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, 2007





OR





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





Commission
File Number     0-28488





ZONES,
INC


(Exact
name of registrant as specified in its charter)





Washington
            91-1431894(State
      of Incorporation)
            (I.R.S.
      Employer  Identification Number)1102
      15th
      Street SW, Suite 102Auburn,
      Washington
            98001-6509(Address
      of Principal Executive Offices)
            (Zip
      Code)


(253)
205-3000


(Registrant's
Telephone


Number,
Including Area Code)





Securities
registered pursuant to Section 12(b) of the Act: Common Stock




Securities
registered pursuant to Section 12(g) of the Act: None





Indicate
by check mark if the registrant is a well-known seasoned issuer, as defined in
Rule 405 of the Securities Act.  Yes £   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 £   No
T





Indicate
by check mark whether the registrant (1) has filed all reports required to be
filed by Section 13 or 15(d) of the Securities Exchange Act of 1934 during the
preceding 12 months (or for such shorter period that the registrant was required
to file such reports), and (2) has been subject to such filing requirements for
the past 90 days.  Yes T   No
£




Indicate
by check mark if disclosure of delinquent filers pursuant to item 405 of
Regulation S-K is not contained herein, and will not be contained, to the best
of the registrant’s knowledge, in definitive proxy or information statements
incorporated by reference in Part III of this Form 10-K or any amendment of this
Form 10-K.  T




Indicate
by check mark whether the registrant is a large accelerated filer, an
accelerated filer, a non-accelerated filer, or a smaller reporting
company.  See the definitions of “large accelerated filer,”
“accelerated filer” and “smaller reporting company” in Rule 12b-2 of the
Exchange Act.  (Check one):   Large accelerated filer
£   Accelerated
filer£   Non-accelerated
filer £   Smaller
reporting company T





Indicate
by check mark whether the registrant is a shell company (as defined in Rule
12b-2 of the Act).  Yes £   No
T





The
aggregate market value of the Common Stock held by non-affiliates as of the
registrant’s most recently completed second fiscal quarter, June 30, 2007, was
approximately $55,246,950, based upon the last sales price per share of $9.00 as
reported by the NASDAQ Global Market.





The
number of shares of the registrant's Common Stock outstanding as of February 27,
2008 was 13,158,595.




DOCUMENTS INCORPORATED BY
      REFERENCE




Portions
of the definitive Proxy Statement for the Registrant’s Annual Meeting of
Shareholders to be held on May 15, 2008 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, 2007


TABLE
OF CONTENTS





PART I





Page No.Item
      1.
            Business
            3Item
      1A.
            Risk Factors
            9Item
      2.
            Properties
            12Item
      3.
            Legal Proceedings
            12Item
      4.
            Submission of Matters to a Vote of Security
      Holders
            13Item
      4A.
            Executive Officers of the Registrant
            13





PART II





Item
      5.
            Market for Registrant’s Common Equity, Related Shareholder
      Matters and Issuer Purchases of Equity Securities
            14Item
      6.
            Selected Financial Data
            16Item
      7.
            Management’s Discussion and Analysis of Financial Condition
      and Results of Operations
            16Item
      7A.
            Quantitative and Qualitative Disclosures about Market
      Risk
            24Item
      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, Executive Officers and Corporate
      Governance
            25Item
      11.
            Executive Compensation
            25Item
      12.
            Security Ownership of Certain Beneficial Owners and
      Management and Related Stockholder Matters
            25Item
      13.
            Certain Relationships and Related Transactions, and
      Director Independence
            25Item
      14.
            Principal Accounting Fees and Services
            25





PART IV





Item
      15.
            Exhibits and Financial Statement
    Schedules
            25Signatures
            28





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 we operate,
management’s beliefs, and certain assumptions made by management. These
statements are made pursuant to the safe harbor provision of the Private
Securities Litigation Reform Act of 1995.All
statements, trends, analyses and other information contained in this report
relative to trends in net sales, gross margin and anticipated expense levels, as
well as other statements, including words such as “anticipate,” “believe,”
“plan,” “expect,” “estimate,” “intend” and other similar expressions, constitute
forward-looking statements. These forward-looking statements involve risks and
uncertainties, and actual results may differ materially from those anticipated
or expressed in such statements. Potential risks and uncertainties include,
among others, those set forth in Item 1A of this Annual Report. Particular
attention should be paid to the cautionary statements involving future
profitability and sales levels, competition, pressure on margins, reliance on
vendor support and relationships, state tax uncertainties, the industry’s rapid
technological change and our exposure to inventory
obsolescence.  Except as required by law, we undertake no obligation
to update any forward-looking statements, whether as a result of new
information, future events or otherwise.





General





Zones,
Inc. (the “Company,” “We”) is a single-source direct marketing reseller of
name-brand information technology (“IT”) products to the small-to-medium-sized
business market (“SMB”), enterprise accounts and public sector
accounts.  Zones sells products through outbound and inbound account
executives, a national field sales force, catalogs and the
Internet.  Zones offers more than 150,000 products from leading
manufacturers, including Adobe, Apple, Avaya, Cisco, HP, IBM, Kingston, Lenovo,
Microsoft, NEC, Nortel Networks, Sony, Symantec and Toshiba.





Incorporated
in 1988, Zones, Inc. is headquartered in Auburn, Washington. Buying information
is available at http://www.zones.com or by calling 800-258-2088.  The
Company’s investor relations information can be accessed online at
www.zones.com/IR.





Industry
Background





We
believe that the direct marketing reseller (“DMR”) channel has reached a level
where most corporate IT customers have selected their vendors of choice, either
direct through DMRs or indirect through value-added resellers
(“VAR”).  Future growth of the channel will be predicated on increased
corporate profit levels, which can support an investment in new
technology.  Generally, we believe that in 2008 the DMR channel will
grow at market rate, with our core business with the SMB expected to outpace the
market.  To exceed the market rate of growth overall, individual DMRs
must take market share from their direct and indirect competitors.





Customers
make their IT purchasing decisions primarily based on service offerings, product
selection, availability, convenience and price.  DMRs offer a broad
product and service selection, purchasing convenience and fast delivery. The DMR
channel serves a fragmented market whose projected annual purchases are in the
multi-billions of dollars.  DMRs are characterized by a low-cost
structure characterized by few fixed costs, rapid inventory turns, centralized
sales forces and highly automated internal processes, including the use of the
Internet and electronic data interchange (“EDI”) links with major vendors and
customers to streamline operations.  Our strategy as a solution
provider emphasizes a fulfillment model that integrates the procurement and
resale of technology and related accessory product lines, and is supported by
sales specialists, as well as value-added configuration and logistics
services.





We
believe that customers’ decisions are based on the level of service they expect
in relation to what they are willing to pay.  Most DMRs have evaluated
other indirect providers to determine which added services will differentiate
and enable DMRs to gain market share from manufacturers selling direct and from
other VARs. We continuously work with our vendor partners to maintain awareness
of and to capitalize on new product announcements and purchasing trends. In
particular, we are focused on the shift by commercial business customers to
virtualization technologies, their need for additional storage and security, and
the anticipated introduction of new software solutions.





3
 Table of Contents





Our
Business





Our
business is the procurement and fulfillment of IT solutions to SMB and
enterprise customers, and the public sector marketplace.  Our core
business is focused on providing name-brand products at competitive prices to
commercial businesses within the United States.  We believe that small
business customers, meaning those with 50 to 100 computer users, are
characterized by transactional purchasing, in contrast to medium-sized business
customers, meaning those with 100 to 1,000 computer users, who are relationship
driven with more frequent transactions.  We believe that SMB customers
have a high adoption rate for IT solutions and prefer a single-source provider
to handle their procurement from end to end.  Enterprise customers,
defined as customers within the Fortune 2000 and having more than 1,000 computer
users, generally demand a much higher level of customer
service.   The public sector market is made up of three primary
customer types:  state and local government, federal government and
education. These sectors require special pricing and participation in bid
processes.





As
value-added services to our customers, we offer asset tagging, configuration and
other third-party services, we also maintain integration of customers’ business
needs and processes through ZonesConnect, our robust, automated Web-based
procurement system.





Our
Business Strategy





We
acquire and develop ongoing relationships with commercial and public sector
accounts primarily through dedicated teams of outbound sales account executives
(“AEs”).  Although outbound telemarketing is our primary customer
contact, we also reach customers through an integrated marketing and
merchandising strategy that utilizes e-marketing and direct marketing vehicles,
catalogs for demand response opportunities and corporate branding, customized
Web stores for our commercial customers through ZonesConnect, and our Business
Development organization which includes a national field sales
force.





We
believe our success in 2008 will depend on optimizing our
strengths.  We have invested in our future over the last few years
through our additional sales center in Portland, Oregon, our national field
sales force and improvements in technology, training and processes to streamline
the buying experience.  We believe organic growth will occur as tenure
and productivity increase in our existing AE base, driving an increase in the
share of each customer’s total IT purchases.  We are committed to
dedicated marketing and sales support staff to focus on our SMB business
customers. The national field sales force will be focused on the identification,
penetration and establishment of relationships with new business customers to
add to the existing client portfolio.





Our
business model relies on building and maintaining relationships with our
customers to provide solutions to solve their needs.  We offer
exemplary customer service in each transaction, which we define as Five-Star
Service.  Five-Star Service is founded on these
principles:  exceeding expectations, providing outstanding customer
service, performing flawless execution, demonstrating the highest level of
personal integrity, and placing the customer first.  We strive to
offer the most competitive value based on pricing, product availability,
distribution and value added service.





Our
specific areas of concentration for realizing growth in our share of the
IT-procurement market are:





Business Development
Organization.  To drive market share growth, we have invested
in client segmentation and geographical expansion, which led to the
establishment of the Business Development organization.  This
organization is a geographically dispersed field sales force focused on
acquisition of new customers in the large and enterprise customer
set.  Our field sales force, along with its management team, ended
2007 with 15 seasoned team members.  We continue to believe that our
field sales force holds significant promise as a key 2008 strategic
initiative.





AE Hiring, Training and
Development. We continually seek to attract, retain and motivate
high-quality personnel.  We believe that success in retaining new AEs
reduces our gross hiring needs during the year.  Management focuses on
training and coaching AEs on best practices, product knowledge and how to access
supportive collateral on the available marketing and merchandising programs and
promotions.  We focus on our relationship-based model, in which our
AEs develop long-term relationships with customers through frequent telephone
contact, knowledgeable technical advice, individual attention, quality service
and convenient one-stop shopping.





Expansion of Customer Base.Relationships with our commercial business and public sector accounts
represent future growth opportunities.  We continue to refine our
customer management program, lead generation and related processes to increase
and accelerate customer acquisition.  Our customer management program
is designed to better understand the purchasing patterns and product needs of
each customer, and thereby increase operational efficiencies.





4
 Table of Contents





Product Breadth and
Depth.  We are dependent upon relationships with key vendors
for opportunistic product purchases to enhance margins.  Through a
strategic mix of products and vendors, we offer our customers a broad selection
at competitive pricing.  We generally stock 20% of our product
offerings, which represent 80% of total revenue, in our warehousing
facilities.  The remaining items are offered to our customers through
virtual warehousing partnerships with key distributors and vendors via
electronic data interchange (“EDI”).  We use our warehouses and EDI
partners to fulfill all our customers’ needs with broad product
availability.  We place individual orders directly with our EDI
partners, who then assemble these orders and ship them directly to our
customers.





Services.We offer custom
configuration services, such as the installation of accessories and expansion
products, loading of software, imaging for custom applications and configuration
of network operating systems, as well as IT lifecycle support services and
supply chain management services. Many of these services are performed at our
distribution centers and benefit our customers by reducing the cost and time
necessary to deploy new products into their existing technology
environments.





Sales
Specialists.  We provide extensive product training to our AEs
to support their interactions with our customer.  We have identified
certain focus and emerging technologies that broaden our solution
offerings.  We have invested in the hiring of specialists to represent
these targeted technologies and augment the knowledge of our AEs.  We
saw the maturation of this strategy during 2007 highlighted by successes in
software, virtualization, storage and networking.  We will
strategically add resources to create a robust customer facing team able to
support all our customers’ needs.





Sales
and Marketing





Recognizing
that our outbound account executives are the main drivers of the business, our
marketing tools are designed to support their relationship with our customers by
delivering an integrated marketing and merchandising approach designed to
attract customers through print, e-marketing, outbound telemarketing and
customer events. Our marketing and merchandising strategy is designed
to:





§
            build
      and reinforce the Zones brand as a world-class IT supplier with nationwide
      reach;


§
            demonstrate
      our breadth of product selection, our partnerships with key brands and
      competitive prices;


§
            communicate
      our value proposition of lowering the cost of IT procurement;
      and


§
            focus
      on the benefits of procurement automation through ZonesConnect, our
      customized online order management
system.





Throughout
the year, our marketing department refines the characteristics of our target
customers in each market and creates specific marketing collateral to reach that
audience.





Outbound
Telemarketing.  As of December 31, 2007, we had a staff of 342
sales AEs who actively pursued sales to commercial business accounts and public
sector institutions by establishing one-to-one relationships through outbound
telemarketing.  Our AEs actively call customers from one of our sales
centers in Seattle, WA, Chicago, IL and Portland, OR, or a member of our
national field sales force meets face-to-face with customers across the
country.  The primary targets for AEs in the SMB department are the
small-to-medium-sized business customers, while enterprise-customer AEs focus on
the mid-market and companies within the Fortune 1000.  These AEs are
responsible to develop long-term relationships with their accounts through
frequent telephone contact, knowledgeable technical advice, individual
attention, quality service and convenient one-stop shopping.





Business Development Field
Sales.  We are investing in a strategy to create a
geographically dispersed field sales force.  Business Development
management and our national field sales force will identify and access customers
within the large and enterprise-business segments in an effort to increase our
existing portfolio through the addition of new customers.





Extranet
Commerce.  We offer no-fee dedicated Web stores for our
customers through ZonesConnect. These dedicated sites provide the customer with
various benefits, including secure online purchasing, customized reporting,
software license trackers, comprehensive product and manufacturer information,
order status information, multiple shopping baskets, varying ship-to options per
order, enhanced search and browse capabilities, and historical purchase
information. In addition, we often provide more customized extranet sites for
our larger customers having specific online procurement needs.





5
 Table of Contents





Internet Commerce and
E-Marketing.  Our electronic commerce site on the Internet,
Zones.com, provides a sales channel to both supplement and enhance our
person-to-person sales model and to provide customers detailed product
information and the convenience of online purchasing.  We drive
traffic to this site by featuring the Internet address throughout our
direct-mail vehicles and on our promotional communications and advertising. We
also utilize marketing through e-catalogs, online price promotions and
affiliations, e-newsletters and webinars to deliver relevant information on key
technology topics.





Direct Mail.  We
market products through targeted mailings of direct-mail vehicles, such as
catalogs, product inserts and targeted customer mailings. We use our 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 our
online site, Zones.com, and to our sales force.  We use cooperative
advertising reimbursements to substantially offset the costs associated with our
catalog circulation and other marketing activities.  The amount of
this type of funding available from our vendors fluctuates quarterly both in
dollars and as a percentage of sales.  Net advertising costs may
continue to fluctuate or rise in the future as we continue to adapt and adjust
our catalog circulation and Internet and other marketing activities to optimize
sales and profitability in light of changing market conditions.





Database
Marketing.  We maintain a proprietary database containing
approximately 35,000 customer records and we have built a prospecting database
of more than 150,000 commercial leads.  In the commercial business
market, we attract new customers by providing qualified leads to our AEs,
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
vehicles.  Catalog circulation is based on customer records,
prospective customer inquiries, and prospecting lists obtained from B2B
sources.  We regularly analyze and update our database and other
available information to keep data current and to enhance customer response and
order rates.





Customer Events and Trade
Shows.  We host business conferences focused on key technology
topics throughout the year to which we invite existing and potential
customers.  Our vendor partners participate by providing speakers and
funding through cooperative marketing funds.  We also attend select
trade shows to further reach potential customers.  Our events showcase
our brand and drive lead generation activities.





Products
and Merchandising





We offer
customers access to more than 150,000 hardware, software, peripheral and
accessory products and services from over 2,000 manufacturers through our sales
force, catalogs, and Internet portal.





Computers and Servers. We
offer a large selection of desktop, laptop and tablet PC systems and servers
from leading manufacturers, such as Acer, Apple, Gateway, Hewlett-Packard,
Intel, Fujitsu, IBM, Lenovo, Panasonic, Sony and Toshiba.





