**UNITED
        STATES**
 **SECURITIES
        AND EXCHANGE COMMISSION**
 **Washington,
        D.C. 20549**
 **FORM
        10-K**
 
 **T**
              **ANNUAL
                  REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                  ACT OF
                  1934**
 **FOR
        THE FISCAL YEAR ENDED DECEMBER 31, 2005**
 
 **OR**
 
 **o**
              **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.
                  Employer Identification Number)**1102
                  15****th****Street SW, Suite 102****Auburn,
                  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: None
 Securities
        registered pursuant to Section 12(g) of the Act: Common Stock
 
 Indicate
        by check mark if the registrant is a well-known seasoned issuer, as defined
        in
        Rule 405 of the Securities Act. Yes o No T
 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 o 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 o
 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 o Accelerated
        filer o Non-accelerated
        filer T
 
 Indicate
        by check mark whether the registrant is a shell company (as defined in Rule
        12b-2 of the Act). Yes o No T
 
 The
        aggregate market value of the Common Stock held by non-affiliates as of June
        30,
        2005 was approximately $26,125,813, based upon the last sales price per share
        of
        $4.05 as reported by the NASDAQ National Market.
 
 The
        number of shares of the registrant's Common Stock outstanding as of February
        20,
        2005 was 13,303,189.
 
 **DOCUMENTS
        INCORPORATED BY REFERENCE**
 
 Portions
        of the definitive Proxy Statement for the Registrant’s Annual Meeting of
        Shareholders to be held on April 27, 2006 have been incorporated by reference
        into Part III of this Annual Report on Form 10-K.
  
 
  **ZONES,
        INC.**
 **FORM
        10-K ANNUAL REPORT**
 **FOR
        THE YEAR ENDED DECEMBER 31, 2005**
 **TABLE
        OF CONTENTS**
 
 **PART
                  I**Page
                  No.Item
                  1.
              Business
              3Item
                  2.
              Properties
              12Item
                  3.
              Legal
                  Proceedings
              12Item
                  4.
              Submission
                  of Matters to a Vote of Security
                  Holders
              12Item
                  4a.
              Executive
                  Officers of the
                  Registrant
              12**PART
                  II**Item
                  5.
              Market
                  for Registrant’s Common Equity, Related
                  Shareholder Matters and Issuer Purchases of Equity
                  Securities
              13Item
                  6.
              Selected
                  Financial Data
              14Item
                  7.
              Management’s
                  Discussion and Analysis of Financial Condition
                  and Results of Operations
              16Item
                  7a.
              Quantitative
                  and Qualitative Disclosures About Market
                  Risk
              23Item
                  8.
              Financial
                  Statements and Supplementary
                  Data
              24Item
                  9.
              Changes
                  in and Disagreements with
                  Accountants on Accounting and Financial Disclosure
              24Item
                  9a.
              Controls
                  and Procedures
              24Item
                  9b.
              Other
                  Information
              24**PART
                  III**Item
                  10.
              Directors
                  and Executive Officers of the
                  Registrant
              24Item
                  11.
              Executive
                  Compensation
              24Item
                  12.
              Security
                  Ownership of Certain Beneficial Owners
                  and Management
              24Item
                  13.
              Certain
                  Relationships and Related
                  Transactions
              25Item
                  14.
              Principal
                  Accounting Fees and
                  Services
              25**PART
                  IV**Item
                  15.
              Exhibits,
                  Financial Statement
                  Schedules
              25Signatures
              27
  2
 *Table
            of Contents*
  **Part
        I**
 
 **Item
                  1.**
              **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” and “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 the risk factors on pages 4 - 6
        of
        this document. 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 statement, whether as a result of new information, future
        events
        or otherwise.
 
 **General**
 
 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,
        large and public sector accounts. Zones sells products through outbound and
        inbound account executives, specialty print and e-catalogs, and the Internet.
        Zones offers more than 150,000 products from leading manufacturers, including
        3Com, Adobe, Apple, Cisco, Epson, HP, IBM, Kingston, 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**
 
 The
        Company believes that the direct marketing reseller (“DMR”) channel has reached
        a level where customers have selected their vendor of choice to purchase,
        from
        either direct through DMRs or indirect through value added resellers (“VAR”).
        The industry growth recorded in 2005 was driven by unit volume. Average selling
        prices declined and top line growth was based on selling more units at a
        lower
        price. Also, 2005 was a year marked by refresh cycles, as there were no
        significant technology changes in the market that would spur increased
        purchasing.
 
 Future
        growth will be predicated on increased corporate profit levels which will
        lead
        to an investment in new technology. The Company believes the 2006 corporate
        profit percentage rate of growth will be in the mid-single digit range.
        Generally, the Company believes that the DMR channel will grow in 2006 at
        market
        rate, with its core business to the SMB expected to outpace the market. To
        exceed the market rate of growth overall, companies must take market share
        from
        both direct and indirect competitors.
 
 Customers
        make their information technology (“IT”) purchasing decisions primarily 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 driven by few fixed costs, rapid inventory turns, a centralized
        sales
        force and highly automated internal processes, specifically including the
        use of
        the Internet and electronic data interchange (“EDI”) links with major vendors
        and customers to streamline operations. The Company’s 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, with value-added configuration and logistics services.
 
 The
        Company believes that a customer’s decision is based on the level of service
        they expect in relation to what they are willing to pay. The DMRs have evaluated
        other indirect providers in the industry to determine which added services
        will
        differentiate DMRs to gain market share from manufacturers selling direct
        and
        from other VARs. The Company continuously works with its vendor partners
        to be
        aware of and to capitalize on new product announcements. In particular, the
        Company is focused on the shift by commercial customers to mobile technology
        and
        the need for additional storage and security, as well as the anticipated
        introduction of new software solutions.
  3
 *Table
            of Contents*
 
 **Risk
        Factors**
 
 There
        are
        a number of important factors that could 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.
 
 *No
        Assurance of Future Profitability.* Our
        operating results are difficult to forecast, and external factors affecting
        sales and operating results are:
 ·
              purchasing
                  cycles of commercial and public sector customers;
 ·
              the
                  level of corporate investment in new IT-related capital
                  equipment;
 ·
              industry
                  announcements of new products or
                  upgrades;
 ·
              industry
                  consolidation;
 ·
              cost
                  of compliance with new legal and regulatory requirements;
                  and
 ·
              general
                  economic conditions.
 We
        have
        taken a number of steps to reduce fixed costs, such as reducing redundant
        headcount. We intend to continue exploring additional means of cost reduction,
        but there is no assurance that we will be able to continue to identify or
        achieve additional cost savings or to maintain profitability going forward.
 
 *No
        Assurance as to Sales Levels.* There is
        no assurance that we will sustain our current sales levels. Sales may decline
        for any number of reasons, such as:
 ·
              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.
 A
        decline
        in sales levels could adversely affect our business, financial condition,
        cash
        flows or results of operations.
 
 *Pressure
        on Margins.* There is
        intense price competition and pressure on profit margins in the computer
        products industry. An increasing number of manufacturers are providing their
        products direct to customers. Various other factors also may create downward
        pressure on our gross margins, such as shifts 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.
 
 *Account
        Executive Hiring, Retention and Productivity.* We
        intend to continue to recruit account executives. We ended 2005 with 250
        account
        executives compared to 281 in 2004. The reduction was due to a qualitative
        review of our account executives. Currently, we hope to hire approximately
        100
        new account executives during 2006 for our Portland, Oregon call center and
        continue hiring for the Auburn headquarters. However, there are no assurances
        that we will be able to hire to these 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 our new Portland, Oregon call center will attract
        qualified account executives, or that we will be able to remotely manage
        and
        retain the new account executives.
 
 *Vendor
        Support.* 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. 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, manufacturers,
        distributors and vendors have been reducing these incentives and curtailing
        these programs. If these forms of vendor support decline further, 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.
  4
 *Table
            of Contents*
 
 *Major
        Shareholder* .
        Firoz
        H. Lalji, our Chairman and Chief Executive Officer, beneficially owns 52.0%
        of
        the outstanding shares of Zones common stock, excluding shares that he may
        acquire upon exercise of stock options that he holds. If Mr. Lalji exercises
        all
        options and retains the shares of common stock issued to him upon such exercise,
        his collective ownership would increase to 55.7% of the outstanding shares
        of
        Zones common stock. 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. Our certification as a Minority
        Business Enterprise is dependent on Mr. Lalji’s maintenance of voting control,
        and a decrease in his level of voting power could have an adverse effect
        on our
        ability to retain certain customers or compete for certain
        opportunities.
 
 *Competition.* The
        computer products industry is highly competitive. We believe that the
        relationships with the customer, prices, service offerings, and product
        selection and availability are the most important competitive factors. We
        compete with other national direct marketers, including CDW Corporation,
        Insight
        Enterprises, Inc., PC Connection, Inc. and PC Mall, Inc. We also compete
        with
        product manufacturers, such as Apple, Dell, Hewlett-Packard, IBM and Lenovo
        that
        sell direct to end-users; 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.
 
 *Rapid
        Technological Change and Inventory Obsolescence* .
        The
        computer industry is characterized by rapid technological change and frequent
        introductions of new products and product enhancements. To satisfy customer
        demand and obtain greater purchase discounts, 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.
 
 *Reliance
        on Vendor Relationships* .
        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
        its
        vendors are terminable without notice or upon short notice. 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.
 
 *Increased
        Expenses of Being a Public Company* .
        The
        costs of being a public company have increased significantly since the enactment
        of the Sarbanes-Oxley Act of 2002. Legal counsel fees specific to the increased
        disclosure requirements and the need to comply with new corporate governance
        requirements have increased under the Sarbanes-Oxley Act as well as SEC
        regulations and new NASDAQ rules. Additionally, independent registered public
        accounting firm audit fees have significantly increased and are expected
        to
        increase even more as requirements associated with corporate governance and
        internal controls become effective. These increasing costs may affect our
        business, financial condition, cash flows or results of operations.
 
 *State
        Tax Uncertainties.* We
        collect and remit sales and use taxes in states in which we have voluntarily
        registered and/or has a physical presence. Various states have sought to
        require
        the collection of state and local sales taxes on products shipped to the
        taxing
        jurisdiction’s residents by 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 that might give rise to future or past tax
        collection obligations based on that Supreme Court case. Many states
        aggressively pursue out of state businesses, and legislation that would expand
        the ability of states to impose sales tax collection obligations on out of
        state
        businesses has been introduced in Congress on many occasions. A change in
        the
        law could require us to collect sales taxes or similar taxes on sales in
        states
        in which hawse 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.
  5
 *Table
            of Contents*
 
 *Reliance
        on Distribution* .
        We
        operate warehouse and distribution centers in Bensenville, Illinois and now
        in
        Seattle, Washington. During the fourth quarter of 2005, we moved our Henderson,
        Nevada warehouse to Seattle, Washington. There are no assurances that
        transitioning the warehouse location will better support our customers on
        the
        West Coast or will be a suitable replacement for the Bensenville, Illinois
        facility in case of disruption. 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.
 
 *Dependence
        on Key Personnel* .
        Our
        future success will depend to a significant extent upon its 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
        a key role 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.
  *Liquidity
        of Stock and NASDAQ National Market Listing* .
        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 National Market. The NASDAQ National Market also
        imposes a requirement for continued listing that mandates 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, price for and liquidity of our stock,
        and
        reduced ability to issue additional securities or to secure additional
        financing.
 
 *Major
        Customer* .
        From
        time to time we have customers that represent more than 10% of total sales.
        For
        the years ended December 31, 2005 and 2004, there were no customers that
        individually represented more than 10% of total net sales.
 
 *Potential
        Disruption of Business From Information Systems Failure* .
        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.
 
 **The
        Business**
 
 The
        Company’s business is the procurement and fulfillment of IT solutions to the
        SMB, enterprise customer and public sector marketplace. Relationships with
        commercial and public sector institutions represented 96.5% of net sales
        in
        2005. The remaining revenue was primarily yielded from inbound consumers
        and
        small office/home office accounts. Substantially, all of the Company’s business
        is done in the United States of America.
 
 The
        Company’s core business is focused on the commercial and public sector markets
        within the United States. This is a large, addressable market of companies
        primarily served by a highly fragmented VAR community. The Company believes
        that
        the small customer, meaning those businesses with 50 to 100 computer users,
        is
        characterized by a transactional business, in contrast to the medium-sized
        customer, meaning those businesses with 100 to 1000 computer users, which
        is
        relationship-driven with more frequent transactions. The small and medium-sized
        business 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 generally are defined as customers within the Fortune 2000, with
        over
        1000 computer users, and 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
        a
        value-add-on to its customers, the Company offers asset tagging, configuration
        and other third-party services, and also maintains integration of customers’
business needs and processes through ZonesConnect, the Company’s robust,
        automated Web-based procurement system.
  6
 *Table
            of Contents*
 
 **The** **Business
        Strategy**
 
 The
        Company acquires and develops ongoing relationships with commercial and public
        sector accounts primarily through dedicated teams of outbound account executives
        (“AE”). Although outbound telemarketing is the Company’s primary customer
        contact, it also reaches customers through an integrated marketing and
        merchandising strategy that utilizes e-marketing and direct marketing vehicles,
        catalogs for demand response opportunities and corporate branding, and
        customized Web stores for its commercial customers through ZonesConnect.
 
