or
        cause
        to be done by virtue thereof.
 
 Pursuant
        to the requirements of the Securities Exchange act of 1934, this report has
        been
        signed below by the following persons on behalf of the registrant and in
        the
        capacities and on the date indicated.
 
 Signature
              
              Title
              
              Date/S/     JOHN
                    H. BAUER*
              
              Director
              
              December
                  20, 2007John
                  H. BauerLARRY
                    BENAROYA
              
              Director
              
              December
                  20, 2007Larry
                  Benaroya/S/     CATHI
                    HATCH*
              
              Director
              
              December
                  20, 2007Cathi
                  Hatch/S/     WILLIAM
                    C. KEIPER*
              
              Director
              
              December
                  20, 2007William
                  C. Keiper/S/     KENNETH
                    M. KIRKPATRICK*
              
              Director
              
              December
                  20, 2007Kenneth
                  M. Kirkpatrick/S/     FIROZ
                    H. LALJI
              
              Director
              
              December
                  20, 2007Firoz
                  H. Lalji
 
 *
        Ronald
        P. McFadden, as attorney-in-fact
  29
 Table
            of Contents
  ZONES,
        INC.
 INDEX
        TO CONSOLIDATED FINANCIAL STATEMENTS
 
 
 Consolidated
                    Financial Statements:Consolidated
                    Balance SheetsDecember 31, 2006 and 2005
                
                31Consolidated
                    Statements of Operations Twelve months ended December 31, 2006,
                    2005 and
                    2004
                
                32Consolidated
                    Statement of Shareholders’ Equity Twelve months ended December 31, 2006,
                    2005 and 2004
                
                33Consolidated
                    Statements of Cash Flows Twelve months ended December 31, 2006,
                    2005 and
                    2004
                
                34Notes
                    to Consolidated Financial Statements
                
                35Report
                    of Grant Thornton LLP, Independent Registered Public Accounting
                    Firm
                
                48Report
                    of PricewaterhouseCoopers LLP, Independent Registered Public
                    Accounting
                    Firm
                
                49Schedule
                    II – Valuation and Qualifying Accounts
                
                50
 30
 Table
            of Contents
  ZONES,
        INC.
 CONSOLIDATED
        BALANCE SHEETS
 (in
        thousands, except share data)
 
 December
                  31,2006
              
              
              2005ASSETSCurrent
                  assets:Cash
                  and cash equivalents
              
              $
              9,191
              
              
              $
              3,195Receivables,
                  net of allowances of $1,936 and $1,562 at December 31, 2006 and
                  2005,
                  respectively
              
              
              65,699
              
              
              
              68,318Vendor
                  receivables
              
              
              12,556
              
              
              
              14,750Inventories
              
              
              21,385
              
              
              
              19,736Prepaid
                  expenses
              
              
              1,076
              
              
              
              922Deferred
                  income taxes
              
              
              1,473
              
              
              
              1,346Total
                  current assets
              
              
              111,380
              
              
              
              108,267Property
                  and equipment, net
              
              
              3,771
              
              
              
              3,810Goodwill
              
              
              5,098
              
              
              
              5,098Deferred
                  income taxes
              
              
              251Other
                  assets
              
              
              195
              
              
              
              179Total
                  assets
              
              $
              120,695
              
              
              $
              117,354LIABILITIES
                  AND SHAREHOLDERS' EQUITYCurrent
                  liabilities:Accounts
                  payable
              
              $
              42,592
              
              
              $
              45,359Inventory
                  financing (Note 5)
              
              
              14,385
              
              
              
              8,469Accrued
                  liabilities
              
              
              12,728
              
              
              
              9,069Line
                  of credit
              
              
              
              
              
              
              10,700Notes
                  payable to former shareholders of CPCS, Inc.
              
              
              
              
              
              
              1,272Total
                  current liabilities
              
              
              69,705
              
              
              
              74,869Note
                  payable for purchase of fixed asset
              
              
              6
              
              
              
              21Deferred
                  income taxes
              
              
              
              
              
              
              35Deferred
                  rent obligation
              
              
              1,502
              
              
              
              1,112Total
                  liabilities
              
              
              71,213
              
              
              
              76,037Commitments
                  and contingencies (Note 8)Shareholders'
                  equity:Common
                  stock, no par value, 45,000,000 authorized; 13,157,719 and 13,265,049
                  shares issued and outstanding at December 31, 2006 and 2005,
                  respectively
              
              
              35,983
              
              
              
              37,503Retained
                  earnings
              
              
              13,499
              
              
              
              3,814Total
                  shareholders' equity
              
              
              49,482
              
              
              
              41,317Total
                  liabilities and shareholders' equity
              
              $
              120,695
              
              
              $
              117,354
  
 The
        accompanying notes are an integral part of the consolidated financial
        statements.
  31
 Table
            of Contents
  ZONES,
        INC.
 CONSOLIDATEDSTATEMENTS
        OF OPERATIONS
 (in
        thousands, except per share data)
 Year
                      ended December 31,2006
                  
                  
                  2005
                  
                  
                  2004Net
                      sales
                  
                  $
                  577,027
                  
                  
                  $
                  566,553
                  
                  
                  $
                  495,563Cost
                      of sales
                  
                  
                  505,508
                  
                  
                  
                  505,997
                  
                  
                  
                  438,426Gross
                      profit
                  
                  
                  71,519
                  
                  
                  
                  60,556
                  
                  
                  
                  57,137Selling,
                      general and administrative expenses
                  
                  
                  48,434
                  
                  
                  
                  43,618
                  
                  
                  
                  42,284Advertising
                      expense
                  
                  
                  7,159
                  
                  
                  
                  6,618
                  
                  
                  
                  7,082Income
                      from operations
                  
                  
                  15,926
                  
                  
                  
                  10,320
                  
                  
                  
                  7,771Interest
                      expense
                  
                  
                  419
                  
                  
                  
                  594
                  
                  
                  
                  404Other
                      income
                  
                  
                  (149
                  )
                  
                  
                  (91
                  )
                  
                  
                  (90
                  )Other  expense,
                      net
                  
                  
                  270
                  
                  
                  
                  503
                  
                  
                  
                  314Income  before
                      income taxes
                  
                  
                  15,656
                  
                  
                  
                  9,817
                  
                  
                  
                  7,457Provision
                      for income taxes
                  
                  
                  5,971
                  
                  
                  
                  3,766
                  
                  
                  
                  2,805Net
                      income
                  
                  $
                  9,685
                  
                  
                  $
                  6,051
                  
                  
                  $
                  4,652Basic
                      income per share
                  
                  $
                  0.73
                  
                  
                  $
                  0.45
                  
                  
                  $
                  0.34Weighted
                      average shares used in computing basic income per share
                  
                  
                  13,195
                  
                  
                  
                  13,382
                  
                  
                  
                  13,549Diluted
                      income per share
                  
                  $
                  0.66
                  
                  
                  $
                  0.42
                  
                  
                  $
                  0.32Weighted
                      average shares used in computing diluted income per share
                  
                  
                  14,756
                  
                  
                  
                  14,527
                  
                  
                  
                  14,469
 The
        accompanying notes are an integral part of the consolidated financial
        statements.
  32
 Table
            of Contents
  ZONES,
        INC.
 CONSOLIDATEDSTATEMENT
        OF SHAREHOLDERS' EQUITY
 (in
        thousands, except share data)
 
 Common
                  Stock
              
              
              Retained
                  EarningsShares
              
              
              Amount
              
              
              (Deficit)
              
              
              TotalBalance,
                  January 1, 2004
              
              
              13,659,371
              
              
              $
              39,590
              
              
              $
              (6,889
              )
              
              $
              32,701Purchase
                  and retirement of common stock
              
              
              (448,390
              )
              
              
              (1,348
              )
              
              
              
              
              
              
              (1,348
              )Exercise
                  of stock options
              
              
              296,746
              
              
              