Peripherals and Accessories.
We carry a full line of peripheral products, such as printers, monitors,
keyboards, handhelds (PDAs), memory, GPS, phones, storage devices, projectors,
scanners and digital cameras, as well as various accessories and printing
supplies, such as toner cartridges, storage media and cables. Brands offered
include APC, Apple, Belkin, Canon, EDGE, Epson, Hewlett-Packard, InFocus, Inkjet
Warehouse, Kingston, Kodak, Fuji, Lexmark, Logitech, LG, Microsoft, NEC, Nikon,
Okidata, palmOne, Planar, Panasonic, Samsung, Sony, Targus, Toshiba, ViewSonic,
Xerox and many more.





Networking and
Storage.  We provide networking and network storage products,
such as switches, hubs, routers, modems, cabling, firewalls, Voice over IP
(VOIP), wireless devices, tape and disk backup, and SAN and NAS
solutions.  Brands offered include Apple, Avaya, Avocent, Belkin,
Cisco, D-Link, EMC, Emulex, Hewlett-Packard, Hitachi Data Systems,
IBM,  Intel,  Iomega, LaCie, LeftHand Networks, Linksys,
Netgear, Nortel Networks, Overland Storage, Polycom, QLogic, Quantum, Seagate,
SonicWALL, Sony, StorVault (NetApp), Tandberg Data (Exabyte), and Western
Digital, among others.





Software. We sell a wide
variety of packaged software and licensing programs in business, personal
productivity, connectivity, utility, language, educational, entertainment and
other categories. We offer products from larger, well-known manufacturers, as
well as numerous specialty products from new and emerging software development
companies. Brands offered include Adobe, Citrix, Computer Associates, Corel,
IBM, Microsoft, Novell, Quark, Symantec and VMware, among others.





6
 Table of Contents





We are a
Microsoft Certified Large Account Reseller, and, as such, can offer our large
customers multiple methods of purchasing Microsoft software.  This
certification enables us to sell Microsoft Select and Enterprise Agreement
contracts designed for medium- to large-sized commercial and academic
customers.





Our
category merchandising group determines the manufacturers’ products that will be
featured in our Internet, catalog and internal marketing offers, and negotiates
the terms and conditions of product coverage.  The merchandising
department reviews product availability and determines stocking strategy, as
well as reviews its managed stock keeping units (“SKU”), so that we are offering
differentiating programs and competitive pricing.  Each managed SKU
also has component and add-on information to assist the AE in the selling
process.  Our merchants have aligned their processes, pricing,
stocking strategies, marketing programs, quotas, communication methodology and
training to the priorities set by each sales department.  The
merchandising group negotiates with manufacturers and distributors to provide us
with incentives in the form of rebates, discounts and trade
allowances.





Purchasing





We
utilize our purchasing and inventory management capabilities to support our
primary business objective of providing name-brand products at competitive
prices.  Our purchasing team works to develop and maintain
relationships with a broad base of reliable, high-quality
suppliers.  The team works to obtain the lowest overall acquisition
cost in an effort to enable us to provide competitive pricing to our customers
while achieving acceptable margins.





We
acquire products directly from manufacturers such as Apple, Hewlett-Packard, IBM
and Lenovo, as well as through distributors such as Ingram Micro, Synnex and
Tech Data, among others.  In 2007, we purchased approximately 54.2% of
our merchandise from distributors, a decrease from 55.9% in 2006.  We
believe that our overall sourcing strategy enables us to take advantage of
significant special offers, discounts and supplier reimbursements, while also
minimizing inventory costs.  We believe we have excellent
relationships with our suppliers and we attempt to take advantage of all
appropriate discounts.





We
utilize a blend of stocking and drop-ship procurement in executing our inventory
management strategy.  We generally stock approximately 20% of our
total product offerings.  The remaining products are provided to our
customers primarily through virtual warehousing partnerships with key
distributors and manufacturers.  Through these relationships, we are
able to offer a broad selection of products and to provide prompt,
cost-efficient fulfillment with minimal inventory exposure.  This
virtual fulfillment model is facilitated through industry-standard EDI linkages
with suppliers.  All associated transactions are managed through and
integrated with our ERP system, which lowers administrative overhead and reduces
our risk of building excess quantities and inventory obsolescence.





At
December 31, 2007, we maintained an investment in inventory of $21.3 million,
and our inventories turned an average of 27 times in 2007.  This
compares to an investment in inventory of $21.4 million at December 31, 2006,
and average inventory turns of 24 times in 2006.





Order
Fulfillment and Distribution





We
distribute products virtually through our EDI arrangement with our vendors, as
well as through our warehouses in Bensenville, Illinois and Seattle,
Washington.





We
provide and operate a full-service warehouse and distribution center in
Bensenville, Illinois to support our nationwide customer base, and a customized
fulfillment center in Seattle, Washington to support our West Coast
customers.  The warehouse personnel utilize our systems, policies and
procedures to receive, record and warehouse inventory shipments from product
suppliers, fill and ship customer orders, and return inventory to product
suppliers when requested. We also use our warehouse facilities to house special
buys, constrained product and other high-velocity product. The Bensenville,
Illinois warehouse is responsible for merchandise that will be returned to
vendors, returned to general inventory, repaired or liquidated.  We
offer limited return rights within 14 days on our product sales, and we
maintained an allowance for sales returns as of December 31, 2007 and 2006 of
$76,000 and $101,000, respectively. Our returns as a percentage of gross sales
increased to 2.5% in 2007 compared to 2.1% in 2006.  Product returns
are closely monitored to identify trends in product offerings, to enhance
customer satisfaction and to reduce overall returns.





Orders
received are electronically transmitted on a dedicated data line to our
distribution centers, where a packing slip is printed out for order fulfillment,
and inventory availability is then automatically updated on all of our
information systems. All inventory items are barcoded and located in designated
areas that are easily identified on the packing slip. All items are checked with
bar code scanners prior to final packing, which helps to ensure that orders are
filled correctly. Orders accepted for items in stock by 8:00 p.m. Eastern
Time can generally be shipped same day to meet our customers delivery
requirements. Upon request, orders may also be shipped for Saturday delivery, by
ground service or by other overnight delivery services.





7
 Table of Contents





Technical
Support and Customer Service





We
maintain a staff of dedicated technical support personnel who provide pre- and
post-sale technical support, for both our AEs and customers.  In
addition to a broad base of technical certifications, the team also maintains a
number of distinguished manufacturer certifications, including Cisco CCNA/CCDA,
VMware VCP, Microsoft MCSE/MCSA, APC Gold, IBM CDAT, EXAct and nSeries, HP
Server and SAN architect (MASE), Symantec Enterprise Vault & Data Protection
and many other hardware-specific technical certifications.





Pre-sales
support is utilized primarily by our AEs to assist in optimizing product
recommendations, assessing compatibility and other technical requirements,
providing technical consulting and design services, and offering configuration
and custom imaging support services.  Post-sales support is provided
primarily to assist customers with their technical questions concerning the
installation and operation of the products they purchase.





We also
employ a staff of dedicated customer service representatives who respond to and
facilitate inquiries regarding order status and related matters, shipment
tracking, billing issues and return requests.  These services are
provided via toll-free telephone support, as well as online tools that allow
customers to self-serve routine inquiries.  We believe these
comprehensive support options improve the quality of our recommended technology
solutions, reduce product returns, increase customer satisfaction and encourage
repeat business.





Systems





We have
committed  significant resources to the development of sophisticated
management information, telecommunication, catalog production and other systems,
which are employed in virtually all aspects of our business, including
marketing, purchasing, inventory management, order processing, product
distribution, accounts receivable, customer service and general accounting
functions.  During 2007, we continued to develop and enhance our sales
interface for order entry. Our graphical user interface ties all of the core
systems together to give AEs a common view of customers, products, inventory and
orders, and to streamline order processing as well as to reduce the training
time for new AEs.  We are continually examining technological
solutions to increase the productivity of our team members.





Team
Members





At
December 31, 2007, we had 705 team members: 342 in the sales force, 204
supporting sales, 52 in warehousing and distribution, and 107 in administrative
overhead departments. We consider our employee relations to be
good.  We also have 35 people working under an outsourced contract in
India to perform various back-office and IT functions in support of our United
States operations.  We have never had a work stoppage and do not
believe that any team members are represented by a labor
organization.  We emphasize the recruiting and training of
high-quality personnel and strive to promote them to positions of increased
responsibility from within.





Sales
Team Education


We
provide a balanced training program consisting of classroom and practical
on-the-job learning within an outbound sales environment.  Our New
Hire Development takes an integrated approach in developing the new hires’
skills for acquiring and developing customers using a relationship building
sales methodology.  AEs learn to utilize various internal and external
systems and receive continuous hardware and software product education through a
variety of onsite vendor trainings.





Mission &
Values


We are
dedicated to being a premier IT reseller, providing the highest level of
Five-Star Service to our customers, while lowering their cost of procurement
through automation and being a proactive partner.





Seasonality





There are
discernable trends regarding sales to our commercial business
customers.  In general, we note that our first quarter sales are
seasonally lower as we believe our customers are slow to spend while firming
their annual budgets and our third quarter has historically been our weakest as
it is characterized by slower spending during the summer
months.  Sales to the public sector market are historically higher in
the third quarter than in other quarters due to the buying patterns of
government and education customers.





8
 Table of Contents





Trademarks





We
conduct our business in the United States primarily under the service mark
Zones® which is registered with the United States Patent and Trademark Office.
We believe that this and our other marks have significant value and are an
important factor in the marketing of our products.





Regulatory
and Legal Matters





In
addition to federal, state and local laws applicable to all corporations and
employers in general, the direct marketing business is subject to the Federal
Trade Commission’s Merchandise Mail Order Rule and related regulations. We are
also subject to laws and regulations relating to truth-in-advertising, Anti-Spam
and other fair trade and privacy practices. We have implemented programs and
systems to promote ongoing compliance with these laws and
regulations.





Available
Information





We make
available free of charge on our website, at www.zones.com/IR, our annual report
on Form 10-K, quarterly reports on Form 10-Q, current reports on Form 8-K, and
amendments to those reports filed or furnished pursuant to Section 13(a) or
15(d) of the Securities Exchange Act of 1934, as soon as reasonably practicable
after electronically filing or furnishing such material to the Securities and
Exchange Commission (“SEC”).





Item 1A. RiskFactors





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





Our
operating results are difficult to predict and may adversely affect our stock
price.


Our
operating results are difficult to forecast, and there are a number of factors
outside of our control, including:


·
            purchasing
      cycles of commercial and public sector
  customers;


·
            the
      level of corporate investment in new IT-related capital
      equipment;


·
            more
      manufacturers going direct;


·
            industry
      announcements of new products or
upgrades;


·
            industry
      consolidation and increased
competition;


·
            cost
      of compliance with new legal and regulatory
  requirements;


·
            general
      economic conditions; and


·
            variability
      of vendor programs.


Based on
those and other risks, there can be no assurance that we will be able to
maintain the profitability we have experienced going forward.





We experience variability in our net
sales and net income on a quarterly basis.


There is
no assurance that we will sustain our current sales or income
levels.  Sales and income may decline for any number of reasons,
including:


·
            a
      decline in corporate profits leading to a change in corporate investment
      in IT-related equipment;


·
            increased
      competition;


·
            more
      manufacturers going direct;


·
            changes
      in customers’ buying habits;


·
            the
      loss of significant customers;


·
            changes
      in the selection of products available for resale;
  or


·
            general
      economic conditions.


A decline
in sales levels could adversely affect our business, financial condition, cash
flows or results of operations.





9
 Table of Contents





Our
narrow gross margins magnify the impact of variations in our operating
costs.


There is
intense price competition and pressure on profit margins in the computer
products industry.  A number of manufacturers also provide their
products directly to customers.  Various other factors also may create
downward pressure on our gross margins, such as the quarter-to-quarter
variability in vendor programs and an increasing proportion of sales to
enterprise, public sector or other competitive bid accounts on which margins
could be lower.  If we are unable to maintain or improve gross margins
in the future, this could have an adverse effect on our business, financial
condition, or results of operations.





Our
increased investments in hiring, retaining and productivity of our sales force
may not improve our profitability or result in expanded market
share.


We ended
2007 with 342 account executives, flat compared to 2006.  We expect to
continue to hire account executives, but at a lower rate of growth due to
corporate initiatives to lower turnover thus reducing hiring requirements in
2008. However, there are no assurances that we will be able to hire to our
expected levels, or recruit the quality individuals that we hope to hire, or
that the individuals hired will remain employed for an extended period of time,
or that we will not lose existing account executives.  The
productivity of account executives has historically been closely correlated with
tenure.  Even if we do retain our account executives, there are no
assurances that they will become productive at historical
levels.  Additionally, there are no assurances that the locations of
our call centers will continue to attract qualified account executives, or that
we will be able to remotely manage and retain the new account
executives.





Certain of our key vendors provide us
with incentives and other assistance, and any future decline in these incentives
and other assistance could materially harm our profit margins and operating
results.


We have a
variety of relationships with our vendors that in the past have contributed
significantly to profit margins.  For example, certain product
manufacturers and distributors provide us with incentives in the form of
rebates, volume incentive rebates, cash discounts and trade
allowances.  Our vendors continue to redefined current programs and
there are no assurances that we will attain the level of vendor support in the
future that we have obtained in the past.  In addition, many of our
vendors provide us with cooperative advertising funds, which reimburse us for
expenses associated with specific forms of
advertising.  Industry-wide, the trend has been for manufacturers,
distributors and vendors to reduce these incentives and programs.  We
believe that the 2008 incentives may decline as a percentage of sales compared
with historical amounts due to changes in available programs and
targets.  If these forms of vendor support significantly decline, or
if we are otherwise unable to take advantage of continuing vendor support
programs, or if we fail to manage the complexity of these programs, our
business, financial condition, cash flows or results of operations could be
adversely affected.





We
are controlled by a principal stockholder.


Firoz H.
Lalji, our Chairman and Chief Executive Officer, beneficially owns 51% of the
outstanding shares of Zones common stock, excluding shares that he may acquire
upon exercise of stock options that he holds.  The voting power of
these shares enables Mr. Lalji to significantly influence our affairs and the
vote on corporate matters to be decided by our shareholders, including the
outcome of elections of directors.  This effective voting control may
preclude other shareholders from being able to influence shareholder votes and
could impede potential merger transactions or block changes to our articles of
incorporation or bylaws, which could adversely affect the trading price of our
common stock.
 
 We
may lose potential revenue and competitive advantage if we lose our
certification as a Minority Business Enterprise.
 We are
certified as a Minority Business Enterprise (“MBE”) based on Mr. Lalji’s
maintenance of voting control of our outstanding common stock.  A
decrease in Mr. Lalji’s level of voting power through the issuance of additional
equity capital or through a business combination transaction could cause us to
lose our MBE certification.  Our MBE certification allows us to
compete for certain sales opportunities for which we otherwise may not be able
to compete and gives us an advantage in other sales
opportunities.  Although we are unable to quantify the portion of our
revenue that we receive as a result of our MBE certification, we believe a loss
of our MBE certification would cause us to lose potential revenue and
competitive advantage in certain sales opportunities and would have an adverse
effect on our ability to retain certain customers, compete for certain sales
opportunities and our financial performance.





We
may not be able to compete successfully against existing or future competitors,
which include some of our largest vendors.


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





10
 Table of Contents





We
are exposed to inventory obsolescence due to the rapid technological changes
occurring in the personal computer industry.


The
computer industry is characterized by rapid technological change and frequent
introductions of new products and product enhancements.  To satisfy
customer demand and obtain greater purchase discounts, we may be required to
carry significant inventory levels of certain products, which would subject us
to increased risk of inventory obsolescence. We participate in first-to-market
and end-of-lifecycle purchase opportunities, both of which carry the risk of
inventory obsolescence. Special purchase products are sometimes acquired without
return privileges, and there can be no assurance that we will be able to avoid
losses related to such products.  Within the industry, vendors are
becoming increasingly restrictive in guaranteeing return
privileges.  While we seek to reduce our inventory exposure through a
variety of inventory control procedures and policies, there can be no assurance
that we will be able to avoid losses related to obsolete inventory.





We
may not be able to maintain existing or build new vendor relationships, which
may affect our ability to offer a broad selection of products at competitive
prices and negatively impact our results of operations.


We
acquire products directly from manufacturers, such as Apple, Hewlett-Packard,
IBM and Lenovo, as well as from distributors such as Ingram Micro, Synnex, Tech
Data and others.  Certain hardware manufacturers limit the number of
product units available to DMRs.  Substantially all of our contracts
and arrangements with vendors are terminable without notice or upon short
notice. If we do not maintain our existing relationships or build new
relationships with vendors on acceptable terms, including favorable product
pricing and vendor consideration, we may not be able to offer a broad selection
of products or continue to offer products at competitive prices. Termination,
interruption or contraction of our relationships with our vendors could have a
material adverse effect on our business, financial condition, cash flows or
results of operations.