 The
        Company’s support departments, such as Marketing and Merchandising, have aligned
        their processes, pricing, stocking strategies, marketing programs, quotas,
        communication methodology and training to the distinct priorities set for
        each
        sales department.
 
 The
        Company believes that its ability to grow in 2006 will depend on the
        continuation of growth in corporate IT spending as well as increases in market
        share and the depth of IT spending generated from existing customers. The
        Company believes that IT spending continues to be a function of growth in
        corporate profits, coupled with businesses perception of future economic
        growth.
        The Company’s business model relies on building and maintaining relationships
        with its customers to provide solutions to solve its customers’
needs.
 
 The
        Company strives to offer exemplary customer service in each transaction,
        which
        it defines 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. The Company offers 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 Account Executives 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.
 
 The
        specific areas of concentration to realize growth in the Company’s share of the
        IT-procurement market are:
 
 *Call
        Center Expansion* .
        To
        drive market share growth, the Company has established an additional sales
        call
        center in Portland, Oregon. The Company hopes to hire as many as 100 new
        AEs in
        Portland by the end of 2006. The Company’s hiring efforts in Portland will not
        diminish its recruiting and training initiatives dedicated to adding AEs
        at its
        Auburn location.
 
 *AE
        Hiring, Training and Development* .
        The
        Company continually seeks to attract, retain and motivate high-quality
        personnel. 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. The Company focuses
        on its
        relationship-based model, in which its 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
        built with the Company’s commercial and public sector accounts represent future
        growth opportunities. The Company continues to refine its lead generation
        programs and processes to increase and accelerate customer acquisition. During
        2006, the Company intends to focus on a customer management program to better
        understand the purchasing patterns and products of each individual customer.
        The
        Company believes this will increase operation efficiencies in the selling
        process and minimize loss of revenues during an account transition from one
        AE
        to another. The Company intends to explore opportunities for introduction
        of
        sales verticals that would create expertise in certain industry segments
        and
        product lines.
 
 *Product
        Breadth and Depth* .
        The
        Company depends upon relationships with key vendors for opportunistic product
        purchases to enhance margins. Through a strategic mix of products and vendors,
        the Company offers its customers a broad selection at competitive pricing.
        The
        Company generally stocks 20% of its product offerings, which represent 80%
        of
        its total revenue, in its warehousing facilities. The remaining items are
        offered to the Company’s customers through its virtual warehousing partnerships
        with key distributors and vendors via electronic data interchange (“EDI”). The
        Company uses its warehouse and EDI partners to fulfill its customers’ needs with
        broad product availability. The Company places individual orders directly
        with
        its EDI partners, who then assemble these orders and ship them directly to
        the
        Company’s customers.
  7
 *Table
            of Contents*
 
 *Services.* The
        Company offers 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. These services
        are
        performed at the Company’s distribution centers. Custom configuration services
        benefit customers by reducing the cost and time necessary to deploy new products
        into their existing technology environments.
 
 **Sales
        and Marketing**
 
 The
        Company reaches 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 through its
        ZonesConnect service. Throughout the year, marketing refines the characteristics
        of the Company’s target customers in each market and creates specific marketing
        collateral to reach that audience.
 
 *Outbound
        Telemarketing* .
        As of
        December 31, 2005, the Company had a staff of 241 AEs who actively pursued
        sales
        to commercial 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.
 
 *Inbound
        Sales* .
        The
        Company believes it has well-trained and knowledgeable inbound telemarketing
        representatives. The Company offers toll-free numbers for inbound sales that
        are
        staffed seven days a week. The Company’s inbound telephone sales personnel are
        also available to assist online customers.
 
 *Extranet
        Commerce* .
        The
        Company offers no-fee dedicated Web stores for its 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, the Company often provides
        more
        customized extranet sites for larger customers with specific online procurement
        needs.
 
 *Internet
        Commerce.* The
        Company’s electronic commerce sites on the Internet, Zones.com and MacZone.com,
        provide 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. The Company drives traffic to these sites
        by
        featuring the Internet address throughout its direct-mail vehicles and on
        the
        Company’s promotional communications and advertising. The Company also utilizes
        marketing through e-catalogs, as well as online price promotions and
        affiliations.
 
 *Direct
        Mail.* The
        Company markets 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 sites, Zones.com and MacZone.com,
        as
        well as to the 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 the Company’s
        vendors has generally declined both in dollars and as a percentage of sales
        over
        the last several years. 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.
  8
 *Table
            of Contents*
  **Products
        and Merchandising**
 
 The
        Company offers 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 the Company's catalogs,
        electronic commerce sites and sales force.
 
 *Computers
        and Servers* .
        The
        Company offers a large selection of desktop, laptop and tablet PC systems
        and
        servers from leading manufacturers, such as Acer, Apple, Dell, Gateway,
        Hewlett-Packard, Intel, Fujitsu, IBM, Lenovo, Panasonic, Sony and Toshiba.
 
 *Peripherals
        and Accessories* .
        The
        Company carries a full line of peripheral products such as printers, monitors,
        keyboards, handhelds (PDAs), memory, storage devices, modems, projectors,
        scanners and digital cameras, as well as various accessories and printing
        supplies such as toner cartridges, storage media and cables. Brands offered
        by
        the Company include APC, Apple, ATI, Belkin, Canon, Edge, Epson,
        Hewlett-Packard, InFocus, Iomega, Kingston, Kodak, Fuji, Lexmark, Logitech,
        LG,
        NEC-Mitsubishi, Nikon, Okidata, palmOne, Planar, Samsung, Sony, Targus,
        ViewSonic, and Xerox.
 
 *Networking
        and Storage* .
        The
        Company provides networking and network storage products such as switches,
        hubs,
        routers, cabling, firewalls, Voice over IP (VOIP), wireless devices, tape
        and
        disk backup, and SAN and NAS solutions. Brands offered by the Company include
        3Com, ADIC, Apple, Avocent, Belkin, Cisco, D-Link, EMC, Emulex, Exabyte,
        Hewlett-Packard, Hitachi Data Systems, IBM, Intel, Iomega, La Cie, Linksys,
        Netgear, Nortel Networks, Overland Storage, Qlogic, Quantum, Seagate, SonicWALL,
        Sony, Western Digital, among others.
 
 *Software* .
        The
        Company sells a wide variety of packaged software and licensing programs
        in
        business, personal productivity, connectivity, utility, language, educational,
        entertainment and other categories. The Company offers products from larger,
        well-known manufacturers, as well as numerous specialty products from new
        and
        emerging software development companies. Brands offered by the Company include
        Adobe, Citrix, Computer Associates, Corel, IBM, Microsoft, Novell, Symantec,
        Quark and VMware, among others.
 
 The
        Company is a Microsoft Certified Large Account Reseller, and, as such, can
        offer
        its large customers multiple methods of purchasing Microsoft software. This
        enables the Company to sell Select and Enterprise Agreement contracts to
        its
        customers. These software licensing agreements are designed for medium- to
        large-sized commercial and academic customers.
 
 The
        Company’s category merchandising group determines the manufacturers’ products
        that will be featured in its 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 reviewing its managed stock keeping units (“SKU”), which ensures that
        the Company is offering differentiating programs and competitive pricing.
        Each
        managed SKU also has component and add-on information to assist the AE in
        the
        selling process. Zones’ 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 the Company with
        incentives in the form of rebates, discounts and trade allowances.
 
 **Purchasing**
 
 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’s 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
        the
        Company to provide competitive pricing to its customers while maximizing
        its
        margins.
 
 The
        Company acquires 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 2005, the Company purchased
        approximately 62.6% of its merchandise from distributors, a decrease from
        71.7%
        in 2004. The Company believes that its overall sourcing strategy enables
        it to
        take advantage of significant special offers, discounts and supplier
        reimbursements, while also minimizing inventory costs. The Company believes
        it
        has excellent relationships with its suppliers and attempts to take advantage
        of
        all appropriate discounts.
  9
 *Table
            of Contents*
 
 The
        Company utilizes a blend of stocking and drop-ship procurement in executing
        its
        inventory management strategy. The Company generally stocks products that
        represent up to 80% of total revenue, including high-velocity and strategic
        products purchases. The remaining products are provided to the Company’s
        customers primarily through virtual warehousing partnerships with key
        distributors and manufacturers. Through these relationships, the Company
        is able
        to offer a broad selection of products and 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 within the Company’s
        ERP system, which lowers administrative overhead.
 
 At
        December 31, 2005, the Company maintained an investment in inventory of $19.7
        million, which turned an average of 26 times in 2005. This compares to an
        investment in inventory of $17.4 million at December 31, 2004, which turned
        an
        average of 29 times during 2004. The Company’s investment in inventory grew at
        December 31, 2005 due to on-hand customer-specific inventory as well as
        inventory supported by binding purchase orders.
 
 **Order
        Fulfillment and Distribution**
 
 The
        Company distributes products virtually through its EDI arrangement with its
        vendors, as well as through its warehouses in Bensenville, Illinois and Seattle,
        Washington.
 
 The
        Company provides and operates a full-service warehouse and distribution center
        in Bensenville, Illinois to support its nationwide customer base and a
        customized fulfillment center in Seattle, Washington to specifically support
        the
        Company’s West Coast customers. The warehouse personnel utilize the Company’s
        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 by the Company. The Company
        also
        uses its 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 vendor, returned to
        general inventory, repaired or liquidated. Returns are at the Company’s
        discretion and the Company maintained an allowance for sales returns during
        2005
        and 2004 of $108,000 and $75,000, respectively. The Company’s return policy
        allows for customer returns in certain cases. Its returns as a percentage
        of
        gross sales increased slightly to 2.2% in 2005 compared to 2.1% in 2004.
        Product
        returns are closely monitored to identify trends in product offerings, to
        enhance customer satisfaction and to reduce overall returns.
 
 Orders
        received by the Company are electronically transmitted on a dedicated data
        line
        to its distribution centers, where a packing slip is printed out for order
        fulfillment, and inventory availability is then automatically updated on
        all of
        the Company’s 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 Time  can
        generally be delivered overnight. Upon request, orders may also be shipped
        for
        Saturday delivery or by ground service or other overnight delivery
        services.
 
 **Technical
        Support and Customer Service**
 
 The
        Company maintains a staff of dedicated technical support personnel who provide
        pre- and post-sale technical support both for Zones account managers and
        its
        customers.  In addition to a broad base of A+ certifications, the team also
        maintains a number of distinguished manufacturer certifications, including
        Cisco
        CCNA, VMware VCP, Microsoft MCSE, APC Gold, LANDesk, Citrix CCA, and several
        other hardware-specific technical certifications.
 
 Pre-sales
        support is utilized primarily by the Company’s account managers to assist them
        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.
 
 The
        Company also employs 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. The Company believes the employment
        of these comprehensive support options improves the quality of its recommended
        technology solutions, reduces product returns, increases customer satisfaction
        and encourages repeat business.
  10
 *Table
            of Contents*
  **Systems**
 
 The
        Company continues to commit significant resources to the development of
        sophisticated management information, telecommunication, catalog production
        and
        other systems, which are employed in virtually all aspects of its business,
        including marketing, purchasing, inventory management, order processing,
        product
        distribution, accounts receivable, customer service and general accounting
        functions. During 2005, the Company continued to develop and enhance its
        sales
        interface for order entry. The Company’s graphical user interface ties all of
        the core systems together to give the AEs a common view of customers, products,
        inventory, and orders to streamline order processing as well as reduce the
        training time for new AEs. The Company is continually examining technological
        advances to increase the productivity of its team members.
 
 **Marketing**
 
 The
        Company maintains a proprietary database containing approximately 35,000
        customer records and has built a prospecting database of more than 150,000
        commercial leads. In the commercial market, the Company attracts new customers
        by providing qualified leads to outbound account executives, warming the
        leads
        with catalogs and direct-mail, and building relationships through outbound
        telephone calls. Retention of customers and account development is supported
        by
        catalog, direct mail and e-marketing. Catalog circulation is based on customer
        records, prospective customer inquirers, and mailing lists obtained from
        list
        brokers, product manufacturers, trade magazine publishers, association
        memberships and other sources. The Company regularly analyzes and updates
        its
        database and other available information to keep data current and to enhance
        customer response and order rates. The Company tracks the buying patterns
        of its
        customers in an attempt to anticipate customers’ needs and generate additional
        product orders. The Company believes that by selectively targeting its print
        media and e-vehicles to specific groups of customers with known product
        affinities and purchasing characteristics, it will be able to increase order
        rates by customers. The Company’s database-marketing capabilities allow it to
        promote products and offers from key manufacturers with strong target customers.
        The Company believes these efforts assist it in promoting and preserving
        positive relationships with manufacturers, as well as proactively presenting
        customers relevant offers.
 
 **Team
        Members**
 
 At
        December 31, 2005, the Company had 577 team members: 250 in the sales force,
        36
        in its warehousing and distribution, and 291 team members in its administrative
        overhead departments. The Company considers its employee relations to be
        good.
        The Company has never had a work stoppage and does not believe that any team
        members are represented by a labor organization. The Company emphasizes the
        recruiting and training of high-quality personnel and strives to promote
        people
        to positions of increased responsibility from within the Company.
 
