**UNITEDSTATESSECURITIES AND EXCHANGE COMMISSION**

**Washington,DC 20549**

 

**FORM 10-K**

 

| **ý** | ** ** | **Annual  Report Pursuant to Section 13 or 15(d) of the Securities Exchange Act of 1934**                                                                                  |
|------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
|       |       | **for  the fiscal year ended December 30, 2005**                                                                                                                           |
|       |       |                                                                                                                                                                       |
|       |       | **Or**                                                                                                                                                                     |
|       |       |                                                                                                                                                                       |
| **o**      | ** ** | **Transition  Report Under Section 13 or 15(d) of the Securities Exchange Act of 1934**                                                                                    |
| ** ** | ** ** | **for  the transition period from              to             .** |

 

**CommissionFile Number: 0-28426**

** **

**ZOMAXINCORPORATED**

(Exact name ofregistrant as specified in its charter)

 
| **Minnesota**                                                    | ** ** | **No.  41-1833089**                |
|------------------------------------------------------------------|------------|------------------------------------|
| (State or Other  Jurisdiction of  Incorporation or Organization) |       | (IRS Employer  Identification No.) |
| ** **                                                       | ** ** | ** **                         |
| **5353  Nathan Lane, Plymouth, MN 55442**                        |
| (Address of  Principal Executive Offices)                        |
|                                                             |
| Registrant’s  telephone number                              |
| **(763)  553-9300**                                              |
| ** **                                                       |
| Securities registered  under Section 12(b) of the Exchange Act:  |
| **None**                                                         |
| ** **                                                       |
| Securities  registered under Section 12(g) of the Exchange Act:  |
| **Common  Stock, no par value**                                  |

 

Indicate by check mark ifthe registrant is a well-known seasoned issuer, as defined in Rule 405 of the SecuritiesAct. YESo  NOý

 

Indicate by check mark ifthe registrant is not required to file reports pursuant to Section 13 or Section15(d) of the Act.YESo  NOý

 

Indicate by check markwhether the registrant (1) has filed all reports required to be filed bySection 13 or 15(d) of the Securities Exchange Act of 1934 during the preceding12 months (or for such shorter period that the registrant was required to filesuch reports), and (2) has been subject to such filing requirements for thepast 90 days. YESý  NOo

 

Indicate by check mark ifdisclosure of delinquent filers pursuant to Item 405 of Regulation S-K is not containedherein and will not be contained, to the best of registrant’s knowledge, indefinitive proxy or information statements incorporated by reference in PartIII of this Form 10-K or any amendment to this Form 10-K. ý

 

Indicate by check markwhether the registrant is a large accelerated filer, an accelerated filer, or anon-accelerated filer. See definition of “accelerated filer and large acceleratedfiler in Rule 12b-2 of the Exchange Act. Large Accelerated Filer o   Accelerated Filer ý   Non-Accelerated Filer o

 

Indicate by check markwhether the registrant is a shell company (as defined in Rule 12b-2 of theExchange Act). YESo  NOý

 

The aggregate marketvalue of the voting stock held by non-affiliates was $92,058,654 based on theclosing sale price of the Company’s Common Stock as reported on the NASDAQStock Market on July 1, 2005.

 

The number of sharesoutstanding of the registrant’s common stock as of March 10, 2006 was 32,492,412shares.

 

**DOCUMENTS INCORPORATED BYREFERENCE**

 

Portions of the ProxyStatement for the 2006 Annual Meeting of Stockholders are incorporated byreference into Part III of this report.

 

 

----

 

**PART I**

 

**ITEM 1.BUSINESS**

 

**General**

 

At Zomax, we helpcompanies develop, manage and improve rapidly changing product and programsupply chains. Zomax delivers acomprehensive supply chain solution by integrating and coordinating theresources, capabilities and technology of our own organization with those of complimentarythird party product and service providers. We believe this model resultsin superior value for our customers by combining our in-house expertise with that of our supplier partners to deliver maximumflexibility and consistently high quality products and servicesjust-in-time.

 

Established in 1993, wehave approximately 1,000 full-time employees and currently operate 11facilities in the United States (“U.S.”), Canada, Mexico, and Ireland. Three ofour United States facilities will be closed in the first half of 2006. Ourexisting business continues to be focused on CD and DVD replication servicesand related assembly, distribution and contract services which we deliverprimarily through company-owned or leased facilities. The Company’s strategy isto evolve our business model towards less vertical integration with our primaryemphasis on program management capabilities and services with less dependencyon our company-owned assets in delivering those services.

 

We market and selloutsourced supply chain services to industry-leading customers in a variety ofmarkets. We believe our experience in supply chain program management as wellas integrating and managing critical supply chain functions allows ourcustomers to focus on their core competencies, reduce costs, accelerate time tomarket, decrease inventory obsolescence, and improve response to customerdemand in a variety of geographic regions.

 

Whether orders arefulfilled directly to our customer’s end-users or channel partners, or just intime (JIT) to the customer’s production facilities, our goal is to helpcompanies deliver “The Perfect Order” - that means the right product, the rightplace, the right time, at the right value.

 

**Industry**

** **

The supply chainoutsourcing services industry manages a vast array of products and content fora wide range of markets. Whether it is IT hardware, software, consumerelectronics, automotive parts, pharmaceuticals or other products, organizationsare increasingly turning to experienced outsourcing partners to bring theirproducts to market more efficiently. The growing complexity of supply chainswith faster time-to-market requirements, quicker turn-times, globalization, andlimited visibility to demand combined with ongoing cost pressures and resourceconstraints have driven the growth of supply chain outsourcing. Companies arealso looking to consolidate the number of outsource providers they use to driveimproved integration, visibility and efficiency with their remaining partners.

 

The same factors thathave led to more outsourcing are driving consolidation in the industry, as manysmall local and regional service providers find it increasingly difficult toaccess the capital required to invest in new capabilities and additional value-addedservices. Consolidation of the industry continues as marginal companiesstruggle to compete.

 

We believe our strongbalance sheet, flexibility, end-to-end solutions, customer list, consistentexecution and solid reputation in the industry continue to be a competitiveadvantage and position us to capture market share as the industry consolidatesand smaller players disappear.

 

**Services**

 

Our supply chainoutsourcing solutions help companies to develop, manage and improve rapidlychanging product and program supply chains. Our program management servicessupport the entire spectrum of a product or program lifecycle from planningthrough production to end-user support. By leveraging both our internalcapabilities and those of our supplier partners, we offer a modular suite ofsupply chain services that enable customers to select the combination ofservices that best meet their unique needs. They include:

 

•      **Customer Contact Services** – To help build sustainable,interactive relationships between our customers and their end-users, we providea broad range of end-customer services. Our end-to-end approach coversinbound/outbound teleservices, order processing, billing services ande-commerce to support the entire customer life-cycle.

 

•     **Sourcing –**Constant change in the availability and quality of materials is a majorchallenge for many of our 

 

2

----

 

customers. To addressthis challenge, we offer a full range of print, packaging, and hardwareprocurement services to support their growing businesses.

 

•      **Production** – High-capacity CD and DVD manufacturing iscritical to meeting the media requirements for our customers.

 

•      **Assembly and Kitting** – Our customers require a highlyflexible set of assembly and kitting services to handle a broad range ofproducts. We provide scalable assembly services that include automatedassembly, a flexible workforce, and JIT capabilities to meet unique customerrequirements.

 

•      **Fulfillment –** We support a full range of retail and end-customerdistribution models and provide integrated returns management services. Ourcapabilities include physical fulfillment and electronic software delivery tomeet the unique needs of our customers.

 

With the breadth andmodularity of our services, customers can choose to outsource some or all oftheir supply chain functions. In all cases, our account and project managementorganizations maintain daily contact with our customers to ensure the highestlevel of quality and responsiveness.

 

**Customers,Markets and Sales**

** **

We market and selloutsourced supply chain services to a variety of customers in several differentindustries. Historically, the majority of our revenue was derived fromcustomers in the computer hardware manufacturing (PC-OEM) and software publishingindustries. We currently service a broad base of customers in these industrysegments including Microsoft®, Dell®, H&R Block®, Apple® and Logitech®. During2005 and 2004, Microsoft revenues accounted for approximately 24% and 22%,respectively, of our total revenues. In addition, Dell accounted forapproximately 17% of our total revenues in 2005, and 19% in 2004.

 

Major customer teams areled by our program managers who are responsible for integrating with ourcustomer’s operations, gaining a detailed understanding of their business,products and program objectives and working within the Zomax network to createsolutions to meet those objectives. Within each customer team are also projectmanagers responsible for ensuring that each order is processed on a timelybasis, all required support materials are in place, and desired quality levelsare achieved. We also employ a direct sales staff that is responsible fordeveloping new business relationships. The sales team focuses on markets wherewe have experience and proven customer references including softwarepublishing, marketing services, customer information services and more.

 

We are an authorizedreplicator of Microsoft, which allows us to replicate Microsoft products forany authorized distributor or OEM in the North and South American regions. Weare also authorized to perform fulfillment services for Microsoft licensed OEMs.These arrangements are pursuant to annual agreements with Microsoft. We alsoprovide replication, telemarketing and fulfillment services for certainMicrosoft programs under a Master Services Agreement. Each of our primarycontracts with Microsoft expires in June 2006. We expect, but cannot guarantee,that these agreements will be renewed.

 

**Competition**

 

The supply chain serviceindustry is highly competitive and is undergoing consolidation. We competeprimarily with supply chain service providers and, to a lesser extent, withmedia replicators and third party logistics companies. Each of these producersgenerally services a defined set of customer needs. Some of these companies aremembers of the Zomax supplier network and partner with us to provide variousservices for our customers.

 

•   *Supply Chain Service Providers*. Companies in this segmentprovide services that help companies manage the flow of their products to theirconsumers from sourcing through manufacturing and distribution. Examplesinclude companies such as Arvato (a division of Bertlesman AG), StartekCorporation, ModusLink, Digital River, and Inoveris. We believe our uniquecombination of in-house capabilities and expertise and our developing networkof supplier partnerships enable us to provide better synchronized programs forcustomers and provide us an advantage over these competitors.

 

•   *Media Replicators*. Companies in this segment manufacture anddistribute CD and DVD media. Examples include Sonopress (a division ofBertlesman, AG), Cinram International Inc., Duplium, Technicolor and Crest. Severalmedia replicators have expanded their solutions to include additional supplychain services such as distribution or returns management. We believe that thebreadth of our supply chain services, including customer contact services andelectronic software delivery (ESD), provides a competitive advantage for Zomax.

 

•   *Third Party Logistics Organizations*. Core services for thesecompanies are distribution and logistics and include 

 

3

----

 

organizations suchas Ingram-Micro Logistics, PFSWeb and UPS. We believe that the breadth of oursupply chain services provides a competitive advantage for Zomax, and in somesituations, enable partnership opportunities with these competitors for largecustomers.

 

•   *Printing and Packaging Firms*. Organizations such as Banta,IPC and Q-Media started in the printing or packaging market and expanded theirservices to include other aspects of the supply chain. We believe that thebreadth of our supply chain service offerings help position us as a morecomplete solution provider than these companies.

 

A number of our nationaland regional competitors are larger and more established with greater financialand other resources than us, particularly as consolidation in the industrycontinues. As a result, such competitors may be able to respond more quickly tomarket changes or to devote greater resources to the manufacture, promotion,and sale of their products and services than we can. Alternatively, othercompetitors are weaker financially in comparison to us. We believe thatfinancial strength continues to be a key decision making component forcustomers, and that the strength of our balance sheet is an advantage over somecompetitors.

 

We believe that we generallycompete favorably with respect to quality, service, reliability, price,manufacturing capability, and timely delivery of product, the principalcompetitive factors in this industry. We also believe that customers value ourbroad service offerings in comparison to some of our competitors’. As such, toenhance our competitive position, we offer a full range of value-added servicesto customers including sourcing, production, fulfillment, returns management,and a range of contact center services. These are performed in-house andthrough strategic supplier partners.

 

**Financial Information About GeographicalAreas:**

 

Financial informationabout our geographic segments is presented in Note 11 to the ConsolidatedFinancial Statements included in Item 8 of this Form 10-K.

 

**Fiscal Year End**

 

Our fiscal year ends onthe last Friday of the calendar year. Unless otherwise indicated, our fiscalyears ended December 30, 2005, December 31, 2004 and December 26, 2003, arereferred to herein as 2005, 2004 and 2003, respectively.

 

**Backlog**

 

Our business ischaracterized by short lead times for customer orders. For this reason andbecause of the timing of orders, delivery intervals, and customer changes inquantities and delivery schedules, our backlog as of any particular date is nota meaningful indicator of future financial results.

 

**Proprietary Rights**

 

Like most other CD andDVD manufacturers, we use patented technology primarily under nonexclusivelicenses. These licenses generally provide for the payment of royalties basedupon the number, type and use of CDs and DVDs sold and terminate either uponthe expiration of the patents being licensed or on a certain date. If we areunable to maintain these licenses, it could have a material adverse effect onour financial results.

 

**Seasonality**

 

The demand for ourservices is seasonal, with demand increasing in the fall due to the new schoolyear and holiday season purchases. In addition, our business is subject to theproduct release cycles of our major customers. Seasonality and product releasecycles can result in significant quarterly variations in financial results,with our fourth quarter generally being our strongest in terms of revenue.

 

**Employees**

 

We have approximately 1,000full-time employees and we contract to hire additional labor resources on atemporary basis to perform manufacturing and fulfillment related services asthe need arises. We believe that our relations with our employees are good andthat we provide competitive salary and benefits programs. None of our employeesare covered by a collective bargaining agreement.

 

**ITEM 1A. RISK FACTORS**

 

## The discussion in this Item 1A and in Item 7, Management’s Discussionand Analysis of Financial Condition and Results of Operations, contain various “forward-lookingstatements” within the meaning of Section 27A of the Securities Act of 

 

4

----

 

## 1933, as amended, and Section 21E of the SecuritiesExchange Act of 1934, as amended. Such statements can be identified by the useof terminology such as “anticipate,” “believe,” “estimate,” “expect,” “intend,”“may,” “could,” “should” “possible,” “plan,” “project,” “will,” “forecast” andsimilar words or expressions. Our forward-looking statements represent ourexpectations or beliefs concerning future events, including but not limited tothe following:

##  

## •      Our ability to successfully executeour plans to achieve our goal of profitability at lower revenue levels than weexperienced in 2005;

##  

## •      Our belief that subsequent to ourplan to achieve profitability at lower levels of revenue, opportunities willexist to allow us to achieve top line growth through both internal efforts andacquisition activities;

##  

## •      The negative effect on our revenuesof our PC-OEM customers’ continuing initiatives to eliminate certain recoveryCDs and print material from some of their new PC shipments, coupled with theopportunity to offset some of this effect with new business from thosecustomers;

##  

•      Thenegative effect on our revenues of the previously discussed announcement by oneof our major customers to expand their internal media production capabilities;

 

## •       The strength of our customerrelationships, the related impact on our ability to retain such customers andour ability to develop new customers in the future;

##  

## •       Our ability to execute ourrestructuring activities and that our existing customers will not be negativelyimpacted due to potential disruption in our ability to provide continuingeffective service;

##  

•       Ourability to transition our business model to one that is less verticallyintegrated and more dependent on strategic supplier partnerships withoutdisrupting service levels to our customers;

 

## •       The impact of polycarbonate andother raw material price increases on our gross profit margins and our abilityto pass these price increases on to our customers;

##  

## •       Ourgeneral expectations about our ability to meet the challenges of our business;

##  

## •       The growth prospects ofsupply-chain outsourcing services;

##  

## •       The impact on our revenues resultingfrom our ability or willingness to perform our services at prices required byor mandated by our customers;

##  

## •       The sufficiency of our cashbalances and cash generated from operating and financing activities for ourfuture liquidity and capital resource needs;

##  

## •      Ourcompetitive position relative to other companies providing similar services;

##  

## •      Our ability to retain key executiveand management personnel through our transition;

##  

## •      Ourrelationships more generally with our employees and managing turnover while thecompany transitions service models;

##  

## •      Thepotential negative impact on profitability due to the growing pricing pressurefrom competitors;

##  

## •      Thepotential threat caused by the development and rate of market acceptance of newmedia storage techniques or other electronic technologies on the need for CDand DVD media in the PC hardware and software industries;

##  

## •      Thegrowth opportunities associated with our efforts to broaden our customer baseoutside our traditional markets; and

##  

## •      Achievementof long-term benefits associated with necessary investments in our business.

##  

We caution that anyforward-looking statements made by us in this report or in other announcementsmade by us are qualified by important risks and uncertainties that could causeactual results to differ materially from those in the forward-lookingstatements. The risks and uncertainties described below may not be the onlyones we face. Additional risks and uncertainties that we do not yet know of orthat we currently think are immaterial may also impair our business operations.If any of the events or circumstances described in the following listing ofrisks and uncertainties actually occur, our business, financial condition orresults of operations could suffer. The risks and uncertainties described belowmay be amended, supplemented or superseded from time to time by other reportswe file with the SEC in the future. These risks and uncertainties include,without limitation the changes and volatility in the personal computer hardwareand software industry, particularly with respect to the demand for CD and DVDmedia, from which a significant portion of our revenues are derived;macroeconomic factors that influence the demand for personal computer hardwareand software and the resulting demand for our services; consolidation among ourcustomers or competitors, which could cause disruption in our customerrelationships or displacement of us as a services provider to one or morecustomers; fluctuations in our operating results from quarter-to-quarter, whichare influenced by many factors outside of our control, including variations inthe demand for particular services we offer or the content included in theproducts we produce for our customers; as well as those identified below.

 

5

----

 

*We aredependent on a small number of key customers in the personal computer (PC)hardware and software industries.*

 

Ourbusiness continues to be dependent on a small number of key customers in the PChardware and software industries. Our top five customers in 2005, 2004, and 2003,were all members of these industries and in the aggregate representedapproximately 62%, 58% and 50% of our total revenue, respectively.Accordingly, our operating results are influenced by the changes and volatility in theseindustries and the macroeconomic factors that influence the demand for personalcomputer hardware and software. In general, our contractual agreements withthese and other customers allow them to terminate service with very littlenotice and without cause. Furthermore, significant portions of our revenue fromthese customers are derived from individually large product programs withinthese customers. As a result, our revenues can be materially sensitive todecisions customers make with respect to these individual programs. Includedin our top five customers are Microsoft and Dell, from which we received, inthe aggregate, approximately 41% of our revenues in each of 2005 and 2004. Theloss of either of these customers or a significant change in their businessrequirements would have a material adverse effect on our operations.

 

 As previously discussed in our filings withthe SEC, starting in the second quarter of 2004, we were informed of changes tocertain programs we support for several of our large customers that would resultin noticeable future declines in the level of business we currently had withthese customers.  The first of these customer-driven changes involves theelimination of certain recovery media and printed materials from some of thenew PCs sold by our PC-OEM customers along with other changes. These changesbegan to significantly impact our revenues starting in the second quarter of2005. In 2005, the continuing effects of these changes contributed approximately$22 million in year-over-year revenue decline in our PC-OEM customer base. Weexpect that this continuing initiative will negatively impact our revenues fromthis segment to a similar if not more significant degree for at least the firstthree quarters of 2006.  While there may be an opportunity to offset someof this decline with program expansion in other segments of our business withsome of our PC-OEM customers, we are not assured of the timing or size of thoseopportunities.

 

We had also been informedin 2004 by one of our key customers that, possibly starting in 2005, a certainportion of their customer base supported by us will be migrated to a newservice delivery system operated by one of our competitors. This new deliverysystem was completed subsequent to the end of the third quarter of 2005 and thechange began to negatively impact our revenues and profitability in the fourthquarter of 2005. Looking forward, we believe this change will result in ayear-over-year reduction in revenue from this customer of approximately $2.0 millionin 2006.

 

As we previouslydiscussed, in the third quarter of 2005 one of our larger customers announcedtheir plans to expand their internal capabilities for producing media. At thattime, we were informed that the internal capabilities would only include DVDmedia and we did not anticipate that this change would have any affect on ourbusiness over the next twelve months.  We were recently informed by thiscustomer that the planned internal capabilities would include both CD and DVDmedia, the current forecasted implementation timeline would be July 2006, andthat the customer’s intention is to supply all of their North American mediafor the programs we support on their behalf after that date. This change onlyimpacts the media manufacturing component of our overall business with thiscustomer. Given the uncertainty of the required program adjustments required toaccommodate this change and the breadth of additional service support we willretain, we are unable to accurately quantify its potential effect on ourbusiness with this customer in 2006 and beyond.

 

In addition to these andother market changes, our customers continue to demand general pricingdecreases in the services we provide.  We continue to evaluate ourresponse to these pricing pressures and in some instances have implementedstrategies designed to properly align our pricing with the value of productsand services we provide.  These pricing strategies may result in losses ofsignificant portions of business if not accepted by our customers and affectour ability to increase or achieve consistent levels of revenue andprofitability. In addition to the riskof program changes, the work we perform for our customers is periodically putout for competitive bid. We believe we have strong relationships withour current customers and that our knowledge of their business, our flexibilityto meet their changing needs, our broad range of service capabilities and ourstrong balance sheet are important decision factors for them. However, the risk exists that we may not bethe successful bidder, our profit margins will be negatively impacted bypricing changes necessary to retain their business, or that consolidation among our customers or competitors couldcause disruption in our existing customer relationships. Some of our larger customers rely on unique information technologysystems that we possess, which provides us a competitive advantage. However,there can be no assurances that this advantage will not be reduced oreliminated by alternative solutions developed internally by these customers orby our competitors. If we were to lose all or a significant portion of ourbusiness with one of these key customers, our revenues and profit margins wouldbe materially and negatively impacted. In addition, competition in theseindustries, particularly the PC hardware industry, has resulted in the need forthese companies to put continued pressure on their vendors, including Zomax,for price reductions and increased service levels.

 

Finally,we have experienced operating losses in the recent past, including 2005. Whileour balance sheet remains strong and we have taken aggressive actions toaddress our operating losses; continued operating losses raise potentialconcerns with major customers that could result in them moving some or all oftheir business to an alternative provider.

 

6

----

 

Whilewe continue to make efforts to expand our base of customers to those outsidethese industries, these initial customer opportunities tend to be smaller,making it very unlikely that we could quickly recover from the loss of one ofour key customers through the acquisition of several new customers outside orwithin these industries.

 

*We maynot be able to maintain our status as a Microsoft Authorized Replicator.*

 

Wehave been designated by Microsoft as an Authorized Replicator (AR) of theirsoftware and are one of a limited number of Microsoft AR’s in the United States.Retaining our status as a Microsoft AR requires that we continue to meet anumber of stringent criteria established by Microsoft. Our status as aMicrosoft AR is a requirement to replicate CD and DVD media software for ourcustomers in the PC hardware industry that sell or use Microsoft software withtheir products.

 

Our AR contract withMicrosoft is scheduled for annual renewal in June 2006. We are unaware of anycurrent matters that would jeopardize this renewal or our AR status.  If,however, we were to lose our Microsoft AR status, we would lose a significantportion of our business with our customers that sell Microsoft software and ourrevenues and profitability would be materially and negatively impacted.

