- Quarterly Report (10-Q)

UNITED STATES

SECURITIES AND EXCHANGE COMMISSION

Washington, D.C. 20549

FORM 10-Q

S	QUARTERLY REPORT PURSUANT TO SECTION 13 OR 15(d) OF THE SECURITIES EXCHANGE ACT OF 1934

FOR THE QUARTERLY PERIOD ENDED SEPTEMBER 30, 2008

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

Commission File Number 0-28488

ZONES, INC

(Exact name of registrant as specified in its charter)

Washington	91-1431894
(State of Incorporation)	(I.R.S. Employer Identification Number)

1102 15 th Street SW, Suite 102
Auburn, Washington	98001-6509
(Address of Principal Executive Offices)	(Zip Code)

(253) 205-3000

(Registrant's Telephone

Number, Including Area Code)

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

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

Large accelerated filer £ Accelerated filer £ Non-accelerated filer £ S maller reporting company S

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

The number of shares of the registrant's Common Stock outstanding as of November 12, 2008 was 13,229,613.

ZONES , INC.

INDEX

PART I. FINANCIAL INFORMATION

Item 1.	Consolidated Financial Statements (unaudited):

	Consolidated Balance Sheets September 30, 2008 and December 31, 2007	3

	Consolidated Statements of Operations Three and nine months ended September 30, 2008 and 2007	4

	Statements of Shareholders’ Equity Nine months ended September 30, 2008	5

	Consolidated Statements of Cash Flows Nine months ended September 30, 2008 and 2007	6

	Notes to Consolidated Financial Statements	7

Item 2.	Management’s Discussion and Analysis of Financial Condition and Results of Operations	12

Item 3.	Quantitative and Qualitative Disclosures About Market Risk	18

Item 4.	Controls and Procedures	18

PART II. OTHER INFORMATION

Item 1.	Legal Proceedings	19

Item 1A.	Risk Factors	19

Item 2.	Unregistered Sales of Equity Securities and Use of Proceeds	24

Item 6.	Exhibits	25

	Signatures	25

Index

P a rt I.

Item 1. Financial Statements

ZONES, INC.

CONSOLIDATED BALANCE SHEETS

(in thousands)

(unaudited)

	September 30,			December 31,
	2008			2007
ASSETS
Current assets:
Cash and cash equivalents	$	12,262		$	12,004
Receivables, net of allowances of $1,436 and $1,213		91,975			73,581
Vendor receivables, net of allowances of $744 and $780		14,917			15,139
Inventories		21,253			21,278
Prepaid expenses		909			861
Deferred income taxes		1,377			1,377
Total current assets		142,693			124,240
Property and equipment, net		3,214			3,383
Goodwill		5,098			5,098
Deferred income taxes		411			411
Other assets		203			190
Total assets	$	151,619		$	133,322

LIABILITIES AND SHAREHOLDERS' EQUITY
Current liabilities:
Accounts payable		46,124		$	37,040
Inventory financing		17,557			20,252
Accrued liabilities		14,736			11,479
Income taxes payable		1,969			510
Total current liabilities		80,386			69,281
Deferred rent obligation		1,567			1,733
Total liabilities		81,953			71,014

Commitments and contingencies

Shareholders' equity:
Common stock		35,672			35,676
Retained earnings		34,001			26,632
Accumulated other comprehensive loss		(7	)
Total shareholders' equity		69,666			62,308
Total liabilities and shareholders' equity	$	151,619		$	133,322

See notes to consolidated financial statements

Index

ZO NES, INC.

CONSOLIDATED STATEMENTS OF OPERATIONS

(in thousands, except per share data)

(unaudited)

	Three months ended September 30,					Nine months ended September 30,
	2008			2007		2008			2007

Net sales	$	197,720		$	162,970	$	522,809		$	503,384
Cost of sales		177,643			144,685		462,366			444,480
Gross profit		20,077			18,285		60,443			58,904

Selling, general and administrative		15,246			12,104		42,397			37,497
Advertising expenses		1,821			2,108		5,385			6,234
Income from operations		3,010			4,073		12,661			15,173

Other (income) expense, net		(127	)		5		(370	)		221
Income before taxes		3,137			4,068		13,031			14,952
Provision for income taxes		1,973			1,457		5,662			5,621
Net income	$	1,164		$	2,611	$	7,369		$	9,331


Basic income per share	$	0.09		$	0.20	$	0.56		$	0.71

Shares used in computing basic income per share		13,196			13,146		13,179			13,137

Diluted income per share	$	0.08		$	0.18	$	0.51		$	0.63

Shares used in computing diluted income per share		14,550			14,736		14,570			14,725

See notes to consolidated financial statements

Index

Z O NES, INC.

CONSOLIDATED STATEMENTS OF SHAREHOLDERS' EQUITY

(in thousands, except share data)

(unaudited)

	Common Stock						Accumulated Other Comprehensive			Retained
	Shares			Amount			Loss			Earnings		Total

Balance, January 1, 2008		13,133,114		$	35,676		$	-		$	26,632	$	62,308
Purchase and retirement of common stock		(47,600	)		(455	)							(455	)
Common stock issued		140,517			63								63
Excess tax benefit from stock options exercised					137								137
Stock-based compensation expense					251								251
Subtotal													62,304
Net income											7,369		7,369
Foreign currency translation adjustments								(7	)				(7	)
Comprehensive income													7,362
Balance, September 30, 2008		13,226,031		$	35,672		$	(7	)	$	34,001	$	69,666

See notes to consolidated financial statements

Index

ZO N ES, INC.

CONSOLIDATED STATEMENTS OF CASH FLOWS

(in thousands)

(unaudited)

	Nine months ended September 30,
	2008			2007
Cash flows from operating activities:
Net income	$	7,369		$	9,331
Adjustments to reconcile net income to net cash provided by (used in) operating activities:
Depreciation		1,201			1,362
Non-cash stock based compensation		251			129
Excess tax benefit from exercise of stock options		(137	)		(140	)
(Increase) decrease in assets and liabilities:
Receivables, net		(18,172	)		(17,247	)
Inventories		25			(1,503	)
Prepaid expenses and other assets		(61	)		240
Accounts payable		8,336			6,175
Accrued liabilities and deferred rent		3,091			(1,721	)
Income taxes payable		1,596			(378	)
Net cash provided by (used in) operating activities		3,499			(3,752	)

Cash flows from investing activities:
Purchases of property and equipment		(1,033	)		(1,301	)
Net cash used in investing activities		(1,033	)		(1,301	)

Cash flows from financing activities:
Net change in book overdraft		748			(1,218	)
Net change in line of credit					2,000
Net change in inventory financing		(2,695	)		1,824
Excess tax benefit from exercise of stock options		137			140
Purchase and retirement of common stock		(455	)		(552	)
Cancellation of common stock		(68	)
Proceeds from exercise of stock options		132			176
Net cash provided by (used in) financing activities		(2,201	)		2,370
Effect of foreign currency on cash flow		(7	)
Net increase (decrease) in cash and cash equivalents		258			(2,683	)
Cash and cash equivalents at beginning of period		12,004			9,191

Cash and cash equivalents at end of period	$	12,262		$	6,508

See notes to consolidated financial statements

Index

Z ON ES, INC.