 *Sales
        Team Education*
 
 The
        Company provides a balanced training program consisting of classroom and
        practical on-the-job learning within an outbound sales environment. Zones
        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*
 
 The
        Company is dedicated to creating a learning organization of empowered
        individuals to serve its customers with integrity, commitment and passion.
        It
        strives to achieve this by stimulating a positive and collaborative workplace
        environment, delivering high-speed and quality service to its customers,
        and
        adapting to external changes with flexibility, innovation and leading-edge
        technology.
 
 **Seasonality**
 
 Sales
        to
        the Company’s commercial customers have not historically experienced significant
        seasonality throughout the year. In 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 customer’s increase as a percentage of overall sales, the Company
        as a whole may experience increased seasonality in future periods.
  11
 *Table
            of Contents*
  **Trademarks**
 
 The
        Company conducts its business in the United States primarily under the service
        marks Zones® and The Mac Zone® both of which are registered with the United
        States Patent and Trademark Office. The Company believes that these and its
        other marks have significant value and are an important factor in the marketing
        of its 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 as conducted by the Company
        is subject to the Federal Trade Commission’s Merchandise Mail Order Rule and
        related regulations. The Company is also subject to laws and regulations
        relating to truth-in-advertising, Anti-Spam and other fair trade and privacy
        practices. The Company has implemented programs and systems to promote ongoing
        compliance with these laws and regulations.
 
 **Available
        Information**
 
 The
        Company makes available free of charge on its website, at www.zones.com/IR,
        its
        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 the Company files 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.
  The
        Company’s Audit Committee Charter, Compensation Committee Charter and Nominating
        and Governance Committee Charter are also available on its 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 15 th Street
        SW, Suite 102, Auburn, WA 98001-6509.
 
 **Item
                  2.**
              **Properties**
 
 The
        Company currently leases approximately 106,000 square feet of space for its
        corporate headquarters, including its telemarketing operations, in Auburn,
        Washington, approximately 27,000 square feet of space for its fulfillment
        warehouse facility in Seattle, Washington, approximately 70,000 square feet
        of
        space for the 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.
 
 **Item
                  3.**
              **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. 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.
 
 **Item4.**
              **Submission
                  of Matters to a Vote of Security Holders**
 
 None.
 
 **Item
                  4a.**
              **Executive
                  Officers of the
                  Registrant**
 
 *Firoz
        H. Lalji* ,
        age 59,
        has served as the Company’s President and 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.
 
 *Ronald
        P. McFadden* ,
        age 49,
        has served as Senior Vice President and Chief Financial Officer 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.
  12
 *Table
            of Contents*
 
 *Anwar
        Jiwani* ,
        age 51,
        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.
 
 *P.
        Sean Hobday* ,
        age 36,
        was appointed Executive Vice President of 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 *.*
 
 *Christina
        Corley* , age
        38,
        was appointed Executive Vice President of Purchasing and Operations for Zones,
        Inc. in February 2005. Prior to this Ms. Corley served as President of Corporate
        PC Source (“CPCS”), a wholly owned subsidiary of the Company, since March 2003.
        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 President of Sales and Marketing for VisionTek Corporation.
        From
        1994 to 1996, Ms. Corley served as the General Manager for the Midwest Division
        of Dataflex Corporation.
 
 **Part
        II**
 
 **Item
        5.** **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 National 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,****2005**
              
              **2004****High**
              
              **Low**
              
              **High**
              
              **Low**First
                  quarter
              
              $
              6.55
              
              $
              3.18
              
              $
              4.25
              
              $
              1.50Second
                  quarter
              
              
              4.15
              
              
              2.90
              
              
              3.50
              
              
              2.34Third
                  quarter
              
              
              4.48
              
              
              3.70
              
              
              3.35
              
              
              2.45Fourth
                  quarter
              
              
              5.50
              
              
              4.03
              
              
              7.40
              
              
              2.61
 
 As
        of the
        March 8, 2006 record date, the Company had approximately 5,700 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 2005 Annual Meeting of
        Shareholders under the caption “Equity Compensation Plan
        Information.”
 
 In
        July
        2004, the Board of Directors authorized a stock repurchase program under
        which
        the Company could repurchase up to $3.0 million in shares of the Company’s
        common stock in either open market or private transactions at then prevailing
        market prices. Under this repurchase program, the Company purchased and retired
        a total of 650,040 shares of its common stock at a total cost of $2.1 million
        (an average price of $3.27 per share).
 
 In
        July
        2005, the Board of Directors authorized the continuation of the Company’s share
        repurchase program until July 2006. The Company is authorized to repurchase
        up
        to an additional $3.0 million in shares of the Company’s common stock through
        July 2006 in open market or private transactions at then prevailing market
        prices. Under this repurchase program, the Company has purchased and retired
        222,800 shares of its common stock at a total cost of $1.0 million (an average
        price of $4.64 per share) during the six-month period ended December 31,
        2005.
 
 In
        February 2006, the Board of Directors authorized an increase to the Company’s
        share repurchase program. The Company is authorized to repurchase up to an
        additional $1.0 million in shares of the Company’s common stock through February
        2007 in open market or private transactions at then prevailing market prices.
        The Company now has a $3.0 million remaining balance in its current repurchase
        program. The Company anticipates the use of the remaining balance by the
        termination of the program in February of 2007. The following table represents
        the Company’s common stock repurchased and retired during the fourth quarter of
        2005.
  13
 *Table
            of Contents*
 
 The
        following table sets forth information on the Company’s common stock repurchase
        program for the quarter ended December 31, 2005:
 
 **Period**
              
              **Total
                  number of shares purchased**
              
              **Average
                  price paid per share**
              
              **Total
                  number of shares purchased as part of a publicly announced plan
                  or
                  program**
              
              **Maximum
                  amount that may yet be purchased under the plan or
                  program**October
                  1, 2005 through
                October
                  31, 2005
              
              
              46,500
              
              $
              4.83
              
              
              46,500
              
              $
              2,460,555November
                  1, 2005 through
                November
                  30, 2005
              
              
              97,500
              
              $
              5.07
              
              
              97,500
              
              $
              1,966,701December
                  1, 2005 through
                December
                  31, 2005
              
              
              0
              
              $
              -
              
              
              0
              
              $
              1,966,701
  **Item
                  6.**
              **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, 2005 and 2004 and the statement of operations data for the
        years
        ended December 31, 2005, 2004 and 2003 have been derived from the audited
        consolidated financial statements and notes thereto included in this Annual
        Report on Form 10-K. The balance sheet data for the years ended December
        31,
        2003, 2002 and 2001 and the statement of operations data for the years ended
        December 31, 2002 and 2001 have been derived from audited consolidated financial
        statements and notes thereto not included in this Annual Report on Form 10-K.
  14
 *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,****2005**
              
              **2004**
              
              **2003****2**
              
              **2002**
              
              **2001****(In
                  thousands, except per share data and operating
                  data)****Statement
                  of Operations Data:**Net
                  sales
              
              $
              566,553
              
              $
              495,563
              
              $
              460,772
              
              $
              414,643
              
              $
              541,075Cost
                  of sales
              
              
              505,997
              
              
              438,426
              
              
              410,078
              
              
              371,725
              
              
              487,450Gross
                  profit
              
              
              60,556
              
              
              57,137
              
              
              50,694
              
              
              42,918
              
              
              53,625Selling,
                  general and administrative expenses
              
              
              43,618
              
              
              42,284
              
              
              43,252
              
              
              40,294
              
              
              51,460Advertising
                  expense
              
              
              6,618
              
              
              7,082
              
              
              6,597
              
              
              1,354
              
              
              2,525State
                  tax (benefit) expense1,3
              
              
              
              
              
              
              
              
              (2,103
              )
              
              2,145Income
                  (loss) from operations
              
              
              10,320
              
              
              7,771
              
              
              2,948
              
              
              (875
              )
              
              (360
              )Other
                  (income) expense, net
              
              
              503
              
              
              314
              
              
              379
              
              
              (58
              )
              
              (26
              )Income
                  (loss) before income taxes
              
              
              9,817
              
              
              7,457
              
              
              2,569
              
              
              (817
              )
              
              (334
              )Provision
                  (benefit) from income taxes
              
              
              3,766
              
              
              2,805
              
              
              1,001
              
              
              (302
              )
              
              (149
              )Net
                  income (loss)
              
              $
              6,051
              
              $
              4,652
              
              $
              1,568
              
              $
              (515
              )
              $
              (185
              )Basic
                  income (loss) per share
              
              $
              0.45
              
              $
              0.34
              
              $
              0.11
              
              $
              (0.04
              )
              $
              (0.01
              )Weighted
                  average shares used in computation of basic income (loss) per
                  share
              
              
              13,382
              
              
              13,549
              
              
              13,644
              
              
              13,587
              
              
              13,488Diluted
                  income (loss) per share
              
              $
              0.42
              
              $
              0.32
              
              $
              0.11
              
              $
              (0.04
              )
              $
              (0.01
              )Weighted
                  average shares used in computation of diluted income (loss) per
                  share
              
              
              14,527
              
              
              14,469
              
              
              13,739
              
              
              13,587
              
              
              13,488**Balance
                  Sheet Data:**Working
                  capital
              
              $
              33,398
              
              $
              27,024
              
              $
              20,884
              
              $
              20,587
              
              $
              18,908Total
                  assets
              
              
              117,354
              
              
              102,144
              
              
              92,885
              
              
              79,952
              
              
              80,001Interest
                  bearing short-term debt
              
              
              11,972
              
              
              7,372
              
              
              8,683
              
              
              226
              
              
              1,412Long-term
                  debt, net of current portion
              
              
              21
              
              
              1,307
              
              
              1,667
              
              
              
              
              
              226Total
                  shareholders’ equity
              
              $
              41,317
              
              $
              36,551
              
              $
              32,701
              
              $
              31,097
              
              $
              31,558**Selected
                  Operating Data (unaudited):**Number
                  of shipments
              
              
              398,437
              
              
              421,836
              
              
              473,098
              
              
              506,877
              
              
              611,002Average
                  order size4
              
              $
              1,455
              
              $
              1,195
              
              $
              982
              
              $
              821
              
              $
              896Sales
                  force, end of period
              
              
              250
              
              
              281
              
              
              234
              
              
              239
              
              
              266
 
 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.
  15
 *Table
            of Contents*
  **Item
                  7.**
              **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” and “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 the risk factors on pages 4 - 6
        of
        this document. 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 statement, whether as a result of new information, future
        events
        or otherwise.
 
 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.
 
 **General**
 
 The
        Company’s net sales consist primarily of sales of computer hardware, software,
        peripherals and accessories, as well as revenue associated with freight billed
        to its customers, net of product returns. Gross profit consists of net sales
        less product and freight costs. Selling, general and administrative ("SG&A")
        expenses include warehousing and distribution costs, selling commissions,
        order
        processing, telephone and credit card fees, and other costs such as
        administrative salaries, depreciation, rent and general overhead expenses.
        Advertising expense is marketing costs associated with vendor programs, net
        of
        vendor cooperative advertising expense reimbursements allowable under EITF
        02-16
“Accounting for Consideration Received from a Vendor by a Customer (Including
        a
        Reseller of the Vendor’s Products).” Other expense represents interest expense,
        net of non-operating income.
 
 **Overview**
 
 Zones,
        Inc. is a direct marketing reseller of technology hardware, software and
        services. The Company procures and fulfills IT solutions to the small to
        medium-business (between 50 and 1000 computer users), enterprise customers
        (greater than 1000 computer users) and the public sector (education and state
        and local governments) markets. Relationships with small to medium sized
        businesses (“SMB”), enterprise customers, and public sector institutions
        represented 96.5% and 91.2% of total net sales during 2005 and 2004,
        respectively. The remaining sales were from inbound customers, primarily
        consumers and small office home office accounts purchasing primarily 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,
        customized Web stores for corporate customers through ZonesConnect, a state
        of
        the art Internet portal at www.zones.com ,
        dedicated e-marketing and direct marketing vehicles, and catalogs for
        demand-response opportunities and corporate branding.
 
 The
        Company utilizes its purchasing and inventory management capabilities to
        support
        its primary business objective of providing name brand products at competitive
        prices. The Company offers more than 150,000 hardware, software, peripheral
        and
        accessory products and services for users of Windows-based and Mac platform
        computers from over 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, co-op advertising reimbursements, advertising expenses, personnel
        costs, productivity per team member, average order size, accounts receivables
        aging, inventory turnover, 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,
        2005, the Company had 577 team members in its consolidated operations, 250
        of
        whom were inbound and outbound account executives. The majority of the Company’s
        team members work at its corporate headquarters in Auburn, Washington.
  16
 *Table
            of Contents*
 
 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. 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. 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 of $108,000 and $75,000 at December 31, 2005 and 2004,
        respectively.
 
 *Valuation
        of Current Assets and Estimation of Market Inventory
        Obsolescence* .
 