 

*Evolutionto a less vertically integrated business model.*

 

Ourexisting business continues to be focused on CD and DVD media replicationservices and related assembly, distribution and contact center services whichwe deliver primarily through Company-owned or leased facilities. Our goal is toevolve into a less vertically integrated model in which we will deliver a morecomprehensive supply chain solution for our customers along with lower fixedcosts and capital tied up in assets for the Company. As our relationships withour customers evolve, we believe many of these customers will place greatervalue on our ability to program manage their end-to-end supply chain and lessemphasis on our ability to directly deliver those services.

 

We began a restructuringplan in 2005 which eliminated over 33% of our CD replication capacity. Whilethis restructuring plan was primarily aimed at reducing this capacity and itsrelated costs, it also represents a move toward less dependency oncompany-owned assets in the delivery of our services and will result in agreater dependence on outsourcing this volume in peak demand periods. We intendto continue to explore this strategy of reducing our reliance on internal replicationcapacity.

 

Weexpect to continue to evolve our strategy of increasing our emphasis on thevalue we provide our customers through our program management capabilities,with less dependency on company-owned assets in delivering those services.However, this value proposition is not fully tested and we can not be assuredthat it will be accepted by the marketplace or that we will be successful inimplementing it. Should we fully implement this model, we will face a number ofrisks and uncertainties, including the following:

 

•      A program management business model isvery dependent on customer relationships, vendor relationships and the abilityof those vendors to commit and deliver to required service levels, and ourability to employ and retain qualified employees. It also requires the abilityto deliver to service levels profitably when the delivery of these services isnot always within the direct control of the company.

 

•      The implementation of this model willrequire that the skill sets of our employees be modified to align with theemphasis on program management capabilities. If we are not successful in doingso, it will impact our ability to be successful.

 

•      Changes in our service offerings resultingfrom this shift could negatively affect our revenue and profitability.

 

•      A shift toward less dependency oncompany-owned or leased facilities and equipment could result in additionalrestructuring activities and the need to continue to develop and implementfuture cost savings initiatives to align costs with the marketplace. Theseactivities may not be successful or meet the changes in the marketplace andcould have a disruptive impact on our customers and employees which couldsignificantly affect future levels of revenue and profitability.

 

•      Aprogram management business model requires a seamless, real time informationtechnology infrastructure to link the supply chain from suppliers and partnersthrough to the end of line customers. Building and supporting thisinfrastructure requires investment and there are no assurances we will be ableto deliver a competitively effective and efficient solution.

 

*We maynot be able to effectively compete in an increasingly competitive environment.*

 

Competitionin the supply chain outsourcing services industry is intense. Our industry iscurrently characterized by many vendors pursuing relatively few and very largecustomers, which provides these customers with the ability to exert significantpressures on their suppliers. We have experienced and anticipate experiencingcontinued pricing pressures from current and 

 

7

----

 

future competitors as well as general pricingpressure from our customers as part of their cost reduction efforts. Thesepricing pressures have, and may continue to limit our ability to achieveacceptable levels of profitability.

 

Inaddition, some of our competitors are larger and have substantially greaterresources and capabilities in information technology, global facilities, staffexpertise and other areas that can limit our ability to make the investmentsrequired to remain competitive and be profitable. We have identified the needto continue to make additional investments in information technology, expansioninto other geographical markets and the development and capabilities of ourstaff. However, we can not be assured that these investments will generate orsustain a particular competitive advantage.

 

While we believe our capabilities are unique, theydo not involve significant proprietary properties. Therefore, we are dependentprimarily on our ability to provide exceptional service to our customers andmaintain strong relationships with them. These relationships may be positivelyor negatively impacted by changes in personnel or shifts in strategies withinZomax, our customers or our competitors.

 

 We continue to face significant costs andresource constraints in connection with our compliance with the necessaryreporting, compliance and administrative aspects of a public company. Theserequirements drive additional SG&A costs for professional services, bothlegal and accounting, governance, and management time to support all of theadditional legislation imposed on public companies. Many of our competitors arenot public entities or are larger public entities, and the related impact ofcomplying with these requirements can affect our ability to performcompetitively.

 

*Beginningin the first half of 2004, supply shortages and petroleum price increases haveplaced significant upward pressures on the price of polycarbonate, certainother raw materials and freight costs.*

 

* *Beginning inthe first half of 2004, supply shortages and petroleum price increases haveplaced significant upward pressures on the price of polycarbonate, a petroleum-basedplastic that is the primary raw material used in the manufacturing of CD andDVD media. While we believe there are alternative sources of polycarbonateavailable in addition to our current inventory of polycarbonate, we haveentered into a new purchase agreement with our polycarbonate supplier thatlimits price increases through June 2006. However, the increases allowedunder the previous agreement have had, and the increases allowed in the newagreement will continue to have, a negative impact on our gross profit margins.We have also experienced increases in other component and freight costs whichsuppliers have also attributed to petroleum price increases. While we workedwith our customers in 2005 and continue to do so in 2006 to pass on to them someor all of these cost increases, we were not successful in every case and thereare no assurances that we will be successful in doing so in the future or thatour attempts to pass along these cost increases will not result in a loss ofbusiness to competitors.

 

*We maynot be able to meet our customers’ requirements regarding the security of theirintellectual property, inventory and other assets.*

 

Wemanage or take possession of many of our customers’ physical and intellectualproperties. Much of this property consists of consigned inventory orintellectual property in our possession, the value of which is not reflected inour financial statements. If we fail to protect their property or meet theirsecurity requirements, we may be liable to these customers for penalties orreimbursement up to full retail value of the property and may lose theirbusiness, which could have a material negative impact on our financialcondition or results of operations.

 

*We aredependent on revenues from the replication of CD and DVD media which may bethreatened by the development and rate of market acceptance of new mediastorage techniques or other electronic media technologies.*

 

Ourbusiness continues to be heavily dependent on the use of CD, and to a lesserdegree, DVD media in the PC hardware and software industries. The increasingavailability of broadband communications services, changes in fixed storagetechniques used in the PC industry, and the development of alternativeelectronic storage and back-up technologies at lower costs, are examples oftechnologies that may threaten to reduce or eliminate the need for CD media inthe PC hardware and software industries. A significant decline in the use of CDmedia in these industries would have a significant negative impact on ourrevenues and profitability.

 

Whilewe have established electronic software download (ESD) capabilities through ourstrategic alliance with Intraware, our success in this market has been limited.If we are unable to develop significant market penetration in the ESD marketthrough this relationship or others, our ability to participate in theincreasing shift to electronic delivery of software may be impacted.

 

8

----

 

*Restructuringto move towards profitability.*

 

Aspreviously discussed, in the second quarter of 2005 we began a restructuringplan that includes both cost reduction activities as well as the implementationof pricing strategies with an overall goal of moving towards profitability at alower revenue level. After a careful study of our U.S. assembly anddistribution infrastructure in the fourth quarter we announced our intent toclose our Fremont, California facility. With the Fremont lease expiring inearly 2006, we are transferring assembly, fulfillment and customer careactivities from this facility to other Zomax operations. Transition of customerprogram support from this facility to other Zomax locations is on track and theclosure of the facility is expected to be completed in early 2006. During thesecond, third and fourth quarters of 2005, the restructuring activitiesnegatively impacted our ability to meet all service level requirements forselected customers. While we believe we have responded appropriately and thatultimately the changes will result in an improved service/delivery model forour customers, the risk of loss of revenue or future opportunities with thesecustomers may be affected by this service level performance. In addition, therestructuring has resulted in some employee turnover and the risk exists thatwe may not be able to replace these employees on a timely basis with qualifiedand experienced people. We also continue to explore additional strategies tolower our overall costs which might result in the need for future facilityclosures, asset restructuring and other spending reductions.

 

*Limitedvisibility to customer demand.*

 

Given the dynamic marketconditions in which we operate, our ability to accurately predict revenue andearnings for a given time period is difficult. Forward looking estimates or statementsare subject to management’s interpretation of the data available at the timethe statements are prepared and may not correlate with the actual results producedin the projected period. We have very limited visibility to our customers’ nearor long-term demand for our services, and changes by our customers in thecontent of the products we produce for them can significantly affect our levelsof reported revenue and related profits relative to our expectations.

 

*We concluded that ourinternal controls over financial reporting were not operating effectively as ofDecember 31, 2004.*

 

During our review ofinternal controls in effect during 2004, we identified a material weakness, asmore fully discussed in our Form 10-K for 2004. The assessment was thatinsufficient supervision and oversight of accounting personnel at our Irelandsubsidiary led to incorrect accounting entries and reconciliations by Irishpersonnel. As a result, our financial statements for 2003 and the first threequarters of 2004 were restated. During 2005, we implemented a series ofremediation steps to address this material weakness, and thus believe that thesedeficiencies have been corrected in 2005. Any additional material weakness maylead to a further negative impact on our financial results, including thepossible loss of business from certain customers as a result of theuncertainties caused by any such weakness, a qualified report from ourauditors, a loss in confidence in the reliability of our financial reports or adecline in the stock price due to an adverse reaction from the financialmarkets. In addition, the SEC has begun an informal inquiry into thecircumstances in Ireland giving rise to the conclusion that a material weaknessin our internal controls existed. While we are fully cooperating with the SECin this matter, we may be the subject of governmental investigations or otherproceedings.

 

*We are subject to foreigncurrency exchange fluctuations*

 

A portion of ouroperations are located in Ireland and Canada. A majority of the revenue fromour Canadian operations, and a portion of the related costs, are denominated inU.S. dollars. As a result, our exposure to the Canadian currency resultsprimarily from Canadian dollar denominated expenses. The majority of revenuesand related costs in our Ireland operations are denominated in Euros. Foreign currency transaction gains andlosses are reflected in our financial statements and historically have not beenmaterial to our results of operations or financial condition. However, weanticipate we will continue to incur exchange gains and losses from foreignoperations in the future which may be significant depending on factorssuch as changes in foreign currency or weak economic conditions in foreignmarkets. In addition, sales of our products and services may be directlyimpacted by the value of the U.S. dollar relative to other currencies.

 

We undertake no obligationto update or revise any forward-looking statements we make in this report dueto new information or future events. Investors are advised to consult anyfurther disclosures we make on this subject in our filings with the Securitiesand Exchange Commission, especially on Forms 10-K, 10-Q and 8-K, in which wediscuss in more detail various important factors that could cause actualresults to differ from expected or historical results.

 

**Available Information**

 

See our web site atwww.zomax.com for additional information regarding our products and services. Allreports we file electronically with the SEC are available by contactingInvestor Relations at investorrelations@zomax.com or (763) 553-9300. Thesefilings are also accessible on the SEC’s web site at www.sec.gov. The publicmay read and copy any materials we file with the SEC at the SEC’s PublicReference Room at 100 F Street NE, Washington, DC 20549. The public may 

 

9

----

 

obtain information for the Public Reference Room by calling the SEC at1-800-SEC-0330.

 

**ITEM 1B. UNRESOLVED STAFFCOMMENTS**

 

Not Applicable.

 

**ITEM 2. PROPERTIES**

 

Our principal facilitiesconsist of the following:

 

•      Welease two facilities in the Minneapolis, Minnesota area, totaling approximately200,000 square feet. In the larger facility, approximately 120,000 square feet,we perform packaging, fulfillment, storage and distribution services. In thesmaller facility, approximately 82,000 square feet, we perform mastering,replication, printing, print management, packaging, warehousing, fulfillment,distribution, and RMA processing activities. Our corporate offices are alsolocated in the latter of these facilities. The lease at our corporate officeexpires on December 31, 2006. We lease this space from a partnership in whichwe believe a former member of our Board of Directors owns a one-third interest.The lease of the larger facility expires on November 30, 2008, although we weregranted early termination rights that we could exercise that would terminatethe lease effective on a date either 16 or 24 months after the lease commencementdate of December 1, 2005. We would incur early termination penalties if weexercise either of these early termination rights.

 

•      Weown a 158,000 square foot facility in Arnprior, Canada, in which we performmastering, replication, print management, printing, packaging, warehousing anddistribution activities.

 

•      Welease a 153,000 square foot facility in Fremont, California. This lease expiresin March 2006 and we are currently involved in the process of closing thisfacility.

 

•      Welease two facilities in Dublin, Ireland, totaling approximately 139,000 squarefeet. In one of the facilities, we perform customer contact center activities. Inthe other, we perform manufacturing, print management, printing, packaging,warehousing, fulfillment, and distribution. The call center lease expires in2026 and the manufacturing facility lease in 2016. We have the option to cancelthe call center lease in 2011 and the replication facility lease in 2007 uponproviding appropriate notice and penalty payments.

 

•      Welease a 46,000 square foot facility in Juarez, Mexico, in which we performwarehousing and distribution activities. This lease expires in September 2007,although we have the option to terminate in September 2006 upon the payment ofa penalty.

 

•      Welease a 227,500 square foot facility in Memphis, Tennessee in which we performpackaging, fulfillment, distribution and RMA processing activities. This leaseexpires in April 2008.

 

•      Welease a 30,000 square foot facility in Concord, California, in which we performcustomer contact center activities. This lease expires in March 2008.

 

•      Welease a 12,800 square foot facility in Austin, Texas which expires in March2006 and another 5,000 square foot facility in Nashville, Tennessee which expiresin April 2006. We are currently in the process of closing both of thesefacilities.

 

We believe that thefacilities used in our operations are adequate to meet our current needs.

 

**ITEM 3.LEGAL PROCEEDINGS**

** **

As previouslydisclosed in our filings with the SEC, we have been the subject of an SECinvestigation and a consolidated class action lawsuit involving allegations ofsecurities law violations. The allegations related to Company disclosures andcertain stock sales by two former officers during the third quarter of the year2000.

 

On April 27, 2005, weannounced, without admission of liability, an agreement to settle theoutstanding class action lawsuit.  This stipulation of settlement receivedCourt approval on September 6, 2005 and resulted in a settlement of $2,250,000in cash and 1,500,000 shares of the Company’s common stock to the class. The entire $2,250,000 cash payment 

 

10

----

 

was paid by proceeds received from our directors’ and officers’insurance carrier.  The settlement payments were distributed toshareholders who incurred losses as a result of stock purchases between May 25,2000 and October 18, 2002, inclusive, and to plaintiffs’ attorneys as fees andcosts awarded by the Court.  As of December 30, 2005, the cash portion ofthis claim has been settled. The charge against earnings associated with theissuance of the 1,500,000 shares of stock was initially recorded in the thirdquarter of 2004, and the charge continued to be adjusted based on the marketprice of the Company’s stock until final Court approval of the settlement wasgranted on September 6, 2005. To date, 375,000 shares of the 1,500,000 shareshave been issued.

 

On June 9, 2005, weannounced that the Company entered into a settlement agreement with theSEC.  Under the terms of the settlement agreement, the Company paid acivil penalty in the amount of $2,000,000 to the SEC during our third quarterof 2005.

 

We have establishedreserves for these two matters which we believe to be adequate and are based onthe terms of the settlement agreements and the provisions of FASB Statement No.5, *“Accounting for Contingencies”*,and FASB Interpretation No. 14, *“ReasonableEstimation of the Amount of a Loss, an interpretation of FASB Statement No. 5”*.These reserves are as follows:

 
| ** **           | ** ** | **December 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------|------------|------------------------|------------|-----------------------------|------------|
|                 |       |                   |       |                        |       |
| Class action lawsuit |       | $                      | 3,353      |                        | $          | 6,520 |   |
| SEC investigation    |       | —                 |       | 2,000                       |       |
|                 |       | $                      | 3,353      |                        | $          | 8,520 |   |

 

The portion of theconsolidated class action lawsuit settlement payable in shares of Company stockhas been valued at $4,470,000 and $6,165,000 based on the closing market pricesof $2.98 and $4.11 on September 6, 2005 and December 31, 2004,respectively. The remaining reserve balance at December 30, 2005 relates to1,125,000 shares remaining to be distributed.

 

 We are involved incertain other claims arising in the normal course of business.  In ouropinion, the final resolution of these claims should not have a materialadverse effect on our financial position, cash flow or results from operations.

 

**ITEM 4. SUBMISSION OF MATTERS TOA VOTE OF SECURITY HOLDERS**

 

No matters were submittedto a vote of security holders during the fourth quarter of 2005.

 

11

----

 

**PART II**

 

**ITEM 5. MARKETFOR REGISTRANT’S COMMON EQUITY AND ISSUER PURCHASES OF EQUITY SECURITIES AND RELATEDSTOCKHOLDER MATTERS**

 

**Market Information**

 

Our Common Stock isquoted on the Nasdaq National Market under the symbol “ZOMX.”  The following table shows the high and lowclosing bid prices of our Common Stock. These bid quotations representinter-dealer prices and do not include retail mark-ups, mark-downs orcommissions and may not necessarily represent actual transactions.

 
| ** **     | ** ** | **2005** | ** ** | **2004** | ** ** |
|----------------|------------|----------|------------|----------|------------|
| ** **     | ** ** | **High** | ** ** | **Low**  | ** ** | **High** | ** ** | **Low** | ** ** |
| First Quarter  |       | $        | 4.73       |     | $          | 2.89 |   | $ | 5.32 |   | $ | 3.93 |   |
| Second Quarter |       | 2.95     |       | 2.16     |       | 4.30 |   | 3.59 |   |
| Third Quarter  |       | 3.39     |       | 2.87     |       | 3.78 |   | 2.93 |   |
| Fourth Quarter |       | 3.10     |       | 2.01     |       | 4.11 |   | 3.10 |   |
|                |            |          |            |          |            |  |  |  |  |  |  |  |  |

 

**Holders**

 

As of March 10, 2006,there were approximately 377 recordholders of our Common Stock, excludingstockholders whose stock is held either in nominee name and/or street namebrokerage accounts. Based on information which we have obtained from ourtransfer agent, there are approximately 11,242 holders of our Common Stockwhose stock is held either in nominee name and/or street name brokerageaccounts.

 

**Dividends**

 

We have never declared orpaid cash dividends on our capital stock and do not anticipate declaring orpaying any cash dividends in the foreseeable future and intend to retain futureearnings for the development of our business.

 

**IssuerPurchases of Equity Securities**

 

The following tableprovides information about purchases made by us of our Common Stock in thefourth quarter of fiscal 2005.

 
| **Period**                          | ** ** | **(a) Total   Number of   Shares (or   Units)   Purchased(1)** | ** ** | **(b) Average   Price Paid per   Share (or   Unit)** | ** ** | **(c) Total Number of   Shares (or Units)   Purchased as Part of   Publicly Announced   Plans or Programs** | ** ** | **(d) Maximum   Number (or   Approximate Dollar   Value) of Shares (or   Units) that May Yet   Be Purchased Under   the Plans or   Programs (1)** | ** ** |
|-------------------------------------|------------|----------------------------------------------------------------|------------|------------------------------------------------------|------------|-------------------------------------------------------------------------------------------------------------|------------|---------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| November 1 – November 30, 2005 |       | 112,633                                                        |       | $                                                    | 2.53       |                                                                                                        | 112,633    |                                                                                                                                              | $          | 9,715,039 |   |
| December 1 - December 30, 2005      |       | 452,928                                                        |       | 2.19                                                 |       | 452,928                                                                                                     |       | $                                                                                                                                                 | 8,723,126  |   |
| Total                               |       | 565,561                                                        |       | 2.26                                                 |       | 565,561                                                                                                     |       | $                                                                                                                                                 | 8,723,126  |   |
|                                     |            |                                                                |            |                                                      |            |                                                                                                             |            |                                                                                                                                                   |            |  |  |

 

----

(1)  On November 2, 2005, our Board of Directorsapproved a share repurchase program, whereby we would repurchase up to $2.0million of our Common Stock in the open market through December 31, 2005 and upto $10.0 million of our Common Stock through December 31, 2006. The repurchaseprogram was announced on November 8, 2005. No share repurchase plan or programexpired, or was terminated, during the period covered by this report. AtDecember 30, 2005, approximately 641,000 shares were traded of whichapproximately 75,000 shares settled in 2006. Average price per share and dollarvalue of shares purchased includes commissions.

 

**ITEM 6. SELECTED FINANCIAL DATA**

 

The following five-yearfinancial summary information should be read in conjunction with theConsolidated Financial Statements and related notes thereto set forth in PartII, Item 8 of this Form 10-K.

 

12

----

 
| ** **                                      | ** ** | **2005****(1)(2)(3)(4)**                  | ** ** | **2004(5)** | ** ** | **2003(6)** | ** ** | **2002**   | ** ** | **2001(7)** | ** ** |
|-------------------------------------------------|------------|-------------------------------------------|------------|-------------|------------|-------------|------------|------------|------------|-------------|------------|
| ** **                                      | ** ** | **(In thousands, except per share data)** | ** ** |
| ** **                                      | ** ** | ** **                                | ** ** | ** **  | ** ** | ** **  | ** ** | ** ** | ** ** | ** **  | ** ** |
| **STATEMENT OF OPERATIONS DATA:**               |       |                                      |       |        |       |        |       |       |       |        |       |
| Revenue                                         |       | $                                         | 166,984    |        | $          | 199,428     |       | $          | 197,816    |        | $          | 185,500 |   | $ | 216,797 |   |
| Gross profit                                    |       | 13,031                                    |       | 30,397      |       | 36,529      |       | 32,812     |       | 50,109      |       |
| Selling, general and administrative expenses    |       | 35,000                                    |       | 45,704      |       | 40,982      |       | 35,264     |       | 31,964      |       |
| Loss on impairment of long-lived assets         |       | 4,318                                     |       | —      |       | —      |       | —     |       | —      |       |
| Restructuring costs                             |       | 3,518                                     |       | —      |       | —      |       | —     |       | —      |       |
| Operating (loss) income                         |       | (29,805                                   | )          | (15,307     | )          | (4,453      | )          | (2,452     | )          | 17,222      |       |
| (Loss) income before income taxes               |       | (28,237                                   | )          | (12,034     | )          | (4,196      | )          | (1,252     | )          | 14,254      |       |
| Income tax (expense) benefit                    |       | (7,909                                    | )          | 3,623       |       | 3,021       |       | 573        |       | 5,221       |       |
| Net earnings (loss)                             |       | (36,146                                   | )          | (8,411      | )          | (1,175      | )          | (679       | )          | 9,033       |       |
| Earnings (loss) per share:                      |       |                                      |       |        |       |        |       |       |       |        |       |
| Basic                                           |       | (1.11                                     | )          | (0.26       | )          | (0.04       | )          | (0.02      | )          | 0.28        |       |
| Diluted                                         |       | (1.11                                     | )          | (0.26       | )          | (0.04       | )          | (0.02      | )          | 0.27        |       |
| Weighted average common shares outstanding:     |       |                                      |       |        |       |        |       |       |       |        |       |
| Basic                                           |       | 32,621                                    |       | 32,628      |       | 32,621      |       | 33,050     |       | 32,364      |       |
| Diluted                                         |       | 32,621                                    |       | 32,628      |       | 32,621      |       | 33,050     |       | 33,152      |       |
|                                            |       |                                      |       |        |       |        |       |       |       |        |       |
| **BALANCE SHEET DATA:**                         |       |                                      |       |        |       |        |       |       |       |        |       |
| Cash and cash equivalents                       |       | $                                         | 45,250     |        | $          | 41,092      |       | $          | 51,899     |        | $          | 66,146 |   | $ | 74,999 |   |
| Short-term available-for-sale securities        |       | —                                    |       | 19,200      |       | 17,000      |       | 6,000      |       | —      |       |
| Working capital                                 |       | 62,213                                    |       | 83,332      |       | 88,140      |       | 89,960     |       | 89,889      |       |
| Total assets                                    |       | 115,172                                   |       | 168,154     |       | 181,039     |       | 167,183    |       | 163,506     |       |
| Long-term notes payable, net of current portion |       | —                                    |       | —      |       | —      |       | 747        |       | 3,720       |       |
| Total shareholders’ equity                 |       | 88,608                                    |       | 128,112     |       | 137,053     |       | 130,549    |       | 124,424     |       |

 

----

 

(1)Based on historical negative cash flows in 2005 and 2004 as well as futureyears’ projected negative cash flows to be generated by the assets at our Clondalkin,Ireland manufacturing and fulfillment operations, in the fourth quarter of fiscal2005 we recorded a pre-tax impairment charge of $4.3 million, or $0.13 pershare, associated with those assets. See Note 12 to the Consolidated FinancialStatements for further discussion related to this impairment charge.