NOTES TO CONSOLIDATED FINANCIAL STATEMENTS

(unaudited)

1. Description of Business

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

On July 30, 2008, we entered into an Agreement and Plan of Merger (the “Merger Agreement”) with Zones Acquisition Corp., a Washington corporation (“Acquisition Co.”). Under the terms of the Merger Agreement, Acquisition Co. will be merged with and into the Company, with the Company continuing as the surviving corporation (the “Merger”). Acquisition Co. is owned by our Chairman and Chief Executive Officer, Firoz Lalji.

On November 7, 2008, we announced that in order to reflect general economic conditions, we have updated our financial projections for 2009 and reached a preliminary understanding relative to a reduced price and other revised terms with Acquisition Co.

At the effective time of the Merger, each issued and outstanding share of common stock of the Company (the “Common Stock”), other than any shares owned by Mr. Lalji and certain related parties who will remain shareholders of the Company (collectively, the “Continuing Investors”), by Acquisition Co., by the Company, and by any shareholders who are entitled to and who properly exercise dissenters’ rights under Washington law, will be converted into the right to receive $7.00 in cash, without interest.

Our Board of Directors approved the Merger Agreement on the unanimous recommendation of a Special Committee composed solely of independent directors (the “Special Committee”).

We have made customary representations, warranties and covenants in the Merger Agreement, which expire at the effective time of the Merger. The Merger Agreement permitted us to solicit superior proposals from third parties until September 4, 2008, subject to an extension to September 17, 2008 in the discretion of the independent members of the Board of Directors. In addition, we may, at any time, subject to the terms of the Merger Agreement, respond to unsolicited proposals. There can be no assurance that this process will result in an alternative transaction to be acquired by a third party. We do not intend to disclose developments with respect to the solicitation process unless and until our Board of Directors has made a decision.

Acquisition Co. has obtained conditional equity and debt financing commitments or term sheets for the transactions contemplated by the Merger Agreement and has represented to us that the aggregate proceeds of such financing commitments or term sheets will be sufficient for Acquisition Co. to pay the aggregate merger consideration and all related fees and expenses. Consummation of the Merger is not subject to a financing condition, but is subject to various other conditions, including approval of the Merger not only by a majority of our shareholders generally but also by shareholders holding a majority of shares present in person or by proxy and voting at the shareholders’ meeting other than Mr. Lalji and the other Continuing Investors, and other customary closing conditions. The parties expect to close the transaction in the fourth quarter of 2008.

The Merger Agreement may be terminated under certain circumstances, including if our Board of Directors (or the Special Committee) has determined in good faith that it has received a superior proposal and otherwise complies with certain terms of the Merger Agreement. Upon the termination of the Merger Agreement, under specified circumstances, we will be required to pay Acquisition Co. a termination fee of $750,000. Additionally, under specified circumstances, Acquisition Co. will be required to pay us a termination fee of $750,000. Mr. Lalji has agreed to guarantee any such amounts payable by Acquisition Co. to us.

Index

This description of the Merger and the Merger Agreement is only a summary, does not purport to be complete and is qualified in its entirety by reference to the Merger Agreement, which was attached as Exhibit 2.1 to our Current Report on Form 8-K as filed with the SEC on July 31, 2008, and is incorporated herein by reference.

2. Summary of Significant Accounting Policies

The accompanying unaudited consolidated financial statements and notes have been prepared in accordance with the rules and regulations of the Securities and Exchange Commission and consequently do not include all of the disclosures normally required by generally accepted accounting principles.

Basis of Presentation

In the opinion of management, the accompanying unaudited consolidated financial statements reflect all adjustments (consisting of normal recurring accruals) which in the opinion of management are necessary for a fair statement of the financial position and operating results for the interim periods presented. The results of operations for such interim periods are not necessarily indicative of results for the full year. These financial statements should be read in conjunction with the audited financial statements and notes thereto contained in our Annual Report on Form 10-K for the year ended December 31, 2007 as filed with the Securities and Exchange Commission on March 3, 2008, as amended on October 15, 2008.

Summary of significant accounting policies

The significant accounting policies used in the preparation of our financial statements are disclosed in our Annual Report on Form 10-K for the year ended December 31, 2007, as amended.

Goodwill

In accordance with SFAS No. 142,"Goodwill and Other Intangible Assets," goodwill is tested for impairment annually on the purchase date or sooner when events indicate that a potential impairment exists. We perform the assessment annually on March 31, and all goodwill relates to the purchase of Corporate PC Source, Inc. There were no changes to the carrying amount of goodwill for the period ended September 30, 2008.

Revenue Recognition

We adhere to the revised guidelines and principles of sales recognition in Staff Accounting Bulletin No. 104 (“SAB 104”), “Revenue Recognition,” issued by the staff of the SEC as a revision to Staff Accounting Bulletin No. 101, “Revenue Recognition.” We recognize revenue on product sales when persuasive evidence of an arrangement exists, delivery has occurred, prices are fixed or determinable, and ability to collect is probable. We consider the point of delivery of the product to be when the risks and rewards of ownership have transferred to the customer. Our shipping terms dictate that the passage of title occurs upon receipt of products by the customer except for the last seven calendar days of each fiscal quarter, when all shipments are insured in the name of the customer. For these seven days, passage of risk of loss and title occur at the shipping point.

The majority of our sales relate to physical products. For all product sales, shipped directly from our warehouse or from our suppliers to customers, we are the primary obligor, have full latitude in establishing price with the customer, select the supplier to provide the product, take title to the product sold upon shipment, bear credit risk, and bear inventory risk for returned products. These sales are recognized on a gross basis with the selling price to the customer recorded as sales and the acquisition cost of the product recorded as cost of sales. Additionally, amounts billed for shipping and handling are recorded as sales.

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

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

Index

Sales are reported net of sales, use or other transaction taxes that are collected from the customers and remitted to taxing authorities. Sales are reported net of returns and allowances. We offer limited return rights on our product sales. We make what we believe to be reasonable estimates of product returns based on significant historical experience. We had allowances for sales returns of $90,000 and $76,000 at September 30, 2008 and December 31, 2007, respectively.