If
we fail to achieve and maintain adequate internal controls, we may not be able
to produce reliable financial reports in a timely manner or prevent financial
fraud.


We will
continue to document and test our internal control procedures on an ongoing
basis in order to satisfy the requirements of Section 404 of the Sarbanes-Oxley
Act of 2002, which requires annual management assessments of the effectiveness
of internal controls over financial reporting and a report by an independent
registered public accounting firm addressing such assessments if applicable.
During the course of our testing we may from time to time identify deficiencies
which we may not be able to remediate. In addition, if we fail to achieve or
maintain the adequacy of our internal controls, as such standards are modified,
supplemented or amended from time to time, we may not be able to ensure that we
can conclude on an ongoing basis that we have effective internal controls over
financial reporting in accordance with Section 404 of the Sarbanes-Oxley Act of
2002. Effective internal controls, particularly those related to revenue
recognition, are necessary for us to produce reliable financial reports and are
important in helping prevent financial fraud. If we cannot provide reliable
financial reports on a timely basis or prevent financial fraud, our business and
operating results could be harmed, investors could lose confidence in our
reported financial information, and the trading price of our stock could drop
significantly.





We
face many uncertainties relating to the collection of state sales and use
tax.


We
collect and remit sales and use taxes in states in which we have voluntarily
registered and/or have a physical presence. Various states have sought to
require the collection of state and local sales taxes on products shipped to the
taxing jurisdiction’s residents by DMRs.  The United States Supreme
Court held in 1992 that it is unconstitutional for a state to impose sales or
use tax collection obligations on an out-of-state company whose contacts with
the state were limited to the distribution of catalogs and other advertising
materials through the mail and the subsequent delivery of purchased goods by
United States mail or by common carrier. We cannot predict the level of contact,
including electronic commerce and Internet activity, which might give rise to
future or past tax collection obligations based on that Supreme Court
case.  Many states aggressively pursue out-of-state businesses, and
legislation that would expand the ability of states to impose sales tax
collection obligations on out-of-state businesses has been introduced in
Congress on many occasions. A change in the law could require us to collect
sales taxes or similar taxes on sales in states in which we have no presence and
could potentially subject us to a liability for prior year sales, either of
which could have a material adverse effect on our business, financial condition,
and results of operations.





We
rely on our distribution centers and certain distributors to meet the product
needs of our customers.


We
operate warehouse and distribution centers in Bensenville, Illinois and in
Seattle, Washington.  There are no assurances that our warehouse
locations will best support our customer base.  Additionally, certain
distributors 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.





11
 Table of Contents





We
are heavily dependent on commercial delivery services.


We
generally ship our products to customers by DHL, Eagle, FedEx, United Parcel
Service and other commercial delivery services and invoice customers for
delivery charges. If we are unable to pass on to our customers future increases
in the cost of commercial delivery services, our profitability could be
adversely affected. Additionally, strikes or other service interruptions by such
shippers could adversely affect our ability to deliver products on a timely
basis.





We
may not be able to attract and retain key personnel.


Our
future success will depend to a significant extent upon our ability to attract,
train and retain skilled personnel.  Although our success will depend
on personnel in all areas of our business, there are certain individuals that
play key roles within the organization.  Loss of any of these
individuals could have an adverse effect on our business, financial condition,
cash flows or results of operations.





We
may be impacted by the loss of a major customer.


From time
to time we have customers that represent more than 10% of total sales. For the
years ended December 31, 2007 and 2006, there were no customers that
individually represented more than 10% of total net sales.  In 2007,
we had a customer that represented 9.9% of total sales.  The loss of
business with any major customer could have a material adverse effect on our
business, financial condition, cash flows or results of operations.




Our
systems are vulnerable to natural disasters or other catastrophic
events.


Our
operations are dependent on the reliability of information, telecommunication
and other systems, which are used for sales, distribution, marketing,
purchasing, inventory management, order processing, customer service and general
accounting functions.  Interruption of our information systems,
Internet or telecommunication systems could have a material adverse effect on
our business, financial condition, cash flows or results of
operations.





Privacy
concerns with respect to list development and maintenance may materially
adversely affect our business.


If third
parties or our team members are able to penetrate our network security or
otherwise misappropriate our customers’ personal information or credit card
information, we could be subject to liability.  We also mail catalogs
and send electronic messages to names in our proprietary customer database and
to potential customers whose names we obtain from rented or exchanged mailing
lists. World-wide public concern regarding personal privacy has subjected the
rental and use of customer mailing lists and other customer information to
increased scrutiny. Any domestic or foreign legislation enacted limiting or
prohibiting these practices could negatively affect our business.





Our
stock price may be volatile.


There is
relatively limited trading of our stock in the public markets, and this may
impose significant practical limitations on any shareholder’s ability to achieve
liquidity at any particular quoted price.  Efforts to sell significant
amounts of our stock on the open market may precipitate significant declines in
the prices quoted by market makers.  The limitation on shareholder
liquidity resulting from this relatively thin trading volume could be
exacerbated if our stock were to be delisted from the NASDAQ Global
Market.  The NASDAQ Global Market imposes a requirement for continued
listing that the value of shares publicly held, excluding those held by
directors, officers and beneficial owners, exceed certain minimums.  A
potential future delisting of our common stock could result in significantly
reduced volume of our common stock traded, more limited press coverage, reduced
interest by investors in the common stock, adverse effects on the trading
market, downward pressure on the price for and liquidity of our stock, and
reduced ability to issue additional securities or to secure additional
financing.





Item 2. Properties





We
currently lease approximately 125,000 square feet of space for our corporate
headquarters, including our telemarketing operations, in Auburn, Washington;
approximately 84,000 square feet of space for our logistics warehouse in
Bensenville, Illinois; approximately 27,000 square feet of space for our
fulfillment warehouse facility in Seattle, Washington; and approximately 23,000
and 200 square feet of space for telemarketing sales offices in Portland, Oregon
and Kansas City, Missouri, respectively.





Item 3.LegalProceedings





From time
to time, we are a party to various legal proceedings, claims, disputes or
litigation arising in the ordinary course of business.  We believe
that the ultimate outcome of any current proceedings, individually or in the
aggregate, will not have a material adverse effect on our business, financial
condition, cash flows or results of operations.





12
 Table of Contents





Item 4.Submissionof Matters to a Vote of Security Holders





None.





Item 4A.ExecutiveOfficers of the Registrant





Firoz H. Lalji, age 61, has
served as the Company’s Chief Executive Officer since May of 1998 and as
Chairman of the Board since March of 1999. Mr. Lalji was co-founder and has
served as a director of the Company since March 1990.  Mr. Lalji is
also President and Chief Executive Officer of Fana Capital Corporation, an
investment holding company.   From 1981 to 1997, he was President
and Chief Executive Officer of Kits Cameras, Inc., which operated more than 140
camera specialty stores in eight western states.





Christina Corley, age 40, was
appointed President and COO of Zones, Inc. in October 2006.  She had
previously held the positions of Executive Vice President for Zones, Inc. from
April 2005 to October 2006, and served as President of Corporate PC Source
(“CPCS”), a wholly owned subsidiary of the Company, from March 2003 to April
2005.  Prior to the acquisition of CPCS by the Company, Ms. Corley was
Chief Executive Officer and President of CPCS from 1999 to 2003. From 1996 to
1999, Ms. Corley served as Vice 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.





Ronald P. McFadden, age 51,
has served as Senior Vice President and Chief Financial Officer of Zones, Inc.
since May 2000. Prior to this position, Mr. McFadden was the Company’s Vice
President of Finance and Administration since May 1999. He joined the Company in
June 1998, initially serving as Vice President of International Operations. From
1991 to 1998, Mr. McFadden was Chief Financial Officer for Kits Cameras, Inc.
Between 1984 and 1991 he served as Vice President of Finance for Interpace
Industries.





P. Sean Hobday, age 38, was
appointed Executive Vice President Sales for Zones, Inc. in February
2005.  Prior to this,


Mr.
Hobday had 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.





ThomasDucatelli, age 42, joined
Zones, Inc. in October 2006 as the Executive Vice President Business
Development.  Previously, Ducatelli served as Senior Vice President of
U.S. Sales at Tech Data Corporation, a $20 billion multi-national distributor of
IT products. Prior to that, he served as senior Vice President of Sales and
Business Development for Dallas-based CompuCom Systems, Inc., a $1.7 billion IT
reseller and solution provider he joined in 1994. Prior to CompuCom, Ducatelli
spent six years as a national sales executive with mid-range computer
manufacturer Digital Equipment Corp.





Anwar Jiwani, age 53, has
served as Senior Vice President and Chief Information Officer since April
1999.  Prior to this Jiwani served for 23 years with The Royal Bank of
Canada.





Robert McGowen, age 42, has
served as Senior Vice President SMB sales since January 2008.  Prior
to this appointment, McGowen served as Vice President SMB Sales since April
2004.  From February 2003 to April 2004, McGowen was a Global Account
Manager for Dell Computers.  From September 2000 to February 2003, McGowen
served as General Manager of Zones, Inc, providing onsite leadership for sales
and operations for a major Fortune 100 customer.





13
 Table of Contents





Part II





Item 5.Marketfor
Registrant’s Common Equity, Related Shareholder Matters and Issuer Purchases of
Equity Securities





Market
Information


Our
Common Stock is quoted on the NASDAQ Global Market under the symbol
ZONS.  The following table sets forth the range of high and low sales
prices for the Common Stock as reported by the NASDAQ Global
Market.





Year
      ended December 31,2007
            
            
            2006High
            
            
            Low
            
            
            High
            
            
            LowFirst
      quarter
            
            $
            11.31
            
            
            $
            7.33
            
            
            $
            7.73
            
            
            $
            4.90Second
      quarter
            
            
            11.68
            
            
            
            8.47
            
            
            
            7.70
            
            
            
            5.86Third
      quarter
            
            
            11.86
            
            
            
            8.39
            
            
            
            10.83
            
            
            
            6.08Fourth
      quarter
            
            
            11.60
            
            
            
            8.95
            
            
            
            14.44
            
            
            
            7.17





As of
March 7, 2008, we had approximately 4,000 beneficial holders of record of our
Common Stock.  We have never paid, and have no present plans to pay, a
cash dividend on our Common Stock.  We intend to retain our earnings
to finance the expansion of our business.





Information
regarding securities authorized for issuance under equity compensation plans is
incorporated by reference from the Proxy Statement for our 2008 Annual Meeting
of Shareholders under the caption “Equity Compensation Plan
Information.”





Since
2004, we have repurchased a total of 1,521,245 shares of our common stock at a
total cost of $7.9 million under our repurchase program authorized by our Board
of Directors.  Share repurchases may be made from time to time in both
open market and private transactions, as conditions warrant, at then prevailing
market prices. The following table presents share repurchases for the years
ended December 31, 2007, 2006 and 2005 (dollars in thousands):








Year
            
            Total
      number of shares purchased
            
            
            Amount
      paid2007
            
            
            80,005
            
            
            $
            7832006
            
            
            568,400
            
            
            $
            3,9882005
            
            
            424,450
            
            
            $
            1,813





As of
December 31, 2007, $2.2 million in shares of our common stock remained available
for repurchase under the program.  In January 2008, the Board of
Directors authorized a continuation of our share repurchase program, pursuant to
which we increased the total amount authorized to $3.0 million available for
repurchase of shares under the program. The current repurchase program is
expected to remain in effect through February 2009, unless earlier terminated by
the Board or completed.





14
 Table of Contents





Performance
Graph





Set forth
below is a graph comparing the annual percentage change in the cumulative total
return on our Common Stock during the period beginning on December 31, 2002, and
ending on December 31, 2007, with the cumulative total return during that period
on the Total Return Index for the NASDAQ Stock Market (U.S. Companies) and the
NASDAQ Retail Trade Index.  The comparison assumes $100.00 was
invested on December 31, 2002 in our Common Stock and each index and also
assumes that all dividends have been reinvested.  No cash dividends
have been declared on the Common Stock.  The return on the Common
Stock shown on the graph should not be considered indicative of future stock
performance.











12/31/2002
            
            
            12/31/2003
            
            
            12/31/2004
            
            
            12/31/2005
            
            
            12/31/2006
            
            
            12/31/2007Zones,
      Inc.
            
            $
            100
            
            
            $
            198
            
            
            $
            771
            
            
            $
            583
            
            
            $
            869
            
            
            $
            1,259NASDAQ
      Composite Index
            
            
            100
            
            
            
            150
            
            
            
            163
            
            
            
            166
            
            
            
            183
            
            
            
            198NASDAQ
      Retail Trade Index
            
            
            100
            
            
            
            139
            
            
            
            177
            
            
            
            178
            
            
            
            195
            
            
            
            177





15
 Table of Contents





Item 6.SelectedFinancial 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, 2007 and 2006 and the statement of operations data
for the years ended December 31, 2007, 2006 and 2005 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, 2005, 2004 and 2003 and the statement of operations data for
the years ended December 31, 2004 and 2003 have been derived from audited
consolidated financial statements and notes thereto not included in this Annual
Report on Form 10-K.





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 31,2007
            
            
            2006
            
            
            2005
            
            
            2004
            
            
            
            2003
            2(In
      thousands, except per share data and sales force data)Statement
      of Operations Data:Net
      sales
            
            $
            679,492
            
            
            $
            577,027
            
            
            $
            566,553
            
            
            $
            495,563
            
            
            $
            460,772Cost
      of sales
            
            
            599,223
            
            
            
            505,508
            
            
            
            505,997
            
            
            
            438,426
            
            
            
            410,078Gross
      profit
            
            
            80,269
            
            
            
            71,519
            
            
            
            60,556
            
            
            
            57,137
            
            
            
            50,694Selling,
      general and administrative expenses
            
            
            51,201
            
            
            
            48,434
            
            
            
            43,618
            
            
            
            42,284
            
            
            
            43,252Advertising
      expense
            
            
            8,038
            
            
            
            7,159
            
            
            
            6,618
            
            
            
            7,082
            
            
            
            6,597State
      tax benefit1
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (2,103
            )Income
      from operations
            
            
            21,030
            
            
            
            15,926
            
            
            
            10,320
            
            
            
            7,771
            
            
            
            2,948Other
      expense, net
            
            
            174
            
            
            
            270
            
            
            
            503
            
            
            
            314
            
            
            
            379Income
      before income taxes
            
            
            20,856
            
            
            
            15,656
            
            
            
            9,817
            
            
            
            7,457
            
            
            
            2,569Provision
      from income taxes
            
            
            7,723
            
            
            
            5,971
            
            
            
            3,766
            
            
            
            2,805
            
            
            
            1,001Net
      income
            
            $
            13,133
            
            
            $
            9,685
            
            
            $
            6,051
            
            
            $
            4,652
            
            
            $
            1,568Basic
      income per share
            
            $
            1.00
            
            
            $
            0.73
            
            
            $
            0.45
            
            
            $
            0.34
            
            
            $
            0.11Weighted
      average shares used in computation of basic income per
    share
            
            
            13,139
            
            
            
            13,195
            
            
            
            13,382
            
            
            
            13,549
            
            
            
            13,644Diluted
      income per share
            
            $
            0.90
            
            
            $
            0.66
            
            
            $
            0.42
            
            
            $
            0.32
            
            
            $
            0.11Weighted
      average shares used in computation of diluted income per
    share
            
            
            14,635
            
            
            
            14,756
            
            
            
            14,527
            
            
            
            14,469
            
            
            
            13,739Balance
      Sheet Data:Working
      capital
            
            $
            54,959
            
            
            $
            41,669
            
            
            $
            33,398
            
            
            $
            27,024
            
            
            $
            20,884Total
      assets
            
            
            133,322
            
            
            
            120,695
            
            
            
            117,354
            
            
            
            102,144
            
            
            
            92,885Short-term
      debt
            
            
            20,252
            
            
            
            14,385
            
            
            
            20,441
            
            
            
            21,678
            
            
            
            23,432Long-term
      debt, net of current portion
            
            
            
            
            
            
            
            
            
            
            21
            
            
            
            1,307
            
            
            
            1,667Total
      shareholders’ equity
            
            $
            62,308
            
            
            $
            49,482
            
            
            $
            41,317
            
            
            $
            36,551
            
            
            $
            32,701Selected
      Operating Data (unaudited):Unassisted
      net sales
            
            $
            215,235
            
            
            $
            172,385
            
            
            $
            103,600
            
            
            $
            65,289
            
            
            $
            36,308Average
      productivity per employee3
            
            $
            964
            
            
            $
            873
            
            
            $
            982
            
            
            $
            853
            
            
            $
            874Sales
      force, end of period
            
            
            342
            
            
            
            342
            
            
            
            250
            
            
            
            281
            
            
            
            2341During 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.3Average productivity
      per employee is calculated by dividing net sales by the number of total
      employees.





