**UNITED
      STATES**


**SECURITIES
      AND EXCHANGE COMMISSION**


**Washington,
      D.C. 20549**


**FORM
      10-K/A**





**x**
            **ANNUAL
                REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE
                ACT OF
                1934**


**FOR
                THE FISCAL YEAR ENDED DECEMBER 31,
                2006**





**OR**





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





**Commission
      File Number     0-28488**





**ZONES,
      INC**


(Exact
      name of registrant as specified in its charter)





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


**(253)
      205-3000**


(Registrant's
      Telephone


Number,
      Including Area Code)





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


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
x


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


Indicate
      by check mark 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.  x


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





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





The
      aggregate market value of the Common Stock held by non-affiliates as of the
      registrant’s most recently completed second quarter, June 30, 2006, was
      approximately $39,820,756, based upon the last sales price per share of $6.37
      as
      reported by the NASDAQ Global Market.





The
      number of shares of the registrant's Common Stock outstanding as of February
      23,
      2007 was 13,159,560.





**DOCUMENTS
      INCORPORATED BY REFERENCE**





Portions
      of the definitive Proxy Statement for the Registrant’s Annual Meeting of
      Shareholders to be held on April 26, 2007 have been incorporated by reference
      into Part III of this Annual Report on Form 10-K.













**Explanatory
      Note**





The
      Company is filing this amendment to its Annual Report on Form 10-K/A (“Form
      10-K/A”) to restate its Consolidated Statements of Cash Flows for the years
      ended December 31, 2006 and 2005 as described in Note 15, Restatement, of the
      Notes to Consolidated Financial Statements.   The Consolidated
      Statement of Cash Flows for the fiscal year ended December 31, 2004 has been
      revised for conformity purposes.  The Company has been in discussion
      with the staff of the Securities and Exchange Commission (“SEC”) regarding the
      Company’s classification of its inventory financing cash inflows and outflows
      within the operating and/or financing sections of its Consolidated Statements
      of
      Cash Flows.  Following these discussions, the Company has concluded it
      would restate it’s Consolidated Statements of Cash Flows by reclassifying net
      cash flows related to its inventory financing, disclosed as a separate line
      item, from operating activities to financing
      activities.  Consequently, this reclassification will result in a
      change to cash flows (used in) provided by operating activities with an equal
      and off-setting impact to cash flows (used in) provided by financing
      activities.





This
      restatement does not have any impact on the Company’s previously reported
      overall net change in cash and cash equivalents in its consolidated statements
      of cash flows for any period presented.   This restatement also
      has no impact on net income or net income per share in the previously reported
      consolidated statements of operations for the fiscal years ended December 31,
      2005 and December 31, 2006 or in the previously reported unaudited condensed
      consolidated statements of operations for the three months ended March 31,
      2006
      and March 31, 2007, the three and six months ended June 30, 2006 and June 30,
      2007, nor was there any effect on the previously reported consolidated balance
      sheets as of December 31, 2005 and December 31, 2006, the previously reported
      unaudited condensed consolidated balance sheets as of March 31, 2007 and June
      30, 2007, or the previously reported consolidated statements of shareholders’
equity for the years ended December 31, 2005 and December 31, 2006.  The
      consolidated statement of cash flows for the fiscal year ended December 31,
      2004
      has been revised to conform to this presentation.





For
      the
      convenience of the reader, this Form 10-K/A sets forth the Company’s original
      Form 10-K as filed with the SEC on March 1, 2007 (the “Original 10-K") in its
      entirety, as amended by, and to reflect, the restatement.  No attempt
      has been made in this Form 10-K/A to update other disclosures presented in
      the
      Original 10-K, except as required to reflect the effects of the
      restatement.  This Form 10-K/A does not reflect events occurring after
      the filing of the Original 10-K or modify or update those disclosures, including
      the exhibits to the Original 10-K affected by subsequent events.  The
      following sections of this Form 10-K/A have been amended to reflect the
      restatement:





§
            Part
                II, Item 7.  Management’s Discussion and Analysis of Financial
                Condition and Results of Operations (Liquidity and Capital
                Resources)


§
            Part
                II, Item 8.  Financial Statements and Supplementary Data
                (Consolidated Statements of Cash Flows and Note 15
                Restatement)





In
      addition, this amendment on Form 10-K/A includes currently dated Sarbanes-Oxley
      Act Section 302 and Section 906 certifications of the Chief Executive Officer
      and Chief Financial Officer, attached hereto as Exhibits 31.1, 31.2, 32.1 and
      32.2.





This
      Form
      10-K/A should be read in conjunction with our filings made with the SEC
      subsequent to the filing of the Original 10-K for the year ended December 31,
      2006, including any amendments to those filings.





2





**ZONES,
      INC.**


**FORM
      10-K ANNUAL REPORT**


**FOR
      THE YEAR ENDED DECEMBER 31, 2006**


**TABLE
      OF CONTENTS**





**PART
      I**




Page
              No.Item
                1.
            Business
            4Item
                1A.
            Risk
                Factors
            10Item
                2.
            Properties
            13Item
                3.
            Legal
                Proceedings
            13Item
                4.
            Submission
                of Matters to a Vote of Security
                Holders
            14Item
                4A.
            Executive
                Officers of the Registrant
            14





**PART
      II**





Item
                5.
            Market
                for Registrant’s Common Equity, Related Shareholder
                Matters and Issuer Purchases of Equity Securities
            14Item
                6.
            Selected
                Financial Data
            15Item
                7.
            Management’s
                Discussion and Analysis of Financial Condition and
                Results of Operations
            17Item
                7A.
            Quantitative
                and Qualitative Disclosures about Market
                Risk
            24Item
                8.
            Financial
                Statements and Supplementary Data
            25Item
                9.
            Changes
                in and Disagreements with Accountants on Accounting and
                Financial Disclosure
            25Item
                9A.
            Controls
                and Procedures
            25Item
                9B.
            Other
                Information
            25





**PART
      III**





Item
                10.
            Directors,
                Executive Officers and Corporate
                Governance
            25Item
                11.
            Executive
                Compensation
            25Item
                12.
            Security
                Ownership of Certain Beneficial Owners and Management
                and Related Stockholder Matters
            26Item
                13.
            Certain
                Relationships and Related Transactions, and Director
                Independence
            26Item
                14.
            Principal
                Accounting Fees and Services
            26





**PART
      IV**





Item
                15.
            Exhibits
                and Financial Statement Schedules
            26Signatures
            28





3
 *Table
            of Contents*





**Part
      I**





**Item
      1.   Business**





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





**General**





Zones,
      Inc. (the “Company,” “We”) is a single-source direct marketing reseller of
      name-brand information technology (“IT”) products to the small-to-medium-sized
      business market (“SMB”), enterprise accounts and public sector
      accounts.  Zones sells products through outbound and inbound account
      executives, catalogs and the Internet.  Zones offers more than 150,000
      products from leading manufacturers, including 3Com, Adobe, Apple, Cisco, Epson,
      HP, IBM, Kingston, Lenovo, Microsoft, Sony and Toshiba.





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





**Industry
      Background**





We
      believe that the direct marketing reseller (“DMR”) channel has reached a level
      where most corporate IT customers have selected their vendor of choice, either
      direct through DMRs or indirect through value-added resellers
      (“VAR”).  Future growth of the channel will be predicated on increased
      corporate profit levels, which can support an investment in new
      technology.  Generally, we believe that in 2007 the DMR channel will
      grow at market rate, with our core business with the SMB expected to outpace
      the
      market.  To exceed the market rate of growth overall, individual DMR
      vendors must take market share from their direct and indirect
      competitors.





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





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





4
 *Table
            of Contents*





**Our
      Business**





Our
      business is the procurement and fulfillment of IT solutions to the SMB,
      enterprise customers and the public sector marketplace.  Our core
      business is focused on providing name-brand products at competitive prices
      to
      the commercial business and public sector markets within the United
      States.  We believe that small business customers, meaning those with
      50 to 100 computer users, are characterized by transactional purchasing, in
      contrast to medium-sized business customers, meaning those with 100 to 1000
      computer users, who are relationship-driven with more frequent
      transactions.  We believe that SMB customers have a high adoption rate
      for IT solutions and prefer a single-source provider to handle their procurement
      from end to end.  Enterprise customers, defined as customers within
      the Fortune 2000 and having more than 1000 computer users, generally demand
      a
      much higher level of customer service.   The public sector market
      is made up of three primary customer types:  state and local
      government, federal government and education. These sectors require special
      pricing and participation in bid processes.





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





**Our
      Business Strategy**





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





We
      believe that our ability to grow in 2007 will depend on organic growth within
      our current account portfolio and increased reach, utilizing our growing force
      of field sales AEs, into the larger end of medium-sized customers and enterprise
      customers. We believe organic growth will develop as tenure and productivity
      increase in our existing AE base, driving an increase in the share of each
      customer’s total IT purchases.  Additionally, we are committed to our
      2006 decision to add dedicated marketing and sales support staff to focus on
      businesses at the smaller end of our SMB customer base, which is believed to
      be
      more transaction oriented. The field sales force will be focused on the
      identification, penetration and closure of new business customers to add to
      the
      existing client portfolio.  Our business model relies on building and
      maintaining relationships with our customers to provide solutions to solve
      their
      needs.





We
      strive
      to offer exemplary customer service in each transaction, which we define as
      Five
      Star Service.  Five Star Service is founded on these
      principles:  exceeding expectations, providing outstanding customer
      service, performing flawless execution, demonstrating the highest level of
      personal integrity, and placing the customer first.  We strive to
      offer the most competitive value based on:





·
            **Price.**
                Zones offers competitive pricing to its
                customers.


·
            **Availability.**
                With more than 150,000 products available from more than 2,000 vendors,
                Zones strives to deliver the products its customers
                need.


·
            **Information.**
                The technology industry is constantly changing with new and upgraded
                products and services, so Zones AEs receive continuous training throughout
                their careers. This allows them to serve as a knowledgeable extension
                of
                each customer's team.


·
            **Fulfillment.**
                Zones strives to deliver every order complete and on
                time.


·
            **Service.**
                Zones offers a breadth of services and sales specialists to support
                the
                customer IT relationship. For example, the Company’s customized online
                order management system, ZonesConnect, helps its customers reduce
                administrative costs and streamline the purchasing process. With
                additional services such as asset tagging, imaging, and product upgrades,
                Zones is a proactive business partner throughout the sales
                cycle.





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





*Business
      Development Organization*.  To drive market share growth, we have
      invested in client segmentation and geographical expansion, which has led to
      the
      introduction of the Business Development organization.  This
      organization is responsible for creating an organization of remote,
      geographically dispersed AEs focused on acquisition of new customers and
      development of existing customers.  This field sales force, along with
      its management team, is expected to grow to 20 team members by the end of the
      first quarter 2007.  This team will be divided into two populations:
      AEs who will call on the larger end of medium-sized customers and AEs who will
      call on enterprise customers.





5
 *Table
            of Contents*





*AE
      Hiring, Training and Development*. We continually seek to attract, retain
      and motivate high-quality personnel.  We intend to continue to
      increase AE headcount, but at a lower rate of growth due to our focus on
      improving the success rate of existing AEs.  The increase in success
      rate should lower turnover and, in turn, reduce our expected 2007 hiring
      requirements.  Management focuses on training and coaching AEs on best
      practices, product knowledge and how to access supportive collateral on the
      available marketing and merchandising programs and promotions.  We
      focus on our relationship-based model, in which our AEs develop long-term
      relationships with customers through frequent telephone contact, knowledgeable
      technical advice, individual attention, quality service and convenient one-stop
      shopping.





*Expansion
      of Customer Base.*Relationships with our commercial business and public
      sector accounts represent future growth opportunities.  We continue to
      refine our customer management program, lead generation and related processes
      to
      increase and accelerate customer acquisition.  During 2007, we believe
      our customer management program is designed to better understand the purchasing
      patterns and product needs of each customer, and thereby increase operational
      efficiencies in the selling process and minimize loss of revenues during account
      transition from one AE to another.





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





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





**Sales
      and Marketing**





We
      reach
      our customers through an integrated marketing and merchandising strategy
      designed to attract customers through dedicated e-marketing and direct marketing
      vehicles, catalogs for demand-response opportunities and corporate branding,
      and
      customized Web stores for corporate customers using our ZonesConnect
      service.  Throughout the year, marketing refines the characteristics
      of our target customers in each market and creates specific marketing collateral
      to reach that audience.





*Outbound
      Telemarketing*.  As of December 31, 2006, we had a staff of 342
      sales AEs who actively pursued sales to commercial business accounts and public
      sector institutions by establishing one-to-one relationships through outbound
      telemarketing.  The primary targets for AEs in the SMB department are
      the small-to-medium-sized business customers, while enterprise-customer AEs
      focus on companies within the Fortune 2000.  These commissioned AEs
      develop long-term relationships with their accounts through frequent telephone
      contact, knowledgeable technical advice, individual attention, quality service
      and convenient one-stop shopping.





*Business
      Development Field Sales*.  In October 2006, we began investing in
      a strategy to create a remote, geographically dispersed sales
      force.  Business Development management and the field sales AEs will
      identify and access customers within the larger end of the medium-sized-business
      and enterprise-business segments in an effort to increase our existing portfolio
      with new customers.





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





6
 *Table
            of Contents*





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





*Direct
      Mail.*  We market products through targeted mailings of
      direct-mail vehicles, such as catalogs, product inserts and targeted customer
      mailings. The Company utilizes its direct mail vehicles as part of a customer
      acquisition and retention strategy, as well as a direct marketing tool and
      branding vehicle to drive significant traffic to its online site, Zones.com,
      and
      to our sales force.  The Company uses cooperative advertising funds,
      which are proof of performance expense reimbursements, to substantially offset
      the costs associated with its catalog circulation and other marketing
      activities.  The amount of this type of funding available from our
      vendors fluctuates quarterly both in dollars and as a percentage of
      sales.  Net advertising costs may continue to fluctuate or rise in the
      future as the Company continues to adapt and adjust its catalog circulation,
      Internet and other marketing activities to optimize sales and profitability
      in
      light of changing market conditions.





*Database
      Marketing*.  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 mailing lists obtained from list brokers,
      product manufacturers, trade magazine publishers, association memberships and
      other sources.  We regularly analyze and update our database and other
      available information to keep data current and to enhance customer response
      and
      order rates.








**Products
      and Merchandising**





We
      offer
      customers access to more than 150,000 hardware, software, peripheral and
      accessory products and services, for users of Windows-based and Mac computers,
      from over 2,000 manufacturers through our catalogs, Internet site and sales
      force.





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





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





*Networking
      and Storage*.  We provide networking and network storage products,
      such as switches, hubs, routers, modems, cabling, firewalls, Voice over IP
      (VOIP), wireless devices, tape and disk backup, and SAN and NAS
      solutions.  Brands offered include 3Com, Apple, Avaya, Avocent,
      Belkin, Cisco, D-Link, EMC, Emulex, Hewlett-Packard, Hitachi Data Systems,
      IBM,  Intel,  Iomega, La Cie, Linksys, Netgear, Nortel
      Networks, Overland Storage, QLogic, Polycom, Quantum, Seagate, SonicWALL, Sony,
      Tandberg Data (Exabyte), and Western Digital, among others.





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





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





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





7
 *Table
            of Contents*





**Purchasing**





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





We
      acquire products directly from manufacturers such as Apple, Hewlett-Packard,
      IBM
      and Lenovo, as well as through distributors such as Ingram Micro, Synnex and
      Tech Data, among others.  In 2006, we purchased approximately 55.9% of
      our merchandise from distributors, a decrease from 62.6% in 2005.  We
      believe that our overall sourcing strategy enables us to take advantage of
      significant special offers, discounts and supplier reimbursements, while also
      minimizing inventory costs.  We believe we have excellent
      relationships with our suppliers and we attempt to take advantage of all
      appropriate discounts.