Stock Based Compensation

We maintain equity incentive plans under which we may grant non-qualified stock options, incentive stock options, restricted stock, restricted stock units (“RSU”) or stock appreciation rights to team members and non-employee directors. We issue new shares of common stock upon exercise of stock options, grant of restricted stock and the vesting of RSUs.

Each stock option granted has an exercise price of 100% of the market value of the common stock on the date of the grant. The options generally have a contractual life of 10 years and vest and become exercisable in 20% increments over five years. As of September 30, 2008, there was $30,000 of total unrecognized pre-tax compensation expense related to non-vested stock options granted under our equity incentive plans. This cost is expected to be recognized over a weighted-average period of 1.00 year. We granted no stock options in the nine months ended September 30, 2008 or 2007. We granted 75,000 shares of performance based restricted stock to certain team members during the second quarter of 2008. As of September 30, 2008, there was $426,000 of total unrecognized pre-tax compensation expense related to non-vested performance-based restricted stock granted under our equity incentive plans. This cost, subject to achieving specific performance milestones, is expected to be recognized over a weighted-average period of 1.91 years.

Earnings Per Share

Earnings per share (“EPS”) is based on the weighted average number of shares outstanding during the period. Basic EPS excludes all dilution. Diluted EPS reflects the potential dilution that would occur if securities or other contracts to issue common stock were exercised or converted into common stock. We exclude all options to purchase common stock from the calculation of diluted net income per share if such securities are antidilutive.

Recent Accounting Pronouncements

In September 2006, the FASB issued SFAS No. 157, “Fair Value Measurements” (“SFAS 157”), which defines fair value, establishes a framework for measuring fair value in generally accepted accounting principles and expands disclosures about fair value measurements. SFAS 157 is effective for financial statements issued for fiscal years beginning after November 15, 2007, and interim periods within those fiscal years. SFAS 157 is effective for our fiscal year 2008. In February 2008, the FASB issued Staff Position No. 157-2, which provides a one-year delayed application of SFAS 157 for nonfinancial assets and liabilities, except for items that are recognized or disclosed at fair value in the financial statements on a recurring basis (at least annually). Early adoption is permitted. The adoption of SFAS 157 did not have a significant effect on our consolidated financial statements.

In February 2007, the FASB issued SFAS No. 159, “The Fair Value Option for Financial Assets and Financial Liabilities” (“SFAS 159”). Under SFAS 159, entities may elect to measure specified financial instruments and warranty and insurance contracts at fair value on a contract-by-contract basis, with changes in fair value recognized in earnings each reporting period. The election, called the fair value option, will enable entities to achieve an offset accounting effect for changes in fair value of certain related assets and liabilities without having to apply complex hedge accounting provisions. SFAS 159 is effective as of the beginning of a company’s first fiscal year that begins after November 15, 2007. The adoption of SFAS 159 did not have a significant effect on our consolidated financial statements.

In December 2007, the FASB issued SFAS No. 141 (revised 2007), “Business Combinations” (“SFAS 141R”), which replaces SFAS No. 141. SFAS 141R establishes principles and requirements for how an acquirer recognizes and measures in its financial statements the identifiable assets acquired, the liabilities assumed, any resulting goodwill, and any noncontrolling interest in the acquiree. SFAS 141R also provides for disclosures to enable users of the financial statements to evaluate the nature and financial effects of the business combination. SFAS 141R is effective for financial statements issued for fiscal years beginning after December 15, 2008 and must be applied prospectively to business combinations completed on or after that date. We will evaluate how the new requirements could impact the accounting for any acquisitions completed beginning in fiscal 2009 and beyond, and the potential impact on our consolidated financial statements.

Index

3. Earnings Per Share

We have 45,000,000 common shares authorized. We have granted options to purchase common shares or restricted stock to certain team members and our non-employee directors. The following is a reconciliation of the numerators and denominators of the basic and diluted earnings per share computations (in thousands, except per share data).

	Three months ended September 30,				Nine months ended September 30,
	2008		2007		2008		2007
Basic earnings per share:

Net income	$	1,164	$	2,611	$	7,369	$	9,331

Weighted average shares outstanding		13,196		13,146		13,179		13,137

Basic income per share	$	0.09	$	0.20	$	0.56	$	0.71

Diluted earnings per share:

Net income	$	1,164	$	2,611	$	7,369	$	9,331

Weighted average shares outstanding		13,196		13,146		13,179		13,137
Stock options		1,354		1,590		1,391		1,588
Total common shares and dilutive securities		14,550		14,736		14,570		14,725

Diluted income per share	$	0.08	$	0.18	$	0.51	$	0.63

For the three and nine months ended September 30, 2008 and 2007, 77,768 shares attributable to outstanding stock options were excluded from the calculation of diluted earnings per share because the effect was anti-dilutive. For the three and nine months ended September 30, 2008, 56,250 shares attributable to outstanding stock grants were excluded from the calculation of diluted earnings per share based on assumptions determining the probability of the performance criterion.

4. Comprehensive Income

Our total comprehensive income was as follows for the periods presented (in thousands):

	Three months ended September 30,					Nine months ended September 30,
	2008			2007		2008			2007

Net income	$	1,164		$	2,611	$	7,369		$	9,331
Other comprehensive income (loss):
Foreign currency adjustments		(4	)				(7	)
Total comprehensive income	$	1,160		$	2,611	$	7,362		$	9,331

Index

5. Commitments and Contingencies

Legal Proceedings

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

On August 13, 2008, a putative shareholder class action was filed in the Superior Court of Washington for King County against us, our Board of Directors and Acquisition Co. The lawsuit alleged that members of our Board of Directors breached their fiduciary duties, and that Acquisition Co. aided and abetted those alleged breaches of fiduciary duties by entering into the Merger Agreement. The lawsuit alleged, among other things, that the merger price was “unfair,” that the merger agreement precluded competitive bidding by other potential acquirers, and that the preliminary proxy statement filed by the Company with the SEC was misleading or incomplete. Plaintiff sought, among other relief, to enjoin the merger, rescission of the merger, accounting for any improper profits received by the defendants, and attorneys’ fees.

On October 14, 2008, the defendants entered into a memorandum of understanding with the plaintiff providing for the settlement of the lawsuit, subject to customary conditions, including completion of appropriate settlement documentation, confirmatory discovery and all necessary court approvals. As contemplated by the memorandum of understanding, we have included certain additional disclosures in our proxy statement filed on October 17, 2008. While we believe this lawsuit is without merit, we have entered into the memorandum of understanding to avoid the risk of delaying the merger and to minimize the expense of defending the action. The settlement, if completed and approved by the court, will resolve all of the claims that were or could have been brought in the action, including all claims relating to the merger. In connection with the settlement, we have agreed not to contest a petition by plaintiff’s counsel for up to $160,000 in attorneys’ fees and up to $10,000 in actual out-of-pocket expenses, subject to court approval.