Item 7.Management’sDiscussion 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, management’s
beliefs, and certain assumptions made by management. These statements are made
pursuant to the safe harbor provision of the Private Securities Litigation
Reform Act of 1995.All
statements, trends, analyses and other information contained in this report
relative to trends in net sales, gross margin and anticipated expense levels, as
well as other statements, including words such as “anticipate,” “believe,”
“plan,” “expect,” “estimate,” “intend” and other similar expressions, constitute
forward-looking statements. These forward-looking statements involve risks and
uncertainties, and actual results may differ materially from those anticipated
or expressed in such statements. Potential risks and uncertainties include,
among others, those set forth in Item 1A of this Annual Report. Particular
attention should be paid to the cautionary statements involving future growth;
pressure on margin; account executive hiring and productivity; reliance on
vendor relationships; competition; state tax uncertainties; rapid technological
change and inventory obsolescence; dependence on personnel; potential disruption
of business from information systems failure; reliance on outsourced
distribution; variations in gross profit margin percentages due to vendor
programs and credits, product and customer mix, pricing strategies, and economic
conditions.  Except as required by law, we undertake no obligation to
update any forward-looking statement, whether as a result of new information,
future events or otherwise.





16
 Table of Contents





The
following discussion and analysis should be read in conjunction with our
Selected Consolidated Financial and Operating Data and the Consolidated
Financial Statements and Notes included in this Annual Report on Form
10-K.





General


Our net
sales consist primarily of sales of computer hardware, software, peripherals and
accessories, as well as revenue associated with freight billed to our customers,
net of product returns. Gross profit consists of net sales less product and
freight costs. Selling, general and administrative (“SG&A”) expenses include
warehousing and distribution costs, selling salaries including commissions,
order processing, telephone and credit card fees, and other costs such as
administrative salaries, stock compensation expense, depreciation, rent and
general overhead expenses. Advertising expense is marketing costs associated
with vendor programs, net of vendor cooperative advertising expense
reimbursements allowable under EITF 02-16 “Accounting for Consideration Received
from a Vendor by a Customer (Including a Reseller of the Vendor’s
Products).”   Other expense represents interest expense, net of
non-operating income.





Overview


We are a
direct marketing reseller of technology hardware, software and services. We
procure and fulfill IT solutions for the SMB market (between 50 and 1000
computer users), large and enterprise customers (greater than 1000 computer
users) and the public sector (education and state and local governments).
Relationships with SMB, large and enterprise customers, and public sector
institutions represented 99.2%, 98.0% and 96.5% of total net sales during 2007,
2006 and 2005, respectively. The remaining sales were from inbound customers,
primarily consumers and small office/home office accounts purchasing mostly Mac
platform products.





We reach
our 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, a
national field sales force, 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.





We
utilize our purchasing and inventory management capabilities to support our
primary business objective of providing name-brand products at competitive
prices. We offer our customers more than 150,000 hardware, software, peripheral
and accessory products and services from more than 2,000
manufacturers.





The
management team regularly reviews our performance using a variety of financial
and non-financial metrics, including, but not limited to, net sales, gross
margin, cooperative advertising reimbursements, advertising expenses, personnel
costs, productivity per team member, accounts receivables aging, inventory
aging, liquidity and cash resources.   Management compares the
various metrics against goals and budgets and takes appropriate action to
enhance performance.





We are
dedicated to creating a learning community of empowered individuals to serve our
customers with integrity, commitment and passion. At December 31, 2007 we had
705 team members in our consolidated operations, 342 of whom were inbound and
outbound account executives. The majority of our team members work at our
corporate headquarters in Auburn, Washington.





We make
additional company information available free of charge on our website,
www.zones.com/IR.





Critical
Accounting Policies


Our
discussion and analysis of our financial condition and results of operations are
based upon consolidated financial statements, which have been prepared in
accordance with accounting principles generally accepted in the United States of
America, which require management to make use of certain estimates and
assumptions that affect the reported amounts of assets and liabilities and
disclosure of contingent assets and liabilities as of the date of the financial
statements and the reported amounts of revenues and expenses during the reported
periods. We base our estimates on historical experience and on various other
assumptions that are believed to be reasonable under the circumstances, the
results of which form the basis for making judgments about carrying values of
assets and liabilities that are not readily apparent from other sources. Actual
results could differ from those estimates, and revisions to estimates are
included in the results for the period in which the actual amounts become
known.





17
 Table of Contents





We
believe the following critical accounting policies affect our more significant
judgments and estimates used in the preparation of our consolidated financial
statements and therefore should be read in conjunction with the summary of
significant accounting policies (see Note 2 of the Notes to Consolidated
Financial Statements).  Our critical accounting policies are as
follows:





Revenue
Recognition.


We adhere
to the revised guidelines and principles of sales recognition in Staff
Accounting Bulletin No. 104 (“SAB 104”), "Revenue Recognition," issued by the
staff of the SEC as a revision to Staff Accounting Bulletin No. 101, “Revenue
Recognition.”  We recognize 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.  We consider the
point of delivery of the product to be when the risks and rewards of ownership
have transferred to the customer.  Our 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 our sales relate to physical products. For all product sales,
shipped directly from our warehouse or from our suppliers to customers, we are
the primary obligor, have full latitude in establishing price with the customer,
select the supplier to provide the product, take title to the product sold upon
shipment, bear credit risk, and bear inventory risk for returned
products.  These sales are recognized on a gross basis with the
selling price to the customer recorded as sales and the acquisition cost of the
product recorded as cost of sales.  Additionally, amounts billed for
shipping and handling are recorded as sales.





For all
third-party services, we are the primary obligor to our customer, we have full
latitude in establishing price with the customer, we select the third-party
service provider, we are obligated to compensate the service provider for work
performed regardless of whether the customer accepts the work and, we bear
credit risk; therefore, these revenues are recognized on a gross basis with the
selling price to the customer recorded as sales and the acquisition cost of the
service recorded as cost of sales.





Software
maintenance contracts, software agency fees, and extended warranties that we
sell (for which we are not the primary obligor), are recognized on a net basis
in accordance with Emerging Issues Task Force Issue No. 99-19 (“EITF 99-19”),
“Reporting Revenue Gross as a Principal versus Net as an Agent.”  We
do not take title to the products or assume any maintenance or return
obligations in these transactions; title is passed directly from the supplier to
our customer. Accordingly, such revenues are recognized in sales either at the
time of sale or over the contract period, based on the nature of the contract,
at the net amount retained by us, with no cost of goods sold.





Sales are
reported net of sales, use or other transaction taxes that are collected from
the customers and remitted to taxing authorities.  Sales are reported
net of returns and allowances.  We offer limited return rights on our
product sales.  We have demonstrated the ability to make reasonable
and reliable estimates of product returns based on significant historical
experience. We had allowances for sales returns of $76,000 and $101,000 at
December 31, 2007 and 2006, respectively.





Valuation of Current Assets,
Allowance for Doubtful Accounts and Estimation of Market Inventory
Obsolescence.


We use
significant judgment and estimates in the preparation of our financial
statements that affect the carrying values of our assets and liabilities. On an
on-going basis, we evaluate our estimates.





We
maintain an allowance for doubtful accounts based on estimates of future
collectibility of our accounts receivable. We regularly analyze our 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.





We
maintain a valuation allowance for potentially uncollectable amounts due from
our 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.   We regularly review our vendor
receivables and provide a valuation allowance based on historical collections
and the comparison of amounts recorded versus subsequently
received.





18
 Table of Contents





We record
inventory at lower of FIFO cost or market.  We estimate 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.


We are
required to estimate income taxes in states in which we are registered and/or
have 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.  We consider future taxable income in
assessing the need for a valuation allowance against our deferred tax assets. We
believe that all net deferred tax assets shown on our balance sheet as of
December 31, 2007, 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, we 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.  We perform the assessment annually on March
31.  We completed the impairment review required by SFAS No. 142 on
March 31, 2007 and determined that our 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 our
Consolidated Statements of Operations expressed as a percentage of net
sales.





Year
      ended December 31,2007
            
            
            2006
            
            
            2005Net
      sales
            
            
            100.0
            %
            
            
            100.0
            %
            
            
            100.0
            %Cost
      of sales
            
            
            88.2
            
            
            
            87.6
            
            
            
            89.3Gross
      profit
            
            
            11.8
            
            
            
            12.4
            
            
            
            10.7SG&A
      expenses
            
            
            7.5
            
            
            
            8.4
            
            
            
            7.7Advertising
      expense
            
            
            1.2
            
            
            
            1.2
            
            
            
            1.2Income
      from operations
            
            
            3.1
            
            
            
            2.8
            
            
            
            1.8Other
      expense, net
            
            
            0.1
            
            
            
            0.1
            
            
            
            0.1Income
      before income taxes
            
            
            3.0
            
            
            
            2.7
            
            
            
            1.7Provision
      for income taxes
            
            
            1.1
            
            
            
            1.0
            
            
            
            0.7Net
      income
            
            
            1.9
            %
            
            
            1.7
            %
            
            
            1.0
            %Product
      Mix:Notebook
      & PDAs
            
            
            14.2
            %
            
            
            12.4
            %
            
            
            15.3
            %Desktops
      & Servers
            
            
            21.3
            
            
            
            20.3
            
            
            
            20.1Software
            
            
            18.6
            
            
            
            17.7
            
            
            
            15.9Storage
            
            
            7.0
            
            
            
            9.1
            
            
            
            9.1NetComm
            
            
            5.2
            
            
            
            4.9
            
            
            
            4.2Printers
            
            
            8.2
            
            
            
            8.2
            
            
            
            11.3Monitors
      & Video
            
            
            9.7
            
            
            
            10.4
            
            
            
            9.6Memory
      & Processors
            
            
            4.8
            
            
            
            6.2
            
            
            
            5.4Accessories
      & Other
            
            
            11.0
            
            
            
            10.8
            
            
            
            9.1Total
            
            
            100.0
            %
            
            
            100.0
            %
            
            
            100.0
            %





Comparison
of Years Ended December 31, 2007 and 2006





Net
Sales.Consolidated net sales increased 17.8% to $679.5
million in 2007 compared to $577.0 million in 2006.  Consolidated
outbound sales to commercial and public sector accounts increased 19.2% to
$673.7 million in 2007 from $565.3 million in 2006.  Sales to our SMB
customers increased 32.5% to $294.2 million in 2007, compared to $222.1 million
in 2006. Growth in SMB sales was primarily due to longer average tenure and
associated increased productivity of sales account executives
(“AEs”).  Additionally, headcount at our Portland sales center, which
began operations in the first quarter of 2006, increased 13.5% to 101 team
members at December 31, 2007 from 89 at December 31, 2006.  We will
continue to focus on our SMB growth initiatives in 2008 including hiring and
retention goals which center on increasing average tenure levels of our AEs,
which we believe translates into increased productivity levels.  Sales
to our enterprise customers increased 14.8% to $346.5 million for the year ended
December 31, 2007, compared to $301.8 million in 2006.  Sales to our
enterprise customers are often defined by large non-recurring project roll-outs
and specific contractual obligations which have expiration
dates.  During 2007, we had one customer which represented 9.9% of
total sales primarily due to a large project roll-out which occurred in the
first half of 2007.  During 2006, this same customer represented 3.6%
of our total sales.  Our 2008 enterprise sales initiatives include
optimizing the foundation laid by our national field sales force which we
believe will complement the outbound call center sales force.  Net
sales to public sector customers decreased 15.6% to $33.1 million in 2007 from
$39.2 million in 2006.  Inbound sales to consumer and small
office/home office (“SOHO”) customers declined 50.8% to $5.7 million, which
represented 0.8% of net sales.





19
 Table of Contents





Gross Profit. Consolidated
gross profit increased to $80.3 million in 2007 compared to $71.5 million in
2006.  The increase in gross profit dollars was primarily related to
our increased sales volumes and vendor programs.  Gross profit as a
percentage of net sales decreased to 11.8% in 2007, compared with 12.4% in 2006,
due primarily to certain cost concessions given to a large customer during the
first half of 2007.  Gross profit margins will continue to vary, and
may decline from current levels, due to changes in vendor programs, product mix,
pricing strategies, customer mix,bid-based
sales, the sale of third-party services and other fee or commission based sales,
and economic conditions.  We anticipate variability in our gross
profit margins in 2008 compared with historical levels due to expected change in
vendor programs, our field sales initiative and expected sales increases to
existing large customers as large enterprise customers tend to record lower
gross profit sales and increased price competition in uncertain economic
times.  Lastly, we categorize our warehousing and distribution network
costs in selling, general and administrative expenses.  Due to this
classification, gross profit may not be comparable to that of a company that
includes its warehousing and distribution network costs as a cost of
sales.





Selling, General and Administrative
Expenses. SG&A expenses increased to $51.2 million for 2007 from
$48.4 million in 2006, but decreased as a percentage of net sales to 7.5% in
2007 compared to 8.4% in 2006. This decrease in operating expense percentage
reflects our ability to leverage our existing infrastructure as we increase our
sales volumes.  The overall increase in SG&A expenses was due to
the following principle factors:





·
            Salaries,
      wages and benefits increased $2.9 million during 2007 as compared with the
      prior year.  The increase was primarily due to increased
      headcount.  We focused on building a national field sales team
      during 2007 which increased wage expense by $1.7 million compared with the
      prior year.  Also, we recorded $900,000 more in expenses
      associated with commissions paid as a result of the increased sales volume
      and profitability.


·
            Facilities
      expense increased $420,000 during 2007 compared with prior year, primarily
      due to the additional rent expense associated with increased leased space
      in our Auburn, Washington and Bensenville, Illinois
      facilities.


·
            Employee
      travel and entertainment costs increased $174,000 during 2007 compared to
      2006, primarily due to increased travel and entertainment associated with
      our Business Development field sales
force.


·
            Professional
      fees decreased $339,000 during 2007 compared with the prior year,
      primarily due to reductions in legal fees, recruiting fees as we focused
      on retention thus reducing the gross hiring requirement, as well as
      consulting fees associated with our outsourcing contract in
      India.





For the
periods ending December 31, 2007 and 2006, warehousing and distribution network
costs totaled $2.3 million and $2.1 million, respectively.





Advertising Expenses,
Net.  We produce and distribute direct mail collateral,
targeted campaign materials and catalogs at various intervals throughout the
year to increase awareness of our brand and stimulate demand
response.  Our net cost of advertising increased to $8.0 million in
2007 from $7.2 million in 2006.


·
            Gross
      advertising expense increased to $9.6 million during 2007 compared with
      $8.9 million during 2006, primarily due to expenses associated with
      vendor-specific marketing programs.


·
            Gross
      advertising vendor reimbursements decreased to $1.6 million during 2007
      from $1.7 million in 2006. We have classified substantially all vendor
      consideration as a reduction of cost of goods sold rather than as a
      reduction of advertising expense.





Other (Income) Expense,
net.  Other expense was $174,000 during 2007 compared to
$270,000 during 2006.   Interest expense related to our use of
the working capital line was $374,000 and $383,000 for the twelve month periods
ended December 31, 2007 and 2006, respectively.  Offsetting this
expense were amounts recorded for interest income of $203,000 during 2007
compared with $149,000 for 2006.  Interest income represent amounts
earned on short-term investments and finance charges collected from certain
customers, which vary from period to period.





20
 Table of Contents





Income Tax
Provision.  The income tax provision for 2007 was $7.7 million,
compared to $6.0 million during 2006.  The effective tax rates
expressed as a percent of income were 37.0% and 38.1% for the years ended
December 31, 2007 and 2006, respectively.  The effective tax rate is
dependent upon state taxes, the magnitude of any nondeductible expenses and
various other factors.





Net Income. Net income for
fiscal year 2007 was $13.1 million, as compared with net income of $9.7 million
for fiscal year 2006.  Basic and diluted income per share were $1.00
and $0.90, respectively, for the twelve months ended December 31, 2007, compared
to $0.73 and $0.66, respectively, for the twelve months ended December 31,
2006.





Comparison
of Years Ended December 31, 2006 and 2005





Net
Sales.Consolidated net sales increased 1.8% to $577.0 million
in 2006 compared to $566.6 million in 2005.  Consolidated outbound
sales to commercial and public sector accounts increased 3.4% to $565.3 million
in 2006 from $547.0 million in 2005.  Sales to the Company’s SMB
customers increased 18.1% to $222.1 million in 2006, compared to $188.2 million
in 2005. Sales to the Company’s enterprise customers decreased 4.0% to $301.8
million for the year ended December 31, 2006, compared to $314.5 million in
2005.  During 2005, one customer represented $48.5 million of
enterprise net sales related to a specific one-time product roll-out during the
second half of the year.  Net sales to public sector customers
decreased 5.9% to $39.2 million in 2006 from $41.6 million in
2005.  Inbound sales to the Company’s legacy Mac-platform consumer and
small office/home office (“SOHO”) customers declined 37.3% to $14.0 million, or
2.4% of net sales.