              453
              
              
              
              
              
              
              
              453Tax
                  effect of stock options exercised
              
              
              
              
              
              
              93
              
              
              
              
              
              
              
              93Net
                  income
              
              
              
              
              
              
              
              
              
              
              4,652
              
              
              
              4,652Balance,
                  December 31, 2004
              
              
              13,507,727
              
              
              
              38,788
              
              
              
              (2,237
              )
              
              
              36,551Purchase
                  and retirement of common stock
              
              
              (424,450
              )
              
              
              (1,813
              )
              
              
              
              
              
              
              (1,813
              )Exercise
                  of stock options
              
              
              181,772
              
              
              
              316
              
              
              
              
              
              
              
              316Tax
                  effect of stock options exercised
              
              
              
              
              
              
              212
              
              
              
              
              
              
              
              212Net
                  income
              
              
              
              
              
              
              
              
              
              
              6,051
              
              
              
              6,051Balance,
                  December 31, 2005
              
              
              13,265,049
              
              
              
              37,503
              
              
              
              3,814
              
              
              
              41,317Purchase
                  and retirement of common stock
              
              
              (568,400
              )
              
              
              (3,988
              )
              
              
              
              
              
              
              (3,988
              )Exercise
                  of stock options
              
              
              461,070
              
              
              
              1,412
              
              
              
              
              
              
              
              1,412Excess
                  tax benefit from stock options exercised
              
              
              
              
              
              
              651
              
              
              
              
              
              
              
              651Stock-based
                  compensation
              
              
              
              
              
              
              405
              
              
              
              
              
              
              
              405Net
                  income
              
              
              
              
              
              
              
              
              
              
              9,685
              
              
              
              9,685Balance,
                  December 31, 2006
              
              
              13,157,719
              
              
              $
              35,983
              
              
              $
              13,499
              
              
              $
              49,482
  The
        accompanying notes are an integral part of the consolidated financial
        statements.
  33
 Table
            of Contents
  ZONES,
        INC.
 CONSOLIDATEDSTATEMENTS
        OF CASH FLOWS
 (in
        thousands)
  Year ended
                  December 31,2006
              
              
              2005
              
              
              2004(as
                  restated, see note 15)Cash
                  flows from operating activities:Net
                  income
              
              $
              9,685
              
              
              $
              6,051
              
              
              $
              4,652Adjustments
                  to reconcile net income to netcash
                  provided by (used in) operating activities:Depreciation
              
              
              1,831
              
              
              
              1,966
              
              
              
              2,468Non-cash
                  stock-based compensation
              
              
              405Excess
                  tax benefit from exercise of stock options
              
              
              (651
              )Deferred
                  tax asset
              
              
              (413
              )
              
              
              2,854
              
              
              
              2,272Tax
                  effect of stock option exercise
              
              
              
              
              
              
              212
              
              
              
              93(Increase)
                  decrease in assets and liabilities:Receivables,
                  net
              
              
              4,813
              
              
              
              (19,130
              )
              
              
              (3,973
              )Inventories
              
              
              (1,649
              )
              
              
              (2,330
              )
              
              
              (5,918
              )Prepaid
                  expenses and other assets
              
              
              (171
              )
              
              
              29
              
              
              
              138Accounts
                  payable
              
              
              128
              
              
              
              3,133
              
              
              
              6,618Income
                  taxes payable
              
              
              353
              
              
              
              107Accrued
                  liabilities and deferred rent
              
              
              4,347
              
              
              
              1,717
              
              
              
              (206
              )Net
                  cash provided by (used in)  operating activities
              
              
              18,678
              
              
              
              (5,391
              )
              
              
              6,144Cash
                  flows from investing activities:Purchases
                  of property and equipment
              
              
              (1,792
              )
              
              
              (1,826
              )
              
              
              (2,029
              )Net
                  cash used in investing activities
              
              
              (1,792
              )
              
              
              (1,826
              )
              
              
              (2,029
              )Cash
                  flows from financing activities:Net
                  change in book overdrafts
              
              
              (2,894
              )
              
              
              7,975
              
              
              
              1,112Net
                  change in line of credit
              
              
              (10,700
              )
              
              
              4,600
              
              
              
              (1,750
              )Net
                  change in inventory financing
              
              
              5,916
              
              
              
              (5,837
              )
              
              
              (443
              )Payments
                  of note payable
              
              
              (1,287
              )
              
              
              (1,286
              )
              
              
              (862
              )Excess
                  tax benefit from exercise of stock options
              
              
              651Purchase
                  and retirement of common stock
              
              
              (3,988
              )
              
              
              (1,813
              )
              
              
              (1,348
              )Proceeds
                  from exercise of stock options
              
              
              1,412
              
              
              
              316
              
              
              
              453Net
                  cash provided by (used in) financing activities
              
              
              (10,890
              )
              
              
              3,955
              
              
              
              (2,838
              )Net
                  increase (decrease) in cash and cash equivalents
              
              
              5,996
              
              
              
              (3,262
              )
              
              
              1,277Cash
                  and cash equivalents at the beginning of the year
              
              
              3,195
              
              
              
              6,457
              
              
              
              5,180Cash
                  and cash equivalents at the end of the year
              
              $
              9,191
              
              
              $
              3,195
              
              
              $
              6,457Supplemental
                  cash flow information:Cash
                  paid for interest
              
              $
              489
              
              
              $
              554
              
              
              $
              335Cash
                  paid for income taxes
              
              $
              6,019
              
              
              $
              594
              
              
              $
              260Noncash
                  investing and financing activity:Cancellation
                  of note payable for acquisition of CPCS
              
              
              
              
              
              
              
              
              
              $
              1,544Note
                  payable replacing earn-out provision of CPCS acquisition
              
              
              
              
              
              
              
              
              
              $
              2,744Non-cash
                  reduction to note payable for purchase price adjustment of
                  CPCS
              
              
              
              
              
              
              
              
              
              $
              295Note
                  payable for fixed asset purchase
              
              
              
              
              
              
              
              
              
              $
              35
 
 The
        accompanying notes are an integral part of the consolidated financial
        statements.
  34
 Table
            of Contents
 
 ZONES,
        INC.
 NOTESTO
        CONSOLIDATED FINANCIAL STATEMENTS
 
 1.  Description
        of
        Business
 
 Zones,
        Inc. (the ”Company”) is a single-source direct marketing reseller of name-brand
        information technology products to the small-to-medium-sized business market,
        enterprise accounts and public sector accounts.  The Company sells
        these products through outbound and inbound account executives, catalogs
        and the
        Internet.  The Company offers more than 150,000 products from leading
        manufacturers, including 3Com, Adobe, Apple, Cisco, Epson, HP, IBM, Kingston,
        Lenovo, Microsoft, Sony and Toshiba.
 
 2.  Summary
        of Significant
        Accounting Policies
 
 Principles
        of
        Consolidation.
 The
        accompanying consolidated financial statements include the accounts of the
        Company and its majority owned subsidiary.  Inter-company transactions
        and balances have been eliminated in consolidation.
 
 Cash
        and Cash Equivalents.
 Cash
        and
        cash equivalents represent highly liquid investments with original maturities
        of
        three months or less at the date of purchase.
 
 Concentration
        of Credit
        Risk.
 Cash
        balances subject to credit risk consist of cash balances held in one financial
        institution in the United States.  The Company has not experienced any
        losses associated with cash balances and believes that there is minimal risk
        associated with the cash balances.  The concentration of credit risk
        with respect to trade receivables is limited due to the Company’s diverse
        customer base.  The Company closely monitors extensions of credit, but
        does not require collateral.  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 each reporting period based
        on
        historical collection experience, customer credit worthiness based on published
        information and other known factors.  Accounts receivable are written
        off as bad debt when it is deemed to be uncollectible.
 