Related Party

In June 2004, Fana Auburn LLC, a company owned by one of our officers, who is a majority shareholder and a member of our board of directors, purchased the property and buildings in which our headquarters are located, subject to the existing 11-year lease. Under the terms of the lease agreement, we are obligated to pay lease payments aggregating from $1.0 million to $1.3 million per year, plus apportioned real estate taxes, insurance and common area maintenance charges. Our Audit Committee reviewed and approved this related party transaction, and also the potential corporate opportunity, recognizing that in the future we may have to renew and renegotiate our lease and that such renewal and renegotiation would also present a related party transaction, which would be subject to further Audit Committee review and consideration. In May 2006, after further review and approval by our Audit Committee, we signed an amendment to the lease agreement increasing the rentable square feet by approximately 18,923 square feet. The additional square feet increased our annual lease payment by $259,000. Effective January 1, 2007, we have approximately 125,196 rentable square feet located at 1102 15 th Street SW, Auburn, WA. In April 2007, we received a tenant improvement reimbursement from Fana Auburn LLC in the amount of $378,000 related to construction on the additional leased space, which will be amortized over the remaining life of the lease. For the three months ended September 30, 2008 and 2007 we paid Fana Auburn LLC $540,000 and $535,000, respectively, related to the lease, which is recorded in selling, general and administrative expenses. For the nine months ended September 30, 2008 and 2007 we paid Fana Auburn LLC $1.6 million related to the lease, which is recorded in selling, general and administrative expenses.

Index

6. Segment Information

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

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

	Three months ended September 30,				Nine months ended September 30,
	2008		2007		2008		2007
Notebooks & PDA’s	$	35,907	$	20,855	$	114,591	$	70,876
Desktops & Servers		37,198		30,383		92,019		111,131
Software		37,795		38,362		94,095		93,269
Storage		10,192		10,517		32,577		35,443
NetComm		9,309		9,285		25,153		26,264
Printers		14,146		13,111		37,587		40,895
Monitors & Video		28,884		16,217		54,227		48,087
Memory & Processors		5,556		7,865		14,871		24,538
Accessories & Other		18,733		16,375		57,689		52,881

Substantially all of our net sales for the three and nine months ended September 30, 2008 and 2007 were made to customers located in the United States. Substantially all of our assets at September 30, 2008 and December 31, 2007 were located within the United States. The amount of service revenue included in net sales for the three and nine months ended September 30, 2008 was $2.1 million and $7.6 million, respectively, and represented 1.1% and 1.5% of net sales, respectively. For the three and nine months ended September 30, 2007, service revenue included in net sales was $1.6 million and $5.3 million, respectively, representing 1.0% and 1.1% of net sales, respectively. For the three months ended September 30, 2008, and the nine months ended September 30, 2008 and 2007, we had one customer that individually represented more than 10% of total net sales. Net sales to this customer were $29.3 million for the three months ended September 30, 2008. Net sales to this customer were $68.6 million and $58.3 million for the nine months ended September 30, 2008 and 2007, respectively. Trade receivables for this customer represented approximately 18.4% and 0.8% of total trade receivables at September 30, 2008 and 2007, respectively. Also, for the three months ended September 30, 2008, we had an additional customer which represented 9.7% of total net sales, or $19.1 million, and represented approximately 5.6% of total trade receivables at September 30, 2008.

7. Share Repurchase Program

Since 2004, we have repurchased a total of 1,568,845 shares of our common stock at a total cost of $8.4 million under our repurchase program authorized by our Board of Directors. Share repurchases may be made from time to time in both open market and private transactions, as conditions warrant, at then prevailing market prices. As of September 30, 2008, $2.5 million remained available for repurchase of shares of our common stock under the program. The current repurchase program is expected to remain in effect through February 2009, unless earlier terminated by the Board or completed.

It em 2. Management’s Discussion and Analysis of Financial Condition and Results of Operations

This section contains forward-looking statements based on management’s current expectations, estimates and projections about the industry, management’s beliefs, and certain assumptions made by management. These statements are made pursuant to the safe harbor provision of the Private Securities Litigation Reform Act of 1995. All statements, trends, analyses and other information contained in this report relative to trends in net sales, gross margin and anticipated expense levels, as well as other statements, including words such as “anticipate,” “believe,” “plan,” “expect,” “estimate,” “intend” and other similar expressions, constitute forward-looking statements. These forward-looking statements involve risks and uncertainties, and actual results may differ materially from those anticipated or expressed in such statements. Potential risks and uncertainties that may cause actual results to differ materially from those expressed or implied include, among others, those set forth in Item 1A of this document and those contained in our Annual Report on Form 10-K for the year ended December 31, 2007 as filed with the Securities and Exchange Commission on March 3, 2008 and amended on October 15, 2008. Except as required by law, we undertake no obligation to update any forward-looking statement, whether as a result of new information, future events or otherwise.

Index

The following discussion and analysis should be read in conjunction with our Consolidated Financial Statements and Notes included in this quarterly report on Form 10-Q. As used in this quarterly report on Form 10-Q, unless the context otherwise requires, the terms “the Company,” “we” and “Zones” refer to Zones, Inc., a Washington corporation.

General

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

Overview

We are a direct marketing reseller of technology hardware, software and services. We procure and fulfill IT solutions for the SMB market (between 50 and 1000 computer users), large and enterprise customers (greater than 1000 computer users) and the public sector (education and state and local governments). Relationships with SMB, large and enterprise customers, and public sector institutions represented 99.5% and 99.1% of total net sales during the nine months ended September 30, 2008 and 2007, respectively. The remaining sales were from inbound customers, primarily consumers and small office/home office accounts purchasing mostly Mac platform products.

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

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

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

We are dedicated to creating a learning community of empowered individuals to serve our customers with integrity, commitment and passion. At September 30, 2008 we had 781 team members in our consolidated operations, 365 of whom were inbound and outbound account executives. The majority of our team members work at our corporate headquarters in Auburn, Washington.

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

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Critical Accounting Policies

In Item 7 (“Management’s Discussion and Analysis of Financial Condition and Results of Operations”) of our Annual Report on Form 10-K for the year ended December 31, 2007, which was filed with the Securities and Exchange Commission on March 3, 2008 as amended on October 15, 2008, we included a discussion of the most significant accounting policies and estimates used in the preparation of our financial statements. There has been no material change in the policies and estimates used in the preparation of our financial statements since the filing of our most recent annual report.