We
      utilize a blend of stocking and drop-ship procurement in executing our inventory
      management strategy.  We generally stock 20% of our total product
      offerings that represent up to 80% of total net sales.  The remaining
      products are provided to our customers primarily through virtual warehousing
      partnerships with key distributors and manufacturers.  Through these
      relationships, we are able to offer a broad selection of products and to provide
      prompt, cost-efficient fulfillment with minimal inventory
      exposure.  This virtual fulfillment model is facilitated through
      industry-standard EDI linkages with suppliers.  All associated
      transactions are managed through and integrated with our ERP system, which
      lowers administrative overhead.





At
      December 31, 2006, we maintained an investment in inventory of $21.4 million,
      and our inventories turned an average of 24 times in 2006.  This
      compares to an investment in inventory of $19.7 million at December 31, 2005,
      and average inventory turns of 26 during 2005.  Our investment in
      inventory grew at December 31, 2006 due to on-hand customer-specific
      inventory.





**Order
      Fulfillment and Distribution**





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





We
      provide and operate a full-service warehouse and distribution center in
      Bensenville, Illinois to support our nationwide customer base and a customized
      fulfillment center in Seattle, Washington to support our West Coast
      customers.  The warehouse personnel utilize our systems, policies and
      procedures to receive, record and warehouse inventory shipments from product
      suppliers, fill and ship customer orders, and return inventory to product
      suppliers when requested. We also use our warehouse facilities to house special
      buys, constrained product and other high-velocity product. The Bensenville,
      Illinois warehouse is responsible for the returned merchandise that will be
      returned to vendors, returned to general inventory, repaired or
      liquidated.  We offer limited return rights within 14 days on our
      product sales, and we maintained an allowance for sales returns, net of cost,
      as
      of December 31, 2006 and 2005 of $101,000 and $108,000, respectively. Our
      returns as a percentage of gross sales decreased slightly to 2.1% in 2006
      compared to 2.2% in 2005.  Product returns are closely monitored to
      identify trends in product offerings, to enhance customer satisfaction and
      to
      reduce overall returns.





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





8
 *Table
            of Contents*





**Technical
      Support and Customer Service**





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





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





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





**Systems**





We
      have
      committed  significant resources to the development of sophisticated
      management information, telecommunication, catalog production and other systems,
      which are employed in virtually all aspects of our business, including
      marketing, purchasing, inventory management, order processing, product
      distribution, accounts receivable, customer service and general accounting
      functions.  During 2006, we continued to develop and enhance our sales
      interface for order entry. Our graphical user interface ties all of the core
      systems together to give AEs a common view of customers, products, inventory
      and
      orders, and to streamline order processing as well as to reduce the training
      time for new AEs.  We are continually examining technological advances
      to increase the productivity of our team members.





**Team
      Members**





At
      December 31, 2006, we had 661 team members: 342 in the sales force, 38 in its
      warehousing and distribution, and 281 team members in administrative overhead
      departments. We consider our employee relations to be good.  We also
      have 37 people under outsourced contract in India performing various back-office
      and IT functions in support of our United States operations.  We have
      never had a work stoppage and do not believe that any team members are
      represented by a labor organization.  We emphasize the recruiting and
      training of high-quality personnel and strive to promote to positions of
      increased responsibility from within.





*Sales
      Team Education*


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





*Mission
      & Values*


We
      are
      dedicated to creating a learning organization of empowered individuals to serve
      our customers with integrity, commitment and passion.  We strive to
      achieve this by creating a positive and collaborative workplace environment,
      delivering high-speed and quality service to our customers, and adapting to
      external changes with flexibility, innovation and leading-edge
      technology.





**Seasonality**





Sales
      to
      our commercial business customers have not historically experienced significant
      seasonality throughout the year. By contrast, sales to the public sector market
      are historically higher in the third quarter than in other quarters due to
      the
      buying patterns of federal government and education customers. If sales to
      public sector customers increase as a percentage of overall sales, we as a
      whole
      may experience increased seasonality in future periods.





9
 *Table
            of Contents*





**Trademarks**





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





**Regulatory
      and Legal Matters**





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





**Available
      Information**





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





Additionally,
      all materials that we file with the SEC can be viewed and copied at the SEC’s
      Public Reference Room at 450 Fifth Street NW, Washington, DC 20549, or via
      the
      SEC’s website at www.sec.gov.  Information on the operation of the
      Public Reference Room can be obtained by calling 1-800-SEC-0330.




Our
      Audit
      Committee Charter, Compensation Committee Charter and Nominating and Governance
      Committee Charter are also available on our website or upon written or verbal
      request. Requests for copies of any of these documents should be directed in
      writing to Zones, Inc. Investor Relations, 1102 15th Street
      SW, Suite
      102, Auburn, WA 98001-6509.





**Item
      1A.  Risk Factors**





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





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


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


·
            purchasing
                cycles of commercial and public sector
                customers;


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


·
            more
                manufacturers going direct;


·
            industry
                announcements of new products or
                upgrades;


·
            industry
                consolidation;


·
            cost
                of compliance with new legal and regulatory
                requirements;


·
            general
                economic conditions; and


·
            variability
                of vendor programs.


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





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


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


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


·
            increased
                competition;


·
            more
                manufacturers going direct;


·
            changes
                in customers’ buying habits;


·
            the
                loss of significant customers;


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


·
            general
                economic conditions.





10
 *Table
            of Contents*





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





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


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




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


We
      ended
      2006 with 342 account executives compared to 250 in 2005.  We expect
      to continue to increase account executive headcount, but at a lower rate of
      growth due to corporate initiatives to lower turnover thus reducing hiring
      requirements in 2007. However, there are no assurances that we will be able
      to
      hire to our expected levels, or recruit the quality individuals that we hope
      to
      hire, or that the individuals hired will remain employed for an extended period
      of time, or that we will not lose existing account executives.  The
      productivity of account executives has historically been closely correlated
      with
      tenure.  Even if we do retain our account executives, there are no
      assurances that they will become productive at historical
      levels.  Additionally, there are no assurances that the locations of
      our call centers will continue to attract qualified account executives, or
      that
      we will be able to remotely manage and retain the new account
      executives.





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


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




**We
      are controlled by a principal stockholder.**


Firoz
      H.
      Lalji, our Chairman and Chief Executive Officer, beneficially owns 52.4% of
      the
      outstanding shares of Zones common stock, excluding shares that he may acquire
      upon exercise of stock options that he holds.  The voting power of
      these shares enables Mr. Lalji to significantly influence our affairs and the
      vote on corporate matters to be decided by our shareholders, including the
      outcome of elections of directors.  This effective voting control may
      preclude other shareholders from being able to influence shareholder votes
      and
      could impede potential merger transactions or block changes to our articles
      of
      incorporation or bylaws, which could adversely affect the trading price of
      our
      common stock.  We are also certified as a Minority Business Enterprise
      based on Mr. Lalji’s maintenance of voting control.  The certification
      allows us to compete for certain sales opportunities.  A decrease in
      Mr. Lalji’s level of voting power through the issuance of additional equity
      capital could have an adverse effect on our ability to retain certain customers
      or compete for certain sales opportunities.




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


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





11
 *Table
            of Contents*




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


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





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


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





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


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




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


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





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


We
      operate warehouse and distribution centers in Bensenville, Illinois and in
      Seattle, Washington.  There are no assurances that our warehouse
      locations will best support our customer base.  Additionally, certain
      distributors also participate in our logistics operations through electronic
      data interchange.  Failure to develop and maintain relationships with
      these and other vendors would limit our ability to obtain sufficient quantities
      of merchandise on acceptable commercial terms and could have a material adverse
      effect on our business, financial condition, cash flows or results of
      operations.





12
 *Table
            of Contents*





**We
      are heavily dependent on commercial delivery services.**


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





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


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





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


From
      time
      to time we have customers that represent more than 10% of total sales. For
      the
      years ended December 31, 2006 and 2005, there were no customers that
      individually represented more than 10% of total net sales.  The
      concentration of credit risk associated with any major customer could have
      a
      material adverse effect on our business, financial condition, cash flows or
      results of operations.




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


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





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


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




**Our
      stock price may be volatile.**


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





**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 27,000 square feet of space for our fulfillment warehouse facility
      in Seattle, Washington; approximately 70,000 square feet of space for our
      logistics warehouse in Bensenville, Illinois; and approximately 23,000 and
      200
      square feet of space for telemarketing sales offices in Portland, Oregon and
      Kansas City, Missouri, respectively.





**Item
      3.    Legal Proceedings**





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





13
 *Table
            of Contents*





**Item
      4.     Submission of Matters to a Vote
      of Security Holders**





None.





**Item
      4A.  Executive Officers of the
      Registrant**





*Firoz
      H. Lalji*, age 60, has served as the Company’s Chief Executive Officer since
      May of 1998 and as Chairman of the Board since March of 1999. Mr. Lalji was
      co-founder and has served as a director of the Company since March
      1990.  Mr. Lalji is also President and Chief Executive Officer of Fana
      Capital Corporation, an investment holding company.   From 1981
      to 1997, he was President and Chief Executive Officer of Kits Cameras, Inc.,
      which operated more than 140 camera specialty stores in eight western
      states.





*Christina
      Corley*, age 39, was appointed President and COO of Zones, Inc. in October
      2006.  She had previously held the positions of Executive Vice
      President for Zones, Inc. from April 2005 to October 2006, and served as
      President of Corporate PC Source (“CPCS”), a wholly owned subsidiary of the
      Company, from March 2003 to April 2005.  Prior to the acquisition of
      CPCS by the Company, Ms. Corley was Chief Executive Officer and President of
      CPCS from 1999 to 2003. From 1996 to 1999, Ms. Corley served as Vice 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 50, has served as Senior Vice President and Chief
      Financial Officer of Zones, Inc. since May 2000. Prior to this position, Mr.
      McFadden was the Company’s Vice President of Finance and Administration since
      May 1999. He joined the Company in June 1998, initially serving as Vice
      President of International Operations. From 1991 to 1998, Mr. McFadden was
      Chief
      Financial Officer for Kits Cameras, Inc. Between 1984 and 1991 he served as
      Vice
      President of Finance for Interpace Industries.





*P.
      Sean Hobday*, age 37, was appointed Executive Vice President Sales for
      Zones, Inc. in February 2005.  Prior to this, Mr. Hobday served as
      President of Zones Corporate Solutions, a wholly owned subsidiary of the
      Company, since September 2003.  Prior to that, Mr. Hobday was Vice
      President of Enterprise Sales for the Company since September 2001. From March
      2000 to September 2001, Mr. Hobday served as Director of Client Development
      for
      the Company.  From February 1999 to March 2000, Mr. Hobday served as
      Account Executive for the Company.  From 1996 to 1998, Mr. Hobday
      served as Managing Director of Blue Ice Leisure in Sydney, Australia, an
      Austral-Asian division of First Team Sports*.*





*Tom
      Ducatelli*, age 41, joined Zones, Inc. in October 2006 as the Executive Vice
      President Business Development.  Previously, Ducatelli served as
      Senior Vice President of U.S. Sales at Tech Data Corporation, a $20 billion
      multi-national distributor of IT products. Prior to that, he served as senior
      Vice President of Sales and Business Development for Dallas-based CompuCom
      Systems, Inc., a $1.7 billion IT reseller and solution provider he joined in
      1994. Prior to CompuCom, Ducatelli spent six years as a national sales executive
      with mid-range computer manufacturer Digital Equipment Corp.





*Anwar
      Jiwani*, age 52, has served as Senior Vice President and Chief Information
      Officer since April 1999.  Prior to this Mr. Jiwani served for 23
      years with The Royal Bank of Canada.




**Part
      II**





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





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





**Year
                  ended December 31,****2006**
            
            
            **2005****High**
            
            
            **Low**
            
            
            **High**
            
            
            **Low**First
                quarter
            
            $
            7.73
            
            
            $
            4.90
            
            
            $
            6.55
            
            
            $
            3.18Second
                quarter
            
            
            7.70
            
            
            
            5.86
            
            
            
            4.15
            
            
            
            2.90Third
                quarter
            
            
            10.83
            
            
            
            6.08
            
            
            
            4.48
            
            
            
            3.70Fourth
                quarter
            
            
            14.44
            
            
            
            7.17
            
            
            
            5.50
            
            
            
            4.03




14
 *Table
            of Contents*





As
      of
      March 9, 2007, the Company had approximately 4,000 beneficial holders of record
      of its Common Stock.  The Company has never paid, and has no present
      plans to pay, a cash dividend on its Common Stock.  The Company
      intends to retain its earnings to finance the expansion of its
      business.





Securities
      authorized for issuance under equity compensation plans are incorporated by
      reference from the Proxy Statement for the Company’s 2007 Annual Meeting of
      Shareholders under the caption “Equity Compensation Plan
      Information.”





Since
      2004, the Company has repurchased a total of 1,441,240 shares of its common
      stock at a total cost of $7.2 million under its repurchase program
      authorized by its Board of Directors.  Share repurchases may be made
      from time to time in both open market and private transactions, as conditions
      warrant, at then prevailing market prices. The following table presents share
      repurchases for the years ended December 31, 2006, 2005 and 2004 (dollars
      in thousands):








**Year**
            
            **Total
                  number of shares purchased**
            
            
            **Amount
                  paid**2006
            
            
            568,400
            
            
            $
            3,9882005
            
            
            424,450
            
            
            $
            1,8132004
            
            
            448,390
            
            
            $
            1,348







As
      of
      December 31, 2006, $979,000 in shares of the Company’s common stock
      remained available for repurchase under the program.  In February
      2007, the Board of Directors authorized a continuation of the Company’s share
      repurchase program, pursuant to which the Company increased the total amount
      authorized.  As of February 2007, $3.0 million in shares of the
      Company’s common stock is available for repurchase under the program. The
      current repurchase program is expected to remain in effect through
      February 2008, unless earlier terminated by the Board or
      completed.




**Item
      6.      Selected Financial
      Data**





The
      following table sets forth the selected historical consolidated income and
      balance sheet data of Zones, Inc. and its subsidiaries.  The balance
      sheet data at December 31, 2006 and 2005 and the statement of operations data
      for the years ended December 31, 2006, 2005 and 2004 have been derived from
      the
      audited consolidated financial statements and notes thereto included in this
      Annual Report on Form 10-K.  The balance sheet data for the years
      ended December 31, 2004, 2003 and 2002 and the statement of operations data
      for
      the years ended December 31, 2003 and 2002 have been derived from audited
      consolidated financial statements and notes thereto not included in this Annual
      Report on Form 10-K.





15
 *Table
            of Contents*





This
      information should be read in conjunction with the consolidated financial
      statements and notes thereto included in Item 8 and Item 7 “Management’s
      Discussion and Analysis of Financial Condition and Results of
      Operations.”