 

(2)Results of operations in 2005 include pre-tax charges of $3.5 million, or $0.11per share, from the restructuring plan we began during the first half of 2005. SeeNote 13 to the Consolidated Financial Statements for further discussion ofthese restructuring charges.

 

(3)2005 net loss includes a valuation allowance of $15.2 million, or $0.47 pershare, established in our third quarter against our net deferred tax assets resultingprimarily from net operating loss carrryforwards. We took this position basedon our history of losses on United States and Ireland operations and theuncertainty of the company’s ability to utilize these carryforwards prior toexpiration. See Note 7 to the Consolidated Financial Statements for furtherdiscussion related to this allowance.

 

(4)  Results of operationsfor 2005 include a pre-tax benefit of $2.0 million, or $0.06 per share resultingfrom a reduction in our litigation reserves related to the SEC and class actionshareholders suit. See Note 9 to the Consolidated Financial Statements forfurther discussion related to this litigation reserve.

 

(5)Results of operations in 2004 include a pretax charge of $8.5 million, or $0.18per share, for litigation reserves related to minimum expected probablelosses that would result from our settlement offers to the SEC and class actionshareholders, and a pretax gain of $2.8million, or $0.05 per share, on sales of a portion of our Intrawareshareholdings. See Note 9 to the Consolidated Financial Statements for furtherdiscussion related to this litigation reserve.

 

(6)  Results of operations in2003 include a pre-tax charge of $2.0 million, or $0.04 per share, for accruedpayments under a separation agreement with our former CEO, a pretax benefit of$2.7 million, or $0.05 per share, for a royalty adjustment relating to amountsaccrued in 2002, and a $1.0 million benefit, or $0.03 per share, related to areduction in our tax accruals following the completion of a Canadian tax audit.

 

(7)  Results of operations in2001 include a pretax charge of $4.4 million, or $0.09 per share, for thewrite-off of our 

 

13

----

 

investment in Microgistix, and apretax charge of $0.9 million, or $0.02 per share, for the write-off ofgoodwill related to our acquisition of Trotter Technologies, Inc.

 

**ITEM 7. MANAGEMENT’S DISCUSSIONAND ANALYSIS OF FINANCIAL CONDITION AND RESULTS OF OPERATIONS**

 

**Fiscal Year-End**

 

Our fiscal year ends onthe last Friday of the calendar year. To simplify our narrative discussion, werefer to the fiscal years ended December 30, 2005, December 31, 2004, and December26, 2003, as 2005, 2004, and 2003, respectively.

 

## **Introduction and Overview**

##  

## Fiscal 2005results are indicative of the increased pressure on revenue and margins in ourindustry particularly in the PC-OEM market, our largest industry vertical. Themarket is maturing and fast becoming commoditized. Revenues for the year were $167.0million in comparison to $199.4 million and $197.8 million in 2004 and 2003,respectively. Our customer base is currently heavily skewed to the PC hardwareand software industry. Program and content changes, especially the eliminationof certain recovery CDs and printed materials from new PC shipments havematerially impacted our revenues in 2005. Gross margins decreased in 2005 as weexperienced significant pricing pressure, cost pressure from inputs such aspolycarbonate, inefficiencies in operations during the realignment of ourCD/DVD replication capacity and a misalignment of our fixed cost structurerelative to our declining revenue base. In response, we initiated a series ofrestructuring initiatives including a reduction in CD replication capacity,organizational streamlining and the announced closure of our Fremont, CAfacility all of which, when combined, resulted in the recording of $3.5 millionin restructuring charges. Additionally we booked a $4.3 million impairmentcharge against our Ireland manufacturing assets. Based on historical negative cash flows in 2004 and continuing negativecash flows in 2005 generated by the assets of our Clondalkin, Irelandmanufacturing and fulfillment operations, management concluded and our auditcommittee concurred, that this change in circumstances indicated that animpairment of the Clondalkin operations fixed assets was required undergenerally accepted accounting principles. This conclusion was made based upon adetermination that the discounted future cash flows expected to be generated bythe fixed assets of the Clondalkin operations over the remaining life of theassets would not be sufficient to recover the assets. We continue toevaluate the alternatives related to these assets and, therefore, are unable atthis time to make a good faith estimate of the amount of future cashexpenditures, if any, that may arise in light of this impairment charge. As aresult of current and prior years’ operating losses in the United States andIreland, the Company had been recording tax benefits related to certain losscarryforwards. The Company is uncertain in its ability to realize thesebenefits prior to their expiration and has recorded a valuation allowance againstits net deferred assets of $16.4 million. We recognized a $2.0 millionreduction in litigation expense resulting primarily from the settlement of thestock component of our class action suit on September 6, 2005 resulting fromour lower per share market price at settlement date. Overall, we posted a netloss of $1.11 per share in 2005 compared to a net loss of $0.26 per share infiscal 2004.

##  

We continuously seek andare successful in locating new customers for our products and services. Evenwith this success, revenue for the company is driven by a limited number oflarge, technologically based companies within the computer hardware andsoftware market segments a number of which Zomax has serviced for many years.They are the leaders in their respective industries and drive the market toreduce costs, improve quality and increase services for their customersresulting in even tighter margins for the company. This, coupled with theover-capacity of CD/DVD replication capacity in the market, drives intensecompetition and continues to limit the ability of Zomax and other companies inour industry to maintain or regain pricing power.

 

Zomax has always and willcontinue to strive to return value to its shareholders by leveraging itsknowledge of its customers’ businesses and service requirements. Three yearsago in an effort to regain profitability, Zomax began working to address theissues facing it and the industry. These efforts included broadening our coremarket of supply-chain outsourcing services and seeking new markets for theseservices. In 2005, we took steps to improve manufacturing efficiencies byeliminating CD production capacity, consolidating facilities, reducing overheadexpense and increasing our attention to higher margin, value added services forour customers. The financial impact of these actions to date will be fullyrealized in the second quarter of 2006 and beyond. Additional actions of asimilar nature may be necessary in the future.

 

Our longer term goalremains to grow revenue via executing on our strategy to transform Zomax into amore flexibly structured supply chain program management company. In this lessvertically integrated model, we will delivera more comprehensive supply chain solution by integrating andcoordinating resources, capabilities and technology of our own organizationwith those of complementary third party service providers.

 

14

----

 

Globalization,customization and shorter product lifecycles are resulting in significantly increasedsupply chain complexity. Companies are also looking to consolidate the numberof outsource providers they use to drive improved integration, visibility andefficiency with their remaining partners. We believe our Program Managementmodel will scale more easily with this rapid growth and change in our customers’supply chains and allow them to consolidate suppliers without sacrificingbest-in-class capabilities. This model also results in a lower fixed cost andasset structure which we believe will result in higher operating leverage andincreased flexibility to change within a market or to migrate to new marketssegments in the future.

 

Our near term planremains to reduce our operating loss via cost reductions in operations and generaloverhead and pursuing new revenue opportunities in existing and new industriesvertical. In parallel, we will look to opportunities available to us to achieveour near and long-term goals through both organic growth and merger andacquisition activities in order to return to profitability. We believe ourheritage as a service provider, strong relationships with our customers, deepunderstanding of their program requirements and our financially strong balancesheet position us well to be successful.

 

**General Factors Affecting OurFinancial Results**

 

*Revenue.*Wederive our revenues from a wide variety of supply chain services provided toour customers. The number of CD and DVD media units that we replicate for ourcustomers, changes in pricing, changes in the composition of the products andservices we provide, consumer demand for our customers’ products, seasonalconsumer buying patterns, and changes in the mix of customers we serve, are allfactors that contribute to changes in our revenues from period to period. Inaddition, a significant portion of revenue from our larger customers is derivedfrom individually large product programs within these customers. As a result,our revenues can be materially sensitive to decisions customers make withrespect to these individual programs. Revenues are generally more favorablyimpacted when our mix of customers is weighted toward those who are using abroad range of our services. Bundled pricing, changes in the content of theproducts we make for our customers, and other dynamics make it difficult toprecisely determine the impact each of these factors has on changes in ourtotal revenue.

 

*Gross Profit Percentage.* Our gross profit percentage has become more volatile as mediareplication becomes a commodity product. A number of other factors impact thispercentage as well. Market pressure from the PC and software industry is pushingdown pricing thereby squeezing margins from the revenue side while inputs suchas polycarbonate increase in cost and apply upward pressure through cost ofgoods. Additionally, due to our high fixed cost base, decreases in revenueunfavorably impact our gross profit percentage as we cannot quickly adjustthese costs to be more in line with revenue.

 

*Selling, General and Administrative (SG&A) Expenses.*A substantial portion of our SG&Aexpenses are fixed in nature. However, certain components such as incentivecompensation, professional services, travel and other expenses can vary basedon business results, individual events, or initiatives we may be pursuing atvarious times throughout the year. In addition to these factors, some of ourSG&A expenses are incurred in Ireland and Canada and changes in therespective foreign currency rates can cause our expenses reported in U.S.dollars to fluctuate.

 

**Results of Operations**

 

The followingtable summarizes certain key information to aid in the understanding of ourdiscussion and analysis of results of operations.

 
| ** **                                               | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|----------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Percent of Revenue:**                                  |       |     |       |     |       |     |       |
| Revenue                                                  |       | 100.0    | %          | 100.0    | %          | 100.0    | %          |
| Gross profit                                             |       | 7.8      |       | 15.2     |       | 18.5     |       |
| Selling, general  and administrative (SG&A) expenses |       | 21.0     |       | 22.9     |       | 20.7     |       |
| Loss on  impairment of long-lived assets                 |       | 2.6      |       | —   |       | —   |       |
| Restructuring  costs                                     |       | 2.1      |       | —   |       | —   |       |
| Operating loss                                           |       | (17.8    | )          | (7.7     | )          | (2.3     | )          |
| Income tax  (expense) benefit                            |       | (4.7     | )          | 1.8      |       | 1.5      |       |
| Net loss                                                 |       | (21.6    | )          | (4.2     | )          | (0.6     | )          |
| **Other Operating Statistics:**                          |       |     |       |     |       |     |       |
| Media units sold  -% change from prior year              |       | (24.2    | )%         | (0.9     | )%         | 4.1      | %          |
| Revenue -%  change from prior year                       |       | (16.3    | )          | 0.8      |       | 6.6      |       |
| SG&A  expenses -% change from prior year             |       | (23.4    | )          | 11.5     |       | 16.2     |       |
| Effective tax  rate                                      |       | (28.0    | )          | 30.1     |       | 72.0     |       |

 

15

----

 

**Revenue**

 

*2005 vs. 2004.*Our revenues decreased 16.3% year over year from $199.4 in 2004 to $167.0million in 2005. Our volume with Microsoft, which remains our largest customer,has grown to a larger percentage of total revenue comprising 24% of totalrevenue in 2005 compared to 22% in 2004**.**Asdiscussed in our 2004 Form 10-K, Dell became a larger customer in 2004 increasingto 19% of total revenue. In 2005, our volume with this key customer hasdecreased to approximately 17% of our total revenue. Over two thirds of our overallrevenue decline occurred in our number one industry vertical, the PC-OEMmarkets, largely driven by program and content changes that will continue wellinto 2006.

 

*2004 vs. 2003.*Our revenues increased on an annual basis, growing 0.8%, from $197.8 in2003 to $199.4 million in 2004. Our volume with Microsoft, our largestcustomer, continued at approximately the same percentage of total revenue, 22%,as in 2003. As discussed in our 2003 Form 10-K, Dell became a greater than 10%customer for the first time in 2003, and our volume with this key customercontinued to grow in 2004, comprising approximately 19% of our total revenue. Offsettingour increased business with Dell in 2004, were decreases in revenue from acustomer to which we provided large volumes of low-priced, bulk CDs in 2003, adecrease in revenue from a large customer which moved a portion of the kitting andassembly work previously performed in the U.S. to Asia, and a general businessdecline experienced by one of our other customers in the PC-OEM industry. Our2004 fiscal calendar, which included 53 weeks, as compared to 52 weeks in 2003,also had a favorable impact on our 2004 revenues

 

**GrossProfit**

 

*2005vs. 2004*. Our gross profit percentage fell 7.4% from 15.2% in2004 to 7.8% in 2005. The major factors contributing to this decline werepricing pressure particularly in media replication. Increases in polycarbonateand other input costs increased by $4.2 million, or 2.5 points compared to 2004,which were unable to be fully offset by pricing action of a one cent surchargeon CD and DVD media effective since the fourth quarter of 2004. The net impactof polycarbonate cost increases relative to our pricing surcharge reduced grossmargin by approximately 1.8 points in 2005. Operational inefficiencies as wellas inefficiencies experienced in the realignment of our CD/DVD replicationcapacity reduced margins by approximately $5.7 million, or 3.4 points, over2004. In addition fixed manufacturing costs were spread over lower revenuesimpacting gross margin by approximately 1.0 point.

 

*2004vs. 2003*. Our gross profit percentage fell 3.3 points from18.5% in 2003 to 15.2% in 2004. Our 2003 gross profit margin was favorablyimpacted by a $4.8 million benefit related to the signing of a revised royaltyagreement which resulted in a retroactive reduction in unpaid royalties accruedin 2002 and 2003. Of this benefit, $2.7 million relates to royalties accruedand charged to cost of revenue in 2002, and accounts for 1.4 points of thetotal 3.3 points decline in gross profit margin from 2003 to 2004. In addition,our 2004 margins were significantly impacted by increases in the price ofpolycarbonate, a petroleum-based plastic that is the primary raw material usedin the manufacturing of CD and DVD media. Over the last three quarters of 2004,petroleum price increases and supply shortages placed significant upwardpressures on the price of polycarbonate. While we entered into a purchaseagreement with our polycarbonate supplier that limited future price increasesand ensured adequate supply for our 2005 production, the increases allowedunder the agreement had a negative impact on our gross profit. Polycarbonatecost increases accounted for an estimated decline of $1.9 million, or 1.0 point,in our gross profit margins as compared to 2003. This decline includes theoffsetting effect of a one cent surcharge on CD and DVD media passed on to ourcustomers in the fourth quarter of 2004. Also, significant operationaldeficiencies in our Ireland manufacturing facility contributed to the declinein our gross profit margin from 2004 to 2003.

 

**Selling,General and Administrative (SG&A) Expenses**

 

*2005 vs. 2004.*Our2005 SG&A expenses decreased $10.7 million, or 23.4%, over 2004. This was primarilyattributable to our 2004 accrual of $8.5 million in litigation charges and thesubsequent reduction of $1.7 million resultingfrom the stock component of our class action proposed****settlementbeing revalued to the closing market price of $2.98 September 6, 2005 from$4.11 per share on December 31, 2004.

 

*2004 vs. 2003.*Our2004 SG&A expenses increased $4.7 million, or 11.5%, over 2003. SG&Aexpenses in 2004 included a $8.5 million charge for litigation reserves relatedto minimum expected probable losses that would result from the settlementoffers made in relation to the pending SEC investigation and consolidated classaction lawsuit as discussed in Item 3 of this Form 10-K. SG&A expenses in2003 include a $3.0 million charge related to a settlement of a customer claimthat alleged unauthorized reproduction of this customer’s software and a $2.0million charge related to a separation agreement with our former CEO. Net ofthe effects of the aforementioned items, SG&A expenses increased $1.2M, or3.3%. Approximately $0.8 million of this increase is attributable toprofessional fees related to the implementation of our Sarbanes-

 

16

----

 

Oxley complianceprocedures and $0.4 million is attributable to the translation effect ofcurrency exchange rate changes on expenses incurred in our Ireland and Canadianoperations.

 

**Other Income and Expense**

 

In 2005 interest incomeincreased $0.8 million, or 91.5%, over 2004. This increase is due to interestreceived on a federal income tax refund as well as higher yields on our cashinvestments driven by the general upward trends in interest rates.****In 2004, we sold a portion of our Intraware shareholdingsin two separate private placements which resulted in a pre-tax gain ofapproximately $2.8 million. See Note 4 to the consolidated financial statementsin Item 8 of this Form 10-K for further discussion.

 

**IncomeTaxes**

 

*2005vs. 2004*. Ourreported 2005 income tax expense represents 28.0% of our pretax loss, comparedto a benefit of 30.1% of our pretax loss in 2004. Based upon the recent historyof losses in our United States and Ireland operations, a full valuationallowance of $15.2 million was recorded in the third quarter of 2005 on therelated net deferred tax assets in these jurisdictions. This valuationallowance was calculated in accordance with SFAS 109 which places primaryimportance on the most recent operating results in each jurisdiction in whichwe operate. While management continues to believe our actions to restructure thecost base and strategically reposition the Company will ultimately result inprofitability, three years of historical operating losses generally dictateprudence in assessing net deferred tax assets. The Company intends to maintainthe valuation allowance for its net deferred tax asset and loss carryforwardsuntil sufficient positive evidence exists to support reversal of the reserve.Going forward this means we will not tax effect income or losses for accountingpurposes, other than in Canada where we are in a tax payable position, untilsuch a time as we revisit the establishment of the reserve. We recordedan additional $1.2 million of deferred tax allowance in the fourth quarter. Dueto this deferred tax allowance, even though the Company posted a loss for theyear, we recorded net tax expense of $7.9 million in the statement ofoperations for the year ended December 30, 2005.

 

*2004vs. 2003*. Ourreported 2004 income tax benefit represents 30.1% of our pretax loss, comparedto 72.0 % of our pretax loss in 2003. While our tax rate in 2003 includedseveral one-time benefits as discussed below, our 2004 tax rate includes theeffect of $0.7 million in non-deductible expenses in 2004 and a $0.4 millionbenefit related to reductions in our tax accruals (see “Income Taxes”under Application of Critical Accounting Policies below). Also, our significant losses in Ireland adversely impacted our taxbenefit as those losses are subject to relatively low tax rates as compared toour U.S. operations. See Note 7 to the consolidated financial statements inItem 8 of the 2004 Form 10-K for a reconciliation of the statutory U.S. federalincome tax rate to our effective income tax rate.

 

**Supplemental Information**

 

Our financialresults as reported in our Consolidated Statement of Operations were preparedin accordance with accounting principles generally accepted in the UnitedStates (GAAP) and are the basis for the information presented in the table below.In 2005, 2004 and 2003 these results include certain significant items which webelieve are not indicative of our results of continuing operations. Forpurposes of our internal understanding of business operations, as well as forplanning and forecasting future periods, we exclude from our GAAP results thoseitems that meet the definition of non-recurring, as defined by the Securitiesand Exchange Commission. Accordingly, to aid in the understanding of ourfinancial results, our discussion and analysis of results of operations is supplementedwith the following reconciliation of our reported results on both a GAAP basis(“as reported”), and on the basis of the exclusion of these non-recurring items(“as adjusted”). However, the presentation of as adjusted results is not meantto be a substitute for financial results prepared in accordance with GAAP.

 

17

----

 

The following Table Apresents a reconciliation of our results of operations as reported, to ourresults of operations adjusted for those significant non-recurring items whichwe believe are not representative of our continuing operations:

 

**Table A –Reconciliation of As Reported Results to As Adjusted Results**

(Dollars in thousands except per share data)

 
| ** **                                 | ** ** | **Gross  Profit** | ** ** | **SG&A  Expenses** | ** ** | **Loss****Before  Income  Taxes** | ** ** | **Income  Tax  (Expense)  Benefit** | ** ** | **Net  Loss** | ** ** | **Diluted  (Loss)****Earnings Per  Share(8)** | ** ** |
|--------------------------------------------|------------|-------------------|------------|------------------------|------------|-----------------------------------|------------|-------------------------------------|------------|---------------|------------|-----------------------------------------------|------------|
| **2005:**                                  | ** ** | ** **        | ** ** | ** **             | ** ** | ** **                        | ** ** | ** **                          | ** ** | ** **    | ** ** | ** **                                    | ** ** |
| As reported                                |       | $                 | 13,013     |                   | $          | 35,000                            |       | $                                   | (28,237    | )             | $          | (7,909                                        | )          | $ | (36,146 | ) | $ | (1.11 | ) |
|                                       |       |              |       |                   |       |                              |       |                                |       |          |       |                                          |       |
| Loss on impairment of long-lived assets(1) |       | —            |       | —                 |       | 4,318                             |       |                                |       | 4,318         |       | 0.13                                          |       |
| Restructuring charges(2)                   |       | —            |       | —                 |       | 3,518                             |       |                                |       | 3,518         |       | 0.11                                          |       |
| Deferred Tax valuation allowance (3)       |       | —            |       | —                 |       | —                            |       | 16,449                              |       | 16,449        |       | 0.50                                          |       |
| Litigation reserve reduction (4)           |       | —            |       | (2,029                 | )          | (2,029                            | )          | —                              |       | (2,029        | )          | (0.06                                         | )          |
| As adjusted                                |       | $                 | 13,013     |                   | $          | 32,971                            |       | $                                   | (22,430    | )             | $          | 8,540                                         |       | $ | (13,890 | ) | $ | (0.42 | ) |
| Percent of revenue                         |       | 7.8               | %          | 19.7                   | %          | (13.4                             | )%         | 5.1                                 | %          | (8.3          | )%         |                                          |       |
|                                       |       |              |       |                   |       |                              |       |                                |       |          |       |                                          |       |
| **2004:**                                  |       |              |       |                   |       |                              |       |                                |       |          |       |                                          |       |
| As reported                                |       | $                 | 30,397     |                   | $          | 45,704                            |       | $                                   | (12,034    | )             | $          | (3,623                                        | )          | $ | (8,411 | ) | $ | (0.26 | ) |
| Litigation reserves(4)                     |       | —            |       | (8,520                 | )          | 8,520                             |       | 2,686                               |       | 5,834         |       | 0.18                                          |       |
| As adjusted                                |       | $                 | 30,397     |                   | $          | 37,184                            |       | $                                   | (3,514     | )             | $          | (937                                          | )          | $ | (2,577 | ) | $ | (0.08 | ) |
| Percent of revenue                         |       | 15.2              | %          | 18.7                   | %          | (1.8                              | )%         | (0.5                                | )%         | (1.3          | )%         |                                          |       |
|                                       |       |              |       |                   |       |                              |       |                                |       |          |       |                                          |       |
| **2003**                                   |       |              |       |                   |       |                              |       |                                |       |          |       |                                          |       |
| As reported                                |       | $                 | 36,529     |                   | $          | 40,982                            |       | $                                   | (4,196     | )             | $          | (3,021                                        | )          | $ | (1,175 | ) | $ | (0.04 | ) |
| Royalty adjustment(5)                      |       | (2,660            | )          | —                 |       | (2,660                            | )          | (1,064                              | )          | (1,596        | )          | (0.05                                         | )          |
| Customer claim settlement(6)               |       | —            |       | (3,000                 | )          | 3,000                             |       | 1,200                               |       | 1,800         |       | 0.06                                          |       |
| Severance costs(7)                         |       | —            |       | (2,000                 | )          | 2,000                             |       | 800                                 |       | 1,200         |       | 0.04                                          |       |
| As adjusted                                |       | $                 | 33,869     |                   | $          | 35,982                            |       | $                                   | (1,856     | )             | $          | (2,085                                        | )          | $ | 229 |   | $ | 0.01 |   |
| Percent of revenue                         |       | 17.1              | %          | 18.2                   | %          | (0.9                              | )%         | (1.1                                | )%         | 0.1           | %          |                                          |       |

 

----

(1)Based on historical negative cash flows in 2004 and 2005, as well as futureyears’ projected negative cash flows to be generated by the assets of ourClondalkin, Ireland manufacturing and fulfillment operations, in our fourthquarter of fiscal year 2005 we recorded a pre-tax impairment charge of $4.3million, or $0.13 per share, associated with those assets. See Note 12 to theConsolidated Financial Statements for further discussion related to thisimpairment charge.