Results of Operations

The following table presents our unaudited consolidated results of operations, as a percentage of net sales, and selected operating data for the periods indicated.

	Three months ended September 30,						Nine months ended September 30,
	2008			2007			2008			2007
Net sales		100.0	%		100.0	%		100.0	%		100.0	%
Cost of sales		89.8			88.8			88.4			88.3
Gross profit		10.2			11.2			11.6			11.7
Selling, general and administrative expenses		7.7			7.4			8.1			7.4
Advertising expenses, net		0.9			1.3			1.0			1.2
Income from operations		1.6			2.5			2.5			3.1
Other (income) expense, net		(0.1	)		0.0			(0.1	)		0.1
Income before income taxes		1.7			2.5			2.6			3.0
Provision for income taxes		1.0			0.9			1.1			1.1
Net income		0.7	%		1.6	%		1.5	%		1.9	%

Selected operating data:
Sales force, end of period		365			337			365			337

Product mix (% of net sales):
Notebooks & PDA’s		18.2	%		12.8	%		21.9	%		14.1	%
Desktops & Servers		18.8			18.6			17.6			22.1
Software		19.1			23.5			18.0			18.5
Storage		5.2			6.5			6.2			7.0
NetComm		4.7			5.7			4.8			5.2
Printers		7.2			8.0			7.2			8.1
Monitors & Video		14.6			10.0			10.4			9.6
Memory & Processors		2.8			4.8			2.8			4.9
Accessories & Other		9.4			10.1			11.1			10.5

Comparison of Three Month Periods Ended September 30, 2008 and 2007

Net Sales. Consolidated net sales for the quarter ended September 30, 2008 increased 21.3% to $197.7 million compared with $163.0 million in the comparable period in 2007. Consolidated outbound sales to commercial and public sector accounts increased 21.8% to $196.9 million in the quarter ended September 30, 2008 from $161.7 million in the comparable period in 2007. Sales to our SMB customers increased 2.3% to $72.9 million for the quarter ended September 30, 2008 from $71.2 million in the comparable period in 2007. Growth in the SMB sales was primarily due to increased sales force headcount and tenure. Sales to our large enterprise customers are often defined by large non-recurring product roll-outs and specific contractual obligations which have expiration dates. Sales to our large enterprise customers increased 48.8% to $114.7 million in the quarter ended September 30, 2008 compared with $77.1 million in the comparable period in 2007. The sales increase is primarily related to two major customers’ third quarter 2008 projects. Sales to these customers increased $39.5 million in the third quarter of 2008 compared to the same period in 2007. Net sales to public sector customers decreased to $9.3 million in the quarter ended September 30, 2008 from $13.3 million in the comparable period in 2007 primarily due to a prior year software sale that was not repeated in the current year. Inbound sales to consumer and small office/home office customers declined 36.9% to $826,000, which represented 0.4% of net sales.

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Gross Profit. Consolidated gross profit increased to $20.1 million for the quarter ended September 30, 2008, compared with $18.3 million in the comparable period in 2007. The increase in gross profit dollars was primarily related to our increased sales volumes. Gross profit as a percentage of net sales decreased to 10.2% in the quarter ended September 30, 2008 compared with 11.2% in the corresponding period of the prior year, driven by the low margin sales to the major customers responsible for the sales increase in the third quarter of 2008. Gross profit margins will continue to vary, and may decline from current levels, due to changes in vendor programs, product mix, pricing strategies, customer mix, the sale of third-party services and other fee or commission based sales, and economic conditions. Lastly, we categorize our warehousing and distribution network costs in selling, general and administrative expenses. Due to this classification, gross profit may not be comparable to a company that includes its warehousing and distribution network costs as a cost of sales.

Selling, General and Administrative Expenses. SG&A expenses increased 26.0% to $15.2 million for the quarter ended September 30, 2008, compared with $12.1 million in the comparable period in 2007. As a percent of sales, SG&A increased to 7.7% for the quarter ended September 30, 2008 from 7.4% in the third quarter of 2007, primarily due to the cost associated with the going-private transaction as well as increases in salaries, wages and benefits.

Salaries, wages and benefits increased $1.6 million during the quarter ended September 30, 2008 compared with the comparable period in 2007, primarily related to increased headcount and variable compensation expense as a result of achieving certain 2008 performance goals.

Professional fees have increased $1.2 million for the quarter ended September 30, 2008 compared with the comparable period in 2007, primarily due to increased legal and consulting fees related to the going–private transaction. We anticipate an additional $2.0 million to $4.0 million in expenses associated with our going-private transaction to occur in the fourth quarter of 2008.

For the quarters ended September 30, 2008 and 2007, warehousing and distribution network costs totaled $510,000 and $482,000, respectively.

Advertising Expenses, net . We produce and distribute direct mail collateral, targeted campaign materials and catalogs at various intervals throughout the year to increase awareness of our brand and stimulate demand response. Our net cost of advertising decreased $300,000 to $1.8 million in the quarter ended September 30, 2008 from $2.1 million in the comparable period in 2007.

Gross advertising expense decreased to $2.2 million for the quarter ended September 30, 2008 compared with $2.6 million in the comparable period in 2007, primarily due to decreased expenses associated with a reduction in catalog circulation.

Gross advertising vendor reimbursements decreased to $396,000 in the quarter ended September 30, 2008 from $530,000 in the comparable period in 2007. As advertising programs with our vendor partners have become more comprehensive, we have classified substantially all vendor consideration as a reduction of cost of goods sold rather than a reduction of advertising expense.

Other Income/Expense, net. Other income was $127,000 for the quarter ended September 30, 2008 compared with $5,000 in other expense for the comparable period in 2007. There was no interest expense in the quarter ended September 30, 2008, as we had no interest-bearing borrowings under our working capital line of credit, compared with expense of $50,000 for the comparable period in 2007. Interest income for the quarter ended September 30, 2008 was $127,000, compared with $45,000 for the comparable period in 2007. Interest income is earned on short-term investments and finance charges collected from certain customers, both which vary from period to period.

Provision for Income Taxes. The provision for income taxes for the quarter ended September 30, 2008 was $2.0 million compared to $1.5 million in the comparable period in 2007. Our effective tax rate expressed as a percentage of income before taxes has increased to 62.9% for the quarter ended September 30, 2008 compared with 35.8% for the comparable period in 2007. The increase was primarily due to a year-to-date rate adjustment required to increase the estimated 2008 annual tax rate to 43.5%. The increase in the estimated 2008 annual tax rate was related to the non-deductibility of the going-private transaction expenses.