**Year
                ended December 31,****2006**
            
            
            **2005**
            
            
            **2004**
            
            
            ****
            **2003**
            **2**
            
            **2002****(In
                thousands, except per share data and operating
                data)****Statement
                of Operations Data:**Net
                sales
            
            $
            577,027
            
            
            $
            566,553
            
            
            $
            495,563
            
            
            $
            460,772
            
            
            $
            414,643Cost
                of sales
            
            
            505,508
            
            
            
            505,997
            
            
            
            438,426
            
            
            
            410,078
            
            
            
            371,725Gross
                profit
            
            
            71,519
            
            
            
            60,556
            
            
            
            57,137
            
            
            
            50,694
            
            
            
            42,918Selling,
                general and administrative expenses
            
            
            48,434
            
            
            
            43,618
            
            
            
            42,284
            
            
            
            43,252
            
            
            
            40,294Advertising
                expense
            
            
            7,159
            
            
            
            6,618
            
            
            
            7,082
            
            
            
            6,597
            
            
            
            1,354State
                tax (benefit) expense1,3
            
            
            
            
            
            
            
            
            
            
            
            
            
            
            (2,103
            )
            
            
            2,145Income
                (loss) from operations
            
            
            15,926
            
            
            
            10,320
            
            
            
            7,771
            
            
            
            2,948
            
            
            
            (875
            )Other
                (income) expense, net
            
            
            270
            
            
            
            503
            
            
            
            314
            
            
            
            379
            
            
            
            (58
            )Income
                (loss) before income taxes
            
            
            15,656
            
            
            
            9,817
            
            
            
            7,457
            
            
            
            2,569
            
            
            
            (817
            )Provision
                (benefit) from income taxes
            
            
            5,971
            
            
            
            3,766
            
            
            
            2,805
            
            
            
            1,001
            
            
            
            (302
            )Net
                income (loss)
            
            $
            9,685
            
            
            $
            6,051
            
            
            $
            4,652
            
            
            $
            1,568
            
            
            $
            (515
            )Basic
                income (loss) per share
            
            $
            0.73
            
            
            $
            0.45
            
            
            $
            0.34
            
            
            $
            0.11
            
            
            $
            (0.04
            )Weighted
                average shares used in computation of basic income (loss) per
                share
            
            
            13,195
            
            
            
            13,382
            
            
            
            13,549
            
            
            
            13,644
            
            
            
            13,587Diluted
                income (loss) per share
            
            $
            0.66
            
            
            $
            0.42
            
            
            $
            0.32
            
            
            $
            0.11
            
            
            $
            (0.04
            )Weighted
                average shares used in computation of diluted income (loss) per
                share
            
            
            14,756
            
            
            
            14,527
            
            
            
            14,469
            
            
            
            13,739
            
            
            
            13,587**Balance
                Sheet Data:**Working
                capital
            
            $
            41,675
            
            
            $
            33,398
            
            
            $
            27,024
            
            
            $
            20,884
            
            
            $
            20,587Total
                assets
            
            
            120,695
            
            
            
            117,354
            
            
            
            102,144
            
            
            
            92,885
            
            
            
            79,952Interest
                bearing short-term debt
            
            
            
            
            
            
            11,972
            
            
            
            7,372
            
            
            
            8,683
            
            
            
            226Long-term
                debt, net of current portion
            
            
            6
            
            
            
            21
            
            
            
            1,307
            
            
            
            1,667Total
                shareholders’ equity
            
            $
            49,482
            
            
            $
            41,317
            
            
            $
            36,551
            
            
            $
            32,701
            
            
            $
            31,097**Selected
                Operating Data (unaudited):**Number
                of shipments
            
            
            406,475
            
            
            
            398,437
            
            
            
            421,836
            
            
            
            473,098
            
            
            
            506,877Average
                order size 4
            
            $
            1,451
            
            
            $
            1,455
            
            
            $
            1,195
            
            
            $
            982
            
            
            $
            821Sales
                force, end of period
            
            
            342
            
            
            
            250
            
            
            
            281
            
            
            
            234
            
            
            
            2391During
                the fourth quarter of
                2003, the Company reached final resolution and settled with the Washington
                State Department of Revenue regarding the tax years 1996 through
                1999. The Company recorded a benefit for this resolution of $2.1
                million.2On
                March 31, 2003, the Company
                acquired Corporate PC Source, Inc. pursuant to a Stock Purchase
                Agreement. Corporate PC Source’s results of operations are included
                in the Company’s consolidated financial statements for the periods after
                the date of acquisition.3During
                the fourth quarter of
                2002, the Company received the final determination from the Washington
                State Department of Revenue regarding the tax years 1996 through
                1999. The Company recorded a charge for this determination of $2.1
                million.4Average
                order
                size is calculated by dividing gross sales by the number of shipped
                orders.




16
 *Table
            of Contents*





**Item
      7.   Management’s Discussion and Analysis of
      Financial Condition and Results of Operations**





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





The
      consolidated statements of cash flows for the years ended December 31, 2006
      and
      2005 have been restated to correct the classification of cash flows related
      to
      inventory financing.   The Company had previously considered cash
      flows from inventory financing as operating activities. However, based upon
      discussions with the staff of the SEC following a periodic review of the Company
      Form 10-K for the year ended December 31, 2006, the Company has now determined
      that cash flows from inventory financing should be reclassified to cash flows
      from financing activities.  This restatement does not have any impact
      on the Company’s previously reported overall net change in cash and cash
      equivalents in its consolidated statements of cash flows for any period
      presented.   This restatement also has no impact on net income or
      net income per share in the previously reported consolidated statements of
      operations for the fiscal years ended December 31, 2006 and December 31, 2005,
      nor was there any effect on the previously reported consolidated balance sheets
      as of December 31, 2006 and December 31, 2005, or the previously reported
      consolidated statements of shareholders’ equity for the years ended December 31,
      2006 and December 31, 2005.  The consolidated statement of cash flows
      for the fiscal year ended December 31, 2004 has been revised to conform to
      this
      presentation.  See Note 15 to the consolidated financial statements
      for further information.





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





**General**


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





**Overview**


Zones,
      Inc. is a direct marketing reseller of technology hardware, software and
      services. The Company procures and fulfills IT solutions for the SMB market
      (between 50 and 1000 computer users), enterprise customers (greater than 1000
      computer users) and the public sector (education and state and local
      governments). Relationships with SMB, enterprise customers, and public sector
      institutions represented 98.0%, 96.5% and 91.2% of total net sales during 2006,
      2005 and 2004, respectively. The remaining sales were from inbound customers,
      primarily consumers and small office/home office accounts purchasing mostly
      Mac
      platform products.





The
      Company reaches its customers through an integrated marketing and merchandising
      strategy designed to attract and retain customers. This strategy involves a
      relationship-based selling model executed through outbound account executives,
      field sales representatives, customized Web stores for corporate customers
      through ZonesConnect, a state of the art Internet portal at
www.zones.com, dedicated e-marketing and direct marketing vehicles, and
      catalogs for demand-response opportunities and corporate branding.





17
 *Table
            of Contents*





The
      Company utilizes its purchasing and inventory management capabilities to support
      its primary business objective of providing name-brand products at competitive
      prices. The Company offers more than 150,000 hardware, software, peripheral
      and
      accessory products and services for users of Windows-based and Mac platform
      computers from more than 2,000 manufacturers.





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





The
      Company is dedicated to creating a learning community of empowered individuals
      to serve its customers with integrity, commitment and passion. At December
      31,
      2006, the Company had 661 team members in its consolidated operations, 342
      of
      whom were inbound and outbound account executives. The majority of the Company’s
      team members work at its corporate headquarters in Auburn,
      Washington.





The
      Company makes additional company information available free of charge on its
      website, www.zones.com/IR.





**Critical
      Accounting Policies**


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





The
      Company believes the following critical accounting policies affect its more
      significant judgments and estimates used in the preparation of its consolidated
      financial statements, and therefore should be read in conjunction with its
      summary of significant accounting policies (see Note 2 of the Company’s Notes to
      Consolidated Financial Statements).  The Company’s critical accounting
      policies are as follows:





*Revenue
      Recognition.*


The
      Company recognizes revenue on product sales when persuasive evidence of an
      arrangement exists, delivery has occurred, prices are fixed or determinable,
      and
      ability to collect is probable.  The Company considers the point of
      delivery of the product to be when the risks and rewards of ownership have
      transferred to the customer.  The Company’s shipping terms dictate
      that the passage of title occurs upon receipt of products by the customer except
      for the last seven calendar days of each fiscal quarter, when all shipments
      are
      insured in the name of the customer. For these seven days, passage of risk
      of
      loss and title occur at the shipping point.




The
      majority of the Company’s net sales relate to physical products. These sales are
      recognized on a gross basis with the selling price to the customer recorded
      as
      net sales and the acquisition cost of the product recorded as cost of sales.
      The
      Company offers limited return rights on its product sales.  At the
      point of sale, the Company provides for an allowance for sales returns, which
      is
      established based on historical experience.  Amounts billed for
      shipping and handling are recorded as revenue.  Pursuant to EITF 99-19
“Reporting Revenue Gross as a Principal versus Net as an Agent,” when the
      Company sets prices, has inventory risk and has credit risk, revenues are
      recorded gross.  Third-party extended warranties, third-party software
      maintenance products and third-party services sold by the Company (for which
      the
      Company is not the primary obligor) are recognized gross in revenues and cost
      of
      sales when the Company sets prices and has inventory risk and credit risk.
      If
      any of those criteria are not present, revenue and cost of sales are recorded
      net. The Company’s warranty sales are generally recorded net.  When
      the sale is recorded, the Company has no further obligation to
      fulfill.  The Company only recognizes revenue when all criteria of
      Staff Accounting Bulletin No. 104 (“SAB 104”), "Revenue Recognition" have been
      met.




Additionally,
      the Company offers limited return rights within 14 days on its product sales.
      The Company has demonstrated the ability to make reasonable and reliable
      estimates of product returns based on significant historical experience. If
      actual credits were to deviate significantly from the Company’s estimates, its
      results of operations could be adversely affected. The Company had allowances
      for sales returns, net of cost, of $101,000 and $108,000 at December 31, 2006
      and 2005, respectively.




18
 *Table
            of Contents*





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


The
      Company uses significant judgment and estimates in the preparation of its
      financial statements that affect the carrying values of its assets and
      liabilities. On an on-going basis, the Company evaluates its
      estimates.





The
      Company maintains an allowance for doubtful accounts based on estimates of
      future collectibility of its accounts receivable.  The Company
      regularly analyzes its accounts receivable in evaluating the adequacy of the
      allowance for doubtful accounts.  The adequacy of the allowance is
      determined during the current period based on historical collection experience,
      customer credit worthiness based on published information, and other known
      factors.





The
      Company maintains a valuation allowance for potentially uncollectable amounts
      due from its vendors that arise from product returns, standard vendor price
      protection programs, cooperative advertisement reimbursements and vendor rebate
      programs.  Amounts received from vendors may vary from amounts
      recorded based on the difference between the current market price of a product
      returned and its acquisition price, the denial of price protection, cooperative
      reimbursement, or vendor rebates due to noncompliance with specific attributes
      of the vendor programs.   The Company regularly reviews its
      vendor receivables and provides a valuation allowance based on historical
      collections and the comparison of amounts recorded versus subsequently
      received.





The
      Company records inventory at lower of FIFO cost or market.  It
      estimates the amount of unmarketable inventory based on the difference between
      the cost of the inventory and the market value, which is based on assumptions
      of
      market demand, current market conditions, most recent actual sales prices,
      and
      age and condition of products.





*Accounting
      for Income Taxes.*


The
      Company is required to estimate income taxes in states in which it is registered
      and/or has a physical presence. This process involves estimating actual tax
      exposure while assessing temporary differences resulting in differing treatment
      for tax and accounting purposes.  These differences result in deferred
      tax assets and liabilities.  The Company considered future taxable
      income in assessing the need for a valuation allowance against its deferred
      tax
      assets. The Company believes that all net deferred tax assets shown on its
      balance sheet as of December 31, 2006, are more likely than not to be
      realized in the future and no valuation allowance is necessary. In the event
      that actual results differ from those estimates or that those estimates are
      adjusted in future periods, the Company may need to record a valuation
      allowance, which would reduce deferred tax assets and the results of operations
      in the period the change is made.





*Goodwill.*


In
      accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill
      will be tested for impairment at least annually, or when events indicate that
      impairment exists.  The Company performs the assessment annually on
      March 31.  The Company completed the impairment review required by
      SFAS No. 142 on March 31, 2006 and determined that its goodwill was not
      impaired.  There have been no significant business changes since the
      last assessment.





**Results
      of Operations**


The
      following table sets forth, for the periods indicated, selected items from
      the
      Company’s Consolidated Statements of Operations expressed as a percentage of net
      sales.





**Year
                  ended December 31,****2006**
            
            
            **2005**
            
            
            **2004**Net
                sales
            
            
            100.0
            %
            
            
            100.0
            %
            
            
            100.0
            %Cost
                of sales
            
            
            87.6
            
            
            
            89.3
            
            
            
            88.5Gross
                profit
            
            
            12.4
            
            
            
            10.7
            
            
            
            11.5SG&A
                  expenses
            
            
            8.4
            
            
            
            7.7
            
            
            
            8.5Advertising
                  expense
            
            
            1.2
            
            
            
            1.2
            
            
            
            1.4Income
                from operations
            
            
            2.8
            
            
            
            1.8
            
            
            
            1.6Other
                expense, net
            
            
            0.1
            
            
            
            0.1
            
            
            
            0.1Income
                before income taxes
            
            
            2.7
            
            
            
            1.7
            
            
            
            1.5Provision
                for income taxes
            
            
            1.0
            
            
            
            0.7
            
            
            
            0.6Net
                income
            
            
            1.7
            %
            
            
            1.0
            %
            
            
            0.9
            %




19
 *Table
            of Contents*




**Product
                  Mix:**Notebook
                  & PDAs
              
              
              12.4
              %
              
              
              15.3
              %
              
              
              14.7
              %Desktops
                  & Servers
              
              
              20.3
              
              
              
              20.1
              
              
              
              21.3Software
              
              
              17.7
              
              
              
              15.9
              
              
              
              16.8Storage
              
              
              9.1
              
              
              
              9.1
              
              
              
              8.7NetComm
              
              
              4.9
              
              
              
              4.2
              
              
              
              4.4Printers
              
              
              8.2
              
              
              
              11.3
              
              
              
              9.6Monitors
                  & Video
              
              
              10.4
              
              
              
              9.6
              
              
              
              10.3Memory
                  & Processors
              
              
              6.2
              
              
              
              5.4
              
              
              
              5.0Accessories
                  & Other
              
              
              10.8
              
              
              
              9.1
              
              
              
              9.2Total
              
              
              100.0
              %
              
              
              100.0
              %
              
              
              100.0
              %




*Comparison
      of Years Ended December 31, 2006 and 2005*





*Net
      Sales.*Consolidated net sales increased 1.8% to $577.0 million
      in 2006 compared to $566.6 million in 2005.  Consolidated outbound
      sales to commercial and public sector accounts increased 3.4% to $565.3 million
      in 2006 from $547.0 million in 2005.  Sales to the Company’s SMB
      customers increased 18.1% to $222.1 million in 2006, compared to $188.2 million
      in 2005. The Company’s 2007 SMB growth initiatives will focus on small 50-to-100
      seat customers, as well as assisting AEs to reach their expected productivity
      levels as tenure increases.  Sales to the Company’s enterprise
      customers decreased 4.0% to $301.8 million for the year ended December 31,
      2006,
      compared to $314.5 million in 2005.  During 2005, one customer
      represented $48.5 million of enterprise net sales related to a specific one-time
      product roll-out during the second half of the year.  The Company’s
      2007 enterprise customer sales initiative includes the formation of a field
      sales force to supplement the outbound call center sales force.  Net
      sales to public sector customers decreased 5.9% to $39.2 million in 2006 from
      $41.6 million in 2005.  Inbound sales to the Company’s legacy
      Mac-platform consumer and small office/home office (“SOHO”) customers declined
      37.3% to $14.0 million, or 2.4% of net sales.