 

(2) Adjustmentrepresents the pre-tax charges of $3.5 million, or $0.11 per share, from therestructuring plan we began during the first half of 2005. See Note 13 to theConsolidated Financial Statements for further discussion of these restructuringcharges.

 

(3) 2005 net loss includes a valuation allowance of$15.2 million, or $0.47 per share, established in our third quarter and $1.2 million,or $.04 per share, in our fourth quarter against our net deferred tax assetsresulting from loss carrryforwards. We took this position based on our historyof losses on United States and Ireland operations and the uncertainty of thecompany’s ability to utilize these carryforwards prior to expiration.

 

(4)Adjustment in 2005 represents the pre-taxbenefit of the reversal of a portion of our 2004 litigation reserves of $2.0million primarily as a result of****the stockcomponent of our class action proposed****settlementbeing revalued to the closing market price of $2.98 on September 6, 2005, thedate of Court approval, from $4.11 per share on December 31, 2004. Adjustment in2004 represents charges for litigation reserves related to minimum expectedprobable losses that would result from the settlement offers made in relation to our pending SECinvestigation and consolidated class action lawsuit as discussed in Item 3 ofthis Form 10-K.

 

(5)In the fourth quarter of 2003, we signed a revised royalty agreement whichresulted in a retroactive reduction in unpaid royalties accrued in 2002 and2003 (See “Application of Critical Accounting Policies” in this Item 7 below). Thisadjustment represents the portion of this retroactive reduction that related toroyalties accrued and charged to cost of revenue in 2002.

 

(6)Adjustment represents a payment made in the settlement of a customer claim thatalleged unauthorized reproduction of this customer’s software (See Note 9 tothe consolidated financial statements in Item 8 of this Form 10-K).

 

(7)Adjustment represents payments accrued in 2003 in accordance with the terms ofa separation agreement with our former CEO who resigned in December 2003,effective in January 2004.

 

(8)Both as reported and as adjusted results in 2004 and 2003 include an income taxbenefit of $0.4 million, or $0.01 per share, and $1.0 million, or $0.03 pershare, respectively, related to a reduction in our tax accruals. See “Applicationof Critical Accounting Policies” below for further discussion. Both as reportedand as adjusted results in 2004 include a pretax gain of $2.8 million, or $0.05per share, on sales of a portion of our Intraware Shareholdings. These itemsare not reflected as an adjustment in the table as they do not meet thedefinition of a non-recurring item as defined by the Securities and ExchangeCommission.

 

18

----

 

**Application of CriticalAccounting Policies**

 

*Revenue Recognition.* We recordrevenue at the time product is shipped or as services are rendered. For certaincustomers, product is invoiced upon completion of production and assemblyservices, with final shipment occurring based on written customer instructions.In these cases, the customer accepts title to the goods as of the date of theinvoice and sales revenue is recognized at that time. In each case of these “billand hold” sales, we ensure that the transaction complies with the conditionsand considerations contained in Staff Accounting Bulletin No. 101 and Accountingand Auditing Enforcement Release No. 108 of the Securities and ExchangeCommission.

 

*Royalties.*We have license agreements with several companies for the useof certain CD and DVD manufacturing technology we use in our business. We donot necessarily have agreements with every patent holder that may assert or hasasserted a claim to royalties. The cost of these royalties is accrued based onunits sold and charged to cost of revenue. Our royalty costs are based upon theterms of our royalty agreements as well as our assessment of the applicabilityof any other known or potential royalties. As previously disclosed in our 2003Form 10-K, we completed negotiations with one of the major patent holdersresulting in the signing of a revised royalty agreement that retroactivelyreduced the royalties payable to this patent holder.

 

*IncomeTaxes*. We file a consolidated federal income tax return andseparate state and foreign returns. Deferred income taxes are provided fordifferences between the tax basis of assets and liabilities and their carryingamounts for financial reporting purposes, based on the expected income taxrates for the year in which these temporary differences are expected toreverse. Foreign net operating loss carryforwards may be carried forwardindefinitely.

 

Based upon the recenthistory of operating losses in the United States and Ireland the Company isuncertain of its ability to realize the benefits of certain loss carryforwardsprior to their expiration. For this reason we recorded a valuation allowanceagainst our net deferred tax assets of approximately $15.2 million in the thirdquarter and an additional $1.2 million in the fourth quarter related to lossesfor that period. Management believes its efforts to restructure the cost baseand reposition the Company will return it to a profitable state. Until then, itintends to maintain the valuation allowance for current and future losscarryforward amounts.

 

The preparation of ourincome tax returns requires the interpretation of the associated tax laws. Manytax laws are complex, and at times ambiguous, and our interpretations of theselaws may differ from the interpretations of the taxing authorities who have theright to audit our returns within statutory time periods. Where we believethere is a quantifiable risk that our interpretations of these laws couldreasonably differ from those of the taxing authorities, we make appropriateprovisions in our tax liabilities. In the fourth quarter of fiscal year 2005,we assessed the probabilities of those provisions which resulted in an accrualreduction of $0.4 million. Our assessment in 2004 resulted in recognition of a $0.4 million benefit related to reductionsin our tax accruals from 2003. In 2003, Canadian tax authoritiescompleted an audit of our Canadian tax returns for the years 1999, 2000 and2001. Accordingly in 2003, we removed $1.0 million of provisions we had made inour tax liabilities related to the risk that tax authorities would rejectcertain positions we had taken in the preparation of these returns.

 

*AccountsReceivable.*We review our accounts receivable balances on aregular basis to determine their collectibility. An allowance for doubtful accountsis recorded based on management’s estimate of those accounts which may becomeuncollectible.

 

*Inventory.*We review our inventory on a regular basis with the objectiveof assessing its net realizable value. We adjust the carrying value ofinventory according to our estimates of the net realizable value of individualinventory components relative to their purchase or carrying value.

 

**New Accounting Standards**

 

See Note 1 of “Notes toConsolidated Financial Statements” included in Item 8 herein for a discussionof new accounting standards.

 

**Liquidity and Capital Resources**

 

*Cash and Cash Equivalents and Short-TermAvailable-for-Sale Securities.*At December 30, 2005, cash andcash equivalents and short-term available-for-sale securities decreased to $45.3million from $60.3 million at December 31, 2004, primarily reflecting thefollowing significant items:

 

•      Cashoperating loss and cash restructuring charges of $16.2 million;

 

•      Capitalexpenditures of $4.0 million;

 

•      Sharere-purchase plan $1.4 million; and

 

•      Changesin working capital – source of $6.8 million.

 

*WorkingCapital and Liquidity*. Working capital totaled $62.2 millionand $83.3 million at December 30, 2005 and December 31, 2004, respectively.This decrease primarily reflects the decrease in our cash balances discussedabove. Our principal source of working capital continues to be cash and cashequivalents and short-term available-for-sale securities. In 

 

19

----

 

addition to our working capital balances, we also hold long termavailable-for-sale securities which represent our investment in Intraware (seeNote 4 to the Consolidated Financial Statements included in Item 8 herein). Thesesecurities are fully registered and had a market value of $2.1 million atDecember 30, 2005.

 

Our future liquidityneeds will depend on, among other factors, the level of cash operating losses, theneed for additional restructuring actions, the timing of capital expenditures,expenditures in connection with possible acquisitions, proceeds from sale ofassets, changes in customer order volume, the timing and collection ofreceivables and the level of share repurchases under the approved stock buybackprogram. With approximately $45.3 million in cash and no debt, we believe thatexisting cash and investment balances will be sufficient to fund our operationsfor the foreseeable future. The company has taken action to rationalize itscost structure and lower its cash operating losses and will be managing capitalexpenditures tightly, while evaluating other opportunities to free up cash fromits assets.

 

*ContractualObligations: *Paymentsdue under known contractual obligations as of the end of 2005 are as follows(in millions):

 
| ** **                     | ** ** | **Less than  1 Year** | ** ** | **2 to 3  Years** | ** ** | **4 to 5  Years** | ** ** | **After  5 Years** | ** ** | **Total** | ** ** |
|--------------------------------|------------|-----------------------|------------|-------------------|------------|-------------------|------------|--------------------|------------|-----------|------------|
| Operating lease obligations    |       | $                     | 5.5        |              | $          | 7.5               |       | $                  | 4.5        |      | $          | 21.1 |   | $ | 38.6 |   |
| Polycarbonate supply agreement |       | 1.8                   |       | —            |       | —            |       | —             |       | 1.8       |       |
| Total                          |       | $                     | 7.3        |              | $          | 7.5               |       | $                  | 4.5        |      | $          | 21.1 |   | $ | 40.4 |   |

 

A number of our facilityleases have early termination clauses that would reduce future contractualobligations with the payment of penalties for early exit.

 

During the third quarterof 2005, we entered into an agreement with our supplier of polycarbonate, apetroleum-based commodity which is the primary raw material used in theproduction of CD and DVD media. For the past two years, supply shortages andincreases in petroleum prices have placed significant upward pressure onpolycarbonate pricing. Under the agreement, which runs through June 2006, wehave agreed to purchase polycarbonate at set price terms. These price termsrestrict monthly price increases and help us to limit our exposure to potentialfuture price increases while also allowing us to reduce our purchase volumeshould the price terms increase above an agreed-upon level over the initialbase price. Minimum remaining commitments for the first half of 2006, underthis agreement, subject to purchase volume reductions, are approximately $1,800,000based on the current adjusted base price and minimum remaining quantity. Webelieve that this agreement will allow us to minimize our near-term exposure tocontinuing upward price pressures on this key raw material.

 

**Off-Balance sheet Arrangements**

 

At December 2005, we had no off-balance sheet financing arrangements.

 

**Market Risk**

 

*ForeignCurrency.*A portion of our operations are located in Irelandand Canada. A majority of the revenue from our Canadian operations, and aportion of the related costs, are denominated in U.S. dollars. As a result, ourexposure to the Canadian currency results primarily from Canadian dollardenominated expenses. The majority of revenues and related costs in our Irelandoperations are denominated in Euros. Foreigncurrency transaction gains and losses are reflected in our financial statementsand historically have not been material to our results of operations orfinancial condition. However, we anticipate we will continue to incur exchangegains and losses from foreign operations in the future which may besignificant depending on factors such as changes in foreign currency or weakeconomic conditions in foreign markets. In addition, sales of our products andservices may be directly impacted by the value of the U.S. dollar relative toother currencies.

 

**Inflation**

 

Historically, inflationhas not had a material impact on our operations. The cost of labor and rawmaterials, particularly the cost of petroleum, which affects the cost ofpolycarbonate used in the manufacture of optical discs, can influence the costof our products and services. There can be no assurance that we will be able topass on any increased material or labor costs to our customers in the future.

 

**ITEM 7A. QUANTITATIVE ANDQUALITATIVE DISCLOSURES ABOUT MARKET RISK**

 

See “Market Risk” underItem 7 above.

 

20

----

 

**ITEM 8. FINANCIAL STATEMENTS ANDSUPPLEMENTARY DATA**

 

**REPORT OF INDEPENDENT REGISTEREDPUBLIC ACCOUNTING FIRM**

 

To the Board of Directorsand Shareholders of Zomax Incorporated:

 

We have audited theaccompanying consolidated balance sheets of Zomax Incorporated and Subsidiaries(the “Company”) as of December 30, 2005 and December 31, 2004, and the relatedconsolidated statements of operations, shareholders’ equity, and cash flows foreach of the three years in the period ended December 30, 2005. Our audits also included the financialstatement schedule listed in the Index at Item 15(a).** **These financial statements and financialstatement schedule are the responsibility of the Company’s management. Ourresponsibility is to express an opinion on these financial statements andfinancial statement schedule based on our audits.

 

We conducted our auditsin accordance with the standards of the Public Company Accounting OversightBoard (United States). Those standards require that we plan and perform theaudit to obtain reasonable assurance about whether the financial statements arefree of material misstatement. An audit includes examining, on a test basis,evidence supporting the amounts and disclosures in the financial statements. Anaudit also includes assessing the accounting principles used and significantestimates made by management, as well as evaluating the overall financialstatement presentation. We believe that our audits provide a reasonable basisfor our opinion.

 

In our opinion, suchconsolidated financial statements present fairly, in all material respects, thefinancial position of Zomax Incorporated and Subsidiaries as of December 30,2005 and December 31, 2004, and the results of their operations and their cashflows for each of the three years in the period ended December 30, 2005, inconformity with accounting principles generally accepted in the United Statesof America. Also, in our opinion, suchfinancial statement schedule, when considered in relation to the basicconsolidated financial statements taken as a whole, present fairly, in allmaterial respects, the information set forth therein.

 

We have also audited, inaccordance with the standards of the Public Company Accounting Oversight Board(United States), the effectiveness of the Company’s internal control overfinancial reporting as of December 30, 2005, based on the criteria establishedin *Internal Control – Integrated Framework*issued by the Committee of Sponsoring Organizations of the Treadway Commissionand our report dated March 15, 2006 expressed an unqualified opinion onmanagement’s assessment of the effectiveness of the Company’s internal controlover financial reporting and an unqualified opinion on the effectiveness of theCompany’s internal control over financial reporting.

 

 
| /s/ Deloitte &  Touche LLP |   |
|--------------------------------|--------|
| Minneapolis, Minnesota         |
| March 15, 2006                 |

 

21

----

 

**ZOMAX INCORPORATED**

**CONSOLIDATEDSTATEMENTS OF OPERATIONS**

## **(In thousands, except per share data)**

##  

| ** **                                      | ** ** | **Year Ended**        | ** ** |
|-------------------------------------------------|------------|-----------------------|------------|
| ** **                                      | ** ** | **December 30, 2005** | ** ** | **December 31, 2004** | ** ** | **December 26,  2003** | ** ** |
|                                            |       |                  |       |   |   |   |   |
| **Revenue**                                     |       | $                     | 166,984    |   | $ | 199,428 |   | $ | 197,816 |   |
|                                            |       |                  |       |   |   |   |   |
| Cost of revenue                                 |       | 153,953               |       | 169,031 |   | 161,287 |   |
|                                            |       |                  |       |   |   |   |   |
| **Gross profit**                                |       | 13,031                |       | 30,397 |   | 36,529 |   |
|                                            |       |                  |       |   |   |   |   |
| Selling, general  and administrative expenses   |       | 35,000                |       | 45,704 |   | 40,982 |   |
| Loss on  impairment of long-lived assets        |       | 4,318                 |       | — |   | — |   |
| Restructuring  costs                            |       | 3,518                 |       | — |   | — |   |
|                                            |       |                  |       |   |   |   |   |
| **Operating loss**                              |       | (29,805               | )          | (15,307 | ) | (4,453 | ) |
|                                            |       |                  |       |   |   |   |   |
| **Other income (expense):**                     |       |                  |       |   |   |   |   |
| Interest expense                                |       | (1                    | )          | (11 | ) | (145 | ) |
| Interest income                                 |       | 1,683                 |       | 879 |   | 864 |   |
| Gain on sale of  available-for-sale securities  |       | —                |       | 2,770 |   | — |   |
| Other, net                                      |       | (114                  | )          | (365 | ) | (462 | ) |
| **Loss before income taxes**                    |       | (28,237               | )          | (12,034 | ) | (4,196 | ) |
|                                            |       |                  |       |   |   |   |   |
| Income tax  (expense) benefit                   |       | (7,909                | )          | 3,623 |   | 3,021 |   |
| **Net loss**                                    |       | $                     | (36,146    | ) | $ | (8,411 | ) | $ | (1,175 | ) |
|                                            |       |                  |       |   |   |   |   |
| **Loss per share:**                             |       |                  |       |   |   |   |   |
| Basic                                           |       | $                     | (1.11      | ) | $ | (0.26 | ) | $ | (0.04 | ) |
| Diluted                                         |       | $                     | (1.11      | ) | $ | (0.26 | ) | $ | (0.04 | ) |
|                                            |       |                  |       |   |   |   |   |
| **Weighted average common shares outstanding:** |       |                  |       |   |   |   |   |
| Basic                                           |       | 32,621                |       | 32,628 |   | 32,621 |   |
| Dilutive effect  of stock options and warrants  |       | —                |       | — |   | — |   |
| Diluted                                         |       | 32,621                |       | 32,628 |   | 32,621 |   |

 

*See notesto consolidated financial statements.*

 

22

----

 

**ZOMAXINCORPORATED**

## **CONSOLIDATEDBALANCE SHEETS**

## **(In thousands)**

 
| ** **                                                                                                                                   | ** ** | **December 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|----------------------------------------------------------------------------------------------------------------------------------------------|------------|------------------------|------------|------------------------|------------|
| **ASSETS**                                                                                                                                   |       |                   |       |                   |       |
| **Current  assets:**                                                                                                                         |       |                   |       |                   |       |
| Cash and cash  equivalents                                                                                                                   |       | $                      | 45,250     |                   | $          | 41,092 |   |
| Available-for-sale  securities                                                                                                               |       | —                 |       | 19,200                 |       |
| Accounts  receivable, net of allowances of $515 in 2005 and $868 in 2004                                                                |       | 26,823                 |       | 36,180                 |       |
| Inventories, net                                                                                                                             |       | 13,978                 |       | 14,633                 |       |
| Deferred income  taxes                                                                                                                       |       | —                 |       | 1,704                  |       |
| Other current  assets                                                                                                                        |       | 2,409                  |       | 10,410                 |       |
|                                                                                                                                         |       |                   |       |                   |       |
| Total current  assets                                                                                                                        |       | 88,460                 |       | 123,219                |       |
|                                                                                                                                         |       |                   |       |                   |       |
| **Property  and equipment, net**                                                                                                             |       | 24,504                 |       | 35,408                 |       |
|                                                                                                                                         |       |                   |       |                   |       |
| **Available-for-sale  securities**                                                                                                           |       | 2,091                  |       | 3,624                  |       |
|                                                                                                                                         |       |                   |       |                   |       |
| **Deferred  income taxes**                                                                                                                   |       | —                 |       | 5,903                  |       |
|                                                                                                                                         |       |                   |       |                   |       |
| **Other  long-term assets**                                                                                                                  |       | 117                    |       | —                 |       |
|                                                                                                                                         |       |                   |       |                   |       |
|                                                                                                                                         |       | $                      | 115,172    |                   | $          | 168,154 |   |
|                                                                                                                                         |       |                   |       |                   |       |
| **LIABILITIES AND SHAREHOLDERS’ EQUITY**                                                                                                |       |                   |       |                   |       |
| **Current  liabilities:**                                                                                                                    |       |                   |       |                   |       |
| Accounts payable                                                                                                                             |       | $                      | 14,709     |                   | $          | 20,710 |   |
| Accrued expenses  and other current liabilities                                                                                              |       | 11,538                 |       | 19,177                 |       |
|                                                                                                                                         |       |                   |       |                   |       |
| Total current  liabilities                                                                                                                   |       | 26,247                 |       | 39,887                 |       |
|                                                                                                                                         |       |                   |       |                   |       |
| **Deferred  income taxes**                                                                                                                   |       | 211                    |       | —                 |       |
|                                                                                                                                         |       |                   |       |                   |       |
| **Other  long-term liabilities**                                                                                                             |       | 106                    |       | 155                    |       |
|                                                                                                                                         |       |                   |       |                   |       |
| Total  liabilities                                                                                                                           |       | 26,564                 |       | 40,042                 |       |
|                                                                                                                                         |       |                   |       |                   |       |
| **Commitments and contingencies (Note 9)**                                                                                                   |       |                   |       |                   |       |
|                                                                                                                                         |       |                   |       |                   |       |
| **Shareholders’ equity:**                                                                                                               |       |                   |       |                   |       |
| Common stock, no  par value, 100,000 shares authorized; 32,425 and 32,536 shares issued  and outstanding in 2005 and 2004, respectively |       | 62,248                 |       | 62,134                 |       |
| Retained  earnings                                                                                                                           |       | 20,715                 |       | 56,861                 |       |
| Accumulated  other comprehensive income                                                                                                      |       | 5,645                  |       | 9,117                  |       |
|                                                                                                                                         |       |                   |       |                   |       |
| Total  shareholders’ equity                                                                                                             |       | 88,608                 |       | 128,112                |       |
|                                                                                                                                         |       |                   |       |                   |       |
|                                                                                                                                         |       | $                      | 115,172    |                   | $          | 168,154 |   |

 

*See notes to consolidated financial statements*.