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Net Income. Net income for the quarter ended September 30, 2008 was $1.2 million compared with $2.6 million in the comparable period in 2007. Basic and diluted income per share was $0.09 and $0.08, respectively, for the three months ended September 30, 2008, compared with $0.20 and $0.18, respectively, for the quarter ended September 30, 2007.

Comparison of Nine Month Periods Ended September 30, 2008 and 2007

Net Sales. Consolidated net sales for the nine months ended September 30, 2008 increased 3.9% to $522.8 million compared with $503.4 million in the nine months ended September 30, 2007. Our sales account executive headcount increased to 365 at September 30, 2008 compared with 337 at September 30, 2007. Consolidated outbound sales to commercial and public sector accounts increased 4.2% to $520.0 million in the nine months ended September 30, 2008 from $499.0 million in the corresponding period of the prior year. Sales to our SMB customers increased 2.9% to $215.6 million for the nine months ended September 30, 2008 from $209.5 million in the comparable period of 2007. Growth in SMB sales was primarily due to increased sales force headcount and tenure of each sales account executive. Sales to our large enterprise customers increased 8.1% to $283.8 million in the first nine months of 2008 compared with $262.5 million for the comparable period in 2007. Most of the sales increase in the nine months ended September 30, 2008 was a result of sales to two major customers’ to fulfill third quarter projects. Sales to these customers for the nine months ended September 30, 2008 were $89.9 million compared with $62.5 million in the corresponding period in 2007. Net sales to public sector customers decreased to $20.7 million in the first nine months of 2008 from $27.0 million for the comparable period in 2007. Inbound sales to consumer and small office home office customers declined 36.6% to $2.8 million, which represented 0.5% of net sales.

Gross Profit. Consolidated gross profit increased 2.6% to $60.4 million for the nine months ended September 30, 2008, compared with $58.9 million in the first nine months of 2007. The increase was primarily due to the increase in sales volumes. Gross profit as a percentage of net sales decreased slightly to 11.6% in the nine months ended September 30, 2008 compared with 11.7% in the corresponding period of the prior year. Gross profit margins will continue to vary, and may decline from current levels, due to changes in vendor programs, product mix, pricing strategies, customer mix, the sale of third-party services and other fee or commission based sales, and economic conditions. Lastly, we categorize our warehousing and distribution network costs in selling, general and administrative expenses. Due to this classification, gross profit may not be comparable to a company that includes its warehousing and distribution network expenses as a cost of sales.

Selling, General and Administrative Expenses. SG&A expenses increased to $42.4 million for the nine months ended September 30, 2008 compared with $37.5 million in the comparable period of 2007. As a percent of sales, SG&A increased to 8.1% for the nine months ended September 30, 2008 from 7.4% in the nine months ended September 30, 2007. The increase in SG&A expenses was primarily due to the following factors:

Salaries, wages and benefits increased $2.9 million during the nine months ended September 30, 2008 compared to the comparable period in 2007, primarily due to the $1.6 million salary increase as the result of headcount change. Our total headcount increased to 781 team members at September 30, 2008 compared to 687 at September 30, 2007. Also, variable compensation expenses increased by $626,000 for the first nine month of 2008 in comparison to the same period of the prior year due to the achievement of certain performance goals.

Professional fees increased $1.6 million for the nine months ended September 30, 2008 compared with the nine months ended September 30, 2007, generally represents increased legal and consulting fees related to the going–private transaction. We anticipate an additional $2.0 million to $4.0 million in expenses associated with our going-private transaction to occur in the fourth quarter of 2008.

Bad debt expense increased $318,000 for the nine months ended September 30, 2008 to $426,000, compared with $108,000 for the nine months ended September 30, 2007, primarily due to the adjustment of allowances for the increase in trade accounts receivable.

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For the nine months ended September 30, 2008 and 2007, warehousing and distribution network costs remained flat at $1.7 million.

Advertising Expenses, net . We produce and distribute direct mail collateral, targeted campaign materials and catalogs at various intervals throughout the year to increase awareness of our brand and stimulate demand response. Our net cost of advertising decreased to $5.4 million for the nine months ended September 30, 2008 from $6.2 million in the comparable period in 2007.

Gross advertising expense decreased to $6.5 million for the first nine months of 2008 compared with $7.5 million in the first nine months of 2007, primarily due to a decline in expenses associated with catalog distribution and vendor-specific marketing activities.

Gross advertising vendor reimbursements decreased to $1.1 million in the nine months ended September 30, 2008 from $1.3 million in the nine months ended September 30, 2007. As advertising programs with our vendor partners have become more comprehensive, we have classified substantially all vendor consideration as a reduction of cost of goods sold rather than a reduction of advertising expense.

Other Income/Expense, net. Other income increased to $370,000 for the nine months ended September 30, 2008 compared with $221,000 other expense recorded in the nine months ended September 30, 2007. Interest expense related to our use of the working capital line was $1,000 and $357,000 for the nine month periods ended September 30, 2008 and 2007, respectively. Interest income was $372,000 for the nine months ended September 30, 2008 compared with $140,000 for the nine months ended September 30, 2007. Interest income is earned on short-term investments and finance charges collected from certain customers, both of which vary from period to period.

Provision for Income Taxes. The provision for income taxes for the nine months ended September 30, 2008 was $5.7 million compared to $5.6 million in the comparable period of the prior year. Our effective tax rate expressed as a percentage of income before taxes was 43.5% for the nine months ended September 30, 2008 compared to 37.6% for the nine months ended September 30, 2007. The increase of our effective tax rate was primarily due to the non-deductibility of the expenses associated with our going-private transaction.

Net Income. Net income for the nine months ended September 30, 2008 was $7.4 million compared to $9.3 million in the first nine months of 2007. Basic and diluted income per share was $0.56 and $0.51, respectively, for the nine months ended September 30, 2008, compared with $0.71 and $0.63, respectively, for the nine months ended September 30, 2007.

Liquidity and Capital Resources

Stock Repurchase Program.

Since 2004, we have repurchased a total of 1,568,845 shares of our common stock at a total cost of $8.4 million under our repurchase program authorized by our Board of Directors. Share repurchases may be made from time to time in both open market and private transactions, as conditions warrant, at then prevailing market prices. As of September 30, 2008, $2.5 million remained available for share repurchases under the program. The current repurchase program is expected to remain in effect through February 2009, unless earlier terminated by the Board or completed.

There was no activity under our repurchase program during the quarter ended September 30, 2008.

Working Capital.

