**UNITED STATES**

**SECURITIES AND EXCHANGE COMMISSION**

**Washington,D.C. 20549**

** **

** **

**FORM 10–K**

 

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

** **

**FORTHE FISCAL YEAR ENDED DECEMBER 31, 2001**

###### **OR**

 
| **o** | **TRANSITION REPORT PURSUANT TO SECTION 13 OR  15(d) OF THE SECURITIES EXCHANGE ACT OF 1934** |
|-------|-----------------------------------------------------------------------------------------------|

** **

**FOR THETRANSITION PERIOD FROM             TO**

** **

**CommissionFile 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) |
|                                     |   |                   |
| **707 South  Grady Way**                 |   |                   |
| **Renton,  Washington**                  |   | **98055–3233**    |
| (Address of Principal Executive Offices) |   | (Zip Code)             |

 

**(425) 430–3000**

(Registrant’s Telephone

Number, Including Area Code)

 

 

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

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

 

Indicate by check mark whether the registrant (1) has filed all reportsrequired to be filed by Section 13 or 15(d) of the Securities Exchange Act of1934 during the preceding 12 months (or for such shorter period that theregistrant was required to file such reports), and (2) has been subject to suchfiling requirements for the past 90 days. Yes   ý   No   o

 

Indicate by check mark if disclosure of delinquent filers pursuant toitem 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 informationstatements incorporated by reference in Part III of this Form 10-K or anyamendment of this Form 10-K.   ý

 

The aggregate market value of the Common Stock held by non-affiliatesas of February 19, 2002 was approximately $4,478,560 (1), based upon the lastsales price per share of $0.80 as reported by the Nasdaq National Market.

 

The number of shares of the registrant’s Common Stock outstanding as ofFebruary 19, 2002, was 13,563,820.

 

(1)          Excludes value ofCommon Stock held of record as of February 19, 2002 by executive officers,directors and other 10% shareholders of the registrant.  Includes Common Stock held of record as ofthat date by certain depository organizations. Exclusion of shares held by any person should not be construed to indicatethat such person possesses the power, direct or indirect, to direct or causethe direction of the management or policies of the registrant, or that suchperson is controlled by or is under common control with the registrant.

 

 

 

**ZONES, INC.**

**FORM 10-K ANNUAL REPORT**

**FOR THE YEAR ENDED DECEMBER 31, 2001**

**TABLE OF CONTENTS**

 

 

PART I

** **
| Item 1.  | Business                                             |   |
|----------|------------------------------------------------------|--------|
|     |                                                 |   |
| Item 2.  | Properties                                           |   |
|     |                                                 |   |
| Item  3. | Legal  Proceedings                                   |   |
|     |                                                 |   |
| Item  4. | Submission  of Matters to a Vote of Security Holders |   |
|     |                                                 |   |
| Item 4a. | Executive  Officers of the Registrant                |   |

 

PARTII

 
| Item  5.  | Market  for Registrant’s Common Equity and Related Shareholder Matters                 |   |
|-----------|---------------------------------------------------------------------------------------------|--------|
|      |                                                                                        |   |
| Item 6.   | Selected Financial Data                                                                     |   |
|      |                                                                                        |   |
| Item  7.  | Management’s  Discussion and Analysis of Financial Condition and Results of Operations |   |
|      |                                                                                        |   |
| Item  7a. | Quantitative  and Qualitative Disclosures About Market Risk                                 |   |
|      |                                                                                        |   |
| Item  8.  | Financial  Statements and Supplementary Data                                                |   |
|      |                                                                                        |   |
| Item  9.  | Changes  in and Disagreements with Accountants on Accounting and Financial Disclosure       |   |

 

PARTIII

 
| Item  10. | Directors  and Executive Officers of the Registrant             |   |
|-----------|-----------------------------------------------------------------|--------|
|      |                                                            |   |
| Item 11.  | Executive Compensation                                          |   |
|      |                                                            |   |
| Item  12. | Security  Ownership of Certain Beneficial Owners and Management |   |
|      |                                                            |   |
| Item  13. | Certain  Relationships and Related Transactions                 |   |

 

PARTIV

 
| Item  14.  | Exhibits,  Financial Statement Schedules and Reports on Form 8-K |   |
|------------|------------------------------------------------------------------|--------|
|       |                                                             |   |
| Signatures |                                                             |   |

 

 

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**Part I**

 

**Item 1.    Business**

 

This section contains forward-looking statements based on management’scurrent expectations, estimates and projections about the industry in which weoperate, management’s beliefs and certain assumptions made by management. Thesestatements are made pursuant to the safe harbor provision of the PrivateSecurities Litigation Reform Act of 1995. All statements, trends, analyses and other information contained in thisreport relative to trends in net sales, gross margin and anticipated expenselevels, as well as other statements, including words such as “anticipate”,“believe”, “plan”, “expect”, “estimate” and “intend” and other similarexpressions, constitute forward-looking statements. These forward-lookingstatements involve risks and uncertainties, and actual results may differmaterially from those anticipated or expressed in such statements. Potentialrisks and uncertainties include, among others, those set forth in thisdocument. Particular attention should be paid to the cautionary statementsinvolving the industry’s rapid technological change and the Company’s exposureto inventory obsolescence, availability and allocations of goods, reliance onvendor support and relationships, competitive risks, pricing risks and economicrisks. Except as required by law, the Company undertakes no obligation toupdate any forward-looking statement, whether as a result of new information,future events or otherwise.

 

**General**

 

**Zones, Inc. (the ‘Company’) is a single-source,multi-vendor direct reseller of name-brand information technology products tothe fast growing small to medium sized business market (‘SMB’), enterprise andgovernment and education accounts. Zones sells these products through outbound and inbound accountexecutives, specialty print and e-catalogs and the Internet.  Zones offers more than 150,000 products fromleading manufacturers including Apple, Compaq, Hewlett-Packard, IBM, Microsoftand Toshiba.**

 

The Company wasincorporated in November 1988 as a Washington corporation.  The Company’s headquarters are located inRenton, Washington.

 

**Industry Background**

 

The Company believes that manybusinesses have become more receptive to direct marketing and now make theirpurchase decisions based primarily on product selection, availability,convenience and price. Direct marketers enjoy efficiencies as a result ofcentralized operations and distribution and also the ability to offer a broadproduct and service selection, and purchasing convenience. The Company believesdirect marketing efficiencies not only better satisfy many segments of thecustomer market but also provide a cost-effective marketing vehicle for productmanufacturers. The emphasis in today’s market is on applying technology to meetall business needs.  The Company believesits competitive advantage will come from its ability to offer an integration ofinformation technology and business strategy. The Company’s business model is afulfillment model, which integrates the procurement and resale of traditionalproduct lines with value added logistics services to create a single solutionbased provider.

 

The Company’s primary target for continued growthis the SMB market whose projected sales are in the multi-billions of dollars.The Company believes the largest growth area for information technology (“IT”)spending to be SMB’s.  The SMB marketover the past several years has steadily increased, while consumer spending hasdeclined.   The SMB market seems to bemost resilient in this current IT spending slowdown with the least sensitivityto price fluctuations.  The Company’sSMB market continues to invest in its IT infrastructure as technology continuesto change and improve.

 

**Risk Factors**

 

There are a number ofimportant factors that could cause the Company’s actual results to differmaterially from historical results or those indicated by any forward-lookingstatements, including the risk factors identified below, or other factors ofwhich the Company may not yet be aware.

 

*Future*Growth. The Company’snet revenue has grown to $541.1 million in 2001 from $499.8 million in 1999when it began its transition away from the consumer business model.  If the Company does not successfully managegrowth in the future, it could significantly limit its ability to meet customerdemand and its business could be harmed. The Company’s current businessstrategy is to pursue additional growth and expand its 

 

 

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customer base throughincreased profitability and productivity in its account executives and targetedmarketing tools for acquisition of new customers, retention of its currentcustomers and reactivation of its previous customers. The Company’s futuresuccess will depend, in part, on its ability to manage this growth.

 

The Company has discontinuedits marketing and sales efforts to the PC consumer market because the Companyshifted its PC strategy to the more profitable and loyal SMB, enterprise,government and education accounts.  ItsMac strategy differs from its PC strategy, because it is not solely focused onthe SMB and enterprise market, but it addresses both the consumer and businesssegments.  During 2001, the technologyindustry has seen pressure due to dramatically slowing growth rates and pricecompression, which may influence the Company’s future sales and growth.  In addition, the economic conditions maymake available financing on terms acceptable to the Company, increasinglydifficult to obtain.  There can be noassurance that the Company will realize future growth in net sales or will notexperience decreases in net sales, or that the Company will be profitable on aquarterly or annual basis.

 

*Pressure on Margins*.The computer products industry has experienced intense price competition. TheCompany believes that its competition may aggressively price their productofferings to gain market share.  TheCompany may be required to reduce its profit margins to remain competitive inthe future.  The slowdown in U.S.corporate IT spending has created a more intense competitive landscape that isdisrupting the stability of pricing and exerting downward pressure on profitmargins across all product lines. Additionally, a number of manufacturers are providing their productsdirect to customers.  There can be noassurance that the Company will be able to maintain its gross margins in thefuture.

 

*Variability of Operating Results*.The Company has experienced significant fluctuations in its operating resultsfrom quarter to quarter as a result of many factors, including investment inactivities to increase the productivity of its sales team, general economicconditions, the condition of the computer products industry, shifts in demandfor computer products and industry announcements of new products or upgrades.For this reason, period to period comparisons of the Company’s financialresults may not accurately forecast future performance.  There can be no assurance that the Companywill be profitable on a quarterly or annual basis or that future operatingresults will not fall below the expectations of securities analysts orinvestors, which may cause the common stock price to decline.

 

*Possible Delisting of Securities from Nasdaq NationalMarket. *TheCompany’s Common Stock is currently quoted on the Nasdaq National Market (the“National Market”).  However, in orderto continue to be included in the National Market, a company must maintain,among other things, a minimum closing bid price of $1.00 per share.  Since January 9, 2002, the Company’s CommonStock has consecutively failed to maintain a minimum closing bid price of $1.00per share.  In order to maintaincompliance with the National Market listing requirements, we may be required totake various measures including, but not limited to, raising additional capitaland effecting a reverse split of the Company’s Common Stock.  Certain of such measures, including anyreverse stock split, would require shareholder approval.  Failure to meet any of the National Marketmaintenance criteria in the future may result in the delisting of the Company’sCommon Stock from the National Market. The delisting of the Company’s Common Stock would have an adverse impacton the market price and liquidity of the Company’s securities and may adverselyaffect the Company’s ability to obtain additional financing.  As a result of such delisting, an investormay find it more difficult to dispose of, or to obtain accurate quotations asto the market value of the Company’s Common Stock.

 

*Competition.*** **The computer productsindustry is highly competitive. The Company believes that product selection,availability and price are the three most important competitive factors.  The Company competes with other nationaldirect marketers, including CDW Computer Centers, Inc., Insight Enterprises,Inc., PC Connection, and PC Mall, Inc. The Company also competes with productmanufacturers, such as Dell and Gateway, that sell direct to end-users andlarge manufacturers, such as Compaq and IBM which are developing a customerdirect model; specialty computer retailers; computer and general merchandisesuperstores; and consumer electronic and office supply stores.  Many of these competitors rely heavily onthe Internet as a marketing and sales channel. Some of the Company’s larger competitors compete principally on thebasis of price and may have lower costs than the Company.  The Company believes that competition mayintensify in the future due to market conditions and consolidation.  In the future, the Company may face fewer,but larger and better-financed competitors as a consequence of suchconsolidation.  Additional competitionmay also arise if other methods of distribution emerge in the future. TheCompany competes not only for customers, but also for co-op advertising supportfrom computer product manufacturers. There can be no assurance that the Company will be able to competeeffectively with existing competitors or new competitors that may enter the 

 

 

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market, or that theCompany’s business, financial condition, cash flows and results of operationswill not be adversely affected by intensified competition.

 

*Vendor Support.*  The Company has various relationships withits vendors, whose programs contribute to profitability.  The Company relies on its vendor partnersfor co-op advertising, which is a pass-through of expenses associated withcatalogs, e-vehicles and direct mail pieces. In addition, certain manufacturersand distributors provide the Company with incentives in the form of rebates,discounts and trade allowances.   Vendorsalso help offset the cost of returned inventory with discretionary returnprivileges.  If any of theserelationships are terminated, there can be no assurance that the Company’sbusiness, financial condition, cash flows or results of operations will not beadversely affected.

 

*Reliance on Vendor Relationships*.The Company acquires products directly from manufacturers, such as Apple andIBM, as well as from distributors such as Ingram Micro, Tech Data andothers.  The Company purchased 51.6% and54.1% of its products from distributors in 2001 and 2000, respectively.Purchases from Ingram Micro, Tech Data and Apple Computer represented 30.8%,14.6% and 10.5%, respectively, of the Company’s total product purchases in2001. No other vendor supplied more than 10.0% of the Company’s total productpurchases in 2001. Certain hardware manufacturers limit the number of productunits available to direct marketers such as the Company.  Substantially all of the Company’s contractsand arrangements with its vendors are terminable without notice or upon shortnotice. Termination, interruption or contraction of the Company’s relationshipswith its vendors could have a material adverse effect on the Company’sbusiness, financial condition, cash flows or results of operations.

 

*Changing Methods of Distribution*.The market for computer products is evolving rapidly in terms of productofferings and methods of distribution. New methods of distribution, such as on-line shopping services andelectronic distribution of software, have emerged. Additionally, somemanufacturers sell their hardware and software products directly to individualend-users or corporate accounts. These methods of distribution have resulted inincreased patronage and other new methods of distribution may emerge in thefuture. The Company will be required to remain competitive with existing andevolving distribution channels and methods, and may be required to develop oradopt new methods for distribution in the future. Failure by the Company to doso could have a material adverse effect on its business, financial condition,cash flows or results of operations.

 

*Potential Disruption of Business*.The Company’s success is dependent in part on the quality, reliability andproper utilization of its information, telecommunication, desktop publishingand other systems, which are used for web-based distribution, marketing,catalog design and production, purchasing, inventory management, orderprocessing, product distribution, accounts receivable, customer service and generalaccounting functions.  Interruption inany of the Company’s operating systems, Internet systems, Internet connectivityor telecommunication systems could have a material adverse effect on theCompany’s business, financial condition, cash flows or results of operations.

 

*Rapid Technological Change and Inventory Obsolescence*.The computer industry is characterized by rapid technological change andfrequent introductions of new products and product enhancements. In order tosatisfy customer demand and obtain greater purchase discounts, the Company maybe required to carry increased inventory levels of certain products, which willsubject it to increased risk of inventory obsolescence. The Companyparticipates in first-to-market and end-of-life-cycle purchase opportunities,both of which carry the risk of inventory obsolescence. Special purchaseproducts are sometimes acquired without return privileges and there can be noassurance that the Company will be able to avoid losses related to obsoleteinventory.  Within the industry, vendorsare becoming increasingly restrictive in guaranteeing return privileges.  While the Company seeks to reduce itsinventory exposure through a variety of inventory control procedures andpolicies such as only holding stock on hand for a two-week sell throughrun-rate, there can be no assurance that the Company will be able to avoidlosses related to obsolete inventory.

 

*Major Customer.*One of the Company’s customers, Microsoft Corporation, represented 28.7% oftotal revenue for the twelve-month period ended December 31, 2001.  Net revenue from Microsoft was $155.2million for fiscal year 2001. The Company’s relationship with this customer haschanged, and sales to this customer may decline in 2002 by approximately 75% ofthis customer’s fiscal year 2001’s revenue. The Company expects the impact of this decline to be approximately 10%of total company revenue.

 

*Reliance on Outsourced Distribution*.Airborne Logistics Services, an affiliate of Airborne Express, provides andoperates a warehouse and distribution center for the Company in Wilmington,Ohio under a renewable contract that expires in August 2003. Any limitation orinterruption of the service being provided by Airborne 

 

 

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Logistics could have amaterial adverse effect on the Company’s business, financial condition andresults of operations.  Certaindistributors also participate in the Company’s logistics through electronicdata interchange (“EDI”).  Failure todevelop and maintain relationships with these and other vendors that wouldlimit the Company’s ability to obtain sufficient quantities of merchandise onacceptable commercial terms could have a material adverse effect on theCompany’s business, financial condition, cash flows and results of operations.

 

*Dependence on Personnel*.The Company’s future success will depend to a significant extent upon theability to attract and retain skilled personnel.  The Company’s success will depend on its ability to hire, trainand retain competent personnel in all areas of its business.

 

*State Sales or Use Tax Uncertainties*.The Company currently collects sales taxes or similar taxes on sales tocustomers in the States of Washington, Nevada, Tennessee, Illinois and Ohio.Various states have sought to require direct marketers to collect sales taxeson sales shipped to residents of those states. The United States Supreme Courtheld in 1992 that it is unconstitutional for a state to impose sales or use taxcollection obligations on an out-of-state mail order company whose contactswith the state are limited to the distribution of catalogs and otheradvertising materials through the mail and the subsequent delivery of purchasedgoods by United States mail or by interstate common carrier. However,legislation that would expand the ability of states to impose sales taxcollection obligations on direct marketers has been introduced in Congress onmany occasions. Due to its presence in various forms of electronic media andother factors, the Company’s current contact with various states may exceed thelevel of contact involved in the Supreme Court case. The Company cannot predictthe level of contact that is sufficient to permit a state to impose a sales taxcollection obligation on the Company. If legislation is passed to overturn theSupreme Court decision, the requirement to collect sales taxes or similar taxeson sales would result in additional administrative expenses for the Company,could result in increased prices to customers and could have a material adverseeffect on the Company’s business, financial condition, cash flows or results ofoperations.