*Gross
      Profit.* Consolidated gross profit increased to $71.5 million in 2006
      compared to $60.6 million in 2005.  Gross profit as a percentage of
      net sales increased to 12.4% in 2006, compared to 10.7% in 2005.  The
      change is due to an increase in the gross profit earned on total net sales
      as
      compared to 2005, and an increase in the amount of vendor programs recorded
      in
      2006.  Gross profit margins as a percent of sales will continue to
      vary due to changes in vendor programs, product and customer mix, pricing
      strategies and economic conditions. The Company expects its gross profit margin
      to decline in 2007 from historical levels due to the Company’s field sales
      initiative and expected sales increases to existing large customers as large
      enterprise customers tend to record lower gross profit sales.  The
      Company categorizes its warehousing and distribution network costs in selling,
      general and administrative expenses.  Due to this classification, the
      Company’s gross profit may not be comparable to that of other companies that
      categorize warehousing and distribution network costs as a cost of
      sales.





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





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


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


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


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


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





For
      the
      periods ending December 31, 2006 and 2005, warehousing and distribution network
      costs totaled $2.1 million and $2.2 million, respectively.  With
      regard to 2007, the Company’s initiative to create a field sales force will
      increase the Company’s SG&A expenses and it is anticipated that the existing
      operations will subsidize this investment until it reaches breakeven by the
      end
      of the year.





20
 *Table
            of Contents*





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


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


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





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





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





*Income
      Tax Provision.*  The income tax provision for 2006 was $5.9
      million, compared to $3.8 million during 2005.  The effective tax
      rates expressed as a percent of income were 38.1% and 38.4% for the years ended
      December 31, 2006 and 2005, respectively.





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





*Comparison
      of Years Ended December 31, 2005 and 2004*





*Net
      Sales.*Consolidated net sales increased 14.3% to $566.6 million
      in 2005 compared to $495.6 million in 2004.  The increase in sales
      resulted primarily from an increase in sales to its outbound customers.
      Consolidated outbound sales to commercial and public sector accounts increased
      21.1% to $547.0 million in 2005 from $451.7 million in 2004, and they now
      represent 96.5% of the Company’s total net sales.  Sales to the
      Company’s SMB customers increased 13.1% to $188.2 million in 2005, compared to
      $168.9 million in 2004.  Sales to the Company’s enterprise customers
      increased 29.3% to $314.5 million for the year ended December 31, 2005, compared
      to $243.2 million in 2004.  One customer represented $48.5 million of
      enterprise net sales related to a specific one-time product roll-out which
      occurred during the second half of 2005.  Net sales to public sector
      customers increased 4.9% to $41.6 million in 2005 from $39.7 million in
      2004.  Inbound sales to the Company’s legacy Mac-platform consumer and
      small office/home office (“SOHO”) customers declined 55.4% to $22.3 million, or
      3.9% of net sales.  This decline was anticipated as the Company’s
      focus is on outbound sales customers who respond to the relationship-based
      selling model.





*Gross
      Profit.* Consolidated gross profit increased to $60.6 million in 2005
      compared to $57.1 million in 2004 primarily due to increased sales
      volume.  Gross profit as a percentage of net sales decreased to 10.7%
      in 2005, compared to 11.5% in 2004, due primarily to strategic cost concessions
      to a customer in support of significant sales in the second half of
      2005.  Gross profit margins as a percent of sales will continue to
      vary due to changes in vendor programs, product mix, pricing strategies,
      customer mix and economic conditions. The Company categorizes its warehousing
      and distribution network costs in selling, general and administrative
      expenses.  Due to this classification, the Company’s gross profit may
      not be comparable to that of other companies that categorize warehousing and
      distribution network costs as a cost of sales.





*Selling,
      General and Administrative Expenses*. SG&A expenses increased 3.2% to
      $43.6 million for 2005 from $42.3 million in 2004, and declined as a percentage
      of net sales to 7.7% in 2005, compared to 8.5% in 2004.  The increase
      in SG&A expenses was impacted by the Company’s increase in sales volume, as
      well as the following:





·
            Salaries,
                wages and benefits increased $1.0 million during 2005 as compared
                to the
                prior year.  The increase was primarily due to increased
                incentive programs and commissions paid as a result of the increased
                sales
                volume.


·
            The
                Company’s state tax expense increased $437,000 in 2005 as compared to the
                prior year.  This primarily relates to increased sales to
                customers in Washington State, a state in which Business and Occupation
                tax (an excise tax based on gross receipts) is
                remitted.


·
            The
                Company’s professional fees increased $434,000 during
                2005.  This is primarily due to an increase in consulting fees
                associated with its outsourcing arrangement in
                India.


·
            Depreciation
                expense declined $456,000 for the year ended December 31, 2005 as
                compared
                to 2004.  This decline was primarily due to the Company’s
                decision to make enhancements to its fully depreciated enterprise
                systems
                rather than purchasing a new
                product.


·
            Credit
                card processing fees during 2005 declined $257,000 as compared to
                2004.  This decline is due to the Company’s increase in outbound
                sales, which tend to purchase on open account versus credit
                card.





21
 *Table
            of Contents*





For
      the
      periods ending December 31, 2005 and 2004, warehousing and distribution network
      costs totaled $2.2 million and $1.9 million, respectively.





*Advertising
      Expenses, Net*.  The Company produces and distributes catalogs at
      various intervals throughout the year, and also engages in other activities,
      to
      increase the awareness of its brand and stimulate demand
      response.  The Company’s net cost of advertising decreased to $6.6
      million in 2005 from $7.1 million in 2004.


·
            Gross
                advertising expense decreased to $7.0 million for fiscal year 2005
                compared to $7.6 million in fiscal year 2004.  The decline was
                primarily due to a reduction in circulation of the Company’s
                catalogs.  During 2005, the Company produced and distributed 5.0
                million catalogs, compared to 7.7 million in
                2004.


·
            The
                Company’s gross advertising reimbursements also decreased to $429,000 in
                2005 from $564,000 in 2004.





*Interest
      Expense.*Interest expense was $594,000 in 2005, compared to
      $404,000 in 2004.  The Company’s use of its line of credit to fund the
      expansion of accounts receivable and inventory incurred interest expense of
      $480,000 and $305,000 for the periods ended December 31, 2005 and 2004,
      respectively.  The interest rate on the working capital line is tied
      to the Prime Rate.  The Prime Rate increased to 7.0% at December 31,
      2005, compared to 5.0% at December 31, 2004.  The remaining expense
      was due to interest owed on the outstanding note payable to the former
      shareholders of CPCS.





*Other
      Income.*  Other income was $91,000 in 2005, compared to $90,000 in
      2004.





*Income
      Tax Provision.*  The income tax provision for 2005 was $3.8
      million, compared to $2.8 million during 2004.  The effective tax
      rates expressed as a percent of income were 38.4% and 37.6% for the years ended
      December 31, 2005 and 2004, respectively.





*Net
      Income.* Net income for fiscal year 2005 was $6.1 million, or $0.42 per
      diluted share, as compared to net income of $4.7 million, or $0.32 per diluted
      share, for fiscal year 2004.





**Inflation**


The
      Company does not believe that inflation has had a material impact on its results
      of operations.  However, there can be no assurance that inflation will
      not have such an effect in future periods.





**Liquidity
      and Capital Resources**


*Working
      Capital.*


The
      Company’s total assets were $120.7 million at December 31, 2006, of which $111.4
      million were current assets.  At December 31, 2006 and 2005, the
      Company had cash and cash equivalents of $9.2 million and $3.2 million,
      respectively, and had working capital of $41.7 million and $33.4 million,
      respectively. The increase in working capital was primarily a result of the
      Company’s operating results which led to decreases in the Company’s usage of its
      line of credit, and the repayment of outstanding notes payable which reduced
      its
      current liabilities.





*Stock
      Repurchase Program.*


Since
      2004, the Company has repurchased a total of 1,441,240 shares of its common
      stock at a total cost of $7.2 million under its repurchase program
      authorized by its Board of Directors.  Share repurchases may be made
      from time to time in both open market and private transactions, as conditions
      warrant, at then prevailing market prices. The following table represents share
      repurchases for the years ended December 31, 2006, 2005 and 2004 (dollars
      in thousands):





22
 *Table
            of Contents*





**Period**
            
            **Total
                  number of shares purchased**
            
            
            **Amount
                  paid**2006
            
            
            568,400
            
            
            $
            3,9882005
            
            
            424,450
            
            
            $
            1,8122004
            
            
            448,390
            
            
            $
            1,348




As
      of
      December 31, 2006, $979,000 in shares of the Company’s common stock
      remained available for repurchase under the program.  In February
      2007, the Board of Directors authorized a continuation of the Company’s share
      repurchase program, pursuant to which the Company increased the total amount
      authorized.  As of February 2007, $3.0 million in shares of the
      Company’s common stock is available for repurchase under the program. The
      current repurchase program is expected to remain in effect through
      February 2008, unless earlier terminated by the Board or
      completed.




Approximately
      92% of the Company’s sales are processed on open account terms offered to its
      customers, which increases the Company’s accounts receivable
      balance.  To finance these sales, the Company leverages its secured
      line of credit for timing differences in cash inflows and cash outflows to
      invest in the growth of its business.  The secured line of credit is
      utilized from time to time to invest in capital purchases, to purchase inventory
      for general stock as well as for certain customers, and to take full advantage
      of available early pay discounts.




At
      December 31, 2006, the Company had $40.0 million available under a secured
      line
      of credit with a major financial institution.  The credit facility is
      collateralized by accounts receivable and inventory, and it can be utilized
      as
      both a working capital line of credit and a flooring facility used to purchase
      inventory from several suppliers under certain terms and conditions.  This
      credit facility has an annual automatic renewal which occurs on November 26
      of
      each fiscal year. Either party can terminate this agreement with 60-days written
      notice prior to the renewal date.  The working capital and inventory
      advances bear interest at a rate of Prime + 0.50%.  The Company’s line
      of credit is defined by quick turnover, large amounts under the flooring
      facility, and short maturities. All amounts owed under the Company’s line of
      credit are due on demand.  Inventory advances do not bear interest if
      paid within terms, usually 30 days from advance date.  The facility
      contains various restrictive covenants relating to tangible net worth, leverage,
      dispositions and use of collateral, other asset dispositions, and merger and
      consolidation of the Company.  At December 31, 2006, the Company was
      compliant with all covenants of this facility.  At December 31, 2006,
      there were no amounts owed for working capital advances, and $14.4 million
      was
      owed to this financial institution for flooring arrangements related to
      inventory purchases.




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





*Cash
      Flows.*


The
      primary factors that affected fiscal year 2006 cash flow from operations were
      account and vendor receivables, inventories, and the increase in accrued
      liabilities and deferred rent.  Account and vendor receivables
      decreased $4.8 million due to aggressive collection
      efforts.  Inventory increased by $1.6 million.  The change
      in the inventory balance is due to the Company’s purchasing
      cycles.  Accrued liabilities and deferred rent increased $4.3
      million.  This increase was primarily due to accrued incentive
      compensation.





Net
      cash
      used in investing activities was $1.8 million for the year ended December 31,
      2006.  Cash outlays for capital expenditures were $1.8 million for the
      years ended December 31, 2006 and 2005.  Capital expenditures were
      primarily for leasehold improvements for the Company’s corporate headquarters
      and continued improvement, and other enhancements, of the Company’s information
      systems.  The Company intends to continue to upgrade its internal
      information systems as a means to increase operational
      efficiencies.





The
      most
      significant components of the Company’s financing activities are the
      purchase of the Company’s common stock under its share repurchase
      program, net change in the Company’s secured line of credit, net change in
      the use of inventory financing and net change in book overdraft.  For
      the year ended December 31, 2006, the Company repurchased $4.0 million of its
      common stock under its share repurchase program.  Net changes in the
      Company’s line of credit and book overdraft were a decrease of $10.7 million and
      $2.9 million, respectively.  The net change in the Company’s inventory
      financing was an increase of $5.9 million due to purchasing and payment
      cycles.  The Company’s financing activities for the year ended
      December 31, 2006 also included the payment of an amount due on the note payable
      issued in its acquisition of CPCS.  The Company paid the final payment
      during the second quarter of 2006.  For the years ended December 31,
      2006 and 2005, the Company paid the former shareholders of CPCS $1.3 million
      each year.





23
 *Table
            of Contents*





**Contractual
      Obligations**


The
      following table summarizes our contractual payment obligations and commitments
      as of December 31, 2006:





**Payments
                Due by Period**Total
            
            
            Less
                  than 1 year
            
            
            1-3
                  years
            
            
            3-5
                  years
            
            
            More
                  than 5 yearsOperating
                Leases (a)
            
            $
            16,665
            
            
            $
            2,236
            
            
            $
            4,480
            
            
            $
            3,870
            
            
            $
            6,079Purchase
                Obligations (b)
            
            
            9,508
            
            
            
            9,508Total
            
            $
            26,173
            
            
            $
            11,744
            
            
            $
            4,480
            
            
            $
            3,870
            
            
            $
            6,079




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


(b)
            Purchase
                obligations represents the amount of open purchase orders the Company
                has
                outstanding with its vendors.  These obligations may be canceled
                prior to shipment at the Company’s
                discretion.





**Other
      Matters**


*New
      Accounting Pronouncements.*


In
      September 2006, the FASB issued SFAS No. 157 (SFAS 157), *Fair Value
      Measurements*. SFAS 157 defines fair value, establishes a framework for
      measuring fair value and expands disclosures about fair-value measurements
      required under other accounting pronouncements, but does not change existing
      guidance as to whether or not an instrument is carried at fair value. SFAS
      157
      is effective for the Company’s fiscal year 2008. The Company is currently
      evaluating the impact of adopting SFAS 157.





In
      September 2006, the SEC released Staff Accounting Bulletin 108 (SAB 108),
*Considering the Effects of Prior Year Misstatements when Quantifying
      Misstatements in Current Year Financial Statements*. The intent of
      SAB 108 is to reduce diversity in practice for the method companies use to
      quantify financial statement misstatements, including the effect of prior year
      uncorrected errors. SAB 108 establishes an approach that requires
      quantification of financial statement errors using both an income statement
      and
      a cumulative balance sheet approach. SAB 108 is effective for fiscal years
      beginning after November 15, 2006, and the Company will adopt the new
      requirements on January 1, 2007. The Company does not believe that the adoption
      of SAB 108 will have a significant effect on its financial
      statements.





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





In
      June
      2006, the FASB ratified the consensus reached on Emerging Issues Task Force
      (EITF) Issue No. 06-03, “*How Sales Taxes Collected from Customers and
      Remitted to Governmental Authorities Should Be Presented in the Income Statement
      (that is, Gross Versus Net Presentation).”*The EITF reached a consensus
      that the presentation of taxes on either a gross or net basis is an accounting
      policy decision that requires disclosure. EITF 06-03 is effective for the first
      interim or annual reporting period beginning after December 15, 2006.
      Amounts collected from members, which under common trade practices are referred
      to as sales taxes, are and have been recorded on a net basis. The Company has
      no
      intention of modifying this accounting policy. Therefore, the adoption of EITF
      06-03 will not have any effect on the Company’s financial
      statements.





**Item
      7A.  Quantitative and Qualitative Disclosures About
      Market Risk**


The
      Company is subject to the risk of fluctuating interest rates in the normal
      course of business, primarily as a result of its short-term borrowing and
      investment activities, which generally bear interest at variable rates. The
      Company invests cash balances in excess of operating requirements in short-term
      securities, generally with maturities of 90 days or less. In addition, the
      Company's unsecured credit agreement provides for borrowings which bear interest
      at variable rates based on the prime rate. The Company had no interest-bearing
      borrowings outstanding pursuant to the credit agreement as of December 31,
      2006.
      The Company believes that the effect, if any, of reasonably possible near-term
      changes in interest rates on the Company's financial position, results of
      operations and cash flows should not be material.