 

23

----

 

**ZOMAX INCORPORATED**

**CONSOLIDATEDSTATEMENTS OF SHAREHOLDERS’ EQUITY**

**(Inthousands)**

 
| ** **                                                                                              | ** ** | **Common stock** | ** ** | **Retained** | ** ** | **Accumulated  other  comprehensive** | ** ** | **Total  shareholders’** | ** ** |
|---------------------------------------------------------------------------------------------------------|------------|------------------|------------|--------------|------------|---------------------------------------|------------|-------------------------------|------------|
| ** **                                                                                              | ** ** | **Shares**       | ** ** | **Amount**   | ** ** | **earnings**                          | ** ** | **income (loss)**             | ** ** | **equity** | ** ** |
|                                                                                                    |       |             |       |         |       |                                  |       |                          |       |   |   |
| **Balance, December 27, 2002**                                                                     |       | 33,028           |       | $            | 64,071     |                                  | $          | 66,447                        |       | $ | 31 |   | $ | 130,549 |   |
|                                                                                                    |       |             |       |         |       |                                  |       |                          |       |   |   |
| Net loss                                                                                                |       | —           |       | —       |       | (1,175                                | )          | —                        |       | (1,175 | ) |
| Unrealized  holding gain on available-for-sale securities, net of tax                                   |       | —           |       | —       |       | —                                |       | 2,819                         |       | 2,819 |   |
| Translation                                                                                             |       | —           |       | —       |       | —                                |       | 6,462                         |       | 6,462 |   |
| Comprehensive  Income                                                                                   |       |             |       |         |       |                                  |       |                          |       | 8,106 |   |
| Common stock  issued under employee stock purchase plan                                                 |       | 184              |       | 533          |       | —                                |       | —                        |       | 533 |   |
| Common stock  issued upon exercise of stock options                                                     |       | 139              |       | 348          |       | —                                |       | —                        |       | 348 |   |
| Tax benefit  realized from exercise of stock options                                               |       | —           |       | 104          |       | —                                |       | —                        |       | 104 |   |
| Common stock  repurchases                                                                               |       | (762             | )          | (2,587       | )          | —                                |       | —                        |       | (2,587 | ) |
|                                                                                                    |       |             |       |         |       |                                  |       |                          |       |   |   |
| **Balance, December 26, 2003**                                                                     |       | 32,589           |       | 62,469       |       | 65,272                                |       | 9,312                         |       | 137,053 |   |
|                                                                                                    |       |             |       |         |       |                                  |       |                          |       |   |   |
| Net loss                                                                                                |       | —           |       | —       |       | (8,411                                | )          | —                        |       | (8,411 | ) |
| Unrealized  holding gain on available-for-sale securities, net of tax                                   |       | —           |       | —       |       | —                                |       | (1,785                        | )          | (1,785 | ) |
| Reclassification  to net loss of previously deferred gain on available-for-sale securities, net  of tax |       | —           |       | —       |       | —                                |       | (1,629                        | )          | (1,629 | ) |
| Translation  adjustments                                                                                |       | —           |       | —       |       | —                                |       | 3,219                         |       | 3,219 |   |
| Comprehensive  Income                                                                                   |       |             |       |         |       |                                  |       |                          |       | (8,606 | ) |
| Common stock  issued under employee stock purchase plan                                                 |       | 174              |       | 496          |       | —                                |       | —                        |       | 496 |   |
| Common stock  issued upon exercise of stock options                                                     |       | 188              |       | 403          |       | —                                |       | —                        |       | 403 |   |
| Tax benefit  realized from exercise of stock options                                               |       | —           |       | 185          |       | —                                |       | —                        |       | 185 |   |
| Common stock  repurchases                                                                               |       | (415             | )          | (1,419       | )          | —                                |       | —                        |       | (1,419 | ) |
|                                                                                                    |       |             |       |         |       |                                  |       |                          |       |   |   |
| **Balance, December 31, 2004**                                                                     |       | 32,536           |       | 62,134       |       | 56,861                                |       | 9,117                         |       | 128,112 |   |
|                                                                                                    |       |             |       |         |       |                                  |       |                          |       |   |   |
| Net loss                                                                                                |       | —           |       | —       |       | (36,146                               | )          | —                        |       | (36,146 | ) |
| Unrealized  holding loss on available-for-sale securities                                               |       | —           |       | —       |       | —                                |       | (1,129                        | )          | (1,129 | ) |
| Translation  adjustments                                                                                |       | —           |       | —       |       | —                                |       | (2,343                        | )          | (2,343 | ) |
| Comprehensive  loss                                                                                     |       |             |       |         |       |                                  |       |                          |       | (39,618 | ) |
| Common stock  issued under employee stock purchase plan                                                 |       | 128              |       | 388          |       | —                                |       | —                        |       | 388 |   |
| Common stock  issued upon exercise of stock options                                                     |       | 27               |       | 41           |       | —                                |       | —                        |       | 41 |   |
| Common stock  issued upon legal settlement                                                              |       | 375              |       | 1,118        |       | —                                |       | —                        |       | 1,118 |   |
| Tax benefit  realized from exercise of stock options                                               |       | —           |       | —       |       | —                                |       | —                        |       | — |   |
| Common stock  repurchases                                                                               |       | (641             | )          | (1,433       | )          | —                                |       | —                        |       | (1,433 | ) |
|                                                                                                    |       |             |       |         |       |                                  |       |                          |       |   |   |
| **Balance, December 30, 2005**                                                                     |       | 32,425           |       | $            | 62,248     |                                  | $          | 20,715                        |       | $ | 5,645 |   | $ | 88,608 |   |

 

*See notes to consolidated financial statements.*

 

24

----

 

# **ZOMAXINCORPORATED**

# **CONSOLIDATEDSTATEMENTS OF CASH FLOWS**

# **(Inthousands)**

##  

| ** **                                                                                   | ** ** | **Year Ended**         | ** ** |
|----------------------------------------------------------------------------------------------|------------|------------------------|------------|
| ** **                                                                                   | ** ** | **December 30,  2005** | ** ** | **December 31,  2004** | ** ** | **December 26,  2003** | ** ** |
| **Operating activities:**                                                                    |       |                   |       |   |   |   |   |
| Net loss                                                                                     |       | $                      | (36,146    | ) | $ | (8,411 | ) | $ | (1,175 | ) |
| Adjustments to  reconcile net loss to net cash (used) provided by operating activities: |       |                   |       |   |   |   |   |
| Depreciation                                                                                 |       | 8,714                  |       | 9,829 |   | 8,668 |   |
| Write-down in  value of long-lived assets                                                    |       | 4,318                  |       | — |   | 347 |   |
| Loss on disposal  of assets during restructuring                                             |       | 980                    |       | — |   | — |   |
| Gain on sale of  available-for-sale securities                                               |       | —                 |       | (1,629 | ) | — |   |
| Provision for  (reversal of) litigation reserves                                             |       | (2,029                 | )          | 5,834 |   | — |   |
| Deferred income  taxes                                                                       |       | 7,906                  |       | (3,806 | ) | 1,338 |   |
| Other, net                                                                                   |       | 4                      |       | — |   | (32 | ) |
| Changes in  operating assets and liabilities:                                                |       |                   |       |   |   |   |   |
| Accounts  receivable                                                                         |       | 8,544                  |       | 4,200 |   | (5,014 | ) |
| Inventories                                                                                  |       | 605                    |       | (2,009 | ) | (2,156 | ) |
| Other current  assets                                                                        |       | 5,083                  |       | (2,717 | ) | 1,450 |   |
| Accounts payable                                                                             |       | (5,729                 | )          | (421 | ) | 5,439 |   |
| Accrued expenses  and other current liabilities                                              |       | (4,978                 | )          | (12,622 | ) | 2,015 |   |
| Income taxes                                                                                 |       | 3,323                  |       | 2,187 |   | (5,595 | ) |
| Net cash (used)  provided by operating activities                                       |       | (9,405                 | )          | (9,565 | ) | 5,285 |   |
|                                                                                         |       |                   |       |   |   |   |   |
| **Investing activities:**                                                                    |       |                   |       |   |   |   |   |
| Purchases of  property and equipment                                                         |       | (3,960                 | )          | (4,695 | ) | (9,589 | ) |
| Purchases of  available-for-sale securities                                                  |       | (14,500                | )          | (28,950 | ) | (11,000 | ) |
| Sales of  available-for-sale securities                                                      |       | 33,700                 |       | 31,980 |   | — |   |
| Escrow deposit  on terminated acquisition                                                    |       | —                 |       | — |   | 3,902 |   |
| Net cash  provided (used) by investing activities                                            |       | 15,240                 |       | (1,665 | ) | (16,687 | ) |
|                                                                                         |       |                   |       |   |   |   |   |
| **Financing activities:**                                                                    |       |                   |       |   |   |   |   |
| Repayment of  notes payable                                                                  |       | —                 |       | — |   | (3,781 | ) |
| Repurchase of  common stock                                                                  |       | (1,433                 | )          | (1,419 | ) | (2,587 | ) |
| Issuance of common  stock                                                                    |       | 429                    |       | 899 |   | 881 |   |
| Net cash used by  financing activities                                                  |       | (1,004                 | )          | (520 | ) | (5,487 | ) |
|                                                                                         |       |                   |       |   |   |   |   |
| **Effect of exchange rate changes on cash and cash  equivalents**                            |       | (673                   | )          | 943 |   | 2,642 |   |
|                                                                                         |       |                   |       |   |   |   |   |
| Net increase  (decrease) in cash and cash equivalents                                        |       | 4,158                  |       | (10,807 | ) | (14,247 | ) |
|                                                                                         |       |                   |       |   |   |   |   |
| Cash and cash  equivalents, beginning of year                                                |       | 41,092                 |       | 51,899 |   | 66,146 |   |
| **Cash and cash equivalents, end of year**                                                   |       | $                      | 45,250     |   | $ | 41,092 |   | $ | 51,899 |   |

 

*See notes to consolidated financial statements.*

 

25

----

 

**NOTES TOCONSOLIDATED FINANCIAL STATEMENTS**

 

**NOTE1. SUMMARY OF SIGNIFICANT ACCOUNTING POLICIES**

 

***Nature of Business.*** Zomax Incorporated (“the Company,” “we”, “us”, or“our”), is a global provider of supply chain outsourcing services. Theseservices, which include program management, sourcing, production, assembly,fulfillment, contact center services and all other management are currentlydelivered through a network of 11 facilities in the United States, Canada,Mexico, and Ireland along with selected supplier partners.

** **

***Principles of Consolidation***. The consolidatedfinancial statements include the accounts of the Company and its wholly-ownedsubsidiaries. All material intercompany accounts and transactions have beeneliminated in consolidation.

** **

*Fiscal Year-End*. Our fiscal year ends on the lastFriday of the calendar year. The fiscal years ended December 30, 2005,December 31, 2004, and December 26, 2003, are referred to as 2005,2004, and 2003, respectively, in the consolidated financial statements andnotes thereto.

 

*Use of Estimates.*The preparation offinancial statements in conformity with accounting principles generallyaccepted in the United States requires management to make estimates andassumptions that affect the reported amounts of assets and liabilities at thedate of the financial statements and the reported amounts of revenues andexpenses during the reporting period. Estimates are used for such items as theallowance for doubtful accounts, inventory net realizable value, tax provisionsand litigation reserves. Actual results could differ from those estimates.

 

*Revenue Recognition*. We record revenue atthe time product is shipped or as services are rendered. For certain customers,product is invoiced upon completion of production and assembly services, withfinal shipment occurring based on written customer instructions. In thesecases, the customer accepts title to the goods as of the date of the invoiceand revenue is recognized. In each case of these “bill and hold” sales, weensure that the transaction complies with the conditions and considerationscontained in Staff Accounting Bulletin No. 101 and Accounting and AuditingEnforcement Release No. 108 of the Securities and Exchange Commission.

 

In2005, 2004, and 2003, one customer accounted for approximately 24%, 22%, and22%, respectively, of our consolidated revenue, and a second customer accountedfor approximately 17%, 19%, and 10%, respectively of our consolidated revenue.

 

*Cost of Revenue*. We include direct labor,direct materials, royalties and production overhead, which includes shippingcosts, in cost of revenue on the consolidated statements of operations.

 

*Royalties.*We have license agreements withseveral companies for the use of certain CD and DVD manufacturing technology weuse in our business. We do not necessarily have agreements with every patentholder that may assert or has asserted a claim to royalties. The cost ofthese royalties is accrued based on units sold and charged to cost of revenue basedupon the terms of our royalty agreements and, in accordance with the provisionsof FASB Statement No. 5 “Accounting for Contingencies” and FASBInterpretation No. 14 “Reasonable Estimation for the Amount of a Loss, aninterpretation of FASB Statement No. 5” our assessment of the likelihoodthat other royalty claims may be asserted against us. Royalty expenseincluded in cost of revenue was $3.3 million and $5.9 million in 2005 and 2004,respectively. In the fourth quarter of 2003, we completed negotiations with oneof the major patent holders resulting in the signing of a revised royaltyagreement. Upon signing the new agreement in the fourth quarter of 2003, werecorded a benefit to cost of revenue totaling $4.8 million related to thesereduced rates as well as smaller adjustments to the rates at which we accrueother known or potential royalties.

 

*Income Taxes*. We file a consolidatedfederal income tax return and separate state and foreign returns. Deferredincome taxes are provided for differences between the tax basis of assets andliabilities and their carrying amounts for financial reporting purposes, basedon the expected income tax rates for the year in which these temporarydifferences are expected to reverse. Foreign net operating loss carryforwardsrelated to our Ireland operations may be carried forward indefinitely.

 

Basedupon the recent history of operating losses in the United States and Ireland,the Company is uncertain of its ability to realize the benefits of certain taxcarryforwards and future expected deductions prior to their expiration. Forthis reason we recorded a valuation allowance against our net deferred taxassets in the United States and Ireland in the third quarter of 2005 ofapproximately $15.2 million and an additional $1.2 million in the fourthquarter related to losses for that period. Management believes its efforts torestructure the cost base and reposition the Company will eventually return itto a profitable state. Until then, it intends to maintain the valuation allowancefor current and future loss carryforward amounts. The remaining tax liabilitiesrelate to the Company’s Canadian operations which continue to have taxableincome.

 

Thepreparation of our income tax returns requires the interpretation of theassociated tax laws. Many tax laws are complex, and at times ambiguous, and ourinterpretations of these laws may differ from the interpretations of thetaxing authorities who have the right to audit our returns within statutorytime periods. Where we believe there is a quantifiable risk that ourinterpretations of these laws could reasonably differ from those of the taxingauthorities, we make appropriate

 

26

----

 

provisionsin our tax liabilities. We assessed these probabilities in 2005 resulting in anaccrual reduction of $0.4 million. In 2004, we assessed the probabilities ofthose provisions and recognized a $0.4million benefit related to reductions in our tax accruals from 2003.

 

In 2003, Canadian tax authorities completed an auditof our Canadian tax returns for the years 1999, 2000 and 2001. Accordingly, weremoved $1.0 million of provisions we had made in our tax liabilities relatedto the risk that tax authorities would reject certain positions we had taken inthe preparation of these returns.

 

*Loss Per Share*. Basic earnings per share (EPS) is computedby dividing net income or loss by the weighted average number of common sharesoutstanding during the year. Diluted EPS is computed by dividing net income bythe sum of the weighted average number of common shares outstanding plus alladditional common shares that would have been outstanding if potentiallydilutive common shares related to stock options had been issued. In years inwhich we experience a net loss, basic EPS and diluted EPS will be the same, asthe potential shares issued related to stock options are anti-dilutive. Potentialcommon shares of 3,511,380 in 2005, 2,831,000 in 2004, and 3,323,000 in 2003,related to outstanding stock options were excluded from the computation ofdiluted earnings per share as inclusion of these shares would have beenanti-dilutive.

 

*Cash and Cash Equivalents*. Cash and cash equivalents consist primarilyof highly liquid short-term investments with original maturities of 90 days orless and are recorded at cost, which approximates market value.

 

*Accounts Receivable.*We review our accounts receivable balances on a regular basis todetermine their collectibility. An allowance for doubtful accounts is recordedbased on management’s estimate of those accounts which may becomeuncollectible. As of the years ended December 31, 2005 and December 31,2004, we had three customers with receivable balances exceeding 10% of thetotal net receivables. These customers totaled approximately 15%, 18% and 15%,respectively, as of December 30, 2005 and approximately 18%, 20% and 14%,respectively, as of December 31, 2004.

 

*Inventories*. Inventories, consisting of material, laborand overhead, are stated at the lower of first-in, first-out cost or market. Wereview our inventory on a regular basis with the objective of assessing its netrealizable value. We adjust the carrying value of inventory according to ourestimates of the net realizable value of individual inventory componentsrelative to their purchase or carrying value.

 

*Property and Equipment*. Property and equipment are stated at costless accumulated depreciation. Repairs and maintenance are charged to expenseas incurred, while significant improvements are capitalized. Depreciation iscalculated using the straight-line method for financial reporting purposes overestimated useful lives of three to thirty years, or in the case of leaseholdimprovements, the term of the lease, if shorter. Both straight-line andaccelerated methods of depreciation are used for income tax purposes. Depreciationexpense totaled approximately $8,714,000 in 2005, $9,829,000 in 2004, and $8,668,000in 2003.

 

*Long-Lived Assets*. Long-lived assets, such as property andequipment, are evaluated for impairment when events or changes in circumstancesindicate that the carrying amount of the assets may not be recoverablethrough the estimated undiscounted future cash flows from the use of theseassets. If any such impairment exists, the related assets would be written downto fair value. There were $4,318,000 of impairments recorded in the fourthquarter of 2005 related to fixed assets at our Ireland manufacturing andassembly facility. See Note 12 for further details on the impairment chargesrecorded in 2005. There were no impairments recorded in 2004 or 2003.

 

*Sales Returns and Allowances.*We generally warrant to all customers that theproducts we make for them will be free from defects in materials andworkmanship. If it is determined that the products sold are defective, wetypically repair or replace such products. The cost of these repairs orreplacements has not had a material effect on our financial condition, resultsof operations or cash flows. The Company records a provision for estimatedreturns and allowances as a reduction to revenues. This estimate is based uponhistorical experience determined by analysis of credit activity and other knownfactors.

 

*Fair Value of Financial Instruments*. The financial instruments with which we areinvolved are primarily of a traditional nature. For these instruments,including cash, available-for-sale securities, receivables, accounts payableand accrued expenses, we believe that the carrying amounts approximate fairvalue because of their short-term nature.

 

27

----

 

*StockBased Compensation.*Wehavea 1996 Stock Option Plan (the 1996 Plan), a 2004 Equity Incentive Plan (the2004 Plan) and an Employee Stock Purchase Plan. The Employee Stock PurchasePlan was terminated on December 30, 2005. Options granted under theseplans are accounted forunder Accounting Principles Board Opinion No. 25, “Accounting for StockIssued to Employees.”  Because our stockoptions are granted at the market value on the date of grant, no relatedcompensation expense is recognized. However, had the compensation expense ofoption grants been determined in accordance with SFAS No. 123, “Accountingfor Stock-Based Compensation,” as amended by SFAS No. 148, “Accounting forStock-Based Compensation—Transition and Disclosure”, our net loss and loss pershare, on a pro forma basis, would have been reported as follows (in thousands,except per share data):

 

| ** **                                                               | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Net loss:                                                                |       |     |       |     |       |     |       |
| As reported                                                              |       | $        | (36,146    | )        | $          | (8,411   | )          | $ | (1,175 | ) |
| Stock-based compensation, net of tax (except for  2005, see Note 7) |       | (1,661   | )          | (1,264   | )          | (1,346   | )          |
| Pro forma                                                                |       | $        | (37,807    | )        | $          | (9,675   | )          | $ | (2,251 | ) |
|                                                                     |       |     |       |     |       |     |       |
| Basic EPS:                                                               |       |     |       |     |       |     |       |
| As reported                                                              |       | $        | (1.11      | )        | $          | (0.26    | )          | $ | (0.04 | ) |
| Pro forma                                                                |       | $        | (1.16      | )        | $          | (0.30    | )          | $ | (0.08 | ) |
|                                                                     |       |     |       |     |       |     |       |
| Diluted EPS:                                                             |       |     |       |     |       |     |       |
| As reported                                                              |       | $        | (1.11      | )        | $          | (0.26    | )          | $ | (0.04 | ) |
| Pro forma                                                                |       | $        | (1.16      | )        | $          | (0.30    | )          | $ | (0.08 | ) |

 

In determining the compensation cost of the optionsgranted, as specified by SFAS No. 123, the fair value of each optiongrant has been estimated on the date of grant using the Black-Scholes optionpricing model. The weighted average assumptions used in these calculations aresummarized below:

 

| ** **                                          | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Risk-free interest rate                             |       | 3.01     | %          | 3.01     | %          | 3.22     | %          |
| Expected life of options granted, in years          |       | 5.7      |       | 5.7      |       | 6.2      |       |
| Expected volatility of options granted         |       | 91.23    | %          | 92.12    | %          | 90.33    | %          |
| Weighted average fair value of options granted |       | $        | 2.05       |     | $          | 3.04     |       | $ | 2.78 |   |
|                                                     |            |          |            |          |            |          |            |  |  |  |

 

*Foreign Currency Translation.*We translate assets and liabilities of our foreignsubsidiaries to their U.S. dollar equivalents at exchange rates in effect atthe balance sheet date and record related translation adjustments as acomponent of shareholders’ equity in the consolidated balance sheets. Statementsof operations of our foreign subsidiaries are translated from their functionalcurrencies to U.S. dollar equivalents at average exchange rates during theperiod and we record the related translation adjustment to a component ofshareholders’ equity. Foreign exchange transaction gains and losses arereported in other income and expense on the consolidated statements ofoperations.

 

*NewAccounting Standards.*In November 2003 and March 2004,the Emerging Issues Task Force (EITF) reached consensuses on Issue No. 03-1,“The Meaning of Other-Than-Temporary Impairment and Its Application to Certaininvestments” (“EITF 03-1”), which addresses how to determine the meaning ofother-than temporary impairments and how that concept should be applied toinvestments accounted for under SFAS No. 115, “Accounting in CertainInvestments in Debt and Equity Securities”, and SFAS No. 124, “Accountingfor Certain Investments Held by Not-for-Profit Organizations.” ** **The effective datefor evaluating whether an investment is other-than-temporarily impaired wasdelayed by the FASB Staff Position (FSP) EITF Issue 03-1-1. In November 2005,the FASB issued FSP FAS 115-1 and FAS 124-1 (a single document) to clarifythese rules. Effectively, the FSP issued in November 2005 reverts to theother-than-temporary guidance that predated the original effective date of EITF03-1; however, it maintains certain guidance in EITF 03-1 relative to testingof cost-method equity securities and the disclosure requirements which have beeneffective since 2003. The FSP issued in November 2005 is effective forreporting periods beginning after December 15, 2005. The adoption of theFSP issued in November 2005 is not anticipated to have a material effecton our consolidated financial statements. The additional disclosures requiredby EITF 03-1 and maintained by the FSP issued in November 2005 have beenconsidered for inclusion in the notes to our audited 2005 consolidated financialstatements.

 

In November 2004the Financial Accounting Standards Board (FASB) issued SFAS No. 151, “InventoryCosts, an amendment of ARB No. 43, Chapter 4” (SFAS 151). SFAS 151 amendsthe guidance in ARB No. 43, Chapter 4, “Inventory Pricing”, to clarify theaccounting for abnormal amounts of idle facility expense, freight, handlingcosts, and spoilage. This statement requires that those items be recognized ascurrent period charges regardless of whether they meet the criterion of “soabnormal” which was the criterion specified in ARB No. 43. In addition,this Statement requires that allocation of fixed 

 

28

----

 

production overheads tothe cost of production be based on normal capacity of the productionfacilities. This pronouncement is effective for the Company beginning in thefirst quarter of 2006. The Company is in the process of evaluating whether theadoption of SFAS 151 will have a significant impact on the Company’s overallresults of operations, financial position or cash flows.

 

In December 2004,the FASB issued SFAS No. 153, “Exchanges of Nonmonetary Assets, anamendment of APB Opinion No. 29, Accounting for Nonmonetary Transactions.”The amendments made by Statement 153 are based on the principle that exchangesof nonmonetary assets should be measured based on the fair value of the assetsexchanged. Further, the amendments eliminate the narrow exception fornonmonetary exchanges of similar productive assets and replace it with abroader exception for exchanges of nonmonetary assets that do not havecommercial substance. The adoption by the Company of the provisions of SFAS 153for the year ended December 30, 2005 did not have an impact on the Company’sconsolidated financial statements.