Gross Profit. Consolidated
gross profit increased to $71.5 million in 2006 compared to $60.6 million in
2005.  Gross profit as a percentage of net sales increased to 12.4% in
2006, compared to 10.7% in 2005.  The change is due to an increase in
the gross profit earned on total net sales as compared to 2005, and an increase
in the amount of vendor programs recorded in 2006.  Gross profit
margins as a percent of sales will continue to vary due to changes in vendor
programs, product and customer mix, pricing strategies and economic
conditions.  The Company categorizes its warehousing and distribution
network costs in selling, general and administrative expenses.  Due to
this classification, the Company’s gross profit may not be comparable to that of
other companies that categorize warehousing and distribution network costs as a
cost of sales.





Selling, General and Administrative
Expenses. SG&A expenses increased to $48.4 million for 2006 from
$43.6 million in 2005, and increased as a percentage of net sales to 8.4% in
2006, compared to 7.7% in 2005. The increase in SG&A expenses was due to the
following:





·
            Salaries,
      wages and benefits increased $4.4 million during 2006 as compared to the
      prior year.  The increase was primarily due to increased
      headcount.  The Company focused on growing its sales account
      executive headcount, particularly with the addition of its Portland,
      Oregon call center.  Also, the Company recorded increased
      expenses associated with incentive compensation programs and commissions
      paid as a result of the increased sales volume and profitability, and
      stock compensation expense.


·
            The
      Company’s state tax expense decreased $411,000 in 2006 as compared to the
      prior year.  This primarily relates to decreased Business and
      Occupation tax (an excise tax based on gross receipts) to the State of
      Washington.


·
            Facilities
      expense increased $254,000 for the year ended December 31, 2006 due to the
      additional rent expense associated with the Portland, Oregon call center,
      which was opened in the first quarter of
2006.


·
            The
      Company’s professional fees increased $485,000 during
      2006.  This is primarily due to an increase in consulting fees
      associated with the Company’s outsourcing arrangement in India, as well as
      recruiting fees associated with the additional sales account executive
      headcount.


·
            Depreciation
      expense declined $164,000 for the year ended December 31, 2006 as compared
      to 2005.  This decline was primarily due to more of the
      Company’s assets becoming fully
depreciated.





For the
periods ending December 31, 2006 and 2005, warehousing and distribution network
costs totaled $2.1 million and $2.2 million, respectively.





21
 Table of Contents





Advertising Expenses,
Net.  The Company produces and distributes catalogs at various
intervals throughout the year, and also engages in other activities, to increase
the awareness of its brand and stimulate demand response.  The
Company’s net cost of advertising increased to $7.2 million in 2006 from $6.6
million in 2005.


·
            Gross
      advertising expense increased to $8.9 million for fiscal year 2006
      compared to $7.0 million in fiscal year 2005.  The increase was
      primarily due to expenses related to corporate and customer
      events.


·
            The
      Company’s gross advertising reimbursements also increased to $1.7 million
      in 2006 from $429,000 in 2005.  The Company’s advertising
      expense increases were offset by the corresponding reimbursement increase,
      which was used to pay for incremental marketing
  activities.





Interest
Expense.Interest expense was $419,000 in 2006, compared to
$594,000 in 2005.  The Company’s use of its line of credit to fund the
expansion of accounts receivable and inventory incurred interest expense of
$383,000 and $480,000 for the periods ended December 31, 2006 and 2005,
respectively.  The interest rate on the working capital line is tied
to the Prime Rate.  The effects of increases in the Prime Rate during
2006 where offset by a reduction in the Company’s usage of the working capital
line of credit compared to 2005.  The remaining expense was due to
interest owed on the outstanding note payable to the former shareholders of
CPCS, which was paid off in April 2006.





Other
Income.  Other income was $149,000 in 2006, compared to $91,000
in 2005.





Income Tax
Provision.  The income tax provision for 2006 was $6.0 million,
compared to $3.8 million during 2005.  The effective tax rates
expressed as a percent of income were 38.1% and 38.4% for the years ended
December 31, 2006 and 2005, respectively.





Net Income. Net income for
fiscal year 2006 was $9.7 million, or $0.66 per diluted share, as compared to
net income of $6.1 million, or $0.42 per diluted share, for fiscal year
2005.





Inflation


We do not
believe that inflation has had a material impact on our 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.


Our total
assets were $133.3 million at December 31, 2007, of which $124.2 million were
current assets.  At December 31, 2007 and 2006, the Company had cash
and cash equivalents of $12.0 million and $9.2 million, respectively, and had
working capital of $55.0 million and $41.7 million, respectively. The increase
in working capital was primarily a result of our increased sales volumes which
led to increases in our receivables, and aggressive collection efforts which
increased our on-hand cash and cash equivalents.





Stock
Repurchase Program.


Since
2004, we have repurchased a total of 1,521,245 shares of our common stock at a
total cost of $7.9 million under our repurchase program authorized by our Board
of Directors.  Share repurchases may be made from time to time in both
open market and private transactions, as conditions warrant, at then prevailing
market prices. The following table presents share repurchases for the years
ended December 31, 2007, 2006 and 2005 (dollars in thousands):








Year
            
            Total
      number of shares purchased
            
            
            Amount
      paid2007
            
            
            80,005
            
            
            $
            7832006
            
            
            568,400
            
            
            $
            3,9882005
            
            
            424,450
            
            
            $
            1,813





As of
December 31, 2007, $2.2 million in shares of our common stock remained available
for repurchase under the program.  In January 2008, the Board of
Directors authorized a continuation of our share repurchase program, pursuant to
which we increased the total amount authorized to $3.0 million available for
repurchase of shares under the program. The current repurchase program is
expected to remain in effect through February 2009, unless earlier terminated by
the Board or completed.





22
 Table of Contents





Approximately
94% of our sales are processed on open account terms offered to our customers,
and we experienced significant sales during the last month of the period on open
account, which increased the accounts receivable balance.  To finance
these sales, we leverage our secured line of credit to offset timing differences
in cash inflows and cash outflows, to invest in capital equipment purchases, to
purchase inventory for general stock as well as for identified customers, and to
take full advantage of available early pay discounts.





We have a
$50.0 million secured line of credit facility with a major financial
institution, which is collateralized by accounts receivable and inventory, and
it can be utilized as both a working capital line of credit and an inventory
financing facility to purchase products 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 plus 0.50%.  Our line of credit is defined by quick
turnover, large amounts and short maturities. All amounts owed under the line of
credit are due on demand.  Amounts owed under the inventory financing
facility do not bear interest if paid within terms, usually 30 days from invoice
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.  At December 31, 2007,
there were no outstanding working capital advances, and inventory financing
arrangements of $20.3 million were owed to this financial
institution.  At December 31, 2007, we were in compliance with all
covenants of this facility.





We
believe that our existing available cash and cash equivalents, operating cash
flow, and existing credit facilities will be sufficient to satisfy our operating
cash needs, and to fund the remaining balance of $3.0 million authorized in our
stock repurchase program, for at least the next 12 months at our current level
of business.  However, if our working capital or other capital
requirements are greater than currently anticipated, we could be required to
reduce or curtail our stock repurchase program and seek additional funds through
sales of equity, debt or convertible securities, or through increased credit
facilities.  There can be no assurance that additional financing will
be available or that, if available, the financing will be on terms favorable to
us and our shareholders.





Cash
Flows.


Net cash
provided by operating activities was $5.9 million in the twelve months ended
December 31, 2007.  The primary factors that affected fiscal year 2007
net cash flow from operations were net income, account and vendor receivables,
and the decrease in accounts payable.  Our operations contributed
$13.1 million of net income.  This was partially offset by increases
in account and vendor receivables of $10.5 million due to increased open account
sales.  Accounts payable decreased by $1.6 million due to the timing
of vendor payments.





Net cash
used in investing activities was $1.4 million for the year ended December 31,
2007.  Cash outlays for capital expenditures were $1.4 million and
$1.8 million for the years ended December 31, 2007 and 2006,
respectively.  Capital expenditures were primarily for leasehold
improvements for our corporate headquarters and continued improvement, and other
enhancements, of our information systems.  We intend to continue to
upgrade our internal information systems as a means to increase operational
efficiencies.





Net cash
used in financing activities was $1.7 million for the year ended December 31,
2007.  The most significant components of our financing activities are
the net change in book overdraft, net change of inventory financing and the
purchase of common stock under our share repurchase program.  The net
change in book overdraft for the twelve month period ended December 31, 2007 was
a decrease of $7.1 million.  Net change in our inventory financing for
the twelve month period ended December 31, 2007 was an increase of $5.9
million.  For the twelve month period ended December 31, 2007, we
repurchased $783,000 of our common stock under our share repurchase
program.





23
 Table of Contents





Contractual
Obligations


The
following table summarizes our contractual payment obligations and commitments
as of December 31, 2007:





Payments
      Due by PeriodTotal
            
            
            Less
      than 1 year
            
            
            1-3
      years
            
            
            3-5
      years
            
            
            More
      than 5 yearsOperating
      Leases (a)
            
            $
            14,590
            
            
            $
            2,419
            
            
            $
            4,194
            
            
            $
            3,790
            
            
            $
            4,187Inventory
      Financing
            
            
            20,252
            
            
            
            20,252Purchase
      Obligations (b)
            
            
            22,096
            
            
            
            22,096Total
            
            $
            56,938
            
            
            $
            44,767
            
            
            $
            4,194
            
            
            $
            3,790
            
            
            $
            4,187








(a)
            Represents
      our commitments under operating leases associated with contracts that
      expire at various times.  One of the commitments is our Auburn,
      Washington headquarters, which is leased from a related
    party.


(b)
            Purchase
      obligations represents the amount of open purchase orders we have
      outstanding with our vendors.  These obligations may be canceled
      prior to shipment at our
discretion.





Other
Matters


New
Accounting Pronouncements.


In July
2006, the Financial Accounting Standards Board (“FASB”) issued FASB
Interpretation No. 48 (FIN 48), “Accounting for Uncertainty in Income Taxes: an
Interpretation of FASB Statement No. 109, Accounting for Income
Taxes.”  FIN 48 clarifies the accounting for uncertainty in income
taxes recognized in a company’s financial statements and prescribes a
recognition threshold and measurement attribute for the financial statement
recognition and measurement of a tax position taken or expected to be taken in
an income tax return. FIN 48 also provides guidance on derecognition,
classification, interest and penalties, accounting in interim periods,
disclosure and transition.  Only tax positions that meet the
more-likely-than-not recognition threshold at the adoption date will be
recognized or continue to be recognized. Any cumulative effect of applying FIN
48 would be reported as an adjustment to retained earnings at the beginning of
the period in which it is adopted.  We adopted FIN 48 on January 1,
2007, and there was no impact to our financial statements in conjunction with
the adoption.





Item 7A.Quantitativeand Qualitative Disclosures About Market Risk


We are
subject to the risk of fluctuating interest rates in the normal course of
business, primarily as a result of our short-term borrowing and investment
activities, which generally bear interest at variable rates. We invest cash
balances in excess of operating requirements in short-term securities, generally
with maturities of 90 days or less. In addition, our credit facility provides
for borrowings which bear interest at variable rates based on the prime rate. We
had no interest-bearing borrowings outstanding pursuant to the credit facility
as of December 31, 2007. We believe that the effect, if any, of reasonably
possible near-term changes in interest rates on our financial position, results
of operations and cash flows should not be material.





Item 8.FinancialStatements and Supplementary Data


The
information required by this item is included in this report beginning at page
30.





Item 9.Changesin
and Disagreements with Accountants on Accounting and Financial
Disclosure


None.





Item 9A.Controland Procedures


At the
end of the period covered by this report, we carried out an evaluation, under
the supervision and with the participation of our management, including our
Chief Executive Officer and Chief Financial Officer, of our 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 our disclosure controls and procedures are effective.





During
the fourth quarter of 2007, there were no changes in our internal control over
financial reporting that have materially affected, or are reasonably likely to
materially affect, our internal control over financial reporting.





Item 9B. OtherInformation


None.





24
 Table of Contents





Part III





Item 10.Directors, Executive Officers and Corporate
Governance


The
information required by this item is contained in, and incorporated by reference
from, the Proxy Statement for our 2008 Annual Meeting of Shareholders under the
caption “Proposal No. 1: Election of Directors,” and “Section 16(a) Beneficial
Ownership Reporting Compliance.”  See also the information concerning
our executive officers included in Item 4A of Part I in this
Report.





The Board
of Directors has determined that each of the members of the Audit Committee
qualifies as an “audit committee financial expert” as such term is defined by
the SEC and that each of the members meets the independence criteria set forth
in the applicable rules of NASDAQ Global Market and the SEC for Audit Committee
Membership.  Our Audit Committee is comprised of Messrs. John H.
Bauer, Kenneth M. Kirkpatrick and William C. Keiper.





Our Code
of Business Conduct and Ethics has been approved by our Board of Directors and
applies to all of our team members and directors, including our principal
executive officer, principal financial officer and principal accounting officer.
Our 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
our Code of Business Conduct and Ethics is available at our website at
www.zones.com/IR. In the event that an amendment to, or a waiver from, a
provision of our Code of Business Conduct and Ethics that applies to any of our
officers or directors is necessary, we intend to post such information on our
website at www.zones.com/IR.





We will
provide without charge to any person, upon request of such person, a copy of our
Code of Business Conduct and Ethics. Requests should be directed in writing to
Zones, Inc. Investor Relations, 1102 15th Street
SW, Suite 102, Auburn, WA 98001-6509.





Item 11.ExecutiveCompensation


The
information required by this item is contained in, and incorporated by reference
from, the Proxy Statement for our 2008 Annual Meeting of Shareholders under the
caption “Executive Compensation.”





Item 12.SecurityOwnership of Certain Beneficial Owners and Management and Related
Stockholder Matters


The
information required by this item is contained in, and incorporated by reference
from, the Proxy Statement for our 2008 Annual Meeting of Shareholders under the
caption “Stock Ownership of Management and Certain Other Holders.”





Item 13.CertainRelationships and Related Transactions, and Director
Independence


The
information required by this item is contained in, and incorporated by reference
from, the Proxy Statement for our 2008 Annual Meeting of Shareholders under the
caption “Certain Relationships and Related Transactions.”





Item 14.PrincipalAccountant Fees and Services


The
information required by this item is contained in, and incorporated by reference
from, the Proxy Statement for our 2008 Annual Meeting of Shareholders under the
caption “Principal Accounting Firm Fees.”





Part IV





Item 15.Exhibitsand Financial Statement Schedules


(a)
            1.  Financial
      Statements:


The
financial statements of Zones, Inc. and the Report of Independent Registered
Public Accounting Firm are included herein beginning on page 30.





2.  Financial
Statement Schedules:





See
Schedule II, Valuation and Qualifying Accounts





25
 Table of Contents





3.  Exhibits:





Exhibit
      No.
            Description
            Filed
      Herewith
            Incorporated
      by ReferenceForm
            Exhibit
      No.
            File
      No.
            Filing
      Date3.1
            Restated
      Articles of Incorporation of Multiple Zones International,
      Inc.
            
            S-1
            3.1
            333-04458
            6/5/963.2
            Articles
      of Amendment of Multiple Zones, Inc.
            
            S-8
            4.2
            333-110750
            11/25/033.3
            Amended
      and Restated Bylaws of Zones, Inc.
            X10.1
            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
            6/5/9610.9
            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 between Zones, Inc.,
      Corporate PC Source, Inc. and Transamerica Commercial Finance
      Corporation
            
            10-Q
            10.1
            000-28488
            8/14/0310.12
            Amendment
      No. 2 to Amended and Restated Loan and Security Agreement
            
            10-Q
            10.5
            000-28488
            5/13/0410.13
            Amendment
      No. 7 to Amended and Restated Loan and Security Agreement
            
            8-K
            10.1
            000-28488
            9/18/0710.14
            Zones,
      Inc. 2003 Equity Incentive Plan*
            
            14-A
            
            000-28488
            3/20/0310.15
            Form
      of Stock Option Agreement (used for grants under the 2003 Stock Equity
      Plan)*
            
            10-K
            10.25
            000-28488
            2/26/0410.16
            Notice
      of Grant of Director Stock Option pursuant to the Zones, Inc 2003 Equity
      Incentive Plan
            
            10-Q
            10.2
            000-28488
            8/10/0510.17
            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
            4/3/0310.18
            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
            9/29/0410.19
            Form
      of Unsecured, Subordinated Promissory Note
            
            8-K
            10.2
            000-28488
            9/29/0410.20
            Office
      lease dated June 9, 2003 between Zones, Inc and Fana Auburn
      LLC
            
            10-Q
            10.2
            000-28488
            8/14/0310.21
            Amendment
      to Office Lease between Zones, Inc and Fana Auburn LLC
            
            10-Q
            10.1
            000-28488
            5/12/06





26
 Table of Contents




10.22
            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
            8/11/0410.23
            Commercial
      Lease Agreement dated March 19, 2004 between Corporate PC Source and AMB
      Property II, L.P.
            