24
 *Table
            of Contents*





**Item
      8.    Financial Statements and
      Supplementary Data**


The
      information required by this item is included in this report beginning at page
      29.





**Item
      9.     Changes in and Disagreements
      with Accountants on Accounting and Financial
      Disclosure**


None.





**Item
      9A. Control and Procedures**


At
      the
      end of the period covered by this report, the Company carried out an evaluation,
      under the supervision and with the participation of the Company's management,
      including the Company’s Chief Executive Officer and Chief Financial Officer, of
      the Company’s disclosure controls and procedures pursuant to Exchange Act Rule
      13 a-15(e). Based upon that evaluation, the Chief Executive Officer and Chief
      Financial Officer concluded that the Company’s disclosure controls and
      procedures are effective.





During
      the fourth quarter of 2006, there were no changes in the Company’s internal
      control over financial reporting that have materially affected, or are
      reasonable likely to materially affect, the Company’s internal control over
      financial reporting.





**Item
      9B. Other Information**


None.





**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 the Company’s 2007 Annual Meeting of Shareholder
      under the caption “Proposal No. 1: Election of Directors,” and “Section 16(a)
      Beneficial Ownership Reporting Compliance.”  See also the information
      concerning executive officers of the Company included in Item 4A of Part I
      in
      this Report.





The
      Board
      of Directors has determined that John Bauer qualifies as an “audit committee
      financial expert” as such term is defined by the SEC and that Mr. Bauer meets
      the independence criteria set forth in the applicable rules of Nasdaq and the
      SEC for Audit Committee Membership.




The
      Company’s Code of Business Conduct and Ethics has been approved by its Board of
      Directors and applies to all of its team members and directors, including its
      principal executive officer, principal financial officer and principal
      accounting officer. The Company’s Code of Business Conduct and Ethics covers all
      areas of professional conduct including, but not limited to, conflicts of
      interest, disclosure obligations, insider trading, confidential information,
      as
      well as compliance with all laws, rules and regulations applicable to its
      business.




A
      copy of
      the Company’s Code of Business Conduct and Ethics is available at its website at
www.zones.com/IR.
      In the event that an amendment to, or a waiver from, a provision of the
      Company’s Code of Business Conduct and Ethics that applies to any of its
      officers or directors is necessary, the Company intends to post such information
      on its website at www.zones.com/IR.




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





**Item
      11.  Executive
      Compensation**


The
      information required by this item is contained in, and incorporated by reference
      from, the Proxy Statement for the Company’s 2007 Annual Meeting of Shareholders
      under the caption “Executive Compensation.”





25
 *Table
            of Contents*





**Item
      12.  Security Ownership of Certain Beneficial Owners
      and Management and Related Stockholder Matters**


The
      information required by this item is contained in, and incorporated by reference
      from, the Proxy Statement for the Company’s 2007 Annual Meeting of Shareholders
      under the caption “Stock Ownership of Management and Certain Other
      Holders.”





**Item
      13.  Certain Relationships and Related Transactions,
      and Director Independence**


The
      information required by this item is contained in, and incorporated by reference
      from, the Proxy Statement for the Company’s 2007 Annual Meeting of Shareholders
      under the caption “Certain Relationships and Related Transactions.”





**Item
      14.  Principal Accountant Fees and
      Services**


The
      information required by this item is contained in, and incorporated by reference
      from, the Proxy Statement for the Company’s 2007 Annual Meeting of Shareholders
      under the caption “Principal Accounting Firm Fees.”





26
 *Table
            of Contents*





**Part
      IV**





**Item
      15.  Exhibits and Financial Statement
      Schedules**




(a)
            1.  Financial
                Statements:


The
      financial statements of Zones, Inc. and the Report of Independent Registered
      Public Accounting Firm is included herein beginning on page 29.





2.  Financial
      Statement
      Schedules:





See
      Schedule II, Valuation and Qualifying Accounts





3.  Exhibits:





Exhibit
                No.
            Description
            Filed
                Herewith
            Incorporated
                by ReferenceForm
            Exhibit
                No.
            File
                No.
            Filing
                Date3.1
            Restated
                Articles of Incorporation of Multiple Zones International,
                Inc.
            
            S-1
            3.1
            333-04458
            6/5/963.2
            Articles
                of Amendment of Multiple Zones, Inc.
            
            S-8
            4.2
            333-110750
            11/25/033.3
            Amended
                and Restated Bylaws of Multiple Zones International, Inc.
            
            10-K
            3.1
            000-28488
            3/4/054.1
            Form
                of Common Stock Certificate of Zones, Inc.10.1
            Multiple
                Zones International, Inc. Amended and Restated 1993 Stock Incentive
                Plan*
            
            10-K
            10.1
            000-28488
            3/4/0510.2
            Multiple
                Zones International, Inc. Amended and 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 dated April 11, 2003 between
                Zones, Inc., Corporate PC Source, Inc. and Transamerica Commercial
                Finance
                Corporation
            
            10-Q
            10.1
            000-28488
            8/14/0310.12
            Zones,
                Inc. 2003 Equity Incentive Plan*
            
            14-A
            
            000-28488
            3/20/0310.13
            Stock
                Purchase Agreement, dated March 31, 2003, by and among Zones, Inc.
                and
                Corporate PC Source, Inc. and Christina Corley, Robert Frauenheim,
                individually and as Trustee of the Robert Frauenheim Declaration
                of Trust
                dated September 17, 1997, and Daniel Frauenheim.
            
            8-K
            2.1
            000-28488
            4/3/0310.14
            Office
                lease dated June 9, 2003 between Zones, Inc and Fana Auburn
                LLC
            
            10-Q
            10.2
            000-28488
            8/14/0310.15
            Form
                of Stock Option Agreement (used for grants under the 2003 Stock Equity
                Plan)*
            
            10-K
            10.25
            000-28488
            2/26/0410.16
            Commercial
                Lease Agreement dated March 19, 2004 between Corporate PC Source
                and AMB
                Property II, L.P.
            
            10-Q
            10.4
            000-28488
            5/13/04




27
 *Table
            of Contents*





10.17
            Amendment
                No. 2 to Amended and Restated Loan and Security Agreement dated January
                9,
                2004 between Zones Inc. and its subsidiaries, and Transamerica Commercial
                Finance Corporation
            
            10-Q
            10.5
            000-28488
            5/13/0410.18
            Subordination,
                Non-disturbance, and Attornment Agreement dated June 22, 2004 between
                US
                Bank National Association, Zones, Inc. and Fana Auburn LLC
            
            10-Q
            10.1
            000-28488
            8/11/0410.19
            Interest
                Termination and Settlement Agreement, dated September 27, 2004, by
                and
                among Zones, Inc. and Christina Corley, Robert Frauenheim, individually
                and as Trustee of the Robert Frauenheim Declarations of Trust dated
                September 17, 1997, and Daniel Frauenheim
            
            8-K
            10.1
            000-28488
            9/29/0410.20
            Form
                of Unsecured, Subordinated Promissory Note
            
            8-K
            10.2
            000-28488
            9/29/0410.21
            Summary
                of Zones, Inc. Board Meeting Fees and Basic Compensation
            
            10-Q
            10.1
            000-28488
            8/10/0510.22
            Notice
                of Grant of Director Stock Option pursuant to the Zones, Inc 2003
                Equity
                Incentive Plan
            
            10-Q
            10.2
            000-28488
            8/10/0510.23
            Office
                Lease dated September 2005 between Zones, Inc. and the Trustees Under
                the
                Will and of the Estate of James Campbell, Deceased
            
            10-Q
            10.1
            000-28488
            11/9/0510.24
            Office
                Lease dated December 2005 between Zones, Inc. and Montgomery Park
                I,
                LLC
            
            10-K
            10.28
            000-28488
            2/24/0610.25
            Amendment
                to Office Lease between Zones, Inc and Fana Auburn LLC
            
            10-Q
            10.1
            000-28488
            5/12/0610.26
            Summary
                of the Zones, Inc. Senior Management Bonus Program*
            
            8-K
            99.2
            000-28488
            2/12/0710.27
            Summary
                of the Zones, Inc. Executive Vice President Bonus Program*
            
            8-K
            99.1
            000-28488
            2/12/0721.1
            Subsidiaries
                of the Registrant
            X23.1
            Consent
                of Grant Thornton LLP, Independent Registered Public Accounting
                Firm
            X23.2
            Consent
                of PricewaterhouseCoopers LLP, Independent Registered Public Accounting
                Firm
            X31.1
            Certification
                of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley
                Act of 2002 and the regulations promulgated thereunder
            X31.2
            Certification
                of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley
                Act of 2002 and the regulations promulgated thereunder
            X32.1
            Certification
                of Chief Executive 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




28
 *Table
            of Contents*





**SIGNATURES**





Pursuant
      to the requirements of Section 13 or 15(d) of the Securities Exchange Act of
      1934, the registrant has duly caused this report to be signed on its behalf
      by
      the undersigned, thereunto duly authorized.





ZONES,
      INC.





Date:  November
      13, 2007


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
            
            November
                13, 2007John
                H. BauerLARRY
                  BENAROYA
            
            Director
            
            November
                13, 2007Larry
                Benaroya/S/     CATHI
                  HATCH*
            
            Director
            
            November
                13, 2007Cathi
                Hatch/S/     WILLIAM
                  C. KEIPER*
            
            Director
            
            November
                13, 2007William
                C. Keiper/S/     KENNETH
                  M. KIRKPATRICK*
            
            Director
            
            November
                13, 2007Kenneth
                M. Kirkpatrick/S/     FIROZ
                  H. LALJI
            
            Director
            
            November
                13, 2007Firoz
                H. Lalji





*
      Ronald
      P. McFadden, as attorney-in-fact





29
 *Table
            of Contents*





**ZONES,
      INC.**


**INDEX
      TO CONSOLIDATED FINANCIAL STATEMENTS**





Consolidated
                Financial Statements:Consolidated
                Balance SheetsDecember
                31, 2006 and 2005
            30Consolidated
                Statements of OperationsTwelve
                months ended December 31, 2006, 2005 and 2004
            31Consolidated
                Statement of Shareholders’ EquityTwelve
                months ended December 31, 2006, 2005 and 2004
            32Consolidated
                Statements of Cash FlowsTwelve
                months ended December 31, 2006, 2005 and 2004
            33Notes
                to Consolidated Financial Statements
            34Report
                of Grant Thornton LLP, Independent Registered Public Accounting
                Firm
            48Report
                of PricewaterhouseCoopers LLP, Independent Registered Public Accounting
                Firm
            49Schedule
                II – Valuation and Qualifying Accounts
            50




30
 *Table
            of Contents*





**ZONES,
      INC.**


**CONSOLIDATED
      BALANCE SHEETS**


**(in
      thousands, except share data)**





**December
                31,****2006**
            
            
            **2005****ASSETS**Current
                assets:Cash
                and cash equivalents
            
            $
            9,191
            
            
            $
            3,195Receivables,
                net of allowances of $1,936 and $1,562 at December 31, 2006 and 2005,
                respectively
            
            
            65,699
            
            
            
            68,318Vendor
                receivables
            
            
            12,556
            
            
            
            14,750Inventories
            
            
            21,385
            
            
            
            19,736Prepaid
                expenses
            
            
            1,076
            
            
            
            922Deferred
                income taxes
            
            
            1,473
            
            
            
            1,346Total
                current assets
            
            
            111,380
            
            
            
            108,267Property
                and equipment, net
            
            
            3,771
            
            
            
            3,810Goodwill
            
            
            5,098
            
            
            
            5,098Deferred
                income taxes
            
            
            251Other
                assets
            
            
            195
            
            
            
            179Total
                assets
            
            $
            120,695
            
            
            $
            117,354**LIABILITIES
                AND SHAREHOLDERS' EQUITY**Current
                liabilities:Accounts
                payable
            
            $
            42,592
            
            
            $
            45,359Inventory
                financing (Note 5)
            
            
            14,385
            
            
            
            8,469Accrued
                liabilities
            
            
            12,728
            
            
            
            9,069Line
                of credit
            
            
            
            
            
            
            10,700Notes
                payable to former shareholders of CPCS, Inc.
            
            
            
            
            
            
            1,272Total
                current liabilities
            
            
            69,705
            
            
            
            74,869Note
                payable for purchase of fixed asset
            
            
            6
            
            
            
            21Deferred
                income taxes
            
            
            
            
            
            
            35Deferred
                rent obligation
            
            
            1,502
            
            
            
            1,112Total
                liabilities
            
            
            71,213
            
            
            
            76,037Commitments
                and contingencies (Note 8)Shareholders'
                equity:Common
                stock, no par value, 45,000,000 authorized; 13,157,719 and 13,265,049
                shares issued and outstanding at December 31, 2006 and 2005,
                respectively
            
            
            35,983
            
            
            
            37,503Retained
                earnings
            
            
            13,499
            
            
            
            3,814Total
                shareholders' equity
            
            
            49,482
            
            
            
            41,317Total
                liabilities and shareholders' equity
            
            $
            120,695
            
            
            $
            117,354





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





31
 *Table
            of Contents*





**ZONES,
      INC.**


**CONSOLIDATED
      STATEMENTS OF OPERATIONS**


**(in
      thousands, except per share data)'**




**Year
                    ended December 31,****2006**
              
              
              **2005**
              
              
              **2004**Net
                  sales
              
              $
              577,027
              
              
              $
              566,553
              
              
              $
              495,563Cost
                  of sales
              
              
              505,508
              
              
              
              505,997
              
              
              
              438,426Gross
                  profit
              
              
              71,519
              
              
              
              60,556
              
              
              
              57,137Selling,
                  general and administrative expenses
              
              
              48,434
              
              
              
              43,618
              
              
              
              42,284Advertising
                  expense
              
              
              7,159
              
              
              
              6,618
              
              
              
              7,082Income
                  from operations
              
              
              15,926
              
              
              
              10,320
              
              
              
              7,771Interest
                  expense
              
              
              419
              
              
              
              594
              
              
              
              404Other
                  income
              
              
              (149
              )
              
              
              (91
              )
              
              
              (90
              )Other  expense,
                  net
              
              
              270
              
              
              
              503
              
              
              
              314Income  before
                  income taxes
              
              
              15,656
              
              
              
              9,817
              
              
              
              7,457Provision
                  for income taxes
              
              
              5,971
              
              
              
              3,766
              
              
              
              2,805Net
                  income
              
              $
              9,685
              
              
              $
              6,051
              
              
              $
              4,652Basic
                  income per share
              
              $
              0.73
              
              
              $
              0.45
              
              
              $
              0.34Weighted
                  average shares used in computing basic income per share
              
              
              13,195
              
              
              
              13,382
              
              
              
              13,549Diluted
                  income per share
              
              $
              0.66
              
              
              $
              0.42
              
              
              $
              0.32Weighted
                  average shares used in computing diluted income per share
              
              
              14,756
              
              
              
              14,527
              
              
              
              14,469





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





32
 *Table
            of Contents*





**ZONES,
      INC.**


**CONSOLIDATED
      STATEMENT OF SHAREHOLDERS' EQUITY**


**(in
      thousands, except share data)**





Common
                Stock
            
            
            Retained
                EarningsShares
            
            
            Amount
            
            
            (Deficit)
            
            
            TotalBalance,
                January 1, 2004
            
            
            13,659,371
            
            
            $
            39,590
            
            
            $
            (6,889
            )
            