 

The Company drop-shipsproduct into various states in which it does not collect sales tax.  There are no assurances that drop-ship saleswill not be taxed in the future and, if such transactions are taxed, there canbe no assurance that the Company will be able to maintain the same level ofsales in these states.

 

*Potential Increases in Postage, Shipping and Paper Costs*.Postage and shipping costs, as well as the cost of paper for the Company’scatalogs, are significant expenses in the operation of the Company’s business.The Company generally mails its catalogs through the U.S. Postal Service andships its products to customers by overnight delivery. Any future increases inpostage, shipping rates or paper costs could have a material adverse effect onthe Company’s business, financial condition, cash flows or results ofoperations.

 

# **BusinessStrategy**

 

The Company’s strategy is to strengthen its position as a leadingbusiness to business direct marketer of IT infrastructure solutions.  Its target clients are becoming increasinglydependent on information technology to compete effectively in today’s markets.  The Company believes the business climatewill be receptive to its single-source strategy, which strives to efficientlyprocure and distribute technology products. The Company resells commodity-based products to customers based on priceand availability.  It is striving tocapture additional market share by delivering a total IT solution to itscustomers.   The Company believes thisstrategy will be effective because of its ability to utilize its combination ofvendor relationships and logistic strengths to provide a true single sourcereselling option to the enterprise, SMB, government and educationalmarketplace.

 

During 2001, the Company completed its transition away from thetraditional consumer based catalog model to its PC customer base.  The discontinuation of the *PC Zone*catalog enabled the Company to focus on its business customer, whilemaintaining its ongoing relationship with its loyal Mac customers.  The focus and clarity gained fromtransitioning its business has allowed the Company to directly align itsresources to successfully service the enterprise accounts, SMB and governmentand educational institutions.

 

The Company acquires and develops on-going relationships primarily withenterprise accounts, SMB and government and educational institutions throughdedicated teams of outbound account executives (“AE”). In addition to outboundtelemarketing, the Company reaches customers through an integrated marketingand merchandising strategy designed to attract customers using dedicatede-marketing and direct marketing vehicles, such as business-focused catalogs,and providing customized web stores for its major corporate customers.  The merchandising strategy involves offeringnext day availability on a broad range of brand name products at competitiveprices.  The Company also offers servicesto customers through individual 

 

 

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ZonesConnect web pages, customized web sites that provide customerswith various benefits, including secure on-line purchasing, comprehensiveproduct and manufacturer information, order status information, multipleshopping baskets, varying ship-to options per order, enhanced search and browsecapabilities and historical purchase information.

 

The Company’s business strategy is comprised of the following central elements:

 

*Expansionof Customer Base*.  Relationships with large enterprise, SMB,government and education institutions represent a strong growth opportunity forthe Company.  During 2001, sales tothese customers comprised 85.1% of sales revenue, an increase from 70.6% in2000.  The Company intends to continueits efforts to increase sales to these accounts through its dedicatedenterprise sales team, sales development to increase productivity andprofitably of its AE’s, and targeted marketing programs.  Additionally, the Company’s average tenureof its current AE’s who service these customers has increased to 33 months atthe end of fiscal year 2001 compared to 19 months a year ago.  Generally, increases in tenure translateinto increased productivity.  In additionto outbound telemarketing, the Company uses dedicated e-marketing and directmarketing vehicles to attract and retain customers.

 

*MacZone.* TheCompany’s legacy is in the Mac market. Due to the nature and strong loyalty of Mac product customers, theCompany continues to develop these relationships differently than its businessto business customers.  It relies uponits *MacZone* catalog and established branding of the Mac Zone to drive salesgrowth.  The Company continues to investin increasing its penetration of the Mac market by increasing the catalogcirculation and direct mail pieces targeted to the Mac market in order toincrease its overall market share.

 

*SalesRetention and Productivity*.   The Companycontinually seeks to attract, retain and motivate high quality personnel.  The Company pays its account executives abase annual salary plus commission. Commission is tied to sales volume and gross profit dollar goals.  AE’s historically reach a self-sustaininglevel of productivity after approximately 9 months of training andexperience.  The Company focuses onoffering intensive training designed to maximize performance andproductivity.   The training begins in atraditional classroom setting.  The AEbegins responding to inbound calls to gain experience with purchasingcustomers.  These inbound calls aregenerated by the Company’s customer acquisition catalogs and the *Mac Zone*catalog.  As the training programprogresses, the AE begins to make outbound calls.  This training program helps the AE migrate to a sales team with abook of business created during training.

*ProductBreadth and Depth*.  The Company depends upon relationships withkey vendors for opportunistic product purchases that enhance its margin.  Through a strategic mix of products andvendors, the Company is able to offer its customer a broad selection andcompetitive pricing.  The Companygenerally stocks 20% of its product offerings, which represent 80% of its totalrevenue, in its Ohio warehousing facility. The remaining items are offered to the customer through the Company’svirtual warehousing partnerships with key distributors and vendors, viaelectronic data interchange (“EDI”). The Company uses its warehouse and EDI partners to fulfill itscustomer’s needs with broad product availability.  EDI provides the Company’s customers access to its partner’sinventory of products and reduces the Company’s handling costs.   Information on price and productavailability is uploaded into the Company’s ERP system.  The Company places individual ordersdirectly with its EDI partner who assembles these orders and ships directly tothe Company’s customers.

 

*Growthof Enterprise Customers.* The Company is actively pursuing development of a niche in theenterprise business arena.  Enterprisebusiness customers often require individually tailored custom treatment andgenerally have longer sales cycles than SMB customers from proposal toimplementation. Despite concessions made for this customer group, the Companybelieves it is in a position to efficiently and profitably fulfill enterprisebusiness level needs.

 

*ZonesConnect.* The Company’s ZonesConnect landing sitesprovide a personalized, self-service tool available 24 hours a day, 7 days aweek.   ZonesConnect adds value byproviding access to information that will simplify customers’ businesspurchasing process.  The Company offersthis customized procurement resource system that delivers customized ordermanagement, online approval and PO management, asset management and customizedcorporate standard product list to its business customers.

*MarketingMix.* The Companyutilizes a combination of e-media, paper catalogs, print advertising and directmail pieces to reach its customers. Each marketing piece is targeted to address the needs of a specificcross-segment of the Company’s customers. The Company has increasingly used the Internet as a cost efficient and 

 

 

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convenient means of communicating with its customers.   In 2001, the Company sent out a combinationof 12.3 million e-marketing messages and 14.9 million paper catalogs.

 

*MaintainingAdvanced Technology Infrastructure*.  The Companyhas implemented a new enterprise-wide customer relationship managemente-business application, CRM.  The CRMsystem augments internal communications between its sales, marketing, serviceand call center functions.  DataMart, acompany wide data repository, was developed to provide flexible andpersonalized reporting for Sales, Marketing, Merchandising, Purchasing,Logistics and Finance.  The Companyintends to continually improve its web site functionality, and intends tocontinue to make technological improvements to the web site.

 

**Sales and Marketing**

 

*Outbound Telemarketing*.  As of December 31, 2001, the Company had astaff of 176 AE’s who actively pursue sales to enterprise, SMB, government andeducation institutions by establishing one-to-one relationships throughoutbound telemarketing.  The primarytargets for these AE’s are the customers representing 50-500 seats.  These commissioned AE’s develop long-termrelationships with their accounts through frequent telephone contact,knowledgeable technical advice, individual attention, quality service, andconvenient one-stop shopping.  Inaddition, the Company utilizes e-marketing, fax broadcast messaging and othermarketing initiatives to enhance sales.

 

*Inbound Sales*.The Company believes it has well trained and knowledgeable inboundtelemarketing representatives.  TheCompany offers toll-free numbers for inbound sales that are staffed seven daysa week.  Sophisticated systems allow theCompany’s representatives to quickly access a customer’s record and billinginformation and review details of past purchases.  For most products sold, the systems also contain an extensiveon-line database of information on product specifications, benefits andfeatures; compatibility of related products; and system requirements forsoftware programs. In addition, the systems automatically prompt telemarketingrepresentatives to offer customers the latest upgrades and complementarysoftware and peripherals. The Company’s inbound telephone sales personnel arealso available to assist online customers.

 

*Extranet Commerce*.  The Company offers no-fee web stores for itscustomers. These web pages provide its customers with various benefits,including secure on-line purchasing, comprehensive product and manufacturerinformation, order status information, multiple shopping baskets, varyingship-to options per order, enhanced search and browse capabilities andhistorical purchase information. A free extension of these customer specificextranets extends buying privileges to their employees.  In addition, we often provide morecustomized extranet sites for larger customers with specific online procurementneeds.

 

*Internet Commerce.*  The Company’s electronic commerce site onthe Internet, Zones.com, provides a lower-cost sales channel to both supplementand enhance our person-to person selling model.  The Company’s electronic commerce sites, Zones.com andMacZone.com, provide its customers detailed product information and theconvenience of on-line purchasing.  Todrive traffic to its Internet sites, the Company leverages its catalogcirculation by featuring the Internet address throughout the catalogs,including on the cover.  The web sitesare featured on all the Company’s promotional communications. The Company alsoutilizes marketing through e-catalogs, as well as on-line price promotions andaffiliations.  The Company sent 12.3million e-catalogs in 2001.

 

*Catalogs.*  The Company markets products throughtargeted mailings of its monthly catalogs. As the business model evolves and continues to focus on outbound salesand e-commerce, reliance on catalogs as a direct response vehicle continues todiminish, except for the Company’s *Mac Zone* catalog. The Company utilizes itscatalog distribution as a customer acquisition strategy by using the catalog asboth a direct marketing tool and a branding vehicle to drive significanttraffic to its web store, zones.com, as well as to the inbound sales force.

 

The Company usescooperative advertising funds, which are a pass-through of expenses, tosubstantially offset the costs associated with its catalog circulation andother marketing activities.  The amountof funding available from the Company’s vendor-partners has generally declinedboth in dollars and as a percentage of sales. The Company’s net cost of advertising totaled $2.5 million in 2001.  Domestic net advertising costs were $3.1million in 2000 and $3.6 million in 1999. Net advertising costs may continue to fluctuate or rise in the future,as the Company continues to adapt and adjust its catalog circulation, Internetand other marketing activities to optimize sales and profitability in light ofchanging market conditions.

 

 

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Each edition of thecatalog is typically produced with several cover versions.  Each catalog is printed with full-colorphotographs, detailed descriptions of product specifications, benefits andfeatures, as well as pricing and ordering information. The catalogs aredesigned to the specification of the vendor and produced in-house by theCompany’s staff of designers and production artists using a sophisticatedcomputer-based catalog production system. The Company also produces direct mailpieces for highly targeted promotions of specific products, such as softwareupgrades, to relevant customers. The Company’s catalogs and direct mail piecesare printed and distributed commercially.

 

**Products and Merchandising**

 

Through the Company’scatalogs, Internet site and consultative sales force, the Company can offercustomers access to over 150,000 hardware, software, peripheral and accessoryproducts and services for users of PC and Mac computers from over 1,000manufacturers.

 

*Computers and Servers*.The Company offers a large selection of desktop, laptop and notebook personalcomputer systems and servers from leading manufacturers such as Apple, Compaq,Hewlett-Packard, Fujitsu, IBM, Sony, and Toshiba.

 

*Peripherals, Accessories and Networking*.The Company carries a full line of peripherals products such as printers,monitors, keyboards, handhelds (PDA’s), memory, storage devices, modems,projectors, scanners, and digital cameras, as well as various accessories andprinting supplies such as toner cartridges, storage media and cables. Brandsoffered by the Company include APC, Apple, Canon, Epson, Hewlett-Packard, InFocus, Iomega, Kingston, Kodak, Fuji, Logitech, NEC, Okidata, Palm, Phillips,Quantum, Sony, UMAX, ViewSonic and Western Digital

 

*Networking*.  The Company provides networking productssuch as switches, hubs, routers, firewalls and wireless devices.  Brands offered by the Company include Cisco,3Com, Linksys, Netgear, Intel, Hewlett-Packard, D-Link and Buffalo.

 

*Software*. The Company sells awide variety of packaged software and licensing programs in the business,personal productivity, connectivity, utility, language, educational,entertainment and other categories. The Company offers products from larger,well-known manufacturers as well as numerous specialty products from new andemerging software development companies. Brands offered by the Company includeAdobe, Computer Associates, Corel, Intuit, Macromedia, Microsoft, Novell, Symantecand Quark, among others.

 

The following tableshows the Company’s gross sales attributable to various product categoriesduring 2001, 2000, and 1999.

 
|                                     |   | **Year ended December 31,** |   |
|------------------------------------------|--------|-----------------------------|--------|
|                                     |   | **2001**                    |   | **2000** |   | **1999** |   |
| Computers  and servers                   |   | 39.7                        | %      | 42.0 | % | 41.0 | % |
| Peripherals,  accessories and networking |   | 48.4                        |   | 46.5 |   | 43.7 |   |
| Total  hardware                          |   | 88.1                        |   | 88.5 |   | 84.7 |   |
| Software                                 |   | 11.9                        |   | 11.5 |   | 15.3 |   |
| Total                                    |   | 100.0                       | %      | 100.0 | % | 100.0 | % |

 

The Company’s categorymerchandising group determines the manufacturers whose products are featured inits Internet and catalog offerings and negotiates the terms and conditions ofproduct coverage.  In exchange forproduct coverage and the benefit of having information about their productsavailable to the Company’s customers, manufacturers provide the Companysupplier investment funds to defray the outside costs of the catalogpublication. The Company uses these funds to defray the expense of Internetmarketing and catalog production, direct mail pieces, brand specific trainingfor sales staff, and promotional activities to incite sales.  The brand management group works withcertain manufacturers and distributors to provide the Company with incentivesin the form of rebates, discounts and trade allowances. Vendors also helpoffset the cost of returned inventory with discretionary returnprivileges.  If any of theserelationships are terminated, there can be no assurance that the Company’sbusiness, financial condition and results of operations will not be adverselyaffected.

 

The merchandising groupis also responsible for developing effective advertising campaigns formanufacturers, managing web-site and catalog design and layout, andcoordinating product procurement and inventory 

 

 

10

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management with theCompany’s purchasing group. In addition, the merchandising group works closelywith the purchasing group to capitalize on opportunities for first-to-marketand end-of-life-cycle product offerings.

 

**Purchasing**

 

The Company utilizes itspurchasing and inventory management capabilities to support its primarybusiness objective of providing name brand products at competitive prices.  The Company’s purchasing team works todevelop and maintain relationships with a broad base of reliable, high-qualitysuppliers.  Through strategicnegotiation, the team works to obtain the lowest overall acquisition cost, inan effort to enable the Company to provide competitive pricing for its clientswhile enhancing its margins.

 

The Company acquiresproducts directly from manufacturers such as Apple, Compaq and IBM, as well asthrough distributors such as Ingram Micro, Tech Data, Synnex, and others.  In 2001, The Company purchased approximately51.6% of its merchandise in 2001 from distributors compared to 54.1% in 2000,and the balance direct from manufacturers. The Company believes that its sourcing strategy enables it to takeadvantage of significant special offers, discounts and supplier reimbursements,while also minimizing inventory costs. The Company believes it has excellent relationships with its suppliersand attempts to take advantage of all appropriate discounts.

 

The Company utilizes ablend of stocking, on-demand procurement, and indirect fulfillment in executingits inventory management strategy.  TheCompany generally stocks those products that represent the top 80% of totalrevenue, including high-velocity and strategic products, as well asopportunistic purchases.  The remainingproducts are provided to its customers primarily through virtual warehousingpartnerships with key distributors and manufacturers.  Through these partnerships, the Company is able to offer a broadselection of products, and provide prompt, cost-efficient fulfillment withminimal inventory exposure.  Thisvirtual fulfillment model is facilitated through industry-standard EDI linkageswith suppliers.  All associatedtransactions are managed through and integrated within the Company’s ERPsystem, which lowers administrative overhead.

 

At December 31, 2001,the Company maintained a net investment in inventory of $16.9 million,representing 20 annual inventory turns.

 

**Order Fulfillment and Distribution**

 

The Company distributesproducts virtually through its EDI arrangement with its vendors, as well asthrough its Airborne Logistics Services (“ALS”) warehouse.

 

ALS provides andoperates a full-service warehouse and distribution center for the Company atthe Airborne Commerce Park in Wilmington, Ohio under a contract that expires inAugust 2003.  Employees of AirborneLogistics utilize the Company’s systems, policies and procedures to receive,log and warehouse inventory shipments from product suppliers, fill and shipcustomer orders, and return inventory to product suppliers when requested bythe Company. The Company also uses this warehouse facility to house specialbuys, constrained product and other high velocity product.