 Inventories.
 Inventories
        consist primarily of computer hardware and software.  Inventory is valued at the
        lower of cost
        or market value. The Company decreases the value of inventory for estimated
        obsolescence equal to the difference between the cost of inventory and the
        estimated market value based upon an aging analysis of the inventory on hand,
        specifically known inventory-related risks, and assumptions about future
        demand
        and market conditions. If future demand or actual market conditions are less
        favorable than those projected by management, additional inventory write-downs
        may be required.
 
 The
        Company currently buys a significant portion of its products from four
        suppliers.  Purchases from Ingram Micro, Tech Data, Synnex and IBM
        represented 21.4%, 13.9%, 12.6% and 11.4%, respectively, of the Company’s total
        product purchases in 2006.  Purchases from Ingram Micro, Tech Data,
        Synnex and Hewlett-Packard represented 19.1%, 18.2%, 15.7% and 12.5%,
        respectively, of the Company’s total product purchases in
        2005.  Purchases from Ingram Micro, Synnex and Tech Data represented
        22.5%, 12.0% and 10.3%, respectively, of the Company’s total product purchases
        in 2004. No other vendor supplied more than 10.0% of the Company’s total product
        purchases in 2006, 2005 or 2004.  Although there are a limited number
        of manufacturers, the Company believes that other suppliers could provide
        similar products if its relationship with any of these suppliers was
        interrupted.
 
 Property
        and Equipment.
 Property
        and equipment is recorded at cost.  Depreciation is computed based on
        the straight-line method over the estimated useful lives of the related
        assets.  Useful lives for computer hardware and software range from
        two to five years and other property and equipment range from three to 11
        years.  Capital leases are amortized based on the straight-line method
        over the estimated useful lives of the related assets or lease term, whichever
        is shorter (generally three to 11 years).  Expenditures for
        maintenance and repairs are charged to expense as incurred, while additions,
        renewals and betterments are capitalized.  The Company evaluates the
        carrying value of long-lived assets based upon current and anticipated
        undiscounted cash flows, and it recognizes its impairment when it is probable
        that such estimated future cash flows will be less than the asset carrying
        value.  No impairments were identified in 2006, 2005 or
        2004.
  35
 Table
            of Contents
 
 Capitalized
        internal software development costs totaled $642,000 and $659,000 for the
        years
        ended December 31, 2006 and 2005, respectively.
 
 Income
        Taxes.
 Deferred
        income taxes are provided based on the estimated future tax effects of temporary
        differences between financial statement carrying amounts of existing assets
        and
        liabilities and their respective tax bases.  Deferred tax assets and
        liabilities are measured using enacted tax rates that are expected to apply
        to
        taxable income in the years in which those temporary differences are expected
        to
        be recovered or settled. A valuation allowance is created when it is believed
        it
        is more likely than not that the Company will not utilize a portion or all
        of
        the net deferred tax assets.
 
 Goodwill.
 In
        accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill
        is tested for impairment annually on the purchase date or sooner when events
        indicate that potential impairment exists.  All goodwill relates to
        the purchase of CPCS.
 
 The
        changes in the carrying amount of goodwill for the years ended December 31,
        2006
        and 2005 are as follows:
 
 Balance
                  as of January 1, 2005
              
              $
              5,098Impairment
                  lossBalance
                  as of December 31, 2005
              
              
              5,098Impairment
                  lossBalance
                  as of December 31, 2006
              
              $
              5,098
 
 Use
        of Estimates.
 The
        preparation of financial statements in conformity with accounting principles
        generally accepted in the United States requires management to make estimates
        and assumptions that affect the reported amounts of assets and liabilities,
        disclosure of contingent assets and liabilities at the date of the financial
        statements, and the reported amounts of revenues and expenses during the
        reporting period.  Actual results could differ from those
        estimates.
 
 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
        ability to collect 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’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, when 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.
        The
        Company offers limited return rights on its product sales.  At the
        point of sale, the Company provides for an allowance for sales returns, which
        is
        established based on historical experience.  Amounts billed for
        shipping and handling are recorded as revenue.  Pursuant to EITF 99-19
“Reporting Revenue Gross as a Principal versus Net as an Agent,” when the
        Company sets prices, has inventory risk and has credit risk, revenues are
        recorded gross.  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 gross in revenues and
        cost of
        sales when the Company sets prices and has inventory risk and credit risk.
        If
        any of those criteria are not present, revenue and cost of sales are recorded
        net. The Company’s warranty sales are generally recorded net.  When
        the sale is recorded, the Company has no further obligation to
        fulfill.  The Company only recognizes revenue when all criteria of
        Staff Accounting Bulletin No. 104 (“SAB 104”), "Revenue Recognition" have been
        met.
  36
 Table
            of Contents
  Cost
        of Sales.
 Cost
        of
        sales primarily consists of the purchase price of products and services sold
        by
        the Company.  Cost of sales also includes inbound and outbound
        shipping charges to the Company, vendor rebates and cash discounts that are
        recorded when earned as a reduction to cost of sales, physical inventory
        adjustments, and vendor consideration classified as a reduction of cost of
        sales.  Vendor rebates from product rebates that require certain
        volumes of product sales or purchases are recorded only after the related
        milestones are met.
 
 
 Selling,
        General and Administrative Expenses.
 Selling,
        general and administrative expenses include payroll, team member benefits
        and
        other headcount-related costs, cost of fulfillment (including warehousing),
        credit card processing and bad debts costs, facilities, professional fees
        and
        administration costs, and depreciation and amortization.
 
 Advertising
        Expenses.
 The
        Company produces and distributes catalogs at various intervals throughout
        the
        year, and also engages in other activities, to increase the awareness of
        its
        brand and stimulate demand response.  The costs to produce and
        distribute individual catalogs, including paper, printing, postage, production
        and design costs, and for other marketing initiatives, such as trade shows,
        direct mail pieces, and customer or vendor events, are capitalized and amortized
        to selling expense during the period in which the catalogs are mailed or
        the
        event takes place.  Capitalized advertising costs of $298,000 and
        $184,000 were included with prepaid expenses at December 31, 2006 and 2005,
        respectively.  The Company receives cooperative advertising expense
        reimbursements from vendors who support the Company’s marketing and advertising
        activities.  The following table presents the gross amounts that are
        netted together in the Company’s advertising expense line item.
 
 2006
              
              
              2005
              
              
              2004Gross
                  advertising expense
              
              $
              8,858
              
              
              $
              7,047
              
              
              $
              7,646Gross
                  advertising reimbursements
              
              
              (1,699
              )
              
              
              (429
              )
              
              
              (564
              )Advertising
                  expense
              
              $
              7,159
              
              
              $
              6,618
              
              
              $
              7,082
 
 
 Other
        Income/Expense.
 Other
        income/expense includes interest income earned on cash and cash equivalents,
        net
        of interest expense.   Interest expense includes fees associated
        with the Company’s working capital line as well as accrued interest associated
        with the notes payable to the former shareholders of CPCS recorded as part
        of
        the acquisition.
 
 Comprehensive
        Income.
 The
        Company has no differences between net income and comprehensive
        income.
 
 Stock
        Compensation.
 The
        Company’s stock option plans grant options to acquire shares of common stock to
        certain team members and non-employee directors.  Each option granted
        has an exercise price of 100% of the market value of the common stock on
        the
        date of the grant. The majority of the options have a contractual life of
        10 years and vest and become exercisable in 20% increments over five
        years.
 
 Effective
        January 1, 2006, the Company adopted Statement of Financial Accounting
        Standards No. 123R, Share-Based Payment(“SFAS 123R”). SFAS 123R supersedes
        the Company’s previous
        accounting under Accounting Principles Board Opinion No. 25, Accounting for Stock Issued
        to
        Employees(“APB 25”), for periods beginning in fiscal year 2006.
        Previously, under APB 25, the Company accounted for stock options under the
        intrinsic value method. Accordingly, the Company did not recognize expense
        related to employee stock options because the exercise price of such options
        equaled the fair value of the underlying stock on the grant date. The Company
        previously disclosed the fair value of its stock options under the provisions
        of
        Statement of Financial Accounting Standards No. 123, Accounting for Stock Based
        Compensation (“SFAS 123”). The fair value of option grants prior to
        January 1, 2006 was estimated on the date of grant using the Black-Scholes
        option-pricing model.
 