            $
            32,701Purchase
                and retirement of common stock
            
            
            (448,390
            )
            
            
            (1,348
            )
            
            
            
            
            
            
            (1,348
            )Exercise
                of stock options
            
            
            296,746
            
            
            
            453
            
            
            
            
            
            
            
            453Tax
                effect of stock options exercised
            
            
            
            
            
            
            93
            
            
            
            
            
            
            
            93Net
                income
            
            
            
            
            
            
            
            
            
            
            4,652
            
            
            
            4,652Balance,
                December 31, 2004
            
            
            13,507,727
            
            
            
            38,788
            
            
            
            (2,237
            )
            
            
            36,551Purchase
                and retirement of common stock
            
            
            (424,450
            )
            
            
            (1,813
            )
            
            
            
            
            
            
            (1,813
            )Exercise
                of stock options
            
            
            181,772
            
            
            
            316
            
            
            
            
            
            
            
            316Tax
                effect of stock options exercised
            
            
            
            
            
            
            212
            
            
            
            
            
            
            
            212Net
                income
            
            
            
            
            
            
            
            
            
            
            6,051
            
            
            
            6,051Balance,
                December 31, 2005
            
            
            13,265,049
            
            
            
            37,503
            
            
            
            3,814
            
            
            
            41,317Purchase
                and retirement of common stock
            
            
            (568,400
            )
            
            
            (3,988
            )
            
            
            
            
            
            
            (3,988
            )Exercise
                of stock options
            
            
            461,070
            
            
            
            1,412
            
            
            
            
            
            
            
            1,412Excess
                tax benefit from stock options exercised
            
            
            
            
            
            
            651
            
            
            
            
            
            
            
            651Stock-based
                compensation
            
            
            
            
            
            
            405
            
            
            
            
            
            
            
            405Net
                income
            
            
            
            
            
            
            
            
            
            
            9,685
            
            
            
            9,685Balance,
                December 31, 2006
            
            
            13,157,719
            
            
            $
            35,983
            
            
            $
            13,499
            
            
            $
            49,482





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





33
 *Table
            of Contents*





**ZONES,
      INC.**


**CONSOLIDATED
      STATEMENTS OF CASH FLOWS**


**(in
      thousands)**





**Year ended
                December 31,****2006**
            
            
            **2005**
            
            
            **2004**(as
                restated, see note 15)Cash
                flows from operating activities:Net
                income
            
            $
            9,685
            
            
            $
            6,051
            
            
            $
            4,652Adjustments
                to reconcile net income to netcash
                provided by (used in) operating activities:Depreciation
            
            
            1,831
            
            
            
            1,966
            
            
            
            2,468Non-cash
                stock-based compensation
            
            
            405Excess
                tax benefit from exercise of stock options
            
            
            (651
            )Deferred
                tax asset
            
            
            (413
            )
            
            
            2,854
            
            
            
            2,272Tax
                effect of stock option exercise
            
            
            
            
            
            
            212
            
            
            
            93(Increase)
                decrease in assets and liabilities:Receivables,
                net
            
            
            4,813
            
            
            
            (19,130
            )
            
            
            (3,973
            )Inventories
            
            
            (1,649
            )
            
            
            (2,330
            )
            
            
            (5,918
            )Prepaid
                expenses and other assets
            
            
            (171
            )
            
            
            29
            
            
            
            138Accounts
                payable
            
            
            128
            
            
            
            3,133
            
            
            
            6,618Income
                taxes payable
            
            
            353
            
            
            
            107Accrued
                liabilities and deferred rent
            
            
            4,347
            
            
            
            1,717
            
            
            
            (206
            )Net
                cash provided by (used in)  operating activities
            
            
            18,678
            
            
            
            (5,391
            )
            
            
            6,144Cash
                flows from investing activities:Purchases
                of property and equipment
            
            
            (1,792
            )
            
            
            (1,826
            )
            
            
            (2,029
            )Net
                cash used in investing activities
            
            
            (1,792
            )
            
            
            (1,826
            )
            
            
            (2,029
            )Cash
                flows from financing activities:Net
                change in book overdrafts
            
            
            (2,894
            )
            
            
            7,975
            
            
            
            1,112Net
                change in line of credit
            
            
            (10,700
            )
            
            
            4,600
            
            
            
            (1,750
            )Net
                change in inventory financing
            
            
            5,916
            
            
            
            (5,837
            )
            
            
            (443
            )Payments
                of note payable
            
            
            (1,287
            )
            
            
            (1,286
            )
            
            
            (862
            )Excess
                tax benefit from exercise of stock options
            
            
            651Purchase
                and retirement of common stock
            
            
            (3,988
            )
            
            
            (1,813
            )
            
            
            (1,348
            )Proceeds
                from exercise of stock options
            
            
            1,412
            
            
            
            316
            
            
            
            453Net
                cash provided by (used in) financing activities
            
            
            (10,890
            )
            
            
            3,955
            
            
            
            (2,838
            )Net
                increase (decrease) in cash and cash equivalents
            
            
            5,996
            
            
            
            (3,262
            )
            
            
            1,277Cash
                and cash equivalents at the beginning of the year
            
            
            3,195
            
            
            
            6,457
            
            
            
            5,180Cash
                and cash equivalents at the end of the year
            
            $
            9,191
            
            
            $
            3,195
            
            
            $
            6,457Supplemental
                cash flow information:Cash
                paid for interest
            
            $
            489
            
            
            $
            554
            
            
            $
            335Cash
                paid for income taxes
            
            $
            6,019
            
            
            $
            594
            
            
            $
            260Noncash
                investing and financing activity:Cancellation
                of note payable for acquisition of CPCS
            
            
            
            
            
            
            
            
            
            $
            1,544Note
                payable replacing earn-out provision of CPCS acquisition
            
            
            
            
            
            
            
            
            
            $
            2,744Non-cash
                reduction to note payable for purchase price adjustment of
                CPCS
            
            
            
            
            
            
            
            
            
            $
            295Note
                payable for fixed asset purchase
            
            
            
            
            
            
            
            
            
            $
            35





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





34
 *Table
            of Contents*





**ZONES,
      INC.**


**NOTES
      TO CONSOLIDATED FINANCIAL STATEMENTS**





**1.  Description
      of Business**





Zones,
      Inc. (the ”Company”) is a single-source direct marketing reseller of name-brand
      information technology products to the small-to-medium-sized business market,
      enterprise accounts and public sector accounts.  The Company sells
      these products through outbound and inbound account executives, catalogs and
      the
      Internet.  The Company offers more than 150,000 products from leading
      manufacturers, including 3Com, Adobe, Apple, Cisco, Epson, HP, IBM, Kingston,
      Lenovo, Microsoft, Sony and Toshiba.





**2.  Summary
      of Significant Accounting Policies**





*Principles
      of
      Consolidation.*


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





*Cash
      and Cash
      Equivalents.*


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





*Concentration
      of Credit
      Risk.*


Cash
      balances subject to credit risk consist of cash balances held in one financial
      institution in the United States.  The Company has not experienced any
      losses associated with cash balances and believes that there is minimal risk
      associated with the cash balances.  The concentration of credit risk
      with respect to trade receivables is limited due to the Company’s diverse
      customer base.  The Company closely monitors extensions of credit, but
      does not require collateral.  The Company maintains an allowance for
      doubtful accounts based on estimates of future collectibility of its accounts
      receivable.  The Company regularly analyzes its accounts receivable in
      evaluating the adequacy of the allowance for doubtful accounts.  The
      adequacy of the allowance is determined during each reporting period based
      on
      historical collection experience, customer credit worthiness based on published
      information and other known factors.  Accounts receivable are written
      off as bad debt when it is deemed to be uncollectible.





*Inventories.*


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





The
      Company currently buys a significant portion of its products from four
      suppliers.  Purchases from Ingram Micro, Tech Data, Synnex and IBM
      represented 21.4%, 13.9%, 12.6% and 11.4%, respectively, of the Company’s total
      product purchases in 2006.  Purchases from Ingram Micro, Tech Data,
      Synnex and Hewlett-Packard represented 19.1%, 18.2%, 15.7% and 12.5%,
      respectively, of the Company’s total product purchases in
      2005.  Purchases from Ingram Micro, Synnex and Tech Data represented
      22.5%, 12.0% and 10.3%, respectively, of the Company’s total product purchases
      in 2004. No other vendor supplied more than 10.0% of the Company’s total product
      purchases in 2006, 2005 or 2004.  Although there are a limited number
      of manufacturers, the Company believes that other suppliers could provide
      similar products if its relationship with any of these suppliers was
      interrupted.





*Property
      and
      Equipment.*


Property
      and equipment is recorded at cost.  Depreciation is computed based on
      the straight-line method over the estimated useful lives of the related
      assets.  Useful lives for computer hardware and software range from
      two to five years and other property and equipment range from three to 11
      years.  Capital leases are amortized based on the straight-line method
      over the estimated useful lives of the related assets or lease term, whichever
      is shorter (generally three to 11 years).  Expenditures for
      maintenance and repairs are charged to expense as incurred, while additions,
      renewals and betterments are capitalized.  The Company evaluates the
      carrying value of long-lived assets based upon current and anticipated
      undiscounted cash flows, and it recognizes its impairment when it is probable
      that such estimated future cash flows will be less than the asset carrying
      value.  No impairments were identified in 2006, 2005 or
      2004.





35
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Capitalized
      internal software development costs totaled $642,000 and $659,000 for the years
      ended December 31, 2006 and 2005, respectively.





*Income
      Taxes.*


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





*Goodwill.*


In
      accordance with SFAS No. 142, “Goodwill and Other Intangible Assets,” goodwill
      is tested for impairment annually on the purchase date or sooner when events
      indicate that potential impairment exists.  All goodwill relates to
      the purchase of CPCS.





The
      changes in the carrying amount of goodwill for the years ended December 31,
      2006
      and 2005 are as follows:





Balance
                as of January 1, 2005
            
            $
            5,098Impairment
                lossBalance
                as of December 31, 2005
            
            
            5,098Impairment
                lossBalance
                as of December 31, 2006
            
            $
            5,098





*Use
      of Estimates.*


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





*Revenue
      Recognition.*


The
      Company recognizes revenue on product sales when persuasive evidence of an
      arrangement exists, delivery has occurred, prices are fixed or determinable,
      and
      ability to collect is probable.  The Company considers the point of
      delivery of the product to be when the risks and rewards of ownership have
      transferred to the customer.  The Company’s shipping terms dictate
      that the passage of title occurs upon receipt of products by the customer except
      for the last seven calendar days of each fiscal quarter, when all shipments
      are
      insured in the name of the customer. For these seven days, passage of risk
      of
      loss and title occur at the shipping point.





The
      majority of the Company’s net sales relate to physical products. These sales are
      recognized on a gross basis with the selling price to the customer recorded
      as
      net sales and the acquisition cost of the product recorded as cost of sales.
      The
      Company offers limited return rights on its product sales.  At the
      point of sale, the Company provides for an allowance for sales returns, which
      is
      established based on historical experience.  Amounts billed for
      shipping and handling are recorded as revenue.  Pursuant to EITF 99-19
“Reporting Revenue Gross as a Principal versus Net as an Agent,” when the
      Company sets prices, has inventory risk and has credit risk, revenues are
      recorded gross.  Third-party extended warranties, third-party software
      maintenance products and third-party services sold by the Company (for which
      the
      Company is not the primary obligor) are recognized gross in revenues and cost
      of
      sales when the Company sets prices and has inventory risk and credit risk.
      If
      any of those criteria are not present, revenue and cost of sales are recorded
      net. The Company’s warranty sales are generally recorded net.  When
      the sale is recorded, the Company has no further obligation to
      fulfill.  The Company only recognizes revenue when all criteria of
      Staff Accounting Bulletin No. 104 (“SAB 104”), "Revenue Recognition" have been
      met.





36
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*Cost
      of Sales.*


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





*Selling,
      General and Administrative Expenses.*


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





*Advertising
      Expenses.*


The
      Company produces and distributes catalogs at various intervals throughout the
      year, and also engages in other activities, to increase the awareness of its
      brand and stimulate demand response.  The costs to produce and
      distribute individual catalogs, including paper, printing, postage, production
      and design costs, and for other marketing initiatives, such as trade shows,
      direct mail pieces, and customer or vendor events, are capitalized and amortized
      to selling expense during the period in which the catalogs are mailed or the
      event takes place.  Capitalized advertising costs of $298,000 and
      $184,000 were included with prepaid expenses at December 31, 2006 and 2005,
      respectively.  The Company receives cooperative advertising expense
      reimbursements from vendors who support the Company’s marketing and advertising
      activities.  The following table presents the gross amounts that are
      netted together in the Company’s advertising expense line item.





**2006**
            
            
            **2005**
            
            
            **2004**Gross
                advertising expense
            
            $
            8,858
            
            
            $
            7,047
            
            
            $
            7,646Gross
                advertising reimbursements
            
            
            (1,699
            )
            
            
            (429
            )
            
            
            (564
            )Advertising
                expense
            
            $
            7,159
            
            
            $
            6,618
            
            
            $
            7,082








*Other
      Income/Expense.*


Other
      income/expense includes interest income earned on cash and cash equivalents,
      net
      of interest expense.   Interest expense includes fees associated
      with the Company’s working capital line as well as accrued interest associated
      with the notes payable to the former shareholders of CPCS recorded as part
      of
      the acquisition.





*Comprehensive
      Income.*


The
      Company has no differences between net income and comprehensive
      income.





*Stock
      Compensation.*


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





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





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





37
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Total
      stock-based compensation expense recognized in the consolidated statement of
      earnings for the year ended December 31, 2006 was $405,000, before income taxes,
      and did not have a material impact on net income or earnings per share.
  The Company used the criteria in SFAS No. 123R to calculate and
      establish the beginning balance of the additional paid-in capital pool (“APIC
      pool”) related to the tax effects of employee stock-based compensation, and also
      used the criteria to determine the subsequent effect on the APIC pool and
      consolidated statements of cash flows of the tax effects of employee stock-based
      compensation awards that were outstanding upon adoption of SFAS No. 123R.
      The tax benefit for stock options exercised during the year ended December
      31,
      2006 was $651,000.





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





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





**Year
                ended December 31,****2005**
            
            
            **2004**Net
                income – as reported
            
            $
            6,051
            
            
            $
            4,652Less:Total
                compensation cost determined under fair value based method for all
                awards,
                net of tax
            
            
            (808
            )
            
            
            (827
            )Net
                income – pro forma
            
            $
            5,243
            
            
            $
            3,825Basic
                income per share – as reported
            
            $
            0.45
            
            
            $
            0.34Diluted
                income per share – as reported
            
            $
            0.42
            
            
            $
            0.32Basic
                income per share – pro forma
            
            $
            0.39
            
            
            $
            0.28Diluted
                income per share – pro forma
            
            $
            0.36
            
            
            $
            0.26





The
      fair
      value of each option grant is estimated on the date of grant using the
      Black-Scholes option-pricing model with the following weighted-average
      assumptions used for grants in 2005 and 2004, respectively: expected volatility
      of 186% and 183%, risk-free interest rate of 4.05% and 3.43%, and expected
      lives
      of 5 years.





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





There
      were no options granted in the twelve months ended December 31, 2006. The
      current expense for all outstanding options granted prior to January 1,
      2006 has been recognized in the consolidated statement of earnings for the
      twelve months ended December 31, 2006. Forfeitures are estimated and revised,
      if
      necessary, in subsequent periods if actual forfeitures differ from those
      estimates. As of December 31, 2006, there is $245,000 of total unrecognized
      pre-tax compensation expense related to nonvested stock options granted under
      the Company’s stock option plans. This cost is expected to be recognized over a
      weighted-average period of 1.4 years.