 

The Company pays a flatrate for each order filled by ALS. Orders received by the Company are electronically transmitted on adedicated data line to its computer equipment at the Airborne Logisticsdistribution center, where a packing slip is printed out for order fulfillmentand inventory availability is automatically updated on all of the Company’sinformation systems. All inventory items are bar coded and located incomputer-designated areas that are easily identified on the packing slip. Allitems are checked with bar code scanners prior to final packing, which helps toensure that orders are filled correctly. Orders accepted by 1:00 a.m. EasternTime can generally be delivered overnight via Airborne Express. Upon request,orders may also be shipped for Saturday delivery or by ground service or otherovernight delivery services.

 

The Company operates areturn logistics warehouse in Henderson, Nevada.  The returns warehouse accepts returns on certain products,processes the return and determines viability of the product.  The warehouse is then responsible for returnto vendor, return to general inventory, repairs or liquidation of the returnedmerchandise.

 

The Company continues toexperience a significant decline in domestic customer return rates.  Its returns remained at 3.5% of gross salesin 2001 compared to 2000, and declined from 4.3% in 1999.  Decreases in 2000 were primarilyattributable to a more effective sales force and mandating certain productreturns be sent directly 

 

 

11

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to the vendor. Productreturns are closely monitored to identify trends in product offerings, enhancecustomer satisfaction and reduce overall returns.

 

**Database Marketing**

 

The Company maintains aproprietary database containing 5.0 million customer and inquirer records. TheCompany attracts new customers and prospective customers through advertising inmajor trade publications, on-line media, targeted direct mail programs andthrough selective mailing of catalogs to names on mailing lists obtained fromlist brokers, product manufacturers, trade magazine publishers, associationmemberships and other sources. The Company regularly analyzes and updates itsdatabase and other available information in order to enhance customer responseand order rates. The Company tracks the buying patterns of its customers in anattempt to anticipate customers’ needs and generate additional product orders.The Company also strives to improve the size, quality and responsiveness of itsdatabase through the use of sophisticated modeling techniques. The Companybelieves that by selectively targeting its print media and e-vehicles tospecific groups of customers with known product affinities and purchasingcharacteristics, it will be able to increase order rates from customers.   This also enhances the effectiveness of theCompany’s print catalogs and e-vehicles, and their desirability as a marketingchannel for product manufacturers. The Company leverages its database marketingcapabilities by providing key product manufacturers with marketing researchsuch as price sensitivity tests, list response analyses, and database marketingconsulting services. The Company believes these efforts assist it in promotingand preserving positive relationships with these manufacturers.

 

**Technical Support and Customer Service**

 

The Company’s customerservice representatives respond to questions regarding order status and relatedmatters, billing issues and assist customers with product returns. Most vendorsoffer an unconditional 30-day warranty on defective products.

 

The Company also has astaff of dedicated technical support personnel who assist customers with theinstallation and operation of the products they purchase and are availabletoll-free 30 days after the customer’s purchase date.  The technical support staff assists the Company’s AccountManagers with pre-sale questions to maximize customer satisfaction at the pointof sale.  These personnel also offercustomers support with customized configuration of their computer systems.   Currently, the technical and engineeringsupport staff have worked diligently to obtain various manufacturercertifications including Cisco CCNP, CCNA, Microsoft MCSE, Citrix CCA, CompaqASE and Sans, and HP STAR.

 

**Systems**

 

The Company has committed significant resourcesto the development of sophisticated management information, telecommunication,catalog production and other systems, which are employed in virtually allaspects of its business, including marketing, purchasing, inventory management,order processing, product distribution, accounts receivable, customer serviceand general accounting functions.  The Company recently upgraded theEnterprise Network to CISCO routers and switches that provide a dedicated100-Mb to each of the desktops and 1-Gb to the enterprise servers.  Concurrently, a new CRM system wasimplemented to provide centralized sales, marketing and customer service datacompany-wide.  DataMart, a datarepository, was developed to provide flexible and personalized reporting forsales, marketing, merchandising, purchasing, logistics and finance.   Additionally, the Company relies on EDI toprocure products from several distributors and vendors as well as accept ordersfrom enterprise customers.  The Companyis continually looking at technological advances to increase the productivityof its employees.

 

**Employees**

 

At December 31, 2001,the Company had 554 employees in its operations.  The Company considers its employee relations to be good.  The Company has never had a work stoppageand believes no employees are represented by a labor organization.  The Company emphasizes the recruiting andtraining of high quality personnel and, to the extent possible, promotes peopleto positions of increased responsibility from within the Company.

 

 

12

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*Sales Team Education*

The Company provides abalance of classroom and practical, on-the-job learning within an outboundsales environment. It provides new AE’s with an 8-week acceleration process,including 208 hours in the classroom and 104 hours on-the-job training.

 

Zones Team Developmenttakes an integrated approach in developing the new hires’ skills for acquiringand retaining customers using a relationship building sales methodology.  AE’s learn to utilize various internal andexternal systems, receive hardware and software product education, and learnthe equities of question based selling to build customer relationships.  In addition, the Company involves key vendorpartners to educate its AE’s by offering monthly vendor fairs, lunch and learnsand on-the-job cart product knowledge training.

 

### *Corporate Education for Teammembers*

### *TheCompany’s training process begins with a new hire orientation program, whichincludes each new teammember being paired with a peer advisor.  The Company offers a wide range of on-linetraining that a teammember can access at any time and is continuing to developa strong management training program that will include such classes asleadership and innovation, creativity and decision making, empowerment,interviewing, supervisory responsibilities, time management and goalsetting.  The Company will continue togrow its management development coursework to reinforces its vision and values.*

 

*Mission & Values.*

The Company is dedicatedto creating a learning community of empowered individuals to serve itscustomers with integrity, commitment and passion.  It strives to achieve this by stimulating a positive andcollaborative workplace environment, delivering high speed and quality serviceto its customers, and adapting to external changes with flexibility, innovationand leading edge technology.

 

**Trademarks**

 

The Company conducts itsbusiness in the United States primarily under the service marks *The PC Zone®*and *TheMac Zone®* registered with the United States Patent and TrademarkOffice. These registrations have an indefinite term, as long as the servicemarks are used in connection with the Company’s business activities.  The Company believes its service marks havesignificant value and are an important factor in the marketing of its products.The Company intends to take appropriate steps to protect and renew its servicemark registrations.  If challenged,there are no assurances that the Company will be able to protect itsintellectual property.

 

**Regulatory and Legal Matters**

 

In addition to federal,state and local laws applicable to all corporations and employers in general,the direct marketing business as conducted by the Company is subject to theFederal Trade Commission’s Merchandise Mail Order Rule and related regulations.The Company is also subject to laws and regulations relating totruth-in-advertising and other fair trade practices. The Company hasimplemented programs and systems to promote ongoing compliance with these lawsand regulations.

 

**Item 2.    Properties**

 

The Company currentlyleases approximately 132,000 square feet of space for its corporateheadquarters, including its telemarketing operations, in Renton, Washington andapproximately 18,000 square feet of space for its return warehouse facility inHenderson, Nevada.  The Company believesthat its facilities are adequate to meet its capacity requirements in the future,but there can be no assurance that the facilities will ultimately do so.

 

**Item 3.    LegalProceedings**

 

Various claims andactions of a type commonly encountered in the Company’s industry have beenasserted and are pending against the Company. The Company believes that suchclaims and actions, individually or in the aggregate, will not have a materialadverse effect upon the Company’s financial position or results of operations.

 

The Washington StateDepartment of Revenue (the “Department”) is currently examining the Company’sstate tax returns for the years 1996, 1997, 1998 and 1999.  The Company has received a final report, andthe Department has assessed $2.1 million plus interest.  Based on discussions with the Department,the Company disagrees with substantially all of the deficiencies and hascontested such deficiencies through the 

 

 

13

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administrative appealsprocess and is pursuing further litigation. There can be no assurance that the Company will be successful, in wholeor in part, in challenging the proposed deficiencies.  Additionally, the Department may also make a similar assessmentfor 2000 and 2001.  An unfavorabledecision could have a material effect on the Company.

 

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

 

None.

 

**Item 4a.  ExecutiveOfficers of the Registrant**

 

*FirozH. Lalji*, age 55,has served as the Company’s President and Chief Executive Officer since May of1998, and as Chairman of the Board since March of 1999. Mr. Lalji wasco-founder and has served as a director of the Company since March 1990.  Mr. Lalji is also President and ChiefExecutive Officer of Fana Capital Corporation, an investment holding company.   From 1981 to 1997, he was President andChief Executive Officer of Kits Cameras, Inc., which operated over 140 cameraspecialty stores in eight western states.

 

*ScottF. Koerner*, age44, has served as Executive Vice President and Chief Operating Officer sinceDecember 2000.  Prior to that, Mr.Koerner was Senior Vice President and General Manager for Zones BusinessSolutions since April 2000. From 1999 to 2000, Mr. Koerner served as VicePresident of Marketing and Merchandising for ZBS.  From 1998 to 1999, Mr. Koerner served as the Senior VicePresident of Sales and Marketing for Sayers Computer Source, a Midwest VARservicing corporation.  From 1996 to1998, Mr. Koerner served as Senior Vice President and General Manager ofElek-Tek/Creative Computers.  From 1994to 1996, he served in various positions while at Montgomery Ward & Companyincluding Vice President, Electric Avenue and Regional Managing Director.

 

*RonaldP. McFadden*, age45, has served as Senior Vice President and Chief Financial Officer since May2000. Prior to this position Mr. McFadden was the Company’s Vice President ofFinance and Administration since May 1999. He joined the Company in June 1998,initially serving as Vice President of International Operations. From 1991 to1998, Mr. McFadden was Chief Financial Officer for Kits Cameras, Inc., whichoperated over 140 camera specialty stores. Between 1984 and 1991 he served asVice President of Finance for Interpace Industries.

 

*AnwarJiwani*, age 47,has served as Senior Vice President and Chief Information Officer since April1999.  Prior to this Mr. Jiwani servedfor 23 years with The Royal Bank of Canada.

 

*E. Diane Parks*, age 55, has served as Senior Vice President andChief Marketing Officer since November 2000. Throughout 2000, she held seniormarketing positions with Clear Logic. During 1999, Ms. Parks served at IMISystems, a division of the Olsten Corporation.   From 1977 to 1986, and from 1987 to 1999, Ms. Parks helddomestic and international marketing positions with Sperry Corporation andUnisys Corporation.

 

**PartII**

 

**Item 5.    Market forRegistrant’s Common Equity and Related Shareholder Matters**

 

The Company’s CommonStock is quoted on the Nasdaq National Market under the symbol ZONS.  The following table sets forth the range ofhigh and low sales prices for the Common Stock as reported by the NasdaqNational Market.

 

|            |   | **Year ended  December 31,** |   |
|-----------------|--------|------------------------------|--------|
|            |   | **2001**                     |   | **2000** |   |
|            |   | **High**                     |   | **Low** |   | **High** |   | **Low** |   |
| First  quarter  |   | $                            | 4.38   |   | $ | 1.25 |   | $ | 17.00 |   | $ | 5.75 |   |
| Second  quarter |   | 2.50                         |   | 1.57 |   | 7.63 |   | 3.13 |   |
| Third  quarter  |   | 2.00                         |   | 0.60 |   | 8.25 |   | 3.59 |   |
| Fourth  quarter |   | 1.10                         |   | 0.55 |   | 4.56 |   | 1.00 |   |
|                 |        |                              |        |  |  |  |  |  |  |  |  |  |  |

 

As of the March 15, 2002record date, the Company had over 7,000 holders of record of its CommonStock.  The Company has never paid, andhas no present plans to pay, a cash dividend on its Common Stock.  The Company intends to retain its earningsto finance the expansion of its business.

 

 

14

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**Item 6.    SelectedFinancial Data**

 

The following table setsforth the selected historical consolidated income and balance sheet data ofZones, Inc. and its subsidiaries.  Thebalance sheet data at December 31, 2001 and 2000 and the statement ofoperations data for the years ended December 31, 2001, 2000 and 1999 have beenderived from the audited financial statements and notes thereto included inthis Annual Report on Form 10-K.  Thebalance sheet data for the years ended December 31, 1999, 1998 and 1997 and thestatement of operations data for the years ended December 31, 1998 and 1997have been derived from audited consolidated financial statements and notesthereto not included in this Annual Report on Form 10-K.  This information should be read inconjunction with the consolidated financial statements and notes theretoincluded in Item 8 and Item 7 “Management’s Discussion and Analysis of FinancialCondition and Results of Operations.”

 

 

15

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|                                                                                          |   | **Year ended  December 31,**                                  |    |
|-----------------------------------------------------------------------------------------------|--------|---------------------------------------------------------------|---------|
|                                                                                          |   | **2001**                                                      |    | **2000** |   | **1999** |   | **1998** |   | **1997** |   |
|                                                                                          |   | **(In  thousands, except per share data and operating data)** |    |
| **Statement  of Operations Data:**                                                            |   |                                                          |    |   |   |   |   |   |   |   |   |
| Net  sales8                                                                                   |   | $                                                             | 541,075 |   | $ | 634,063 |   | $ | 499,792 |   | $ | 512,473 |   | $ | 500,770 |   |
| Cost  of sales 4,5,8                                                                          |   | 487,450                                                       |    | 574,080 |   | 451,025 |   | 458,037 |   | 442,650 |   |
| Gross  profit8                                                                                |   | 53,625                                                        |    | 59,983 |   | 48,767 |   | 54,436 |   | 58,120 |   |
| Selling,  general and administrative expenses 3,4,5                                           |   | 53,985                                                        |    | 61,632 |   | 57,502 |   | 63,409 |   | 62,910 |   |
| Loss  from operations                                                                         |   | (360                                                          | )       | (1,649 | ) | (8,735 | ) | (8,973 | ) | (4,790 | ) |
| Other  (income) expense, net 1,3,4,5                                                          |   | (26                                                           | )       | (1,106 | ) | 561 |   | 3,474 |   | 1,618 |   |
| Loss  before income taxes                                                                     |   | (334                                                          | )       | (543 | ) | (9,296 | ) | (12,447 | ) | (6,408 | ) |
| Benefit  from income taxes                                                                    |   | (149                                                          | )       | (188 | ) | (2,637 | ) | (4,114 | ) | (965 | ) |
| Loss  before cumulative effect of change in accounting principle3,4,5                         |   | (185                                                          | )       | (355 | ) | (6,659 | ) | (8,333 | ) | (5,443 | ) |
| Cumulative  effect of change in method of revenue recognition2                                |   |                                                          |    | (59 | ) |   |   |   |   |   |   |
| Net  loss                                                                                     |   | $                                                             | (185    | ) | $ | (414 | ) | $ | (6,659 | ) | $ | (8,333 | ) | $ | (5,443 | ) |
|                                                                                          |   |                                                          |    |   |   |   |   |   |   |   |   |
| Basic  and diluted loss per share 3,4,5                                                       |   | $                                                             | (0.01   | ) | $ | (0.03 | ) | $ | (0.50 | ) | $ | (0.64 | ) | $ | (0.42 | ) |
|                                                                                          |   |                                                          |    |   |   |   |   |   |   |   |   |
| Weighted  average shares used in computation of basic and diluted loss per share              |   | 13,488                                                        |    | 13,383 |   | 13,287 |   | 13,079 |   | 12,965 |   |
|                                                                                          |   |                                                          |    |   |   |   |   |   |   |   |   |
| Pro  forma amounts assuming the new revenue recognition principle is applied  retroactively-2 |   |                                                          |    |   |   |   |   |   |   |   |   |
| Net  loss                                                                                     |   |                                                          |    | $ | (355 | ) | $ | (6,543 | ) | $ | (8,359 | ) | $ | (5,377 | ) |
| Basic  and diluted loss per share                                                             |   |                                                          |    | $ | (0.03 | ) | $ | (0.49 | ) | $ | (0.64 | ) | $ | (0.41 | ) |
|                                                                                          |   |                                                          |    |   |   |   |   |   |   |   |   |
| **Balance  Sheet Data:**                                                                      |   |                                                          |    |   |   |   |   |   |   |   |   |
| Working  capital                                                                              |   | $                                                             | 19,277  |   | $ | 17,180 |   | $ | 17,484 |   | $ | 27,601 |   | $ | 35,057 |   |
| Total  assets                                                                                 |   | 77,901                                                        |    | 111,270 |   | 96,494 |   | 133,047 |   | 104,810 |   |
| Short-term  debt                                                                              |   | 1,412                                                         |    | 1,905 |   | 1,615 |   | 2,943 |   | 3,045 |   |
| Long-term  debt, net of current portion                                                       |   | 226                                                           |    | 1,197 |   | 986 |   | 338 |   | 892 |   |
| Total  shareholders’ equity                                                              |   | $                                                             | 31,558  |   | $ | 31,603 |   | $ | 31,840 |   | $ | 37,350 |   | $ | 44,971 |   |
|                                                                                          |   |                                                          |    |   |   |   |   |   |   |   |   |
| **Selected  Operating Data: 6**                                                               |   |                                                          |    |   |   |   |   |   |   |   |   |
| Catalogs  distributed                                                                         |   | 14,895,000                                                    |    | 18,877,000 |   | 31,075,000 |   | 46,300,000 |   | 50,500,000 |   |
| e-media  distributed                                                                          |   | 12,291,000                                                    |    | 17,456,000 |   | 10,319,000 |   |   |   |   |   |
| Number  of shipments 7                                                                        |   | 611,002                                                       |    | 866,916 |   | 844,646 |   | 1,033,182 |   | 1,116,664 |   |
| Average  order size 7                                                                         |   | $                                                             | 896     |   | $ | 748 |   | $ | 556 |   | $ | 435 |   | $ | 406 |   |
| Number  of outbound account executives                                                        |   | 176                                                           |    | 274 |   | 238 |   | 142 |   | 91 |   |

 

----

1 During the first quarter of 2000, theCompany recognized a one time gain on the sale of its Indian subsidiary of $1.3million.