 The
        Company adopted SFAS 123R using the modified prospective transition method,
        which requires the application of the accounting standard as of January 1,
        2006, the first day of the Company’s fiscal year 2006. The Company’s condensed
        consolidated financial statements for prior periods have not been restated
        to
        reflect, and do not include, the impact of SFAS 123R.
  37
 Table
            of Contents
  Total
        stock-based compensation expense recognized in the consolidated statement
        of
        earnings for the year ended December 31, 2006 was $405,000, before income
        taxes,
        and did not have a material impact on net income or earnings per share.
  The Company used the criteria in SFAS No. 123R to calculate and
        establish the beginning balance of the additional paid-in capital pool (“APIC
        pool”) related to the tax effects of employee stock-based compensation, and also
        used the criteria to determine the subsequent effect on the APIC pool and
        consolidated statements of cash flows of the tax effects of employee stock-based
        compensation awards that were outstanding upon adoption of SFAS No. 123R.
        The tax benefit for stock options exercised during the year ended December
        31,
        2006 was $651,000.
 
 Prior
        to
        the adoption of SFAS 123R, the Company presented all tax benefits resulting
        from
        the exercise of stock options as operating cash inflows in the consolidated
        statements of cash flows, in accordance with the provisions of the Emerging
        Issues Task Force (“EITF”) Issue No 00-15, “Classification in the Statement of
        Cash Flows of the Income Tax Benefit Received by a Company upon Exercise
        of a
        Nonqualified Employee Stock Option.” SFAS 123R requires the benefits of tax
        deductions in excess of the compensation cost recognized for those options
        to be
        classified as financing cash inflows rather than operating cash inflows,
        on a
        prospective basis. This amount is shown as “Excess tax benefit from exercise of
        stock options” on the consolidated statement of cash flows.
 
 The
        following table shows the prior year effect on net earnings and earnings
        per
        share had compensation cost been recognized based upon the estimated fair
        value
        on the grant date of stock options, in accordance with SFAS 123, as amended
        by
        SFAS No. 148 “Accounting for Stock-Based Compensation – Transition and
        Disclosure” (in thousands,
        except earnings per share):
 
 
 Year
                    ended December 31,2005
                
                
                2004Net
                    income – as reported
                
                $
                6,051
                
                
                $
                4,652Less:Total
                    compensation cost determined under fair value based method for
                    all awards,
                    net of tax
                
                
                (808
                )
                
                
                (827
                )Net
                    income – pro forma
                
                $
                5,243
                
                
                $
                3,825Basic
                    income per share – as reported
                
                $
                0.45
                
                
                $
                0.34Diluted
                    income per share – as reported
                
                $
                0.42
                
                
                $
                0.32Basic
                    income per share – pro forma
                
                $
                0.39
                
                
                $
                0.28Diluted
                    income per share – pro forma
                
                $
                0.36
                
                
                $
                0.26
 The
        fair
        value of each option grant is estimated on the date of grant using the
        Black-Scholes option-pricing model with the following weighted-average
        assumptions used for grants in 2005 and 2004, respectively: expected volatility
        of 186% and 183%, risk-free interest rate of 4.05% and 3.43%, and expected
        lives
        of 5 years.
 
 Disclosures
        for the 2006 are not presented because the amounts are recognized in the
        consolidated financial statements.
 
 There
        were no options granted in the twelve months ended December 31, 2006. The
        current expense for all outstanding options granted prior to January 1,
        2006 has been recognized in the consolidated statement of earnings for the
        twelve months ended December 31, 2006. Forfeitures are estimated and revised,
        if
        necessary, in subsequent periods if actual forfeitures differ from those
        estimates. As of December 31, 2006, there is $245,000 of total unrecognized
        pre-tax compensation expense related to nonvested stock options granted under
        the Company’s stock option plans. This cost is expected to be recognized over a
        weighted-average period of 1.4 years.
 
 Segment
        Reporting
 In
        2004,
        the Company reported its then subsidiary, CPCS, and its Zones reporting unit
        as
        separate segments.  On April 1, 2005, the Company merged the CPCS
        subsidiary into the Zones reporting unit.  Accordingly, no separate
        segment for this subsidiary currently exists.  The Company is now
        represented by one reportable segment: a single-source, multi-vendor,
        direct-marketing reseller of name-brand information technology products and
        services to small to medium-sized businesses, enterprise accounts and the
        public
        sector markets.
  38
 Table
            of Contents
 
 A
        summary
        of the Company’s operations by product mix is detailed in Note 13.
 
 Reclassifications
 Certain
        reclassifications of prior years’ balances have been made to conform to the
        fiscal year 2006 presentation.  Such reclassifications had no effect
        on shareholders’ equity or net income as previously reported.
 
 
 Recent
          Accounting Pronouncements
 In
        September 2006, the FASB issued SFAS No. 157 (SFAS 157), Fair Value Measurements. SFAS
        157 defines fair value, establishes a framework for measuring fair value
        and
        expands disclosures about fair-value measurements required under other
        accounting pronouncements, but does not change existing guidance as to whether
        or not an instrument is carried at fair value. SFAS 157 is effective for
        the
        Company’s fiscal year 2008. The Company is currently evaluating the impact of
        adopting SFAS 157.
 
 In
        September 2006, the SEC released Staff Accounting Bulletin 108 (SAB 108),
Considering the Effects
        of Prior
        Year Misstatements when Quantifying Misstatements in Current Year Financial
        Statements. The intent of
        SAB 108 is to reduce diversity in practice for the method companies use to
        quantify financial statement misstatements, including the effect of prior-year
        uncorrected errors. SAB 108 establishes an approach that requires
        quantification of financial statement errors using both an income statement
        and
        a cumulative balance sheet approach. SAB 108 is effective for fiscal years
        beginning after November 15, 2006, and the Company will adopt the new
        requirements on January 1, 2007.The Company does not believe that the
        adoption of SAB 108 will have a significant effect on its financial
        statements.
 
 In
        July
        2006, the FASB issued FASB Interpretation No. 48 (FIN 48), Accounting for Uncertainty
        in Income
        Taxes: an Interpretation of FASB Statement No. 109, Accounting for
        Income
        Taxes.  FIN 48clarifies
        the
        accounting for uncertainty in income taxes recognized in a company’s financial
        statements and prescribes a recognition threshold and measurement attribute
        for
        the financial statement recognition and measurement of a tax position taken
        or
        expected to be taken in an income tax return. FIN 48 also provides guidance
        on
        derecognition, classification, interest and penalties, accounting in interim
        periods, disclosure and transition.  Only tax positions that meet the
        more-likely-than-not recognition threshold at the adoption date will be
        recognized or continue to be recognized. The cumulative effect of applying
        Interpretation 48 will be reported as an adjustment to retained earnings
        at the
        beginning of the period in which it is adopted.  FIN 48 will be
        adopted by the Company on January 1, 2007. The Company currentlydoes not believe
        that
        the adoption of Interpretation 48 will have a significant effect on its
        financial statements.
 
 In
        June
        2006, the FASB ratified the consensus reached on Emerging Issues Task Force
        (EITF) Issue No. 06-03, “How Sales Taxes Collected
        from
        Customers and Remitted to Governmental Authorities Should Be Presented in
        the
        Income Statement (that is, Gross Versus Net Presentation).”The EITF
        reached a consensus that the presentation of taxes on either a gross or net
        basis is an accounting policy decision that requires disclosure. EITF 06-03
        is
        effective for the first interim or annual reporting period beginning after
        December 15, 2006. Amounts collected from members, which under common trade
        practices are referred to as sales taxes, are and have been recorded on a
        net
        basis. The Company has no intention of modifying this accounting policy.
        Therefore, the adoption of EITF 06-03 will not have any effect on the Company’s
        financial statements.
 