*Segment
      Reporting*


In
      2004,
      the Company reported its then subsidiary, CPCS, and its Zones reporting unit
      as
      separate segments.  On April 1, 2005, the Company merged the CPCS
      subsidiary into the Zones reporting unit.  Accordingly, no separate
      segment for this subsidiary currently exists.  The Company is now
      represented by one reportable segment: a single-source, multi-vendor,
      direct-marketing reseller of name-brand information technology products and
      services to small to medium-sized businesses, enterprise accounts and the public
      sector markets.





38
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            of Contents*





A
      summary
      of the Company’s operations by product mix is detailed in Note 13.





*Reclassifications*


Certain
      reclassifications of prior years’ balances have been made to conform to the
      fiscal year 2006 presentation.  Such reclassifications had no effect
      on shareholders’ equity or net income as previously reported.





*Recent
      Accounting Pronouncements*


In
      September 2006, the FASB issued SFAS No. 157 (SFAS 157), *Fair Value
      Measurements*. SFAS 157 defines fair value, establishes a framework for
      measuring fair value and expands disclosures about fair-value measurements
      required under other accounting pronouncements, but does not change existing
      guidance as to whether or not an instrument is carried at fair value. SFAS
      157
      is effective for the Company’s fiscal year 2008. The Company is currently
      evaluating the impact of adopting SFAS 157.





In
      September 2006, the SEC released Staff Accounting Bulletin 108 (SAB 108),
*Considering the Effects of Prior Year Misstatements when Quantifying
      Misstatements in Current Year Financial Statements*. The intent of
      SAB 108 is to reduce diversity in practice for the method companies use to
      quantify financial statement misstatements, including the effect of prior-year
      uncorrected errors. SAB 108 establishes an approach that requires
      quantification of financial statement errors using both an income statement
      and
      a cumulative balance sheet approach. SAB 108 is effective for fiscal years
      beginning after November 15, 2006, and the Company will adopt the new
      requirements on January 1, 2007. The Company does not believe that the adoption
      of SAB 108 will have a significant effect on its financial
      statements.





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





In
      June
      2006, the FASB ratified the consensus reached on Emerging Issues Task Force
      (EITF) Issue No. 06-03, “*How Sales Taxes Collected from Customers and
      Remitted to Governmental Authorities Should Be Presented in the Income Statement
      (that is, Gross Versus Net Presentation).”*The EITF reached a consensus
      that the presentation of taxes on either a gross or net basis is an accounting
      policy decision that requires disclosure. EITF 06-03 is effective for the first
      interim or annual reporting period beginning after December 15, 2006.
      Amounts collected from members, which under common trade practices are referred
      to as sales taxes, are and have been recorded on a net basis. The Company has
      no
      intention of modifying this accounting policy. Therefore, the adoption of EITF
      06-03 will not have any effect on the Company’s financial
      statements.





**3.  Fair
      Value of Financial Instruments**





The
      estimated fair value of the Company’s financial instruments approximates their
      carrying value due to their short-term nature.  The estimated fair
      value of the line of credit approximates the carrying value, as this instrument
      requires interest payments at a market rate of interest plus a margin.




39
 *Table
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**4.  Property
      and Equipment**





Property
      and equipment consist of the
      following (in thousands):





**December
                31,****2006**
            
            
            **2005**
            
            **Estimated
                Useful Lives**Equipment
            
            $
            15,831
            
            
            $
            15,679
            
            2
                to 5 yearsComputer
                software/Web development
            
            
            18,105
            
            
            
            17,436
            
            2
                to 5 yearsFurniture
                and fixtures and leasehold improvements
            
            
            1,662
            
            
            
            1,357
            
            3
                to 11 years35,598
            
            
            
            34,472Less
                accumulated depreciation and amortization
            
            
            (31,827
            )
            
            
            (30,662
            )Property
                and equipment, net
            
            $
            3,771
            
            
            $
            3,810








**5.  Line
      of Credit**





At
      December 31, 2006, the Company had a $40,000,000 credit facility, collateralized
      by accounts receivable and inventory, that can be utilized as both a working
      capital line of credit and a flooring facility used to purchase inventory from
      several suppliers under certain terms and conditions.  This credit facility
      has an annual automatic renewal, which occurs on November 26 of each fiscal
      year. Either party can terminate this agreement with 60 days written notice
      prior to the renewal date.  The working capital and inventory advances bear
      interest at a rate of Prime + 0.50%.   The Company’s line of
      credit is defined by quick turnover, large amounts and short maturities. All
      amounts owed under the Company’s line of credit are due on
      demand.  Inventory advances do not bear interest if paid within terms,
      usually 30 days from advance date.  There were no working capital advances
      outstanding at December 31, 2006, but the Company had working capital advances
      of $10.7 million at December 31, 2005.  The flooring arrangement
      included $14.4 million owed to this financial institution related to inventory
      purchases at December 31, 2006, compared to $8.5 million at December 31,
      2005.





The
      Company uses this credit facility under its cash management system to cover
      checks presented for payment in excess of cash balances.  As of
      December 31, 2006 and 2005, the Company had book overdrafts of $10.2 million
      and
      $13.1 million, respectively, which are recorded as a component of accounts
      payable on the accompanying balance sheet.





The
      facility contains various restrictive covenants relating to tangible net worth,
      leverage, dispositions and use of collateral, other asset dispositions, and
      merger and consolidation of the Company.  The Company was in
      compliance with all the covenants contained in the agreement at December 31,
      2006.





**6.  Accrued
      Liabilities and Other**


Accrued
      liabilities consist of the
      following (in thousands):





**December
                31,****2006**
            
            
            **2005**Accrued
                payroll
            
            $
            4,932
            
            
            $
            3,842Accrued
                taxes
            
            
            3,268
            
            
            
            2,823Accrued
                advertising
            
            
            50
            
            
            
            20Accrued
                interest
            
            
            7
            
            
            
            104Other
                accruals
            
            
            4,471
            
            
            
            2,280Total
            
            $
            12,728
            
            
            $
            9,069




40
 *Table
            of Contents*





**7.  Income
      Taxes**





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





**Year
                ended December 31,****2006**
            
            
            **2005**
            
            
            **2004**Current
            
            $
            6,384
            
            
            $
            912
            
            
            $
            533Deferred
            
            
            (413
            )
            
            
            2,854
            
            
            
            2,272Total
            
            $
            5,971
            
            
            $
            3,766
            
            
            $
            2,805








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





**December
                31,****2006**
            
            
            **2005**Assets:Allowance
                for doubtful accounts
            
            $
            728
            
            
            $
            585Merchandise
                inventory
            
            
            302
            
            
            
            331Deferred
                rent obligation
            
            
            549
            
            
            
            418Accrued
                liabilities and other
            
            
            443
            
            
            
            424$
            2,022
            
            
            $
            1,758Liabilities:Property
                and equipment
            
            
            (298
            )
            
            
            (447
            )(298
            )
            
            
            (447
            )Net
                deferred tax asset
            
            $
            1,724
            
            
            $
            1,311





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








**Year
                ended December 31,****2006**
            
            
            **2005**
            
            
            **2004**Statutory
                rate
            
            
            35.0
            %
            
            
            34.0
            %
            
            
            34.0
            %State
                income tax, net of federal benefit
            
            
            2.0
            
            
            
            2.0
            
            
            
            2.7Stock
                compensation
            
            
            0.5Other
            
            
            0.6
            
            
            
            2.4
            
            
            
            0.9Effective
                tax rate
            
            
            38.1
            %
            
            
            38.4
            %
            
            
            37.6
            %








**8.  Commitments
      and Contingencies**





*Operating
      Leases*


The
      Company leases its offices, returns warehouse facility, and other equipment
      under non-cancelable operating leases that expire through 2016.  Under
      the terms of certain leases, the Company is responsible for its share of taxes,
      insurance and common area charges.  At December 31, 2006, future
      minimum payments under operating leases were as follows (in
      thousands):





2007
            
            $
            2,2362008
            
            
            2,3242009
            
            
            2,1562010
            
            
            1,9842011
            
            
            1,886Thereafter
            
            
            6,079Total
            
            $
            16,665




Certain
      portions of the Company’s lease agreements provide for scheduled rent increases
      during the lease terms.  Minimum rental expenses are recognized on a
      straight-line basis over the terms of the lease.  Rental expense,
      which is recorded on a straight-line basis, totaled $3.1 million, $2.5 million
      and $2.2 million for the years ended December 31, 2006, 2005 and 2004,
      respectively.





41
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            of Contents*





*Related
      Party*


In
      June
      2004, Fana Auburn LLC, a company owned by an officer and majority shareholder
      of
      the Company, purchased the property and buildings in which the Company’s
      headquarters are located, subject to the Company’s existing 11-year
      lease.  Under the terms of the lease agreement, the Company will pay
      lease payments aggregating from $1.0 million to $1.3 million per year, plus
      apportioned real estate taxes, insurance and common area maintenance charges.
      For the years ended December 31, 2006, 2005 and 2004 the Company paid Fana
      Auburn LLC $1.6 million, $1.7 million and $543,000, respectively, related to
      the
      lease.  The Company’s Audit Committee reviewed and approved this
      related party transaction, and also the potential corporate opportunity,
      recognizing that in the future the Company may have to renew and renegotiate
      its
      lease and that such renewal and renegotiation would also present a related
      party
      transaction, which would be subject to further Audit Committee review and
      consideration.  In May 2006, after the Company’s Audit Committee
      reviewed and approved this related party transaction, the Company signed an
      amendment to the lease agreement.  Pursuant to the terms of the
      amendment, Fana Auburn LLC has agreed to increase the rentable square feet
      by
      approximately 18,923 square feet.  The additional square feet will
      increase the annual lease payment by $259,000. Effective January 1, 2007, the
      Company will have approximately 125,196 rentable square feet located at 1102
      15th Street
      SW,
      Auburn, WA.





*Notes
      Payable*


On
      March
      31, 2003, the Company acquired Corporate PC Source, Inc. (“CPCS”) pursuant to a
      Stock Purchase Agreement (“SPA”).  Under the terms of the SPA, the
      Company issued notes to the former shareholders of CPCS. The Company paid the
      final payment during the second quarter of 2006.  For the years ended
      December 31, 2006 and 2005, the Company paid the former shareholders of CPCS
      $1.3 million each year.





*Legal
      Proceedings*


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





**9.  Shareholders'
      Equity**





*Stock
      Options*


In
      1993,
      the Company adopted a Stock Incentive Plan (the “Plan”) whereby the Company
      issued incentive or nonqualified stock options, restricted shares, stock units
      or stock appreciation rights to certain team members.  As of December
      31, 2006, only stock options had been granted under the Plan.  The
      term of each option granted was for such periods as determined by the Board
      of
      Directors, but not for more than ten years from date of
      grant.  Options may be exercised based on a vesting schedule
      determined by the Board of Directors, and the Plan provides for acceleration
      of
      outstanding options under certain conditions, including certain changes in
      control of the Company.  Grants are nontransferable, and shares
      acquired upon exercise of options may be subject to repurchase at the option
      of
      the Company under certain conditions.  The maximum number of shares to
      be granted under the Plan was 2,650,000 at December 31, 2006.





In
      addition to options granted under the Plan, the Company has granted options
      under a separate plan to the Board of Directors.  Options outstanding
      to these individuals at December 31, 2006 were 80,000 shares at option prices
      of
      $0.73 - $12.00 per share.  The maximum number of shares to be granted
      under this plan was 325,000.  As of December 31, 2006, the Company had
      indefinitely suspended this program and therefore had no available
      shares.





In
      January 2003, the Board of Directors adopted the Zones, Inc. 2003 Equity
      Incentive Plan (the “New Plan”), under which the Company may issue, among other
      things, incentive or nonqualified stock options, restricted shares, stock units
      or stock appreciation rights.  Under the New Plan, stock options are
      granted solely at the discretion of the Board of Directors, and the term of
      each
      option granted will be for such periods as determined by the Board of Directors,
      but not for more than ten years from date of grant.  Options will be
      exercisable based on a vesting schedule determined by the Board of Directors,
      and the plan provides for acceleration of outstanding options under certain
      conditions, including certain changes in control of the
      Company.  Grants are nontransferable, and shares acquired upon
      exercise of options may be subject to repurchase at the option of the Company
      under certain conditions.  The maximum number of shares that may be
      granted under the New Plan is 1,175,000.





42
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            of Contents*





Information
      regarding the stock option plans is as follows:





**Options**
            
            
            **Weighted-Average
                  Exercise Price**
            
            
            **Options
                  Exercisable**Outstanding,
                January 1, 2004
            
            
            3,329,682
            
            
            
            2.68
            
            
            
            1,310,817Granted
            
            
            925,300
            
            
            
            2.95Exercised
            
            
            (296,746
            )
            
            
            1.53Canceled
            
            
            (684,843
            )
            
            
            3.70Outstanding,
                December 31, 2004
            
            
            3,273,393
            
            
            
            2.63
            
            
            
            1,471,617Granted
            
            
            282,200
            
            
            
            3.38Exercised
            
            
            (181,772
            )
            
            
            1.74Canceled
            
            
            (306,102
            )
            
            
            1.77Outstanding,
                December 31, 2005
            
            
            3,067,719
            
            
            
            2.84
            
            
            
            2,181,673GrantedExercised
            
            
            (461,070
            )
            
            
            3.06Canceled
            
            
            (36,358
            )
            
            
            4.70Outstanding,
                December 31, 2006
            
            
            2,570,291
            
            
            $
            2.78
            
            
            
            2,138,483





There
      were no options granted in the year ended December 31, 2006.  For the
      years ended December 31, 2005 and 2004, the weighted-average fair value of
      options granted was as follows:





**Year
                ended December 31,****2005**
            
            
            **2004**Exercise
                price equals market price
            
            $
            2.29
            
            
            $
            2.58





The
      following tables summarize information about fixed-price stock options
      outstanding at December 31, 2006:





**Options
                  Outstanding****Range
                  of Exercise Prices**
            
            
            **Number Outstanding
                  at December 31, 2006**
            
            
            **Weighted-
                  Average Remaining Contractual Years**
            
            
            **Weighted-
                  Average Exercise Price**$
            0.73
                - $ 0.96
            
            
            
            446,980
            
            
            
            5.90
            
            
            $
            0.91$
            1.05
                - $ 1.06
            
            
            
            501,000
            
            
            
            6.59
            
            
            
            1.06$
            1.07
                - $ 2.92
            
            
            
            602,682
            
            
            
            6.94
            
            
            
            2.40$
            2.99
                - $ 3.13
            
            
            
            430,846
            
            
            
            7.03
            
            
            
            3.00$
            3.19
                - $ 5.81
            
            
            
            446,811
            
            
            
            4.55
            
            
            
            4.38$
            6.00
                  - $15.00
            
            
            
            141,972
            
            
            
            2.06
            
            
            
            10.66$
            0.73
                  - $15.00
            
            
            
            2,570,291
            
            
            
            6.02
            
            
            $
            2.78








**Options
                  Exercisable****Range
                  of Exercise Prices**
            
            
            **Number
                  at December 31, 2006**
            
            
            **Weighted-Average
                  Exercise Price**$
            0.73
                - $ 0.96
            
            
            
            373,430
            
            
            $
            0.91$
            1.05
                - $ 1.06
            
            
            
            384,802
            
            
            
            1.06$
            1.07
                - $ 2.92
            
            
            
            468,182
            
            
            
            2.32$
            2.99
                - $ 3.13
            
            
            
            323,386
            
            
            
            3.00$
            3.19
                - $ 5.81
            
            
            
            446,711
            
            
            
            4.38$
            6.00
                  - $15.00
            
            
            
            141,972
            
            
            
            10.66$
            0.73
                  - $15.00
            
            
            
            2,138,483
            
            
            $
            2.94





**10.  Earnings
      Per Share**





The
      Company has 45,000,000 common shares authorized, and 13,157,719 issued and
      outstanding at December 31, 2006.  The Company has also granted
      options to purchase common shares to the team members and directors of the
      Company.  The following is a reconciliation of the numerator and
      denominator of the basic and diluted earnings-per-share computations (in
      thousands, except per share data).