            10-Q
            10.4
            000-28488
            5/13/0410.24
            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
            11/9/0510.25
            Office
      Lease dated December 2005 between Zones, Inc. and Montgomery Park I,
      LLC
            
            10-K
            10.28
            000-28488
            2/24/0610.26
            Summary
      of Zones, Inc. Board Meeting Fees and Basic Compensation
            
            10-Q
            10.1
            000-28488
            11/13/0710.27
            Summary
      of the Zones, Inc. Senior Management Bonus Program*
            
            8-K
            99.2
            000-28488
            2/12/0710.28
            Summary
      of the Zones, Inc. Executive Vice President Bonus Program*
            
            10-Q
            10.1
            000-28488
            11/13/0721.1
            Subsidiaries
      of the Registrant
            X23.1
            Consent
      of Grant Thornton 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 Officer pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002 and the regulations promulgated thereunder
            X32.2
            Certification
      of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley
      Act of 2002 and the regulations promulgated thereunder
            X*
            Management
      contract or compensatory plan or arrangement





27
 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:  March
3, 2008


By:
            /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
            
            March
      3, 2008John
      H. Bauer/S/     CATHI
      HATCH
            
            Director
            
            March
      3, 2008Cathi
      Hatch/S/     WILLIAM
      C. KEIPER
            
            Director
            
            March
      3, 2008William
      C. Keiper/S/     KENNETH
      M. KIRKPATRICK
            
            Director
            
            March
      3, 2008Kenneth
      M. Kirkpatrick/S/     FIROZ
      H. LALJI
            
            Director
            
            March
      3, 2008Firoz
      H. Lalji





28
 Table of Contents





ZONES,
INC.


INDEX
TO CONSOLIDATED FINANCIAL STATEMENTS








Consolidated
      Financial Statements:Consolidated
      Balance SheetsDecember 31, 2007 and 2006
            30Consolidated
      Statements of OperationsTwelve months ended December 31, 2007,
      2006 and 2005
            31Consolidated
      Statement of Shareholders’ EquityTwelve months ended December 31,
      2007, 2006 and 2005
            32Consolidated
      Statements of Cash FlowsTwelve months ended December 31, 2007,
      2006 and 2005
            33Notes
      to Consolidated Financial Statements
            34Report
      of Grant Thornton LLP, Independent Registered Public Accounting
      Firm
            45Schedule
      II – Consolidated Valuation and Qualifying Accounts
            46





29
 Table of Contents





ZONES,
INC.


CONSOLIDATED
BALANCE SHEETS


(in
thousands, except share data)





December 31,2007
            
            
            2006ASSETSCurrent
      assets:Cash
      and cash equivalents
            
            $
            12,004
            
            
            $
            9,191Receivables,
      net of allowances of $1,213 and $1,200
            
            
            73,581
            
            
            
            65,699Vendor
      receivables, net of allowances of $780 and $736
            
            
            15,139
            
            
            
            12,556Inventories
            
            
            21,278
            
            
            
            21,385Prepaid
      expenses
            
            
            861
            
            
            
            1,076Deferred
      income taxes
            
            
            1,377
            
            
            
            1,473Total
      current assets
            
            
            124,240
            
            
            
            111,380Property
      and equipment, net
            
            
            3,383
            
            
            
            3,771Goodwill
            
            
            5,098
            
            
            
            5,098Deferred
      income taxes
            
            
            411
            
            
            
            251Other
      assets
            
            
            190
            
            
            
            195Total
      assets
            
            $
            133,322
            
            
            $
            120,695LIABILITIES
      AND SHAREHOLDERS' EQUITYCurrent
      liabilities:Accounts
      payable
            
            $
            37,040
            
            
            $
            42,592Inventory
      financing (Note 5)
            
            
            20,252
            
            
            
            14,385Accrued
      liabilities
            
            
            11,479
            
            
            
            12,584Income
      taxes payable
            
            
            510
            
            
            
            150Total
      current liabilities
            
            
            69,281
            
            
            
            69,711Deferred
      rent obligation
            
            
            1,733
            
            
            
            1,502Total
      liabilities
            
            
            71,014
            
            
            
            71,213Commitments
      and contingencies (Note 8)Shareholders'
      equity:Common
      stock, no par value, 45,000,000 shares authorized; 13,133,114 and
      13,157,719 shares issued and outstanding at December 31, 2007 and 2006,
      respectively
            
            
            35,676
            
            
            
            35,983Retained
      earnings
            
            
            26,632
            
            
            
            13,499Total
      shareholders' equity
            
            
            62,308
            
            
            
            49,482Total
      liabilities and shareholders' equity
            
            $
            133,322
            
            
            $
            120,695





The
accompanying notes are an integral part of the consolidated financial
statements.





30
 Table of Contents





ZONES,
INC.


CONSOLIDATED
STATEMENTS OF OPERATIONS


(in
thousands, except per share data)





Year
      ended December 31,2007
              
              
              2006
              
              
              2005Net
      sales
              
              $
              679,492
              
              
              $
              577,027
              
              
              $
              566,553Cost
      of sales
              
              
              599,223
              
              
              
              505,508
              
              
              
              505,997Gross
      profit
              
              
              80,269
              
              
              
              71,519
              
              
              
              60,556Selling,
      general and administrative expenses
              
              
              51,201
              
              
              
              48,434
              
              
              
              43,618Advertising
      expense
              
              
              8,038
              
              
              
              7,159
              
              
              
              6,618Income
      from operations
              
              
              21,030
              
              
              
              15,926
              
              
              
              10,320Other
      expense, net
              
              
              174
              
              
              
              270
              
              
              
              503Income
      before income taxes
              
              
              20,856
              
              
              
              15,656
              
              
              
              9,817Provision
      for income taxes
              
              
              7,723
              
              
              
              5,971
              
              
              
              3,766Net
      income
              
              $
              13,133
              
              
              $
              9,685
              
              
              $
              6,051Basic
      income per share
              
              $
              1.00
              
              
              $
              0.73
              
              
              $
              0.45Weighted
      average shares used in computing basic income per share
              
              
              13,139
              
              
              
              13,195
              
              
              
              13,382Diluted
      income per share
              
              $
              0.90
              
              
              $
              0.66
              
              
              $
              0.42Weighted
      average shares used in computing diluted income per share
              
              
              14,635
              
              
              
              14,756
              
              
              
              14,527





The
accompanying notes are an integral part of the consolidated financial
statements.





31
 Table of Contents





ZONES,
INC.


CONSOLIDATED
STATEMENT OF SHAREHOLDERS' EQUITY


(in
thousands, except share data)





Common
      Stock
            
            
            Retained
      EarningsShares
            
            
            Amount
            
            
            (Deficit)
            
            
            TotalBalance,
      January 1, 2005
            
            
            13,507,727
            
            
            $
            38,788
            
            
            $
            (2,237
            )
            
            $
            36,551Purchase
      and retirement of common stock
            
            
            (424,450
            )
            
            
            (1,813
            )
            
            
            
            
            
            
            (1,813
            )Exercise
      of stock options
            
            
            181,772
            
            
            
            316
            
            
            
            
            
            
            
            316Tax
      effect of stock options exercised
            
            
            
            
            
            
            212
            
            
            
            
            
            
            
            212Net
      income
            
            
            
            
            
            
            
            
            
            
            6,051
            
            
            
            6,051Balance,
      December 31, 2005
            
            
            13,265,049
            
            
            
            37,503
            
            
            
            3,814
            
            
            
            41,317Purchase
      and retirement of common stock
            
            
            (568,400
            )
            
            
            (3,988
            )
            
            
            
            
            
            
            (3,988
            )Exercise
      of stock options
            
            
            461,070
            
            
            
            1,412
            
            
            
            
            
            
            
            1,412Excess
      tax benefit from stock options exercised
            
            
            
            
            
            
            651
            
            
            
            
            
            
            
            651Stock-based
      compensation
            
            
            
            
            
            
            405
            
            
            
            
            
            
            
            405Net
      income
            
            
            
            
            
            
            
            
            
            
            9,685
            
            
            
            9,685Balance,
      December 31, 2006
            
            
            13,157,719
            
            
            
            35,983
            
            
            
            13,499
            
            
            
            49,482Purchase
      and retirement of common stock
            
            
            (80,005
            )
            
            
            (783
            )
            
            
            
            
            
            
            (783
            )Exercise
      of stock options
            
            
            55,400
            
            
            
            178
            
            
            
            
            
            
            
            178Excess
      tax benefit from stock options exercised
            
            
            
            
            
            
            143
            
            
            
            
            
            
            
            143Stock-based
      compensation
            
            
            
            
            
            
            155
            
            
            
            
            
            
            
            155Net
      income
            
            
            
            
            
            
            
            
            
            
            13,133
            
            
            
            13,133Balance,
      December 31, 2007
            
            
            13,133,114
            
            
            $
            35,676
            
            
            $
            26,632
            
            
            $
            62,308





The
accompanying notes are an integral part of the consolidated financial
statements.





32
 Table of Contents





ZONES,
INC.


CONSOLIDATED
STATEMENTS OF CASH FLOWS


(in
thousands)





Year ended
      December 31,2007
            
            
            2006
            
            
            2005Cash
      flows from operating activities:Net
      income
            
            $
            13,133
            
            
            $
            9,685
            
            
            $
            6,051Adjustments
      to reconcile net income to net cash provided by (used in) operating
      activities:Depreciation
            
            
            1,800
            
            
            
            1,831
            
            
            
            1,966Non-cash
      stock-based compensation
            
            
            155
            
            
            
            405Excess
      tax benefit from exercise of stock options
            
            
            (143
            )
            
            
            (651
            )Deferred
      tax asset
            
            
            (64
            )
            
            
            (413
            )
            
            
            2,854Tax
      effect of stock options exercise
            
            
            
            
            
            
            
            
            
            
            212(Increase)
      decrease in assets and liabilities:Receivables,
      net
            
            
            (10,465
            )
            
            
            4,813
            
            
            
            (19,130
            )Inventories
            
            
            107
            
            
            
            (1,649
            )
            
            
            (2,330
            )Prepaid
      expenses and other assets
            
            
            220
            
            
            
            (171
            )
            
            
            29Accounts
      payable
            
            
            1,552
            
            
            
            128
            
            
            
            3,133Income
      taxes payable
            
            
            503
            
            
            
            353
            
            
            
            107Accrued
      liabilities and deferred rent
            
            
            (875
            )
            
            
            4,347
            
            
            
            1,717Net
      cash provided by (used in) operating activities
            
            
            5,923
            
            
            
            18,678
            
            
            
            (5,391
            )Cash
      flows from investing activities:Purchases
      of property and equipment
            
            
            (1,412
            )
            
            
            (1,792
            )
            
            
            (1,826
            )Net
      cash used in investing activities
            
            
            (1,412
            )
            
            
            (1,792
            )
            
            
            (1,826
            )Cash
      flows from financing activities:Net
      change in book overdrafts
            
            
            (7,104
            )
            
            
            (2,894
            )
            
            
            7,975Net
      change in line of credit
            
            
            
            
            
            
            (10,700
            )
            
            
            4,600Net
      change in inventory financing
            
            
            5,868
            
            
            
            5,916
            
            
            
            (5,837
            )Payments
      of note payable
            
            
            
            
            
            
            (1,287
            )
            
            
            (1,286
            )Excess
      tax benefit from exercise of stock options
            
            
            143
            
            
            
            651Purchase
      and retirement of common stock
            
            
            (783
            )
            
            
            (3,988
            )
            
            
            (1,813
            )Proceeds
      from exercise of stock options
            
            
            178
            
            
            
            1,412
            
            
            
            316Net
      cash provided by (used in) financing activities
            
            
            (1,698
            )
            
            
            (10,890
            )
            
            
            3,955Net
      increase (decrease) in cash and cash equivalents
            
            
            2,813
            
            
            
            5,996
            
            
            
            (3,262
            )Cash
      and cash equivalents at the beginning of the year
            
            
            9,191
            
            
            
            3,195
            
            
            
            6,457Cash
      and cash equivalents at the end of the year
            
            $
            12,004
            
            
            $
            9,191
            
            
            $
            3,195Supplemental
      cash flow information:Cash
      paid for interest
            
            $
            385
            
            
            $
            489
            
            
            $
            554Cash
      paid for income taxes
            
            $
            7,383
            
            
            $
            6,019
            
            
            $
            594





The
accompanying notes are an integral part of the consolidated financial
statements.





33
 Table of Contents





ZONES,
INC.


NOTES
TO CONSOLIDATED FINANCIAL STATEMENTS





1.  Description of
Business


Zones,
Inc. (the “Company,” “We”) is a single-source direct marketing reseller of
name-brand information technology products to the small-to-medium-sized business
market, enterprise accounts and public sector accounts.  We sell these
products through outbound and inbound account executives, a national field sales
force, catalogs and the Internet.  We offer more than 150,000 products
from leading manufacturers, including Adobe, Apple, Avaya, Cisco, Epson, HP,
IBM, Kingston, Lenovo, Microsoft, NEC, Nortel Networks, Sony, Symantec and
Toshiba.





2.  Summary of Significant
Accounting Policies


Principles of Consolidation.


The
accompanying consolidated financial statements include the accounts of the
Company and our wholly owned subsidiary.  Inter-company transactions
and balances have been eliminated in consolidation.





Cash and Cash
Equivalents.


Cash and
cash equivalents represent highly liquid investments with original maturities of
three months or less at the date of purchase.





Concentration of Credit
Risk.


Cash
balances subject to credit risk consist of cash balances held in one financial
institution in the United States.  We have not experienced any losses
associated with cash balances and believe that there is minimal risk associated
with the cash balances.  Trade accounts receivable are recorded at the
invoiced amount and do not bear interest. The concentration of credit risk with
respect to trade receivables is limited due to our diverse customer
base.  We closely monitor extensions of credit, but we do not require
collateral.  We maintain an allowance for doubtful accounts based on
estimates of future collectibility of our accounts receivable.  We
regularly analyze our 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
they are deemed to be uncollectible.





Inventories.


Inventories
consist primarily of computer hardware and software.  Inventory is
valued at the lower of cost or market value. We decrease the value of inventory
for estimated obsolescence equal to the difference between the cost of inventory
and the estimated market value based upon an aging analysis of the inventory on
hand, specifically known inventory-related risks, and assumptions about future
demand and market conditions. If future demand or actual market conditions are
less favorable than those projected by management, additional inventory
write-downs may be required.





We
currently buy a significant portion of our products from four
suppliers.  Purchases from Hewlett-Packard, Tech Data, Ingram Micro
and Synnex represented 22.1%, 18.1%, 17.9% and 10.4%, respectively, of our total
product purchases in 2007.  Purchases from Ingram Micro, Tech Data,
Synnex and IBM represented 21.4%, 13.9%, 12.6% and 11.4%, respectively, of our
total product purchases in 2006.  Purchases from Ingram Micro, Tech
Data, Synnex and Hewlett-Packard represented 19.1%, 18.2%, 15.7% and 12.5%,
respectively, of the Company’s total product purchases in 2005.  No
other vendor supplied more than 10.0% of our total product purchases in 2007,
2006 or 2005.  Although there are a limited number of manufacturers,
we believe that other suppliers could provide similar products if our
relationship with any of these suppliers were interrupted.





Property and
Equipment.


Property
and equipment is recorded at cost.  Depreciation is computed based on
the straight-line method over the estimated useful lives of the related
assets.  Useful lives for computer hardware and software range from
two to five years and other property and equipment range from three to 11
years.  Capital leases are amortized based on the straight-line method
over the estimated useful lives of the related assets or lease term, whichever
is shorter (generally three to 11 years).  Expenditures for
maintenance and repairs are charged to expense as incurred, while additions,
renewals and betterments are capitalized.  We evaluate the carrying
value of long-lived assets based upon current and anticipated undiscounted cash
flows, and recognize any impairment when it is probable that such estimated
future cash flows will be less than the asset carrying value.  No
impairments were identified in 2007, 2006 or 2005.





34
 Table of Contents





Capitalized
internal software development costs totaled $479,000 and $642,000 for the years
ended December 31, 2007 and 2006, respectively.