2 During the fourth quarter of 2000, theCompany implemented Staff Accounting Bulletin (SAB) 101, *Revenue Recognition in FinancialStatements.*  EffectiveJanuary 1, 2000, the Company recorded the cumulative effect of the accountingchange.  The pro forma amounts shown onthe income statement have been adjusted for the effect of retroactiveapplication of the revenue recognition method, which would have been made hadthe new method been in effect, and related income taxes.

3 During 1999, the Company recognizedgains and losses on the divestiture of an investment with majority control inAustria, France, Germany, Mexico, Switzerland and the United Kingdom, resultingin a net loss of $541,000.

4 During 1998, the Company recordedcharges related to the write-off of inventory, the closure of internationalsubsidiaries, staffing reductions and the disposal of unproductive computerhardware and software.  Excluding theeffect of these charges, the Company would have reported a net loss of$2,600,000 or $0.20 per share.

5 During 1997, the Company recordedcharges related to the write-off of goodwill, accounts receivable, inventoryand the closure of three international subsidiaries.  Excluding the effect of these charges, the Company would havereported net income of $2,713,000 or $0.21 per share.

6 Selected operating data excludesinternational operations.

7 Number of shipments is the number ofdomestic outbound orders to customers from the third-party distribution centerutilized by the Company.  Average ordersize is calculated by dividing domestic gross sales by the number of domesticorders. 

8 Net sales and Cost of sales include areclassification for presentation purposes in accordance with EITF 00-10“Accounting for Shipping and Handling Fees and Costs”.

 

 

16

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

 

The followingdiscussion and analysis of the Company’s financial condition and results ofoperations contains certain forward-looking statements.  For this purpose, any statements containedherein that are not statements of historical fact may be deemed to beforward-looking statements.  Withoutlimiting the foregoing, the words “believes,” “anticipates,” “plans,” “expects”and similar expressions are intended to identify forward-lookingstatements.  There are a number ofimportant factors that could cause the Company’s actual results to differmaterially from those indicated by any such forward-looking statements.  These factors include, without limitation,those items set forth in Item 1 above under the caption “Risk Factors.”

 

The followingdiscussion and analysis should be read in conjunction with the Company’sSelected Consolidated Financial and Operating Data and the ConsolidatedFinancial Statements and Notes included in this Annual Report on Form 10-K.

 

**General**

 

The Company’srevenues consist primarily of sales of computer hardware, software, peripheralsand accessories, as well as revenue associated with freight billed to itscustomers. Net sales are product sales only, and reflect the effects of productreturns. Gross profit consists of net sales less product and freight costs.Selling, general and administrative (“SG&A”) expenses include advertisingexpense net of vendor co-op, warehousing, selling commissions, orderprocessing, telephone and credit card fees and other costs such asadministrative salaries, depreciation, rent and general overhead expenses.Other expense represents interest expense net of non-operating income andminority interests in the Company’s subsidiary.

 

# **Critical Accounting Policies**

 

The Company’s discussion and analysis of itsfinancial condition and results of operations are based upon its consolidatedfinancial statements, which have been prepared in accordance with accountingprinciples generally accepted in the United States.  TheCompany believes the following critical accounting policies affect its moresignificant judgments and estimates used in the preparation of its consolidatedfinancial statements, and should be read in conjunction with its summary ofsignificant accounting policies (see Note 2 of the Company’s Notes toConsolidated Financial Statements).  TheCompany’s critical accounting policies are as follows:

 

o            Revenuerecognition

o            Estimatingvaluation allowances, specifically allowance for doubtful accounts andinventory obsolescence

o            Accountingfor income taxes

 

*Revenuerecognition.*

The Company recognizes revenue on product sales when persuasive evidenceof an arrangement exists, delivery has occurred, prices are fixed ordeterminable, and collectability is probable. The Company considers the point of delivery of the product to be whenthe risks and rewards of ownership have transferred to the customer.  The Company offers limited return rights onits product sales.  At the point ofsale, the Company also provides for an allowance for sales returns, which isestablished based on historical experience.

 

*Estimatingvaluation allowances and accrued liabilities*.

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

 

The Company maintains allowances for doubtful accounts based onestimates of future collectibility of its accounts receivable.  The Company analyzes its accounts receivableand customer credit worthiness in evaluating the adequacy of the allowance fordoubtful accounts.

 

The Company maintains a valuation allowance for potentiallyuncollectable amounts due from its vendors which arise from product returns,standard vendor price protection programs and vendor rebate programs.  Amounts received from vendors may vary fromamounts recorded based on the difference between the current market price of aproduct returned and its acquisition price or the denial of price protection orvendor rebates due to noncompliance with specific attributes of the vendorprograms.   The Company reviews its vendorreceivables and provides a valuation allowance based on historical collectionsand the comparison of amounts recorded versus subsequently received.

 

 

17

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The Company maintains allowances for the valuation of itsinventory.  It estimates theobsolescence or unmarketable inventory based on the difference between the costof the inventory and the market value based on assumptions of market demand andmarket conditions.

 

*Accountingfor income taxes.*

The Company isrequired to estimate income taxes in the jurisdiction in which itoperates.  This process involvesestimating actual tax exposure while assessing temporary differences resultingin differing treatment for tax and accounting purposes.  These differences result in deferred taxassets and liabilities.  The Companymust assess the likelihood that its deferred tax assets will be recoveredthrough future taxable income and or other tax planning strategies.  The Company exercised judgment as ofDecember 31, 2001 and 2000, and did not provide a valuation allowance againstits deferred tax asset asserting that it is more likely than not that futuretaxable income and tax planning strategies will be sufficient to recover thedeferred tax asset.  However, the guidelinesprovided by SFAS 109 are stringent and if the Company is unable to providepositive evidence that the deferred tax asset is recoverable, it will berequired to provide a valuation allowance against the deferred tax asset.  If a valuation allowance is deemed to berequired, an expense will be recorded within the tax provision in the statementof operations.

 

**Results of Operations**

The followingtable sets forth, for the periods indicated, selected items from the Company’sConsolidated Statements of Operations expressed as a percentage of net revenue.

 

|                       |   | **Year ended  December 31,** |   |
|----------------------------|--------|------------------------------|--------|
|                       |   | **2001**                     |   | **2000** |   | **1999** |   |
| Net  sales                 |   | 100.0                        | %      | 100.0 | % | 100.0 | % |
| Cost  of sales             |   | 90.1                         |   | 90.5 |   | 90.2 |   |
| Gross  profit              |   | 9.9                          |   | 9.5 |   | 9.8 |   |
| SG&A  expenses         |   | 10.0                         |   | 9.8 |   | 11.5 |   |
| Loss  from operations      |   | (0.1                         | )      | (0.3 | ) | (1.7 | ) |
| Other  expense             |   | 0.0                          |   | (0.2 | ) | 0.1 |   |
| Loss  before income taxes  |   | (0.1                         | )      | (0.1 | ) | (1.8 | ) |
| Benefit  from income taxes |   | 0.0                          |   | 0.0 |   | (0.5 | ) |
| Net  loss                  |   | (0.1                         | )%     | (0.1 | )% | (1.3 | )% |

 

*Comparison of Years Ended December31, 2001 and 2000*

 

*Net Sales. *Net sales decreased 14.7%, to $541.1 million in 2001from $634.1 million in 2000.  Thedecrease was primarily due to the economic recession experienced over the pastseveral quarters, exacerbated by the tragic events of September 11, 2001,whichhas contracted both the volume of units sold and associated sellingprices.  Business customers have slowedthe purchases of technology products across all targeted markets.  Additionally, due to an expected reductionin product sales to a major customer of approximately 75% of that customer’s2001 net revenue, the Company is anticipating a 10% decline in comparable totalcompany sales for fiscal year 2002.  TheCompany believes it has scaled its business to ensure the highest customerservice at the most efficient cost structure, positioning itself to move inaccordance with future market demand.

 

PC platform product sales declined 2.3% to $407.8 million in 2001 from$417.4 million in 2000. Mac platform sales fell 38.5% to $133.3 million in 2001from $216.6 million in 2000 as the Company reduced the circulation of the *Mac Zone*catalog due to an industry wide Mac sales slow down and lack of fresh productsin the market.

*Gross Profit.* Gross profit decreased to $53.6 millionin 2001 from $60.0 million in 2000, but increased to 9.9% of net sales in 2001from 9.5% of net sales in 2000.  Grossprofit dollars declined as a function of the decline in total sales.  The increase in gross profit percentage isprimarily due to the Company’s focus on higher margin product lines, a changein the Company’s customer mix and opting out of certain revenue opportunitiesthat did not offer economical benefits to the Company.

 

*Selling,General and Administrative Expenses*. SG&A expenses decreased to $54.0 million in 2001from $61.6 million in 2000, but increased as a percentage of net sales betweenperiods to 10.0% from 9.8%.  Thepercentage increase is due to the Company’s decline in sales volume. Thedecrease in SG&A expense dollars is primarily due to tightened controlsplaced on discretionary spending and the elimination of redundant processes 

 

 

18

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and headcount.  Credit card feesdecreased in conjunction with the Company’s transition away from the PCconsumer, as business accounts generally tend to be open accountcustomers.  Additionally, the Companyreduced its net cost of advertising in fiscal year 2001 by $588,000 compared tofiscal year 2000.  The reductions incosts are, for the most part, permanent and will not increase proportionatelywith sales as growth resumes.  TheCompany believes that its current administrative infrastructure can beleveraged as it drives sales growth.

 

*Other Income/Expense. *Other income was $26,000 in 2001 compared to $1.1million in 2000.  In the first quarterof 2000, the Company realized a one-time gain on the sale of its Indiansubsidiary of $1.3 million.

 

*Income Tax Benefit.* The income tax benefit for 2001 was $149,000.  The income tax benefit for 2000 was $188,000.  The tax rates were 44.6% and 34.6% for theyears ended December 31, 2001 and 2000, respectively.

 

*Net Loss.* For the year ended December 31, 2001,the Company reduced its net loss by 55.3% compared to prior year.  It recorded a net loss of $185,000, or $0.01per share, in fiscal year 2001.  Thiscompares to fiscal year 2000’s net loss of $414,000, or $0.03 per share, whichincluded the cumulative effect of the change in accounting principle thatincreased the net loss by $59,000, or $0.01 per share.

 

*Comparison of Years Ended December 31,2000 and 1999*

 

*NetSales. *Consolidated net sales increased 26.9%, to $634.1million in 2000 from $499.8 million in 1999. This includes a reclassificationof freight revenue in compliance with EITF 00-10 “Accounting for Shipping andHandling Fees and Costs” of $12.4 million for the years ending December 31,2000 and 1999.  Previously, the chargeswere accounted for as a reduction of cost of goods sold.  Core business net sales increased 37.2% to$633.9 million in 2000 from $462.2 million in 1999.  The increase was primarily due to a shift in focus to outboundsales to enterprise and small to medium sized business (“SMB”) accounts.  Sales to these customers grew 76.1%, to$449.9 million in 2000 from $255.5 million in 1999.   The Company’s sales to customers over the Internet and throughinbound catalog operations declined 10.8%, to $183.9 million in 2000.  The Company continued to reduce its printcatalog circulation as it transitioned to an integrated e-commerce model. The38.0% decline in traditional catalog sales was partially offset by Internetrevenue increases of 22.5%, to $113.6 million in 2000.

 

Core net PC product sales increased 73.3%, to $400.5 million in 2000from $231.0 million in 1999. The growth was driven primarily by the increase inoutbound sales which, as a percentage of total net sales, increased to 71.0% in2000 from 55.3% in 1999. The increase in sales was also impacted by an increasein the number of outbound account executives, 274 at the end of 2000, comparedwith 238 at the end of 1999.

 

Net core Mac product sales increased to $221.1 millionin 2000 from $218.8 million in 1999. Mac platform sales increased despite anindustry wide Mac sales slow down.

 

International subsidiary net sales in 1999 were $37.6 million.  The Company divested all its majorityinterest in its international subsidiaries throughout 1999.  No sales for international operations wereconsolidated in the Company’s 2000 results.

*Gross Profit.* Gross profit increased to $60.0 millionin 2000 from $48.8 million in 1999, but declined to 9.5% of net revenue in 2000from 9.8% of net revenue in 1999.  Dueto the implementation of EITF 00-10 “Accounting for Shipping and Handling Feesand Costs,” the Company changed its classification of freight revenue from areduction of cost of goods sold to net sales. Although gross profit as apercentage of revenue was impacted by the reclassification by 0.2% and 0.3% in2000 and 1999, respectively, the reclassification did not impact gross profitdollars.  In addition to these adjustments,gross profit declined due to increased price competition and a change in theCompany’s customer mix as it shifted its focus to increase PC product sales andsales to enterprise, SMB and government and education accounts, which generallycarry a lower average gross profit.

 

*Selling,General and Administrative Expenses*. SG&A expenses increased to $61.6 million in 2000from $57.5 million in 1999, but decreased as a percentage of net revenuebetween periods to 9.8% from 11.5%. The increase in SG&A expense dollarswas primarily due to an increase in depreciation costs associated with theinvestment the Company made in its system upgrades, as well as an increase inpayroll expense related to the continued growth and investment in its accountexecutives.  The percentage decline wasprimarily due to the Company leveraging its existing infrastructure over alarger sales base.

 

 

19

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*Other Income/Expense. *Other income was $1.1 million in 2000 compared to anexpense of $561,000 in 1999.   TheCompany recognized a one-time gain on the sale of its Indian subsidiary of $1.3million in the first quarter of 2000.

 

*Income Tax Benefit.* The income tax benefit for 2000 was $188,000.  The income tax benefit for 1999 was $2.6 million.  The tax rates were 34.6% and 28.4% for theyears ended December 31, 2000 and 1999, respectively.

 

*Net Loss.* For the year ended December 31, 2000,the Company recorded a net loss of $414,000, or $0.03 per share, which includesthe cumulative effect of the change in accounting principle that increased thenet loss by $59,000.  This compares to anet loss of  $6.7 million, or $0.50 pershare, for the year ended December 31, 1999. In addition to the above factors, in the fourth quarter of fiscal 2000, theCompany adopted, and retroactively applied as of January 1, 2000, the guidanceprovided in SAB 101 “Revenue Recognition” for the recognition, presentation anddisclosure of revenue in the financial statements.  The adoption of SAB 101 increased the net loss for the year by$275,000, or $0.02 per share, excluding the cumulative effect of a change inaccounting principle of a loss of $59,000.

 

### ***Industry***

 

The market for computer products is characterized by rapid changes andfrequent introductions of new products and product enhancements.  These changes result in rapid pricefluctuations and have led to continued average price reductions and lowermargin dollars per transaction.  Anumber of Internet-based competitors are selling computer products at cost plusa transaction fee.   In order to remaincompetitive, the Company may be required to reduce its prices.  Such a reduction in prices could have amaterial adverse effect on the Company’s future results of operations.

 

### ***Seasonal Factors***

 

As the Company transitioned away from its consumer based businessmodel, the seasonal impact has diminished. Historically, the Company had experienced stronger fourth quartersales.  However, the fourth quarter isno longer disproportionate to the other quarters for sales trends to thebusiness to business market.

 

# **Inflation**

 

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

 

**Liquidity and Capital Resources**

 

The Company had total assets of $77.9 million atDecember 31, 2001, of which $64.8 million were current assets.  At December 31, 2001 and 2000, the Companyhad cash, cash equivalents, and restricted cash of $13.1 million and $4.7million respectively, and working capital of $19.3 million and $17.2 million,respectively. Net cash provided by operating activities was $19.5 million in2001 and net cash used by operating activities was $22.5 million in 2000.  The cash inflow in 2001 was primarily due toa significant decline in accounts receivable and inventory, offset by areduction in accounts payable.  Accounts receivable and inventory declined by $24.5 million and $12.2million, respectively, while accounts payable declined by $20.4 million.  Accounts receivable days outstanding atDecember 31, 2001 remained unchanged at 33 days compared to the year endedDecember 31, 2000.   The Company expectsthe days outstanding to increase to approximately 45 days by the end of thefirst quarter of 2002 due to a change in payment terms with a majorcustomer.  The cash outflows during 2000were primarily due to increased inventory and accounts receivable, partlyoffset by increased accounts payable. The increase in inventory was financed principally from the Company’scash flow from operations.

 

Cash outlays for capitalexpenditures were $1.9 million in 2001 and $3.8 million for 2000. Theseexpenditures were primarily for information systems and software, leaseholdimprovements, telecommunications system enhancements and furniture andequipment.  During 2001, the Companyfinanced $573,000 for additional system hardware and a telephone systemupgrade.  The Company financed $2.2million during 2000 under capital lease obligations to finance its CRM system.