 The
        Company uses significant judgment and estimates in the preparation of its
        financial statements that affect the carrying values of its assets and
        liabilities. 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.
  17
 *Table
            of Contents*
 
 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, 2005, 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
        31st.
        The Company completed the impairment review required by SFAS No. 142 on March
        31, 2005 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,****2005**
              
              **2004**
              
              **2003**Net
                  sales
              
              
              100.0
              %
              
              100.0
              %
              
              100.0
              %Cost
                  of sales
              
              
              89.3
              
              
              88.5
              
              
              89.0Gross
                  profit
              
              
              10.7
              
              
              11.5
              
              
              11.0SG&A
                  expenses
              
              
              7.7
              
              
              8.5
              
              
              9.4Advertising
                  expense
              
              
              1.2
              
              
              1.4
              
              
              1.4State
                  tax (benefit) expense
              
              
              
              
              
              
              
              
              (0.4
              )Income
                  (loss) from operations
              
              
              1.8
              
              
              1.6
              
              
              0.6Other
                  expense, net
              
              
              0.1
              
              
              0.1
              
              
              0.1Income
                  (loss) before income taxes
              
              
              1.7
              
              
              1.5
              
              
              0.5Provision
                  (benefit) from income taxes
              
              
              0.7
              
              
              0.6
              
              
              0.2Net
                  income (loss)
              
              
              1.0
              %
              
              0.9
              %
              
              0.3
              %**Product
                  Mix:**Notebook
                  & PDAs
              
              
              15.3
              %
              
              14.7
              %
              
              14.8
              %Desktops
                  & Servers
              
              
              20.1
              
              
              21.3
              
              
              20.9Software
              
              
              15.9
              
              
              16.8
              
              
              13.7Storage
              
              
              9.1
              
              
              8.7
              
              
              10.7NetComm
              
              
              4.2
              
              
              4.4
              
              
              5.4Printers
              
              
              11.3
              
              
              9.6
              
              
              8.9Monitors
                  & Video
              
              
              9.6
              
              
              10.3
              
              
              9.6Memory
                  & Processors
              
              
              5.4
              
              
              5.0
              
              
              6.0Accessories
                  & Other
              
              
              9.1
              
              
              9.2
              
              
              10.0Total
              
              
              100.0
              %
              
              100.0
              %
              
              100.0
              %
  18
 *Table
            of Contents*
  *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 $190.9 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 twelve months 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 our legacy
        Mac-platform consumer and small office/home office (“SOHO”) customers declined
        55.4% to $19.6 million, or 3.5% 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.
                  The
                  Company expects this expense to continue to increase in 2006 as
                  it focuses
                  on growing its sales force and modifying its account executive
                  compensation package to remain competitive in the hiring market
                  place.
 ·
              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.
 ·
              Changes
                  in other administrative expenses individually are not significant,
                  but
                  taken as a whole reflect the remaining
                  variance.
 
 For
        the
        periods ending December 31, 2005 and 2004, warehousing and distribution network
        costs totaled $2.3 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. The Company’s marketing vehicles create the opportunity for advertising
        reimbursements. As the Company’s advertising expense declines, reimbursements
        will decline.
 
 *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.
  19
 *Table
            of Contents*
 
 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.
 
 In
        fiscal
        2006, the Company will begin to account for stock based compensation in
        accordance with Financial Accounting Standards Board (“FASB”) SFAS No. 123R,
“Share-Based Payment” (“SFAS 123R”), a revision of SFAS No. 123,
“Accounting for Stock-Based Compensation.” Although the effects of adopting this
        standard have not been fully quantified, the Company estimates that it will
        increase expenses in fiscal 2006 in the range of $300,000 to $400,000 before
        income taxes for stock options.
 
 *Comparison
        of Years Ended December 31, 2004 and 2003*
 
 *Net
        Sales.* Consolidated
        net sales increased 7.6% to $495.6 million in 2004, compared to $460.8 million
        in 2003. The increase in sales resulted primarily from an increase in sales
        to
        large and public sector customers. Sales to the Company’s large customers,
        including sales by its subsidiary CPCS, increased 11.6% to $243.2 million
        for
        the twelve months ended December 31, 2004, compared to $217.8 million in
        the
        prior year. Large customer sales for the twelve months ended December 31,
        2003
        included $37.7 million in net sales to a former major customer, whose contract
        expired in June 2003. Net sales to public sector customers increased 66.7%
        to
        $39.7 million in 2004 from $23.8 million in 2003. Consolidated outbound sales,
        to commercial and public sector accounts, increased 9.8% to $451.7 million
        in
        2004 from $411.3 million in 2003. Sales by the Company’s CPCS segment increased
        34.2% to $80.9 million when compared to $60.3 million in 2004. The increase
        was
        impacted by a March 31, 2003 acquisition date. Inbound sales to our legacy
        Mac-platform consumers and SOHO customers declined $5.7 million, or 11.5%
        year
        over year. This decline was anticipated and was partially offset by increases
        in
        sales by our Creative Professional Group, which is a focused outbound channel
        the Company began within the last year.
 
 *Gross
        Profit.* Consolidated gross profit increased to $57.1 million in 2004 as compared
        to
        $50.7 million in 2003. Gross profit as a percentage of net sales increased
        to
        11.5% in 2004 as compared to 11.0% in 2003. The increase in gross profit
        margin
        during 2004 was primarily due to increases in vendor volume incentive rebates
        and cooperative advertising funds classified as a reduction of cost of sales.
        These items were partially offset by the impact of freight promotions and
        changes in other components of cost of sales. Vendor volume incentive rebates
        increased due to performance against goals set by our vendor partners. The
        increase in cooperative advertising funds classified as a reduction of cost
        of
        sales was due to the classification of a higher percentage of these funds
        as a
        reduction of cost of sales rather than as a reduction of advertising expense
        as
        compared to 2003. 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 a company which categorizes its warehousing and distribution network
        costs as a cost of sales.
 
 *Selling,
        General and Administrative Expenses* .
        SG&A expenses decreased 2.3% to $42.3 million for the twelve months ended
        December 31, 2004 from $43.3 million in 2003, and declined as a percentage
        of
        net sales to 8.5% in 2004 compared to 9.4% in 2003. The decrease in SG&A
        expenses is primarily due to the process improvements we made throughout
        2003,
        partially offset by an increase in salaries, wages and benefits.
 
 ·
              The
                  Company moved its headquarters in September 2003, which resulted
                  in a
                  decrease in facilities expense during 2004 of $406,000 compared
                  to the
                  prior year.
 ·
              Depreciation
                  expense declined $758,000 for the year ended December 31, 2004
                  as compared
                  to 2003. 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.
 ·
              The
                  Company’s professional fees declined $323,000 during 2004. This is
                  primarily due to a decline in legal fees associated with the aborted
                  going
                  private transaction in 2003.
  20
 *Table
            of Contents*
 
 ·
              Credit
                  card processing fees during 2004 declined $214,000 as compared
                  to 2003.
                  This decline is due to the Company’s increase in outbound sales which tend
                  to purchase on open account versus credit card.
 ·
              Declines
                  in other administrative expenses individually are not significant,
                  but
                  taken as a whole reflect a $400,000 decline in 2004 due to management’s
                  ongoing fiscal initiative to reduce
                  costs.
 ·
              Salaries,
                  wages and benefits increased $1.1 million during 2004 as compared
                  to the
                  prior year as the Company increased its total headcount by 54 team
                  members.
 
 For
        both
        the periods ending December 31, 2004 and 2003, warehousing and distribution
        network costs totaled $1.9 million.
 
 *Advertising
        Expenses, Net* .
        The
        Company produces and distributes catalogs at various intervals throughout
        the
        year, as well as engaging in other activities, to increase the awareness
        of its
        brand and as demand-response vehicles. The Company’s net cost of advertising
        increased to $7.1 million in 2004 from $6.6 million in 2003. Gross advertising
        expense decreased to $7.6 million for fiscal year 2004, compared to $10.0
        million in fiscal year 2003. The decline primarily related to a reduction
        in the
        circulation of the Company’s catalogs. During 2004, the Company produced and
        distributed 7.7 million catalogs as compared to 9.4 million in 2003.
        Additionally, the Company eliminated certain unproductive marketing costs.
        The
        Company’s gross advertising reimbursements decreased to $564,000 in 2004 from
        $3.4 million in 2003. This decline was primarily due to an increase in
        cooperative advertising funds classified as a reduction of cost of sales.
        Comparatively, a higher percentage of the 2004 funds were classified as a
        reduction of cost of sales rather than as a reduction of advertising expense
        as
        in 2003.
 
 *Other
        Income/Expense, Net.* Other
        expense was $314,000 in 2004, compared to $379,000 in 2003. The decreased
        expense was primarily due to a decline in interest costs associated with
        the
        Company’s working capital line combined with an increase in the Company’s
        interest income. Other income/expense included interest expense due to the
        Company’s use of its working capital line of $275,000 in 2004 as compared to
        $310,000 in 2003.
 
 *Income
        Tax Provision/Benefit.* The
        income tax provision for 2004 was $2.8 million, compared to $1.0 million
        during
        2003. The effective tax rates expressed as a percent of income were 37.6%
        and
        38.9% for the years ended December 31, 2004 and 2003, respectively.
 
 *Net
        Income.* Net
        income for fiscal year 2004 was $4.7 million, or $0.32 per diluted share.
        The
        Company recorded net income of $1.6 million, or $0.11 per diluted share,
        for
        fiscal year 2003. Net income for 2003 includes a benefit relating to the
        settlement of a Washington State tax audit.
 
 **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 $117.4 million at December 31, 2005, of which $108.3
        million were current assets. At December 31, 2005 and 2004, the Company had
        cash
        and cash equivalents of $3.2 million and $6.5 million respectively, and had
        working capital of $33.4 million and $27.0 million, respectively. The increase
        in working capital was primarily a result of increases in accounts receivable
        and inventory, and was partially offset by increases in accounts payable.
 
 The
        Company committed to a stock repurchase program in July of 2004 under which
        the
        Company could repurchase up to $3.0 million in shares of the Company’s common
        stock through July 2005 in either open market or private transactions at
        then
        prevailing market prices. During the twelve months ended June 30, 2005, the
        Company purchased and retired a total of 650,040 shares of its common stock
        at a
        total cost of $2.1 million (an average price of $3.27 per share).
 
 In
        July
        2005, the Board of Directors authorized the continuation of the Company’s share
        repurchase program, pursuant to which the Company may repurchase up to an
        additional $3.0 million in shares of the Company’s common stock through July
        2006 in open market or private transactions at then prevailing market prices.
        For the three months ended December 31, 2005, the Company purchased and retired
        144,000 shares of its common stock at a total cost of $719,000 (an average
        price
        of $4.99 per share). For the six months ended December 31, 2005, the Company
        purchased and retired 222,800 shares of its common stock at a total cost
        of $1.0
        million (an average price of $4.64 per share).
  21
 *Table
            of Contents*
 
 In
        February 2006, the Board of Directors authorized an increase to the Company’s
        share repurchase program. The Company is authorized to repurchase up to an
        additional $1.0 million in shares of the Company’s common stock through February
        2007 in open market or private transactions at then prevailing market prices.
        The Company now has a $3.0 million remaining balance in its current repurchase
        program. The Company anticipates the use of the remaining balance by the
        termination of the program in February of 2007. The following table represents
        the Company’s common stock repurchased and retired during the fourth quarter of
        2005.
 
 **Period**
              
              **Total
                  number of shares purchased**
              
              **Average
                  price paid per share**
              
              **Total
                  number of shares purchased as part of a publicly announced plan
                  or
                  program**
              
              **Maximum
                  amount that may yet be purchased under the plan or
                  program**October
                  1, 2005 through
                October
                  31, 2005
              
              
              46,500
              
              $
              4.83
              
              
              46,500
              
              $
              2,460,555November
                  1, 2005 through
                November
                  30, 2005
              
              
              97,500
              
              $
              5.07
              
              
              97,500
              
              $
              1,966,701December
                  1, 2005 through
                December
                  31, 2005
              
              
              0
              
              $
              -
              
              
              0
              
              $
              1,966,701
  A
        larger
        portion of the Company’s business is now being done on terms rather than on
        credit cards, which increases the Company’s accounts receivable balance. Due to
        the fundamental shift in its cash flow cycle, the Company leverages its secured
        line of credit for timing difference in cash inflows and cash outflows to
        invest
        in the growth of its business. The secured line of credit is utilized to
        invest
        in capital purchases, investments in inventory for certain customers, and
        available early pay discounts.
 
 At
        December 31, 2005, 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 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, 2005, the Company
        was compliant with all covenants of this facility. At December 31, 2005,
        $10.7
        million of working capital advances were outstanding and amounts owed for
        flooring arrangements of $8.5 million were owed to this financial institution
        related to inventory purchases.
 
 The
        Company believes that its existing available cash and cash equivalents,
        operating cash flow, and existing credit facilities will be sufficient to
        satisfy its operating cash needs, as well as principal payments of $1.3 million
        owed to the former shareholders of CPCS, and up to the remaining balance
        of $3.0
        million authorized in the Company’s stock repurchase program, which will
        terminate in July 2006 unless renewed, 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 curtail its stock repurchase program and seek additional funds
        through sales of equity, debt or convertible securities, or increased credit
        facilities. There can be no assurance that additional financing will be
        available or that, if available, the financing will be on terms favorable
        to the
        Company and its shareholders.
 