Income Taxes.


Deferred
income taxes are provided based on the estimated future tax effects of temporary
differences between financial statement carrying amounts of existing assets and
liabilities and their respective tax bases.  Deferred tax assets and
liabilities are measured using enacted tax rates that are expected to apply to
taxable income in the years in which those temporary differences are expected to
be recovered or settled. A valuation allowance is created when it is believed it
is more likely than not that we will not utilize a portion or all of the net
deferred tax assets.





Goodwill.


In
accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill
is tested for impairment annually on the purchase date or sooner when events
indicate that potential impairment exists.  All goodwill relates to
the purchase of Corporate PC Source, Inc.  There were no changes in
the carrying amount of goodwill for the years ended December 31, 2007 and
2006.





Use of Estimates.


The
preparation of financial statements in conformity with accounting principles
generally accepted in the United States requires management to make estimates
and assumptions that affect the reported amounts of assets and liabilities,
disclosure of contingent assets and liabilities at the date of the financial
statements, and the reported amounts of revenues and expenses during the
reporting period.  Actual results could differ from those
estimates.





Revenue Recognition.


We adhere
to the revised guidelines and principles of sales recognition in Staff
Accounting Bulletin No. 104 (“SAB 104”), “Revenue Recognition,” issued by the
staff of the SEC as a revision to Staff Accounting Bulletin No. 101, “Revenue
Recognition.”  We recognize 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.  We consider the
point of delivery of the product to be when the risks and rewards of ownership
have transferred to the customer.  Our 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 our sales relate to physical products. For all product sales,
shipped directly from our warehouse or from our suppliers to customers, we are
the primary obligor, have full latitude in establishing price with the customer,
select the supplier to provide the product, take title to the product sold upon
shipment, bear credit risk, and bear inventory risk for returned
products.  These sales are recognized on a gross basis with the
selling price to the customer recorded as sales and the acquisition cost of the
product recorded as cost of sales.  Additionally, amounts billed for
shipping and handling are recorded as sales.





For all
third-party services, we are the primary obligor to our customer, we have full
latitude in establishing price with the customer, we select the third-party
service provider, we are obligated to compensate the service provider for work
performed regardless of whether the customer accepts the work and we bear credit
risk; therefore, these revenues are recognized on a gross basis with the selling
price to the customer recorded as sales and the acquisition cost of the service
recorded as cost of sales.





Software
maintenance contracts, software agency fees, and extended warranties that we
sell (for which we are not the primary obligor), are recognized on a net basis
in accordance with Emerging Issues Task Force Issue No. 99-19 (“EITF 99-19”),
“Reporting Revenue Gross as a Principal versus Net as an Agent.”  We
do not take title to the products or assume any maintenance or return
obligations in these transactions; title is passed directly from the supplier to
our customer. Accordingly, such revenues are recognized in sales either at the
time of sale or over the contract period, based on the nature of the contract,
at the net amount retained by us, with no cost of goods sold.





Sales are
reported net of sales, use or other transaction taxes that are collected from
the customers and remitted to taxing authorities.  Sales are reported
net of returns and allowances.  We offer limited return rights on our
product sales.  We have demonstrated the ability to make reasonable
and reliable estimates of product returns based on significant historical
experience. We had allowances for sales returns of $76,000 and $101,000 at
December 31, 2007 and 2006, respectively.





35
 Table of Contents





Cost of Sales.


Cost of
sales primarily consists of the purchase price of products and
services.  Cost of sales also includes inbound and outbound shipping
charges, vendor rebates and cash discounts that are recorded when earned as a
reduction to cost of sales, physical inventory adjustments, and vendor
consideration classified as a reduction of cost of sales.  Vendor
rebates from product rebates that require certain volumes of product sales or
purchases are recorded only after the related milestones are met.





Selling, General and Administrative Expenses.


Selling,
general and administrative expenses include payroll, team member benefits and
other headcount-related costs, cost of fulfillment (including warehousing),
credit card processing and bad debts costs, facilities, professional fees and
administration costs, and depreciation and amortization.





Advertising Expenses.


We
produce and distribute catalogs at various intervals throughout the year, and
also engage in other activities, to increase the awareness of our brand and
stimulate demand response.  The costs to produce and distribute
individual catalogs, including paper, printing, postage, production and design
costs, and for other marketing initiatives, such as trade shows, direct mail
pieces, and customer or vendor events, are capitalized and amortized to selling
expense during the period in which the catalogs are mailed or the event takes
place.  Capitalized advertising costs of $145,000 and $298,000 were
included with prepaid expenses at December 31, 2007 and 2006,
respectively.  We receive cooperative advertising expense
reimbursements from vendors who support our marketing and advertising
activities.  Cooperative reimbursements from vendors are recorded in
the period the related advertising expenditure is incurred. We classify vendor
consideration as either a reduction of advertising expense or as a reduction of
cost of sales in accordance with Emerging Issues Task Force Issue No. 02-16,
“Accounting for Consideration Received from a Vendor by a Customer (Including a
Reseller of the Vendor’s Products).” Most vendor consideration received for
cooperative advertising is considered a reduction of cost of sales. Advertising
expense is offset by cooperative advertising funds when the reimbursement
represents specific, incremental and identifiable costs.  The
following table presents the gross amounts that are netted together in our
advertising expense line item (in thousands).





2007
            
            
            2006
            
            
            2005Gross
      advertising expense
            
            $
            9,638
            
            
            $
            8,858
            
            
            $
            7,047Gross
      advertising reimbursements
            
            
            (1,600
            )
            
            
            (1,699
            )
            
            
            (429
            )Advertising
      expense
            
            $
            8,038
            
            
            $
            7,159
            
            
            $
            6,618





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 our 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.


We have
no differences between net income and comprehensive income.





Stock Compensation.


Our stock
option plans grant options to acquire shares of common stock to certain team
members and non-employee directors.  Each option granted has an
exercise price of 100% of the market value of the common stock on the date of
the grant. The options generally have a contractual life of 10 years and vest
and become exercisable in 20% increments over five years.





Effective
January 1, 2006, we adopted Statement of Financial Accounting Standards No.
123R, “Share-Based Payment”(“SFAS 123R”). SFAS
123R supersedes our previous accounting under Accounting Principles Board
Opinion No. 25, “Accounting for Stock Issued to Employees”(“APB 25”), for periods
beginning in fiscal year 2006. Previously, under APB 25, we accounted for stock
options under the intrinsic value method. Accordingly, we did not recognize
expense related to employee stock options because the exercise price of such
options equaled the fair value of the underlying stock on the grant date. We
previously disclosed the fair value of our stock options under the provisions of
Statement of Financial Accounting Standards No. 123, “Accounting for Stock Based
Compensation” (“SFAS 123”). The fair value of option grants prior to January 1,
2006 was estimated on the date of grant using the Black-Scholes option-pricing
model.





36
 Table of Contents





We
adopted SFAS 123R using the modified prospective transition method, which
requires the application of the accounting standard as of January 1, 2006, the
first day of our fiscal year 2006. Our condensed consolidated financial
statements for prior periods have not been restated to reflect, and do not
include, the impact of SFAS 123R.





Total
stock-based compensation expense recognized in the consolidated statements of
operations for the years ended December 31, 2007 and 2006 was $155,000 and
$405,000, respectively, before income taxes, and did not have a material impact
on net income or earnings per share.   We used the criteria in
SFAS No. 123R to calculate and establish the beginning balance of the additional
paid-in capital pool (“APIC pool”) related to the tax effects of employee
stock-based compensation, and also used the criteria to determine the subsequent
effect on the APIC pool and consolidated statements of cash flows of the tax
effects of employee stock-based compensation awards that were outstanding upon
adoption of SFAS No. 123R. The tax benefit for stock options exercised during
the years ended December 31, 2007 and 2006 was $143,000 and $651,000,
respectively.





Prior to
the adoption of SFAS 123R, we presented all tax benefits resulting from the
exercise of stock options as operating cash inflows in the consolidated
statements of cash flows, in accordance with the provisions of the Emerging
Issues Task Force (“EITF”) Issue No 00-15, “Classification in the Statement of
Cash Flows of the Income Tax Benefit Received by a Company upon Exercise of a
Nonqualified Employee Stock Option.” SFAS 123R requires the benefits of tax
deductions in excess of the compensation cost recognized for those options to be
classified as financing cash inflows rather than operating cash inflows, on a
prospective basis. This amount is shown as “Excess tax benefit from exercise of
stock options” on the consolidated statements of cash flows.





The
following table shows the effect on 2005 net earnings and earnings per share had
compensation cost been recognized based upon the estimated fair value on the
grant date of stock options, in accordance with SFAS 123, as amended by SFAS No.
148 “Accounting for Stock-Based Compensation – Transition and Disclosure” (in
thousands, except earnings per share):








Year
      ended December 31,2005Net
      income – as reported
            
            $
            6,051Less:Total
      compensation cost determined under fair value based method for all awards,
      net of tax
            
            
            (808
            )Net
      income – pro forma
            
            $
            5,243Basic
      income per share – as reported
            
            $
            0.45Diluted
      income per share – as reported
            
            $
            0.42Basic
      income per share – pro forma
            
            $
            0.39Diluted
      income per share – pro forma
            
            $
            0.36





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: expected volatility of 186%, risk-free
interest rate of 4.05% and expected lives of 5 years.





Disclosures
for 2007 and 2006 are not presented because the amounts are recognized in the
consolidated financial statements.





There
were no options granted in the twelve months ended December 31, 2007. The
current expense for all outstanding options granted prior to January 1, 2006 has
been recognized in the consolidated statement of earnings for the twelve months
ended December 31, 2007 and 2006. Forfeitures are estimated and revised, if
necessary, in subsequent periods if actual forfeitures differ from those
estimates. As of December 31, 2007, there was $89,000 of total unrecognized
pre-tax compensation expense related to nonvested stock options granted under
our stock option plans. This cost is expected to be recognized over a
weighted-average period of 1.21 years.





37
 Table of Contents





Segment Reporting


Our
operations are represented by one reportable segment: a single-source,
multi-vendor, direct-marketing reseller of name-brand information technology
products and services to small-to-medium-sized businesses, enterprise accounts
and public sector customers.





A summary
of our operations by product mix is detailed in Note 13.





Reclassifications


Certain
reclassifications of prior years’ balances have been made to conform to the
fiscal year 2007 presentation.  Such reclassifications had no effect
on shareholders’ equity or net income as previously reported.




Recent Accounting Pronouncements


In July
2006, the Financial Accounting Standards Board (“FASB”) issued FASB
Interpretation No. 48 (“FIN 48”), “Accounting for Uncertainty in Income Taxes:
an Interpretation of FASB Statement No. 109, Accounting for Income
Taxes.”  FIN 48 clarifies the accounting for uncertainty in income
taxes recognized in a company’s financial statements and prescribes a
recognition threshold and measurement attribute for the financial statement
recognition and measurement of a tax position taken or expected to be taken in
an income tax return. FIN 48 also provides guidance on derecognition,
classification, interest and penalties, accounting in interim periods,
disclosure and transition.  Only tax positions that meet the
more-likely-than-not recognition threshold at the adoption date will be
recognized or continue to be recognized. Any cumulative effect of applying FIN
48 would be reported as an adjustment to retained earnings at the beginning of
the period in which it is adopted.  We adopted FIN 48 on January 1,
2007, and there was no impact to our financial statements in conjunction with
its adoption.





3.  Fair Value of Financial
Instruments


The
estimated fair value of our 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 consist of the
following (in thousands):





December
      31,2007
            
            
            2006
            
            Estimated
      Useful LivesEquipment
            
            $
            16,052
            
            
            $
            15,831
            
            2
      to 5 yearsComputer
      software/Web development
            
            
            18,568
            
            
            
            18,105
            
            2
      to 5 yearsFurniture
      and fixtures and leasehold improvements
            
            
            2,221
            
            
            
            1,662
            
            3
      to 11 years36,841
            
            
            
            35,598Less
      accumulated depreciation and amortization
            
            
            (33,458
            )
            
            
            (31,827
            )Property
      and equipment, net
            
            $
            3,383
            
            
            $
            3,771








5.  Line of
Credit


At
December 31, 2007, we had a $50.0 million credit facility with a major financial
institution, which is collateralized by accounts receivable and inventory, that
can be utilized as both a working capital line of credit and an inventory
financing facility to purchase products 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 plus 0.50%.   Our line of credit is defined by
quick turnover, large amounts and short maturities. All amounts owed under our
line of credit are due on demand.  Amounts owed under the inventory
financing facility do not bear interest if paid within terms, usually 30 days
from advance date.  There were no working capital advances outstanding
at December 31, 2007 or 2006.  At December 31, 2007 and 2006,
inventory financing arrangements of $20.3 million and $14.4 million,
respectively, were owed to this financial institution.





We use
this credit facility under our cash management system to cover checks presented
for payment in excess of cash balances.  As of December 31, 2007 and
2006, we had book overdrafts of $3.1 million and $10.2 million, respectively,
which are recorded as a component of accounts payable on the accompanying
balance sheet.





38
 Table of Contents





The
facility contains various restrictive covenants relating to tangible net worth,
leverage, dispositions and use of collateral, other asset dispositions, and
merger and consolidation.  At December 31, 2007, we were in compliance
with all the covenants of this facility.




6.  Accrued Liabilities and
Other


Accrued liabilities consist of the
following (in thousands):





December
      31,2007
            
            
            2006Accrued
      payroll
            
            $
            5,444
            
            
            $
            4,932Accrued
      taxes
            
            
            2,742
            
            
            
            3,118Accrued
      advertising
            
            
            70
            
            
            
            50Accrued
      interest
            
            
            
            
            
            
            7Other
      accruals
            
            
            3,223
            
            
            
            4,477Total
            
            $
            11,479
            
            
            $
            12,584





7.  Income
Taxes


The income tax expense consists of the
following (in thousands):





Year
      ended December 31,2007
            
            
            2006
            
            
            2005Current
            
            $
            7,787
            
            
            $
            6,384
            
            
            $
            912Deferred
            
            
            (64
            )
            
            
            (413
            )
            
            
            2,854Total
            
            $
            7,723
            
            
            $
            5,971
            
            
            $
            3,766





The components of deferred taxes were
as follows (in thousands):





December
      31,2007
            
            
            2006Assets:Allowance
      for doubtful accounts
            
            $
            736
            
            
            $
            728Merchandise
      inventory
            
            
            357
            
            
            
            302Deferred
      rent obligation
            
            
            698
            
            
            
            549Accrued
      liabilities and other
            
            
            445
            
            
            
            443$
            2,236
            
            
            $
            2,022Liabilities:Property
      and equipment
            
            
            (287
            )
            
            
            (298
            )Prepaid
      expenses
            
            
            (161
            )(448
            )
            
            
            (298
            )Net
      deferred tax asset
            
            $
            1,788
            
            
            $
            1,724





A
reconciliation of the effective income tax rate on income before taxes with the
federal statutory rate as follows:








Year
      ended December 31,2007
            
            
            2006
            
            
            2005Statutory
      rate
            
            
            35.0
            %
            
            
            35.0
            %
            
            
            34.0
            %State
      income tax, net of federal benefit
            
            
            2.0
            
            
            
            2.0
            
            
            
            2.0Stock
      compensation
            
            
            0.1
            
            
            
            0.5Other
            
            
            (0.1
            )
            
            
            0.6
            
            
            
            2.4Effective
      tax rate
            
            
            37.0
            %
            
            
            38.1
            %
            
            
            38.4
            %





We
adopted the provisions of FIN48 on January 1, 2007. The implementation of FIN48
had no material impact on our financial position.  We have no material
unrecognized tax benefits as of January 1, 2007 or December 31,
2007.  We do not expect any significant changes in the total amount of
unrecognized tax benefits within the next 12 months.  We recognize
interest and penalties related to uncertain tax positions in income tax
expense.  As of December 31, 2007, we had no accrued interest or
penalties related to unrecognized tax benefits.  We are subject to
federal income tax and state taxes in several jurisdictions.  Tax
years 2004 through 2007 remain open to examination by the major taxing
jurisdictions to which we are subject, and tax years back to 1999 may also be
open to examination due to the utilization of net operating losses in
2005.





39
 Table of Contents





8.  Commitments and
Contingencies


Operating
Leases


We lease
our offices, warehouse facilities, and other equipment under non-cancelable
operating leases that expire through 2016.  Under the terms of certain
leases, we are responsible for our share of taxes, insurance and common area
charges.  At December 31, 2007, future minimum payments under
operating leases were as follows (in thousands):





2008
            
            $
            2,4192009
            
            
            2,2062010
            
            
            1,9882011
            
            
            1,8892012
            
            
            1,901Thereafter
            
            
            4,187Total
            
            $
            14,590





Certain
portions of our lease agreements provide for scheduled rent increases during the
lease terms.  Minimum rental expenses are recognized on a
straight-line basis over the terms of the lease.  Rental expense,
which is recorded on a straight-line basis, totaled $3.5 million, $3.1 million
and $2.5 million for the years ended December
31, 2007, 2006 and 2005, respectively.