 

The net amount of vendor credit outstanding at December 31, 2001 was$38.0 million of which $14.3 million was drawn from a $35.0 million flooringfacility and working capital line, collateralized by inventory and 

 

 

20

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accounts receivable.  Thiscredit facility expires June 30, 2002 and is subject to annual renewals.  At this time the Company expects torenew.  The facility contains variousrestrictive covenants relating to profitability, tangible net worth, leverage,dispositions and use of collateral, other asset dispositions, and merger andconsolidation of the Company. At December 31, 2001, the Company had nooutstanding borrowing amount on the working capital line of credit.  Additionally, at December 31, 2001 theCompany had restricted cash representing an unused standby letter of credit of$930,000.

 

The Company believes thatits existing available cash and cash equivalents, 2002 operating cash flow andexisting credit facilities will be sufficient to satisfy its operating cashneeds for at least the next 12 months at its current level of business.  However, due to a change in payment termswith a major customer, we expect our cash position to decline in the firstquarter of 2002.  Additionally, if theCompany’s working capital or other capital requirements are greater thancurrently anticipated, the Company could be required to seek additional fundsthrough sales of equity, debt or convertible securities or increased creditfacilities.  There can be no assurancethat additional financing will be available or that, if available, thefinancing will be on terms favorable to the Company.

 

## **OtherMatters**

 

*New Accounting Pronouncements*

 

In June 1998, the Financial Accounting StandardsBoard issued SFAS No. 133, “Accounting for Derivative Instruments and HedgingActivities” (“SFAS No. 133).  Amongother provisions, SFAS No. 133 requires that entities recognize all derivativesas either assets or liabilities in the statement of financial position and measurethose instruments at fair value.  Gainsand losses resulting from changes in the fair values of those derivatives wouldbe accounted for depending on the use of the derivative and whether itqualifies for hedge accounting.  Theeffective date of SFAS No. 133 was delayed by the issuance of SFAS No. 137until the fiscal years beginning January 1, 2001. In June 2000, SFAS 138 wasissued, which amends provisions of SFAS 133. The adoptionof these standards on January 1, 2001 did not have a material impact on theCompany’s financial position, as the Company currently holds no derivatives.

 

In July 2001, the Financial Accounting StandardsBoard issued SFAS 141, “Business Combinations” (“SFAS 141”).   SFAS 141 addresses financial accounting andreporting for business combinations. SFAS 141 is effective for all business combinations for which the dateof acquisition is July 1, 2001 or later. Adoption of SFAS 141 in 2001 did not have a significant impact on theCompany’s results of operations, financial position and cash flows.

 

In July 2001, the Financial Accounting StandardsBoard issued SFAS 142, “Goodwill and Other Intangible Assets” (“SFAS 142”).SFAS 142 addresses financial accounting and reporting for acquired goodwill andother intangible assets.  The provisionsof SFAS 142 will be effective for fiscal years beginning after December 15,2001, except that certain provisions of SFAS 142 shall be applied to goodwilland other acquired intangible assets for which the acquisition date is afterJune 30, 2001. The Company does not believe SFAS 142 will have a significantimpact on its results of operations, financial position and cash flows.

 

In July 2001, the Financial Accounting StandardsBoard issued SFAS 143, “Accounting for Asset Retirement Obligations” (“SFAS143”).  SFAS 143 addresses financialaccounting and reporting for obligations associated with the retirement oftangible long-lived assets and the associated asset retirement costs. Itapplies to legal obligations associated with the retirement of long-livedassets that result from the acquisition, construction, development, and (or)the normal operation of a long-lived asset, except for certain obligations oflessees. The provisions of SFAS 143 will be effective for fiscal yearsbeginning after June 15, 2002, however early application is permitted. TheCompany does not believe SFAS 143 will have a significant impact on its resultsof operations, financial position and cash flows.

 

In August 2001, the Financial Accounting Standards Boardissued SFAS 144 “Accounting for the Impairment or Disposal of Long-LivedAssets” (“SFAS 144”).  SFAS 144addresses financial accounting and reporting for the impairment or disposal oflong-lived assets.  SFAS 144 supersedesFASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets andfor Long-Lived Assets to Be Disposed Of, and the accounting and reportingprovisions of APB Opinion No. 30, Reporting the Results of Operations —Reporting the Effects of Disposal of a Segment of a Business, and Extraordinary,Unusual and Infrequently Occurring Events and Transactions, for the disposal ofa segment of a business.  The provisionsof SFAS 144 will be effective for 

 

 

21

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fiscal years beginning after December 15, 2001. TheCompany is currently evaluating the implications of adoption of FAS 144 on itsresults of operations, financial position and cash flows.

 

**Item 7a.  Quantitativeand Qualitative Disclosures About Market Risk**

 

The Company is subject tothe 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 cashbalances in excess of operating requirements in short-term securities,generally with maturities of 90 days or less. In addition, the Company’sunsecured credit agreement provides for borrowings which bear interest atvariable rates based on the prime rate. The Company had no borrowings outstandingpursuant to the credit agreement as of December 31, 2001. The Company believesthat the effect, if any, of reasonably possible near-term changes in interestrates on the Company’s financial position, results of operations and cash flowsshould not be material.

 

**Item 8.    FinancialStatements and Supplementary Data**

 

The information requiredby this item is included in this report beginning at page 23.

 

**Item9.    Changes in and Disagreements withAccountants on Accounting and Financial Disclosure**

 

None.

 

 

**PartIII**

 

**Item10.  Directors and Executive Officersof the Registrant**

 

The information required by this item is contained in, and incorporatedby reference from, the Proxy Statement for the Company’s 2002 Annual Meeting ofShareholder under the caption “Proposal No. 1: Election of Directors,” and“Section 16(a) Beneficial Ownership Reporting Compliance.”  See also the information concerningexecutive officers of the Company included in Item 4a of Part I in this Report.

 

**Item11.  Executive Compensation**

 

The information required by this item is contained in, and incorporatedby reference from, the Proxy Statement for the Company’s 2002 Annual Meeting ofShareholders under the caption “Executive Compensation.”

 

**Item12.  Security Ownership of CertainBeneficial Owners and Management**

 

The information required by this item is contained in, and incorporatedby reference from, the Proxy Statement for the Company’s 2002 Annual Meeting ofShareholders under the caption “Stock Ownership of Management and Certain OtherHolders.”

 

**Item13.  Certain Relationships and RelatedTransactions**

 

None.

 

 

22

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**Part IV**

 

**Item 14.  Exhibits,Financial Statement Schedules and Reports on form 8-K**

 

(a)          1. Financial Statements:

 

The financialstatements of Zones, Inc. and subsidiaries and the Report of IndependentAccountants are included herein beginning on page 23.

 

(b)         2. Financial Statement Schedules:

 

Schedules areomitted since the required information is not present or is not present in amountssufficient to require submission of the schedule, or because the informationrequired is included in the Consolidated Financial Statements and Notesthereto.

 

(c)          3. Exhibits:

 
| **Exhibit  No.** |   | **Description**                                                                                                                      |   | **Filed  Herewith** |   | **Incorporated by Reference** |
|------------------|--------|--------------------------------------------------------------------------------------------------------------------------------------|--------|---------------------|--------|-------------------------------|
| **Form**         |   | **Exhibit No.**                                                                                                                      |   | **File No.**        |   | **Filing Date**               |
| 3.1              |   | Restated  Articles of Incorporation of Multiple Zones International, Inc.                                                            |   |                |   | S-1                           |   | 3.1 |   | 333-04458 |   | 6/5/96 |
| 3.2              |   | Articles  of Amendment of Multiple Zones, Inc.                                                                                       |   |                |   | 8-K                           |   | 3.1 |   | 000-28488 |   | 5/10/01 |
| 3.3              |   | Amended  and Restated Bylaws of Multiple Zones International, Inc.                                                                   |   |                |   | 10-K                          |   | 3.2 |   | 000-28488 |   | 3/31/99 |
| 4.1              |   | Form  of Common Stock Certificate of Zones, Inc.                                                                                     |   | X                   |   |                          |   |   |   |   |   |   |
| 10.1             |   | Multiple  Zones International, Inc. Amended and Restated 1993 Stock Incentive Plan*                                                  |   | X                   |   |                          |   |   |   |   |   |   |
| 10.2             |   | Multiple  Zones International, Inc. 1999 Director Stock Option Plan*                                                                 |   | X                   |   |                          |   |   |   |   |   |   |
| 10.3             |   | Form  of Stock Option Agreement (used for grants to executive officers after March  31, 1996)*                                       |   |                |   | S-1                           |   | 10.4 |   | 333-04458 |   | 6/5/96 |
| 10.4             |   | Form  of Stock Option Agreement (used for grants to outside directors)*                                                              |   |                |   | S-1                           |   | 10.16 |   | 333-04458 |   | 6/5/96 |
| 10.5             |   | Multiple  Zones International, Inc. 401(k) Plan*                                                                                     |   |                |   | S-1                           |   | 10.5 |   | 333-04458 |   | 6/5/96 |
| 10.6             |   | Multiple  Zones International, Inc. Employee Stock Purchase Plan*                                                                    |   |                |   | S-1                           |   | 10.6 |   | 333-04458 |   | 6/5/96 |
| 10.7             |   | Multiple  Zones International, Inc. Management Incentive Plan*                                                                       |   |                |   | S-1/A                         |   | 10.7 |   | 333-04458 |   | 6/6/96 |
| 10.8             |   | Form  of Indemnification Agreement between Multiple Zones International, Inc. and  certain executive officers and outside directors* |   |                |   | S-1                           |   | 10.15 |   | 333-04458 |   | 6/5/96 |
| 10.90            |   | Employment  Agreement dated as of February 1, 2001 between Multiple Zones, Inc. and Scott  Koerner*                                  |   |                |   | 10-Q                          |   | 10.1 |   | 000-28488 |   | 11/9/01 |
| 10.10            |   | Standard  Office Lease — Gross dated October 4, 1993 between Multiple Zones International,  Inc. and Hewlett-Packard Company    |   |                |   | S-1/A                         |   | 10.23 |   | 333-04458 |   | 6/6/96 |
| 10.11            |   | Office  Lease dated April 1, 1996 between Multiple Zones International, Inc. and  Renton Talbot Delaware, Inc.                       |   |                |   | S-1                           |   | 10.24 |   | 333-04458 |   | 6/5/96 |
| 10.12            |   | Industrial  Real Estate Lease dated April 10, 1997 between Multiple Zones International,  Inc. and Pacific Industrial Park, LLC      |   |                |   | 10-K                          |   | 10.18 |   | 000-28488 |   | 4/1/98 |
| 10.13            |   | Ingram  Micro Resale Agreement dated April 1, 1996 between Multiple Zones  International, Inc. and Ingram Micro                      |   |                |   | S-1                           |   | 10.25 |   | 333-04458 |   | 6/5/96 |

----

*              Management contract or compensatory plan or arrangement

 

23

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| 10.14 |   | Authorized  Apple Catalog Reseller Agreement between Multiple Zones International, Inc.  and Apple Computer, Inc.                                            |   |   |   | S-1    |   | 10.26  |   | 333-04458 |   | 6/5/96   |
|-------|--------|--------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|--------|--------|--------|--------|-----------|--------|----------|
| 10.15 |   | Storage  and Distribution Agreement dated September 28, 1992 between Multiple Zones  International, Inc. and Advanced Logistics Services Corp.               |   |   |   | S-1    |   | 10.27  |   | 333-04458 |   | 6/5/96   |
| 10.16 |   | Amendment  to Storage and Distribution Agreement dated September 1, 2000 between  Multiple Zones International, Inc. and Airborne Logistics Services Corp.   |   |   |   | 10-K   |   | 10.18  |   | 000-28488 |   | 3/13/01  |
| 10.17 |   | Agreement  for Wholesale Financing dated January 15, 1996 between Multiple Zones International,  Inc. and Deutsche Financial Services Corporation            |   |   |   | S-1    |   | 10.19  |   | 333-04458 |   | 6/5/96   |
| 10.18 |   | Amendment  to Agreement for Wholesale Financing dated April 23, 1997 between Multiple  Zones International, Inc. and Deutsche Financial Services Corporation |   |   |   | 10-K   |   | 10.24  |   | 000-28488 |   | 4/1/98   |
| 10.19 |   | Business  Loan Agreement dated December 10, 1999 between Multiple Zones International,  Inc. and U.S. Bank National Association                              |   |   |   | 10-K   |   | 10.21  |   | 000-28488 |   | 3/29/00  |
| 10.20 |   | Microsoft  Corporation Authorized Source Agreement dated July 1, 2000 between Multiple  Zones International, Inc. and Microsoft Corporation                  |   |   |   | 10-Q   |   | 99.1   |   | 000-28488 |   | 11/14/00 |
| 10.21 |   | Inventory  and Working Capital Financing Agreement dated July 21, 2000 between Multiple  Zones International, Inc. and IBM Credit Corporation                |   |   |   | 10-K   |   | 10.23  |   | 000-28488 |   | 3/13/01  |
| 23.1  |   | Consent  of PricewaterhouseCoopers LLP                                                                                                                       |   | X      |   |   |   |   |   |      |   |     |

 

 

(d)  3. Reports on Form 8-K

 

None.

 

24

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**SIGNATURES**

 

 

 

 

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

 

 

 
|                          |   | ZONES, INC.                                           |
|-------------------------------|--------|-------------------------------------------------------|
|                          |   |                                                  |
|                          |   |                                                  |
|                          |   |                                                  |
| Date:  February 26, 2002 |   |                                                  |
|                          | By:    | /S/ FIROZ H. LALJI                                    |
|                          |   | Firoz H. Lalji,  Chairman and Chief Executive Officer |
|                          |   |                                                  |
|                          |   |                                                  |
|                          |   | /S/ RONALD P. MCFADDEN                                |
|                          |   | Ronald P. McFadden,  Chief Financial Officer          |

 

Pursuant to therequirements of the Securities Exchange act of 1934, this report has beensigned below by the following persons on behalf of the registrant and in thecapacities and on the date indicated. 

 

 
| **Signature**                      |   | **Title** |   | **Date**          |
|------------------------------------|--------|-----------|--------|-------------------|
|                               |   |      |   |              |
| /S/   JOHN H.  BAUER     |   | Director  |   | February 26, 2002 |
| John H. Bauer                      |   |      |   |              |
|                               |   |      |   |              |
| /S/   JOHN T. CARLETON   |   | Director  |   | February 26, 2002 |
| John T. Carleton                   |   |      |   |              |
|                               |   |      |   |              |
| /S/   RICHARD E. CARTER  |   | Director  |   | February 26, 2002 |
| Richard E. Carter                  |   |      |   |              |
|                               |   |      |   |              |
| /S/   FIROZ H. LALJI     |   | Director  |   | February 26, 2002 |
| Firoz H. Lalji                     |   |      |   |              |
|                               |   |      |   |              |
| /S/   KATHLEEN S. PUSHOR |   | Director  |   | February 26, 2002 |
| Kathleen S. Pushor                 |   |      |   |              |

 

 

25

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**ZONES, INC.**

**INDEX TO CONSOLIDATED FINANCIALSTATEMENTS**

 

** **
| Consolidated Financial Statements:                                                                                  |   |
|---------------------------------------------------------------------------------------------------------------------|--------|
|                                                                                                                |   |
| Consolidated Balance Sheets  December 31, 2001 and 2000                                                             | 27     |
|                                                                                                                |   |
| Consolidated  Statements of Operations and Comprehensive Loss Twelve months ended December  31, 2001, 2000 and 1999 | 28     |
|                                                                                                                |   |
| Statements of  Shareholders’ Equity Twelve months ended December 31, 2001, 2000 and 1999                       | 29     |
|                                                                                                                |   |
| Consolidated  Statements of Cash Flows Twelve months ended December 31, 2001, 2000 and 1999                         |   |
|                                                                                                                |   |
| Notes to  Consolidated Financial Statements                                                                         | 31     |
|                                                                                                                |   |
| Report of Independent  Accountants                                                                                  | 42     |

 

 

26

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**ZONES, INC.**

**CONSOLIDATEDBALANCE SHEETS**

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

** **
|                                                                                                                                                      |   | **December  31,** |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------|--------|-------------------|--------|
|                                                                                                                                                      |   | **2001**          |   | **2000** |   |
| **ASSETS**                                                                                                                                                |   |              |   |   |   |
| Current  assets:                                                                                                                                          |   |              |   |   |   |
| Cash  and cash equivalents                                                                                                                                |   | $                 | 12,141 |   | $ | 3,816 |   |
| Restricted  cash                                                                                                                                          |   | 930               |   | 930 |   |
| Receivables,  net                                                                                                                                         |   | 32,120            |   | 56,608 |   |
| Inventories,  net                                                                                                                                         |   | 16,896            |   | 29,050 |   |
| Prepaid  expenses                                                                                                                                         |   | 979               |   | 1,110 |   |
| Deferred  tax asset                                                                                                                                       |   | 1,743             |   | 1,970 |   |
| Notes  Receivable                                                                                                                                         |   |              |   | 1,080 |   |
| Total  current assets                                                                                                                                     |   | 64,809            |   | 94,564 |   |
| Property  and equipment, net                                                                                                                              |   | 7,543             |   | 11,710 |   |
| Deferred  tax asset                                                                                                                                       |   | 5,207             |   | 4,810 |   |
| Other  assets                                                                                                                                             |   | 342               |   | 186 |   |
| Total  assets                                                                                                                                             |   | $                 | 77,901 |   | $ | 111,270 |   |
|                                                                                                                                                      |   |              |   |   |   |
| **LIABILITIES  AND SHAREHOLDERS’ EQUITY**                                                                                                            |   |              |   |   |   |
| Current  liabilities:                                                                                                                                     |   |              |   |   |   |
| Accounts  payable                                                                                                                                         |   | $                 | 37,994 |   | 66,267 |   |
| Accrued  liabilities and other                                                                                                                            |   | 6,126             |   | 9,212 |   |
| Current  portion of capital lease obligations                                                                                                             |   | 1,412             |   | 1,905 |   |
| Total  current liabilities                                                                                                                                |   | 45,532            |   | 77,384 |   |
| Capital  lease obligations, net of current portion                                                                                                        |   | 226               |   | 1,197 |   |
| Deferred  rent                                                                                                                                            |   | 585               |   | 955 |   |
| Total  liabilities                                                                                                                                        |   | 46,343            |   | 79,536 |   |
|                                                                                                                                                      |   |              |   |   |   |
| Minority  interest                                                                                                                                        |   |              |   | 131 |   |
|                                                                                                                                                      |   |              |   |   |   |
| Commitments  and contingencies (Note 9)                                                                                                                   |   |              |   |   |   |
|                                                                                                                                                      |   |              |   |   |   |
| Shareholders’  equity:                                                                                                                               |   |              |   |   |   |
| Common  stock, no par value, 45,000,000 authorized;  13,536,406 and 13,403,658 shares issued and outstanding at  December 31, 2001 and 2000, respectively |   | 39,500            |   | 39,360 |   |
| Accumulated  deficit                                                                                                                                      |   | (7,942            | )      | (7,757 | ) |
| Total  shareholders’ equity                                                                                                                          |   | 31,558            |   | 31,603 |   |
| Total  liabilities and shareholders’ equity                                                                                                          |   | $                 | 77,901 |   | $ | 111,270 |   |

 

Theaccompanying notes are an integral part of the consolidated financialstatements.