 

In December 2004,the FASB issued SFAS No. 123(R) “Share-Based Payment.” SFAS 123(R)requires the recognition of compensation cost relating to share-based paymenttransactions in financial statements. That cost will be measured based on thefair value of the equity or liability instruments issued as of the grant date,based on the estimated number of awards that are expected to vest. SFAS 123(R)covers a wide range of share-based compensation arrangements including shareoptions, restricted share plans, performance-based awards, share appreciationrights, and employee share purchase plans. Statement 123(R) replaces FASBStatement No. 123, “Accounting for Stock-Based Compensation,” andsupersedes APB Opinion No. 25, “Accounting for Stock Issued to Employees.”In April 2005, the SEC delayed the effective date of SFAS 123(R) to fiscalyears beginning after June 15, 2005. As a result, SFAS 123(R) will beeffective for the Company beginning in the first quarter of 2006. The companyis in the process of evaluating the impact of SFAS 123(R) on the Company’s overallresults of operations, financial position and cash flows. Refer to pro formadisclosure under “Accounting for Stock-Based Compensation” in Note 1 above foran indication of ongoing expense that will be included in the income statementbeginning in the first quarter of 2006.

 

On October 22,2004, the FASB issued FASB Staff Position (FSP) 109-1, Application of FASBStatement No. 109,*Accounting forIncome Taxes*, for the Tax Deduction Provided to U.S. BasedManufacturers by the American Job Creation Act of 2004, and FAP 109-2,Accounting and Disclosure Guidance for the Foreign Earnings RepatriationProvisions within the American Jobs Creation Act of 2004. FSP No. 109-1clarifies how to apply SFAS No. 109 to the new law’s tax deduction forincome attributable to “domestic production activities.” The fully phased-indeduction is up to nine percent of the lesser of taxable income or “qualifiedproduction activities income.” The staff proposal would require that thededuction be accounted for as a special deduction in the period earned, not asa tax-rate reduction.

 

FSP No. 109-2,provides guidance under SFAS No. 109 with respect to recording thepotential impact of the repatriation provisions of the American Jobs CreationAct of 2004 (the “Jobs Act”) on enterprises’ income tax expense and deferredtax liability. FSP 109-2 states that an enterprise is permitted time beyond thefinancial reporting period of enactment to evaluate the effect of the Jobs Acton its plan for reinvestment or repatriation of foreign earnings for purposesof applying SFAS No. 109. By electing to apply the provisions of Section 965of the Internal Revenue Code, enacted as part of the Jobs Act, torepatriate extraordinary dividends we would therefore be eligible to claim aneighty-five percent dividends received deduction for income tax purposes on theeligible amounts. We completed our evaluation of this deduction and elected notto take advantage of it due to our large net operating loss carryforward.

 

In March 2005,the FASB issued FASB Interpretation No. 47, “Accounting for ConditionalAsset Retirement Obligations — an Interpretation of FASB Statement No. 143”(FIN 47). This Interpretation clarifies that the term “conditional asset retirement obligation”*,* as used in SFAS No.143, refers to a legalobligation to perform an asset retirement activity in which the timingand/or method of settlement are conditional on a future event that may or may notbe within the control of the entity. Thus, the timing and/or method ofsettlement may be conditional on a future event. Accordingly, an entity isrequired to recognize a liability for the fair value of a conditional assetretirement obligation if the fair value of the liability can be reasonablyestimated. The fair value of a liability for the conditional asset retirementobligation should be recognized when incurred — generally upon acquisition,construction, or development and/or through the normal operation of the asset.Uncertainty about the timing and/or method of settlement of a conditional assetretirement obligation should be factored into the measurement of the liabilitywhen sufficient information exists. SFAS No. 143 acknowledges that in somecases, sufficient information may not be available to reasonably estimatethe liability. The adoption by the Company of the provisions of FIN 47 for theyear ended December 30, 2005 did not have a material impact on the Company’sbalance sheet or consolidated financial statements.

 

In May 2005,the FASB issued Statement of Financial Accounting Standards (SFAS) No. 154“Accounting Changes and Error Corrections - A Replacement of APB Opinion No. 20and FASB Statement No. 3.” The new standard changes the requirements forthe accounting for and reporting of a change in accounting principle. Amongother changes, SFAS No. 154 requires that a voluntary change in accountingprinciple be applied retrospectively with all prior period financial statementspresented based on the new accounting principle unless it is impracticable todo so. SFAS No. 154 also provides that (1) a 

 

29

----

 

change in method ofdepreciating or amortizing a long-lived non-financial asset be accounted for asa change in estimate (prospectively) that was effected by a change inaccounting principle, and (2) correction of errors in previously issuedfinancial statements should be termed a “restatement.”  The new standard is effective for accountingchanges and corrections of errors made in fiscal years beginning after December 15,2005. The Company does not anticipate that the adoption of SFAS No. 154will have a material effect on its financial statements.

 

In September 2005,the Emerging Issues Task Force (EITF) reached consensus on Issue No. 04-13,“Accounting for Purchases and Sales of Inventory with the Same Counterparty”**(EITF 04-13), which addresses the circumstances under whichtwo or more inventory purchase and sales transactions with the samecounterparty should be viewed as a single exchange transaction within the scopeof APB Opinion No. 29, “Accounting for Nonmonetary Transactions” for newarrangements entered into, or modifications or renewals of existingarrangements, beginning in the first interim or annual reporting periodbeginning after March 15, 2006. Full adoption of EITF 04-13 is notexpected to have a material effect on the Company’s financial statements.

 

**NOTE 2. OTHER FINANCIAL STATEMENT INFORMATION**

 

*Consolidated Balance Sheet Information (in thousands):*

 
| ** **                                       | ** ** | **2005** | ** ** | **2004** | ** ** |
|--------------------------------------------------|------------|----------|------------|----------|------------|
| *Inventories:*                                   |       |     |       |     |       |
| Raw materials                                    |       | $        | 8,197      |     | $          | 7,531 |   |
| Work in process                                  |       | 443      |       | 2,821    |       |
| Finished goods                                   |       | 5,338    |       | 4,281    |       |
|                                             |       | $        | 13,978     |     | $          | 14,633 |   |
| *Property and equipment, net:*                   |       |     |       |     |       |
| Manufacturing equipment                          |       | $        | 72,436     |     | $          | 78,269 |   |
| Office equipment                                 |       | 4,195    |       | 9,002    |       |
| Land, building and leasehold improvements        |       | 9,599    |       | 10,338   |       |
|                                             |       | 86,230   |       | 97,609   |       |
| Less: Accumulated depreciation and amortization  |       | (61,726  | )          | (62,201  | )          |
|                                             |       | $        | 24,504     |     | $          | 35,408 |   |
| *Accrued expense and other current liabilities:* |       |     |       |     |       |
| Compensation and benefits                        |       | $        | 3,164      |     | $          | 3,914 |   |
| Royalties                                        |       | 1,408    |       | 2,765    |       |
| Litigation reserves                              |       | 3,353    |       | 10,720   |       |
| Other                                            |       | 3,613    |       | 1,778    |       |
|                                             |       | $        | 11,538     |     | $          | 19,177 |   |

 

*Supplemental Cash Flow Information (in thousands):*

 
| ** **                                                                                                                           | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|--------------------------------------------------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| *Cash paid for:*                                                                                                                     |       |     |       |     |       |     |       |
| Interest                                                                                                                             |       | $        | —     |     | $          | 97       |       | $ | 151 |   |
| Income taxes                                                                                                                         |       | 719      |       | 902      |       | 1,045    |       |
| *Non-cash transactions:*                                                                                                             |       |     |       |     |       |     |       |
| Unrealized (loss) gain on available-for-sale  securities, net of deferred taxes of $0 in 2005, $1,007 in 2004, and $(1,815)  in 2003 |       | (1,129   | )          | (1,785   | )          | 2,819    |       |
| Common stock issued upon legal settlement                                                                                            |       | 1,118    |       | —   |       | —   |       |
|                                                                                                                                      |            |          |            |          |            |          |            |  |  |  |

 

**NOTE3. AVAILABLE-FOR-SALE SECURITIES**

 

Ourshort-term investments consisted of auction rate preferred securities andmunicipal auction rate notes. These investments, which had original maturitiesbeyond one year, may be classified as short-term based on their highlyliquid nature and because these securities represent the investment of cashthat is available for current operations. These investments are classified asavailable-for-sale and recorded at fair value. The carrying value of short termavailable-for-sale securities approximates fair market value due to their shortmaturities. As of December 30, 2005 and December 31, 2004, we had $0and $19,200,000 in short term available-for-sale securities, respectively.

 

Ourlong-term investment in available-for-sale securities consists of shares of Intrawarecommon stock and is discussed further in Note 4.

 

30

----

 

**NOTE 4. ACQUISITIONS AND STRATEGIC ALLIANCES**

 

*Strategic Alliance Agreement.*OnApril 30, 2004, we announced the restructuring of our agreement withIntraware, Inc. (Intraware), whereby our Strategic Alliance Agreement(SAA), originally signed in August 2002, was terminated and replaced witha Reseller Agreement under which we will continue to offer Intraware globalelectronic software delivery (ESD) services to our customers. Under theoriginal SAA, as amended, we had an exclusive right to market and resellIntraware’s ESD services in the supply chain outsourcing market. Revenuesearned under the SAA prior to the restructuring had not been significant. Additionally,the SAA required us to pay annual license fees for which we expensed $435,000 and$656,000 in 2004 and 2003, respectively.

 

Inaddition to restructuring the agreement, during 2004 we sold 3,000,000 sharesof our Intraware shareholdings in two separate private placements whichresulted in proceeds of approximately $5,230,000 and a pre-tax gain ofapproximately $2,770,000. These shares

 

31

----

 

were originally obtainedin August 2002 when we purchased approximately 6,098,000 shares ofIntraware common stock (Nasdaq Symbol: ITRA) in a private placement at $0.82per share, representing approximately 12% of the outstanding shares ofIntraware at that time. The common stock was issued in a private placementwithout registration under the Securities Act of 1933. In 2003, Intraware fileda registration statement with the Securities and Exchange Commission toregister the resale of the common stock issued to us. On September 26,2005, Intraware implemented a 1 for 10 reverse split of its common stock. As aresult of this split, the number of shares owned by us decreased from 3,098,000to 309,000. We have classified this investment as an available-for-salesecurity, and accordingly, unrealized holding gains and losses are excludedfrom earnings and reported as a component of other comprehensive income. Themarket value of our investment in Intraware was $2,091,000 and $3,624,000 as ofthe end of 2005 and 2004, respectively.

 

*Investment in Unconsolidated Entity.*On October 2,1998, we acquired 4,310,345 shares of the common stock of Microgistix (formerlyChumbo Holdings Corporation), a private company, in exchange for cash andwarrants for total consideration of $5,000,000. In December 2001, based onMicrogistix’ historical operating results and cash flow requirements, wedetermined that we could not justify any carrying amount of this investment,and accordingly, wrote off the remaining value. Microgistix has continued tooperate at a loss. Our sales to Microgistixwere approximately $1,530,000 in 2005, $1,430,000 in 2004, and $2,305,000 in2003. Microgistix accounts receivable balances owing to us as of the end of theyear were approximately $284,000 in 2005 and $345,000 in 2004.

 

**NOTE 5. SHAREHOLDERS’ EQUITY**

 

*Stock Repurchases*. In October 2002, our Board of Directorsauthorized a stock repurchase plan that allowed us to repurchase up to$10,000,000 of our common stock. In 2003, we repurchased a total of 761,900shares at a cost of $2,587,000. On July 8, 2004, in connection withthe resignation of one of our non-employee directors, we entered into anagreement to purchase 415,000 shares of the Company’s common stock held by theformer director in a private transaction at a price of $3.42 per share, theclosing market price on that day.

 

On November 8,2005, we announced that our Board of Directors had authorized a new $10,000,000share repurchase program. Under the share buyback program, the Company may repurchaseshares from time to time and in accordance with applicable securities laws,through solicited or unsolicited transactions in the open market. December 31,2006 was established as the time limit to execute against the authorized sharebuyback program. Moreover, such purchases will be at times and in amounts Zomaxdeems appropriate and the purchases may be discontinued at any time. During2005, we repurchased atotal of 641,000 shares at a cost of $1,433,000 under this program.

 

*LitigationSettlement.*As discussed in more detail in Note 9 to theconsolidated financial statements, we settled a consolidated class actionlawsuit. A portion of the settlement includes the proposed issuance of1,500,000 shares of our common stock. To date, 375,000 shares of the 1,500,000shares have been issued.

 

**NOTE 6. STOCK PLANS**

 

***EmployeeStock Purchase Plan***. Through year-end 2005, we hadan employee stock purchase plan that enabled our employees to contribute up to10 percent of their compensation toward the purchase of the Company’scommon stock at a price equal to the lower of 85 percent of fair market valueas of the beginning or end of each plan period. A total of approximately 2,549,358shares had been reserved for issuance under this plan. This amount is increasedon January 1st of each year in accordance with the plan. We reservedshares totaling approximately 152,966, 176,000, and 219,000, in 2005, 2004, and2003, respectively. Shares issued under the plan totaled approximately 113,106in 2005, 174,000 in 2004, and 184,000 in 2003. Our employee stock purchase planwas terminated effective December 30, 2005.

** **

*Stock Option Plans*. We have a 1996 Stock Option Plan (the “1996Plan”) that provides for the granting of stock options to employees, officers,directors and independent consultants at exercise prices not less than100 percent of the fair market value of the Company’s common stock on thedate of grant. These options, which can be either incentive stock options ornonqualified options, vest over a three- to five-year schedule and expire10 years after the grant date. The authorized number of shares reserved forissuance under the 1996 Plan total 6,400,000, of which there were 141,959 remainingshares available for grant at the end of 2005.

 

Wealso have a 2004 Equity Incentive Plan (the “2004 Plan”) that provides for the granting of stock awardsto employees, officers, directors and independent consultants. These awards,which can be either incentive stock options, restricted stock or nonqualifiedoptions, vest over a one to five-year schedule and expire 10 years afterthe grant date. Exercise prices for stock options granted under the 2004 Planwill not be less than 100 percent of the fair market value of the Company’scommon stock on the date of grant. The authorized number of shares reserved forissuance under the 2004 Plan 

 

32

----

 

total2,000,000, of which 1,348,500 remained available for grant at the end of 2005.

 

We have also issued nonqualified stock options to ouremployees outside of these Plans for the purchase of 1,659,350 shares of commonstock, of which options to purchase 578,489 shares were outstanding as of December 30,2005. These options were issued at the fair market value of the Company’s stockon the date of grant and vest over a four- to five-year schedule.

 

Information regarding all stock option activityduring the year is summarized as follows (shares in thousands):

 
| ** **                             | ** ** | **2005**   | ** ** | **2004**                               | ** ** | **2003**   | ** ** |
|----------------------------------------|------------|------------|------------|----------------------------------------|------------|------------|------------|
| ** **                             | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** | **Shares** | ** ** | **Weighted  Average  Exercise  Price** | ** ** |
|                                   |       |       |       |                                   |       |       |       |   |   |   |   |   |   |
| Options outstanding, beginning of year |       | 2,831      |       | $                                      | 4.61       |       | 3,323      |   | $ | 5.03 |   | 3,674 |   | $ | 5.07 |   |
| Granted                                |       | 1,025      |       | 2.72                                   |       | 849        |       | 3.91 |   | 273 |   | 3.65 |   |
| Exercised                              |       | (27        | )          | 2.15                                   |       | (188       | )          | 2.06 |   | (138 | ) | 2.52 |   |
| Canceled                               |       | (318       | )          | 4.88                                   |       | (1,153     | )          | 5.71 |   | (486 | ) | 5.30 |   |
| Options outstanding, end of year       |       | 3,511      |       | $                                      | 4.08       |       | 2,831      |   | $ | 4.61 |   | 3,323 |   | $ | 5.03 |   |
|                                   |       |       |       |                                   |       |       |       |   |   |   |   |   |   |
| Options exercisable, end of year       |       | 1,854      |       | $                                      | 4.77       |       | 1,298      |   | $ | 4.69 |   | 1,463 |   | $ | 4.53 |   |

 

Information regarding all outstanding stock optionsas of December 30, 2005 is summarized as follows (shares in thousands):

 
| ** **                              | ** ** | ** ** | ** ** | **Options Outstanding** | ** ** | **Options Exercisable**             | ** ** |
|-----------------------------------------|------------|------------|------------|------------------------------|------------|------------------------------------------|------------|
| **Range of  Exercise Prices** | ** ** | ** ** | ** ** | **Weighted  Average**        | ** ** | **Weighted  Average**                    | ** ** | ** ** | ** ** | **Weighted  Average** | ** ** |
| **Low**                                 | ** ** | **High**   | ** ** | **Shares**                   | ** ** | **Remaining  Life (in years)** | ** ** | **Exercise  Price** | ** ** | **Shares** | ** ** | **Exercise  Price** | ** ** |
|                                    |       |       |       |                         |       |                                     |       |   |   |   |   |   |   |
| $                                       | 1.13       |       | $          | 2.86                         |       | 851                                      |       | 6.0 |   | $ | 2.23 |   | 453 |   | $ | 2.22 |   |
| 2.87                                    |       | 5.71       |       | 1,779                        |       | 8.1                                      |       | 3.67 |   | 557 |   | 3.95 |   |
| 5.72                                    |       | 8.57       |       | 849                          |       | 5.3                                      |       | 6.11 |   | 812 |   | 6.07 |   |
| 8.58                                    |       | 22.85      |       | 32                           |       | 4.3                                      |       | 20.94 |   | 32 |   | 20.94 |   |
|                                    |       |       |       | 3,511                        |       | 6.8                                      |       | $ | 4.08 |   | 1,854 |   | $ | 4.77 |   |
|                                         |            |            |            |                              |            |                                          |            |  |  |  |  |  |  |  |  |  |  |

 

33

----

 

**NOTE 7. INCOME TAXES**

 

Details regarding the income tax expense included in theconsolidated statement of operations are as follows (in thousands):

 
| ** **                         | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Current:                           |       |     |       |     |       |     |       |
| U.S. Federal                       |       | $        | 357        |     | $          | 868      |       | $ | 3,628 |   |
| State                              |       | —   |       | (626     | )          | 578      |       |
| Foreign                            |       | (360     | )          | (425     | )          | 153      |       |
|                               |       | (3)      |       | (183     | )          | 4,359    |       |
|                               |       |     |       |     |       |     |       |
| Deferred                           |       |     |       |     |       |     |       |
| U.S. Federal                       |       | (5,362   | )          | 2,438    |       | (1,190   | )          |
| State                              |       | (1,341   | )          | 1,069    |       | —   |       |
| Foreign                            |       | (1,203   | )          | 299      |       | (148     | )          |
|                               |       | (7,906   | )          | 3,806    |       | (1,338   | )          |
| Total income tax (expense) benefit |       | $        | (7,909     | )        | $          | 3,623    |       | $ | 3,021 |   |

 

Excluded from our provision for income taxes are taxbenefits we realize from employee sales of stock issued under our stock optionand employee stock purchase plans of $0 in 2005, $185,000 in 2004, and $104,000in 2003. These tax benefits are recorded directly to stockholders’ equity. Theprovision for foreign income taxes is based upon foreign pretax (loss) incomeof approximately ($8,376,000) in 2005, ($1,487,000) in 2004, and $3,812,000 in2003.

 

Thedetermination of annual income tax expense takes into consideration amountswhich may be needed to cover exposures for open tax years. In 2005 and 2004, we assessed the probabilitiesof those exposures and recognized a $357,000 and $385,000 benefit, respectively related to reductions in our taxaccruals. In 2003, Canadian tax authorities completed an audit of ourCanadian tax returns for the years 1999, 2000 and 2001 and, accordingly, weremoved $1,010,000 of provisions we had made in our tax liabilities related tothe risk that tax authorities would reject certain positions we had taken inthe preparation of these returns. We do not expect any material impacton earnings to result from the resolution of matters related to open tax years;however, actual settlements may differ from amounts accrued.

 

A reconciliation of the statutory U.S. federal incometax rate to our effective income tax rate is as follows:

 
| ** **                                                                                | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-------------------------------------------------------------------------------------------|------------|----------|------------|----------|------------|----------|------------|
| Statutory U.S. federal income tax rate                                                    |       | 34.0     | %          | 34.0     | %          | 34.0     | %          |
| State income taxes, net of federal income  tax benefit and state valuation allowance |       | (3.1     | )          | 2.4      |       | 6.3      |       |
| Reduction in tax accruals                                                                 |       | 1.3      |       | 3.2      |       | 24.4     |       |
| Non-deductible expenses                                                                   |       | —   |       | (5.7     | )          | —   |       |
| Foreign tax effect                                                                        |       | (15.6    | )          | (5.3     | )          | 4.0      |       |
| Tax deductible goodwill                                                                   |       | 0.5      |       | 1.3      |       | 3.8      |       |
| Increase in valuation allowance                                                           |       | (45.4    | )          | —   |       | —   |       |
| Other                                                                                     |       | 0.3      |       | 0.2      |       | (0.5     | )          |
| Effective income tax rate                                                                 |       | (28.0    | )%         | 30.1     | %          | 72.0     | %          |

 

34

----

 

The components of our deferred tax assets andliabilities are as follows (in thousands):

 
| ** **                                     | ** ** | **2005** | ** ** | **2004** | ** ** |
|------------------------------------------------|------------|----------|------------|----------|------------|
| Deferred tax assets:                           |       |     |       |     |       |
| Accounts receivable reserves                   |       | $        | 163        |     | $          | 301 |   |
| Inventory valuation                            |       | 1,095    |       | 1,320    |       |
| Accrued liabilities                            |       | 1,903    |       | 693      |       |
| Foreign tax credit                             |       | 850      |       | 850      |       |
| Capital loss carryforward                      |       | 1,556    |       | 1,556    |       |
| Ireland operating loss carry forward           |       | 2,719    |       | 2,241    |       |
| Domestic operating loss carry forward          |       | 11,215   |       | 4,609    |       |
| Other                                          |       | 128      |       | 224      |       |
| Gross deferred tax assets                      |       | 19,629   |       | 11,794   |       |
| Valuation Allowance                            |       | (18,782  | )          | (2,333   | )          |
|                                           |       | $        | 847        |     | $          | 9,461 |   |
| Deferred tax liabilities:                      |       |     |       |     |       |
| Depreciation and amortization                  |       | $        | (1,053     | )        | $          | (1,317 | ) |
| Unrealized gain on available-for-sale security |       | 170      |       | (410     | )          |
| Other                                          |       | (175     | )          | (127     | )          |
|                                           |       | $        | (1,058     | )        | $          | (1,854 | ) |
| Net deferred tax asset (liability)             |       | $        | (211       | )        | $          | 7,607 |   |

 

Inaccordance with SFAS 109, we recorded an additional valuation allowance of$16,449,000 for our deferred tax assets in 2005. Based upon recent history oflosses in the United States and Ireland, a full valuation allowance wasrecorded on the net deferred tax assets in these jurisdictions. This allowanceis in addition to the previously recorded and disclosed allowance of $2,333,000related to the uncertainty of realizing the benefits of certain losscarryforwards before they begin to expire in 2024. The additional valuationallowance recorded in 2005 was calculated in accordance with the provisions ofSFAS 109 which places primary importance on the most recent operating resultsin each jurisdiction in which we operate. While management continues to believeour actions to restructure the cost base and strategically reposition theCompany will ultimately result in profitability, three years of historicaloperating losses generally dictate prudence in assessing the deferred taxasset. The Company intends to maintain the valuation allowance for its netdeferred tax asset and loss carryforwards until sufficient positive evidenceexists to support reversal of the reserve. At December 30, 2005 and December 31,2004, we had a valuation allowance of $18,782,000 and $2,333,000, respectively.