 *Cash
        Flows*
 The
        primary factors that affected fiscal year 2005 cash flow from operations
        were
        account and vendor receivables, the net balance of accounts payable and
        inventory financing, the use of net operating loss carry-forwards, and the
        increase in inventory levels. Account and vendor receivables increased $19.1
        million. This is partially offset by the net balance in accounts payable
        and
        inventory financing increase of $2.7 million. The net accounts payable and
        inventory financing balance change is due to purchasing and payment cycles.
        The
        Company utilized $2.8 million of its net operating loss carry-forwards, which
        reduced the current federal income tax obligation. The Company has now fully
        utilized its net operating loss carry-forwards and will be required to submit
        funds for federal taxes in 2006. Inventories increased $2.3 million. The
        Company’s inventory turnover was 26 days during the year ended December 31, 2005
        as compared to 29 days during the year ended December 31, 2004. Included
        in
        inventory at December 31, 2005, was $1.9 million of inventories not
        available for sale that represent inventories segregated pursuant to binding
        customer contracts, which will be recorded as net sales when the criteria
        for
        sales recognition are met.
  22
 *Table
            of Contents*
 
 Net
        cash
        used in investing activities was $1.8 million at December 31, 2005. Cash
        outlays
        for capital expenditures were $1.8 million and $2.0 million for the twelve
        months ended December 31, 2005 and 2004, respectively. The 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 capital expenditures during 2004 were primarily for leasehold improvements
        for the Company’s new corporate headquarters, costs to transition the Company’s
        warehousing facility to its Bensenville, Illinois facility from a third-party
        vendor, and continued improvement, and other enhancements, of the Company’s
        information systems.
 
 The
        Company’s financing activities for the period ended December 31, 2005 included
        the payment of an amount due on the note payable issued in its acquisition
        of
        CPCS. The Company paid the former shareholders of CPCS $1.3 million during
        2005
        as compared to $862,000 in 2004. The Company has a remaining balance of $1.3
        million due to the former shareholders of CPCS which will by paid by the
        end of
        the second quarter of 2006.
 
 **Contractual
        Obligations**
 
 The
        following table summarizes our contractual payment obligations and commitments
        as of December 31, 2005:
 
 **Payments
                  Due by Period**Total
              
              Less
                  than 1 year
              
              1-3
                  years
              
              3-5
                  years
              
              More
                  than 5 yearsLong-Term
                  Debt (a)
              
              $
              1,272
              
              $
              1,272
              
              $
              
              
              $
              
              
              $Operating
                  Leases (b)
              
              
              12,297
              
              
              1,639
              
              
              3,392
              
              
              2,812
              
              
              4,454Purchase
                  Obligations (c)
              
              
              10,379
              
              
              10,379Total
              
              $
              23,948
              
              $
              13,290
              
              $
              3,392
              
              $
              2,812
              
              $
              4,454
 
 (a)
              Reflects
                  a note payable recorded in connection to the Company’s acquisition of CPCS
                  and the negotiated payments to the former shareholders.
 (b)
              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.
 (c)
              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
        December 2004, the Financial Accounting Standards Board (“FASB”) issued
        SFAS No. 123R, “Share-Based Payment” (“SFAS 123R”), a revision of SFAS
        No. 123, “Accounting for Stock-Based Compensation.” SFAS 123R will require
        the Company to, among other things, measure all employee stock-based
        compensation awards using a fair value method and record such expense in
        the
        Company’s consolidated financial statements. The provisions of SFAS 123R are
        effective for the first annual reporting period that begins after June 15,
        2005; therefore, the Company will adopt the new requirements beginning January
        1, 2006. Adoption of the expensing requirements will reduce the Company’s
        reported earnings. The Company has elected to implement this new standard
        under
        the modified prospective application. Under the modified prospective
        application, the Company will expense the cost of new or modified awards
        over
        the requisite service period and the cost of previously granted unvested
        awards
        for the requisite service period remaining after December 31, 2005. Although
        the
        effects of adopting this standard have not been fully quantified, the Company
        estimates that it will increase expenses in fiscal 2006 in the range of $300,000
        to $400,000 before income taxes for stock options relating to vesting of
        grants
        made prior to January 1, 2006.
 
 **Item
                  7A.**
              **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 $10.7 million
        of
        interest bearing borrowings outstanding pursuant to the credit agreement
        as of
        December 31, 2005. 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.
  23
 *Table
            of Contents*
 
 **Item
                  8.**
              **Financial
                  Statements and Supplementary
                  Data**
 
 The
        information required by this item is included in this report beginning at
        page
        29.
 
 **Item
                  9.**
              **Changes
                  in and Disagreements with Accountants on Accounting and Financial
                  Disclosure**
 
 None.
 
 **Item****9A.**
              **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 2005, 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.
 
 **Part
        III**
 
 **Item10.**
              **Directors
                  and Executive Officers of the
                  Registrant**
 
 The
        information required by this item is contained in, and incorporated by reference
        from, the Proxy Statement for the Company’s 2006 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 in recently adopted rules of the
        Securities and Exchange Commission implementing requirements of the
        Sarbanes-Oxley Act of 2002.
  The
        Company’s Code of Business Conduct and Ethics has been approved by its Board of
        Directors and will apply 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 undertakes to provide without charge to any person, upon written
        or
        verbal 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 15 th 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 2006 Annual Meeting of Shareholders
        under the caption “Executive Compensation.”
  24
 *Table
            of Contents*
  **Item
                  12.**
              **Security
                  Ownership of Certain Beneficial Owners and
                  Management**
 
 The
        information required by this item is contained in, and incorporated by reference
        from, the Proxy Statement for the Company’s 2006 Annual Meeting of Shareholders
        under the caption “Stock Ownership of Management and Certain Other
        Holders.”
 
 **Item13.**
              **Certain
                  Relationships and Related
                  Transactions**
 
 The
        information required by this item is contained in, and incorporated by reference
        from, the Proxy Statement for the Company’s 2006 Annual Meeting of Shareholders
        under the caption “Certain Relationships and Related Transactions.”
 
 **Item
                  14.**
              **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 2006 Annual Meeting of Shareholders
        under the caption “Principal Accounting Firm Fees.”
 
 **Part
        IV**
 
 **Item
                  15.**
              **Exhibits,
                  Financial Statement
                  Schedules**
 (a)
                1.
                    Financial Statements:
 The
                    financial statements of Zones, Inc. and its subsidiary, 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.
                
                8-K
                3.1
                000-28488
                5/10/013.3
                Articles
                    of Amendment of Multiple Zones, Inc.
                
                S-8
                4.2
                333-110750
                11/25/033.4
                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 Restated 1999 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
                    after
                    March 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
                6/5/96
  25
 *Table
              of Contents*
 
 10.9
                Amended
                    and Restated Indemnification Agreement
                
                10-Q
                10.1
                000-28488
                11/14/0310.10
                Loan
                    and Security Agreement 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 dated April 11, 2003
                    between
                    Zones, Inc., Corporate PC Source, Inc. and Transamerica Commercial
                    Finance
                    Corporation
                
                10-Q
                10.1
                000-28488
                8/14/0310.12
                Zones,
                    Inc. 2003 Equity Incentive Plan*
                
                14-A
                
                000-28488
                3/20/0310.13
                Stock
                    Purchase Agreement, dated March 31, 2003, by and among Zones,
                    Inc. and
                    Corporate PC Source, Inc. and Christina Corley, Robert Frauenheim,
                    individually and as Trustee of the Robert Frauenheim Declaration
                    of Trust
                    dated September 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 grants under the 2003 Stock
                    Equity
                    Plan)*
                
                10-K
                10.25
                000-28488
                2/26/0410.16
                Employment
                    and Non-Competition Agreement dated March 31, 2003 by and between
                    Zones,
                    Inc. and Christina Corley*
                
                10-Q
                10.2
                000-28488
                5/13/0410.17
                Amendment
                    to Christina Corley’s Employment and Non-Competition
                    Agreement*
                
                8-K
                99.1
                000-28488
                8/1/0510.18
                Commercial
                    Lease Agreement dated March 19, 2004 between Corporate PC Source
                    and AMB
                    Property II, L.P.
                
                10-Q
                10.4
                000-28488
                5/13/0410.19
                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
                5/13/0410.20
                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
                8/11/0410.21
                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
                9/29/0410.22
                Form
                    of Unsecured, Subordinated Promissory Note
                
                8-K
                10.2
                000-28488
                9/29/0410.23
                Summary
                    of Zones, Inc. Board Meeting Fees and Basic Compensation
                
                10-Q
                10.1
                000-28488
                8/10/0510.24
                Notice
                    of Grant of Director Stock Option pursuant to the Zones, Inc
                    2003 Equity
                    Incentive Plan
                
                10-Q
                10.2
                000-28488
                8/10/0510.25
                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
                11/9/0510.26
                Summary
                    of the Zones, Inc. Senior Management Bonus Program*
                
                8-K
                99.2
                000-28488
                2/8/0610.27
                Summary
                    of the Zones, Inc. Executive Vice President Bonus Program*
                
                8-K
                99.1
                000-28488
                2/8/0610.28
                Office
                    Lease dated December 2005 between Zones, Inc. and Montgomery
                    Park I, LLC
                X21.1
                Subsidiaries
                    of the Registrant
                X23.1
                Consent
                    of Grant Thornton LLP, Independent Registered Public Accounting
                    Firm
                X23.2
                Consent
                    of PricewaterhouseCoopers 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
                    ofChief
                    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
  26
 *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:
                  February 22, 2006By:
              /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
              
              February
                  22, 2006John
                  H. Bauer/S/
                  JOHN T. CARLETON
              
              Director
              
              February
                  22, 2006John
                  T. Carleton/S/
                  CATHI HATCH
              
              Director
              
              February
                  22, 2006Cathi
                  Hatch/S/
                  WILLIAM C. KEIPER
              
              Director
              
              February
                  22, 2006William
                  C. Keiper/S/
                  KENNETH M. KIRKPATRICK
              
              Director
              
              February
                  22, 2006Kenneth
                  M. Kirkpatrick/S/
                  FIROZ H. LALJI
              
              Director
              
              February
                  22, 2006Firoz
                  H. Lalji
  27
 *Table
            of Contents*
  **ZONES,
        INC.**
 **INDEX
        TO CONSOLIDATED FINANCIAL STATEMENTS**
 
 
 Consolidated
                  Financial Statements:Consolidated
                  Balance SheetsDecember
                  31, 2005 and 2004
              29Consolidated
                  Statements of OperationsTwelve
                  months ended December 31, 2005, 2004 and 2003
              30Consolidated
                  Statement of Shareholders’ EquityTwelve
                  months ended December 31, 2005, 2004 and 2003
              31Consolidated
                  Statements of Cash FlowsTwelve
                  months ended December 31, 2005, 2004 and 2003
              32Notes
                  to Consolidated Financial Statements
              33Report
                  of Grant Thornton LLP, Independent Registered Public Accounting
                  Firm
              46Report
                  of PricewaterhouseCoopers LLP, Independent Registered Public Accounting
                  Firm
              47Schedule
                  II - Valuation and Qualifying Accounts
              48
  28
 *Table
            of Contents*
  **ZONES,
        INC.**
 **CONSOLIDATED
        BALANCE SHEETS**
 **(in
        thousands, except share data)**
 **December
                    31,****2005**
                
                **2004****ASSETS**Current
                    assets:Cash
                    and cash equivalents
                
                $
                3,195
                
                $
                6,457Receivables,
                    net of allowance for doubtful accounts of $1,562 and
                    $2,666
                
                
                68,318
                
                
                53,903Vendor
                    receivables
                
                
                14,750
                
                
                10,035Inventories
                
                
                19,736
                
                
                17,405Prepaid
                    expenses
                
                
                922
                
                
                958Deferred
                    income taxes
                
                
                1,346
                
                
                1,525Total
                    current assets
                
                
                108,267
                
                
                90,283Property
                    and equipment, net
                
                
                3,810
                
                
                3,951Goodwill
                
                
                5,098
                
                
                5,098Deferred
                    income taxes
                
                
                
                
                
                2,640Other
                    assets
                
                
                179
                
                
                172Total
                    assets
                
                $
                117,354
                
                $
                102,144**LIABILITIES
                    AND SHAREHOLDERS' EQUITY**Current
                    liabilities:Accounts
                    payable
                
                $
                45,359
                
                $
                34,250Inventory
                    financing (Note 5)
                
                
                8,469
                
                
                14,306Accrued
                    liabilities
                
                
                8,621
                
                
                6,989Line
                    of credit
                
                
                10,700
                
                
                6,100Income
                    taxes payable
                
                
                448
                
                
                342Notes
                    payable to former shareholders of CPCS, Inc.
                