 

 

27

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**ZONES,INC.**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS AND COMPREHENSIVE LOSS**

**(inthousands, except per share data)**

 
|                                                                                             |   | **Year ended  December 31,** |    |
|--------------------------------------------------------------------------------------------------|--------|------------------------------|---------|
|                                                                                             |   | **2001**                     |    | **2000** |   | **1999** |   |
| Net  sales                                                                                       |   | $                            | 541,075 |   | $ | 634,063 |   | $ | 499,792 |   |
| Cost  of sales                                                                                   |   | 487,450                      |    | 574,080 |   | 451,025 |   |
| Gross  profit                                                                                    |   | 53,625                       |    | 59,983 |   | 48,767 |   |
|                                                                                             |   |                         |    |   |   |   |   |
| Selling,  general and administrative                                                             |   | 53,985                       |    | 61,632 |   | 57,502 |   |
| Loss  from operations                                                                            |   | (360                         | )       | (1,649 | ) | (8,735 | ) |
|                                                                                             |   |                         |    |   |   |   |   |
| Interest  expense                                                                                |   | 309                          |    | 968 |   | 512 |   |
| Other  (income) expense                                                                          |   | (204                         | )       | (2,058 | ) | 150 |   |
| Minority  interest                                                                               |   | (131                         | )       | (16 | ) | (101 | ) |
|                                                                                             |   | (26                          | )       | (1,106 | ) | 561 |   |
| Loss  before taxes                                                                               |   | (334                         | )       | (543 | ) | (9,296 | ) |
| Benefit  for income taxes                                                                        |   | (149                         | )       | (188 | ) | (2,637 | ) |
| Net  loss before cumulative effect of change in accounting principle                             |   | (185                         | )       | (355 | ) | (6,659 | ) |
| Cumulative  effect of change in method of revenue recognition                                    |   |                         |    | (59 | ) |   |   |
| Net  loss                                                                                        |   | $                            | (185    | ) | $ | (414 | ) | $ | (6,659 | ) |
|                                                                                             |   |                         |    |   |   |   |   |
| Other  comprehensive loss, net of tax:                                                           |   |                         |    |   |   |   |   |
| Foreign  currency translation adjustment                                                         |   |                         |    |   |   | 31 |   |
| Reclassification  for gains included in net loss                                                 |   |                         |    |   |   | 290 |   |
| Other  comprehensive loss                                                                        |   |                         |    |   |   | 321 |   |
| Comprehensive  loss                                                                              |   | $                            | (185    | ) | $ | (414 | ) | $ | (6,980 | ) |
|                                                                                             |   |                         |    |   |   |   |   |
| Basic  and diluted loss per share before cumulative effect                                       |   | $                            | (0.01   | ) | $ | (0.03 | ) | $ | (0.50 | ) |
| Basic  and diluted loss per share of cumulative effect                                           |   |                         |    | (0.00 | ) |   |   |
| Basic  and diluted loss per share after cumulative effect                                        |   | $                            | (0.01   | ) | $ | (0.03 | ) | $ | (0.50 | ) |
|                                                                                             |   |                         |    |   |   |   |   |
| Weighted  average shares used in computing basic and diluted loss per share                      |   | 13,488                       |    | 13,383 |   | 13,287 |   |
|                                                                                             |   |                         |    |   |   |   |   |
| Pro  forma amount assuming the new revenue recognition principle is applied  retroactively— |   |                         |    |   |   |   |   |
| Net  loss                                                                                        |   |                         |    | $ | (355 | ) | $ | (6,543 | ) |
| Basic  and diluted loss per share                                                                |   |                         |    | $ | (0.03 | ) | $ | (0.49 | ) |

 

Theaccompanying notes on an integral part of the consolidated financialstatements.

 

 

28

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**ZONES, INC.**

**STATEMENTS OF SHAREHOLDERS’ EQUITY**

**(inthousands, except share data)**

** **
|                                   |   | **Common  Stock** |   | **Accumulated** |   | **Accumulated    Other   Comprehensive   Income (Loss)** |   |       |   |
|----------------------------------------|--------|-------------------|--------|-----------------|--------|----------------------------------------------------------|--------|------------|--------|
|                                   |   | **Shares**        |   | **Amount**      |   | **(Deficit)**                                            |   | **Amount** |   | **Total** |   |
| Balance,  January 1, 1999              |   | 13,173,692        |   | $               | 38,434 |                                                     | $      | (982       | )      | $ | (102 | ) | $ | 37,350 |   |
| Issuance  of common stock              |   | 18,130            |   | 98              |   |                                                     |   |       |   | 98 |   |
| Exercise  of stock options             |   | 154,465           |   | 652             |   |                                                     |   |       |   | 652 |   |
| Net  loss                              |   |              |   |            |   | (6,659                                                   | )      |       |   | (6,659 | ) |
| Tax  effect of stock options exercised |   |              |   |            |   | 273                                                      |   |       |   | 273 |   |
| Translation  adjustment                |   |              |   |            |   |                                                     |   | 126        |   | 126 |   |
| Balance,  December 31, 1999            |   | 13,346,287        |   | 39,184          |   | (7,368                                                   | )      | 24         |   | 31,840 |   |
| Issuance  of common stock              |   | 23,053            |   | 92              |   |                                                     |   |       |   | 92 |   |
| Exercise  of stock options             |   | 34,318            |   | 84              |   |                                                     |   |       |   | 84 |   |
| Net  loss                              |   |              |   |            |   | (414                                                     | )      |       |   | (414 | ) |
| Tax  effect of stock options exercised |   |              |   |            |   | 25                                                       |   |       |   | 25 |   |
| Translation  adjustment                |   |              |   |            |   |                                                     |   | (24        | )      | (24 | ) |
| Balance,  December 31, 2000            |   | 13,403,658        |   | 39,360          |   | (7,757                                                   | )      |       |   | 31,603 |   |
| Issuance  of common stock              |   | 131,248           |   | 136             |   |                                                     |   |       |   | 136 |   |
| Exercise  of stock options             |   | 1,500             |   | 4               |   |                                                     |   |       |   | 4 |   |
| Net  loss                              |   |              |   |            |   | (185                                                     | )      |       |   | (185 | ) |
| Balance,  December 31, 2001            |   | 13,536,406        |   | $               | 39,500 |                                                     | $      | (7,942     | )      |   |   | $ | 31,558 |   |
|                                        |        |                   |        |                 |        |                                                          |        |            |        |  |  |  |  |  |  |

 

The accompanying notes are an integral part of theconsolidated financial statements.

 

 

29

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**ZONES,INC.**

**CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

**(inthousands)**

 
|                                                                             |   | **Year ended  December 31,** |   |
|----------------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                             |   | **2001**                     |   | **2000** |   | **1999** |   |
| Cash  flows from operating activities:                                           |   |                         |   |   |   |   |   |
| Net  loss                                                                        |   | $                            | (185   | ) | $ | (414 | ) | $ | (6,659 | ) |
| Adjustments  to reconcile net loss to net cash provided by operating activities: |   |                         |   |   |   |   |   |
| Depreciation  and amortization                                                   |   | 6,115                        |   | 5,929 |   | 4,184 |   |
| Deferred  income taxes                                                           |   | (170                         | )      | (288 | ) | 1,357 |   |
| Loss  on disposal of assets                                                      |   |                         |   | 165 |   | 260 |   |
| (Gain)loss  on disposal of subsidiaries                                          |   |                         |   | (1,674 | ) | 541 |   |
| Minority  interest                                                               |   | (131                         | )      | (16 | ) | 229 |   |
| Tax  effect of stock options exercised                                           |   |                         |   | 24 |   | 273 |   |
| Changes  in assets and liabilities:                                              |   |                         |   |   |   |   |   |
| Accounts  receivable                                                             |   | 24,488                       |   | (24,310 | ) | 5,864 |   |
| Inventories                                                                      |   | 12,154                       |   | (11,428 | ) | 27,805 |   |
| Prepaid  expenses and other assets                                               |   | 1,054                        |   | 434 |   | (1,091 | ) |
| Accounts  payable                                                                |   | (20,413                      | )      | 7,958 |   | (19,572 | ) |
| Accrued  liabilities                                                             |   | (3,456                       | )      | 1,085 |   | (703 | ) |
| Income  taxes payable                                                            |   |                         |   |   |   | (1,077 | ) |
|                                                                             |   |                         |   |   |   |   |   |
| Net  cash provided by (used in)  operating  activities                      |   | 19,456                       |   | (22,535 | ) | 11,411 |   |
|                                                                             |   |                         |   |   |   |   |   |
| Cash  flows from investing activities:                                           |   |                         |   |   |   |   |   |
| Purchases  of property and equipment                                             |   | (1,948                       | )      | (3,830 | ) | (6,016 | ) |
| Proceeds  on disposal of subsidiaries                                            |   |                         |   | 500 |   | 740 |   |
|                                                                             |   |                         |   |   |   |   |   |
| Net  cash used in investing activities                                           |   | (1,948                       | )      | (3,330 | ) | (5,276 | ) |
|                                                                             |   |                         |   |   |   |   |   |
| Cash  flows from financing activities:                                           |   |                         |   |   |   |   |   |
| Net  borrowing (payments) under line of credit agreement                         |   |                         |   |   |   | 333 |   |
| Net  change in book overdrafts                                                   |   | (7,860                       | )      | 6,040 |   | (1,003 | ) |
| Net  payments on capital leases                                                  |   | (1,463                       | )      | (1,379 | ) | (1,552 | ) |
| Restricted  cash                                                                 |   |                         |   | (930 | ) |   |   |
| Net  proceeds from sale of common stock                                          |   | 140                          |   | 176 |   | 750 |   |
| Capital  lease obligation                                                        |   |                         |   |   |   | 2,101 |   |
|                                                                             |   |                         |   |   |   |   |   |
| Net  cash provided by (used in) financing activities                             |   | (9,183                       | )      | 3,907 |   | 629 |   |
|                                                                             |   |                         |   |   |   |   |   |
| Effect  of exchange rate on cash and cash equivalents                            |   |                         |   |   |   | (82 | ) |
| Net  increase (decrease) in cash and cash equivalents                            |   | 8,325                        |   | (21,958 | ) | 6,682 |   |
| Cash  and cash equivalents at beginning of period                                |   | 3,816                        |   | 25,774 |   | 19,092 |   |
|                                                                             |   |                         |   |   |   |   |   |
| Cash  and cash equivalents at end of period                                      |   | $                            | 12,141 |   | $ | 3,816 |   | $ | 25,774 |   |
|                                                                             |   |                         |   |   |   |   |   |
| Supplemental  cash flow information:                                             |   |                         |   |   |   |   |   |
| Cash  paid for interest                                                          |   | $                            | 290    |   | $ | 838 |   | $ | 512 |   |
| Cash  paid (received) for income taxes                                           |   | $                            | 16     |   | $ | (235 | ) | $ | (3,043 | ) |
|                                                                             |   |                         |   |   |   |   |   |
| Noncash  investing and financing activity:                                       |   |                         |   |   |   |   |   |
| Capital  leases to finance purchases of  equipment                          |   | $                            | 573    |   | $ | 2,158 |   | $ | 233 |   |
| Note  received on sale of subsidiary                                             |   |                         |   | $ | 1,400 |   |   |   |

 

Theaccompanying notes are an integral part of the consolidated financialstatements.

 

30

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**ZONES,INC.**

**NOTESTO CONSOLIDATED FINANCIAL STATEMENTS**

 

**1. Description of Business**

 

**Zones, Inc. (the “Company”) is a single-source,multi-vendor direct reseller of name-brand information technology products tothe fast growing small to medium sized business market (“SMB”), enterprise andgovernment and education accounts. Zones sells these products through outbound and inbound accountexecutives, specialty print and e-catalogs and the Internet.  Zones offers more than 150,000 products fromleading manufacturers including Apple, Compaq, Hewlett-Packard, IBM, Microsoftand Toshiba.**

 

The Company wasincorporated in November 1988 as a Washington corporation.  The Company’s headquarters are located inRenton, Washington.

 

**2. Summary of Significant Accounting Policies**

 

*Principles of Consolidation*

The accompanyingconsolidated financial statements include the accounts of the Company and itsmajority owned subsidiaries. Intercompany transactions and balances have been eliminated inconsolidation.

 

*Cash and Cash Equivalents*

Cash and cash equivalentsrepresent highly liquid investments with initial maturities of three months orless.

 

*Restricted Cash*

The Companypurchased a certificate of deposit in the amount of $930,000 in December2000.  This certificate of deposit wasrequired as security in obtaining a new lease and was restricted for one fullyear.  In December 2001, the restrictionwas extended for one more year.  As ofDecember 31, 2001, this certificate of deposit had not been redeemed.

 

*Concentration of Credit Risk*

Cash balances subject to credit risk consist of cash balancesheld in one financial institution in the United States.  The Company has not experienced any lossesassociated with cash balances and believes that there is minimal riskassociated with the cash balances.  Exceptfor amounts due from a significant customer (see Note 13), concentration ofcredit risk with respect to trade receivables is limited due to the Company’sdiverse customer base.  The Companyclosely monitors extensions of credit but does not require collateral.

 

*Inventories*

Inventoriesconsist primarily of computer hardware and software.  Inventories are valued at the lower of first-in, first-out (FIFO)cost or market.  Balances at December31, 2001 and 2000 are net of allowances for obsolescence of approximately$1,531,000 and  $1,691,000,respectively.  The balance at December31, 2001 and 2000 includes inventory in transit to customers of $1,595,000 and$4,561,000, respectively due to the change in accounting principle for SAB 101“Revenue Recognition”.

 

The Company currently buys a significant portion of itsproducts from three suppliers. Purchases from Ingram Micro, Tech Data and AppleComputer represented 30.8%, 14.6% and 10.5%, respectively, of the Company’stotal product purchases in 2001. Purchases from Ingram Micro and Apple Computerrepresented 39.1% and 10.8%, respectively, of the Company’s total productpurchases in 2000. No other vendor supplied more than 10.0% of the Company’stotal product purchases in 2001 or 2000. Although there are a limited number ofmanufacturers, the Company believes that other suppliers could provide similarproducts if its relationship with any of these suppliers was interrupted.

 

*Property and Equipment*

Property andequipment is recorded at cost. Depreciation is computed based on the straight-line method over theestimated useful lives of the related assets. Useful lives for computer hardware and software range from 3 to 5 yearsand other property and equipment from 3 to 10 years.  Capital leases are amortized based on the straight-line methodover the estimated useful lives of the related assets or lease life, whicheveris shorter, generally 3 to 10 years. Expenditures for maintenance and repairs are charged to expense as incurred,while additions, renewals and betterments are capitalized.  Gains or losses from sales or retirementsare included in other income and expense. The Company evaluates the carrying value of long-lived assets based uponcurrent and anticipated undiscounted cash flows, and recognizes an impairmentwhen it is probable that such estimated

 

31

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future net incomeor cash flows will be less than the asset carrying value.