Related Party


In June
2004, Fana Auburn LLC, a company owned by one of our officers, who is a majority
shareholder, purchased the property and buildings in which our headquarters are
located, subject to the existing 11-year lease.  Under the terms of
the lease agreement, we are obligated to pay lease payments aggregating from
$1.0 million to $1.3 million per year, plus apportioned real estate taxes,
insurance and common area maintenance charges. Our Audit Committee reviewed and
approved this related party transaction, and also the potential corporate
opportunity, recognizing that in the future we may have to renew and renegotiate
our lease and that such renewal and renegotiation would also present a related
party transaction, which would be subject to further Audit Committee review and
consideration.  In May 2006, after further review and approval by our
Audit Committee, we signed an amendment to the lease agreement increasing the
rentable square feet by approximately 18,923 square feet.  The
additional square feet increased our annual lease payment by $259,000. Effective
January 1, 2007, we have approximately 125,196 rentable square feet located at
1102 15th Street
SW, Auburn, WA.   In April 2007, we received a tenant improvement
reimbursement from Fana Auburn LLC in the amount of $378,000 related to
construction on the additional leased space, which will be amortized over the
remaining life of the lease.  For the years ended December 31, 2007,
2006 and 2005 we paid Fana Auburn LLC $2.2 million, $1.6 million and $1.7
million, respectively, related to the lease.





Notes Payable


On March
31, 2003, we acquired Corporate PC Source, Inc. (“CPCS”) pursuant to a Stock
Purchase Agreement (“SPA”).  Under the terms of the SPA, we issued
notes to the former shareholders of CPCS. We paid the final payment during the
second quarter of 2006.  For the year ended December 31, 2006, we paid
the former shareholders of CPCS $1.3 million.





Legal Proceedings


From time
to time, we are party to various legal proceedings, claims, disputes or
litigation arising in the ordinary course of business, some of which may involve
material amounts.  We currently believe that the ultimate outcome of
any of these proceedings, individually or in the aggregate, will not have a
material adverse effect on our business, financial condition, cash flows or
results of operations.





9.  Shareholders'
Equity


Stock Options


In 1993,
we adopted a Stock Incentive Plan (the “Plan”) whereby we issued incentive or
nonqualified stock options, restricted shares, stock units or stock appreciation
rights to certain team members.  As of December 31, 2007, only stock
options had been granted under the Plan.  The term of each option
granted was for such periods as determined by the Board of Directors, but not
for more than ten years from date of grant.  Options may be exercised
based on a vesting schedule determined by the Board of Directors, and the Plan
provides for acceleration of outstanding options under certain conditions,
including certain corporate changes in control.  Grants are
nontransferable, and shares acquired upon exercise of options may be subject to
repurchase at our option under certain conditions.  The maximum number
of shares to be granted under the Plan was 2,650,000 at December 31,
2007.





40
 Table of Contents





In
addition to options granted under the Plan, we have granted options under a
separate plan to the Board of Directors.  Options outstanding to these
individuals at December 31, 2007 were 65,000 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, 2007, 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 we may issue, among other things,
incentive or nonqualified stock options, restricted shares, stock units or stock
appreciation rights.  Under the New Plan, stock options are granted at
the discretion of the Board of Directors, and the term of each option granted
will be for such periods as determined by the Board of Directors, but not for
more than ten years from date of grant.  Options will be exercisable
based on a vesting schedule determined by the Board of Directors, and the plan
provides for acceleration of outstanding options under certain conditions,
including certain corporate changes in control.  Grants are
nontransferable, and shares acquired upon exercise of options may be subject to
repurchase at our option under certain conditions.  The maximum number
of shares that may be granted under the New Plan is 1,175,000.





Information regarding the stock option
plans is as follows:





Options
            
            
            Weighted-Average
      Exercise Price
            
            Weighted
      Average Remaining Contractual Term
                (Years)
            
            
            Aggregate
      Intrinsic Value
              (in
      thousands)Outstanding,
      January 1, 2005
            
            
            3,273,393
            
            
            
            2.63Granted
            
            
            282,200
            
            
            
            3.38Exercised
            
            
            (181,772
            )
            
            
            1.74Canceled
            
            
            (306,102
            )
            
            
            1.77Outstanding,
      December 31, 2005
            
            
            3,067,719
            
            
            
            2.84GrantedExercised
            
            
            (461,070
            )
            
            
            3.06Canceled
            
            
            (36,358
            )
            
            
            4.70Outstanding,
      December 31, 2006
            
            
            2,570,291
            
            
            
            2.78GrantedExercised
            
            
            (55,400
            )
            
            
            3.22Canceled
            
            
            (32,925
            )
            
            
            8.63Outstanding,
      December 31, 2007
            
            
            2,481,966
            
            
            $
            2.69
            
            5.12
            
            $
            20,200Exercisable,
      December 31, 2007
            
            
            2,287,266
            
            
            $
            2.71
            
            5.03
            
            $
            18,573





The
aggregate intrinsic value is calculated based on the difference between the
exercise price of the underlying awards and the closing price of our common
stock on December 31, 2006, which was $10.83.





Year
      ended December 31,2007
            
            
            2006
            
            
            2005Weighted
      average grant date fair value of options granted during the
      period
            
            
            
            
            
            
            
            $
            2.29Intrinsic
      value of options exercised during the period (in
thousands)
            
            $
            382
            
            
            $
            1,921
            
            
            $
            417





There
were no options granted in the years ended December 31, 2007 and
2006.  For the year ended December 31, 2005, the weighted-average fair
value of options granted was $2.29.





41
 Table of Contents





10.  Earnings Per
Share


We have
45,000,000 common shares authorized, and 13,133,114 issued and outstanding at
December 31, 2007.  We have also granted options to purchase common
shares to the team members and directors.  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).





Year
      ended December 31,2007
            
            
            2006
            
            
            2005Basic
      earnings per share:Net
      income
            
            $
            13,133
            
            
            $
            9,685
            
            
            $
            6,051Weighted-average
      shares used in computing basicincome
      per share
            
            
            13,139
            
            
            
            13,195
            
            
            
            13,382Basic
      income per share
            
            $
            1.00
            
            
            $
            0.73
            
            
            $
            0.45Diluted
      earnings per share:Net
      income
            
            $
            13,133
            
            
            $
            9,685
            
            
            $
            6,051Weighted-average
      shares used in computing basic income per share
            
            
            13,139
            
            
            
            13,195
            
            
            
            13,382Stock
      Options
            
            
            1,496
            
            
            
            1,561
            
            
            
            1,145Weighted-average
      shares used in computing diluted income per share
            
            
            14,635
            
            
            
            14,756
            
            
            
            14,527Diluted
      income per share
            
            $
            0.90
            
            
            $
            0.66
            
            
            $
            0.42





For the
years ended December 31, 2007, 2006 and 2005, 77,768, 106,258 and 516,045
shares, respectively, attributable to outstanding stock options were excluded
from the calculation of diluted earnings per share because the effect was
anti-dilutive.





11.  Deferred Income 401(k)
Plan


We offer
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. We provide a discretionary match as
recommended by our Compensation Committee and voted upon by our Board of
Directors on a quarterly basis.  During 2007, 2006 and 2005, our Board
of Directors approved a match in each of the quarters.  For fiscal
years 2007, 2006 and 2005, we provided a 50% match for all team member
contributions, up to 6% of the team member’s annual compensation, subject to
certain limitations specified by the Internal Revenue Code.  During
fiscal 2007, 2006, and 2005, we expensed $462,000, $389,000 and $362,000,
respectively, relating to employer contributions under the plan.





12.  Stock Repurchase
Program


Since
2004, we have repurchased a total of 1,521,245 shares of our common stock at a
total cost of $7.9 million under our repurchase program authorized by our Board
of Directors.  Share repurchases may be made from time to time in both
open market and private transactions, as conditions warrant, at then prevailing
market prices. The following table presents share repurchases for the years
ended December 31, 2007, 2006 and 2005 (dollars in thousands):








Period
            
            Total
      number of shares purchased
            
            
            Amount
      paid2007
            
            
            80,005
            
            
            $
            7832006
            
            
            568,400
            
            
            $
            3,9882005
            
            
            424,450
            
            
            $
            1,813





42
 Table of Contents





As of
December 31, 2007, $2.2 million in shares of our common stock remained available
for repurchase under the program.  In January 2008, the Board of
Directors authorized a continuation of our share repurchase program, pursuant to
which we increased the total amount authorized to $3.0 million available for
repurchase of shares under the program. The current repurchase program is
expected to remain in effect through February 2009, unless earlier terminated by
the Board or completed.





13.  Segment
Information


Our
business comprises one reportable segment: a single-source, multi-vendor,
direct-marketing reseller of name-brand information technology products to
small-to-medium-sized businesses, enterprise accounts and the public sector
markets.





A summary
of our sales by product mix follows (in thousands):





December
      31,2007
            
            
            2006
            
            
            2005Notebook
      & PDAs
            
            $
            96,394
            
            
            $
            71,477
            
            
            $
            86,861Desktops
      & Servers
            
            
            144,721
            
            
            
            117,148
            
            
            
            113,779Software
            
            
            126,314
            
            
            
            102,055
            
            
            
            90,199Storage
            
            
            47,838
            
            
            
            52,785
            
            
            
            51,453NetComm
            
            
            35,264
            
            
            
            28,325
            
            
            
            23,968Printers
            
            
            55,870
            
            
            
            47,479
            
            
            
            63,964Monitors
      & Video
            
            
            66,060
            
            
            
            59,761
            
            
            
            54,460Memory
      & Processors
            
            
            32,337
            
            
            
            35,815
            
            
            
            30,407Accessories
      & Other
            
            
            74,694
            
            
            
            62,182
            
            
            
            51,462





Substantially
all of our net sales for the years ended December 31, 2007, 2006 and 2005 were
made to customers located in the United States.  Substantially all of
our assets at December 31, 2007 and 2006 were located within the United
States.  The amount of service revenue included in net sales for the
twelve months ended December 31, 2007 was $7.2 million, or 1.1% of net
sales.  No one customer represented more than 10% of total sales, or
had a credit concentration of more than 10% of trade accounts receivable, for
the years ended December 31, 2007, 2006 and 2005.





43
 Table of Contents





14.  Selected Quarterly Financial
Data (Unaudited)


The
following information is for the years ended December 31, 2007 and
2006:





(in
thousands, except per share data)


December
      31, 2007
            
            First
                Quarter
            
            
            Second
                Quarter
            
            
            Third
                Quarter
            
            
            Fourth
                QuarterNet
      sales
            
            $
            148,182
            
            
            $
            192,231
            
            
            $
            162,970
            
            
            $
            176,109Cost
      of sales
            
            
            129,982
            
            
            
            169,812
            
            
            
            144,685
            
            
            
            154,744Gross
      profit
            
            
            18,200
            
            
            
            22,419
            
            
            
            18,285
            
            
            
            21,365SG&A
      expenses
            
            
            12,596
            
            
            
            12,797
            
            
            
            12,104
            
            
            
            13,704Advertising
      expenses, net
            
            
            1,883
            
            
            
            2,243
            
            
            
            2,108
            
            
            
            1,804Income
      from operations
            
            
            3,721
            
            
            
            7,379
            
            
            
            4,073
            
            
            
            5,857Other
      expense
            
            
            (24
            )
            
            
            239
            
            
            
            5
            
            
            
            (46
            )Income  before
      income  taxes
            
            
            3,745
            
            
            
            7,140
            
            
            
            4,068
            
            
            
            5,903Provision
      for  income taxes
            
            
            1,433
            
            
            
            2,731
            
            
            
            1,458
            
            
            
            2,101Net
      income
            
            $
            2,312
            
            
            $
            4,409
            
            
            $
            2,610
            
            
            $
            3,802Basic
      earnings per share1
            
            $
            0.18
            
            
            $
            0.33
            
            
            $
            0.20
            
            
            $
            0.29Diluted
      earnings per share 1
            
            $
            0.16
            
            
            $
            0.30
            
            
            $
            0.18
            
            
            $
            0.26December
      31, 2006
            
            First
                Quarter
            
            
            Second
                Quarter
            
            
            Third
                Quarter
            
            
            Fourth
                QuarterNet
      sales
            
            $
            133,998
            
            
            $
            145,210
            
            
            $
            137,900
            
            
            $
            159,919Cost
      of sales
            
            
            117,411
            
            
            
            125,822
            
            
            
            121,522
            
            
            
            140,753Gross
      profit
            
            
            16,587
            
            
            
            19,388
            
            
            
            16,378
            
            
            
            19,166SG&A
      expenses
            
            
            11,862
            
            
            
            12,765
            
            
            
            11,291
            
            
            
            12,516Advertising
      expenses, net
            
            
            1,802
            
            
            
            1,768
            
            
            
            1,717
            
            
            
            1,872Income
      from operations
            
            
            2,923
            
            
            
            4,855
            
            
            
            3,370
            
            
            
            4,778Other
      expense
            
            
            178
            
            
            
            122
            
            
            
            (19
            )
            
            
            (11
            )Income  before
      income  taxes
            
            
            2,745
            
            
            
            4,733
            
            
            
            3,389
            
            
            
            4,789Provision
      for  income taxes
            
            
            1,040
            
            
            
            1,816
            
            
            
            1,309
            
            
            
            1,806Net
      income
            
            $
            1,705
            
            
            $
            2,917
            
            
            $
            2,080
            
            
            $
            2,983Basic
      earnings per share1
            
            $
            0.13
            
            
            $
            0.22
            
            
            $
            0.16
            
            
            $
            0.23Diluted
      earnings per share 1
            
            $
            0.12
            
            
            $
            0.20
            
            
            $
            0.14
            
            
            $
            0.20




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.





44
 Table of Contents





Report of Independent
Registered Public Accounting Firm











Board of
Directors and Shareholders


Zones,
Inc.





We have
audited the accompanying consolidated balance sheets of Zones, Inc. as of
December 31, 2007 and 2006, and the related consolidated statements of
operations, shareholders’ equity, and cash flows for each of the three years in
the period ended December 31, 2007.  Our audits of the basic
consolidated financial statements included the consolidated financial statement
schedule listed in the index appearing underItem
15(a)(2).  These consolidated financial statements and consolidated
financial statement schedule are the responsibility of the Company’s
management.  Our responsibility is to express an opinion on these
consolidated financial statements and consolidated financial statement schedule
based on our audits.





We
conducted our audits in accordance with the standards of the Public Company
Accounting Oversight Board (United States).  Those standards require
that we plan and perform the audit to obtain reasonable assurance about whether
the financial statements are free of material misstatement.  The
Company is not required to have, nor were we engaged to perform an audit of its
internal control over financial reporting.  Our audit included
consideration of internal control over financial reporting as a basis for
designing audit procedures that are appropriate in the circumstances, but not
for the purpose of expressing an opinion on the effectiveness of the Company’s
internal control over financial reporting.  Accordingly, we express no
such opinion.  An audit also includes examining, on a test basis,
evidence supporting the amounts and disclosures in the financial statements,
assessing the accounting principles used and significant estimates made by
management, as well as evaluating the overall financial statement
presentation.  We believe that our audits provide a reasonable basis
for our opinion.





In our
opinion, the financial statements referred to above present fairly, in all
material respects, the financial position of Zones, Inc. as of December 31, 2007
and 2006, and the results of its operations and its cash flows for each of the
three years in the period ended December 31, 2007 in conformity with accounting
principles generally accepted in the United States of America.  Also
in our opinion, the related financial statement schedule, when considered in
relation to the basic financial statements taken as a whole, presents fairly, in
all material respects, the information set forth therein.










/s/ Grant
Thornton, LLP


Seattle,
Washington


February
21, 2008





45
 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, 2007Allowance
      for doubtful accounts
            
            $
            1,936
            
            
            $
            310
            
            
            $
            
            
            
            $
            253
            (a)
            
            $
            1,993Year
      Ended December 31, 2006Allowance
      for doubtful accounts
            
            $
            1,562
            
            
            $
            772
            
            
            $
            
            
            
            $
            398
            (a)
            
            $
            1,936Year
      Ended December 31, 2005Allowance
      for doubtful accounts
            
            $
            2,666
            
            
            $
            458
            
            
            $
            
            
            
            $
            1,562
            (a)
            
            $
            1,562(a)
      Uncollectible items written off, less recoveries of items previously
      written off.







46