43
 *Table
            of Contents*





**Year
                        ended December 31,****2006**
                  
                  
                  **2005**
                  
                  
                  **2004****Basic
                      earnings per share:**Net
                      income
                  
                  $
                  9,685
                  
                  
                  $
                  6,051
                  
                  
                  $
                  4,652Weighted-average
                      shares used in computing basicincome
                      per share
                  
                  
                  13,195
                  
                  
                  
                  13,382
                  
                  
                  
                  13,549Basic
                      income per share
                  
                  $
                  0.73
                  
                  
                  $
                  0.45
                  
                  
                  $
                  0.34**Diluted
                      earnings per share:**Net
                      income
                  
                  $
                  9,685
                  
                  
                  $
                  6,051
                  
                  
                  $
                  4,652Weighted-average
                      shares used in computing basic income per share
                  
                  
                  13,195
                  
                  
                  
                  13,382
                  
                  
                  
                  13,549Stock
                      Options
                  
                  
                  1,561
                  
                  
                  
                  1,145
                  
                  
                  
                  920Weighted-average
                      shares used in computing diluted income per share
                  
                  
                  14,756
                  
                  
                  
                  14,527
                  
                  
                  
                  14,469Diluted
                      income per share
                  
                  $
                  0.66
                  
                  
                  $
                  0.42
                  
                  
                  $
                  0.32




For
      the
      years ended December 31, 2006, 2005 and 2004, 106,258, 516,045 and 501,087
      shares, respectively, attributable to outstanding stock options were excluded
      from the calculation of diluted earnings per share because the effect was
      anti-dilutive.





**11.  Deferred
      Income 401(k) Plan**





The
      Company offers a deferred income 401(k) plan to substantially all full-time
      team
      members with a minimum of six months of service.  Participants may
      make tax-deferred contributions of up to 60% of annual compensation subject
      to
      certain limitations specified by the Internal Revenue Code. The Company provides
      a discretionary match as recommended by its Compensation Committee and voted
      upon by its Board of Directors on a quarterly basis.  During 2006,
      2005 and 2004, the Company’s Board of Directors approved a match in each of the
      quarters.  For fiscal years 2006, 2005 and 2004, the Company provided
      a 50% match for all team member contributions, up to 6% of the team member’s
      annual compensation, subject to certain limitations specified by the Internal
      Revenue Code.  During fiscal 2006, 2005, and 2004, the Company
      expensed $389,000, $362,000 and $315,000, respectively, relating to employer
      contributions under the plan.





**12.  Stock
      Repurchase Program**





Since
      2004, the Company has repurchased a total of 1,441,240 shares of its common
      stock at a total cost of $7.2 million under its repurchase program
      authorized by its Board of Directors.  Share repurchases may be made
      from time to time in both open market and private transactions, as conditions
      warrant, at then prevailing market prices. The following table presents share
      repurchases for the years ended December 31, 2006, 2005 and 2004 (dollars
      in thousands):




**Period**
            
            **Total
                  number of shares purchased**
            
            
            **Amount
                  paid**2006
            
            
            568,400
            
            
            $
            3,9882005
            
            
            424,450
            
            
            $
            1,8132004
            
            
            448,390
            
            
            $
            1,348




44
 *Table
            of Contents*




As
      of
      December 31, 2006, $979,000 in shares of the Company’s common stock
      remained available for repurchase under the program.  In February
      2007, the Board of Directors authorized a continuation of the Company’s share
      repurchase program, pursuant to which the Company increased the total amount
      authorized.  As of February 2007, $3.0 million in shares of the
      Company’s common stock is available for repurchase under the program. The
      current repurchase program is expected to remain in effect through
      February 2008, unless earlier terminated by the Board or
      completed.




**13.  Segment
      Information**





In
      2004,
      the Company reported its subsidiary, CPCS, and its Zones reporting unit as
      separate segments.  On April 1, 2005, the Company merged the CPCS
      subsidiary into the Zones reporting unit.  Accordingly, no separate
      segment for this subsidiary currently exists.  The Company is now
      represented by one reportable segment: a single-source, multi-vendor,
      direct-marketing reseller of name-brand information technology products to
      small
      to medium-sized businesses, enterprise accounts and the public sector
      markets.





A
      summary
      of the Company’s sales by product mix follows (in thousands):





**December
                31,****2006**
            
            
            **2005**
            
            
            **2004**Notebook
                & PDAs
            
            $
            71,477
            
            
            $
            86,861
            
            
            $
            72,672Desktops
                & Servers
            
            
            117,148
            
            
            
            113,779
            
            
            
            105,636Software
            
            
            102,055
            
            
            
            90,199
            
            
            
            83,415Storage
            
            
            52,785
            
            
            
            51,453
            
            
            
            43,198NetComm
            
            
            28,325
            
            
            
            23,968
            
            
            
            21,936Printers
            
            
            47,479
            
            
            
            63,964
            
            
            
            47,406Monitors
                & Video
            
            
            59,761
            
            
            
            54,460
            
            
            
            50,939Memory
                & Processors
            
            
            35,815
            
            
            
            30,407
            
            
            
            24,807Accessories
                & Other
            
            
            62,182
            
            
            
            51,462
            
            
            
            45,554








Substantially
      all of the Company’s net sales for the years ended December 31, 2006, 2005 and
      2004 were made to customers located in the United States.  All of the
      Company’s assets at December 31, 2006 and 2005 were located within the United
      States.  No one customer represented more than 10% of total sales for
      the years ended December 31, 2006, 2005 and 2004.





45
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            of Contents*





**14.  Selected
      Quarterly Financial Data (Unaudited)**





The
      following information is for the years ended December 31, 2006 and
      2005:





(in
      thousands, except per share data)


**December
                31, 2006**
            
            **First**
                **Quarter**
            
            
            **Second**
                **Quarter**
            
            
            **Third**
                **Quarter**
            
            
            **Fourth**
                **Quarter**Net
                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





**December
                31, 2005**
            
            **First**
                **Quarter**
            
            
            **Second**
                **Quarter**
            
            
            **Third**
                **Quarter**
            
            
            **Fourth**
                **Quarter**Net
                sales
            
            $
            126,331
            
            
            $
            127,630
            
            
            $
            152,758
            
            
            $
            159,834Cost
                of sales
            
            
            111,569
            
            
            
            113,093
            
            
            
            138,146
            
            
            
            143,189Gross
                profit
            
            
            14,762
            
            
            
            14,537
            
            
            
            14,612
            
            
            
            16,645SG&A
                expenses
            
            
            11,199
            
            
            
            10,978
            
            
            
            10,068
            
            
            
            11,373Advertising
                expenses, net
            
            
            1,738
            
            
            
            1,401
            
            
            
            1,608
            
            
            
            1,871Income
                from operations
            
            
            1,825
            
            
            
            2,158
            
            
            
            2,936
            
            
            
            3,401Other
                expense
            
            
            61
            
            
            
            51
            
            
            
            191
            
            
            
            200Income  before
                income  taxes
            
            
            1,764
            
            
            
            2,107
            
            
            
            2,745
            
            
            
            3,201Provision
                for  income taxes
            
            
            673
            
            
            
            811
            
            
            
            1,055
            
            
            
            1,227Net
                income
            
            $
            1,091
            
            
            $
            1,296
            
            
            $
            1,690
            
            
            $
            1,974Basic
                earnings per share1
            
            $
            0.08
            
            
            $
            0.10
            
            
            $
            0.13
            
            
            $
            0.15Diluted
                earnings per share 1
            
            $
            0.08
            
            
            $
            0.09
            
            
            $
            0.12
            
            
            $
            0.14





1  Earnings
      per share is computed independently for each of the quarters presented,
      therefore the sum of the quarterly earnings per share may not equal the total
      computed for the year due to shares issued each quarter.





46
 *Table
            of Contents*





**15.  Restatement**





The
      Consolidated Statements of Cash Flows for the years ended December 31, 2006
      and
      2005 have been restated, the year ended December 31, 2004 has been revised
      in
      the amount of $443,000 for conformity purposes.  The Company has
      restated its Consolidated Statements of Cash Flows by reclassifying cash flows
      related to its inventory financing, disclosed as a separate line item, from
      operating activities to financing activities.  Consequently, this
      reclassification will result in a change to cash flows (used in) provided by
      operating activities with an equal and off-setting impact to cash flows (used
      in) provided by financing activities. This restatement does not impact the
      Company’s previously reported overall net change in cash and cash equivalents in
      its Consolidated Statements of Cash Flows for any period
      presented.  Additionally, this restatement does not impact the
      Company’s Consolidated Balance Sheets, Consolidated Statements of Operations or
      Consolidated Statements of Shareholders’ Equity for any period
      presented.





The
      following table presents the effect of the restatement on the Consolidated
      Statements of Cash Flows for the years ended December 31, 2006 and 2005 (in
      thousands):





**For
                the Year ended December 31, 2006****As
                  Reported**
            
            
            **Adjustment**
            
            
            **As
                  Restated**Cash
                flows from operating activities:Net
                change in inventory financing
            
            $
            5,916
            
            
            $
            (5,916
            )
            
            $
            -Net
                cash provided by (used in)  operating activities
            
            
            24,594
            
            
            
            (5,916
            )
            
            
            18,678Cash
                flows from investing activities:Net
                cash used in investing activities
            
            
            (1,792
            )
            
            
            -
            
            
            
            (1,792
            )Cash
                flows from financing activities:Net
                change in inventory financing
            
            
            -
            
            
            
            5,916
            
            
            
            5,916Net
                cash provided by (used in) financing activities
            
            
            (16,806
            )
            
            
            5,916
            
            
            
            (10,890
            )Net
                increase in cash and cash equivalents
            
            
            5,996
            
            
            
            -
            
            
            
            5,996Cash
                and cash equivalents at the beginning of the year
            
            
            3,195
            
            
            
            -
            
            
            
            3,195Cash
                and cash equivalents at the end of the year
            
            $
            9,191
            
            
            $
            -
            
            
            $
            9,191





**For
                the Year ended December 31, 2005****As
                  Reported**
            
            
            **Adjustment**
            
            
            **As
                  Restated**Cash
                flows from operating activities:Net
                change in inventory financing
            
            $
            (5,837
            )
            
            $
            5,837
            
            
            $
            -Net
                cash provided by (used in)  operating activities
            
            
            (11,228
            )
            
            
            5,837
            
            
            
            (5,391
            )Cash
                flows from investing activities:Net
                cash used in investing activities
            
            
            (1,826
            )
            
            
            -
            
            
            
            (1,826
            )Cash
                flows from financing activities:Net
                change in inventory financing
            
            
            -
            
            
            
            (5,837
            )
            
            
            (5,837
            )Net
                cash provided by (used in) financing activities
            
            
            9,792
            
            
            
            (5,837
            )
            
            
            3,955Net
                decrease in cash and cash equivalents
            
            
            (3,262
            )
            
            
            -
            
            
            
            (3,262
            )Cash
                and cash equivalents at the beginning of the year
            
            
            6,457
            
            
            
            -
            
            
            
            6,457Cash
                and cash equivalents at the end of the year
            
            $
            3,195
            
            
            $
            -
            
            
            $
            3,195




47
 *Table
            of Contents*





**Report
      of Independent Registered Public Accounting Firm**





Board
      of
      Directors and Shareholders of


Zones,
      Inc.





We
      have
      audited the accompanying consolidated balance sheets of Zones, Inc. as of
      December 31, 2006 and 2005, and the related consolidated statements of
      operations, shareholders’ equity, and cash flows for each of the two years in
      the period ended December 31, 2006.  These financial
      statements are the responsibility of the Company’s management.  Our
      responsibility is to express an opinion on these financial statements based
      on
      our audits.





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





In
      our
      opinion, the financial statements referred to above present fairly, in all
      material respects, the financial position of Zones, Inc. as of
      December 31, 2006 and 2005, and the results of its operations and its
      cash flows for each of the two years in the period ended
      December 31, 2006, in conformity with accounting principles generally
      accepted in the United States of America.





Our
      audit
      was conducted for the purpose of forming an opinion on the basic consolidated
      financial statements taken as a whole.  The consolidated financial
      statement schedule listed in Item 15 as of and for the years ended
      December 31, 2006 and 2005 is presented for purposes of additional
      analysis and is not a required part of the basic consolidated financial
      statements.  This schedule has been subjected to the auditing
      procedures applied in the audit of the basic consolidated financial statements
      and, in our opinion, is fairly stated in all material respects in relation
      to
      the basic consolidated financial statements taken as a whole.





As
      described in note 15, the consolidated statements of cash flows for the year
      ended December 31, 2006 and 2005 have been restated.





Grant
      Thornton LLP


Seattle,
      Washington


February
      16, 2007


(Except
      for note 15, as to which the date is November 8, 2007)





48
 *Table
            of Contents*





**Report
      of Independent Registered Public Accounting Firm**








To****the
      Shareholders of


Zones,
      Inc.




In
      our
      opinion, the accompanying consolidated statements of income, shareholders’
equity and cash flows listed in the index appearing under Item 15(a)(1) present
      fairly, in all material respects, the results of operations and cash flows
      of
      Zones, Inc and its subsidiaries for the year ended December 31,
      2004****in conformity with accounting principles generally
      accepted in the United States of America. In addition, in our opinion, the
      financial statement schedule listed in the index appearing under Item 15(a)(2)
      presents fairly, in all material respects, the information as of and for the
      year ended December 31, 2004 set forth therein when read in conjunction with
      the
      related consolidated financial statements. These financial statements and
      financial statement schedule are the responsibility of the Company’s management.
      Our responsibility is to express an opinion on these financial statements and
      financial statement schedule based on our audit. We conducted our audit of
      these
      statements in accordance with the standards of the Public Company Accounting
      Oversight Board (United States). Those standards require that we plan and
      perform the audit to obtain reasonable assurance about whether the financial
      statements are free of material misstatement. An audit includes examining,
      on a
      test basis, evidence supporting the amounts and disclosures in the financial
      statements, assessing the accounting principles used and significant estimates
      made by management, and evaluating the overall financial statement presentation.
      We believe that our audit provides a reasonable basis for our
      opinion.








PricewaterhouseCoopers
      LLP


Seattle,
      Washington


February
      28, 2005 except for Note 15, as to which


the
      date
      is November 13, 2007





49
 *Table
            of Contents*





**ZONES,
      INC.**


**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, 2006Allowance
                for doubtful accounts
            
            $
            1,562
            
            
            $
            772
            
            
            $
            
            
            
            $
            398
            (a)
            
            $
            1,936Year
                Ended December 31, 2005Allowance
                for doubtful accounts
            
            $
            2,666
            
            
            $
            458
            
            
            $
            
            
            
            $
            1,562
            (a)
            
            $
            1,562Year
                Ended December 31, 2004Allowance
                for doubtful accounts
            
            $
            2,734
            
            
            $
            297
            
            
            $
            
            
            
            $
            365
            (a)
            
            $
            2,666(a)
                Uncollectible items written off, less recoveries of items previously
                written off.







50