 

*Income Taxes*

Deferred incometaxes are provided based on the estimated future tax effects of temporarydifferences between financial statement carrying amounts of existing assets andliabilities and their respective tax bases. Deferred tax assets and liabilities are measured using enacted tax ratesthat are expected to apply to taxable income in the years in which thosetemporary differences are expected to be recovered or settled.

 

*Useof Estimates*

The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States of America requires management to make estimatesand assumptions that affect the reported amounts of assets and liabilities anddisclosure of contingent assets and liabilities at the date of the financialstatements and the reported amounts of revenues and expenses during thereporting period.  Actual results coulddiffer from those estimates.

 

*Foreign Currency Translation*

As of December 31,2000, the Company no longer has any foreign subsidiaries.  In previous years, the assets andliabilities of the Company’s foreign subsidiaries were translated into U.S.dollars at the exchange rate in effect at the balance sheet date, and revenuesand expenses were translated at weighted average rates during the period.   The resulting translation adjustment wasreflected as a component of other comprehensive income (loss).

 

*Revenue Recognition*

The Companyrecognizes revenue on product sales when persuasive evidence of an arrangementexists, delivery has occurred, prices are fixed or determinable, andcollectability is probable.  The Companyconsiders the point of delivery of the product to be when the risks and rewardsof ownership have transferred to the customer. The Company offers limited return rights on its product sales.  At the point of sale, the Company alsoprovides for an allowance for sales returns, which is established based onhistorical experience.

 

The Companyadopted Staff Accounting Bulletin No. 101 “Revenue Recognition” (“SAB 101”) inthe fourth quarter of fiscal year 2000 and retroactively applied it to January1, 2000, which resulted in a cumulative effect adjustment for a change inaccounting principle of a $59,000 charge to income.  The adjustment resulted from the change in timing of revenuerecognition resulting from the implementation of SAB 101, from the point ofshipment to the point of delivery to the customer.  The pro forma amounts shown on the consolidated statements ofoperations and comprehensive loss have been adjusted for the effect ofretroactive application of the revenue recognition method, which would havebeen made had the new method been in effect, and related income taxes.

 

The Companyadopted EITF Issue 00-10 “Accounting for Shipping and Handling Fees and Costs”in the fourth quarter of fiscal year 2000. For all future fiscal years, the Company will classify amounts billedfor shipping and handling as revenue. Prior year comparative balances have been reclassified to conform to thecurrent year presentation.  Reclassificationsof freight revenue amounted to $9.2 million, $12.4 million and $12.4 millionfor the years ending December 31, 2001, 2000 and 1999, respectively.

 

*Catalog Costs and Revenues*

The Company produces and distributes catalogs at variousintervals throughout the year.  Costs toproduce and distribute individual catalogs, including paper, printing, postage,production and design costs, are capitalized and amortized to selling expenseduring the period in which the catalogs are generating substantial sales(generally one month).  Capitalized advertisingcosts of $416,000 and $523,000 were included with prepaid expenses at December31, 2001 and 2000, respectively.  TheCompany receives cooperative advertising funds from most vendors for whom theCompany places advertisements in its catalogs. These funds reduce the net expense in the same period in which thecorresponding catalog cost is recognized. Advertising expense, net of co-op advertising funds, is included inselling, general and administrative expenses and totaled $2,525,000, $3,113,000and $3,622,000 for the years ended December 31, 2001, 2000 and 1999,respectively.

 

### *SegmentReporting*

The Company’sreportable segment is a single-source, multi-vendor direct reseller ofname-brand information technology products to small to medium sized businesses,enterprise, and government and education markets.

 

32

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*Recent AccountingPronouncements*

In June 1998, the Financial Accounting StandardsBoard issued SFAS No. 133, “Accounting for Derivative Instruments and HedgingActivities” (“SFAS No. 133).  Amongother provisions, SFAS No. 133 requires that entities recognize all derivativesas either assets or liabilities in the statement of financial position andmeasure those instruments at fair value. Gains and losses resulting from changes in the fair values of thosederivatives would be accounted for depending on the use of the derivative andwhether it qualifies for hedge accounting. The effective date of SFAS No. 133 was delayed by the issuance of SFAS No.137 until the fiscal years beginning January 1, 2001. In June 2000, SFAS 138was issued, which amends provisions of SFAS 133.  Theadoption of these standards on January 1, 2001 did not have a material impacton the Company’s financial position, as the Company currently holds noderivatives.

 

In July 2001, the Financial Accounting StandardsBoard issued SFAS 141, “Business Combinations” (“SFAS 141”).   SFAS 141 addresses financial accounting andreporting for business combinations. SFAS 141 is effective for all business combinations for which the dateof acquisition is July 1, 2001 or later. Adoption of SFAS 141 in 2001 did not have a significant impact on theCompany’s results of operations, financial position and cash flows.

 

In July 2001, the Financial Accounting StandardsBoard issued SFAS 142, “Goodwill and Other Intangible Assets” (“SFAS 142”).SFAS 142 addresses financial accounting and reporting for acquired goodwill andother intangible assets.  The provisionsof SFAS 142 will be effective for fiscal years beginning after December 15, 2001,except that certain provisions of SFAS 142 shall be applied to goodwill andother acquired intangible assets for which the acquisition date is after June30, 2001. The Company does not believe SFAS 142 will have a significant impacton its results of operations, financial position and cash flows.

 

In July 2001, the Financial Accounting StandardsBoard issued SFAS 143, “Accounting for Asset Retirement Obligations” (“SFAS143”).  SFAS 143 addresses financialaccounting and reporting for obligations associated with the retirement oftangible long-lived assets and the associated asset retirement costs. Itapplies to legal obligations associated with the retirement of long-livedassets that result from the acquisition, construction, development, and (or) thenormal operation of a long-lived asset, except for certain obligations oflessees. The provisions of SFAS 143 will be effective for fiscal yearsbeginning after June 15, 2002, however early application is permitted. TheCompany does not believe SFAS 143 will have a significant impact on its resultsof operations, financial position and cash flows.

 

In August 2001, the Financial Accounting Standards Boardissued SFAS 144 “Accounting for the Impairment or Disposal of Long-LivedAssets” (“SFAS 144”).  SFAS 144addresses financial accounting and reporting for the impairment or disposal oflong-lived assets.  SFAS 144 supersedesFASB Statement No. 121, Accounting for the Impairment of Long-Lived Assets andfor Long-Lived Assets to Be Disposed Of, and the accounting and reportingprovisions of APB Opinion No. 30, Reporting the Results of Operations —Reporting the Effects of Disposal of a Segment of a Business, andExtraordinary, Unusual and Infrequently Occurring Events and Transactions, forthe disposal of a segment of a business. The provisions of SFAS 144 will be effective for fiscal years beginningafter December 15, 2001. The Company is currently evaluating the implicationsof adoption of SFAS 144 on its results of operations, financial position andcash flows.

 

### *Reclassifications*

Certainreclassifications of prior years’ balances have been made to conform to thefiscal year 2001 presentation.

 

**3. Fair Value of Financial Instruments**

 

The estimated fairvalue of the Company’s financial instruments approximates their carrying valuedue to their short-term nature.  Theestimated fair value of the line of credit approximates the carrying value asthis instrument requires interest payments at a market rate of interest plus amargin.

 

33

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**4. Receivables**

 

Receivables consist ofthe following (in thousands):

** **
|                                  |   | **December  31,** |   |
|---------------------------------------|--------|-------------------|--------|
|                                  |   | **2001**          |   | **2000** |   |
| Trade                                 |   | $                 | 27,020 |   | $ | 43,178 |   |
| Vendor  receivables/Co-op advertising |   | 5,987             |   | 14,175 |   |
| Licensees  and other                  |   | 958               |   | 1,411 |   |
|                                  |   | 33,965            |   | 58,764 |   |
| Less  allowances                      |   | (1,845            | )      | (2,156 | ) |
|                                  |   | $                 | 32,120 |   | $ | 56,608 |   |

 

**5. Property and Equipment**

 

Property andequipment consists of the following (in thousands):

 
|                                                 |   | **December  31,** |   |
|------------------------------------------------------|--------|-------------------|--------|
|                                                 |   | **2001**          |   | **2000** |   |
| Equipment                                            |   | $                 | 8,539  |   | $ | 8,396 |   |
| Computer  hardware and software under capital leases |   | 7,375             |   | 6,937 |   |
| Computer  software/Web development                   |   | 11,808            |   | 10,581 |   |
| Furniture  and fixtures and leasehold improvements   |   | 3,301             |   | 3,175 |   |
|                                                 |   | 31,023            |   | 29,089 |   |
| Less  accumulated depreciation and amortization      |   | (23,480           | )      | (17,379 | ) |
| Property  and equipment, net                         |   | $                 | 7,543  |   | $ | 11,710 |   |

 

Included in accumulateddepreciation and amortization is accumulated amortization associated withcapital leases at December 31, 2001 and 2000 of $5,722,000 and $4,519,000,respectively.

 

**6. Line of Credit**

 

At December 31, 2001, theCompany had a $35,000,000 credit facility with a major financial institutionthat can be utilized as both a working line and as a flooring line.  This credit facility expires June 30, 2002 andis subject to annual renewals.  At thistime the Company expects to renew this credit facility.  This credit facility is collateralized bythe Company’s accounts receivable and inventory.  Interest on the working line was charged at the prime lendingrate of 4.75% and 9.50% at December 31, 2001 and 2000, respectively.  No borrowing amounts were outstanding on theworking line at December 31, 2001 or 2000. The flooring line facilitates the purchase of inventory from varioussuppliers under certain terms and conditions. At December 31, 2001, accounts payable included $14,270,000 owed to thisfinancial institution under the flooring line, compared to $11,505,000 atDecember 31, 2000.  Amounts purchasedunder the flooring line generally require payment within a period of 30 days,and no interest is charged.  Interestwill accrue on amounts not paid by the end of this period at variable rates.

 

The Company uses thiscredit facility under its cash management system to cover checks presented forpayment in excess of cash balances.  Asof December 31, 2001 and 2000, the Company had book overdrafts of $404,000 and$8,264,000, respectively, which are included with accounts payable.

 

The line of creditagreement contains certain covenants and restrictions requiring, among otherthings, a minimum tangible net worth and certain other financial ratios andrestrictions.  The Company was incompliance with the restrictive covenants contained in the agreements atDecember 31, 2001.

 

34

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**7.****             ****Accrued Liabilities and Other**

 

Accrued liabilitiesconsists of the following (in thousands):

 
|                 |   | **December  31,** |   |
|----------------------|--------|-------------------|--------|
|                 |   | **2001**          |   | **2000** |   |
| Accrued  payroll     |   | $                 | 2,302  |   | $ | 3,013 |   |
| Accrued  taxes       |   | 1,664             |   | 1,915 |   |
| Accrued  advertising |   | 443               |   | 1,083 |   |
| Other  accruals      |   | 1,717             |   | 3,201 |   |
| Total                |   | $                 | 6,126  |   | $ | 9,212 |   |

 

**8. Income Taxes**

 

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

 
|                                        |   | **Year ended  December 31,** |   |
|---------------------------------------------|--------|------------------------------|--------|
|                                        |   | **2001**                     |   | **2000** |   | **1999** |   |
| Current                                     |   | $                            | 27     |   | $ | (27 | ) | $ | (690 | ) |
| Deferred                                    |   | (176                         | )      | (161 | ) | (452 | ) |
| Valuation  allowance for deferred tax asset |   |                         |   |   |   | (1,495 | ) |
| Total                                       |   | $                            | (149   | ) | $ | (188 | ) | $ | (2,637 | ) |

 

The components ofdeferred taxes were as follows (in thousands):

 
|                                 |   | **December  31,** |   |
|--------------------------------------|--------|-------------------|--------|
|                                 |   | **2001**          |   | **2000** |   |
| Assets:                              |   |              |   |   |   |
| Allowance  for doubtful accounts     |   | $                 | 684    |   | $ | 782 |   |
| Inventory  allowances                |   | 585               |   | 643 |   |
| Deferred  rent                       |   | 215               |   | 352 |   |
| Accrued  liabilities and other       |   | 512               |   | 686 |   |
| Net  operating losses                |   | 5,207             |   | 5,704 |   |
|                                 |   | $                 | 7,203  |   | $ | 8,167 |   |
| Liabilities:                         |   |              |   |   |   |
| Property  and equipment depreciation |   | (253              | )      | (1,387 | ) |
|                                 |   | (253              | )      | (1,387 | ) |
| Net  deferred tax asset              |   | $                 | 6,950  |   | $ | 6,780 |   |

 

The net deferredtax asset is recognized in the accompanying balance sheet as follows (inthousands):

 
| Current  deferred tax asset            |   | $     | 1,743  |   | $      | 1,970 |   |
|----------------------------------------|--------|-------|--------|--------|--------|-------|--------|
| Non-current  deferred income tax asset |   | 5,207 |   | 4,810  |   |
| Net  deferred tax asset                |   | $     | 6,950  |   | $      | 6,780 |   |

 

Although realization isnot assured, management believes it is more likely than not that the deferredtax asset will be realized through future taxable income.  The Company’s net operating losses beginexpiring in 2019.

 

35

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A reconciliation of theeffective income tax rate on loss before taxes with the federal statutory ratefollows:

 
|                                         |   | **Year ended  December 31,** |   |
|----------------------------------------------|--------|------------------------------|--------|
|                                         |   | **2001**                     |   | **2000** |   | **1999** |   |
| Statutory  rate                              |   | (35.0                        | )%     | (35.0 | )% | (35.0 | )% |
| State  income tax                            |   | 5.3                          |   | (2.3 | ) | (0.6 | ) |
| Permanent  differences                       |   | 13.8                         |   | 2.7 |   | 0.8 |   |
| Changes  in prior year estimated taxes       |   | (28.7                        | )      |   |   |   |   |
| Valuation  allowance for deferred tax assets |   |                         |   |   |   | 6.4 |   |
| Effective  tax rate                          |   | (44.6                        | )%     | (34.6 | )% | (28.4 | )% |

 

**9. Commitments and Contingencies**

 

*Operating Leases*

The Company leases itsoffice, returns warehouse space and other equipment under noncancelableoperating leases that expire through 2004. Under the terms of certain leases, the Company is responsible for itsshare of taxes, insurance and common area charges.  At December 31, 2001, future minimum payments under operatingleases were as follows (in thousands):

 
| 2002  |   | $     | 2,017  |   |
|-------|--------|-------|--------|--------|
| 2003  |   | 1,114 |   |
| 2004  |   | 55    |   |
| Total |   | $     | 3,186  |   |

 

Rental expense, which is recorded on a straight line basis,totaled $2,823,000, $2,405,000 and $2,165,000 for the years ended December 31,2001, 2000 and 1999, respectively.

 

*Obligations Under Capital Leases*

The Company leasesequipment and software under various long-term capital leases that expire through2003.  Future lease payments as ofDecember 31, 2001 were as follows (in thousands):

 
| 2002                                         |   | $      | 1,491  |   |
|----------------------------------------------|--------|--------|--------|--------|
| 2003                                         |   | 231    |   |
| Total  future minimum lease payments         |   | 1,722  |   |
| Less  amount representing interest           |   | (84    | )      |
| Present  value of net minimum lease payments |   | 1,638  |   |
| Less  current portion                        |   | (1,412 | )      |
| Non-current  portion                         |   | $      | 226    |   |

### * *

### *Distribution Center*

The Company hascontracted with a logistics company to provide and operate its primarydistribution center under a renewable contract that expires August 31,2003.  Under this contract, the Companypays a flat rate for each purchase order received and customer order filled.

 

### *Letter of Credit*

The Company had a standbyletter of credit totaling $930,000 at December 31, 2001, which wascollateralized by a certificate of deposit that is recorded as restricted cash.

 

*Legal Proceedings*

Various claims andactions considered normal to the Company’s business have been asserted and arepending against the Company.  TheCompany believes that such claims and actions will not have a material adverseeffect upon the Company’s financial position, cash flows or results ofoperations.

 

The Washington StateDepartment of Revenue (the “Department”) is currently examining the Company’sstate tax returns for the years 1996, 1997, 1998 and 1999.  The Company has received a final report, andthe Department has assessed $2.1 million plus interest.  Based on discussions with the Department,the Company disagrees with substantially all of the deficiencies and hascontested such deficiencies through the administrative appeals process and ispursuing further litigation.  There canbe no assurance that the Company 

 

36

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will be successful, inwhole or in part, in challenging the proposed deficiencies.  Additionally, the Department may also make asimilar assessment for 2000 and 2001. An unfavorable decision could have a material effect on the Company.

 

### *Liquidity*

While the Company hasexperienced losses in the last three years, it believes that its existingavailable cash and cash equivalents, operating cash flow in 2002 and existingcredit facilities will be sufficient to satisfy its operating cash needs for atleast the next 12 months at its current level of business.  However, if the Company’s working capital orother capital requirements are greater than currently anticipated, the Companycould be required to seek additional funds through sales of equity, debt orconvertible securities or increased credit facilities.  There can be no assurance that additionalfinancing will be available or that, if available, the financing will be onterms favorable to the Company.