 3.  Fair
        Value of Financial
        Instruments
 
 The
        estimated fair value of the Company’s financial instruments approximates their
        carrying value due to their short-term nature.  The estimated fair
        value of the line of credit approximates the carrying value, as this instrument
        requires interest payments at a market rate of interest plus a margin.
  39
 Table
            of Contents
  4.  Property
        and
        Equipment
 
 Property
        and equipment consist of the
        following (in thousands):
  
 December
                  31,2006
              
              
              2005
              
              Estimated
                Useful
                  LivesEquipment
              
              $
              15,831
              
              
              $
              15,679
              
              2
                  to 5 yearsComputer
                  software/Web development
              
              
              18,105
              
              
              
              17,436
              
              2
                  to 5 yearsFurniture
                  and fixtures and leasehold improvements
              
              
              1,662
              
              
              
              1,357
              
              3
                  to 11 years35,598
              
              
              
              34,472Less
                  accumulated depreciation and amortization
              
              
              (31,827
              )
              
              
              (30,662
              )Property
                  and equipment, net
              
              $
              3,771
              
              
              $
              3,810
 
 
 5.  Line
        of
        Credit
 
 At
        December 31, 2006, the Company had a $40,000,000 credit facility, collateralized
        by accounts receivable and inventory, that 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.  There were no working capital advances
        outstanding at December 31, 2006, but the Company had working capital advances
        of $10.7 million at December 31, 2005.  The flooring arrangement
        included $14.4 million owed to this financial institution related to inventory
        purchases at December 31, 2006, compared to $8.5 million at December 31,
        2005.
 
 The
        Company uses this credit facility under its cash management system to cover
        checks presented for payment in excess of cash balances.  As of
        December 31, 2006 and 2005, the Company had book overdrafts of $10.2 million
        and
        $13.1 million, respectively, which are recorded as a component of accounts
        payable on the accompanying balance sheet.
 
 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.  The Company was in
        compliance with all the covenants contained in the agreement at December
        31,
        2006.
 
 6.  Accrued
        Liabilities and Other
 Accrued
        liabilities consist of the
        following (in thousands):
 
 December
                  31,2006
              
              
              2005Accrued
                  payroll
              
              $
              4,932
              
              
              $
              3,842Accrued
                  taxes
              
              
              3,268
              
              
              
              2,823Accrued
                  advertising
              
              
              50
              
              
              
              20Accrued
                  interest
              
              
              7
              
              
              
              104Other
                  accruals
              
              
              4,471
              
              
              
              2,280Total
              
              $
              12,728
              
              
              $
              9,069
   40
 Table
            of Contents
  7.  Income
        Taxes
 
 The
        income tax expense consists of the
        following (in thousands):
 
 Year
                  ended December 31,2006
              
              
              2005
              
              
              2004Current
              
              $
              6,384
              
              
              $
              912
              
              
              $
              533Deferred
              
              
              (413
              )
              
              
              2,854
              
              
              
              2,272Total
              
              $
              5,971
              
              
              $
              3,766
              
              
              $
              2,805
 
 
 The
        components of deferred taxes were as follows (in thousands):
 
 December
                  31,2006
              
              
              2005Assets:Allowance
                  for doubtful accounts
              
              $
              728
              
              
              $
              585Merchandise
                  inventory
              
              
              302
              
              
              
              331Deferred
                  rent obligation
              
              
              549
              
              
              
              418Accrued
                  liabilities and other
              
              
              443
              
              
              
              424$
              2,022
              
              
              $
              1,758Liabilities:Property
                  and equipment
              
              
              (298
              )
              
              
              (447
              )(298
              )
              
              
              (447
              )Net
                  deferred tax asset
              
              $
              1,724
              
              
              $
              1,311
 
 A
        reconciliation of the effective income tax rate on income before taxes with
        the
        federal statutory rate as follows:
 
 
 Year
                  ended December 31,2006
              
              
              2005
              
              
              2004Statutory
                  rate
              
              
              35.0
              %
              
              
              34.0
              %
              
              
              34.0
              %State
                    income tax, net of federal benefit
              
              
              2.0
              
              
              
              2.0
              
              
              
              2.7Stock
                  compensation
              
              
              0.5Other
              
              
              0.6
              
              
              
              2.4
              
              
              
              0.9Effective
                  tax rate
              
              
              38.1
              %
              
              
              38.4
              %
              
              
              37.6
              %
 
 
 8.  Commitments
        and
        Contingencies
 
 Operating
        Leases
 The
        Company leases its offices, returns warehouse facility, and other equipment
        under non-cancelable operating leases that expire through 2016.  Under
        the terms of certain leases, the Company is responsible for its share of
        taxes,
        insurance and common area charges.  At December 31, 2006, future
        minimum payments under operating leases were as follows (in
        thousands):
 
 2007
              
              $
              2,2362008
              
              
              2,3242009
              
              
              2,1562010
              
              
              1,9842011
              
              
              1,886Thereafter
              
              
              6,079Total
              
              $
              16,665
  
 Certain
        portions of the Company’s lease agreements provide for scheduled rent increases
        during the lease terms.  Minimum rental expenses are recognized on a
        straight-line basis over the terms of the lease.  Rental expense,
        which is recorded on a straight-line basis, totaled $3.1 million, $2.5 million
        and $2.2 million for the years ended December 31, 2006, 2005 and 2004,
        respectively.
  41
 Table
            of Contents
 
 Related
        Party
 In
        June
        2004, Fana Auburn LLC, a company owned by an officer and majority shareholder
        of
        the Company, purchased the property and buildings in which the Company’s
        headquarters are located, subject to the Company’s existing 11-year
        lease.  Under the terms of the lease agreement, the Company will pay
        lease payments aggregating from $1.0 million to $1.3 million per year, plus
        apportioned real estate taxes, insurance and common area maintenance charges.
        For the years ended December 31, 2006, 2005 and 2004 the Company paid Fana
        Auburn LLC $1.6 million, $1.7 million and $543,000, respectively, related
        to the
        lease.  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 renegotiate
        its
        lease and that such renewal and renegotiation would also present a related
        party
        transaction, which would be subject to further Audit Committee review and
        consideration.  In May 2006, after the Company’s Audit Committee
        reviewed and approved this related party transaction, the Company signed
        an
        amendment to the lease agreement.  Pursuant to the terms of the
        amendment, Fana Auburn LLC has agreed to increase the rentable square feet
        by
        approximately 18,923 square feet.  The additional square feet will
        increase the annual lease payment by $259,000. Effective January 1, 2007,
        the
        Company will have approximately 125,196 rentable square feet located at 1102
        15th
        Street SW, Auburn, WA.
 
 Notes
        Payable
 On
        March
        31, 2003, the Company acquired Corporate PC Source, Inc. (“CPCS”) pursuant to a
        Stock Purchase Agreement (“SPA”).  Under the terms of the SPA, the
        Company issued notes to the former shareholders of CPCS. The Company paid
        the
        final payment during the second quarter of 2006.  For the years ended
        December 31, 2006 and 2005, the Company paid the former shareholders of CPCS
        $1.3 million each year.
 
 Legal
        Proceedings
 From
        time
        to time, the Company is party to various legal proceedings, claims, disputes
        or
        litigation arising in the ordinary course of business, some of which may
        involve
        material amounts.  The Company currently believes that the ultimate
        outcome of any of these proceedings, individually or in the aggregate, will
        not
        have a material adverse effect on the Company’s business, financial condition,
        cash flows or results of operations.
 