Our total assets were $151.6 million at September 30, 2008, of which $142.7 million were current assets. At September 30, 2008 and December 31, 2007, we had cash and cash equivalents of $12.3 million and $12.0 million, respectively, and had working capital of $62.3 million and $55.0 million, respectively. The increase in working capital was primarily a result of an increase in our trade accounts receivable.

Approximately 95% of our sales are processed on open account terms offered to our customers, and we typically experience significant sales during the last month of the period on open account, which could cause fluctuation in our accounts receivable balance. To finance these sales, we leverage our secured line of credit to offset timing differences in cash inflows and cash outflows, to invest in capital equipment purchases, to purchase inventory for general stock as well as for identified customers, and to take full advantage of available early pay discounts.

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We have a $50.0 million secured line of credit facility with a major financial institution, which is collateralized by accounts receivable and inventory, and it can be utilized as both a working capital line of credit and an inventory financing facility to purchase products from several suppliers under certain terms and conditions. This credit facility has an annual automatic renewal which occurs on November 26 of each year. Either party can terminate this agreement with 60 days written notice prior to the renewal date. The working capital and inventory advances bear interest at a rate of Prime plus 0.50%. Our line of credit is defined by quick turnover, large amounts and short maturities. All amounts owed under the line of credit are due on demand. Amounts owed under the inventory financing facility do not bear interest if paid within terms, usually 30 days from invoice date. The facility contains various restrictive covenants relating to tangible net worth, leverage, dispositions and use of collateral, other asset dispositions, and merger and consolidation. At September 30, 2008, there were no outstanding working capital advances, and inventory financing arrangements of $14.5 million were owed to this financial institution. At September 30, 2008, we were in compliance with all covenants of this facility.

We believe that our existing available cash and cash equivalents, operating cash flow, and existing credit facilities will be sufficient to satisfy our operating cash needs, and to fund the remaining balance of $2.5 million authorized in our stock repurchase program, for at least the next 12 months at our current level of business. However, if our working capital or other capital requirements are greater than currently anticipated, we could be required to reduce or curtail our stock repurchase program and seek additional funds through sales of equity, debt or convertible securities, or through increased credit facilities. There can be no assurance that additional financing will be available or that, if available, the financing will be on terms favorable to us and our shareholders.

Cash Flows

Net cash provided by operating activities was $3.5 million in the nine months ended September 30, 2008. The primary factors that affected cash flow from operating activities during this period were account and vendor receivables and accounts payable levels. Account and vendor receivables increased $18.2 million, offset by increases in accounts payable of $8.3 million, due to increased sales volumes.

Net cash used in investing activities was $1.0 million in the nine months ended September 30, 2008. Cash outlays for capital expenditures were $1.0 million for the nine months ended September 30, 2008. Capital expenditures were primarily for leasehold improvements to our corporate headquarters, and continued improvement and other enhancements of our information systems. We intend to continue to upgrade our internal information systems as a means to increase operational efficiencies.

The most significant components of our financing activities are: the net change in inventory financing and the purchase of common stock under our share repurchase program. For the nine month period ended September 30, 2008, inventory financing decreased $2.7 million due to fluctuations in our purchasing and payment cycles. During the same period we repurchased $455,000 of our common stock under our share repurchase program.

I te m 3. Quantitative and Qualitative Disclosures About Market Risk

We are subject to the risk of fluctuating interest rates in the normal course of business, primarily as a result of our short-term borrowing and investment activities, which generally bear interest at variable rates. Because the short-term borrowings and investments have maturities of three months or less, we believe that the risk of material loss is low.

I te m 4. Controls and Procedures

Under the supervision and with the participation of our management team, including our Chief Executive Officer and Chief Financial Officer, we evaluated the effectiveness of our disclosure controls and procedures, as such term is defined in Rule 13a-15(e) and 15d-15(e) promulgated under the Securities Exchange Act of 1934, as amended. Based on this evaluation, our Chief Executive Officer and Chief Financial Officer concluded that our disclosure controls and procedures were effective as of the end of the period covered by this quarterly report.

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There has been no change in our internal control over financial reporting during our most recently completed fiscal quarter that materially affected, or is reasonably likely to materially affect, our internal control over financial reporting.

The certifications required by Section 302 of the Sarbanes-Oxley Act of 2002 are filed as exhibits 31.1 and 31.2, respectively, to this Quarterly Report on Form 10-Q.

P ar t II.

It e m 1. Legal Proceedings

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

On August 13, 2008, a putative shareholder class action was filed in the Superior Court of Washington for King County against us, our Board of Directors and Acquisition Co. The lawsuit alleged that members of our Board of Directors breached their fiduciary duties, and that Acquisition Co. aided and abetted those alleged breaches of fiduciary duties by entering into the Merger Agreement. The lawsuit alleged, among other things, that the merger price was “unfair,” that the Merger Agreement precluded competitive bidding by other potential acquirers, and that the preliminary proxy statement filed by the Company with the SEC was misleading or incomplete. Plaintiff sought, among other relief, to enjoin the merger, rescission of the merger, accounting for any improper profits received by the defendants, and attorneys’ fees.

I te m 1A. Risk Factors

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

Failure to complete the going private transaction would likely have an adverse effect on us.

On July 30, 2008, we entered into a Merger Agreement pursuant to which Acquisition Co., which is owned by our Chairman and Chief Executive Officer, Firoz H. Lalji, will merge with and into Zones in a going private transaction. Following the Merger, Mr. Lalji and the Continuing Investors will own all of the outstanding shares of the surviving corporation, and shares of Common Stock held by all other shareholders will be converted into the right to receive $8.65 per share. On November 7, 2008, we announced that we have reached a preliminary understanding with Acquisition Co. relative to a reduced price of $7.00 per share. There can be no assurance that the conditions to closing specified in the Merger Agreement will be satisfied. In connection with the going private transaction, we are subject to several risks, including the following:

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On July 30, 2008, the last trading day prior to the announcement of management’s proposal of the merger, our common stock closed at $5.44 per share. After that announcement, the stock price rose to trade close to the $8.65 per share proposal price. Since the merger agreement was signed, our common stock has traded generally between $8.23 and $8.35 per share. The current price of our common stock may reflect a market assumption that the merger will close. If the merger is not consummated, the stock price would likely retreat from its current trading range.

Certain costs relating to the merger, including legal, accounting and financial advisory fees, are payable by us whether or not the merger is completed. These costs will be substantial and may materially reduce our earnings per share.

Under circumstances set out in the Merger Agreement, if the going private transaction is not completed, we may be required to pay the acquiring company a termination fee of $750,000 and reimburse up to $300,000 of the acquiring company’s expenses, which will be credited against the termination fee if it becomes payable.