 

**10. Shareholders’ Equity**

 

*Stock Options*

In 1993, the Companyadopted a Stock Incentive Plan (the “Plan”) whereby the Company may issue incentiveor nonqualified stock options, restricted shares, stock units or stockappreciation rights to key employees. As of December 31, 2001, only stock options have been granted under theplan.  Stock options are granted solelyat the discretion of the Board of Directors and are generally issued at a priceequal to the estimated fair market value of the stock at the date ofgrant.  The term of each option grantedis for such period as determined by the Board of Directors, but not more thanten years from date of grant.  Optionsmay generally be exercised based on a vesting schedule determined by the Boardof Directors, and the plan provides for acceleration of outstanding optionsunder certain conditions, including certain changes in control of the Company.  Grants are nontransferable, and sharesacquired upon exercise of options may be subject to repurchase at the option ofthe Company under certain conditions. The maximum number of shares to be granted under the Plan was 2,650,000at December 31, 2001.

 

In addition to optionsgranted under the Plan, the Company has granted options under a separate planto the Board of Directors.  Optionsoutstanding to these individuals at December 31, 2001 were 135,000 shares atoption prices of $2.13 - $12.00 per share. The maximum number of shares to be granted under this plan was 150,000at December 31, 2001.

 

The Company has adoptedthe disclosure-only provisions of Statement of Financial Accounting StandardsNo. 123, “Accounting for Stock-Based Compensation” (“SFAS 123”).  Accordingly, no compensation cost has beenrecognized for the stock option plans. Had compensation cost for the Company’s stock option plans beendetermined based on the fair value at the grant date of the awards, consistentwith the provisions of SFAS 123, the Company’s net loss and loss per sharewould have increased to the pro forma amounts indicated below (in thousands,except per share data):

 
|                                                 |   | **Year ended  December 31,** |   |
|------------------------------------------------------|--------|------------------------------|--------|
|                                                 |   | **2001**                     |   | **2000** |   | **1999** |   |
| Net  loss — as reported                         |   | $                            | (185   | ) | $ | (414 | ) | $ | (6,659 | ) |
| Net  loss — pro forma                           |   | $                            | (1,068 | ) | $ | (1,803 | ) | $ | (7,342 | ) |
|                                                 |   |                         |   |   |   |   |   |
| Basic  and diluted loss per share — as reported |   | $                            | (0.01  | ) | $ | (0.03 | ) | $ | (0.50 | ) |
| Basic and diluted loss per share — pro forma    |   | $                            | (0.08  | ) | $ | (0.13 | ) | $ | (0.55 | ) |

 

Thefair value of each option grant is estimated on the date of grant using theBlack-Scholes option-pricing model with the following weighted-averageassumptions used for grants in 2001, 2000 and 1999, respectively: expectedvolatility of 119%, 106% and 99%; risk-free interest rate of 4.55%, 6.15% and5.54%; and expected lives of 4 years

 

37

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Information regarding thestock option plans is as follows:

 
|                            |   | **Options** |   | **Weighted-  Average   Exercise Price** |   | **Options   Exercisable** |    |
|---------------------------------|--------|-------------|--------|-----------------------------------------|--------|---------------------------|---------|
| Outstanding,  January 1, 1999   |   | 1,245,296   |   | $                                       | 4.84   |                      | 197,124 |   |
| Granted                         |   | 682,039     |   | 9.35                                    |   |                      |    |
| Exercised                       |   | (154,465    | )      | 3.64                                    |   |                      |    |
| Cancelled                       |   | (556,877    | )      | 6.18                                    |   |                      |    |
| Outstanding,  December 31, 1999 |   | 1,215,993   |   | 6.93                                    |   | 206,864                   |    |
| Granted                         |   | 871,951     |   | 5.00                                    |   |                      |    |
| Exercised                       |   | (34,318     | )      | 3.33                                    |   |                      |    |
| Cancelled                       |   | (529,933    | )      | 6.17                                    |   |                      |    |
| Outstanding,  December 31, 2000 |   | 1,523,693   |   | 6.14                                    |   | 273,040                   |    |
| Granted                         |   | 892,532     |   | 1.87                                    |   |                      |    |
| Exercised                       |   | (1,500      | )      | 3.13                                    |   |                      |    |
| Cancelled                       |   | (393,990    | )      | 6.22                                    |   |                      |    |
| Outstanding,  December 31, 2001 |   | 2,020,735   |   | $                                       | 4.24   |                      | 576,939 |   |

 

For the years ended December 31, 2001, 2000 and 1999, theweighted-average fair value of options granted was as follows:

 
|                                |   | **Year ended  December 31,** |   |
|-------------------------------------|--------|------------------------------|--------|
|                                |   | **2001**                     |   | **2000** |   | **1999** |   |
| Exercise  price equals market price |   | $                            | 1.65   |   | $ | 4.23 |   | $ | 6.42 |   |
|                                     |        |                              |        |  |  |  |  |  |  |  |

 

Thefollowing tables summarize information about fixed-price stock optionsoutstanding at December 31, 2001:

 
| **Options  Outstanding**       |   |
|--------------------------------|--------|
| **Range of   Exercise Prices** |   | **Number   Outstanding   at 12/31/01** |   | **Weighted-   Average   Remaining   Contractual Years** |   | **Weighted-  Average   Exercise Price** |   |
| $0.92 — $0.92             |   | 430,000 |   | 9.84 |   | $ | 0.92 |   |
| $1.25 — $3.19             |   | 569,379 |   | 8.29 |   | 2.83 |   |
| $3.25 — $5.03             |   | 454,517 |   | 8.45 |   | 4.31 |   |
| $5.19 — $10.50            |   | 426,653 |   | 7.78 |   | 6.78 |   |
| $10.63 — $18.25           |   | 140,186 |   | 7.24 |   | 12.23 |   |
| $0.92 — $18.25            |   | 2,020,735 |   | 8.48 |   | $ | 4.24 |   |

 
| **Options  Exercisable**       |   |
|--------------------------------|--------|
| **Range of   Exercise Prices** |   | **Number   at 12/31/01** |   | **Weighted-Average    Exercise Price** |   |
| $0.92 — $0.92             |   | 0 |   | $ | 0.00 |   |
| $1.25 — $3.19             |   | 116,003 |   | 3.08 |   |
| $3.25 — $5.03             |   | 121,241 |   | 4.39 |   |
| $5.19 — $10.50            |   | 266,498 |   | 6.68 |   |
| $10.63 — $18.25           |   | 73,197 |   | 12.16 |   |
| $0.92 — $18.25            |   | 576,939 |   | $ | 6.17 |   |

 

*Employee Stock Purchase Plan*

InDecember 1995, the Company adopted an Employee Stock Purchase Plan (the“Purchase Plan”) which was effective upon the completion of the publicoffering.  Under the terms of thePurchase Plan, employees other than officers and employees of the Company’ssubsidiaries may purchase a total of up to 450,000 shares of common stock. Thepurchase price per share is 85% of the lower of the market value per share ofcommon stock determined as of the beginning or end of the quarterly purchaseperiod specified in the Purchase Plan. As of December 31, 2001, the Company had 130,300 available shares.

 

38

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**11. Earnings Per Share**

 

The Company has 45,000,000 common shares authorized, and 13,536,406issued and outstanding at December 31, 2001. The Company has also granted options to purchase common shares to theemployees and directors of the Company. The options may have a dilutive effect on the calculation of earningsper share.  The following is areconciliation of the numerator and denominator of the basic and dilutedearnings per share computations as required by SFAS 128 (in thousands, exceptper share data).

 
|                                                                                        |   | **Year ended  December 31,** |   |
|---------------------------------------------------------------------------------------------|--------|------------------------------|--------|
|                                                                                        |   | **2001**                     |   | **2000** |   | **1999** |   |
| **Basic  and diluted earnings per share:**                                                  |   |                         |   |   |   |   |   |
|                                                                                        |   |                         |   |   |   |   |   |
| Net loss                                                                                    |   | $                            | (185   | ) | $ | (414 | ) | $ | (6,659 | ) |
|                                                                                        |   |                         |   |   |   |   |   |
| Weighted-average  shares used in computing basic   And diluted loss per share               |   | 13,488                       |   | 13,383 |   | 13,287 |   |
|                                                                                        |   |                         |   |   |   |   |   |
| Basic and  diluted loss per share                                                           |   | $                            | (0.01  | ) | $ | (0.03 | ) | $ | (0.50 | ) |
|                                                                                        |   |                         |   |   |   |   |   |
| Pro forma amounts assuming the new revenue  recognition principle is applied retroactively- |   |                         |   |   |   |   |   |
| Net  loss                                                                                   |   |                         |   | $ | (355 | ) | $ | (6,543 | ) |
| Basic  and diluted loss per share                                                           |   |                         |   | $ | (0.03 | ) | $ | (0.49 | ) |

 

All options to purchase common stockwere excluded from the computation of diluted earnings per share for the yearsended December 31, 2001, 2000, and 1999 because the effect of the options onthe calculation would have been antidilutive.

 

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

 

The Company offers a deferred income 401(k) plan to substantially allfull time employees with a minimum of six months of service.  Participants may make tax-deferredcontributions of up to 15% of annual compensation subject to certainlimitations specified by the Internal Revenue Code. During fiscal year 1999,the Company provided a 10% match for all employee contributions, up to$200.  During fiscal year 2000, theCompany provided a 25% match for all employee contributions, up to 6% of theemployee’s annual compensation.  Duringfiscal year 2001, the Company provided a 35% match for all employeecontributions, up to 6% of the employee’s annual compensation.   During fiscal 2001, 2000, and 1999, theCompany expensed $191,000, $109,000 and $26,000, respectively, relating to ourcontributions under the plan.

 

**13. Related Party Transactions**

 

Related partytransactions for 2001, 2000 and 1999 were as follows (in thousands):

 
|                |   | **Year ended  December 31,** |   |
|---------------------|--------|------------------------------|--------|
|                |   | **2001**                     |   | **2000** |   | **1999** |   |
| Sales  to licensees |   | $                            | 0      |   | $ | 6 |   | $ | 541 |   |
|                     |        |                              |        |  |  |  |  |  |  |  |

 

**14. Segment Information**

 

SFAS No. 131, “Disclosures About Segments of an Enterprise and RelatedInformation,” requires that public companies report profits and losses andcertain other information on their reportable operating segments.  These segments are based on the method ofinternal reporting used by the decision-maker of the Company to allocateresources and assess its performance.

 

In fiscal year 2000, theCompany reported its subsidiary, touchMarketing.com, and its two distinctoperating units as separate segments. On January 2, 2001, the Companydiscontinued its touchMarketing.com subsidiary.  Accordingly, no separate segment for this subsidiary exists infiscal year 2001.  As of the thirdquarter of 2001, the Company replaced its operating unit approach with asingle-segment approach.  Additionally,in conjunction with the replacement of its reporting approach, the Company nolonger separates its internal functions by operating units.  The Company’s one reportable segment is asingle-source, multi-vendor direct reseller of name-brand informationtechnology products to small to medium sized businesses, enterprise, andgovernment and education markets.

 

39

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### *Substantially,all of the Company’s net sales for the twelve month periods ended December 31,2001 and December 31, 2000 were made to customers located in the UnitedStates.  All of the Company’s assets atDecember 31, 2001 and December 31, 2000 were located within the UnitedStates.  One of the Company’s customersrepresented over 10% of total sales for the years ended December 31, 2001 and2000, respectively.  Net sales to thiscustomer were $155.2 million and $128.3 million for the years December 31, 2001and 2000, respectively. The Company expects a decline in revenue from thiscustomer during 2002 of approximately 75% of the customer’s 2001 revenue.*

### * *

### *Divestiture of International Subsidiaries*

### *Duringthe first quarter of 2000, the Company entered into a definitive agreement tosell its remaining minority interest in its India subsidiary.  The Company recognized a gain on thetransaction of $1,330,000 in fiscal year 2000. The Company has no further commitments to any subsidiaries.*

 

40

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**15.  Selected Quarterly Financial Date(Unaudited)**

 

The following information is for theyears ended December 31, 2001 and 2000:

 

(in thousands, except pershare data)

 
| **December 31, 2001**                                 |   | **First   Quarter** |    | **Second   Quarter** |   | **Third   Quarter** |   | **Fourth   Quarter** |    |
|-------------------------------------------------------|--------|---------------------|---------|----------------------|--------|---------------------|--------|----------------------|---------|
| Net  sales                                            |   | $                   | 161,169 |                 | $      | 145,163             |   | $                    | 120,723 |   | $ | 114,020 |   |
| Cost  of sales                                        |   | 145,691             |    | 130,894              |   | 108,551             |   | 102,314              |    |
|                                                  |   |                |    |                 |   |                |   |                 |    |
| Gross  profit                                         |   | 15,478              |    | 14,269               |   | 12,171              |   | 11,706               |    |
| SG&A  expenses                                    |   | 15,199              |    | 14,089               |   | 12,629              |   | 12,068               |    |
|                                                  |   |                |    |                 |   |                |   |                 |    |
| Income  (loss) from operations                        |   | 279                 |    | 180                  |   | (457                | )      | (362                 | )       |
| Other  (income) expense                               |   | 110                 |    | 15                   |   | (14                 | )      | (137                 | )       |
|                                                  |   |                |    |                 |   |                |   |                 |    |
| Income  (loss) before income  taxes              |   | 169                 |    | 165                  |   | (443                | )      | (225                 | )       |
| Provision  (benefit from) for  income taxes |   | 65                  |    | 73                   |   | (186                | )      | (101                 | )       |
|                                                  |   |                |    |                 |   |                |   |                 |    |
| Net  income (loss)                                    |   | $                   | 104     |                 | $      | 92                  |   | $                    | (257    | ) | $ | (124 | ) |
|                                                  |   |                |    |                 |   |                |   |                 |    |
| Basic  and diluted earnings (loss) per share 1        |   | $                   | 0.01    |                 | $      | 0.01                |   | $                    | (0.02   | ) | $ | (0.01 | ) |

 
| **December 31, 2000**                                    |   | **First****Quarter** |    | **Second****Quarter** |   | **Third****Quarter** |   | **Fourth****Quarter** | ** ** |
|----------------------------------------------------------|--------|----------------------|---------|-----------------------|--------|----------------------|--------|-----------------------|------------|
| Net  sales                                               |   | $                    | 126,306 |                  | $      | 171,839              |   | $                     | 169,671    |   | $ | 166,247 |   |
| Cost  of sales                                           |   | 113,865              |    | 156,310               |   | 154,143              |   | 149,763               |       |
|                                                     |   |                 |    |                  |   |                 |   |                  |       |
| Gross  profit                                            |   | 12,441               |    | 15,529                |   | 15,528               |   | 16,484                |       |
| SG&A  expenses                                       |   | 14,846               |    | 15,437                |   | 15,409               |   | 15,939                |       |
|                                                     |   |                 |    |                  |   |                 |   |                  |       |
| Income  (loss) from operations                           |   | (2,405               | )       | 92                    |   | 119                  |   | 545                   |       |
| Other  (income) expense                                  |   | (1440                | )       | (360                  | )      | 313                  |   | 381                   |       |
|                                                     |   |                 |    |                  |   |                 |   |                  |       |
| Income  (loss) before income  taxes                 |   | (965                 | )       | 452                   |   | (194                 | )      | 164                   |       |
| Provision  (benefit from) for  income taxes    |   | (351                 | )       | 152                   |   | (57                  | )      | 68                    |       |
|                                                     |   |                 |    |                  |   |                 |   |                  |       |
| Net  income (loss) before change in accounting principle |   | (614                 | )       | 300                   |   | (137                 | )      | 67                    |       |
|                                                     |   |                 |    |                  |   |                 |   |                  |       |
| Cumulative  effect of change in accounting principle     |   | (59                  | )       |                  |   |                 |   |                  |       |
|                                                     |   |                 |    |                  |   |                 |   |                  |       |
| Net  income (loss)                                       |   | $                    | (673    | )                     | $      | 300                  |   | $                     | (137       | ) | $ | 67 |   |
|                                                     |   |                 |    |                  |   |                 |   |                  |       |
| Basic  and diluted earnings (loss) per share 1           |   | $                    | (0.05   | )                     | $      | 0.02                 |   | $                     | (0.01      | ) | $ | 0.01 |   |

 

----

1 Net income (loss) per share is computed independently for each of thequarters presented therefore, the sum of the quarterly net income (loss) pershare may not equal the total computed for the year due to shares issued eachquarter.

 

41

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**REPORTOF INDEPENDENT ACCOUNTANTS**

 

 

Board of Directors

Zones, Inc.

Renton, Washington

 

In our opinion, the accompanying consolidated balance sheets and therelated consolidated statements of operations and comprehensive loss, ofshareholders’ equity and of cash flows present fairly, in all materialrespects, the financial position of Zones, Inc. at December 31, 2001 and 2000,and the results of its operations and its cash flows for each of the threeyears in the period ended December 31, 2001, in conformity with accountingprinciples generally accepted in the United States of America.  These financial statements are the responsibilityof the Company’s management; our responsibility is to express an opinion onthese financial statements based on our audits.  We conducted our audits of these statements in accordance withauditing standards generally accepted in the United States of America, whichrequire that we plan and perform the audit to obtain reasonable assurance aboutwhether 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 bymanagement, and evaluating the overall financial statement presentation.  We believe that our audits provide areasonable basis for our opinion.

 

 

PRICEWATERHOUSECOOPERSLLP

 

Seattle,Washington

January 28, 2002

 

 

 

 

 

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