 9.  Shareholders'
        Equity
 
 Stock
        Options
 In
        1993,
        the Company adopted a Stock Incentive Plan (the “Plan”) whereby the Company
        issued incentive or nonqualified stock options, restricted shares, stock
        units
        or stock appreciation rights to certain team members.  As of December
        31, 2006, only stock options had been granted under the Plan.  The
        term of each option granted was for such periods as determined by the Board
        of
        Directors, but not for more than ten years from date of
        grant.  Options may be exercised based on a vesting schedule
        determined by the Board of Directors, and the Plan provides for acceleration
        of
        outstanding options under certain conditions, including certain changes in
        control of the Company.  Grants are nontransferable, and shares
        acquired upon exercise of options may be subject to repurchase at the option
        of
        the Company under certain conditions.  The maximum number of shares to
        be granted under the Plan was 2,650,000 at December 31, 2006.
 
 In
        addition to options granted under the Plan, the Company has granted options
        under a separate plan to the Board of Directors.  Options outstanding
        to these individuals at December 31, 2006 were 80,000 shares at option prices
        of
        $0.73 - $12.00 per share.  The maximum number of shares to be granted
        under this plan was 325,000.  As of December 31, 2006, the Company had
        indefinitely suspended this program and therefore had no available
        shares.
 
 In
        January 2003, the Board of Directors adopted the Zones, Inc. 2003 Equity
        Incentive Plan (the “New Plan”), under which the Company may issue, among other
        things, incentive or nonqualified stock options, restricted shares, stock
        units
        or stock appreciation rights.  Under the New Plan, stock options are
        granted solely at the discretion of the Board of Directors, and the term
        of each
        option granted will be for such periods as determined by the Board of Directors,
        but not for more than ten years from date of grant.  Options will be
        exercisable based on a vesting schedule determined by the Board of Directors,
        and the plan provides for acceleration of outstanding options under certain
        conditions, including certain changes in control of the
        Company.  Grants are nontransferable, and shares acquired upon
        exercise of options may be subject to repurchase at the option of the Company
        under certain conditions.  The maximum number of shares that may be
        granted under the New Plan is 1,175,000.
  42
 Table
            of Contents
  Information
        regarding the stock option plans is as follows:
 
 Options
              
              
              Weighted-Average
                    Exercise Price
              
              
              Options
                    ExercisableOutstanding,
                  January 1, 2004
              
              
              3,329,682
              
              
              
              2.68
              
              
              
              1,310,817Granted
              
              
              925,300
              
              
              
              2.95Exercised
              
              
              (296,746
              )
              
              
              1.53Canceled
              
              
              (684,843
              )
              
              
              3.70Outstanding,
                  December 31, 2004
              
              
              3,273,393
              
              
              
              2.63
              
              
              
              1,471,617Granted
              
              
              282,200
              
              
              
              3.38Exercised
              
              
              (181,772
              )
              
              
              1.74Canceled
              
              
              (306,102
              )
              
              
              1.77Outstanding,
                  December 31, 2005
              
              
              3,067,719
              
              
              
              2.84
              
              
              
              2,181,673GrantedExercised
              
              
              (461,070
              )
              
              
              3.06Canceled
              
              
              (36,358
              )
              
              
              4.70Outstanding,
                  December 31, 2006
              
              
              2,570,291
              
              
              $
              2.78
              
              
              
              2,138,483
 
 There
        were no options granted in the year ended December 31, 2006.  For the
        years ended December 31, 2005 and 2004, the weighted-average fair value of
        options granted was as follows:
 
 Year
                  ended December 31,2005
              
              
              2004Exercise
                  price equals market price
              
              $
              2.29
              
              
              $
              2.58
 
 The
        following tables summarize information about fixed-price stock options
        outstanding at December 31, 2006:
 
 Options
                    OutstandingRange
                    of
                  Exercise
                    Prices
              
              Number
                  Outstanding
                  at
                    December 31, 2006
              
              Weighted-
                  Average
                  Remaining
                  Contractual
                    Years
              
              Weighted-
                  Average
                  Exercise
                    Price$  0.73
                  - $  0.96
              
              446,980
              
              5.90
              
              $  0.91$  1.05
                  - $  1.06
              
              501,000
              
              6.59
              
              1.06$  1.07
                  - $  2.92
              
              602,682
              
              6.94
              
              2.40$  2.99
                  - $  3.13
              
              430,846
              
              7.03
              
              3.00$  3.19
                  - $  5.81
              
              446,811
              
              4.55
              
              4.38$  6.00
                    - $15.00
              
              141,972
              
              2.06
              
              10.66$  0.73
                    - $15.00
              
              2,570,291
              
              6.02
              
              $  2.78
 
 
 Options
                    ExercisableRange
                    of
                  Exercise
                    Prices
              
              Number
                  at
                    December 31, 2006
              
              Weighted-Average
                  Exercise
                    Price$  0.73
                  - $  0.96
              
              373,430
              
              $  0.91$  1.05
                  - $  1.06
              
              384,802
              
              1.06$  1.07
                  - $  2.92
              
              468,182
              
              2.32$  2.99
                  - $  3.13
              
              323,386
              
              3.00$  3.19
                  - $  5.81
              
              446,711
              
              4.38$  6.00
                    - $15.00
              
              141,972
              
              10.66$  0.73
                    - $15.00
              
              2,138,483
              
              $  2.94
 
 10.  Earnings
        Per
        Share
 
 The
        Company has 45,000,000 common shares authorized, and 13,157,719 issued and
        outstanding at December 31, 2006.  The Company has also granted
        options to purchase common shares to the team members and directors of the
        Company.  The following is a reconciliation of the numerator and
        denominator of the basic and diluted earnings-per-share computations (in
        thousands, except per share data).
  43
 Table
            of Contents
  Year
                    ended December 31,2006
                
                
                2005
                
                
                2004Basic
                      earnings per share:Net
                      income
                
                $
                9,685
                
                
                $
                6,051
                
                
                $
                4,652Weighted-average
                      shares used in computing basic income per share
                
                
                13,195
                
                
                
                13,382
                
                
                
                13,549Basic
                      income per share
                
                $
                0.73
                
                
                $
                0.45
                
                
                $
                0.34Diluted
                    earnings per share:Net
                    income
                
                $
                9,685
                
                
                $
                6,051
                
                
                $
                4,652Weighted-average
                      shares used in computing basic income per share
                
                
                13,195
                
                
                
                13,382
                
                
                
                13,549Stock
                    Options
                
                
                1,561
                
                
                
                1,145
                
                
                
                920Weighted-average
                      shares used in computing diluted income per share
                
                
                14,756
                
                
                
                14,527
                
                
                
                14,469Diluted
                    income per share
                
                $
                0.66
                
                
                $
                0.42
                
                
                $
                0.32
 For
        the
        years ended December 31, 2006, 2005 and 2004, 106,258, 516,045 and 501,087
        shares, respectively, attributable to outstanding stock options were excluded
        from the calculation of diluted earnings per share because the effect was
        anti-dilutive.
 
 11.  Deferred
        Income 401(k)
        Plan
 
 The
        Company offers a deferred income 401(k) plan to substantially all full-time
        team
        members with a minimum of six months of service.  Participants may
        make tax-deferred contributions of up to 60% of annual compensation subject
        to
        certain limitations specified by the Internal Revenue Code. The Company provides
        a discretionary match as recommended by its Compensation Committee and voted
        upon by its Board of Directors on a quarterly basis.  During 2006,
        2005 and 2004, the Company’s Board of Directors approved a match in each of the
        quarters.  For fiscal years 2006, 2005 and 2004, the Company provided
        a 50% match for all team member contributions, up to 6% of the team member’s
        annual compensation, subject to certain limitations specified by the Internal
        Revenue Code.  During fiscal 2006, 2005, and 2004, the Company
        expensed $389,000, $362,000 and $315,000, respectively, relating to employer
        contributions under the plan.
 