 

Wehave not recorded deferred income taxes applicable to undistributed earnings ofour non-U.S. subsidiaries as all such earnings are deemed to be indefinitelyreinvested in those operations. If earnings of these non-U.S. subsidiaries werenot indefinitely reinvested, a deferred liability would have been required: however,it is not practicable to determine the amount of such liability. We reviewedwhether we would elect to utilize provisions of the American Jobs Creation Actof 2004, which provides a one-time election to repatriate earnings from foreignsubsidiaries at a reduced U.S. tax rate. As a result of this Act, we would havehad the opportunity to repatriate cash in 2005 that has been generated overtime by our foreign operations, which would have resulted in an increase in ourtax provision in 2005. We completed our evaluation of this deduction andelected not to take advantage of this deduction due to our large net operatingloss carryforward.

 

35

----

 

**NOTE 8. RELATED-PARTY TRANSACTIONS**

 

*Operating Lease.*We lease one of our manufacturing and office facilitiesfrom a partnership that is one-third owned by a former member of our Board ofDirectors. We believe the terms of this lease are equivalent to those thatwould be paid in an arm’s-length transaction. Payments under this lease totaled$656,880 in 2005, $656,000 in 2004, and $642,000 in 2003.

 

*Sales to Related Party.*One of our customers is owned by a formermember of our Board of Directors. We believe our terms of sale with thiscustomer are equivalent to those offered to all our customers for similarservices and volume of business. Sales to this customer were approximately $44,000in 2005, $17,000 in 2004, and $234,000 in 2003. Amounts owed to us as of theend of the year were $5,500 in 2005, $0 in 2004.

 

*Stock Repurchase.*As discussed in more detail in Note5 to the consolidated financial statements, in 2004 we repurchased 415,000shares of the Company’s common stock from a significant shareholder and formermember of our Board of Directors in a private transaction. The repurchase pricewas the $3.42 per share, the closing market price on the repurchase date.

 

**NOTE 9. COMMITMENTS AND CONTINGENCIES**

 

*Operating Leases*. We are committed under operating leases withrelated and unrelated parties for the rental of manufacturing, warehouse andoffice facilities. Future minimum lease obligations as of December 30, 2005are as follows (in thousands):

 
| 2006       |   | $      | 5,449  |   |
|------------|--------|--------|--------|--------|
| 2007       |   | 4,289  |   |
| 2008       |   | 3,241  |   |
| 2009       |   | 2,265  |   |
| 2010       |   | 2,265  |   |
| Thereafter |   | 21,118 |   |
|       |   | $      | 38,627 |   |

 

A number of our facility leases have early terminationclauses that would reduce future contractual obligations with payment ofpenalties for early exit.

 

Rent expense under all operating leases, exclusive of realestate taxes, insurance and maintenance expense, was $7,281,000 in 2005, $7,081,000in 2004, and $6,104,000 in 2003.

 

*IrelandEmployment Grants*. Our Ireland businesses have received employmentgrants from the Ireland Development Authority (IDA) totaling $3,454,000 duringthe period from 1995 through 2000. We recognized these grants as income inprevious years on an straight-line basis in selling, general and administrativeexpenses in the consolidated statements of operations. These grants wereawarded by the IDA for creating and maintaining permanent employment positionsin Ireland for a period of at least five years. Termination of any number ofthese positions within a five-year period may, at the election of the IDA,result in the pro rata return of the grants based on the number of positionsterminated compared to the number of new positions originally created. At December 30,2005, our employment levels in Ireland were below the levels for which we hadreceived grants. However, the IDA has informed us that it does not intend toseek repayment of any grant monies at this time or in the foreseeable future,and accordingly, we have not provided for such repayment in our financialstatements. Under FASB Statement No. 5, *“Accountingfor Contingencies”*, and FASB Interpretation No. 14, *“Reasonable Estimation of the Amount of a Loss, an interpretation ofFASB Statement No. 5”*, we have determined that repayment is notprobable and have not accrued a liability in the consolidated financialsstatements as of December 30, 2005.

 

*Polycarbonate Supply Agreement.*Duringthe third quarter of 2005, we entered into an agreement with our supplier ofpolycarbonate, a petroleum-based commodity which is the primary raw materialused in the production of CD and DVD media. Beginning in the first half of2004, supply shortages and increases in petroleum prices have placedsignificant upward pressure on polycarbonate pricing. Under the agreement,which runs through June 2006, we have agreed to purchase polycarbonate atset price terms. These price terms restrict monthly price increases and help usto limit our exposure to potential future price increases while also allowingus to reduce our purchase volume should the price terms increase above anagreed-upon level over the initial base price. Minimum remaining commitmentsunder this agreement, subject to purchase volume reductions, are approximately$1,800,000 based on the current adjusted base price and minimum remainingquantity. We believe that this agreement will allow us to minimize ournear-term exposure to continuing upward price pressures on this key rawmaterial.

 

*401(k) Plan.*We have a discretionary 401(k) plan for allemployees who are at least 21 years of age and have completed 60 days ofservice with the Company. Our discretionary contributions totaled $236,000 in2005, $283,000 in 2004, and $245,000 in 2003.

 

36

----

 

*“Wells Notice” and Shareholder Lawsuit.*Aspreviously disclosed in our filings with the SEC, we have been the subject ofan SEC investigation and a consolidated class action lawsuit involvingallegations of securities law violations. The allegations related to Companydisclosures and certain stock sales by two former officers during the thirdquarter of the year 2000.

 

On April 27, 2005, we announced,without admission of liability, an agreement to settle the outstanding class actionlawsuit. This stipulation of settlement received Court approval on September 6,2005 and resulted in a settlement of $2,250,000 in cash and 1,500,000 shares ofthe Company’s common stock to the class. The entire $2,250,000 cash payment waspaid by proceeds received from our directors’ and officers’ insurance carrier. Thesettlement payments will be distributed to shareholders who incurred losses asa result of stock purchases between May 25, 2000 and October 18,2002, inclusive, and to plaintiffs’ attorneys as fees and costs awarded by theCourt. As of December 30, 2005, the cash portion of this claim has beensettled. The charge against earnings associated with the issuance of the1,500,000 shares of stock was initially recorded in the third quarter of 2004,and the charge continued to be adjusted based on the market price of theCompany’s stock until final Court approval of the settlement was granted on September 6,2005. As of December 30, 2005, 375,000 of these shares have been issued.

 

On June 9, 2005, we announced thatthe Company entered into a settlement agreement with the SEC. Under the termsof the settlement agreement, the Company paid a civil penalty in the amount of$2,000,000 to the SEC during our third quarter of 2005.

 

We have established reserves for thesetwo matters which we believe to be adequate and are based on the terms of thesettlement agreements and the provisions of FASB Statement No. 5, *“Accounting for Contingencies”*, and FASB Interpretation No. 14,*“Reasonable Estimation of the Amount of a Loss, aninterpretation of FASB Statement No. 5”*. These reserves are asfollows (in thousands):

 
| ** **                | ** ** | **December 30,  2005** | ** ** | **December 31,  2004** | ** ** |
|---------------------------|------------|-----------------------------|------------|-----------------------------|------------|
| ** **                | ** ** | ** **                  | ** ** | ** **                  | ** ** |
| Class action lawsuit |       | $                           | 3,353      |                        | $          | 6,520 |   |
| SEC investigation         |       | —                      |       | 2,000                       |       |
|                      |       | $                           | 3,353      |                        | $          | 8,520 |   |

 

The portion of the consolidated class actionlawsuit settlement payable in shares of Company stock was valued at $4,470,000and $6,165,000 based on the closing market prices of $2.98 and $4.11 on September 6,2005 and December 31, 2004, respectively. As of December 30, 2005 theremaining liability represents 1,125,000 shares to be distributed at theclosing price on September 6, 2005.

 

*Customerclaim of unauthorized production of software*. During the secondquarter of 2003, one of our majorcustomers alleged that Zomax Ireland, a subsidiary we acquired from KaoCorporation in January 1999, was responsible for unauthorized productionof the customer’s software. Our customer claimed that because of these allegedunauthorized activities it had suffered significant damages representing lostprofits on displaced product sales. In the fourth quarter of 2003, we and our customer reached a finalaccommodation related to these claims. While we continue to deny these claims,in order to avoid potentially lengthy and expensive litigation, we agreed tomake a one-time payment to our customer of $3,000,000. As a part of thesettlement agreement, neither party admitted any liability and both partiesobtained mutual releases related to the claims.

 

We are involved in certain other claims arising inthe normal course of business. In our opinion, the final resolution of theseclaims should not have a material adverse effect on our financial position,cash flow or results from operations.

 

**NOTE 10. QUARTERLY FINANCIAL DATA (UNAUDITED)**

 

Unaudited quarterly data is as follows (in thousands,except per share data):

 

37

----

 
| ** **                        | ** ** | **Quarter Ended** | ** ** |
|-----------------------------------|------------|------------------------|------------|
| ** **                        | ** ** | **March**              | ** ** | **June** | ** ** | **September** | ** ** | **December** | ** ** |
| **2004**                          | ** ** | ** **             | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                           |       | $                      | 50,035     |   | $ | 45,082 |   | $ | 45,718 |   | $ | 58,593 |   |
| Gross profit                      |       | 6,950                  |       | 8,020 |   | 7,222 |   | 8,205 |   |
| Operating loss                    |       | (2,455                 | )          | (1,602 | ) | (9,485 | ) | (1,765 | ) |
| Net earnings (loss)               |       | (1,546                 | )          | 534 |   | (6,037 | ) | (1,362 | ) |
| Basic earnings (loss) per share   |       | $                      | (0.05      | ) | $ | 0.02 |   | $ | (0.19 | ) | $ | (0.04 | ) |
| Diluted earnings (loss) per share |       | $                      | (0.05      | ) | $ | 0.02 |   | $ | (0.19 | ) | $ | (0.04 | ) |

 
| ** **             | ** ** | **Quarter Ended** | ** ** |
|------------------------|------------|-------------------|------------|
| ** **             | ** ** | **March**         | ** ** | **June** | ** ** | **September** | ** ** | **December** | ** ** |
| **2005**               | ** ** | ** **        | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** | ** ** |
| Revenue                |       | $                 | 42,181     |   | $ | 42,585 |   | $ | 38,094 |   | $ | 44,124 |   |
| Gross profit           |       | 1,796             |       | 3,316 |   | 4,122 |   | 3,797 |   |
| Operating loss         |       | (6,831            | )          | (8,182 | ) | (5,101 | ) | (9,691 | ) |
| Net loss               |       | (4,148            | )          | (5,679 | ) | (18,135 | ) | (8,184 | ) |
| Basic loss per share   |       | $                 | (0.13      | ) | $ | (0.17 | )  | $ | (0.55 | ) | $ | (0.26 | ) |
| Diluted loss per share |       | $                 | (0.13      | ) | $ | (0.17 |  ) | $ | (0.55 | ) | $ | (0.26 | ) |

 

Duringthe first and third quarters of 2005 the Company recorded a cumulative non-cashbenefit of $1.7 million on its stock portion of the SEC class actionlawsuit due to the decrease in the market value of our shares at the settlementdate. In the second quarter of 2005 we incurred $2.4 million in restructuringcharges related to media replication equipment consolidation within our NorthAmerican and Ireland asset groups and reductions in headcount in both NorthAmerica and Ireland. We incurred $1.1 million in additional restructuringcharges during the third and fourth quarters of 2005. In accordance with SFAS109 “Accounting for Income Taxes” we recorded a total allowance against our netdeferred tax assets of $15.2 million and $1.2 million in the third and fourthquarters, respectively. In the fourth quarter the Company recorded $4.3 millionof impairment on it Clondalkin Ireland assets and an additional $.8 million inrestructuring charges.

 

Inthe second quarter of 2004, we sold a portion of our investment inIntraware and recorded a pre-tax gain of $2,770,000. See “Strategic AllianceAgreement” in Note 4 to the consolidated financial statements. Additionally, inthe third quarter and fourth quarter of 2004 we recognized pre-tax charges of$7,500,000 and $1,020,000, respectively, to establish reserves for liabilitiesthat represent the Company’s estimate of the minimum expected probable lossesresulting from settlement offers made by the Company in connection with thepending Securities and Exchange Commission investigation and consolidated class actionlawsuit. See “‘Wells Notice” and “Shareholder Lawsuit” in Note 9 to theconsolidated financial statements.

 

38

----

 

**NOTE 11. SEGMENT AND GEOGRAPHICAL INFORMATION**

 

We operate in one industry segment. The geographicdistributions of our revenues, operating income (loss) and identifiable assetsfor 2005, 2004 and 2003 are summarized as follows (in thousands):

 
| ** **                        | ** ** | **2005** | ** ** | **2004** | ** ** | **2003** | ** ** |
|-----------------------------------|------------|----------|------------|----------|------------|----------|------------|
| **Revenue:**                      |       |     |       |     |       |     |       |
| United States                     |       | $        | 120,705    |     | $          | 152,763  |       | $ | 145,259 |   |
| Ireland                           |       | 29,500   |       | 34,978   |       | 36,084   |       |
| Canada                            |       | 37,846   |       | 32,321   |       | 31,203   |       |
| Inter-geographic revenue          |       | (21,067  | )          | (20,634  | )          | (14,730  | )          |
|                              |       | $        | 166,984    |     | $          | 199,428  |       | $ | 197,816 |   |
| **Operating income (loss):**      |       |     |       |     |       |     |       |
| United States                     |       | $        | (5,496     | )        | $          | 4,609    |       | $ | 9,669 |   |
| Ireland                           |       | (9,374   | )          | (3,287   | )          | 994      |       |
| Canada                            |       | 145      |       | 3,963    |       | 2,888    |       |
| Corporate and eliminations   |       | (15,080  | )          | (20,592  | )          | (18,004  | )          |
|                              |       | $        | (29,805    | )        | $          | (15,307  | )          | $ | (4,453 | ) |
| **Assets:**                       |       |     |       |     |       |     |       |
| United States                     |       | $        | 34,486     |     | $          | 42,946   |       | $ | 52,506 |   |
| Ireland                           |       | 13,700   |       | 27,646   |       | 31,264   |       |
| Canada                            |       | 20,193   |       | 17,384   |       | 25,257   |       |
| Total identifiable assets         |       | 68,379   |       | 87,976   |       | 109,027  |       |
| Corporate assets and eliminations |       | 46,793   |       | 80,178   |       | 72,012   |       |
|                              |       | $        | 115,172    |     | $          | 168,154  |       | $ | 181,039 |   |
| **Capital expenditures:**         |       |     |       |     |       |     |       |
| United States                     |       | $        | 1,735      |     | $          | 3,035    |       | $ | 3,716 |   |
| Ireland                           |       | 229      |       | 1,160    |       | 1,409    |       |
| Canada                            |       | 1,996    |       | 500      |       | 4,464    |       |
|                              |       | $        | 3,960      |     | $          | 4,695    |       | $ | 9,589 |   |
| **Depreciation:**                 |       |     |       |     |       |     |       |
| United States                     |       | $        | 4,349      |     | $          | 5,928    |       | $ | 5,897 |   |
| Ireland                           |       | 2,201    |       | 1,388    |       | 1,132    |       |
| Canada                            |       | 2,164    |       | 2,513    |       | 1,639    |       |
|                              |       | $        | 8,714      |     | $          | 9,829    |       | $ | 8,668 |   |

 

39

----

 

**NOTE12. LOSS ON IMPAIRMENT OF LONG-LIVED ASSETS**

 

Based on historical negative cash flows in 2004 andcontinuing negative cash flows in 2005 generated by the assets of ourClondalkin, Ireland manufacturing and fulfillment operations, we determinedthat this change in circumstances indicated that a review of the Clondalkin operationsfixed assets was required. We reviewed the discounted future cash flowsexpected to be generated by the fixed assets of the Clondalkin operations overthe remaining life of the assets and determined that it did not appear theassets would be recovered by future cash flows, indicating the assets appearedto be impaired. As a result, in the fourth quarter of fiscal year 2005, werecorded a pre-tax impairment charge of $4.3 million associated with the write-down in value ofthe fixed assets of our Clondalkin, Ireland manufacturing and fulfillmentoperations.

 

**NOTE13. RESTRUCTURING AND OTHER RELATED COSTS**

 

At theend of the first quarter of 2005, we announced our intentions to begin arestructuring plan in the second quarter of 2005. The activities undertaken in thefirst phase of this plan consisted primarily of media replication equipmentconsolidation and elimination of CD replication capacity within our NorthAmerican and Ireland asset groups and reductions in headcount in both NorthAmerica and Ireland. As a part of the consolidation efforts we had assetsapproximating $980,000 in aggregate net book value which were either abandonedor disposed of and were accounted for as long-lived assets to be abandoned andadjusted to be fully depreciated as of the end of our second quarter (the dateof abandonment or disposal). Additionally, the useful lives of certain assetsin North America approximating $109,000 in aggregate carrying value were depreciatedover the next six months (their approximate original remaining useful lives)and continue to be accounted for as assets held and used. In Ireland, assetsapproximating $310,000 in aggregate value are considered abandoned and held fordisposal.

 

On November 8, 2005, we announced thatwe plan to close our Fremont, California facility, from which we had alreadyeliminated CD/DVD replication capacity. The site closure is expected to resultin cash restructuring charges of approximately $1,800,000 for employeeliabilities, retention and related facility transition activities. Closure ofthe facility is expected to be completed in early 2006. Assembly, fulfillmentand customer care activities currently performed in Fremont will be transferredprimarily to other Zomax operations. Related charges and accruals will berecorded in our fourth quarter of 2005 and first quarter of 2006.

 

Wehave recorded pretax charges related to this restructuring plan of $3,518,000during the year ended December 30, 2005, including employee separationcosts, accelerated depreciation on assets held and used until disposal andother costs directly related to the restructuring plan, including decommissioncosts. Liabilities accrued as part of the plan were $683,000 as of December 30,2005. Details of the restructuring activity for 2005 are as follow (inthousands):

 
| ** **                                  | ** ** | **Employee  Severance  and Benefits** | ** ** | **Accelerated  Depreciation** | ** ** | **Other** | ** ** | **Total** | ** ** |
|---------------------------------------------|------------|--------------------------------------------|------------|-------------------------------|------------|-----------|------------|-----------|------------|
|                                        |       |                                       |       |                          |       |      |       |      |       |
| Total liabilities at December 31, 2004 |       | $                                          | —     |                          | $          | —    |       | $         | —     |   | $ | — |   |
|                                        |       |                                       |       |                          |       |      |       |      |       |
| Total charges                               |       | 1,518                                      |       | 980                           |       | 1,020     |       | 3,518     |       |
| Non-cash                                    |       | —                                     |       | (980                          | )          | —    |       | (980      | )          |
| Cash payments                               |       | (1,354                                     | )          | —                        |       | (501      | )          | (1,855    | )          |
|                                        |       |                                       |       |                          |       |      |       |      |       |
| Total liabilities at December 30, 2005 |       | $                                          | 164        |                          | $          | —    |       | $         | 519        |   | $ | 683 |   |

 

Weexpect to complete our previously announced restructuring activities in the firstquarter 2006 with approximately $1 million of restructuring expense remainingto be recorded.

 

40

----

 

**ITEM 9. CHANGES IN AND DISAGREEMENTS WITH ACCOUNTANTS ON ACCOUNTING ANDFINANCIAL DISCLOSURE**

 

None.

 

**ITEM 9A. CONTROLS AND PROCEDURES**

 

**Evaluationof Disclosure Controls and Procedures**

 

As ofthe end of the period covered by this report, we conducted an evaluation, underthe supervision and with the participation of our chief executive officer andchief financial officer, of our disclosure controls and procedures (as definedin Rules 13a-15(e) and 15d-15(e) under the Securities ExchangeAct of 1934). Based on this evaluation the chief executive officer and chieffinancial officer concluded that, as of December 30, 2005, the disclosurecontrols and procedures for Zomax Incorporated were effective****to ensure that information required to be disclosed inreports that it files or submits under the Securities Exchange Act is recorded,processed, summarized and reported within the time periods specified in SEC rules andforms.

 

**Management’sReport on Internal Control over Financial Reporting**

 

Themanagement of Zomax Incorporated is responsible for establishing andmaintaining adequate internal control over financial reporting. Our internalcontrol system was designed to ensure that material information regarding ourconsolidated operations is made available to management and the board ofdirectors to provide them reasonable assurance that the published financialstatements are fairly presented. There are limitations inherent in any internalcontrol, such as the possibility of human error and the circumvention oroverriding of controls. As a result, even effective internal controls canprovide only reasonable assurance with respect to financial statementpreparation. As conditions change over time so too may the effectivenessof internal controls.

 

Aninternal control significant deficiency is a control deficiency, or combinationof control deficiencies, that adversely affects a company’s ability toinitiate, authorize, record, process, or report external financial datareliably in accordance with generally accepted accounting principles such thatthere is more than a remote likelihood that a misstatement of the company’sannual or interim financial statements that is more than inconsequential willnot be prevented or detected. An internal control material weakness is asignificant deficiency, or combination of significant deficiencies, thatresults in more than a remote likelihood that a material misstatement of theannual or interim financial statements will not be prevented or detected.

 

Ourmanagement evaluated our internal control over financial reporting as of December 30,2005, based on the framework in Internal Control - Integrated Framework issuedby the Committee of Sponsoring Organizations (“COSO”) of the TreadwayCommission. Based on this assessment, our management concluded that ourinternal control over financial reporting was effective as of December 30,2005.

 

**Change inInternal Control Over Financial Reporting**

 

TheCompany is responsible for establishing and maintaining adequate internalcontrol over financial reporting. The Company’s internal control system wasdesigned to provide reasonable assurance to the Company’s management and theboard of directors regarding the preparation and fair presentation of publishedfinancial statements. All internal control systems, no matter how well designed,have inherent limitations. Therefore, even those systems determined effectivecan provide only reasonable assurance with respect to financial statementpreparation and presentation.

 

Asof December 31, 2004, the Company’s assessment of the effectiveness of itsinternal control over financial reporting identified a material weakness in theCompany’s internal control over financial reporting in the supervision andoversight of accounting personnel at the Company’s Ireland subsidiary. Thismaterial weakness in internal control permitted (i) the intentionalrecording of incorrect accounting entries by local accounting personnel, (ii) theinadequate preparation and review of certain balance sheet accountreconciliations, and (iii) failure of our Ireland subsidiary to followcertain Company accounting policies. As discussed in prior filings with theSEC, the Company identified and addressed the following remediation steps toaddress the material weakness:

 

•                  Theformer Ireland financial controller has been replaced by an individual withappropriate experience and qualifications.

 

•                  Ourcorporate controller has been assigned to directly oversee and implementchanges to the monthly financial close process in Zomax Ireland. These changesinclude the implementation of appropriate journal entry reviews, balance sheetreconciliation processes and procedures to ensure Company policies arefollowed.

 

41

----

 

•                  Wehave established owners of all primary business processes across our globaloperations who are responsible for ensuring formalized policies and proceduresare created and that employees are properly trained on these policies. Thistraining emphasizes employee’s general understanding of our control system withparticular attention to their responsibility for the integrity of the controlprocedures within their respective operations.

 

•                  Weare evaluating the establishment of an internal audit program for possibleimplementation in 2006.