                
                1,272
                
                
                1,272Total
                    current liabilities
                
                
                74,869
                
                
                63,259Note
                    payable for purchase of fixed asset
                
                
                21
                
                
                35Notes
                    payable to former shareholders of CPCS, Inc., net of current
                    portion
                
                
                
                
                
                1,272Deferred
                    income tax
                
                
                35Deferred
                    rent obligation
                
                
                1,112
                
                
                1,027Total
                    liabilities
                
                
                76,037
                
                
                65,593Commitments
                    and contingencies (Note 8)Shareholders'
                    equity:Common
                    stock, no par value, 45,000,000 authorized; 13,265,049 and 13,507,727
                    shares issued and outstanding at December 31, 2005 and 2004,
                    respectively
                
                
                37,503
                
                
                38,788Retained
                    earnings (deficit)
                
                
                3,814
                
                
                (2,237
                )Total
                    shareholders' equity
                
                
                41,317
                
                
                36,551Total
                    liabilities and shareholders' equity
                
                $
                117,354
                
                $
                102,144
 The
        accompanying notes are an integral part of the consolidated financial
        statements.
  29
 *Table
            of Contents*
  **ZONES,
        INC.**
 **CONSOLIDATED
        STATEMENTS OF OPERATIONS**
 **(in
        thousands, except per share data)**
 **Year
                      ended December 31,****2005**
                  
                  **2004**
                  
                  **2003**Net
                      sales
                  
                  $
                  566,553
                  
                  $
                  495,563
                  
                  $
                  460,772Cost
                      of sales
                  
                  
                  505,997
                  
                  
                  438,426
                  
                  
                  410,078Gross
                      profit
                  
                  
                  60,556
                  
                  
                  57,137
                  
                  
                  50,694Selling,
                      general and administrative expenses
                  
                  
                  43,618
                  
                  
                  42,284
                  
                  
                  43,252Advertising
                      expense
                  
                  
                  6,618
                  
                  
                  7,082
                  
                  
                  6,597State
                      tax benefit
                  
                  
                  
                  
                  
                  
                  
                  
                  (2,103
                  )Income
                      from operations
                  
                  
                  10,320
                  
                  
                  7,771
                  
                  
                  2,948Interest
                      expense
                  
                  
                  594
                  
                  
                  404
                  
                  
                  424Other
                      income
                  
                  
                  (91
                  )
                  
                  (90
                  )
                  
                  (45
                  )Other
                      expense, net
                  
                  
                  503
                  
                  
                  314
                  
                  
                  379Income
                      before income taxes
                  
                  
                  9,817
                  
                  
                  7,457
                  
                  
                  2,569Provision
                      for income taxes
                  
                  
                  3,766
                  
                  
                  2,805
                  
                  
                  1,001Net
                      income
                  
                  $
                  6,051
                  
                  $
                  4,652
                  
                  $
                  1,568Basic
                      income per share
                  
                  $
                  0.45
                  
                  $
                  0.34
                  
                  $
                  0.11Weighted
                      average shares used in computing basic income per share
                  
                  
                  13,382
                  
                  
                  13,549
                  
                  
                  13,644Diluted
                      income per share
                  
                  $
                  0.42
                  
                  $
                  0.32
                  
                  $
                  0.11Weighted
                      average shares used in computing diluted income per share
                  
                  
                  14,527
                  
                  
                  14,469
                  
                  
                  13,739
 
 The
        accompanying notes are an integral part of the consolidated financial
        statements.
  30
 *Table
            of Contents*
  **ZONES,
        INC.**
 **CONSOLIDATED
        STATEMENT OF SHAREHOLDERS' EQUITY**
 **(in
        thousands, except share data)**
   Common
                  Stock
              
              Accumulated
                  EarningsShares
              
              Amount
              
              (Deficit)
              
              TotalBalance,
                  January 1, 2003
              
              
              13,609,956
              
              $
              39,554
              
              $
              (8,457
              )
              $
              31,097Issuance
                  of common stock
              
              
              44,415
              
              
              32
              
              
              
              
              
              32Exercise
                  of stock options
              
              
              5,000
              
              
              4
              
              
              
              
              
              4Net
                  income
              
              
              
              
              
              
              
              
              1,568
              
              
              1,568Balance,
                  December 31, 2003
              
              
              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
              
              $
              41,317
 
 
 The
        accompanying notes are an integral part of the consolidated financial
        statements.
  31
 *Table
            of Contents*
  **ZONES,
        INC.**
 **CONSOLIDATED
        STATEMENTS OF CASH FLOWS**
 **(in
        thousands)**
 
 **Year
                  ended December 31,****2005**
              
              **2004**
              
              **2003**Cash
                  flows from operating activities:Net
                  income
              
              $
              6,051
              
              $
              4,652
              
              $
              1,568Adjustments
                  to reconcile net income to netcash
                  provided by (used in) operating activities:Depreciation
              
              
              1,966
              
              
              2,470
              
              
              3,228Deferred
                  taxes
              
              
              2,854
              
              
              2,272
              
              
              950Tax
                  effect of stock option exercise
              
              
              212
              
              
              93Loss
                  on disposal of assets
              
              
              
              
              
              (2
              )(Increase)
                  decrease in assets and liabilities:Receivables,
                  net
              
              
              (19,130
              )
              
              (3,973
              )
              
              (5,301
              )Inventories
              
              
              (2,330
              )
              
              (5,918
              )
              
              1,651Prepaid
                  expenses and other assets
              
              
              29
              
              
              138
              
              
              289Accounts
                  payable
              
              
              3,133
              
              
              6,618
              
              
              (10,808
              )Inventory
                  financing
              
              
              (5,837
              )
              
              (443
              )
              
              5,627Income
                  taxes payable
              
              
              107Accrued
                  liabilities and deferred rent
              
              
              1,717
              
              
              (206
              )
              
              (2,844
              )Net
                  cash provided by (used in) operating activities
              
              
              (11,228
              )
              
              5,701
              
              
              (5,640
              )Cash
                  flows from investing activities:Purchases
                  of property and equipment
              
              
              (1,826
              )
              
              (2,029
              )
              
              (1,627
              )Payment
                  for acquisition, net of cash acquired
              
              
              
              
              
              
              
              
              (3,719
              )Net
                  cash used in investing activities
              
              
              (1,826
              )
              
              (2,029
              )
              
              (5,346
              )Cash
                  flows from financing activities:Net
                  change in book overdrafts
              
              
              7,975
              
              
              1,112
              
              
              1,639Net
                  change in line of credit
              
              
              4,600
              
              
              (1,750
              )
              
              5,669Payments
                  of note payable
              
              
              (1,286
              )
              
              (862
              )Payments
                  on capital lease obligations
              
              
              
              
              
              
              
              
              (226
              )Proceeds
                  from exercise of stock options
              
              
              316
              
              
              453
              
              
              36Purchase
                  and retirement of common stock
              
              
              (1,813
              )
              
              (1,348
              )Net
                  cash provided by (used in) financing activities
              
              
              9,792
              
              
              (2,395
              )
              
              7,118Net
                  increase (decrease) in cash and cash equivalents
              
              
              (3,262
              )
              
              1,277
              
              
              (3,868
              )Cash
                  and cash equivalents at beginning of years
              
              
              6,457
              
              
              5,180
              
              
              9,048Cash
                  and cash equivalents at end of years
              
              $
              3,195
              
              $
              6,457
              
              $
              5,180Supplemental
                  cash flow information:Cash
                  paid for interest
              
              $
              554
              
              $
              335
              
              $
              265Cash
                  paid for income taxes
              
              $
              594
              
              $
              260
              
              $
              2Noncash
                  investing and financing activity:Note
                  payable for acquisition of Corporate PC Source (“CPCS”)
              
              
              
              
              
              
              
              $
              2,500Cancellation
                  of note payable for acquisition of CPCS
              
              
              
              
              $
              1,544Note
                  payable to replace 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
              
              
              
              
              $
              35The
                  Company purchased all of the capital stock of CPCS on March 31,
                  2003 for
                  $6.2 million, net of cash acquired. In conjunction with the acquisition,
                  liabilities were assumed as follows:Fair
                  value of assets acquired
              
              
              
              
              
              
              
              $
              17,448Cash
                  paid for capital stock
              
              
              
              
              
              
              
              
              (5,177
              )Note
                  payable issued for acquisition of capital stock
              
              
              
              
              
              
              
              
              (2,500
              )Liabilities
                  assumed
              
              
              
              
              
              
              
              $
              9,771
   The
        accompanying notes are an integral part of the consolidated financial
        statements.
  32
 *Table
            of Contents*
 
 **ZONES,
        INC.**
 **NOTES
        TO 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,
        and enterprise and public sector accounts. Zones sells these products through
        outbound and inbound account executives, specialty print and e-catalogs,
        and the
        Internet. Zones offers more than 150,000 products from leading manufacturers
        including 3Com, Adobe, Apple, Cisco, Epson, HP, IBM, Kingston, 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 subsidiaries. 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. Inventories are valued
        at
        the lower of first-in, first-out (FIFO) cost or market. The Company has provided
        allowances for obsolescence at December 31, 2005 and 2004 of approximately
        $693,000 and $814,000, respectively .
 
 The
        Company currently buys a significant portion of its products from four
        suppliers. 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. Purchases from Ingram Micro, Synnex and Tech Data represented
        21.4%, 11.6% and 8.9%, respectively, of the Company’s total product purchases in
        2003. No other vendor supplied more than 10.0% of the Company’s total product
        purchases in 2005, 2004 or 2003. 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 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 life, 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 recognizes its impairment when it
        is
        probable that such estimated future cash flows will be less than the asset
        carrying value.
 
 Capitalized
        internal software development costs totaled $823,000 and $604,000 for the
        years
        ended December 31, 2005 and 2004, respectively.
  33
 *Table
            of Contents*
 
 *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
        will be tested for impairment annually on the purchase date or sooner when
        events indicate that potential impairment exists. All goodwill related to
        the
        purchase of CPCS.
 
 The
        changes in the carrying amount of goodwill for the years ended December 31,
        2005
        and 2004 are as follows:
 
 Balance
                  as of January 1, 2004
              
              $
              4,193Adjustment
                  to goodwill for purchase price adjustment of Corporate PC Source
                  (Note
                  12)
              
              
              905Impairment
                  lossBalance
                  as of December 31, 2004
              
              
              5,098Impairment
                  lossBalance
                  as of December 31, 2005
              
              $
              5,098
 
 *Use
        of Estimates*
 The
        preparation of financial statements in conformity with accounting principles
        generally accepted in the United States of America 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. 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.
 
 *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 the
        cooperative advertising funds classified as a reduction of cost of
        sales.
  34
 *Table
            of Contents*
  *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. The costs to produce and distribute individual catalogs, including
        paper,
        printing, postage, production and design costs, are capitalized and amortized
        to
        selling expense during the period in which the catalogs are generating
        substantial sales (generally one month). Capitalized advertising costs of
        $184,000 and $277,000 were included with prepaid expenses at December 31,
        2005
        and 2004, respectively. The Company receives cooperative advertising expense
        reimbursements from most vendors for whom the Company places advertisements
        in
        its catalogs. The following table presents the gross amounts that are netted
        together in the Company’s advertising expense line item.
 
 **2005**
              
              **2004**
              
              **2003**Gross
                  advertising expense
              
              $
              7,047
              
              $
              7,646
              
              $
              9,990Gross
                  advertising reimbursements
              
              
              (429
              )
              
              (564
              )
              
              (3,393
              )Advertising
                  expense
              
              $
              6,618
              
              $
              7,082
              
              $
              6,597
 
 
 *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 accounted for its stock option plans described in Note 9 by measuring
        compensation cost using the intrinsic value-based method presented by Accounting
        Principles Board Option No. 25, “Accounting for Stock Issued to Employees,” and
        related interpretations. No compensation cost is reflected in consolidated
        net
        income (loss), as all options granted under the plans had an exercise price
        equal to the market value of the underlying common stock on the date of grant.
        Had compensation cost for the Company’s stock option plans been determined based
        on the fair value at the grant date of the awards, consistent with the
        provisions of SFAS 123, as amended by SFAS 148, the Company’s net income and
        income per share would have changed to the pro forma amounts indicated below
        (in
        thousands, except per share data):
 
 **Year
                  ended December 31,****2005**
              
              **2004**
              
              **2003**Net
                  income - as reported
              
              $
              6,051
              
              $
              4,652
              
              $
              1,568Add:Total
                  compensation cost included in net income (loss), net of
                  taxLess:Total
                  compensation cost determined under fair value based method for
                  all awards,
                  net of tax
              
              
              (808
              )
              
              (827
              )
              
              (468
              )Net
                  income - pro forma
              
              $
              5,243
              
              $
              3,825
              
              $
              1,100Basic
                  income per share - as reported
              
              $
              0.45
              
              $
              0.34
              
              $
              0.11Diluted
                  income per share - as reported
              
              $
              0.42
              
              $
              0.32
              
              $
              0.11Basic
                  income per share - pro forma
              
              $
              0.39
              
              $
              0.28
              
              $
              0.08Diluted
                  income per share - pro forma
              
              $
              0.36
              
              $
              0.26
              
              $
              0.08
 
 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, 2004 and 2003, respectively: expected
        volatility of 186%, 183% and 218%; risk-free interest rate of 4.05%, 3.43%
        and
        2.87%; and expected lives of 5 years.
 
 35
 *Table
            of Contents*
  *Segment
        Reporting*
 In
        fiscal
        years 2004 and 2003, 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 to small to medium-sized
        businesses, enterprise and the public sector markets.
 
 A
        summary
        of the Company’s operations by product mix is detailed in Note 15.
 
 *Reclassifications*
 Certain
        reclassifications of prior years’ balances have been made to conform to the
        fiscal year 2005 presentation. Such reclassifications had no effect on
        shareholders’ equity or net income as previously reported.
 