 12.  Stock
        Repurchase
        Program
 
 Since
        2004, the Company has repurchased a total of 1,441,240 shares of its common
        stock at a total cost of $7.2 million under its repurchase program
        authorized by its Board of Directors.  Share repurchases may be made
        from time to time in both open market and private transactions, as conditions
        warrant, at then prevailing market prices. The following table presents share
        repurchases for the years ended December 31, 2006, 2005 and 2004 (dollars
        in thousands):
 
 
 Period
              
              Total
                    number
                  of
                    shares
                  purchased
              
              Amount
                    paid2006
              
              568,400
              
              $3,9882005
              
              424,450
              
              $1,8132004
              
              448,390
              
              $1,348
  44
 Table
            of Contents
  As
        of
        December 31, 2006, $979,000 in shares of the Company’s common stock
        remained available for repurchase under the program.  In February
        2007, the Board of Directors authorized a continuation of the Company’s share
        repurchase program, pursuant to which the Company increased the total amount
        authorized.  As of February 2007, $3.0 million in shares of the
        Company’s common stock is available for repurchase under the program. The
        current repurchase program is expected to remain in effect through
        February 2008, unless earlier terminated by the Board or
        completed.
  13.  Segment
        Information
 
 In
        2004,
        the Company reported its subsidiary, CPCS, and its Zones reporting unit as
        separate segments.  On April 1, 2005, the Company merged the CPCS
        subsidiary into the Zones reporting unit.  Accordingly, no separate
        segment for this subsidiary currently exists.  The Company is now
        represented by one reportable segment: a single-source, multi-vendor,
        direct-marketing reseller of name-brand information technology products to
        small
        to medium-sized businesses, enterprise accounts and the public sector
        markets.
 
 A
        summary
        of the Company’s sales by product mix follows (in thousands):
 
 December
                  31,2006
              
              
              2005
              
              
              2004Notebook
                  & PDAs
              
              $
              71,477
              
              
              $
              86,861
              
              
              $
              72,672Desktops
                  & Servers
              
              
              117,148
              
              
              
              113,779
              
              
              
              105,636Software
              
              
              102,055
              
              
              
              90,199
              
              
              
              83,415Storage
              
              
              52,785
              
              
              
              51,453
              
              
              
              43,198NetComm
              
              
              28,325
              
              
              
              23,968
              
              
              
              21,936Printers
              
              
              47,479
              
              
              
              63,964
              
              
              
              47,406Monitors
                  & Video
              
              
              59,761
              
              
              
              54,460
              
              
              
              50,939Memory
                  & Processors
              
              
              35,815
              
              
              
              30,407
              
              
              
              24,807Accessories
                  & Other
              
              
              62,182
              
              
              
              51,462
              
              
              
              45,554
  Substantially
        all of the Company’s net sales for the years ended December 31, 2006, 2005 and
        2004 were made to customers located in the United States.  All of the
        Company’s assets at December 31, 2006 and 2005 were located within the United
        States.  No one customer represented more than 10% of total sales for
        the years ended December 31, 2006, 2005 and 2004.
  45
 Table
            of Contents
  14.  Selected
        Quarterly Financial
        Data (Unaudited)
 
 The
        following information is for the years ended December 31, 2006 and
        2005:
 
 (in
        thousands, except per share data)
 December
                  31, 2006
              
              First
                  Quarter
              
              
              Second
                  Quarter
              
              
              Third
                  Quarter
              
              
              Fourth
                  QuarterNet
                  sales
              
              $
              133,998
              
              
              $
              145,210
              
              
              $
              137,900
              
              
              $
              159,919Cost
                  of sales
              
              
              117,411
              
              
              
              125,822
              
              
              
              121,522
              
              
              
              140,753Gross
                  profit
              
              
              16,587
              
              
              
              19,388
              
              
              
              16,378
              
              
              
              19,166SG&A
                  expenses
              
              
              11,862
              
              
              
              12,765
              
              
              
              11,291
              
              
              
              12,516Advertising
                  expenses, net
              
              
              1,802
              
              
              
              1,768
              
              
              
              1,717
              
              
              
              1,872Income
                  from operations
              
              
              2,923
              
              
              
              4,855
              
              
              
              3,370
              
              
              
              4,778Other
                  expense
              
              
              178
              
              
              
              122
              
              
              
              (19
              )
              
              
              (11
              )Income  before
                  income  taxes
              
              
              2,745
              
              
              
              4,733
              
              
              
              3,389
              
              
              
              4,789Provision
                  for  income taxes
              
              
              1,040
              
              
              
              1,816
              
              
              
              1,309
              
              
              
              1,806Net
                  income
              
              $
              1,705
              
              
              $
              2,917
              
              
              $
              2,080
              
              
              $
              2,983Basic
                  earnings per share1
              
              $
              0.13
              
              
              $
              0.22
              
              
              $
              0.16
              
              
              $
              0.23Diluted
                  earnings per share 1
              
              $
              0.12
              
              
              $
              0.20
              
              
              $
              0.14
              
              
              $
              0.20December
                  31, 2005
              
              First
                  Quarter
              
              
              Second
                  Quarter
              
              
              Third
                  Quarter
              
              
              Fourth
                  QuarterNet
                  sales
              
              $
              126,331
              
              
              $
              127,630
              
              
              $
              152,758
              
              
              $
              159,834Cost
                  of sales
              
              
              111,569
              
              
              
              113,093
              
              
              
              138,146
              
              
              
              143,189Gross
                  profit
              
              
              14,762
              
              
              
              14,537
              
              
              
              14,612
              
              
              
              16,645SG&A
                  expenses
              
              
              11,199
              
              
              
              10,978
              
              
              
              10,068
              
              
              
              11,373Advertising
                  expenses, net
              
              
              1,738
              
              
              
              1,401
              
              
              
              1,608
              
              
              
              1,871Income
                  from operations
              
              
              1,825
              
              
              
              2,158
              
              
              
              2,936
              
              
              
              3,401Other
                  expense
              
              
              61
              
              
              
              51
              
              
              
              191
              
              
              
              200Income  before
                  income  taxes
              
              
              1,764
              
              
              
              2,107
              
              
              
              2,745
              
              
              
              3,201Provision
                  for  income taxes
              
              
              673
              
              
              
              811
              
              
              
              1,055
              
              
              
              1,227Net
                  income
              
              $
              1,091
              
              
              $
              1,296
              
              
              $
              1,690
              
              
              $
              1,974Basic
                  earnings per share1
              
              $
              0.08
              
              
              $
              0.10
              
              
              $
              0.13
              
              
              $
              0.15Diluted
                  earnings per share 1
              
              $
              0.08
              
              
              $
              0.09
              
              
              $
              0.12
              
              
              $
              0.14
 
 1  Earnings
        per share is computed independently for each of the quarters presented,
        therefore the sum of the quarterly earnings per share may not equal the total
        computed for the year due to shares issued each quarter.
  46
 Table
            of Contents
  15.  Restatement
 
 The
        Consolidated Statements of Cash Flows for the years ended December 31, 2006
        and
        2005 have been restated, the year ended December 31, 2004 has been revised
        in
        the amount of $443,000 for conformity purposes.  The Company has
        restated its Consolidated Statements of Cash Flows by reclassifying cash
        flows
        related to its inventory financing, disclosed as a separate line item, from
        operating activities to financing activities.  Consequently, this
        reclassification will result in a change to cash flows (used in) provided
        by
        operating activities with an equal and off-setting impact to cash flows (used
        in) provided by financing activities. This restatement does not impact the
        Company’s previously reported overall net change in cash and cash equivalents in
        its Consolidated Statements of Cash Flows for any period
        presented.  Additionally, this restatement does not impact the
        Company’s Consolidated Balance Sheets, Consolidated Statements of Operations or
        Consolidated Statements of Shareholders’ Equity for any period
        presented.
 