Our management’s and our team members’ attention will be diverted from our day-to-day operations; we may experience team member attrition; and our business, including our vendor and customer relationships, may be disrupted during the period while the going private transaction remains pending. These risks could increase if the transaction is not consummated.

While the Merger Agreement is in effect, we are subject to restrictions on our business activities.

While the Merger Agreement is in effect, we are subject to significant restrictions on our business activities and must generally operate our business in the ordinary course (subject to certain exceptions or the consent of the acquiring company). These restrictions on our business activities could have a material adverse effect on our future results of operations or financial condition.

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

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

purchasing cycles of commercial and public sector customers;

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

more manufacturers going direct;

industry announcements of new products or upgrades;

industry consolidation and increased competition;

cost of compliance with new legal and regulatory requirements;

general economic conditions; and

variability of vendor programs.

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

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

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

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

increased competition;

more manufacturers going direct;

changes in customers’ buying habits;

the loss of significant customers;

changes in the selection of products available for resale; or

general economic conditions.

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

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

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

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

We ended the third quarter of 2008 with 365 account executives. We expect to continue to hire account executives, but at a lower rate of growth due to corporate initiatives to lower turnover thus reducing hiring requirements in 2008. However, there are no assurances that we will be able to hire to our expected levels, or recruit the quality individuals that we hope to hire, or that the individuals hired will remain employed for an extended period of time, or that we will not lose existing account executives. The productivity of account executives has historically been closely correlated with tenure. Even if we do retain our account executives, there are no assurances that they will become productive at historical levels. Additionally, there are no assurances that the locations of our call centers will continue to attract qualified account executives, or that we will be able to remotely manage and retain the new account executives.

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

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

We are controlled by a principal stockholder.

Firoz H. Lalji, our Chairman and Chief Executive Officer, beneficially owns approximately 51% of the outstanding shares of Zones common stock, excluding shares that he may acquire upon exercise of stock options that he holds. The voting power of these shares enables Mr. Lalji to significantly influence our affairs and the vote on corporate matters to be decided by our shareholders, including the outcome of elections of directors. This effective voting control may preclude other shareholders from being able to influence shareholder votes and could block changes to our articles of incorporation or bylaws, which could adversely affect the trading price of our common stock.

On July 30, 2008, we entered into a Merger Agreement pursuant to which Acquisition Co., which is owned by our Chairman and Chief Executive Officer, Firoz H. Lalji, will merge with and into Zones in a going private transaction, and the shares of Common Stock held by shareholders other than Mr. Lalji and the Continuing Investors will be converted into the right to receive $8.65 per share. On November 7, 2008, we announced that we have reached a preliminary understanding with Acquisition Co. relative to a reduced price of $7.00 per share. Although the Merger Agreement contains a “go-shop” provision that permits us to solicit superior proposals during a limited time period and to terminate the Merger Agreement and enter into an alternative transaction to be acquired by a third party, any alternative transaction would be subject to the approval of Mr. Lalji as our majority shareholder. In addition, Mr. Lalji’s effective voting control and matching rights contained in the Merger Agreement may discourage other bidders from making a superior proposal.

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We may lose potential revenue and competitive advantage if we lose our certification as a Minority Business Enterprise.

We are certified as a Minority Business Enterprise (“MBE”) based on Mr. Lalji’s maintenance of voting control of our outstanding common stock. A decrease in Mr. Lalji’s level of voting power through the issuance of additional equity capital or through a business combination transaction could cause us to lose our MBE certification. Our MBE certification allows us to compete for certain sales opportunities for which we otherwise may not be able to compete and gives us an advantage in other sales opportunities. Although we are unable to quantify the portion of our revenue that we receive or retain primarily as a result of our MBE certification, we believe a loss of our MBE certification would cause us to lose potential revenue and competitive advantage in certain sales opportunities and could have an adverse affect on our ability to retain certain customers and compete for certain sales opportunities, as well as on our financial performance.

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

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

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

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

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

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

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

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

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

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

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

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

We are heavily dependent on commercial delivery services.

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

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

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

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

From time to time we have customers that represent more than 10% of total sales. For the three months ended September 30, 2008, and the nine months ended September 30, 2008 and 2007, we had one customer that individually represented more than 10% of total net sales. Net sales to the State Farm Group were $29.3 million for the three months ended September 30, 2008. Net sales to the State Farm Group were $68.6 million and $58.3 million for the nine months ended September 30, 2008 and 2007, respectively. Trade receivables for this customer represented approximately 18.4% and 0.8% of total trade receivables at September 30, 2008 and 2007, respectively. Also, for the three months ended September 30, 2008, we had an additional customer, H&R Block, which represented 9.7% of total net sales, or $19.1 million, and represented approximately 5.6% of total trade receivables at September 30, 2008. The loss of business with any major customer could have a material adverse effect on our business, financial condition, cash flows or results of operations.

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

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

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

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

Our stock price may be volatile.

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

I te m 2. Unregistered Sales of Equity Securities and Use of Proceeds

Since 2004, we have repurchased a total of 1,568,845 shares of our common stock at a total cost of $8.4 million under our repurchase program authorized by our Board of Directors. Share repurchases may be made from time to time in both open market and private transactions, as conditions warrant, at then prevailing market prices. As of September 30, 2008, $2.5 million remained available for share repurchases under the program. The current repurchase program is expected to remain in effect through February 2009, unless earlier terminated by the Board or completed.

There was no activity under our repurchase program during the quarter ended September 30, 2008.

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It e m 6. Exhibits

Exhibit No.	Description	Filed Herewith	Incorporated by Reference
			Form	Exhibit No.	File No.	Filing Date
2.1	Agreement and Plan of Merger		8-K	2.1	00-28488	7/31/08
31.1	Certification of Chief Executive Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 and the regulations promulgated thereunder	X
31.2	Certification of Chief Financial Officer pursuant to Section 302 of the Sarbanes-Oxley Act of 2002 and the regulations promulgated thereunder	X
32.1	Certification of Chief Executive Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and the regulations promulgated thereunder	X
32.2	Certification of Chief Financial Officer pursuant to Section 906 of the Sarbanes-Oxley Act of 2002 and the regulations promulgated thereunder	X

Si gn atures

Pursuant to the requirements of the Securities Exchange Act of 1934, the registrant has duly caused this report to be signed on its behalf by the undersigned thereunto duly authorized:

		ZONES, INC.

Date: November 14, 2008

	By:	/S/ FIROZ H. LALJI
		Firoz H. Lalji, Chairman and Chief Executive Officer
		(Principal Executive Officer)

		/S/ RONALD P. MCFADDEN
		Ronald P. McFadden, Chief Financial Officer
		(Principal Financial and Accounting Officer)