 *Recent
        Accounting Pronouncements*
 In
        December 2004, the Financial Accounting Standards Board (“FASB”) issued
        SFAS No. 123R, “Share-Based Payment” (“SFAS 123R”), a revision of SFAS
        No. 123, “Accounting for Stock-Based Compensation.” SFAS 123R will require
        the Company to, among other things, measure all employee stock-based
        compensation awards using a fair value method and record such expense in
        the
        Company’s consolidated financial statements. The provisions of SFAS 123R are
        effective for the first annual reporting period that begins after June 15,
        2005; therefore, the Company will adopt the new requirements beginning January
        1, 2006. Adoption of the expensing requirements will reduce the Company’s
        reported earnings. The Company has elected to implement this new standard
        under
        the modified prospective application. Under the modified prospective
        application, the Company will expense the cost of new or modified awards
        over
        the requisite service period and the cost of previously granted unvested
        awards
        for the requisite service period remaining after December 31, 2005. Although
        the
        effects of adopting this standard have not been fully quantified, the Company
        estimates that it will increase expenses in fiscal 2006 in the range of $300,000
        to $400,000 before income taxes for stock options relating to vesting of
        grants
        made prior to January 1, 2006.
 
 The
        adoption of SFAS No. 123R is expected to have an effect on the consolidated
        financial statements of the Company. See the pro forma impact on net earnings
        and earnings per share from calculating stock-related compensation costs
        under
        the fair value alternative of SFAS No. 123 in Note 2 of Notes to the
        Consolidated Financial Statements. The pro forma computation in Note 2 provides
        the possible effect under SFAS No. 123R, which may be different from the
        calculation of compensation cost under SFAS No. 123. In addition, full year
        effects of share-based payments issued late in fiscal 2005 are not fully
        reflected in these calculations. Such potential differences have not yet
        been
        fully quantified. Also, past usage of option plans and stock purchase plans
        may
        not reflect our practices in future periods.
 
 **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 .
 
 **4.**
              **Property
                  and Equipment**
  Property
        and equipment consists of the following (in thousands):
  **December
                  31,****2005**
              
              **2004**
              
              **Estimated
                  Useful Lives**Equipment
              
              $
              15,679
              
              $
              14,885
              
              
              2
                  to 5 yearsComputer
                  software/Web development
              
              
              17,436
              
              
              16,704
              
              
              2
                  to 5 yearsFurniture
                  and fixtures and leasehold improvements
              
              
              1,357
              
              
              896
              
              
              3
                  to 11 years34,472
              
              
              32,485Less
                  accumulated depreciation and amortization
              
              
              (30,662
              )
              
              (28,534
              )Property
                  and equipment, net
              
              $
              3,810
              
              $
              3,951
  36
 *Table
            of Contents*
  **5.**
              **Line
                  of Credit**
 
 At
        December 31, 2005, 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.  Working
        capital advances outstanding at December 31, 2005 and 2004 were $10,700,000
        and
        $6,100,000, respectively. The flooring arrangement included $8,469,000 owed
        to
        this financial institution related to inventory purchases at December 31,
        2005,
        compared to $14,306,000 at December 31, 2004.
 
 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,
        2005
        and 2004, the Company had book overdrafts of $13,077,000 and $5,184,000,
        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
        the
        all covenants contained in the agreement at December 31, 2005.
 
 **6.**
              **Accrued
                  Liabilities and Other**
 Accrued
        liabilities consist of the following (in thousands):
 
 **December
                  31,****2005**
              
              **2004**Accrued
                  payroll
              
              $
              3,842
              
              $
              3,162Accrued
                  taxes
              
              
              2,375
              
              
              1,809Accrued
                  advertising
              
              
              20
              
              
              110Accrued
                  interest
              
              
              104
              
              
              67Other
                  accruals
              
              
              2,280
              
              
              1,841Total
              
              $
              8,621
              
              $
              6,989
  37
 *Table
            of Contents*
  **7.**
              **Income
                  Taxes**
 
 The
        income tax (benefit) expense consists of the following (in
        thousands):
 
 **Year
                  ended December 31,****2005**
              
              **2004**
              
              **2003**Current
              
              $
              912
              
              $
              533
              
              $
              51Deferred
              
              
              2,854
              
              
              2,272
              
              
              950Total
              
              $
              3,766
              
              $
              2,805
              
              $
              1,001
 
 The
        components of deferred taxes were as follows (in thousands):
 
 **December
                  31,****2005**
              
              **2004**Assets:Allowance
                  for doubtful accounts
              
              $
              585
              
              $
              813Inventory
                  allowances
              
              
              331
              
              
              358Deferred
                  rent obligation
              
              
              418
              
              
              386Accrued
                  liabilities and other
              
              
              424
              
              
              337Net
                  operating losses
              
              
              
              
              
              2,854$
              1,758
              
              $
              4,748Liabilities:Property
                  and equipment
              
              
              (447
              )
              
              (583
              )(447
              )
              
              (583
              )Net
                  deferred tax asset
              
              $
              1,311
              
              $
              4,165
 
 A
        reconciliation of the effective income tax rate on income or loss before
        taxes
        with the federal statutory rate follows:
  **Year
                  ended December 31,****2005**
              
              **2004**
              
              **2003**Statutory
                  rate
              
              
              34.0
              %
              
              34.0
              %
              
              35.0
              %State
                  income tax, net of federal benefit
              
              
              2.0
              
              
              2.7
              
              
              2.0Other
              
              
              2.4
              
              
              0.9
              
              
              2.0Effective
                  tax rate
              
              
              38.4
              %
              
              37.6
              %
              
              39.0
              %
  **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 2014. Under the
        terms
        of certain leases, the Company is responsible for its share of taxes, insurance
        and common area charges. At December 31, 2005, future minimum payments under
        operating leases were as follows (in thousands):
 
 2006
              
              $
              1,6392007
              
              $
              1,7052008
              
              $
              1,6872009
              
              $
              1,5012010
              
              $
              1,311Thereafter
              
              $
              4,454Total
              
              $
              12,297
  Certain
        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 $2,520,000, $2,234,000 and $2,766,000 for the
        years
        ended December 31, 2005, 2004 and 2003, respectively.
  38
 *Table
            of Contents*
 
 *Distribution
        Center*
 Prior
        to
        September 2004, the Company contracted with a logistics company to provide
        and
        operate its primary distribution center under a renewable contract. Under
        this
        contract, the Company paid a flat rate for each purchase order received and
        customer order filled. In September 2004, the Company moved its warehouse
        and
        distribution operations from a third-party logistics provider to its Illinois
        facility. The Company now directly bears the cost of this facility.
 
 During
        the years ended December 31, 2005, 2004 and 2003, warehousing expense totaled
        $2,288,000, $1,874,000 and $1,892,000, respectively, and was included in
        selling, general and administrative expense on the Statement of
        Operations.
 
 *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,
        2005,
        only stock options had been granted under the Plan. The term of each option
        granted was for such period as determined by the Board of Directors, but
        not
        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, 2005.
 
 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, 2005 were 165,000 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, 2005, 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. 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 period as determined by the Board of Directors, but not
        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.
  39
 *Table
            of Contents*
  Information
        regarding the stock option plans is as follows:
 
 **Options**
              
              **Weighted-Average
                  Exercise Price**
              
              **Options
                  Exercisable**Outstanding,
                  December 31, 2002
              
              
              2,323,411
              
              
              3.58
              
              
              961,248Granted
              
              
              1,678,900
              
              
              1.00Exercised
              
              
              (5,000
              )
              
              0.85Cancelled
              
              
              (667,629
              )
              
              1.75Outstanding,
                  December 31, 2003
              
              
              3,329,682
              
              
              2.68
              
              
              1,310,817Granted
              
              
              925,300
              
              
              2.95Exercised
              
              
              (296,746
              )
              
              1.53Cancelled
              
              
              (684,843
              )
              
              3.70Outstanding,
                  December 31, 2004
              
              
              3,273,393
              
              
              2.63
              
              
              1,471,617Granted
              
              
              282,200
              
              
              3.38Exercised
              
              
              (181,772
              )
              
              1.74Cancelled
              
              
              (306,102
              )
              
              1.77Outstanding,
                  December 31, 2005
              
              
              3,067,719
              
              $
              2.84
              
              
              2,181,673
 
 For
        the
        years ended December 31, 2005, 2004 and 2003, the weighted-average fair value
        of
        options granted was as follows:
 
 **Year
                  ended December 31,****2005**
              
              **2004**
              
              **2003**Exercise
                  price equals market price
              
              $
              2.29
              
              $
              2.58
              
              $
              1.00
 
 The
        following tables summarize information about fixed-price stock options
        outstanding at December 31, 2005:
 **Options
                    Outstanding****Range
                    of****Exercise
                    Prices**
                
                **Number****Outstanding****at
                    December 31, 2005**
                
                **Weighted-****Average****Remaining****Contractual
                    Years**
                
                **Weighted-****Average****Exercise
                    Price**$ 
                    0.73 - $  0.96
                
                
                518,270
                
                
                6.85
                
                
                $ 
                    0.90$ 
                    1.05 - $  1.06
                
                
                551,000
                
                
                7.58
                
                
                1.06$ 
                    1.07 - $  2.92
                
                
                665,982
                
                
                7.66
                
                
                2.38$ 
                    2.94 - $  2.99
                
                
                519,200
                
                
                8.28
                
                
                2.99$ 
                    3.13 - $  5.81
                
                
                623,739
                
                
                5.13
                
                
                4.32$ 
                    6.00 - $15.00
                
                
                189,528
                
                
                3.10
                
                
                9.73$ 
                    0.73 - $15.00
                
                
                3,067,719
                
                
                6.82
                
                
                $ 
                    2.84
  **Options
                    Exercisable****Range
                    of****Exercise
                    Prices**
                
                **Number****at
                    December 31, 2005**
                
                **Weighted-Average****Exercise
                    Price**$ 
                    0.73 - $  0.96
                
                
                352,607
                
                
                $ 
                    0.91$ 
                    1.05 - $  1.06
                
                
                233,934
                
                
                1.06$ 
                    1.07 - $  2.92
                
                
                442,585
                
                
                2.35$ 
                    2.94 - $  2.99
                
                
                353,440
                
                
                2.99$ 
                    3.13 - $  5.81
                
                
                609,579
                
                
                4.31$ 
                    6.00 - $15.00
                
                
                189,528
                
                
                9.73$ 
                    0.73 - $15.00
                
                
                2,181,673
                
                
                $ 
                    3.73
 
 **10.**
              **Earnings
                  Per Share**
 
 The
        Company has 45,000,000 common shares authorized, and 13,265,049 issued and
        outstanding at December 31, 2005. 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).
  40
 *Table
              of Contents*
 **Year
                    ended December 31,****2005**
                
                **2004**
                
                **2003****Basic
                    earnings per share:**Net
                    income
                
                $
                6,051
                
                $
                4,652
                
                $
                1,568Weighted-average
                    shares used in computing basic income per share
                
                
                13,382
                
                
                13,549
                
                
                13,644Basic
                    income per share
                
                $
                0.45
                
                $
                0.34
                
                $
                0.11**Diluted
                    earnings per share:**Net
                    income
                
                $
                6,051
                
                $
                4,652
                
                $
                1,568Weighted-average
                    shares used in computing basic income per share
                
                
                13,382
                
                
                13,549
                
                
                13,644Stock
                    Options
                
                
                1,145
                
                
                920
                
                
                95Weighted-average
                    shares used in computing diluted income per share
                
                
                14,527
                
                
                14,469
                
                
                13,739Diluted
                    income per share
                
                $
                0.42
                
                $
                0.32
                
                $
                0.11
 The
        options may have a dilutive effect on the calculation of earnings per share.
        For
        the years ended December 31, 2005, 2004 and 2003, 516,045, 501,087 and 2,536,302
        shares, respectively, attributable to outstanding stock options were excluded
        from the calculation of diluted earnings per share because the effect was
        anti-dilutive. For the year ended December 31, 2003, the Company had $250,000
        of
        contingent convertible notes outstanding which were not included in the
        calculation of earnings per share, as the necessary earnings threshold to
        initiate conversion was not achieved by CPCS.
 
 **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 2005 and 2004,
        the
        Company’s Board of Directors approved a match in each of the quarters. The
        Company’s Board of Directors approved a fourth quarter match during 2003. For
        fiscal years 2005, 2004 and 2003, the Company provided a 50% match for all
        team
        member contributions, up to 6% of the team member’s annual compensation. During
        fiscal 2005, 2004, and 2003, the Company expensed $362,000, $315,000 and
        $74,000, respectively, relating to employer contributions under the
        plan.
 
 **12.**
              **Acquisition
                  of Corporate PC Source,
                  Inc.**
 
 On
        March
        31, 2003, the Company acquired Corporate PC Source, Inc. (“CPCS”), an Illinois
        corporation, pursuant to a Stock Purchase Agreement (“SPA”) by and among the
        Company, CPCS and the shareholders of CPCS. Through this acquisition, the
        Company added complementary product and service offerings to enterprise size
        customers by expanding its market opportunities into the Midwest. These
        opportunities, along with the ability to acquire CPCS’s workforce, were
        significant contributing factors to the establishment of the purchase price,
        resulting in the recognition of a significant amount of goodwill. Upon
        consummation of the transactions contemplated by the SPA, CPCS became a wholly
        owned subsidiary of the Company. Goodwill of approximately $5.1 million at
        December 31, 2005 represents the balance of the excess of the purchase price
        over the fair value of the net identifiable assets acquired.
 