 

•                  Witha new chief financial officer recently appointed, we continue to assess ourglobal financial organization structure for possible staffing and structuralchanges. The assessment is focused toward better positioning the organizations’ability to supervise and oversee the performance and compliance of all aspectsof the financial reporting and control requirements necessary for support ofthe Company.

 

Therewere no other changes in the Company’s internal control over financialreporting during its most recently completed fiscal quarter that havematerially affected or are reasonably likely to materially affect its internalcontrol over financial reporting, as defined in Rule 13a-15(f) underthe Exchange Act.

 

42

----

 

**REPORT OFINDEPENDENT REGISTERED PUBLIC ACCOUNTING FIRM**

 

To the Board of Directorsand Shareholders of

Zomax Incorporated:

 

We have audited management’s assessment,included in the accompanying “Management’s Report on Internal Control overFinancial Reporting” included in Item 9A, that Zomax Incorporated andSubsidiaries (the “Company”) maintained effective internal control overfinancial reporting as of December 30, 2005, based on the**criteria established in *Internal Control—Integrated Framework*issuedby the Committee of Sponsoring Organizations of the Treadway Commission. TheCompany’s management is responsible for maintaining effective internal controlover financial reporting and for its assessment of the effectiveness ofinternal control over financial reporting. Our responsibility is to express anopinion on management’s assessment and an opinion on the effectiveness of theCompany’s internal control over financial reporting based on our audit.

 

We conducted our audit in accordance with thestandards of the Public Company Accounting Oversight Board (United States). Thosestandards require that we plan and perform the audit to obtain reasonableassurance about whether effective internal control over financial reporting wasmaintained in all material respects. Our audit included obtaining anunderstanding of internal control over financial reporting, evaluatingmanagement’s assessment, testing and evaluating the design and operatingeffectiveness of internal control, and performing such other procedures as weconsidered necessary in the circumstances. We believe that our audit provides areasonable basis for our opinions.

 

A company’s internal control over financialreporting is a process designed by, or under the supervision of, the company’sprincipal executive and principal financial officers, or persons performingsimilar functions, and effected by the company’s board of directors,management, and other personnel to provide reasonable assurance regarding thereliability of financial reporting and the preparation of financial statementsfor external purposes in accordance with generally accepted accountingprinciples. A company’s internal control over financial reporting includesthose policies and procedures that (1) pertain to the maintenance ofrecords that, in reasonable detail, accurately and fairly reflect thetransactions and dispositions of the assets of the company; (2) providereasonable assurance that transactions are recorded as necessary to permitpreparation of financial statements in accordance with generally accepted accountingprinciples, and that receipts and expenditures of the company are being madeonly in accordance with authorizations of management and directors of thecompany; and (3) provide reasonable assurance regarding prevention ortimely detection of unauthorized acquisition, use, or disposition of thecompany’s assets that could have a material effect on the financial statements.

 

Because of the inherent limitations ofinternal control over financial reporting, including the possibility ofcollusion or improper management override of controls, material misstatementsdue to error or fraud may not be prevented or detected on a timely basis. Also,projections of any evaluation of the effectiveness of the internal control overfinancial reporting to future periods are subject to the risk that the controlsmay become inadequate because of changes in conditions, or that the degreeof compliance with the policies or procedures may deteriorate.

 

In our opinion, management’s assessment thatthe Company maintained effective internal control over financial reporting asof December 30, 2005, is fairly stated, in all material respects, based onthe criteria established in *InternalControl—Integrated Framework*issued by the Committee of SponsoringOrganizations of the Treadway Commission. Also in our opinion, the Companymaintained, in all material respects, effective internal control over financialreporting as of December 30, 2005, based on the criteria established in *Internal Control—Integrated Framework*issuedby the Committee of Sponsoring Organizations of the Treadway Commission.

 

We have also audited, in accordance with thestandards of the Public Company Accounting Oversight Board (United States),**the consolidated financial statements andfinancial statement schedule listed in the Index at Item 15(a) as ofand for the year ended December 30, 2005 of the Company and our reportdated March 15, 2006 expressed**anunqualified opinion on those financial statements and financialstatement schedule.

 

 
| /s/ Deloitte &  Touche LLP |   |
|-------------------------------------|--------|
| Minneapolis,  Minnesota             |
| March 15,  2006                |

 

 

43

----

** **

**ITEM 9B.****                    OTHER INFORMATION**

 

        None.

 

**PART III**

 

**ITEM 10.****                      DIRECTORS AND EXECUTIVE OFFICERSOF THE REGISTRANT**

 

Theinformation concerning directors and executive officers and compliance with Section 16(a) requiredby this item is contained in the sections entitled “Corporate Governance,” “Electionof Directors,” “Executive Officers of the Company” and “Compliance with Section 16(a) ofthe Exchange Act,” appearing in our Proxy Statement to be delivered tostockholders in connection with the 2006 Annual Meeting of Stockholders. Suchinformation is incorporated herein by reference.

 

Wehave adopted a Code of Ethics and Business Conduct (the “Code”), which isavailable free of charge through our website at www.zomax.com and is availablein print to any stockholder who sends a request for a paper copy to ZomaxIncorporated, Attn. Investor Relations, at the address listed on the frontcover of this report. The Code applies to all of our employees including ourprincipal executive officer, principal financial officer and corporatecontroller. Zomax intends to include on its website any amendment to, or waiverfrom, a provision of the Code that for any of these individuals that relates toany element of the code of ethics definition enumerated in Item 406(b) ofRegulation S-K.

 

**ITEM 11.****                      EXECUTIVECOMPENSATION**

 

Theinformation required by this item is contained in the sections entitled “ExecutiveCompensation,” “Corporate Governance – Compensation to Non-Employee Directors”appearing in the Company’s Proxy Statement to be delivered to stockholders inconnection with the 2006 Annual Meeting of Stockholders. Such information isincorporated herein by reference.

 

**ITEM 12.****                      SECURITYOWNERSHIP OF CERTAIN BENEFICIAL OWNERS AND MANAGEMENT AND RELATED STOCKHOLDERMATTERS**

 

The information required by this item relating to the securityownership of certain holders is contained in the section entitled “PrincipalStockholders and Management Shareholdings” appearing in our Proxy Statement tobe delivered to stockholders in connection with the 2006 Annual Meeting ofStockholders. Such information is incorporated herein by reference.

 

The following table summarizes our equitycompensation plan information as of December 30, 2005.

 
| **Plan Category**                                         | ** ** | **Number of Securities to  be  issued upon exercise of  outstanding options** | ** ** | **Weighted average exercise  price  of outstanding options** | ** ** | **Number of securities  remaining  available for future  issuance  (excluding securities  reflected in  column (a))** | ** ** |
|----------------------------------------------------------------|------------|------------------------------------------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------|------------|----------------------------------------------------------------------------------------------------------------------------------------------------------|------------|
| ** **                                                     | ** ** | **(a)**                                                                                                          | ** ** | **(b)**                                                                          | ** ** | **(c)**                                                                                                                                                  | ** ** |
| Equity compensation plans approved by security  holders(1)     |       | 3,511,380                                                                                                        |       | $                                                                                | 4.08       |                                                                                                                                                     | 3,231,095  |   |
| Equity compensation plans not approved by security  holders(2) |       | 578,489                                                                                                          |       | 4.84                                                                             |       | N/A                                                                                                                                                      |       |
| Total                                                          |       | 4,089,869                                                                                                        |       | $                                                                                | 4.18       |                                                                                                                                                     |       | 3,231,095 |   |
|                                                                |            |                                                                                                                  |            |                                                                                  |            |                                                                                                                                                          |            |  |  |  |

 

----

| (1) | Plan category includes the Company’s 2004 Equity Incentive Plan (the  “2004 Plan”), 1996 Stock Option Plan (the “1996 Plan”), stock options granted  outside of the 1996 Plan that were subsequently approved by stockholders and  the Company’s 1996 Employee Stock Purchase Plan. The number of shares in  column (c) includes 1,148,347 shares available for issuance under the  1996 Employee Stock Purchase Plan**.** |
|-----|---------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| (2) | Plan category includes stock options that were granted to employees  outside of our 1996 Plan and prior to the approval of the 2004 Plan due to an  insufficient number of shares available under the 1996 Plan. The agreements  with respect to these options are substantially the same as agreements with  respect to options under the 1996 Plan and generally provide for a ten-year  term with vesting over a period of four to five years.             |

 

44

----

 

**ITEM 13.****                      CERTAINRELATIONSHIPS AND RELATED TRANSACTIONS**

 

Theinformation required by this item is contained in the section entitled “CertainTransactions” appearing in our Proxy Statement to be delivered to stockholdersin connection with the 2006 Annual Meeting of Stockholders. Such information isincorporated herein by reference.

 

**ITEM14.****                      PRINCIPALACCOUNTANT FEES AND SERVICES**

 

The information required by this item is containedin the section entitled “Principal Accountant Fees and Services” appearingin our Proxy Statement to be delivered to stockholders in connection with the2006 Annual Meeting of Stockholders. Such information is incorporated byreference.

 

**PART IV**

** **

**ITEM15.****                      EXHIBITSAND FINANCIAL STATEMENT SCHEDULES**

 

(a)          Listof Financial Statements, Financial Statement Schedules and Exhibits

 

(1)          *Financial Statements*. The followingconsolidated financial statements of the Company are filed with this report andcan be found at Item 8 of this Form 10-K**:**

 
| Consolidated  Statements of Operations for Years Ended December 30, 2005, December 31,  2004, and December 26, 2003 (as restated)                |   | 22     |   |
|-----------------------------------------------------------------------------------------------------------------------------------------------------------------|--------|--------|--------|
|                                                                                                                                                            |   |   |   |
| Consolidated Balance  Sheets as of December 30, 2005 and December 31, 2004                                                                            |   | 23     |   |
|                                                                                                                                                            |   |   |   |
| Consolidated  Statements of Shareholders’ Equity for Years Ended December 30, 2005,  December 31, 2004, and December 26, 2003 (as restated) |   | 24     |   |
|                                                                                                                                                            |   |   |   |
| Consolidated  Statements of Cash Flows for Years Ended December 30, 2005,  December 31, 2004, and December 26, 2003 (as restated)                |   | 25     |   |
|                                                                                                                                                            |   |   |   |
| Notes to  Consolidated Financial Statements                                                                                                                     |   | 26     |   |

 

(2)          *Financial Statement Schedules*. Allschedules for which provision is made in the applicable accounting regulationsof the SEC have been omitted as not required or not applicable, or theinformation required has been included elsewhere by reference in the financialstatements and related notes, except for Schedule II, which is included inthis Form 10-K.

 

(3)          *Exhibits*. See “Exhibit Index” on page 47of this Form 10-K for a description of the documents that are filed asExhibits to this report on Form 10-K or incorporated by reference herein.

 

(b)         SeeItem 15(a)(3) above.

(c)          SeeItem 15(a)(2) above.

 

45

----

 

**SIGNATURES**

 

Inaccordance with Section 13 or 15(d) of the Exchange Act, the registrantcaused this report to be signed on its behalf by the undersigned, thereuntoduly authorized.

 
| Date: March 15,  2006 | **ZOMAX  INCORPORATED** |
|----------------------------|-------------------------|
|                       | ** **              |
|                       | By                      | /s/ Anthony  Angelini |   |
|                       |                    | Anthony Angelini |
|                       |                    | Chief Executive  Officer |

 

Inaccordance with the Exchange Act, this report has been signed below by thefollowing persons on behalf of the registrant and in the capacities and on thedates indicated below.

 

Eachperson whose signature appears below constitutes and appoints Anthony Angeliniand Richard Barnes as the undersigned’s true and lawful attorneys-in-fact andagents, each acting alone, with full power of substitution and resubstitution,for the undersigned and in the undersigned’s name, place and stead, in any andall amendments to this Annual Report on Form 10-K and to file the same,with all exhibits thereto, and other documents in connection therewith, withthe Securities and Exchange Commission, granted unto said attorneys-in-fact andagents, each acting alone, full power and authority to do and perform eachand every act and thing requisite and necessary to be done in and about thepremises, as fully to all intents and purposes as the undersigned might orcould do in person, hereby ratifying and confirming all said attorneys-in-factand agents, each acting alone, or his substitute or substitutes, may lawfullydo or cause to be done by virtue thereof.

 
| **Name**                 | ** ** | **Title**                                             | ** ** | **Date**            | ** ** |
|--------------------------|------------|-------------------------------------------------------|------------|---------------------|------------|
|                     |       |                                                  |       |                |       |
| /s/Anthony Angelini      |       | Chief Executive  Officer and Director                 |       | March 15, 2006 |       |
| Anthony Angelini         |       | (principal  executive officer)                        |       |                |       |
|                     |       |                                                  |       |                |       |
| /s/Richard Barnes        |       | Executive Vice  President and Chief Financial Officer |       | March 15, 2006 |       |
| Richard Barnes           |       | (principal  financial and accounting officer)         |       |                |       |
|                     |       |                                                  |       |                |       |
| /s/Robert Ezrilov        |       | Director                                              |       | March 15, 2006 |       |
| Robert Ezrilov           |       |                                                  |       |                |       |
|                     |       |                                                  |       |                |       |
| /s/Howard P. Liszt       |       | Director                                              |       | March 15, 2006 |       |
| Howard P. Liszt          |       |                                                  |       |                |       |
|                     |       |                                                  |       |                |       |
| /s/Janice Ozzello Wilcox |       | Director                                              |       | March 15, 2006 |       |
| Janice Ozzello Wilcox    |       |                                                  |       |                |       |
|                     |       |                                                  |       |                |       |
| /s/Joseph J. Lahti       |       | Director                                              |       | March 15, 2006 |       |
| Joseph J. Lahti          |       |                                                  |       |                |       |
|                     |       |                                                  |       |                |       |
| /s/Paul F. Foley         |       | Director                                              |       | March 15, 2006 |       |
| Paul F. Foley            |       |                                                  |       |                |       |

 

46

----

 

**ZOMAX INCORPORATED**

**Schedule II - Valuation andQualifying Accounts**

**Year Ended December 30, 2005**

 
| **Description**                           | ** ** | **Balance at  beginning of  period** | ** ** | **Charges to  costs and  expenses** | ** ** | **Charged to  other  accounts** | ** ** | **Write-offs,  net of  recoveries** | ** ** | **Balance at  end of  period** | ** ** |
|-------------------------------------------|------------|------------------------------------------------|------------|-----------------------------------------------|------------|--------------------------------------|------------|------------------------------------------|------------|------------------------------------------|------------|
| **Allowance for doubtful accounts:**      |       |                                           |       |                                          |       |                                 |       |                                     |       |                                     |       |
|                                      |       |                                           |       |                                          |       |                                 |       |                                     |       |                                     |       |
| For the year ended December 30, 2005 |       | $                                              | 868,000    |                                          | (75,000    | )                                    | —     |                                     | (278,000   | )                                        | 515,000    |   |
|                                      |       |                                           |       |                                          |       |                                 |       |                                     |       |                                     |       |
| For the year ended December 31, 2004 |       | $                                              | 1,362,000  |                                          | (250,000   | )                                    | —     |                                     | (244,000   | )                                        | 868,000    |   |
|                                      |       |                                           |       |                                          |       |                                 |       |                                     |       |                                     |       |
| For the year ended December 26, 2003 |       | $                                              | 1,937,000  |                                          | (420,000   | )                                    | —     |                                     | (155,000   | )                                        | 1,362,000  |   |

 

47

----

 

**EXHIBIT INDEX TO FORM 10-K**

 
| **For the Fiscal Year Ended:** | ** ** | **Commission File No.** |
|--------------------------------|------------|-------------------------|
| **December 30, 2005**     | ** ** | **0-28426**             |

 
| **Exhibit  Number** | ** ** | **Description**                                                                                                                                                                                                                                                                                                                                                                               |
|---------------------|------------|-----------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------------|
| 3.1                 |       | Articles of Incorporation,  as amended (Incorporated by reference to Exhibit 3.1 to Annual Report on  Form 10-K for year ended December 29, 2000)                                                                                                                                                                                                                              |
| 3.2                 |       | Bylaws. (1)                                                                                                                                                                                                                                                                                                                                                                                   |
| **4.1**             | ** ** | **Form of Stock Certificate.  (1)**                                                                                                                                                                                                                                                                                                                                                      |
| 4.2                 |       | Articles of Incorporation (See Exhibit 3.1).                                                                                                                                                                                                                                                                                                                                             |
| 4.3                 |       | Bylaws (See Exhibit 3.2).                                                                                                                                                                                                                                                                                                                                                                |
| 10.1                |       | 1996 Stock Option Plan, as  amended through January 19, 2000, and Forms of Incentive and  Nonqualified Stock Option Agreements (Incorporated by reference to Exhibit 10.1  to Annual Report on Form 10-K for the year ended December 31,  1999).**                                                                                                                        |
| 10.2                |       | Lease between the Company and Nathan Lane Partnership, LLP dated January 1,  1995, as amended October 28, 1997 (Incorporated by reference to Exhibit 10.5  to Registration Statement on Form S-1, SEC File No. 333-2430 and Exhibit 10.15  to Annual Report on Form 10-KSB for the year ended December 26,  1997).                                    |
| 10.3                |       | License Agreement with U.S. Philips Corporation effective January 1,  1996 (Incorporated by reference to Exhibit 10.7 to Registration  Statement on form S-1, SEC File No. 333-2430).                                                                                                                                                                                     |
| 10.4                |       | License Agreement with  Discovision Associates dated January 1, 1994 (Incorporated by reference  to Exhibit 10.8 to Registration Statement on Form S-1, SEC File No. 333-2430).                                                                                                                                                                                           |
| 10.5                |       | Revolving Credit and Term  Loan Agreement between the Company and Marquette Capital Bank dated December 31,  1995, as amended April 30, 1997 (Incorporated by reference to Exhibit 10.16  to Registration Statement on Form S-1, SEC File No. 333-2430, and Exhibit 10.16  to Quarterly Report on Form 10-QSB for the quarter ended March 27,  1997). |
| 10.6                |       | Credit Agreement dated as of January 6, 1999 among the Company,  Certain Lenders and General Electric Capital Corporation. (2)                                                                                                                                                                                                                                                           |
| 10.7                |       | Credit Agreement dated as  of January 6, 1999 among Zomax Canada Company, Certain Lenders and  General Electric Capital Canada Inc. (2)                                                                                                                                                                                                                                                  |
| 10.8                |       | Lease between the Company  and The Scottish Provident Institution effective March 2, 2001  (Incorporated by reference to Exhibit 10.13 to Annual Report on Form 10-K  for the year ended December 28, 2001).                                                                                                                                                              |
| 10.9                |       | Form of Nonqualified  Option Agreement for options granted outside of 1996 Stock Option Plan  (Incorporated by reference to Exhibit 10.14 to Annual Report on Form 10-K  for the year ended December 27, 2002).**                                                                                                                                                         |
| 10.10               |       | 2004 Equity Incentive Plan  (Incorporated by reference to Appendix to proxy statement for 2004 Annual  Stockholders’ Meeting on April 23, 2004).**                                                                                                                                                                                                                                  |
| 10.11               |       | Stock Purchase Agreement dated July 8, 2004 between the Company  and Phillip T. Levin (Incorporated by reference to Exhibit 10.15 to  Annual Report on Form 10-K for the year ended December 31, 2004).                                                                                                                                                                   |
| 10.12               |       | Forms of Incentive Stock Option Agreement and Nonqualified Stock  Option Agreement currently used under 2004 Equity Incentive Plan  (Incorporated by reference to Exhibit 10.16 to Annual Report on Form 10-K  for the year ended December 31, 2004).**                                                                                                                        |
| 10.13               |       | Form of Restricted Stock Agreement currently used under 2004  Equity Incentive Plan (Incorporated by reference to Exhibit 10.17 to  Annual Report on Form 10-K for the year ended December 31, 2004).**                                                                                                                                                                   |
| 10.14               |       | 2004 Corporate Bonus Plan (Incorporated by reference to Exhibit 10.18  to Annual Report on Form 10-K for the year ended December 31,  2004).**                                                                                                                                                                                                                                 |
| 10.15               |       | Non-Employee Director Compensation Plan as of November 17, 2004  (Incorporated by reference to Exhibit 10.19 to Annual Report on Form 10-K  for the year ended December 31, 2004).**                                                                                                                                                                                      |
| 10.16               |       | Employment Agreement with Anthony Angelini effective April 14,  2005 (Incorporated by reference to Exhibit 10.1 to Current Report on Form 8-K  dated April 14, 2005 and filed April 15, 2005).**                                                                                                                                                                     |
| 10.17               |       | Employment Agreement with Michael L. Miller effective April 14,  2005 (Incorporated by reference to Exhibit 10.2 to Current Report on Form 8-K  dated April 14, 2005 and filed April 15, 2005).**                                                                                                                                                                    |
| 10.18               |       | Stipulation and Agreement of Settlement dated April 27, 2005  (Incorporated by reference to Exhibit 10.1 to Quarterly Report on Form 10-Q  for the quarter ended July 1, 2005).                                                                                                                                                                                           |
| 10.19               |       | Separation Agreement and Release with Robert J. Rueckl dated June 14,  2005 (Incorporated by reference to Exhibit 10.2 to Quarterly Report on Form 10-Q  for quarter ended July 1, 2005).**                                                                                                                                                                               |
| 10.20               |       | Replication Agreement with Microsoft Licensing, GP dated July 1,  2005 (Incorporated by reference to Exhibit 10.1 to Quarterly Report on Form 10-Q  for quarter ended July 1, 2005).                                                                                                                                                                                      |
| 10.21               |       | Employment Agreement with Richard D. Barnes effective August 22,  2005 (Incorporated by reference to Exhibit 10.1 to Current Report on Form 8-K  dated August 9, 2005 and filed August 10, 2005).**                                                                                                                                                                  |
| 10.22*              |       | Amendment to 2004 Equity Incentive Plan dated November 9, 2005**                                                                                                                                                                                                                                                                                                                         |
| 21.2                |       | Subsidiaries (Incorporated by reference to Exhibit 21.1 to Annual  Report on Form 10-K for the year ended December 31, 2004).                                                                                                                                                                                                                                                  |
| 23.1*               |       | Consent of Independent Registered Public Accounting Firm — Deloitte &  Touche LLP.                                                                                                                                                                                                                                                                                              |
| 24*                 |       | Power of Attorney (included on signature page of this report).                                                                                                                                                                                                                                                                                                                           |

 

48

----

 
| 31.1* |   | Certification of Chief Executive Officer pursuant to Section 302  of the Sarbanes-Oxley Act. |
|-------|--------|---------------------------------------------------------------------------------------------------|
| 31.2* |   | Certification of Chief Financial Officer pursuant to Section 302  of the Sarbanes-Oxley Act. |
| 32.1* |   | Certification of Chief Executive Officer pursuant to Section 906  of the Sarbanes-Oxley Act. |
| 32.2* |   | Certification of Chief Financial Officer pursuant to Section 906  of the Sarbanes-Oxley Act. |

 

49

----

 

----

| *   | Filed herewith.                                                                                                                            |
|-----|--------------------------------------------------------------------------------------------------------------------------------------------|
| **  | Management agreement or  compensatory plan or arrangement.                                                                                 |
| (1) | Incorporated by reference to the  corresponding exhibit numbers to Form S-1 Registration Statement,  SEC File No. 333-2430. |
| (2) | Incorporated by reference to  exhibits to current report on Form 8-K/A-1 dated January 7, 1999.                                  |

 

50

----