 The
        following table presents the effect of the restatement on the Consolidated
        Statements of Cash Flows for the years ended December 31, 2006 and 2005 (in
        thousands):
 
 For
                  the Year ended December 31, 2006As
                    Reported
              
              
              Adjustment
              
              
              As
                    RestatedCash
                  flows from operating activities:Net
                  change in inventory financing
              
              $
              5,916
              
              
              $
              (5,916
              )
              
              $
              -Net
                  cash provided by (used in)  operating activities
              
              
              24,594
              
              
              
              (5,916
              )
              
              
              18,678Cash
                  flows from investing activities:Net
                  cash used in investing activities
              
              
              (1,792
              )
              
              
              -
              
              
              
              (1,792
              )Cash
                  flows from financing activities:Net
                  change in inventory financing
              
              
              -
              
              
              
              5,916
              
              
              
              5,916Net
                  cash provided by (used in) financing activities
              
              
              (16,806
              )
              
              
              5,916
              
              
              
              (10,890
              )Net
                  increase in cash and cash equivalents
              
              
              5,996
              
              
              
              -
              
              
              
              5,996Cash
                  and cash equivalents at the beginning of the year
              
              
              3,195
              
              
              
              -
              
              
              
              3,195Cash
                  and cash equivalents at the end of the year
              
              $
              9,191
              
              
              $
              -
              
              
              $
              9,191For
                  the Year ended December 31, 2005As
                    Reported
              
              
              Adjustment
              
              
              As
                    RestatedCash
                  flows from operating activities:Net
                  change in inventory financing
              
              $
              (5,837
              )
              
              $
              5,837
              
              
              $
              -Net
                  cash provided by (used in)  operating activities
              
              
              (11,228
              )
              
              
              5,837
              
              
              
              (5,391
              )Cash
                  flows from investing activities:Net
                  cash used in investing activities
              
              
              (1,826
              )
              
              
              -
              
              
              
              (1,826
              )Cash
                  flows from financing activities:Net
                  change in inventory financing
              
              
              -
              
              
              
              (5,837
              )
              
              
              (5,837
              )Net
                  cash provided by (used in) financing activities
              
              
              9,792
              
              
              
              (5,837
              )
              
              
              3,955Net
                  decrease in cash and cash equivalents
              
              
              (3,262
              )
              
              
              -
              
              
              
              (3,262
              )Cash
                  and cash equivalents at the beginning of the year
              
              
              6,457
              
              
              
              -
              
              
              
              6,457Cash
                  and cash equivalents at the end of the year
              
              $
              3,195
              
              
              $
              -
              
              
              $
              3,195
  47
 Table
            of Contents
 
 Reportof
        Independent Registered Public Accounting
        Firm
 
 
 Board
        of
        Directors and Shareholders of
 Zones,
        Inc.
 
 We
        have
        audited the accompanying consolidated balance sheets of Zones, Inc. as of
        December 31, 2006 and 2005, and the related consolidated statements of
        operations, shareholders’ equity, and cash flows for each of the two years in
        the period ended December 31, 2006.  These financial
        statements are the responsibility of the Company’s management.  Our
        responsibility is to express an opinion on these financial statements based
        on
        our audits.
 
 We
        conducted our audits in accordance with the standards of the Public Company
        Accounting Oversight Board (United States).  Those standards require
        that we plan and perform the audit to obtain reasonable assurance about whether
        the financial statements are free of material misstatement.  The
        Company is not required to have, nor were we engaged to perform an audit
        of its
        internal control over financial reporting.  Our audit included
        consideration of internal control over financial reporting as a basis for
        designing audit procedures that are appropriate in the circumstances, but
        not
        for the purpose of expressing an opinion on the effectiveness of the Company’s
        internal control over financial reporting.  Accordingly, we express no
        such opinion.  An audit also includes examining, on a test basis,
        evidence supporting the amounts and disclosures in the financial statements,
        assessing the accounting principles used and significant estimates made by
        management, as well as evaluating the overall financial statement
        presentation.  We believe that our audits provide a reasonable basis
        for our opinion.
 
 In
        our
        opinion, the financial statements referred to above present fairly, in all
        material respects, the financial position of Zones, Inc. as of
        December 31, 2006 and 2005, and the results of its operations and its
        cash flows for each of the two years in the period ended
        December 31, 2006, in conformity with accounting principles generally
        accepted in the United States of America.
 
 Our
        audit
        was conducted for the purpose of forming an opinion on the basic consolidated
        financial statements taken as a whole.  The consolidated financial
        statement schedule listed in Item 15 as of and for the years ended
        December 31, 2006 and 2005 is presented for purposes of additional
        analysis and is not a required part of the basic consolidated financial
        statements.  This schedule has been subjected to the auditing
        procedures applied in the audit of the basic consolidated financial statements
        and, in our opinion, is fairly stated in all material respects in relation
        to
        the basic consolidated financial statements taken as a whole.
 
 As
        described in note 15, the consolidated statements of cash flows for the year
        ended December 31, 2006 and 2005 have been restated.
   Grant
        Thornton LLP
 Seattle,
        Washington
 February
        16, 2007
 (Except
        for note 15, as to which the date is November 8, 2007)
 
  48
 Table
            of Contents
  Reportof
        Independent Registered Public Accounting
        Firm
 
 
 Tothe
        Shareholders
        of
 Zones,
        Inc.
  In
        our
        opinion, the accompanying consolidated statements of income, shareholders’
equity and cash flows listed in the index appearing under Item 15(a)(1) present
        fairly, in all material respects, the results of operations and cash flows
        of
        Zones, Inc and its subsidiaries for the year ended December 31, 2004in conformity with
        accounting principles generally accepted in the United States of America.
        In
        addition, in our opinion, the financial statement schedule listed in the
        index
        appearing under Item 15(a)(2) presents fairly, in all material respects,
        the
        information as of and for the year ended December 31, 2004 set forth therein
        when read in conjunction with the related consolidated financial statements.
        These financial statements and financial statement schedule are the
        responsibility of the Company’s management. Our responsibility is to express an
        opinion on these financial statements and financial statement schedule based
        on
        our audit. We conducted our audit of these statements in accordance with
        the
        standards of the Public Company Accounting Oversight Board (United States).
        Those standards require that we plan and perform the audit to obtain reasonable
        assurance about whether the financial statements are free of material
        misstatement. An audit includes examining, on a test basis, evidence supporting
        the amounts and disclosures in the financial statements, assessing the
        accounting principles used and significant estimates made by management,
        and
        evaluating the overall financial statement presentation. We believe that
        our
        audit provides a reasonable basis for our opinion.
 
 
 PricewaterhouseCoopers
        LLP
 Seattle,
        Washington
 February
        28, 2005 except for Note 15, as to which
 the
        date
        is November 13, 2007
  49
 Table
            of Contents
  ZONES,
        INC.
 SCHEDULEII
–
CONSOLIDATED
        VALUATION AND QUALIFYING
        ACCOUNTS
 
 
 Description
              
              Balance
                    at beginning of period
              
              
              Charges
                    to costs and expenses
              
              
              Charges
                    to other accounts
              
              
              Deductions
              
              
              Balance
                    at end of periodYear
                  Ended December 31, 2006Allowance
                  for doubtful accounts
              
              $
              1,562
              
              
              $
              772
              
              
              $
              
              
              
              $
              398
              (a)
              
              $
              1,936Year
                  Ended December 31, 2005Allowance
                  for doubtful accounts
              
              $
              2,666
              
              
              $
              458
              
              
              $
              
              
              
              $
              1,562
              (a)
              
              $
              1,562Year
                  Ended December 31, 2004Allowance
                  for doubtful accounts
              
              $
              2,734
              
              
              $
              297
              
              
              $
              
              
              
              $
              365
              (a)
              
              $
              2,666(a)
                  Uncollectible items written off, less recoveries of items previously
                  written off.
   50