 During
        the quarter ended September 30, 2004, the Company renegotiated certain terms
        of
        the SPA with the former shareholders of CPCS to eliminate the financial
        uncertainty associated with the earn-out provision. The Company and the former
        shareholders of CPCS agreed to reduce the amount of the potential earn out
        payments to a fixed sum and to cancel each outstanding convertible promissory
        note and non-convertible promissory note in exchange for the issuance of
        an
        unsecured, subordinated non-convertible promissory note in a principal amount
        equal to the former CPCS shareholders’ ratio of former shareholdings of such
        fixed sum (the “New Notes”). Under the terms of the Agreement, the Company
        issued New Notes in the aggregate principal amount of $2,743,864 to the former
        shareholders of CPCS. This aggregate principal is equal to the remaining
        note
        payable balance under the original SPA of $1,543,864, plus the fixed sum
        of
        $1,200,000 which increased goodwill.
  41
 *Table
            of Contents*
 
 Interest
        will accrue on the unpaid principal amount of the New Notes at the prime
        rate
        plus 0.25%. At December 31, 2005 the rate was 7.00%. The Company will make
        payments on accrued interest and the outstanding principal amount on the
        New
        Notes on a fixed payment schedule through April 2006. During 2005, the Company
        paid the former shareholders of CPCS $300,000 on March 15, 2005, $771,932
        on
        April 28, 2005 and $200,000 on October 1, 2005 due under the New Notes fixed
        payment schedule.
 
 Prior
        to
        the September 27, 2004 renegotiation, under the terms of the March 31, 2003
        SPA,
        the Company paid to the shareholders of CPCS $4,881,000 in cash and issued
        notes
        in the aggregate principal amount of $2,500,000: $2,250,000 non-convertible
        notes and $250,000 convertible notes. Each non-convertible note had
        a three-year term, with interest paid quarterly, and one-third of the principal
        amount was due and payable at the end of each of the earn-out periods, which
        occurred annually on the transaction date. Each convertible note had a
        three-year term and one-third of the amount outstanding was payable at the
        end
        of each of the earn-out periods. Should CPCS have reached a threshold of
        earnings before income tax, depreciation and amortization (“EBITDA”), they
        may at any
        time before
        the payment thereof, at the option of the prior shareholders, have been
        converted into the Company’s common shares at $2.50 per share. The Company’s
        general corporate funds were the source of the funds used for the cash portion
        of the purchase price. The notes bore interest at the rate the Company paid
        to
        its primary lender less 0.25%. In addition, the old notes were subject to
        reduction for failure of CPCS to reach a threshold of EBITDA, which would
        have
        adjusted the purchase price in the future. The Company measured the EBITDA
        thresholds annually on March 31st, which is the end of each earn-out
        period.
 
 At
        the
        end of the first earn-out period, March 31, 2004, CPCS did not reach threshold
        EBITDA. Therefore, the principal amount of the notes was adjusted by $295,000,
        and goodwill was reduced by the adjustment. The amount due on the
        non-convertible notes payable at the end of the first earn-out period was
        $662,000, which was paid to the former shareholders of CPCS on April 2,
        2004.
 
 Additionally,
        prior to the September 27, 2004 renegotiation, the SPA contained a provision
        for
        an earn-out over three years contingent upon CPCS exceeding minimum levels
        of
        EBITDA. The former shareholders of CPCS would have received a percentage
        of
        earnings each year up to 200% of the applicable EBITDA target. The targeted
        EBITDA grew 10% per year after the initial earn-out period. The maximum payment
        available was $4.95 million in the initial earn-out period and 10% annually
        in
        the second and third year. No contingent payment would have been required
        if
        CPCS earned less than 70% of the target EBITDA in any of the earn-out periods.
        The Company measured the EBITDA targets annually on March 31 st .
 
 The
        first
        earn-out period ended on March 31, 2004. During the first earn-out period,
        CPCS
        did not meet the minimum level of annual EBITDA required in order for the
        former
        shareholders of CPCS to be owed an earn-out payment.
 
 Any
        contingent payments made to the former shareholders of CPCS would be based
        exclusively on the ratio of their former shareholdings. If any contingent
        payment was made the Company would have recorded these payments as a purchase
        price adjustment to goodwill. Their continued employment with CPCS is not
        a
        requirement for receipt of any future contingent payments.
 
 CPCS’s
        results of operations are included in the Company’s consolidated financial
        statements only for the periods after the date of closing: March 31,
        2003.
  42
 *Table
            of Contents*
  The
        following table summarizes the original fair values of the assets acquired
        and
        liabilities assumed at the date of the acquisition.
 
 **At
                  March 31, 2003**Current
                  Assets
              
              $
              12,709Property,
                  plant and equipment
              
              
              349Other
                  assets
              
              
              32Intangible
                  assets
              
              
              44Deferred
                  tax asset
              
              
              121Goodwill
              
              
              4,193Total
                  assets acquired
              
              
              17,448Current
                  liabilities
              
              
              9,771Net
                  assets acquired
              
              
              7,677Less
                  cash acquired
              
              
              1,458Purchase
                  price for acquisition, net of cash acquired
              
              $
              6,219
 
 Subsequent
        to the date of acquisition, certain events have increased the amount of goodwill
        associated with the Company’s acquisition of CPCS. These events are discussed in
        the above disclosure.
 
 The
        following unaudited pro forma information presents the results of the Company’s
        operations as if the acquisition of CPCS had taken place as of the beginning
        of
        the periods presented (amounts in thousands, except per share
        data):
 
 **Twelve
                  months ended December 31, 2003****Zones**
              
              **CPCS**
              
              **Eliminations**
              
              **Consolidated**Net
                  sales
              
              $
              401,428
              
              $
              84,359
              
              $
              (1,003
              )
              $
              484,784Net
                  income
              
              $
              481
              
              $
              1,517
              
              
              
              
              $
              1,998Earnings
                  per share:Basic
              
              
              
              
              
              
              
              
              
              
              $
              0.15Diluted
              
              
              
              
              
              
              
              
              
              
              $
              0.14
 
 
 **13****.**
              **Related
                  Party Disclosure**
 
 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 $1.2 million per year, plus real estate
        taxes,
        insurance and common area maintenance charges. For the twelve months ended
        December 31, 2005 and 2004, the Company paid Fana Auburn LLC $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 subject to further Audit Committee
        review and consideration.
 
 **14****.**
              **Stock
                  Repurchase Program**
 
 In
        July
        2004, the Board of Directors authorized a stock repurchase program under
        which
        the Company could repurchase up to $3.0 million in shares of the Company’s
        common stock in either open market or private transactions at then prevailing
        market prices. Under this repurchase program, the Company purchased and retired
        a total of 650,040 shares of its common stock at a total cost of $2.1 million
        (an average price of $3.27 per share).
 
 In
        July
        2005, the Board of Directors authorized the continuation of the Company’s share
        repurchase program until July 2006. The Company is authorized to repurchase
        up
        to an additional $3.0 million in shares of the Company’s common stock through
        July 2006 in open market or private transactions at then prevailing market
        prices. Under this repurchase program, the Company has purchased and retired
        222,800 shares of its common stock at a total cost of $1.0 million (an average
        price of $4.64 per share) during the six-month period ended December 31,
        2005.
  43
 *Table
            of Contents*
 
 In
        February 2006, the Board of Directors authorized an increase to the Company’s
        share repurchase program. The Company is authorized to repurchase up to an
        additional $1.0 million in shares of the Company’s common stock through February
        2007 in open market or private transactions at then prevailing market prices.
 
 **15.**
              **Segment
                  Information**
 
 In
        fiscal
        years 2003 and 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 and the public sector markets.
 
 A
        summary
        of the Company’s sales by product mix follows (in thousands):
 **December
                    31,****2005**
                
                **2004**
                
                **2003**Notebook
                    & PDA’s
                
                $
                86,861
                
                $
                72,672
                
                $
                68,081Desktops
                    & Servers
                
                
                113,779
                
                
                105,636
                
                
                96,415Software
                
                
                90,199
                
                
                83,415
                
                
                63,070Storage
                
                
                51,453
                
                
                43,198
                
                
                49,497NetComm
                
                
                23,968
                
                
                21,936
                
                
                24,781Printers
                
                
                63,964
                
                
                47,406
                
                
                40,930Monitors
                    & Video
                
                
                54,460
                
                
                50,939
                
                
                44,445Memory
                    & Processors
                
                
                30,407
                
                
                24,807
                
                
                27,388Accessories
                    & Other
                
                
                51,462
                
                
                45,554
                
                
                46,165
 Substantially
        all of the Company’s net sales for the twelve months ended December 31, 2005
        were made to customers located in the United States. All of the Company’s assets
        at December 31, 2005 and 2004 were located within the United States. No one
        customer represented more than 10% of total sales for the years ended December
        31, 2005, 2004 and 2003.
  44
 *Table
            of Contents*
  **16.**
              **Selected
                  Quarterly Financial Data
                  (Unaudited)**
 
 The
        following information is for the years ended December 31, 2005 and
        2004:
 
 (in
        thousands, except per share data)
 **December
                  31, 2005**
              
              **First**
                **Quarter**
              
              **Second**
                **Quarter**
              
              **Third**
                **Quarter**
              
              **Fourth**
                **Quarter**Net
                  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 share1
              
              $
              0.08
              
              $
              0.09
              
              $
              0.12
              
              $
              0.14
 
 **December
                  31, 2004**
              
              **First**
                **Quarter**
              
              **Second**
                **Quarter**
              
              **Third**
                **Quarter**
              
              **Fourth**
                **Quarter**Net
                  sales
              
              $
              114,091
              
              $
              124,023
              
              $
              129,829
              
              $
              127,620Cost
                  of sales
              
              
              100,176
              
              
              109,765
              
              
              115,693
              
              
              112,792Gross
                  profit
              
              
              13,915
              
              
              14,258
              
              
              14,136
              
              
              14,828SG&A
                  expenses
              
              
              10,649
              
              
              10,602
              
              
              10,162
              
              
              10,871Advertising
                  expenses
              
              
              1,889
              
              
              1,695
              
              
              1,634
              
              
              1,864Income
                  (loss) from operations
              
              
              1,377
              
              
              1,961
              
              
              2,340
              
              
              2,093Other
                  (income) expense
              
              
              77
              
              
              90
              
              
              49
              
              
              98Income
                  (loss) before income taxes
              
              
              1,300
              
              
              1,871
              
              
              2,291
              
              
              1,995Provision
                  (benefit from) for income taxes
              
              
              509
              
              
              720
              
              
              889
              
              
              687Net
                  income (loss)
              
              $
              791
              
              $
              1,151
              
              $
              1,402
              
              $
              1,308Basic
                  earnings per share1
              
              $
              0.06
              
              $
              0.08
              
              $
              0.10
              
              $
              0.10Diluted
                  earnings per share1
              
              $
              0.05
              
              $
              0.08
              
              $
              0.10
              
              $
              0.09
 
 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.
  45
 *Table
            of Contents*
  **Report
        of Grant Thornton LLP, Independent Registered Public Accounting
        Firm**
 
 
 Board
        of
        Directors and Shareholders of
 Zones,
        Inc.
  We
        have
        audited the accompanying consolidated balance sheet of Zones, Inc. as of
        December 31, 2005, and the related consolidated statements of operations,
        shareholders’ equity, and cash flows for the year then ended. 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 audit.
 
 We
        conducted our audit 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 audit provides 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,
        2005, and the results of its operations and its cash flows for the year then
        ended, 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 year ended December
        31,
        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.
 
 
 Grant
        Thornton LLP
 Seattle,
        Washington
 February
        14, 2006
  46
 *Table
            of Contents*
  **Report
        of PricewaterhouseCoopers LLP, Independent Registered Public Accounting
        Firm**
 
 
 To **** the
        Shareholders of
 Zones,
        Inc.
  In
        our
        opinion, the accompanying consolidated balance sheets and the related
        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 financial position of Zones, Inc. and its subsidiaries **** at
        December 31, 2004 and December 31, 2003, and the results of their operations
        and
        their cash flows for each of the two years in the period ended December 31,
        2004 **** in
        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 set forth therein when read in conjunction with
        the
        related consolidated financial statements. 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 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 audits provide a reasonable basis
        for our opinion.
  
 PricewaterhouseCoopers
        LLP
 Seattle,
        Washington
 February
        28, 2005
  47
 *Table
            of Contents*
  **ZONES,
        INC.**
 **SCHEDULE
        II - 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, 2005Allowance
                  for doubtful accounts
              
              $
              2,666
              
              $
              458
              
              $
              
              
              $
              $1,562
                  (a
              )
              $
              1,562Allowance
                  for inventory obsolescence
              
              $
              814
              
              $
              438
              
              $
              
              
              $
              $
                  559 (a
              )
              $
              693Year
                  Ended December 31, 2004Allowance
                  for doubtful accounts
              
              $
              2,734
              
              $
              297
              
              $
              
              
              $
              $
                  365 (a
              )
              $
              2,666Allowance
                  for inventory obsolescence
              
              $
              763
              
              $
              740
              
              $
              
              
              $
              $
                  689 (a
              )
              $
              814Year
                  Ended December 31, 2003Allowance
                  for doubtful accounts
              
              $
              2,600
              
              $
              636
              
              $
              
              
              $
              $
                  502 (a
              )
              $
              2,734Allowance
                  for inventory obsolescence
              
              $
              1,084
              
              $
              725
              
              $
              
              
              $
              $1,046
                  (a
              )
              $
              763(a)
                  Uncollectible items written off, less recoveries of items previously
                  written off.
  48